The global financial crisis and its implications for the Islamic financial ...

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International Shari'ah Research Academy for Islamic Finance, Kuala Lumpur,. Malaysia, and. Abbas Mirakhor. The International Centre for Education in Islamic ...
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The global financial crisis and its implications for the Islamic financial industry

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Edib Smolo International Shari’ah Research Academy for Islamic Finance, Kuala Lumpur, Malaysia, and

Abbas Mirakhor The International Centre for Education in Islamic Finance (INCEIF), Kuala Lumpur, Malaysia Abstract Purpose – The purpose of this paper is to review the evolution of the global financial crisis, draw lessons from it, and analyse its effect(s) on the Islamic financial industry (IFI). Design/methodology/approach – Based on an extensive literature review, this paper aims to highlight, explain, and discuss the implications of the global financial crisis for IFI and suggest necessary steps for the future development of the industry. Findings – The findings show that although the crisis had limited impact on IFI the major flaws of the capitalist financial system are relevant to the development of IFI. Without learning and applying the lessons from the crisis, IFI runs a risk of committing the same mistakes. Finally, greater attention should be given to the fundamental principles of Islamic finance in order to ensure the future development of industry. Research limitation/implications – The effects of the global financial crisis are still being felt all over the world, and its implications on IFI have yet to be fully understood. Owing to unavailability of relevant data, an empirical study is needed to show the real effects of the crisis on IFI. Originality/value – The lessons drawn in this paper will raise awareness among both academicians and practitioners about the inherent weaknesses of current financial practices. Furthermore, the paper highlights the major areas that need to be improved for the future development and success of IFI. Keywords Islam, Finance, Capitalist systems, Debts, Interest Paper type Research paper

International Journal of Islamic and Middle Eastern Finance and Management Vol. 3 No. 4, 2010 pp. 372-385 q Emerald Group Publishing Limited 1753-8394 DOI 10.1108/17538391011093306

Introduction The global financial crisis shook the international financial system around the globe, and its repercussions are still being felt globally. Owing to its severity it has been labeled as the worst crisis since the Great Depression. It is now, more than ever before, clear that the current financial system is not stable and that the invisible hand is not doing what its proponents claimed. The assertion by Minsky (2008) that stability breeds instability, i.e. his “financial instability hypothesis”, seems to be gaining greater acceptance. The prolonged period of “the great moderation”, together with runaway credit growth, paved the way for the current crisis. Easy money, uncontrolled growth of credit and debt, lax regulation and supervision, innovation of complex and opaque financial products, mismanagement of risks involved, lack of disclosure and transparency, predatory lending and high leverage – among other factors – are thought to be the main culprits behind the crisis.

The current global financial crisis brought Islamic financial industry (IFI) into the limelight as a possible alternative. However, IFI has not been totally immune to the crisis; it has been hit as well, although to a much more moderate extent. This may indicate a possible correlation between IFI and its conventional counterpart, as it lives under the same umbrella and is governed by the same rules of the game. Being a niche industry, Islamic finance faces considerable challenges. The way the industry responds to these challenges will determine whether it will become “a significant alternative to the conventional system in global financial markets” (Karuvelil, 2000, p. 155). Moreover, lack of an efficient legal framework and of standards and procedures, qualified manpower and effective government support exacerbate the risk exposures of IFI (Khorshid, 2009). The paper briefly reviews the global financial crisis and its implications for IFI. Section 2 traces the evolution of the crisis. Section 3 discusses the main lessons arising from the crisis. Section 4 the current status of IFI is succinctly reviewed, highlighting the main features of the industry. Section 5 discusses major steps that need to be implemented in order to avoid serious crises in Islamic finance. Section 6 concludes the paper. Evolution of the global financial crisis In the last 27 years, the world has witnessed more than 124 distinct financial crises. Leading economists call the current global financial crisis the most severe and the worst crisis since the Great Depression ( Jones, 2009; Nonomiya and Lanman, 2008; The New York Times, 2010; Volcker, 2010). The crisis has shaken the very foundations of the capitalist financial system. The financial crisis started in the summer of 2007, triggered initially by the implosion of the USA’s housing bubble. It gained momentum and then sharply intensified in September 2008, although many authors point out that the crisis started much earlier and that previous crises had a major role to play in the current global financial crisis (Mizen, 2008; The New York Times, 2010; Oxlade, 2010; Wang and Wen, 2009). The crisis was triggered by the collapse of the sub-prime[1] mortgage market (Mirakhor and Krichene, 2009, p. 23). In 2006, lenders made $640 billion in subprime loans which amounted to about 20 percent of all mortgage lending and about 17 percent of home purchases in the same year (CNNMoney.com, 2007). Many believe that the prolonged period of low interest rates combined with lax regulation and supervision encouraged rapid and substantial growth of credit and, as a result, pushed house prices up. The Federal Reserve lowered the interest rate in 2001 from 6.5 percent to 1.75 percent and then to 1 percent in 2003, a 45-year low (Nonomiya and Lanman, 2008). During the same period, in a furious search for yield, the banks and other financial institutions resorted to widespread financial engineering and innovations. Some of the products they came up with were mortgage-backed securities (MBSs), collateralized debt obligations (CDOs), and credit default swaps (CDSs). Most of these products derived their value mainly from mortgage payments and rising housing prices. As a result, they were positively correlated with the movement of prices in the mortgage market. Prior to 2006, housing prices were skyrocketing before declining by more than 30 percent in the following three years. The low-interest-rate regime was about to end;

