G Lobal F Inancial C Rises & Muslim World

Making of the Crisis

1

GLOBAL FINANCIAL CRISES &

MUSLIM WORLD

A CRITICAL ANALYSIS

Making of the Crisis

2

Banks/financial institutions engaged in sub-prime lending (with adjustable interest rates)

Loans packaged as Mortgage Backed Securities (MBS) / Collateralized Debt Obligations (CDO)

Investors (investment banks, hedge and pension funds, municipalities, schools, etc.) bought these securities

Investors bought Credit Default Swaps (CDS) to hedge credit risks

Issuers of CDS (Investment banks & Insurance companies) took on the risk of default

From the Mortgage Crisis to the Global Economic & Financial Crisis

3

Banks adopted an easy approach to lending in order to have a bigger slice of the pie

Loan volume gained greater priority over loan quality

Several factors that have contributed directly or indirectly to the occurrence and the spread of the

current credit crisis:Derivatives and excessive leveraging of US

financial institutions

Complexity of credit derivative products

Poor enforcement of inadequate regulatory systems and lax on lending standards

The model worked while borrowers were making payments.

When they stopped, the system, literally, caved in.

The Current Global Financial Crisis:The Deepest since World War II

4

Current disruptions in financial markets causing constraint to the flow of credit to families and

businesses

Adverse effect on the real economy in terms of recession and high unemployment rates

Investors unexpectedly lose substantial amount of their investments

Financial institutions suddenly lose significant proportion of their value

5

Global Financial Crisis:Impacts on OIC Countries

Major Impacts

6

Major Impacts of the Current Global Economic & Financial Crisis

Slowdown in economic growth

Fall in export demand and commodity prices

Sharp drops in private capital inflows

Interruption in flows of ODA and remittances

Deterioration in current account balances

Increase in unemployment and poverty

Slowdown in Economic Growth

7

From October 2008 to July 2009, IMF revised down its projections for economic growth of 2009 many times.

World: From 3.0% to -1.4%Advanced Economies: From 0.5% to -3.8%Developing Countries: From 6.1% to 1.5%

October 2008November 2008

January 2009April 2009

July 2009

Slowdown in Economic Growth

8

Average growth for OIC countries is expected to decelerate to 1.5% in 2009, compared to 5.1% in 2008.

Members in Europe & Central Asia are expected to suffer deep contraction by 3%.

Growth in East Asian members is projected to decelerate significantly, from 5.5% in 2008 to 0.8% in

2009.The other regions are expected to record growth rates

around 3%.

Fall in Export Demand and Commodity Prices

9

Decline in the volume of global exports in 2009

WTO: -9%IMF: -11%

“The largest contraction since World War II”

Exports of developing countries to decline by 6.4%

The most affected

Open Economies

Exporters of a small range of products

Dependants on markets of major economies, mainly the US and EU

Sharp decline in commodity prices

Manufactures and food prices to fall back to 2007 levelsPrices of oil and non-oil primary commodities to roll back to

2005 levels

Exporters are to suffer while importers, especially the LIFDCs, are to benefit

Sharp Drops in Private Capital Inflows

10

Private capital flows to developing countries declined by about $500 billion in 2008.

A further $630 billion is expected for 2009.

Global FDI flows reached a record high level of $1.9 trillion in 2007.

Estimated to have fallen by 15% in 2008 due to tighter credit conditions and falling corporate profits.

Decline in developed countries by 25%

Increase in developing countries by 7% (20% in 2007)

Projections signal for a more remarkable decline in 2009.

Interruption in Flows of Official Development Assistance (ODA)

11

Global Financial & Economic Crisis

Negative impacts on flows of ODA to low-income countries, particularly the LDCs.

Threat for achievements in MDGs

European aid, providing over half of global aid flows, accounted for 0.40% of GNI in 2008 (+ €4 billion over 2007)

+ €20 billion needed over the next 2 years to meet the target

Since December 2008, many European countries have announced cuts to their 2009 aid budgets.

Interruption in Flows of Remittances

12

In 2008, developing countries received $305 billion of remittances.

South Asia and Europe & Central Asia are expected to witness sharper decline compared to other regions.

2007 2008Billion $ 73 80

Growth % 24.7 10.3

Remittances in OIC countries

2007 2008 200922 8 -(5 to 8)

Growth of Remittances (%)

OIC member countries like Tajikistan, Lebanon, Jordan, and Guyana, where remittances account for 20 to 40 percent of their GDPs, will be more affected than the

others.

Deterioration in Current Account Balances

13

Decline in global demand

Fall in oil & commodity prices

Credit crunch in export markets

Decline in Remittances

Slowdown in economic activity/growth

Decrease in imports(volume and import bill)

Current AccountBalance

Decrease in exports (volume and revenues) ( - )

( + )

In 2008, the combined current account balance of OIC countries was over +$400 billion.

In 2009, estimations indicate a deficit of around $35 billion; due mainly to declining oil revenues and growing deficits of Sub-

Saharan African members.

The number of OIC member countries with deficit was 30 in the last three years, but expected to grow to 43 in 2009, mainly from the

MENA region.

Increase in Unemployment and Poverty

14

ILO: Global unemployment could reach to 210-239

million in 2009 (2007=180 million)

Unemployment rate to 6.5% - 7.4% (2007=5.7%)

The increase originates mainly in;

• Developed Economies & the EU

• East Asia • Latin America & Caribbean • Central and South Eastern

Europe (non-EU) & CIS

Ratio of workers living on less than $2 a day:

• 2007 40.9% (1.2 billion)• 2009 46.8% (1.4 billion)

15

Islamic Financeas a Solution

The Global Economic & Financial Crisis:The Real Causes

16

The main, but not the only cause of the financial crisis, is attributed to a laxity of lending standards.

