Category Archives: Financial crisis of 2008

Could Islamic finance have prevented the global economic crisis?

Could Islamic finance have prevented the global economic crisis?

boat in lake

By: Saud Masud

A question that is often discussed is: if the global economic crisis triggered by the housing bubble burst and the sub-prime credit crisis in the US would have been averted if the Islamic finance framework were in place. It is a question that is asked often and one that has generated global interest.  The answer is that in principle, Islamic finance may have prevented the sub-prime crisis leading to the global economic crunch.

In my opinion, the very founding spirit of Islamic finance is anti-speculation and “anti-bubbles,” if you will. I would qualify that improper risk management and lack of execution of principles in any financial system conventional or Islamic can potentially lead to similar negative results. However, understanding the general concepts behind Islamic finance, one may begin to appreciate the positives of this form of banking that is one of the fastest growing in the world and stands at around $1 trillion.

Islamic finance prohibits usury or charging interest for the use of money (Riba in Arabic), investing in speculative financial products like certain derivatives and engaging in businesses, products and services that are considered forbidden (Haram) in Islam. Furthermore, Islamic banking emphasizes partnership (Musharakah) in profit and loss sharing, asset-backed investing and more importantly it is not restricted to Muslims. As a matter of fact several secular states including Singapore have seen an increase in demand for Islamic financial products. In essence under Islamic law (Shariah) one cannot lend money to make money or engage in predatory lending which leads to poor getting poorer and rich getting richer, i.e. exploitation is strictly forbidden. Also, debt cannot be taken on without collateral or an asset backing. One must refrain from gambling (Maisar) and uncertainty (Gharar), i.e. you cannot sell what you don’t own. Both buyer and seller are involved in the transaction with a no-pain, no-gain approach to making profits or sharing losses. This sounds common sense, ethical, trust-fostering and would appeal to most people.

Now lets examine what caused the sub-prime crisis. Coming out the dot-com bubble crash the central bank kept interest rates low in order to stimulate growth in the economy. So far so good. At low interest rates however banks started engaging in sub-prime lending with adjustable rate mortgages or ARMs. Simply put, you extend a house loan to someone with high credit risk at low interest rates but as the rates adjust upwards, which means the monthly mortgage payments shoot up the same high risk borrower becomes a “very high risk” borrower. While these loans were being issued innovation kicked in and several financial institutions repackaged the very same loans and sold them as “bundled” debt or MBS (Mortgage Backed Securities) to other investors. Rating agencies continued to rate these bundles of debt as relatively safe and high grade, which turned out not to be the case. To make this even worse based on these ratings many investors bought these securities and some also bought credit default swaps or CDS as insurance against these loan packages. On the other side insurance companies and other financials took on the credit default risk, i.e. if the loans went bad these insurance companies would pay for the shortfall. Recall these insurance companies were also relying on ratings agencies on the credit worthiness of the loans. With all of this playing out over several years leading up to 2006 as the markets started recovering from the dot-com bubble, interest rates now started going up. That in turn led to a trigger in sub-prime mortgage defaults, which in turn led to severe drop in MBS prices or the value of bundled loans, which further led to insurance companies having to pay for the shortfall. All of this led to freezing up of credit and money markets as capital was getting destroyed and investors just didn’t know how bad this could get. We saw markets collapse fairly quickly and while we have seen a global recovery since the 2007/2008 period. I am still not very convinced if we have fully averted the global crisis just yet. The US economy is still witnessing a jobless recovery for the most part with unemployment at 9.5% and the European Union crisis seems to have a revolving door, first with Greece and now with Ireland needing a bailout.

By no means should one assume that as an alternative, Islamic finance framework alone would be a 100% water-tight solution as the regulation and execution within the system is just as important as its underlying principles. However if we just examine the sub-prime crisis chain of events and the level of leverage and speculation not to mention lack of regulatory oversight, we may deduce that under Islamic finance principles much of the excess would have been “checked at the door” and not have come about at several times during the birth of the crisis. For example under Islamic banking regulations loans would not have been repackaged and traded as MBS and CDS would not be linked to these speculative products thus mitigating the chance for a ballooning effect. While Islamic finance continues to evolve rapidly the recent economic crisis has bought it some market share! In the end market decides the value of any goods and services and over last five years the Dow Jones Islamic Index is up 18% compared to the S&P 500 down 8%.

