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Islamic Finance Research Paper

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Islamic Finance is a financial system that doesn’t work like other conventional banking systems. It follows the Islamic law, Shariah, which doesn’t allow certain aspects of a normal banking system such as usury and speculation. There are some main principles to be followed in Islamic banking. First of all, it prohibits interest, or Riba. Riba is forbidden in Islam, and therefore Islamic banking system adopts the principle of profit and loss sharing. It also prohibits uncertainty, gambling, and prohibits certain products and industries such as alcohol and tobacco. Islamic Finance needs to be in accordance with the Shariah. All products and contracts follow Islamic principles that conventional financial systems do not, such as interest and risk sharing, and uncertainty. Conventional financial systems have never worked this way and it worked for them for many years until they were hit by the financial crisis. The crisis had a minimal impact on the Islamic financial systems because they did not comply with all the factors that created the crisis in the first place. There were 3 main factors in the creation of the financial crises. First, subprime loans, which was lending to certain people who did not have a good credit history and were bound to default. The banks than charged them with higher rates that increased their risk of defaulting. Secondly, there was securitization, which was creating securities from un-liquid assets. This process is used by banks to create securities from loans and other income producing assets, and then these securities are sold to investors. Finally, it was the credit default swaps that increased the effect of the crisis. There would be many different people having an insurance on the same house (for example both the lender and the borrower), which makes it that insurance companies at one point would have to pay more than the amount of just the house. In the case of the crisis, we can say that the Islamic banking systems would have avoided it. It would be a more suitable system in the sense that all of the reasons above that were the cause of the crisis, would not have been done if all the systems were Islamic. With a good implementation of profit and loss sharing, Islamic finance promotes fairness. Subprime loans would not have been allowed, and credit done with profit loss sharing would have avoided having so many people taking loans and defaulting in the first place. In Islamic finance, assets should back up all loans. Finally, Islamic finance is against insurance companies. They use another way where a group of people will all pitch in and put some money together in case someone loses their home or something important. In this case, people are helping each other and promoting safe economic needs. With an Islamic system, credit default sways would not have occurred because insurance companies are not allowed. So this 3rd effect on the crisis, which actually made things worse for everyone, would not have occurred. Islamic Finance is a system that could have avoided the financial crisis.

Following the Shariah, there are many laws and regulations that are in fact for the benefit of the whole. The only problem is that we have been used to the conventional system and all of its principles and ways of working. The Islamic system seems harder to understand and to work with, especially for non-Muslims who do not have the same beliefs and therefore do not see why they should comply with it. Even Muslim believers, who follow the Shariah for their everyday life, do not all use an Islamic banking system. The benefits of this system do not look appealing at first, compared to the conventional system everyone is used to working with, but when you think about it, this new system could have avoided many troubles people are facing today because of the crisis. Maybe the crisis would have still occurred, but it wouldn’t have hit as hard.

The current global financial crisis, also called the subprime mortgage crisis, has been the worst kind of crisis since the Great Depression. It started in 2007, with the collapse of many financial companies in the United States. The crisis started with people buying expensive houses they could not actually afford. It was an easy time to get a loan for housing. This caused the price of houses to increase, and financing firms gave subprime loans to borrowers who did not have a good credit history. The crisis did not only affect mortgage credits to risky borrowers, it also affected the banking and financial system. It has shown that conventional finance is vulnerable. Such a financial crisis would not have happened under the Islamic finance, due primarily to the fact that Islamic finance complies with Islamic laws, Shariah. Shariah prohibits most, if not all of the factors that contributed to starting this crisis. These factors include: negative relationship between borrowers and lenders, faulty and risky behaviors, asymmetry of information, and actions who lead to a deliberate underpricing of risk. With the crisis, Islamic finance is presenting itself as being a more reliable alternative to the conventional financial system.

Islamic Finance is an expanding industry that is sustaining a secure and steady growth. The concept of Islamic finance started only 40 years ago, and was able to remain positively steady throughout the current financial crisis. Eventually, it is starting to appear more efficient and capable of bringing stability to financial systems. Economists and financial experts all agree upon the causes of the crisis, however finding solutions to the crisis is proving itself to be very difficult. Some think the market will repair itself on its own, others believe governments should intervene in the markets. For now, there is no long-term solution and no guarantee that an identical crisis will not happen again in the future. The only think that can be seen is that the crisis has shown that markets are not always efficient on their own.
The aim of this paper is to try to find an alternative that would be able to bring back stability to financial markets. We will be analyzing Islamic finance principles and doing a cross-section with causes of the crisis in order to show how the crisis could have been prevented under an Islamic financial system.

