gousia mir & malik bilal: global financial crisis & islamic equity instruments: a profile of...

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“ GLOBAL FINANCIAL CRISIS & ISLAMIC EQUITY INSTRUMENTS:

A PROFILE OF SURVIVAL”

The Dissertation

Submitted In Partial Fulfillment Of The Requirement For Masters In

Islamic Studies.

Submitted By

Bilal Malik (IS-10-16)

Gousia Mir (IS-10-26)

Under the Supervision Of

Dr. Showkat Hussain

(Assistant Prof Dept. of Islamic Studies)

DEPARTMENT OF ISLAMIC STUDIES

ISLAMIC UNIVERSITY OF SCIENCE AND TECHNOLOGY,AWANTIPORA

(2012)

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ACKNOWLEDGEMENT

All praise be to Allah, the lord of the worlds, who gave us accession of thought to

learn.

This dissertation would have not been possible without the help and support of

many people.

First and foremost we would like to thank Dr. Showkat Hussain, Incharge

Department of Islamic Studies, our dissertation supervisor. We owe a debt of

gratitude to him for his high level of interest, enthusiasm and unending help

throughout the completion of the study.

Secondly, we are thankful to all faculty members of the Department of Islamic

Studies, the non-teaching staff of the said department, the people associated with

SEC(skill enhancement center) for their assistance.

We are also thankful to our friends and batch mates for their valuable suggestions

throughout the study.

At last but not least we are thankful to our parents and family members whose

encouragement and cordial support became a source of inspiration for us.

Gousia Mir Bilal Malik

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TABLE OF CONTENTSTABLE OF CONTENTSTABLE OF CONTENTSTABLE OF CONTENTS

INTRODUCTION 1-4

1. GLOBAL FINANCIAL CRISIS:ITS CAUSES & IMPACT

1.1 Globalisation and the global financial crisis 5-6

1.2 Origin of the crisis 6-7

1.3 Causes of the current global financial crisis 7-9

1.3.1 Excessive and imprudent lending 9-12

1.3.2 Securitization 12-15

1.3.3 Regulatory Failure 15-17

1.3.4 Over-Leveraging 17-19

1.3.5 Inherent Stability 19-20

1.4 General Impact of the global financial crisis 20-21

1.4.1 Impact of GFC on finance sector 21-22

1.4.2 Impact of GFC on Conventional finance industry 22-26

1.4.3 Impact of GFC on Islamic finance industry 26-31

2. LITERATURE REVIEW

2.1 Books 32-50

2.2 Articles and Research Papers 51-61

3. ISLAMIC EQUITY INSTRUMENTS

3.1 Islamic Equity Instruments 62-63

3.2 Musharakah (Equity Participation) 63-64

3.2.1 Application and Scope 64-68

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3.3 Murabahah (Cost-Plus Sales) 68-70


3.4 Mudarabah (Co-Partnership Sales) 73-74


3.5 Ijarah (Lease Contract) 75-77


3.6 Takaful (Islamic Insurance) 78-81

3.6.1 Application and Scope 81

3.6.2 Mudarabah Model 81-82

3.6.3 Wakalah Model 82-83

3.6.4 Waqaf Model 83-84

3.6.5 Microtakaful 84

3.7 Sukuk (Islamic Bond) 84-85

3.7.1 Ijarah Sukuk 85-86

3.7.2 Murabahah Sukuk 86

3.7.3 Convertible Sukuk 86-87

3.7.4 Musharakah Sukuk 87

4. RELEVANCE

4.1 Current Position of Islamic Finance Industry: A Brief Review 88-93

4.2 Islamic Banking Investment: A Flourishing Sector 94-98

4.3 Islamic Banking in MENA Region: A Growing Trend 98-100

4.4 Growth of Islamic Takaful Industry 100-103

4.5 Sukuk: A Global Success for Islamic Finance Industry 103-107

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5. CONCLUSION 108-110

6. REFRENCES 111-119

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FIGURES

1. Graph showing chronological list of various crisis. 8

2. Graph showing rise in U.S subprime lending between 2004-2006. 10

3. Graph showing Securitization market activity. 15

4. Leverage ratio of various banks from 2003-2007. 18

5.Initial effects of crisis on conventional and Islamic banks. 29

6. IMF staff estimates and calculations. 30

7. Mechanism of Musharakah contract. 64

8. Mechanism of Murabaha contract. 70

9. Mechanism of Mudarabah contract. 74

10. Diagram of Mudarabah model. 82

11. Wakalah Takaful diagram. 83

12. Graph showing global assets of Islamic finance. 92

13. Graph showing banking assets in Mena region. 100

14. Graph showing Global Takaful Market. 101

15. Graph Showing Global Sukuk Issues. 103

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INTRODUCTION

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INTRODUCTION

Periodic crises appear to be part of the financial systems of dominant and global

powers. The 2008 global financial crisis that started in the U.S in late 2007 has

given a wide array of impacts to operating and financial performance of many

banks all over the world. The severity of the current crisis has led to the

evaluation that, world economy has entered a phase of extraordinary instability

and its future course is absolutely uncertain. Enjoying a unipolar moment

following the collapse of the Soviet Union and the failure of Communism, the

United States was confident that economic liberalization and the proliferation of

computer and communications technologies would contribute to ever-increasing

global economic growth and prosperity. Globalization contributed to the

extraordinary accumulation of wealth by a relatively few individuals and created

greater inequality. The golden years of capitalism ended when U.S President

Nixon in 1971 suspended the convertibility of the US dollars which brought an

end to the fixed exchange rate - the basis of Bretton Wood’s system. The end of

Bretton Wood system diminished the relationship between real money and real

assets and built the market sentiments upon confidence and trust. One can say

that it was a time of transition of capitalism to financialization or finance-led-

capitalism. Under this new economic system financial institutions enjoyed the

right to raise capital for the purpose of creating, selling and trading securities and

derivatives that do not finance industry but rather trade within markets.

The main characteristics of this new economic system as described by Pereira

(2010) are firstly, the increase in the value of financial assets as consequences of

the multiplication of financial assets due to securitization and derivatives.

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Secondly, finance-led-capitalist leads to the innovation of creating fictitious

financial wealth that only helps capitalist renters. It can be seen that under

financialization, credit ceased to exist from bank to business but was channelized

through securities traded in financial markets that are pension funds, hedge funds

and mutual funds. Pereira (2010) stated that the financial crisis was the

consequence of financialization that created fictitious financial wealth that began

in 1980s and the consequence of the neoliberalism, which believed in the transfer

of power from public to private sector, based on self-regulated markets.

The onset of the present crisis can be traced back to July 2007 with the liquidity

crisis due to the loss of confidence in the mortgage credit markets in the United

States. At first, there was uncertainty about the possible spillovers to the rest of

the economy, and there was also discussion about the risks of contagion and

decoupling, that is to say, the capacity of other countries – especially developing

countries – to isolate themselves from the problems originating in the United

States (which is the largest market for many countries). The hope was that the

crisis would be restricted to financial markets, with few repercussions on the real

economy and the rest of the world. This hope was shattered in September 2008

as the crisis entered an acute phase, with strong downward fluctuations in the

stock markets, substantially reduced rates of economic growth, volatile exchange

rates, and squeezes in demand and consumption, leading to falls in industrial

production and decreasing flows of international trade and FDI, and causing

impacts on related areas such as transfer of technology. As a result, many banks

across the world reported financial loss on their financial report due to their

connections with subprime mortgage in the U.S. or were simply affected by

economic recession in their own countries. The impact of the crisis have even

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forced around 123 banks in the U.S. to file for bankruptcy in the year, including

American giant bank Lehman Brother that was never been expected to fail. The

crisis has also been accompanied by increases in unemployment, with

concomitant declining incomes and demand. The situation have encouraged

economic analysts to construe this crisis to be the most severe since the Great

Depression of the 1930s, crude oil prices have seen yet another historical hike

since 2003. It is in the light of these two major global recessions that Islamic

finance has experienced its conception and renaissance. Through the lens of

Islamic economic thought, it is clear that “in the absence of a moral

transformation and change in economic thinking, any effort by governments to be

realistic promotes recession, unemployment, and unrest” (Chapra,1985). This

trend has given rise to an increasing appeal of Islamic finance to Western policy

makers. In fact, besides a remarkable influx in the amount of Islamic banks and

banking units in the Middle East and Asia, Western banking institutions have

commenced offering Shari’ah-abiding financial products. European governments

such as France, Germany, and The Netherlands have voiced their interest in

Islamic finance and instructed policy makers to generate a legal framework in

order to pave the way for Islamic financial products to enter Western financial

markets. What is more, since 1999, the Dow Jones has been issuing financial

information on Shari’ah-adhering companies under the umbrella of the Dow

Jones Islamic Market Indexes, in order to cater toward Muslim investors who

prefer to invest in accordance with the teachings of the Quran.

The present study has been compiled to bring forth the detailed summary about

the causes and the impact of the crisis on both conventional as well as Islamic

financial industry. It will also discuss the nature, mechanism, and scope of some

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significant financing instruments used by the Islamic finance industry. Also a brief

summary has been made with the help of empirical data in order to search out

the current position and relevance of the Islamic finance industry in the current

financial scenario. Overall content of the dissertation has been segmentized into

four chapters as per the subject matter of the dissertation. A brief introduction

has been added up at the beginning and finally a precise conclusion at the end.

Throughout the completion of the study near about 20 books and more than 80

articles have been consulted and the selection of literature was done as per the

relevance with the objective of the study.

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Chapter - 1

GLOBAL FINANCIAL CRISIS:

ITS CAUSES AND IMPACT

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1.1 GLOBALISATION AND THE GLOBAL FINANCIAL CRISIS

Globalization is a multi-dimensional process of economic and structural

transformation that has a variety of meanings and interpretations. It generally

refers to both the increasing flows of capital, goods and resources and knowledge

across national boundaries and to the emergence of a complementary set of

organizational structures to manage the expanding network of international

economic activity and transactions. However defined, globalization has led to the

greater integration of national economies through trade liberalization, financial

sector deregulation and capital account liberalization, and flows of Foreign Direct

Investment (FDI) by Transnational Corporations (TNCs). Globalization has opened

up new opportunities to low and middle income countries, through improved

market access, increased flows of FDI, often integrating them into Global Value

Chains (GVCs) or Global Production Networks (GPNs) and accelerated technology

transfer, both product and process technologies.1

Global financial crisis has been defined as a situation, where in the worldwide

integrated economy, in the form of financial institutions, banks or assets suddenly

lose a large part of their value, generally accompanied by banking panics, stock

market crashes, bursting of financial bubbles, currency crisis and sovereign

defaults.2 The 2007–2012 financial crisis, also known as the Global Financial Crisis

(GFC), is considered by many economists to be the worst financial crisis since the

Great Depression of the 1930s. The ‘sub-prime mortgage crisis’ as it is to be

1 Ludovico Alcorta and Frederick Nixson, The Global Financial Crisis and the Developing World: Impact

on and Implications for the Manufacturing Sector, United Nations Industrial Development Organization,

Vienna, 2011, P.1. 2 Prajpati Trivedi, “Global Financial Crisis: Causes And Consequences”, Indian Forum Riyadh, 2008.

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known, began with the bursting of the housing bubble in the U.S, rocked the U.K,

the Euro zone, East-Asia, and the so-called ‘emerging market economies’ and has

not yet reached its end. The crisis played a significant role in the failure of key

businesses, declines in consumer wealth estimated in trillions of US dollars, and a

downturn in economic activity leading to the 2008–2012 global recession and

contributing to the European sovereign-debt crisis The crisis threatens a

worldwide economic recession, potentially bringing to a halt more than a decade

of increasing prosperity and employment for western economies and potentially

wiping a staggering $1 trillion off of the value of the world economy.3

1.2 ORIGIN OF THE CRISIS

The current global financial crisis is rooted in the subprime crisis which surfaced

few years ago in the United States of America. During the boom years, mortgage

brokers attracted by the big commissions, encouraged buyers with poor credit to

accept housing mortgages with little or no down payment and without credit

checks. A combination of low interest rates and large inflow of foreign funds

during the booming years helped the banks to create easy credit conditions for

many years. Banks lent money on the assumption that housing prices would

continue to rise. Also the real estate bubble encouraged the demand for houses

as financial assets. Surplus inventory of houses and increase in interest rates led

to a decline in housing prices in 2006-2007 resulting in an increased defaults and

foreclosure activity that collapsed the housing market. Consequently, a large

number of properties were up for sale affecting mortgage companies, investment

firms and government sponsored enterprises which had invested heavily in

subprime mortgages. Banks and financial institutions later repackaged these 3 Carol J.William, "Euro Crisis Imperils Recovering Global Economy, OECD Warns”, Los Angeles Times,

May 22, 2012.

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debts with other high-risk debts and sold them to worldwide investors creating

financial instruments called CDOs or Collateralized Debt Obligations.4 In this way

risk was passed on multifold through derivatives trade. Since the collateral debt

instruments had been globally distributed, many banks and other financial

institutions around the world were affected. Thus with the failure of a few leading

institutions in United States, the entire financial system in the world has been

affected.5

1.3 CAUSES OF THE CURRENT GLOBAL FINANCIAL CRISIS

The world economy is still suffering from the crisis, considered the most severe

since the Great Depression, where economic downturn at historic magnitude and

many countries across the globe, irrespective of their development level, are still

under strain dealing with this crisis. The severity of the crisis can be visualized

from the fact that it spilled from the financial sector to the real economy,

including international trade in manufactures commodities and services.

According to one estimate, there have been more than 100 crises over the last

four decades but none could be brought in comparison to the current financial

crisis in terms of consequences.6 There has been burgeoning literature compiled

on the GFC, Which is characterized by agreements and disagreements about its

main causes. The U.S. Senate's Levin–Coburn Report asserted that the crisis was

the result of "high risk, complex financial products, undisclosed conflicts of

interest, the failure of regulators, the credit rating agencies, and the market itself

4 Ross Morrow, “A Critical Analysis Of the U.S. Causes Of The Global Financial Crisis 2007-2008” ,

Marxism Fresh Daily, Jan 4, 2011. 5 Tito Boeri and Luigi Guiso, “The Sub-prime Crisis: Greenspan’s Legacy”, in Andrew

Felton and Carmen Reinhart, eds., The First Global Financial Crisis of the 21st Century, July 2008, p.38. 6 Joseph Stiglitz “Dealing with Debt: How to Reform the Global Financial System”,

Harvard International Review, 2003, pp.54-59.

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to rein in the excesses of Wall Street.7 A healthy bench of economists like

Dell’Ariccia, 2008, Igan, 2009, Leaven, 2010, Danielson, 2008, Alarag, 2009,

Stiglitz, 2009, Butler, 2010 and others have discussed the role of inherent

uncertainty in conventional financial operations in bringing out the current global

financial crisis in the form of subprime lending boom. On the other hand Muslim

economists (e.g., Siddiqui, 2009, Chapra, 2009, Bag siraj, 2009, Hussain, 2010,

Khursheed, 2012) continually refer to the global economic crisis as a result of

interest- based financial operations. As mentioned above that economists view

the current financial crisis as the greatest one that beat the world economy, even

if compared with the great Depression in 1930’s. Ali Sakti’s chronological list of

various crises in graphical form is evident to the above fact.8

Figure No.1 Source: Ali Sakti’s Chronological Crisis Graph9

7 Senate Financial Crisis Report, http://hsgac.senate.gov/public/ , Retrieved April 22, 2011. 8 Miranti Kartika Dewi and Ilham Reza Ferdian, ‘Islamic Finance: A Therapy for Healing the Global

Financial Crisis’ , Centre for Islamic Economics and Business, University of Indonesia, 2009. 9 Ali Sakti, “Islamic Economic: Challenges And Opportunities Of Monetary Authority In The Global

Financial Crisis” Paper presented on Public Lecture Series held by Centre of Islamic Economics and

Business, Faculty of Economics, University of Indonesia, Depok, Indonesia, February 18, 2009.

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Many risk spreads have ballooned, liquidity in some market segments has dried

up, and large complex financial institutions have admitted significant losses.

These events have challenged policymakers, and the responses have varied across

region. The European Central Bank has injected reserves in unprecedented

volumes. The Bank of England participated in the bail-out and, ultimately, the

nationalization of a depository, Northern Rock. The U.S. Federal Reserve has

introduced a variety of new facilities and extended its support beyond the

depository sector. These events have also challenged economists to explain why

the crisis developed, how it is unfolding, and what can be done.10

However, as

always done by a doctor before suggesting any medical treatment to his patient,

it is more significant firstly to observe the ground of the problem. Thus before

discussing the consequences of the GFC or any reformative policy in connection

to smooth functioning of the financial institutions worldwide, it is important to

describe some of the determinant causes responsible for GFC.

1.3.1 Excessive and imprudent lending

Economists have undoubtedly identified a number of causes responsible for the

crisis. The generally recognized most important cause is, however, excessive and

imprudent lending by banks.11

The best example in this regard is US subprime*

mortgage crisis. Intense competition between mortgage lenders for revenue and

market share, and the limited supply of creditworthy borrowers, caused mortgage

lenders to relax underwriting standards and originate riskier mortgages to less

10 Carmen M. Reinhart, ‘The First Global Financial Crisis Of The 21st Century: Introduction’, in Andrew

Felton and Carmen Reinhart, eds., The First Global Financial Crisis Of The 21st Century, July 2008. 11 Mohammad Umer Chapra, “The global financial Crisis: Can Islamic Finance Help?”, New Horizon, Issue

no: 170, Jan-Mar 2009, p.20.

*Subprime loan is a type of loan that is offered at a rate above prime to individuals who do not qualify

for prime rate loans. The loan is usually stipulated with a relatively higher interest rate because it is

often issued to a higher-risk borrower.

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creditworthy borrowers. Most of the US’s banks got indulged in this practice with

an intention to maximize their profits, adopting the policy ‘more credit they

extend, the higher will be the profit’. Prime mortgages dropped to 64% of the

total in 2004, 56% in 2005, and 52% in 2006, meaning that nearly half of the

mortgage originations in 2006 were subprime, Alt-A*, or home equity loans.

Figure No.2 Source: Harvard University Report, 200812

Even the government-sponsored enterprises (GSEs), Fannie Mae and Freddie

Macs**, were caught-up by the apparent glamour of housing market, as they

12 U.S Census Bureau, Harvard University, State of the Nation’s Housing Report, 2008. *Alt-A mortgage loans are made to borrowers with pretty good credit ratings but who do not provide full income

and asset documentation

**U.S government sponsored, biggest underwriter of home mortgages. .

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sought to expand home ownership for the benefits it brings in terms of sustaining

neighborhoods.

It has been observed that lending standards deteriorated around 2004 or 2005.

Families that lacked the income and down payment to buy a house under the

terms of a mortgage were encouraged to take out a mortgage that had a very

high loan-to-value ratio, perhaps as high as 100% (often using second or even

third mortgages). As it became easier to borrow using a home as collateral and as

home prices continued to rise, families started using their homes as an ATM,

refinancing and taking out any equity that had built up. Americans were tapping

into the rising wealth they had in their homes in order to finance consumption.

