Theoretical Aspects of Financial Crisis Finance Essay

Sapir 2008 analysed that there were a combination of three things that were related to the financial crisis; a crisis of capitalism, a financial crisis and a liquidity crisis. This unusual combination explains how serious the impacts of the crisis were. Each element had different repercussions and at the same time was tightly linked. Allais 2002 blamed excessive development of payment promises and their financing. He argued that the same causes generate the same effect, which explains some of the crises that had occurred in history and also explains the events of the last crisis that became a global issue. A journal article written by Kern Alexander 2008 'Principles v Rules in financial' recommended efficient regulation to prevent misconduct and misdemeanour of excessive lending to people that are unable to pay back loans, which has become a burden on the economy. Regulators do have the resources and expertise to cope with this issue. However efficient regulation is difficult because of the incentives financial institutions have to develop means to avoid the impact of regulations by loophole missing (Eaglesham 2012). Therefore it will always be a case where changes in regulations would not generally respond promptly to the pace of change in markets and economy (Kern 2009). Sapir 2008 concluded the emergence of new development models and that the crises imply a global re-evaluation of international integration strategies. Many would assume that Sapir is questioning as to what should be done about this issue. Boccara 2009 indirectly expressed his desire for Islamic finance and suggested that Islamic banking could be a new economic system base. Boccara 2009 complimented Islamic finance as a potential alternative. On the other hand Khan and Bhatti 2008 argued that Islamic banking will face challenges that could be difficult to overcome. A similar study to this research Bellalah et al. 2004 mentioned that there is a strong relationship between interest and instability, which are to do with financial and liquidity crisis mentioned by Sapir 2008. Akerlof and Shiller 2009 believe that financial crisis exist mainly because of changes in confidence, envy, illusions, temptations and stories about the nature of the economy. To understand Akerlof and Shiller 2009 theory Catts 2013 explained the theory in reference to reality and argued that those who could not afford a house or could not make payments were astonished by the fact that house prices would never fall. Therefore a lot of people were starting to take out subprime (high risk) mortgages and these were usually supplied by loan/mortgage brokers. Keynes 1937 believes how economic fluctuations are explained by spontaneous changes in the moods of people (optimism and pessimism). Minsky 1986 explained how a financial crisis would occur when a bubble in asset prices collapse. Greenspan 2003 said: "The notion of a bubble bursting and the whole price level coming down seems to me as far as a national nationwide phenomenon, is really unlikely" (CRAIG, Page 10). Keynes 1937 made the following argument: "Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Nobody was aware of the consequences. Both Akerlof and Shiller's (2009) point agrees with Keynes's (1937) statement to an extent. However they point out that non economic motivations play a role in this, as they believe that the classical and new classical model ignores non economic factors. Barny 2005 argues that there was a substantial excessive inflation of house prices and on top of that interest rates were historically low. This created a mania for home ownership and lead to people optimistically buying homes, as explained by Minsky 1986 and Keynes 1937. Kindleberger 1987 and Friedman & Schwartz 1963 argued that many banks would be forced to close. Economists Hayek 1935 and Wicksell 1935 (both subscribed to the Austrian school of economics) have in further depth elaborated the relationship between interest and instability. However Hayek 1935 examined Wickell's 1935 study with the assumption of employment levels fluctuating, where as Wicksell's 1935 assumed full employment. This would mean that both conclusions would slightly differ. Nevertheless the theories of the two economists in the end supported that interest leads to economic instabilities. The first part of the literature review managed to identify some of the causes that lead to a global financial crisis. It was important to have taken economic theories into consideration, as this dissertation will focus on how Islamic finance can assist the conventional system into becoming more resilient to the crisis. Therefore the second part of the literature review will look at the principles of Islamic finance.

