Class
Lecture
Islamic
Financial System (Fin-5402)
Financial Crisis
“Financial crisis” broadly refers to disruptions in financial markets
causing constraint to the flow of credit to families and businesses
and
consequently having adverse effect on the real economy
of goods
and
services. The term is generally used to describe a
variety of situations in
which investors
unexpectedly lose substantial amount of their investments, and financial institutions suddenly lose significant proportion of their value.
Financial crises include, among others, stock
market crashes, financial bubbles, currency crises, and sovereign defaults.
(Collected from The Global Financial Crisis and Islamic Finance, M. Kabir
Hassan, University of New Orleans, USA Rasem Kayed, Arab-American
University, Palestine)
Causes
and consequences of financial crisis
Financial bubbles
are
generally linked to easy credit, excessive debt, speculation, greed, fraud, and corruption. Easy credit leads to lack of adequate
market discipline, which
in
turn instigates excessive
and imprudent lending. Chart 1
below presents a summary of the most frequently cited
factors
as
being potential contributors to financial crisis.
|
Chart 1:
Causes and consequences
of financial crisis
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|
Causes
of financial
crisis
|
Description
|
Risk/Consequence
|
|
Leverage
|
Borrowing to finance investment
|
Bubble
that leads to bankruptcy
|
|
Asset-liability
mismatch
|
The disparity between a bank‟s deposits
and
its long term assets
leads to the inability of
banks
to renew short term debt they used to finance
long term investments in mortgage
securities
|
Bank runs1
|
|
Regulatory failure
|
Improper (insufficient/excessive) regulatory
control:
-Insufficient regulation:
1) Results
in
failure of making institutions‟
financial
situation publicly known (lack of transparency)
2) Makes
it possible
for financial institutions
to operate without having sufficient assets
to meet their contractual obligations.
-Excessive
regulations that require
banks
to increase their capital when risks
rise leading to substantial decrease in lending when
capital is
in short supply.
|
-Excessive risk-taking
-Financial crisis
(of 2008)
Potential deterioration of
financial crisis
|
|
Fraud,
corruption and greed
|
-Enticing depositors
through misleading
claims
about their investment strategies and manipulating information.
-Creating financial
assets without any real
economic activity
-Extreme economic greed overrides basic ethical consideration in investments
|
Subprime mortgage
crisis
|
|
Contagion
|
Where the failure
of one particular financial
institution to meet its
financial obligations
(due to lack of liquidity, bad loans or a sudden withdrawal of savings) causes other
financial
institutions
to be unable to meet
their financial
obligations when due. Such a failure may cause
damage
to many other
institutions and threatens
the
stability of
financial markets
|
Systemic risk2
|
|
Money
supply
|
Uncontrolled printing of paper money that is
not backed
by real assist/commodity (gold)
|
Higher inflation
|
1 Bank runs occur when investors panic and rush to withdraw their money more quickly
than the bank can
reclaim the proceeds of its outstanding loans (Diamond & Dybvig, 1983).
2 Systemic risk has far-reaching implications that go beyond the institution in question and even outside the boundaries of the country that houses the failing institution. Financial globalization facilitates risk to be
transferred across national boundaries. Therefore, the failure of one participant in financial markets could lead
to global financial crises (Kaufman
& Scott, 2003). This is evident by the current global financial meltdown caused by the collapse of some US financial institutions associated with the subprime mortgage scheme
Implications
of
the global financial crisis:
Needless to say those
conventional financial institutions, by and large, were
the first to feel the full
impact of the crisis that they have initiated. The 2008-year was packed of unparalleled events, which have created mass uncertainty,
such
as:
1.
Sharp decline in
global equity markets
2.
The failure or collapse of numerous
global financial institutions
3.
Governments of a
number of industrialized
countries
allocated
in excess of $7 trillion bailout and liquidity injections to revive their economies
4.
Commodity and oil prices reached
record highs followed
by a slump
5.
Central banks
reduced interest rates in
coordinated efforts to increase liquidity and avoid
recession
and to restore
some
(confidence) in
the
financial markets.
Financial crisis: Islamic solution:
Chart
2 links key principles of Islamic finance to „market failures‟ and suggests
that the likelihood of market failure will be significantly reduced, if not
eliminated, when these principles are adhered to and put into practice in all
financial transactions.
