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Unpublished Paper
Islamic Financial System Rescue to the Global Financial Crisis A Study on the Origin of Subprime Mortgage Crisis and rescue offered by Islamic Financial System
(2010)
  • Shafaq Khan
Abstract
The severity of the Subprime mortgage crisis has traumatised the foundations of the conventional financial system and has led to the search for cure of losses suffered and reforms against such crisis in future. During this crisis we have witnessed the impacts of irregularities done and insufficient monitoring of the complex financial products in the financial market. Standard regulations in the loan industry under conventional financial system proved to be insufficient to tackle the crisis. During the Subprime mortgage crisis, when the hot real estate markets were converting into foreclosure capitals, Islamic financial market was impervious from its impacts. This thesis focuses on the point of view of the author that the fundamentals of conventional financial system resulted in degeneration of an artificial economy, as the elements of interest, debt trading, speculation and uncertainty fuelled the voracity of the entities. Imperative doctrine and mechanism of conventional financial system is against the fundamentals on which the principles of Islamic financial system rest upon, therefore, proving them to be two alternative financial systems; we see that main features, which are prohibited in Islamic financial system, are the primary postulates of conventional financial system. As by following the principles of Islamic finance, there is no prospect for any kind of transactions involving interest, gambling and practice of speculation. Hence, the adoption of Islamic finance would have prevented the occurrence of the crisis on the first place. This system mitigates the risk at the levels of institutions in such a way that makes sure the real economic activity should be the main player, supervising the financial activity. Under Islamic financial system transactions involving interest or a commodity which are not owned or possessed can’t be transacted unless some kind of risk is born by the parties. Similarly debt is based on some real underlying asset it can’t be backed by some artificial financial arrangement. We know that interest in its nature creates artificial money supply which is not backed by real assets; as a result Interest allows the money to circulate and grow in large amount which ultimately becomes unpayable. Compounding interest, mere speculation, gambling and debt trading were the active causes of Subprime mortgage crisis. Securitisation instruments were not backed by the real assets consequently this created an economic bubble which ended up with the default of securitised debts. Unlike conventional financial system, Islamic financial system focuses more on productivity rather than credit worthiness. In the view of the author The worse part of this situation is that we are trying to fix the damage caused by the crisis on the same fragile foundations that basically caused the Subprime crisis, instead of trying to avoiding those principles and foremost causes that gave rise to these economic failures. The focus of this work is that Islamic financial system can not only be developed and used to mitigate the losses suffered as a result of Subprime mortgage crisis, but can successfully replace the conventional financial system and is capable of transmitting better economic results on longer terms.
Keywords
  • Islamic Financial System Rescue to the Global Financial Crisis A Study on the Origin of Subprime Mortgage Crisis and rescue offered by Islamic Financial System
Publication Date
2010
Comments
We had cheap global debt searching for high returns. This search was channelled into a deregulated market by the innovations of complex financial instruments based on the fundamentals of interest, uncertainty and speculation. The Subprime mortgage crisis was the result of a market that was too much involved in debt rather than equity based transactions. Use of faulty financial models, equally faulty credit ratings and the effects of securitisation of financial instruments which were not accurately reviewed for their risk coupled with debt and compounding interest on such financial transactions gave an open invitation to a devastating Subprime mortgage crisis. And when all these rudiments combined together under the effects of globalisation in financial market, we were in the middle of a classic panic which influenced the financial markets through out the globe. The Subprime mortgage crisis exposed vulnerability of various regulatory frameworks operating in the financial market. Without vigorous financial and economic conditions in the financial market, contagious risks are very common, and market expansion in such circumstances is a definite threat to the stability of real economy. More than three trillion dollar bail out and liquidity injections to a dying economy did not come out of blue there are number of causes and Islamic economists frequently linked the results of compounding interest rate, Imbalance between the equity and debt based transactions, excessive expansions of the firms through debt borrowings, and inadequate regulations in the financial market to the Subprime mortgage crisis. Taxpayer money was injected as capital into major financial organisations by governments as an attempt to reinstate the consumers’ confidence in the banking system. Robert Priester, head of department of Banking Supervision and Financial Markets observed; “… Crisis was due to the combination of three levels: First level: ... Sub prime loans in US were regulated by institutions which were not regulated by the Fed and lending conditions