1

GLOBAL FINANCIAL CRISIS & ISLAMIC EQUITY INSTRUMENTS: A PROFILE OF SURVIVAL

The Dissertation Submitted In Partial Fulfillment Of The Requirement For Masters In Islamic Studies.

Submitted By Bilal Malik (IS-10-16) Gousia Mir (IS-10-26)

Under the Supervision Of Dr. Showkat Hussain (Assistant Prof Dept. of Islamic Studies)

DEPARTMENT OF ISLAMIC STUDIES ISLAMIC UNIVERSITY OF SCIENCE AND TECHNOLOGY,AWANTIPORA (2012)

ACKNOWLEDGEMENT
All praise be to Allah, the lord of the worlds, who gave us accession of thought to learn. This dissertation would have not been possible without the help and support of many people. First and foremost we would like to thank Dr. Showkat Hussain, Incharge

Department of Islamic Studies, our dissertation supervisor. We owe a debt of gratitude to him for his high level of interest, enthusiasm and unending help throughout the completion of the study. Secondly, we are thankful to all faculty members of the Department of Islamic Studies, the non-teaching staff of the said department, the people associated with SEC(skill enhancement center) for their assistance. We are also thankful to our friends and batch mates for their valuable suggestions throughout the study. At last but not least we are thankful to our parents and family members whose encouragement and cordial support became a source of inspiration for us.

Gousia Mir

Bilal Malik

TABLE OF CONTENTS

INTRODUCTION 1. GLOBAL FINANCIAL CRISIS:ITS CAUSES & IMPACT 1.1 Globalisation and the global financial crisis 1.2 Origin of the crisis 1.3 Causes of the current global financial crisis 1.3.1 Excessive and imprudent lending 1.3.2 Securitization 1.3.3 Regulatory Failure 1.3.4 Over-Leveraging 1.3.5 Inherent Stability 1.4 General Impact of the global financial crisis

1-4

5-6 6-7 7-9 9-12 12-15 15-17 17-19 19-20 20-21 21-22 22-26 26-31

1.4.1 Impact of GFC on finance sector 1.4.2 Impact of GFC on Conventional finance industry 1.4.3 Impact of GFC on Islamic finance industry 2. LITERATURE REVIEW 2.1 2.2 Books Articles and Research Papers

32-50 51-61

3. ISLAMIC EQUITY INSTRUMENTS 3.1 3.2 Islamic Equity Instruments Musharakah (Equity Participation) 62-63 63-64 64-68

3.2.1 Application and Scope

3.3

Murabahah (Cost-Plus Sales)

68-70 71-73 73-74 74-75 75-77 77-78 78-81 81 81-82 82-83 83-84 84 84-85 85-86 86 86-87 87

3.3.1 Application and Scope 3.4 Mudarabah (Co-Partnership Sales)

3.4.1 Application and Scope 3.5 Ijarah (Lease Contract)

3.5.1 Application and Scope 3.6 Takaful (Islamic Insurance)

3.6.1 Application and Scope 3.6.2 Mudarabah Model 3.6.3 Wakalah Model 3.6.4 Waqaf Model 3.6.5 Microtakaful 3.7 Sukuk (Islamic Bond)

3.7.1 Ijarah Sukuk 3.7.2 Murabahah Sukuk 3.7.3 Convertible Sukuk 3.7.4 Musharakah Sukuk 4. RELEVANCE 4.1 4.2 4.3 4.4 4.5 Current Position of Islamic Finance Industry: A Brief Review Islamic Banking Investment: A Flourishing Sector Islamic Banking in MENA Region: A Growing Trend Growth of Islamic Takaful Industry Sukuk: A Global Success for Islamic Finance Industry

88-93 94-98 98-100 100-103 103-107

5. CONCLUSION 6. REFRENCES

108-110 111-119

FIGURES 1. Graph showing chronological list of various crisis. 2. Graph showing rise in U.S subprime lending between 2004-2006. 3. Graph showing Securitization market activity. 4. Leverage ratio of various banks from 2003-2007. 5.Initial effects of crisis on conventional and Islamic banks. 6. IMF staff estimates and calculations. 7. Mechanism of Musharakah contract. 8. Mechanism of Murabaha contract. 9. Mechanism of Mudarabah contract. 10. Diagram of Mudarabah model. 11. Wakalah Takaful diagram. 12. Graph showing global assets of Islamic finance. 13. Graph showing banking assets in Mena region. 14. Graph showing Global Takaful Market. 15. Graph Showing Global Sukuk Issues. 74 82 83 92 100 101 103 15 18 29 30 64 70 8 10

INTRODUCTION

INTRODUCTION

Periodic crises appear to be part of the financial systems of dominant and global powers. The 2008 global financial crisis that started in the U.S in late 2007 has given a wide array of impacts to operating and financial performance of many banks all over the world. The severity of the current crisis has led to the evaluation that, world economy has entered a phase of extraordinary instability and its future course is absolutely uncertain. Enjoying a unipolar moment following the collapse of the Soviet Union and the failure of Communism, the United States was confident that economic liberalization and the proliferation of computer and communications technologies would contribute to ever-increasing global economic growth and prosperity. Globalization contributed to the extraordinary accumulation of wealth by a relatively few individuals and created greater inequality. The golden years of capitalism ended when U.S President Nixon in 1971 suspended the convertibility of the US dollars which brought an end to the fixed exchange rate - the basis of Bretton Woods system. The end of Bretton Wood system diminished the relationship between real money and real assets and built the market sentiments upon confidence and trust. One can say that it was a time of transition of capitalism to financialization or finance-ledcapitalism. Under this new economic system financial institutions enjoyed the right to raise capital for the purpose of creating, selling and trading securities and derivatives that do not finance industry but rather trade within markets. The main characteristics of this new economic system as described by Pereira (2010) are firstly, the increase in the value of financial assets as consequences of the multiplication of financial assets due to securitization and derivatives.

Secondly, finance-led-capitalist leads to the innovation of creating fictitious financial wealth that only helps capitalist renters. It can be seen that under financialization, credit ceased to exist from bank to business but was channelized through securities traded in financial markets that are pension funds, hedge funds and mutual funds. Pereira (2010) stated that the financial crisis was the consequence of financialization that created fictitious financial wealth that began in 1980s and the consequence of the neoliberalism, which believed in the transfer of power from public to private sector, based on self-regulated markets. The onset of the present crisis can be traced back to July 2007 with the liquidity crisis due to the loss of confidence in the mortgage credit markets in the United States. At first, there was uncertainty about the possible spillovers to the rest of the economy, and there was also discussion about the risks of contagion and decoupling, that is to say, the capacity of other countries especially developing countries to isolate themselves from the problems originating in the United States (which is the largest market for many countries). The hope was that the crisis would be restricted to financial markets, with few repercussions on the real economy and the rest of the world. This hope was shattered in September 2008 as the crisis entered an acute phase, with strong downward fluctuations in the stock markets, substantially reduced rates of economic growth, volatile exchange rates, and squeezes in demand and consumption, leading to falls in industrial production and decreasing flows of international trade and FDI, and causing impacts on related areas such as transfer of technology. As a result, many banks across the world reported financial loss on their financial report due to their connections with subprime mortgage in the U.S. or were simply affected by economic recession in their own countries. The impact of the crisis have even

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forced around 123 banks in the U.S. to file for bankruptcy in the year, including American giant bank Lehman Brother that was never been expected to fail. The crisis has also been accompanied by increases in unemployment, with concomitant declining incomes and demand. The situation have encouraged economic analysts to construe this crisis to be the most severe since the Great Depression of the 1930s, crude oil prices have seen yet another historical hike since 2003. It is in the light of these two major global recessions that Islamic finance has experienced its conception and renaissance. Through the lens of Islamic economic thought, it is clear that in the absence of a moral transformation and change in economic thinking, any effort by governments to be realistic promotes recession, unemployment, and unrest (Chapra,1985). This trend has given rise to an increasing appeal of Islamic finance to Western policy makers. In fact, besides a remarkable influx in the amount of Islamic banks and banking units in the Middle East and Asia, Western banking institutions have commenced offering Shariah-abiding financial products. European governments such as France, Germany, and The Netherlands have voiced their interest in Islamic finance and instructed policy makers to generate a legal framework in order to pave the way for Islamic financial products to enter Western financial markets. What is more, since 1999, the Dow Jones has been issuing financial information on Shariah-adhering companies under the umbrella of the Dow Jones Islamic Market Indexes, in order to cater toward Muslim investors who prefer to invest in accordance with the teachings of the Quran. The present study has been compiled to bring forth the detailed summary about the causes and the impact of the crisis on both conventional as well as Islamic financial industry. It will also discuss the nature, mechanism, and scope of some

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significant financing instruments used by the Islamic finance industry. Also a brief summary has been made with the help of empirical data in order to search out the current position and relevance of the Islamic finance industry in the current financial scenario. Overall content of the dissertation has been segmentized into four chapters as per the subject matter of the dissertation. A brief introduction has been added up at the beginning and finally a precise conclusion at the end. Throughout the completion of the study near about 20 books and more than 80 articles have been consulted and the selection of literature was done as per the relevance with the objective of the study.

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Chapter - 1

GLOBAL FINANCIAL CRISIS: ITS CAUSES AND IMPACT

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1.1 GLOBALISATION AND THE GLOBAL FINANCIAL CRISIS Globalization is a multi-dimensional process of economic and structural transformation that has a variety of meanings and interpretations. It generally refers to both the increasing flows of capital, goods and resources and knowledge across national boundaries and to the emergence of a complementary set of organizational structures to manage the expanding network of international economic activity and transactions. However defined, globalization has led to the greater integration of national economies through trade liberalization, financial sector deregulation and capital account liberalization, and flows of Foreign Direct Investment (FDI) by Transnational Corporations (TNCs). Globalization has opened up new opportunities to low and middle income countries, through improved market access, increased flows of FDI, often integrating them into Global Value Chains (GVCs) or Global Production Networks (GPNs) and accelerated technology transfer, both product and process technologies.1 Global financial crisis has been defined as a situation, where in the worldwide integrated economy, in the form of financial institutions, banks or assets suddenly lose a large part of their value, generally accompanied by banking panics, stock market crashes, bursting of financial bubbles, currency crisis and sovereign defaults.2 The 20072012 financial crisis, also known as the Global Financial Crisis (GFC), is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. The sub-prime mortgage crisis as it is to be

Ludovico Alcorta and Frederick Nixson, The Global Financial Crisis and the Developing World: Impact on and Implications for the Manufacturing Sector, United Nations Industrial Development Organization, Vienna, 2011, P.1. 2 Prajpati Trivedi, Global Financial Crisis: Causes And Consequences, Indian Forum Riyadh, 2008.

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known, began with the bursting of the housing bubble in the U.S, rocked the U.K, the Euro zone, East-Asia, and the so-called emerging market economies and has not yet reached its end. The crisis played a significant role in the failure of key businesses, declines in consumer wealth estimated in trillions of US dollars, and a downturn in economic activity leading to the 20082012 global recession and contributing to the European sovereign-debt crisis The crisis threatens a worldwide economic recession, potentially bringing to a halt more than a decade of increasing prosperity and employment for western economies and potentially wiping a staggering $1 trillion off of the value of the world economy.3 1.2 ORIGIN OF THE CRISIS The current global financial crisis is rooted in the subprime crisis which surfaced few years ago in the United States of America. During the boom years, mortgage brokers attracted by the big commissions, encouraged buyers with poor credit to accept housing mortgages with little or no down payment and without credit checks. A combination of low interest rates and large inflow of foreign funds during the booming years helped the banks to create easy credit conditions for many years. Banks lent money on the assumption that housing prices would continue to rise. Also the real estate bubble encouraged the demand for houses as financial assets. Surplus inventory of houses and increase in interest rates led to a decline in housing prices in 2006-2007 resulting in an increased defaults and foreclosure activity that collapsed the housing market. Consequently, a large number of properties were up for sale affecting mortgage companies, investment firms and government sponsored enterprises which had invested heavily in subprime mortgages. Banks and financial institutions later repackaged these
Carol J.William, "Euro Crisis Imperils Recovering Global Economy, OECD Warns, Los Angeles Times, May 22, 2012.
3

15

debts with other high-risk debts and sold them to world- wide investors creating financial instruments called CDOs or Collateralized Debt Obligations.4 In this way risk was passed on multifold through derivatives trade. Since the collateral debt instruments had been globally distributed, many banks and other financial institutions around the world were affected. Thus with the failure of a few leading institutions in United States, the entire financial system in the world has been affected.5 1.3 CAUSES OF THE CURRENT GLOBAL FINANCIAL CRISIS The world economy is still suffering from the crisis, considered the most severe since the Great Depression, where economic downturn at historic magnitude and many countries across the globe, irrespective of their development level, are still under strain dealing with this crisis. The severity of the crisis can be visualized from the fact that it spilled from the financial sector to the real economy, including international trade in manufactures commodities and services. According to one estimate, there have been more than 100 crises over the last four decades but none could be brought in comparison to the current financial crisis in terms of consequences.6 There has been burgeoning literature compiled on the GFC, Which is characterized by agreements and disagreements about its main causes. The U.S. Senate's LevinCoburn Report asserted that the crisis was the result of "high risk, complex financial products, undisclosed conflicts of interest, the failure of regulators, the credit rating agencies, and the market itself

Ross Morrow, A Critical Analysis Of the U.S. Causes Of The Global Financial Crisis 2007-2008 , Marxism Fresh Daily, Jan 4, 2011. 5 Tito Boeri and Luigi Guiso, The Sub-prime Crisis: Greenspans Legacy, in Andrew Felton and Carmen Reinhart, eds., The First Global Financial Crisis of the 21st Century, July 2008, p.38. 6 Joseph Stiglitz Dealing with Debt: How to Reform the Global Financial System, Harvard International Review, 2003, pp.54-59.

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to rein in the excesses of Wall Street.7 A healthy bench of economists like DellAriccia, 2008, Igan, 2009, Leaven, 2010, Danielson, 2008, Alarag, 2009,

Stiglitz, 2009, Butler, 2010 and others have discussed the role of inherent uncertainty in conventional financial operations in bringing out the current global financial crisis in the form of subprime lending boom. On the other hand Muslim economists (e.g., Siddiqui, 2009, Chapra, 2009, Bag siraj, 2009, Hussain, 2010, Khursheed, 2012) continually refer to the global economic crisis as a result of interest- based financial operations. As mentioned above that economists view the current financial crisis as the greatest one that beat the world economy, even if compared with the great Depression in 1930s. Ali Saktis chronological list of various crises in graphical form is evident to the above fact.8

Figure No.1 Source: Ali Saktis Chronological Crisis Graph9

7 8

Senate Financial Crisis Report, http://hsgac.senate.gov/public/ , Retrieved April 22, 2011. Miranti Kartika Dewi and Ilham Reza Ferdian, Islamic Finance: A Therapy for Healing the Global Financial Crisis , Centre for Islamic Economics and Business, University of Indonesia, 2009. 9 Ali Sakti, Islamic Economic: Challenges And Opportunities Of Monetary Authority In The Global Financial Crisis Paper presented on Public Lecture Series held by Centre of Islamic Economics and Business, Faculty of Economics, University of Indonesia, Depok, Indonesia, February 18, 2009.

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Many risk spreads have ballooned, liquidity in some market segments has dried up, and large complex financial institutions have admitted significant losses. These events have challenged policymakers, and the responses have varied across region. The European Central Bank has injected reserves in unprecedented volumes. The Bank of England participated in the bail-out and, ultimately, the nationalization of a depository, Northern Rock. The U.S. Federal Reserve has introduced a variety of new facilities and extended its support beyond the depository sector. These events have also challenged economists to explain why the crisis developed, how it is unfolding, and what can be done.10 However, as always done by a doctor before suggesting any medical treatment to his patient, it is more significant firstly to observe the ground of the problem. Thus before discussing the consequences of the GFC or any reformative policy in connection to smooth functioning of the financial institutions worldwide, it is important to describe some of the determinant causes responsible for GFC. 1.3.1 Excessive and imprudent lending Economists have undoubtedly identified a number of causes responsible for the crisis. The generally recognized most important cause is, however, excessive and imprudent lending by banks.11 The best example in this regard is US subprime* mortgage crisis. Intense competition between mortgage lenders for revenue and market share, and the limited supply of creditworthy borrowers, caused mortgage lenders to relax underwriting standards and originate riskier mortgages to less
Carmen M. Reinhart, The First Global Financial Crisis Of The 21st Century: Introduction, in Andrew Felton and Carmen Reinhart, eds., The First Global Financial Crisis Of The 21st Century, July 2008. 11 Mohammad Umer Chapra, The global financial Crisis: Can Islamic Finance Help?, New Horizon, Issue no: 170, Jan-Mar 2009, p.20. *Subprime loan is a type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. The loan is usually stipulated with a relatively higher interest rate because it is often issued to a higher-risk borrower.
10

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creditworthy borrowers. Most of the USs banks got indulged in this practice with an intention to maximize their profits, adopting the policy more credit they extend, the higher will be the profit. Prime mortgages dropped to 64% of the total in 2004, 56% in 2005, and 52% in 2006, meaning that nearly half of the mortgage originations in 2006 were subprime, Alt-A*, or home equity loans.

Figure No.2 Source: Harvard University Report, 200812 Even the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Macs**, were caught-up by the apparent glamour of housing market, as they

12

U.S Census Bureau, Harvard University, State of the Nations Housing Report, 2008.

*Alt-A mortgage loans are made to borrowers with pretty good credit ratings but who do not provide full income and asset documentation **U.S government sponsored, biggest underwriter of home mortgages. .