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Chart
2: The economics
of Islamic finance and ‘market
failures’
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|
Islamic finance
principle
|
Intuitive description
|
Linkage to
‘market failures’?
|
|
1. Riba prohibited
|
„Earning money from money‟ or
interest, is prohibited. Profit,
which is created
when „money‟ is
transformed into capital via effort, is allowed. However,
some forms of debt are
permitted
where these are linked to „real
transactions‟, and where
this is not used for purely speculative
purposes
|
A real return for real effort is
emphasised (investments cannot be
„too safe‟), while speculation is
discouraged (investments cannot be
„too risky‟). This might have
productive efficiency spillover benefits
(„positive externalities‟) for the
economy through linking returns to real entrepreneurial effort
|
|
2. Fair
profit sharing
|
Symmetric profit-sharing (eg.
Musharakah) is the
preferred contract form, providing effort
incentives for the manager of the
venture, while both the
investor and management have a fair
share
in the venture‟s realised profit (or loss)
|
Aligning the
management‟s incentives
with those of the investor may (in contrast to pure debt financing) once again have productive
efficiency
spillover benefits for the economy, through linking realisable returns to
real entrepreneurial effort
|
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3. No
undue ambiguity
or uncertainty
|
This principle
aims to eliminate
activities or contracts
that are
gharar, by eliminating
exposure of either party to excessive
risk. Thus the investor and manager must be
transparent in writing
the contract, must take steps to mitigate controllable risk, and
avoid speculative
activities with
high levels
of
uncontrollable
risk
|
This may limit the extent to which
there
are imperfect and asymmetric
information problems
as part of a
profit-sharing arrangement.
Informational problems might, for example, provide
the conditions
for
opportunistic behaviour by the venture
(moral hazard),
undermining investment in all similar ventures in
the first instance.
|
|
4. Halal versus haram
sectors
|
Investing in certain haram
sectors is prohibited (eg, alcohol,
armaments, pork, pornography, and tobacco) since they are
considered to cause individual
and/or collective
harm.
|
Arguably, in certain sectors, there are
negative
effects
for society that the investor or venture
might not otherwise take
into account (negative
externalities). Prohibiting investment
in these sectors might limit these externalities
|
|
Source: (Iqbal &
Llewellyn, 2002 cited in Oxera, 2007, p. 2).
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The regulatory authorities, experts in Sharia‟h law
and teachings need to address the issues of intermediation, risk management and
financial engineering within the
framework of
Islamic finance. Islamic finance Policy makers must also strive to
transform Islamic finance model into working policies and
build enabling institutions to overcome
the challenge of implementing
Islamic finance
at global stage.
Top 10 World’s Biggest Financial Crises Ever
Article by Jayasmita Ray, March 23, 2015
A financial crisis is said to
occur when an asset loses a large part of its face value. This can lead to a
wide range of adverse consequences such as a fall in output or stagnancy,
currency crashes and worse, sovereign defaults. Such notable crises have been
occurring since 4th century BCE (Dionysus of Syracuse) and have continued on
different scales and levels. They have far reaching effects into the very
roots of the economy. The causes of the crises can be manifold, and they have
evolved as man as discovered means to propel society to higher levels of
development.
Our world is now very
inter-connected through currency markets, trade relations and capital flows.
The advent of multinational corporations has also added to these
inter-linkages. Thus, crises that may occur in one country can often get transmitted
to another like a bad case of financial influenza driven by fears and
speculation. In view of the various crises that have occurred in the world over
time, i present a list of 10 notable ones in terms of the transforming effects
they had on a wide scale:
10. Black Monday
In the finance world, The Black Monday refers to the time of
October 19, 1987. During that day, there was a widespread stock market crash
all around the world. The beginning of this crash originated in Honk Kong and
eventually spread to Europe. Ultimately, the United States was affected as
well. The Dow Jones dropped by 22.1%, and it took almost 2 years to reach even
the previous high of 1987. This recovery occurred despite fears that the crash
would spell economic gloom like the 1930s. Many explanations exist for this
sudden crash, but none is conclusive. Program trading is one popular
theory. It is said that the level of computerization of stock trading had gone
up during the 1970s. As a result, computers often performed arbitrage based on
external prices. Thus when prices of stock fell, they rapidly sold more and
more, thereby worsening the crash. However, this has been contested because of
the origin of the crises being in Honk Kong, whereas program trading was
more prevalent in USA and also due to the level it spread across the
globe. Institutional rigidity and market psychology have been cited as other
causes.
