Financial Crisis Explained

Assignment for Islamic Economics 2012

The Financial Crisis Explained

The Financial Institutions globally are based on riba or interest. The Central Bank lends money to the government and other banks on interest. Thus money equals debt. In order to pay back the debt and get a profit, banks lend their money to their customers with a higher interest. It’s a vicious cycle.

The root cause of the financial crisis in the USA which spilled over to the European countries in 2008 is due to excessive and impudent lending by the banks. Investment bankers bought mortgages from banks and packaged it as Collateralized Debt Obligations (CDOs) to be sold to investors like the Pension Funds. The CDOs were highly rated and gained a lot of revenue. By the end of 2006, about 55 % of the US$ 10.2 trillion mortgage loans in the U.S.A was packaged and sold to local as well foreign markets. Since the CDOs were very successful, the investment bankers persuaded the mortgage bankers to give more loans to the less creditworthy home buyers called the subprime mortgage. The risk of default of the subprime debt was passed from the mortgage originator to the ultimate purchasers of the CDOs who were not aware of the inherent risks due to the packaging of the CDOs. When the home buyer defaults payment, the investment banker forecloses the house. The price of houses plummets when more houses are foreclosed. The investment banker has worthless houses on his hands which he cannot sell and debt to pay the mortgage bankers. Nobody wants the CDOs. The investment banker becomes bankrupt. The mortgage bankers cannot get their money back from the investment bankers and become bankrupt. The investors lose all their money and the home owner owns a house that is not worth his mortgage. It’s a vicious cycle.

The US government had to bail out the banks by borrowing money from other countries which led to the higher sovereign debts and started minting more money causing an inflation. With higher debts the country has to cut down on spending and charge higher taxes. Unemployment rate increases as cost cutting measures are taken or production is moved to other countries with lower labor costs. The “Occupy Wall Street” protest in New York shows the sentiments of the people who were unhappy that the banks got a bailout but the common man continues to suffer.

A similar scenario unfolded in Europe. The European Union consists of 23 countries that used the Euro currency. Greece a member of the European Union was having difficulty to pay its bills. It started to borrow more money from other member countries like Germany, Spain and Portugal. As its sovereign debt increased with compounding interests, Greece started defaulting payments. This in turn caused the lender countries to borrow from other countries to make up for the default payments. Greece could no longer borrow as no one wanted to lend it money. The country had a liquidity crisis and riots broke out. The European Union had to step in and bailout Greece. The member countries had to write off its debts and are still in talks to remove Greece from the European Union as the crisis in Greece will cause the Euro to plummet with it. The other countries significantly affected are Ireland, Portugal, Spain and Italy.

Other countries like China, Brazil and Canada are also badly affected by the declining value of the dollar because their economy depends heavily on exports to the US. Many emerging market economies like Russia, the OPEC countries and Latin America are being affected by the falling prices of international commodities. Countries like India though not affected badly, have faced falling stock prices. Japan is in a stage of stagflation which is inflation and longstanding recession and heading towards a financial crisis of its own. A crisis this big in the financial center of the world has led to a domino effect on other countries of the world, since all nations are part of the global market.

Could the Islamic Financial Institution have prevented this crisis and managed it better? The answer is a resounding YES. The Islamic finance is vehemently against the core principle of the conventional financial system which is Interest/Riba. Money cannot be made by simply lending money but must be made through trade as is clearly stated in the Quran 2:275 “Trade is permitted, Riba is forbidden”. 

The crisis in the US occurred because the investment bankers thought nothing about selling the CDOs and CDS to the investors. They thought there was no harm in selling debts, because the risk/gamble (maisir) is taken by the investors who buy the CDOs. There are elements of uncertainty (gharar) whether the payments for the mortgages will be made or defaulted. There are elements of deception when the rating agency gives a high rating to a subprime mortgage. There were no regulators to limit the irresponsible behavior of the bankers.

The rules in Shariah are very clear when a contract is made between the seller and the buyer. The subject matter must be in existence. The selling price is known and the seller is forbidden from making excessive amount of profit or taking advantage of the buyer. There must not be any elements of gharar and all terms and conditions are agreed upon and documented. Maisir (gambling) is clearly forbidden to  Muslims,  as one  party wins  while  the  other loses -a  zero  sum game  with  risky  payoffs. In other  words, speculative  and  gambling  activities  were merely  shifting  the  risk from  one  party  to another.  Hence, derivatives such as CDS would have been prohibited if Islamic finance were applied.  The prohibition of riba’ in debt trading would mean products such as CDOs would have been non-existent in the Islamic Finance system.

Unfortunately some of the financial products offered by Islamic Financial Institution are similar to the conventional products that brought about the crisis. In the Ijarah /Musyarakah Mutanaqisa  sukuk structure  (where asset is securitized as sukuk) ,the sukuk is packaged like a CDO. The rating agencies are giving these sukuks good ratings though these products were not understood.

While the Islamic Finance Institution tries very hard to compete with the Conventional Banking Institution in providing financial products that cater to market needs; it also needs to make sure that the objectives of the Shariah are kept.