Analyzing Causes and Consequences of Global Financial Crisis 2008-09: Is Islamic Banking a Remedial Option?

1. Analyzing Causes and Consequences of Global Financial Crisis 2008-09: Is Islamic Banking a Remedial Option? Dr. S. M. Ali Akkas Director (Planning & Development) Bangladesh Open University

2. Focus area of My Discussion • I would concentrate on dimensions of the global crisis which are not touched in previous paper. This is just to avoid duplication in discussion. • Impact of global financial crisis on Bangladesh, policy responses and prospective economic outlook • Approaching analysis of global financial crisis from Business Cycle perspective • Is Islamic Banking a Remedial Option?

3. Collapse of US Financial System: Impact on World Economy • The collapse of the US sub-prime mortgage market and the reversal of the housing boom in other industrialized economies have had a ripple effect around the world. Furthermore, other weaknesses in the global financial system have surfaced. Some financial products and instruments have become so complex and twisted, that as things started to unravel, the trust in the whole system started failing. • Housing prices fell continuously in Japan since the last half of 1990s. In case of United States, Britain and Australia the reversal of housing prices started from the beginning of 2005 after steady rise from 1995 until it boomed in 2005. • The extent of this problem has been so severe that some of the world’s largest financial institutions have collapsed. Others have been bought out by their competitors at low prices and in other cases, the governments of the wealthiest nations in the world have resorted to extensive bail-out and rescue packages for the remaining large banks and financial institutions. The crisis became so severe that after the failure and buyouts of major institutions, the Bush Administration offered a $700 billion bailout plan for the US financial system. • In Europe, a number of major financial institutions have failed, or needed rescuing. For example, some nations have stepped in to nationalize or in some way attempt to provide assurance for people. This may include guaranteeing 100% of people’s savings or helping broker deals between large banks to ensure there isn’t a failure.

4. The Financial Crisis and the Developing World UNCTAD report, the Third World Network notes that • the impacts of the crisis could have around the world, especially ondeveloping countries that are dependent on commodities for import or export. • Commodity-dependent economies are exposed to considerable external shocks stemming from price booms and busts in international commodity markets. • Market liberalization and privatization in the commodity sector have not resulted in greater stability of international commodity prices. There is widespread dissatisfaction with the outcomes of unregulated financial and commodity markets, which fail to transmit reliable price signals for commodity producers.

5. World Financial Crisis and Bangladesh 1. Impact on Stock Market • While other emerging economy stock markets have crashed, cut in half in a couple of months, the Bangladesh bourses have only experienced a mild correction - down 11 per cent from their peaks. There are two key reasons: • First, foreign capital inflow limited (closer to 5%). • Second, banks iand other financial institutions n Bangladesh not affected by the global financial meltdown, which have heavy concentration in stock exchange (44.23% of Dhaka Stock Exchange).

6. World Financial Crisis and Bangladesh..Contd. 2. Impact on the Export-oriented Sector • Rather than being affected instantly by the global financial crisis, Bangladesh's apparel sector bagged adequate orders for ready-made garments (RMG) up to November 2008. • But with the global recession prolonging, some garment industries have reportedly started to feel the impact.

7. World Financial Crisis and Bangladesh..Contd. 3. Impact on Real Estate Sector • The country's housing sector is likely to face a slump due to the ongoing financial crisis in developed countries. • As a result of a prolonged economic crisis, Bangladeshi expatriates living in the USA, Britain and other countries might face job cuts. This will hit real estate sector hard as they are major buyers of Bangladesh real estate sector. • Bangladeshi expatriates are engaged in construction work and self-employed as taxi drivers abroad. So they will be the victims of the recession. • The country's real estate sector which had been growing at a pace of double digit until 2006 could have a negative growth in 2009 and 2010 as a result of global recession.

