Islamic Finance: A Way Out Of Financial Crisis

This informal CPD article on Islamic Finance: A Way Out Of Financial Crisis was provided by N M Shafiul Islam Chowdhury ACCA, Programme Director at Academy of Business Professionals (ABP), one of the leading and fastest-growing training and consultancy institutes in Bangladesh.

Introduction

Financial crisis is a broad issue; fundamentally, it refers to the distress in financial markets which leads to disruption in businesses as well as families. The impact of financial crisis in a big picture can go beyond the national boundary, which we have seen during the financial crisis of 2008.

As a consequence of financial crisis, asset value of financial institutions may fall drastically, investors may lose their investments significantly, value of stocks may deteriorate, number of defaulters increase, remarkable commodity price hike and overall inflation could increase in the economy.

Critical analysis of the financial crisis in 2008 reflects some factors which stimulate the catastrophe during that time and those derive from a conventional financial system. Still, there is no obvious elucidation to alleviate these factors for establishing a sustainable financial system. On the contrary, envisaging these factors from an Islamic finance perspective shows light at the end of the tunnel.

Objective of the Article

The secular view anticipates that the financial crisis occurred in 2008 due to uncontrolled lending practice, unethical competition between financial institutions, high liquidity, lack of transparency, use of derivatives and other financial engineering model. These factors lead the business environment into a risky position. Flexibility of supervisory body was also a major reason and due to this, institutions became involved in ambiguous dealings without considering the risk properly.

During that financial crisis, it was apparent that the institutions under Islamic Financial system have not been affected to a great extent. Though Islamic Finance is evolving gradually over the years this indicates that Islamic Finance could be the resilient system for ensuring the sustainability of the financial system as well as the economy. There are different products complying shariah which might be a good alternative of conventional banking. Though, market participants think that these are not sufficient enough against conventional banking products.

Different research and development work is ongoing in the field of Islamic Finance to find out more shariah compliant product as well as programmes are undertaken for raising awareness in the market. So, this is also obvious that Islamic Finance is facing challenges in implementation stage compared to a conventional system.

Secular Economic System vs. Islamic Economic System

Financial solvency is desired by every human being. To ensure financial solvency or a standard of human living, sustainable financial system or economic growth is essential. According to the view of secular economics, there is shortage of resources and economy is performing by best utilization of available resources, ensuring supply and demand matching concept. Though Islamic finance principles disagree with this view, secular economics view also reflects the significance of proper wealth distribution. Otherwise, some people may be fully deprived of resources and some may get enormous beyond their need. The idea of globalization also demonstrated futile during the financial crisis of 2008. So the financial catastrophe drives us to think alternative of conventional financial system (AL MANASEER, 2017).

On the contrary, Islamic economic system believes that Allah is the owner of all property in the world and humans are sent to the earth to perform his responsibilities as per guideline provided by Allah, encourage good deeds and discourage bad deeds (al-Amr bil Maruf wa al-Nahy anil Munkar). Source of sharia is the Quran (word of Allah sent through Jibreel to Prophet Muhammad (SM), Sunnah (Authentic hadith of Prophet Muhammad (SM), Ijma (consensus of the Muslim scholars) and Qiyas (process of deductive analogy).

As per sharia, Allah provides all the resources required for a living being who sent to the earth. So there is no shortage of resources, the thing is inappropriate distribution of wealth which leads some people to poverty and some to the extreme wealthy level (Alqahtani and G. Mayes, 2017).

Secular economic system focuses on individual well being and maximization of profit or return without considering others interest whereas Islamic economic system motivates individuals to fulfill his/her duty as per sharia guideline, which covers prohibition of several factors (discussed below), accountability and maintaining brotherhood. 

As per sharia, universal maqasid are essentials, necessities and luxuries. Once an individual achieves essential part of his/her life then he/she moves to necessity and  towards luxury. Sharia makes it mandatory that after a certain level of wealth gain an individual has to donate or charity 2.5% of the wealth to poor and deprived people of society, which is called Zakat. In addition to that, there are some other models e.g. Sadaqah, Jizyah, Waqf in Islamic economic system which ensure proper wealth distribution among the society (AL MANASEER, 2017).

Islamic Legal Maxims

First, matters in Islamic finance e.g. contract are determined based on intentions not only word and form. The substance of the transaction, contract or deal is considered as underlying subject matter.

Second, as per sharia hardship begets facility in all circumstances. For example, when a thing become essential (e.g. for life saving) it will be permissible under that condition. Once the essential is fulfilled the rule of prohibition return (Alrifai, 2015).

Third, according to sharia maxim, harm must be eliminated. Based on this maxim Islamic finance never invest in haram (prohibited) commodities/services e.g. pork, alcohol, pornography, because these things have a great negative impact on society as well as in personal life.

