Sunday, 1 March 2009 www.sundayobserver.

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Global Financial Crisis Unthinkable Under Islamic Banking Principles.

By Riyazi Farook, MA (UK), DipM (UK), PgDip IBI (UK)
www.islamicfinanceandbanking.com

As the economy superpowers on the brink of recession, the global financial industry declines into ever-deeper
crisis, the collapse in the sub-prime market begins to have an impact on banking around the world, now credit
crunch creates turmoil throughout the global economy. Recent years we had heard of the term 'Credit Crunch',
defined as "A severe shortage of money or credit", the slogan has now entered dictionaries. The consequences of
taking higher risks have led to unprecedented banking collapse around the world and have also emphasised the
core philosophical methods between Islamic and conventional or interest based finance. Islamic banking institutions
do take risk. But the clear distinction is risk-sharing being a fundamental principle of Islamic banking, the more
ethical and risk sharing method offered by the Islamic banking industry is emerging and attracting an increasing
amount of demand.

The global economic crisis sparked by the US subprime mortgage meltdown would not have occurred if Islamic
principles were applied in international financial markets, an Islamic scholar said. International Centre for Education
in Islamic Finance (INCEIF) said US subprime mortgage crisis would technically be unthinkable in the Islamic
financial markets sector because it would be against Shari’ah (Islamic Law) principles to sell a debt against a debt.
The rule is very simple and clear, you can’t sell unless you posses the asset in Islamic trade. But in the subprime
mortgage crisis had seen trillions of dollars traded without backing of assets and not supposed to be traded on
Islamic principles. If such transactions followed the Islamic finance model it would have easily prevented and
stabilised the global economic crisis by the use of Islamic Finance and Banking principles.

Global Islamic Finance and Banking Industry

According to Financial Times, over the past decade Islamic banking is estimate to have grown more than fivefold
from around $150bn in 1990 to $900bn in 2008 and growing at a rate of 15% to 20% a year and are set to hit $2
trillion in 2010. Global Islamic banking assets worth, based on the latest figures released by the Financial Times in
2008 November, grew by 27.6% over the past year to reach over $800 billion from around 50 countries. Although
this is a relatively small compared with the $90, 256bn in total assets amassed by the top 1000 conventional banks
around the world.

Analysing the $800bn global market, the six states of the Gulf Cooperation Council-GCC (Bahrain, Kuwait, Oman,
Qatar, Saudi Arabia and UAE) offer the largest portion of the total but the non-GCC Middle East and North Africa
(MENA) states are not far behind. While the overall total grew by 27.6% to $800bn in the listing, the GCC
institutions expanded the most by a staggering 47.5% to $262.7bn and the non-GCC MENA institutions grew by
40.4% to reach $248.3bn. Asia, led by Malaysia, Brunei, Pakistan, Bangladesh, Indonesia and Thailand, is the
largest region in the world for Shari’ah-compliant assets, growing by 32.3% to 119.3bn. Australia, Europe and North
America grown by 60.6% to account $35.1bn with sub-Saharan African institutions contributed $4.7bn in assets.
Now Global banking giant such as America's Citigroup, Britain's HSBC and Germany's Deutsche Bank have also
established Shari’ah-compliant banking units.

The Financial Crisis: How it happened

US Federal Reserve increased the key interest rates from 1% to 5.35% following a two year time between 2004 and
2006, the US housing market starts to experience the worst, with prices decreasing and a rise in mortgages fail
homeowners to make their payments. These default rates on high risk sub-prime loans to consumers with poor or
no credit histories has risen to record levels. As colossal losses in US financial market led to a crunch on global
credit markets and subsequent fall in international equity markets. The collapse in the sub-prime market begins to
have an impact at banks around the world. Federal Reserve brought a warning that the US sub-prime crisis could
cost up to $400bn. 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. It is the obvious sign that conventional banks are refusing to
lend and do business with each other. To improve this situation the European Central Bank subsidised 108.7bn
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.

In August 2007 French bank BNP Paribas produced quick climb in the cost of credit, and made global financial
recognize how serious the circumstances was, however, start off much earlier. Investment bank BNP Paribas
announced investors they would not be able to obtain money out of two of its main funds because it cause
difficulties in valuing the assets, owing to a "complete evaporation of liquidity" in the market. 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. Following, American banking giant Citigroup posted a sub-prime loss
of $40bn. US investment bank Merrill Lynch revealed a $7.9bn disclosure to bad debt. A major bond insurer MBIA,
announced a loss of $2.3bn. 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 US Federal Reserve pledge an $85bn
rescue package the nation's largest insurance company AIG, to keep it away from liquidation.

