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International Financial Stability: The Role of Islamic Finance PDF Print E-mail
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Policy Perspectives, Vlm 4, No.2


[A number of financial crises that visited the world over the last three to four decades have put the international financial system in question. This article reviews these crisis and reasons behind them. It also argues that the weaknesses of the prevailing interest-based financial system create a strong rationale for introducing a new system of the international finance. The article also dilates on the principles of Islamic banking which deter interest and introduce in its place the principle of risk/reward-sharing. Financing through the Islamic modes expands in tandem with the real economy and help curb excessive credit expansion which leads to lavishness and contributes to the instability in the international financial markets. The article also cites a strong rationale behind the prohibition of interest from major religions of the world. The paper concludes with solution based on Islamic principles. – Author]

Debate and discussion on interest is something that is deeply rooted in history as well as religion. Why is it that not just Islam, but also some other major religions, including Hinduism, Judaism, and Christianity, have prohibited interest? Even some philosophers, like Socrates, have questioned the legitimacy of interest. Nevertheless, interest is very much current in modern times and it is, therefore, natural for people to ask about the rationale behind its prohibition in these great religions. The answer in short is that it hurts mankind in several different ways. It is responsible for a great deal of instability and inequities prevailing in the international financial system, which is the focus of this discussion.

It is commonly known that the world has experienced a number of financial crises over the last three to four decades, starting from a few years before the devaluation of the dollar in 1971 when foreign exchange markets became highly unstable. The crises continued in spite of two devaluations of the dollar and the Second Amendment to the International Monetary Fund (IMF) Articles of Agreement. There was the US stock market crash in October 1987 followed by the bursting of the Japanese stock market bubble in the 1990s, the breakdown of the European Exchange Rate Mechanism (ERM) in 1992–93, the East Asia crisis in 1997, the Russian crisis in 1998, the US hedge fund crisis in 1998, and the Brazilian exchange rate crisis in 1999. These are just a few of the crises that the world has experienced. All of them have created an uneasy feeling that there is perhaps something basically wrong in the international financial system. Hence, there is a call for a “new architecture.”


A new architecture cannot be designed, however, unless the causes or the ultimate cause of these crises has been determined. It would be highly simplistic to say that there is a single cause of these crises. However, it may not be unrealistic to say that there is a major cause — a ‘cause of all causes,’ so to speak. This discussion aims to try to point out this cause of all causes.


The Roots of the Crises
A number of economists have made an effort to determine why these crises occurred. Some consider the reason to be financial liberalization in an environment where the financial systems of many countries are not sound due to improper regulation and supervision. Others feel that the ultimate cause is the bursting of the speculative bubble in asset prices driven initially by the excesses of financial intermediaries. It has also been argued that the root cause of the crises was the maturity mismatch: short-term international liabilities were far greater than short-term assets. The available literature indicates a number of other causes as well.


Even though all these factors have had some role to play in the crises, no consensus seems to have developed so far on the ultimate cause or the cause of all causes. In the absence of a proper understanding of this root cause, conflicting remedies have been proposed. This makes it difficult to lay down an effective reform program. Hence, the proposals for the new architecture have been unable to step beyond the basic principles of conventional wisdom, and emphasize sound macroeconomic policies along with sustainable exchange rates, proper regulation and supervision, and greater transparency. These principles are undoubtedly indispensable because, in the last analysis, all crises have their roots in unhealthy fiscal, monetary, and exchange rate policies. Hence, no one has ever denied the need for their honest implementation. Nevertheless, these principles have been, and continue to be, violated.


The continued violation of these principles brings to mind a number of questions. First, what enables the continuation of macroeconomic imbalances, unsustainable exchange rates, and unhealthy financial practices over a prolonged period? One would expect that market discipline would normally be able to bring about a correction in these by ensuring honest and effective implementation of the basic principles of conventional wisdom. It is quite obvious that market discipline is unable to prevent macroeconomic imbalances in the public sector and living beyond means in the private sector. What is it that makes it possible to have excessive leverage, when this has proved to be the major factor that leads speculative bubbles to the point of bursting? Is this because there is inadequate market discipline?


A second related question is why some of the countries that have followed sound fiscal and monetary policies have also faced crises. The Exchange Rate Mechanism (ERM) crisis of the early 1990s challenges the view that foreign exchange market crises stem from undisciplined fiscal and monetary policies. Many of the countries caught up in the crisis did not have overly expansionary policies. Even the East Asian countries do not convincingly fit into the mould of unhealthy macroeconomic policies. A third and equally important question is: Why the apparently well-regulated financial systems, like those of the United States of America and the United Kingdom, have also faced crises?


A closely related question is whether greater regulation, supervision and transparency will by themselves help avoid such crises.

Inadequate Market Discipline: Is this the Root Cause?

