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THE GLOBAL FINANCIAL CRISIS:

?CAN ISLAMIC FINANCE HELP
by
M. UMER CHAPRA
Research Advisor
Islamic Research and Training Institute
Islamic Development Bank
Jeddah, Saudi Arabia
1. INTRODUCTION
 The prevailing crisis is the most severe link
in a chain of crises over the last four
decades
 Can anything be done to minimize the
frequency and severity of such crises in
the future?
 This is not possible without first analyzing
the primary cause/s of the crises
2. The Primary Cause
• Excessive and imprudent lending?
• Why is this possible?
o Inadequate market discipline?
o Inadequate regulation and supervision?
 HAS THE FINANCIAL SYSTEM .3
?FAILED ON BOTH THESE COUNTS
 Why?
• When does the market operate effectively?
 The role of incentives and deterrents
• False sense of security against loss?
 Is it because of collateral? No
• Sale of Debt
• Securitization: Asset-backed Securities (ABSs) or
Collateralized Debt Obligations (CDOs)
 Mixing of prime and subprime debt
 Lack of transparency
 Fraud
o Emergence of Credit Default Swaps (CDSs)
 The role of wagering
o Failure of rating agencies
o Concept of ‘too big to fail’
o Supervisors’ failure
 SALIENT FEATURES OF THE .4
ISLAMIC FINANCIAL SYSTEM
 Justice: hallmark of Islamic teachings
• Risk-sharing: “No risk, no gain”
• Equitable allocation of Credit
 Greater emphasis on equity and profit and loss
sharing (pls)
• Will make banks more cautious in lending
 What about debt?
• Debt is not created through direct lending and borrowing
but rather through the sale and purchase of real goods
and services
CONDITIONS FOR DEBT FINANCING .5

1. The asset being sold or leased must be real

and not notional or imaginary
2. Seller must own and possess the assets being
sold or leased
3. The transaction must be a genuine trade
transaction with the full intention of giving
and taking delivery
4. The debt cannot be sold: The risk of default
associated with it must be borne by the
lender himself. This will motivate him to be
more careful in lending. Will help prevent
fraud?
 IMPLICATIONS .6

 The market discipline that Islam imposes will

put a check on excessive expansion of debt.
 The person who is going to suffer the loss is
the best one to provide the discipline
 Regulation and supervision are necessary but
not sufficient
o Regulation and supervision can be inadequate
o Without moral consciousness regulations may be
circumvented
o The supervisor can be negligent
 A PROBLEM .7

 The discipline will deprive the subprime

borrowers of credit
 Therefore, some arrangement needs to be
made for making credit available to them
 The market is profit-oriented and may do
this only to a limited extent
 Role of the government and the private
sector altruism
 ISLAMIC FINANCE IN .8
PRACTICE
 Islamic finance is still in its infancy
• PLS: small share
• Debt: major share – every effort is being
made to transfer the risk to the borrower or
the lessee
• The emergence of tawarruq has partly
severed the link with the real sector
• Reason:
• Absence of shared institutions to support the
system
• The maqasid al-Shari‘ah are not taken into
account while giving fiqhi verdicts
 SOME SUGGESTIONS FOR REFORM OF .9
THE INTERNATIONAL FINANCIAL SYSTEM
1. Raise the share of equity and lower that of debt in total
financing
2. Control leverage
3. Allow credit primarily for promoting development of the
real sector
4. Require banks to hold debt until maturity to motivate
them to ensure careful underwriting – If, however,
debt is to be sold, there must be full transparency
along with right of recourse. If not, the issuer must
hold a meaningful proportion of it
5. CDSs should not be allowed to become instruments for
wagering
6. All financial institutions must be regulated
7. Some arrangement must be made to enable the
subprime borrowers to get credit
THANKS