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.

Aftermath of Financial Crisis

Global:

The World Bank predicted that global economic growth will slow in 2009, as the financial crunch hits the wealthiest
nations. Following this announcement global stock markets, including London's FTSE 100 index, experience their
major collapses since 11 September 2001. International Monetary Fund (IMF) warns that world economy
development could decline to its lowest point ever since World War II to just 0.5% this year. As the result of
economy slowdown by the end of this year up to 51 million jobs will be lost worldwide that has creating a global
unemployment crisis, International Labour Organisation (ILO) reported.

Extreme market volatility caused a loss of 600m Euros to French savings bank Caisse d'Epargne during the
financial market crisis. South Korea announced a $130bn financial rescue package to stabilise 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 stabilisation fund.

United States of America:

Mr Obama took over the White House with 11 million Americans unemployed, More than half a million Americans
jobs slashed in last month, creating the worst year for US unemployment since the end of the Second World War
and trillions of dollars of lost in stock market savings, Mr Obama pledged economy was his first and greatest
priority. As Mr Obama already been proposed and presented $838 billion stimulus package to Congress has just
been passed by the US senate and the infusion of $350 billion left over from the bail-out package agreed in
October, 2008.

The crisis had a significant domino effect on the US economy and, which in turn affected almost all stock markets
worldwide. The interest rate has been cut hugely by the Federal Reserve from the 5.25% where it stood in
September 2007.The US Federal Reserve has slashed its key interest rate from 1% to a range of between 0.00 -
0.25% as it battles the country's recession. Since 1954 it is the lowest the central bank's key rate - the target rate for
banks to charge to lend to each other. Analysts said that the key interest rate is now virtually zero, however it's zero
or 0.25% actually does not make a huge difference.
United Kingdom:

While pound at a 23-year low against the dollar the Bank of England has cut interest rates to a record low of 1%
from 1.5% in February, the first time since the Bank of England was founded in 1694—the lowest level in its 315-
year history. Ernst & Young, said that the Bank should not stop here rates will be cut again. UK government
considered once interest rates brought to zero as an approach to help both fuel the economy and avoid deflation.

According to figures released by the Office for National Statistics (ONS) that the UK is on the brink of a recession.
The UK economy failed to grow at all for the first time since 1992 between July and September, as economic
growth down by 0.5%. Housing market in the UK has fallen to its lowest point in 30 years in March this year led to
one of the UK’s biggest nationalisation in which the UK government had to pump billions of pounds of taxpayers'
money into three UK banks (Royal Bank of Scotland (RBS), Lloyds TSB and HBOS). Bank of England officially
gave the figures in its latest bi-annual Financial Stability Report that globally financial institutions have already lost
$2.8 trillion from the latest financial meltdown.

Scam or failure?

During the financial crisis the The FBI has arrested 406 people, including well-respected Wall Street figure Bernard
Madoff, a former chairman of Nasdaq has been charged with operating alleged $50bn (£30bn) "Ponzi scheme",
world's biggest banks have become the victims of this biggest fraud in history stretched wider and deeper than
anyone imagined. Housing developers and brokers also on alleged mortgage frauds worth $1bn linked to sub-prime
mortgages.

The financial model used by many investment banks including American investment bank Lehman Brothers and
British retail banks HBOS has been questioned about the financial and model. Confidence and trust, two of the
most invaluable principles, are at the lowest point following the bailout of Fannie Mae, Freddie Mac and AIG. The
financial crisis perhaps the worst since 1929 when Bank of America took over the collapsed Lehman Brothers, Bear
Stearns and Merrill Lynch.

From Wall street & Canary Wharf in London, there has been growing accusations that state-backed banks paid and
preparing pay out billions of pounds in bonuses to reward failure lavishly from taxpayers money Even if bankers are
legally entitled to enjoy bonuses there is a moral responsibility on some of these bankers, will bring accusations that
the taxpayer-funded bank is happy to reward failure lavishly.

How could have prevented and unthinkable

Islamic or conventional, in today’s global volatiles condition all types are effected. However, while the global
financial crisis losses of more than $400 billion from conventional banks worldwide, Islamic banks are virtually nil.
Because the Islamic Finance and Banking have defining characteristics in the conventional finance world after the
unprecedented crisis of the U.S. subprime mortgage market left financial institutions hundreds of billions of dollars
of worthless credit instruments attached to home loans by complex structures.

