+ All Categories
Home > Documents > Islamic Banking Com Islamic Finance Aspx

Islamic Banking Com Islamic Finance Aspx

Date post: 03-Jun-2018
Category:
Upload: asadzahid
View: 237 times
Download: 0 times
Share this document with a friend

of 44

Transcript
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    1/44

    pdfcrowd comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    This text is replaced by the Flash mo vie.

    Founded in 19 90 28 Rabbi'al-Akhir 1435 H

    IIBI Services Search

    Courses | Student Login

    Training

    Lectures & Seminars

    Executive Development

    Publications

    NewHorizon Magazine

    Information Services

    Research

    Knowledge

    Links

    Test Your Knowledge

    Islamic Banking

    Takaful

    Glossary

    Upcoming Events

    Home > Knowledge > Islamic Financial System

    Islamic Financial SystemDescribing the Islamic financial systemsimply as "interest-free" does not provide a truepicture of the system as a whole. While prohibitingthe receipt and payment of interest is the nucleus of the system, it is supported by other principles of Islamicteachings advocating individuals' rights and duties, property

    rights, equitable distribution of wealth, risk-sharing, fulfilmentof obligations and the sanctity of contracts. Similarly, the Islamicfinancial system is not limited to banking but covers insurance,capital formation, capital m arkets, and all types of financialintermediation and suggests that moral and ethical aspects in theregulatory framework are also necessary in addiiton to prudentand sound controls.

    The philosophical foundation of an Islamic financial system goes beyond theinteraction of factors of production and economic behavior. The Islamic financialsystem can be fully appreciated only in the context of Islam's teachings on thebusiness ethic, wealth distribution, social and economic justice, and the role of thestate. W hereas the conventional financial system focuses primarily on theeconomic and fi nancial aspects of transactions, the Islamic sys tem places equalemphasis on th e ethical, moral, social, and religious dimensions, to enhanceequality and fair ness `the principles of Islamic law (Shariah) and its practicalapplication through the development of Islamic economics. Practitioners and clientsneed not be Muslims, but they must accept the ethical restrictions underscored byIslamic values. Islamic finance may be viewed as a form of ethical investing, or ethical lending,except that no loans are possible unless they are interest-free. The general

    IIBI Discussion Forum

    Video Presentations

    Islamic Economic Thought

    Islamic Jurisprudence

    Islamic Economics

    Islamic Financial System

    Islam and Business Ethics

    Shari'ah Rulings and Finance

    Islamic Finance Glossary

    Corporate Social Responsibility

    Heritage of Islam

    Vision of The Qur'anThis text is replaced by the Flash movie.This text is replaced by the Flash movie.

    http://www.islamic-banking.com/resources/3/BAC%20Certificate.pdfhttp://www.islamic-banking.com/quick_registration.aspxhttp://www.islamic-banking.com/default.aspxhttp://www.islamic-banking.com/default.aspxhttp://www.islamic-banking.com/default.aspxhttp://www.islamic-banking.com/default.aspxhttp://www.islamic-banking.com/default.aspxhttp://www.islamic-banking.com/default.aspxhttp://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdfhttp://www.islamic-banking.com/default.aspxhttp://www.islamic-banking.com/quick_registration.aspxhttp://www.islamic-banking.com/resources/3/BAC%20Certificate.pdfhttp://www.islamic-banking.com/default.aspxhttp://www.islamic-banking.com/knowledge.aspx
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    2/44

    pdfcrowd comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    objectives (maqsid) of Islamic finance transactions may be summarised as below:

    To be true to the Shariah principles;Should be free from unjust enrichment;Must be based on true consent of all parties; must be an integral part of areal trade or economic activity such as a sale, lease, manufacture or partnership.

    Islamic Financial System The global financial crisis: can Islamic finance help?' Stability of the Islamic Financial System Conventional and Islamic Financial Systems Quotes about Banking and Monetary System Islamic Banking Islamic Insurance

    Islamic Financial System[ Extract from article on Islamic Financial System by Zamir Iqbal, World Bank publication

    What is Islamic finance?Islamic finance was practiced predominantly in the Muslim world throughout theMiddle Ages, fostering trade and business activities with the development of credit.In Spain and the Mediterranean and Baltic states, Islamic merchants becameindispensable middlemen for trading activities. In fact, many concepts, techniques,and instruments of Islamic finance were later adopted by European financiers andbusinessmen.

    In contrast, the term Islamic financial system is relatively new, appearing only inthe mid-1980s. In fact, all the earlier references to commercial or mercantileactivities conforming to Islamic principles were made under the umbrella of either interest-free or Islamic banking. However, describing the Islamic financial systemsimply as interest-free does not provide a true picture of the system as a whole.Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of thesystem, but it is supported by other principles of Islamic doctrine advocating risksharing, individuals' rights and duties, property rights, and the sanctity of contracts.Similarly, the Islamic financial system is not limited to banking but covers capitalformation, capital markets, and all types of financial intermediation.

    Interpreting the system as interest free tends to create confusion. The

    http://www.islamic-banking.com/resources/3/BAC%20Certificate.pdfhttp://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdfhttp://www.islamic-banking.com/resources/3/BAC%20Certificate.pdfhttp://www.islamic-banking.com/IIBI_magazine.aspxhttp://www.islamic-banking.com/islamic_banking.aspxhttp://www.islamic-banking.com/takaful_insurance.aspx
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    3/44

    pdfcrowd comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    philosophical foundation of an Islamic financial system goes beyond the interactionof factors of production and economic behavior.

    Whereas the conventional financial system focuses primarily on the economic andfinancial aspects of transactions, the Islamic system places equal emphasis on theethical, moral, social, and religious dimensions, to enhance equality and fairnessfor the good of society as a whole. The system can be fully appreciated only in thecontext of Islam's teachings on the work ethic, wealth distribution, social andeconomic justice, and the role of the state.

    The Islamic financial system is founded on the absolute prohibition of the paymentor receipt of any predetermined, guaranteed rate of return. This closes the door tothe concept of interest and precludes the use of debt-based instruments. Thesystem encourages risk-sharing, promotes entrepreneurship, discouragesspeculative behavior, and emphasizes the sanctity of contracts.

    An Islamic financial system can be expected to be st able owing to the eliminationof debt-financing and enhanced allocation efficiency. A two-windows model for Islamic financial intermediaries has been suggested in which demand deposits arebacked 100 percent by reserves, and investment deposits are accepted purely onan equity-sharing basis. Analytical models demonstrate that such a system will bestable since the term and structure of the liabilities and the assets are

    symmetrically matched through profit-sharing arrangements, no fixed interest costaccrues, and refinancing through debt is not possible.

    Allocat ion efficiency occurs because investment alternatives are s trict ly s electedbased on their productivity and the expected rate of return. Finally, entrepreneurshipis encouraged as entrepreneurs compete to become the agents for the suppliers of financial capital who, in turn, will closely scrutinize projects and managementteams.

    Basic instrumentsIslamic markets offer different instruments to satisfy providers and users of funds ina variety of ways: sales, trade financing, and investment.

    Basic instruments include cost-plus financing ( murabaha ), profit-sharingmudaraba), leasing ( ijara ), partnership ( musharaka ), and forward sale ( bay' salam ). These instruments serve as the basic building blocks for developing a widearray of more complex financial instruments, suggesting that there is great potentialfor financial innovation and expansion in Islamic financial markets.

    Principles of an Islamic financial systemThe basic framework for an Islamic financial system is a set of rules and laws,collectively referred to as shariah , governing economic, social, political, and culturalaspects of Islamic societies. Shariah originates from the rules dictated by theQuran and its practices, and explanations rendered (more commonly known as

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    4/44

    pdfcro d comopen in bro ser PRO ersion Are you a developer? Try out the HTML to PDF API

    Sunnah ) by the Prophet Muhammad. Further elaboration of the rules is provided byscholars in Islamic jurisprudence within the framework of the Quran and Sunnah .

    The basic principles of an Islamic financial system can be summarized as follows:

    Prohibition of interest. Prohibition of riba , a term literally meaning an excessand interpreted as any unjustifiable increase of capital whether in loans or sales isthe central tenet of the system.