It may not be possible to answer these questions without looking at the underlying reason for the failure to implement the basic principles of the new architecture in spite of their being a part of conventional wisdom. The primary cause, it would appear, is the inadequate market discipline in the conventional financial system. Instead of making the depositors and the bankers share in the risks of business, it assures them of the repayment of their deposits or loans with interest. This makes the depositors take little interest in the soundness of the financial institution. It also makes the banks rely on the crutches of the collateral to extend financing for practically any purpose, including speculation. The collateral cannot, however, be a substitute for a more careful evaluation of the project financed. This is because the value of the collateral can itself be impaired by the same factors that diminish the ability of the borrower to repay the loan. The ability of the market to impose the required discipline thus gets impaired and leads to an unhealthy expansion in the overall volume of credit, to excessive leverage, and to living beyond means. This tendency of the system gets further reinforced by the bias of the tax system in favor of debt-financing — dividends are subject to taxation while interest payments are allowed to be treated as a tax deductible expense.

The system’s inadequate market discipline is, however, not something new. It has existed throughout the development and spread of the conventional financial system. Then, why, one may ask, has there been greater volatility in the last two decades? What has created the difference is the rise in the volume of funds as a result of rapid economic development after the Second World War, the revolution in information and communications technology, and the liberalization of foreign exchange markets. These developments are, however, a manifestation of human progress and cannot be blamed for the crises. When the volume of funds was small, there were controls on their free movement, and exchange rates were fixed, inadequate market discipline was not able to create havoc. However, now the position is different.

Instead of blaming the new developments, it would be more appropriate to examine carefully the fault line in the international financial system resulting from the lack of adequate market discipline because of the absence of explicit risk-sharing. It is this fault line which makes it possible for the financier to lend excessively and also to move funds rapidly from place to place at the slightest change in the economic environment. A high degree of volatility thus gets injected into interest rates and asset prices. This generates uncertainty in the investment market, which in turn discourages capital formation and leads to misallocation of resources. It also drives the borrowers and lenders alike from the long end of the debt market to the shorter end. Consequently, there is a steep rise in highly-leveraged short-term debt, which has accentuated economic and financial instability. The IMF has acknowledged this fact in its May 1998 World Economic Outlook by stating that countries with high levels of short-term debt are “likely to be particularly vulnerable to internal and external shocks and thus susceptible to financial crises.”

One may raise the question here why a rise in debt, and particularly short-term debt, should accentuate instability. One of the major reasons for this is the close link between easy availability of credit, macroeconomic imbalances, and financial instability. The easy availability of credit makes it possible for the public sector to have a high debt profile. The private sector is also able to live beyond its means and to have a high leverage. If the debt is not used productively, the ability to service the debt does not rise in proportion to the debt. This leads to financial fragility and debt crises. The greater the reliance on short-term debt and the higher the leverage, the more severe the crises may be. This is because short-term debt is easily reversible as far as the lender is concerned, but repayment by the borrower is difficult. This is particularly so if the amount borrowed is locked up in loss-making speculative assets or medium- and long-term investments with a long gestation period. While there may be nothing basically wrong in a reasonable amount of short-term debt that is used for financing the purchase and sale of real goods and services, an excess of it is likely to get diverted to unproductive uses as well as speculation in the foreign exchange, stock and property markets. Jean-Claude Trichet, President of the European Central Bank, was right in pointing out that “a bubble is more likely to develop when investors can leverage their positions by investing borrowed funds.”

To make the argument clearer I would like to present four examples. These are:

  1. The East Asia Crisis;
  1. The collapse of the hedge fund, Long-Term Capital Management (LTCM);
  2. Foreign exchange market instability; and


  1. The prevailing imbalances in the US economy.

These examples will help explain why the easy availability of credit and the resultant steep rise in debt, particularly short-term debt, are the result of inadequate market discipline in the financial markets caused by the absence of risk-sharing.


The East Asia Crisis: The Eastern Tigers had been considered among the global economy’s shining success stories. They had high domestic saving and investment rates coupled with low inflation. They also pursued healthy fiscal policies that could be the envy of a number of developing countries. Since one of the major causes of financial instability is the financing of government deficit by bonds or fixed-interest-bearing assets, the fiscal discipline of these countries should have helped in saving them from such instability. However, it did not. There was rapid growth in bank credit in local currency to the private sector by domestic banks on the basis of easily available short-term inflows in foreign currency loans from abroad. This created speculative heat in the stock and property markets, which generated a mood of ‘irrational exuberance’ and pushed up asset prices far beyond what was dictated by fundamentals.

The large foreign exchange inflows from abroad also enabled the central banks to peg exchange rates. This helped providing the assurance needed by foreign banks for lending. The relatively high domestic interest rates helped attracting further inflows of funds from abroad in foreign currencies to finance the ongoing boom in the assets markets. Since about 64 percent of the inflows in the five seriously affected countries (South Korea, Indonesia, Thailand, Malaysia and the Philippines) were short-term, there was a serious maturity and currency mismatch. This joined hands with political corruption and ineffective banking regulation to lend heavily to favored companies. These became highly over-leveraged.


The fast growth of these companies was thus made possible by the availability of easy money from conventional banks. In a system where risk/reward-sharing does not exist, commercial banks are generally not under a constraint to scrutinize the projects minutely. It was the old mistake of lending on collateral without adequately evaluating the underlying risks. Risk-sharing would have obliged the banks to scrutinize the projects more carefully. They would not have yielded even to political pressures if they considered the projects to be too risky.

