Islamic Finance and the Economic Crisis: Facts and Fallacies
Of all discussions that I read concerning Islamic finance, perhaps the most frustrating are those that deal with the question of whether or not Islamic finance would have avoided the global financial crisis in which we find ourselves. Even the Vatican has gotten in on that game apparently. Yet it's hard to explain how wrongheaded so much of the chatter on this subject is.
First of all, the premise of the question is based on a fallacy in logic. The fact that X could be avoided if Y is done doesn't mean Y is good, as its consequences could be far worse than whatever X is. That is, it is obviously true that we would have had no banking or financial crisis if we had adopted the fiscal policies of Marx, Lenin and Mao. That doesn't necessarily make the adoption of communism a good idea. My nose wouldn't be cold if I amputated it. Again, doesn't make amputation a good idea.
Now Islamic banking isn't the disaster that Mao was, but it is important to understand its current limits. In any reasonably developed economy, it functions largely within financial systems dominated by conventional banks. There are any number of commonplace transactions in any developed economy that are impossible in Islamic finance, or at least highly controversial. That's okay when other non Islamic banks are there to do those transactions, it's a much bigger problem if nobody can do them. Something as fundamental to modern banking as the Fed doesn't work very well under Islamic finance principles. Takaful, the standard Islamic insurance, won't work, since the Fed's guarantee is effectively backed by the taxpayer, and takaful relies on the fiction that those paying the insurance are giving money charitably. Futures trading is just about impossible, which would wreak havoc in particular industries where the future is necessary to hedge risk. (An orange juice manufacturer needs to trade in futures to hedge the risk of a hurricane, which will send the price of oranges skyrocketing). The same might be said of options which are highly controversial.
So to take the latter two examples, it is true that options and futures, once forbidden, also forbid credit default swaps and the types of esoteric derivatives issued by AIG that caused so much trouble. But it's also true as mentioned above that the elimination of derivatives entirely from the market would be cataclysmic to it. It's one thing for a single bank, or some subset of consumers calling themselves the Islamic finance market, not to engage in options. It is another for an entire economy not to do it. That is like amputating a nose that's cold, rather than turning up the AC.
The second problem with this theory of Islamic finance as savior is that there are any number of transactions that helped contribute to the economic crisis that are perfectly allowable under Islamic finance principles, even if the proponents of the industry now say they are not. For example, the subprime mortgage. Adjustable rates are readily achievable under the ijara, they are done all the time. They are pegged to LIBOR with a spread for the bank's profit, and there is no limit on what the bank can take as a spread. So it just increases its spread for subprime borrowers. It adjusts its spread all the time, what's different about this adjustment? There is really nothing doctrinal at all that would prevent the practice.
Now mechanically that's clearly true. Islamic financiers don't admit it openly, but cannot deny that adjustable rates, adjusted at higher rates for particular borrowers, can be done in Islamic finance through the ijara. The argument instead is that one should look beyond mechanics, because Islamic finance is about ethics! We don't make loans that increase social ills. We don't make loans in a manner that exploits the poor. Therefore this could never happen in an Islamic finance world.
There is some almost naive idealism in that notion one might argue, but more importantly, it is really little more than a spectacular exercise in hindsight. Was there anyone who well before the bubble burst, let's say 2004, thought that record homeownership levels was a social ill? Was there anyone who thought it was unethical to extend credit to the poor at slightly higher levels than the middle class? Everyone that was a good thing, we were letting everyone own their homes, government policy promoted it, and I don't remember Islamic banks anywhere objecting to this at all. I challenge anyone to come up with a statement, prior to 2006, where an Islamic bank declined to enter the subprime market on the grounds that it created social ills, or was exploitative to the poor, or something equivalent. In the words of the thoughtful and careful Islamic finance advocate Yusuf Talal DeLorenzo, Islamic finance "dodged a bullet" in the subprime crisis, it didn't consciously for doctrinal reasons avoid this market.
Securitization of the loans made in subprime and broader markets is also possible through the creation of SPV's whose sole asset is the payment obligations of the borrower/investors. Float the shares of that SPV in the market, and you have securitized the mortgages of homeowners. Again, that Islamic banks didn't do it does not mean they couldn't. Sure now everyone will tell you it's not acceptable because Islam doesn't exploit the poor or take unnecessary risks, but nobody was taking that game at the time, everyone at the time, until the end was near, thought this was all working fine.
This isn't meant as a diatribe against Islamic finance, only against simplistic panacea cures, religiously inspired or otherwise, of what ails us. The fact is Islamic finance in its current state couldn't carry an entire economy as multifaceted and sophisticated as ours, and in any event was capable of engaging in many (though not all) of the transactions that turned out to be so harmful in retrospect.
HAH
First of all, the premise of the question is based on a fallacy in logic. The fact that X could be avoided if Y is done doesn't mean Y is good, as its consequences could be far worse than whatever X is. That is, it is obviously true that we would have had no banking or financial crisis if we had adopted the fiscal policies of Marx, Lenin and Mao. That doesn't necessarily make the adoption of communism a good idea. My nose wouldn't be cold if I amputated it. Again, doesn't make amputation a good idea.