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sought to expand home ownership for the benefits it brings in terms of sustaining neighborhoods. It has been observed that lending standards deteriorated around 2004 or 2005. Families that lacked the income and down payment to buy a house under the terms of a mortgage were encouraged to take out a mortgage that had a very high loan-to-value ratio, perhaps as high as 100% (often using second or even third mortgages). As it became easier to borrow using a home as collateral and as home prices continued to rise, families started using their homes as an ATM, refinancing and taking out any equity that had built up. Americans were tapping into the rising wealth they had in their homes in order to finance consumption. Greenspan and Kennedy (2007) estimate that homeowners extracted US$743.7 billion in net equity from their homes at the peak of the housing boom in 2005, up from US$229.6 billion in 2000 and US$74.2 billion in 1991. The increase in house prices allowed a borrowing spree.13 This policy created a situation of high supply and high demand of money in the market and banks earned a healthy proportion of wealth in the first two, three years. It was unfortunate that this policy couldnt help the US mortgage industry, the worlds best, to go for a long run. By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. As prices declined, borrowers with adjustable-rate mortgages could not refinance to avoid the higher payments associated with rising interest rates and began to default. During 2007, lenders began foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs.
13

Martin Neil Baily and Douglas J. Elliott, The Causes Of The Financial Crisis, published by World Scientific Publishing Co. Pte. Ltd In The International Financial Crisis- Have the Rules of Finance Changed?, 2009, pp.61-62.

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2007. By August 2008, 9.2% of all U.S. mortgages outstanding were either delinquent or in foreclosure. By September 2009, this had risen to 14.4%. The situation became much worse when banks became reluctant to lend each other and ultimately the bubble burst-out, resulted constrain in US economy.14 Although it is impractical to single out one factor as being the source of financial crisis, but it is not wrong to argue that the main cause of financial crisis can be attributed to the laxity of lending standards adopted by conventional financial institutions driven by greed and appetite for higher returns, and facilitated by the absence of adequate and appropriate government regulatory control. This easy approach to lending when practiced over an extended period of time and mixed up with other so called financial necessities like overleveraging, speculation and securitization leads to risky a lending environment that eventually works against the interests of both borrowers and lenders alike and ultimately ends up with an economic downturn. 1.3.2 Securitization The second ingredient that triggered the current global financial crisis is securitization, which evolved as a result of un-judged financial innovations. Historically, banks used only the money they received from depositors to lend to borrowers. They were not able to obtain money from other sources other than depositors. However in recent years, banks have been able to rely not only on depositors but also on the wholesale money markets, where they could borrow money from other banks and then resell it to their borrowers at a higher interest rate. This secondary market was in part made possible by the creation of credit default swaps (CDSs). Credit default swaps were widely used, especially by
14

MBA Survey-Q3.2009, http://www.mbaa.org, Nov.2009, Retrieved May 1, 2010.

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insurance companies such as the American International Group (AIG). These allowed a bank to effectively insure itself against the risk that a borrower might not pay back a loan. This led to an illusion that loans were now much lower risk and allowed such loans to be bought and sold. This then led to the creation of CDOs (collateralized debt obligations), which were bought by banks as interestbearing investments. The sub-prime lenders then invented another way of making money in a sector which was already highly risky and this new technique was securitization.15 Securitization is a process of financial engineering that allows global investment to be spread out and separated into multiple income streams to reduce risk. Securitization became an important component of financial markets in the 1980s and was warmly welcomed in finance sector, to be used as a weapon against the financial crisis.16 This innovation made vast sums of money available to borrowers. For example, securitization increased the amount of money available to individuals purchasing homes, leading to unprecedented growth in house prices. From 2000 to 2005, the percentage of non-conforming mortgages that became securitized increased from 35% to 60%, and the volume of nonconforming origination also rose dramatically. Subprime mortgage originations rose from $160 billion in 2001 to $600 billion in 2006. And many of these securitized mortgages became re-securitized as backing for CDOs* (Collateral Debt Obligation). As of October 2006, 39.5% of existing CDO pools covered by Moodys consisted of MBS (Mortgage Backed Securities), of which 70% were
Abul Hassan, The Global Financial Crisis and Islamic Banking, The Islamic Foundation, UK, 2009 J. Rasmus, The Deepening Global Financial Crisis: From Minksy to Marx and Beyond, Critique, Vol. 36, No.1, pp.5-29. *CDO is an instrument that redistributes the underlying risks from a mortgage or other assets lying beneath it.
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subprime or second-lien mortgages and as of June 30, 2008, the MBS market was worth $6 trillion, more than US Treasury bonds.17 In 2009, an estimated $8.7 trillion of assets globally were funded by securitization.18 Securitization played a main role in spreading the financial risks globally. Once financial assets, such as debts, were securitized into MBSs and CDOs they were sold to central banks, private banks and wealthy investment funds around the world. Thus in the name of securitization, debt was sold to a third party, which would then receive the loan repayments and pay a fee for this privilege. Thus debt became tradable, just like a car. The ability to securitize debt provided a way for risk to be sliced, diced and spread, allowing more mortgages to be sold. Initially securitization process allowed originators of loans and especially of subprime mortgages to remove part of the associated risks from their balance sheet and reduced their regulatory capital requirement, as long as interest rate remained low and house prices appreciated the issue volume of mortgages as well as other loans massively increased because most of these loans were securitized the volume of ABSs, MBSs and CDOs rose as well.

Charles W. Calomiris, Not (yet) a Minsky Moment , in Andrew Felton and Carmen Reinhart, eds., The First Global Financial Crisis of the 21st Century, July 2008, p.78. 18 Too Big to Swallow, Economist, 16 May 2009, 11.

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Figure No.3 Source: Thomson Reuters SMA Graph The risk embedded in mortgages and especially in related securities was hidden for quite for some time. However, as interest rates rose and the housing price tumbled, mortgage delinquency and foreclosure rates drastically increased. The degree to which mortgage markets impacted financial instruments and financial markets drastically overcome all market participants expectations. 1.3.3 Regulatory Failure As the global financial crisis unfolded, it was obvious that many of those in the banking and investment communities did not fully comprehend how the financial system they created functioned, or the scope and severity of the crisis. The financial wizards, the best and the brightest from leading business schools, could not really explain what was happening on Wall Street and in global financial markets. The failure of regulators to force financial institutions to follow sound risk management practices was also one of the most important reasons for the financial crisis. The widespread belief developed over the past 20 years, that markets can regulate themselves may have contributed to the regulatory laxity, which in turn contributed heavily to the crisis, invalidating the argument

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promoted by free market advocates and particularly policy makers of the US market that markets are efficient their own and market forces are capable of managing and regulating market inefficiencies.19 Describing this theory as a fundamental misconception regarding modern financial market regulation, the UNCTD (United Nations Conference on Trade and Development) in its report has said, the assumption that markets know best and that regulators should take a back seat is a wrong argument.20 The same reality is exposed by Paul Krugman, laureate of the Nobel Prize in Economics in his book The Return of Depression Economics and the Crisis of 2008, described the run on the shadow banking system as the "core of what happened" to cause the crisis. He referred to this lack of controls as "malign neglect" and argued that regulation should have been imposed on all banking-like activity.21 The housing price bubble, itself as a result of the deregulation of financial markets on a global scale affirmed the principle, that competitive markets are not necessarily the best co-ordination tool in the real world. The market deregulation of international as well as national finance has been, hence detected as the third major factor responsible for the global financial crisis. It helped, in accelerating the development of credit overhang and at the same time has enabled the US economy to contaminate the world.22 The problem has occurred during an extremely accelerated process of financial innovation in market segments that were poorly or ambiguously regulated

M.Kabir Hassan, The Global Financial Crisis &Islamic Finance, University of New Orleans ,USA ,2008, p.2. 20 UNCTADs report on The Global Economic Crisis: Failures and Multilateral Remedies , Geneva, 19 Mar. 2009. 21 Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton Company Limited, 2009. 22 Jacques Sapir, From Financial Crisis To Turning Point, Real world Economics Review, vol. 46, 2008, p.34.

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mainly in the U.S. The fall of the financial institutions is a reflection of the lax internal controls and the ineffectiveness of regulating oversight in the context of a large volume of non transparent assets. It is indeed amazing that there were simply no checks and balances in the financial system to prevent such a crisis and not one of the so called pundits in the field has sounded a word of cautions. There are doubts whether the operations of derivatives markets have been transparent as they should have been or if they have been manipulated. Insufficient market regulation results in failure of making institutions financial situation publicly known (lack of transparency) and also makes it possible for financial institutions to operate without having sufficient assets to meet their contractual obligations. There was a general loss of control at all levels, which led to exponential risk taking at many companies, largely hidden from public scrutiny. Violations of financial regulations went largely unpunished23. During the crisis, market deregulation was at its epitome, added up with financial liberalization, finally resulted in deepening the effects of the crisis. 1.3.4 Over-Leveraging The global economy is facing difficult challenges, and such a situation is attributable to the phenomenon that leverages* markedly increased around the globe in the periods preceding the current financial crisis.24 Prior to the crisis, financial Institutions became highly leveraged, increasing their appetite for risky investments and reducing their resilience in case of losses. Much of this leverage was achieved using complex financial instruments such as off-balance sheet
Frank Partnoy, Infectious Greed, New York: Times Books, Issue No. 3, 2003 Masaaki Shirakawa: International Banks Amid Global Financial Crisis, Bank of International Settlements Review, 2009, p: 3. *Leverage allows a financial institution to increase the potential gains or losses on a position or Investment beyond what would be possible through a direct investment of its own funds.
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securitization and derivatives, which made it difficult for creditors and regulators to monitor and try to reduce financial institution risk levels. These instruments also made it virtually impossible to reorganize financial institutions in bankruptcy, and contributed to the need for government bailouts.25

Figure No.4 Source: Company Annual Reports (SEC Form) Leverage ratios of investment banks increased significantly 200307. U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis.26 Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period, contributing to economic growth worldwide. U.S. home mortgage debt relative to GDP increased from an average of 46% during the

25 26

"The End Of The Affair", Economist, October 30, 2008.

Ibid

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1990s to 73% during 2008, reaching $10.5 trillion.27 Although Banks intended to make money out of this risky financial technique but unfortunately results

reversed and most of the financial institutions were caught up in bankruptcy. 1.3.5 Inherent Instability This is the major issue that is contentiously discussed by Muslim economists as well as healthy band of Western economists as a threat to the stability of world economy. The crisis has shown that advanced conventional financial systems are very vulnerable. Financial instability has been a recurring phenomenon in contemporary economic history, affecting countries with varying intensity. The current phase of global financial crisis has proved, what Dr. Minksy, Nobel prizewinning economist, argued, that the modern finance was far from the stabilizing force that mainstream economics portrayed: rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.28 Eminent economists who lived through the Great Depression fought very hard to establish a banking system capable of achieving and preserving financial stability. Irving Fisher, a prominent American economist of the Great Depression era, strongly argued that two dominant factors were responsible for each boom and depression: over-indebtedness in relation to equity, gold, or income which starts a boom, and deflation consisting of a fall in asset prices or a fall in the price level which starts a depression.

27

Colin Barr, "Fortune-The $4 Trillion Housing Headache", http://money.cnn.com, CNN. May 27, 2009 Retrieved May 1, 2010. 28 Rauf Mammadov, Expert views, 36 Global Islamic Finance, January, 2010.

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American economist, Hyman Minsky, considered that conventional finance dominated by interest-based debt contracts is inherently unstable. This assertion is based on a construct known as Financial Instability Hypothesis (FIH), which posits that stability is inherently unsustainable. A fundamental characteristic of a conventional financial system, according to Minsky, is that it swings between robustness and fragility and these swings are an integral part of the process that generates business cycles. Talking about the working standard of conventional banks, George Soros wrote, when money is free, the rational lender will keep on lending until there is no one else to lend to. Rapidly expanding money and credit combined with an ideologically-based fierce de-regulation movement which began in the early 1980s in industrial economies and continued throughout the next two decades. It put at high risk the financial stability of these countries and as the result of rapid financial globalization, the rest of the world as well.29 1.4 GENERAL IMPACT OF GLOBAL FINANCIAL CRISIS The financial crisis began in July 2007, triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States, with major adverse consequences for banks and financial markets around the globe. As the crisis was worst of its kind, its far reaching repercussions were not seen only in finance sector but also in real economy as well. According to estimates by the World Bank, the total world economy contracted by 2.1% in 2009 an unprecedented fall in the post-war era. According to a report, in the OECD* area, there was an
29

Abbas Mirkhor and Noureddine Krichene, Resilience And Stability Of Islamic Finance, IDB Jeddah, 2009, pp.1-2. *The OECD (Organization for Economic Co-operation and Development) is a unique forum where the governments of 32 democracies work together to address the economic, social and environmental challenges of globalization.

29

economic contraction of 4.7% between the first quarter of 2008 and the second quarter of 2009. A plunge in global trade was another sign of the seriousness of the crisis. Worldwide, the volume of world trade in goods and services fell by 12% in 2009, according to the WTO.30 Of course, the price of a recession is felt not just in the economy but also in society. Unemployment hit just under 10% in the United States in December 2009 (falling back to 9.7% the following month), which was more than double the 2007 rate of 4.6%. In the euro zone, the figure for December 2009 was 10%, up from 7.5% in 2007. To put those numbers in perspective, even by mid-2009, when unemployment in the OECD area stood at 8.3%, it meant an extra 15 million people were out of work compared with 2007. By the end of 2009, the unemployment rate had risen still further, to 8.8% and is continuously increasing as was seen in we, the 99 movement in U.S in August 2011.31 1.4.1 IMPACT OF GFC ON FINANCE SECTOR The economies in Western countries over the last 30 years have shifted their focus from industry to services. The service sector now represents over 80 percent of the US economy, with the financial sector being the largest service. The financial economy is now valued more than the real economy. The size of the worldwide bond market by 2009 was estimated $45 trillion. The size of the worlds stock markets in the same year was estimated $51 trillion. The world derivatives market was estimated at $480 trillion, more than 30 times the size of the US economy and 12 times the size of the entire world economy by the end of 2009. As a result of globalization financial system has become an interwoven web
30 31

Brain Keeley and Patrick Love, From Crisis to Recovery, OECD Insights, 2010, p.12. TradingEconomics.com, U.S. Bureau of Labor Statistics, April 2012.

30

in the form of Transnational Financial Organizations and Foreign Direct Investment plans. As the current financial crisis has hit financial economy it is obvious that it might have laid serious consequences over the worldwide finance industry. In the current financial scenario there are only two working industries at global level, one is centuries old conventional financial system holding 99% of total global assets and second is newly born Islamic finance industry, just decades old, holding the remaining 1% of the global asset share. The impact of the GFC on both industries will discussed separately. Firstly we will analyze the impact of GFC on conventional banks and financial institutions: 1.4.2 IMPACT OF GFC ON CONVENTIONAL FINANCE INDUSTRY Economists observed that the difference between the interest rates on interbank loans and short-term U.S. government debt spread, an indicator of perceived credit risk in the general economy, spiked up in July 2007, remained volatile for a year, and then spiked even higher in September 2008. The crisis deepened, as stock markets worldwide crashed, entering into a severe-impact phase marked by failures of some prominent American and European banks, like the bankruptcy of Lehman Brothers, which is the largest in U.S history with Lehman holding $639 billion in assets. The situation prompted a substantial injection of capital into financial markets by the United States Federal Reserve, Bank of England and the European Central Bank.32 In October 2007 major failures start to appear in the worlds financial industry, Swiss banking giant UBS bank has announced losses $3.4bn from investments linked to sub-prime. In March 2008, the investment bank and brokerage Bear Stearns collapsed. Following, American banking giant Citigroup posted a sub-prime loss of $40 billion. US investment bank Merrill Lynch
32

Hussein Alasrag, Global Financial Crisis And Islamic Finance , World commerce Review, vol. 36, 2009, pp.31-32.

31

revealed a $7.9 billion disclosure to bad debt. It wasnt just investment banks that found themselves in trouble. The biggest insurer in the US, American Insurance Group (AIG) teetered on the brink of failure due to bad bets it had made on insuring complex financial securities. It survived only after billions of dollars of bailouts from Washington.33 A major bond insurer MBIA announced a loss of $2.3 billion. After failing to search for a potential buyer, Lehman Brothers becoming the first major US investment bank to collapse since beginning of the credit crisis. The Federal Reserve slashes the key interest rate to by 0.5% to 5.75% at which it lends banks, warning the financial crisis could be a risk to economic growth. Not only the US Federal Reserve, the Bank of Canada and the Bank of Japan also begin to intervene. To improve this situation the European Central Bank subsidized 108.7 billion Euros into the financial market to try to improve liquidity. UK high risk mortgage providers set to pull out mortgages and increased the cost of borrowing for UK homeowners with poor credit histories.34 Former Federal Reserve chief Alan Greenspan described the current financial crisis as "probably a once in a century type of event" and cautioned that this financial calamity will lead to the closure of major firms. The US House of Representatives passes a $700bn (394bn) government plan to rescue the US financial sector a part of $900bn (600bn) economic stimulus package. Since the collapse of Lehman Brothers, the global economy and financial markets have changed dramatically. The fourth quarter figures for GDP, industrial production, and exports have started to be released in various countries, and a sharp decline that could be indeed expressed as jump off a cliff has been witnessed
33

34

Brain Keeley and Patrick Love, From Crisis to Recovery, OECD Insights, 2010, p.18. Riyazi Farook, Global Financial Crisis Unthinkable Under Islamic Banking Principles, Islamic Finance and Banking, Srilanka, 2009, p.2.