Islamic Finance

History

Islamic banking is one of the major economic developments in the early 1970's. However, the concept is not new. (Choudhury and Hussain 2005) discussed that Islamic banks have emerged since the 20th century and that they offer banking services through their resourced based view. Both Khan and Bhatti 2008 argued that Islamic finance made tremendous breakthroughs that have made the system viable and a competitive alternative to conventional banking. Currently Islamic banking is growing at 15-20% per year. Mawlana Maudidi proposed the idea of Islamic finance in the 1940s and was further developed by Anwar when Maududi died in 1979. According to Visser 2009 the main motivation of the development of specific Islamic views on the economy was due to the conviction that Islam was seen as backward by the European civilisation, which had little time for the tenents of Islam in the economic sphere (Visser, 2008 p4 - 8). Siddiqi 2002 has credited Maudidi for the development of Islamic finance, but argued that strong political ideas of Maudidi should be ignored as they might have arisen from a reaction of what the European civilisation thought of Islam and that no anti-western feelings need to be involved. Siddiqi 2002 has also stated that the world needs to participate in Islamic finance. Karbhari et al. 2004 explained that conventional banks have acknowledged the potential of Islamic finance. As result a number of conventional banks such as ANZ bank, Barclays, Citybank, HBSC and Lloyds TSB offer Islamic finance products, which not only illustrates there has been much recognised growth, but also how valuable the idea proposed by Maudidi has been. On the other hand, it must be mentioned that some scholars raised concerns about the legitimacy of Islamic products offered by conventional windows (Abdurahman, 2006, Yaquby, 2005 and Malik et al. 2011). Not one person can guarantee that funds provided to establish these windows did not involve interest, which means that that capital could be unacceptable according to the Shariah principles. These are potential challenges that many that many conventional banks that wish to open Islamic windows will face as mentioned by Khan and Bhatti 2008. These challenges could also explain as to why HSBC has decided to withdraw some of its Islamic windows. Different people have different ideology on why interest might be prohibited. However there are debates going on amongst scholars as to whether it is allowed for a transformed conventional institution to Islamic institution, could be classed Islamic if it commits to make charitable donations to purify their money. Tlemsani 2010 argued whether both Islamic and conventional banking can work together in a mutually productive manner. Lewis 2008 believes that Islamic finance varies little from conventional banking, which indicates a possibility that the two financial systems could co-evolve. Both might be correct in their suggestions, but Berger and Huntingdon 2002 believe that the two systems are irreconcilable and conflict between each other, as conventional banking is merely profit motivated whereas Islamic banking focuses on the economic wellbeing and also profit. In addition Islamic banking completely avoids interest. Ahmad 1992 acknowledged that Islam completely prohibits interest. But if Islamic economics completely prohibits interest, then why do Muslim countries run their financial institution with the involvement of interest? This raised many questions and not one single person has managed to answer this (John Foster, 2009)., which also lead to people enquiring about whether Islamic finance is really Islamic (Foster, 2009).

Shariah Board

The activities and behaviours that caused the financial crisis are completely unacceptable in Islam. Every Islamic bank institution has its own Shariah board, and their responsibilities are to ensure operations adhere to Shariah law and give approval to management team regarding any operations and activities (Wilson, 2004 p9). After any approval the board monitors the ongoing activities and ensures that they are performed in the practice of the Shariah law. Both Hasan 2008 and Malik et al. 2011argue that there is no single organisation that governs the Islamic banking industry. It would be more beneficial to Islamic banking as a whole if there was a universal set of Islamic banking rules. Indonesia is a very good example, as the rulings are mandatory for all Shariah boards within the nation. Dr Hassan in a recent report that looked at 'the toughest issues facing Islamic finance' admitted that the reason for this was that scholars with both Islam and finance knowledge are extremely scarce (which Malik et al. 2011 mentioned too) (Isra, 2012). In the same report Dr Laldin disagreed with Dr Hasan's point as he claimed that there is no shortage of Shariah advisors in the market. As mentioned in the previous paragraph scholars in the Shariah board identify whether Islamic banking products are Shariah compliant. According to Wilson 2004 merely stating whether a product is Shariah compliant or not is insufficient. He recommends Shariah scholars should be more involved in the marketing as well as regulation. This shows that scholars are more proactive. Wilson 2004 also argued that Islamic banks need to consider ways to convince new and existing customers about the benefits of their innovative products and also demonstrate their products to new business circumstances and at the same time ensure customers that they are Shariah compliant. Van Gaal claimed that Islamic banks do engage with their customers. Therefore it can be assumed that Wilson 2004 might have been trying to explain that Islamic banking need to improve on their marketing (Van Gaal, 2012, p27). This assumption has been also made by a number of individuals who have analysed the challenges faced by Islamic finance' (Mustafa 2011, Askari et al. 2010, Ramal & Hussain 2010).

Principles of Islamic finance

Interest

For many centuries Muslim nations have been developing ways of co-operating their religious beliefs and values within their business and banking. The fundamentals of Islamic banking are concepts in compliance with Islamic Sharia law principles. "The Islamic bank is a banking establishment that solicits funds and employs them in accordance with the Islamic Shariah, for the purpose of building Islamic solidarity and ensuring justice of distribution and employment of funds in accordance with the Islamic principles. " Abdelgadir B, Graham H.R, Cyril R.T ( 1994, p.6). In Islam there are two sources of principles that determine the Islamic structure, which primarily is the Quran itself and the Sunnah. The structure and basics of Islamic finance is different to the Western Commercial banking and financing system in many aspects. One way in which it distinguishes itself from conventional finance, is through the complete prohibition of interest (riba), whereas with conventional banking interest is the main driver (El-Gamal, 2006). Shariah law (Islamic law) strictly forbids interest. However it does not prohibit gains on capital. The Shariah law requires that performance of capital is taken into consideration when rewarding capital. In financial terms, use of capital must add value and not be devoid of risk (Arberry, 1964, p. 4). It is stated in the Holy Quran in the following verses: Those who devour usury will not stand except as stands one whom the Evil One by his touch hath driven to madness. That is because they say: "Trade is like usury", But Allah hath permitted trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (to judge); but those who repeat (the offence) are companions of the fire; they will abide therein (forever). Holy Qur'an, Surah al Baqarah, 2:275 (23 Source: The Meaning of the Holy Qur'an. (Translated by Abdullah Yusuf Ali. Ninth Edition 1997. Amana Publications, Beltsville, Maryland, USA). The former president Obasanjo speaking in 2000 about Nigeria's mounting debt to international creditors stated: "All that we have borrowed up to 1985 was around US$ 5 billion, and we have paid about US$ 16 billion. Yet we are still being told-that we owe about US$ 28 billion. That US$28 billion came about because of the injustice in the foreign creditor's interest rates. If you ask me what the worst thing in the world is, I will say it is compound interest" (Shakespeare, 2011)(PRESSTV) The repercussions of interest are so severe to not only cause unable mortgage payers to lose their property, but enough to put a whole country into debt. Many more countries in the world, especially third world countries have very large debts to be clearing. According to Shakespeare 2011, the region of Sub-Sharan Africa pays $10billion every year in debt services which is four times the amount countries within that specific region spend on health care and education (NewsInt 1998). Shah 20005 pointed out that there is $523 billion debt burden after $550 billion has been paid in both principal and interest. Although this might be irrelevant to the topic it still is a very good example to consider and understand why Islamic finance prohibits interest. A general agreement among Islamic scholars is that the charging of interest and any positive, fixed, predetermined rate of return which are promised regardless of how well a project performs is prohibited and also usury. (Iqbal and Tsubota 2006). The financial crisis started with the subprime mortgage where mortgage originators collateralized the debt by mixing prime and subprime debt. This means that they had less incentive to undertake careful underwriting Ghafour 2008. Zarqa 1983; Siddiqi 1983 have described Islamic banking as one that is value based and aims to ensure moral and material well being of individuals and society as a whole, whereas conventional banking can act inconsiderate about the economic well being.