were based on the unrealistic projection on real estate prices evaluation and completely over looked the borrower’s repayment capacity. Second level: CDOs were not easily understood…and Third level: Imprudent behaviour of the banks…” On one hand banks were selling money (when there was no actual money in existence) and Assets (before their existence); while on the other hand they allowed the debt to grow unchecked. This unchecked excessive and imprudent lending worsen by excessive derivative and speculative transactions on the capital market and resulted in unavoidable default causing the capital market to crash, further destabilising banking market which brought another episode of financial crisis harming real economic sector. Edward Estlin once said "I'm living so far beyond my income that we may almost be said to be living apart." and this was what exactly happening in our real economy. Wolfgang Munchau in Financial Times describes this too much involvement of financial market in debt base financing as “… The US market was overprized with 40 to 50%. People took loan after loan and you have reports that people in US having 25 credit cards, taking mortgages that are 20 times more than their incomes, 130% of the Value of the house…” Current Subprime crisis can be evident as a crisis of failed morality , that innovated financial relationships created by voracity of “investment originators” and ended up on exploitation of “investors”, who where unaware of the risk they were investing in. As a consequence we have witnessed a sharp decline in equity markets through out the globe, collapse of numerous financial institutions and rescues by central banks and governments by investing trillions of tax payers money on bailouts, liquidity injections, and by reducing interest rates in order to Increase liquidity and avoid recession to revive the financial market and to restore assurance in the monetary system. Under the pressure of reviving economy government supported the “Too Big to Fail”, and one after another the major financial institutions received government assistance. There is a famous Arabic proverb which says: “Whoever is secure from punishment may do what he pleases”. This really fits well on such voracious organisations. This chance of receiving regulatory forbearance is making big organisations to go beyond the boundaries of prudent financial transactions and pushes them to the limits of recklessness. “With big position comes a big responsibility” but these organisations used this position to black mail governments for their voracious and self-interested drives, as if governments let them fail they fear that there failures would cause havoc to the real economy. These organisations assumed their immunity from losses on two assumptions. 1. First that the “Indispensable and Unavoidable Collaterals” stand in front for managing the risk of default. 2. And then comes the “Too Big To Fail” concept that protects and ensures their survival and proved to be encouraging reckless behaviour and negligence to undertake a careful evaluation of loan applications eventually resulting in unhealthy expansion in the overall volume of credit, to excessive leverage, and above all unsustainable speculative investment that gives rise to financial fragility and debt crises and builds instability into the fiscal structure. False sense of immunity and assurance against losses provided bankers with such a safety net which is like incentive to take greater risk than what they otherwise would in normal circumstances. Because as soon the big banks and borrowers are threatened by the default they are immoderately bailed out by IMF or central banks or the governments. This kind of free subsidy proved to be very harmful for the financial system this is “Rewarding Greed and Stupidity” not the “Ingenuity of the Market” against the norms of moral hazards. Islamic financial system on the other hand strikes a balance between flexibility and oversight. Such situations of credit crunch could not happen under Islamic financial system because this system is based on partnership between the client and the banks or a social commitment within the Islamic banking and financial market. The financial crisis has proven very clearly that the apparent strength of modern financial markets was illusionary. The happy-go-lucky mood vanished instantly, with the write down of losses accompanied by the sackings of executives followed by more rigorous lending for the real victims of the credit crunch. Moreover, this crisis has stunned the economies through out the globe. The modern financial system differs from Islamic financial system in many critical respects. One thing is very apparent that the elements which caused the global crisis are the elements completely prohibited under Islamic financial system. In principle impacts and causes of the present catastrophe were not different from other significant crisis, as economic and monetary crises are not strange to financial history. From the Mexican currency crisis (1994) to Asian currency crisis (1997), Russian sovereign default (1998) and LTCM bailout (1998) till devastating dot-com (2000), and very recent housing (2006) and commodity bubble burst (2008) they always have showed indicating signs of the bigger problems ahead influencing the world economy at large. The panic that began in US mortgage sector rapidly spread through out the globe. Since the experience of Great Depression 1930, the Subprime mortgage crisis has exposed the world economy to a worse and very long period of economic slowdown. This default and failure of financial market has brought down a notable spill in economic progress. Mainly this time, the credit risk assumed by lenders in US on Subprime clients was