A financial tsunami is gathering momentum across the globe. The effects have devastated companies, leaving them unprofitable or bankrupt. Businesses in just about every sector of the economy have been affected. Millions have been laid off. Consumers, due to job loss, reduced earnings or fear of the worst, have tightened their belts and spending has slowed or contracted. World leaders and the governments they represent aggressively work to fix things or at least take steps to ensure that they do not get worse. At this time of turmoil, a glimmer of hope shines through. A beacon coming, ironically, from within the banking sector which is greatly responsible for the trouble the world finds itself faced with today. Islamic banking.
Fascinating Islamic Banking
Islamic financial services and products are particularly fascinating to us today for a number of reasons. Dwarfed by their conventional counterparts and until recently only confined to Muslim countries, they have come under the spotlight and have attracted the interest of banks, industry sectors and populations, the world over. Hardly a day goes by without some new news. This is primarily because they appear to be immune to the effects of the current global financial crisis. In fact they seem to be growing and among banks, it is not just the Islamic Banks that have benefited. Conventional banks have reported good results coming from their Islamic products, sufficient to stabilise those banks’ positions, despite the negative economic effects on their conventional banking products. On top of that are Malaysia’s ambitions to become a regional if not global Islamic financial hub and the fact that Malaysia is the largest Islamic bond (sukuk) market in the world. In a toxic global economy, Islamic banking and financial instruments stand out like a pristine, healthy and growing oasis full of life, amid a devastated, nuked landscape. While the toppling of the U. S. housing market in 2007 may have started the ball rolling, it was the vulnerability of the traditional financial system that led to its eventual collapse in 2008. Beginning notably with Lehmann Brothers and then spreading to other major institutions. Governments have had to step in and bail out the huge financial giants that play such a major role in economies the world over. What exactly is this vulnerability and why does the Islamic financial sector appear to be largely unaffected by it? To understand this better, we need to examine the role of banks in keeping economies going, how the collapse of the financial system came about and the key differences between Islamic and conventional banking that have insulated the former from the effects that conventional banks are now experiencing.
Banks and the economy: providing capital for growth
Banks originally served as safe houses for traders goods. Security was the primary benefit offered, driven by trust in the institution offering the service. Over time banks added lending to their original service of keeping things safe and secure. Because of this lending of additional funds, the exchanges of goods and services became larger, the rate of exchange of goods and services increased and economies grew.
How banks generate income for themselves and their stockholders
Today, three of the main ways in which Banks earn money are: 1. they make money from the difference between the interest rate they pay for deposits and the interest rate they receive on the loans they make; 2. they earn interest or other income on the securities they hold or buy; and 3. they earn fees from customer services.
Lending to those who could not repay
As its name (subprime) suggests, it involves financial institutions lending to those who do not meet prime underwriting guidelines and are more likely not to pay the money back. Subprime lending began in America around 1993 when financial institutions realised there was a demand in the marketplace for loans to high-risk borrowers with less than perfect credit. To exploit this market of doubtful or even bad creditors, lenders had to assume the risks associated with lending to people with poor credit ratings or limited credit histories. To mitigate these risks lenders charged higher interest rates, higher late fees, over-the-limit, annual or upfront fees for subprime credit card holders and such. Borrowers took on difficult-to-repay mortgages believing they could refinance quickly at more favourable terms driven largely by easy initial terms coupled with the trend of rising housing prices.
Bad mortgage repayments in America
In early 2005 U. S. housing prices reached their peak. Then interest rates started to rise. In 2006 housing inventories ballooned. House prices fell, sharply. Refinancing became more difficult from 2006 through to 2007. Defaults and foreclosure activity increased dramatically, accelerating in late 2006. Easy initial terms expired. Home prices failed to go up and adjustable-rate mortgage (ARM) interest rates reset higher. America’s sub-prime mortgage industry collapsed in March 2007. Subprime adjustable rate mortgage represented forty-three percent of the foreclosures started.