Islamic banking and finance generally presents very low risk profile than conventional western finance, this presents
a very meaningful way for both consumers and institutional investors and suggests that investment with Islamic
financial institutions will grow dramatically as investors switch to more secure products in this environment. As the
risk profile of Islamic Banks is generally lower than conventional western banks, this opportunity offers a more solid
option for both consumers and institutional investors, also proposes that Islamic Finance and Banking industry will
create positive awareness and confidence among people to grow faster as they switch to more secure products in
this environment. Unlike the western banks, who will continue to restrict their lending policies in light of the current
economic crisis Islamic banks posses huge sum of capital to finance wealthy individuals and corporate.

While the conventional financial system failing catastrophically, Islamic banking and finance system seems to take
root, with 17% of Qatari and 15% of Malaysian banking assets and impressively, over 95% of finance and banking
transactions in Saudi Arabia comply with Shari’ah (Islamic law). Global banks have written down more than $400
billion while none of Malaysia's Islamic banks have been written down from the resulting global credit crunch. The
Wall Street Journal, highlighted points out that conventional financial system is facing ever-deeper crisis while
Islamic banking playing a pivotal role in over $200bln worth of projects fascinating the Middle East and North Africa
(MENA) region.

According to Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) senior Islamic
financial products should to be compliant with Islamic Shari’ah principle to avoid excessive gearing and speculation
and the stricter rules imposed on lending by Islamic law prohibits the payment of interest and requires transactions
to be linked to assets and require tight controls on debt levels - precisely what regulators of conventional finance
are looking for the world over the current financial crisis.

Greater transparency, this is one of the key unique selling points of Islamic Finance and Banking, as the industry
seeks to capitalise on the market wracked with turmoil and many filled with gloom from failing of the conventional
market. Liquidity risk is one of the key challenges for conventional finance industry which has been created by the
ongoing financial crisis. Due to the fact that Shari’ah constraints the revenue generation from interest based
sources, the conventional market is out of reach for Islamic financial institutions. Therefore, surplus liquidity cannot
simply be capitalised to conventional financial institutions. However, it is permissible to exchange of funds between
Islamic banks, by the use of Mudarabah and Musharakah instruments. Islamic Development Bank, Bahrain
Monetary Agency and Bank Negara Malaysia few of the most respected entities in Islamic Finance and Banking
industry playing key role in this area.

What is Islamic Finance really?

Islamic banking is a comprehensive financial concept which rapidly grows globally. Islamic banking is different from
conventional banking in many directions, where principles and core values of Islamic Banking are originated from
religion is very important. Awareness of Islamic Banking is expanding very fast. Politics and history have a high
influence in implementing the Islamic banking practice in the countries where the system operates its highest
standard. Islamic Banking is an unfamiliar concept in the Western World. The core concept of Islamic Banking
contains much more than its prohibition of usury (Impose a fee for transacting money - "interest" or "excessive
interest"). Islamic Banking priority objective is that ethic and finance can be dedicated to serve the society. The
main idea behind the banking system is to eliminate the widespread economy injustice in society.

Prohibition of interest (Riba) is not only limited to Islam but it is also clearly forbidden in Judaism and Christianity.
Main difference between Islamic and conventional banking is not that conventional banking allows interest bearing
transaction and Islamic banking does not. But the core principles of Islamic banking and finance are;

I. Prohibition of Riba (Interest or Usury) or 0.0% interest

II. Application of trade and commerce (Al Bay) in all transactions to ensure the profit & loss sharing
III. Avoid of Gharar and Maisir, particular types of uncertainty or contingency in contracts such as
speculation, derivatives and short selling as well gambling and high risk
IV. Disengagement from financing alcohol, tobacco & drugs, weapons, porn, gambling, and environmentally
harmful products.

The origin of Islamic banking is from the religion Islam might cause reluctance and suspicion among Western world
possibly this can be even worse as its concept is still unknown to world in general. In today’s world various
approaches has been undergoing to gets closer the Islamic Banking to all consumers encourage to be dealt with.

The Bailout

When financial crisis hit Asia ten yeas ago there was a flow of funds from the western financial institutions in Asia
which helped in some way to overcome the crisis. However, interestingly this time the case is reverse, the funds
flow from Middle East and Asia. The global financial crisis offered the $1 trillion worth Islamic Finance and Banking
industry with an opportunity to expand its appeal beyond its Muslim consumers and investors and is also drawing
the interest of companies outside the Middle East.