    More precisely, any positive, fixed, predetermined rate tied to the maturity and theamount of principal (i.e., guaranteed regardless of the performance of theinvestment) is considered riba and is prohibited. The general consensus amongIslamic scholars is that riba covers not only usury but also the charging of interestas widely practiced.

    This prohibition is based on arguments of social justice, equality, and propertyrights. Islam encourages the earning of profits but forbids the charging of interestbecause profits, determined ex post, symbolize successful entrepreneurship andcreation of additional wealth whereas interest, determined ex ante, is a cost that isaccrued irrespective of the outcome of business operations and may not createwealth if there are business losses. Social justice demands that borrowers and

    lenders share rewards as well as losses in an equitable fashion and that theprocess of wealth accumulation and distribution in the economy be fair andrepresentative of true productivity.

    Risk sharing. Because interest is prohibited, suppliers of funds become investorsinstead of creditors. The provider of financial capital and the entrepreneur sharebusiness risks in return for shares of the profits.

    Money as potential capital. Money is treated as potential capitalthat is, itbecomes actual capital only when it joins hands with other resources to undertakea productive activity. Islam recognizes the time value of money, but only when itacts as capital, not when it is potential capital.

    Prohibition of speculative behavior. An Islamic financial system discourageshoarding and prohibits transactions featuring extreme uncertainties, gambling, andrisks.

    Sanctity of contracts. Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of symmetric information and moral hazard.

    Shariah-approved activities . Only those business activities that do not violate therules of shariah qualify for investment. For example, any investment in businessesdealing with alcohol, gambling, and casinos would be prohibited.

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    5/44

    df di b PRO i Are you a developer? Try out the HTML to PDF API

    Simple derivatives, such as forward contracts, are being examined because their basic elements are similar to those of the Islamic instrument of deferred sale.Project finance, which puts emphasis on equity participation, is another natural fitfor Islamic finance.

    MicrofinanceMicrofinance is another candidate for the application of Islamic finance. Islamicfinance promotes entrepreneurship and risk sharing, and its expansion to the poor could be an effective development tool. The social benefits are obvious, since thepoor currently are often exploited by lenders charging usurious rates.

    Economic Development of Islamic countries An Islamic financial system can play a vital role in the economic development of Islamic countries by mobilizing dormant savings that are being intentionally keptout of interest-based financial channels and by facilitating the development of capital markets. At the same time, the development of such systems would enablesavers and borrowers to choose financial instruments compatible with their business needs, social values, and religious beliefs. > Start of page

    The Global Financial Crisis: Can Islamic Finance Help?'[Extract from article by Dr Umer Chapra in NEWHORIZON magazine published by theInstitute of Islamic Banking and Insurance 01 January, 2009]Greater Justice in Human Society One of the most important objectives of Islam is to realise greater justice in humansociety. According to the Quran, a society where there is no justice will ultimatelyhead towards decline and destruction (Quran, 57:25). Justice requires a set of rulesor moral values, which everyone accepts and faithfully complies with. The financialsystem may be able to promote justice if, in addition to being strong and stable, itsatisfies at least two conditions based on moral values. One of these is that thefinancier should also share in the risk so as not to shift the entire burden of lossesto the entrepreneur, and the other is that an equitable share of financial resourcesmobilised by financial institutions should become available to the poor to helpeliminate poverty, expand employment and self-employment opportunities and,thus, help reduce inequalities of income and wealth. First Condition of JusticeTo fulfill the first condition of justice, Islam requires both the financier and theentrepreneur to equitably share the profit as well as the loss. For this purpose, oneof the basic principles of Islamic finance is no risk, no gain'. This should helpintroduce greater discipline into the financial system by motivating financialinstitutions to assess the risks more carefully and to effectively monitor the use of funds by the borrowers. The double assessment of risks by both the financier andthe entrepreneur should help inject greater discipline into the system, and go a long

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdfhttp://www.islamic-banking.com/islamic-finance.aspx
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    6/44

    df di b PRO i Are you a developer? Try out the HTML to PDF API

    way in reducing excessive lending.

    Islamic finance should, in its ideal form, help raise substantially the share of equityand Profit-Loss-Sharing (PLS) in businesses. Greater reliance on equity financinghas supporters even in mainstream economics. Professor Kenneth Rogoff of Harvard University states that in an ideal world equity lending and direct investmentwould play a much bigger role.

    Greater reliance on equity does not necessarily mean that debt financing is ruledout. This is because all the financial needs of individuals, firms, or governmentscannot be made amenable to equity and PLS. Debt is, therefore, indispensable, butshould not be promoted for nonessential and wasteful consumption andunproductive speculation.

    For this purpose, the Islamic financial system does not allow the creation of debtthrough direct lending and borrowing. It rather requires the creation of debt throughthe sale or lease of real assets by means of its sales - and lease-based modes of financing ( murabaha, ijara, salam, istisna and sukuk ). The purpose is to enable anindividual or firm to buy now the urgently needed real goods and services inconformity with his/her ability to make the payment later. It has, however, laid downa number of conditions, some of which are:

    The asset which is being sold or leased must be real, and not imaginary or notional.The seller or lessor must own and possess the goods being sold or leased.The transaction must be a genuine trade transaction with full intention of giving and taking delivery.The debt cannot be sold and thus the risk associated with it must be borneby the lender himself.

    The first condition will help eliminate a large number of derivatives transactionswhich involve nothing more than gambling by third parties who aspire to claimcompensation for losses which have been actually suffered only by the principalparty and not by them. Second Condition of JusticeThe second condition will help ensure that the seller (or lessor) also shares a partof the risk to be able to get a share in the return. Once the seller (financier)acquires ownership and possession of the goods for sale or lease, he/she bears therisk. This condition also puts a constraint on short sales, thereby removing thepossibility of a steep decline in asset prices during a downtown. The Shari'ah has,however, made an exception to this rule in the case of salam and istisna where thegoods are not already available in the market and need to be produced or manufactured before delivery. Financing extended through the Islamic modes canthus expand only in step with the rise of the real economy and thereby help curb

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    7/44

    df di b PRO i Are o a de eloper? Tr o t the HTML to PDF API

    excessive credit expansion. Third and Fourth Conditions of JusticeThe third and the fourth conditions will not only motivate the creditor to be morecautious in evaluating the credit risk but also prevent an unnecessary explosion inthe volume and value of transactions. This will prevent t he debt from ris ing far abovethe size of the real economy and also release a substantial volume of financialresources for the real sector, thereby helping expand employment and self-employment opportunities and the production of need-fulfilling goods and services.The discipline that Islam wishes to introduce in the financial system may not,

    however, materialise unless governments reduce their borrowing from the centralbank to a level that is in harmony with the goal of price and financial stability.

    One may raise an objection here that all these conditions will perhaps end upshrinking the size of the economy by reducing the number and volume of transactions. This is not likely to happen because a number of the speculative andderivatives transactions are generally known to be zero-sum games and have rarelycontributed positively to total real output. Hence a decline in them is also not likelyto hurt the real economy.

    While a restriction on such transactions will cut the commissions earned by thespeculators during an artificially generated boom, it will help them avert losses and

    bankruptcy that become unavoidable during the decline and lead to a financialcrisis.

    The injection of a greater discipline into the financial system may tend to deprivethe subprime borrowers from access to credit. Therefore, justice demands thatsome suitable innovation be introduced in the system to ensure that even smallborrowers are also able to get adequate credit. Such borrowers are generallyconsidered to be subprime and their inability to get credit will deprive them fromrealising their dream of owning their own homes and establishing their ownmicroenterprises.

    Microfinance

    There is no doubt that a number of countries have established special institutions togrant credit to the poor and lower middle class entrepreneurs. Even though thesehave been extremely useful, there are two major problems that need to be resolved.One of these is the high cost of finance, ranging from 30 to 84 per cent in theinterest-oriented microfinance system. This causes serious hardship to theborrowers in servicing their debt. No wonder the minister of finance for Bangladeshdescribed microcredit interest rates in that country as extortionate in an address hedelivered at a microcredit summit in Dhaka in 2004. It is, therefore, important thatmicrocredit is provided to the very poor on a humane, interest-free basis (qardhasan). This may be possible if the microfinance system is integrated with zakatand waqf institutions. For those who can afford to bear the cost of microfinance, it

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    8/44

    df di b PRO i A d l ? T t th HTML t PDF API

    would be better to popularise the Islamic modes of PLS and sales- and lease-basedmodes of finance, not only to avoid interest but also to prevent the misuse of creditfor personal consumption.

