Islamic Finance: A Safeguard Against Contemporary Global Financial Crisis

Global Financial Crisis

The world had once again experienced a financial crisis from 2007 to 2009. This crisis was considered to be the worst financial crisis since the Great Depression in 1929. This crisis was said to have occurred due to the failure of the financial system which was adopted by the United States Central Bank. There were various reasons cited on how the crisis had started, however the primary causes to this crisis was said to be based on three factors: inadequate market discipline in the financial system, excessive use of derivatives, and inappropriate regulations (e.g. too big to fail) which had led major financial companies to fall one after another by offering risky investments with lenders money (Chapra, 2011). The crisis was additionally said to be caused by improper administrative measures embraced by regulators to ensure customer security, as well as monetary and products transparency which emerged from securitization of credits (Trabelsi, 2011).

This crisis started with excessive and imprudent lending that occurred in the United States. This practice was rampant within the area of subprime mortgage, for which a loan is given to creditors who have poor credit scores. Subprime mortgage was pushed by the demand for real estate assets. As higher demand was expected to give higher profit to both the bank and investors, banks decided to lend numerous amount of loan to subprime mortgage customer. This situation indicates that the bank has failed to prioritise quality over the quantity of the loan lending towards subprime borrowers. Many of the subprime borrowers subsequently failed to repay their due, which resulted with an uncertainty that led to a doubt of repayment. Since borrowers eventually fail to repay their loan, the bank decided to confiscate their houses with an intention to sell these house back into the market.

However, since the number of default mortgages became too large, the amount of house supply in the market eventually blew up. High supply with low demand hence caused the real estate market to fall. This situation caused the banks to find it difficult to find extended financing for their operations. As such, numerous banks in the United States, the United Kingdom, Europe, and a number of other places have failed, had to be bailed out, or nationalised by their respective governments.

Another impact discovered from the failure of borrower repayment was the rise of risk aversion behaviour between investors. This hence raises trust issues between investors and lenders that led to an excessive diversion towards derivatives, mainly the Credit Default Swap (CDS) to gain protection of their investment. CDS is used as protection from any form of default by lenders, where sellers of CDS (a hedge fund) are obliged to compensate (in case the debtor defaults) lender in return of a premium paid by the lender.

Be that as it may, support reserves sold the swaps not to the loaning bank as how it should be, but rather to a huge number of others who were willing to wager on the debtor's default. In turn, these swap holders sold their swaps to other parties, hence this pattern is repeated into a loop. This caused the hedge funds and banks to have difficulty in paying their amount due to swap holders, since there are several parties that needed to be compensated with the fall out of retail assets industries in the United States. The total of CDS outstanding compensation at that time was $54.6 trillion, and the amount of all kinds of derivatives outstanding was said to be ten times bigger than the size of the world economy at that time, which was around $600 trillion.

This crisis was also triggered by the failure of financial system discipline applied by financial institutions. Investment banks failed to be transparent in disclosing the true information with regard to the credit situation where questionable mortgage holders were approved of their loans. In the end, greed and improper market system discipline have caused the global financial crisis, just like a domino’s effect.

Islamic Finance

Islamic finance takes an arrangement of money-related administrations in agreement with Sharīʿah point of view, where its laws, standards, and rules are referred to as a point of reference. Sharīʿah prohibits transactions involving short sales, gharar (uncertainty), riba (interest), maysir (gambling), and other financing activities that are considered to be detrimental to society. Furthermore, both risks and benefits of business transactions must be shared fairly between related parties and must have real economic objectives without speculation or exploitation by either party.

Since 2009, Islamic finance has become the fastest-growing global financial system, with an estimated compound annual growth rate of 17 percent from one of its segments, namely Shariah Compliant Financing (SCF). According to the Asian Development Bank (ADB), the industry's global assets were estimated to have reached at least $1.9 trillion in 2015. Islamic finance eventually came to a point of reaching systemic significance in several Asian countries, thanks to the continuous expansion of the industry in countries such as Bangladesh, Brunei, and Malaysia. In these countries, Islamic finance has achieved at least a 15 percent share in the countries’ domestic banking sector. On the other hand, countries whose population is not dominated by Muslims have started to open their gates to Islamic finance after looking into the industry's exponential growth. Countries such as China, the United Kingdom, Hong Kong, South Africa, and Luxembourg had issued their own state Sukuk or Islamic trust certificates. Issuance of this financial instrument was projected to be produced at least twice as oversubscribed. This showed a fairly strong demand for SCF globally.

