Global Financial Crisis Causes and Remedies Sami AlSuwailem

Global Financial Crisis: Causes and Remedies Sami Al-Suwailem IRTI, IDB Safar 1430 – February 2009

Overview Worst in 100 years Capital Markets lost $30 -35 trillions this year Real estate lost $30 -35 trillions—total $60 trillions Financial institutions lost $3+ trillions Central banks injected $8+ trillions since start For comparison: Insured catastrophe losses (earthquakes, tsunamis, man-made disasters) 19702007: $745 billions

Root Causes Excessive leverage Excessive speculation

Inverted Pyramid Debt Wealth

Unsustainable System Debt accumulates faster than wealth Minor shocks make the system crash Financial fragility Crashes needed to “clean up” the system Then debts start to accumulate again faster than wealth Recurrent crashes Very costly system

Sources of Danger Riba: usury and interest on loans Gharar: gambling and wagering Prohibited by all Divine revelations

Riba Separates debt creation from wealth creation Debt grows faster than wealth Debt maturities shorter than assets Debt services become unbearable Pressure on wealth base accumulates Crash is imminent to restore balance

Debt in the US

Figures Average growth annual rate for debt: 39%, GDP: 21%, M 2: 19% Debt-GDP ratio grew from 1. 3 to 2. 2 Debt-M 2 ratio grew from 2. 2 to 4. 2 Unsustainable system

Imbalance sheets Borrowing short and lending long causes financial fragility By end of 2006, investment banks were rolling over 25% of their liabilities daily Extreme mismatch of assets and liabilities “The original sin”

Derivatives Caused more imbalances, thus made the system overall more risky Derivatives themselves are imbalanced—even more than underlying assets and liabilities

Gharar High risk transactions Zero-sum games that create no wealth

Toxic Assets By definition, they are more likely to lose Meet classical definition of gharar Cannot be allowed in Islamic finance

Zero-sum games Derivatives by definition are zero-sum transactions Make the system more risky

Derivatives

Credit Default Swaps Semi-insurance contract Why to insurance subprime? Upfront fees Rising house prices Large markets for risk trading Size of CDS: $62 trillions in 2007 Naked CDS: ~80% of the market

CDS

How CDS Fueled the Bubble? Rising home prices encourage insurance Insurance encourages lending Lending fuels housing demand, which raises prices, etc. Moral hazard and reckless behavior

Home Prices

CDS vs. Casino CDS: side bets CNN: “The largest casino in the world” CDS vs. casino: CDS not regulated; casino is CDS highly interlinked; CDS highly linked with outside institutions

CDS and Amplification of Risk Side bets magnify risks Inter-related financial contracts make the system very sensitive Concentration of risk Downturns cause higher counter-party risk The result: losses are amplified

Risk in Financial Markets Financial risks are mostly endogenous: 70% Real sector volatility is decreasing, while that of financial markets is increasing Conventional finance is more risky than natural disasters

Summary: Causes of Crisis Uncontrolled debt financing Uncontrolled risk taking Both lead to excessive financial commitments and inverted pyramid of wealth They fuel each other

Ineffective Policy “Privatization of profits and nationalization of losses” Capitalism in during upturns, but communism in downturns Markets on steroids more than 2 decades Recovery cannot be brought back using more steroids Liquidity trap and the Japanese case

Search for New Paradigm Jean-Claude Trichet, President of the European Central Bank: “What we need is a new paradigm” Angela Merkel and Nicola Sarkozi: New economic order

Islamic Economics Universal principles Solid economic ground Tested financial instruments

Islamic Finance Debt creation is integrated with wealth creation Excessive risk and zero-sum games are excluded Finance is integrated with real transactions Since real economy is less risky than financial markets, Islamic finance is less risky than conventional finance

Safety Net Non-profit safety-net is integral to economic activities: Forbearance Zakat Interest free lending Other social activities Cycles in an Islamic economy are bounded

Economics Cycles Unregulated credit expansion Regulated credit expansion Forbearance enacted No forbearance

Role of Zakat Economies now face the risk of deflation As prices decline, more incentives to hoard money As every one hoards, downturns intensifies Zakat: a benevolence tax on hoarded money

Interest-free Lending Commercial banks face difficulties lending during crises Non-profit institutions serve social objectives A complementary channel for lending

Non-profit Institutions For each dollar spent by non-profits, $8 are generated in direct economic and social returns Government support shall be directed towards social institutions rather than those that caused the crisis

Moral Hazard Conventional safety net causes moral hazard Financial systems become more risky Islamic safety net minimizes moral hazard: Directed to the needy—No “too big to fail” Not guaranteed—they are private Wrongdoer s are not rewarded!

Conclusion Roots of danger: riba & maysir Both allow mountains of commitments and debt to accumulate beyond existing wealth Fuel each other Islamic economics builds a stable system with bounded cycles