32

simultaneously worldwide. The Bank of Japan released the economic outlook, according to which the median forecast of Japans economic growth for fiscal 2009 among Policy Board members was substantially revised downward from 0.6% as of end-October 2008 to -2.0%35. Extreme market volatility caused a loss of 600 million Euros to French savings bank Caisse d'Epargne during the financial market crisis. South Korea announced a $130bn financial rescue package to stabilize its financial markets. The Dutch government funded 20bn Euros ($26.8bn) to protect the financial sector from the credit crisis. Sweden's government also announced its financial rescue plan, with credit guarantees to banks and mortgage providers up to a level of 1.5 trillion kroner (117.2bn, $205bn). The government also announced it will establish aside 15bn kroner as a bank stabilization fund.36 In the first few months of the financial crisis, there was the widely held view that the impact on African countries would be minimal because of their low integration into the global economy. Recent developments have, however, shown that the negative contagion effects of the crisis were already evident in the Africa region. For example, stock market volatility has increased since the onset of the crisis and wealth losses have been observed in the major stock exchanges. In Egypt and Nigeria, the stock market indices declined by about 67 percent between March 2008 and March 2009. Significant losses have also been observed in Kenya, Mauritius, Zambia and Botswana. The turmoil in African stock markets is beginning to have significant negative effects on the financial sector and on aggregate demand. For example, there is growing evidence that it has a negative effect on bank balance sheets and, if present trends continue, non-performing
35 36

Ibid, p.3. ibid

33

loans in the banking sector would likely increase, with dire consequences for financial stability in the region. In Ghana, the ratio of non-performing loans to gross loans increased from 7.9 per cent to 8.7 per cent between 2006 and the third quarter of 2008. In Lesotho, it increased from 2 per cent to 3.5 per cent over the same period.37 The impact of the crisis was equally seen in Asian Banking sector. Most of the Asian countries, being underdevelopment (referred as Low Income Countries also as Emerging Market Economies) constitute a large proportion of their GDP* in the form of ODA (Official Development Assistance) and FDIs (Foreign Direct Investment). In response to the crisis, the donors reduced ODA flow in the region and there was a healthy decline in FDI flow as well. As a result, the top 20 LIC banks were caught by surprise by the global financial crisis at the height of their balance sheet expansion and also experienced a sharper decline of deposit growth in 2008.38 Moreover, amid the current financial and economic crisis, global FDI flow has shown downward trend and, according to UNCTAD, global FDI fell by 21 percent annually in 2008, after five years of strong growth and a record level of US$1.8 trillion in 2007. Developed countries witnessed the sharpest downturn of 33 percent while FDI flows to developing countries remained positive in 2008. However, growth rate decreased from over 20 percent in 2007 to 3.6 percent in 2008. Developing countries in regions like Africa which received huge amount of
African Union Commission, The Global Financial Crisis: Impact, Responses and Way Forward, 2nd Joint Annual Meetings of the AU Conference of Ministers of Economy and Finance and ECA Conference of Ministers of Finance, Planning and Economic Development, Cairo, Egypt, 2009, p.2. 38 Jack Joo K. Ree, Impact of the Global Crisis On Banking Sector Soundness In Asian Low-Income Countries, IMF Working Paper no.115, May 2011, P.10. *Gross Domestic Product (GDP), is the total market value of all the final goods and services within an economy in a given year.
37

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FDI in recent years faced a sharper decline in FDI mainly triggered by the decrease in commodity prices, as most of the FDI in these economies was resource motivated.39 1.4.3 IMPACT OF GFC ON ISLAMIC FINANCE INDUSTRY The current global financial crisis has not only shed doubts on the proper functioning of conventional Western banking, but has also increased the attention on Islamic banking. Internationally, Islamic banks appear to have been more resilient to the primary effects of the global economic turndown and international financial crisis than conventional banks. The main reason for this being the inherent nature of Islamic banks, which shun the risky and much misunderstood financial products and also the fact that it is an asset backed banking. They tend to avoid the speculative investments, such as derivatives, that many analysts believe led to the financial crisis affecting conventional banks. For some observers, Islamic finance serves as a vehicle for recovering from the international financial crisis. The Islamic banking industry may be able to strengthen its position in the international market as investors and companies seek alternate sources of financing.40 However, as Islamic banks operate within a global financial system, they have not been completely insulated from the recent economic and financial shocks. For instance, on the one hand, the Islamic financial industry is considered by many to be less risky because financial transactions are backed by physical assets. On the other hand, Islamic banks may be more vulnerable to fluctuations in the mortgage
Riyazi Farook, Global Financial Crisis Unthinkable Under Islamic Banking Principles, Islamic Finance and Banking, Srilanka, 2009. 40 Stephen Timewell, A Template For Averting Disaster? - Roundtable, The Banker, January 1, 2009, Academic One File, Gale, Library of Congress, accessed February 6, 2009.
39

35

market, given their high activity in the real estate sector compared to conventional banks. The recent slowdown in real estate activity in the Gulfeconomies raises concerns about some Islamic banks financial positions.41 Some economists, particularizing their research, have made attempts in this direction. For example Sat Paul Parashar and Jyoti Vankatesh, in their research paper have tried to show that Islamic banks have suffered more than conventional banks during recent global financial crisis in terms of capital ratio, leverage and return on average equity, while conventional banks have suffered more than Islamic banks in terms of return on average assets and liquidity.42 Tracing impact of the crisis on both financing industries i.e. Islamic as well as conventional, Beck et al. (2010) have compared the two types of banking and their performance across many countries, during recent crisis and have come up with the conclusion that though both types of banking were affected by the crisis, Islamic banks had higher capitalization coupled with higher liquidity reserves, resulted in better performance of Islamic banks.43 Answering to the question whether Islamic banks were equally affected during the current global financial crisis or not Dr. Linda Eagle, member of The Edcomm Bankers Academy responds, Unlike many Western financial institutions, Islamic banks have remained relatively unharmed during the current global financial crisis. In fact, Islamic finance has gained a greater acceptance and more widespread recognition in recent years, as more and more Muslims and non41

Shayerah Ilias, Islamic Finance: Overview and Policy Concerns, Congressional Research Service, 2010, p.3. 42 Sat Paul Parashar and Jyothi Venkatesh, How Did Islamic Banks Do During Global Financial Crisis?, Banks and Bank Systems, Volume 5, Issue 4, 2010, P.55. 43 Thorton Beck, Asli Demirgue-Kent and Merrouche Quarda, Islamic vs. Conventional Banking Business Model, Efficiency And Stability, The World Bank, Development Research Group, Policy Research Working Paper 5446, October. 2010.

36

Muslims worldwide have taken an interest in Shariah-compliant banking products and services due to its more prudent investment and risk philosophy. In response, Islamic Banks are starting to open up in many countries across the globe, helping this segment of the financial industry to continue to flourish. Islamic finance remained steady in this tough global economy primarily due to the nature of the industry. According to the laws of Shariah, the buying or selling of debt is strictly prohibited, as well as insurance and investment gains and excessive risk-taking. In other words, Shariah-law does not allow individuals or companies to borrow money that does not exist it must be invested into productive enterprises. It is this more cautious attitude towards money that has kept Islamic banks relatively safer from the effects of the global financial crisis today compared to their conventional banking counterparts.44 A new IMF study compares the performance of Islamic banks and conventional banks during the recent financial crisis, and found that Islamic banks, on average, showed stronger resilience during the global financial crisis. Figure No.5 provides a comparison of the average profitability, credit and asset growth in 2008 to its 2007 level (cumulative impact) shows that IBs fared better in all countries, except Bahrain, Qatar, and the UAE. In four countries (Bahrain offshore, Jordan, Saudi Arabia, and Turkey), the change in profitability was significant in favor of IBs.45

44 45

Dr. Linda Eagle, Expert Views, 36 Global Islamic Finance, Jan 2010. Maher Hassan & Jemma Dridi, The Effects of the Global Crisis On Islamic And Conventional Banks: A Comparative Study IMF Working Paper no. 210, Sep. 2010, P.16.

37

Figure No. 5 Source: Maher Hassan & Jemma Dridi, IMF, 2010 The above cited IMF study report suggests that Islamic finance system has a great potential for further market share expansion and a possible contribution to market stability through the available credit. Performing well in the first phase of the crisis, however weaknesses in risk management practices in some of the Islamic banks led to a larger decline in profitability compared to seen in conventional banks during the second phase of the crisis. While talking to Arab News Online, M. Parker has pointed towards the same reality.46 Parkers observation can be summed as, the lack of contract standardization, the absence of instruments to hedge against the volatility in currency and commodity markets, the incomplete legal framework, and the insufficient expertise at the supervisory and industry level may weaken the potential of Islamic finance sector and may affect its reputation. This decline can be visualized in the figure No.6. It was also

46

M. Parker, Islamic Banks Fared Better During Financial Crisis, Arab news on-line 19 September, 2010, Retrieved on 18 February 2011 from http://arabnews.com/economy/islamicfinance/article142384.ece.

38

seen that large Islamic banks fared better than small ones, perhaps as a result of better diversification, economies of scale, and stronger reputation.47

Figure No.6 Source: IMF Staff Estimates and Calculations48 The global market for Islamic bonds is estimated to be $80 billion currently. After increasing more than five-fold from 2004 to 2007, global issuance of sukuk hit a three-year low point in 2008. Sukuk issuance began slowing down in late 2008, partly due to the global economic turndown, the international sukuk market faced lower levels of liquidity, resulting from declines in oil prices and reduced confidence from investor. According to some estimates the total Islamic Bond Market decline in year 2008 was 24%. Despite current challenges, many analysts believe that the long-term viability of the Islamic bond market appears strong, owing to the growing popularity of Islamic financial products, increased

47

Samir Srairi, Imen Kouki, and Nizar Harrathi, The Relationship Between Islamic Bank Efficiency and Stock Market Performance: Evidence From GCC countries, Center for Islamic Economics and Finance, Qatar Faculty of Islamic Studies, Qatar Foundation, 2010, P.2. 48 IMF Survey Online, Islamic Banks: More Resilient to Crisis? , October 4, 2010.

39

government interest in Islamic finance, investment and financing needs of the Gulf countries, and financial institution seeking greater diversification.49 It is relevant to end up this chapter with the evaluations made by Sat Paul Parashar and Jyothi Venkatesh. After comparing six different ratios CAR, CTI, ROAA, LA/TA and E/TA of Islamic and conventional banking systems for full four years, and also before and during the crisis, inter and intra group, they have concluded their research paper in following words, In conclusion, it may be stated that Islamic banks did suffer during crisis in terms of lowering of CAR, E/TA and ROAE, but overall, over four years period, they performed better than conventional banks.50

Hussein Alasrag, Global Financial Crisis And Islamic Finance, , World commerce Review, vol. 36, 2009, p.56.
50

49

Sat Paul Parashar and Jyothi Venkatesh, How did Islamic Banks Do During Global Financial Crisis?, Banks and Bank Systems, Volume 5, Issue 4, 2010, P.61.

40

Chapter-2

LITERATURE REVIEW

41

2.1 LTERATURE REVIEW Like all previous crisis, many theories have been proposed to explain the causes and impact of the current global crisis. A vast literature in the form of books, articles and research papers was brought to compilation. This chapter will present a brief review of some books and articles compiled in this direction by Muslim as well Western experts for socio-professional benefits. 2.2 BOOKS Book: Author: Publisher: Pages: Description Despite being an evolving industry, the PLS (profit loss sharing) orchestrated and low risk equity based instruments has potentialised the Islamic financial sector to uplift its growth curve. The present book is a scholastic endeavour, wherein the author has examined the nature and operating mechanism of some elementary financial techniques and their role in bringing up Islamic finance industry in the contemporary financial scenario. The book has been divided into six sections including an introductory and concluding section. In its introductory section, the avoidance of the interest based transactions has been described as the elementary character which differentiates Islamic banking from conventional banking. It also provides basic information Contemporary practices of Islamic Financing Techniques Ausaf Ahmad Islamic Research Training Institute, Jeddah, 1993 75

42

about the objectives, dimensions and entire structural plan of the study. This section has direct relevance with the chapter 3rd of the present study. In second section Common practices of Islamic banks in the sources of Islamic finance of the book, a detailed description has been made about the services and practices offered by most of the Islamic banks so to make funds available for business transactions to gain profit. Current accounts, saving deposits, investment deposits, joint/general investment account, limited and unlimited investment deposits, specified investment deposits together with deposit management in Iran and Pakistan have been also explored under the same section. This section is relevant to chapter 3rd and 4th of the present study. Islamic financial tools and equity based transactions that formulate the central body of Islamic banking have been elucidated in detailed account in section third common practices of Islamic banks in the uses of funds of the book. The author visualizes that, in an Islamic bank, application of funds is being carried out through these instruments. Mostly operated instruments like Musharakah, Mudarabah, Ijarah, Murabahah, Bai, Qard al- hasan etc have been fully elaborated along with their types. This section is in relevance to the chapter 3rd of the present study. Section four Islamic financing techniques specifically used in Pakistan and five Islamic financing techniques specifically used in Iran describes the respective Islamic financing techniques used in Pakistan and Iran, particularly those tools which have not been covered in earlier sections. Trade, investment and loan related financial techniques mostly being observed in Pakistan and salaf transactions, Juaalah, Musaqat, Muzarah etc in Iranian context have been

43

discussed very skillfully. Last section based on conclusion, summarizes the overall study and author has ended up with some valuable suggestions with respect to further research on the same subject. Section no. 4, 5 and 6 are having relevance with chapter 3rd and 4th of the present study. As all sections of the book are in relevance with the subject matter of the present study, hence it has cited in both literature review as well as bibliography of the present study.

Book :

From Crisis To Recovery: The Causes, course And Consequences Of The Great Recession.

Authors: Publisher:

Brain Keeley & Patrick Love. Organization For Economic Co-operation And Development (OECD) Publishing, France, 2010.

Pages: ISBN: Description:

144. 978-92-64-06911-4

2007, 2008, the worst of crisis in the decades ripped through the global financial systems. Along with massive unemployment, collapse of housing prices and spread of distress throughout the markets and economics around the world, it has become a greater threat for economists and finance experts to predict where global economy might go next. The book under review has been brought to publication by the publishing unit of OCED (Organization For Economic Cooperation And Development), intending to provide a strategic response to the

44

above said problem. The book draws on the OCEDs analyses of why the financial crisis occurred and added to its rapid expansion into the real economy. The book offers a structural framework, what authors believe is a Green Growth Strategy to guide national and international economic policies. The book also demand governments to take a stronger lead in fostering production, procurement and consumption patterns by abstaining opaque frameworks and ensuring transparency in market working. The book comprises of seven healthy chapters, each chapter authenticated with graphics, charts from OECDs publications and papers as well as quotations from their direct texts and is ended up information source links. Chapter first, entitled as Introduction is an overview of the actual study. It makes a reader conversant about what a financial bubble burst means and what can be its hitting areas. Discussing the recession and its legacies from 2008 onwards, the unprecedented contraction in world economy, the growing unemployment rate, the excessive borrowing by governments and fall in the volume of world trade in goods and services have been numerically evaluated with special reference to OCED countries. Second chapter The Roots of a Crisis deals with the question, what caused a financial crisis? It also looks at the pressure that built up in global finance in the years before the crisis struck. In authors observance the factors like easy access to cheap borrowing, asset price bubble, poor regulation, high securitization in banking and opaque marketing activities added to global liquidity bubble. Encompassing the spheres of its affect, it has been found that not only investment banks were caught in trouble but insurance companies like American

45

Insurance Group, the bigger insurer in US teetered on the brink of failure. It survived only after billions of bailout from Washington. While locating the birth place of the current financial crisis, the key economies like Japan and United States have been pointed out. This chapter is relevant to the chapter 1st of the present study. The third chapter Routes, Reach, Responses examines the routes of the recession, the sphere that it has brought under its affect and the responses from various sectors to its stimuli. It has also enumerated the factors, which resulted in the transformation of financial bubble from individual economies to global economy. Tracing the route of the crisis, it has been observed that the central route for the current financial crisis is slowdown in banking markets which started with decline in housing prices simultaneously in United States and Japan. It has also discussed how the bank crisis spurred governments and central banks to respond. This chapter is relevant to chapter 1st of the present study. Chapter 4 The Impact On Jobs looks at the impact on jobs, including the risk that the recession will be followed by a jobless recovery that contributes to a lost generation of young people in the work force . Chapter 5 Pensions And The Crisis looks at the impact on pensions: the crisis highlighted issues in both funding and benefits that population ageing and changing career patterns could aggravate. Chapter 6 New World, New Rule? considers the push for new rules and standards in three key areas financial markets, tax evasion and business and economic ethics.

46

Finally, Chapter 7 The Future, Five Questions examines some longer-term issues arising from the recession, including rising national debts, the prospects for turning the recovery into an opportunity for green growth and the challenges facing economics as a profession. Chapter no. 4th, 5th, 6th, and 7th are in relevance with 4th and 5th chapter of the present study. Since the subject matter of the book is in relevance to the present study, hence it has included in the literature review and bibliography as well.

Book : Author: Publisher: Pages: ISBN: Description:

Islamic Finance. Dr. Venkataraman Sundararajan. SAGE Publications India Pvt. Ltd., 2011 291 978-81-321-0706-4 (HB)

Islamic finance, is a collection of selected writings of Dr. Sundararajan (19452010) edited by Jaseem Ahmad and Harinder S. Kohli. The papers accumulated in this book, are significant, perceptive and insightful presenting a comprehensive overview of the Islamic financial architecture. Outlining many complexities in the development and mainstreaming of Islamic finance industry, that can help it in becoming a competitive, resilient and an important global financial intermediary. The chapters in this book are blend that would benefit lay readers, casual students of Islamic finance and policy makers at national and international level.

47

The chapterization of the book follows a chronological order and has been structured into three parts. Part 1 consists of the first chapter of the book, Current developments and Key Issues in Islamic Finance. In this chapter the author has described the basic foundations, core principles and key features of Islamic finance. It also discusses the structure, size and expanding scope of Islamic finance industry. Part 2, comprises of four comprehensive chapters. Chapter 2 Monetary Operations and Government Debt management under Islamic banking focuses on three critical issues: firstly issuance of government securities under Islamic finance principles, secondly recent developments in monetary instruments under Islamic banks and thirdly issues in institutional arrangements for monetary operations. Chapter 3rd Islamic Financial Institutions and Products in the Global Financial System: Key Issues in risk Management and Challenges Ahead addresses various issues related to risk management policies and also suggests ways to manage the risks, including invigorating the regulatory and disclosure framework. Chapter 4th Risk Measurement and Disclosure in Islamic Finance and the

Implications of the Profit Sharing Investment Accounts defines a specific approach to measure the actual of the risks between share-holders and profitsharing investment account holders, based on the value-at- risk methodology. Part 2nd ends up chapter 5, titled as A Note on Strengthening Liquidity Management of Institutions Offering Islamic Financial Services: The Development of Islamic Money Markets focuses on, the rationale for Islamic money markets development, an overview of factors affecting the money markets including legal

48

and Shariah issues, structure and instruments of Islamic lone markets, financial management and role of monetary operations. Part 3rd consists of three chapters. Chapter 6 Issues in managing Profit Equalization Reserves and Investment risk Reserves in Islamic Banks outlines the main determinants of profit equalization and investment risk reserves and their relationship to displaced commercial risk. Chapter 7, Towards Developing a Template to Assess Islamic Financial Services Industry (IFSI) in the World Bank-IMF Financial Sector Assessment Program (FSAP) describes the structural plan for FSAPs and IFSIs. The voluminous work ends with chapter 8, Supervisory, and Capital Adequacy Implications Of Profit-Sharing Investment Accounts In Islamic Finance. The chapter describes the main types and characteristics of PSIAs under mudarabah contracts. The chapter concludes with suggestions for risk-sharing as well as implications of these PSIAs for the supervisory and regulatory authorities. As all parts of the book are in relevance with the chapter 3rd and 4th of the present study, thus it has been cited in both literature review as well as bibliography. Book: The Global Financial Crisis: Can Islamic Finance Help Minimize The Severity And Frequency Of Such A Crisis In The Future?. Author: Publisher: Muhammad Umer Chapra Center for Islamic Area Studies at Kyoto University (KIAS), Japan,2009. Pages: 51.

