Download Abstract Financial crises - gsmi

Journal of Finance, Accounting and Management, 7(2), 31-38, July 2016 31
Does Islamic Finance Prevent Financial Crises: A Global Perspective
Syed Zulfiqar Ali Shah, Nousheen Tariq Bhutta
International Islamic University, Islamabad, Pakistan
[email protected]
Abstract
Financial crises become a key obstacle towards the sustainable development of countries. Based on standard
finance, many researchers investigated the financial crises in different countries in order to find the
underlying reason for preventing future crises. It discusses the measures taken by different nations in response
to financial crises; however it lacks. In this essence Islamic finance may be helpful in prevention of future
financial crises. In this paper, we explore the how Islamic practices may be helpful in preventing the severe
economic outcomes that hit the economies. At the end policy recommendation has been presented for both
developed and developing countries
Keywords— Financial crises, Islamic Finance, Developed Economies and Emerging Economies
Introduction
Financial crises occurred repeatedly since the termination of Gold Standard regime which contributes
towards a great depression in 1929-1930 ( Davis, 1996). Normally, it has been seen that financial crises
frequently occurred in the period of Bretton Woods Agreements and in deeper volume. However, the latest
financial crises had been triggered by mortgage crises in USA which suffered many financial institutions in
trouble and mostly got bankrupt like Lehman Brothers. These crises had been called the worst one by
economist because it causes severe effects on other economies like Greece and Portugal. These crises did not
happened due to managerial faults however; it is mainly attributable to structure faults under different
regulatory policies and mechanism. (Lietaer, et al., 2009).
Numerous factors are responsible for bringing financial crises; however they occur due to happening of
either the mismanagement of financial liberalization and globalization, or severe fiscal imbalances, in
developing countries .(Web Chapter)
Financial crises severely impact the economy through dampening of following ways:
 Financial sector and market downturn
 Market Weakness
 Equity blockage and bankruptcies
 Economic shortfalls like unemployment, inflation and workers layoff
 Decline in crude oil prices
 Loss of confidence in financial markets
 Currency and exchange rate fluctuations
Since the financial crises occurred repeatedly, economies still did not find any solution to control or
prevent future financial crises. This financial instability prompts to posture new challenging regarding
Journal of Finance, Accounting and Management, 7(2), 31-38, July 2016 32
financial stability and constructing a stable financial system in future. However, Islamic Finance may be able
to better solution in healing of financial crises. (Zerban, at,al, 2012)
Problem Statement
“Does Islamic finance prevent the financial crises”.
Research Questions
1) Does the Islamic Finance help in preventing the financial crises?
2) What are main root causes of financial crises from different school of thoughts?
3) Do policy reforms for repression from financial crises different for developed and developing
economies?
Objectives and Potential Contributions
1) The main objective of this study is to investigate whether Islamic finance prevent financial crises or
not?
2) Policy reforms would be provided from recovering of financial crises for both developed and
developing economies.
Main Causes Of Financial Crises
Financial crises have been viewed under different school of thoughts. In this study, root causes of financial
crises has been presented under economic and Islamic perspective in ensuing paragraphs
From Economic Perspective
Under economic perspective, financial crises have been caused due to following factors
 Boost up in Interest rate:
Due to adverse selection, credit rationing in which borrowers denied loans even they can pay high interest
rate. High interest rate is an important element in bringing the financial crises because it will decrease the
supply of loans. High interest rate leads to better chance that lender will lend even to bad credit risks and
even a probable crumple in loan market
 Asset Market Effects on Balance Sheets:
Deterioration of balance sheet creates the adverse selection and moral hazard problem in financial
markets and leads to financial crises if deterioration is significantly higher. Moreover, stock market crash
translates the decline in net worth of companies that increases the moral hazards chances for borrowing
companies to make riskier investments. Deflation also contributes to financial crises as it declines the net
worth of companies.