The credit crunch or the financial crisis of 2007 to 2009
The credit crunch began in July 2007 with the loss of confidence by investors in the value of securitised mortgages in the United States and the resulting liquidity crisis that prompted substantial injections of capital into financial markets by the United States Federal Reserve, Bank of England and the European Central Bank. An emergency 28-day loan to keep Bear Stearns afloat was not enough. Two days later on March 16th 2008 it sold out to JP Morgan Chase in a stock swap that saw Bear’s stock, once traded at $172 a share as late as January 2007, and $93 a share as late as February 2008, valued at $2 or less than 10 percent of Bear Stearns’ market value. In September, the crisis deepened. Stock markets world-wide crashed and entered a period of high volatility. A great number of banks, mortgage lenders and insurance companies failed. On September 14, 2008, Merrill Lynch was sold to the Bank of America. On September 15th Lehman Brothers filed for bankruptcy protection, China cut its interest rate for the first time since 2002, Indonesia reduced its overnight repo rate (OPR) by two percentage points to 10.25 percent, the Reserve Bank of Australia injected nearly $1.5 billion into the banking system, nearly three times as much as the market’s estimated requirement and the Reserve Bank of India added almost $1.32 billion, through a refinancing operation. On September 22nd Morgan Stanley and Goldman Sachs, announced their conversion or reversion to traditional bank holding companies. On September 16th Taiwan’s central bank said it would cut its required reserve ratios for the first time in eight years and promptly added $3.59 billion into the foreign-currency interbank market the same day. The following day on September 17th the Bank of Japan injected $29.3 billion into the financial system and the Reserve Bank of Australia added $3.45 billion. In mid October 2008 Singapore’s ministry of trade and industry announced the island state had fallen into a technical recession. On November 9th China announced its RMB¥ 4 trillion ($586 billion) 2008 Chinese economic stimulus plan. On December 1st, the National Bureau of Economic Research officially declared that the U.S. economy had entered recession in December 2007, a full year earlier. Australia’s economy shrank 0.5 percent in the last quarter of 2008.
The flaws and vulnerability of the global financial system
Rudi Prenzlin, the chief financial officer of the Hong Kong Islamic Index, says two main reasons behind the global credit crunch are firstly the immense increase in the availability and active trading of derivatives and secondly the lack of liquidity. Prenzlin says of derivatives that in many cases, the paper held was highly leveraged and unlikely to be secured by physical assets directly but by more paper. Because of this, banks increasingly held securities that were far removed from their core activities which in turn led to a corresponding increase in risk. Prenzlin notes that up until mid September 2008, banks were quite content to lend to each other in the global interbank market. This stopped almost overnight with the bankruptcy of New York-based Lehman Brothers. An important reason why Lehman Brothers went under was because of its overexposure to some of the complex derivative instruments. International banks found they could not trust each other’s balance sheets any more. This dried up the liquidity in the interbank market and brought the global economy to a grinding halt. Leaders of the Group of 20 (G-20) in their “Declaration of the Summit on Financial Markets and the World Economy,” of November 15th, 2008, note, “During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovations or take into account the systemic ramifications of domestic regulatory actions.” Normally, the lender (or bank) bears the credit risk on the mortgages they issue to the borrower. In our case, borrowers were subprime borrowers or people who are doubtful or bad creditors. When things turned sour, it should have been those subprime lender banks who would have suffered directly from the defaults on the mortgages they issued but that’s not what happened. Through a financial system evolution spanning the last sixty years, it became possible for those primary lenders to “sell the right to receive payments” on the mortgages they issue through a process called securitisation, resulting in securities called mortgage backed securities (MBS) and collateralised debt obligations (CDO). Through the issuance of MBSs and CDOs, the risk that would have otherwise been assumed directly by subprime lender banks were spread wider and farther than they needed to go.