Gambling and Speculation

Kunhibiva 2010 stated that any activity that involved a form of gambling is strictly forbidden in Islam, as well as speculations that lead to zero sum outcome. It is stated in the Holy Quran: They ask thee concerning wine and gambling. Say: "in them is great sin, and some profit, for men; but the sin is greater than the profit" (Holy Qur'an, Surah al Baqarah 2:219). The main reason why gambling is forbidden, is due to the fact that one gains through no effort (Damansari 2007, p.219). Campbell 2008 in an interview unveiled that conventional banks were aware of the risks involved in the activities of excessive lending, leading to a zero-sum outcome. Although gambling in conventional thought is widely accepted as McGowan and Brown 1994 believe that one should have the economic freedom to do as they desire. However there are some that argue against it Borna and Lowry 1987 believe that such activity does not take the economic well being into account. Tickell 1999 on the other hand argues that it should be totally avoided in the conventional banking system. It is to be said that Islamic finance principles can assist conventional banking on how to be more resilient to a future crisis. Islamic banking has shown more resilience during the time of the crisis compared to conventional banking, where a number of big players had to be bailed out by the government. A published document by Nankin and Schmidth 2009 showed some of the institutions in the conventional system that had to be bailed out, because of the way the crisis had affected them: Fannie Mae / Freddie Mac: $400 Billion American International Group (A.I.G.): $180 Billion Bank of America: $142.2 Billion These were companies with huge reputations. They had to be bailed out, for the reasons that they were all involved with the subprime mortgage crisis.

Islamic banking principles and why

Khan 1985 noted that the abolition of interest based transactions is not a subject that is new to conventional economic thought. A number of economists have agreed that the conventional system is instable compared to Islamic finance and Islamic scholars blamed interest rates. People who supported the conventional system such as Metzler 1950 and many more were familiar with the fact that the conventional system was not stable in the long term. For that reason Metzler proposed an interest free model where contracts should only be based on equity. This illustrated a more economic stability, because as explained by Keynes 1937 and Akerlof & Shiller 2009 economic fluctuations are caused by changing moods of individuals and the existence of illusions which are both influenced by interest rates. This explains that interest is an act of exploitation and injustice (Lewis 2008). However scholars such as Chapra (1985), Khan (1985) and Siddiqi (1980 and 1982) are not fully against interest. They argued that interest should be rewarded only if savings are used to create additional capital and wealth. In the real world however, this is not the case, because interest rates have nothing to do with capital productivity. Instead, interest is paid on money and has to be paid regardless of whether an investment is a success or not. A lot of research has been carried out in this field with many similar opinions. Choudry's and Hussain 's 2005 have also stressed their point of view which closely relates to Zarqa 1983 and Siddiqi 1983 way of thinking. There are many more researchers such as Dusuki and Abdullah 2007 who have critically reviewed and explained how Islamic banking aims to create a much fairer and balanced society as prescribed by Islamic economics. Chapra 2009 discussed this issue and added on how it has the potential to minimise the chances for a future crisis. All these compliments to Islamic finance are thanks to the Shariah principles which ensure proper Islamic banking to act in an appropriate manner John & LIU , ; Iqbal and Mirakhor, 2006 and Islamic prohibits interest because: Alternative products and alternative options (musharakah, ijarah sukuk etc) Whether Islamic finance principles can be adopted (scholarly reviewed articles To organise valuable ideas and findings To identify other research that may be in progress To generate research issues To develop a critical perspective To organise valuable ideas and findings To identify other research that may be in progress To generate research issues To develop a critical perspective

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