Greenspan and Kennedy (2007) estimate that homeowners extracted US$743.7

billion in net equity from their homes at the peak of the housing boom in 2005, up

from US$229.6 billion in 2000 and US$74.2 billion in 1991. The increase in house

prices allowed a borrowing spree.13

This policy created a situation of ‘high supply and high demand’ of money in the

market and banks earned a healthy proportion of wealth in the first two, three

years. It was unfortunate that this policy couldn’t help the US mortgage industry,

the world’s best, to go for a long run. By September 2008, average U.S. housing

prices had declined by over 20% from their mid-2006 peak. As prices declined,

borrowers with adjustable-rate mortgages could not refinance to avoid the higher

payments associated with rising interest rates and began to default. During 2007,

lenders began foreclosure proceedings on nearly 1.3 million properties, a 79%

increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs.

13 Martin Neil Baily and Douglas J. Elliott, “The Causes Of The Financial Crisis”, published by World

Scientific Publishing Co. Pte. Ltd In “The International Financial Crisis- Have the Rules of Finance

Changed?”, 2009, pp.61-62.

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2007. By August 2008, 9.2% of all U.S. mortgages outstanding were either

delinquent or in foreclosure. By September 2009, this had risen to 14.4%. The

situation became much worse when banks became reluctant to lend each other

and ultimately the bubble burst-out, resulted constrain in US economy.14

Although it is impractical to single out one factor as being the source of financial

crisis, but it is not wrong to argue that the main cause of financial crisis can be

attributed to the laxity of lending standards adopted by conventional financial

institutions – driven by greed and appetite for higher returns, and facilitated by

the absence of adequate and appropriate government regulatory control. This

easy approach to lending when practiced over an extended period of time and

mixed up with other so called financial necessities like overleveraging, speculation

and securitization leads to risky a lending environment that eventually works

against the interests of both borrowers and lenders alike and ultimately ends up

with an economic downturn.

1.3.2 Securitization

The second ingredient that triggered the current global financial crisis is

securitization, which evolved as a result of un-judged financial innovations.

Historically, banks used only the money they received from depositors to lend to

borrowers. They were not able to obtain money from other sources other than

depositors. However in recent years, banks have been able to rely not only on

depositors but also on the wholesale money markets, where they could borrow

money from other banks and then resell it to their borrowers at a higher interest

rate. This secondary market was in part made possible by the creation of “credit

default swaps” (CDSs). Credit default swaps were widely used, especially by

14 MBA Survey-Q3.2009, http://www.mbaa.org, Nov.2009, Retrieved May 1, 2010.

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insurance companies such as the American International Group (AIG). These

allowed a bank to effectively insure itself against the risk that a borrower might

not pay back a loan. This led to an illusion that loans were now much lower risk

and allowed such loans to be bought and sold. This then led to the creation of

CDOs (collateralized debt obligations), which were bought by banks as interest-

bearing investments. The sub-prime lenders then invented another way of making

money in a sector which was already highly risky and this new technique was

securitization.15

Securitization is a process of financial engineering that allows global investment

to be spread out and separated into multiple income streams to reduce risk.

Securitization became an important component of financial markets in the 1980’s

and was warmly welcomed in finance sector, to be used as a weapon against the

financial crisis.16

This innovation made vast sums of money available to

borrowers. For example, securitization increased the amount of money available

to individuals purchasing homes, leading to unprecedented growth in house

prices. From 2000 to 2005, the percentage of non-conforming mortgages that

became securitized increased from 35% to 60%, and the volume of non-

conforming origination also rose dramatically. Subprime mortgage originations

rose from $160 billion in 2001 to $600 billion in 2006. And many of these

securitized mortgages became re-securitized as backing for CDOs* (Collateral

Debt Obligation). As of October 2006, 39.5% of existing CDO pools covered by

Moody’s consisted of MBS (Mortgage Backed Securities), of which 70% were

15 Abul Hassan, “The Global Financial Crisis and Islamic Banking”, The Islamic Foundation, UK, 2009 16 J. Rasmus, “The Deepening Global Financial Crisis: From Minksy to Marx and Beyond”, Critique, Vol.

36, No.1, pp.5-29.

*CDO is an instrument that redistributes the underlying risks from a mortgage or other assets lying

beneath it.

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subprime or second-lien mortgages and as of June 30, 2008, the MBS market was

worth $6 trillion, more than US Treasury bonds.17

In 2009, an estimated $8.7

trillion of assets globally were funded by securitization.18

Securitization played a main role in spreading the financial risks globally. Once

financial assets, such as debts, were securitized into MBS’s and CDO’s they were

sold to central banks, private banks and wealthy investment funds around the

world. Thus in the name of securitization, debt was sold to a third party, which

would then receive the loan repayments and pay a fee for this privilege. Thus

debt became tradable, just like a car. The ability to securitize debt provided a way

for risk to be sliced, diced and spread, allowing more mortgages to be sold.

Initially securitization process allowed originators of loans and especially of

subprime mortgages to remove part of the associated risks from their balance

sheet and reduced their regulatory capital requirement, as long as interest rate

remained low and house prices appreciated the issue volume of mortgages as

well as other loans massively increased because most of these loans were

securitized the volume of ABS’s, MBS’s and CDO’s rose as well.

17 Charles W. Calomiris, “Not (yet) a Minsky Moment” , in Andrew Felton and Carmen Reinhart, eds., The

First Global Financial Crisis of the 21st Century, July 2008, p.78. 18 “Too Big to Swallow,” Economist, 16 May 2009, 11.

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Figure No.3 Source: Thomson Reuters SMA Graph

The risk embedded in mortgages and especially in related securities was hidden

for quite for some time. However, as interest rates rose and the housing price

tumbled, mortgage delinquency and foreclosure rates drastically increased. The

degree to which mortgage markets impacted financial instruments and financial

markets drastically overcome all market participants’ expectations.

1.3.3 Regulatory Failure

As the global financial crisis unfolded, it was obvious that many of those in the

banking and investment communities did not fully comprehend how the financial

system they created functioned, or the scope and severity of the crisis. The

financial wizards, the best and the brightest from leading business schools, could

not really explain what was happening on Wall Street and in global financial

markets.

The failure of regulators to force financial institutions to follow sound risk

management practices was also one of the most important reasons for the

financial crisis. The widespread belief developed over the past 20 years, that

markets can regulate themselves may have contributed to the regulatory laxity,

which in turn contributed heavily to the crisis, invalidating the argument

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promoted by free market advocates and particularly policy makers of the US

market that “markets are efficient their own” and market forces are capable of

managing and regulating market inefficiencies.19

Describing this theory as a

fundamental misconception regarding modern financial market regulation, the

UNCTD (United Nations Conference on Trade and Development) in its report has

said, the assumption that “markets know best” and that regulators should take a

back seat is a wrong argument.20

The same reality is exposed by Paul Krugman,

laureate of the Nobel Prize in Economics in his book “The Return of Depression

Economics and the Crisis of 2008”, described the run on the shadow banking

system as the "core of what happened" to cause the crisis. He referred to this lack

of controls as "malign neglect" and argued that regulation should have been

imposed on all banking-like activity.21

The housing price bubble, itself as a result

of the deregulation of financial markets on a global scale affirmed the principle,

that competitive markets are not necessarily the best co-ordination tool in the

real world. The market deregulation of international as well as national finance

has been, hence detected as the third major factor responsible for the global

financial crisis. It helped, in accelerating the development of credit overhang and

at the same time has enabled the US economy to contaminate the world.22

The

problem has occurred during an extremely accelerated process of financial

innovation in market segments that were poorly or ambiguously regulated –

19 M.Kabir Hassan, ‘’The Global Financial Crisis &Islamic Finance’’, University of New Orleans ,USA ,2008,

p.2. 20 UNCTAD’s report on “The Global Economic Crisis: Failures and Multilateral Remedies” , Geneva, 19

Mar. 2009. 21 Paul Krugman, “The Return of Depression Economics and the Crisis of 2008”, W.W. Norton Company

Limited, 2009. 22 Jacques Sapir, ‘’From Financial Crisis To Turning Point’’, Real world Economics Review, vol. 46, 2008,

p.34.

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mainly in the U.S. The fall of the financial institutions is a reflection of the lax

internal controls and the ineffectiveness of regulating oversight in the context of a

large volume of non transparent assets. It is indeed amazing that there were

simply no checks and balances in the financial system to prevent such a crisis and

“not one of the so called pundits” in the field has sounded a word of cautions.

There are doubts whether the operations of derivatives markets have been

transparent as they should have been or if they have been manipulated.

Insufficient market regulation results in failure of making institutions financial

situation publicly known (lack of transparency) and also makes it possible for

financial institutions to operate without having sufficient assets to meet their

contractual obligations. There was a general loss of control at all levels, which led

to exponential risk taking at many companies, largely hidden from public scrutiny.

Violations of financial regulations went largely unpunished23

. During the crisis,

market deregulation was at its epitome, added up with financial liberalization,

finally resulted in deepening the effects of the crisis.

1.3.4 Over-Leveraging

The global economy is facing difficult challenges, and such a situation is

attributable to the phenomenon that leverages* markedly increased around the

globe in the periods preceding the current financial crisis.24

Prior to the crisis,

financial Institutions became highly leveraged, increasing their appetite for risky

investments and reducing their resilience in case of losses. Much of this leverage

was achieved using complex financial instruments such as off-balance sheet

23 Frank Partnoy, “Infectious Greed”, New York: Times Books, Issue No. 3, 2003 24 Masaaki Shirakawa: “International Banks Amid Global Financial Crisis”, Bank of International

Settlements Review, 2009, p: 3.

*Leverage allows a financial institution to increase the potential gains or losses on a position or

Investment beyond what would be possible through a direct investment of its own funds.

26

securitization and derivatives, which made it difficult for creditors and regulators

to monitor and try to reduce financial institution risk levels. These instruments

also made it virtually impossible to reorganize financial institutions in bankruptcy,

and contributed to the need for government bailouts.25

Figure No.4 Source: Company Annual Reports (SEC Form)

Leverage ratios of investment banks increased significantly 2003–07. U.S.

households and financial institutions became increasingly indebted or

overleveraged during the years preceding the crisis.26

Free cash used by

consumers from home equity extraction doubled from $627 billion in 2001 to

$1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion

dollars over the period, contributing to economic growth worldwide. U.S. home

mortgage debt relative to GDP increased from an average of 46% during the

25

"The End Of The Affair", Economist, October 30, 2008. 26

Ibid

27

1990s to 73% during 2008, reaching $10.5 trillion.27

Although Banks intended to

make money out of this risky financial technique but unfortunately results

reversed and most of the financial institutions were caught up in bankruptcy.

1.3.5 Inherent Instability

This is the major issue that is contentiously discussed by Muslim economists as

well as healthy band of Western economists as a threat to the stability of world

economy. The crisis has shown that advanced conventional financial systems are

very vulnerable. Financial instability has been a recurring phenomenon in

contemporary economic history, affecting countries with varying intensity. The

current phase of global financial crisis has proved, what Dr. Minksy, Nobel prize-

winning economist, argued, “that the modern finance was far from the stabilizing

force that mainstream economics portrayed: rather, it was a system that created

the illusion of stability while simultaneously creating the conditions for an

inevitable and dramatic collapse”.28

Eminent economists who lived through the

Great Depression fought very hard to establish a banking system capable of

achieving and preserving financial stability. Irving Fisher, a prominent American

economist of the Great Depression era, strongly argued that two dominant

factors were responsible for each boom and depression: over-indebtedness in

relation to equity, gold, or income which starts a boom, and deflation consisting

of a fall in asset prices or a fall in the price level which starts a depression.

27 Colin Barr, "Fortune-The $4 Trillion Housing Headache", http://money.cnn.com, CNN. May 27, 2009

Retrieved May 1, 2010. 28 Rauf Mammadov, Expert views, 36 Global Islamic Finance, January, 2010.

28

American economist, Hyman Minsky, considered that conventional finance

dominated by interest-based debt contracts is inherently unstable. This assertion

is based on a construct known as Financial Instability Hypothesis (FIH), which

posits that stability is inherently unsustainable. A fundamental characteristic of a

conventional financial system, according to Minsky, is that it swings between

robustness and fragility and these swings are an integral part of the process that

generates business cycles. Talking about the working standard of conventional

banks, George Soros wrote, ‘when money is free, the rational lender will keep on

lending until there is no one else to lend to’. Rapidly expanding money and credit

combined with an ideologically-based fierce de-regulation movement which

began in the early 1980s in industrial economies and continued throughout the

next two decades. It put at high risk the financial stability of these countries and

as the result of rapid financial globalization, the rest of the world as well.29

1.4 GENERAL IMPACT OF GLOBAL FINANCIAL CRISIS

The financial crisis began in July 2007, triggered by a dramatic rise in mortgage

delinquencies and foreclosures in the United States, with major adverse

consequences for banks and financial markets around the globe. As the crisis was

worst of its kind, its far reaching repercussions were not seen only in finance

sector but also in real economy as well. According to estimates by the World

Bank, the total world economy contracted by 2.1% in 2009 – an unprecedented

fall in the post-war era. According to a report, in the OECD* area, there was an

29 Abbas Mirkhor and Noureddine Krichene, “ Resilience And Stability Of Islamic Finance”, IDB Jeddah,

2009, pp.1-2.

*The OECD (Organization for Economic Co-operation and Development) is a unique forum where the

governments of 32 democracies work together to address the economic, social and environmental

challenges of globalization.

29

economic contraction of 4.7% between the first quarter of 2008 and the second

quarter of 2009. A plunge in global trade was another sign of the seriousness of

the crisis. Worldwide, the volume of world trade in goods and services fell by 12%

in 2009, according to the WTO.30

Of course, the price of a recession is felt not just

in the economy but also in society. Unemployment hit just under 10% in the

United States in December 2009 (falling back to 9.7% the following month), which

was more than double the 2007 rate of 4.6%. In the euro zone, the figure for

December 2009 was 10%, up from 7.5% in 2007. To put those numbers in

perspective, even by mid-2009, when unemployment in the OECD area stood at

8.3%, it meant an extra 15 million people were out of work compared with 2007.

By the end of 2009, the unemployment rate had risen still further, to 8.8% and is

continuously increasing as was seen in “we, the 99” movement in U.S in August

2011.31

1.4.1 IMPACT OF GFC ON FINANCE SECTOR

The economies in Western countries over the last 30 years have shifted their

focus from industry to services. The service sector now represents over 80

percent of the US economy, with the financial sector being the largest service.

The financial economy is now valued more than the real economy. The size of the

worldwide bond market by 2009 was estimated $45 trillion. The size of the

world’s stock markets in the same year was estimated $51 trillion. The world

derivatives market was estimated at $480 trillion, more than 30 times the size of

the US economy and 12 times the size of the entire world economy by the end of

2009. As a result of globalization financial system has become an interwoven web

30 Brain Keeley and Patrick Love, From Crisis to Recovery, OECD Insights, 2010, p.12. 31 TradingEconomics.com, U.S. Bureau of Labor Statistics, April 2012.

30

in the form of Transnational Financial Organizations and Foreign Direct

Investment plans. As the current financial crisis has hit financial economy it is

obvious that it might have laid serious consequences over the worldwide finance

industry. In the current financial scenario there are only two working industries

at global level, one is centuries old conventional financial system holding 99% of

total global assets and second is newly born Islamic finance industry, just decades

old, holding the remaining 1% of the global asset share. The impact of the GFC on

both industries will discussed separately. Firstly we will analyze the impact of GFC

on conventional banks and financial institutions:

1.4.2 IMPACT OF GFC ON CONVENTIONAL FINANCE INDUSTRY

Economists observed that the difference between the interest rates on interbank

loans and short-term U.S. government debt spread, an indicator of perceived

credit risk in the general economy, spiked up in July 2007, remained volatile for a

year, and then spiked even higher in September 2008. The crisis deepened, as

stock markets worldwide crashed, entering into a severe-impact phase marked by

failures of some prominent American and European banks, like the bankruptcy of

Lehman Brothers, which is the largest in U.S history with Lehman holding $639

billion in assets. The situation prompted a substantial injection of capital into

financial markets by the United States Federal Reserve, Bank of England and the

European Central Bank.32

In October 2007 major failures start to appear in the

world’s financial industry, Swiss banking giant UBS bank has announced losses

$3.4bn from investments linked to sub-prime. In March 2008, the investment

bank and brokerage Bear Stearns collapsed. Following, American banking giant

Citigroup posted a sub-prime loss of $40 billion. US investment bank Merrill Lynch 32

Hussein Alasrag, “Global Financial Crisis And Islamic Finance” , World commerce Review, vol. 36,

2009, pp.31-32.

31

revealed a $7.9 billion disclosure to bad debt. It wasn’t just investment banks that

found themselves in trouble. The biggest insurer in the US, American Insurance

Group (AIG) teetered on the brink of failure due to bad bets it had made on

insuring complex financial securities. It survived only after billions of dollars of

bailouts from Washington.33

A major bond insurer MBIA announced a loss of $2.3

billion. After failing to search for a potential buyer, Lehman Brothers becoming

the first major US investment bank to collapse since beginning of the credit crisis.

The Federal Reserve slashes the key interest rate to by 0.5% to 5.75% at which it

lends banks, warning the financial crisis could be a risk to economic growth. Not

only the US Federal Reserve, the Bank of Canada and the Bank of Japan also begin

to intervene. To improve this situation the European Central Bank subsidized

108.7 billion Euros into the financial market to try to improve liquidity. UK high

risk mortgage providers set to pull out mortgages and increased the cost of

borrowing for UK homeowners with poor credit histories.34

Former Federal Reserve chief Alan Greenspan described the current financial

crisis as "probably a once in a century type of event" and cautioned that this

financial calamity will lead to the closure of major firms. The US House of

Representatives passes a $700bn (£394bn) government plan to rescue the US

financial sector a part of $900bn (£600bn) economic stimulus package. Since the

collapse of Lehman Brothers, the global economy and financial markets have

changed dramatically. The fourth quarter figures for GDP, industrial production,

and exports have started to be released in various countries, and a sharp decline

that could be indeed expressed as “jump off a cliff” has been witnessed

33

Brain Keeley and Patrick Love, From Crisis to Recovery, OECD Insights, 2010, p.18. 34 Riyazi Farook, “Global Financial Crisis Unthinkable Under Islamic Banking Principles”, Islamic Finance

and Banking, Srilanka, 2009, p.2.