49

IBN: Description:

978-4-904039-13-7

The present book describes the primary causes that contributed about the present global financial crisis. In authors observance excessive landings, high leverage speculations and non availability of risk-sharing mechanism are some of the key factors responsible for the current financial crisis. While analyzing the question, whether Islamic finance industry could minimize the frequency of the crisis, the author has come up with the conclusion that, because of its equity based transactions, risk mitigation policies and market management discipline Islamic finance industry has a substantial tendency to reduce the financial instability. The book has been divided into three chapters. In the first chapter The primary causes of the crisis the author has highlighted those determining factors responsible for the current crisis that has taken more than three million dollars of bailout and liquidity injections by a number of industrial countries abate somewhat intensity of the crisis. Excessive lending, inadequate discipline in financial markets and excessive leverage have been detected as major causes of the crisis. This chapter has relevance with chapter 1 of the present study. Chapter 2nd The Islamic Financial System provides an overview of the Islamic financial system. It has discussed its themes and objectives as well. This chapter is in relevance o the chapter 3rd of the present study. Is This of Any Relevance to the Conventional System has become chapter 3rd of this book. This chapter is based on suggestions and recommendations. How

50

financial institutions can minimize the growing speed of current financial crisis by applying Islamic equity instruments, is central subject of this chapter. As this book is relevant with the subject matter of the present study, hence it has been mentioned in literature review as well as bibliography. Book : The Stability Of Islamic Finance: Creating A Resilient Financial Environment For A Secure Future. Authors: Hussein Askari, Zamir Iqbal, Noureddin Krichene and Abbas Mirkhor Publisher: Pages: ISBN: Description: This book is a collective effort of four renowned trained Islamic economists, holding a strong expertise in banking and finance sector. The book is of vital use both in academics as well as for Islamic financial institutions in sophisticating their financial operations. The authors argue, that Islamic financial engineering and financial tools, inheriting a much balanced potential, have attained such a position where they are able to provide the world a stable and much resilient financial environment in the twenty-first century. This argument has become central theme of the book. In this connection the authors have significantly developed themes that link Islamic finance to existing traditions in economics, that assess the stability property of Islamic financial instruments and that explain John Wiley & Sons (Asia) Pte. Ltd. 2007. 256. 978-0-470-82519-8

51

some key Islamic concepts in economists terms. Using valid arguments, the authors intend to demonstrate, how conventional finance can generate cyclical instability in credit creation which in turn leads economic booms and busts. While tracing out the various causes responsible for the worldwide financial crisis, the book blames that, the monetary expansion in reserve centers leading to internationalization of the crisis, negligence towards monitoring of monetary aggregates, lapses in corporate governance and lack of profit-loss scheme are some of the major causes. The authors also argue that, Islamic financial system is inherently more stable than conventional system because its equity based instruments are directly linked to the productivity of the real investments they finance, and therefore not only enhance social objective of sharing risks and rewards, but cushion financial intermediation against the inherent risks of excess, both in booms and slumps. Excluding the first chapter the overall content of book is in relevance to the present study and has been included in the literature overview. The authors have divided the overall content of the book into thirteen chapters. In chapter 1, the authors have dealt with the problem of nature of the capital and the rate of return. Under the same chapter some classical capital theories have been critically evaluated like the capital theory of Adam Smith and David Ricardo through the writings of Stanely Jevons, Karl Marx, Eugen Von Bohm-Bawerk, Knut Wicksell and others. In chapter 2, 3, 4 and 5, authors have wrestled with the problem of global financial instability, its origins, its causes, its implications over world economy and its frequent shift from individual economy to global economy what the

52

authors have cited as internationalization of the financial crisis. These chapters also discuss the interwoven network of inherent causes like Carelessness in monitoring the monetary systems, uncontrolled bank money creation, beggarthy-neighbor policies in pursuit of short economic growth gains, floating exchange rates and increasing recourse to debt financing responsible for misbalancing the equilibrium of conventional financial sectors. These chapters are in relevance to the first chapter of the present study. In the chapter 6 the main theme of the book: the inherent stability of the Islamic financial sector, has been discussed with a detailed account. The Islamic financial system which completely avoids interest and interest based assets, has been projected and modeled as non-speculative equity ownership that is ultimately linked to the real sector and where demand for new shares is determined by the real savings in the economy. This chapter has relevance with third chapter of the present study. From chapter No.7 to chapter No.13, authors have overviewed the various dimensions of Islamic finance. Chapter 7 analyses the theoretical model that deals with the inherent stability of Islamic finance. Chapter 8 discusses the escape of Islamic finance from a systemic risk, either at the central banking or financial institutional level. Chapter 9 reviews the nature of Islamic financial intermediation and highlights how the combination of such type of banking and markets will lead to stable financial system. Chapter 10 discusses the risk profile of an Islamic financial intermediary. In chapter 11 the authors have examined, that the exclusively debt operations and speculations investments lead towards financial instability. It also discusses the appropriate safeguards and regulatory framework

53

to strengthen the stability of Islamic finance. Chapter 12 of the book has visualized the importance of corporate governance for the progress of financial institutions. Chapter 13 the last chapter of the book, deals with the role and performance of the Islamic financial intermediaries and Islamic finance instruments that helped the Islamic finance industry to save its investors as well as institutions from the disastrous effects of the ongoing financial crisis. This part of the book is in relevance with the chapter third and fourth of the present study. The book ends with a healthy conclusion wherein the authors suggest for some constructive reforms and remedies towards building up a stable economy. Book : Author: Publisher: Pages: ISBN: Description: Economists where hopeful that 2008 crisis would be restricted to financial markets, with few repercussions on the real economy and the rest of the world. According to author this hope was shattered in September 2008 as the crisis entered an acute phase, with strong downward fluctuations in the stock markets, substantially reduced rates of economic growth, volatile exchange rates, and squeezes in demand and consumption, leading to falls in industrial production and decreasing flows of international trade and FDI, and causing impacts on related areas such as transfer of technology. This book is an attempt to bring forth the major causes and impact of the current financial and economic crisis. It Global Financial Crisis And Islamic Finance. Hussein Alasrag VDM vesrlag, Germany, 2010. 70. 3639252276.

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has also taken a critical evaluation of the claim made by Islamic finance sector that the Islamic finance and its prospective is a viable alternative to the ailing global financial sector. As per its subject matter, the author has divided the book into five chapters. The introductory chapter of the book has taken a brief overview of the origin, severity and consequences of the current financial crisis on the globally integrated economy. It also provides a short summary about the Islamic investment and financing mechanism, together with the multiple reasons for its constant growth in the recent years. Chapter 2nd,Fundamentals of the Islamic finance describes nature, principles and sources of Islamic economics in general and Islamic finance in particular. It also discusses some basic issues related to the application and interpretation of its Laws in the current times. Islamic banking, its origin and emergence and some key financial tools like Murabaha, Mudarabah, Musharakah, Ijarah, Salam and Sukuk have been also discussed in the same chapter. This chapter has relevance with the chapter 3rd of the present dissertation. Chapter 3rd,Nature of the global financial and economic crisis has explored the structural causes that helped to bring about the crisis from an Islamic perspective. It has also taken a detailed account of impact of the crisis, approaches towards possible solutions and an agenda for a systematic reform. This chapter is in relevance to the chapter 1st of the present work. In Chapter 4th, Islamic finance and the global crisis Sukuk, the most significant Islamic bond has been brought to full exploration. Some valid suggestions have been put forward from authors side, to weaken the list of limitations in Islamic financial sector. According to author, financial engineering, risk management and

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diversification and development of capital are some dimensions which need an immediate attention. This chapter is relevant to the chapter 3rd and 4th of the present study. In the concluding chapter The global financial crisis: Lessons from and for Islamic finance the author has come up with some practical suggestions for both Islamic as well as conventional system of banking and finance. Firstly author recommends, that what lessons conventional banks should have derived from the Islamic banks during crisis and secondly, what innovations Islamic banks should adopt in order to maintain a constant pace. This chapter is relevant to the chapter 4th of the present study. Since overall content of the book, is in close relevance to the subject matter of the present study, thus it has been included in both literature survey as well as in bibliography. Book : Author: Publisher: Pages: ISBN: An Introduction to Islamic Finance. Mufti Muhammad Taqi Usmani Adam Publishers & Distributors, India, 2010. 246. 81-7435-595-2.

Description: Due to the growing importance of the Islamic finance, Muslim economists felt a severe need to bring forth such compilations, which will explore the mechanism

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and instruments used in the Islamic financial system. The present book is an endeavor towards the same cause. Based on the collection of different articles written by the author, it provides basic information about the principles and precepts of Islamic finance, with special reference to the modes of financing used by the Islamic banks and non-banking financial institutions. This book comprises of eight chapters. Chapter one Some Preliminary Points has discussed some basic themes related to Islamic economics and purpose behind its establishment. Chapter 2nd Musharakah describes the basic principles of Musharakah and the scope of its application. The basic problems which may be faced in implementing it in a modern situation. Chapter 3rd Murabaha has discussed the Murabaha as vital mode of financing, its features, the issues involved in its application, the securities guaranteed against Murabaha price and some basic mistakes in its operation. Chapter 4th Ijarah deals with principles of leasing. The relationship between lease and leaser, the commencement of lease, the insurance of the assets and finally the securitization of Ijarah has been also discussed in this chapter. Chapter 5th Salam and Istisna provides detailed information Salam as mode of financing, its contemporary relevance and conditions attached to it. This chapter also highlights the difference between Salam, Istisna and Ijarah. It has also discussed Istisna as a mode of financing. Chapter 6th Islamic Investment Funds attempts to explore the nature of Islamic investment funds within the premises of Islamic Shariah. It also gives detailed

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account about Equity fund, Commodity fund, Murabaha fund, Bai-al-dain and Mixed fund. Chapter 7th The Principle of Limited Liability aims to explain the concept of limited liability and evaluate it from the Shariah perspective, to know whether or not this principle is acceptable in Islamic economics. It has also discussed some economic institutions like Waqaf, Baitul- mal and Joint stock which are somehow related to limited liability. The last chapter The Performance of the Islamic Banks seeks to analyze the operation of Islamic banks and financial institutions in the light of Shariah. It also highlights what they have achieved and what is yet to achieve. The overall content of this book is in relevance with the chapter 3rd of the present study, hence it has been included in the literature review as well as in the bibliography. Book : Author: Publisher: Pages: ISBN: Description: Introducing Islamic finance in academia is a real commencement towards building a stable economy within the permits of Shariah. Continuing the same objective, Understanding Islamic Finance. Mohammad Ayoub. John Wiley & Sons Ltd, England, 2007. 516. 978-470-03069 (HB)

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this voluminous book Understanding Islamic Finance is also a vital stuff from authors side. The author has made every possible effort, in exploring the nature, workability and practicality of Islamic financial tools and practices in the contemporary financial scenario. The author has divided the book into three comprehensive parts. Part first comprising of four chapters, part second comprising of three chapters and part third comprising of ten chapters. In chapter 1, 2, 3 and 4 of the part first, the author has critically analyzed the foundational principles of conventional system of economy and its applied tools. In authors observance the conventional system of economy is heavily engulfed by interest based financial policies and debt financing mechanism which in turn has created an obstacle in observing the socioeconomic egalitarianism all-round the world. Bringing out the portfolio of Islamic finance the author argues that, because of its inherent numinous character Islamic finance industry carries a potent capability to ensure socio-economic wellbeing. The characteristic features, principles and philosophy of Islamic system of economy together with its laws and contracts have been elucidated very skillfully. The rationale behind prohibition of interest (Riba in Quranic terminology) has been also discussed with sound argumentations. In the part second that includes chapter 5, 6 and 7, the author has presented a work plan for Islamic banks and financial institutions through which different financial tools and operations can be undertaken very effectively. Along with sketching the nature of Shariah based financial contracts, the author has also endeavored to explore their field of application. Some of the significantly beaten

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financial tools like loan, sale and debt have been discussed within the periphery of Islamic commercial law. From chapter no. 8 up to chapter no. 18th, covers part third of the book. It starts with a detailed description of both conventional as well as Islamic financial institutions and also provides a healthy comparison between the two. Chapter no. 9, 10, 11, 12 and 13 is related to Islamic financial instruments including Musharakah, Mudarabah, Musawamah, Ijarah, Rahn, Murabahah, Tawarruq and Istijar. Each and every financial tool has been discussed in detail i.e. its recognition by Shariah, its operational standard and its dimensions of

application. Some guiding principles associated with product development issues and deposit management have been briefly discussed in chapter 14th. Some of the vital financial tools like Takaful and sukuk which were lately introduced into Islamic finance industry have been discussed in chapter no. 14th and 16th. Mechanism of their operation has been also described in relevance to the 21st century context. Chapter 17th is based on the cross evaluation of some critical writings on complied on Islamic finance and finally this voluminous work ends with a healthy discussion about the prospects and challenges hindering the streamline flow of Islamic finance industry. The book has a significant relevance with chapter no. 3rd and 4th of the present study, hence it has been incorporated in both literature review as well as bibliography.

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2.3 ARTICLES: Article: Structural Causes of the Global Financial crisis: A critical assessment of the new financial architecture. Author: Publisher: Volume: Description: According to James Crotty, a macro economist and Professor Emeritus of economics at university of Massachusetts, Amherst, the present financial crisis has taken the form of cycles in which the deregulation accompanied by rapid financial innovations has stimulated powerful financial booms that ended in the global financial recession. Forcing the governments to respond, the crisis took trillions of dollars to bailout. In this paper the author has analyzed the structural flaws in the prevailing financial system that helped to bring on the global financial recession. In authors observance the excessive growth of financial markets in relation to the non financial economy, increasing complexity in important financial tools, opaqueness and illiquidity in financial transactions and wide spread leverage caused a greater contraction in financial institutions. As a result financial crisis became more threatening. The key structure flaws of new financial architecture, build on very weak theoretical foundation have been also discussed by the author in detailed account. James Crotty. Cambridge Journal of Economics, U.K, 2009. 33.

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In the conclusion, the author has come up with healthy reformative policies for banks and financial institutions. In order to invigorate the authenticity of the paper the author has quoted from different journals of international repute. The article has relevance with chapter 1st of the present study hence it has been included in literature review as well as bibliography. Article : Author: Publisher: Description: The pervasively virulent and far reaching repercussion unleashed by the current global financial crisis has shaken the foundations of the global financial system. As a reaction, it has sparkled the international call for the reformation of the existing financial architecture. Despite this constraint situation, the Islamic financial industry has been able to weather this first wave of the global financial crisis, demonstrating its robustness as a stable form of financial intermediation. The dynamic nature of the Islamic financial system is reflected by its solid growth and the increased range of its services. As the role and relevance of Islamic finance in the global financial system gains significance, it will not only increase its potential to contribute to global financial stability but also towards strengthening global growth. Financial products and services and the establishment of new Islamic financial service providers from the different parts of the world including from the non-Muslim world. The present paper is as such an attempt to explore the dimensions and conceptual applicability of the Islamic finance principles in order to overcome the situation. According to authors study, with its emphasis on a strong linkage to productive Islamic finance and global financial stability. Dr Zeti Akhtar Aziz. Islamic Financial Services Board (IFSB), 2009.

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economic activity, its inbuilt check and balances and its higher level of disclosure and transparency Islamic finance industry offers a more resilient and robust system of financial operations. As Islamic finance industry continues to become an integral part of the global financial system, it will be increasingly exposed to risks of financial stress arising from global financial instability. In this concern it needs much sophistication, well balanced risk management and proper liquidity techniques together with productive financial innovations, which will not go against the maqasid alShariah, the objectives of Shariah. As the role and relevance of Islamic finance in the global financial system gains significance, it will not only increase its potential to contribute to global financial stability but also towards strengthening global growth." The article has relevance with chapter 3rd and 4th of the present study and has been included in both literature review as well as bibliography. Article : Author: Publisher: Description: The present paper has been written for a panel discussion on the evolution of global financial crisis from the current crisis, which was held at Harvard Law School, Islamic Legal Studies and Islamic Finance Project in 2009. This paper presents an insight study of, what where the determining causes which resulted in the transformation of U.S subprime crisis into global financial crisis. It also describes that whether Islamic financial tools does hold the potential to somehow The Relevance of Islamic Principles to Global Financial Crisis. Amir A. Rehman. Harvard Law School, Islamic Legal Studies Program, 2009.

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reduce the intensity of the crisis, together with their relevance in the continuing crisis situation. The Islamic financial sector, which according to author is a new global player, has not been immune from the current financial crisis but the impact was very less and to a large extent it managed its institutions as well as investors to escape from the virulent affects of the current crisis. Several aspects of Islamic Banking, holding an inherent potential to provide insulation to its mechanism and operation from the major risks of crisis. As a supportive argument, the author has cited an official Vatican publication, ethical principles on which Islamic finance is based, may bring banks closer to their clients and to the true spirit which should mark every financial service. The paper also claims that the relevance of Islamic financial operations is very significant today and it is believed to grow further due the three major factors. These are as: 1) The conceptual applicability of principles inherent in Islamic finance. 2) The increasing importance of Muslim economics in an interdependent global economy. 3) The increasing Shariah affinity observed in key Muslim countries. Among the above mentioned three factors, the author has focused on the first factor, thus it has become the central theme of the paper and the relevance of Islamic financial principles from the conceptual perspective has been discussed in detail. The article has relevance with chapter 3rd and 4th of the present study and has been included in the literature review and bibliography too.