    Another problem faced by microfinance is that t he resources at the disposal of microfinance institutions are inadequate. This problem may be difficult to solveunless the microfinance sector is scaled up by integrating it with the commercialbanks. Commercial banks do not generally lend to small borrowers because of thehigher risk and expense involved in such financing. It is, therefore, important toreduce their risk and expense. This may be done partly by a subsidy from zakat

    and waqf funds for those borrowers who are eligible for zakat.Islamic Financial System capable of minimising the severity and frequency of financial crisesThus we can see that the Islamic financial system is capable of minimising theseverity and frequency of financial crises by getting rid of the major weaknesses of the conventional system. It introduces greater discipline into the financial systemby requiring the financier to share in the risk. It links credit expansion to the growthof the real economy by allowing credit primarily for the purchase of real goods andservices which the seller owns and possesses, and the buyer wishes to takedelivery. It also requires the creditor to bear the risk of default by prohibiting thesale of debt, thereby ensuring that he evaluates the risk more carefully. In addition,

    Islamic finance can also reduce the problem of subprime borrowers by providingcredit to them at affordable terms. Reform of the Conventional Financial SystemSince the current architecture of the conventional financial system has existed for along time, it may perhaps be too much to expect the international community toundertake a radical structural reform of the kind that the Islamic financial systemenvisages. However, the adoption of some of the elements of the Islamic system,which are also a part of the western heritage, is indispensable for ensuring thehealth and stability of the global financial system. These are:

    The proportion of equity in total financing needs to be increased and that of debt reduced.Credit needs to be confined primarily to transactions that are related to thereal sector so as to ensure that credit expansion moves more or less in stepwith the growth of the real economy and does not promote destabilisingspeculation and gambling.Leverage needs to be controlled to ensure that credit does not exceedbeyond the ability of the borrower to repay.If the debt instruments, and in particular CDOs, are to be sold, then there

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    9/44

    df di b PRO i A d l ? T t th HTML t PDF API

    should be full transparency about their quality so that the purchaser knowsexactly what he is getting into. It would also be desirable to have the right of recourse for the ultimate purchaser of the CDOs so as to ensure that thelender has incentive to underwrite the debt carefully.While there may be no harm in the use of CDOs to provide protection to thelender against default, it needs to be ensured that the swaps do not become instruments for wagering. Their protective role should be confined tothe original lender only and should not cover the other purchasers of swapswho wish to wager on the debtor's default. For this purpose the derivatives

    market needs to be properly regulated to remove the element of gambling init.

    All financial ins titut ions, and not just the commercial banks , need to beproperly regulated and supervised so that they remain healthy and do notbecome a source of systemic risk.Some arrangement needs to be made to make credit available to subprimeborrowers at affordable terms to enable them to buy a home and to establishtheir own microenterprises. This will help save the financial system fromcrises resulting from widespread defaults by such borrowers.

    > Start of page

    Stability of the Islamic Financial System

    Resilience and Stability of the Islamic Financial System An Overview byNoureddine Kirchene and Abbas Mirakhor presented at the seminar held on 30January 2009 on Comparative Development of the Islamic Economic Model incontext of current market conditions', organised by KPMG, London, UK.

    Introduction: the Concept of StabilityThe financial crisis, that broke out in August 2007, was considered to be the worstin the post war period. Representing the collapse of trillions of fictitious creditderivatives and the meltdown of uncontrolled credit growth, the scope of the crisisand its intensity only kept worsening and could reach unmanageable size [The sizeof the credit derivatives (ABSs, CDSs, etc.) is unknown, which makes the financialcrisis complex. Most of the derivatives are over the counter (OTC). Contrary, toexchange transactions (futures contracts, options, stocks), there is no centralizedclearing institutions for credit derivatives. Reform efforts will seek to establishclearing facility for credit derivatives in order to be able to quantify them]. It hascrippled the financial system of many advanced countries, and has claimed longestablished banking institutions that were deemed too big too fail. Large bailouts bygovernments and massive liquidities injections by central banks have only fannedmore the flames. Capital markets have frozen, leading in turn to unexpected crashin stock markets, wiping out trillions of dollars in share values and in retirement

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdfhttp://www.islamic-banking.com/islamic-finance.aspxhttp://www.islamic-banking.com/islamic-finance.aspx
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    10/44

    df di b O i A d l ? T h HTML PDF API

    investment accounts. Economic uncertainty has never been as high. Has the crisisbeen correctly tackled or has it only been made worse? In view of incredibly highliquidity injection by major central banks, has money supply become out of control?How long the crisis will last? How many sectors and countries will it affect? Whatwill be its impact on growth and employment? What will be its fiscal and inflationarycost? Will inflation finally run out of control? While precise answers are notpossible, the present crisis has already slowed down economic growth in manyindustrial countries, triggered food riots and energy protests in many vulnerablecountries, increased unemployment, and imposed extraordinary fiscal costs.Notwithstanding its far reaching and devastating consequences, the crisis has

    made the quest for financial stability a pressing and fundamental issue ineconomics and finance.

    Financial instability has been a recurrent phenomena in contemporary economichistory, affecting countries with varying intensity. The most enduring crisis was theGreat Depression 1929-33. Eminent economists who lived through the GreatDepression fought very hard to establish a banking system, based on some pillarsof Islamic finance, capable of preserving long-term financial stability. Their proposals became known as the Chicago Reform Plan, as they were elaborated byeconomic professors at the University of Chicago [The Chicago Plan waselaborated by Henry Simons, Frank Knight, Aaron Director, Garfield Cox, LloydMints, Henry Schultz, Paul Douglas, and A. G. Hart. Professor Irving Fisher from

    Yale University was a strong supporter of the Plan. His book, 100% Money, was anattempt to win support among academics and policy makers for the Plan]. TheChicago Plan basically divides the banking system into two components: awarehousing component with 100% reserve requirement and an investmentcomponent with no money contracts and interest payments, where deposits areconsidered as equity shares and are remunerated with dividends, and maturities arefully observed. What transpired from the Chicago Plan and subsequent literaturewas that only a financial system along Islamic principles is immune to financialinstability.

    Financial stability is a basic concept in finance. It applies to a household, firm,bank, government, or a country. It is an accounting concept conveying notions of

    solvency, or equilibrium. For a given entity, financial stability can be defined asregularly liquid treasury position, whereby the sources of funds exceed uses of funds. The sources of funds are diverse and include income streams (salaries,transfers, taxes, interest income, dividends, profits, etc.), borrowing or loanrecovery, and sales of real and financial assets. The uses of funds include currentexpenditures (including interest payments), capital expenditures, purchase of assets, lending or debt amortization. Accounts are separated into income or current accounts, and balance sheet or capital accounts. Financial stability meansthat the consolidated account tends to be regularly in surplus [The consolidatedaccount can be compared to the overall fiscal account of the government or to thebalance of payments of a country. Each account is composed of two components:

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    11/44

    df db A d l ? T h HTML PDF API

    a current account component and a capital account component. The overallbalance of the consolidated account should be sustainable for financial stability tobe maintained over time].

    Financial instability can be defined as the opposite of financial stability. It can beassociated with notions of default, arrears, or insolvency. It manifests itself througha regularly deficient treasury position, whereby the sources of funds fall short of uses of funds or payments obligations. When financial instability persists, accessto borrowing becomes unavailable. The entity facing financial instability may have torecapitalize, liquidate assets, restructure liabilities, seek a bailout, or may besubject to merger or liquidation.

