ISLAMIC BANKING’S RESILIENCE TO CRISIS Abdulhakeem Abudawood FNAN 498 Jun/10/2017 Islamic Banking’s Resilience to Crisis Introduction The latest financial crisis, which set itself in the later years of 2000s, would prove to be one of the most significant economic disasters to affect the world. Originated in the United States due to a “failure of risk assessment and management at the institutional (legal and regulatory), organizational and product levels”1. It would eventually reach Europe and Latin America, even reaching certain parts of Asia. Is is not difficult to see why such a phenomena would spread, given the interdependence between national economies. Although its scope was large, there was a particular region that remained unaffected by the occurrence. Islamic banks, contrary to conventional banks, managed the crisis with surprising ease; a feat that was achieved due to the way these institutions are built. Islamic banks have incorporated certain aspects of religious belief into their practice, which have caused several provisions to be placed upon the system that cannot be found in the Western World. Although Islamic Banks are relatively new in their entrance to the market, the philosophies from which they draw influence have been around for centuries. Just as they inspired marketers to handle their business in earlier times, they have been adopted, more recently, to distinctly shape these gigantic institutions. The practice can be looked down upon at certain times by Westerners for mixing religious matters with corporate matters; it has certainly been of fruition to those who manage these banks. When we consider their ability to remain solvent 1 Ahmed, et al., “Islamic Banking and Financial Crisis”, 2. through the crisis, then the benefits of these practices might be shared by more people than just the few who are directly profiting from the institutions. In the West, as it happens, economic depressions or recessions will undoubtedly affect the banks, even when they have not played a major part in causing it. For the specific recession of the late 2000s, the roles that the banks played in its creation and development cannot be dismissed. The real estate bubble, for example, that catalyzed the recession, was a direct result of the high-risk loans that were sold to cover for the costs of housing. For banks that had been depending on these riskier deals, the possibilities of significant loss only increased. When these ventures demonstrated why they were considered high-risk, it was too late for the financial standing of the entire markets. The real estate market failed and with it, many financial institutions were also devastated. Islamic banks, however, do not tend to suffer major losses during these events. By creating a system of banking that allows them to be relatively exempt from the damages of financial instability, there is an added sense of security for those who seek to operate under them. Certain losses can also be prevented, particularly those felt by the general population, if the process of inflation and collapse can be severed at its roots. And, while Islamic banking is not without its faults, they can turn out to be better survivors of economic instability. There are five major components that differentiate Islamic banking from conventional banking, which allow for the institutions to be better prepared to face off financial crisis. Literature Review There are many texts that have been devoted to cover the subject of Islamic banking. However this particular method of handling finances is relatively new to the international setting, it comes with sufficient innovations to attract the attention of the world. Still, I wanted to obtain as much literature as possible that was created or curated by people who have closer ties to the region. At times, the Western eye can be a bit distrusting of ventures that present an opposition to their standards of handling them. As such, I mainly focused on a textbook that was written with the collaboration of various Islamic economists and other scholars. The text, Islamic Banking and Finance: Reputation, Stability and Risks, gives a lengthy but complete explanation of the basic aspects of Islamic Banking, particularly when it is facing a crisis. This text serves as the perfect introduction to the subject, as it is written in a way that does not expect prior knowledge to the terminology included. Considering that many practices are based on Islamic principles, which might not be as easily recognizable by foreign audiences, the way in which they are explained is particularly helpful. Nevertheless, this document also focuses, almost on its entirety, on the relationship that Islamic banking has had on the system’s ability to withstand the adversities of recessions. The authors make the claim that, under the specific system that governs Islamic banking, it might be possible to stop financial instability from taking place, or, at the very least, minimize the consequences that these situations tend to have on society at large. To not only base myself on the information contained in this text to understand how the system is structured, I sought out a second opinion in the form of a journal entry by Imtiaz A. Pervez, which only focuses on the intricacies of Islamic finance. For further specification and explanations about two important concepts of Islam, Musharaka and Muharaba and riba, I