 Increase in Uncertainty:
An increase in uncertainty due to stock market crash, recession and political instability makes the
selection problems worse that leads to financial crises. Due to uncertainty in financial markets lenders will
not willing to lend that may leads to a decline in lending and investment, consequently lead to aggregate
economic activity.
From Islamic Perspective:
Under Islamic perspective, financial crises are mainly triggered by natural causes like natural disasters and
human errors like disputation of stakeholders due to disobedience of God’s Laws in their financial dealings.
The main root causes of financial crises under Islamic system have been presented in following points:
Journal of Finance, Accounting and Management, 7(2), 31-38, July 2016 33





Misbehavior of Economic factors including self interest, criminals actions, speculation and greediness
(Mirakhor and Krichene, 2009)
External Factors including natural disasters, political insecurity, weak internal monetary system
(Hassan and Kayed, 2009)
Pitiable Governance which includes corruption and poor administration, lack of revelation and
regulatory system, qualification disparity and wrong hiring in certain institution (Al-Masri, 2009)
Wobbly monetary system including reserve system, fiat money and interest rate, and product
derivation (Trabelsi, 2011)
Unsound fiscal system includes excessive fiscal deficits and colossal expenditures and taxes and
poor inventory management (Chapra, 2007)
Literature Review
Financial Crises
Financial crises have become vital phenomenon in current years. Financial crises not only demolish
the economy of developed countries like USA and Japan but also greatly influence the developing economies
like Mexico. According to asymmetric information theory, “A financial crisis is a nonlinear disruption to
financial markets in which adverse selection and moral hazard problems become much worse, so that
financial markets are unable to efficiently charnel funds to those who have the most productive investment
opportunities”.
Much research has been cited in the context of financial crises like Lestano et al. (2003) studied the financial
crises ; Lizondo, and Reinhart (1998) depict the currency crises; Bustelo (2000) and
Burkart and Coudert (2002) talked about East Asian crises; Gonzales-Hermosillo
(1996) and Dermirgüç-Kunt and Detragiache (1997) highlighted the banking crises and Marchaesi’ (2003)
focus on debt crises
Financial integration plays an important role towards economic development in liberalization as well as
globalization. Through opening to capital flow and trade flow enhances financial development. (Rajan and
Zingales, 2003). Such openness in capital flow leads to financial fragility in economy (Ramey and Ramey,
1995). Moreover, Fukuda and Dahalan (2011) provided that financial deepening is key factor leading to
financial crises in India, Indonesia and Mexico. It investigates that an economy is over financialized; and
deviation between the real and financial sectors contributed towards financial crises.
Financial deepening is a multi-faceted procedure comprises of markets, instruments and stakeholders.
According to Shaw (1973:8), financial deepening involves “specialization in financial functions and
institutions, and organized domestic institution and markets gain relation to foreign markets and the curb
(informal). He maintained that an increase in the real size of the monetary system will generate opportunities
for the profitable operations of other institutions as well, from bill dealers to industrial banks and insurance
companies”.
Moreover, Nnanna and Dogo (1999) defined the financial deepening as “state of an atomized financial
system which is free from which is largely free from financial repression”. According to Levine (2005),
financial deepening is a process in which financial markets as well as financial institutions exchange goods
and services; pool the savings of large volume of investors, enquire information regarding investments and
projects of companies; implement corporate governance and managing risk.
Regarding theory of financial liberalization (mckinnon,1973 and Shaw,1973) government restriction on
financial system can negatively effect on financial development. So they argued to discourage financial
repression policies in order to boost up financial development in the economy. Moreover, high inflation may
also adversely affect on financial deepening, which depicts the importance of macroeconomic stability.
(Moore, 1986). However, Stiglitz (1994) criticized this theory as financial liberation may lead to negative
impact on financial development.
Financial deepening can improve economic scenario through increasing efficiency in financial markets.
There are two ways through which financial deepening can improve the economic growth of country. First,
Journal of Finance, Accounting and Management, 7(2), 31-38, July 2016 34
it induces more investments through reducing transaction cost and effective mobility of resources (Merton
and Bodie 1995) and second, it increases the productivity through properly allocation of financial resources.
