Today, as the global economy is experiencing its first green shoots, one cannot forget the trauma of the economic winter precipitated by the global financial crisis of 2007-2008, one of the worst in living memory.
Following the crisis, many economists revisited the perennial question as to whether ‘the seeds of these recurrent crises lie in the systemic flaws in the financial system?’
A number of studies have shown that Islamic banks did indeed weather the financial storm better than their conventional counterparts exhibiting lower hazard rates.
This is mainly attributed to the higher levels of capital adequacy and liquidity of Islamic banks, prior the crisis, laying the foundations for regulatory bodies such as Basel Committee to proffer new amendments on additional capital adequacy requirements and stress-measured liquidity.
This remedy is much akin to installing better ‘airbags in a car’ rather than prevention of the crash in the first place.
What else might we assimilate from Islamic finance for the benefit of the long- term financial stability of our economy? To answer this question, we need to divulge into the three prohibitions in which Islamic finance is premised upon: (i) interest, (ii) excessive speculation and (iii) information asymmetry in contracts.
The most conspicuous facet of Islamic finance is prohibition of the interest/usury-based finance model. Experts would argue that the burgeoning ethical finance industry falls short of addressing the dominant issue of the inequity and unfairness inherent in the interest-based financial model.
The potential exploitative nature of interest-based finance in favour of ‘capital owners’ and the evermore tenuous link between financial transactions and the real economy create dire conditions for our economic system.
Islamic banks were intrinsically constrained from investing in the abstract financial products such as Collateral Debt Obligations (CDOs) and Credit Default Swaps (CDSs) due to the prohibition of sale of debt concept in Islamic finance and excessive speculation involved in these products.
Even if sale of debt was allowed, the products would not have been sanctioned on the grounds that their complex structures engender information asymmetry between parties.
The specialised knowledge required to unravel the complexity of mathematical models of risk aggregation and pool tranching meant that even international credit rating agencies had failed to understand properly the underlying risks; hence they were appropriately termed by Warren Buffett as ‘financial weapons of mass destruction’.
How does Islamic finance work if it does not earn income from interest? Two main ways: (i) financing contracts comprising of sale or lease of tangible assets and (ii) partnership financing.
Whilst the borrower can incur debt from transacting via sale contracts, the debt is collateralised by a tangible asset and the profit margin is pre-determined and fixed, avoiding the spiralling costs to the borrower with the variance of time mitigating the likelihood of business insolvency.
In the case of partnership financing, the general format is Profit & Loss Sharing (PLS). The common PLS structure creates more parity between those who own capital, and those who employ ‘knowledge and skill’, normally the client, in a form of partnership where both profits and loss are shared.
Implicitly, the capital owners partake in the risk of the client’s financed business. The internal dynamics of this structure embeds firmer risk mitigation by virtue of the capital owner undertaking enhanced and constant due diligence commensurate with additional risk assumed by them.
In contrast to the normative models of finance constituted on profit maximising proposition, Islamic finance is predicated on the achievement of socio-economic well-being of all segments of society.
It is therefore of no surprise that Islamic finance has created a number of innovations to serve the wider community for the furtherance of social goals such as endowment trusts and microfinance.
The Islamic endowment funds – that arguably inspired the development of endowment trusts in English law - have played a pivotal role for centuries in aiding vulnerable and disadvantaged persons and alleviating poverty levels in society.
The endowment trust model has been instrumentally employed also to fund other communal initiatives such as universities, libraries and museums.
Islamic microfinance and SME financing has also been inherent facet of Islamic finance offerings as it accomplishes the social responsibility of Islamic finance institutions despite their higher risk.
In one reputable Islamic bank, it apportions part of risk capital to fund these riskier ventures despite lower returns as part of its community responsibility mandate.
While Islamic finance does not claim to be a panacea for all of the ills of the financial system, it has the potential to answer the calls of some financial regulators who harken a return to ‘back-to-basic’ banking to rebuild trust and greater social justice in the banking system.
Farrukh Raza is Managing director Islamic Finance Advisory and Assurance Services.