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Analyzing Causes and Consequences of Global Financial Crisis 2008-09: Is Islamic Banking a Remedial Option?


Analyzing Causes and Consequences of Global Financial Crisis 2008-09: Is Islamic Banking a Remedial Option? Dr. S. M. Ali Akkas Director (Planning & Development) – PowerPoint PPT presentation

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Title: Analyzing Causes and Consequences of Global Financial Crisis 2008-09: Is Islamic Banking a Remedial Option?

Analyzing Causes and Consequences of Global
Financial Crisis 2008-09 Is Islamic Banking a
Remedial Option?
  • Dr. S. M. Ali Akkas
  • Director (Planning Development)
  • Bangladesh Open University

Focus area of My Discussion
  • I would concentrate on dimensions of the global
    crisis which are not touched in previous paper.
    This is just to avoid duplication in discussion.
  • Impact of global financial crisis on Bangladesh,
    policy responses and prospective economic outlook
  • Approaching analysis of global financial crisis
    from Business Cycle perspective
  • Is Islamic Banking a Remedial Option?

Collapse of US Financial System Impact on World
  • The collapse of the US sub-prime mortgage market
    and the reversal of the housing boom in other
    industrialized economies have had a ripple effect
    around the world. Furthermore, other weaknesses
    in the global financial system have surfaced.
    Some financial products and instruments have
    become so complex and twisted, that as things
    started to unravel, the trust in the whole system
    started failing.
  • Housing prices fell continuously in Japan since
    the last half of 1990s. In case of United States,
    Britain and Australia the reversal of housing
    prices started from the beginning of 2005 after
    steady rise from 1995 until it boomed in 2005.
  • The extent of this problem has been so severe
    that some of the worlds largest financial
    institutions have collapsed. Others have been
    bought out by their competitors at low prices and
    in other cases, the governments of the wealthiest
    nations in the world have resorted to extensive
    bail-out and rescue packages for the remaining
    large banks and financial institutions. The
    crisis became so severe that after the failure
    and buyouts of major institutions, the Bush
    Administration offered a 700 billion bailout
    plan for the US financial system.
  • In Europe, a number of major financial
    institutions have failed, or needed rescuing. For
    example, some nations have stepped in to
    nationalize or in some way attempt to provide
    assurance for people. This may include
    guaranteeing 100 of peoples savings or helping
    broker deals between large banks to ensure there
    isnt a failure.

The Financial Crisis and the Developing World
  • UNCTAD report, the Third World Network notes that
  • the impacts of the crisis could have around the
    world, especially on developing countries that
    are dependent on commodities for import or
  • Commodity-dependent economies are exposed to
    considerable external shocks stemming from price
    booms and busts in international commodity
  • Market liberalization and privatization in the
    commodity sector have not resulted in greater
    stability of international commodity prices.
    There is widespread dissatisfaction with the
    outcomes of unregulated financial and commodity
    markets, which fail to transmit reliable price
    signals for commodity producers.

World Financial Crisis and Bangladesh
  • 1. Impact on Stock Market
  • While other emerging economy stock markets have
    crashed, cut in half in a couple of months, the
    Bangladesh bourses have only experienced a mild
    correction - down 11 per cent from their peaks.
    There are two key reasons
  • First, foreign capital inflow limited (closer to
  • Second, banks iand other financial institutions n
    Bangladesh not affected by the global financial
    meltdown, which have heavy concentration in
    stock exchange (44.23 of Dhaka Stock Exchange).

World Financial Crisis and Bangladesh..Contd.
  • 2. Impact on the Export-oriented Sector
  • Rather than being affected instantly by the
    global financial crisis, Bangladesh's apparel
    sector bagged adequate orders for ready-made
    garments (RMG) up to November 2008.
  • But with the global recession prolonging, some
    garment industries have reportedly started to
    feel the impact.

World Financial Crisis and Bangladesh..Contd.
  • 3. Impact on Real Estate Sector
  • The country's housing sector is likely to face a
    slump due to the ongoing financial crisis in
    developed countries.
  • As a result of a prolonged economic crisis,
    Bangladeshi expatriates living in the USA,
    Britain and other countries might face job cuts.
    This will hit real estate sector hard as they are
    major buyers of Bangladesh real estate sector.
  • Bangladeshi expatriates are engaged in
    construction work and self-employed as taxi
    drivers abroad. So they will be the victims of
    the recession.
  • The country's real estate sector which had been
    growing at a pace of double digit until 2006
    could have a negative growth in 2009 and 2010 as
    a result of global recession.