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Article : Author: Publisher: Volume: Description:

Introduction: the global financial crisis. Stephanie Blankenburg and Jose Gabriel Palma. Cambridge Journal of Economics,2009. 33.

The current financial crisis that has forced governments, institutions and financial centers to respond to come up with new a financial structure, which would be resilient to such long cycles. The present paper is an attempt to take an in-depth analysis of particulars facets and features of the financial crisis with a breadth of coverage that spans its antecedents, its immediate causes and its potential consequences in the longer term. The authors S. Blankenburg and J.G Palma have much relied on the empirical grounds connected with the growth rate of the current crisis and net fall in the global economic activity. The paper predicts that the present financial crisis resulted in 1.3% fall in the overall world-wide economic activity. Tracing reference from European Central Bank, it has been exposed that the recession in the European Union state members would be twice bad and EUs output is expected to contract by 3.4% in the coming years. Searching out the far reaching repercussions of ongoing financial crisis, the authors have referred to the International Labour Organization, which claims that world-wide unemployment would increase by at least 30 million people in coming years. Constructive reform proposals and discussions of advocate policy responses have been also discussed in details. The article has relevance with chapter 1st of the present study and has been cited in the literature review and bibliography.

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Article:

Lessons We Should Have Learned from the Global Financial Crisis but Didnt.

Author: Publisher: Paper no: Description:

L. Randall Wray. Levy Economics Institute of Bard College, 2011, U.K. 681.

The author is a senior scholar at Levy institute of Bard college U.K. The present research work is actually a recount of the causes and consequences of the global financial crisis. It also blames that the existing financial system is so fragile that anything could have disturbed its overall orchestra .While discussing the primary causes of the crisis, authors observance is incoherence with a general adopted view that the birth place of current crisis is USA, in the form of housing price bubble. Next part of the paper is based on authors assessment of the lessons which financial institutions should have learned from the impact and consequences of the current crisis. These include, (a) Global financial crisis was not absolute outcome of liquidity crisis (b) underwriting matters (c) unregulated and unsupervised financial institutions disrupted the rhythmatic flow of banks and financial institutions, that led to stagnation of economic activities (d) the opaqueness in financial transactions. The paper ends up with a reform agenda wherein the author has put forward some recommendations and suggestions for the financial institutions and in this area the author has heavily relied on masters like Hyman P. Minsky, Keynes and

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his followers. The article has relevance with chapter 1st of the present study hence has been included in the literature review as well as bibliography. Article : Author: Publisher: Journal No: Description: The subprime mortgage crisis getting birth in USA in 2007, spread very frequently to the other economies of the world. The crisis spurred massive media attention as a result of that many different explanations of the crisis have been proffered. The present article seeks to analyze the quality of subprime mortgage loans by adjusting their performance for differences in borrower characteristics, loan characteristics and macroeconomic conditions. The authors research is evident to the fact that the rise and fall of subprime mortgage market follows a classic lending. The paper predicts that the seeds for the crisis were sown long before 2007, but detecting them was complicated by high house price appreciation between 2003 and 2005 that masked the true riskiness of subprime mortgages. The paper also makes the contribution towards quantifying how much different determinants have contributed to the observed high delinquency rates for vintage 2006 and 2007 loans which led up to the 2007 subprime mortgage crisis. The article has relevance with chapter 1st of the present study hence it has been included in the literature review as well as bibliography. Understanding the subprime mortgage crisis. Yuliya Demyanyk and Otto Van Hemert. The Review of Financial studies, 2011. 24.

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Article :

From Financial Crisis to Turning point: How the US Subprime Crisis Turned into a world-wide One and Will Change the Global Economy.

Author: Publisher: Volume No: Description:

Jacques Sapia. Real World Economics Review, 2009. 46.

Although most of the economists and financial experts label the present crisis as purely financial because the securitization process was definitely a key factor. But Sapir has observed that the collapse of a specific model of capitalism and the breakdown of the post-Bretton woods International Monetary order, also played a an active role in bringing up the crisis. While analyzing the nature of the crisis, the author claims it to be a three tiered process embedded in a particular context. Credit over extension, which developed in the United States and also in UK, Spain and Ireland has been pointed out as the root of the crisis. Viewing the crisis in a global context, the author observes that the inability of the surviving Bretton Woods institutions, the IMF and the World Bank to check or even manage the crisis process. The unsustainable growths in the US economy, the European divergence and the possible reforms to the crisis have been evaluated empirically. The paper ends at describing the consequences of the crisis, the re-regulation of financial markets and the theoretical framework for a new monetary order. The article has relevance with chapter 1st of the present study and has been included in the literature review and bibliography.

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Article:

Effects of Central Bank Intervention on the Inter-bank Market during the Subprime Crisis.

Author: Publisher: Volume No: Description:

C. M Bruntti, Di Fillippo & J. H Harris. Review of Financial Studies, 2011. 24.

While the financial crisis created problems for firms, some undoubtedly failed as a result, and many worried that large swaths of the banking sector would go under. The present article examines the role of government policies before and during the crisis towards helping or hurting the both. Basing their data on the European e-MID market, the authors have observed, how European Central Banks intervention impacted prices, spreads and overall liquidity. Once the crisis hit, banks became reluctant to lend each other, but the threat that they would be never paid back was increasingly going up. The expansion in inter-bank spreads stimulated ECB to provide liquidity through openmarket operations in order to keep the banks afloat. ECB tried this practice repeatedly practice but this time it did not work. Despite the ECB,s best efforts, the market continued demanding usually high rates for inter-bank loans. This situation was apparently taken as a signal that things were worse than previously suspected. The paper concludes that Central Banks need to rethink how to deal with markets in crisis time. The article has relevance with the chapter 1st of the present study and has been included in the literature review as well as bibliography.

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Article :

Islamic vs. Conventional Banking: Business, Model, Efficiency and Stability.

Authors: Publisher:

Thorsten Beck, Asli Demirguc-Kunt & Ouarda Merrouche. The World Bank, Development Research Group, Finance and Private Sector Development Team, Oct. 2010.

Paper No: Description:

5446.

The current global crisis has not only shed doubts on the proper functioning of Conventional western banking, but also increased the attention in Islamic banking. The paper describes some of the most common Islamic banking products and links their structure in the theoretical literature in financial intermediation. The business model, efficiency quality and stability of Islamic banks and conventional banks have been assessed with the help of array indicators constructed from balance sheet and income statement data. A data based comparison also has been done between the performance of conventional and Islamic banks during the crisis to test whether one type is better positioned to with stand large exogenous financial shocks. While Islamic banks seem more cost effective than Conventional banks in a broad cross-country sample, this finding reverses in a sample of countries with both Islamic and Conventional banks. However, conventional banks that operate in countries with a higher market share of Islamic banks are more cost-effective but less stable. There is also consistent evidence of higher capitalization of Islamic banks and this capital cushion plus higher liquidity reserves explains the relatively better

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performance of Islamic banks during the recent crisis. The article has relevance with chapter 1st, 3rd and 4th of the present study and has been included in the literature survey as well as bibliography.

Article :

Islamic Finance: A Therapy for Healing the Global Financial Crisis.

Author: Publisher:

Miranti Kartika Dewi & Ilham Reza Ferdian. First Scientific Conference and Challenges of Globalizing Financial Systems, 2009.

Description: Being able to endure the implications of the global financial crisis and remain relatively positive in the midst of the crisis and eventually to emerge as more equitable and efficient system have raised the profile of Islamic finance and underscored its capacity to bring stability to the global financial system. The question whether Islamic Finance can become solution on the current global financial crisis? Is yet to be explored in a much practical manner. The present paper has been penned down in the same orientation. The content of the paper is segmentized into three parts and each part has been illustrated with the help of figures. Part one, has described nature of the current financial crisis and its roots. Part second, analyses were the immediate and long-run consequences of the crisis and also how it took a global shape. The third part of this paper seeks to highlight whether or not Islamic finance can heal-up the oozing wound of banks and finance institutions by offering them a much resilient and robust mechanism. This article has relevance with chapter 3rd and 4th of the present study and has been included in the literature survey.

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Chapter - 3

ISLAMIC EQUITY INSTRUMENTS

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3.1 ISLAMIC EQUITY INSTRUMENTS Islamic finance has continued to expand and demonstrate its resilience in the current more challenging international financial environment. This expansion has been in terms of the increased range of Islamic financial products and services, the development of the Islamic financial infrastructure and institutions, the greater maturity of the Islamic financial markets and the more comprehensive supporting legal, regulatory and Shariah framework. Being able to endure the implications of the global financial crisis and remain relatively positive in the midst of the crisis and eventually to emerge as more equitable and efficient system have raised the profile of Islamic finance and underscored its capacity to bring stability to the global financial system. Islamic financial services, as measured by Shariah compliant assets, is estimated by the UK Islamic Finance Secretariat (UKIFS) to have reached $1,130bn at end-2010, 21% up on $933bn in 2009. According to a report, Islamic finance assets worldwide continued a long run of growth to reach an estimated USD$1.3 trillion in 2011, 150% up over the previous five years.51 The principles of Islamic finance are laid down in the Shariah, Islamic law. Islamic finance, comprising financial transactions in banks and non-bank financial institutions formal and non-formal financial institutions, is based on the concept of a social order of brotherhood and solidarity. The participants in banking transactions are considered business partners who jointly bear the risks and profits. Islamic financial instruments and products are equity-oriented and based on various forms of profit and loss sharing. In this chapter we will describe some

51

Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, P.3.

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equity instruments, their scope of application and their contemporary significance in connection to broadening the spheres of Islamic finance industry. 3.2 Musharakah (Equity Participation) Musharakah as a financial contract refers to an arrangement where two or more parties establish a joint commercial enterprise and all contribute capital as well as labour and management as a general rule. The profit of the enterprise is shared among the partners in agreed proportions while the loss will have to be shared in strict proportion of capital contributions. The basic rules governing the musharakah contract include: I) Profit of the enterprise can be distributed in any proportion by mutual consent. However, it is not permissible to fix a lump sum profit for anyone. ii) In case of loss, it has to be shared strictly in proportion to the capital contributions. iii) As a general rule all partners contribute both capital and management. However, it is possible for any partner to be exempted from contributing labour/ management. In that case, the share of profit of the sleeping partner has to be in strict proportion of his capital contribution. iv) The liability of all the partners is unlimited.

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Figure No.7 Mechanism of a Simple Musharakah contract 3.2.1 Application and Scope As a mode of finance, an Islamic bank can advance money to a client using the contract of musharakah. Normally the bank will use the option of being a sleeping partner. The contract can be more widely used by Islamic funds whereby the unit holders can assume the role of sleeping partners. The contract can also be used in securitized assets. An Islamic bank can finance industry, trade, real estate, contracting and almost all legal enterprises through partnership. Musharakah is arranged on the basis of a written agreement between the bank and the client for a specific transaction, consignment, or project or for a fixed period of time that can be renewed. They can also enter into musharakah with interest-based banks to carry out operations acceptable in the Shariah, provided it is ensured that the rules and principles of the Shariah are observed during the operation of the

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partnership. A partnership business or its assets can also be securitized, giving musharakah certificates to the investors. Clients desiring to raise funds for investment in a large project can use musharakah and offer to sell musharakah certificates in the market. The musharakah certificate represents the direct prorata (proportional) ownership of the holder in the assets of the project. If all the assets of the project are in liquid form, the certificate will represent a certain proportion of money at face value owned by the project, in such cases the musharakah Certificates cannot be sold in the market except at their face value, as an increase would fall under the prohibition of Riba under the Shariah. However, after the project is started and has acquired non-liquid assets representing tangible assets, these certificates can be traded in the secondary market and above the par value. It is allowed under the Shariah, as the subject matter of the sale is a share in the tangible assets and not in money alone, therefore the certificate may be taken as any other commodity which can be sold at a profit or at a loss. In the case of a completed project, the business will involve a combination of tangible assets and non-liquid assets arising from the sale in business transactions. In such cases, the Muslim jurists generally find it acceptable to trade in musharakah certificates, where the musharakah portfolio should not comprise more than 50% in the form of non liquid assets. Another form of musharakah, developed more recently, is Diminishing musharakah. According to this concept, a financier and his client participate either in the joint ownership of a property, or piece of equipment, or in a joint commercial enterprise. The share of the financier is further divided into a number of units and it is understood that the client will purchase the units of the share of the financier, one by one, periodically, until all the units of the financier have

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been purchased by the client so as to make the client the sole owner of the property or the commercial enterprise. When used in home financing, musharakah is applied as a diminishing partnership. In home financing, the customer forms a partnership with the financial institution for the purchase of a property. The financial institution rents out their part of the property to the client and receives compensation in the form of rent, which is based on a mutually agreed fair market value. Any amount paid above the rental value increases the share of the customer in the property and reduces the share of the financial institution.52 The Al Baraka Islamic Bank of Sudan also employs musharakah technique to finance the import of goods. The importer requests the bank to participate in the import and sale of certain goods. The total cost of importing the goods is declared and the capital contribution of each party is specified. The cost of the whole transaction is designated in the appropriate foreign currency. The importer pays a part of his contribution immediately after the contract has been signed and pays the rest after receiving the invoices. A special musharakah account is opened at the bank. The bank then opens a letter of credit in favour of the importer and pays the full amount to the exporter after receiving the shipment document. The cost of insurance is charged to the transaction account. The importer is responsible for the import, clearance and final sale of the goods in question. The net profits are distributed among the partners in the agreed proportion and any

G. Rammal Hussein, Lecturer in International Management in the School of Commerce, University of Adelaide, 233 North Terrace, Adelaide, South Australia 5005, Australia.

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loss is shared in the same proportion as the actual capital contribution.53 Musharakah can be also used in trade. In this type of contract the financier contributes e.g. 60% of the capital for launching a business suppose of readymade garments. The arrangement may be of two types: (a) In the first place the arrangement is simply a musharakah where by two partners invest different amounts of capital in a joint enterprise. (b) Purchase of different units of the share of the financier by the client. This may be in the form of a separate and independent promise by the client. The requirements of Shariah regarding this promise are same as explained in the case of house financing with one very important difference. Here the price of the units of the financier cannot be fixed in the promise to purchase, because if the price is fixed before hand at the time of entering into musharakah it will practically mean that the client has ensured the principal invested by the financier with or without profit, which is strictly prohibited in the case of musharakah. Therefore, there are two options for the financier about fixing the price of his units to be purchased by the client. One option is that he agrees to sell the units on the basis of valuation of the business at the time of the purchase of each unit. If the value of the purchase has increased, the price will be higher and if it has decreased the price will be less. The second option is that the financier allows the client to sell these units to anybody else at whatever price he can, but at the same time he offers a specific price to the client, meaning thereby that if he finds a purchaser of that

Ausaf Ahmad, Contemporary Practices Of Islamic Financing Techniques, Islamic Research and Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 2010.

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unit at a higher price, he may sell it to him, but if he wants to sell to the financier, the latter will be agreeable to purchase it at the price fixed by him before hand.54 3.3 Murabahah (Trustee Partnership) Murabahah* has become one of the most popular financing techniques among Islamic banks. It has been estimated that 70 to 80 per cent of the total finance provided by Islamic banks is through murabahah.55 Murabahah-based financial operations are practiced by Islamic financial institutions under such various names as: mark-up, cost plus financing, production support programs, short-term financing or even, simply, sale-purchase contract. The basic ingredient of murabahah is that the seller discloses the actual cost he has incurred in acquiring the commodity, and then adds some profit thereon. This profit may be in lump sum or may be based on a percentage. Islamic bank use the concept of murabahah sale to satisfy the requirements of various types of financing, such as financing of raw materials, machinery, equipment and consumer durables as well as short-term trade financing. As an illustration, a typical murabahah transaction at an Islamic bank may be described as follows: i) The client approaches the Islamic bank with the request to finance his specific requirement, be it the purchase of capital goods, raw materials, machinery, equipment or a consumer durable.
Muhammad Taqi Usmani, An Introduction to Islamic Finance, Adam publishers and distributors, New Delhi , 2010, pp.91-92. 55 Khalil Jarrar, Modern Murabaha - A Fiduciary Sale Or A Misnomer?, Opaleseque Islamic Finance Intelligence, Issue 1, July 2009. * Murabahah (also called Bay muajjal) refers to a sales agreement whereby the seller purchases the goods described by the buyer and sells them at an agreed marked-up price, the payment being settled within a specified time frame, either in installments or lump sum. The seller bears the risk of the goods until they have been delivered to the buyer.
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ii) The client not only gives the specifications of the goods but also provides information about the price, nature and availability of the goods in the market. The bank, after being convinced of the viability of the project, informs the client of the margin of profit the bank would like to make on the original price. The bank may reserve the right to use its own or independent sources to check the information provided by the client. If the terms and conditions are acceptable to both parties, a request for a murabahah transaction is signed. In some banks it is referred to as a "Promise to Buy/Sell" document. It may be mentioned here that under Islamic law, a promise is not legally enforceable in the same sense as a contract. The client has a right to change his mind and may decide not to go ahead with the transaction after all. Since the bank takes further steps to complete the transaction acting upon this request or promise, the possibility that the client may go back on his promise introduces an element of risk in the transaction which is borne by the bank. It may also be mentioned that, although a promise is not legally binding, Islam strongly encourages its followers to keep the promises they make. Hence, the probability of a breach of promise is indeed low, if the contracting parties are motivated by Islamic morality. iii) Acting upon this request (or promise), the bank purchases the goods specified and requested by the client, paying the seller directly on a cash basis, either in full or in part. iv) At this stage, a contract of murabahah sale is signed between the bank and the client. v) The client undertakes to purchase the goods against a profit margin which has been agreed upon by the client and the bank. The payment of the final price of the commodity, which includes the price of the commodity paid by the bank to

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the original seller and the bank's profit, is deferred to a later date. In certain cases, banks may agree to accept this payment on an installment basis. In such cases, the client is made aware of the number of installments, the amount of each installment, the date each installment is due, etc., beforehand.56 The mechanism of a murabahah financial contract can be viewed in figure No.8 given below,

Figure No.8 Mechanism of a simple Murabahah contract

Ausaf Ahmad, Contemporary Practices Of Islamic Financing Techniques, Islamic Research and Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 2010. p.14.