(Beck et al, 2000). It also assist the choice of financial services come as the result of financial infrastructure.
In developed countries like US, the lending booms ends in lending crash. Additionally, balance sheet
weakens, mainly attributable to significant losses which prompt to lending crash. Consequently, there is no
significant body which can solve the adverse selection, ultimately lead to financial crises
Financial Crises Evidences to Past Episodes
United States
Regarding the nineteenth and early twentieth century’s, United States has rich history of economic and
financial crises which occur after every twenty years, were mainly attributable to rapid rise in interest rates,
a stock market crash and an increase in uncertainty occur after the recession period and from major financial
or non-financial firms’ failure that leads to moral hazard problems. This seems to be unattractive to lender
transpires to decline in investment and aggregate economic growth. The worse situation of economic growth
prompts the depositors to withdrawn their money due to risk of insolvency to banks. To overcome to this
situation, banks have to increase their interest rates that further create moral hazard problems and severe
economic slowdown. Then, sorting out of firms from healthy to bankrupt would subsidize the financial crises
through eliminating uncertainty in financial markets, would lead to recovery of stock market and decline in
interest rates.( Mishkin, 1991)
Mexico
In Mexico financial crises occur in the period of 1994-1995; however, it is quite different from the financial
crises hit in United States due to different debt structure of Mexico because Mexican banks did not have
formal credit bureaus for household as well as small business lending which would check loans to make sure
that borrowers were not taking on excessive risk. Due to lack of monitoring, this lending boom occurred both
as a result of increased savings and an increasing lending to private firms. The second factor contributing to
Mexico financial crises is the rise in interest rate which may increase the moral hazard problems and
deterioration in households’ balance sheets (Tornell, et.al , 2004)
Islamic Financial System
Under financial system, the realization of justice in society serves the crucial objective of Islamic. The society
which exhibits lack of justice will face downfall according to Quran verse (57:25). The financial system can
be promoted justice in society through fulfilling the two conditions. The both parties have to share the risk
of loss which satisfies the “no gain no risk” rule; and second one is efficient mobilization of resources by
financial institutions among people in society which ultimately reduces the poverty, inadequate distribution
of wealth. Additionally, Islamic system prohibits the direct borrowing and lending; however, it requires the
debt creation through sale and lease of real assets. It requires four conditions for debt creation process, have
been presented in ensuing points:
 The assets must be real which has to be sold or leased. It assists to eliminate the speculative
dealings basically constitutes gharar ( excessive uncertainty) as well as qimar (gambling)

The seller must possess the assets which he has to deal with. It ensures that seller also share a part
of risk; and resist the short selling.

Transaction must be real in term of exchange of assets and money.

Debt can’t be sold as lender must the risk
Journal of Finance, Accounting and Management, 7(2), 31-38, July 2016 35
The last two conditions ensure the dual purpose through restricting from speculative transaction and
motivation the lender towards credit risk evaluation. Additionally, it helps regarding the excessive release of
financial resources towards society; ultimately leads to employment opportunities and production of goods
and services.
Thus Islam motivates to introduce the non materialistic financial system however; one can criticize that this
condition may lead to shrinkage of economy through reducing the number and volume of transactions. The
answer to that query is that speculative transactions are not real; don’t significantly dampen economy through
decline in output. Additionally, in financial system justice should be incorporated through ensuring that every
small borrower may be able to get enough credit. However, many countries are still giving credit grant to
poor and needy people. Although this approach is quiet useful however, two major issues need to be resolved
for its proper implementation. The first problem is high cost of finance (30%-70%) in micro finance
institutions; which leads to major hurdle towards getting loan. The other issue is inadequate resources of
microfinance institutions for their disposal. Both problems would be resolve if the microfinance institutions
are integrated on the basis of Zakat and awaqf mechanism. (Chapra, 2009)
Methodology
The basic aim of our paper is to investigate whether Islamic finance prevents financial crises. We provide
theoretical justification for the above mentioned link. On the basis of above literature our proposed model
has been presenting as follow:
Islamic Finance
Financial Crises
Discussion
How Islamic Finance is helpful in reducing Financial Crises?