World Financial Crisis and Bangladesh..Contd.
  • 4. Impact on Rural Bangladesh
  • The country's shipments of primary and
    agriculture products such as shrimps, jute and
    jute goods, vegetables, betel leaf, cut flowers
    are sliding fast amid a global recession,
    dragging down export growth and directly hitting
    millions of rural people.
  • Both raw jute and jute goods such as yarn,
    hessian and sackings have been faring worse since
    the economic crisis gripped the developed nations
    in the latter half of 2008. Jute spinners have
    shut down three factories, shed some 25,000 jobs
    and cut raw jute purchases to cope with ebbing
    demand caused by the global economic crisis.
  • European Union sees Bangladesh's economy,
    particularly exports and remittances, to be hit
    hard in the next fiscal year, beginning in July
    2009 due to falling demand for Bangladeshi
    products and workers. Overseas jobs for
    Bangladeshis fell 38 percent in the first quarter
    of 2009 due to declining demand in major labour
    markets, including Saudi Arabia, United Arab
    Emirates and Malaysia.

The Causes of the Crisis
  • 1. Personifying the Responsibility
  • Some analysts hold former Federal Reserve Board
    Chairman Alan Greenspan, Treasury Secretary
    Robert Rubin, and SEC Chairman Arthur Levitt for
    not regulating financial instruments known as
    derivatives. According to these analysts, it was
    the collapse of a specific kind of derivative,
    the Mortgage Backed Security, that triggered the
    economic crises of 2008. It was Alan Greenspan's
    actions and inactions that triggered the economic
    crises of 2008, wrote attorney Timothy D. Naegele
    producing economic tsunami that has been rolling
    worldwide with devastating effects. He asserts
    that Greenspan is the architect of the enormous
    economic "bubble" that burst globally.
  • 2. Unregulated Practice of Neo-liberal Ideology
  • What followed that crisis was not an egalitarian
    restructuring of world-trade relations but the
    rise of a neo-liberal ideology in the late 1970s
    that was embodied in Reaganomics and Thatcherism
    in the global north and the Washington consensus
    and structural adjustment in the global south.
  • 3. Flawed Institutions of often referred New
    Financial Architecture
  • The ultimate cause of the current global
    financial crisis is to be found in the deeply
    flawed institutions and practices of what is
    often referred to as the New Financial
    Architecture (NFA) a globally integrated system
    of giant bank conglomerates and the so-called
    'shadow banking system' of investment banks,
    hedge funds and bank-created Special Investment
    Vehicles. The NFA has generated a series of
    ever-bigger financial crises that have been met
    by larger and larger government bailouts.
  • 4. Deregulation and Risk Shifting by Banks to
    Investment Banks
  • Change in the focus of banking activity. While
    banks did provide credit and create assets that
    promised a stream of incomes into the future,
    they did not hold those assets any more. Rather
    they structured them into pools, securitized
    those pools, and sold these securities for a fee
    to institutional investors and portfolio
    managers. Banks transferred the risk for a fee,
    and those who bought into the risk looked to the
    returns they would earn in the long term. The
    role of assessing risk was given to private
    rating agencies, which were paid to grade these
    instruments according to their level of risk.
    Investment banks served as prime brokers for
    these funds and therefore provided them credit.

The Missing Context of Global Financial Crisis
Analysis A Deliberate Avoidance?
  • The global financial crisis that started with the
    bursting of October 2008 US financial bubble is
    not an isolated phenomenon rather it is deeply
    linked to the recession of US economy following
    the boom in November 2007.
  • The U.S. recession that began in December 2007 is
    expected to be the longest in post World War II
    history, according to the latest survey of
    business economists by Blue Chip Economic
    Indicators. The January 5th-6th poll of 52
    economists from top financial firms,
    manufacturers and academia found that most
    expected a tepid recovery to begin later this
    year, with growth returning to more normal levels
    in 2010.
  • This recession is predicted to be the longest
    because it will exceed the 16-month long
    recessions of 1981-1982 and 1973-1975. The other
    recessions occur during 1990-91 and 2000-01.
  • Why the Avoidance? Perhaps, it uncovers devils
    Olympiad of conventional banking based on

G-20 Interpretation
  • 15 November 2008, leaders of the Group of 20
    cited the following causes
  • "During a period of strong global growth, growing
    capital flows, and prolonged stability earlier
    this decade, market participants sought higher
    yields without an adequate appreciation of the
    risks and failed to exercise proper due
    diligence. At the same time, weak underwriting
    standards, unsound risk management practices,
    increasingly complex and opaque financial
    products, and consequent excessive leverage
    combined to create vulnerabilities in the system.
    Policy-makers, regulators and supervisors, in
    some advanced countries, did not adequately
    appreciate and address the risks building up in
    financial markets, keep pace with financial
    innovation, or take into account the systemic
    ramifications of domestic regulatory actions."