32

simultaneously worldwide. The Bank of Japan released the economic outlook,

according to which the median forecast of Japan’s economic growth for fiscal

2009 among Policy Board members was substantially revised downward from

0.6% as of end-October 2008 to -2.0%35

. Extreme market volatility caused a loss of

600 million Euros to French savings bank Caisse d'Epargne during the financial

market crisis. South Korea announced a $130bn financial rescue package to

stabilize its financial markets. The Dutch government funded 20bn Euros

($26.8bn) to protect the financial sector from the credit crisis. Sweden's

government also announced its financial rescue plan, with credit guarantees to

banks and mortgage providers up to a level of 1.5 trillion kroner (£117.2bn,

$205bn). The government also announced it will establish aside 15bn kroner as a

bank stabilization fund.36

In the first few months of the financial crisis, there was the widely held view that

the impact on African countries would be minimal because of their low

integration into the global economy. Recent developments have, however, shown

that the negative contagion effects of the crisis were already evident in the Africa

region. For example, stock market volatility has increased since the onset of the

crisis and wealth losses have been observed in the major stock exchanges. In

Egypt and Nigeria, the stock market indices declined by about 67 percent

between March 2008 and March 2009. Significant losses have also been observed

in Kenya, Mauritius, Zambia and Botswana. The turmoil in African stock markets is

beginning to have significant negative effects on the financial sector and on

aggregate demand. For example, there is growing evidence that it has a negative

effect on bank balance sheets and, if present trends continue, non-performing 35 Ibid, p.3. 36 ibid

33

loans in the banking sector would likely increase, with dire consequences for

financial stability in the region. In Ghana, the ratio of non-performing loans to

gross loans increased from 7.9 per cent to 8.7 per cent between 2006 and the

third quarter of 2008. In Lesotho, it increased from 2 per cent to 3.5 per cent over

the same period.37

The impact of the crisis was equally seen in Asian Banking sector. Most of the

Asian countries, being underdevelopment (referred as Low Income Countries also

as Emerging Market Economies) constitute a large proportion of their GDP* in the

form of ODA (Official Development Assistance) and FDI’s (Foreign Direct

Investment). In response to the crisis, the donors reduced ODA flow in the region

and there was a healthy decline in FDI flow as well. As a result, the top 20 LIC

banks were caught by surprise by the global financial crisis at the height of their

balance sheet expansion and also experienced a sharper decline of deposit

growth in 2008.38

Moreover, amid the current financial and economic crisis, global FDI flow has

shown downward trend and, according to UNCTAD, global FDI fell by 21 percent

annually in 2008, after five years of strong growth and a record level of US$1.8

trillion in 2007. Developed countries witnessed the sharpest downturn of 33

percent while FDI flows to developing countries remained positive in 2008.

However, growth rate decreased from over 20 percent in 2007 to 3.6 percent in

2008. Developing countries in regions like Africa which received huge amount of

37 African Union Commission, “The Global Financial Crisis: Impact, Responses and Way Forward”, 2nd

Joint Annual Meetings of the AU Conference of Ministers of Economy and Finance and ECA Conference

of Ministers of Finance, Planning and Economic Development, Cairo, Egypt, 2009, p.2. 38 Jack Joo K. Ree, “Impact of the Global Crisis On Banking Sector Soundness In Asian Low-Income

Countries”, IMF Working Paper no.115, May 2011, P.10.

*Gross Domestic Product (GDP), is the total market value of all the final goods and services within an

economy in a given year.

34

FDI in recent years faced a sharper decline in FDI mainly triggered by the decrease

in commodity prices, as most of the FDI in these economies was resource

motivated.39

1.4.3 IMPACT OF GFC ON ISLAMIC FINANCE INDUSTRY

The current global financial crisis has not only shed doubts on the proper

functioning of conventional “Western” banking, but has also increased the

attention on Islamic banking. Internationally, Islamic banks appear to have been

more resilient to the primary effects of the global economic turndown and

international financial crisis than conventional banks. The main reason for this

being the inherent nature of Islamic banks, which shun the risky and much

misunderstood financial products and also the fact that it is an asset backed

banking. They tend to avoid the speculative investments, such as derivatives, that

many analysts believe led to the financial crisis affecting conventional banks. For

some observers, Islamic finance serves as a vehicle for recovering from the

international financial crisis. The Islamic banking industry may be able to

strengthen its position in the international market as investors and companies

seek alternate sources of financing.40

However, as Islamic banks operate within a global financial system, they have not

been completely insulated from the recent economic and financial shocks. For

instance, on the one hand, the Islamic financial industry is considered by many to

be less risky because financial transactions are backed by physical assets. On the

other hand, Islamic banks may be more vulnerable to fluctuations in the mortgage

39 Riyazi Farook, “Global Financial Crisis Unthinkable Under Islamic Banking Principles”, Islamic Finance

and Banking, Srilanka, 2009. 40 Stephen Timewell, “A Template For Averting Disaster? - Roundtable,” The Banker, January 1, 2009,

Academic One File, Gale, Library of Congress, accessed February 6, 2009.

35

market, given their high activity in the real estate sector compared to

conventional banks. The recent slowdown in real estate activity in the Gulf-

economies raises concerns about some Islamic banks’ financial positions.41

Some

economists, particularizing their research, have made attempts in this direction.

For example Sat Paul Parashar and Jyoti Vankatesh, in their research paper have

tried to show that Islamic banks have suffered more than conventional banks

during recent global financial crisis in terms of capital ratio, leverage and return

on average equity, while conventional banks have suffered more than Islamic

banks in terms of return on average assets and liquidity.42

Tracing impact of the

crisis on both financing industries i.e. Islamic as well as conventional, Beck et al.

(2010) have compared the two types of banking and their performance across

many countries, during recent crisis and have come up with the conclusion that

though both types of banking were affected by the crisis, Islamic banks had higher

capitalization coupled with higher liquidity reserves, resulted in better

performance of Islamic banks.43

Answering to the question whether Islamic banks were equally affected during

the current global financial crisis or not Dr. Linda Eagle, member of ‘The Edcomm

Bankers Academy’ responds, “Unlike many Western financial institutions, Islamic

banks have remained relatively unharmed during the current global financial

crisis. In fact, Islamic finance has gained a greater acceptance and more

widespread recognition in recent years, as more and more Muslims and non-

41 Shayerah Ilias, “Islamic Finance: Overview and Policy Concerns”, Congressional Research Service, 2010,

p.3. 42 Sat Paul Parashar and Jyothi Venkatesh, “How Did Islamic Banks Do During Global Financial Crisis?”,

Banks and Bank Systems, Volume 5, Issue 4, 2010, P.55. 43 Thorton Beck, Asli Demirgue-Kent and Merrouche Quarda, “Islamic vs. Conventional Banking –

Business Model, Efficiency And Stability”, The World Bank, Development Research Group, Policy

Research Working Paper 5446, October. 2010.

36

Muslims worldwide have taken an interest in Shari’ah-compliant banking products

and services due to its more prudent investment and risk philosophy. In response,

Islamic Banks are starting to open up in many countries across the globe, helping

this segment of the financial industry to continue to flourish. Islamic finance

remained steady in this tough global economy primarily due to the nature of the

industry. According to the laws of Shari’ah, the buying or selling of debt is strictly

prohibited, as well as insurance and investment gains and excessive risk-taking. In

other words, Shari’ah-law does not allow individuals or companies to borrow

money that does not exist – it must be invested into productive enterprises. It is

this more cautious attitude towards money that has kept Islamic banks relatively

safer from the effects of the global financial crisis today compared to their

conventional banking counterparts.44

A new IMF study compares the performance of Islamic banks and conventional

banks during the recent financial crisis, and found that Islamic banks, on average,

showed stronger resilience during the global financial crisis. Figure No.5 provides

a comparison of the average profitability, credit and asset growth in 2008 to its

2007 level (cumulative impact) shows that IBs fared better in all countries, except

Bahrain, Qatar, and the UAE. In four countries (Bahrain offshore, Jordan, Saudi

Arabia, and Turkey), the change in profitability was significant in favor of IBs.45

44 Dr. Linda Eagle, Expert Views, 36 Global Islamic Finance, Jan 2010. 45 Maher Hassan & Jemma Dridi, “The Effects of the Global Crisis On Islamic And Conventional Banks: A

Comparative Study” IMF Working Paper no. 210, Sep. 2010, P.16.

37

Figure No. 5 Source: Maher Hassan & Jemma Dridi, IMF, 2010

The above cited IMF study report suggests that Islamic finance system has a great

potential for further market share expansion and a possible contribution to

market stability through the available credit. Performing well in the first phase of

the crisis, however weaknesses in risk management practices in some of the

Islamic banks led to a larger decline in profitability compared to seen in

conventional banks during the second phase of the crisis. While talking to Arab

News Online, M. Parker has pointed towards the same reality.46

Parker’s

observation can be summed as, the lack of contract standardization, the absence

of instruments to hedge against the volatility in currency and commodity markets,

the incomplete legal framework, and the insufficient expertise at the supervisory

and industry level may weaken the potential of Islamic finance sector and may

affect its reputation. This decline can be visualized in the figure No.6. It was also

46 M. Parker, “Islamic Banks Fared Better During Financial Crisis”, Arab news on-line 19 September, 2010,

Retrieved on 18 February 2011 from http://arabnews.com/economy/islamicfinance/article142384.ece.

38

seen that large Islamic banks fared better than small ones, perhaps as a result of

better diversification, economies of scale, and stronger reputation.47

Figure No.6 Source: IMF Staff Estimates and Calculations48

The global market for Islamic bonds is estimated to be $80 billion currently. After

increasing more than five-fold from 2004 to 2007, global issuance of sukuk hit a

three-year low point in 2008. Sukuk issuance began slowing down in late 2008,

partly due to the global economic turndown, the international sukuk market faced

lower levels of liquidity, resulting from declines in oil prices and reduced

confidence from investor. According to some estimates the total Islamic Bond

Market decline in year 2008 was 24%. Despite current challenges, many analysts

believe that the long-term viability of the Islamic bond market appears strong,

owing to the growing popularity of Islamic financial products, increased

47 Samir Srairi, Imen Kouki, and Nizar Harrathi, “ The Relationship Between Islamic Bank Efficiency and

Stock Market Performance: Evidence From GCC countries”, Center for Islamic Economics and Finance,

Qatar Faculty of Islamic Studies, Qatar Foundation, 2010, P.2. 48 IMF Survey Online, Islamic Banks: More Resilient to Crisis? , October 4, 2010.

39

government interest in Islamic finance, investment and financing needs of the

Gulf countries, and financial institution seeking greater diversification.49

It is relevant to end up this chapter with the evaluations made by Sat Paul

Parashar and Jyothi Venkatesh. After comparing six different ratio’s CAR, CTI,

ROAA, LA/TA and E/TA of Islamic and conventional banking systems for full four

years, and also before and during the crisis, inter and intra group, they have

concluded their research paper in following words, “In conclusion, it may be

stated that Islamic banks did suffer during crisis in terms of lowering of CAR, E/TA

and ROAE, but overall, over four years period, they performed better than

conventional banks”.50

49 Hussein Alasrag, “Global Financial Crisis And Islamic Finance”, , World commerce Review, vol. 36,

2009, p.56. 50

Sat Paul Parashar and Jyothi Venkatesh, “How did Islamic Banks Do During Global Financial Crisis?”, Banks and

Bank Systems, Volume 5, Issue 4, 2010, P.61.

40

Chapter-2

LITERATURE REVIEW

41

2.1 LTERATURE REVIEW

Like all previous crisis, many theories have been proposed to explain the causes

and impact of the current global crisis. A vast literature in the form of books,

articles and research papers was brought to compilation. This chapter will present

a brief review of some books and articles compiled in this direction by Muslim as

well Western experts for socio-professional benefits.

2.2 BOOKS

Book: Contemporary practices of Islamic Financing Techniques

Author: Ausaf Ahmad

Publisher: Islamic Research Training Institute, Jeddah, 1993

Pages: 75

Description

Despite being an evolving industry, the PLS (profit loss sharing) orchestrated and

low risk equity based instruments has potentialised the Islamic financial sector to

uplift its growth curve. The present book is a scholastic endeavour, wherein the

author has examined the nature and operating mechanism of some elementary

financial techniques and their role in bringing up Islamic finance industry in the

contemporary financial scenario.

The book has been divided into six sections including an introductory and

concluding section. In its introductory section, the avoidance of the interest based

transactions has been described as the elementary character which differentiates

Islamic banking from conventional banking. It also provides basic information

42

about the objectives, dimensions and entire structural plan of the study. This

section has direct relevance with the chapter 3rd

of the present study.

In second section “Common practices of Islamic banks in the sources of Islamic

finance” of the book, a detailed description has been made about the services and

practices offered by most of the Islamic banks so to make funds available for

business transactions to gain profit. Current accounts, saving deposits, investment

deposits, joint/general investment account, limited and unlimited investment

deposits, specified investment deposits together with deposit management in

Iran and Pakistan have been also explored under the same section. This section is

relevant to chapter 3rd

and 4th


Islamic financial tools and equity based transactions that formulate the central

body of Islamic banking have been elucidated in detailed account in section third

“common practices of Islamic banks in the uses of funds” of the book. The author

visualizes that, in an Islamic bank, application of funds is being carried out

through these instruments. Mostly operated instruments like Musharakah,

Mudarabah, Ijarah, Murabahah, Bai, Qard al- hasan etc have been fully

elaborated along with their types. This section is in relevance to the chapter 3rd

of

the present study.

Section four “Islamic financing techniques specifically used in Pakistan” and five

“Islamic financing techniques specifically used in Iran” describes the respective

Islamic financing techniques used in Pakistan and Iran, particularly those tools

which have not been covered in earlier sections. Trade, investment and loan

related financial techniques mostly being observed in Pakistan and salaf

transactions, Jua’alah, Musaqat, Muzarah etc in Iranian context have been

43

discussed very skillfully. Last section based on conclusion, summarizes the overall

study and author has ended up with some valuable suggestions with respect to

further research on the same subject. Section no. 4, 5 and 6 are having relevance

with chapter 3rd

and 4th


As all sections of the book are in relevance with the subject matter of the present

study, hence it has cited in both literature review as well as bibliography of the

present study.

Book : From Crisis To Recovery: The Causes, course And

Consequences Of The Great Recession.

Authors: Brain Keeley & Patrick Love.

Publisher: Organization For Economic Co-operation And

Development (OECD) Publishing, France, 2010.

Pages: 144.

ISBN: 978-92-64-06911-4

Description:

2007, 2008, the worst of crisis in the decades ripped through the global financial

systems. Along with massive unemployment, collapse of housing prices and

spread of distress throughout the markets and economics around the world, it

has become a greater threat for economists and finance experts to predict where

global economy might go next. The book under review has been brought to

publication by the publishing unit of OCED (Organization For Economic Co-

operation And Development), intending to provide a strategic response to the

44

above said problem. The book draws on the OCED’s analyses of why the financial

crisis occurred and added to its rapid expansion into the real economy. The book

offers a structural framework, what authors believe is a “Green Growth Strategy”

to guide national and international economic policies. The book also demand

governments to take a stronger lead in fostering production, procurement and

consumption patterns by abstaining opaque frameworks and ensuring

transparency in market working.

The book comprises of seven healthy chapters, each chapter authenticated with

graphics, charts from OECD’s publications and papers as well as quotations from

their direct texts and is ended up information source links.

Chapter first, entitled as “Introduction” is an overview of the actual study. It

makes a reader conversant about what a financial bubble burst means and what

can be its hitting areas. Discussing the recession and its legacies from 2008

onwards, the unprecedented contraction in world economy, the growing

unemployment rate, the excessive borrowing by governments and fall in the

volume of world trade in goods and services have been numerically evaluated

with special reference to OCED countries.

Second chapter “The Roots of a Crisis” deals with the question, what caused a

financial crisis? It also looks at the pressure that built up in global finance in the

years before the crisis struck. In authors observance the factors like easy access to

cheap borrowing, asset price bubble, poor regulation, high securitization in

banking and opaque marketing activities added to global liquidity bubble.

Encompassing the spheres of its affect, it has been found that not only

investment banks were caught in trouble but insurance companies like American

45

Insurance Group, the bigger insurer in US teetered on the brink of failure. It

survived only after billions of bailout from Washington. While locating the birth

place of the current financial crisis, the key economies like Japan and United

States have been pointed out. This chapter is relevant to the chapter 1st

of the

present study.

The third chapter “Routes, Reach, Responses” examines the routes of the

recession, the sphere that it has brought under its affect and the responses from

various sectors to its stimuli. It has also enumerated the factors, which resulted in

the transformation of financial bubble from individual economies to global

economy. Tracing the route of the crisis, it has been observed that the central

route for the current financial crisis is slowdown in “banking markets” which

started with decline in housing prices simultaneously in United States and Japan.

It has also discussed how the “bank crisis” spurred governments and central

banks to respond. This chapter is relevant to chapter 1st


Chapter 4 “The Impact On Jobs” looks at the impact on jobs, including the risk

that the recession will be followed by a jobless recovery that contributes to a “lost

generation” of young people in the work force . Chapter 5 “Pensions And The

Crisis” looks at the impact on pensions: the crisis highlighted issues in both

funding and benefits that population ageing and changing career patterns could

aggravate.

Chapter 6 “New World, New Rule?” considers the push for new rules and

standards in three key areas – financial markets, tax evasion and business and

economic ethics.

46

Finally, Chapter 7 “The Future, Five Questions” examines some longer-term issues

arising from the recession, including rising national debts, the prospects for

turning the recovery into an opportunity for “green growth” and the challenges

facing economics as a profession. Chapter no. 4th

, 5th

, 6th

, and 7th

are in relevance

with 4th

and 5th

chapter of the present study.

Since the subject matter of the book is in relevance to the present study, hence it

has included in the literature review and bibliography as well.

Book : Islamic Finance.

Author: Dr. Venkataraman Sundararajan.

Publisher: SAGE Publications India Pvt. Ltd., 2011

Pages: 291

ISBN: 978-81-321-0706-4 (HB)

Description:

Islamic finance, is a collection of selected writings of Dr. Sundararajan (1945-

2010) edited by Jaseem Ahmad and Harinder S. Kohli. The papers accumulated in

this book, are significant, perceptive and insightful presenting a comprehensive

overview of the Islamic financial architecture. Outlining many complexities in the

development and mainstreaming of Islamic finance industry, that can help it in

becoming a competitive, resilient and an important global financial intermediary.

The chapters in this book are blend that would benefit lay readers, casual

students of Islamic finance and policy makers at national and international level.

47

The chapterization of the book follows a chronological order and has been

structured into three parts. Part 1 consists of the first chapter of the book,

“Current developments and Key Issues in Islamic Finance”. In this chapter the

author has described the basic foundations, core principles and key features of

Islamic finance. It also discusses the structure, size and expanding scope of Islamic

finance industry.

Part 2, comprises of four comprehensive chapters. Chapter 2 “Monetary

Operations and Government Debt management under Islamic banking” focuses

on three critical issues: firstly issuance of government securities under Islamic

finance principles, secondly recent developments in monetary instruments under

Islamic banks and thirdly issues in institutional arrangements for monetary

operations.

Chapter 3rd

“Islamic Financial Institutions and Products in the Global Financial

System: Key Issues in risk Management and Challenges Ahead” addresses various

issues related to risk management policies and also suggests ways to manage the

risks, including invigorating the regulatory and disclosure framework.

Chapter 4th

“Risk Measurement and Disclosure in Islamic Finance and the

Implications of the Profit Sharing Investment Accounts” defines a specific

approach to measure the actual of the risks between share-holders and profit-

sharing investment account holders, based on the value-at- risk methodology.