Absence of adequate and appropriate government regulatory control due to:

Inadequate market discipline in the financial system resulting from the absence of profit-and-

loss sharing (PLS)

The mind-boggling expansion in the size of derivatives, particularly credit default swaps

(CDSs)

The ‘too big to fail’ concept, which tends to give an assurance to big banks that central bank will

definitely come to their rescue and not allow them to fail.

Common Views on the Causes

17

Global financial crisis in reality is a crisis of failed morality

Cause of greed, exploitation and corruption

Failure in the relationship between investment originators and investors

Failure to communicate potential risks involved in these transactions with the investors (borrowers)

Implications for Islamic Banking

18

There is a potential role that Islamic banking is suited to assume in order to deliver noteworthy contributions

to the international financial system

Direct impact of the crisis on the Islamic banking sector was minimal due in part to the intrinsic principles

Islamic banks were not caught by toxic assets as interest is banned.

Lack of structured products and the reluctance of Islamic banks to exploit sophisticated

financial instruments

Lending under Islamic law is based on the concept of asset backing, where real estate is being the

preferred instrument to protect these investments.

Islamic Finance as a Solution

19

Advocates and the opponents of both schools of thought (government intervention and free market

economies) thus far have failed to deliver a viable long-term solution to the crisis.

Nobel Prize Winner, French economist Maurice Allais believes that the way out of such crises is best

achieved through structural reforms.

Given that the current crisis has clearly shown up the weaknesses of the conventional banking and finance

system,the resilience of the Islamic institutions to the current financial turmoil has led many analysts to come to a

conclusion that Islamic finance and banking system could provide the

solution to the weaknesses of the conventional financial system and could be a feasible alternative.

Islamic Theory of Finance and the Global Financial Crisis

20

Based on themes of Community Banking

Ethical and Socially Responsible Investments

Socio-economic justice

Wealth accumulation and wealth distribution that is fair

Supply of money therefore must be proportionate with the prospects of real growth


21

Islam establishes a unique system that protects individual investors and financial institutions from

potential risks

Islamic finance is governed by Islamic principles

usury (riba)

gambling (maisir)

ambiguity (gharar)

income must be an outcome of productive economic activities based on the principles of

profit-and-loss-sharing contracts


22

Financial approach of Muslims should be governed by major sets of rules:

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on Muslims are, not only

discouraged but also, forbidden from

investing in businesses that are engaged in

illicit (haram) activities

Islam prohibits paying or receiving any

predetermined fixed rate of return on borrowed/lent

money; Charging interest (riba) tends to drive the

poor into more poverty and create more wealth for the

wealthy

Trad

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IslamicEconomics


23

Absence of interest-based financial transactions under Islamic finance, financial relationships between

financiers and borrowers are best understood within the framework of profit-and-loss sharing (PLS)

contracts, where both parties share the risk (and returns)

Islamic finance advocate fairness in payoffs and reward structures and embrace socio-economic justice amongst

all

Principle of ‘no pain no gain’ embedded in the Islamic financial structure entails that no one has the right to rewards (profit) if they do not equally share the risk of

incurring loss


24

“If global banking practices adhere to the principles of Islamic finance, which are based on

noble ideas of entrepreneurship and transparency, the current global crisis would

have been prevented.”


25

Not to sell a debt against a debt: one can’t sell or lease unless he/she posses real assets

Islamic finance is based on equity rather than debt, and lending transactions are founded-on the concept of assets backing: mortgage loans under such system would have been backed by solid asset structure

Islam takes particular interest in fostering close relationship and trust between originators (financial

institutions) of Islamic financial products and investors

Potential investors are well versed about the prospects (opportunities and risks) that their investments are subject to when entering into new contracts - Risk

must be explicitly communicated !


26

Honest implementation of Profit-and-Loss Sharing (PLS) transactions (such as Mudarabah and Musharakah contracts) in accordance with the spirit of Islamic principles entails full disclosure and transparency.

Islam regards the relationship between the lender (financial institution) and the borrower (investor) as a

partnership.

Risk sharing as apposed to risk taking is extended to include the prohibition of risk shifting as in CDS - risk

shifting is gambling.

Islamic finance provides a moral and practical option for those keen to invest in socially responsible and/or in

ethical investment portfolios.

Concluding Remarks

27

Current financial crisis demonstrates that Islamic finance is an effectual economic authority.

Today, investments through Islamic finance systems are acceptable in a significant number of countries –both

Islamic and others– such as Indonesia, Malaysia, Turkey, Japan, China, England, and the USA, and

continue to expand to many other countries as an alternative or complementary to the conventional

financial and banking system.Transformation of Islamic financial paradigm into

working policies and enabling institutions is a long-term evolutionary process.

Private and public sectors at country level and the cross-country coordination between member states of

the Organization of Islamic Conference (OIC) undoubtedly will play a crucial role.

Future of Islamic financing looks exceptionally promising, one should not be under the illusion that such transformation would happen without shrewd vision and hard work particularly in terms of human

capacity building and innovative financial engineering

Concluding Remarks

28

There is an urgent need for more integrated and concerted policy actions to recover from the crisis and improve the economic situation of the OIC community through, inter alia,

Designing sound financial systems at national level that would prevent the adverse impacts of future global financial crises

Promoting and encouraging financial systems based on Islamic principles such as equity-based financing and real activity-based transactions.

In such a system, the conventional financial instruments such as collateral debt obligations (CDOs) and credit default swaps (CDSs), which stand at the heart of the current crisis, are either not allowed or regulated very tightly.

Many researchers come to argue that the current global financial crisis could have been avoided if such a system had been in place.

Economy & Finance

G Lobal F Inancial C Rises & Muslim World