The Islamic Financial System As A Viable AlternativeAnd Solution To Financial Crises
Apr 2010
Abstract
The paper tries to determine the primary cause or causes of the financial crises that have plaguedalmost every country around the world over the last three decades. Of particular significance arethe 1998 LTCM breakdown , the current subprime mortgage crisis in the United States, and thecurrent global financial crisis. The major causes of these crises is the lack of adequate market
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discipline in the financial system. This leads to excessive lending, high leverage and ultimatelythe crisis.Risk-sharing, which Islamic finance wishes to introduce, can help instill greater discipline in thesystem and curb lax lending. Effective operation of such a system in Muslim countries will,however, not be possible without the establishment of a number of shared institutions that do notexist at present. It is also necessary to adopt a number of specific measures to make creditavailable to small- and micro-entrepreneurs in order to make the existing financial system moreequitable.
The Islamic Financial System As A Viable Alternative And SolutionTo Financial Crises
The whole world is now in the grip of a financial crisis which is far more serious than anyexperienced since the Great Depression. It has taken more than $3 trillion of bailout and liquidityinjections by a number of industrial countries to abate somewhat the intensity of the crisis. Nevertheless, there are fears that this crisis may have exposed the world economy to a long
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period of economic slowdown. There is, hence, a call for a new architecture that would helpminimize the frequency and severity of such crises in the future.Primary cause of the crisis : It is not possible to design a new architecture without firstdetermining the primary cause of the crisis. The generally recognized most important cause of almost all crises has been excessive and imprudent lending by banks over a long period. This isclearly acknowledged by the Bank for International Settlements (BIS), which states as much inits annual report (released on 30th June 2008).This raises the question of what makes it possible for banks to resort to such an unhealthy practice which not only destabilizes the financial system but is also not in their own long-runinterest. There are three factors that make this possible. One of these is inadequate marketdiscipline in the financial system resulting from the absence of profit-and-loss sharing (PLS).The second is the mind-boggling expansion in the size of derivatives, particularly credit defaultswaps (CDSs), and the third is the ‘too big to fail’ concept, which tends to give an assurance to big banks that the central bank will definitely come to their rescue and not allow them to fail.The false sense of immunity from losses that all these factors together provide, has introduced afault line in the financial system. Banks have not, therefore, undertaken a careful evaluation of the loan applications. This has led to an unhealthy expansion in the overall volume of credit, toexcessive leverage, and to an unsustainable rise in asset prices, living beyond means, andspeculative investment. Unwinding later on gives rise to a steep decline in asset prices, and tofinancial frangibility and debt crises, particularly if there is over-indulgence in short sales. JeanClaude Trichet, president of the European Central Bank, has rightly pointed out that ‘a bubble ismore likely to develop when investors can leverage their positions by investing borrowed funds’.
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The Islamic Financial System as a Viable Alternative and Solution to Financial Crises Presented by Caligula68
The paper tries to determine the primary cause or causes of the financial crises that have plagued almost every country around the world over the last three decades. Of particular significance are the 1998 LTCM breakdown…
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