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3.3.1 Application and Scope An interesting application of murabahah sale is in the issuing of a letter of credit (L/C)*. At the Dubai Islamic Bank, letters of credit are opened in the following manner: I) The customer requests the bank to open a letter of credit to import goods from abroad through an application enclosing a proforma invoice and providing all the necessary details and information. ii) After securing the necessary guarantee and scrutinizing the application, the bank opens a letter of credit in favor of the client and sends copies to the correspondent bank abroad and to the exporter. iii) The customer endorses a "Promise to Buy" the merchandise. The cost of the goods and the conditions of delivery are negotiated. iv) The exporter makes arrangements to export the goods and delivers the documents to the correspondent bank abroad. The shipment of the good stakes place and the correspondent bank advises the bank and sends the documents. v) After the confirmation of the bank's ownership of the goods in question through the acquisition of related documents an agreement of Sale is signed with the client57. At the Jordan Islamic Bank, murabahah sale is used to finance the purchase of goods, such as cars, that are subject to mortgage. The individual submits an application to the bank requesting the purchase of a motor car. He promises to buy it at a later stage. The bank issues an invoice to the seller who registers the motor car in the name of the bank. The seller submits the required document to
57

Ibid, p.17.

*A letter of credit is a document that a financial institution or similar party issues to a seller of goods or services which provides that the issuer will pay the seller for goods or services the seller delivers to a third party.

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the bank and receives his payment. The bank sells the car to the purchaser, with the registration in the name of the purchaser, on a deferred payment basis after getting an appropriate guarantee. The guarantee condition may stipulate the mortgage of the car to the bank. Murabahah is also applied to the purchase of land and buildings in a similar manner.58 The Jordan Islamic Bank also provides finance to individuals in order to enable them to purchase goods which are not subject to mortgage, such as household equipment, electrical appliances, etc. The method is essentially the same, the difference being that in the case of goods which cannot be mortgaged, payment by the purchaser is deferred on the strength of a promissory note which is regulated by the bank in accordance with the conditions of the murabahah contract. The merchandise is delivered to the client by the bank.59 Commodity Murabahah, another form of murabahah is based on the concept of tawarruq that is, receiving cash for a debt of a higher amount. Commodity murabahah is the one Islamic money market tool that can help provide liquidity in the Islamic banking system. There is no other instrument that is as widely used as commodity murabahah, especially in the short term money markets. According to Bursa Malaysias Islamic markets global head Raja Teh Maimunahiin, it is estimated that commodity murabahah has an annual turnover of over US$1 trillion. The structure of a common commodity murabahah financing arrangement goes in a scheme, that a Bank purchases commodity from Commodity Broker A on spot basis and sells the commodity to the customer on deferred basis at cost price plus profit margin, then on behalf of the customer

58 59

Ibid Ibid, p:18.

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Bank, acting as Wakeel, sells commodity to Commodity Broker B on spot basis on behalf of the customer.60 3.4 Mudarabah Mudarabah contract is a form of a business contract in which one party offers capital and another party undertakes some business with this capital, the former is termed Rabb al-mal and the latter Mudarib. Figure No.9 is a simplified diagram that explains the structure of the mudarabah contract. Under this structure, the Islamic bank accepts deposits through mudarabah contract as an intermediary, where the depositor enters into a profit sharing partnership or agency contract with the bank as a Mudarib (partner/agent). Also, as noted previously, the Islamic bank (as a principal fund-provider) can enter into a partnership or agency contract with an entrepreneur who only contributes the management skills.61 Thus, the capital is provided by the fund supplier, who operates as a sleeping partner, and work is provided by the entrepreneur.62 The following rules must govern all mudarabah transactions: 1) The division of profits between the two parties must necessarily be on a proportional basis and cannot be a lump sum or guaranteed return. 2) The investor is not liable for losses beyond the capital he has contributed. The mudarib does not share in the losses except for the loss of his time and efforts. 3) Briefly, an Islamic bank lends money to a client to finance a factory, for example, in return for which the bank will get a specified percentage of the
Hermione Harrison, Commodity Murabahah: Concerns, Challenges and Market Appetite, Islamic Finance Asia, February 2010. 61 Yongqiang Li, Abdi Hassan, Esse Abdirashid and Bruno Zeller, Equity Investor Protection And Financial Performance Of Islamic Banks: An Econometric Analysis, Center for Islamic Economics and Finance, Qatar Faculty of Islamic Studies, Qatar Foundation, 2008. 62 A. Archer and A. Abdel-Karim, Profit-Sharing Investment Accounts In Islamic Banks: Regulatory Problems And Possible Solutions, Journal of Banking Regulations, vol.10, 2009.
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factory's net profits every year for a designated period. This share of the profits provides for repayment of the principal and a profit for the bank to pass on to its depositors. Should the factory lose money, the bank, its depositors and the borrower all jointly absorb the losses, thereby putting into practice the pivotal Islamic principle that the providers and users of capital should share risks and rewards.63

Figure No.9 Mechanism of a Simple Mudarabah Contract 3.4.1 Application and Scope Although it has been widely suggested in the theoretical literature on Islamic banking that mudarabah can be a viable basis of financial intermediation in an interest free framework, there are certain difficulties with its contemporary application. For example, the legal system operating in the country should provide legal safeguards to the provider of capital so that he can finance projects
Hussein Alasrag, Global Financial Crisis And Islamic Finance , University Library of Munich, Germany, MPRA Paper, 22167, 2011.
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on the basis of mudarabah. For this and other reasons, the number of banks providing finance on the basis of mudarabah is not very large. Even among those banks which use mudarabah as a financing technique, the frequency of its use is not very high. In view of the dearth of relevant information, it is not easy to describe the manner in which different Islamic banks practice Mudarabah and whether there are any differences in these practices. However, some available information is presented below: In Iran, mudarabah is considered a short-term commercial partnership between a bank and an entrepreneur. All of the financial requirements of the project are provided by the bank and the managerial input is provided by the entrepreneur. Both parties of the mudarabah agreement share in the net profits of the project in an agreed proportion. Iranian banks are directed by the monetary authorities to give priority in their mudarabah activities to cooperatives. Furthermore, commercial banks in Iran are not allowed to engage in the mudarabah financing of imports by the private sector. Article 9 of the Law of Usury Free Banking provides for banks to expand their commercial activities through mudarabah, within the overall framework of the commercial policy of the government.64 3.5 Ijarah (Lease) Leasing (Ijarah)* is emerging as a popular technique of financing among Islamic banks. Some of the important Islamic banks which use leasing as a financing technique include the Islamic Development Bank, the Bank Islam Malaysia and

Ausaf Ahmad, Contemporary Practices Of Islamic Financing Techniques, Islamic Research and Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 2010, pp.23-24. *Ijarah is a financial contract whereby the owner of an asset, other than consumerable, transfers its usufruct to another person for an agreed period at an agreed consideration.

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commercial banks in Pakistan. Like murabahah, lease is not originally a mode of financing rather it is a simple transaction, however as mentioned it has been used as a mode of financing by many financial institutions in the current economic scenario.65 There are two main types of lease under the Ijarah structure. The first involves a longer term lease which usually ends with the transfer of ownership of the asset to the lessee (Ijarah wa lqtina), as in a modern finance lease. The second type of lease is for a shorter term and will usually end with the financial institution retaining ownership of the asset, in common with an operating lease. The rental income in this second type of lease will take into account wear and tear of the a s se t. To comply with Shariah, the leased assets must not be prohibited items (f or example, machinery for the manufacturing of alcohol) and must be used in ways deemed lawful by Shariah. Like any other contract, a lease contract has to fulfill all of the conditions of a valid contract stipulated by the Shariah. Muslim economists have designed some rulings to confirm lease as a valid mode of financing. These rulings are as: 1) Leasing is a contract whereby the owner of something transfers its usufruct to another person for an agreed period, at an agreed consideration. 2) The subject of lease must have a valuable use. 3) It is necessary for a valid contract of lease that the corpus of the leased property remains in the ownership of the seller, and only its usufruct is transferred to the lessee. 4) As the corpus of the leased property remains in the ownership of the lesser, all the liabilities emerging from the ownership shall be borne by the lesser

65

AIMS-UK Islamic Banking & Finance, www.learnislamicfinance.com

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but the liabilities referable to the use of the property shall be borne by the lessee.66 3.5.1 Application and Scope Under this scheme of financing, the bank purchases a real asset (the bank may even purchase the asset as per the specifications provided by the prospective client) and leases it to the client. The period of lease, which may be from three months to five years or more, is determined by mutual agreement according to the nature of the asset. During the period of lease, the asset remains in the ownership of the bank but the physical possession of the asset and the right of use is transferred to the lessee. After the expiry of the leasing period these revert to the lesser. A lease payment schedule based on the amount and terms of financing is agreed upon by the bank and the lessee. The agreement may or may not include a grace period. According to the Islamic view, the maintenance of the asset during the leasing period is the responsibility of the owner of the asset, as the benefit (rental) is linked to this responsibility (maintenance).67 The Al Baraka Investment Company uses the technique of Ijarah wa lqtina to finance the purchase of large capital items such as property, industrial plants and heavy machinery. It involves direct leasing where investors in the scheme receive regular monthly payments which represent an agreed rental. At the expiry of the lease, the lessee purchases the equipment. The Bank Islam Malaysia also uses lease purchase contracts. The procedure adopted is the same as that described above except that the client and the bank

Muhammad Taqi Usmani, An Introduction to Islamic Finance, Adam publishers and distributors, New Delhi , 2010, pp.159-160. 67 Ausaf Ahmad, Contemporary Practices Of Islamic Financing Techniques, Islamic Research and Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 2010, p.24.

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enter into an agreement at the time of the lease that the client will purchase the equipment at an agreed price with the provision that the lease rentals previously paid shall constitute part of the price. The lease purchase arrangement is also used by Islamic banks in Iran, which purchase the needed machinery, equipment or immovable property and lease it to firms. At the time of the contract, the firms guarantee to take possession of the leased assets if the terms of the contract are fulfilled. The terms of the lease cannot exceed the useful life of the asset which is determined by the Central Bank of Iran. Banks in Iran are not allowed to lease those assets whose useful life is less than two years. What has been described above as a lease purchase arrangement (Ijarah wa lqtina) is called hire and purchase in Pakistan. a client requests to participate in this scheme, a "hire purchase" account is opened in his name. The value of the asset as well as the amount of profit over cost payable by the client to the bank are recorded as debits. The installment payable by the client has two distinct components: the agreed rental and a part of the amount of profit. The asset remains in the ownership of the bank unless all installments have been fully paid. The ownership title is transferred upon the receipt of full payment. The installments are so devised that the agreed price is fully amortized during the useful life of the asset.68 3.6 Takaful (Islamic Insurance) Takaful*, or Islamic insurance is a relatively new industry. During the past two decade takaful operations have been opened in many countries throughout the

68

Ibid, pp.25-26. *Takaful is an Arabic word that means mutual protection and indemnity: one party, while providing help to others is also identified by them and this idea of mutual protection is in clear contrast to the profit motive which underlines conventional proprietary insurance.

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world, primarily in Islamic countries and countries with a large Muslim community. In the Far East, Malaysia has been at the forefront of takaful development with Bank Negara taking the lead with the introduction of separate takaful regulations allowing the takaful business to flourish in that country. Singapore, Indonesia, Brunei have all followed with the development of takaful operations. In the Middle East, takaful operations have developed in Saudi Arabia, Bahrain, Iran, Qatar and Iran with new operations opening up in Egypt, UAE and Kuwait in recent years. Takaful, similar to mutual insurance, is a risk sharing entity that allows for the transparent sharing of risk by pooling individual contributions for the benefit of all subscribers. The global market remains at an early stage of development with premiums estimated to have reached $16.5bn in 2011. This includes an estimated $4.5bn generated in Iran where takaful is the compulsory form of insurance, and Ernst & Youngs estimate of $12.0bn for the rest of the world .69 The concept of takaful is fundamentally different from conventional proprietary insurance, although it has affinities with conventional mutual insurance. Takaful is centered on the principle of mutuality and avoids any commercial contract between the insurer (insurance company) and the insured (the policy holder). Thus it is a financial transaction of mutual co-operation between two or more parties (participants) to protect one of them from unexpected future material risk.70 Being different in concept and practice, takaful is based on a set of principles that are both Shariah compliant and economically valid. Freeness from

69 70

Financial Market Series, Islamic Finance, www.thecityuk.com, 2012.s Simon Archer, Rifaat Ahmed Addel Karim and Volker Nienhaus, Takaful Islamic Insurance: Concepts and Regulatory Issues, John Wiley & Sons (Asia) Pte. Ltd, 2009, p.120.

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riba, gharar, ghabun (fraud: lack of clarity regarding the object of the contract), ignorance (al-jahalah) and gambling testifies the validity of takaful. In a takaful plan, the participant pays a particular amount of money as a contribution (the premium) partly to a risk fund (the participants special account) under the rubric of tabbaru (donation), and partly to another party (the takaful company) with a mutual agreement that, the kafil is under a legal responsibility to provide for the participants financial protection against unexpected loss, should it occur within the agreed period. In the event that no loss occurs to the participants within the specified period, the participants are entitled to the whole amount of the paid premium, together with the share of profits made out of the accumulated paid premiums on the basis of mudarabah financing.71 A takaful company has the following features: I) The company is not the one who assumes risks nor the one taking any profit. Rather, it is the participants, the policy holders, who mutually cover each other. ii) All contributions (premiums) are accumulated into a fund. This fund is invested using Islamic modes of investment and the net profit resulting from these investments is credited back to the fund. iii) All claims are paid from this fund. The policy holders, as a group, are the owners of any net profit that remains after paying all the claims. They are also collectively responsible if the claims exceed the balance in the fund.

71

Adnan Alamasi, Surveying Developments in Takaful Industry: Prospects And Challenges, Review of Islamic Economics, Vol. 13, No. 2, 2010.

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iv) The company acts as a Trustee on behalf of the participants to manage the operations of the takaful business. The relationship between the company and the policy holders is governed by the terms of mudarabah contract. Therefore, should there be a surplus from the operation, the company (mudarib) will share the surplus with the participants (rabb al-mal) according to a pre-agreed profitsharing ratio.72 3.6.1 Application and Scope The basic structure of takaful undertaking is designed by Takaful Operator (TO) from a regulatory perspective, a major concern is how the TO is remunerated for its services. During the past two decades, three standard models have emergedthe wakalah model, the mudarabah model and the waqaf model. 3.6.2 Mudarabah Model This is considered an excellent and praiseworthy model in the market of takaful. In many ways it goes one better than a mutual insurance model in that no expenses are charged to the participants funds. Another important feature of this model is that the operator does not share in any surplus, therefore there is no mudarabah issue to debate. It is very difficult business model as a stand-alone family/individual life takaful operation (especially as no charging of expenses to participants fund is envisaged). It is perhaps only really viable where a composite takaful operation is being considered. It could take many years to realize a commercial profit from such a business model as it relies on the build-up of reserves and savings funds. As a stand-alone model, it would lend itself to a
72

Rating Takaful (Shariah Compliant)Insurance Companies, A.M. Best Company, www.ambest.com, January 10, 2012.

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philanthropic, state-sponsored operation or one where participants provide capital. In the single example of this model in Malaysia, no expenses are charged to the participants pool. There could be use of this model in Sudan with charging of expenses to the pool for both family and general takaful.73

Figure No.10 A Simplified Diagram of Mudarabah Model (Abouzaid, 2007)

3.6.3 wakalah Model In the wakalah model, all relations between TO and the participants are based on an agency contract, the TO is the Wakeel (agent) who acts on behalf of the participants (principal) both in underwriting and investment. The wakeels services in both fields are remunerated by fees, which are contractually specified either as an absolute amount or as percentage of the turnover (that is, the volume of contributions or of invested funds), but not as a percentage of the profit of the undertaking. The fees must cover all management costs (not
73

Adnan Alamasi, Surveying Developments in Takaful Industry: Prospects and Challenges, Review of Islamic Economics, Vol. 13, Issue No. 2, 2010.

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including claims and direct cost of claim handling) plus the profit for the share holders.74 The best examples of operating wakalah takaful are Al-Jazirah Bank and Jordan Islamic Insurance. The overall mechanism of wakalah takaful operation is illustrated in the below given diagram:

Figure No.11 Wakalah Takaful Diagram (Abouzaid, 2007)

3.6.4 Waqaf Model: Unlike the Al-Mudarabah and Al-Wakalah models, Waqaf operates as a social/governmental enterprise, and programs are operated on a nonprofit basis. Under the Waqaf model, the surplus or profit is not owned directly by either the insurer or the participants, and there is no mechanism to distribute the surplus funds. In effect, the insurer retains the surplus funds to support the participant community. This model, with a single surplus fund, is most like a conventional mutual insurance model. As such, it is rated in a very similar manner to
Simon Archer, Rifaat Ahmed Addel Karim and Volker Nienhaus, Takaful Islamic Insurance: Concepts and Regulatory Issues, John Wiley & Sons (Asia) Pte. Ltd, 2009, p.120.
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conventional mutuals. For further information on the rating dynamics of mutual insurance companies, please see A.M. Bests Rating European Mutual Insurance Companies. The remainder of the report will highlight the unique elements of takaful companies following the Taawuni model, and how these factors are incorporated in the rating analysis. 3.6.5 Microtakaful Another recently applied takaful instrument in the Islamic finance market. It is an institution that can well serve especially low income people. All takaful products, like takaful financing, takaful education, fire, pension, etc., can be delivered to the poor with some modification to allow for low premium contributions collected on a periodic basis. It seems as an important component in any poverty alleviation strategy. In Indonesia, partner-agent model is applied for microtakaful model.75 3.7 Sukuk (Islamic Bond) In the Islamic capital and money market Sukuk* has emerged as a very important instrument, over the past decade, not only in the Muslim world but also in the global markets due to its characteristics. Sukuk issues have expanded strongly in the past three years, with Zawya Sukuk Monitor reporting a 62% increase in sukuk issuance to $84bn in 2011 from $52bn in 2010. This follows a recovery from a low point of $20bn in 2008 to $33bn in 2009. Sukuk made a strong start to 2012 with $20bn of issuance in January. Sustained growth in the sukuk market demonstrates appetite for quality issuers of sukuk from both Islamic and non-Islamic investors.

