Currently, there are Islamic banks in most Muslims nations and in the non-Muslim economies. The Islam bank has been very successful for many years, but it has been associated with certain problems especially in the financing areas. Dubai Islamic Bank is considered the first ever private interest-free bank across the world and was established in 1975 (Al-Jarhi, 2004). By the year 1977, two extra private banks have been created and referred to as Faisal Islamic Bank of Egypt and Sudan. After Dubai Islamic Bank development, approximately 50 interest-free financial institutions have been established particularly in the Muslim countries and Western Europe. These banks adopt the basic principle an agreed nevertheless each bank has diverse approaches to putting into practice these principles (Kubiszewska & Komorowski, 2014). Studies have shown that most of the divergence is as a result of the state’s laws, goals, and objectives and the bank’s relationship with other banks. The essay seeks to analyze the financial crisis, mitigation, effects, implications, the consequences of business cycles for Islamic bank risk and lessons for an Islamic bank.
History
Throughout the history of Islam, Muslims established a unique system with no interest to assemble essential assets to fund productive operations. About 50 years ago, a revitalization of interest in creating a contemporary version of the Islamic bank emerged with the aim of avoiding interest and financial dealings in line with the principles of Shariá (Kubiszewska & Komorowski, 2014). The majority of the Muslims greatly desisted from transacting with any commercial bank. Nonetheless, the increasing needs of merchants and industrialists in swiftly monetizing economies were critical thus they developed a substitute strategy of monetary intermediation (Chapra, 2010). A radical experiment to put Islamic principles that governed the financial transactions into practice was carried out in Mit-Ghamr, Egypt, around 1963.
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The first ever interest-free institution was Nasser Social Bank created in Egypt in 1971. The participation of a public authority in interest-free banking attracted the Muslim businessmen with surplus funds who created the Dubai Islamic Bank in the year 1975. Perhaps, the most crucial developments in the Islamic banking history occurred with the institution of the Islamic Development Bank (IDB) in the year 1975 with the primary objective to uphold economic and social growth throughout the Islamic world in accord with the Shariá’s principles. Around 1975 and Islamic financial system changed into a substitute method of monetary intermediation. The IMF together with the World Bank acknowledged its services as a substitute approach to the financial intermediation (Salim, Mahmoud & Atiatallah, 2015).
Features of the Islamic banks
Islamic banks as interest-free financial institutions have three distinct deposits. The current accounts of these banks function like the rest of the conventional banks. Focusing on the savings accounts, they differently treated based on the bank’s policies. According to Chapra (2010), there are instances where some banks are permitted to utilize the money of the customers but must pledge to return complete amount. Savings accounts are explicitly considered as a type of investment accounts with less inflexible withdrawal condition. In the investment accounts, the deposit is allowed within specified time where investors agree in advance on ways to share revenues between banks (Kubiszewska & Komorowski, 2014).
Financial Crisis
According to Salim, Mahmoud & Atiatallah, (2015), financial liberalization and deregulation, offers incentives and at the same time aids the financial sector to amplify disclosure to new money-making sectors. The increase in demand, as a result, is propelled by mounting debt offered by the financial industry, leading to an asset-price boom. Ultimately, the price bubble rupture as a result of some pessimistic shocks, resulting in a crisis in over-leveraged financial institutions and resulting from the economic depression. According to Chapra (2010), the government’s reaction to the predicament in the banking industry leads to the supreme debt disaster. The global financial crisis of the year 2008 emerged in the US because of the failure of risk assessment and management at the institutional, organizational and product levels. The regulatory and legal regimes that the financial sector was operating inexperienced a shift towards deregulation and dependence on the market economy. In 1999 the Gramm–Leach–Bailey Act was passed, repealing portions of the Glass–Steagall Act that had prevented banks from intermingling (Waemustafa, 2014). The Federal Reserve System sanctioned the notion that the financial institutions were in a better position to self-regulation.
Similarly, the Securities and Exchange Commission (SEC) in the United States loosened capital requirements for large investment banks in 2004. Furthermore, reflecting on Islamic banking and the financial crisis there was opposition to manage the rapidly growing over-the-counter derivatives market, which further increased the vulnerability of the financial markets (Salim, Mahmoud & Atiatallah, 2015). The 2008 financial crisis was prompted by the crumple of an investment bank, Lehman Brothers Holdings Inc., which blew the already bubbling financial markets (Chapra, 2009). The fundamental problem was the derivatives it issued and traded, in particular, securitized packages of mortgages, many of which contained a significant sub-prime element, but yet were favorably rated, as they were collateralized by real estate assets that had enjoyed a substantial increase in value. From both an Islamic and broader moral perspective there was much to critique in the system that added to the 2008 financial crisis and the ensuing gloom for those whose properties were repossessed (Chapra, 2009). In Islamic finance, interest is equated with ribā, which is explicitly forbidden.
