The Global Financial Crisis: Can Islamic Finance Help Minimize the Severity and Frequency of Such a Crisis in the Future?

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October 21, 2008


(A paper prepared for presentation at the Forum on the Global Financial Crisis to be held at the Islamic Development Bank on 25 October 2008)

* The author is Research Adviser at the Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB). This paper is a revised and updated version of the keynote Forum lecture delivered by him at the inaugural session of the Eighth Harvard University Forum on Islamic Finance held on 19-20 April 2008 in the Harvard Law School. The views expressed in this paper are his own and do not necessarily reflect those of IRTI or IDB. He is grateful to Shaikh Muhammad Rashid for the excellent secretarial assistance he has provided. He is also grateful to Bashir Khallat, Acting Director of IRTI, for the encouragement and support he has provided and to his colleagues, Drs. Sami alSuwailem, Tariqullah Khan and Salman Syed Ali for their valuable comments on an earlier draft.

ABSTRACT The paper tries to determine the primary cause or causes of the financial crises that have plagued almost every country around the world over the last three decades. Of particular significance are the 1998 LTCM breakdown and the prevailing subprime mortgage crisis in the United States which is more severe than any in the past and has had devastating spillover effects worldwide. It argues that one of the major causes of these crises is the lack of adequate market discipline in the financial system. This leads to excessive lending, high leverage and ultimately the crisis. Unwinding gives rise to a vicious cycle of selling that feeds on itself and leads to a steep decline in asset prices accompanied by bank failures and economic slowdown. Risk-sharing along with the availability of credit for primarily the purchase of real goods and services and restrictions on the sale of debt, short sales, excessive uncertainty (gharar), and gambling (qimar), which Islamic finance stands for, can help inject greater discipline into the system and, thereby, substantially reduce financial instability. INTRODUCTION The financial system has decidedly played an active role in the accelerated development of the world economy, particularly after the Second World War. An unending stream of financial innovations, including the revolution in information and communications technology, has played a crucial role in this development. The system is, however, now plagued by persistent crises. According to one estimate, there have been more than 100 crises over the last four decades (Stiglitz, 2003, p. 54). Not a single geographical area or major country has been spared the effect of these crises. Even some of the countries that have generally followed sound fiscal and monetary policies have become engulfed in these crises. The prevailing financial crisis, which started in the summer of 2007, is more severe than any in the past and shows no sign of abating despite a coordinated bail out of three to four trillion dollars by the US, the UK, Europe and a number of other countries. It has seized-up money markets and led to a precipitous decline in property and stock values, bank failures, and nervous anxiety about the fate of the global economy and the financial system. This has created an uneasy feeling that there is something basically wrong with the system. There is, hence, a call for a new architecture. The new architecture demands an innovation that could help prevent the outbreak and spread of crises or, at


least, minimize their frequency and severity. Since a number of the crises experienced around the world are generally of a serious nature and have been recurring persistently, cosmetic changes in the existing system may not be sufficient. It is necessary to have an innovation that would be really effective. It may not be possible...
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