A. Haryadi, Reaching To The Poor with Microtakaful, Middle East Review of Insurance, July 2007, pp.62-63. *Sukuk is a plural of Sakk. Which means legal documents, deed, check. It is an Arabic name for financial certificate but it can be seen as an Islamic equivalent of the conventional bonds.

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Agreement in 2011 on a debt restructuring for Dubai World has improved sentiment towards sukuk in general.76 It is asset-backed trust certificates evidencing ownership of an asset or its usufruct (earnings or fruits). It has a stable income and complies with the principle of Shariah. Unlike conventional bonds, Sukuk need to have an underlying tangible asset transaction either in ownership or in a master lease agreement. The primary condition for the issuance of Sukuk is the existence of assets on the balance sheet of the issuing entity that wants to mobilize its financial resources. However, identification of suitable asset is the first important step in the process of issuing Sukuk certificates.77 3.7.1 Ijarah Sukuk Ijarah forms the most common and simplest form of Shariah compliant Sukuk. The Ijarah Sukuk have all been issued more or less using the same four Shariah compliant contracts, namely, the Purchase Agreement, the Master Ijarah Agreement, the Purchase Undertaking and the Sale Undertaking. The Ijarah Sukuk is governed by two more Shariah compliant contracts that in a way guarantee the payment of face value at the end of the term of the Sukuk, or in case of a default or any other such contingency. It has been also Ijarah based sovereign Sukuk bearing the same credit rating as that of the issuing country or Ijarah based corporate Sukuk being rated in line with the debt rating of the entity providing the purchase undertaking. Ijarah Sukuk are either backed by tangible assets or based on tangible assets and therefore are tradable and negotiable. Ijarah based sovereign Sukuk bearing the same credit rating as that of the issuing country or
76 77

Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, P.6. A comprehensive study of the International Sukuk market, International Islamic Finance Market, www.iifm.net, 1st edition, 2009, p.5.

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Ijarah based corporate Sukuk being rated in line with the debt rating of the entity providing the purchase undertaking. Ijarah Sukuk are either backed by tangible assets or based on tangible assets and therefore are tradable and negotiable. Ijarah based sovereign Sukuk bearing the same credit rating as that of the issuing country or Ijarah based corporate Sukuk being rated in line with the debt rating of the entity providing the purchase undertaking. Ijarah Sukuk are either backed by tangible assets or based on tangible assets and therefore are tradable and negotiable. 3.7.2 Mudarabah Sukuk Mudarabah Sukuk are tradable and negotiable if the Mudarabah assets do not comprise entirely of the Sukuk proceeds (in which case it will be all liquid assets and cannot be traded). In most Sukuk, there is a combination of tangible assets and Sukuk proceeds, plus the Mudarib is allowed to mingle its own assets with those of the Mudarabah, hence mostly meeting the Shariah compliance requirement of having more than 51% of the assets in tangible form for tradability and negotiability. 3.7.3 Convertible or Exchangeable Sukuk Convertible or exchangeable Sukuk certificates are convertible into the issuers shares or exchangeable into a third partys shares at an exchange ratio which is determinable at the time of exercise with respect to the going market price and a pre-specified formula. The convertible or exchangeable feature can be exercised anytime before maturity and works in the same way as for any conventional convertible or exchangeable issue. It is permissible under Shariah as long as the conversion price or the exchange price fluctuates with the market price of the

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shares. An issue would arise where such price is required to be a minimum amount equivalent to the face value of the Sukuk, however, that is unlikely as it defeats the very purpose of issuing a convertible security. Some Sukuk combine exchangeability with another Shariah compliant structure such as Mudarabah or Musharakah. For instance the Dana Gas Sukuk issued in October 2007 is an exchangeable Mudarabah. Khazanah nationals three issues are only

exchangeable issues, not mingling it with Mudarabah or any other form of Shariah based financing.78 3.7.4 Musharakah Sukuk Musharakah Sukuk is an investment partnership between two or more entities which together provide the capital of the musharakah and share in its profits and losses in preagreed ratios. The Musharakah Sukuk has been next only to Ijarah in terms of its popularity so far. The Sukuk that had been issued until the AAOIFI ruling of February 2008 were very similar to the Mudarabah Sukuk structures except that in place of a Rabb-al-Maal. Mudarib relationship between the Sukuk holders and the Obligor, there is a Musharik or partnership between the Sukuk holders and the Obligor.79

78 79

Ibid, P.39. Ibid, P.40.

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Chapter - 4

RELEVANCE

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4.1 CURRENT POSITION OF ISLAMIC FINANCE INDUSTRY: A BRIEF REVIEW Islamic finance is rooted in Shariah law, which prohibits interest-based financial transactions, gambling high-risk speculation, and financing any form of economic activity that can be considered detrimental to society. The industrys modern-day evolution, beginning in the 1970s to the present day, was still considered an infant industry at the turn of the 21st century.80 The ascent of oil prices and petrodollar driven investments, however, accelerated the industrys expansion in the early 2000s a trend that was sustained with robust economic growth in emerging markets and liquidity in capital markets. Although most of the Islamic Banking and financial operations are carried out within Middle Eastern and Emerging countries, some universal banks based in developed countries have started to satisfy a large demand of Islamic financial products. It is the case in the United Kingdom and the United States. As the economies around the world slowly recover from the destabilizing effects of the global financial crisis, increasing numbers of investors are looking to Islamic financial solutions as a stable alternative to the fluctuations and uncertainties of current financial systems.81 To examine and analyze the experience with Islamic finance industry, in the current financial scenario has become the subject matter of this chapter. The developments in infrastructure of its financial institutions, its achievements in creating a better robustness in its applied dimensions, its expansion in terms of geography and finally its sustainable growth rate in terms of asset ratio has been described with the help of empirical data collected from various authentic

sources. Proponents claim that Islamic finance contributes to the stability of the
80

Mercy Kuo, The Emergence of Asias Islamic Finance Industry, Bankers Academy Briefings, June 08, 2011. 81 Islamic Finance News 2012 Guide, www.IslamicFinanceNews.com, February 2012 , P.30.

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financial system. During the recent financial crisis, Islamic financial institutions were affected by the adverse second- round effects of the crisis: when the real economy contracted, real estate prices got depressed, and in some cases, issues of Islamic bonds (Sukuk or certificate of ownership) defaulted. However, Islamic banks generally escaped the worst effects of the 2008 financial crisis, because they were not exposed to subprime and toxic assets, and had maintained their close connection to the real sector. Hence, some observers have suggested that conventional banking can learn from the alternative systems offered by Islamic finance, which is less skewed toward debt instruments, uses equity for greater risk sharing, and limits the mismatch of short-term demand deposits with longterm loan contracts.82 Islamic financial products offer an appealing alternative to conventional portfolios. In 2002, not long after the tragic events of September 11, 2001, then U.S. Treasury Secretary Paul ONeill was quoted as saying, It took me six months to realize that Islamic finance was a legitimate way of doing businessa statement that aptly captured non-Muslim public sentiments about the industry. Islamic finance is becoming an integral part of the global finance industry and has taken its roots in almost all of the Muslim countries but has also been under discussion and penetration in selective Western and Far Eastern jurisdictions. According to Dr. Zeti Aziz, Today the Islamic financial system has evolved significantly to become a dynamic and competitive form of financial intermediation in the global financial system. This transformation has been achieved in an increasingly challenging environment. She further adds, Most significant have been the development of the Islamic financial markets, the
82

Mahmud Mohieldin, Realizing The Potential Of Islamic Finance, The World Bank Economic Premise, Number 77, March 2012.

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growth in the range of financial products and services, the increasing significance of the international dimension of Islamic finance, the development of an international Islamic financial architecture, and the enhanced international interlinkages that have been brought about by these developments.83 The Islamic financial industry comprises of the Islamic capital market which is an area that has grown to become an increasingly popular sector within the global financial market. Islamic capital markets have gained considerable interest as a viable and efficient alternative model of financial intermediation. The demand for investing in adherence to the principles of the Shariah on a global scale have been spearheading towards making the Islamic financial services industry a successful sector. This is also an indication of the increasing wealth and major capacity of investors who are both Muslim and non-Muslim, wishing to invest in new investment products that serve and meet their individual needs. The Islamic Capital Market (ICM) refers to the market where financial activities are carried out in adherence to the Shariah financial principles of Islam. The ICM represents a reflection of religious law in the capital market transactions where the financial market is free from prohibited activities such as gambling. Indeed, the pace of development in the Islamic financial market has gathered momentum with the formation of various international Islamic organizations to study and promote this alternative market. The Islamic financial capital market runs adjacent to the conventional financial market and provides the scope for investors to be given the opportunity for an alternative investment philosophy that is rapidly gaining acceptance. The fact that the Islamic financial market does not prohibit participation from non-Muslims creates unlimited upside to the depth and Riba
83

Zeti Akhtar Aziz, Islamic Finance: Global Trends and Challenges, The National Bureau of Asian Research (NBR), volume 18, number 4, march 2008.

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(usury), Maisir (gambling) and Gharar (ambiguity). The Islamic capital market operates as a market to the conventional capital market for capital seekers and providers. It has played a complementary role to the Islamic banking operations and systems in creating a well defined, comprehensive Islamic financial market especially in Islamic financial hubs such as Malaysia. The ICMs in 2011 have much scope worldwide especially since the Shariahcompliant Islamic finance industry is growing on a global scale. The total worldwide Muslim population is 1.5 billion, representing a significant 24% of total world population of 6.3 billion. Shariah-compliant assets are growing over the last 20 years and are representing an estimated US$ 300 billion banking assets & approximately $400 billion Capital Market. In addition there are over 700 Islamic financial institutions currently operating in about 75 countries worldwide.84 Out of these IFIs there is estimated to be more than 100 Islamic Equity funds managing assets is in excess of US$500 billion, and still growing by at least 10-15% annually. In the GCC, liquid wealth with Shariah sensitive investors will add more than US$70b to this pool by 2013.85 The estimated annual growth for the overall Islamic capital market is 15% to 20% annually which shows the scope for further progression. Global Islamic Finance assets are predicted to increase 33% from their 2010 levels to $1.1 trillion by the end of 2012 as Fig. No.12 highlights the continuity of growth rate from 2006 up to 2011.

84

85

Islamic Finance News 2012 Guide, www.IslamicFinanceNews.com, February 2012 , P.30. Ernest and Young, Islamic Funds and Investments 2011:Achieving growth in challenging times, 7th Annual World Islamic Funds and Financial Markets Conference (WIFFMC 2011), 2011.

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Fig. No.12 Source: The Banker, Ernest and Young The Middle East and North Africa will show signs of increase, with assets rising $990 billion by 2015 from the $410 billion in 2010. The ICMs can further pave the way by implementing cross border trading within OIC countries in order to further diversify and minimize risk and volatility. In addition progressive developments of information technology can further increase ICM and this is already taking place due to innovative software solutions such as Path Solutions and iMAL which provides the latest Islamic Shariah-compliant services to cater for the ICM monitoring and maintenance. An improvement in transparency in the market needs to be implemented in order to attract an increased number of foreign investors. There also needs to be more standardization on guidelines in Shariah compliancy in order for the ICM to further progress in the years to come. The potential of the Islamic finance capital market is huge as the ICM has the potential

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to reach several trillion USD by 2015. The GCC surplus may continue for the next 4 to 5 years mainly due to oil demands and price which will cause significant growth in the sector. The unprecedented demand from customers who are both Muslims and Non-Muslims, is increasing realize the benefits of the Shariah markets. Therefore there is much potential for the ICM.86 While discussing the Euro zone crisis and future policies of Islamic finance industry in such a financial climate, in opening address of the 3rd Annual World Islamic Banking Conference: Asia Summit, Singapore, Mr. Ravi Memon, managing director of the Monetary Authority of Singapore, said, But Islamic finance has a window of opportunity in the current climate of deleveraging in the global financial system. With its strict prohibition on excessive leverage, Islamic finance has been spared the worst of the financial crisis. Islamic banks are well positioned to reach out to new customers who are in need of financing as many global institutions pull back on their lending due to the need to repair their balance sheets.87 Although Islamic banks received such an opportunity in 2007-2008 also in the form of U.S subprime mortgage crisis and dealt with it in such a way that motivated investors and customers to go with it, as parallel system of economy. The less effect of GFC on Islamic finance industry persuaded economists and finance experts to admit that, carrying its major functioning in the real estate sector, Islamic finance industry potentially managed its clients as well as institutions to escape from the venomous and far reaching repercussions of the GFC.

Global Islamic Finance, The Ultimate Islamic Finance Review 2011, December - January 2012, p.6. Mr. Ravi Menon, The next phase in Islamic finance, BIS central bankers speeches , 3rd Annual World Islamic Banking Conference: Asia Summit (WIBC Asia 2011), Singapore, 5 June 2012.
87

86

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4.2 Islamic Banking and Investment: A Flourishing Sector Islamic banking is now expanding out of its niche to become a market that could rival the conventional sector in many countries. It is an increasingly visible alternative to conventional banks in Islamic countries and in countries with large Muslim populations, such as the UK. Globally, the assets of these institutions have grown at double-digit rates for a decade, and some conventional banks have opened Islamic windows. The International Organization of Securities Commissions predicts that as much as half of the savings of the world's 1.3 billion Muslims will be in Islamic financial institutions by 2015.88 Islamic financial services are nearing $trillion in reported managed assets, with about 700 Islamic financial institutions(IFIs) spread throughout every region of the world. The Islamic banking system (IBs) market- that is, the market of the technologies that enable these financial products to be bought, sold and distributed- is predicted to raise to grow at 10.9% compound annual growth rate (CAGR) between 2009 and 2014, while the external IT spending component will have a higher CAGR, at 18.1%. The IBS market is expected to reach $1.6 billion in 2014. As consumer trust in conventional banking waned during the recent economic downturn, Islamic banking enjoyed marked market expansion, Islamic banking is perceived by its customers as a mutually beneficial partnership, and is regarded by some banks as an opportunity to re-establish and connection with consumers. Growing demand is evident for Islamic products from new markets such as African and Western countries. An increasing number of conventional branch environment, mixing both conventional and Islamic banking capabilities.

88

Patrick Imam and Kangni Kpodar, Islamic Banking: How Has it Spread?, International Monetary Fund, 2010.

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The Islamic banking market will continue to grow at a double digit pace. This is based on: 1) The increasing Muslim populations in particular regions. 2) Newly available assets from unbanked populations and 3) The relatively low effect of the financial downturn in the high economic growth regions such Middle East and Asia Pacific.89 In the first-half of 2011, the UAEs Islamic retail banks have been busy in the promotion of new products and services. In January 2011, Noor Islamic Bank opened its largest branch for Islamic insurances Noor Takaful which is excelling in the retail sector. Ajman Bank has recently launched the Mahra Ladies Banking as around a quarter of the UAEs private wealth is controlled by women, Maryam Al Shorafa, Head of Ajman Banks Ladies Banking, told AME info.com. Dubai Bank, one of the smallest local banks in the UAE, has also just opened a new branch at Dubais prestigious Jumeira Road. People who drive down the road from the famous Jumeira Mosque to Burj Al Arab cant miss the huge building near the Miraj Islamic Art Centre. Also in June 2011 it was reported that, Dubai Islamic Bank launched access to a new Shariah-compliant fund, the Prudential Shariah Opportunities - Asia Pacific Equity Fund. Abu Dhabi Islamic Bank (ADIB) offers 25% discounts on online transactions for those who open an online brokerage account, along with the chance to win an iPad, which are all exclusive retail banking promotions to attract both Muslims and Non-Muslim customers into the Islamic retail banking sector. Many Islamic financial institutions are tapping into the Islamic wealth management sector. Abu Dhabi Islamic Bank (ADIB) is one such example as in September 2010 ADIB launched its specialized wealth management
Gartner Research, Islamic Banking: Opportunity or Money Pit For conventional Banks, ITS, Issue: 2, p.10.
89

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services. In 2010 the Islamic retail sector needed more pushing as reported by Ernst & Young however it is slowly picking up with the advancement of technology and the Islamic banking industry. The Islamic Banking sector has progressed tremendously in the last 25 years of its succession as competition in the banking sector has further intensified due to globalization and technological advancement. Shariah-compliant investments have continued to attract the attention of global investors and consumers wanting to utilize Islamic modes of financing. In attempting to meet the demands of the growing Islamic financial sector the industry has to effectively implement conventional banks use of modern day technology through the use of mobile internet banking and other current software. Many Islamic banks are choosing to offer Islamic financial products and services through mobile internet banking and it is becoming an increasingly popular method of handling transactions quickly and efficiently. Another key example of implemented mobile technology facilities in Islamic banks are Dubai Islamic Banks recent launch of Al-Islamic Mobile Banking. Al Islamic mobile banking allows customers to check their statements on their mobile, carry out transactions, and check their Murabahah accounts and investment accounts.90 In Bangladesh, Islamic banking accounts for 65% of total banking assets, in Bahrain 46% and Saudi Arabia 35%. However penetration in other countries is limited with Islamic banking accounting for only 4% to 5% of total banking assets in Turkey, Egypt and Indonesia.91 Islamic banks, including those with Islamic windows, are now looking to enhance their position in faster growing core regions of Middle
90 91

Global Islamic Finance, The Ultimate Islamic Finance Review 2011, December - January 2012, P.16. Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, P.3.