A growing number of investors are adapting to Islamic financial instruments to get projects off the ground. Islamic
Finance and Banking principles emphasised that gains are from ethical, shared investment rather than being
interest-based. Ethical nature of the Islamic banking policies may appeal to consumers from various cultural
backgrounds. Gulf Cooperation Council (GCC) is increasing financial providers of fully-fledge Islamic banks and
finance units at conventional banks and introducing more instruments in the GCC market to investable wealth which
is increasing by one of the highest rates in the world.

Zurich based investment bank Credit Suisse believe investment in Islamic Finance and Banking products are not
expose to interest rates since Islam prohibits charging interest and Sukuk or Islamic bonds, unaffected to the credit
crisis in the international finance and banking industry. Islamic insurance (Takaful) works by policyholders paying
into and claiming from a central pool - the system works on a "risk-sharing" model on contrast to the conventional
insurance model. Credit Suisse advices that before Islamic Finance and Banking institutions provide traditional
Islamic and non-Muslim investors asset allocation it needs more liquid instruments that can compete with orthodox
investment vehicles.

The popularity of Islamic Finance and Banking has set to a remarkable demand in the development of innovative
and creative products. This significant development has particularly focused on the on the instrument of Sukuk,
where number of diverse Sukuk products have been created. Islamic bonds, or Sukuk backed by the tangible
assets. Islamic bonds, designed with unique structures and features, cannot fall into catastrophe such as subprime
mortgage. Subprime mortgages are backed by dubiously rated collateralised debt packages which eventually
caused unprecedented global credit crunch. Islamic Finance experts and scholars firmly believe that Sukuks or
Islamic Bonds could provide answer to this current global credit crisis.

The Gulf Finance House in Bahrain will invest in energy production projects to meet the greater demand for
alternative energy needs by the launch of a Shari'ah compliant "Energy Bank". There are many investors and
developers worldwide adopting the Islamic financial models to finance their projects. The most recent activity is
Singapore based CapitaLand Limited, South East Asia´s largest property company, which planning to issue
US$700 million worth of Islamic bond.

The U.K. government is at the final stage of the process to issue government Sukuk, the first of its kind sovereign
Sukuk to come out of the G8. The recent comments of the Archbishop of Canterbury have backed the growth of
Islamic finance in London. In fact, the Sukuk (Islamic Bonds) is now appealing at corporate and government at
internationally acceptable Islamic capital market instrument to raise finance. Similar to sovereigns such as the UK
Treasury, the Japanese Ministry of Finance is also seriously studying the Sukuk structure to utilise as a debt
management instrument in the wholesale sterling and yen markets. Outstanding issued Sukuks are value at
US$97.3 billion globally, Sukuk market expecting to grow to US$200 billion dollars by 2010. London is already being
successful with listing more than 15 Sukuk (Islamic Bonds) at London Stock Exchange (LSE) worth nearly £5 billion.
LSE has also established the World's first secondary market for trading of Islamic bonds.

Challenges Ahead

The financial crisis does not cause much of a danger to Islamic Finance and Banking industry; not because it is
fundamentally insulated from the conventional financial industry but because oil prices. The industry's development
has largely happened throughout a period in which oil prices, the basis of added liquidity, mostly in the Middle East
that has fuelled the industry's growth. The stability of the Islamic financial industry will face its major challenge if oil
prices continue to drop considerably.
Islamic Finance and Banking industry has experienced faster growth since 2001 and the regulatory changes
needed for the industry to continue growing. Leading Islamic Finance and Banking experts cautioned the industry
was in danger because both banks and Shari’ah scholars were not developing solutions which are Shari’ah-
compliant.

Global financial meltdown has demonstrated that the Islamic Finance and Banking industry cannot remain totally
immune to global financial market. However Islamic Finance and Banking industry evaded the toxic debt problems
experienced by the conventional finance industry.

Riyazi Farook, holding a Masters Degree in Marketing Management from Middlesex University London and also a
Postgraduate Diploma in Marketing from the Chartered Institute of Marketing (CIM), UK and Postgraduate Diploma in Islamic
Banking and Insurance from the Institute of Islamic Banking & Insurance (IIBI), UK. He is a member of the CIM-UK and
Associate Fellow of the IIBI-UK.
He can be reached via email at riyazif@yahoo.com or visit his website www.islamicfinanceandbanking.com