Islamic Finance and Financial Crisis – Analysis

August 19, 2011

Much has been written about the current financial crisis. The current crisis not only impacted the US and the UK but it affected the global economy. The crisis was due to excess leverage of financial institutions, revaluation of assets, financial innovation, investments in speculative and uncertain investment. This revealed the need for financial system that prevents all these factors that led to financial crisis. This is where an Islamic Financial System can play an important part.

Islamic Finance Industry during the last decade grew at 15 – 20 percent per annum. The growth in Sharia Compliant assets amounted to 29.7 percent during the last decade. In 2008, Dow Jones Islamic Financial Index showed a decline of 7 percent as compare to 38.5 percent and 33.8 percent in S&P 500 index and Dow Jones Industrial Index respectively.

The basic principles of Islamic Economics System are Justice, Equity, and Welfare. Islamic economic system aims to develop an economic system with full employment and sustainable rate of economic growth. It is based on set of values such as honesty, credibility, transparency and co-operation. These values ensure stability and security for all those parties who are involved in the financial system. It prohibits such financial transactions that involve interest, lying, gambling, cheating, gharar (risk and uncertainty), monopoly, exploitation, greed, and unfairness.

One of the important aspects of Islamic Finance transactions is that banks act as venture capital firm and share in profit / loss in their investment so the banks are prudent in making their investments and do not make investment just to make profit. Also money is fully asset backed (tied to an identified tangible asset) and is traded at par. Islamic Economic System does not allow credit expansion (creation of money through fractional reserve banking) and wealth expansion at the expense of society.

Sharia Laws also impose ban on uncertainty investments unless all the terms and conditions of risk are clearly understood. Islamic banks appeared to be more resilient in the international financial crisis than conventional banks because they avoided speculative investment such as derivatives which is one of the causes of financial crisis. During the financial crisis Islamic banks were less exposed to sub prime mortgage fiasco, as they require greater initial deposits thus automatically restricting the exposure to sub prime borrowers.  

Islamic banks cannot sell something that they do not own and cannot sell products and services that they are not in a position to deliver. Due to this reason they did not invest in derivatives and conventional future contracts. The price and nature of goods are also determined at the time of transaction that restrains gambling.

The performance of the Islamic Banks’ during the financial crisis justifies that the factors that caused and fuelled the crisis could be avoided if Islamic Sharia Compliant principles are adopted. The adoption of Islamic Finance principles could prevent excess credit creation, speculative and uncertain investment (such as derivatives and future contracts), sub prime mortgage financing and will channeled the money in the productive sector of the economy. This will lead to stable long-term growth of the economy benefiting the entire society.