Fourth, sharia maxim ensures that certainty is not overruled by doubt. Under this concept it is assumed that a human being is free from liability by birth. Additionally, a matter should be considered at its original form until any discrepancy is proven.

Fifth, custom can be used as a basis for judgment. This maxim means that any matter which is established by custom can be considered as constructive contract. For example, any common business practice recognized by the merchants will be considered as contractual obligation (Alrifai, 2015).

Above maxims of Islamic finance ensures the legitimacy and rationality of a contract, transaction or deal under any business environment.

Major Prohibition in Islamic Finance

According to sharia, Islamic Finance prohibits the following matters in business: 

• Riba (Interest)
• Gharar (Ambiguity)
• Maysir (Gambling)
• Tala’ub (Manipulation)
• Ihtikar (Hoarding)
• Najs (Artificial Price Hiking)
• Tadlis (Deception) 

Most of the time commercial contracts or deals become unsuccessful due to these above factors, which are strictly prohibited in Islamic finance. So, complying with Islamic finance result a transparent and enduring business relationship, this is the main factor of establishing a sustainable financial system (Alrifai, 2015).

Major Reasons and Consequences of Financial Crisis

The first and key reason behind financial crisis is leverage. In conventional system people used to borrow fund to finance investment or to purchase asset against providing a security or mortgage. In return financial institutions charge interest on the borrowed amount. There is no economic activity occurred during the transactions and it is like exchanging money against money. In long run, clients fall into the vicious cycle of debt and leads to bankruptcy. High leverage also creates bubble in economy through illusory increase of asset price (Alqahtani and G. Mayes, 2017).

Second reason refers to the asset-liability mismatch of financial institutions. Asset-liability mismatch arise when a financial institution backup its asset base through short term source of fund. This ultimately leads to bank run which means when depositors will ask for their money financial institution will fail to provide due to lending those funds with longer maturity period. This creates lack of confidence to the fund provider and ultimately can lead to liquidity crisis (Hassan, 2018).

Third reason behind the financial crisis involves the regulatory failure. Regulatory body has failed to prove their foresight to deal with the financial crisis. There are improper regulatory controls, in some cases this was insufficient and in some cases this was excessive. For example, until collapse of some major banks people couldn’t know the real financial picture of those institutions. This is due to the lax of regulatory control which leads to lack of transparency. At the same time financial institutions regularly engaged with financial dealings e.g. derivatives without having adequate asset backup. So, financial intuitions usually take more risks and ultimately institutions failed to meet their contractual obligations. On the contrary, excessive regulations are in place which deteriorated the overall financial crisis e.g. regulatory body requires increasing the bank capital in line with risk which attributed to significant decrease in lending during shortage of capital (Hassan, 2018).

Fourthly the unethical practice like fraud, greed and corruption triggered the financial crisis. For showing performance and making more profit, financial institutions entice depositors and clients through manipulating information and create more financial assets whereas real economic activity occurred. Institutions undertake investments without proper risk screening even without considering the risk impact and showing lack of transparency in reporting. As a result the market experience crisis of subprime mortgage whereas people are unaware regarding the real scenario (Hassan, 2018).

Fifth factor is the systematic risk arises from the failure of particular financial institutions which afterward spread out over other financial institutions. This is not remains under the national boundary rather it spreads over the other countries following the US market. This contagion happens due to incapability of institutions to meet the short term demand of clients which ultimately create lack of confidence into the client base and resulted financial market instability.

Sixth cause comes to pass due to money supply, a macroeconomic factor. Uncontrolled money supply without any real commodity (gold) backup leads to higher inflation in economy. As a result, commodity price surge deteriorate the financial crisis further (Hassan, 2018).

Revisit Financial Crisis Issues under Islamic Finance Principle

One of the key Islamic finance principles is, Riba is prohibited in all circumstances. Riba refers to the increase of money against money, which is above the principal amount. Against riba making profit is halal (accepted) in Islamic finance. As mentioned above, when a conventional loan has been offered there is no real economic activity occurred based on the transaction. But to make profit instead of interest, institutions ought to engage with business contract and to complete the contract economic activity need to be performed through exchange of commodity or real investment (Alqahtani and G. Mayes, 2017).

Profit and loss sharing is another major principle of Islamic finance. According to Islamic finance the principle borrower and investor both have to share profit and loss as a per pre agreed ratio and this should be motioned clearly in the contract (e.g. Musharakah). This way risk profile has been shared between the participators. Moreover, entrepreneurship has been encouraged in the economy as well as benefit spread over the society through real economic activity (AL MANASEER, 2017).

Islamic finance principle prohibits ambiguity and uncertainty. This principle refers to clear and transparent subject matter, terms and conditions in a contract or report. So that contracting parties will not be mislead as well as stakeholders will get clear view on a reporting subject. In addition to that, speculation is not allowed in Islamic finance. So deal with financial instruments without having asset backup and clear guidelines is prohibited under Islamic financial system. It is obvious that application of this principal can protect financial assets as well as rights of market participants.