Business Cycle Approach to Financial Crisis
  • Pro-cyclicality of Financial Institutions
  • The foregoing analyses of the credit crunch have
    all blamed the wrong Fed policy, deregulation or
    the bad innovation of so-called credit
    derivatives, and last but not the least, the
    failure of the financial system in managing risk
    and allocating capital, the systemic
    inefficiency, as mentioned by Joseph Stiglitz.
  • It is the fragility of the conventional banking
    system based on interest, which is the internal
    cause of accelerating business cycle. It is the
    spread between the fixed payment commitments to
    bank against uncertain cash flow of the borrowers
    that widens while the economy switches over from
    boom to recession. The implication is that
    interest-based conventional banks become
    desperate in recovering dues from the borrowers
    leading to foreclosure of already sick
    enterprises, bring other solvent ventures in line
    of foreclosure diverting funds from these units
    to the already sick ones.

Business Cycle Approach to Financial Crisis
  • Pro-cyclicality of Financial Institutions
  • Nouriel Roubini cites the great but relatively
    unknown Post-Keynesian economist Hyman Minsky in
    his latest despatch about the state of US
    financial markets and economy. Minskys main
    contribution to economics was a model of asset
    bubbles driven by credit cycles. In his view,
    periods of economic and financial stability lead
    to a lowering of investors risk aversion and a
    process of releveraging. Investors start to
    borrow excessively and push up asset prices
    excessively high. In this process of releveraging
    there are three types of investors/borrowers.
    First, sound or hedge borrowers who can meet
    both interest and principal payments out of their
    own cash flows. Second, speculative borrowers
    who can only service interest payments out of
    their cash flows. These speculative borrowers
    need liquid capital markets that allow them to
    refinance and roll over their debts as they would
    not otherwise be able to service the principal of
    their debts. Finally, there are Ponzi borrowers
    who can service neither interest nor principal
    payments. They are called Ponzi borrowers as
    they need persistently increasing prices of the
    assets they invested in to keep on refinancing
    their debt obligations.
  • The other important aspect of the Minsky Credit
    Cycle model is the loosening of credit standards
    both among supervisors and regulators and among
    the financial institutions/lenders who, during
    the credit boom/bubble, find ways to avoid
    prudential regulations and supervisions.
  • The Minsky idea of loosening of credit/lending
    standards among mortgage lenders is also now
    evident in the recent mortgage credit cycle. A
    supervisory ideology that tried to minimize any
    prudential supervision and regulation and totally
    reckless lending practices by mortgage lenders
    led to a massive housing and mortgage bubble that
    has now gone bust. The toxic waste in the
    aftermath of this bust includes more than fifty
    subprime lenders going out of business this year,
    soaring rates of delinquency, default and
    foreclosure on subprime, near prime and
    non-conventional mortgages, and the biggest
    housing recession in the last few decades since
    the Great Depression of the 1930s.

Business Cycle Approach to Financial Crisis
  • Pro-cyclicality of Financial Institutions
  • While the process of releveraging started in the
    household sector, the releveraging more recently
    spread to the corporate and financial system. In
    the corporate sector, given the cheapness - until
    recently - of credit, there was a massive switch
    from equity to debt that took the form of
    leveraged buyouts, share buybacks and
    privatization of formerly public companies. This
    releveraging fed that equity/asset bubble as
    expectations of more LBOs occurred, equity
    valuation of many firms went higher and higher.
    The excesses took recently the form of premia of
    40-50 or higher on the stock price of firms that
    were a leveraged takeover target. Also, the
    amount of issuance of low grade corporate bonds
    (below investment grade junk bonds) had been
    rapidly rising in the last few years.
  • While pure Ponzi borrowers were not as common
    in the corporate system, there is wide evidence
    of speculative borrowers who relied and still
    rely on continued refinancing of their debts.

Business Cycle Approach to Financial Crisis
  • Need for a Counter-Cyclical Banking System
  • The foregone Roubini interpretation of Minisky
    Credit Cycle applied to the last three credit
    boom and asset bubbles, including the recent one
    in October 2008, may be summarized as follows
  • all of the three credit cycles started with the
    economic boom and ended with recession. That
    means, each credit cycle is linked to business
    cycle with the implication that crisis in
    financial sector generates instability in real
    sector following each boom and accelerates
    recession or depression in the economy.
  • In other words, the financial sector has a
    pro-cyclicality effect on the real sector and
    that works through the fixed payment commitment
    of the borrowers against their uncertain cash
    flows an uneven contractual practice between
    the traditional financial institutions and the
    borrowers expediting credit defaults,
    foreclosures and deepening recession, thereby
    aggravating business cycle each time.