Part 2nd

ends up chapter 5, titled as “A Note on Strengthening Liquidity

Management of Institutions Offering Islamic Financial Services: The Development

of Islamic Money Markets” focuses on, the rationale for Islamic money markets

development, an overview of factors affecting the money markets including legal

48

and Shari’ah issues, structure and instruments of Islamic lone markets, financial

management and role of monetary operations.

Part 3rd

consists of three chapters. Chapter 6 “Issues in managing Profit

Equalization Reserves and Investment risk Reserves in Islamic Banks” outlines the

main determinants of profit equalization and investment risk reserves and their

relationship to displaced commercial risk.

Chapter 7, “Towards Developing a Template to Assess Islamic Financial Services

Industry (IFSI) in the World Bank-IMF Financial Sector Assessment Program

(FSAP)” describes the structural plan for FSAP’s and IFSI’s.

The voluminous work ends with chapter 8, “Supervisory, and Capital Adequacy

Implications Of Profit-Sharing Investment Accounts In Islamic Finance”. The

chapter describes the main types and characteristics of PSIA’s under mudarabah

contracts. The chapter concludes with suggestions for risk-sharing as well as

implications of these PSIA’s for the supervisory and regulatory authorities.

As all parts of the book are in relevance with the chapter 3rd

and 4th

of the present

study, thus it has been cited in both literature review as well as bibliography.

Book: The Global Financial Crisis: Can Islamic Finance Help Minimize The

Severity And Frequency Of Such A Crisis In The Future?.

Author: Muhammad Umer Chapra

Publisher: Center for Islamic Area Studies at Kyoto University (KIAS),

Japan,2009.

Pages: 51.

49

IBN: 978-4-904039-13-7

Description:

The present book describes the primary causes that contributed about the

present global financial crisis. In authors observance excessive landings, high

leverage speculations and non availability of risk-sharing mechanism are some of

the key factors responsible for the current financial crisis. While analyzing the

question, whether Islamic finance industry could minimize the frequency of the

crisis, the author has come up with the conclusion that, because of its equity

based transactions, risk mitigation policies and market management discipline

Islamic finance industry has a substantial tendency to reduce the financial

instability.

The book has been divided into three chapters. In the first chapter “The primary

causes of the crisis” the author has highlighted those determining factors

responsible for the current crisis that has taken more than three million dollars of

bailout and liquidity injections by a number of industrial countries abate

somewhat intensity of the crisis. Excessive lending, inadequate discipline in

financial markets and excessive leverage have been detected as major causes of

the crisis. This chapter has relevance with chapter 1 of the present study.

Chapter 2nd

“The Islamic Financial System” provides an overview of the Islamic

financial system. It has discussed its themes and objectives as well. This chapter is

in relevance o the chapter 3rd


“Is This of Any Relevance to the Conventional System” has become chapter 3rd

of

this book. This chapter is based on suggestions and recommendations. How

50

financial institutions can minimize the growing speed of current financial crisis by

applying Islamic equity instruments, is central subject of this chapter.

As this book is relevant with the subject matter of the present study, hence it has

been mentioned in literature review as well as bibliography.

Book : The Stability Of Islamic Finance: Creating A Resilient

Financial Environment For A Secure Future.

Authors: Hussein Askari, Zamir Iqbal, Noureddin Krichene and

Abbas Mirkhor

Publisher: John Wiley & Sons (Asia) Pte. Ltd. 2007.

Pages: 256.

ISBN: 978-0-470-82519-8

Description:

This book is a collective effort of four renowned trained Islamic economists,

holding a strong expertise in banking and finance sector. The book is of vital use

both in academics as well as for Islamic financial institutions in sophisticating their

financial operations. The authors argue, that Islamic financial engineering and

financial tools, inheriting a much balanced potential, have attained such a

position where they are able to provide the world a stable and much resilient

financial environment in the twenty-first century. This argument has become

central theme of the book. In this connection the authors have significantly

developed themes that link Islamic finance to existing traditions in economics,

that assess the stability property of Islamic financial instruments and that explain

51

some key Islamic concepts in economist’s terms. Using valid arguments, the

author’s intend to demonstrate, how conventional finance can generate cyclical

instability in credit creation which in turn leads economic booms and busts. While

tracing out the various causes responsible for the worldwide financial crisis, the

book blames that, the monetary expansion in reserve centers leading to

internationalization of the crisis, negligence towards monitoring of monetary

aggregates, lapses in corporate governance and lack of profit-loss scheme are

some of the major causes. The authors also argue that, Islamic financial system is

inherently more stable than conventional system because its equity based

instruments are directly linked to the productivity of the real investments they

finance, and therefore not only enhance social objective of ‘’sharing’’ risks and

rewards, but cushion financial intermediation against the inherent risks of excess,

both in booms and slumps. Excluding the first chapter the overall content of book

is in relevance to the present study and has been included in the literature

overview.

The authors have divided the overall content of the book into thirteen chapters.

In chapter 1, the authors have dealt with the problem of nature of the capital and

the rate of return. Under the same chapter some classical capital theories have

been critically evaluated like the capital theory of Adam Smith and David Ricardo

through the writings of Stanely Jevons, Karl Marx, Eugen Von Bohm-Bawerk, Knut

Wicksell and others.

In chapter 2, 3, 4 and 5, authors have wrestled with the problem of global

financial instability, its origins, its causes, its implications over world economy

and its frequent shift from individual economy to global economy what the

52

authors have cited as ‘internationalization’ of the financial crisis. These chapters

also discuss the interwoven network of inherent causes like Carelessness in

monitoring the monetary systems, uncontrolled bank money creation, beggar-

thy-neighbor policies in pursuit of short economic growth gains, floating exchange

rates and increasing recourse to debt financing responsible for misbalancing the

equilibrium of conventional financial sectors. These chapters are in relevance to

the first chapter of the present study.

In the chapter 6 the main theme of the book: the inherent stability of the Islamic

financial sector, has been discussed with a detailed account. The Islamic financial

system which completely avoids interest and interest based assets, has been

projected and modeled as non-speculative equity ownership that is ultimately

linked to the real sector and where demand for new shares is determined by the

real savings in the economy. This chapter has relevance with third chapter of the

present study.

From chapter No.7 to chapter No.13, authors have overviewed the various

dimensions of Islamic finance. Chapter 7 analyses the theoretical model that deals

with the inherent stability of Islamic finance. Chapter 8 discusses the escape of

Islamic finance from a systemic risk, either at the central banking or financial

institutional level. Chapter 9 reviews the nature of Islamic financial intermediation

and highlights how the combination of such type of banking and markets will lead

to stable financial system. Chapter 10 discusses the risk profile of an Islamic

financial intermediary. In chapter 11 the authors have examined, that the

exclusively debt operations and speculations investments lead towards financial

instability. It also discusses the appropriate safeguards and regulatory framework

53

to strengthen the stability of Islamic finance. Chapter 12 of the book has

visualized the importance of corporate governance for the progress of financial

institutions. Chapter 13 the last chapter of the book, deals with the role and

performance of the Islamic financial intermediaries and Islamic finance

instruments that helped the Islamic finance industry to save its investors as well

as institutions from the disastrous effects of the ongoing financial crisis. This part

of the book is in relevance with the chapter third and fourth of the present study.

The book ends with a healthy conclusion wherein the authors suggest for some

constructive reforms and remedies towards building up a stable economy.

Book : Global Financial Crisis And Islamic Finance.

Author: Hussein Alasrag

Publisher: VDM vesrlag, Germany, 2010.

Pages: 70.

ISBN: 3639252276.

Description:

Economists where hopeful that 2008 crisis would be restricted to financial

markets, with few repercussions on the real economy and the rest of the world.

According to author this hope was shattered in September 2008 as the crisis

entered an acute phase, with strong downward fluctuations in the stock markets,

substantially reduced rates of economic growth, volatile exchange rates, and

squeezes in demand and consumption, leading to falls in industrial production

and decreasing flows of international trade and FDI, and causing impacts on

related areas such as transfer of technology. This book is an attempt to bring

forth the major causes and impact of the current financial and economic crisis. It

54

has also taken a critical evaluation of the claim made by Islamic finance sector

that the Islamic finance and its prospective is a viable alternative to the ailing

global financial sector. As per its subject matter, the author has divided the book

into five chapters.

The ‘introductory’ chapter of the book has taken a brief overview of the origin,

severity and consequences of the current financial crisis on the globally integrated

economy. It also provides a short summary about the Islamic investment and

financing mechanism, together with the multiple reasons for its constant growth

in the recent years.

Chapter 2nd

,“Fundamentals of the Islamic finance” describes nature, principles

and sources of Islamic economics in general and Islamic finance in particular. It

also discusses some basic issues related to the application and interpretation of

its Laws in the current times. Islamic banking, its origin and emergence and some

key financial tools like Murabaha, Mudarabah, Musharakah, Ijarah, Salam and

Sukuk have been also discussed in the same chapter. This chapter has relevance

with the chapter 3rd

of the present dissertation.

Chapter 3rd

,“Nature of the global financial and economic crisis” has explored the

structural causes that helped to bring about the crisis from an Islamic perspective.

It has also taken a detailed account of impact of the crisis, approaches towards

possible solutions and an agenda for a systematic reform. This chapter is in

relevance to the chapter 1st

of the present work.

In Chapter 4th

, “Islamic finance and the global crisis” Sukuk, the most significant

Islamic bond has been brought to full exploration. Some valid suggestions have

been put forward from author’s side, to weaken the list of ‘limitations’ in Islamic

financial sector. According to author, financial engineering, risk management and

55

diversification and development of capital are some dimensions which need an

immediate attention. This chapter is relevant to the chapter 3rd

and 4th

of the

present study.

In the concluding chapter “The global financial crisis: Lessons from and for Islamic

finance” the author has come up with some practical suggestions for both Islamic

as well as conventional system of banking and finance. Firstly author

recommends, that what lessons conventional banks should have derived from the

Islamic banks during crisis and secondly, what innovations Islamic banks should

adopt in order to maintain a constant pace. This chapter is relevant to the chapter

4th


Since overall content of the book, is in close relevance to the subject matter of

the present study, thus it has been included in both literature survey as well as in

bibliography.

Book : An Introduction to Islamic Finance.

Author: Mufti Muhammad Taqi Usmani

Publisher: Adam Publishers & Distributors, India, 2010.

Pages: 246.

ISBN: 81-7435-595-2.

Description:

Due to the growing importance of the Islamic finance, Muslim economists felt a

severe need to bring forth such compilations, which will explore the mechanism

56

and instruments used in the Islamic financial system. The present book is an

endeavor towards the same cause. Based on the collection of different articles

written by the author, it provides basic information about the principles and

precepts of Islamic finance, with special reference to the modes of financing used

by the Islamic banks and non-banking financial institutions. This book comprises

of eight chapters.

Chapter one “Some Preliminary Points” has discussed some basic themes related

to Islamic economics and purpose behind its establishment.

Chapter 2nd

“Musharakah” describes the basic principles of Musharakah and the

scope of its application. The basic problems which may be faced in implementing

it in a modern situation.

Chapter 3rd

“Murabaha” has discussed the Murabaha as vital mode of financing,

its features, the issues involved in its application, the securities guaranteed

against Murabaha price and some basic mistakes in its operation.

Chapter 4th

“Ijarah” deals with principles of leasing. The relationship between

lease and leaser, the commencement of lease, the insurance of the assets and

finally the securitization of Ijarah has been also discussed in this chapter.

Chapter 5th

“Salam and Istisna” provides detailed information Salam as mode of

financing, its contemporary relevance and conditions attached to it. This chapter

also highlights the difference between Salam, Istisna and Ijarah. It has also

discussed Istisna as a mode of financing.

Chapter 6th

“Islamic Investment Funds” attempts to explore the nature of Islamic

investment funds within the premises of Islamic Shari’ah. It also gives detailed

57

account about Equity fund, Commodity fund, Murabaha fund, Bai’-al-dain and

Mixed fund.

Chapter 7th

“The Principle of Limited Liability” aims to explain the concept of

‘limited liability’ and evaluate it from the Shari’ah perspective, to know whether

or not this principle is acceptable in Islamic economics. It has also discussed some

economic institutions like Waqaf, Baitul- mal and Joint stock which are somehow

related to ‘limited liability’.

The last chapter “The Performance of the Islamic Banks” seeks to analyze the

operation of Islamic banks and financial institutions in the light of Shari’ah. It also

highlights what they have achieved and what is yet to achieve.

The overall content of this book is in relevance with the chapter 3rd

of the present

study, hence it has been included in the literature review as well as in the

bibliography.

Book : Understanding Islamic Finance.

Author: Mohammad Ayoub.

Publisher: John Wiley & Sons Ltd, England, 2007.

Pages: 516.

ISBN: 978-470-03069 (HB)

Description:

Introducing Islamic finance in academia is a real commencement towards building

a stable economy within the permits of Shari’ah. Continuing the same objective,

58

this voluminous book ‘ Understanding Islamic Finance’ is also a vital stuff from

author’s side. The author has made every possible effort, in exploring the nature,

workability and practicality of Islamic financial tools and practices in the

contemporary financial scenario.

The author has divided the book into three comprehensive parts. Part first

comprising of four chapters, part second comprising of three chapters and part

third comprising of ten chapters. In chapter 1, 2, 3 and 4 of the part first, the

author has critically analyzed the foundational principles of conventional system

of economy and its applied tools. In authors observance the conventional system

of economy is heavily engulfed by interest based financial policies and debt

financing mechanism which in turn has created an obstacle in observing the socio-

economic egalitarianism all-round the world. Bringing out the portfolio of Islamic

finance the author argues that, because of its inherent numinous character

Islamic finance industry carries a potent capability to ensure socio-economic well-

being. The characteristic features, principles and philosophy of Islamic system of

economy together with its laws and contracts have been elucidated very skillfully.

The rationale behind prohibition of interest (Riba in Qur’anic terminology) has

been also discussed with sound argumentations.

In the part second that includes chapter 5, 6 and 7, the author has presented a

work plan for Islamic banks and financial institutions through which different

financial tools and operations can be undertaken very effectively. Along with

sketching the nature of Shari’ah based financial contracts, the author has also

endeavored to explore their field of application. Some of the significantly beaten

59

financial tools like loan, sale and debt have been discussed within the periphery of

Islamic commercial law.

From chapter no. 8 up to chapter no. 18th

, covers part third of the book. It starts

with a detailed description of both conventional as well as Islamic financial

institutions and also provides a healthy comparison between the two. Chapter no.

9, 10, 11, 12 and 13 is related to Islamic financial instruments including

Musharakah, Mudarabah, Musawamah, Ijarah, Rahn, Murabahah, Tawarruq and

Istijar. Each and every financial tool has been discussed in detail i.e. its

recognition by Shari’ah, its operational standard and its dimensions of

application. Some guiding principles associated with product development issues

and deposit management have been briefly discussed in chapter 14th

. Some of the

vital financial tools like Takaful and sukuk which were lately introduced into

Islamic finance industry have been discussed in chapter no. 14th

and 16th

.

Mechanism of their operation has been also described in relevance to the 21st

century context. Chapter 17th

is based on the cross evaluation of some critical

writings on complied on Islamic finance and finally this voluminous work ends

with a healthy discussion about the prospects and challenges hindering the

streamline flow of Islamic finance industry.

The book has a significant relevance with chapter no. 3rd

and 4th

of the present

study, hence it has been incorporated in both literature review as well as

bibliography.

60

2.3 ARTICLES:

Article: “Structural Causes of the Global Financial crisis: A critical

assessment of the ‘new financial architecture”.

Author: James Crotty.

Publisher: Cambridge Journal of Economics, U.K, 2009.

Volume: 33.

Description:

According to James Crotty, a macro economist and Professor Emeritus of

economics at university of Massachusetts, Amherst, the present financial crisis

has taken the form of cycles in which the deregulation accompanied by rapid

financial innovations has stimulated powerful financial booms that ended in the

global financial recession. Forcing the governments to respond, the crisis took

trillions of dollars to bailout. In this paper the author has analyzed the structural

flaws in the prevailing financial system that helped to bring on the global financial

recession. In authors observance the excessive growth of financial markets in

relation to the non financial economy, increasing complexity in important

financial tools, opaqueness and illiquidity in financial transactions and wide

spread leverage caused a greater contraction in financial institutions. As a result

financial crisis became more threatening. The key structure flaws of new financial

architecture, build on very weak theoretical foundation have been also discussed

by the author in detailed account.

61

In the conclusion, the author has come up with healthy reformative policies for

banks and financial institutions. In order to invigorate the authenticity of the

paper the author has quoted from different journals of international repute. The

article has relevance with chapter 1st

of the present study hence it has been

included in literature review as well as bibliography.

Article : “Islamic finance and global financial stability”.

Author: Dr Zeti Akhtar Aziz.

Publisher: Islamic Financial Services Board (IFSB), 2009.

Description:

The pervasively virulent and far reaching repercussion unleashed by the current

global financial crisis has shaken the foundations of the global financial system. As

a reaction, it has sparkled the international call for the reformation of the existing

financial architecture. Despite this constraint situation, the Islamic financial

industry has been able to weather this first wave of the global financial crisis,

demonstrating its robustness as a stable form of financial intermediation. The

dynamic nature of the Islamic financial system is reflected by its solid growth and

the increased range of its services.

As the role and relevance of Islamic finance in the global financial system gains

significance, it will not only increase its potential to contribute to global financial

stability but also towards strengthening global growth. Financial products and

services and the establishment of new Islamic financial service providers from the

different parts of the world including from the non-Muslim world. The present

paper is as such an attempt to explore the dimensions and conceptual

applicability of the Islamic finance principles in order to overcome the situation.

According to author’s study, with its emphasis on a strong linkage to productive

62

economic activity, its inbuilt check and balances and its higher level of disclosure

and transparency Islamic finance industry offers a more resilient and robust

system of financial operations.

As Islamic finance industry continues to become an integral part of the global

financial system, it will be increasingly exposed to risks of financial stress arising

from global financial instability. In this concern it needs much sophistication, well

balanced risk management and proper liquidity techniques together with

productive financial innovations, which will not go against the ‘maqasid al-

Shari’ah’, the objectives of Shari’ah. As the role and relevance of Islamic finance

in the global financial system gains significance, it will not only increase its

potential to contribute to global financial stability but also towards strengthening

global growth." The article has relevance with chapter 3rd

and 4th

of the present

study and has been included in both literature review as well as bibliography.

Article : “The Relevance of Islamic Principles to Global Financial Crisis”.

Author: Amir A. Rehman.

Publisher: Harvard Law School, Islamic Legal Studies Program, 2009.

Description:

The present paper has been written for a panel discussion on the evolution of

global financial crisis from the current crisis, which was held at Harvard Law

School, Islamic Legal Studies and Islamic Finance Project in 2009. This paper

presents an insight study of, what where the determining causes which resulted

in the transformation of U.S subprime crisis into global financial crisis. It also

describes that whether Islamic financial tools does hold the potential to somehow

63

reduce the intensity of the crisis, together with their relevance in the continuing

crisis situation.