Islamic finance only considers investments in halal sectors. There is no boundary of sectors for investment in conventional system. But Islamic finance outlaw investments in haram (prohibited) sectors e.g. pork, alcohol, pornography). The underlying maxim behind this is ‘harm must be removed’. As per sharia there is no social welfare in haram service/commodity. This is the beauty of the Islamic economic system, which not only ensures the financial sustainability as well as the wellbeing of the society (Chapra, 2017).

Contract Methods in Islamic Finance

There are various types of Islamic banking product which are an alternative of conventional bank. Some of the major contract methods are discussed below:

Musharaka refers to the equity finance contract or joint venture where two or more parties can participate in an investment. In this contract, participants share the profit according to their predetermined ratio, but loss is shared according the portion of capital investment (Hassan, 2018).

Mudaraba is a partnership contract where one party (Rab-ul-mal) provide the capital and another party (Mudarib) provides his time and effort. In this contract, profit is shared as per predetermined ratio between the parties and loss is only borne by the capital provider (Rab-ulmal).

Murabaha is a sales based contract. In this contract, the bank purchase the asset or commodity through its own finance and reserve under own custody. Then sell to customer with adding markup. This profit rate is mutually predetermined between the bank and customer (Hassan, 2018).

Ijara is a form of lease agreement. By using this contract a customer can take out an asset (e.g. equipment, vehicle, building, any durable asset) as lease. In this case, the customer buys the asset eventually. As return the customer pays rent to the bank against the use of asset and also instalment as purchase price of the asset. The payment structure is determined mutually between bank and the customer which is part of the subject matter of the Ijara contract (Alrifai, 2015).

Challenges of Islamic Finance

One of the primary challenges of Islamic finance is the lack of public awareness. Even in different Muslim countries, people are ignorant about the fundamentals and functions of Islamic finance. This ultimately negatively impact on the implementation phase of overall Islamic financial system.

Lack of expertise is another key challenge for establishing Islamic finance. Still there are many areas which need to be covered and research & development should be performed. But due to shortage of Islamic finance professionals and academics, the market share remains unsatisfactory.

In recent time, it is apparent that many non-muslims are also contributing in Islamic finance. This is because people are now becoming more conscious about financial decisions. Mostly the negative side of riba e.g. vicious credit cycle drives people to Islamic banks. But still the percentage is very low and most of the people couldn’t understand or refuse to understand the extreme consequences of riba and the conventional banking system. For this reason, growth of Islamic finance is low in western countries (Chapra, 2017).

There is a perception in the market that at the end of the day the consequence of the Islamic finance and conventional finance is the same. Though this information is wrong, but the Islamic finance institutions and professionals working on implementation layer are reluctant to educate the market participants. Nowadays, it becomes a great challenge in some parts of the global market.

Adverse regulatory environment is another great challenge for Islamic finance in the implementation stage. In some countries, Islamic financial institutions are facing different regulatory barriers to perform sharia compliant contracts and dealings. In some cases, regulatory barriers lead to liquidation of Islamic finance services (Chapra, 2017).

Conclusion

In accordance with above discussion, we can establish the opinion that the implementation of Islamic financial system can present a sustainable financial structure to the world. Though in implementation phase, Islamic financial system is not established in a great extent. Fundamentally, Islamic finance proves the resilience of financial system as well as greater social welfare.

As evolving financial systems, there are large numbers of challenges that prevail in the implementation phase. Muslim leaders should come forward and strong Islamic finance association or networks e.g. AAOIFI should be established to promote the Islamic finance as a sustainable financial system, and extend cooperation among national and international boundaries

A common framework should be developed for all Islamic financial institutions around the globe. This eradicates the misconceptions prevailing in the market, as well as ensures the operational efficiency through defined guidelines. Policy makers of Islamic finance should emphasize in transformation of principles into working policies and facilitate the financial institutions to achieve the global market by implementing Islamic finance more efficiently.

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References

AL MANASEER, M., 2017. HOW ISLAMIC FINANCE MITIGATE FINANCIAL CRISES. Journal of Internet Banking and Commerce, 22.

Alqahtani, F. and G. Mayes, D., 2017. The global financial crisis and Islamic banking: the direct exposure to the crisis. Banks and Bank Systems, 12(3), pp.100-112.

Alrifai, T., 2015. Islamic finance and the new financial system. Wiley.

Chapra, M., 2017. The Looming International Financial Crisis : Can the Introduction of Risk Sharing in the Financial System as Required by Islamic Finance, Play a Positive Role in Reducing Its Severity ?. Islamic Economic Studies, 25(2), pp.1-13.

Hassan, M., 2018. The Global Financial Crisis and Islamic Finance. SSRN Electronic Journal,