The Current Financial Crisis

 
The current global financial crisis has called the attention of world leaders and financial decision makers to seriously consider building a new world financial system. We believe that Islamic economics has much to offer for building a more just and stable market system that encourages real wealth creation and contains market fluctuations.
The current crisis stemmed from excessive indebtedness resting on a relatively small base of equity and real wealth, “the inverted debt pyramid”.     A significant chunk of finance became merely the selling present for future money.  Besides, poor regulations have encouraged over indebtedness.
To build a sustainable system, debt must grow in tandem with real (as opposed to financial) wealth; leverage must be capped by productivity potentials. This allows for real wealth to grow without being hurdled with too heavy debt.
Heavy reliance on debt intensifies economic instability, hence human insecurity, and generates significant negative economy-wide externalities, as painfully exemplified by the present crisis.  The collapse of financial institutions inflicts harm upon shareholders, employees, and a host of innocent bystanders.  Common economic sense suggests discouraging debt financing and encouraging benign alternatives.  However, the exact opposite (e.g. preferential tax treatment of personal and corporate debt) is still the rule.

 

The sale of present for future money is based on Riba or interest on loans, which is condemned and prohibited by all religions. It allows debt to multiply independently of real wealth, by mere passage of time. Obviously, this can make debt grow much faster than real wealth. Any big shock can crash such a system of unsustainable debt. 
The two basic implications of the prohibition of Riba are: removal of interest-based loans from the arena of business finance and the elimination of debt trading.  This must be supplemented by instilling more equitable rules for directing a fair share of financing to the poor.
Financial markets have been riddled with risk trading.  When pure risk is traded, transactions become indistinguishable from gambling: zero-sum games that create no value. At the macro level, gambling ends up with a negative-sum result, thanks to moral hazard. If risk is cut off from ownership, owners lose interest in protecting the quality of their assets in exchange for higher returns. In the current crisis, financial institutions were able to shed off the risks of their assets, and thus became increasingly reckless in pursuing other objectives.
Gambling, like interest, increases the divergence of financial commitments from real wealth. As the number of bettors rises, total loss when market turns down multiplies. With fictitious derivatives approaching $600 trillion, losses may be more than enough to wipe out the real wealth of the losers.
Historically, Islamic finance has been functioning as an integral part of market exchange for centuries.  Its recent incarnation into modern institutional structure (banks and financial institutions) is only about 30 years old compared with three centuries of conventional finance.  Islamic finance has been struggling to prove itself within the mainstream of interest-based finance.  In some aspects, it has succeeded; in others it still has a long way to go. The current crisis proves that Islamic finance is much less influenced by a downturn, as it avoids trading in debt and risk.

 

Business financing can be based on profit or revenue sharing where no debt is created. It can also be based on sale for a deferred price, where debt is integrated with real value creation and cannot grow separately. Such a system is free from inverted debt pyramids. The possibility of sharing losses by depositors motivates them to demand greater transparency.  Banks are pressed to exercise extra care in risk monitoring.
Risk is effectively integrated with ownership; legitimate risk taking cannot exceed the value of underlying assets; Again, the system is inherently immune to side  bets and derivative bubbles.
Debtors are provided extra time when they become temporarily insolvent, with no increase in the amount of debt.  Forbearance has both ethical and economic justification. When markets turn down, decline of collateral value triggers downward spiral as creditors try to protect their positions. However, this would make the market self-destructive, transforming a downturn into a crash. Forbearance relieves debtors, giving them better chances for repayment, while preserving the value of collaterals and preventing market crash.
While, forbearance mitigates the downward pressures on markets, non-interest-based finance mitigates the upward pressures during expansion, as excessive credit extension can turn it into a bubble. Thus, the two principles help contain market fluctuations and maintain reasonable stability, with minimum constraints on growth.
Islamic finance is ultimately governed by ethics and passion for human welfare.  Morality is imbedded in the rules, through the prohibition of production and exchange of goods harmful to life and environment.  In addition, contracts that do not carefully balance the interests of both parties and those that make pure risk a subject of trade are not permissible.
Islamic banks have shown resilience in the current crisis.  Most are at no risk of becoming bankrupt, and continue to be profitable and serve their clients well. Their experiences may provide lessons for conventional banks.
Islamic finance is a viable paradigm that is based on moral values that are more universally shared than the present system and can potentially be more just and efficient.  Principles of Islamic finance are justifiable by rational analysis, economic wisdom and viability.  We call on world leaders and decision makers to take them to heart in reformulating a new world financial order.