In contrast, the banking relations before the crisis and after it were based on a lender and borrower relationship with interest at its core. However, the relationship was asymmetric and exploitative, with the interest charge for the borrowing quoted on a take-it-or-leave-it basis rather than the rate being agreed through a process of negotiation (Azid & Chaudhry, 2014). All too often the terms of the borrowing were deliberately complicated to prevent clients comparing like with like, with trade-offs between the interest charged and the level of arrangement fees and also exit or termination fees frequently levied. Front discounting and back loading were also used, so that the borrower may believe they had a cheap deal, whereas, in reality, the long-term charges were great. In short, the ignorance of borrowers was being exploited, which in Islam is referred to as jahalah, something discouraged in economic transactions.
Mitigating Financial Crises
The relationship between lenders and borrowers in the conventional banking is based on risk transfer rather than risk sharing. Risk transfers are, however, seen as unjust and exploitative in Islamic finance. The reflecting on Islamic banking and financial crisis borrower who has signed a variable rate contract is vulnerable to rises in interest rates that result from monetary policy tightening that is entirely exogenous from the lender–borrower contract (Waemustafa, 2014). Of course, borrowers can opt for fixed interest contracts, but these are usually more expensive and not necessarily advantageous, as borrowers can end up paying well over the market price should interest rates fall. In other words, with both variable and fixed interest contracts clients face pricing risk, but this is mitigated for the bank given its power to set interest rates unilaterally. Within Islamic personal and corporate finance, potential risks are equally distributed between the bank and the customer a concept that rationalizes the bank’s return. In contrast with conventional banks, the risks are not shared but entirely borne by a client (Chapra, 2009). Of course, there is the possibility of client default, which is admittedly a risk for the bank, although typically the consequences for the business client are worse, as it is the client who becomes bankrupt, not usually the bank.
In case all the banks were Islamic, then it would have followed that the crisis would have been less probable. In particular, having investment depositors whose accounts are governed by mudārabah contracts provides a safety net. If an Islamic bank finds its profits diminishing because of a worsening financial environment, not only will dividends to shareholders be reduced, but less will be paid out in profit shares to investment account holders. If losses occur, none of the bank’s current revenue can be paid to these depositors; rather, any payouts can be financed from the profit equalization reserve that most Islamic banks maintain. If these reserves are insufficient, the investment depositors will not receive a return, or in an extreme case could suffer losses through the bank writing down the value of their deposits, although this has never happened in practice (Waemustafa, 2014).
The effects of financial crisis on Islamic banking
It has been shown that these financial institutions often takes into consideration Sharia law for direction in all their actions and further prohibits potential trading debt. According to Chapra (2010), currently, Islamic banking is widely encouraged as a strategy to deal with potential global financial crises. It is vital that economies take on the Islamic finance strategies to run their economies effectively. Its industry currently is undergoing greater issues especially in the real estate and stock prices (Waemustafa, 2014).
Islamic banks’ transaction is connected to the economic operation which comprises of items and service provision. This system is further differentiated from conventional systems based on its obligation to keeping uprightness and its strategy to evade dangerous business operations. The global financial crises impacted other banks particularly the World Bank because of their engagement in debt purchasing with no real dealings conducted. Islamic financial institutions were the slightest impacted by the financial catastrophe, and this has made them highly striking. They portray various exclusive notions that portray the Islamic Bank as an approach to attaining full employment, equal wealth distribution, price stability, and continued development (Waemustafa, 2014).
The absence of debt within the Islamic banks has sheltered them from various potential challenges brought about by bad credit enhancing their survival throughout irregular financial periods. The Islamic bank’s ban on a risk-free interest on the various trading agreement has made all the financial acts within Islamic banking environment to be real estate based giving them the capability to bring about value addition (Waemustafa, 2014).
Islamic banking success irrespective of the global financial crises has been shown to be highly credited to its capitalist financial system (Lai, 2015). The main rationale these banks have been able to remain immune to the mortgage problem that is often facing the global financial system is their basic elements such as taking defensive strategies against money laundering and trade debt elimination. The impact of this crisis on the Islamic finance was unknown because they received massive governmental support. These financial institutions have taken preventive actions and expanded their economic operations to prevent any potential financial crisis effect.