The Islamic finance industry is prosperous, with a market representing about 1000 billion dollars. Islamic finance is developing due to an increase in Muslim populations who are looking for Shariah compliant products, and also due to the efficiency of their products and their good performance in financial markets. For many, choosing Islamic finance is part of making ethical choices and having such values as trust, which is lacking these days in conventional finance. Under Islamic finance principles, it is forbidden to invest in sectors such as alcohol and gambling, and interest and speculation are prohibited. Investments are limited to such things as tangible assets, which makes it more secure. Islamic finance is going through annual growth rates of up to 20%, making it one of the fastest growing sectors in the finance industry.
Both Islamic finance and the conventional financial system are there to assemble resources and allocate them into investment projects, but the basic principles behind Islamic finance are very different from those of the conventional system. The conventional system is much more based on making profit than the Islamic system.
Islamic finance is primarily based on the principles of Shariah, which is a set of Islamic laws, which govern Muslim life. This system tries to assure that their financial products are compliant with the principles of Islam and its ethics. There are 6 basic principles of Islamic finance. 1. The prohibition of riba, which is interest or usury. In Islam, interest is prohibited and it is seen as wrongful earnings. 2. The prohibition of gharar, which is uncertainty. This means there should be no asymmetry of information and full disclosure in a contract. 3. The prohibition of investing or financing any sinful activity such as alcohol, pork, prostitution, and gambling. 4. Sharing profits and losses, which is risk sharing. The profits and losses are to be shared by all the parties in a financial transaction. 5. Materiality, which means all financial transactions need to be linked to a real economic transaction. 6. All financial transactions should not lead to the exploitation of a party.

The financial crisis is associated with easy credit, debt, and speculation. Below is a table of the main factors that caused the current financial crisis:

It's quite difficult to decide on one main factor that caused the crisis, but one of them is the bad lending decisions made that were driven by the need of higher profits. This was facilitated by the fact that government regulations were absent. This new way of lending was practiced for an extended period of time and caused damage to both lenders and borrowers.
The question is why did banks change their lending norms even though they were aware of the risks and damage it could cause? Chapra explains that they were motivated by three leading factors which are lack of profit and loss sharing between lenders and borrowers, too big expansions in the size of derivatives such as credit default swaps, and finally the assurance that the central bank would help banks out in order to avoid a collapse.
Every economic crisis is usually caused by bad credit. It starts with low interest rates, which attracts more customers for loans, and when the interest rates increase the loans aren't repaid. For the borrowers low interest rates made it more affordable to get houses, which increased the demand. On the other hands, banks whose only motives where to make profit decided to make it easier for people to get loans. The problem got bigger when banks started to sell their customers on subprime loans, and when default risk started to be transferred by the creation of new complex products.
Many Islamic finance experts believe the global financial crisis is especially due to the failure of morality and ethics, which is mainly caused by greed. They also consider it to be a failure in maintaining a good relationship between banks and their customers. Those who started subprime loans didn't effectively communicate the risks that were in hand.