Therefore, there is a strong rationale in drawing the conclusion that one of the most important underlying causes of excessive short-term lending was the inadequate market discipline resulting from the absence of risk-sharing on the part of banks as well as depositors. It is very difficult for regulators to impose such a discipline unless the operators in the market are themselves rightly motivated. The assurance of receiving the deposits or the principal amount of the loan with the predetermined rate of return stands in the way.


There was a reverse flow of funds as soon as there was a negative shock. Such shocks lead to a decline in confidence in the borrowing country’s ability to honor its liabilities in foreign exchange. The rapid outflow of foreign exchange led to a sharp fall in exchange rates and asset prices. There was also a steep rise in the local currency value of the debt. The private sector borrowers, who were expected to repay their debts in the local currency, were unable to reimburse as per the schedule. There was a domestic banking crisis, which had its repercussions on foreign banks because of the inability of domestic banks to meet their external obligations. All this would not have been possible in case of equity financing or even medium- and long-term debt.


Governments have only two options in such circumstances. The first option is to bail out the domestic banks at a great cost to the tax payer. The second option is to allow the problem banks to fail. The second option is generally not considered to be politically feasible even though there have been suggestions to the contrary. This is because in a financial system which assures, in principle, the repayment of deposits with interest, it is not possible for the governments to allow the violation of this principle and, thereby, commit a breach of trust. Moreover, there is also a presumption that if the big banks are allowed to fail, the financial system will break down as a result of spill-over and contagion effects. The economy will consequently suffer a severe setback — hence the “too big to fail” doctrines. The governments, therefore, generally feel politically safer in choosing the first alternative of bailing out the banks.


For the governments confronting the East Asian crisis, this raised the problem of how to bail out the external banks when the domestic banks’ external liabilities were in foreign exchange and the central banks did not have the foreign exchange needed for this purpose. Their foreign exchange reserves had declined steeply. It was, therefore, necessary to get assistance from some external institution. IMF came in handy in providing such assistance. This naturally raised a storm of criticism from those who were against the bailout. There was a call for the reform of IMF by reducing its role. However, IMF did not have a choice. There was a great deal of pressure on it from its influential members whose banks were in difficulty. The IMF refusal to provide resources would have destabilized the entire international financial system. It, therefore, yielded to the pressure. However, its bailout unintentionally transferred the debt from the private foreign banks to the central banks and the governments of the affected countries. Joseph Stiglitz, a Nobel Laureate, has wisely stated that “private debts should not be converted into public debts — a mistake that was made in many instances as a result of pressure from Western banks and governments.” Professor James Tobin, another Nobel Laureate, has also concluded that “when private banks and businesses can borrow in whatever amounts, maturities and currencies they choose, they create future claims on their country’s reserves.”


This discussion of the role of excessive reliance on short-term inflow of funds in the case of the East Asian crisis should not lead to the false impression that this is not possible in industrial countries. It is possible even there, in spite of the fact that they have better regulated and supervised banking systems. IMF has clearly warned of the existence of such a possibility, stating that “whatever their causes, the market dynamics of surges and reversals are not peculiar to emerging markets and it is unrealistic to think that they will ever be completely eliminated.”


The Collapse of the Long-term Capital Management Hedge Fund: We now come to the second example. This concerns the collapse of the US hedge fund, LTCM, in 1998. This was also due to highly-leveraged short-term lending. Even though the name “hedge fund” brings to mind the idea of risk reduction, “hedge funds typically do just the opposite of what their name implies: they speculate.” They are “nothing more than rapacious speculators, borrowing heavily to beef up their bets.” These hedge funds are mostly unregulated and are not encumbered by the restrictions on leverage or short sales. They are free to take concentrated positions in a single firm, industry, or sector, even though such positions are considered ‘imprudent’ if taken by other institutional fund managers. They are, therefore, able to pursue the investment or trading strategies they choose in their own interest without due regard to the impact that this may have on others.


There is a strong suspicion that these hedge funds do not operate in isolation. If they did, they would probably not be able to make large gains and the risks to which they are exposed would also be much greater. They, therefore, normally tend to operate in unison. This becomes possible because their chief executives often go to the same clubs, dine together, and know each other very intimately. On the strength of their own wealth and the enormous amounts that they can borrow, they are able to destabilize the financial market of any country around the world whenever they find it to their advantage. Hence, they are generally blamed for manipulating markets from Hong Kong to London and New York. Former Malaysian Prime Minister Mahathir Muhammad charged that short-term currency speculators, and particularly large hedge funds, were the primary cause of the collapse of the Malaysian Ringgit, as well as the Malaysian economy in the summer of 1997. It is, of course, difficult to prove this charge because these funds collude and operate with great skill and secrecy. There is, however, no reason to doubt what Mr. Muhammad has said. It is very likely that these funds may have been instrumental in the collapse of not only the Malaysian Ringgit but also the Thai Bhat and some other East Asian currencies.