The Implications of Business Cycles for Islamic Bank Risk
Financial crisis highlights the potential dissimilarity between the Islamic financial system and the conventional financial system. Some of the common risks that Islamic banks face include credit, liquidity, operational and market risk. The unsecured interest based loan implies that there is no collateral, to be sold for the bank to realize some of the debt (Lai, 2015). The financial crisis was further driven by the credit risk. Islamic current accounts further do not provide overdraft facilities, and as a result of this, their average monthly credit balance is very high, and the accounts are conventionally managed. It is worth noting that a change in the business cycles of n economy will have a greater impact on the operations of Islamic banks and financial institution.
Lessons for Islamic Banks
Islamic banking system has been shown to be less vulnerable especially during the financial crises. Research has shown no single Islamic bank failed in the 2008 crisis and during the aftermath. It is important for the Islamic bank board’s not to be complacent but rather, to learn from the crises as they plan for the future (Chapra, 2011). The crisis has further been argued to have strengthened the principles governing Islamic banking especially the principle governing profit and loss and risk sharing. The management should ensure Islamic finance is about long-term relationship building rather than focusing on the short-term profits. When mortgages are sold for instance to a third party, it will break the clients and bank’s relationship. Additionally, it has been established that securitizing mortgages is highly detrimental for Islamic banks. A major lesson that can be learned from the financial crisis is the fact that any uncertainty will feed on itself and as a result cause huge loss of confidence (Ainley et al., 2007).
It has been established that the global financial crisis might go on for the next two years, however; the Islamic banks have successfully secured liquidity hence able to face the financial crises. As a result of the massive success associated with Islamic banking system, there have been serious considerations to adopt and use Islamic banking principles. It has been established that the downturn in the real estate market in the United States caused many to question the value of this collateral, which became more apparent when sub-prime borrowers started to default on their payments and their property was repossessed. These defaults were because many had taken out interest-only mortgages on a floating basis so that when rates rose, they could no longer afford the payments. What happened was not accidental, and it is evident that the banks that sold the mortgages had some responsibility for the Islamic banking and financial crisis financial difficulties their clients ultimately faced. In particular, there was an incentive structure of salary bonuses, which encouraged bank employees to sign up as many mortgage customers as possible. As the banks subsequently sold on the mortgages to investment banks such as Lehman, they were unconcerned about whether their clients could meet their long-term commitments.
References
Ainley, M., Mashayekhi, A., Hicks, R., Rahman, A., & Ravalia, A. (2007). Islamic finance in the UK: Regulation and challenges. London: Financial Services Authority , 13.
Al-Jarhi, M. (2004). Remedy for banking crises: What Chicago and Islam have in common: A comment.
Azid, T., & Chaudhry, M. O. (2014). Islamic Financial Instruments and their Impact on Islamic Economies: A Lesson from International Financial Crises. Pakistan Journal of Social Sciences (PJSS) , 34 (1), 333-350.
Chapra, M. U. (2009). The Global Financial Crisis: Can Islamic Finance Help Minimise the Severity and Frequency of Such a Crisis in the Future?. Islam and Civilisational Renewal (ICR) , 1 (2).
Chapra, M. U. (2010). The Global Financial Crisis: Can Islamic Finance Help Minimise the Severity and Frequency of such a Crisis in the Future?. Islam and Civilisational Renewal , 1 (2), 226.
Chapra, M. U. (2011). The global financial crisis: Some suggestions for reform of the global financial architecture in the light of Islamic finance. Thunderbird International Business Review , 53 (5), 565-579.
Kubiszewska, K., & Komorowski, R. (2014). The UK's banking system as financial hub for Islamic banking. International Journal of Behavioural Accounting and Finance , 4 (3), 245-258.
Lai, J. (2015). Industrial policy and Islamic finance. New Political Economy , 20 (2), 178-198.
Salim, B. F., Mahmoud, M. H., & Atiatallah, S. (2015). Role of Capital Adequacy Standard of (IFSB) on Minimizing the Financial Crisis Impact for Financial Institutions: Evidence from Middle East. European Journal of Economics, Finance and Administrative Sciences , (77).
Waemustafa, W. (2014). Comparative evaluation of credit risk determinants between Islamic and conventional banking (Doctoral dissertation, Universiti Utara Malaysia).