    In banking, stability means that assets and liabilities maturities are matched,assets preserve their values and do not depreciate, and the amount of IOUs is fullybacked by gold or warehouse deposits that served for issuing these IOUs. Over issues of gold or warehouse certificates, bank notes, or scriptural money maycause instability in case of a run from domestic or international depositors [For instance, the United Kingdom suspended gold standard in September 1931following a run on its gold reserves. Similarly, the US suspended gold standard in

    August 1971 when its gold reserves fell critically ]. The amount of claims mayexceed largely the stock of gold or merchandise; in these conditions, conversionmay be suspended, bankruptcies may happen, or IOUs may be devalued. Under a

    fiat money system, the central bank may act as the last resort lender to preservestability by printing new money which may lead to currency depreciation.

    The paper reviews in Section II some examples of financial instability, both indistant and recent past and the ordeal that followed this instability. The generalpattern was that each episode was preceded by a speculative boom and excessiveprice volatility in one or many types of assets, which could be common stocks,gold, commodities, land, housing, foreign currencies, or any other asset. Thebursting of the boom caused in turn asset price deflation and banking failure. Eachmajor financial crisis has wiped out real income gains setting real GDP and real per capita income at levels much lower than pre-crisis levels [For instance, US realGDP was reported to have fallen by over one third during 1929-1933 and was not

    able to return to 1929 level until 1939. In Japan, financial instability, caused by thecollapse of stock and real estate prices following an asset boom during 1985-1989,was responsible for economic stagnation of 1990-2001].

    In Section III, the paper reviews the causes of financial instability and economicdepression or recession it causes. Credit expansion and abundant liquidity,supported by cheap money policy and low interest rates, lead to speculative boomsand asset price bubbles. Financial innovations, Ponzi finance, swindles, and frauddevelop during a speculative boom. During a bubble, many illiquid creditinstruments become monetized, for instance through securitization, and fuel further liquidity. Over indebtedness erodes creditworthiness and causes defaults. Sharp

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    12/44d l h

    credit contraction, deflation of asset prices, and bankruptcies that follow thereafter explain economic recession or depression. The paper discusses Minsky'shypothesis that in a conventional system stability is unstable and that instability isendogenous to such a financial system which is apparently destined to experienceperiods of financial instability. However, Minsky's endogeneity analysis, whileintegrating Keynes' views regarding instability of expectations and Schumpeter'sview on creative destruction adapted to financial innovations, is not fully supportedby facts.

    Subsequently, Section IV establishes that, in many episodes of financial instability,monetary policy contributed directly to speculative booms and to their severedeflationary or inflationary consequences. Contrary to Minsky's endogeneityhypothesis, financial instability could have been easily avoided had the central bankacted to pre-empt a speculative boom by precluding risky lending, or had it kepttight control on liquidity creation and credit expansion. By being entrusted withachieving full employment, central banks have relied on interest rate setting for achieving this objective to the neglect of close monitoring of monetary aggregates.Such mandate of the central bank, besides undermining long-term economicgrowth, has created an uncertain money framework and has become a source of serious financial instability [Henry Simons (1948) considered the central bank to bealmost solely responsible for financial instability for allowing multiplication of moneysubstitutes by banking institutions and for failing to strictly control monetary

    aggregates and credit. The same views were held by Allais (1999) who considereduncontrolled money expansion and destruction by the banking system to be amajor cause of financial instability].

    Section V analyzes the recent episode of international financial instability, andshows that it was caused by monetary expansion in reserve centers and beggar-thy-neighbor policies in pursuit of short-term economic growth gains, and recallsthe notion of a common world currency as a remedy to international financialinstability. Section VI analyzes the mechanics of the credit multiplier. It shows thatbanks do create money substitutes through issuing liabilities. Under securitization,the credit multiplier becomes theoretically infinite. If not controlled by the monetaryauthority, bank money creation can lead to excessive credit and money growth in

    the economy and become a source of instability.Section VII discusses the main theme of the paper: the stability of the Islamicfinancial system [The paper discusses stability of Islamic banks at a theoreticallevel. Deviations from basic Islamic banking precepts could expose Islamic financialinstitutions to the same instability as conventional banking. In many instances,troubled Islamic banks were found to apply the same principles as conventionalbanking]. An Islamic financial system avoids interest and interest-based assets[Hassan and Lewis (2007) offered a comprehensive description of Islamic modes of financing which are based on profit and loss sharing investment, types of risks inIslamic banking, and financial innovations, including access to capital markets and

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    13/44Are you a developer? Try out the HTML to PDF API

    securitization, introduced by Islamic banks], and thus restricts speculation[Speculation may create a disconnect between the market price of an asset (e.g.,common stock, house, etc.) and its true economic value or fundamentals. For instance, if a stock market crash happens and shares drop by 20 percent, thisdoes not mean that existing real capital has deteriorated by 20 percent. Similarly, if the stock price index increases by 50 percent over a year period, it does not implythat existing real capital has appreciated in real terms in the same proportion. Inthe same vein, the construction cost of a house may decrease, due to productivitygains; however, because of speculation, its market price may increase two, three,or fourfold]. Mirakhor (1988) showed that an Islamic financial system can be

    modeled as non-speculative equity ownership model that is intimately linked to thereal sector and where demand for new shares is determined by real savings in theeconomy. All causes of financial instability analyzed in previous sections, namelymoney creation out of thin air, speculation, and interest-based financial assets areabsent in Islamic finance. Banks own directly real assets and operate like an equityholding system. Savings is redeployed into productive investment with no ex-nihilomoney creation. Mirakhor (1988) showed that the rate of return on equities isdetermined in a growth model by the marginal efficiency of capital and timepreference and is significantly positive in a growing economy, implying that anIslamic banking is always profitable provided that real economic growth is positive.Mirakhor (1988) finding establishes a basic difference between Islamic bankingwhere profitability is fully secured by real economic growth and conventional

    banking where profitability is not driven primarily by the real sector [Conventionalbanks may suffer large losses, as seen recently in many industrial countries, inspite of continuing real economic growth].

    An Islamic banking system has two types of banking activity. A deposit banking for safekeeping and payment purposes. This system operates on 100 percent reserverequirement, and fees may be collected for this type of banking services. Aninvestment banking system which operates on risk and profit sharing basis with anoverall rate of return which is positive and determined by the economy growth rate.The paper shows that Islamic banks do not create and destroy money;consequently, the money multiplier, defined by the savings rate in the economy assuggested by Mirakhor (1988), is much lower in an Islamic system compared to aconventional system, providing thus a basis for strong financial stability, greater price stability, and a sustained economic growth [This inherent stability of Islamicbanking has led famous economists (Irving Fisher (1936), Henry Simons (1948),Maurice Allais (1999), and many others) to formulate monetary reform proposalsalong Islamic banking principles. These proposals are known as the Chicago Plan;they call for dissociating banking into two independent activities: (i) 100 percentreserve deposit banks; and (ii) investment banks that redeploy savings intoinvestment through selling securities]. In Section VIII, the paper discusses the types of finance that can be excluded fromIslamic banking and safeguards and regulatory framework for the Islamic finance

    [A i f l d i i h ll i I l i

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    14/44Are you a developer? Try out the HTML to PDF API

    system [A penetrating treatment of regulatory and supervision challenges in Islamicbanking can be found in Archer and Abdel Karim (2007)]. Section IX concludes. Itfocuses on the social cost of financial instability; namely, when the central banktries to socialize losses from a speculative boom through large bailouts, it sets aninflationary process. Such an outcome penalizes the public for policymismanagement, and causes large wealth redistribution from fixed income, wageearners, and creditors in favors of banks and debtors. Moreover, high inflationcauses a deflation of real output and may degenerate into stagflation wheninflationary expectations become fully embedded in the price and wage system.Last resort bailouts are tantamount to validating uncontrolled money creation byfinancial institutions. An Islamic sys tem avoids such an outcome. By its absence,last resort lending in an Islamic system does not validate uncontrolled liquiditycreation, and therefore it would rule out monetary-policy-based inflation. As recentfinancial crisis as well as previous financial instability episodes were essentiallycaused by overly expansionary monetary and credit policies in many industrial aswell developing countries there is certainly a need for a Basle III agreement thatwould regulate regulators, i.e., central banks, and set guidelines for safe centralbanking aimed at financial stability and not at full employment. Absent suchregulatory framework, existing Basle agreements I and II, even if fully observed,would not prevent severe financial instability [In October 2008, failing to force banksto resume lending to unqualified borrowers, major central banks have bypassedbanks and decided to lend directly to these borrowers immense loans at negative

