Finance Research Paper on Islamic Finance and the Financial crisis

Islamic Finance and the Financial crisis

The bursting of the US housing bubble between 2005 and 2008 due to subprime mortgage lending is one of the main triggers of the subsequent financial crisis that ravaged the global economy. The crisis led to the collapse of financial institutions and the bailing out of others as the crisis peaked in 2008. The crisis raised a serious debate on the structure of the banking industry and how the financial industry carried out its business. To avoid the recurrence of the crisis, there needs to be a paradigm shift in the way the financial sector does its business. The Islamic banking model provides a way through which financial transactions can be done in a saner way that to some extent reigns in on the greed of bankers by curtailing their speculative activities. The articles reviewed in this essay help to shed more light on the various aspects of Islamic banking, and how Islamic banking can be a stabilizing force in the dynamic financial sector.

Ahmed Adel “Global financial crisis: an Islamic finance perspective.” International Journal of Islamic and Middle Eastern Finance and Management 3.4 (2010): 306 – 320. Print.

The article is an examination of the Islamic banking model and how useful it can be in ameliorating the severity of the banking crisis. According to the article, the Islamic banking model links expansion of credit to the real economy by facilitating the purchase of goods and or services, which the seller owns that a buyers wishes to take. The model allows for the sharing of profit and losses between the lender and the borrower, and is not based on the paying of interest by the borrower. This ensures that financial organizations make due diligence before lending money and also ensure that a borrower has capacity to repay before lending. This reduces the likelihood of default because the lender not only lends money but also has an interest and a stake in the success of the borrower. The article is an analysis of published literature focusing on Islamic banking and applies critical thinking to propose a new banking model as well as a different view on international finance. Ahmed argues that the Islamic banking model can be a viable alternative to the conventional banking industry in terms of offering quality and safe banking services to clients. In addition, the system has inherent safety feature that make it safer for investors.

 The article is useful in delineating the fundamentals of Islamic banking and explaining the tenets upon which the system is based. It provides information on how the system works and gives insights on why the Islamic banking system is more stable compared to the conventional financial services. In addition, the article provides an in-depth review of academic literature on Islamic banking that is useful in making a decision to adopt the system.

Ahmed, Habib. “Financial crisis: risks and lessons for Islamic finance.” International Journal of Islamic Finance 1.1 (2009): 7-32

In this article, Ahmed examines the sources of risk in the financial sector that may have contributed to the financial crisis. The first source he identifies is institutional, where government agencies tasked with oversight can fail in their duties. Secondly, there are institutional risks that are due to the nature of the business done by banks. Banks specialize in dealing with risks and are rewarded handsomely for the risks they take. There is a correlation between risk and reward for banks and often the bigger the risks taken the bigger the rewards. Lastly, the product can be a source of risk. Banks offer various types of products, and each of these products has a unique risk profile. The formulation of complex derivatives in the financial sector made it impossible to accurately quantify the risk associated with the products. In his analysis of the Islamic banking model, Ahmed is not persuaded that the model is adequately insulated from these risks. The regulatory regime for the Islamic banking products is very weak and thus Islamic banks can be tempted to break the rules in the pursuit if super profits, just like Western banks did prior to the crisis. The Islamic financial industry has also experienced unprecedented expansion, leading to the formation of complex financial products that may eventually lead to the recurrence of the financial crisis.

The article is useful because it helps to highlight some of the weaknesses of the Islamic banking model. In particular, he identifies the risks that the model is exposed to and suggests that these risks have to be tackled. The article provides a critical view of the model and identifies facets that need to be improved.

Alzalabani Abdulmonem & Reji Nair. “Financial recession, credit crunch and Islamic banks: a case study of Al Rajhi Bank in the Kingdom of Saudi Arabia.” Journal of Economics and Business 15.1 (2013): 15-36.

In this paper, Alzalabani & Reji attempt to address the hypothetical question of whether the financial crisis could have been averted if Islamic banking principles were used instead of the Western financial models. According to the authors, Islamic banking is very stable, unlike conventional banking because it only creates value where there are assets, hence insulating the system from major losses. Under Islamic banking, papers and the securitization of assets, which is in vogue in conventional banking is not accepted. This innate feature of Islamic banking makes it more immune to speculation and over-ambitious risk taking compared to conventional banking. In addition, Islamic banking prohibits usury, or the demand for interest on money lent. In the Islamic banking system, money does not have a value per se, but is merely a means of exchanging value. It emphasizes partnerships and sharing of profits and loses between the bank and the borrower. To demonstrate the effectiveness of the Islamic banking model, the authors use a case study of Al Rajhi Bank in Saudi Arabia. The bank is one of the largest banks in the world. The bank has maintained profitability by focusing on increasing business volumes, reducing its labor costs and having relatively high margins. During the recessionary period, the bank’s financial indicates remained bullish and it still posted a substantial profit. There was a marginal decline in profitability and other business indicators, mainly due to loss of brokerage fees. However, its general performance during the recession was above par, and its fundamentals remained strong throughout the period.