Business Cycle Approach to Financial Crisis
  • Need for a Counter-Cyclical Banking System
  • In a recent conference Building an International
    Monetary and Financial System in 21st Century
    Agenda for Reform held in New York during
    November 24-25, 2008 Erich Harbrecht, Head of
    International Financial System Division, Deutsche
    Bundesbank said
  • IMFs main task would be to analyze the
    interaction between the real economy and the
    financial system, and monitoring, particularly
    while implementing supervisory standards and
    stability risk in the context of Article IV
    consultations and the ESAP
  • Some participants in the conference argued that
    Basel II had enhanced pro-cyclicality and the
    three-pillar system (minimum capital
    requirements, supervisory review, and market
    discipline) was inadequate. In this regard
    prudential regulation should become anti-cyclical
    rather than pro-cyclical. The real challenge lies
    in the pro-cyclicality of banking, not in the
    pro-cyclicality of the capital regime.
  • This calls for bringing reforms in contractual
    obligations of and relationship between the
    financier and borrower so that corrective
    measures can be taken towards removing
    pro-cyclical character of the financial

Is Islamic Banking a Remedy to Global Financial
  • Dr. Umer Chapra, an Islamic Finance expert has
    said in the first of the IIBI lecture series that
    Islamic financial system is capable of minimizing
    the severity and frequency of financial crises by
    getting rid of the major weaknesses of the
    conventional system. It introduces greater
    discipline into the financial system by requiring
    the financier to share in the risk. It links
    credit expansion to the growth of the real
    economy by allowing credit primarily for the
    purchase of real goods and services which the
    seller owns and possesses, and the buyer wishes
    to take delivery. It also requires the creditor
    to bear the risk of default by prohibiting the
    sale of debt, thereby ensuring that he evaluates
    the risk more carefully. In addition, Islamic
    finance can also reduce the problem of subprime
    borrowers by providing credit to them at
    affordable terms. This will save the billions
    that are spent after the crisis to bail out the
    rich bankers. These do not, however, help the
    poor because their home may have already become
    subject to foreclosure and auctioned at a
    give-away price.
  • The problem is that the Islamic finance is still
    in its infancy and shares a very small proportion
    of international finance. In addition, it does
    not genuinely reflect the ethos of Islamic
    teachings. The use of equity and PLS is still
    very small while that of debt-creating modes is
    preponderant. Moreover, even in the case of
    debt-creating modes, all the conditions laid down
    by the Shariah are not being faithfully observed
    by the use of legal stratagems (hiyal). This is
    partly due to a lack of proper understanding of
    the ultimate objectives of Islamic finance, the
    non-availability of trained personnel, and the
    absence of a number of shared or support
    institutions that are needed to minimize the
    risks associated with anonymity, moral hazard,
    principal/agent conflict of interest, and late
    settlement of financial obligations. The system
    is, thus, not fully prepared at present to play a
    significant role in ensuring the health and
    stability of the international financial system.
    It is, however, expected that the system will
    gradually gain momentum with the passage of time
    and complement the efforts now being made
    internationally for promoting the health and
    stability of the global financial system.

  • Recession follows every boom that has been the
    usual feature of the market economy. When the
    boom turns to recession, financial bubbles burst
    a scenario repeatedly orchestrated in the world
    history of economic development. The havoc starts
    every time with the collapse of a certain thrust
    sector, this time the housing. Artificial pouring
    of money in the housing sector through a
    securitization process by means of derivatives,
    the so-called financial innovations, is now
    blamed to be the culprit of the perceived worst
    ever disaster, an analysis within a capitalist
    frame of reference where recurrence of business
    cycle is taken as a rule and the conventional
    banking system based on interest has nothing to
    do with it a perception little questioned.
    Therefore, adoption of conventional fiscal and
    monetary measures together with bringing back the
    conventional banking to regulatory framework has
    so far been the policy recommendation by most
  • The implication of this sort of prescription is
    that the taxpayers of the national economies
    should be ready for contributions to bailout
    packages for financial institutions each time of
    the business cycle havoc. This is tantamount to
    making taxpayers, instead of the central bank or
    sovereign, the lender of the last resort. This is
    a situation which indicates systemic failure of
    the conventional banking system . The change in
    structure is expected to be counter-cyclical in
    nature. Moreover, the reformed banking structure
    should have built-in systemic linkages to the
    real-sector economy. In other words, the changed
    banking structure should have a kind of
    contractual obligation bonding the bank and the
    borrowing investors in the real sector enabling
    the mechanism to counter downswing of the
    business cycle.
  • Islamic Banking in its pure form has its built-in
    counter cyclical operational framework and is
    directly linked to the real sector economy.
    However, it is yet to develop as a PLS-banking
    system in investment financing, and thus can
    hardly claim to be a financial system which is
    counter-cyclical and fully linked to real sector
    economy. The reason for Islamic banks world over
    have had not yet been shattered by the current
    global financial crisis is its non-adherence to
    develop so-called credit derivatives, and that it
    does not deal in debt trading and distances
    itself from market speculation and the shock
    absorption capability it has in the deposit side
    by offering flexible profit rates to the
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