The ability of these hedge funds to borrow heavily is clearly indicated by LTCM’s leverage of 25:1 in mid-1998. The losses that it suffered reduced its equity (net asset value) from the initial $4.8 billion to $2.3 billion in August 1998. Its leverage, therefore, rose to 50:1 on its balance sheet positions alone. However, its equity continued to be eroded further by losses, reaching just $600 million, or one-eighth of its original value, on September 23, 1998. Since its balance-sheet positions were in excess of $100 billion on that date, its leverage rose to 167 times the capital. There was, thus, a tier upon tier of debt which became difficult to manage. The Federal Reserve had to come to its rescue because its default would have posed risks of systemic proportions. Many of the top commercial banks, which are supervised by the Federal Reserve and considered to be healthy and sound, had lent huge amounts to these funds. If the Federal Reserve had not come to their rescue, there may have been a serious crisis in the US financial system with spillover and contagion effects around the world. If the misadventure of a single hedge fund with an initial equity of only $4.8 billion could take the USA and the world economy to the precipice of a financial disaster, then it would be perfectly legitimate to raise the question of what would happen if a greater number of the 6,000 or so hedge funds got into trouble.


A hedge fund is able to pursue its operations in secrecy because, according to Alan Greenspan, the Chairman of the Board of Governors of the US Federal Reserve System, it is “structured to avoid regulation by limiting its clientele to a small number of highly sophisticated, very wealthy individuals.” He does not explain, however, how the banks found it possible, in a supposedly very well-regulated and supervised banking system, to provide excessively leveraged lending to such “highly sophisticated, very wealthy individuals” for risky speculation. Were they unaware of the well-known fact that the higher the leverage, the greater the risk of default? The unwinding of leveraged positions can cause major disruption in financial markets by exaggerating market movements and generating knock-on effects.


This example shows that a financial crisis does not arise merely where there is improper regulation of banks, as in the East Asian case, but can also occur in a properly regulated and supervised system, as in the USA. Even though the hedge funds were not regulated, the banks were. Then why did the banks lend huge amounts to the LTCM and other funds? What were the supervisors doing and why were they unable to detect and correct this problem before the crisis? Is there any assurance that the regulation of hedge funds would, in the absence of risk-sharing by banks, stop excessive flow of funds to other speculators who are not regulated?


Foreign Exchange Market Instability: We now come to the third example of foreign exchange market instability. Heavy reliance on short-term borrowing has also injected a substantial degree of instability into the international foreign exchange markets. According to a survey conducted by the Bank for International Settlements (BIS), the daily turnover in traditional foreign exchange markets, adjusted for double-counting, had escalated to $1,830 billion in April 2004 compared with $590 billion in April 1989. The daily foreign exchange turnover in April 2004 was more than 37 times the daily volume of world merchandise trade (exports plus imports). Even if an allowance is made for services, unilateral transfers, and non-speculative capital flows, the turnover is far more than warranted. Only 35 percent of the 2004 turnover was related to spot transactions, which have risen at the compounded annual rate of about 1.9 percent per annum over the 15 years since April 1989. The balance of the turnover — 65 percent — was related largely to outright forwards and foreign exchange swaps. These have registered a compounded growth of 11.8 percent per annum, far more than the growth of 7.6 percent per annum in world trade over this period.


Bankers normally assert that they give due consideration to the end use of funds. If this assertion was correct, would there have been such a high degree of leveraged credit extension for speculative transactions? High leverage has had the effect of driving foreign exchange markets by short-term speculation rather than long-run fundamentals. This has made them highly volatile and injected excessive instability into them. The efficient operation of these markets has, therefore, been adversely affected. The effort by central banks to overcome this instability through small changes in interest rates or the intervention of a few hundred million dollars a day has generally not proved to be significantly effective.

The dramatic growth in speculative transactions, of which derivatives are only the latest manifestation, has also resulted in an enormous expansion in the payments system; so much so that the former General Manager of the Bank for International Settlement and Chairman of the Financial Stability Forum Andrew Crockett, has been led to acknowledge that “our economies have thus become increasingly vulnerable to a possible breakdown in the payments system.” Even Mr. Greenspan, watching from the nerve center of international finance, finds this expansion in cross border finance relative to the trade it finances as startling. Such a large expansion implies that if problems were to arise, they could quickly spread throughout the financial system, exerting a domino effect on financial institutions.


The Prevailing Imbalances in the US Economy : Let us now look at the fourth example, which concerns the prevailing economic imbalances of the USA. Even though the USA has been doing well over the past few years by most measures of overall economic performance, the large and growing discrepancy between what it produces and what it consumes is worrying. The US trade account has been persistently in deficit since the late 1970s and the current account has been in a similar state since the mid-1980s. The current account deficit has now reached a record level of 6.3 percent of gross domestic product (GDP). As a result of these persistent deficits, the US net foreign indebtedness has reached a record high, both in absolute terms and as a percentage of its GDP.


The current account deficit is a reflection of the public sector budgetary deficit and the private sector saving deficiency. The federal government has spent more than what it has taken in every year since 1970, except for a brief respite between 1998 and 2001. The budget has moved from a surplus of $236 billion in fiscal year 2000 to a deficit of $400 billion in 2004. The US private sector net saving, i.e. saving by households and businesses minus their investment, has been negative since the mid-1990s as a result of a borrowing and spending spree by both households and firms. The personal saving rate has been declining since the mid-1990s. In 2004, the households saved only one percent of the after-tax income compared with 8 percent on average from 1950 to 2000. Nevertheless, investment in real estate and plant and equipment is high. This has generated a saving discrepancy that should have pushed up interest rates, but has not. The reason is the inflow of funds from abroad, particularly from China, Japan and India. Low interest rates have generated a boom in residential real estate prices. The resultant increase in household net worth, combined with low interest rates, has had the effect of boosting consumer spending further at the cost of saving.