The Islamic financial sector, which according to author is a ‘new global player’, has

not been immune from the current financial crisis but the impact was very less

and to a large extent it managed its institutions as well as investors to escape

from the virulent affects of the current crisis. Several aspects of Islamic Banking,

holding an inherent potential to provide insulation to its mechanism and

operation from the major risks of crisis. As a supportive argument, the author has

cited an official Vatican publication, “ethical principles on which Islamic finance is

based, may bring banks closer to their clients and to the true spirit which should

mark every financial service”. The paper also claims that the relevance of Islamic

financial operations is very significant today and it is believed to grow further due

the three major factors. These are as:

1) The conceptual applicability of principles inherent in Islamic finance.

2) The increasing importance of Muslim economics in an interdependent

global economy.

3) The increasing Shari’ah affinity observed in key Muslim countries.

Among the above mentioned three factors, the author has focused on the first

factor, thus it has become the central theme of the paper and the relevance of

Islamic financial principles from the conceptual perspective has been discussed in

detail. The article has relevance with chapter 3rd

and 4th

of the present study and

has been included in the literature review and bibliography too.

64

Article : “Introduction: the global financial crisis”.

Author: Stephanie Blankenburg and Jose´ Gabriel Palma.

Publisher: Cambridge Journal of Economics,2009.

Volume: 33.

Description:

The current financial crisis that has forced governments, institutions and financial

centers to respond to come up with new a financial structure, which would be

resilient to such long cycles. The present paper is an attempt to take an in-depth

analysis of particulars facets and features of the financial crisis with a breadth of

coverage that spans its antecedents, its immediate causes and its potential

consequences in the longer term. The authors S. Blankenburg and J.G Palma have

much relied on the empirical grounds connected with the growth rate of the

current crisis and net fall in the global economic activity. The paper predicts that

the present financial crisis resulted in 1.3% fall in the overall world-wide economic

activity. Tracing reference from European Central Bank, it has been exposed that

the recession in the European Union state members would be twice bad and EU’s

output is expected to contract by 3.4% in the coming years.

Searching out the far reaching repercussions of ongoing financial crisis, the

authors have referred to the International Labour Organization, which claims that

world-wide unemployment would increase by at least 30 million people in coming

years. Constructive reform proposals and discussions of advocate policy

responses have been also discussed in details. The article has relevance with

chapter 1st

of the present study and has been cited in the literature review and

bibliography.

65

Article: “Lessons We Should Have Learned from the Global Financial

Crisis but Didn’t”.

Author: L. Randall Wray.

Publisher: Levy Economics Institute of Bard College, 2011, U.K.

Paper no: 681.

Description:

The author is a senior scholar at Levy institute of Bard college U.K. The present

research work is actually a recount of the causes and consequences of the global

financial crisis. It also blames that the existing financial system is so fragile that

‘anything’ could have disturbed its overall orchestra .While discussing the primary

causes of the crisis, author’s observance is incoherence with a general adopted

view that the birth place of current crisis is USA, in the form of housing price

bubble. Next part of the paper is based on author’s assessment of the lessons

which financial institutions should have learned from the impact and

consequences of the current crisis. These include, (a) Global financial crisis was

not absolute outcome of liquidity crisis (b) underwriting matters (c) unregulated

and unsupervised financial institutions disrupted the rhythmatic flow of banks

and financial institutions, that led to stagnation of economic activities (d) the

opaqueness in financial transactions.

The paper ends up with a ‘reform agenda’ wherein the author has put forward

some recommendations and suggestions for the financial institutions and in this

area the author has heavily relied on masters like Hyman P. Minsky, Keynes and

66

his followers. The article has relevance with chapter 1st

of the present study

hence has been included in the literature review as well as bibliography.

Article : “Understanding the subprime mortgage crisis”.

Author: Yuliya Demyanyk and Otto Van Hemert.

Publisher: The Review of Financial studies, 2011.

Journal No: 24.

Description:

The subprime mortgage crisis getting birth in USA in 2007, spread very frequently

to the other economies of the world. The crisis spurred massive media attention

as a result of that many different explanations of the crisis have been proffered.

The present article seeks to analyze the quality of subprime mortgage loans by

adjusting their performance for differences in borrower characteristics, loan

characteristics and macroeconomic conditions. The author’s research is evident to

the fact that the rise and fall of subprime mortgage market follows a classic

lending. The paper predicts that the seeds for the crisis were sown long before

2007, but detecting them was complicated by high house price appreciation

between 2003 and 2005 that masked the true riskiness of subprime mortgages.

The paper also makes the contribution towards quantifying how much different

determinants have contributed to the observed high delinquency rates for vintage

2006 and 2007 loans which led up to the 2007 subprime mortgage crisis. The

article has relevance with chapter 1st

of the present study hence it has been

included in the literature review as well as bibliography.

67

Article : “From Financial Crisis to Turning point: How the US Subprime

Crisis Turned into a world-wide One and Will Change the

Global Economy”.

Author: Jacques Sapia.

Publisher: Real World Economics Review, 2009.

Volume No: 46.

Description:

Although most of the economists and financial experts label the present crisis as

‘purely financial’ because the securitization process was definitely a key factor.

But Sapir has observed that the collapse of a specific model of capitalism and the

breakdown of the post-Bretton woods International Monetary order, also played

a an active role in bringing up the crisis. While analyzing the nature of the crisis,

the author claims it to be a ‘three tiered’ process embedded in a particular

context. Credit –over extension, which developed in the United States and also in

UK, Spain and Ireland has been pointed out as the root of the crisis. Viewing the

crisis in a global context, the author observes that the inability of the surviving

Bretton Wood’s institutions, the IMF and the World Bank to check or even

manage the crisis process.

The unsustainable growths in the US economy, the European divergence and the

possible reforms to the crisis have been evaluated empirically. The paper ends at

describing the consequences of the crisis, the re-regulation of financial markets

and the theoretical framework for a new monetary order. The article has

relevance with chapter 1st

of the present study and has been included in the

literature review and bibliography.

68

Article: “Effects of Central Bank Intervention on the Inter-bank Market

during the Subprime Crisis”.

Author: C. M Bruntti, Di Fillippo & J. H Harris.

Publisher: Review of Financial Studies, 2011.

Volume No: 24.

Description:

While the financial crisis created problems for firms, some undoubtedly failed as a

result, and many worried that large swaths of the banking sector would go under.

The present article examines the role of government policies before and during

the crisis towards helping or hurting the both.

Basing their data on the European e-MID market, the authors have observed, how

European Central Bank’s intervention impacted prices, spreads and overall

liquidity. Once the crisis hit, banks became reluctant to lend each other, but the

threat that they would be never paid back was increasingly going up. The

expansion in inter-bank spreads stimulated ECB to provide liquidity through open-

market operations in order to keep the banks afloat. ECB tried this practice

repeatedly practice but this time it did not work. Despite the ECB,s best efforts,

the market continued demanding usually high rates for inter-bank loans. This

situation was apparently taken as a signal that things were worse than previously

suspected. The paper concludes that Central Banks need to rethink how to deal

with markets in crisis time. The article has relevance with the chapter 1st

of the

present study and has been included in the literature review as well as

bibliography.

69

Article : “Islamic vs. Conventional Banking: Business, Model,

Efficiency and Stability”.

Authors: Thorsten Beck, Asli Demirguc-Kunt & Ouarda Merrouche.

Publisher: The World Bank, Development Research Group, Finance

and Private Sector Development Team, Oct. 2010.

Paper No: 5446.

Description:

The current global crisis has not only shed doubts on the proper functioning of

Conventional “western” banking, but also increased the attention in Islamic

banking. The paper describes some of the most common Islamic banking products

and links their structure in the theoretical literature in financial intermediation.

The business model, efficiency quality and stability of Islamic banks and

conventional banks have been assessed with the help of array indicators

constructed from balance sheet and income statement data.

A data based comparison also has been done between the performance of

conventional and Islamic banks during the crisis to test whether one type is better

positioned to with stand large exogenous financial shocks. While Islamic banks

seem more cost effective than Conventional banks in a broad cross-country

sample, this finding reverses in a sample of countries with both Islamic and

Conventional banks. However, conventional banks that operate in countries with

a higher market share of Islamic banks are more cost-effective but less stable.

There is also consistent evidence of higher capitalization of Islamic banks and this

capital cushion plus higher liquidity reserves explains the relatively better

70

performance of Islamic banks during the recent crisis. The article has relevance

with chapter 1st

, 3rd

and 4th

of the present study and has been included in the

literature survey as well as bibliography.

Article : “Islamic Finance: A Therapy for Healing the Global Financial

Crisis”.

Author: Miranti Kartika Dewi & Ilham Reza Ferdian.

Publisher: First Scientific Conference and Challenges of Globalizing

Financial Systems, 2009.

Description:

Being able to endure the implications of the global financial crisis and remain

relatively positive in the midst of the crisis and eventually to emerge as more

equitable and efficient system have raised the profile of Islamic finance and

underscored its capacity to bring stability to the global financial system.

The question whether Islamic Finance can become solution on the current

global financial crisis? Is yet to be explored in a much practical manner. The

present paper has been penned down in the same orientation. The content of the

paper is segmentized into three parts and each part has been illustrated with the

help of figures. Part one, has described nature of the current financial crisis and

its roots. Part second, analyses were the immediate and long-run consequences

of the crisis and also how it took a global shape. The third part of this paper seeks

to highlight whether or not Islamic finance can heal-up the oozing wound of banks

and finance institutions by offering them a much resilient and robust mechanism.

This article has relevance with chapter 3rd

and 4th

of the present study and has

been included in the literature survey.

71

Chapter - 3

ISLAMIC

EQUITY INSTRUMENTS

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3.1 ISLAMIC EQUITY INSTRUMENTS

Islamic finance has continued to expand and demonstrate its resilience in the

current more challenging international financial environment. This expansion has

been in terms of the increased range of Islamic financial products and services,

the development of the Islamic financial infrastructure and institutions, the

greater maturity of the Islamic financial markets and the more comprehensive

supporting legal, regulatory and Shari’ah framework. Being able to endure the

implications of the global financial crisis and remain relatively positive in the

midst of the crisis and eventually to emerge as more equitable and efficient

system have raised the profile of Islamic finance and underscored its capacity to

bring stability to the global financial system. Islamic financial services, as

measured by Shari’ah compliant assets, is estimated by the UK Islamic Finance

Secretariat (UKIFS) to have reached $1,130bn at end-2010, 21% up on $933bn in

2009. According to a report, Islamic finance assets worldwide continued a long

run of growth to reach an estimated USD$1.3 trillion in 2011, 150% up over the

previous five years.51

The principles of Islamic finance are laid down in the Shari’ah, Islamic law. Islamic

finance, comprising financial transactions in banks and non-bank financial

institutions formal and non-formal financial institutions, is based on the concept

of a social order of brotherhood and solidarity. The participants in banking

transactions are considered business partners who jointly bear the risks and

profits. Islamic financial instruments and products are equity-oriented and based

on various forms of profit and loss sharing. In this chapter we will describe some

51 Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, P.3.

73

equity instruments, their scope of application and their contemporary significance

in connection to broadening the spheres of Islamic finance industry.

3.2 Musharakah (Equity Participation)

Musharakah as a financial contract refers to an arrangement where two or more

parties establish a joint commercial enterprise and all contribute capital as well as

labour and management as a general rule. The profit of the enterprise is shared

among the partners in agreed proportions while the loss will have to be shared in

strict proportion of capital contributions. The basic rules governing the

musharakah contract include:

I) Profit of the enterprise can be distributed in any proportion by mutual consent.

However, it is not permissible to fix a lump sum profit for anyone.

ii) In case of loss, it has to be shared strictly in proportion to the capital

contributions.

iii) As a general rule all partners contribute both capital and management.

However, it is possible for any partner to be exempted from contributing labour/

management. In that case, the share of profit of the sleeping partner has to be in

strict proportion of his capital contribution.

iv) The liability of all the partners is unlimited.

74

Figure No.7 Mechanism of a Simple Musharakah contract

3.2.1 Application and Scope

As a mode of finance, an Islamic bank can advance money to a client using the

contract of musharakah. Normally the bank will use the option of being a sleeping

partner. The contract can be more widely used by Islamic funds whereby the unit

holders can assume the role of sleeping partners. The contract can also be used in

securitized assets. An Islamic bank can finance industry, trade, real estate,

contracting and almost all legal enterprises through partnership. Musharakah is

arranged on the basis of a written agreement between the bank and the client for

a specific transaction, consignment, or project or for a fixed period of time that

can be renewed. They can also enter into musharakah with interest-based banks

to carry out operations acceptable in the Shari´ah, provided it is ensured that the

rules and principles of the Shari´ah are observed during the operation of the

75

partnership. A partnership business or its assets can also be securitized, giving

musharakah certificates to the investors. Clients desiring to raise funds for

investment in a large project can use musharakah and offer to sell musharakah

certificates in the market. The musharakah certificate represents the direct pro-

rata (proportional) ownership of the holder in the assets of the project. If all the

assets of the project are in liquid form, the certificate will represent a certain

proportion of money at face value owned by the project, in such cases the

musharakah Certificates cannot be sold in the market except at their face value,

as an increase would fall under the prohibition of Riba under the Shari’ah.

However, after the project is started and has acquired non-liquid assets

representing tangible assets, these certificates can be traded in the secondary

market and above the par value. It is allowed under the Shari’ah, as the subject

matter of the sale is a share in the tangible assets and not in money alone,

therefore the certificate may be taken as any other commodity which can be sold

at a profit or at a loss. In the case of a completed project, the business will involve

a combination of tangible assets and non-liquid assets arising from the sale in

business transactions. In such cases, the Muslim jurists generally find it acceptable

to trade in musharakah certificates, where the musharakah portfolio should not

comprise more than 50% in the form of non liquid assets.

Another form of musharakah, developed more recently, is ‘Diminishing

musharakah’. According to this concept, a financier and his client participate

either in the joint ownership of a property, or piece of equipment, or in a joint

commercial enterprise. The share of the financier is further divided into a number

of units and it is understood that the client will purchase the units of the share of

the financier, one by one, periodically, until all the units of the financier have

76

been purchased by the client so as to make the client the sole owner of the

property or the commercial enterprise.

When used in home financing, musharakah is applied as a diminishing

partnership. In home financing, the customer forms a partnership with the

financial institution for the purchase of a property. The financial institution rents

out their part of the property to the client and receives compensation in the form

of rent, which is based on a mutually agreed fair market value. Any amount paid

above the rental value increases the share of the customer in the property and

reduces the share of the financial institution.52

The Al Baraka Islamic Bank of Sudan also employs musharakah technique to

finance the import of goods. The importer requests the bank to participate in the

import and sale of certain goods. The total cost of importing the goods is declared

and the capital contribution of each party is specified. The cost of the whole

transaction is designated in the appropriate foreign currency. The importer pays a

part of his contribution immediately after the contract has been signed and pays

the rest after receiving the invoices. A special musharakah account is opened at

the bank. The bank then opens a letter of credit in favour of the importer and

pays the full amount to the exporter after receiving the shipment document. The

cost of insurance is charged to the transaction account. The importer is

responsible for the import, clearance and final sale of the goods in question. The

net profits are distributed among the partners in the agreed proportion and any

52 G. Rammal Hussein, Lecturer in International Management in the School of Commerce, University of

Adelaide, 233 North Terrace, Adelaide, South Australia 5005, Australia.

77

loss is shared in the same proportion as the actual capital contribution.53

Musharakah can be also used in trade. In this type of contract the financier

contributes e.g. 60% of the capital for launching a business suppose of readymade

garments. The arrangement may be of two types:

(a) In the first place the arrangement is simply a musharakah where by two

partners invest different amounts of capital in a joint enterprise.

(b) Purchase of different units of the share of the financier by the client. This may

be in the form of a separate and independent promise by the client. The

requirements of Shari’ah regarding this promise are same as explained in the case

of house financing with one very important difference. Here the price of the units

of the financier cannot be fixed in the promise to purchase, because if the price is

fixed before hand at the time of entering into musharakah it will practically mean

that the client has ensured the principal invested by the financier with or without

profit, which is strictly prohibited in the case of musharakah. Therefore, there are

two options for the financier about fixing the price of his units to be purchased by

the client. One option is that he agrees to sell the units on the basis of valuation

of the business at the time of the purchase of each unit. If the value of the

purchase has increased, the price will be higher and if it has decreased the price

will be less. The second option is that the financier allows the client to sell these

units to anybody else at whatever price he can, but at the same time he offers a

specific price to the client, meaning thereby that if he finds a purchaser of that

53

Ausaf Ahmad, “Contemporary Practices Of Islamic Financing Techniques”, Islamic Research and

Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 2010.

78

unit at a higher price, he may sell it to him, but if he wants to sell to the financier,

the latter will be agreeable to purchase it at the price fixed by him before hand.54

3.3 Murabahah (Trustee Partnership)

Murabahah* has become one of the most popular financing techniques among

Islamic banks. It has been estimated that 70 to 80 per cent of the total finance

provided by Islamic banks is through murabahah.55

Murabahah-based financial

operations are practiced by Islamic financial institutions under such various

names as: mark-up, cost plus financing, production support programs, short-term

financing or even, simply, sale-purchase contract. The basic ingredient of

“murabahah” is that the seller discloses the actual cost he has incurred in

acquiring the commodity, and then adds some profit thereon. This profit may be

in lump sum or may be based on a percentage. Islamic bank use the concept of

murabahah sale to satisfy the requirements of various types of financing, such as

financing of raw materials, machinery, equipment and consumer durables as well

as short-term trade financing. As an illustration, a typical murabahah transaction

at an Islamic bank may be described as follows:

i) The client approaches the Islamic bank with the request to finance his specific

requirement, be it the purchase of capital goods, raw materials, machinery,

equipment or a consumer durable.

54 Muhammad Taqi Usmani, An Introduction to Islamic Finance, Adam publishers and distributors, New

Delhi , 2010, pp.91-92. 55 Khalil Jarrar, “Modern Murabaha - A Fiduciary Sale Or A Misnomer?”, Opaleseque Islamic Finance

Intelligence, Issue 1, July 2009.

* Murabahah (also called Bay’ mu’ajjal) refers to a sales agreement whereby the seller purchases the

goods described by the buyer and sells them at an agreed marked-up price, the payment being settled

within a specified time frame, either in installments or lump sum. The seller bears the risk of the goods

until they have been delivered to the buyer.

79

ii) The client not only gives the specifications of the goods but also provides

information about the price, nature and availability of the goods in the market.

