sami al-suwailem irti, idb safar 1430 – february 2009 global financial crisis: causes and remedies
TRANSCRIPT
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Sami Al-SuwailemIRTI, IDB
Safar 1430 – February 2009
Global Financial Crisis:
Causes and Remedies
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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
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Root CausesExcessive leverageExcessive speculation
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Debt
Wealth
Inverted Pyramid
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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
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Sources of DangerRiba: usury and interest on loansGharar: gambling and wageringProhibited by all Divine revelations
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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
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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
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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
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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”
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DerivativesCaused more imbalances, thus made the
system overall more riskyDerivatives themselves are imbalanced—even
more than underlying assets and liabilities
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GhararHigh risk transactionsZero-sum games that create no wealth
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Toxic AssetsBy definition, they are more likely to loseMeet classical definition of ghararCannot be allowed in Islamic finance
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Zero-sum gamesDerivatives by definition are zero-sum
transactionsMake the system more risky
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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
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Credit Default SwapsSemi-insurance contractWhy to insurance subprime?
Upfront feesRising house pricesLarge markets for risk trading
Size of CDS: $62 trillions in 2007Naked CDS: ~80% of the market
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CDS
-
10,000
20,000
30,000
40,000
50,000
60,000
70,000
2001 2002 2003 2004 2005 2006 2007
Credit Default Swaps Notional Value ($B)
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How CDS Fueled the Bubble?Rising home prices encourage insuranceInsurance encourages lendingLending fuels housing demand, which raises
prices, etc.Moral hazard and reckless behavior
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Home Prices
80
100
120
140
160
180
200
220
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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
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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
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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
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Summary: Causes of CrisisUncontrolled debt financingUncontrolled risk takingBoth lead to excessive financial commitments
and inverted pyramid of wealthThey fuel each other
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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
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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
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Islamic EconomicsUniversal principlesSolid economic groundTested financial instruments
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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
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Safety NetNon-profit safety-net is integral to economic
activities:ForbearanceZakatInterest free lendingOther social activities
Cycles in an Islamic economy are bounded
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Economics Cycles
Unregulated credit expansion
Regulated credit expansion
Forbearance enacted
No forbearance
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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
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Interest-free LendingCommercial banks face difficulties lending
during crisesNon-profit institutions serve social objectivesA complementary channel for lending
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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
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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!
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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