    real interest rates. Such desperate and disorderly conduct of central banksundermines every regulatory framework]. Financial instability: Recurrence a nd SeverityFinancial instability has been a recurrent event that plagued economies both indistant and recent pasts and can render even the most advanced financial systemsvulnerable. Its costs are unavoidable either in terms of widespread bankruptcies anddeflation or in terms of runaway inflation that generates a wealth redistribution infavor of debtors at the expense of creditors, pensioners, and wage earners. It eruptswhen a speculative boom bursts. The object of speculation has varied from boom toboom. The list of assets and goods that may attract speculation could be endless,and may include all types of commodities futures, bonds, gold, agriculture land,buildings, housing, stocks, and foreign exchange. Often, financial instability has itsroots in a previous instability episode and lays, in turn, the ground for another episode of financial instability. Hence, conventional banking system seems to becaught in cycles of instability. While financial instability has not been a rareoccurrence, its severity and duration have varied. Instability may manifest itself though a temporary crisis of the banking system and limited spillover to the realeconomy. It may, however, evolve into a severe banking and economic crisis, aswas the case in Argentina for example, resulting in large number of bankruptcies,deposits losses, deflation or inflation episodes, contraction in output and massiveunemployment, collapse of exchange rates, paralysis of international trade andemergence of trade restrictions. Economic decline can persist for many years

    b f t t d ti it t t i i l l

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    15/44

    Are you a developer? Try out the HTML to PDF API

    before recovery starts and activity returns to pre-crisis level.

    The present financial crisis in the US and Europe, which finds its origin in theGreenspan put in the wake of the collapse of the stock market in late 1990s andthe collapse of long-term capital management (LTCM) hedge funds, has manifesteditself through a burst in housing bubble, collapse of credit derivatives andsecuritization, meltdown of sub-prime market loans, and massive bailout of financialinstitutions in the US and Europe. [The "Greenspan Put" refers to the monetarypolicy that Alan Greenspan, the former Chairman of the US Federal Reserve Board,fostered from the late 1980s to the middle of 2000. During this period, when a crisisarose, the Fed came to the rescue by significantly lowering the federal funds rate,often resulting in a negative real yield. In essence, the Fed pumped liquidity backinto the market to avert further deterioration. The Fed did so after the 1987 stockmarket crash, the Gulf war, the Mexican crisis, the Asian crisis, the LTCM debacle,Y2K, and the internet bubble burst. The Fed set interest rates at record low levelsduring 2001-2004 causing a phenomenal credit expansion at about 12 percent per year. The Fed's pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. This created a moral hazard problemwhere investors increasingly believed that when there is a financial crisis, the Fedwould step in and inject liquidity until the problem got better. Invariably, the Fed didso each time, and the expectation became firmly embedded in asset pricing in theform of higher valuation, narrower credit spreads, and excess risk taking. The end

    result has been moral hazard in risk taking and successive bubbles in equities, realestate, and commodities].

    As writedowns have so far exceeded US$500 billion, old-established instit utionshave fallen (e.g., Lehman Brothers) and many financial giants are rescued throughmassive bailouts (including the recently rescued Fannie Mae, Freddie Mac, and

    AIG) the spread of the unfolding cris is at tests to the severity of this episode of financial instability. Destabilizing financial and economic shocks are stillintensifying in credit, commodities, and currency markets; as in the case of Japanduring 1990-2001, they could foreshadow a prolonged contraction of output growthand employment. Although reminiscent of the 1970s stagflation, the presentfinancial crisis has set off highest inflation in modern history in energy and food

    prices, triggering widespread food riots and protests, and has been reducing realincomes at a fast rate. The last-resort lending by central banks is eroding realsavings, undermining capital accumulation, and long-term economic growth. As thecrisis is still evolving, uncertainties are rising and economic recession could belonger and more severe than any other postwar recession.

    Financial instability is not restricted to developed countries. It has played havocwith a number of major South East Asian economies, causing banking andcorporation bankruptcies, severe contraction of output and employment (exceeding10 percent in real terms), and loss of international reserves. Many highly indebtedpoor countries and middle income countries have experienced severe debt crisis

    which have disrupted their economic growth In spite of major debt write offs many

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    16/44

    Are you a developer? Try out the HTML to PDF API

    which have disrupted their economic growth. In spite of major debt write-offs, manydebt-burdened countries have not yet been able to experience sustained recovery or achieve debt sustainability.

    History is replete with recurrent financial instability. Many episodes and their causes have been documented (e.g., Friedman and Schwartz, 1963, Galbraith,1954, Kindleberger, 1977, Minsky, 1986). Severe financial turbulences occurredin1837,1873,1893, and 1907. In the wake of each episode, massive bankruptciesensued, leading to millions of jobs lost and to economic decline. Certainly, theGreat Depression of 1929-1933 was the worst episode of financial instability inmodern history. It hit hard in the US and Europe, causing large scale bankruptcies,debt deflation, steep fall in output (by over one third in real terms) and prices, andmassive unemployment and poverty. It was responsible for monetary chaos thatprevailed in 1930s, leading to the human tragedy of the Second World War. Soonafter the war, warring powers rushed to establish the Bretton-Woods system withthe mandate to stabilize world economy, adopt fixed instead of highly volatile andflexible exchange rates, and take steps to mitigate the causes that led to monetaryinstability of the pre-war period.

    Financial instability led to abandonment of the gold standard after the First War 1914-1918 and its replacement by the gold exchange standard and flexibleexchange rates (1922 Genoa agreement). It was then replaced by the fixedexchange rates system, which was in turn abandoned and replaced by a return tofloating exchange rates. The suspension of gold standard has made inflation aregular feature of the conventional monetary system leading to prolonged anddestabilizing inflationary episodes.

    Causes of financial instabilityIn view of its devastating effects, considerable research effort has been devoted toexplaining the causes of financial instability and to prescribe remedies that wouldreduce the risk of instability and spare the economy dire and needless costs interms of deep contraction in output, large scale unemployment, bankruptcies,dramatic fall in real incomes, and social hardship. Financial instability has oftenbeen caused by war or large fiscal deficits which were financed by printing money.

    However, financial instability could also be caused by ill-designed monetarypolicies, abundant liquidity and excessive and imprudent credit expansion, or bymarket forces endogenous to the financial system.

    1. Over-indebtedness and Deflation

    Irving Fisher (1933) reviewed many possible causes that may lead to financialinstability. He argued that two dominant factors were responsible for each boomand depression: over-indebtedness in relation to equity, gold, or income whichstarts a boom, and deflation consisting of a fall in asset prices or a fall in the pricelevel which starts a depression. He noted that over-investment and over-speculation

    are often important but they would have far less serious results if they were not

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    17/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    are often important, but they would have far less serious results if they were notconducted with borrowed money. That is, over-indebtedness may reinforceoverinvestment and over-speculation. Disturbance in these two factors: debt and thepurchasing power of a monetary unit, will adversely impact all other economicvariables. If debt and deflation are absent, other disturbances would be powerless tobring on crises comparable in severity to those of 1837, 1873, or 1929-1933.

    Fisher found that easy money was the great cause of over-borrowing. When aninvestor thinks he can earn high returns by borrowing at low rates, he will betempted to borrow and to invest or speculate with borrowed money [Henry Simons(1948) advanced similar analysis for financial instability. He wrote It is noexaggeration to say that the major proximate factor in the present crisis (i.e., 1929-1933 Great Depression) is commercial banking. We have reached a situation whereprivate-bank credit represents all but a small fraction of our total circulatingmedium. Fast expansion of bank credit at the expense of creditworthiness wasfollowed by sharp credit contraction as banks attempt to restore the quality of theassets and recover from their losses. The power of banks to create and destroymoney on a large scale has caused large fluctuations in output and employmentand became a source of considerable monetary uncertainties. In Simons (1948),financial instability is compounded by price and wage rigidities, with the brunt of adjustment born by decline in quantities (i.e., output and employment)]. Hemaintained that this was the prime cause leading to over-indebtedness of 1929.