The bank, after being convinced of the viability of the project, informs the client

of the margin of profit the bank would like to make on the original price. The bank

may reserve the right to use its own or independent sources to check the

information provided by the client. If the terms and conditions are acceptable to

both parties, a request for a murabahah transaction is signed. In some banks it is

referred to as a "Promise to Buy/Sell" document. It may be mentioned here that

under Islamic law, a promise is not legally enforceable in the same sense as a

contract. The client has a right to change his mind and may decide not to go

ahead with the transaction after all. Since the bank takes further steps to

complete the transaction acting upon this request or promise, the possibility that

the client may go back on his promise introduces an element of risk in the

transaction which is borne by the bank. It may also be mentioned that, although a

promise is not legally binding, Islam strongly encourages its followers to keep the

promises they make. Hence, the probability of a breach of promise is indeed low,

if the contracting parties are motivated by Islamic morality.

iii) Acting upon this request (or promise), the bank purchases the goods specified

and requested by the client, paying the seller directly on a cash basis, either in full

or in part.

iv) At this stage, a contract of murabahah sale is signed between the bank and the

client.

v) The client undertakes to purchase the goods against a profit margin which has

been agreed upon by the client and the bank. The payment of the final price of

the commodity, which includes the price of the commodity paid by the bank to

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the original seller and the bank's profit, is deferred to a later date. In certain

cases, banks may agree to accept this payment on an installment basis. In such

cases, the client is made aware of the number of installments, the amount of each

installment, the date each installment is due, etc., beforehand.56

The mechanism

of a murabahah financial contract can be viewed in figure No.8 given below,

Figure No.8 Mechanism of a simple Murabahah contract

56

Ausaf Ahmad, “Contemporary Practices Of Islamic Financing Techniques”, Islamic Research and

Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 2010. p.14.

81


An interesting application of murabahah sale is in the issuing of a letter of credit

(L/C)*. At the Dubai Islamic Bank, letters of credit are opened in the following

manner:

I) The customer requests the bank to open a letter of credit to import goods from

abroad through an application enclosing a proforma invoice and providing all the

necessary details and information.

ii) After securing the necessary guarantee and scrutinizing the application, the

bank opens a letter of credit in favor of the client and sends copies to the

correspondent bank abroad and to the exporter.

iii) The customer endorses a "Promise to Buy" the merchandise. The cost of the

goods and the conditions of delivery are negotiated.

iv) The exporter makes arrangements to export the goods and delivers the

documents to the correspondent bank abroad. The shipment of the good stakes

place and the correspondent bank advises the bank and sends the documents.

v) After the confirmation of the bank's ownership of the goods in question

through the acquisition of related documents an agreement of Sale is signed with

the client57

.

At the Jordan Islamic Bank, murabahah sale is used to finance the purchase of

goods, such as cars, that are subject to mortgage. The individual submits an

application to the bank requesting the purchase of a motor car. He promises to

buy it at a later stage. The bank issues an invoice to the seller who registers the

motor car in the name of the bank. The seller submits the required document to 57

Ibid, p.17.

*A letter of credit is a document that a financial institution or similar party issues to a seller of goods or

services which provides that the issuer will pay the seller for goods or services the seller delivers to a

third party.

82

the bank and receives his payment. The bank sells the car to the purchaser, with

the registration in the name of the purchaser, on a deferred payment basis after

getting an appropriate guarantee. The guarantee condition may stipulate the

mortgage of the car to the bank. Murabahah is also applied to the purchase of

land and buildings in a similar manner.58

The Jordan Islamic Bank also provides finance to individuals in order to enable

them to purchase goods which are not subject to mortgage, such as household

equipment, electrical appliances, etc. The method is essentially the same, the

difference being that in the case of goods which cannot be mortgaged, payment

by the purchaser is deferred on the strength of a promissory note which is

regulated by the bank in accordance with the conditions of the murabahah

contract. The merchandise is delivered to the client by the bank.59

Commodity Murabahah, another form of murabahah is based on the concept of

tawarruq that is, receiving cash for a debt of a higher amount. Commodity

murabahah is the one Islamic money market tool that can help provide liquidity in

the Islamic banking system. There is no other instrument that is as widely used as

commodity murabahah, especially in the short term money markets. According to

Bursa Malaysia’s Islamic markets global head Raja Teh Maimunahiin, it is

estimated that commodity murabahah has an annual turnover of over US$1

trillion. The structure of a common commodity murabahah financing

arrangement goes in a scheme, that a Bank purchases commodity from

Commodity Broker A on spot basis and sells the commodity to the customer on

deferred basis at cost price plus profit margin, then on behalf of the customer

58

Ibid 59

Ibid, p:18.

83

Bank, acting as Wakeel, sells commodity to Commodity Broker B on spot basis on

behalf of the customer.60

3.4 Mudarabah

Mudarabah contract is a form of a business contract in which one party offers

capital and another party undertakes some business with this capital, the former

is termed Rabb al-mal and the latter Mudarib. Figure No.9 is a simplified diagram

that explains the structure of the mudarabah contract. Under this structure, the

Islamic bank accepts deposits through mudarabah contract as an intermediary,

where the depositor enters into a profit sharing partnership or agency contract

with the bank as a Mudarib (partner/agent). Also, as noted previously, the Islamic

bank (as a principal fund-provider) can enter into a partnership or agency contract

with an entrepreneur who only contributes the management skills.61

Thus, the

capital is provided by the fund supplier, who operates as a sleeping partner, and

work is provided by the entrepreneur.62

The following rules must govern all

mudarabah transactions:

1) The division of profits between the two parties must necessarily be on a

proportional basis and cannot be a lump sum or guaranteed return.

2) The investor is not liable for losses beyond the capital he has contributed. The

mudarib does not share in the losses except for the loss of his time and efforts.

3) Briefly, an Islamic bank lends money to a client to finance a factory, for

example, in return for which the bank will get a specified percentage of the

60 Hermione Harrison, “Commodity Murabahah: Concerns, Challenges and Market Appetite”, Islamic

Finance Asia, February 2010. 61 Yongqiang Li, Abdi Hassan, Esse Abdirashid and Bruno Zeller, “Equity Investor Protection And Financial

Performance Of Islamic Banks: An Econometric Analysis”, Center for Islamic Economics and Finance,

Qatar Faculty of Islamic Studies, Qatar Foundation, 2008. 62 A. Archer and A. Abdel-Karim, “Profit-Sharing Investment Accounts In Islamic Banks: Regulatory

Problems And Possible Solutions”, Journal of Banking Regulations, vol.10, 2009.

84

factory's net profits every year for a designated period. This share of the profits

provides for repayment of the principal and a profit for the bank to pass on to its

depositors. Should the factory lose money, the bank, its depositors and the

borrower all jointly absorb the losses, thereby putting into practice the pivotal

Islamic principle that the providers and users of capital should share risks and

rewards.63

Figure No.9 Mechanism of a Simple Mudarabah Contract


Although it has been widely suggested in the theoretical literature on Islamic

banking that mudarabah can be a viable basis of financial intermediation in an

interest free framework, there are certain difficulties with its contemporary

application. For example, the legal system operating in the country should

provide legal safeguards to the provider of capital so that he can finance projects

63 Hussein Alasrag, “Global Financial Crisis And Islamic Finance ”, University Library of Munich, Germany,

MPRA Paper, 22167, 2011.

85

on the basis of mudarabah. For this and other reasons, the number of banks

providing finance on the basis of mudarabah is not very large. Even among those

banks which use mudarabah as a financing technique, the frequency of its use is

not very high. In view of the dearth of relevant information, it is not easy to

describe the manner in which different Islamic banks practice Mudarabah and

whether there are any differences in these practices. However, some available

information is presented below:

In Iran, mudarabah is considered a short-term commercial partnership between a

bank and an entrepreneur. All of the financial requirements of the project are

provided by the bank and the managerial input is provided by the entrepreneur.

Both parties of the mudarabah agreement share in the net profits of the project

in an agreed proportion. Iranian banks are directed by the monetary authorities

to give priority in their mudarabah activities to cooperatives. Furthermore,

commercial banks in Iran are not allowed to engage in the mudarabah financing

of imports by the private sector. Article 9 of the Law of Usury Free Banking

provides for banks to expand their commercial activities through mudarabah,

within the overall framework of the commercial policy of the government.64

3.5 Ijarah (Lease)

Leasing (Ijarah)* is emerging as a popular technique of financing among Islamic

banks. Some of the important Islamic banks which use leasing as a financing

technique include the Islamic Development Bank, the Bank Islam Malaysia and

64 Ausaf Ahmad, “Contemporary Practices Of Islamic Financing Techniques”, Islamic Research and

Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 2010, pp.23-24.

*Ijarah is a financial contract whereby the owner of an asset, other than consumerable, transfers its

usufruct to another person for an agreed period at an agreed consideration.

86

commercial banks in Pakistan. Like murabahah, lease is not originally a mode of

financing rather it is a simple transaction, however as mentioned it has been used

as a mode of financing by many financial institutions in the current economic

scenario.65

There are two main types of lease under the Ijarah structure. The first

involves a longer term lease which usually ends with the transfer of ownership of

the asset to the lessee (Ijarah wa lqtina), as in a modern finance lease. The second

type of lease is for a shorter term and will usually end with the financial

institution retaining ownership of the asset, in common with an operating lease.

The rental income in this second type of lease will take into account wear and

tear of the asset. To comply with Shari’ah, the leased assets must not be

prohibited items ( for example, machinery for the manufacturing of alcohol) and

must be used in ways deemed lawful by Shari’ah. Like any other contract, a lease

contract has to fulfill all of the conditions of a valid contract stipulated by the

Shari’ah. Muslim economists have designed some rulings to confirm lease as a

valid mode of financing. These rulings are as:

1) Leasing is a contract whereby the owner of something transfers its usufruct

to another person for an agreed period, at an agreed consideration.

2) The subject of lease must have a valuable use.

3) It is necessary for a valid contract of lease that the corpus of the leased

property remains in the ownership of the seller, and only its usufruct is

transferred to the lessee.

4) As the corpus of the leased property remains in the ownership of the lesser,

all the liabilities emerging from the ownership shall be borne by the lesser

65 AIMS-UK Islamic Banking & Finance, www.learnislamicfinance.com

87

but the liabilities referable to the use of the property shall be borne by the

lessee.66


Under this scheme of financing, the bank purchases a real asset (the bank may

even purchase the asset as per the specifications provided by the prospective

client) and leases it to the client. The period of lease, which may be from three

months to five years or more, is determined by mutual agreement according to

the nature of the asset. During the period of lease, the asset remains in the

ownership of the bank but the physical possession of the asset and the right of

use is transferred to the lessee. After the expiry of the leasing period these revert

to the lesser. A lease payment schedule based on the amount and terms of

financing is agreed upon by the bank and the lessee. The agreement may or may

not include a grace period. According to the Islamic view, the maintenance of the

asset during the leasing period is the responsibility of the owner of the asset, as

the benefit (rental) is linked to this responsibility (maintenance).67

The Al Baraka Investment Company uses the technique of Ijarah wa lqtina‘ to

finance the purchase of large capital items such as property, industrial plants and

heavy machinery. It involves direct leasing where investors in the scheme receive

regular monthly payments which represent an agreed rental. At the expiry of the

lease, the lessee purchases the equipment.

The Bank Islam Malaysia also uses lease purchase contracts. The procedure

adopted is the same as that described above except that the client and the bank

66 Muhammad Taqi Usmani, An Introduction to Islamic Finance, Adam publishers and distributors, New

Delhi , 2010, pp.159-160. 67 Ausaf Ahmad, “Contemporary Practices Of Islamic Financing Techniques”, Islamic Research and

Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 2010, p.24.

88

enter into an agreement at the time of the lease that the client will purchase the

equipment at an agreed price with the provision that the lease rentals previously

paid shall constitute part of the price. The lease purchase arrangement is also

used by Islamic banks in Iran, which purchase the needed machinery, equipment

or immovable property and lease it to firms. At the time of the contract, the firms

guarantee to take possession of the leased assets if the terms of the contract are

fulfilled. The terms of the lease cannot exceed the useful life of the asset which is

determined by the Central Bank of Iran. Banks in Iran are not allowed to lease

those assets whose useful life is less than two years.

What has been described above as a lease purchase arrangement (Ijarah wa

lqtina) is called hire and purchase in Pakistan. a client requests to participate in

this scheme, a "hire purchase" account is opened in his name. The value of the

asset as well as the amount of profit over cost payable by the client to the bank

are recorded as debits. The installment payable by the client has two distinct

components: the agreed rental and a part of the amount of profit. The asset

remains in the ownership of the bank unless all installments have been fully paid.

The ownership title is transferred upon the receipt of full payment. The

installments are so devised that the agreed price is fully amortized during the

useful life of the asset.68

3.6 Takaful (Islamic Insurance)

Takaful*, or Islamic insurance is a relatively new industry. During the past two

decade takaful operations have been opened in many countries throughout the

68 Ibid, pp.25-26.

*Takaful is an Arabic word that means mutual protection and indemnity: one party, while providing help

to others is also identified by them and this idea of mutual protection is in clear contrast to the profit

motive which underlines conventional proprietary insurance.

89

world, primarily in Islamic countries and countries with a large Muslim

community. In the Far East, Malaysia has been at the forefront of takaful

development with Bank Negara taking the lead with the introduction of separate

takaful regulations allowing the takaful business to flourish in that country.

Singapore, Indonesia, Brunei have all followed with the development of takaful

operations. In the Middle East, takaful operations have developed in Saudi Arabia,

Bahrain, Iran, Qatar and Iran with new operations opening up in Egypt, UAE and

Kuwait in recent years. Takaful, similar to mutual insurance, is a risk sharing entity

that allows for the transparent sharing of risk by pooling individual contributions

for the benefit of all subscribers. The global market remains at an early stage of

development with premiums estimated to have reached $16.5bn in 2011. This

includes an estimated $4.5bn generated in Iran where takaful is the compulsory

form of insurance, and Ernst & Young’s estimate of $12.0bn for the rest of the

world .69

The concept of takaful is fundamentally different from conventional proprietary

insurance, although it has affinities with conventional mutual insurance. Takaful is

centered on the principle of mutuality and avoids any commercial contract

between the insurer (insurance company) and the insured (the policy holder).

Thus it is a financial transaction of mutual co-operation between two or more

parties (participants) to protect one of them from unexpected future material

risk.70

Being different in concept and practice, takaful is based on a set of

principles that are both Shari’ah compliant and economically valid. Freeness from

69 Financial Market Series, Islamic Finance, www.thecityuk.com, 2012.s 70 Simon Archer, Rifaat Ahmed Addel Karim and Volker Nienhaus, Takaful Islamic Insurance: Concepts

and Regulatory Issues, John Wiley & Sons (Asia) Pte. Ltd, 2009, p.120.

90

riba, gharar, ghabun (fraud: lack of clarity regarding the object of the contract),

ignorance (al-jahalah) and gambling testifies the validity of takaful.

In a takaful plan, the participant pays a particular amount of money as a

contribution (the premium) partly to a risk fund (the participants’ special account)

under the rubric of tabbaru (donation), and partly to another party (the takaful

company) with a mutual agreement that, the kafil is under a legal responsibility to

provide for the participants’ financial protection against unexpected loss, should

it occur within the agreed period. In the event that no loss occurs to the

participants within the specified period, the participants are entitled to the whole

amount of the paid premium, together with the share of profits made out of the

accumulated paid premiums on the basis of mudarabah financing.71

A takaful

company has the following features:

I) The company is not the one who assumes risks nor the one taking any profit.

Rather, it is the participants, the policy holders, who mutually cover each other.

ii) All contributions (premiums) are accumulated into a fund. This fund is invested

using Islamic modes of investment and the net profit resulting from these

investments is credited back to the fund.

iii) All claims are paid from this fund. The policy holders, as a group, are the

owners of any net profit that remains after paying all the claims. They are also

collectively responsible if the claims exceed the balance in the fund.

71 Adnan Alamasi, “Surveying Developments in Takaful Industry: Prospects And Challenges”, Review

of Islamic Economics, Vol. 13, No. 2, 2010.

91

iv) The company acts as a Trustee on behalf of the participants to manage the

operations of the takaful business. The relationship between the company and

the policy holders is governed by the terms of mudarabah contract. Therefore,

should there be a surplus from the operation, the company (mudarib) will share

the surplus with the participants (rabb al-mal) according to a pre-agreed profit-

sharing ratio.72


The basic structure of takaful undertaking is designed by Takaful Operator (TO)

from a regulatory perspective, a major concern is how the TO is remunerated for

its services. During the past two decades, three standard models have emerged-

the wakalah model, the mudarabah model and the waqaf model.

3.6.2 Mudarabah Model

This is considered an excellent and praiseworthy model in the market of takaful.

In many ways it goes one better than a mutual insurance model in that no

expenses are charged to the participants’ funds. Another important feature of this

model is that the operator does not share in any surplus, therefore there is no

mudarabah issue to debate. It is very difficult business model as a stand-alone

family/individual life takaful operation (especially as no charging of expenses to

participants fund is envisaged). It is perhaps only really viable where a composite

takaful operation is being considered. It could take many years to realize a

commercial profit from such a business model as it relies on the build-up of

reserves and savings funds. As a stand-alone model, it would lend itself to a

72 Rating Takaful (Shari’ah Compliant)Insurance Companies, A.M. Best Company, www.ambest.com,

January 10, 2012.

92

philanthropic, state-sponsored operation or one where participants provide

capital. In the single example of this model in Malaysia, no expenses are charged

to the participants’ pool. There could be use of this model in Sudan with charging

of expenses to the pool for both family and general takaful.73

Figure No.10 A Simplified Diagram of Mudarabah Model (Abouzaid, 2007)

3.6.3 wakalah Model

In the wakalah model, all relations between TO and the participants are based on

an agency contract, the TO is the Wakeel (agent) who acts on behalf of the

participants (principal) both in underwriting and investment. The wakeel’s

services in both fields are remunerated by fees, which are contractually specified

either as an absolute amount or as percentage of the turnover (that is, the

volume of contributions or of invested funds), but not as a percentage of the

profit of the undertaking. The fees must cover all management costs (not

73

Adnan Alamasi, “Surveying Developments in Takaful Industry: Prospects and Challenges”, Review of

Islamic Economics, Vol. 13, Issue No. 2, 2010.

93

including claims and direct cost of claim handling) plus the profit for the share

holders.74

The best examples of operating wakalah takaful are Al-Jazirah Bank

and Jordan Islamic Insurance. The overall mechanism of wakalah takaful

operation is illustrated in the below given diagram:

Figure No.11 Wakalah Takaful Diagram (Abouzaid, 2007)

3.6.4 Waqaf Model:

Unlike the Al-Mudarabah and Al-Wakalah models, Waqaf operates as a

social/governmental enterprise, and programs are operated on a nonprofit basis.

Under the Waqaf model, the surplus or profit is not owned directly by either the

insurer or the participants, and there is no mechanism to distribute the surplus

funds. In effect, the insurer retains the surplus funds to support the participant

community. This model, with a single surplus fund, is most like a conventional

mutual insurance model. As such, it is rated in a very similar manner to

74 Simon Archer, Rifaat Ahmed Addel Karim and Volker Nienhaus, Takaful Islamic Insurance: Concepts

and Regulatory Issues, John Wiley & Sons (Asia) Pte. Ltd, 2009, p.120.

94

conventional mutual’s. For further information on the rating dynamics of mutual

insurance companies, please see A.M. Best’s “Rating European Mutual Insurance

Companies.” The remainder of the report will highlight the unique elements of

takaful companies following the Ta’awuni model, and how these factors are

incorporated in the rating analysis.