8. World Financial Crisis and Bangladesh..Contd. 4. Impact on Rural Bangladesh • The country's shipments of primary and agriculture products such as shrimps, jute and jute goods, vegetables, betel leaf, cut flowers are sliding fast amid a global recession, dragging down export growth and directly hitting millions of rural people. • Both raw jute and jute goods such as yarn, hessian and sackings have been faring worse since the economic crisis gripped the developed nations in the latter half of 2008. Jute spinners have shut down three factories, shed some 25,000 jobs and cut raw jute purchases to cope with ebbing demand caused by the global economic crisis. • European Union sees Bangladesh's economy, particularly exports and remittances, to be hit hard in the next fiscal year, beginning in July 2009 due to falling demand for Bangladeshi products and workers. Overseas jobs for Bangladeshis fell 38 percent in the first quarter of 2009 due to declining demand in major labour markets, including Saudi Arabia, United Arab Emirates and Malaysia.

9. The Causes of the Crisis 1. Personifying the Responsibility • Some analysts hold former Federal Reserve Board Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and SEC Chairman Arthur Levitt for not regulating financial instruments known as derivatives. According to these analysts, it was the collapse of a specific kind of derivative, the Mortgage Backed Security, that triggered the economic crises of 2008. It was Alan Greenspan's actions and inactions that triggered the economic crises of 2008, wrote attorney Timothy D. Naegele producing economic tsunami that has been rolling worldwide with devastating effects. He asserts that Greenspan is the architect of the enormous economic "bubble" that burst globally. 2. Unregulated Practice of Neo-liberal Ideology • What followed that crisis was not an egalitarian restructuring of world-trade relations but the rise of a neo-liberal ideology in the late 1970s that was embodied in Reaganomics and Thatcherism in the global north and the Washington consensus and structural adjustment in the global south. 3. Flawed Institutions of often referred New Financial Architecture • The ultimate cause of the current global financial crisis is to be found in the deeply flawed institutions and practices of what is often referred to as the New Financial Architecture (NFA) – a globally integrated system of giant bank conglomerates and the so-called 'shadow banking system' of investment banks, hedge funds and bank-created Special Investment Vehicles. The NFA has generated a series of ever-bigger financial crises that have been met by larger and larger government bailouts. 4. Deregulation and Risk Shifting by Banks to Investment Banks • Change in the focus of banking activity. While banks did provide credit and create assets that promised a stream of incomes into the future, they did not hold those assets any more. Rather they structured them into pools, “securitized” those pools, and sold these securities for a fee to institutional investors and portfolio managers. Banks transferred the risk for a fee, and those who bought into the risk looked to the returns they would earn in the long term. The role of assessing risk was given to private rating agencies, which were paid to grade these instruments according to their level of risk. Investment banks served as prime brokers for these funds and therefore provided them credit.

10. The Missing Context of Global Financial Crisis Analysis: A Deliberate Avoidance? • The global financial crisis that started with the bursting of October 2008 US financial bubble is not an isolated phenomenon; rather it is deeply linked to the recession of US economy following the boom in November 2007. • The U.S. recession that began in December 2007 is expected to be the longest in post World War II history, according to the latest survey of business economists by Blue Chip Economic Indicators. The January 5th-6th poll of 52 economists from top financial firms, manufacturers and academia found that most expected a tepid recovery to begin later this year, with growth returning to more normal levels in 2010. • This recession is predicted to be the longest because it will exceed the 16-month long recessions of 1981-1982 and 1973-1975. The other recessions occur during 1990-91 and 2000-01. • Why the Avoidance? Perhaps, it uncovers devil’s Olympiad of conventional banking based on interest.

11. G-20 Interpretation 15 November 2008, leaders of the Group of 20 cited the following causes: • "During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions."

12. Business Cycle Approach to Financial Crisis Analysis Pro-cyclicality of Financial Institutions • The foregoing analyses of the credit crunch have all blamed the wrong Fed policy, deregulation or the bad innovation of so-called credit derivatives, and last but not the least, the failure of the financial system in managing risk and allocating capital, the systemic inefficiency, as mentioned by Joseph Stiglitz. • It is the fragility of the conventional banking system based on interest, which is the internal cause of accelerating business cycle. It is the ‘spread’ between the fixed payment commitments to bank against uncertain cash flow of the borrowers that widens while the economy switches over from boom to recession. The implication is that interest-based conventional banks become desperate in recovering dues from the borrowers leading to foreclosure of already sick enterprises, bring other solvent ventures in line of foreclosure diverting funds from these units to the already sick ones.