    Low interest rate policy adopted by the US to help England to return to the goldstandard in 1925 contributed to unchecked credit expansion. Brokers' loans, withvery small margins and low interest rates, expanded very fast and fueled stockmarket speculation. Inventions and technological improvements created investmentopportunities leading to large debts. Other causes were the left-over domestic andforeign war debts and the reconstruction loans to Europe.

    The depression was triggered by debt liquidation which led to distress selling and tocontraction of deposit currency as bank loans were paid off, and to a slowing downof velocity of circulation. The contraction of deposits caused a fall in the level of prices. There followed a greater fall in the net worth of businesses, precipitatingbankruptcies, a fall in profits leading to a reduction in output, trade, and

    employment, which in turn led to hoarding and slowing down of the velocity of circulation.

    Fisher's analysis showed that financial instability of the scale of the GreatDepression was avoidable if over-indebtedness was precluded. He emphasized theimportant corollary of his debt-deflation theory that great depressions are curablethrough reflation and stabilization. He maintained that the government can reflatethe price level through printing money to finance deficit needed to kick-starteconomic recovery. The central bank can also re-inflate through open marketoperations or lending as a last resort. Referring to Sweden where economic policywas able to maintain stability during 1929-33, he believed that price level was

    controllable through appropriate policy instruments.

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    18/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    controllable through appropriate policy instruments.

    Friedman and Schwartz (1963), and Friedman (1959, 1969, 1972) conceived of financial instability as a monetary phenomenon--described as faster moneyexpansion due to unchecked credit expansion-- and significantly downplayed realfactors. In each financial crisis, banks suspended conversion of deposits intocurrency, and a wave of bank failures ensued. The analysis of the causes of theGreat Depression by Friedman and Schwartz (1963) sheds light on the causes thatled to the present financial crisis characterized by meltdown of sub prime loans andthe burst of the housing boom. They argued that fierce competition among banksand financial innovation evaded prudential regulations, contributed to over borrowingfor speculation in housing and stock markets and a deterioration of the quality of loans. They noted that financial instability of the scale of the Great Depression didnot happen prior to the creation of the Federal Reserve System (Fed) in 1913. Thefounders of the Fed were expecting that financial instability of the 19th and early20th century would be thwarted or significantly reduced by the creation of a centralbank. With regard to the Great Depression, Friedman and Schwartz held the viewthat the Fed was accountable for two policy errors: it was reluctant to prevent aspeculative boom at an early stage and it was not able to move fast enough to avoidmassive bank failures and deep depression. Based on a comprehensive study of the US monetary history, they observed that financial stability prevailed only whenmoney supply was increasing at a stable and moderate rate of 2-3 percent. In linewith Simons (1948), Friedman strongly rejected discretionary and unpredictablemonetary policy and prescribed the rule of setting fixed targets for the growth of monetary aggregates in line with the expansion of economic activity [Maurice Allais(1999) was a strong supporter of fixed rule. In full agreement with Friedman, heproposed a fixed target for money supply, compatible with a long-term inflation atabout 2 percent a year].

    Galbraith (1954), Kindleberger (1977), and Soros (2008) found that speculativemanias gather speed through expansion of money and credit. During a speculativeeuphoria, many credit instruments become monetized, fueling speculation. TheRadcliffe Commission in Britain in 1959 claimed that in a developed economy thereis a wide range of financial institutions and many highly liquid assets which are

    close substitutes for money, as good to hold, and only inferior when the actualmoment for a payment arrives. Call money, more specifically brokers' loans,combined with small margins and low interest rates, financed stock marketspeculation in 1929. Credit instruments can be monetized during a speculativeboom; these instruments include bills of exchange, negotiable CDs, installmentcredit, NOW accounts, c redit cards, mortgages, and students loans. When aspeculative boom bursts, these credit instruments become illiquid and there is arush back to liquidity and safety.

    2. Mi nsky: stabil ity is unstable

    Minsky (1986, 1992) considered financial instability to be endogenous to

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    19/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    y ( , ) y gconventional financial system. His core model is known as Financial InstabilityHypothesis (FIH), which simply declares stability is inherently unsustainable. Afundamental characteristic of a conventional financial system, according to Minsky,is that it swings between robustness and fragility and these swings are an integralpart of the process that generates business cycles. His theory stability isunstable was influenced by Keynes's notion of the fundamental instability of market expectations, and by Schumpeter's notion that capitalism renews itself through competition and innovation creative destruction' that chucks out the badand ushers in the good. But while Schumpeter focused on technology's role indriving capitalism, Minsky's focus was on banking and finance. Minsky contendedthat nowhere is evolution, change and Schumpeterian entrepreneurship moreevident and the drive for profits more clearly a factor in making for change than inthe conventional banking and finance. Financial innovation as a destabilizinginfluence becomes evident with the burst of a speculative boom.

    Minsky looked at all participants in the economy -- households, companies andfinancial institutions -- in terms of their balance sheets and cash flows. Balancesheets are composed of assets and liabilities, while cash flows validate theliabilities. Minsky's economy comprises what he calls a "web of interlockingcommitments" -- a vast and complex network of interconnected balance sheets andcash flows that is always changing and evolving. During periods of stability peoplefeel more confident. According to Minsky, they respond by increasing their liabilities relative to income; the "margin of safety" declines.

    Minsky classified borrowers, according to their balance sheet and ability to makeinterest and principal payments, in three distinct categories, which are labeled ashedge, speculative, and Ponzi finance. Hedge financing units are those which canfulfill all of their contractual payment obligations by their cash flows. According toMinsky's definition, the greater the weight of equity financing in the liabilitystructure, the greater the likelihood that the unit is a hedge financing unit.Speculative finance units are units that can meet their commitments on interestpayment, even as they cannot repay the principal out of income cash flows. Suchunits need to roll over their liabilities issue new debt to meet commitments on

    maturing debt. For Ponzi units, the cash flows from operations are not sufficient tofill either the repayment of principal or the interest on outstanding debts. Such unitscan sell assets or borrow. Borrowing or selling assets to pay interest (and evendividends) on common stocks lowers the equity of a unit. The key feature of aPonzi scheme is its need to attract ever greater sums of money. To survive, Ponziunits must refinance, either by selling assets or by raising more debt. For this tohappen asset prices must continue to rise. Ponzi finance typically emerges duringa speculative bubble, when the margin of safety has been undermined.

    Minsky stated that if hedge financing dominates, then the economy may well be anequilibrium-seeking and containing system. In contrast, the greater the weight of

    speculative and Ponzi finance, the greater the likelihood that the economy is a

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    20/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    deviation-amplifying system. The first theorem of the financial instability hypothesisis that the economy has financing regimes under which it is stable, and financingregimes in which it is unstable. The second theorem of the financial instabilityhypothesis is that over periods of prolonged prosperity, the economy transits fromfinancial relations that make for a stable system to financial relations that make for an unstable system.

    Minsky observed that financial institutions compete furiously, both when investingand when providing credit to others. Inspired by Schumpeter's notion of "creativedestruction", he described the proliferation of financial innovations as means toattract more borrowers and to bypass existing regulations. The level of productinnovation has run far in advance of the capacity to utilize these products and theability to understand the characteristics of risks and long-term consequences.Recent instruments-- based on the idea of originate and distribute, instead of originate and hold, as well as securitization models--include mortgage backedsecurities (MBS), collateralized debt obligations (CDO), and CDO tranches, letalone CDO-squared (tranches from CDO tranches), CDO-cubed (tranches on top of CDO-squared) or the most abusive credit default swaps (CDS). The more the layersof derivatives on top of each other, the more sensitive they are to even smallchanges in the underlying variables and assumptions (No wonder that many AAArated CDOs have only a 50% rate of recovery, and everything else including AAsand single As are pretty much wipe outs).

    Banks are not the only financial institutions competing fiercely with one another for profits. Swindles, fraud, theft, embezzlement, and deceptive rating dominate asPonzi financing units multiply. They make large gains in the process. When their liabilities become valueless, losses are born by banks, and massive bankruptcieserupt. Present day hedge funds, as contrasted with Minsky's notion of hedge unit,play an increasingly important role in the credit markets, providing liquidity to thehousing market by buying mortgage-backed securities and fueling the growth of leveraged buyouts and structured finance. As hedge funds are not regulated, little isknown about the true extent of their leverage or the positions they take.