overlooked. The transactions were not balanced between debt and equity based financing. Stress of financial market on debt based transactions ultimately ended up in entering into a recession spreading the economic slowdown and panic through out the globe. People acquired debt, which they were unable to pay back. Debt was not the problem; the crunch was caused by the compounding interest which people were unable to pay. There is nothing wrong in borrowing money; the problem comes when there is too much money borrowed by the borrowers on interest rate (which is not fixed). As stated earlier after the Great Depression in 1930s the current financial crisis is the greatest one that hit the world economy making the speculative explosion a reality. Charlie McCreevy Commissioner for the Internal Market and Services, European Commission in his speech states that “the only way to prudently lend money is on the basis of a realistic assessment of the capacity of the borrower to repay- not from crystal ball gazing about the prospects of finding some one to refinance but from the borrower’s sustainable cash flows. In the US much of the market moved towards the assumption that one could indefinitely rely on mortgage refinancing with increase debt on the back of rising asset values and an environment of permanently low interest rates… fragility of this system became clear once falls in US house prices were followed by inevitable high default levels among over leveraged borrowers. Exposure to these losses was transmitted partly via the securitisation markets to financial intuitions around the world, trading of these underlying financial instruments on over the counter markets made these loses hard to locate… . As market confidence fell, problem started to appear in other credit markets and default spread to higher quality segments of the US market, to credit card debt and to car loans.” In the monetary world maximisation of income and wealth is the highest measure of human achievement and banks also wish to maximise their profits by extending more credit resulting in high profits. It is high leverage which enables excessive lending. M. Umer Chapra, who is a research adviser at the Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB) states that excessive lending, however, leads to an unsustainable and shaky boom in asset prices, followed by an artificial rise in consumption and speculative investment. The higher the leverage the more difficult it is to unwind it in a downturn. And this unwinding gives rise to a vicious cycle of selling that feeds on itself and leads to a steep decline in asset prices followed by a serious financial crisis, particularly if it is also accompanied by overindulgence in short sales. Almost all crises are the result of excessive and imprudent lending by banks that can not only damage its own long-run interest structure but can blow-off the balance of whole economic system. Mr. Bernanke, Chairman of the Board of Governors of the Federal Reserve System, stated in one of his speeches that “far too much of the lending in recent years was neither responsible nor prudent. ...in addition, abusive, unfair or deceptive lending practices led some borrowers into mortgages that they would not have chosen knowingly”. As stated earlier that the interest on lending operations is the major source of profit in the conventional financial system by banks, but the bad episode of loss starts when banks are unable to recover these loans with interest. Hence it is very prudent to think that banks would carefully analyse their lending operations to avoid loss. But during the current crisis we have witnessed that the excessive and imprudent mortgage lending by financial institutions for example financial institutions like Washington Mutual to many high-risk home purchasers boomed the defaults of Subprime mortgages in the US. i.e. 1. The lenders paid certain amount of service fees to Washington Mutual in return of the sale. Mutual securitised this lending and sold to mortgage guarantee institutions (Fannie Mae and Freddie Mac) to earn more funds. 2. The guarantors pooled and packaged the mortgages into instrument called Mortgage backed Securities (MBS). 3. MBSs were sold to the Wall Street. After that, the Wall Street re-packaged the MBS into another derivative instrument called as Collateralized Debt Obligations (CDOs) and sold them to some investment banks, e.g. Lehman Brothers. 4. The investment banks mixed prime and Subprime debt to pass the entire risk of default of even Subprime debt from mortgage originators and sold the instruments to the ultimate purchasers who due to this disguise packaging could not see the inherent risk of the financial instrument they bought against their default. The high ratings and higher yields on CDOs, made it easier for mortgage originators to pass the risk of default to the ultimate purchasers. Unscrupulous lenders also used deceptive tactics to sell adjustable rate mortgages (ARMs) to promote the sale of debt to unsophisticated borrowers. Loan volume accordingly gained greater priority over loan quality and the amount of lending to Subprime borrowers and speculators increased steeply. This bundle of doughy debt became structured investment vehicle (SIV). In the end they structured no risk but crisis. This camouflage created uncertainty in creditors and they sought for protection against default by buying derivatives like Credit Default Swaps (CDSs). They paid premium to hedge funds for the compensation they will receive in case the debtor defaults. An additional dilemma was that the hedge funds not only sold these CDSs to creditors, but also to a large number of others who were willing to bet on the default of these debtors, and those speculators further resold