A brief history of the Islamic financial sector in Malaysia
Modern global Islamic banking can be traced back to the commencement of business of the Islamic Development Bank ( Jeddah, Saudi Arabia) in 1975, founded by the first conference of Finance Ministers of the Organisation of the Islamic Conference (1973). Alongside Saudi Arabia, Indonesia, the UAE and Pakistan, Malaysia is seen as being in the forefront of Islamic finance and banking. In September 1963 Perbadanan Wang Simpanan Bakal-Bakal Haji (PWSBH) was set up as an institution for Muslims to save for their pilgrimage to Mecca. In 1969, PWSBH merged with Pejabat Urusan Haji to form Lembaga Urusan dan Tabung Haji, known today as Lembaga Tabung Haji. On April 7th, 1983, the Islamic Banking Act (IBA), enabling Bank Negara Malaysia (BNM) to supervise and regulate Islamic banks, came into effect. On July 1st, 1983 Bank Islam Malaysia Berhad, our first Islamic bank, began business. In 1984 the Takaful Act was enacted. On November 29th, 1984, Malaysia’s first takaful company, Takaful Malaysia, was incorporated. It commenced operations on July 22nd, 1985 prior to its official launching (August 2nd, 1985). On March 4th, 1993 BNM introduced the ‘Skim Perbankan Tanpa Faedah’ (Interest-free Banking Scheme), later on known as the “Skim Perbankan Islam (SPI or Islamic Banking Scheme). Commercial banks, merchant banks and finance companies were then allowed to offer Islamic banking products and services under the Islamic Banking Scheme (IBS) which required them to separate the funds and activities related to Islamic banking from those of their conventional banking business to ensure that there would be no inter-mingling of funds. In January 1994, an Islamic inter-bank money market (IIMM) was introduced to facilitate the interbank trading of Islamic financial instruments and Mudharabah interbank investments. On May 1st 1996, BNM’s National Shariah Advisory Council on Islamic Banking and Takaful was established to advise the central bank on the syariah aspects of the operations, and products and services of commercial banks, merchant banks and finance companies offering Islamic banking products and services under the (IBS). In 1996 Malaysia’s Securities Commission (SC) also established its own National Syariah Advisory Council for the Islamic capital market. In June 2005, Dow Jones and Company (New York) and RHB Securities jointly launched the “Islamic Malaysia Index” — a collection of 45 stocks representing Malaysian companies that comply with a variety of Syariah-based criteria. In 2007 the SC teamed up with BNM to offer a framework to allow multilateral financial institutions, sovereigns and quasi-sovereigns as well as local and foreign multinational corporations to issue non-ringgit sukuks.
How the Islamic financial sector in Malaysia is doing
In the last 15 years, the Islamic finance sector here has been registering a compound annual growth rate (CAGR) of 28 percent. According to a report in Arab News (March 4th, 2009) Malaysia is by far the most holistic and systemically-developed Islamic finance market in the world. Malaysia already has the third biggest Islamic banking market in the world after Iran and Saudi Arabia. As at the end of 2006, total financing extended by the Islamic banking sector stood at RM78.5bil. Last year Malaysia’s Islamic banking system kept on growing. Last year assets, deposits and financing registered annual increases of 23 percent, 26.9 percent and 22.5 percent respectively. Total Islamic banking assets to date stand at RM192.8 billion, deposits RM154.6 billion and financing RM104.6 billion. Risk rated capital ratio stands at 15.2 percent and surplus capital was RM8.0 billion as at end of December
last year. By the end of November last year, our Islamic banking assets made up 14.3 percent of total assets in the banking sector. A month later that figure improved to 16.7 percent, a long way away from the 6.9 percent it represented in 2000. BNM expects the Islamic banking industry to grow to 20 percent of the overall banking and insurance market by 2010. The growth rate of takaful averaged 23 percent per annum in the last five years, family and general takaful making up 11 percent and 7 percent, respectively, of the overall insurance sector. In 2006, the total value of Malaysian sukuk issues was RM42 billion ($12 billion), which accounted for over half of all local bonds issued that year and making up 67 percent of the world’s sukuk. As at the end of 2007, RM213 billion of the world’s outstanding sukuk or Islamic bonds, originated from Malaysia. That’s 68.9 percent of the global outstanding sukuk for that period. US$8.8 billion (RM32.12 billion) worth of sukuk was issued worldwide by October 2008 with US$5.7 billion issued in Malaysia coming from Malaysia. Malaysia is the world’s largest sukuk market, making up over 37 percent of the world’s sukuk issuances in 2008. This coming June Bursa Malaysia will launch its Commodity Murabaha House system, enabling banks to access a global murabaha commodity market worth over US$100 billion.
Could Islamic finance have avoided the U. S. subprime crisis and the resulting global financial and economic crisis?
