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Management

The Global Financial Crisis: Can Islamic Finance Help?

Muhammad Umer Chapra

The whole world is now in the grip of a financial crisis which is far more serious than any experienced since the Great Depression. It has taken more than $3 trillion of bailout and liquidity injections by a number of industrial countries to abate somewhat the intensity of the crisis. Nevertheless, there are fears that this crisis may have exposed the world economy to a long period of economic slowdown. There is, hence, a call for a new architecture that would help minimise the frequency and severity of such crises in the future.
Primary Cause of the Crisis
It is not possible to design a new architecture without first determining the primary cause of the crisis. The generally recognised most important cause of almost all crises has been excessive and imprudent lending by banks over a long period. This is clearly acknowledged by the Bank for International Settlements (BIS), which states as much in its annual report (released on 30th June 2008).
This raises the question of what makes it possible for banks to resort to such an unhealthy practice which not only destabilises the financial system but is also not in their own long-run interest. There are three factors that make this possible. One of these is inadequate market discipline in the financial system resulting from the absence of profit and-loss sharing (PLS). The second is the mind-boggling expansion in the size of derivatives, particularly credit default swaps (CDSs), and the third is the ‘too big to fail’ concept, which tends to give an assurance to big banks that the central bank will definitely come to their rescue and not allow them to fail.
The false sense of immunity from losses that all these factors together provide, has introduced a fault line in the financial system. Banks have not, therefore, undertaken a careful evaluation of the loan applications. This has led to an unhealthy expansion in the overall volume of...