Source: http://www.elanthemag.com/index.php/site/blog_detail/could_islamic_finance_have_prevented_the_global_economic_crisis-nid35879827/

Saud Masud is the CEO of SM Advisory Group, LLC. a consultancy firm focused on Middle East, North Africa and South Asia region (MENASA). Previously, Mr. Masud was the Head of Investment Research at UBS for Middle East and North Africa based in Dubai. In addition to overseeing the research platform he was also a Sr. Analyst covering Real Estate sector for the Middle East region. Before moving to Dubai Mr. Masud was a Sr. Analyst for 5 years covering the tech sector for UBS in New York. Prior to Wall Street Mr. Masud ran an Internet start-up, Synapse Worldwide and engaged in management roles at Lucent Technologies based in New Jersey. Mr. Masud holds both a Bachelor of Science in Electrical Engineering and MBA in finance from Virgina Tech. Mr. Masud has often appeared as guest on TV and radio including CNBC, Bloomberg, CNN, BBC, Voice of America, etc. and has been frequently quoted in business news outlets like Wall Street Journal, Financial Times, TIME, Reuters, etc.

IMF study concludes that Shari`ah-Compliant Banks showed “Stronger Resilience” to the Financial Crisis

IMF study concludes that Shari`ah-compliant banks showed “stronger resilience” to the financial crisis — SeekersGuidance.org Blog

 

 

 

 

 

  • Islamic banks fared differently from conventional banks during global crisis
  • Weaknesses in risk management hurt Islamic bank profitability in 2009
  • Crisis revealed important regulatory and supervisory challenges

A new IMF study compares the performance of Islamic banks and conventional banks during the recent financial crisis, and finds that Islamic banks, on average, showed stronger resilience during the global financial crisis.

But the study also finds that Islamic banks faced larger losses than their conventional peers when the crisis hit the real economy.

In “The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study,” economists Jemma Dridi of the IMF’s Middle East and Central Asia Department and Maher Hasan of the IMF’s Monetary and Capital Market Department look at the effects of the crisis on bank profitability, credit, and asset growth in countries where both types of banks have a significant market share. The new working paper adds an empirical dimension to the debate on the relationship between Islamic banking and financial stability, a topic that has generated renewed interest since the global crisis.

Too big to ignore

Islamic finance is one of the fastest growing segments of the global financial industry. In some countries, it has become systemically important and, in many others, it is too big to be ignored. It is estimated that the size of the Islamic banking industry at the global level was close to $820 billion at end-2008. The largest Islamic banks are located in the countries of the Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates).

While Islamic banks play roles similar to conventional banks, fundamental differences exist between the two models. The main difference between Islamic and conventional banks is that the former operate in accordance with the rules of Shariah, the legal code of Islam. The central concept in Islamic banking and finance is justice, which is achieved mainly through the sharing of risk. Stakeholders are supposed to share profits and losses, and charging interest is prohibited.

There are also differences in terms of financial intermediation, the paper notes. While conventional intermediation is largely debt based, and allows for risk transfer, Islamic intermediation, by contrast, is asset based, and centers on risk sharing. One key difference between conventional banks and Islamic banks is that the latter’s model does not allow investing in or financing the kind of instruments that have adversely affected their conventional competitors and triggered the global financial crisis. These include toxic assets, derivatives, and conventional financial institution securities.

Crisis impact

To control for varying conditions across financial systems, the paper looks at the actual performance of Islamic banks and conventional banks in countries where both have significant market shares (see Chart 1). It uses bank-level data covering 2007−10 for about 120 Islamic banks and conventional banks in eight countries—Bahrain, Jordan, Kuwait, Malaysia, Qatar, Saudi Arabia, Turkey, and the United Arab Emirates. These countries host most of the world’s Islamic banks (more than 80 percent of the industry, excluding Iran) but also have large conventional banking sectors. The key variables used to assess the impact are the changes in profitability, bank lending, bank assets, and external bank ratings.

Scholars and bankers invited at George Washington University to discuss nuances of Islamic finance

Scholars and bankers invited at George Washington University to discuss nuances of Islamic finance

The event featured five distinguished scholars and experts in the field of Islamic finance. They included Prof. Frank Vogel, senior fellow and head of Muslim World Law and Islamic Finance, Institution Quraysh for Law and Policy and Umar Moghul, Partner at Murtha Cullina LLP and co-chair of the firm’s Islamic Finance and Investments Group.

Yusuf Talal deLorenzo, chief Shariah officer at Shariah Capital, Aamir Rehman, managing director at Fajr Capital Limited and Ibrahim Warde, adjunct professor of International Business at the Fletcher School of Law and Diplomacy, Tufts University, were the others.

The panelists addressed a several hundred attendees on the various aspects of contemporary Islamic finance such as its historical legacy, the compatibility of Shariah-compliant institutions with US law, derivative instruments and the development of sukuk in the Gulf, Shariah financial regulation and practice in the GCC (Gulf Cooperation Council) and Islamic finance in the light of the recent financial crisis.

It also addressed Shariah financial regulation, how the rise of Gulf capital is affecting financial markets and how it should be regulated, as well as the compatibility of Shariah institutions with US law and regulation and the objections of Shariah scholars challenging the permissibility of derivatives under Islamic Law.

