sami al-suwailem irti, idb safar 1430 – february 2009 global financial crisis: causes and remedies

Sami Al-SuwailemIRTI, IDB

Safar 1430 – February 2009

Global Financial Crisis:

Causes and Remedies

OverviewWorst in 100 yearsCapital Markets lost $30-35 trillions this yearReal estate lost $30-35 trillions—total $60

trillionsFinancial institutions lost $3+ trillionsCentral banks injected $8+ trillions since

startFor comparison: Insured catastrophe losses

(earthquakes, tsunamis, man-made disasters) 1970-2007: $745 billions

Root CausesExcessive leverageExcessive speculation

Debt

Wealth

Inverted Pyramid

Unsustainable SystemDebt accumulates faster than wealthMinor shocks make the system crashFinancial fragilityCrashes needed to “clean up” the systemThen debts start to accumulate again faster

than wealthRecurrent crashesVery costly system

Sources of DangerRiba: usury and interest on loansGharar: gambling and wageringProhibited by all Divine revelations

RibaSeparates debt creation from wealth creationDebt grows faster than wealthDebt maturities shorter than assetsDebt services become unbearablePressure on wealth base accumulatesCrash is imminent to restore balance

Debt in the US

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

1975 1980 1985 1990 1995 2000 2005 2007

M2 GDP Non-financial debt

FiguresAverage growth annual rate for

debt: 39%,GDP: 21%,M2: 19%

Debt-GDP ratio grew from 1.3 to 2.2Debt-M2 ratio grew from 2.2 to 4.2Unsustainable system

Imbalance sheetsBorrowing short and lending long causes

financial fragilityBy end of 2006, investment banks were

rolling over 25% of their liabilities dailyExtreme mismatch of assets and liabilities“The original sin”

DerivativesCaused more imbalances, thus made the

system overall more riskyDerivatives themselves are imbalanced—even

more than underlying assets and liabilities

GhararHigh risk transactionsZero-sum games that create no wealth

Toxic AssetsBy definition, they are more likely to loseMeet classical definition of ghararCannot be allowed in Islamic finance

Zero-sum gamesDerivatives by definition are zero-sum

transactionsMake the system more risky

Derivatives

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Global Derivatives Notional Values, $B

OTC OE

Credit Default SwapsSemi-insurance contractWhy to insurance subprime?

Upfront feesRising house pricesLarge markets for risk trading

Size of CDS: $62 trillions in 2007Naked CDS: ~80% of the market

CDS

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

2001 2002 2003 2004 2005 2006 2007

Credit Default Swaps Notional Value ($B)

How CDS Fueled the Bubble?Rising home prices encourage insuranceInsurance encourages lendingLending fuels housing demand, which raises

prices, etc.Moral hazard and reckless behavior

Home Prices

80

100

120

140

160

180

200

220

CDS vs. CasinoCDS: side betsCNN: “The largest casino in the world”CDS vs. casino:

CDS not regulated; casino isCDS highly interlinked;CDS highly linked with outside institutions

CDS and Amplification of RiskSide bets magnify risksInter-related financial contracts make the

system very sensitiveConcentration of riskDownturns cause higher counter-party riskThe result: losses are amplified

Risk in Financial MarketsFinancial risks are mostly endogenous: 70%Real sector volatility is decreasing, while that

of financial markets is increasingConventional finance is more risky than

natural disasters

Summary: Causes of CrisisUncontrolled debt financingUncontrolled risk takingBoth lead to excessive financial commitments

and inverted pyramid of wealthThey fuel each other

Ineffective Policy“Privatization of profits and nationalization of

losses”Capitalism in during upturns, but

communism in downturnsMarkets on steroids more than 2 decadesRecovery cannot be brought back using more

steroidsLiquidity trap and the Japanese case

Search for New ParadigmJean-Claude Trichet, President of the

European Central Bank: “What we need is a new paradigm”

Angela Merkel and Nicola Sarkozi: New economic order

Islamic EconomicsUniversal principlesSolid economic groundTested financial instruments

Islamic FinanceDebt creation is integrated with wealth

creationExcessive risk and zero-sum games are

excludedFinance is integrated with real transactionsSince real economy is less risky than

financial markets, Islamic finance is less risky than conventional finance

Safety NetNon-profit safety-net is integral to economic

activities:ForbearanceZakatInterest free lendingOther social activities

Cycles in an Islamic economy are bounded

Economics Cycles

Unregulated credit expansion

Regulated credit expansion

Forbearance enacted

No forbearance

Role of ZakatEconomies now face the risk of deflationAs prices decline, more incentives to hoard

moneyAs every one hoards, downturns intensifiesZakat: a benevolence tax on hoarded money

Interest-free LendingCommercial banks face difficulties lending

during crisesNon-profit institutions serve social objectivesA complementary channel for lending

Non-profit InstitutionsFor 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 HazardConventional safety net causes moral hazardFinancial systems become more riskyIslamic safety net minimizes moral hazard:

Directed to the needy—No “too big to fail”Not guaranteed—they are privateWrongdoer s are not rewarded!

ConclusionRoots of danger: riba & maysirBoth allow mountains of commitments and

debt to accumulate beyond existing wealthFuel each otherIslamic economics builds a stable system with

bounded cycles