islamic bankig - a solution to the global financial crisis

8/14/2019 Islamic Bankig - A Solution to the Global Financial Crisis

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By

JAWAID IQBALJAWAID IQBAL

Al- Sadiq (A.S) Institute of Islamic Banking, Finance &Takaful


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CONTENTS

MAJOR ECONOMIC SYSTEMS

BANKING DEFINED

BANKING INDUSTRY

THE GLOBAL BANKING CRISIS

ISLAMIC BANKING - A SOLUTION

CONCLUSION


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MAJOR ECONOMIC SYSTEMS

There are the three major Economic Systems:

o Capitalism

o Socialism

o Islamic Economic System


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CAPITALISM DEFINED

Capitalism is an economic and social system in which tradeand industry are privately controlled for profit rather thanby the state. The main features of capitalism are:

Every individual has unconditional and absolute right toparticipate in any business to maximize profits

Market forces will determine the priorities and decidewhere to invest resources

Right to wealth vests with the factors of production


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DRAWBACKS OF CAPITALISM

No moral or regulatory bindings / restrictions while maximizingprofits

Monopolies and cartels are created that exploit the society

Government and industrialists may join hands for mutualbenefit and against the interest of the common man

Imbalance in the distribution of income due to whichconcentration of wealth takes place in a few hands


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SOCIALISM DEFINED

Socialism is a system in which the means of production and

distribution are controlled by the government and ostensibly isoperated according to the principles of equity and fairness ratherthan market forces.

No individual has the right to participate in any businessindependently

State determines the priorities as per the overall planning

Government decides where to allocate resources

Right to wealth is with the government which then distributes itamong the various factors of production as it deems fit


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DRAWBACKS OF SOCIALISM

It violates the basic human right of freedom of theindividual

Governments are assumed to be angels incapable ofnepotism and favoritism

It needs a strong and forceful dictatorship to succeed

It creates a society where there are no incentives thereforeefficiency is compromised


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ISLAMIC ECONOMIC SYSTEM

This system accepts the marketforces of demand/supply, the right to

private property as well as the rightto maximize profits. However, allthese rights are not unbridled andunconditional rather they are limitedby certain restrictions andprohibitions:


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PROHIBITIONS & RESTRICTIONS IN THEISLAMIC ECONOMIC SYSTEM Divine Prohibitions

o Economic activities like

Interest

Gambling

Hoarding

Government Intervention

o In cases where exploitation is feared, Government

intervention is allowed Moral Restrictions

o Worldly life is a way to get maximum benefit for the lifehereafter therefore, both the means and the end have tobe right.


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Socialism Islamic EconomicSystem

Capitalism

Extreme left Middle of the path Extreme right

Man made system System based onDivine principles

Man madesystem

Imperfect, chancesof errors

No chance of error Imperfect,chances oferrors

Based on fear Based on justice andfair play

Based on greed

COMPARISON OF ECONOMIC SYSTEMS


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CONVENTIONAL BANKING

Banks act as a financial intermediary between the depositor andthe borrower

It pays fixed rate of interest to the depositor and receives fixed

rate of interest from the borrower

The difference between the rate paid to the depositor and therate received from the borrower is the Gross Profit Margin ofthe bank

Lending can be done without any physical asset backing it


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ISLAMIC BANKING

Islamic banking is a banking activity which is consistent with the Islamic law(Shariah), known as Fiqh e Muamalat (Islamic rules on transactions)

It does not allow the paying and receiving of Riba (interest) and promotesgreater degree of fairness and equity in the conduct of banking business

Islam not only prohibits Riba but there are also some impermissible businessessuch as

o Liquor

o Pork

o Gambling

o Pornographyo Anything else, which the Shariah (Islamic Law) deems Haram (unlawful)


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ISLAMIC BANKING (CONTINUED)

Financing is primarily done with physical assets backing it

Relationship between bank and customer may be of these

types:o Buyer and Seller (Murabaha)

o Lessee and Lessor (Ijarah)

o Agent in Principle (Wakalah)

o Partnership in Business Venture (Musharakah)


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Believer! Be conscious of Allah and give up what

remains of riba if you are indeed believers.

