PPP THE GLOBAL FINANCIAL CRISIS CAN ISLAMIC FINANCE

PPP THE GLOBAL FINANCIAL CRISIS: CAN ISLAMIC FINANCE HELP? by M. UMER CHAPRA Research Advisor Islamic Research and Training Institute Islamic Development Bank Jeddah, Saudi Arabia

1. INTRODUCTION n The prevailing crisis is the most severe link in a chain of crises over the last four decades n Can anything be done to minimize the frequency and severity of such crises in the future? n This is not possible without first analyzing the primary cause/s of the crises

2. The Primary Cause • Excessive and imprudent lending? • Why is this possible? o o Inadequate market discipline? Inadequate regulation and supervision?

3. HAS THE FINANCIAL SYSTEM FAILED ON BOTH THESE COUNTS? § Why? • When does the market operate effectively? Ø The role of incentives and deterrents • False sense of security against loss? • • Sale of Debt Securitization: Asset-backed Securities (ABSs) or Collateralized Debt Obligations (CDOs) Ø Is it because of collateral? No Ø Ø Ø Mixing of prime and subprime debt Lack of transparency Fraud o Emergence of Credit Default Swaps (CDSs) o o o Failure of rating agencies Concept of ‘too big to fail’ Supervisors’ failure Ø The role of wagering

4. SALIENT FEATURES OF THE ISLAMIC FINANCIAL SYSTEM § Justice: hallmark of Islamic teachings • • § Greater emphasis on equity and profit and loss sharing (pls) • § Risk-sharing: “No risk, no gain” Equitable allocation of Credit Will make banks more cautious in lending What about debt? • Debt is not created through direct lending and borrowing but rather through the sale and purchase of real goods and services

5. CONDITIONS FOR DEBT FINANCING 1. The asset being sold or leased must be real and notional or imaginary 2. Seller must own and possess the assets being sold or leased 3. The transaction must be a genuine trade transaction with the full intention of giving and taking delivery 4. The debt cannot be sold: The risk of default associated with it must be borne by the lender himself. This will motivate him to be more careful in lending. Will help prevent fraud?

6. IMPLICATIONS § The market discipline that Islam imposes will put a check on excessive expansion of debt. § The person who is going to suffer the loss is the best one to provide the discipline § Regulation and supervision are necessary but not sufficient o Regulation and supervision can be inadequate o Without moral consciousness regulations may be circumvented o The supervisor can be negligent

7. A PROBLEM The discipline will deprive the subprime borrowers of credit § Therefore, some arrangement needs to be made for making credit available to them § The market is profit-oriented and may do this only to a limited extent § Role of the government and the private sector altruism §

§ 8. ISLAMIC FINANCE IN PRACTICE Islamic finance is still in its infancy • PLS: small share • Debt: major share – every effort is being made to transfer the risk to the borrower or the lessee • The emergence of tawarruq has partly severed the link with the real sector • Reason: • Absence of shared institutions to support the system • The maqasid al-Shari‘ah are not taken into account while giving fiqhi verdicts

9. SOME SUGGESTIONS FOR REFORM OF THE INTERNATIONAL FINANCIAL SYSTEM 1. 2. 3. 4. 5. 6. 7. Raise the share of equity and lower that of debt in total financing Control leverage Allow credit primarily for promoting development of the real sector Require banks to hold debt until maturity to motivate them to ensure careful underwriting – If, however, debt is to be sold, there must be full transparency along with right of recourse. If not, the issuer must hold a meaningful proportion of it CDSs should not be allowed to become instruments for wagering All financial institutions must be regulated Some arrangement must be made to enable the subprime borrowers to get credit

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