    However, their capacity to leverage is potentially enormous. By borrowing five timesits assets and investing in the riskiest part of a structured security such ascollateralized mortgage obligations, a credit hedge fund could in theory becomelender of $850 million worth of residential securities by committing just $10 millionof its own funds. Credit hedge funds rely on short-term financing to pursueleveraged strategies. A synchronous deleveraging of credit hedge funds couldbecome a new risk element in the credit markets.

    Following the teaching of Irving Fisher, Minsky held that the crisis has adeflationary impact as people seek to pay off debts. His prescription wasconventional: more government spending and lower interest rates from the central

    bank could prevent debt deflation. His view on the consequences of these actions

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    21/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    was less conventional. Minsky contended that successful interventions duringcrises discouraged financial conservatism. If the boom is unwound with littletrouble, it becomes quite easy for the economy to enter a new phase of instability.Financial institutions respond to the fact that the authorities are protecting themfrom financial catastrophe by plunging anew into risky activities; hence anenhancement of moral hazard risk.

    The successful resolution of a crisis further strengthens moral hazard. Moreover,large government deficits combined with low interest rates and high inflation reducedramatically real savings and erode capital accumulation, thus reducing economicgrowth or even bringing it to a halt [In the Harrod-Domar model, real economicgrowth rate is equal to the savings rate, i.e., ratio of savings in percent of GDP,divided by the incremental capital output rate. The lower the savings rate, the lower economic growth will be. In the United States, low interest rates have caused largeexternal deficits during 2001-2008, about 6-7 percent of GDP, negative nationalsavings, and full dependence on foreign financing of economic growth].

    Fisher and Minsky's prescription for massive bailouts and large scale last resortlending could be debatable from social equity and economic point of views. Recentlarge bailouts by the Fed was extended to investment banks which did not payinsurance premium to the FDIC, and were not regulated; they were therefore noteligible for Fed's lending facilities. Moreover, bailouts validate uncontrolled creditexpansion and socialize losses from speculative booms while the gains enjoyed byspeculators remain private. High Inflation resulting from last resort lending erodesreal incomes of pensioners and wage earners. While the Fed has prevented bankliquidations, it has set off liquidation of real savings and investment, agonizingeconomic slowdown, and loss of jobs and incomes.

    Destabilizing Monetary Policy

    Minsky's endogeneity hypothesis, while integrating Keynes view on instability of expectations and Schumpeter's view on destructive innovations, has yet to besupported empirically when confronted with actual role of central banks in major financial crisis. Notably, the present crisis was almost solely the work of centralbanks; it was caused by lowest interest rates in post war period set by the Fedfollowing the bursting of the Internet bubble in late 2000. As a consequence, totalcredit expanded at an exceptionally high rate of 12 percent per year in the USduring 2001-2008. This phenomenal credit growth was at the cost of creditworthiness and erosion of underwriting standards [[1]As liquidity became of little value, loans were extended to subprime markets. Examples of sub primeloans were NINJA loans (no income, no job, no asset borrowers) that wereextended to NINJA borrowers and were rated AAA by reputed rating agencies].Soros (2008) wrote when money is free, the rational lender will keep on lendinguntil there is no one else to lend to. Monetarists have sharply criticized interest

    rate setting and unbacked money creation by central banks and considered themh i f ibl f fi i l i bili d i fl i i d

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    22/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    as the main factors responsible for financial instability and inflationary episodes[Maurice Allais (1999) wrote: in essence, the present creation of money, out of nothing by the banking system, is similar - I do not hesitate to say it in order tomake people clearly realize what is at stake here - to the creation of money bycounterfeiters, so rightly condemned by law].

    1. Interest rate setting as a cause of financial instability

    Interest rate setting by the Fed at low levels during 1926-1929 to help Britainrestore gold standard at pre-1914 parity was found to have led to speculative boomsin housing and stock markets and to high economic growth. Reluctance of the Fedto raise interest rates with a view to protect farmers, builders, and the rest of theeconomy, contributed to uncontrolled credit growth during 1927-1929, which endedwith the Great Depression. Interest rate setting by central bank has been sharplycriticized throughout contemporary economic history by famous economists suchas Thornton (1802), Wicksell (1898), and Friedman (1968, 1972), who opposeddiscretionary policy which creates both excessive credit and market risks for financial institutions. Interest rate setting is a form of price control that causesconsiderable distortions and inefficiencies; beside creating monetary uncertainties,it leads to an excessive credit expansion, speculation, and therefore to assets andcommodities price instability [The current commodities boom could be easilyexplained by distortionary effect of interest rate setting. Interest rate on governmentbonds was 3 percent per year in July 2008. Return on oil futures contractsexceeded 120 percent per year in July 2008. Fixing prices in one market leads tolucrative speculation in parallel markets. Moreover, very low interest rates during2002-2005 were found to be main driving factor for securitization. To bolster their incomes in the context of reduced margins and gain from abundant liquidity, bankswere led to expand their assets through funds from securitization and supplementtheir incomes through fees and commissions from larger number of loans].

    By targeting interest rate, a central bank abandons monetary aggregates andreduce substantially its direct contacts with individual banks. For instance, in theUnited States the role of District Banks has been curtailed and liquidity operationshave been concentrated in the New York Fed [Under the regime of controllingmonetary aggregates, District Banks used to have direct control of member banks'portfolio and could detect problem banks at an early stage at the discount windowlevel. Since mid-sixties, such direct contacts have become very limited]. Thecentral bank wants only to control interest rates and stands ready to supply anyamount of money required to maintain interest rate pegged at a fixed target rate,regardless of creditworthiness, and to support the price of government bonds andfinance fiscal deficits, via essentially open market operations. Furthermore, as thegeneral price level increases or asset prices rise, the central bank stands toaccommodate higher money demand for transactions or for fueling creditexpansion, which in turn increases liquidity [[1] As the German hyperinflation

    (1920-1923) showed, the central bank can indefinitely accommodate rising pricel l d hi h d d f t ti i h i fl ti

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    23/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    levels and higher demand for transaction money in a hyperinflationary process. Actual policy actions of central banks undermine the stated objective of bankingsoundness and stability].

    Thornton (1802), in his classic The Paper Credit of Great Britain, provided the firstrigorous and systematic analysis of a two-way relation between interest rates andinflation. He distinguished between the market (loan) rate of interest rate and theinterest rate (marginal rate of profit or natural rate) which equilibrates savings andinvestment. He expressed the doctrine that inflation results from a divergencebetween the two rates. Under fiat money, when the central bank pegs loan rate of interest below the marginal rate of profit, it sets in motion a cumulative expansion inthe demand for and supply of loans, currency issue, and the price level. Inflationcould continue without limit because, contrary to gold standard which precludedcredit expansion that would drain gold reserves, there existed no automaticallycorrective mechanism under costless fiat money system to bring it to an end.Inflation, in turn, signals that real savings are rapidly falling, and therefore economicgrowth is slowing.

    Thornton analyzed the reverse causation from inflation to loan interest rate anddiscussed the effect of inflationary expectations on loan interest rates. Even if thecentral bank increases the loan rate of interest in response to inflation, the realinterest, if not negative, may remain indefinitely below the real marginal rate of profitinducing further demand for bank credit. Accordingly, Thornton argued that centralbank should abandon interest rate pegging and regain control of money supplythrough ceilings on credit and monetary aggregates [In the same vein, Friedman(1968) strongly argued that central bank cannot control interest rate or unemployment rate. Its actions to do so can only destabilize the financial system.It can only control money supply and credit]. Control of credit has also beenstrongly recommended by Soros (2008).

    In order to contain runaway inflation caused by low interest rates, the central bankmight be compelled to apply practical quantity theory of money and force ceilingson money and credit, thus abandoning interest rates control. Under theseconditions, interest rates will explode. Given the huge amount of outstanding debtand their low credit worthiness, such a rise in interest rates will set off a financialcrisis and mass defaults. Given the large amount of public debt, sharp rise of interest rates will cause fiscal deficits to widen [The US Treasury may compel theFed to maintain low interest rate. The 1951 Accord between the Fed and Treasurywas meant to alleviate Treasury's pressure regarding the setting of interest rates atlow levels].

