Revised on 13 May 2009 by M UMER

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Revised on 13 May 2009 by M. UMER CHAPRA Research Advisor Islamic Research and Training Institute Islamic Development Bank Jeddah, Saudi Arabia

1. INTRODUCTION THE PREVAILING CRISIS IS THE MOST SEVERE IN LIVING MEMORY CAN ANYTHING BE DONE TO MINIMIZE THE FREQUENCY AND SEVERITY OF SUCH CRISES IN THE FUTURE? THIS IS NOT POSSIBLE WITHOUT FIRST ANALYZING THE PRIMARY CAUSE/S OF THE CRISES

2 THE PRIMARY CAUSE • EXCESSIVE AND IMPRUDENT LENDING? • WHY IS THIS POSSIBLE? INADEQUATE MARKET DISCIPLINE? INADEQUATE REGULATION AND SUPERVISION? A FAULT LINE IN THE SYSTEM?

3. HAS THE FINANCIAL SYSTEM FAILED ON BOTH THESE COUNTS? WHY? • INADEQUATE MARKET DISCIPLINE? WHEN DOES THE MARKET OPERATE EFFECTIVELY? THE ROLE OF INCENTIVES AND DETERRENTS FALSE SENSE OF SECURITY AGAINST LOSS? • • • MIXING OF PRIME AND SUBPRIME DEBT LACK OF TRANSPARENCY FRAUD • • IS IT BECAUSE OF COLLATERAL? NO THE ROLE OF WAGERING SALE OF DEBT SECURITIZATION: ASSET-BACKED SECURITIES (ABSS) OR COLLATERALIZED DEBT OBLIGATIONS (CDOS) EMERGENCE OF CREDIT DEFAULT SWAPS (CDSS) FAILURE OF RATING AGENCIES CONCEPT OF ‘TOO BIG TO FAIL’ SUPERVISORS’ FAILURE? FAULT LINE IN THE SYSTEM?

. SALIENT FEATURES OF THE SLAMIC FINANCIAL SYSTEM INJECTION OF A MORAL DIMENSION IN ALL ASPECTS OF HUMAN LIFE RESOURCES ARE A TRUST FROM GOD AND MUST BE UTILIZED FOR THE WELL-BEING OF ALL JUSTICE: HALLMARK OF ISLAMIC TEACHINGS • • RISK-SHARING: “NO RISK, NO GAIN” EQUITABLE ALLOCATION OF CREDIT • WILL MAKE BANKS MORE CAUTIOUS IN LENDING • DEBT IS NOT CREATED THROUGH DIRECT LENDING AND BORROWING BUT RATHER THROUGH THE SALE AND PURCHASE OF REAL GOODS AND SERVICES GREATER EMPHASIS ON EQUITY AND PROFIT AND LOSS SHARING (PLS) WHAT ABOUT DEBT? 4

5. CONDITIONS FOR DEBT FINANCING THE ASSET BEING SOLD OR LEASED MUST BE REAL AND NOTIONAL OR IMAGINARY SELLER MUST OWN AND POSSESS THE ASSETS BEING SOLD OR LEASED THE TRANSACTION MUST BE A GENUINE TRADE TRANSACTION WITH THE FULL INTENTION OF GIVING AND TAKING DELIVERY THE DEBT CANNOT BE SOLD: THE RISK OF DEFAULT ASSOCIATED WITH IT MUST BE BORNE BY THE LENDER HIMSELF. THIS WILL MOTIVATE HIM TO BE MORE CAREFUL IN LENDING. WILL HELP PREVENT FRAUD?

6. IMPLICATIONS THE MARKET DISCIPLINE THAT ISLAM IMPOSES WILL PUT A CHECK ON EXCESSIVE EXPANSION OF DEBT. THE PERSON WHO IS GOING TO SUFFER THE LOSS IS THE BEST ONE TO PROVIDE THE DISCIPLINE REGULATION AND SUPERVISION ARE NECESSARY BUT NOT SUFFICIENT • • • REGULATION AND SUPERVISION CAN BE INADEQUATE WITHOUT MORAL CONSCIOUSNESS REGULATIONS MAY BE CIRCUMVENTED THE SUPERVISOR CAN BE NEGLIGENT

7. A PROBLEM THE DISCIPLINE WILL DEPRIVE THE SUBPRIME BORROWERS OF CREDIT THEREFORE, SOME ARRANGEMENT NEEDS TO BE MADE FOR MAKING CREDIT AVAILABLE TO THEM THE MARKET IS PROFIT-ORIENTED AND MAY DO THIS ONLY TO A LIMITED EXTENT ROLE OF THE GOVERNMENT AND THE PRIVATE SECTOR ALTRUISM

8. ISLAMIC FINANCE IN PRACTICE ISLAMIC FINANCE IS STILL IN ITS INFANCY • PLS: SMALL SHARE • DEBT: MAJOR SHARE - EVERY EFFORT IS BEING MADE TO TRANSFER THE RISK TO THE BORROWER OR THE LESSEE • THE EMERGENCE OF TABWARRUQ HAS PARTLY SEVERED THE LINK WITH THE REAL SECTOR. SOME JURISTS HAVE EVEN ALLOWED THE SALE OF DEBT • REASON: • ABSENCE OF SHARED INSTITUTIONS TO SUPPORT THE SYSTEM • THE MAQASID AL-SHARI‘AH ARE NOT TAKEN INTO ACCOUNT WHILE GIVING FIQHI VERDICTS

9. SOME SUGGESTIONS FOR REFORM OF THE INTERNATIONAL FINANCIAL SYSTEM RAISE THE SHARE OF EQUITY AND LOWER THAT OF DEBT IN TOTAL FINANCING CONTROL LEVERAGE ALLOW CREDIT PRIMARILY FOR PROMOTING DEVELOPMENT OF THE REAL SECTOR REQUIRE BANKS TO HOLD DEBT UNTIL MATURITY TO MOTIVATE THEM TO ENSURE CAREFUL UNDERWRITING – IF, HOWEVER, DEBT IS TO BE SOLD, THERE MUST BE FULL TRANSPARENCY ALONG WITH RIGHT OF RECOURSE. IF NOT, THE ISSUER MUST HOLD A MEANINGFUL PROPORTION OF IT CDSS SHOULD NOT BE ALLOWED TO BECOME INSTRUMENTS FOR WAGERING ALL FINANCIAL INSTITUTIONS MUST BE REGULATED SOME ARRANGEMENT MUST BE MADE TO ENABLE THE SUBPRIME BORROWERS TO GET CREDIT

THANKS

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