The discussions were moderated by Jean-Francois Seznec, visiting associate professor at Georgetown University’s Center for Contemporary Arab Studies.

Regarding the question of sukuk in the Gulf, DeLorenzo said ownership is an important issue for Shariah scholars to understand.

“Ownership is always a sticky subject and it is not always a failure of the Shariah advisers when ownership and sukuk is questioned,” he said.

DeLorenzo, wrote the introduction to Islamic bonds, a book that introduced sukuk to the world’s Islamic capital markets as well as a three volume Compendium of Legal Opinions on the operations of Islamic banks, the first English/Arabic reference on fatwas issued by Shariah boards.

One clear lesson, he said, “is the need for more and more diligence on the business side.”

Questioned on whether sukuk is a sound investment, he said there are serious Shariah issues that need to be addressed. “There are tensions between GCC investors and Malaysian investors who have different philosophies in the jurisprudence.”

He said that sukuk need to have a viable trading market.

“We need to confront these issues. The tensions need to be resolved before real trading can take place.

“Sukuk are hybrids, some look like equity, others like debt. They need to be traded and exchanged, and unless everyone understands the rules there will be a lot of confusion in the marketplace and people will leave. There is a need to deal with this sooner than later.”

DeLorenzo’s 30-year career as a scholar of Islamic Transactional Law was a front-page story in the Wall Street Journal in 2007.

“It’s a rules-based business; people need to understand that, whether they’re in Hong Kong or Chicago, and the way to do this is through an exchange of information,” he said.

“Many of the high profile sukuk defaults have taken place as the result of poor business decisions, not Shariah.”

He said the problem was that the “press picks up on a sukuk default and then blames it on Shariah. We need to explain it better.”

The expert said a new generation of sukuk coming to the market also needs to be closely examined.

“My feeling is that the issuers need to be more transparent to investors, and feel the same way about Shariah boards. We need to be careful about managing perceptions.”

Read the rest …

The role of sukuk after recent defaults

The role of sukuk after recent defaults

 

 

 

 

 

 

 

Dubai World is presenting creditors with a restructuring plan for $26bn of debt. Questions remain about how Islamic financial structures will fare in financial distress. Usman Hayat discusses the role of sukuk after recent defaults.

Are sukuk holders treated differently from conventional bondholders in the event of default?
Defaults pertaining to sukuk are a recent phenomenon, and how the underlying legal structures would fare in a court of law vis-à-vis conventional bonds is uncertain. Although sukuk must comply with Islamic law, they are governed as well by the secular law under which they are issued, like bonds. In the case of Dubai World, a last-minute bail-out by Abu Dhabi has obviated the need to address this question directly.

What is the difference between asset-backed and asset-based sukuk?
The key difference is the concept of true sale. In asset-backed sukuk, there is a true sale between the originator and the special purpose vehicle (SPV) that issues the sukuk and sukuk holders do not have recourse to the originator. Assets are owned by the SPV, returns are derived from assets, and asset prices may vary over time. The majority of sukuk issues, however, are not asset backed.

What issues have arisen following recent defaults in sukuk?
One of the most critical issues is whether the SPV—and thus sukuk holders—completely owns the underlying assets. In addition, the role and efficacy of sharia governance arrangements and due diligence for sharia compliance have attracted attention. Given the relatively nascent stage of development of sukuk in particular and of Islamic finance in general, sukuk are likely to continue to evolve.

Read the rest …

Islamic banks’ assets grow by 66% in 2008

Islamic banks’ assets grow by 66% in 2008

growth

Despite the global financial crisis, assets held by the 100 largest Islamic banks in the world raised by 66 percent in 2008 compared with previous year.

A study published by Asian Banker Research magazine says the assets of the Islamic banks increased to a total of $580 billion in 2008 — up from $350 billion in 2007.

This is while, the assets held by Asia’s 300 largest banks lifted by just 13.4 percent, the report says.

“Islamic finance has seen an incredible surge in popularity, based on stronger regulatory regimens and a better international understanding of its dynamics,” said Emmanuel Daniel, the magazine’s chief.

Islamic banking refers to a system of banking that is consistent with the principles of Islamic law. Islamic law or Sharia prohibits the payment of fees for the renting of money (Riba) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haraam).
Islamic banks are not authorized to invest in companies associated with tobacco, alcohol or gambling.

The report concludes that despite the current economic meltdown in the world “Islamic banks have continued to grow in prominence and size”.

The report said Saudi Arabian lenders were more profitable among other banks with Al-Rajhi Bank netting the highest earnings of $1.74 billion, according to the report, and Iranian banks were the biggest players in the global Islamic banking system.

Iran holds seven out of the top 10 rankings and 12 out of the 100 top Islamic banks, the magazine said.

More than 40 percent of the total assets of the top 100 banks belong to Iranian banks, according to the report.

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