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.
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.
(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.
(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.
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.
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.