sought out two essays that specialize on the matter. One, written by Muhammad Ali Shaikh, called “Contemporary Islamic Banking: The Issue of Murabahah”, provides an in-depth explanation of both concepts first discussed, as well as an equally detailed analysis on the practice of Murabahah. The other document, titled “The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation”, by Harrington, provides a deeper explanation on the topic of interest; specifically, it shows the relationship that exist between interest rates and financial crisis within the setting of the Western World. Other journals were consulted to clarify other specific sections of the article. Characteristics of Islamic Banking The concept of Islamic finance is aimed to be one of the simplest ways in which basic, ethical, and egalitarian financing can be undertaken. In a way, this is guaranteed due by provisions found within Sharia Law, which is based on the Qur’an and the Sunnah. Basically, the vision that Islamic businesses have about economics is deeply inspired by the obligations that man is given when it comes to the organization of their matters directly by their ideation of God. The will of God demands, from all Muslim participants, that certain characteristics are abided by in order to be on the fulfilling end of their devotion to God. The goal of Islamic banking becomes not just equanimity, but also the avoidance of an unequal and unjust distribution of wealth. In this sense, we could say that Islamic baking is governed by a very strong sense of ethics. Amongst the pillars of Islamic banking, we can find five rules of Sharia. Thus, it should be noted that financial institutions are not the only ones where Sharia has some bearing. Most of Islamic Markets need to uphold themselves to the standards called upon by Sharia Law. For example, through the selling of alcohol and tobacco can be highly profitable, but their sale is not permitted under the rule of Sharia, because their consumption would be in direct contradiction with the teachings of the Qur’an. Better put, financial institutions were not made exempt from abiding to the regulations placed upon by Sharia Law. The five principles that we can see in Islamic Banking, derived from the Sharia law, are the concepts of Mudarabah, Wadiah, Musharaka, Murabahah and Ijarah. Before going into depth in how these methods help build up financial banking, a brief explanation should be made about each of them. First, Wadiah refers to the way in which banks are expected to act, within their responsibilities; they are considered, after all, as trusted institutions that should be grateful for the trust of their clients. Mudarabah refers to agreements of profit-and-loss sharing, where one partner loans money to the other to invest in a particular enterprise, but both partners are, further on, responsible for the contribution of capital to the venture. Musharaka refers to the relationship between two, or more parties that funnel capital into a shared investment that could be used towards the purchase of property. Finally, there is Ijarah, which is an arrangement for leasing wherein one of the parties purchases an item and lends it to another, which will then begin to pay off the loan given and acquire complete ownership of the item. Hence, there are some provisions that should be looked at from a more in-depth perspective, because of their importance. One of the fundamental aspects of Islam calls for the acquisition of better conditions for social justice. For example, the practices of Mudabarah and Musharaka both set up conditions for profit and risk sharing. In fact, “the asset portfolio of Islamic Banks consists of Profit and Loss sharing or Fixed incomes”2. The financial system, as it engages in the search for social justice, would have to make some changes in order to facilitate its reach. Beyond 2 Shaikh, “Contemporary Islamic Banking”, 435. being strong and stable, they need to be based in an ethical background that does not keep the average consumer stranded in case things go bad or the person running the business is bankrupted. While it is true that without risk there are no profits, this statement does not require unequal conditions for them to take place. In Islamic banking, for example, under these provisions, it is required that the risk is shared equally between the party providing the financing and the person receiving it. Likewise, the profits of the venture will be shared equally between both parties. Under the PLS model, there is an expected risk that should be accounted for, and, under Islamic banking, risk assessment is done in a bit of a different manner. It actively distinguishes between good and bad investments, and those that are completely lackluster. This differentiation incentivizes the creation of more stable and less dangerous forms of investments, as the portfolios that are assumed to be of high risk will not be taken with much consideration in an Islamic financial institution. In fact, when designing their portfolios, financial institutions might find it harder to sell those that possess more PLS agreements than Fixed-Income.3 If PLS is associated with high risk, then fixed income provides the opposite. Fixed income plans are taken up with ventures that do not convey as much risk for the financial institution, which allows them to absorb the initial cost of the investment without worry of