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East, Asia and Africa. Offering products that are competitive on price and service could help to generate business not only from Muslims with a preference for Shariah compliant services, but also from Muslims and other customers that currently use conventional banking services. Significant international developments in the past year have included: Launch in November 2011 by Thomson Reuters of the worlds first Islamic interbank rate, which is designed to provide an indicator for the average expected return on Shariah compliant short term interbank funding. Omans decision in May 2011 to permit the establishment of Islamic banks in the country the last of the six GCC states to do so. The aim is to tap into regional demand for Shariah compliant banking services and other products currently being met elsewhere in the region and therefore to curtail the current outflow of investment from Oman. Qatars move in February 2011 of preventing conventional banks from offering Shariah compliant products through Islamic windows. The boundary is expected to provide opportunities for Islamic banks to gain market share. In the UK, the five fully Shariah compliant banks were established between 2004 and 2008 and put the UK in the lead in Western Europe. There are also an estimated 17 conventional banks that have set up windows in the UK to provide Islamic financial services. HSBC Amanah is the only conventional bank with an Islamic window to report to The Bankers survey: its assets of $16.7bn account for 88% of the UKs identified assets, with a further 6% from BLME and 3% from the HSBC parent bank. The 22 Islamic banks in the UK substantially exceed that in any other Western country or offshore centre. The Islamic Bank of Britain (IBB) is a retail bank and the only Islamic bank with a high street presence having five

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branches and around 50,000 customers. IBBs founding shareholder Qatar International Islamic Bank took full control of the bank in 2011. IBBs admission to the AIM market was cancelled in April 2011. The Bank of London and The Middle East (BLME) is an independent wholesale Shariah compliant UK bank based in the London. BLMEs offering spans corporate banking, treasury and wealth management that comprises private banking and asset management. BLME aims to strengthen its services and market penetration in the GCC. QIB UK took on its new branding in 2010 to reinforce its identity within QIBs global network. QIB UK offers a range of Shariah compliant financing and investment products for both Islamic and non-Islamic clients alike. It provides Shariah compliant investment banking services including trade finance, private equity and asset management. Gatehouse Bank is a Shariah compliant wholesale investment bank operating in capital markets, real estate, asset finance, treasury business and Shariah advisory services. In 2010, Gatehouse Bank completed more than 160m in Shariah compliant real estate acquisitions.92 4.3 Islamic Banking in MENA Region: A Growing Trend Islamic finance in the Middle East and North African (MENA) countries has now become an important element in their societies development agendas and it is also gaining ground in the financial landscape of the region as well as in the individual countries. It is also a growing business as it caters to the financial needs of the people without conflicting with their social and religious values.93 The Islamic banks in the MENA region have achieved strong growth during the years 2003 to 2007 with a CAGR of over 31% in assets. They outperformed the banking
92 93

Ibid, p.5. Salman Alman Syed Ali, Islamic Banking In The MENA Region, Islamic Development Bank Islamic Research And Training Institute, February, 2011.

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system as a whole that registered an average CAGR of about 23.9%. At the end of 2007, there were 20 publicly listed pure Islamic banks in the region with a combined asset base of USD 148.3 billion.94 Islamic banking assets in the MENA region have been growing exponentially over the last several years. For example, in 2004 the proportion of Islamic banking assets of the Middle Eastern banks was only about 29 percent of the worldwide Islamic banking assets, which grew to 50 percent of the worldwide share in 2008.6 Not only the aggregate but the average asset per bank has increased in the Middle East as well. Most of this growth was taking place in the GCC countries, but recently the non-GCC countries are also witnessing growth of Islamic banking both by establishing domestically incorporated Islamic banks and by cross-border expansion of GCC based Islamic banks through their subsidiaries. The Islamic banking sector is not of similar size and scope across MENA countries. Figure No.13 shows the asset size distribution for various countries. The assets have been growing in all countries with the highest growth in Qatar of 48 percent and lowest in Egypt of 10 percent. Lebanon with an asset growth of 145 percent is an exception as Islamic banks opened in the country only in 2006, thus, it is starting from a very small base. Saudi Arabia, UAE and Kuwait stand out as giants in terms of aggregate assets of Islamic banks while Egypt, Jordan, Yemen, and Lebanon constitute the lower tail with Qatar and Bahrain in between (see Figure 13).

94

Islamic Banking in the MENA Region, Blominvest Bank, Feb. 2009, P.7.

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Figure No.13 Source: Islamic Development Bank (2011) 4.4 Growth of Islamic Takaful Industry Takaful, similar to mutual insurance, is a risk sharing entity that allows for the transparent sharing of risk by pooling individual contributions for the benefit of all subscribers. The global market remains at an early stage of development with premiums estimated to have reached $16.5bn in 2011. This includes an estimated $4.5bn generated in Iran where takaful is the compulsory form of insurance, and Ernst & Youngs estimate of $12.0bn for the rest of the world.95 Figure No. 14 shows the growth of takaful premium and takaful assets in Iran and rest of the world.

95

Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, P.7.

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Figure No.14 Takaful Global Market (Ernst & Young, 2011) The very first Takaful company called the Islamic Insurance Company of Sudan was established in 1979. In 2011, there are over 30 registered Takaful companies worldwide writing Takaful directly and 10 more as Islamic windows or marketing agencies placing insurance risk with conventional and Takaful companies and the number continues to grow. In fact the number of Takaful companies is higher as all insurance companies in Sudan are deemed to operate in accordance to the Shariah principles. In addition, new Takaful companies have been established recently in Sri Lanka and Tunisia. At least four more Takaful companies are under formation in the Middle East in countries such as Kuwait, UAE and Egypt. Several other Takaful companies are being contemplated in various countries such as Pakistan, Australia and Lebanon. The countries of South Africa, Nigeria, and some of the former states of the Soviet Union are also contemplating tapping into the Takaful market.

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Takaful industry in Bahrain is said to be prospering from last few years especially in 2011 as people are favoring Shariah-compliant methods of Islamic insurance. Takaful total contributions grew by 16.5 percent to reach BD13.4 million ($35.6m) in the first quarter of the year compared with BD11.5 million for the same period last year, according to the Central Bank of Bahrain (CBB). Traditional insurance still took the largest share of the market, down slightly at BD43.3 million in the first quarter compared to BD44 million. The Takaful market in Bahrain consists of 27 domestic insurance companies and 11 branches of foreign insurance companies covering both direct insurance and reinsurance. The recorded data for the insurance market during the first quarter of the year shows a slight increase of 1.8 percent in gross written premiums in the quarter up from BD55.7 million to BD56.7 million. The global Takaful market which has increased potentials for employees, students and professionals who want to tap into the Islamic insurance industry. The graph spans from the year of 2006 which shows that the market for Takaful was at $2.10 billion dollars however the demand for Takaful insurance has increased year by year and is expected to reach $7.39 billion dollars by 2015 if it maintains growth in the highly competitive financial insurance industry. Many countries have various different global markets for Takaful. Malaysia has the largest market for Takaful premiums reaching 1,220 with Syria with the least market. It is estimated that the global Takaful premium could be in the region of US $7.4 billion in 15 years time in 2026, growing at nearly 20% per annum. This is not an unachievable task as the Malaysian Takaful sector is successfully growing at 60% annually and the Middle East at 10% annually. With a focused effort on

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part of the Takaful operators worldwide there can be the potential of a significant growth of 20% annually.96 4.5 Sukuk: A Global Successes for Islamic Finance Industry The Sukuk Islamic bonds sector is a global success for the Islamic finance industry with it growing at subsequently fast rates it is a driving force for the progression of the Islamic finance industry. Many Muslims and Non- Muslims find Sukuk the perfect alternative to conventional bonds. The Sukuk market has become an emerging sector during the years and after the global economic crisis the appeal for the market increased with many investors turning to utilize Sukuk Islamic bonds for their projects and investments. Figure No.15 depicts the dynamic growth of Sukuk industry.

Sukuk Global Issues

90 80 70 60 50 40 30 20 10 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Jan-12

Figure No. 15 Source: Zawya Sukuk Monitor In reviewing the rapid growth of Sukuk it is imperative to look at the development which aroused the emerging sector when it was in its infancy. Many countries around the world such as Qatar have made unprecedented developments in the Sukuk arena. Malaysia is the global market leader for Sukuk issuance, accounting
96

Global Islamic Finance, The Ultimate Islamic Finance Review 2011, December - January 2012, p.16.

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for 63 percent of cumulative Sukuk issuances between 1996 and 2010. Malaysia issues long-term, local currency Sukuk to fund infrastructure projects and contribute to financial stability.97 Qatar International Islamic Bank (QIIB) and HSBC issued US $700 million worth of Trust Certificates (Sukuk) which was due in the year 2010 and is now progressing in 2011. The proceeds from this issuance were utilized to finance the construction and development of a major infrastructure project which was the Hamad Medical City located in Doha, Qatar. The certificates issued in 2003 were redeemable in 2010, hence, the period for the issue was seven years. The joint lead managers for the issue were HSBC Bank and the Qatar International Islamic Bank, with the co-managers being the Abu Dhabi Islamic Bank, Gulf International Bank, Kuwait Finance House, Commerce International Merchant Bankers of Malaysia, the Islamic Development Bank and the Qatar Islamic Bank. Bahrain is another country which is making milestones in the Sukuk arena and holds many investment opportunities in 2011 for the facilitation of Sukuk Islamic bonds. Bahrain had an oversubscribed demand for the Sukuk market as Bahrains 750 million sovereign issue attracted an order book of about $4 billion with a strong demand from the Middle East. The initial size of the Sukuk offering was $500 million, but the issue was oversubscribed by almost eight times. As a result, the value of the Sukuk was raised to $750 million, a Central Bank of Bahrain statement said. One of the major reasons behind this issue was to establish a yield curve benchmark for longer-term Islamic securities, said Sheikh Salman bin Isa Al Khalifa, executive director, banking operations, CBB. This is a testament to Bahrains strong credit and the confidence which International markets place on the kingdoms financial
97

Mahmud Mohieldin, Realizing The Potential Of Islamic Finance, The World Bank Economic Premise, No. 77, March 2012.

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sector, added Sheikh Salman. The GCC and the UAE have made several milestones throughout the years in the issuance of Sukuk and with the Islamic financial sector set to rise there is much scope for the countries to further develop Sukuk issuances. With correct implementation of legislation and regulatory bodies which support the Sukuk system the Sukuk issuances can be performed smoothly. Europe has also been making progressive developments in the Sukuk arena. The Sukuk market in Europe grew by a massive 75% to US $85 billion in total outstanding issues in the first half of 2007. The US $24.5 billion of funds raised in the first half nearly surpassed the total amount of new issuance in 2006 of US $26.8 billion, according to the Islamic Finance Information Service, online media partner of the forum.98 In early 2010, the UK House of Commons decided to adopt the Financial Services and Markets Act 2000 Order 2010. It is aimed at removing barriers and uncertainty in the regulation of alternative finance investment bonds (Sukuk) and which the Treasury stresses will reduce compliance and legal costs for these instruments, and facilitate the issuance of corporate Sukuk in the UK this made it more accessible to issue Sukuk. Germany and France are also making progressive developments in Sukuk Islamic bonds. Germany was the first country to issue Sukuk in Europe as in September 2004 Saxony-Anhalt became the first state government in Germany and Europe to issue a sub sovereign bond under Islamic principles. The 100 million bond does not offer interest payments to its investors and Germany abided by the Shariah principles outlined for issuing the first Sukuk. German banks such as Deutsche Bank, Commerzbank and Dresdner Bank are already well involved in the sector albeit in overseas markets. Deutsche Bank for
98

Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, p.7.

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instance has co-lead managed MTN issuances for the Jeddah-based Islamic Development Bank and pioneered the Islamic Equity Certificates with National Commercial Bank of Saudi Arabia a product which the promoters claimed was the first Islamic retail product with universal marketing application and capability99. Overall the main issuers of European Sukuk in UK, France and Germany exhibit potential to further develop the Sukuk industry and allow scope for more issuances to pave the way for Islamic finance as a major sector in Europe. Many Non-Muslims and Muslims alike have embraced the Sukuk industry in Europe and are keen to further encourage the development and implementation of laws which accommodate and make it easy for investors to utilize Sukuk issuances. In 2010 the UAE holds a significant presence in the Sukuk market accounting for 20 percent of the total Global Sukuk market. Global Sukuk issuance totaled $19 billion last year and the UAE also recorded the second highest Islamic loan volume in the region after Saudi Arabia, the data released at the Reuters Islamic Banking and Finance Summit in Dubai. America and Canada still have a way to go with Sukuk as in 2011 not much has been done to facilitate Islamic Sukuk bonds in comparison to the Middle East and UAE. America launched its very first debut Sukuk on the 16th of June 2006 which was the East Cameron Gas Sukuk which has been described as being the most innovative and interesting Sukuk to date. Sukuk in Canada also flourished between the years of 2009 to 2010 and Siraj Capital Dubai which had also helped to issue Americas first Sukuk issuance had also been proactive in launching Canadas debut Sukuk. One of Canadas very first major Sukuk deals was quite recently issued in 2009 as Canada was quite late to tap into the Islamic financial market. On the 7th of July 2009 Siraj Capital Dubai
99

Ibid, P.8.

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announced the Bear Mountain Resort Sukuk at the London Sukuk Summit.100 The Islamic financial sector and is rapidly emerging as a prominent financial sector in the mainstream. Sukuk issuances which are mainly made from successful Islamic financial hubs such as Malaysia and the UAE are slowly crossing the borders into the Western world and soon America and Canada can take a leading role in the issuances of lucrative Sukuk deals.101 From the above figures, it becomes clear that Islamic finance industry has become one of the growing financial segments in the international financial system. Its phase of development that began in earnest as domestic-centric for Muslim economies, has rapidly transformed in this recent decade to become internationally recognized and accepted as a competitive and robust form of financial intermediation by all communities.

Islamic Finance News 2012 Guide, www.IslamicFinanceNews.com, February 2012 , P: 8 Global Islamic Finance, The Ultimate Islamic Finance Review 2011, December - January 2012, pp.1617.
101

100

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Conclusion

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Conclusion The current global financial crisis, believed to be worst of its kind since Great Depression 1929, has dramatically changed the values, requirements and opinions of common masses in general and economists and finance experts in particular, in viewing the economic performance of banks and financial

institutions. The Credit crunch as it has come to be known brought panic and turmoil in the summer of 2007 to the worlds financial markets causing the United States housing market bubble to burst. The crisis threatens a worldwide economic recession, potentially bringing to a halt more than a decade of increasing prosperity and employment for western economies and potentially wiping a staggering $1 trillion off of the value of the world economy. Economists analyzed that imprudent lending, high leveraging, unnecessary financial innovations and speculations are the determinant factors responsible for financial ripples leading to economic slowdown and the ongoing crisis situation. Representing the collapse of trillions of dollars of fictitious credit derivatives and the meltdown of uncontrolled credit growth, the scope of the crisis could reach unmanageable size. The crisis has shown that advanced financial systems are very vulnerable and share the character of inherent instability. The global financial crisis brought to the fore the inadequacy of conventional banking regulations in general and their capital inadequacy in particular in relation to the risk associated with their businesses both aspects require serious consideration. The crisis also vividly highlighted the importance of the stability as a prerequisite for economic progress. The Islamic Financial Services Industry is of course part of the broader global financial system, but it is comprised of instruments, infrastructure, institutions

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and markets that apply Shariah rules and principles in their design and operations. The Islamic financial system appears to be able to perform substantially all of the functions associated with typical conventional financial transactions and it therefore has sub-sectors that are similar to the conventional financial system. These sub-sectors consist of, among other things, the Islamic banking industry, the Islamic money market, Islamic capital markets (equity and bond markets), the Takaful (Islamic insurance) industry and the Islamic asset/wealth management industry. With global Islamic finance assets projected to reach $1.6 trillion by 2012, the industry is an emerging force of liquidity and investment in global markets across multiple sectors real estate, construction, financial services, transportation, oil and gas, power and utilities, consumer goods and telecommunications. The Islamic finance industry, having more than 700 institutions, spread in 75 countries including Europe and America, has covered 15-20% average annual growth rate over the past decade and is projected to cover 20% annual growth rate over the next five years. While not immune from the effects of the global financial crisis of 2008-2009, the Islamic finance industry due to its asset-backed nature of financial operations, has weathered the storm somewhat better than its conventional counterparts. However the Islamic

financial industry still faces many challenges, many bankers as well as regulators are assessing the market opportunity, risk management policies, operational standardization and robustness of the industry. The Islamic financial system, while just coming out of its niche, if compared to the conventional financial, centuries old, has proven to have a solid foundation. As Islamic banking and most of its financial contracts are based on the risk sharing it is intrinsically more stable. If this intrinsic feature is combined with prudent regulations and supervision and

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implementation of risk management, transparency and corporate governance that are up to international standards, Islamic finance industry can virtually develop into a model alternative to the conventional financial system in attaining equity, stability and effectiveness. While operating its banking system in the current financial scenario, Islamic finance industry goes on with the following structures: (a) Dual system (Malaysia and Indonesia), (b) Dual system with clear separation between the conventional system and the Islamic system (Bahrain and Jordan). In a dual-system environment, it is not uncommon to see big global banks such as HSBC, Citibank, Standard Chartered, Deutsche Bank, BNP Paribas and ABN Amro setting up Islamic window operations or even Islamic banking subsidiaries, and (c) Full Islamization of the financial system: virtual absence of conventional financial institutions, since only full-fledged Islamic financial institutions are licensed to operate in a country (Iran, Pakistanmaking its way in this direction-- and until recently, Sudan). A healthy group of economic experts and finance analysts are unanimous in their opinion that the continuity of financial crisis, firstly hitting U.S and now rocking the Euro-zone has set the stage for Islamic finance to demonstrate its availability as a potentially genuine alternative financial system. History teaches that opportunities presented, can be seized and realized or neglected and wasted. It is time for Islamic finance industry to seize its movement of opportunity and prove its inherent tendency towards creating a much resilient financial environment governed by the Divinely guided regulatory framework.

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Reference

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