This raises the question why it has been possible for the imbalances to persist for such a long period and why a correction has not been brought about by market forces. The reason, as already discussed in the case of other examples, is the lack of adequate market discipline in the financial system. Why should the public and private sectors curtail spending when interest rates are low and it is easy to borrow? Borrowing is easy because of the absence of risk-sharing by both the depositors and banks. In the current scenario, the market forces may not succeed in imposing fiscal discipline on the US government but they can at least contribute towards a decline in lending to the private sector. The resultant rise in saving might be able to offset the impact of public sector deficits.


This brings into focus the crucial question of how long the foreigners will be willing to continue lending to the USA. Confidence in the strength and stability of the dollar is necessary to enable it to serve as a reserve currency. What will happen if the deficits continue, create loss of confidence in the dollar, and lead to an outflow of funds from the USA? This is not just a theoretical question. In the last 30 years, the dollar has experienced four bouts of marked depreciation. Since nearly two-thirds of the world’s foreign exchange holdings are still in dollars, a movement out of the dollar into other currencies and commodities, as happened in the late-1960s, could lead to a sharp fall in the exchange rate of the dollar, a rise in interest rates and commodity prices, and a recession in the US economy. This might lead the whole world into a prolonged recession. The correction would then come with a vengeance, which would be especially unfortunate because market discipline now can bring it about much earlier and with significantly less suffering.

The Remedy

This brings us to the most important question and the gist of this discussion: how can the instability in the international financial markets be minimized? If curbing heavy reliance on short-term debt is the answer, then the best way to achieve this goal needs to be identified. One of the ways is greater regulation. However, regulation, while unavoidable, cannot be relied upon completely because of the difficulties involved in applying it uniformly in all countries and to all financial institutions. There are three reasons for this. Firstly, there are the complications created by the off-balance sheet accounts, bank secrecy standards, and the difficulty faced by bank examiners in accurately evaluating the quality of banks’ assets. Secondly, there is the fear that if there is uneven enforcement of regulations funds will fly to offshore havens where almost half of all hedge funds are already located. Emerging market banking crises provide a number of examples of how apparently well-capitalized banks may be found to be insolvent because they failed to recognize the poor quality of their loan portfolio. Even the LTCM crisis shows how banks in an apparently well-regulated system can become entangled in a speculative spree. Thirdly, bringing banks under a watertight regulatory umbrella may not only raise the costs of enforcement but also mislead depositors into thinking that their deposits enjoy a regulatory stamp of security.


This does not mean that regulation is not necessary. However, regulation and supervision would be more effective if they were complemented by a paradigm shift in favor of greater discipline in the financial system affected by making investment depositors as well as banks share in the risks of business. The mere bailing in of banks, as is being suggested by some analysts, may not take us far enough. What is necessary is not just to allow the shareholders to suffer when a bank fails, but also to strongly motivate depositors to be cautious in choosing their bank, and the bank management to be more careful in making loans and investments. Bank managers are better placed to evaluate the quality of their assets than regulators and depositors, and risk-sharing would motivate them to make the decisions that they feel are in the best interest of their banks and depositors.


Thus, it is necessary to reinforce regulation and supervision of banks by the injection of self-discipline into the financial system. This could be accomplished by making banks as well as shareholders and investment depositors (those who wish to obtain a return on their deposits) share in the risks of banking by increasing reliance on equity and reducing reliance on debt. In addition to the introduction of risk-sharing, it is also necessary to confine the availability of credit to the financing of real goods and services with some risk-sharing by the lender as well.


Making depositors participate in the risks of business would help motivate them to take greater care in choosing their banks, and to keep an eye on them to make sure that they are well-managed. Similarly, making the bank participate in the risks would make the bank management assess the risks of financing more carefully, and to monitor the use of funds by the borrowers more effectively. The double assessment of investment proposals by both the borrower and the lender would help raise market discipline and introduce greater health into the financial system. IMF has also thrown its weight in favor of equity financing by arguing that “Foreign direct investment, in contrast to debt-creating inflows, is often regarded as providing a safer and more stable way to finance development because it refers to ownership and control of plant, equipment, and infrastructure and therefore funds the growth-creating capacity of an economy, whereas short-term foreign borrowing is more likely to be used to finance consumption. Furthermore, in the event of a crisis, while investors can divest themselves of domestic securities and banks can refuse to roll over loans, owners of physical capital cannot find buyers so easily.”


This may raise an objection that investment depositors are generally risk averters and, unlike equity investors, would not like to expose their deposits to risk. Forcing them to take risk may create insecurity and difficulty for them and their families. To avoid such a problem, it should be possible for banks to invest the funds provided by risk-averting investment depositors in less risky assets. The banks may also be required to build adequate loss-offsetting reserves so that the depositors do not necessarily have to suffer losses. Such an approach should have the added advantage of making the banks more effective in managing their risks and, thereby, making the banking system safer and healthier.


