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Professor Mahmood Faruqui is a London based visiting Professor and senior lawyer advising international professional firms, Regulators and financial institutions on Islamic Finance Strategic, Policy, Governance, and Transactional issues. He was Advisor/Board Member of Habib Bank, Faysal Bank, Alfaysal Investment Bank, Faisal Islamic Bank of Bahrain, Shamil Bank, DMI Group, Habib Bank AG Zurich. He was Chairman of Banks’ Presidents Committee for introducing Islamic Banking in Pakistan. His current clients include Bank of London and the Middle East where he is Senior Advisor. The article reflects his own personal views.

The causes1 of the banking crisis2, termed as the worst in the last 100 years3, and the Regulatory repairs initiatives4, have been eloquently covered by industry voices. My ‘Brief’ this morning is to provide an Islamic Finance perspective to possible models post Banking crises. I am conscious that despite its high rate of growth in the last 10 years, Islamic Finance represents only about 1% of global Finance and you may well see me as a small pond frog lecturing Oceanic Whales on the art of safe swimming.

Crisis causing Mischiefs and Remedies

I will identify only two Mischief Drivers of the Banking Crisis and suggest some possible remedial solutions offered by the theory of Islamic Finance.

Mischief #1

Financial economy vanquished real economy. Financialisation of the economy increasingly accelerated. In 1970s, the volume of foreign exchange trade was double the volume of international trade and investment flows. In 2009 this had grown to almost 50 times e.g. two cents of real trade were supporting the inverted Forex transaction pyramid of one dollar. The Efficient Market theory and trade multiplier benefits law were sacrosanct.

Remedy

(a) Islamic finance, neither permits interest, nor financial transactions without an identifiable linked underlying trade transaction. The rationale is that the purpose of financial economy is to serve the real economy, not the other way round. Wall Street exists to serve, and not to unbridled rule over the High Street. Interest spurs Financialisation. The return to the financier is fixed ex ante independent of the success or failure of the project to be financed. The financier is less interested in adding value to the real economy, and more in extracting rent of money which in itself is sterile and should not be treated as commodity.

(b) Trade is encouraged in Islamic finance as it facilitates market liquidity and is beneficial to the real economy. But avarice inspired excessive trade volumes are not permitted. This rule negates the trade multiplier benefit rule. Recent evidence has shown that trade was growing faster in the 70’s, when FX transactions volumes were twice trade and Investment flows, than in 2009 when they had ballooned from 2 to 50 times. Thus, beyond the optimal point, larger trade volumes yield negative returns.

(c) Trading in debt instruments unlinked to underlying trade is not permitted by a section of Sharia’a scholars. This rule influences a pari passu growth between financial and real economy. Financial instruments are quicker to replicate than manufacturing tangible goods. Technology can easily initiate, close and replicate complex 100 million dollar deals by mere clicks of the key board. This swells trade volumes, fans traders herd instinct, increases volatility and fudges the measurement of value at risk.

Mischief #2

Derivatives and Hedge Funds have opacity, complexity and therefore high uncertainty facilitating ‘miss-selling’, particularly when trade opportunity slots are transient. As the margins are very fine, to earn relatively small amount of profit very large deals are to be done very quickly with exorbitant values at risk.

Remedy

(a) Islamic Finance permits derivatives for risk management but not for gambling-like speculative bets. The Rule avoiding Gharar (eschew excessive uncertainty and unquantifiable risk) promotes due diligence and transparency, and reduces embedded surprises or inherent uncertainty. A transaction imbued with excessive uncertainty, is actuated by the taint of greed or fear and clouds risk assessment, a common phenomenon in the Banking Crisis.

(b) Even in normal conditions, complex products are less liquid than simple products. In the market breakdown of trust, derivative products were hard to shift because of suspicion as to which bank had what quantum of toxic assets parked in which SIV. This uncertainty congealed individual banks’ funding liquidity and temporarily froze market liquidity - the classic Minsky moment: the investment banker orders “sell” and the broker replies “to whom?”

(c) Islamic finance general Rule prescribes that the seller must own and possess, actually or constructively, the subject of sale. This Rule acts as an effective antibiotic to: short selling, market manipulation and the opaque and unregulated culture of hedge fund-like vehicles.

Resolving Islamic Finance Strategic Issues

Islamic Finance needs to recognize its own issues and sincerely seek wisdom and their resolution road map from its big brothers of conventional finance. The unprecedented banking crisis is a last chance saloon situation. Because the repair and radical overhaul has to be all encompassing, even the small fry Islamic finance is in the same boat with Big Whigs International Banks who do realize that an unnoticed hole in Islamic finance may precariously wobble the boat. This real and present danger will force both Conventional and Islamic Finance to move out of their cloistered corners to evolve workable solutions to the specificities of Islamic Finance and to genuinely collaborate in their sustained implementation. To assist this process, I flag some strategic issues, rather than raising technicalities of Accounting, fair valuation, Capital adequacy and compliance concerns.