After the financial crisis in 2008, extensive research on Islamic banking and finance was conducted in line with the idea of performance and growth factors. As a result of its significance and growth, regulatory authorities have also decided to include it in the curricula of various education institutions (Alshater et al., 2022). At the start of its implementation, it was challenging for regulators to standardise items relating to Islamic finance across multiple states. Hence, worldwide standards-creation organizations were created to guide Islamic economic activity at an international scale. Since 1991, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) which is based in Bahrain, has published Shariah-compliant accounting, auditing, and financial reporting standards. Islamic Financial Services Board (IFSB), which was established in Malaysia in 2002, is placed to be in charge of formulating regulatory and supervisory standards and recommendations. IFSB also provide support to regulatory bodies to implement these standards and directives where appropriate.

Factors Influencing Islamic Finance in Global Financial Crisis

The global financial crisis that occurred in the United States in 2008 had affected the entire economy of both developed and developing countries. One of the issues that arose at the time of this incident was directed towards the Cypriot financial crisis that occurred in Europe. This issue highlighted many weaknesses in the banking sector, which became the main cause of the global financial crisis. Many efforts was since taken by developed and developing countries to avoid further damage from the global financial crisis.

There were several causes identified from the crisis which are closely aligned with the perspective of Islamic finance, such as creating interest, selling subprime mortgage debt, short selling, and the absence of risk sharing. With many discussions being put in place, it was discovered by various parties that there is a need for an alternative to prevent future financial collapse. One of the suggestions provided was by making the capital market work more effectively through financing as a form of alternative to the banking system. The Islamic financial system is considered to have proper control by introducing greater discipline to real economic growth. There is no doubt that usury and maysir emerged as the main factors causing the global financial crisis.

In the Islamic financial system, interest-based transactions are prohibited, as Islam encourages fair and lawful business or trade. This is so that the risks faced by customers are not fully borne by the customers who suffer losses. Through profit-loss sharing (PLS), these risks can be shared across multiple customers, in other words they would be sharing the risk. This alternative was introduced to avoid subprime mortgage practices, which were a root cause towards the global financial crisis. In the last three decades, Islamic Financial Institutions (IFIs) have established a world presence with an indication that the asset base of these IFIs will continue to grow in the longer run (Trabelsi, 2011).

Therefore, it can be said that the Islamic financial system is able to at least minimise the severity and frequency experienced from financial crises by eliminating the major weaknesses of the conventional system. Asking investors to share risk is one way of introducing greater discipline into the financial system. Allowing credit, especially for the purchase of real goods and services owned by sellers, is able to link real economic growth with credit expansion, which is already an advantage to buyers. The Islamic financial system also prohibits the sale of debt by requiring creditors to assume the risk of default. This instrument helps to ensure that creditors would assess their risks more carefully. Furthermore, Islamic finance is also able to help the financial sector to minimise problems arising from subprime borrowers by extending credit to them on agreed terms. These instruments have the potential to save billions of dollars spent after the crisis to save wealthy bankers. However, this may not help the poor, as it is possible that their homes may have been foreclosed on or auctioned off at giveaway prices (Chapra, 2011).

Role of Islamic Finance to Overcome the Global Financial Crisis

Implementing Islamic financial system would enhance economic discipline and link loan expansion towards the actual economic growth. The implementation of this system may also minimise the severity and frequency of financial crises. Subprime borrowers remains a constant worry in this system, however Islamic finance may be able to help reduce risks by providing loans with appropriate terms. In theory, gharar prohibits Islamic banks from making extremely risky subprime and toxic asset investments or trading in zero intrinsic value derivative contracts. Hence, these banks are made to be are more resistant towards shocks, as compared to conventional banks. As a result, billions of dollars that are currently being used to bail out wealthy bankers can be saved. Asset-based paradigm of Islamic finance encourages risk sharing rather than risk transfer. Investment in wealth-creating activities would inherently curb excessive leverage.