Basically, Islamic finance deals the operations according to Islamic fundamentals, majorly focus on the
ethical values and social responsibility. Islamic finance strictly follows the prohibition of paying and
receiving a fixed amount, transpires the assets based system. Moreover, money has no intrinsic values and
speculation and gambling are also prohibited (Alexakis and Tsikouras, 2009)
The basic principle of Islamic Finance is profit and risk sharing principle among borrowers and lenders
equally; particularly focusing to two major financial tools under this principle. One is Mudarabah, which is
normally used as investment fund in which one party provides the financial capital and other one provides
the management. In terms of profit, it is being shared equally among two parties; however, in case of loss
sharing, it is being wholly beard by financial provider and other party loses his efforts. The other financial
tool is Musharakah, which is partnership contract through equity participation. The profit and loss is shared
according to participation stake in financing. (Mouawad, 2009)
Islamic Finance application may be helpful in preventing the financial crises into following ways:
 Through prohibition of interest, investors can be able to convert his money into profit yielding assets
which coincides the real function of stock exchange (Zerban, et al, 2012)
 Investor should focus on the ethical value and corporate social responsibility for the welfare of society
because if there are overlooked financial crises may arise due huge redemption by portfolio manager
which is the solely responsible for stock exchange volatility. Furthermore, New York court reported
that broker, bankers and traders are involved in information transmission about the company before
the actual trades, also transpires the illegal act. Through Islamic finance they illegal behavior can be
reduced to some extent unless it is fully promoted and compensated according to Islamic styles
(Mazumder and Ahmed, 2010).
Journal of Finance, Accounting and Management, 7(2), 31-38, July 2016 36


Financial crises can be reduced through prohibition of gambling because many hedge funds normally
made bets about the stock price of company declines through getting private and confidential
information about the company. Secondly, hedge funds normally sold short financial stock in order
to gain the profit on the expense of other targeted company’s performance, which would create
downward pressure among various companies and high volatility (Strasburg and Bary, 2009)
Financial crises can be prevented through the prohibition of naked short selling which ultimately
anticipate the fall in price however, exposes seller to the risk of high price. The other ways under this
category is the prohibition of future contracts. (Mazumder and Ahmed, 2010)
Conclusion
Conventional banks did not facilitate small lender mainly attributable to high cost and expense in this
financing. Hence, it can infer that Islamic financial system has a potential towards saving from financial
crises as compared to conventional system. Islamic financial system assists to bind the lender towards loss
sharing, which directly associated with credit expansion towards economic development as well as restricting
the speculations based on gharar and qimar through dealing real transactions. It also forces that lender to
prohibit the sale of debt and ensures the careful risk evaluation. Moreover, it reduces the hurdles of subprime
borrowers towards assess of credit through allowing them on suitable rates. Ultimately, it will save huge
money towards recovery of financial institutions after occurrence of financial crises. These amounts didn’t
save poor as their property may have already auctioned at a call price.
Still the Islamic finance may contribute very small portion towards global finance however, it has a potential
to save from severity of financial crises towards entire world. If all Muslim nations build a strong and well
developed framework of Islamic financial system, then the other economies would also come to adopt its
fundamentals. According to latest report mostly developed economies are still working on proper
implementation of Islamic financial system in the wake of financial stability and prevent future financial
crises.
Policy Reforms
Developed Countries
 Central bank should pursue an explanatory monetary policy, which increase the money supply and
price level.
 Injecting reserves in economy raises the asset prices that will enhance the net worth of company
and diminish the moral hazards and adverse selection problem.
 Debt contract should be denominated in home currency and of long time period
 To pursue lender of last resort role by central bank that it can ready to facilitate loan facility in
financial crises.
Developing Countries
 A restrictive monetary policy should be used in developing countries to bring low inflation and
confidence in home currency.