9. Dot-Com Bubble
This speculative bubble related to internet based companies
saw massive rises in equity stock values of industrialized nations from
1997-2000. This bubble began because of easy credit availability in 1997-1998.
These start-up companies wanted to establish a high market share by
establishing more coverage. This meant that many of the services were freely
provided, and large operational losses were actually occurring. They wanted to
establish a brand and then charge profitable rates. The phrase “Get large
or get lost” operated in the minds of company founders. The quick
expansion of growth rates of these companies led to a self-perpetuating boom in
the share prices. This was riding vastly on hopes of further expansions due to
technology. However, in early 2000, the FED spiked interest rates 6 times and
the economy began to slow down. The market was also triggered further by the
findings of the Microsoft vs USA case. A bearish trend started prevailing, and
by 2001, most of the dot-com companies crashed after finishing off their
venture capital. These failed companies called “dot-bombs” never actually made
any profit.
8. Credit Crisis of 1772
This crisis originated in London and spread to other parts of
Europe, such as Netherlands. Ironically, it had been preceded by a period of
great prosperity for Britain. The mid 1760s and 1770s saw a credit boom which
spurred greater manufacturing and industrial activity. The period of 1770 to
1772 was politically very stable for Britain and its colony, America. However,
there was a deeper systemic problem that prevailed under the surface of this
prosperity. Speculative practices thrived to generate more credit, and this led
to a false feeling of optimism in the market. On June 8, 1772, the fleeing of
one of the partners of the Banking House “Neal, James, Fordyce and Down” due to
failure to repay debts led to panic. During that time, investment was heavily
dependent on the confidence of the market as even today. The confidence of the
people in banks collapsed, and they rushed to reclaim their money. As a result,
several bankruptcies were reported in London. In order to repay its debts,
London exerted further pressure on the tea colonial trade to repay its debts.
This eventually led to the protest of American colonies of New York, Boston,
etc led to the famous Boston Tea Party of 1773.
7. OPEC Oil Price Shock (1973)
his crises began in 1973 when the member countries of the
OPEC (Oil and Petroleum Exporting Countries) declared an oil embargo
(prevention of trade). This was done specifically in retaliation to USA’s
unflagging supply of arms to Israel which was retaliating against Arab warfare
on its holiest day that day. This lasted till March 1974. The negotiations by
the Nixon Administration with Israel and the other Arab countries eventually
led to the end of this embargo. However, even before this, the other factor
that operated was the collapse of Bretton Woods which led different economies
to use their own respective floating currencies. However, oil was priced in
dollars and the depreciation of several currencies that followed (due to
fluctuations to adjustment that led to money printing) also reduced the
earnings of the oil exporting nations. Thus raising oil prices was an effective
means to stabilize their real incomes over the years. The embargo that followed
later because of the political warfare aspect eventually forced the developed
nations to consider energy conservation and a far more restrictive monetary
policy to curb inflation.
6. 1998 Russian Crises
This crises, also known as the “rubble crises” saw a wide
ranging effect on countries of the world such as the Baltic States, Moldova,
Kazakhstan, Ukraine, USA, Belarus, Uzbekistan etc. There was a wide range of
reasons for this crises. The internal decline in productivity, ballooning
fiscal deficit which was aggravated further by the Chechnya War which ended in
1996 were enough to set the stage for other events that triggered the crises.
The 1997 Asian crises led to a fall in prices of metals and oil which severely
affected the exchange rate in real terms. The rubble had been kept artificially
fixed all this time, and when the value of these important capital goods fell,
there was a fall in GDP, unemployment and capital flight. Political uncertainty
occurred when there was a massive dismissal of cabinet members by the President
of Russia. Despite the efforts to attract more capital and generate liquidity,
the debt on wages of the people (particularly miners) grew. The switch to a
floating exchange rate led to a massive depreciation that didn’t help investor
confidence. It was really the rise in oil prices in 1999-2000 that helped
Russia to finally have a trade surplus and the domestic industries had
benefited from the spike in prices of imports as a result of depreciation.
5. 1997 Asian Crises
The Asian Crises originated in a rather small economy called
Thailand. The country had experienced rapid expansion in the 1980s and most of
the 1990s. However, much of this growth had previously been financed by
domestic savings and industrialization occurred due to Japanese subsidiaries.
However, speculative capital flows, particularly from developed economies
eventually led to currency crises. The Thai government had maintained a fixed
exchange rate and rising demand for Thai currency, baht had led to increase in
the money supply that threatened to make the exchange rate non-competitive.