3.6.5 Microtakaful

Another recently applied takaful instrument in the Islamic finance market. It is an

institution that can well serve especially low income people. All takaful products,

like takaful financing, takaful education, fire, pension, etc., can be delivered to

the poor with some modification to allow for low premium contributions

collected on a periodic basis. It seems as an important component in any poverty

alleviation strategy. In Indonesia, partner-agent model is applied for microtakaful

model.75

3.7 Sukuk (Islamic Bond)

In the Islamic capital and money market Sukuk* has emerged as a very important

instrument, over the past decade, not only in the Muslim world but also in the

global markets due to its characteristics. Sukuk issues have expanded strongly in

the past three years, with Zawya Sukuk Monitor reporting a 62% increase in sukuk

issuance to $84bn in 2011 from $52bn in 2010. This follows a recovery from a low

point of $20bn in 2008 to $33bn in 2009. Sukuk made a strong start to 2012 with

$20bn of issuance in January. Sustained growth in the sukuk market demonstrates

appetite for quality issuers of sukuk from both Islamic and non-Islamic investors.

75 A. Haryadi, “Reaching To The Poor with Microtakaful”, Middle East Review of Insurance, July 2007,

pp.62-63.

*Sukuk is a plural of Sakk. Which means “legal documents, deed, check”. It is an Arabic name for

financial certificate but it can be seen as an Islamic equivalent of the conventional bonds.

95

Agreement in 2011 on a debt restructuring for Dubai World has improved

sentiment towards sukuk in general.76

It is asset-backed trust certificates evidencing ownership of an asset or its

usufruct (earnings or fruits). It has a stable income and complies with the principle

of Shari’ah. Unlike conventional bonds, Sukuk need to have an underlying tangible

asset transaction either in ownership or in a master lease agreement. The primary

condition for the issuance of Sukuk is the existence of assets on the balance sheet

of the issuing entity that wants to mobilize its financial resources. However,

identification of suitable asset is the first important step in the process of issuing

Sukuk certificates.77

3.7.1 Ijarah Sukuk

Ijarah forms the most common and simplest form of Shari’ah compliant Sukuk.

The Ijarah Sukuk have all been issued more or less using the same four Shari’ah

compliant contracts, namely, the Purchase Agreement, the Master Ijarah

Agreement, the Purchase Undertaking and the Sale Undertaking. The Ijarah Sukuk

is governed by two more Shari’ah compliant contracts that in a way guarantee the

payment of face value at the end of the term of the Sukuk, or in case of a default

or any other such contingency. It has been also Ijarah based sovereign Sukuk

bearing the same credit rating as that of the issuing country or Ijarah based

corporate Sukuk being rated in line with the debt rating of the entity providing the

purchase undertaking. Ijarah Sukuk are either backed by tangible assets or based

on tangible assets and therefore are tradable and negotiable. Ijarah based

sovereign Sukuk bearing the same credit rating as that of the issuing country or

76 Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, P.6. 77 A comprehensive study of the International Sukuk market, International Islamic Finance Market,

www.iifm.net, 1st edition, 2009, p.5.

96

Ijarah based corporate Sukuk being rated in line with the debt rating of the entity

providing the purchase undertaking. Ijarah Sukuk are either backed by tangible

assets or based on tangible assets and therefore are tradable and negotiable.

Ijarah based sovereign Sukuk bearing the same credit rating as that of the issuing

country or Ijarah based corporate Sukuk being rated in line with the debt rating of

the entity providing the purchase undertaking. Ijarah Sukuk are either backed by

tangible assets or based on tangible assets and therefore are tradable and

negotiable.

3.7.2 Mudarabah Sukuk

Mudarabah Sukuk are tradable and negotiable if the Mudarabah assets do not

comprise entirely of the Sukuk proceeds (in which case it will be all liquid assets

and cannot be traded). In most Sukuk, there is a combination of tangible assets

and Sukuk proceeds, plus the Mudarib is allowed to mingle its own assets with

those of the Mudarabah, hence mostly meeting the Shari’ah compliance

requirement of having more than 51% of the assets in tangible form for tradability

and negotiability.

3.7.3 Convertible or Exchangeable Sukuk

Convertible or exchangeable Sukuk certificates are convertible into the issuer’s

shares or exchangeable into a third party’s shares at an exchange ratio which is

determinable at the time of exercise with respect to the going market price and a

pre-specified formula. The convertible or exchangeable feature can be exercised

anytime before maturity and works in the same way as for any conventional

convertible or exchangeable issue. It is permissible under Shari’ah as long as the

conversion price or the exchange price fluctuates with the market price of the

97

shares. An issue would arise where such price is required to be a minimum

amount equivalent to the face value of the Sukuk, however, that is unlikely as it

defeats the very purpose of issuing a convertible security. Some Sukuk combine

exchangeability with another Shari’ah compliant structure such as Mudarabah or

Musharakah. For instance the Dana Gas Sukuk issued in October 2007 is an

exchangeable Mudarabah. Khazanah national’s three issues are only

exchangeable issues, not mingling it with Mudarabah or any other form of

Shari’ah based financing.78

3.7.4 Musharakah Sukuk

Musharakah Sukuk is an investment partnership between two or more entities

which together provide the capital of the musharakah and share in its profits and

losses in preagreed ratios. The Musharakah Sukuk has been next only to Ijarah in

terms of its popularity so far. The Sukuk that had been issued until the AAOIFI

ruling of February 2008 were very similar to the Mudarabah Sukuk structures

except that in place of a Rabb-al-Maal. Mudarib relationship between the Sukuk

holders and the Obligor, there is a Musharik or partnership between the Sukuk

holders and the Obligor.79

78

Ibid, P.39. 79

Ibid, P.40.

98

Chapter - 4

RELEVANCE

99

4.1 CURRENT POSITION OF ISLAMIC FINANCE INDUSTRY: A BRIEF REVIEW

Islamic finance is rooted in Shari’ah law, which prohibits interest-based financial

transactions, gambling high-risk speculation, and financing any form of economic

activity that can be considered detrimental to society. The industry’s modern-day

evolution, beginning in the 1970s to the present day, was still considered an

infant industry at the turn of the 21st century.80

The ascent of oil prices and

petrodollar driven investments, however, accelerated the industry’s expansion in

the early 2000s – a trend that was sustained with robust economic growth in

emerging markets and liquidity in capital markets. Although most of the Islamic

Banking and financial operations are carried out within Middle Eastern and

Emerging countries, some universal banks based in developed countries have

started to satisfy a large demand of Islamic financial products. It is the case in the

United Kingdom and the United States. As the economies around the world

slowly recover from the destabilizing effects of the global financial crisis,

increasing numbers of investors are looking to Islamic financial solutions as a

stable alternative to the fluctuations and uncertainties of current financial

systems.81

To examine and analyze the experience with Islamic finance industry,

in the current financial scenario has become the subject matter of this chapter.

The developments in infrastructure of its financial institutions, its achievements

in creating a better robustness in its applied dimensions, its expansion in terms of

geography and finally its sustainable growth rate in terms of asset ratio has been

described with the help of empirical data collected from various authentic

sources. Proponents claim that Islamic finance contributes to the stability of the

80 Mercy Kuo, “The Emergence of Asia’s Islamic Finance Industry”, Banker’s Academy Briefings, June 08,

2011. 81 Islamic Finance News 2012 Guide, www.IslamicFinanceNews.com, February 2012 , P.30.

100

financial system. During the recent financial crisis, Islamic financial institutions

were affected by the adverse second- round effects of the crisis: when the real

economy contracted, real estate prices got depressed, and in some cases, issues

of Islamic bonds (Sukuk or certificate of ownership) defaulted. However, Islamic

banks generally escaped the worst effects of the 2008 financial crisis, because

they were not exposed to subprime and toxic assets, and had maintained their

close connection to the real sector. Hence, some observers have suggested that

conventional banking can learn from the alternative systems offered by Islamic

finance, which is less skewed toward debt instruments, uses equity for greater

risk sharing, and limits the mismatch of short-term demand deposits with long-

term loan contracts.82

Islamic financial products offer an appealing alternative to conventional

portfolios. In 2002, not long after the tragic events of September 11, 2001, then

U.S. Treasury Secretary Paul O’Neill was quoted as saying, “It took me six months

to realize that Islamic finance was a legitimate way of doing business”—a

statement that aptly captured non-Muslim public sentiments about the industry.

Islamic finance is becoming an integral part of the global finance industry and has

taken its roots in almost all of the Muslim countries but has also been under

discussion and penetration in selective Western and Far Eastern jurisdictions.

According to Dr. Zeti Aziz,” Today the Islamic financial system has evolved

significantly to become a dynamic and competitive form of financial

intermediation in the global financial system. This transformation has been

achieved in an increasingly challenging environment”. She further adds, “Most

significant have been the development of the Islamic financial markets, the 82 Mahmud Mohieldin, “Realizing The Potential Of Islamic Finance”, The World Bank Economic Premise,

Number 77, March 2012.

101

growth in the range of financial products and services, the increasing significance

of the international dimension of Islamic finance, the development of an

international Islamic financial architecture, and the enhanced international inter-

linkages that have been brought about by these developments”.83

The Islamic financial industry comprises of the Islamic capital market which is an

area that has grown to become an increasingly popular sector within the global

financial market. Islamic capital markets have gained considerable interest as a

viable and efficient alternative model of financial intermediation. The demand for

investing in adherence to the principles of the Shari’ah on a global scale have

been spearheading towards making the Islamic financial services industry a

successful sector. This is also an indication of the increasing wealth and major

capacity of investors who are both Muslim and non-Muslim, wishing to invest in

new investment products that serve and meet their individual needs. The Islamic

Capital Market (ICM) refers to the market where financial activities are carried

out in adherence to the Shari’ah financial principles of Islam. The ICM represents

a reflection of religious law in the capital market transactions where the financial

market is free from prohibited activities such as gambling. Indeed, the pace of

development in the Islamic financial market has gathered momentum with the

formation of various international Islamic organizations to study and promote this

alternative market. The Islamic financial capital market runs adjacent to the

conventional financial market and provides the scope for investors to be given the

opportunity for an alternative investment philosophy that is rapidly gaining

acceptance. The fact that the Islamic financial market does not prohibit

participation from non-Muslims creates unlimited upside to the depth and Riba 83 Zeti Akhtar Aziz, “ Islamic Finance: Global Trends and Challenges”, The National Bureau of Asian

Research (NBR), volume 18, number 4, march 2008.

102

(usury), Maisir (gambling) and Gharar (ambiguity). The Islamic capital market

operates as a market to the conventional capital market for capital seekers and

providers. It has played a complementary role to the Islamic banking operations

and systems in creating a well defined, comprehensive Islamic financial market

especially in Islamic financial hubs such as Malaysia.

The ICMs in 2011 have much scope worldwide especially since the Shari’ah-

compliant Islamic finance industry is growing on a global scale. The total

worldwide Muslim population is 1.5 billion, representing a significant 24% of total

world population of 6.3 billion. Shari’ah-compliant assets are growing over the

last 20 years and are representing an estimated US$ 300 billion banking assets &

approximately $400 billion Capital Market. In addition there are over 700 Islamic

financial institutions currently operating in about 75 countries worldwide.84

Out

of these IFI’s there is estimated to be more than 100 Islamic Equity funds

managing assets is in excess of US$500 billion, and still growing by at least 10-15%

annually. In the GCC, liquid wealth with Shari’ah sensitive investors will add more

than US$70b to this pool by 2013.85

The estimated annual growth for the overall

Islamic capital market is 15% to 20% annually which shows the scope for further

progression. Global Islamic Finance assets are predicted to increase 33% from

their 2010 levels to $1.1 trillion by the end of 2012 as Fig. No.12 highlights the

continuity of growth rate from 2006 up to 2011.

84

Islamic Finance News 2012 Guide, www.IslamicFinanceNews.com, February 2012 , P.30. 85Ernest and Young, Islamic Funds and Investments 2011:Achieving growth in challenging times, 7th

Annual World Islamic Funds and Financial Markets Conference (WIFFMC 2011), 2011.

103

Fig. No.12 Source: The Banker, Ernest and Young

The Middle East and North Africa will show signs of increase, with assets rising

$990 billion by 2015 from the $410 billion in 2010. The ICMs can further pave the

way by implementing cross border trading within OIC countries in order to further

diversify and minimize risk and volatility. In addition progressive developments of

information technology can further increase ICM and this is already taking place

due to innovative software solutions such as Path Solutions and iMAL which

provides the latest Islamic Shari’ah-compliant services to cater for the ICM

monitoring and maintenance. An improvement in transparency in the market

needs to be implemented in order to attract an increased number of foreign

investors. There also needs to be more standardization on guidelines in Shari’ah

compliancy in order for the ICM to further progress in the years to come. The

potential of the Islamic finance capital market is huge as the ICM has the potential

104

to reach several trillion USD by 2015. The GCC surplus may continue for the next 4

to 5 years mainly due to oil demands and price which will cause significant growth

in the sector. The unprecedented demand from customers who are both Muslims

and Non-Muslims, is increasing realize the benefits of the Shari’ah markets.

Therefore there is much potential for the ICM.86

While discussing the Euro zone

crisis and future policies of Islamic finance industry in such a financial climate, in

opening address of the 3rd

Annual World Islamic Banking Conference: Asia

Summit, Singapore, Mr. Ravi Memon, managing director of the Monetary

Authority of Singapore, said,” But Islamic finance has a window of opportunity in

the current climate of deleveraging in the global financial system. With its strict

prohibition on excessive leverage, Islamic finance has been spared the worst of

the financial crisis. Islamic banks are well positioned to reach out to new

customers who are in need of financing as many global institutions pull back on

their lending due to the need to repair their balance sheets”.87

Although Islamic

banks received such an opportunity in 2007-2008 also in the form of U.S subprime

mortgage crisis and dealt with it in such a way that motivated investors and

customers to go with it, as parallel system of economy. The less effect of GFC on

Islamic finance industry persuaded economists and finance experts to admit that,

carrying its major functioning in the real estate sector, Islamic finance industry

potentially managed its clients as well as institutions to escape from the

venomous and far reaching repercussions of the GFC.

86 Global Islamic Finance, “The Ultimate Islamic Finance Review 2011”, December - January 2012, p.6. 87 Mr. Ravi Menon, “The next phase in Islamic finance”, BIS central bankers’ speeches , 3rd Annual World

Islamic Banking Conference: Asia Summit (WIBC Asia 2011), Singapore, 5 June 2012.

105

4.2 Islamic Banking and Investment: A Flourishing Sector

Islamic banking is now expanding out of its niche to become a market that could

rival the conventional sector in many countries. It is an increasingly visible

alternative to conventional banks in Islamic countries and in countries with large

Muslim populations, such as the UK. Globally, the assets of these institutions have

grown at double-digit rates for a decade, and some conventional banks have

opened Islamic windows. The International Organization of Securities

Commissions predicts that as much as half of the savings of the world's 1.3 billion

Muslims will be in Islamic financial institutions by 2015.88

Islamic financial services

are nearing $trillion in reported managed assets, with about 700 Islamic financial

institutions(IFIs) spread throughout every region of the world. The Islamic banking

system (IBs) market- that is, the market of the technologies that enable these

financial products to be bought, sold and distributed- is predicted to raise to grow

at 10.9% compound annual growth rate (CAGR) between 2009 and 2014, while

the external IT spending component will have a higher CAGR, at 18.1%. The IBS

market is expected to reach $1.6 billion in 2014. As consumer trust in

conventional banking waned during the recent economic downturn, Islamic

banking enjoyed marked market expansion, Islamic banking is perceived by its

customers as a mutually beneficial partnership, and is regarded by some banks as

an opportunity to re-establish and connection with consumers. Growing demand

is evident for Islamic products from new markets such as African and Western

countries. An increasing number of conventional branch environment, mixing

both conventional and Islamic banking capabilities.

88 Patrick Imam and Kangni Kpodar, “Islamic Banking: How Has it Spread?”, International Monetary

Fund, 2010.

106

The Islamic banking market will continue to grow at a double digit pace. This is

based on:

1) The increasing Muslim populations in particular regions.

2) Newly available assets from unbanked populations and

3) The relatively low effect of the financial downturn in the high economic

growth regions such Middle East and Asia Pacific.89

In the first-half of 2011, the UAE’s Islamic retail banks have been busy in the

promotion of new products and services. In January 2011, Noor Islamic Bank

opened its largest branch for Islamic insurances Noor Takaful which is excelling in

the retail sector. Ajman Bank has recently launched the Mahra Ladies Banking as

“around a quarter of the UAE’s private wealth is controlled by women,” Maryam

Al Shorafa, Head of Ajman Bank’s Ladies Banking, told AME info.com. Dubai Bank,

one of the smallest local banks in the UAE, has also just opened a new branch at

Dubai’s prestigious Jumeira Road. People who drive down the road from the

famous Jumeira Mosque to Burj Al Arab can’t miss the huge building near the

“Miraj” Islamic Art Centre. Also in June 2011 it was reported that, Dubai Islamic

Bank launched access to a new Shari’ah-compliant fund, the Prudential Shari’ah

Opportunities - Asia Pacific Equity Fund. Abu Dhabi Islamic Bank (ADIB) offers 25%

discounts on online transactions for those who open an online brokerage account,

along with the chance to win an iPad, which are all exclusive retail banking

promotions to attract both Muslims and Non-Muslim customers into the Islamic

retail banking sector. Many Islamic financial institutions are tapping into the

Islamic wealth management sector. Abu Dhabi Islamic Bank (ADIB) is one such

example as in September 2010 ADIB launched its specialized wealth management 89 Gartner Research, Islamic Banking: Opportunity or Money Pit For conventional Banks, ITS, Issue: 2,

p.10.

107

services. In 2010 the Islamic retail sector needed more pushing as reported by

Ernst & Young however it is slowly picking up with the advancement of

technology and the Islamic banking industry.

The Islamic Banking sector has progressed tremendously in the last 25 years of its

succession as competition in the banking sector has further intensified due to

globalization and technological advancement. Shari’ah-compliant investments

have continued to attract the attention of global investors and consumers

wanting to utilize Islamic modes of financing. In attempting to meet the demands

of the growing Islamic financial sector the industry has to effectively implement

conventional bank’s use of modern day technology through the use of mobile

internet banking and other current software.

Many Islamic banks are choosing to offer Islamic financial products and services

through mobile internet banking and it is becoming an increasingly popular

method of handling transactions quickly and efficiently. Another key example of

implemented mobile technology facilities in Islamic banks are Dubai Islamic

Bank’s recent launch of Al-Islamic Mobile Banking. Al Islamic mobile banking

allows customers to check their statements on their mobile, carry out

transactions, and check their Murabahah accounts and investment accounts.90

In

Bangladesh, Islamic banking accounts for 65% of total banking assets, in Bahrain

46% and Saudi Arabia 35%. However penetration in other countries is limited with

Islamic banking accounting for only 4% to 5% of total banking assets in Turkey,

Egypt and Indonesia.91

Islamic banks, including those with Islamic ‘windows’, are

now looking to enhance their position in faster growing core regions of Middle

90 Global Islamic Finance, “The Ultimate Islamic Finance Review 2011”, December - January 2012, P.16. 91 Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, P.3.