Annotated Bibliography
Ainley, M., Mashayekhi, A., Hicks, R., Rahman, A., & Ravalia, A. (2007). Islamic finance in the UK: Regulation and challenges. London: Financial Services Authority, 13.
This article states that the future growth of the Islamic banks is vivid and that the UK government has been promoting its objectives. London has emerged as a global hub for Islamic finance. As a result of various core factors including a wide skills base, innovation, flexibility in addition to the historical links with the Middle East. In addition to this, the author has argued that the government tax in addition to the current legislative framework has played a critical role in establishing a playing field for the Islamic banking products mainly insurance, mortgages and even bonds. This article is highly credible because it has been produced by professionals in the field of finance and banking and all data used are based on reliable statistics in London. The article is relevant in this study because it provides a clear picture of the role played by an Islamic bank in the UK and the government role towards promoting Islamic finance.
Al-Jarhi, M. (2004). The remedy for banking crises: What Chicago and Islam have in common: A comment.
The author stated that stability plays a vital role to enhance proper functioning of the Islamic banking system and its contribution to the economic growth. A continuous failure of the banks might imply that they are suffering from the structural problems hence the need for an urgent fundamental reform. The Islamic monetary system only considers the demand and investment deposits as two major contracts. Islamic banking improves the overall competitiveness of the banks making them more market responsive. Just like Islamic banking, narrow banking guarantees theoretically and practically the extent of the demand deposit. This can be said to be a credible source to use in the study because the author focused the analysis on valid articles and journals from reliable agencies. Therefore, it will contribute reliable information on the potential remedy that can be adopted during the banking crises. It further emphasizes the importance of Islamic bank as a strategy to counter financial crisis.
Chapra, M. U. (2009). The Global Financial Crisis: Can Islamic Finance Help Minimise the Severity and Frequency of Such a Crisis in the Future?. Islam and Civilisational Renewal (ICR), 1(2).
The articles analyzed the primary cause of financial crises that has affected various parts of the world in the last three decades. The author specifically emphasized on the 1998 Long-Term Capital Management (LTCM) breakdown and the widespread subprime mortgage crisis in the US. This has been established to be the most severe global financial crisis in the US history and had the most devastating spill-over effects globally. It has been argued that the primary cause of the crisis is the lack of sufficient market restraint within the financial system. There has been excessive lending and high leverage caused by the crisis. The principles of the Islamic banking such as risk sharing and restriction on debt sale gharar and qimar can help inject greater discipline into the banking system. The data used in this journal has been collected from the government and economist articles focusing on the Global Financial Crisis. The article will provide in-depth information on the causes of the international financial crisis and potential mitigation strategy.
Chapra, M. U. (2011). The global financial crisis: Some suggestions for reform of the global financial architecture in the light of Islamic finance. Thunderbird International Business Review, 53(5), 565-579 .
This article also states that the primary cause of the current subprime mortgage crisis in the US is the lack of sufficient market discipline in the banking system. The author argues that lack of discipline in this system has resulted in the promotion of excessive lending, high leverage, and speculation. It has been established that Islamic principle is the only way to go when it comes to managing and addressing the financial crisis. Risk sharing has been shown to be effective besides the services that Islamic finance focuses on. When these are introduced in the banking system, a high level of discipline will be injected into the system thus reducing financial instability. Chapra is a professional in banking and financial sectors implying that the information derived from the article are highly credible and reliable. The articles have also contributed to this study by adding information on causes of the global financial crisis and what can be done to address it especially through the adoption of the Islamic banking principles.
Chapra, M. U. (2010). The Global Financial Crisis: Can Islamic Finance Help Minimise the Severity and Frequency of such a Crisis in the Future?. Islam and Civilisational Renewal, 1(2), 226.
In this article, Chapra established various causes of the financial crisis in the world and how it has affected the global banking system. It is evident that the emergence of the financial crisis significantly destabilizes the effective functioning of the banking system. There are numerous factors associated with its emergence such as indiscipline within the system which results into excessive lending amounting to the crisis. It is important to maintain a significant level of discipline in the banking system to counter the crisis. This can only be achieved through adopting the principles that govern Islamic banking. The most suitable principle that can be used is the risk sharing where the bank and the client will share the benefits and risks equally. Chapra used reliable articles to develop his analysis and further used research information from global journals enhancing the credibility of the article. The article is suitable for the study since it contributes on the importance of the Islamic finance as a strategy to minimize financial crises.