Moreover, as Hicks has argued, interest has to be paid in good or bad times alike, but dividends can be reduced in bad times and, in extreme situations, even passed. So the burden of finance by shares is less. There is no doubt that in good times an increased dividend would be expected, but it is precisely in such times that the burden of higher dividend can be borne. “The firm would be insuring itself to some extent,” to use his precise words, “against a strain which in difficult conditions can be serious, at the cost of an increased payment in conditions when it would be easy to meet it. It is in this sense that the riskiness of its position would be diminished.” This factor should tend to have the effect of substantially reducing business failures and, in turn, dampening, rather than accentuating, economic instability.


Greater reliance on equity financing has supporters even in mainstream economics. Kenneth Rogoff, Professor of Economics at Harvard University, states that “In the ideal world equity lending and direct investment would play a much bigger role.” He further asserts that: “With a better balance between debt and equity, risk-sharing would be greatly enhanced and financial crises sharply muted.” However, if, in addition to a better balance between debt and equity, the debt is also linked to the purchase of real goods and services, as required by Islamic teachings, it would take us a step further in reducing instability in the financial markets by curbing excessive credit expansion for speculative transactions. The introduction of greater discipline in the financial system, which the prohibition of interest has the potential of ensuring, along with more effective regulation and supervision, should go a long way in substantially reducing volatility in the financial market and promoting faster development.


The Islamic Financial System
The above-mentioned weaknesses of the prevailing interest-based financial system create a strong rationale for the introduction of a new architecture for the international financial system. This brings us to Islamic banking, which tries to remove interest and introduce in its place the principle of risk/reward-sharing. Since demand deposits do not participate in the risks of financing by the financial institutions, they do not earn any return and must, therefore, be guaranteed. However, investment deposits do participate in the risks and must share in the profits or losses in agreed proportions. What this will do is turn investment depositors into temporary shareholders. Placing investment deposits in financial institutions will be like purchasing their shares and withdrawing them will be like redeeming these shares. The same would be the case when these institutions lend to, and get repaid by, businesses. They will be sharing in the risks of businesses they finance. This will substantially raise the share of equity in total financing and reduce that of debt. Equity will take the form of either shares in joint stock companies, other businesses or of profit and loss sharing (PLS) in projects and ventures through the mudarabah and musharakah modes of financing.


Greater reliance on equity does not necessarily mean that debt financing is totally ruled out. This is because all financial needs of individuals, firms or governments cannot be made amenable to PLS. Debt is, therefore, indispensable. Being a practical religion, Islam has not ruled out debt totally in its effort to bring about greater reliance on equity. However, debt gets created in the Islamic financial system through the sale or lease of real goods and services via the sales- and lease-based modes of financing (murahabah, ijarah, salam and istisna). In this case, the rate of return is stipulated in advance and becomes a part of the deferred-payment price. Since the rate of return is fixed in advance and the debt is associated with real goods or services, it is less risky than equity or PLS financing.


The predetermined rate of return on sales-based modes of financing may make them appear like interest-based instruments. However, this is not the case; there are significant differences between the two types of instruments, among which two are particularly important. Firstly, the sales-based modes do not involve direct lending and borrowing. Rather, they are purchase and sale or lease transactions involving real goods and services. TheShari’ah has imposed a number of conditions for the validity of these transactions. One is that the seller (financier) must also share a part of the risk to be able to get a share in the return. This he cannot avoid doing because of the second condition, which requires that the seller (financier) must own and possess the goods being sold. The Shari‘ah does not allow a person to sell what he does not own and possess except in the case of salam and istisana’ which are exceptions to this general rule. Once the seller/financier acquires ownership and possession of the goods for sale on credit, s/he bears the risk. All speculative short sales, therefore, get ruled out automatically. Financing extended through the Islamic modes can thus expand only in step with the rise of the real economy and thereby help curb excessive credit expansion, which is one of the major causes of instability in the international financial markets.


The second key point of difference is that it is the price of the good or service sold, and not the rate of interest, which is stipulated in the case of sales-based modes of finance. Once the price has been set, it cannot be altered, even if there is a delay in payment due to unforeseen circumstances. This helps protect the interest of the buyer in strained circumstances. However, it may also lead to a liquidity problem for the bank if the buyer willfully delays payment. This is a major unresolved problem in Islamic finance and jurists are working together to find a solution that isShari‘ah-compliant.

The share of PLS modes is, so far, relatively small in the financing operations of Islamic banks and that of sales-based modes is predominantly high. The reason may be that the task is difficult and, in the initial phase of their operations, these banks do not wish to be exposed to risks that they cannot manage effectively. They are not properly equipped for this in terms of skilled manpower as well as the needed institutional infrastructure. However, most scholars feel that, even though the sales-based modes are different from interest-based financing and are allowed by the Shari‘ah,the socioeconomic benefits of the prohibition of interest argued above may not be realized fully until the share of PLS modes rises substantially in total financing. It would hence be desirable for the use of PLS modes to gain momentum.