This paper is relevant because it offers an example of a successful institution employing the Islamic financial model. It also shows that the Islamic banking model can be useful for sustainable development. In arguing the need for a change, this example of success when using the model is useful for purposes of illustration.

Ahmed, Parvez “The Current Economic Crisis – Is Islamic Finance a Solution?” Huffington Post               29 March 2010. Web. 19 June 2014. Web

In this article, Ahmed focuses on the Islamic Financial Services Industry (IFSI), and the products and services offered by the industry. The industry has been on an upward trajectory of growth since its inception. IFSI markets itself as a viable alternative to the Western model of banking and was estimated to be worth US$ 700 billion as at 2010. It is expected that its worth shall continue rising and it may be worth US$ 2.8 trillion. This represents a quadrupling of its worth over a short span of time. Ahmed states that a distinguishing feature of IFSI in contrast to Conventional Financial Institutions (CFI) is its insistence on complying with Shariah law. Although in theory IFSI is against the charging of interest, in practice, interest is charged indirectly, and sometimes directly, although the rates are lower. The difference between IFSI and CFI products is minimal in practice. The IFSI has a responsibility of declaring the Islamicity of contacts, and changing them to reflect Islamic principles, where need arises. However, this process is opaque and open to abuse, since the Shariah-boards in charge of the process are often beset with conflicts of interest. The lack of transparency in the system is a major stumbling block in fostering confidence in the Islamic banking system. International best practice insists in openness, declaration of interests, and an above-board process. The lack of this safeguards in the declaration of Islamicity does not help in breeding confidence in investors.

This article is useful to the topic because it suggests innovations required in Islamic banking, if it is to play a major role in the financial world. The products offered by IFSI are mainly focused on Muslims. There is a need to offer these services to more people and secular banks can play a role in this change.

Bershidsky, Leonid. “Islamic finance can save the world.” Bloomberg View 29 October 2013.     Web. 19 June 2014.

In this article, Bershidsky discusses the implications of the UK’s action of issuing a sukuk-, which is a bond that is compliant with the Shariah law. The UK is among the first non-Islamic sovereigns to issue a Shariah compliant bond. The market for Shariah-compliant bonds has remained untapped in Western nations for a long time. Although the Islamic banking industry represents a small fraction of the world’s financial dealings, it is a sector that is growing rapidly compared to conventional banking and may soon command a sizeable portion of the world’s financial sector. Bershidsky admits that the UK’s decision is mainly a political move aimed at making London a financial hub of choice for Islamic investors. However, he says that should other governments switch to issuing Islamic bonds, the world will be a better place and the risks associated with financial dealings will reduce considerably. Bershidsky offers a brief history of Islamic bonds offered by sovereigns and explains how they work. He states that since these bonds are issued against assets, it is hard for money to be issued for speculative purposes, something that can stop nations from racking up huge amounts of debts that they eventually default. It is important to note that the restriction of lending to assets or expected incomes does not in any way hamper the prospects of growth. Rather, this acts a safety valve against speculation and helps to promote sustainable growth and development.

The article is useful as it gives information on Islamic bonds and elaborates on the types of sukuk and how they work. In addition, the article shows that even secular sovereigns are attempting to embrace Islamic banking, hence signaling a shift in attitude towards the model. Soon the model may be in the mainstream and early adopters are likely to benefit.

Vizcaino, Bernardo. “Islamic finance yet to be fully tested –report.” Reuters 22 May, 2014. Web.            19 June 2014.

In this article, Vizcaino dissects a report produced by the Islamic Financial Services Board (IFSB), examining the financial health of Islamic banks. Even though the Islamic banks were not significantly affected by the global financial crisis and generally came out unscathed, there are potential risks that are yet to be addressed. Among the challenges that Islamic banks face are declining profitability, asset quality, capital adequacy, and liquidity management. Vizcaino notes that although the Islamic banks were to some extent shielded from the sub-prime mortgages that precipitated the financial crisis, their profitability declined during the crisis. Islamic banks in the Middle East also have a considerable real estate portfolio in their books. The property bubble that burst in the West had an adverse effect on the property industry in the Middle East. Although the real industry has began to recover and has a positive outlook in the medium and long-term, some of the banks are overexposed to the property market and should the sector experience a downturn, their stability will be adversely affected. In addition, they have a high non-performing loan portfolio that is much higher compared to that of conventional banks. Islamic banks have higher levels of capitalization compared to those of conventional banks. This has been mainly due to the fact that Islamic interbank financial transactions are limited, and the market is not well-developed. In addition, the limited foreign currency deposits have hampered the ability of Islamic banks to expand their customer base beyond their borders, hence stifling growth.

This article gives an Islamic perspective on the problems facing the Islamic banking industry. This is useful in analyzing the limiting factors that have stopped the Islamic financial industry from becoming a serious alternative to the conventional; banking industry at the international level. It is important that the hindrances to expansion are articulated well so that they can be addressed when adopting the model.