Some people argue that it could have. In April 2008 a report in Arab News quoted Mohammed Mahmud Awan, a scholar at Malaysia-based International Center for Education in Islamic Finance (INCEIF), who said the mortgage crisis was “unthinkable” under Islamic principles regarding debt. Speaking at a globalisation conference at the University of Bahrain, he said, “A crisis such as the mortgage one, would technically be unthinkable in the Islamic capital markets sector because it would be against Syariah principles to sell a debt against a debt.” The subprime mortgage crisis has seen trillions of dollars traded without the backing of assets, he said, adding, “if such transactions followed the Islamic finance model it would have easily prevented the current economic crisis.” Professor Rodney Wilson, Director of Postgraduate Studies, School of Government and International Affairs of Durham University believes the problem boils down to exploitation which, he says, is avoided due to the teachings of Islam, incorporated into Islamic banking principles, which promote justice in financial contracts. Islamic housing finance, he says, involves risk sharing between the bank and the client, rather than transferring all the risk to the latter. Ali Khan, Professor of Law at Washburn University in Topeka, Kansas, puts forward a strong yet simple argument in favour of Islamic financing. Among the things he talked about at the 8th Harvard University Forum on Islamic Finance held in April 2008 were two fundamental principles of Islamic financing, maysir (speculative risk) and riba (no risk). Because the Quran prohibits al-Maysir or speculative risk, warning the faithful to avoid games of chance in which the probability of loss is much higher than the probability of gain (2:219) he points out that syariah-compliant investments, therefore, avoid speculative risk, including interest rate options, naked equity options, futures, derivative and numerous leveraged products purportedly designed to hedge investments, products that tend to attract speculators hoping to make easy money quickly. Commenting on the prohibition of riba where interest on loans is strictly prohibited he notes that contrary to Islamic principles, lending in general and subprime lending in particular was predestined to harm American financial markets for two distinct reasons: (1) debt braced with high interest was being extended to persons who simply could not afford to pay back loans such as usury and (2) real estate mortgage was no longer a prudent investment decision, since numerous investors were trading in real estate with inflated prices. Putting it simply, he stated that investment bankers and other geniuses on Wall Street were securitising mortgage debts, turning them into interest-bearing securities which then began to fail when their underlying assets were foreclosed or deflated making the debt deadly and bankrupting its holders. According to the Islamic code of religious law it is forbidden to trade in pork, pornography or gambling. Michael Saleh Gassner, Managing Director of Michael Gassner Consultancy Ltd., London, an expert on the Islamic banking system explains that the last ban does not only apply to doing business with casinos. It also includes gambling-like behaviour on the international finance markets, where conventional rules of economics are abandoned and where “financial products” that are not even understood by many of those who are dealing in them suddenly appeared. Pointing to this major problem he says, “The economy lacks a strong ethical orientation.”
That which is not forbidden, is allowed
Abdulazeem Abozaid, member of the syariah department in UAE-based Emirates Islamic Bank, told ArabianBusiness.com that banks only aimed to maximise profits. “They know that there is no real difference between conventional banking and Islamic finance,” he said. He is right. And wrong. Fundamental to the institution of banking and indeed to the entire financial system, is trust, born out of managing risk responsibly and ethically. So what’s the real issue here, when we look back on all of this? What’s really so special about Islamic banking and the instruments it employs? With Islamic banking you have a system predicated on religious principles dictating the prudence, justice and fairness which ought to be at the heart of any ethical business anyway. In the Merchant of Venice, Shylock holds Antonio to his contractual promise, repayment of a 3,000 ducat loan with interest or a pound of flesh as penalty. The contract, of course makes no mention of the shedding of blood, an important point noted by Antonio’s lawyer. Business is connected to wealth but as many win-win advocates hold to, not at the mortal expense of our fellow man. People should not be allowed to break the rules unless they truly understand them and know how to follow them. The rules I am talking about here are the rules of society. The rules of being in a common community. The rules taught to us, as children, as members of our
own families. Do we really need Islamic banking? In a world where every banker is naturally responsible, ethical and fair – and I use the term banker loosely to include decision-makers and practitioners throughout the financial system – then perhaps there would be no difference at all between conventional banking and Islamic finance. However, in a world such as the one we find ourselves living, where shareholders care more for quarterly dividends pushing operating managers to do whatever it takes to deliver the numbers and where morality takes a back seat, then perhaps we do need a system where everything is strictly laid down, limiting the freedoms available for people to work with. The freedom of self regulation is one that comes with experience, maturity and personal accountability. If we agree that the search for wealth should not be divorced from the rules of society, then either the lawmakers need to take another look at the rules governing the activities of financial institutions or banks need to grow up. And until that happens, we have Islamic financing to fall back on.