JEDDAH — Islamic finance can cut the severity and frequency of financial crises, and also reduce the problem of subprime borrowers by providing them loans at affordable terms, according to Umer Chapra, a well-known Saudi economist.
Chapra estimates the derivatives market to be around $600 trillion, more than 10 times the size of the world economy. The derivatives include credit default swaps (CDS) worth $54.6 trillion.
He said that the Islamic finance system introduces greater discipline into the economy and links credit expansion to the growth of the real economy.
However, the discipline that Islam wishes to introduce in the financial system may not materialise unless the governments reduce their borrowing from the central bank to a level that is in harmony with the goal of price and financial stability, he said.
“In the Islamic system, credit is primarily for the purchase of real goods and services which the seller owns and possesses and the buyer wishes to take delivery. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully,” he explained.
He said excessive and imprudent lending by banks was the main cause of the current global crisis.
There are three factors that make this possible: inadequate market discipline in the financial system resulting from the absence of profit and loss sharing (PLS); the mind-boggling expansion in the size of derivatives, particularly CDSs; and too big to fail concept of banks who believe that the central bank would come to their rescue.
The false sense of immunity from losses introduces a fault line in the system as banks do not undertake a careful evaluation of their loan projects. This leads to an unhealthy expansion in the overall volume of credit, to excessive leverage, and to an unsustainable rise in asset prices, living beyond means, and speculative investment. Unwinding later on gives rise to a steep decline in asset prices, and to financial frangibility and debt crisis, particularly if there is overindulgence in short sales.
Chapra said the subprime mortgage crisis in the United States was also the result of excessive and imprudent lending. “Securitisation or the originate-to-distribute model of financing has played a crucial role in this. Mortgage originators collateralised the debt by mixing prime and subprime debt. By selling the collateralised debt obligations (CDOs), they passed the entire risk of default to the ultimate purchaser. They had, therefore, less incentive to undertake careful underwriting,” he said.
Consequently a number of banks have either failed or have had to be bailed out or nationalised by governments in the US, the United Kingdom, Europe and a number of other countries.
“This has created uncertainty in the market and led to a credit crunch, which has made it hard for even healthy banks to find financing,” he said.