The current financial crisis has made it urgent today to completely reshape the international was financial systems work. So far, no one has been able to deliver an achievable long-term solution to the crisis. Maurice Allais, a Nobel prize winner and French economist was said to have warned against the consequences of such a crisis. He says that the best way to cure the system is by structural reforms that will prevent the crisis from happening again. He first proposes that interest rates should be 0%, and tax rate should be 2%. We can notice that this resembles very much the Islamic financial system. Under this system, interest is prohibited and requires that people should pay a tax of 2.5% of yearly earnings, zakat.
Muslim scholars think that Islamic finance “has the potential to become an alternative model for global system” (Ayub, 2007) . Islamic finance works under values such as fairness, justice, caring for future generations and the environment. Its purpose is to create a financial system that is fair for both the rich and the poor. The ultimate goal is to be able to spread social and economic justice. Taymiyyah, a highly respected scholar, says: “Hence, justice towards everything and everyone is an imperative for everyone, and injustice is prohibited to everything and everyone. Injustice is absolutely not permissible irrespective of whether it is to a Muslim or a non-Muslim or even to an unjust person".
When we look at the causes of the financial crisis, we can notice that the underlying principles of Islamic finance show potential as an alternative to the conventional system. We first see that under Islamic finance, there are moral guidelines to be followed about how to deal with money. It works in order that money supply is always equivalent to real growth in the economy. We also notice that under Islamic finance, some activities are forbidden because they are harmful and unlawful. In such a system, there are no assets without risk and financial transactions are based on profit and loss sharing. Options, swaps, and speculation are forbidden under the principle of Gharar.
The global crisis did have an effect on Islamic banks, however Islamic finance remained quite resistant compared to other financial institutions. If global financing followed the Islamic principles, the crisis would have never occurred or would have had a significantly less important effect. This argument is mainly based on the fact that most of the factors that caused the crisis are prohibited in the Shariah compliant financial institutions. A crisis that was due to subprime mortgage, poor evaluation of risk, use of complex financial instruments to shift the risk, speculation, and bad lending, could not have occurred under Islamic finance for many reasons: 1. Under Shariah law, debt shouldn’t be sold against another debt. A person is not allowed to sell or lease an asset they don’t own, and it is prohibited to sell debt and risky speculative transactions. All financial transactions are supposed to be fair and just, with full disclosure in contracts in order for the risk to be correctly assessed by all parties 2. Rather than being based on debt, Islamic finance is more based on equity. When they lend, all assets need to be backed up by solid assets. In this system housing loans would all have had to been backed up, which would have stopped the defaults on loans. This would therefore mean that in no way would defaulting, occurring under Islamic finance, affect other banking systems. In the conventional system, trillions of dollars were lent out without being backed up with assets, which was one of the main causes of the crisis. Under Islamic finance, this would have never happened. Muslims are expected to live within their means and what they can afford, and are not supposed to get a loan they are not able to repay just because the interest is low. There would be none of this because interest under Islamic finance is prohibited. 3. In Islamic institutions, it is very important for them to keep a good and trustworthy relationship between the institution and clients or investors. A high level of transparency is supposed to be kept, in order for the relationship to be an honest one. Both the institution and the investor open up to each other. The institution then knows when to give loans to those who need them and will be able to repay them through business activity that is known to the institution. 4. One of the causes of the crisis was the lack of regulatory control systems, which are supposed to help investors. Under the Islamic regulatory system, all parties are aware of all the opportunities and risks in a contract. Islamic banks have an obligation towards their investors of full disclosure and transparency. Full disclosure and transparency helps to control lending and enables a financial stability to take place. 5. Under Mudarabah and Musharakah contracts, with the concept of Profit and loss sharing, risk is easily managed. Investors can see the opportunities of gain as well as losses, which does not give place to speculation and uncertainty. 6. In Islamic Finance, the relationship between the institution and the borrower is seen as a partnership. Both parties have a mutual interest in the business transaction, which makes subprime and default shifting very unlikely to occur. Siddiqi says that “risk shifting is gambling”. Under profit and loss sharing, all parties will share the losses, whereas in risk shifting only one party will incur the losses.
We can link Islamic principles with market failures to show how market failures could have been reduced, or even stopped under Islamic finance. Below is a graph explaining this:

To conclude, it is hard to decide on one main factor that caused the crisis. There are many factors in cause such as bad lending done by conventional financial institutions, whose main goal was the returns. In this paper, we aimed to explain how the current financial crisis could have been avoided under Islamic financing. Evidence shows that Islamic finance is more stable, and a good implementation of this kind of financing could possible be a solution to the crisis and would not let another crisis happen again. This is simply due to the fact that most, if not all of the factors that caused or contributed to the financial crisis are prohibited under Islamic finance.

References

Ayub, M. (2007). Understanding Islamic finance. USA: John Wiley & Sons.

Chapra, U. (2009). The global financial crisis: Can Islamic finance help?

Hassan, K., & Lewis, K. (2007). Handbook of Islamic banking, UK: Edward Elgar Publishing Iqbal, Z. (1997), Islamic Financial Systems

Iqbal, M., & Llewellyn, D. (eds.) (2002). Islamic banking and finance, Cheltenham: Edward Elgar Publishing.

