Credit crunch: islamic perspective

The Credit Crunch: An Islamic Perspective

A THESIS SUBMITTED IN THE FULFILMENT OF THE REQUIREMENT FOR THE DEGREE OF

MASTER IN BANKING AND FINANCIAL LAW

QUEEN MARY UNIVERSITY OF LONDON

AUGUST 2009

Examination number: HM 550

Supervisor: Georges Walker

Introduction

`Markets are just neither moral nor immoral, they are just amoral'

Andre Compte- Sponville^1(*)

The financial crisis can be really damaging for the economies affected bringing them into recession. Starting the 14^th of August 2007, the subprime mortgage crisis expanded into a world financial crisis. Banks and financial institutions fell down.

Despite the last news that some banks had realised some benefits for the last quarter^2(*), we are currently witnessing a severe recession which transpires through the levels of unemployment and lack of growth registered for the last year.

As opposed to conventional banks, Islamic banks were not or were much less affected by the crisis.

The main banking activity is to take deposits and grant loans. Depending on the nature of such grants or loans, a bank must set aside capital as required by the regulation authorities.

As a result of their activity, banks may suffer a bank run because of the maturity mismatch between the deposits they receive usually available on demand and the loans they give. On the long term, banks find themselves unable to meet the sudden withdrawal demand, which leaves them under the threat of insolvency. The situation in which bank runs are spread over to other banks or financial institutions is called a systemic financial crisis^3(*).

A situation in which banks are reluctant to lend each other is called credit crunch^4(*). This situation can be the catalyst of a financial crisis.

According to Kindleberger^5(*), a financial crisis anatomy includes 4 stages:

At first, the investor will foresee an opportunity for benefit arising from a sudden change for example a new financial innovation, market improvement or technology discovery.

The price of the asset rising and a profit is expected which participates in creating a bubble or a «boom».

Following this euphoria, other unsophisticated investors try to copy other individuals in pursuing easy profits. It is called «herd behaviour». They invest in illiquid commodities without a real understanding of the markets.

Unexpectedly, prices become stagnant and some investors start selling which leads the prices into dropping down. This is «distress» which may lead to panic or crash.

The most popular financial crises since the 19^th century would include The Great depression in the 1930's, the 1973-1974 oil market crash, the 1980s Latin American debt crisis, in 1997 the Asian Financial Crisis and the last subprime mortgage crisis which started in 2007 with the fall of Northern Rock and grew internationally with the fall of Lehman Brothers and ended up pulling the world into recession^6(*).

Some studies try to forge a theory for financial crises:

Some proclaim that the markets are going to fix themselves according to the invisible hands theory of Adam Smith (Efficient market theory)^7(*).

Others are proclaiming the end of capitalism.

Fraser, the author of the book «Wall Street» says we are entering a new chapter of our history^8(*).

According to Marx^9(*), crises are an inherent element to the economy.

Economics are linked to profit, when the profit is minimized then crises emerge.

On the long run crises are more recurrent and more severe and the capitalist system will eventually fail.

A politically-based business cycle pioneered by Michael Kalacki, suggested that ups and downs in the economy are the result of political decisions. When a party policy enhances inflation and growth, the opposition will endeavour to access power and follow the opposite policy of low inflation and unemployment. This succession of opposite political orientation can be the origin of financial crises.

In opposition to the efficient market theory, Neo-Keynesian period economist Minsky theorised^10(*) that financial fragility is a typical risk inherent to the economy^11(*).

When the economy is growing, firms tend to move towards speculative financing leading lenders into the cycle of speculative investments too. When big firms default, all the system falls down^12(*).

Minsky presents 3 forms of speculators: the safe investors who can pay principal and interest, the more risky ones which can pay interest only and the Ponzi or speculative investors which rely on the rise of the prices of their assets to pay their debts.

If the theory of efficiency is correct then financial markets are destabilised by the presence of central banks, then pushing that reasoning to the extreme, the mere existence of central banks is questionable^13(*).

If Minsky's theory is the correct one, then the markets are inefficient and we must stabilise the system by adopting different policies using central banking and regulatory bodies to govern the financial markets.

Some recent theories criticise the conventional banking system accusing it of being incompetent and try to present Islamic finance as an anti-crisis model to follow^14(*).

As opposed to conventional banks, Islamic banks were not or were much less affected by the crisis.' Contrary to the commonly held perception, Islamic banks have to some extent been affected by the global financial crisis, especially due to the inherent risks of Islamic finance such as a higher maturity mismatch than conventional banks and many players having significant exposure to real estate sector.  The impact of the financial crisis has, however, been lower in comparison to conventional banks. Islamic banks are less debt reliant and more dependent on customer deposits for liquidity, thus limiting their exposure to credit markets'^15(*).

The question is: why did the lack of liquidity in the interbank market not have repercussions on the Islamic banking community? What is the difference between the Islamic banks and the conventional banks that helped them overcome the crisis? Is Islamic finance the alternative solution to our established conventional banking system?

Islamic finance, deals with «the provision of financial services on a basis that is compliant with the principles and rules of Islamic jurisprudence».^16(*)

It is based on risk sharing, prohibition of speculation and interest.

However Islamic finance is still a niche market and it is in perpetual evolution in the purpose of finding a balance between morale and business.

Most literature on Islamic finance considers it as a philosophy difficult to apply to conventional markets where Islam is not the main religion in practice.

Different arguments defend this theory, among others:

-The inability of Islamic banks to fulfil all the client's needs in a world surrounded by conventional banks.

-The principle of Islamic finance is self-destructive. The loss sharing principle common in Islamic finance leads to a high correlation of institutions falling down.