Lai, J. (2015). Industrial policy and Islamic finance. New Political Economy, 20(2), 178-198.
The article states that the financial sector has figured powerfully in the discussions focusing on the industrial policy and the Islamic finance. Recently, Islamic banking development has been deeply focused and further considered within the context of serving the ‘real’ sector. The government has established policies aimed at developing financial sectors into independent and globally competitive sources of economic development through an analysis of the growth of Islamic finance in Malaysia. The emergence of Islamic finance in Malaysia has been established to be vital in the banking system. Islamic finance has suggested the continuing relevance of the industrial policy for development. All information used in this article was obtained from reliable sources that were written by professionals implying that it is also reliable. It will provide information on the importance of the industrial policy and its effect on the Islamic finance.
Waemustafa, W. (2014). Comparative evaluation of credit risk determinants between Islamic and conventional banking (Doctoral dissertation, Universiti Utara Malaysia).
The author states that Islamic and conventional banking operations in Malaysia use a similar approach towards the banking risks. He has further analyzed the Islamic philosophy of risks as outlined in the Quran and Hadith, and differentiate them from the conventional perspectives. It identified numerous risk concepts that might face the Islamic banks including mukhatarah and al ghunm bil ghurm. It was established that credit risk was higher within conventional banking system compared to the Islamic system. Islamic bank’s credit risk has been shown to be significantly influenced by risky sector financing, regulatory capital, and Islamic contract. The article is credible because it is founded on the empirical investigation on the credit-risk level. Additionally, it employed financial data from reliable annual reports of 15 Islamic banks and 13 conventional banks for the period between 2000– 2010. The article is vital in the study because it adds more information on the credit risk and how it can be addressed by adopting Islamic financing principles.
Azid, T., & Chaudhry, M. O. (2014). Islamic Financial Instruments and their Impact on Islamic Economies: A Lesson from International Financial Crises. Pakistan Journal of Social Sciences (PJSS), 34(1), 333-350.
In this article, the author deeply analyzed the effect of the extensive growth of credit. It has been established that a continuous and unchecked growth of credit in the economy may result in the collapse of economies. The author has further deeply analyzed the underlying causes of the international financial crisis and potential strategies that can be adopted to mitigate the crisis. One of the most effective strategies to counter financial crisis is to adopt the Islamic principles. It has been shown that the conventional financial system is much weaker when compared with Islamic financial system. Therefore, there is the need to strengthen Islamic financial system to stabilize the economies. This journal is also reliable and credible because it is founded on information done by competent authors in the international finance. The article will also contribute information on the instruments of the Islamic banking and its impact on the economy.
Kubiszewska, K., & Komorowski, R. (2014). The UK's banking system as the financial hub for Islamic banking. International Journal of Behavioural Accounting and Finance, 4(3), 245-258.
The article has critically analyzed the phenomenon of London as the global Islamic banking hub. London clearly understands the importance and effectiveness of the Islamic financial system to the economy hence has been advocated for its adoption throughout the economy. There has been a growing demand for Islamic services and products in London. Further, the authors had argued that Islamic banking system and its principles may offer a permanent solution for most problems that were facing Europe since 2007 when the global debt crisis began. Just like the other articles, this journal has been developed using vital information undertaken by reliable and credible authors in the field of finance and banking. Reliable sources were consulted to gather data and statistics to develop this article implying that the information can be relied on. The articles contribute information on the state of Islamic banking system in the UK and its importance to the economy.
Salim, B. F., Mahmoud, M. H., & Atiatallah, S. (2015). The role of Capital Adequacy Standard of (IFSB) on Minimising the Financial Crisis Impact for Financial Institutions: Evidence from the Middle East. European Journal of Economics, Finance and Administrative Sciences, (77).
The journal focused on the primary role of the Capital Adequacy Standard of the Islamic Financial Service Board (IFSB) towards the prevention and minimizing global financial crisis impact on the conventional financial system versus Islamic banking system in the Middle East. It has been shown that Islamic banking system is necessary for the banking sector especially in the management of the financial crisis. The study is highly reliable and credible because it has also been founded on the empirical study to investigate a sample of three fully Islamic banks using Capital adequacy standard of the IFSB as the regulatory tool, compared to the sample of three entirely conventional banks using Basel II capital standard. This implies that the information is derived from real life events and can be relied on. The journal has also added information to this study by outlining the role of the capital adequacy standard of the IFSB on reducing financial crisis effect in the financial institution.