such instruments ahead. Consequently, the default of hedge funds and investment banks to pay such promised incentives to the instrument buyers brought them to unavoidable bankruptcy and those buyers to extremely high investment losses. The lack of transparency in the financial market also played its part as the inadequate information led to adverse selection of transactions. Assessments that were based on complex modelling did not provide a clear picture of tail risks or liquidity risk and this put creditors to have a heavy reliance on rating agencies. Credit rating agencies were providing triple AAA rating to the institutions in deception or due to lack of understanding about the nature of the new financial instruments, what ever the reasons were they were acting recklessly by playing with the life time wealth of the people by putting very little of their own in this zero sum game. The set-up was so unclear that After August 2007 when London market went down a well know city firm Lake Street Global Market issued a statement saying: “Market participant don’t know whether to buy on rumor or sell on news, do the opposite do both or do neither depending on which way the wind is blowing.” This brings us to a conclusion that the current financial crisis is self created by the market system under the huge influence of voracity. Advocates and the opponents of both who believe in government intervention and free market economies have failed to deliver a practical long-term solution to the crisis. The break down of old relationships of depositors and borrowers for sources of funds moved to capital markets through Securitisation process. This ultimately created a web of Innovation driven new risks by creation of complex and opaque financial instruments of hedging and speculation for transfer of risk that were not well understood by the investors resulting in crisis of financial markets. This phenomenon on one hand caused the financial institutions to suddenly lose significant proportion of their value and on other unexpectedly affected the Investors to lose substantial amount of their investments. This created a constraint on the flow of credit to families and businesses, bringing adverse effects on the real economy. Conventional financial system promoted derivatives to transfer one kind of risk, but created newer risks through complex securities which being novel in their nature were difficult to assess. Investors were unable to know the exact nature and inherent risks of assets underlying these securities due to lack of transparency. All this defacing of financial system was originated by excessive profit-motives driving the creation of complex instruments and deregulation of financial market which brought the nightmares of default and crisis into a reality. The situation of misunderstanding the complexity of new financial instrument was not limited to the common consumer but many members of financial institutions boards have proved to be too ignorant and incompetent to serve as directors. Like consumers using them the originators originating these financial instruments were also unable to understand leverage or the implicit risks behind these derivatives. For example a well known Swiss bank which prompted for the government aid had only one member on board with experience in derivatives, similarly the Lehman Brother’s financial board included the head of US Red Cross and a well known Broadway play writer… experience in derivatives and risk was sacrificed at the expense of diversity. The financial sector became too removed from the real world economy. Islamic financial system can make a valuable contribution in overcoming the losses of present crisis. Its techniques, if applied and executed properly can create a much closer nexus between the asset, the customer and the financier. This system prohibits the creation of debt through direct lending and borrowing, hence prohibiting excessive leverage, which was one of the root causes of the present crisis. The creation of debt, through the sale or lease of real assets (via the Murabahah, Ijarah, and Salam or Istasnah modes of financing) is very suitable mode of financing to be used as a rescue method. As these transactions are based on the principles which prohibit compounding interest, sale of debt, speculation and uncertainty in financial transactions. The crisis has proven that Islamic financial system is a credible alternative system that is free of the major weaknesses found in the conventional system. Islamic financial system not only encourages the equity based financing against debt based financing but under this system the due to its inherent risk structure the market risk can not be over stretched like we have seen during the present crisis as result of conventional financing. The current crisis shows the soundness of a trade and investment-based financial system, which is firmly present in the foundations of Islamic financial system. The strengths of Islamic finance are derived from its adherence to ethical finance and socially responsible investment. In the view of the author, “although Islamic financial system is new and obviously requires time to develop against its rival, but indeed provides perfect set of basic principals on which new alternate financial instruments can be developed to avoid further crisis. A prudent and rational solution for further avoidance of financial crisis is not possible without following the basic guidelines advocated by Islamic financial system.”
Citation Information
Shafaq Khan. "Islamic Financial System Rescue to the Global Financial Crisis A Study on the Origin of Subprime Mortgage Crisis and rescue offered by Islamic Financial System" (2010)
Available at: http://works.bepress.com/shafaq_khan/1/