 Creating and maintaining a regulatory system might be helpful in reducing the excessive risk
taking in their financial systems.
 Adequate resources should be available in regulatory system to performance job effectively.
 Accounting and disclosure requisites for financial institutions need to be beefed up significantly.
 To take corrective action for those institutions those don’t have sufficient net worth.
 Adopt a financial liberalization strategy that leads to the efficient functioning of financial markets
and prolific investment opportunities.
Journal of Finance, Accounting and Management, 7(2), 31-38, July 2016 37
References
1. Al-Masri, R.Y. (2009) The Global Financial Crisis: Its Causes and Solutions from an Islamic
Perspective. In: Islamic Economic Research Center. Issues in the International Financial Crisis
from an Islamic Perspective. Jeddah, KSA: Scientific Publishing Center King Abdulaziz
University, pp 287-295.
2. Alexakis, C. and Tsikouras, A. (2009), “Islamic Finance: Regulatory Framework Challenges
Lying Ahead” , International Journal of Islamic and Middle Eastern Finance and Management,
Vol.2, No.2, 2009, pp.90-104.
3. Bukart, O. and V. Coudert, (2002). “Leading indicators of currency crises for emerging
countries”, Emerging Markets Review, Vol. 3, No. 2, pp. 107-133.
4. Chapra, M.U. (2007). The Case Against Interest: Is It Compelling? Thunderbird International
Business Review, 49(2), pp.161-186
5. Demirgüç-Kunt, A. & Detragiache, E. 1998, Financial Liberalization and Financial Fragility, IMF
Working Paper 98/83, Washington DC, International Monetary Fund.
6. Davies, G. (1996). A History of Money from Ancient Times to the Present Day. Cardiff, United
Kingdom: University of Wales Press
7. Hassan, M.K. and Kayed, R.N. (2009). The Global Financial Crisis, Risk Management and Social
Justice in Islamic Finance. ISRA International Journal of Islamic Finance, 1(1), pp.33-58.
8. Lestano, Jan Jacobs, and Gerard H, Kuper. (2003). “Indicators of Financial Crises do Work! An
Early Warning System for Six Asian Countries”. Department of Economics, University of
Groningen
9. Lietaer, B., Ulanowicz, R. and Goerner, S. (2009). Options for Managing a Systemic Bank Crisis.
S.A.P.I.EN.S, 2(1).
10. Mazumder M. Imtiaz and Ahmad. Nazneen (2010) “Greed, Financial innovation or laxity of
regulation? A close look into the 2007-2009 financial crisis and stock market volatility”, Studies
in Economics and Finance, Vol. 27 Iss: 2, pp.110 – 134.
11. Mirakhor, A. and Krichene, N. (2009). Recent Crisis: Lessons for Islamic Fiance. Journal of
Islamic Economics, Banking and Finance, 5(1), pp.9-57.
Journal of Finance, Accounting and Management, 7(2), 31-38, July 2016 38
12. Rajan, R. G. and Zingales, L. (2003). “ The great reversals: the politics of financial development
in the twentieth century”.Journal of Financial Economics, Vol. 69, No.1, pp. 5-50.
13. Ramey, G. and Ramey, V. A. (1995). “Cross-country evidence on the link between volatility and
growth”. American Economic Review, Vol. 85, No. 5, pp. 1138–1151.
14. Strasburg, J. and Bary, C. (2009), "Six charged in vast insider-trading ring", Wall Street Journal
October 17, p.1.
15. Trabelsi, M.A. (2011). The Impact of the Financial Crisis on the Global Economy: Can the Islamic
Financial System Help? The Journal of Risk Finance, 12(1), pp.15-25. Emerald Group Publishing
Limited
16. Web Chapter. “Financial Crises in Emerging Market Economies”
17. Zerban, Ayman., Elkady, Eslam H. and Omar, Rafik F. (2012). “Islamic Finance and Global
Financial Crises: How to Keep Finance on Track?”.s Middle Eastern and African Economies Vol.
14, pp. 190-222