If you do not do so then beware there is a declaration ofwar against you by

Allah and his ProphetSurah Al-Baqarah 278-79


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BANKING INDUSTRY

Total Banking Assets (Conventional & Islamic) US $35 Trillion

Total Islamic Banking Assets US $650 Billion

Islamic Banking Assets ( %) 1.87%


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GROWTH OF ISLAMIC BANKING According to Arab News, it

was reported as of June2008 that: Islamic Bankinghad grown at an annual

rate of35% worldwide to astaggering $600 billion

McKinsey & Co -Management Consultants

have forecasted the sectorto reach $1 Trillion inassets by 2010


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(in $ Billions)

Year 2009 2010 2011 2012 2013 2014

Total Asset Size 650 1000 1414 2000 2828 4000

Annual growth (%) - 54% 41% 41% 41% 41%


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The global banking crisis started few years back when in US, a boom inthe housing sector was driving the economy to a new level

A combination of low interest rates and large inflows of foreign fundscreated an easy credit environment for people to take home loans

The demand for homes increased and fueled the home prices

The loan agencies widened the loan disbursement and relaxed loanconditions

The lending institutions and mortgage firms were giving loans andignoring important risk management principles.

As a result, customers like NINJA (No Income, No Job & Assets) werealso given housing loans


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Most of these types of loan were commonly known as Sub Prime Loans

The interest rate charged on Sub Prime Loans were Substantially higher thanthe Prime loans

For lenders, Sub Prime loans were on the surface quite lucrative

If borrower paid, lender would get good return

If borrower default, the lender could sell the home at the market price

Sub Prime loans seemed like a good option when housing market was booming


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DERIVATIVES

Derivatives traders developed a collateralized debt obligations (CDOs) through which afinancial institution combined their assets of various types (for example prime mortgageswith subprime ones).

The packaged debt was then sold to a special purpose vehicle, generally registered offshorein a low tax jurisdiction.

The new entity then issued its own equity or bonds to resell the debt to other investors,carving it up into different tranches with different risk ratings using complex mathematicalmodels.

Financial derivatives create only money, with no real value, causing inflation and price

rise ,as well as moral decadence, thats s why economic experts assert that the system offinancial derivatives can not bring about real development. Which is what happened in theUS Housing Industry.


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FINANCIAL CRISIS


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CURRENT BANKING PROBLEMS No moral controls

Relaxation in regulatory control

Man made laws which are imperfect & have high chance of

error. Systems based on human instincts of fear & greed.

Major Violations of risk management principles and bankingfundamentals.

Use of subprime loans & use of derivative instruments

without understanding the risks. Bonus culture, people being rewarded for short term

performance rather than long term risk adjusted return oncapital (RAROC)


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KARL MARX, DAS CAPITAL, 1867Owner of capital will stimulate the workingclass to buy more and more of expensivegoods, houses and technology, pushing themto take more and more expensive credits,until their debt becomes unbearable. Theunpaid debt will lead to bankruptcy of banks,which will have to be nationalized, and thestate will have to take the road which willeventually lead to communism.


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ISLAMIC BANKING- A SOLUTION TO THEFINANCIAL CRISISCRISIS SOLUTION

No moral controls Islamic economic and financial system is based on a set ofvalues, ideals, and morals, such as honesty, credibility,

transparency, clear evidence, facilitation, co-operation.

Relaxation inregulatory control

It does not allow any relaxation both in terms of shariahas well regulatory compliance.

Man made laws

which are imperfect& have high chanceof error.

Islamic banking does not follow man made principles,

rather it follows the Islamic economic system, which isbased on Divine Principles. Hence, has a low chance oferror.


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CRISIS SOLUTION

Systems based on humaninstincts of fear & greed.

It is not based on greed as Islamiceconomy promotes participation in profit, loss, andactual exchanges of money and assets. It does notallow making money from money which leads togreed rather promotes risk sharing andentrepreneurship

Conventional banking usedto believe in a freeeconomy and nogovernment interventionbut in the end governmentbailout plans were unavoidable to save banks

from defaults.