In contrast, direct borrowing and lending are restricted by the Islamic financial system due to the production of debt. Instead, through sales or lease-based forms of financing, banks would need to borrow money via sales, productions, and leasing of tangible assets (Ahmed, 2010). Islamic regulatory frameworks demand that for sales or lease-based financing, the item being sold or leased need to be genuine; the item is not hypothetical or notional, and the seller owns and possesses the things being sold or leased. When the debt cannot be sold, the risk associated with it cannot be transferred to someone else. As such, transactions must be presented at real time, with both the buyer and seller intending to provide and receive the asset. In order to reduce a majority of speculative transactions, the requirements of Islamic system would be helpful. The financing of Islamic products can only increase according to real economic growth, which prevents excessive credit expansion (Siddiqi, 2006).

Islamic scholars have emphasized the importance of a provision that prohibits creditors from selling debt and transferring risks to third parties. This will help to eliminate speculative and derivative transactions, where delivery and receipt are unexpected. Furthermore, it will help to avoid unnecessary explosions in transaction volume and value, as well as a significant increase in debt which is relative to the size of real economy. Additionally, this instrument will allow for a significant amount of financial resources to be provided to the real economic sectors, which will help create jobs and chances for self-employment, as well as providing goods and services that are needed by the real economy (Hassan & Kayed, 2009).

In addition, intimate linkages between the financial sector and the commercial nature of real estate sectors may help to prevent future bubbles and technical speculation in both sectors. Stricter oversight by owners of investment accounts could force banks to adhere towards market discipline and maintain the stability of the overall nation’s financial system.

Current Issues in Malaysia

Challenges in the Adoption of Islamic Finance

This paper found several challenges in developing Islamic finance institutions in Malaysia. One of the challenges to Islamic finance's adoption in Malaysia revolved around the misunderstanding of concepts and a need to standardize Islamic financial concepts. According to Gerrard and Barton Cunningham (2003), there is a tiny minority of Muslims who might be familiar with Islamic banking procedures, while there could be almost no non-Muslims that is able to thoroughly understand the Islamic financial culture. These observations showed that consumer knowledge of the Islamic banking industry is still lacking. Therefore, Malaysian customers would still require more information with regards to the Islamic banking services.

Secondly, there is a limited number of market-based financial intermediation and product. Askari et al. (2011) stated that IFIs are at risk of liquidity issues with little capital risk and significant yields which comes as a result from an absence of stable market and short-term assets such as treasury bills and securities. These financial instruments are prohibited from a Sharīʿah point of view because the profits obtained are not based on productive and real business. At present, the market has already seen substitute products which offer similar liquidity features as the original product (e.g. Bai’ al-inah, Bai' bithamanajil, Murabahah, and Mudarabah). Islamic financial institutions struggled to deal with liquidity shortages and excesses since the Sharīʿah point of view prohibited them from conducting riba-based lending activities.

Thirdly, the operations of IFIs involve concentrated banking, which has limited risk management functionality. According to Iqbal (2007), IFIs would usually avoid direct competition by concentrating on a few niche industries. One Islamic bank for instance, would place focus on lending to information technology businesses, while another which has yet to diversify into other industries, would place focus on financing the agricultural sector. Lacking a formal marketplace to mitigate risk and create diversity, this approach severely limits the potential for risk transfer. As a result, Islamic banks are highly vulnerable towards cyclical shocks in specific sectors (Iqbal, 2007).

The last challenge concerns more on the legal aspects governing IFIs. According to Oseni (2011), the Malaysian legal system has been amended multiple times in an effort to eliminate disagreements, especially when determining which transaction or situation is considered halal and haram. One of the efforts made in the Islamic finance scoop was the establishment of the Muamalat bench at Kuala Lumpur high court to encourage a sort of expert determination of Islamic finance disputes, albeit through jurisdiction. Despite the effort, it is still faced with problems in determining the right judgment, especially in the manpower aspect that lack of mastering Islamic finance. Customers of Malaysian banks are ultimately more inclined to subscribe to consumer-friendly financial institutions, especially when it comes to dispute resolution in ensuring that the transaction carried out is in accordance with sharia.

Islamic banking plays a vital role in Malaysia's financial industry. Therefore, it is crucial to consider elements that influence its ability for further expansion among both Muslims and non-Muslims. As such, various parties need to work together in overcoming challenges which are being faced from the development of Islamic banking sector in Malaysia.