sami al-suwailem irti, idb safar 1430 – february 2009
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Global Financial Crisis: Causes and Remedies. Sami Al-Suwailem IRTI, IDB Safar 1430 – February 2009. Overview. Worst in 100 years Capital Markets lost $30-35 trillions this year Real estate lost $30-35 trillions—total $60 trillions Financial institutions lost $3+ trillions - PowerPoint PPT PresentationTRANSCRIPT
Sami Al-SuwailemIRTI, IDB
Safar 1430 – February 2009
Global Financial Crisis:
Causes and Remedies
OverviewWorst in 100 yearsCapital Markets lost $30-35 trillions this yearReal estate lost $30-35 trillions—total $60
trillionsFinancial institutions lost $3+ trillionsCentral banks injected $8+ trillions since
startFor comparison: Insured catastrophe losses
(earthquakes, tsunamis, man-made disasters) 1970-2007: $745 billions
Root CausesExcessive leverageExcessive speculation
Debt
Wealth
Inverted Pyramid
Unsustainable SystemDebt accumulates faster than wealthMinor shocks make the system crashFinancial fragilityCrashes needed to “clean up” the systemThen debts start to accumulate again faster
than wealthRecurrent crashesVery costly system
Sources of DangerRiba: usury and interest on loansGharar: gambling and wageringProhibited by all Divine revelations
RibaSeparates debt creation from wealth creationDebt grows faster than wealthDebt maturities shorter than assetsDebt services become unbearablePressure on wealth base accumulatesCrash is imminent to restore balance
Debt in the US
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
1975 1980 1985 1990 1995 2000 2005 2007
M2 GDP Non-financial debt
FiguresAverage growth annual rate for
debt: 39%,GDP: 21%,M2: 19%
Debt-GDP ratio grew from 1.3 to 2.2Debt-M2 ratio grew from 2.2 to 4.2Unsustainable system
Imbalance sheetsBorrowing short and lending long causes
financial fragilityBy end of 2006, investment banks were
rolling over 25% of their liabilities dailyExtreme mismatch of assets and liabilities“The original sin”
DerivativesCaused more imbalances, thus made the
system overall more riskyDerivatives themselves are imbalanced—even
more than underlying assets and liabilities
GhararHigh risk transactionsZero-sum games that create no wealth
Toxic AssetsBy definition, they are more likely to loseMeet classical definition of ghararCannot be allowed in Islamic finance
Zero-sum gamesDerivatives by definition are zero-sum
transactionsMake the system more risky
Derivatives
0
100,000
200,000
300,000
400,000
500,000
600,000
700,000
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Global Derivatives Notional Values, $B
OTC OE
Credit Default SwapsSemi-insurance contractWhy to insurance subprime?
Upfront feesRising house pricesLarge markets for risk trading
Size of CDS: $62 trillions in 2007Naked CDS: ~80% of the market
CDS
-
10,000
20,000
30,000
40,000
50,000
60,000
70,000
2001 2002 2003 2004 2005 2006 2007
Credit Default Swaps Notional Value ($B)
How CDS Fueled the Bubble?Rising home prices encourage insuranceInsurance encourages lendingLending fuels housing demand, which raises
prices, etc.Moral hazard and reckless behavior
Home Prices
80
100
120
140
160
180
200
220
CDS vs. CasinoCDS: side betsCNN: “The largest casino in the world”CDS vs. casino:
CDS not regulated; casino isCDS highly interlinked;CDS highly linked with outside institutions
CDS and Amplification of RiskSide bets magnify risksInter-related financial contracts make the
system very sensitiveConcentration of riskDownturns cause higher counter-party riskThe result: losses are amplified
Risk in Financial MarketsFinancial risks are mostly endogenous: 70%Real sector volatility is decreasing, while that
of financial markets is increasingConventional finance is more risky than
natural disasters
Summary: Causes of CrisisUncontrolled debt financingUncontrolled risk takingBoth lead to excessive financial commitments
and inverted pyramid of wealthThey fuel each other
Ineffective Policy“Privatization of profits and nationalization of
losses”Capitalism in during upturns, but
communism in downturnsMarkets on steroids more than 2 decadesRecovery cannot be brought back using more
steroidsLiquidity trap and the Japanese case
Search for New ParadigmJean-Claude Trichet, President of the
European Central Bank: “What we need is a new paradigm”
Angela Merkel and Nicola Sarkozi: New economic order
Islamic EconomicsUniversal principlesSolid economic groundTested financial instruments
Islamic FinanceDebt creation is integrated with wealth
creationExcessive risk and zero-sum games are
excludedFinance is integrated with real transactionsSince real economy is less risky than
financial markets, Islamic finance is less risky than conventional finance
Safety NetNon-profit safety-net is integral to economic
activities:ForbearanceZakatInterest free lendingOther social activities
Cycles in an Islamic economy are bounded
Economics CyclesUnregulated credit expansion
Regulated credit expansion
Forbearance enacted
No forbearance
Role of ZakatEconomies now face the risk of deflationAs prices decline, more incentives to hoard
moneyAs every one hoards, downturns intensifiesZakat: a benevolence tax on hoarded money
Interest-free LendingCommercial banks face difficulties lending
during crisesNon-profit institutions serve social objectivesA complementary channel for lending
Non-profit InstitutionsFor each dollar spent by non-profits, $8 are
generated in direct economic and social returns
Government support shall be directed towards social institutions rather than those that caused the crisis
Moral HazardConventional safety net causes moral hazardFinancial systems become more riskyIslamic safety net minimizes moral hazard:
Directed to the needy—No “too big to fail”Not guaranteed—they are privateWrongdoer s are not rewarded!
ConclusionRoots of danger: riba & maysirBoth allow mountains of commitments and
debt to accumulate beyond existing wealthFuel each otherIslamic economics builds a stable system with
bounded cycles