13. Business Cycle Approach to Financial Crisis Analysis…Contd. Pro-cyclicality of Financial Institutions • Nouriel Roubini cites the great but relatively unknown Post-Keynesian economist Hyman Minsky in his latest despatch about the state of US financial markets and economy. Minsky’s main contribution to economics was a model of asset bubbles driven by credit cycles. In his view, periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of releveraging. Investors start to borrow excessively and push up asset prices excessively high. In this process of releveraging there are three types of investors/borrowers. First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flows. Second, “speculative borrowers” who can only service interest payments out of their cash flows. These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts. Finally, there are “Ponzi borrowers” who can service neither interest nor principal payments. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations. • The other important aspect of the Minsky Credit Cycle model is the loosening of credit standards both among supervisors and regulators and among the financial institutions/lenders who, during the credit boom/bubble, find ways to avoid prudential regulations and supervisions. • The Minsky idea of loosening of credit/lending standards among mortgage lenders is also now evident in the recent mortgage credit cycle. A supervisory ideology that tried to minimize any prudential supervision and regulation and totally reckless lending practices by mortgage lenders led to a massive housing and mortgage bubble that has now gone bust. The toxic waste in the aftermath of this bust includes more than fifty subprime lenders going out of business this year, soaring rates of delinquency, default and foreclosure on subprime, near prime and non-conventional mortgages, and the biggest housing recession in the last few decades since the Great Depression of the 1930s.

14. Business Cycle Approach to Financial Crisis Analysis…Contd. Pro-cyclicality of Financial Institutions • While the process of releveraging started in the household sector, the releveraging more recently spread to the corporate and financial system. In the corporate sector, given the cheapness - until recently - of credit, there was a massive switch from equity to debt that took the form of leveraged buyouts, share buybacks and privatization of formerly public companies. This releveraging fed that equity/asset bubble: as expectations of more LBOs occurred, equity valuation of many firms went higher and higher. The excesses took recently the form of premia of 40-50% or higher on the stock price of firms that were a leveraged takeover target. Also, the amount of issuance of low grade corporate bonds (below investment grade “junk bonds”) had been rapidly rising in the last few years. • While pure “Ponzi” borrowers were not as common in the corporate system, there is wide evidence of “speculative borrowers” who relied and still rely on continued refinancing of their debts.

15. Business Cycle Approach to Financial Crisis Analysis…Contd. Need for a Counter-Cyclical Banking System • The foregone Roubini interpretation of Minisky Credit Cycle applied to the last three credit boom and asset bubbles, including the recent one in October 2008, may be summarized as follows: • all of the three credit cycles started with the economic boom and ended with recession. That means, each credit cycle is linked to business cycle with the implication that crisis in financial sector generates instability in real sector following each boom and accelerates recession or depression in the economy. • In other words, the financial sector has a pro-cyclicality effect on the real sector and that works through the fixed payment commitment of the borrowers against their uncertain cash flows – an uneven contractual practice between the traditional financial institutions and the borrowers – expediting credit defaults, foreclosures and deepening recession, thereby aggravating business cycle each time.

16. Business Cycle Approach to Financial Crisis Analysis…Contd. Need for a Counter-Cyclical Banking System • In a recent conference “Building an International Monetary and Financial System in 21st Century: Agenda for Reform” held in New York during November 24-25, 2008 Erich Harbrecht, Head of International Financial System Division, Deutsche Bundesbank said • “IMF’s main task would be to analyze the interaction between the real economy and the financial system, and monitoring, particularly while implementing supervisory standards and stability risk in the context of Article IV consultations and the ESAP” • Some participants in the conference argued that “Basel II had enhanced pro-cyclicality and the three-pillar system (minimum capital requirements, supervisory review, and market discipline) was inadequate. In this regard prudential regulation should become anti-cyclical rather than pro-cyclical. The real challenge lies in the pro-cyclicality of banking, not in the pro-cyclicality of the capital regime.” • This calls for bringing reforms in contractual obligations of and relationship between the financier and borrower so that corrective measures can be taken towards removing pro-cyclical character of the financial institutions.