108

East, Asia and Africa. Offering products that are competitive on price and service

could help to generate business not only from Muslims with a preference for

Shari’ah compliant services, but also from Muslims and other customers that

currently use conventional banking services.

Significant international developments in the past year have included:

● Launch in November 2011 by Thomson Reuters of the world’s first Islamic

interbank rate, which is designed to provide an indicator for the average expected

return on Shari’ah compliant short term interbank funding.

● Oman’s decision in May 2011 to permit the establishment of Islamic banks in

the country the last of the six GCC states to do so. The aim is to tap into regional

demand for Shari’ah compliant banking services and other products currently

being met elsewhere in the region and therefore to curtail the current outflow of

investment from Oman.

● Qatar’s move in February 2011 of preventing conventional banks from offering

Shari’ah compliant products through Islamic windows. The boundary is expected

to provide opportunities for Islamic banks to gain market share.

In the UK, the five fully Shari’ah compliant banks were established between 2004

and 2008 and put the UK in the lead in Western Europe. There are also an

estimated 17 conventional banks that have set up windows in the UK to provide

Islamic financial services. HSBC Amanah is the only conventional bank with an

Islamic window to report to The Banker’s survey: its assets of $16.7bn account for

88% of the UK’s identified assets, with a further 6% from BLME and 3% from the

HSBC parent bank. The 22 Islamic banks in the UK substantially exceed that in any

other Western country or offshore centre. The Islamic Bank of Britain (IBB) is a

retail bank and the only Islamic bank with a high street presence having five

109

branches and around 50,000 customers. IBB’s founding shareholder Qatar

International Islamic Bank took full control of the bank in 2011. IBB’s admission to

the AIM market was cancelled in April 2011. The Bank of London and The Middle

East (BLME) is an independent wholesale Shari’ah compliant UK bank based in the

London. BLME’s offering spans corporate banking, treasury and wealth

management that comprises private banking and asset management. BLME aims

to strengthen its services and market penetration in the GCC. QIB UK took on its

new branding in 2010 to reinforce its identity within QIB’s global network. QIB UK

offers a range of Shari’ah compliant financing and investment products for both

Islamic and non-Islamic clients alike. It provides Shari’ah compliant investment

banking services including trade finance, private equity and asset management.

Gatehouse Bank is a Shari’ah compliant wholesale investment bank operating in

capital markets, real estate, asset finance, treasury business and Shari’ah advisory

services. In 2010, Gatehouse Bank completed more than £160m in Shari’ah

compliant real estate acquisitions.92

4.3 Islamic Banking in MENA Region: A Growing Trend

Islamic finance in the Middle East and North African (MENA) countries has now

become an important element in their societies‟ development agendas and it is

also gaining ground in the financial landscape of the region as well as in the

individual countries. It is also a growing business as it caters to the financial needs

of the people without conflicting with their social and religious values.93

The

Islamic banks in the MENA region have achieved strong growth during the years

2003 to 2007 with a CAGR of over 31% in assets. They outperformed the banking

92 Ibid, p.5. 93 Salman Alman Syed Ali, “Islamic Banking In The MENA Region”, Islamic Development Bank – Islamic

Research And Training Institute, February, 2011.

110

system as a whole that registered an average CAGR of about 23.9%. At the end of

2007, there were 20 publicly listed pure Islamic banks in the region with a

combined asset base of USD 148.3 billion.94

Islamic banking assets in the MENA

region have been growing exponentially over the last several years. For example,

in 2004 the proportion of Islamic banking assets of the Middle Eastern banks was

only about 29 percent of the worldwide Islamic banking assets, which grew to 50

percent of the worldwide share in 2008.6 Not only the aggregate but the average

asset per bank has increased in the Middle East as well. Most of this growth was

taking place in the GCC countries, but recently the non-GCC countries are also

witnessing growth of Islamic banking both by establishing domestically

incorporated Islamic banks and by cross-border expansion of GCC based Islamic

banks through their subsidiaries. The Islamic banking sector is not of similar size

and scope across MENA countries. Figure No.13 shows the asset size distribution

for various countries. The assets have been growing in all countries with the

highest growth in Qatar of 48 percent and lowest in Egypt of 10 percent. Lebanon

with an asset growth of 145 percent is an exception as Islamic banks opened in

the country only in 2006, thus, it is starting from a very small base. Saudi Arabia,

UAE and Kuwait stand out as giants in terms of aggregate assets of Islamic banks

while Egypt, Jordan, Yemen, and Lebanon constitute the lower tail with Qatar and

Bahrain in between (see Figure 13).

94 Islamic Banking in the MENA Region, Blominvest Bank, Feb. 2009, P.7.

111

Figure No.13 Source: Islamic Development Bank (2011)

4.4 Growth of Islamic Takaful Industry

Takaful, similar to mutual insurance, is a risk sharing entity that allows for the

transparent sharing of risk by pooling individual contributions for the benefit of all

subscribers. The global market remains at an early stage of development with

premiums estimated to have reached $16.5bn in 2011. This includes an estimated

$4.5bn generated in Iran where takaful is the compulsory form of insurance, and

Ernst & Young’s estimate of $12.0bn for the rest of the world.95

Figure No. 14

shows the growth of takaful premium and takaful assets in Iran and rest of the

world.

95

Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, P.7.

112

Figure No.14 Takaful Global Market (Ernst & Young, 2011)

The very first Takaful company called the Islamic Insurance Company of Sudan

was established in 1979. In 2011, there are over 30 registered Takaful companies

worldwide writing Takaful directly and 10 more as Islamic windows or marketing

agencies placing insurance risk with conventional and Takaful companies and the

number continues to grow. In fact the number of Takaful companies is higher as

all insurance companies in Sudan are deemed to operate in accordance to the

Shari’ah principles. In addition, new Takaful companies have been established

recently in Sri Lanka and Tunisia. At least four more Takaful companies are under

formation in the Middle East in countries such as Kuwait, UAE and Egypt. Several

other Takaful companies are being contemplated in various countries such as

Pakistan, Australia and Lebanon. The countries of South Africa, Nigeria, and some

of the former states of the Soviet Union are also contemplating tapping into the

Takaful market.

113

Takaful industry in Bahrain is said to be prospering from last few years especially

in 2011 as people are favoring Shari’ah-compliant methods of Islamic insurance.

Takaful total contributions grew by 16.5 percent to reach BD13.4 million ($35.6m)

in the first quarter of the year compared with BD11.5 million for the same period

last year, according to the Central Bank of Bahrain (CBB). Traditional insurance

still took the largest share of the market, down slightly at BD43.3 million in the

first quarter compared to BD44 million. The Takaful market in Bahrain consists of

27 domestic insurance companies and 11 branches of foreign insurance

companies covering both direct insurance and reinsurance. The recorded data for

the insurance market during the first quarter of the year shows a slight increase

of 1.8 percent in gross written premiums in the quarter up from BD55.7 million to

BD56.7 million. The global Takaful market which has increased potentials for

employees, students and professionals who want to tap into the Islamic insurance

industry. The graph spans from the year of 2006 which shows that the market for

Takaful was at $2.10 billion dollars however the demand for Takaful insurance

has increased year by year and is expected to reach $7.39 billion dollars by 2015 if

it maintains growth in the highly competitive financial insurance industry.

Many countries have various different global markets for Takaful. Malaysia has

the largest market for Takaful premiums reaching 1,220 with Syria with the least

market. It is estimated that the global Takaful premium could be in the region of

US $7.4 billion in 15 years time in 2026, growing at nearly 20% per annum. This is

not an unachievable task as the Malaysian Takaful sector is successfully growing

at 60% annually and the Middle East at 10% annually. With a focused effort on

114

part of the Takaful operators worldwide there can be the potential of a significant

growth of 20% annually.96

4.5 Sukuk: A Global Successes for Islamic Finance Industry

The Sukuk Islamic bonds sector is a global success for the Islamic finance industry

with it growing at subsequently fast rates it is a driving force for the progression

of the Islamic finance industry. Many Muslims and Non- Muslims find Sukuk the

perfect alternative to conventional bonds. The Sukuk market has become an

emerging sector during the years and after the global economic crisis the appeal

for the market increased with many investors turning to utilize Sukuk Islamic

bonds for their projects and investments. Figure No.15 depicts the dynamic

growth of Sukuk industry.

Figure No. 15 Source: Zawya Sukuk Monitor

In reviewing the rapid growth of Sukuk it is imperative to look at the development

which aroused the emerging sector when it was in its infancy. Many countries

around the world such as Qatar have made unprecedented developments in the

Sukuk arena. Malaysia is the global market leader for Sukuk issuance, accounting 96 Global Islamic Finance, “The Ultimate Islamic Finance Review 2011”, December - January 2012, p.16.

0

10

20

30

40

50

60

70

80

90

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Jan-12

Sukuk Global Issues

115

for 63 percent of cumulative Sukuk issuances between 1996 and 2010. Malaysia

issues long-term, local currency Sukuk to fund infrastructure projects and

contribute to financial stability.97

Qatar International Islamic Bank (QIIB) and

HSBC issued US $700 million worth of Trust Certificates (Sukuk) which was due in

the year 2010 and is now progressing in 2011. The proceeds from this issuance

were utilized to finance the construction and development of a major

infrastructure project which was the Hamad Medical City located in Doha, Qatar.

The certificates issued in 2003 were redeemable in 2010, hence, the period for

the issue was seven years. The joint lead managers for the issue were HSBC Bank

and the Qatar International Islamic Bank, with the co-managers being the Abu

Dhabi Islamic Bank, Gulf International Bank, Kuwait Finance House, Commerce

International Merchant Bankers of Malaysia, the Islamic Development Bank and

the Qatar Islamic Bank. Bahrain is another country which is making milestones in

the Sukuk arena and holds many investment opportunities in 2011 for the

facilitation of Sukuk Islamic bonds. Bahrain had an oversubscribed demand for the

Sukuk market as Bahrain’s 750 million sovereign issue attracted an order book of

about $4 billion with a strong demand from the Middle East.

The initial size of the Sukuk offering was $500 million, but the issue was

oversubscribed by almost eight times. As a result, the value of the Sukuk was

raised to $750 million, a Central Bank of Bahrain statement said. “One of the

major reasons behind this issue was to establish a yield curve benchmark for

longer-term Islamic securities,” said Sheikh Salman bin Isa Al Khalifa, executive

director, banking operations, CBB. “This is a testament to Bahrain’s strong credit

and the confidence which International markets place on the kingdom’s financial 97 Mahmud Mohieldin, “Realizing The Potential Of Islamic Finance”, The World Bank Economic Premise,

No. 77, March 2012.

116

sector,” added Sheikh Salman. The GCC and the UAE have made several

milestones throughout the years in the issuance of Sukuk and with the Islamic

financial sector set to rise there is much scope for the countries to further

develop Sukuk issuances. With correct implementation of legislation and

regulatory bodies which support the Sukuk system the Sukuk issuances can be

performed smoothly. Europe has also been making progressive developments in

the Sukuk arena. The Sukuk market in Europe grew by a massive 75% to US $85

billion in total outstanding issues in the first half of 2007. The US $24.5 billion of

funds raised in the first half nearly surpassed the total amount of new issuance in

2006 of US $26.8 billion, according to the Islamic Finance Information Service,

online media partner of the forum.98

In early 2010, the UK House of Commons decided to adopt the Financial Services

and Markets Act 2000 Order 2010. It is aimed at removing barriers and

uncertainty in the regulation of alternative finance investment bonds (Sukuk) and

which the Treasury stresses will reduce compliance and legal costs for these

instruments, and facilitate the issuance of corporate Sukuk in the UK this made it

more accessible to issue Sukuk. Germany and France are also making progressive

developments in Sukuk Islamic bonds. Germany was the first country to issue

Sukuk in Europe as in September 2004 Saxony-Anhalt became the first state

government in Germany and Europe to issue a sub sovereign bond under Islamic

principles. The €100 million bond does not offer interest payments to its investors

and Germany abided by the Shari’ah principles outlined for issuing the first Sukuk.

German banks such as Deutsche Bank, Commerzbank and Dresdner Bank are

already well involved in the sector albeit in overseas markets. Deutsche Bank for

98 Islamic Finance, UK Islamic Finance Secretariat Sponsored by Gatehouse Bank, March, 2012, p.7.

117

instance has co-lead managed MTN issuances for the Jeddah-based Islamic

Development Bank and pioneered the Islamic Equity Certificates with National

Commercial Bank of Saudi Arabia a product which the promoters claimed was the

first Islamic retail product with universal marketing application and capability99

.

Overall the main issuers of European Sukuk in UK, France and Germany exhibit

potential to further develop the Sukuk industry and allow scope for more

issuances to pave the way for Islamic finance as a major sector in Europe. Many

Non-Muslims and Muslims alike have embraced the Sukuk industry in Europe and

are keen to further encourage the development and implementation of laws

which accommodate and make it easy for investors to utilize Sukuk issuances. In

2010 the UAE holds a significant presence in the Sukuk market accounting for 20

percent of the total Global Sukuk market. Global Sukuk issuance totaled $19

billion last year and the UAE also recorded the second highest Islamic loan volume

in the region after Saudi Arabia, the data released at the Reuters Islamic Banking

and Finance Summit in Dubai. America and Canada still have a way to go with

Sukuk as in 2011 not much has been done to facilitate Islamic Sukuk bonds in

comparison to the Middle East and UAE. America launched its very first debut

Sukuk on the 16th of June 2006 which was the East Cameron Gas Sukuk which has

been described as being the most innovative and interesting Sukuk to date. Sukuk

in Canada also flourished between the years of 2009 to 2010 and Siraj Capital

Dubai which had also helped to issue America’s first Sukuk issuance had also been

proactive in launching Canada’s debut Sukuk. One of Canada’s very first major

Sukuk deals was quite recently issued in 2009 as Canada was quite late to tap into

the Islamic financial market. On the 7th of July 2009 Siraj Capital Dubai

99

Ibid, P.8.

118

announced the Bear Mountain Resort Sukuk at the London Sukuk Summit.100

The

Islamic financial sector and is rapidly emerging as a prominent financial sector in

the mainstream. Sukuk issuances which are mainly made from successful Islamic

financial hubs such as Malaysia and the UAE are slowly crossing the borders into

the Western world and soon America and Canada can take a leading role in the

issuances of lucrative Sukuk deals.101

From the above figures, it becomes clear that Islamic finance industry has become

one of the growing financial segments in the international financial system. Its

phase of development that began in earnest as domestic-centric for Muslim

economies, has rapidly transformed in this recent decade to become

internationally recognized and accepted as a competitive and robust form of

financial intermediation by all communities.

100 Islamic Finance News 2012 Guide, www.IslamicFinanceNews.com, February 2012 , P: 8 101 Global Islamic Finance, “The Ultimate Islamic Finance Review 2011”, December - January 2012, pp.16-

17.

119

Conclusion

120

Conclusion

The current global financial crisis, believed to be worst of its kind since Great

Depression 1929, has dramatically changed the values, requirements and

opinions of common masses in general and economists and finance experts in

particular, in viewing the economic performance of banks and financial

institutions. The ‘Credit crunch’ as it has come to be known brought panic and

turmoil in the summer of 2007 to the world’s financial markets causing the United

States’ housing market bubble to burst. The crisis threatens a worldwide

economic recession, potentially bringing to a halt more than a decade of

increasing prosperity and employment for western economies and potentially

wiping a staggering $1 trillion off of the value of the world economy. Economists

analyzed that imprudent lending, high leveraging, unnecessary financial

innovations and speculations are the determinant factors responsible for financial

ripples leading to economic slowdown and the ongoing crisis situation.

Representing the collapse of trillions of dollars of fictitious credit derivatives and

the meltdown of uncontrolled credit growth, the scope of the crisis could reach

unmanageable size. The crisis has shown that advanced financial systems are very

vulnerable and share the character of inherent instability. The global financial

crisis brought to the fore the inadequacy of conventional banking regulations in

general and their capital inadequacy in particular in relation to the risk associated

with their businesses both aspects require serious consideration. The crisis also

vividly highlighted the importance of the stability as a prerequisite for economic

progress.

The Islamic Financial Services Industry is of course part of the broader global

financial system, but it is comprised of instruments, infrastructure, institutions

121

and markets that apply Shari’ah rules and principles in their design and

operations. The Islamic financial system appears to be able to perform

substantially all of the functions associated with typical conventional financial

transactions and it therefore has sub-sectors that are similar to the conventional

financial system. These sub-sectors consist of, among other things, the Islamic

banking industry, the Islamic money market, Islamic capital markets (equity and

bond markets), the Takaful (Islamic insurance) industry and the Islamic

asset/wealth management industry. With global Islamic finance assets projected

to reach $1.6 trillion by 2012, the industry is an emerging force of liquidity and

investment in global markets across multiple sectors – real estate, construction,

financial services, transportation, oil and gas, power and utilities, consumer goods

and telecommunications. The Islamic finance industry, having more than 700

institutions, spread in 75 countries including Europe and America, has covered

15-20% average annual growth rate over the past decade and is projected to

cover 20% annual growth rate over the next five years. While not immune from

the effects of the global financial crisis of 2008-2009, the Islamic finance industry

due to its asset-backed nature of financial operations, has weathered the storm

somewhat better than its conventional counterparts. However the Islamic

financial industry still faces many challenges, many bankers as well as regulators

are assessing the market opportunity, risk management policies, operational

standardization and robustness of the industry. The Islamic financial system, while

just coming out of its niche, if compared to the conventional financial, centuries

old, has proven to have a solid foundation. As Islamic banking and most of its

financial contracts are based on the risk sharing it is intrinsically more stable. If

this intrinsic feature is combined with prudent regulations and supervision and

122

implementation of risk management, transparency and corporate governance

that are up to international standards, Islamic finance industry can virtually

develop into a model alternative to the conventional financial system in attaining

equity, stability and effectiveness. While operating its banking system in the

current financial scenario, Islamic finance industry goes on with the following

structures: (a) Dual system (Malaysia and Indonesia), (b) Dual system with clear

separation between the conventional system and the Islamic system (Bahrain and

Jordan). In a dual-system environment, it is not uncommon to see big global

banks such as HSBC, Citibank, Standard Chartered, Deutsche Bank, BNP Paribas

and ABN Amro setting up Islamic window operations or even Islamic banking

subsidiaries, and (c) Full Islamization of the financial system: virtual absence of

conventional financial institutions, since only full-fledged Islamic financial

institutions are licensed to operate in a country (Iran, Pakistan—making its way in

this direction-- and until recently, Sudan).

A healthy group of economic experts and finance analysts are unanimous in their

opinion that the continuity of financial crisis, firstly hitting U.S and now rocking

the Euro-zone has set the stage for Islamic finance to demonstrate its availability

as a potentially genuine alternative financial system. History teaches that

opportunities presented, can be seized and realized or neglected and wasted. It is

time for Islamic finance industry to seize its movement of opportunity and prove

its inherent tendency towards creating a much resilient financial environment

governed by the Divinely guided regulatory framework.

123

Reference

124

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WEBSITES:

1.www.islamicfinancenews.com

2. http://hsgac.senate.com

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