In Global Crisis, Islamic Finance May be the Answer

The newspapers are stirring emotions with headlines such as “meltdown”, “economic crisis”, “global recession” and “billions written-off”. Political parties and governments are putting aside their differences and working together to come up with a joint approach to the problems. Established institutions such as the Lehman Brothers and AIG are falling before our eyes. Trust is at an all-time low with no one willing to lend.

As billions of cash is injected back into the global economies, politicians and economists are wondering what went wrong, what lessons can be learnt and how to change things so that such problems don’t happen again. Gordon Brown, the British Prime Minister, suggested that he wanted world leaders to gather for a new Bretton Woods -- the conference held to decide how the post-war financial system should be run. He said there had to be “a new financial architecture for the years ahead”.

This is all well and good, but are these solutions going to be radically different from the current ones? Will this new proposal really help prevent the mini crises we have seen every decade or so? I think it is time that the world leaders and central bankers considered a fundamentally different system. One that is not based on debt or encourages people to live beyond their means. A system that pushes individuals to “save now, buy later” rather than “buy now, pay later”.

A system that moves away from wealth being concentrated amongst a select few whilst hundreds of millions go hungry. Now is the right time to look at an alternative solution. Something that ensures that money is invested with people that have good ideas and viable projects rather than being given to people who have the best credit which leads to the rich getting richer and the poor getting poorer.

But what is this alternative solution? Let us look at some of the causes of the current crisis and how this alternative solution would have dealt with it.

It is universally agreed that the economic crisis we are in now, started with the sub-prime mortgages. This is where banks and other financial institutions lent money to individuals in the United States, often at more than the value of the properties they intended to purchase.

The loans were offered at attractive fixed rates that would revert to the market-floating rate after a couple of years. As rates rose and property prices fell, most of these individuals were not able to pay back their loans resulting in many defaults and re-possessions.

The alternative solution I propose does not believe in lending to buy property but instead the financial institution will either buy the property by itself or in partnership with the individual and then allow them to pay rent for the part they don’t own. Since the financing is based on the value of the property it does not allow it to exceed the asset cost.

Furthermore, when people are unable to pay, this system encourages the wealthy financial institutions to give them time to reorganise their finances rather than kicking them out onto the street.

The risk from these sub-prime loans did not stay with the institutions that provided them to individuals. Instead the loans were aggregated, split into different components (e.g. interest only, principal etc) and sold to third parties. The institutions buying these loans created further instruments with different risk characteristics and sold them on to other parties willing to take them on.

This continued until the risk from these sub-prime loans were spread to institutions far removed from the original borrower. This led to a couple of problems, firstly those buying these instruments didn’t often understand fully the risks involved and hence were not able to manage them appropriately.

Secondly, it was difficult for regulators and central banks to determine the extent of this distribution, hence when something went wrong, the impact would be impossible to assess.

So, how would this alternative system have handled this situation? Firstly, the sale of debt is not allowed. This is because money is not considered to be a commodity, which has a price of its own -- instead it is only a medium of exchange and a measure of value. A loan or debt to be repaid in cash is considered as “money” hence this system does not allow it to be sold for anything other than its par value. Secondly, the concept of risk management is different. In the current system, risk is transferred i.e. split and sold. In the alternative system, risk is shared, almost like a collective insurance scheme.

This means that instead of the sub-prime loan risk being sold and sold until it reaches a bank in the Middle East or Asia, it will be concentrated and managed by the institutions that can assess and react to any changes in circumstances.

Another advantage of this alternative system is that when two parties transact with each other, for the trade to be valid both parties must have full knowledge of the potential risks and rewards.

In other words, those individuals taking out the mortgages would be fully aware of what they were getting into if market conditions turned. Also, those institutions buying complex instruments such as CDOs would not consider it as another ‘black-box’ transaction priced for its credit, but understand the parameters involved in the valuation, including understanding the assumptions being made.

This alternative system also discourages speculation. It insists that transactions are linked to the real-world economy rather than being paper being pushed around.

One of the reasons that led to the collapse of Lehmans and the dramatic falls in share price of various established institutions such as HBOS, was due to the concept of short-selling whereby you sell something you don’t own by borrowing it on the premise that you will return it after purchasing it a lower price. When you sell a lot of something, the price falls, as there is more supply. However, when people start short selling, this drop in the price is accentuated resulting in a more dramatic price reduction.

This activity was highlighted when the UK and US central banks temporarily put a ban on short-selling.

The alternative system, I recommend, does not allow short selling because you are only allowed to sell something you own. So, what is this alternative system I have been discussing here? It is not something I have thought up myself. In fact it has been around for over 1400 years and is currently one of the fastest growing areas of finance. It is, for those who haven’t guessed already, Islamic Finance. Though the abandonment of the current economic system to be replaced by Islamic economics is unlikely to happen in the near future, there are advantages in considering or even applying some of the basic principles involved.

Imran Iqbal is a Saudi Arabia-based banker