Over time, imports rose, and exports fell. The trade deficit worsened as a
result. This led to a fall in investor’s confidence. The souring of Japanese
currency also contributed to fall in desirability of the “emerging economies”
attractiveness. The handover of Honk Kong sovereignty on July 1, 1997 was the
final trigger for growing panic in the market about the success of Asian
economies. The next day, the Thai stock market crashed, and the government was
forced to allow the currency to float and depreciate. The crises had officially
begun. It spread widely to most of the South East Asian economies particularly
and heavily affected USA.
4. Wall Street Crash
This was the most shocking crash of the United States Stock
Market. It began in October 1929. Also known as black Monday, it came as a blow
to the market which was riding on the highs of early 1920s. There was a feeling
of euphoria in the market that the stock market would rise indefinitely, and
that wealth would keep on rising. There was a warning bell of crash in March
1929 that had been warded off by the efforts of National City Bank. The
previous prosperity had encouraged people to take more loans, and the stock
market rise was considered a good sign. However, the economy was not doing
well in the late 1920s. The production of steel, construction activity and car
sales were all going down. Consumers had built up large debts due to easy
credit. An over-supply of wheat depressed prices and farmers were losing
heavily. The fall of commodity markets shook American confidence and eventually
the faltering trend of the stock market reflected this. Thus a period of panic
selling started and further worsened the self-fulfilling prophecy that the
market would go down even more.
3. The Great Depression
It was the worst economic disaster of the 20th century and
started in 1930s. Many countries of the world, especially the heavily
industrialized ones were badly affected by contraction in output growth, high
unemployment, severe deflation and fall in trade. This lasted till 1933 in USA,
but many countries were affected even till World War II period. Many
explanations operate to explain why this crises happened in the first place.
The major trigger is said to be the Wall Street Crash of 1929 which caused many
USA citizens to lose a chunk of their incomes. An agricultural drought
occurred in 1930 that worsened the agricultural scenario in the country. There
was already a contraction in steel, mining and construction prevailing. The
enactment of Smoot-Hawley Act by USA to protect the competitiveness of its
currency also worsened international trade scenario. The decline of USA led to
a transmission effect to other parts of the world. Each country’s difficulties
were either worsened and improved because of prevailing structural component
and regulatory environment. However, one aftermath of this event was the
implementation of social democracy in European countries after World War II.
2. Eurozone Crises
This is an ongoing crisis that began in 2009 in the European
region. It occurred due to growing fears of defaults by sovereigns of the
European Union, particularly Greece, Portugal,Ireland, Spain and Italy. It
exposed the fiscal inefficiencies of many countries. Previously in 1992, the
members of the EU had signed the Maastricht Treaty which designated the levels
of necessary levels of fiscal performance. However, countries like Greece spent
heavily on public sector wages and social payments. The means to achieve the
funds was done by securing future payments. This meant that they borrowed today
on the basis of revenue expected to be generated later. Unfortunately, the
economic slowdown in 2008 had trimmed these future revenues. Practices had
been undertaken to evade international agreements. They were now exposed. The
banking crashes, bursting of property bubbles in the countries prompted bailout
programs to generate liquidity for these cash-strapped nations. However, much remains
to be seen before relatively bigger economies such as Spain and Italy can be
helped entirely. The main problem that exists even today is the nature of the
common euro currency that makes monetary policy inflexible while fiscal policy
was greatly undermined already.
1. Financial crises of 2008
This crises was considered the worst one since the Great
Depression itself. This easy availability of credit propelled greater demand
for housing and a bubble started. However, once this ended, there was a big
crash in housing prices. Mortgage values now exceeded the values of houses
bought. A great level of lending to less credit worthy borrowers had also
prevailed, called sub-prime lending. The existence of financial instruments
like Collateralized Mortgage obligations (CMOs) allowed the effect to spread to
the entire financial market. Financial innovations led to far greater risk
taking appetite. However, the eventual collapse of trust in the market
froze lending activity. The real economy had already begun to be affected since
2006. In 2008, this decline in investment spread further even to consumer
goods. Over time, in the summer when spending on consumption fell massively,
the economy began to decline. Big banking organizations like the Lehman
Brothers collapsed and massive bailouts started. The USA also began to import
less from the other countries and their exports languished. Thus their GDPs too
began getting affected through this route and the various financial instruments
that bound the world economy together. Credit became scarce, confidence fell
and unemployment continues to be a problem even now in the USA
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