Now Islamic banking isn't the disaster that Mao was, but it is important to understand its current limits. In any reasonably developed economy, it functions largely within financial systems dominated by conventional banks. There are any number of commonplace transactions in any developed economy that are impossible in Islamic finance, or at least highly controversial. That's okay when other non Islamic banks are there to do those transactions, it's a much bigger problem if nobody can do them. Something as fundamental to modern banking as the Fed doesn't work very well under Islamic finance principles. Takaful, the standard Islamic insurance, won't work, since the Fed's guarantee is effectively backed by the taxpayer, and takaful relies on the fiction that those paying the insurance are giving money charitably. Futures trading is just about impossible, which would wreak havoc in particular industries where the future is necessary to hedge risk. (An orange juice manufacturer needs to trade in futures to hedge the risk of a hurricane, which will send the price of oranges skyrocketing). The same might be said of options which are highly controversial.
So to take the latter two examples, it is true that options and futures, once forbidden, also forbid credit default swaps and the types of esoteric derivatives issued by AIG that caused so much trouble. But it's also true as mentioned above that the elimination of derivatives entirely from the market would be cataclysmic to it. It's one thing for a single bank, or some subset of consumers calling themselves the Islamic finance market, not to engage in options. It is another for an entire economy not to do it. That is like amputating a nose that's cold, rather than turning up the AC.
The second problem with this theory of Islamic finance as savior is that there are any number of transactions that helped contribute to the economic crisis that are perfectly allowable under Islamic finance principles, even if the proponents of the industry now say they are not. For example, the subprime mortgage. Adjustable rates are readily achievable under the ijara, they are done all the time. They are pegged to LIBOR with a spread for the bank's profit, and there is no limit on what the bank can take as a spread. So it just increases its spread for subprime borrowers. It adjusts its spread all the time, what's different about this adjustment? There is really nothing doctrinal at all that would prevent the practice.
Now mechanically that's clearly true. Islamic financiers don't admit it openly, but cannot deny that adjustable rates, adjusted at higher rates for particular borrowers, can be done in Islamic finance through the ijara. The argument instead is that one should look beyond mechanics, because Islamic finance is about ethics! We don't make loans that increase social ills. We don't make loans in a manner that exploits the poor. Therefore this could never happen in an Islamic finance world.
There is some almost naive idealism in that notion one might argue, but more importantly, it is really little more than a spectacular exercise in hindsight. Was there anyone who well before the bubble burst, let's say 2004, thought that record homeownership levels was a social ill? Was there anyone who thought it was unethical to extend credit to the poor at slightly higher levels than the middle class? Everyone that was a good thing, we were letting everyone own their homes, government policy promoted it, and I don't remember Islamic banks anywhere objecting to this at all. I challenge anyone to come up with a statement, prior to 2006, where an Islamic bank declined to enter the subprime market on the grounds that it created social ills, or was exploitative to the poor, or something equivalent. In the words of the thoughtful and careful Islamic finance advocate Yusuf Talal DeLorenzo, Islamic finance "dodged a bullet" in the subprime crisis, it didn't consciously for doctrinal reasons avoid this market.
Securitization of the loans made in subprime and broader markets is also possible through the creation of SPV's whose sole asset is the payment obligations of the borrower/investors. Float the shares of that SPV in the market, and you have securitized the mortgages of homeowners. Again, that Islamic banks didn't do it does not mean they couldn't. Sure now everyone will tell you it's not acceptable because Islam doesn't exploit the poor or take unnecessary risks, but nobody was taking that game at the time, everyone at the time, until the end was near, thought this was all working fine.
This isn't meant as a diatribe against Islamic finance, only against simplistic panacea cures, religiously inspired or otherwise, of what ails us. The fact is Islamic finance in its current state couldn't carry an entire economy as multifaceted and sophisticated as ours, and in any event was capable of engaging in many (though not all) of the transactions that turned out to be so harmful in retrospect.
HAH
That's great, I never thought about Islamic Finance and the Economic Crisis like that before.
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You have broached a really important subject. Islamic banking needs to be more thoroughly studied by the West, as our financial realities become more and more entangled. I don't think that many even in the financial industries really understand how different the ideology behind Islamic banking is, not to mention its processes.
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you gave me a new way to look at Islamic Finance. Today it`s meet many limitations but there are many different factors that affect it so it is not so simple to change the current state
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Their (I mean Islam) success may be considered by the example of Dubai. But in general I believe that their economy is growing at the expense of oil.
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I am still unable to get it how an Islamic finance is different from a normal fianance. If any body is into business then he would like to earn profit and it doesn't matter if he follows Islamic or non islamic finance
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Now Islamic banking isn't the disaster that Mao was, but it is important to understand its current limits. In any reasonably developed economy, it functions largely within financial systems dominated by conventional banks..... Finance is useful to everyone....
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Whiteblack
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