17. Is Islamic Banking a Remedy to Global Financial Crisis? • Dr. Umer Chapra, an Islamic Finance expert has said in the first of the IIBI lecture series that Islamic financial system is capable of minimizing the severity and frequency of financial crises by getting rid of the major weaknesses of the conventional system. It introduces greater discipline into the financial system by requiring the financier to share in the risk. It links credit expansion to the growth of the real economy by allowing credit primarily for the purchase of real goods and services which the seller owns and possesses, and the buyer wishes to take delivery. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully. In addition, Islamic finance can also reduce the problem of subprime borrowers by providing credit to them at affordable terms. This will save the billions that are spent after the crisis to bail out the rich bankers. These do not, however, help the poor because their home may have already become subject to foreclosure and auctioned at a give-away price. • The problem is that the Islamic finance is still in its infancy and shares a very small proportion of international finance. In addition, it does not genuinely reflect the ethos of Islamic teachings. The use of equity and PLS is still very small while that of debt-creating modes is preponderant. Moreover, even in the case of debt-creating modes, all the conditions laid down by the Shari’ah are not being faithfully observed by the use of legal stratagems (hiyal). This is partly due to a lack of proper understanding of the ultimate objectives of Islamic finance, the non-availability of trained personnel, and the absence of a number of shared or support institutions that are needed to minimize the risks associated with anonymity, moral hazard, principal/agent conflict of interest, and late settlement of financial obligations. The system is, thus, not fully prepared at present to play a significant role in ensuring the health and stability of the international financial system. It is, however, expected that the system will gradually gain momentum with the passage of time and complement the efforts now being made internationally for promoting the health and stability of the global financial system.

18. Conclusion • Recession follows every boom– that has been the usual feature of the market economy. When the boom turns to recession, financial bubbles burst – a scenario repeatedly orchestrated in the world history of economic development. The havoc starts every time with the collapse of a certain thrust sector, this time the housing. Artificial pouring of money in the housing sector through a securitization process by means of derivatives, the so-called financial innovations, is now blamed to be the culprit of the perceived worst ever disaster, an analysis within a capitalist frame of reference where recurrence of business cycle is taken as a rule and the conventional banking system based on interest has nothing to do with it – a perception little questioned. Therefore, adoption of conventional fiscal and monetary measures together with bringing back the conventional banking to regulatory framework has so far been the policy recommendation by most experts. • The implication of this sort of prescription is that the taxpayers of the national economies should be ready for contributions to bailout packages for financial institutions each time of the business cycle havoc. This is tantamount to making taxpayers, instead of the central bank or sovereign, the lender of the last resort. This is a situation which indicates systemic failure of the conventional banking system . The change in structure is expected to be counter-cyclical in nature. Moreover, the reformed banking structure should have built-in systemic linkages to the real-sector economy. In other words, the changed banking structure should have a kind of contractual obligation bonding the bank and the borrowing investors in the real sector enabling the mechanism to counter downswing of the business cycle. • Islamic Banking in its pure form has its built-in counter cyclical operational framework and is directly linked to the real sector economy. However, it is yet to develop as a PLS-banking system in investment financing, and thus can hardly claim to be a financial system which is counter-cyclical and fully linked to real sector economy. The reason for Islamic banks world over have had not yet been shattered by the current global financial crisis is its non-adherence to develop so-called credit derivatives, and that it does not deal in debt trading and distances itself from market speculation; and the shock absorption capability it has in the deposit side by offering flexible profit rates to the depositors.