In contrast to conventional banks, no Islamic bankhas failed and has needed governmentrecapitalization. As in Islamic Economic Systemgovernment intervention is accepted only up to acertain time.

The conventional systemallows multiple debtcreation on a particularasset without a realunderlying transaction

Islamic finance requires that financial dealings mustbe backed by real assets and be in line with theIslamic law.


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CRISIS SOLUTION

Major Violations of riskmanagement principles andbanking fundamentals

Islamic system follows the shariah guidelines . Itbelieves in minimizing the risks and restrictstransactions with gharar ( uncertainty). It furtherallows to adapt to the prevailing rules andregulations if they are not contradicting to shariahguidelines.

Conventional banks have togive fixed rate of interest tothe depositors, even if theyare making losses. There isno concept of profit- losssharing. Hence more Riskinvolved.

Banks enjoy a built-in stabilizer to help them copewith economic downturns, as instead of payinginterest to depositors, those with investmentmudaraba accounts share in the banks profits. Thus,if profitability declines in an economic downturn,depositors receive lower returns, but if profits risethey enjoy higher returns. This profit sharingreduces risk for the banks compared to fixed rate ofinterest return on investment.


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CRISIS SOLUTION

Conventional bank doesntbelieve in equity-basedfinancing and hence no risksharing. The Depositor getsfixed rate of interest, whereas the borrower has to payfixed rate of interest, hencerisk is not equallydistributed.

Financial dealings in Islamic banking and finance areguided by the ultimate objective of achieving theideals of equitable justice where priority is given toequity-based financing rather than debt-basedfinancing.Equity-based financing distributes risk and liability toboth the lenders and borrowers so as to justify thereturn to both sides of the transacting parties.

Use of fancy derivativeinstruments without

understanding the risks

In principle, Islamic banking does not allow the useof derivative or any other speculative instrument like

forwards and futures, rather deals in real assets


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CRISIS SOLUTION

Riba( interest or usury) isone source of exploitation,especially, as in the case ofsub-prime lending, thehighest rates were chargedto lower earners. Suchdiscriminatory charging by

conventional banks was justified as being areflection of the risksinvolved.

Financial dealings must be free from Riba (interest),Gharar (uncertainty), and maysir (gambling) ensurethat the elements of exploitation and excessivespeculation are avoided.

Islamic housing finance involves risk sharing betweenthe bank and the client, rather than transferring all the

risk to the latter. Under the most commonly useddiminishing musharaka (partnership) contract, thebank and the client form a partnership.


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THE RESILIENCE OF ISLAMIC BANKING

The Conventional banking system collapsed in the financialcrisis. Big banks and Insurance agencies such as Citi group,RBS & AIG, suffered major losses. One of the BankingLeader Lehmann brothers had to declare bankruptcy and

lost its entity, Major cut downs were done and employees,even CEOs were fired.

On the other hand Islamic banking system has flourished inthis financial crisis and has grown greatly. Instead of firing,

Islamic bank has been hiring people. This financial crisis hasshown a positive shift of people towards Islamic Bankingwhich can be seen by the growth of Islamic Banking.


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VIEWS OF RENOWNED PERSONALITIES ON

ISLAMIC BANKING

"The ethical principles on which Islamicfinance is based may bring banks closerto their clients and to the true spirit whichshould mark every financial service"

Western banks could use tools such as theIslamic bonds, known as sukuk, ascollateral. Sukuk may be used to fund the

car industry or the next Olympic Gamesin London

The Vatican's official newspaper


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The Vatican offered Islamic financeprinciples to Western banks as asolution for worldwide economic crisis.

The Vatican paper wrote that banksshould look at the rules of Islamicfinance to restore confidence amongsttheir clients at a time of globaleconomic crisis


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They try to patch up here and there with bailouts. But that isnot going to solve anything,

So in the process of trying to solve the problem, dontdismiss any idea including Islamic banking. Maybe not thewhole Islamic banking, but elements of it can contributetowards stabilising the banking system of the world.

Dr Mahathir Mohammad


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islamic bankig - a solution to the global financial crisis

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