Substantial progress has been made by the Islamic banks worldwide, even though the niche that they have been able to create for themselves in the total volume of the international or even in the Muslim world finance is very small. This was to be expected because they are trying to make headway in a new system of financial intermediation without the help of trained staff and of auxiliary or shared institutions that are needed for their successful operation. What counts, however, is not the volume of their deposits and assets, but rather the respectability that the interest-free financial intermediation has attained around the world and the positive evidence that it has provided about the workability and viability of this new system.


In the 1950s and 1960s, Islamic banking was only an academic dream. Few people were aware of it, even among educated Muslims. However, now it has become a practical reality. It has also attracted the attention of Western central banks like the Federal Reserve Board and the Bank of England, international financial institutions like IMF and World Bank, and prestigious centers of learning like the Harvard and Rice Universities in the USA and the London School of Economics and Loughborough and Durham Universities in the United Kingdom. It has also received favorable coverage in the Western media.


Prospects for the future are expected to be better, particularly if the instability that now prevails in the international financial system continues to accentuate. This may lead to a realization that the instability may be difficult to remove through mere cosmetic changes in the system. Rather, it is necessary to inject greater market discipline into the system. The interest-free risk/reward-sharing system can help inject such a discipline.


Evidently, there is a strong rationale behind the prohibition of interest by the major religions of the world. It would help inject greater discipline into the financial system and, thereby, make it healthier and more stable. If the share of equity is increased and that of debt is reduced substantially, it may be hoped that the volatility now prevailing in the international financial markets will be substantially reduced. The result may be even better if credit is confined primarily to the purchase or lease of real goods and services. As a result, a great deal of the speculative expansion of credit may be eliminated or at least minimized. The ultimate outcome may be not only reduction in financial instability but also better allocation of resources and faster economic growth.


Another thing that Islam has done in addition to linking borrowing and lending to assets is to curb living beyond means and promote simple livelihood. This curbing of living beyond means should help promote saving and reduce the reliance of people on debt for investment purposes. This is, of course, possible. Japan financed its development in this manner and even some other Eastern Tigers are doing the same. Simple living can, thus, help promote saving and enable countries to finance their development without resorting to a great deal of borrowing. This does not mean there can be no borrowing. There may have to be borrowing. But excessive borrowing, as has been the case with Pakistan, has to be avoided. However, instead of promoting simple living, we are promoting conspicuous consumption in Pakistan. The result is that our rate of saving is extremely low.


Yet another benefit that Islamic finance will bring is the curbing of speculation. How will it curb speculation? There is a ruling in the Shari’ah that prohibits one from selling what one does not have. This implies that the short sales that create havoc in the stock foreign exchange and commodity markets will be prohibited In speculative short sales, the intention is not to give and take delivery. Rather, an offsetting purchase transaction is made and there is settlement of the difference. Mr. [George] Soros did this during the exchange rate crisis in Britain in the early 1990s and made a profit of one billion pounds sterling. Encouraged by this success, he, along with other speculators, did the same thing in the Far East and destabilized the foreign exchange markets there. Curbing speculation will help stabilize the financial markets.


So, this is the reason why most world religions have prohibited interest. But is it enough? Living beyond means hurts society in several other ways. First, it promotes inflation and this inflation generally affects the poor people more. Since resources are scarce, living beyond means promotes luxury consumption. The rich who borrow do not necessarily borrow to meet their needs. They borrow it to finance their luxury consumption. Governments also do not necessarily borrow for development purposes. They also borrow for the white elephant variety of projects. A number of white elephant projects were financed in Pakistan by borrowing. They are now being sold at giveaway prices. If there was profit and loss sharing, these projects would have not been undertaken in the first place, especially when there are excessive claims on resources available for the supply of need fulfilling goods while the shortage of services is apparent.


It has to be said that Islamic finance has not yet reached the ideal state. It will still in its preliminary state. A very small proportion of Islamic bank financing is in the form of equity; a predominantly large proportion is in the form of debt finance. Moreover, even the debt financing is not in accordance with the rules of the game. In the Islamic-oriented debt financing, the financier is supposed to take some risk. If there is no risk, there is no gain. However, the banks are trying everything to shift the risk to the borrower or the purchaser. The central banks in Muslim countries should regulate and supervise these banks to ensure that Islamic finance is provided according to its own rules. Unless the central banks take greater interest, this is not going to happen. Regrettably, a large number of central banks in Muslim countries have essentially been allergic to Islamic finance. They have not taken any major steps to make the system move according to the rules. Banks are trying to avoid risk taking, and keeping away from equity finance. If Islamic finance continues in this direction, it will not bear the fruits that the theory promises.


Glossary of Arabic Terms

Some of these terms have a much wider meaning. It is, however, not possible to encompass this in a glossary. Given below is the basic sense in which these terms have been generally used.






A contract whereby a manufacturer (contractor) agrees to produce (build) and deliver a certain good (or premise) at a given price on a given date in the future. This is an exception to the general Shari’ah ruling, which does not allow a person to sell what he does not own and possess. As against salam (q.v.), the price here need not be paid in advance. It may be paid in installments in step with the preferences of the parties or partly upfront and the balance later on as agreed.