significant losses in case the venture does not hold. They are often agreed upon in advance, stipulating the length and the cost of the venture. These types of measures do not see much change, or at least, not any drastic change; they are not the type of business where its failure could harm, significantly, the lender or the society where the lender develops themselves. Thus, if a risk is taken, this is a venture that is often seen as in need of compensation. However, normally this could be 3 Shaikh, “Contemporary Islamic Banking”, 436. considered a practice of banality, it is specifically rewarded because there was a successful result. If the venture had failed, the lender would be in the worst position out of both parties. There is another important aspect of Islamic banking that is very important to understand, given its contrast to the West and its role in financial crisis. The prohibition of interest is one of the most fundamentally Qur’anic aspects of the banking system. There are various verses in the Qur’an which forbid the acquisition of wealth through the implementation of interest rates. “Interest is construed by Islamic economists as only a theoretical concept that does not correspond to or is representative of real growth of capital” 4It becomes synonymous with an extra profit that is collected, without any price for its collection. This can be found in direct opposition to the management and existence of conventional, western banks. Most of the financial institutions that thrive on the West have a certain margin of their profits, sometimes a very large margin, acquired from the interest rates that they add to their services. These are all characteristics that are not commonly found in western banks, yet there are certain conventions that may seem familiar to these ones. There are methods put in place, by certain institutions, to try and implement some form of regulation. While the West may lack a system of interest that is as prosperous for the 4 Pervez, “Islamic finance”, 263. working classes, there are some boundaries put in place to avoid institutions being given almost unlimited power over their consumers. Unfortunately, the market still allows for some flexibility to the way the business is handled, so that loopholes are always available for those who seek to exploit the market beyond what is beneficial for the majority of society. The costs, after all, when the conditions that makes a society thrive become detrimental for their well-being. And, in times of crisis, conventional banks, with their antagonistic practices, are often involved in their occurrence and aftermath. And, their particular practices, which have always found themselves questioned after every recession, must share some cause of the blame. Hence, as seen in (chart1) it explains how Islamic banks and conventional banks in countries where both have significant market shares before the occurrence of the crisis. However, after the crisis have occurred, factors related to the Islamic banking business model helped contain the impact on their profitability in 2008 as explained in (chat 2) Islamic Banking and Financial Crisis The different provisions that characterize Islamic Bbanking have made them better equipped to deal with the financial crises that are common to conventional banking. These same practices make them, as well, less likely to create a crises of their own. During the crisis of 2008, Islamic banks managed to move from principle to practice, with no banks failing during the crisis itself, or its aftermath. (Et al. 6) One of the situations that brought forth instability in the Western world was the selling and purchasing of derivatives, which was often indulged in without clear knowledge of what was in stake with each acquisition. The market, incentivized by some of the lowest interest rates that had been seen, became willing to risk more and more to try gain the most profit. In this scenario, though, the market becomes a zerosum situation where it is only possible to win at the expense of another. With Islamic principles in place, or their Western equivalent, which prohibit these situations from developing a serious danger could have been adverted. Some of the benefits of adopting these practices, in the long run, would imply significant amount of savings for the government and the people. However there are certain risks that can be played in the field of economics, they should never be so broad as to encompass an entire economy. In this regard, the Islamic version of the market puts in place certain restrictions to the ways in which the market could develop. It would not allow for negotiations to be made if there was any kind of information being hidden from one of the parties involved. Business does require complete transparency because one of the aspects that are important for the striking of just deals is the ability of negotiation. Instead of simply offering a customer different set levels of interest, Islamic banking would rather give a client a more diverse set of options for their financial deals. To ensure that these negotiations are taken place in the most just scenario transparency needs to be called upon, as well as “the prohibition of any attempt to conceal information from a client while respecting the confidentiality of both parties.”5 While this might be a difficult practice to implement in a society. The cost of dealing with depressions is not something that an Islamic government would have to concern themselves with. Given that the banks are not likely to be affected by such movements, they do not generate the need for relief or intervention from their state. The financial crisis of 2008 cost the United States’ government more than a billion dollars. Once the aftermath of the depression had set, Congress had to enact the Troubles Asset Relief Program that cost $700 billion dollars. 