Kayed, Rasem N. and M. Kabir Hassan (2009), “The Global Financial Crisis and Islamic Finance Response,” University of New Orleans Working Paper.

Siddiqi, M. N. (2008). Current financial crisis and Islamic economics.

Winners of the Bank of Sweden Prize in Economics. (2008). Bank of Sweden prize in economic sciences in memory of Alfred Nobel 2008-1969.…...

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...which investors lose unexpectedly substantial amount of their investments, and financial institutions suddenly lose significant proportion of their value. Financial crises include, among others, stock market crashes, financial bubbles, currency crises and sovereign defaults. of the financial crisis  Causes and Consequences Financial bubbles are usually associated with easy credit, excessive leverage, speculation, greed, fraud and corruption. Easy credit led to a lack of adequate market discipline, which in turn causes excessive and imprudent lending. Causes of financial crisis Description Risk/Consequence Leverage Borrowing to finance investment Bubble that leads to bankruptcy Asset-liability mismatch The disparity between a bank’s deposits and its long term assets leads to the inability of banks to renew short term debt they used to finance long term investments in mortgage securities Bank runs Regulatory failure Improper (insufficient/excessive) regulatory control: -Insufficient regulation: 1) Results in failure of making institutions‟ financial situation publicly known (lack of transparency) 2) Makes it possible for financial institutions to operate without having sufficient assets to meet their contractual obligations. -Excessive regulations that require banks to increase their capital when risks rise leading to substantial decrease in lending when capital is in short supply. -Excessive risk-taking -Financial crisis (of 2008) Potential......

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Premium Essay

Islamic Finance

...analysis of Mudarabah & a new approach to equity financing in Islamic finance Shaikh, Salman Ahmed International Association of Islamic Banks 01. July 2011 Online at http://mpra.ub.uni-muenchen.de/19697/ MPRA Paper No. 19697, posted 19. September 2011 / 12:03 A Critical Analysis of Mudarabah & A New Approach to Equity Financing in Islamic Finance Journal of Islamic Banking & Finance, ISSN 1814-8042 By Salman Ahmed Shaikh Project Director, Islamic Economics Project islamiceconomicsproject@gmail.com www.islamiceconomics.viviti.com Abstract Financial intermediation serves a valuable purpose, but it can also be structured using equity modes of financing. This can relieve the financee and increase diversity of entrepreneurial undertakings as in debt based commercial financing, there is little room for diversity with obligatory and stipulated servicing of debt. Using Islamic equity modes of financing poses the challenge of the agency problem and moral hazard. The extent of this agency problem in Mudarabah and its impact on economic payoffs between counterparties is analyzed in this study with a simulation model. Based on review of alternate solutions proposed, the author presents two possible covenants which could make Mudarabah mode of financing more acceptable and widely usable in financial intermediation. This would also further the egalitarian objectives of an Islamic economic order. Keywords: Interest free economy, Islamic Economic System, Mudarabah, Agency Problem,......

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Premium Essay

Islamic Finance

...In the name of Allah, the Most- Merciful, the Very-Merciful Looking for New Steps in Islamic Finance jìÑíá=jìÜ~ãã~Ç=q~èá=rëã~åá Islamic banking industry has grown rapidly during the past three decades spreading its operations in many parts of the globe. Making its first debut in the small Savings Association of Mitghamr (Egypt) in 1963, its strength has now reached over 250 financial institutions operating in more than 40 countries with assets valuing USD 750 billions, and an annual growth rate of 15 per cent. Almost all the giant conventional banks are in queue to establish their Islamic units to capture the new emerging market. This rapid growth of Islamic financial industry is, no doubt, encouraging for those who wished to relieve themselves from the prohibition of interest on the one hand and to remain a part of the modern market economy on the other. Now that a substantial period of more than three decades has passed on the experience of Islamic Banks and Financial Institutions, it is imperative to review what they have achieved so far and what they have missed. It is, no doubt, a great achievement of these institutions that they relieved the Muslims from clear prohibition of riba, and came up with some alternatives that might be adopted in financial market without indulging in interest. In an atmosphere entirely dominated by interest-based transactions, it was really a formidable task. I do not agree with those who criticize them on the basis of utopian idealism,......

Words: 1576 - Pages: 7