Issue #1

Islamic Finance is a young industry. The adolescent energies of some Islamic finance players need to be better directed, cooled and nurtured. They must face the reality that, despite its high growth rate, Islamic Finance has insufficient market depth. The business model is ‘Universal Bank’. Hence small and new banks, tend to target the market of older & bigger banks, which fragments the market rather than add new segments. The small size of capital in absolute terms (even if regulatory capital ratio is not breached) is not enough to allocate high resources for investment in technology and human capital. Basel II & reform pressures will lead Regulators to nudge owners and controllers of smaller Islamic banks towards mergers.

Issue #2

Islamic Finance does not have accessible adequate size money market and robust liquidity management tools. Even Sukuk have only marginal liquid secondary market. Islamic products do not have a large portfolio across a wide range of markets. IIFM, AAOIFI and IFSB have developed templates and standards for liquidity management. However, as Islamic Finance enters the main stream it needs industry acceptable tools and stable systems. The recent Bursa Suq Al-Sila’ established in Malaysia is a right step forward.

Issue #3

Legal and Regulatory Framework, particularly in the GCC has to be girdled. Land & property rights & their effective registration, Insolvency, Enforcement of securities, harmonization of Regulatory and Sharia’a Standards and Home-Host Regulators responsibilities in a crisis; are some of the issues. Their satisfactory resolution will assure reasonable certainty to local and foreign stakeholders in Islamic finance transactions.

Issue #4

Corporate Governance, in a comprehensive sense, not just constituting Board Committees and appointing ‘independent’ Non Executive Directors. It is difficult even in the US where time and again a domineering chief executives have flagarantly binned Governance Rule Book- without appropriate action by the Regulators and Reporting Accountants.

Issue#5

Moral Hazard: is common to both conventional and Islamic Societies. The ultimate sanction against greed and corrupting power is a belief in moral accountability, whether rooted in Maqasid-e-Sharia’a, or other divine faith or ethical foundations of a secular society. If Islamic finance can demonstrate in practice that its system of moral values and social distributive justice, does work, then it will gain greater credibility and consequential benefits to the entire financial universe.

The Way Forward

Islamic Financial Institutions, directly and via the Islamic Finance Stability Board under the aegis of the IDB-IFSB must allocate resources for timely and effective engagement5 with the office and committees of the new Global Financial Stability Board whose work will be assisted by relevant international and national agencies, trade and professional associations. If they do not, the case of Islamic Finance will go by default - noisy meetings and conferences, after the event, will sadly generate more heat than light.

Footnotes

1- There are reams of reports analyzing the causes, some of which have been articulated earlier in the seminar. There is agreement that the causes are embedded in multi faceted complex interlinked cross sect oral relationships. In the blame game all come out diminished: Governments, Regulators, Market players, professional advisers like Accountants and Lawyers, Rating Agencies and investors.

2- Since 1982, there have been at least 10 major financial crises. 1989: Collapse of the Japanese asset price bubble; 1992: Speculative attacks on European Exchange Rate Mechanism currencies; 1994: Speculative attack and default of Mexican debt; 1997: Devaluations and banking crises across Asia; 1998: Russian financial crisis, devaluation of the rubble and default on debt; 2000: Dot.com crash; 2001: Breakdown of Argentine banking system; 2008: disastrous tsunami of US subprime assets. But this Crisis challenged the triumphal wisdom of, amongst others, the efficient market theory, creaking the Regulatory Architecture of several jurisdictions, and brought the financial and the real economy on the brink of Armageddon.

3- Bear Stern, Lehman, Citi Group, UBS, Merrill Lynch, Washington Mutual, AIG, Northern Rock, ABN Amro, Fortis, RBS either wiped out or, but for Governmental action would have gone under. The tax payer will, over many years, have to pay the price and bear the burden of their resuscitation.

4- Financial Stability Board is expected to make workable recommendations, not with a vengeance to punish, but to repair the damage and build sustainable barriers against repetition of Financial and Banking crises. The Volker Rule, announced by president Obama on the eve of Davos 2010, the transaction tax, the Insurance levy, are all ideas to inspire not theoretical but practical solutions for recovery and sustainable stability of the system.

5- Particularly where specificities of Islamic Finance need to be properly appreciated in Macro and Prudential Regulation; Accounting and Valuation standards, standards for Rating agencies, capacity building for Sharia’a standards and their harmonization.