6 Following this program of relief, another massive grant of capital was given to various banks, including the nine largest banks in the nation, to help them cope with the financial crisis. 7 To have the biggest financial institutions affected, demonstrates that there is an intrinsic flaw in the ways things are being handled. There is a reason why, after the great depression, measures were enacted to stop the banking and investment sectors completely separate.8 Conclusion While Islamic banking can be judged, a priori, as becoming a victim to religious doctrine, it would be more honest to say that Islamic banking has benefited from the inclusion of the religious aspects. Islamic banking has been formed within the same standards that the Qur’an demands of most enterprises. In this process, the entire system has become more ethical and transparent than what can be seen in the West. When we look at its characteristics, we can see aspects that would make it better equipped to dealing with financial crisis: with the majority of their assets localized on Ahmed, et al., “Islamic Banking and Financial Crisis”, 6. Harrington, “The Financial Crisis”, 785. 7 Harrington, “The Financial Crisis”, 785. 8 Cassis, “Regulatory responses to financial crises” 10. 5 6 safer ventures, there are fewer risks of decapitalization or bankruptcy. The lack of interest, too, forces financial institutions to look for other methods of acquiring capital that do not rely on the exploitation of the masses. For a western context, the existence of interest is so entrenched that calling it exploitation might appear unseemly, however, when we consider how many families have been harmed due to the high levels of interest that are added to their loans, a certain truth can be taken from the statement. Western society can definitely implement some of the practices that have made Islamic banking immune to the devastating effects of financial crisis. For the sake of cultural diversity, these changes do not need to be implemented, as is the case for Islamic banking, in the name and honor of God and his Qur’anic teachings. However, there are similar provisions in the other Judeo-Christian texts; it is entirely possible to arrive to these measures through secular pathways. Perhaps, making a change as drastic as eliminating interest from the existing institutions might actually prove, if done too hastily, dangerous for their financial well-being. Nonetheless, some of these practices and attitudes do require some consideration, when we consider the financial and humanitarian costs of falling into a cycle of expansion and collapse. Banking institutions, which deal with the finances of millions of people, should not be allowed to gamble with this money. Islamic banking sets itself aside from conventional western banking due to the moral and economic build that is particular to Islam finance. This difference has allowed these banks to sustain themselves against crises with more security and without risking as much. The entire economic landscape could be benefited from some reform, and Islamic banking could serve as a source of inspiration for the possible changes to come. Bibliography Ahmed, Habib, Mehmet Asutay, and Rodney Wilson. Islamic banking and financial crisis: reputation, stability and risks. Edinburgh: Edinburgh University Press, 2014. Al-Awsat, Asharq. "Islamic Banks Unaffected by Global Financial Crisis." ASHARQ AL-AWSAT English. September 29, 2008. Accessed June 10, 2017. http://english.aawsat.com/theaawsat/business/islamic-banks-unaffected-by-globalfinancial-crisis. Harrington, Scott E. "The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation." The Journal of Risk and Insurance 76, no. 4 (2009): 785-819. http://www.jstor.org/stable/20685274. "Islamic Banking : All You Need To Know." Simply Decoded : Making sense out of chaos!! Accessed June 10, 2017. http://www.simplydecoded.com/2013/12/18/islamicbanking-all-you-need-to-know/. "Jasig." Mason Central Authentication Service. Accessed June 10, 2017. https://global-factivacom.mutex.gmu.edu/redir/default.aspx?P=sa&NS=16&AID=9VIV000400&an=DNA DAI0020160614ec6e00035&cat=a&ep=ASI. Online, IMF Survey. "IMF NEWS." IMF Survey: Islamic Banks: More Resilient to Crisis? Accessed June 10, 2017. https://www.imf.org/en/News/Articles/2015/09/28/04/53/sores100410a. Pervez, Imtiaz A. "Islamic Finance." Arab Law Quarterly 5, no. 4 (1990): 259-81. doi:10.2307/3381929. SHAIKH, MUHAMMAD ALI. "Contemporary Islamic Banking: The Issue of Murābaḥah." Islamic Studies 50, no. 3/4 (2011): 435-48. http://www.jstor.org/stable/41932606. Staff, Investopedia. "Islamic Banking." Investopedia. May 17, 2016. Accessed June 10, 2017. http://www.investopedia.com/terms/i/islamicbanking.asp. "The Mudaraba Contract in Islamic Finance." Dummies. Accessed June 10, 2017. http://www.dummies.com/personal-finance/islamic-finance/the-mudaraba-contractin-islamic-finance/.
Purchase answer to see full attachment