But counter-arguments developed especially during this most recent financial crisis have revealed that Islamic banks might be a viable solution for a more stable system or at least that there can be lessons to be learnt from those institutions to invigorate the system.

The diversification in the investments, the type of supervision and regulation of the Islamic Banking system and the control of the final use of the funds will limit the possibility of failure and insolvency.

The role of the central banking control is key and its intervention to develop laws promoting investing in safe and sound financial instruments is pretty essential.

The major objective of this study is to link between the credit crisis and Islamic law.

In order to achieve that objective, the study will follow the following outline:

1) We will try to present the development of Islamic banking, its background and the current modern situation of Islamic institutions.

2) We will briefly study Islamic principles and the difference between Islamic and conventional banks.

3) After presenting these core principles, we will analyse the structures of Islamic contracts which apply these principles.

4) We will present Islamic banking fundamental sources, their various interpretations and the different schools they enhance.

5) Then after having understood the fundamentals of Islamic finance, we will examine the factors that have led to its rise and future after the financial crisis.

The areas of research covered in this study involve:

1) A collection of material on Islamic banking and Islamic countries from UK and Lebanon

2) The use of an English translation of the Quran as a source of Islamic law

3) The examination of journals and newspapers related to the matter

Islamic financial law is a new discipline and is increasingly attracting attention from educational bodies. Some universities are even including it as part of their optional course offerings.

Some commentators question the prohibition of Riba and its practice to the point of accusing the Islamic financial markets of being a «300 million deception». Dr Muhammad Saleem, a prominent Islamic banking scholar in a brief presentation of the Islamic principles and their adaption to the modern world^17(*) describes the hypocrisy of some Islamic institutions and their «disguised» use of Islamic products.

So, is Islamic finance the solution to the financial crisis that hit the world starting August 2007 and the recession we are suffering now from? Will applying Islamic financial principles bring investor confidence back to the market?

We will try to answer all of these questions in our thesis by adopting the following analytical approach:

1) Checking the difference between Islamic finance and conventional banking.

2) Scrutinising the crisis, its causes and its consequences and the lessons we learn from it.

3) Trying to establish the link and to analyze the causes that kept Islamic banks away from being affected by the crisis and the lesson we can learn to transfer to conventional banks.

For this purpose the study is divided into 4 chapters:

The first chapter is an introduction to Islamic principles, Islamic concepts and issues.

Then, the second chapter discusses the application of these concepts in the financial markets in the form of Islamic contracts.

The third chapter presents a sorrow brief of the recent financial crisis.

And finally, the fourth chapter provides lessons to learn generally from the recent crisis and from Islamic banking during financial crises so we will talk about advantages and disadvantages of Islamic finance in the light of the recent turmoil.

* 1 ^_French philosopher, André Comte-Sponville, «Le capitalisme est-il moral?» (Albin Michel, Paris, 2004).

* 2 ^_ Fransesco Guerrera and others `Citi and BofA Fail to Allay Fears' Financial Times, London, 17July 2009) Accessed August 26, 2009 < http://www.ft.com/cms/s/0/72045088-72cc-11de-ad98 00144feabdc0.html?nclick_check=1.

* 3 ^_ Charles Goodhart and Gerhard llling, Financial Crises Contagion and the Lender of Last Resort (a Reader,2002)252.

* 4 ^_Robert T. Clair and Paula Tucker, 'Six causes of the Credit Crunch 'Federal Reserve Bank of Dallas Economic Review, Third Quarter 1993,1, http://www.dallasfed.org/research/er/1993/er9303a.pdf...SIx causes of the credit crunch: Robert T.Clair and Paula Tucker.p.1 > accessed August 26, 2009 .

* 5 ^_ Charles Kindleberger, Manias, Panics and Crashes: A History of Financial Crises, 3^rd edition (New York John Wiley & sons,, 1996). The book was originally published in 1978

* 6 ^_ Seminar on history of financial crisis by Lee C.Buchbeit Clearly Gottlieb Steen & Hamilton LLP New York

* 7 ^_ George Cooper `'The origins of Financial Crisis»Vintage,USA,2008,13

* 8 ^_ http://www.nytimes.com/2008/10/05/business/05era.html?_r=1&dlbk

* 9 ^_ `The enormous power, inherent in the factory system, of expanding by jumps, and the dependence of that system on the markets of the world, necessarily beget feverish production, followed by over-filling of the markets, whereupon contraction of the markets brings on crippling of production'. The Capital, Volume I, Chap 25.

* 10 ^_Hyman P. Minsky Stabilizing an Unstable Economy (Economic review, 2008) Foreword XV.

* 11 ^_ http://www.nytimes.com/2008/10/05/business/05era.html?_r=1&dlbk

* 12 ^_ Hyman P.Minsky, Stabilizing an unstable economy (Economic Review,2008)Foreword p.XV

* 13 ^_ George Cooper `'The origins of Financial Crisis»(Vintage,USA,2008)37

* 14 ^_ Martin Matthew,' Credit crunch winners emerge', MEED: Middle East Economic Digest 10/24/2008,Vol 2,Issue 43 p.24-25.ISSN 0047-7230

* 15 ^_ The World Islamic Banking Conference' Further Growth For Islamic Institutions Still Outperforming Conventional Counterparts'2008/2009 Competitiveness Report http://www.megaevents.net/islamic_banking/report_pr.html> last accessed 26 August 2009

* 16 ^_ Simon Archer and Rifaat Ahmed Abdel Karim Islamic Finance: Innovation and Growth - Chapter 1 (Euromoney Books and AAOIFI ) 4

* 17 ^_. This book assesses the Islamic dishonest and deceptive practices and concludes that Islamic banks do not practice what they preach.

Dr.Muhammad Saleem, Islamic Banking a 300$billion deception (Xlibris Corporation, 2006).