An agreement between two or more persons whereby one or more of them provide finance, while the others provide entrepreneurship and management to carry on any business venture whether trade, industry or service, with the objective of earning profits. The profit is shared by them in an agreed proportion. The loss is borne only by the financiers in proportion to their share in total capital. The entrepreneur’s loss lies in not getting any reward for his/her services.


Sale at a specified profit margin. The term is, however, now used to refer to a sale agreement whereby the seller purchases the goods desired by the buyer and sells them at an agreed marked-up price, the payment being settled within an agreed time frame, either in installments or lump sum. The seller bears the risk for the goods until they have been delivered to the buyer. Also referred to as bay mu’ajjal.


An Islamic financing technique whereby all the partners share in equity as well as management. The profits can be distributed among them in accordance with agreed ratios. However, losses must be shared according to the share in equity.


Sale in which payment is made in advance by the buyer and the delivery of goods is deferred by the seller. This is also, like Istisna’, an exception to the general Shari’ah ruling that one cannot sell what one does not own and possess.


Refers to the divine guidance as given by the Qur’an and the Sunnah and embodies all aspects of the Islamic faith, including beliefs and practices.


The example of the Prophet Muhammad (pbuh) as documented in the collections of ahadith—reports about the sayings, deeds and reactions of the Prophet (pbuh). The most important source of the Islamic faith after the Qur’an.

Glick, 1998 and Bisignano, 1998.

Krugman, 1998.

Chang and Velasco, 1998 and Radelet and Sachs, 1998.

For these principles, see Camdessus, 2000, p. 1 and pp. 7–10.

IMF, 1999, p. 67.

BIS, 1982, p. 3.

IMF, 1998a, p. 83.

Trichet, 2005, p. 4.

Christ, 1979; Searth, 1979.

BIS, 1999, p. 10.

Shocks can result from a number of factors. These may be natural calamities, changes in the polices of major importing or exporting countries, as well as unanticipated declines in the economies of borrowing countries as a result of changes in interest rates or relative export and import prices.

Meltzer, 1998; Schwartz, 1998 and Calomiris, 1998.

Schwartz, 1998 and Meltzer, 1998.

Stiglitz, 2003, p. 58.

World Bank, 1998, p. 3.

IMF, 1998b, p. 98.

Edwards, 1999, p. 189.

Economist, 1998, p. 21.

Edwards, 1999, p. 190.

Plender, 1998.

Economist, 1998.

Muhammad, 1997, p. C1.

BIS, 1999, p. 108.

IMF, 1998c, p. 55.

This was clearly acknowledged by Alan Greenspan, former Chairman of the Federal Reserve System, in the following words: “Had the failure of the LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own.” (Greenspan, 1998a, p. 1046).

The figure for hedge funds is from Economist, 2004, p. 72.

Greenspan, 1998a, p.1046.

IMF, 1998c, pp. 51–53.

BIS, 2004. The Bank for International Settlements conducts a survey of foreign exchange markets every three years in the month of April. The daily global foreign exchange turnover has increased continuously since the first survey in April 1989, except in 2001 when it was $1,200 billion compared with $1,490 billion in 1998. The major reasons for this fall in 2001 were, according to BIS, the introduction of the Euro, the growing share of electronic banking in the spot inter-bank market, and the consolidation in the banking industry (BIS, 2001, p. 1).

World trade (exports plus imports) rose from $499.0 billion in April 1989 to $1489.7 billion in April 2004 (IMF, 2000 and 2004). The average value of daily world trade in the month of April during these two years comes to $16.6 and $49.7 billion, respectively.

The decline in average daily turnover in April 2001, as indicated in footnote 29, was most pronounced in spot markets, where average daily turnover fell from $568 billion to $387 billion. Trading in forwards rose from $128 billion to $131 billion while that in swaps dropped from $734 billion to $656 billion (BIS, 2001, p.1 and Table 1 on p. 3).

Crockett, 1994, p. 3.

Greenspan, 1998b, p. 3.

See the address entitled “Imbalances in the US Economy” by Donald Kohn, Member of the Board of Governors of the US Federal Reserve System, on 22 April 2005 at the 15th Annual Hyman Minsky Conference at the Levy Economics Institute of Bard College, Annandale in Hudson, New York (Kohn, 2005).

Kohn, 2005, pp.1–2.

Economist, 2005, p. 87.

Kohn, 2005, p. 1.

Edwards, 1999; Calomiris, 1999 and Stiglitz, 1998.

Edwards, 1999, p. 1919.

Meltzer, 1998; Calomiris, 1998 and Yeager, 1998.

IMF, 1998a, p. 82.

Hicks, 1982, p. 14.

Rogoff, 1999, p. 40

A number of Islamic economists have argued this point. See, for example, Siddiqi, 1983; Chapra, 1985, pp. 117–22; Chishti, 1985; Khan, 1987; Mirakhor and Zaidi, 1987; and Siddiqi and Fardmanesh, 1994.

For a description of these and other Arabic terms used in this article, please refer to the Glossary.

For a discussion of this problem, see Section 3.1 on the “Late Settlement of Financial Obligations” in Chapra and Khan, 2000.

For a discussion of the required institutional infrastructure, see Chapra and Ahmed, 2002, pp. 79–84.


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