Imagine a world without a financial crisis. No moral hazard, so brokers won't sell mortgages without carrying out appropriate credit checks. Imagine banks not deliberately selling complex derivatives, knowing that they will be worthless. No short-selling speculation, so companies tinkering on the edge won't be pushed over. Imagine a world with Islamic finance.
"The practices that caused the financial crisis would not have passed muster with sharia boards – committees of religiously inspired legal scholars who conduct a religious audit of a bank's activities. Neither the securitisation of sub-prime loans nor credit-default swaps are acceptable in Islamic finance," says Ibrahim Warde, author of Islamic Finance in the Global Economy and a professor at Tufts University.
"Similarly, negative Islamic attitudes towards short-selling were vindicated by the role short-selling played in many aspects of the crisis and subsequent limits placed on short-selling in London and New York. Some old-fashioned principles such as the distrust of excessive leverage and of open-ended innovation proved well founded. As for the systematic vetting of new products by sharia advisers, it could be looked at as a system of checks and balances, a useful corrective to the groupthink that had overtaken conventional finance."
Islamic finance extends beyond its well-known characteristics: interest-free banking and the prohibition of investment in items or activities deemed un-Islamic, such as prostitution, gambling, pornography, pig farming and alcohol. In contrast to conventional loans, Islamic bank loans are confined to financing the purchase of physical assets, to which they have recourse in case of default.
Creditors and debtors alike must share business risk, Islamic finance prohibits speculation (such as was practised by AIG with credit default swaps) and similarly prohibits trades that are considered to have excessive risk due to uncertainty, such as naked short-selling, where there is uncertainty involved in the future delivery of the underlying asset. Arguably, Islamic finance also prohibits speculation that property prices will forever continue to rise, as well as bailouts, since they are only loss and not profit sharing for governments. (The UAE may disagree.)
Islamic banks largely mimic conventional commercial banks through profit- and loss-sharing contracts. The bank will buy goods on behalf of the borrower and then sell it on a deferred basis at a markup. The profit-sharing principle prevents Islamic banks from outsourcing debt origination to brokers who would have no incentive to perform thorough due diligence on prospective debtors.
Additionally, according to Warde, Islamic mortgages are attractive to customers because they are vetted by sharia advisers, and predatory practices, which are common practice with traditional mortgages, are forbidden. If customers are unable to keep up with their payments, banks are encouraged to show forbearance and are allowed to count such losses as part of their mandatory annual zakat payment, the Islamic equivalent of a charitable tax.
"This has a cost, but if you weigh the social benefit, it's a worthwhile cost. The obligation can be handled in a prudential way. At the time of the Asian crisis, the Malaysian banks reasoned that they would have collapsed had they shown forbearance to all of their debtors. The socially desirable thing should not come at the expense of a bank's ability to survive as a business," says Warde.
Islamic finance has its limitations. It does not wave a magic wand to do away with inherent business risk, nor does it have a way of dictating that investors avoid correlated and fat-tail risks that lead to bubbles prone to bursting.
Auditing, too, remains a problem. Though standards are set by external bodies – the Islamic Financial Services Board and the Accounting and Auditing Organisation for Islamic Financial Institutions – it is the bank-employed sharia advisers who decide whether a financial institution is compliant with those standards or not. This maintains the inherent conflict of interest present in the relationship between traditional financial institutions and their auditors, such has been seen with KPMG and New Century Finance, a US sub-prime lender.
With Islam being the diverse religion that it is, there is some scope for hiring scholars who will interpret the standards liberally. Western banks, with their more liberal advisers, are increasingly responsible for innovations in Islamic finance. But there are no checks to stop banks from paying for fatwas. Islamic finance has, like its non-Islamic counterpart, yet to devise a system whereby auditors are paid for by an external body.
Would Islamic finance have allowed the world to realise the technologies that it has? Perhaps not. One spinal-repair researcher at University College London, Jacqueline Kueh, recalls how more research was funded during the boom times. Secondly, the elimination of interest that most sharia boards require would have created a highly inefficient debt market. Here, businesses would be at the mercy of Islamic bankers for the purchase of every asset they required as the banks contrived to stick to the form of their interpretation of Islamic requirements. Greater inefficiency in financing means slower growth.
Islamic finance is not necessarily an end in itself, but it does serve to remind of the need for humane banking, the elimination of moral hazard and the reassessment of assumptions that speculators and derivatives add more value than they destroy.
7th January, 2011