    2. Unbacked lending and the central bank's key role in financial instability

    Financial instability erupts when there are not sufficient real savings to support

    lending. This occurs when a lender creates fictitious claims on final consumer goods and lends these claims out The borrower who holds the empty money so to

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    24/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    goods and lends these claims out. The borrower who holds the empty money, so tospeak, exchanges it for final consumer goods. He takes from the pool of realsavings without any additional real savings having taken place, all other thingsbeing equal. The genuine wealth producers who have contributed to the pool of finalconsumer goods the pool of real saving discover that the money in their possession will get them fewer final goods [Rueff (1964) showed that excessivecredit expansion creates a purchasing power that has no real goods counterpart; itcan undermine real economic growth and even trigger starvation].

    The reason is that the borrower has consumed some of the final goods. There is adiversion of real wealth (final consumer goods) from wealth-generating act ivitiestowards the holders of new money, created "out of thin air."

    As the pace of unbacked credit expands, relative to the supply of real savings, lessbecomes available to genuine wealth generators, all other things being equal.Consequently, with less real savings, less real wealth can now be generated. Realsavings are required to support the life and well-being of individuals who areengaged in the various stages of production. In the extreme case, if everybody wereto just consume without making any contribution to the pool of real saving, theneventually no one would be able to consume.

    By means of monetary policy, the central bank makes it possible for banks toengage in the expansion of unbacked credit. Thus if Bank A is short of $100, it cansell some of its assets to the central bank for cash. It can also secure the $100 byborrowing it from the central bank. Where does the central bank get the money?Under fiat money system, it just makes it "out of thin air." Obviously, Bank A couldalso attempt to borrow the money from other banks. However, this will push interestrates higher and will slow down the demand from borrowers, which will diminish thecreation of credit "out of thin air".

    The conventional banking system can be seen as one huge monopoly bank, whichis guided and coordinated by the central bank. Banks in this framework can beregarded as branches of the central bank. Through ongoing monetary pumping, thecentral bank makes sure that all banks engage jointly in the expansion of credit"out of thin air." The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out. In short, by means of monetaryinjections, the central bank makes sure that the banking system is "liquid enough"so that banks will not bankrupt each other.

    It appears therefore that the role of the central bank makes the present conventionalfinancial system unstable and vulnerable to financial turmoil. It is not the expansionof credit as such that leads to an economic bust but the expansion of credit "out of thin air," since it is through unbacked credit that real savings are diverted fromproductive activities to nonproductive activities, which in turn weakens the process

    of real wealth expansion. The deliberate role of central banks in financial instabilitymakes Minsky's endogeneity hypothesis debatable

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    25/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    makes Minsky s endogeneity hypothesis debatable.

    As central banks in many industrial countries have been entrusted with themandate of achieving full employment, financial stability has not been given theattention it deserves [Full employment is an important objective. However, it shouldnot fall under the central bank prerogative. It should be under the governmentdevelopment planning. Progress toward full employment can be achieved througheducation, sectoral development (agriculture, industry, infrastructure, etc.), and fullycompetitive labor markets. In many countries, unions and labor laws can be anobstacle for full employment, since price and wage rigidities can become inimical tofull employment in any economy and a source of exchange rate overvaluation].Their pursuit of this mandate has been self-defeating. By insisting on long-termdemand-led and inflationary growth, low interest rate policy has fueled assetbubbles in stock, real estate, and commodities markets, and has slowed growthand increased unemployment [Central banks do not seem to accept the notion thatlong-term growth depends on increasing savings and investment. Demand policiescan only reduce savings and capital accumulation and will undermine long-termeconomic growth. Moreover, the bursting of asset bubbles can become a drag onlong-term economic growth as in Japan in 1990-2001 or during the GreatDepression 1929-33]. With the central banks forcing credit expansion in order tostimulate growth and employment, at the expense of creditworthiness, or to financefiscal deficits through abundant liquidity, financial institutions will not be immune tofinancial instability, even if they comply fully with Basle I and II guidelines. Absenthighly stable and predictable monetary framework, financial institutions will facerecurrent financial instability with increased frequency [Henry Simons (1948)sharply criticized monetary uncertainty, which stems from unpredictable changes incredit and money and near-money aggregates, unpredictable changes in interestrates, and proliferation of money and credit instruments (i.e., financial innovations)].Recent as well as past financial crises demonstrate the need for safe andpredictable central banking. Promoting such safe central banking in the Basleframework, geared toward financial stability and not full employment objective,should be a top priority in the quest for financial stability.

    Causes of International Financial Instability.

    Because financial instability in one major reserve currency center could spread tothe rest of the world, causes of financial instability were also analyzed at theinternational level by Keynes (1943), Triffin (1959), Mundell (2005), Rueff (1964), andmany others. There is general consensus that contagious financial instability iscaused by unsustainable fiscal and money policies and by beggar-thy-neighbor trade policies at the level of reserve currency centers. Inflating reserve currencycountries are unwilling to tighten monetary policy and undergo a temporarycontraction needed for stability. The resulting large fluctuations in exchange ratesexpose banks to foreign exchange risks. One solution advocated by all authors

    mentioned is the creation of a common central bank and a common currency whichis to be issued under strict quantitative guidelines, not exceeding a growth of 2-5

    http://pdfcrowd.com/http://pdfcrowd.com/redirect/?url=http%3a%2f%2fwww.islamic-banking.com%2fislamic-finance.aspx&id=ma-140228163841-6eac53dehttp://pdfcrowd.com/customize/http://pdfcrowd.com/html-to-pdf-api/?ref=pdf
  • 8/12/2019 Islamic Banking Com Islamic Finance Aspx

    26/44

    pdfcrowd.comopen in browser PRO version Are you a developer? Try out the HTML to PDF API

    is to be issued under strict quantitative guidelines, not exceeding a growth of 2 5percent per year. A proposed common central bank would be independent of anygovernment, and therefore of any fiscal or full employment pressure. Hence, itwould be able to provide a stable currency.

    In an insightful analysis Rueff (1964) strongly argued that collapse of gold standardhas created more instability and brought the world economy to the age of inflation.He pointed out that the balance of payments deficits of reserve currencies provide abasis for creation of new credit and therefore to more speculation. He showed that areserve center can run an indefinite balance of payments deficit without losing realresources as these deficits are financed through issuing currency. Indeed, externaldeficits of the US have caused substantial capital inflows in the US banks thatcontributed, to a large extent, to recent housing bubble. Central banks and foreignfinancial institutions ex-patriate or place their dollar holdings in interest earningassets in US banks. These deposits provide a basis for US banks to increasecredit. According to Rueff, there was large monetary expansion in relation to worldstock of gold in the post-war period. He proposed a devaluation of currencies toreflect new price of gold, restoration of gold standard, and actual transfer of goldfrom deficit to a surplus country. Rueff's analysis remains pertinent. Reservecurrencies (such as dollar, euro, or yen) governments pursue national priorities atthe expense of the rest of the world. They maintain monetary expansion in order topreserve full employment at home and prevent currency revaluation in order tomaintain export competitiveness. This monetary expansion has created a hotbed of generation of financial instability. It has been inflationary and costly in terms of world economic growth, trade, and social stability.

    Recourse to gold as reserve money has recently been gaining larger support in viewof the fast depreciation of reserve currencies and mounting inflationary pressure inall reserve currencies centers. Monetary expansion has translated into rapidincrease in foreign reserves of central banks, which rose by more than six foldduring 2000-2007. In view of large currencies depreciation in relation to commoditiesand real purchasing power, these reserves will lose their real value rapidly. Use of gold as a reserve money will allow hedging foreign reserves against inflation.

    Monetary Expansion and the Credit Multiplier

    1. The credit multiplier in a credit system without securitization

    By examining the monetary survey of any country, it can easily be observed thatmoney in circulation is many folds the high powered money, or the base money.This is explained by the money creation process. Deposit banks do crea


Recommended