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the Fed started raising it from 1.25 percent in May 2004 to 5.25 percent in May 2006 ( Jones, 2009). This rise in the interest rate made payments difficult for subprime borrowers, and defaults on payments began. At the same time, borrowing decreased due to the increased cost, and real estate prices started to fall. The decline in house prices reduced the value of MBSs and other derivative instruments. This, in turn, had a further effect on the initial borrowers, who were relying on the value of the properties and on the financial institutions’ solvency to validate their highly leveraged assets. Very quickly, the crisis reached Europe and the rest of the world as the interbank market ceased functioning. In the UK, Northern Rock was hit by the crisis in September 2007, and in February 2008 it was nationalized (Croft and Giles, 2008; Oxlade, 2010). Banks in Germany were also hard pressed. IKB Deutsche Industriebank, affected by losses related to the US subprime market, was rescued by a government-led bailout in August 2007. At the same time Landesbank Baden-Wu¨rttemberg (LBBW), the German public-sector bank, bailed out the troubled Sachsen LB (Simensen, 2007; Simensen and Benoit, 2007). BNP Paribas, France’s biggest bank, was so badly hit by the US subprime mortgage crisis that it decided to halt withdrawals from three investment funds (Boyd, 2007). Governments all over the world began pumping money into credit markets and bailing out institutions “too big to fail”. The US Treasury sponsored its Troubled Asset Relief Plan (TARP), with $700 billion dedicated to the purchase of heavily discounted MBSs and other securities (Bordo, 2008). Furthermore, the Fed contributed $38 billion to the banking system and stood ready to provide funds as necessary to keep the financial system functioning smoothly. The European Central Bank injected over e150 billion into the Eurozone banking system. Central banks in Europe, Asia, and the Americas injected more than $300 billion in order to save the financial market from what George Soros called “cardiac arrest” (Mirakhor and Krichene, 2009, p. 28). The Bank of Japan, Bank of Canada, Swiss National Bank and the Reserve Bank of Australia also contributed funds for bailouts (For details see Somerville and Milliken (2007)). The measures taken were only partially successful, as the giant institutions were still under threat of impending failure. Just as the markets were starting to calm down, new waves of fear inundated investors when Bear Stearns and Lehman Brothers collapsed in March and September of 2008, respectively. This failure of Lehman Brothers turned the liquidity crisis into a global credit crunch and stock market crash (Bordo, 2008). Despite all the efforts by governments, the banks were reluctant to lend. This led to additional stimulus packages by governments. Bloomberg reported that by February 2009 the US Government had pledged more than $11.6 trillion (for details see Pittman and Ivry (2009) and Shah (2009)). The challenges facing countries were manifold. In order to find the best solution to these challenges, the diagnosis must be accurate. Once the main causes of the current global financial crisis are identified, correct remedies can be adopted. Section 3 will briefly discuss the most commonly highlighted causes of the crisis. Assessment of the causes and lessons of the global financial crisis Several causes have been highlighted by various analysts. While no consensus has yet emerged as to the exact causal factors, the following reasons have been mentioned in the following sections.

i. An interest-based and debt-driven financial system The current financial system is predominantly interest-based and debt-driven. Achieving sustained full employment in a financial system “dominated by ex ante, fixed interest-based debt contracts [. . .]” is “difficult if not impossible” (Mirakhor and Krichene, 2009, p. 56). Both Keynes and Minsky argued that a system dominated by interest-based debt contracts is inherently unstable. Minsky (2008, p. 48) pointed out that an arrangement “in which borrowing is necessary to repay debt is speculative finance”. Further, he called the banks “merchants of debt” (Minsky, 2008, p. 279; Mirakhor and Krichene, 2009). Interest and debt are the two fundamental causes of banking instability and, as such, fundamental causes of the current financial crisis (Mirakhor, 2009b, p. 15). Minsky’s ideas, summarized in what is known as the “financial instability hypothesis”, are mainly “derived from Keynes’s General Theory, Irving Fisher’s description of a debt deflation, and the writings of Henry Simons” (Minsky, 2008, p. 192). This hypothesis implies that interest-based debt contracts breed systemic disturbances (Minsky, 2008; Mirakhor and Krichene, 2009, p. 57). Moreover, short-term stability is itself ultimately destabilizing as it promotes complacency followed by excessive risk taking and, in the end, exacerbated instability (Buiter, 2009; Minsky, 2008; Yellen, 2009). ii. Subprime mortgages and securitization The initial trigger of the crisis was the dramatic fall of housing prices and defaults on subprime mortgages (Allen and Carletti, 2008). Through the process of securitization[2], the financial institutions devised new products, packaged them and sold them in the market. In the early 1990s, there were no subprime mortgages. But one result of the adoption of the now infamous “originate and distribute” model was that subprime mortgage originations rose to $625 billion in 2005 from zero in 1993, with an average annual growth rate of 26 percent during that period. Gramlich called this market the “Wild West” (Gramlich, 2007, p. 106). While subprime mortgages were on the rise, securitization lengthened the distance between borrowers and lenders. Underwriting standards deteriorated dramatically as the major players in the “originate and distribute” model were also those in the “shadow banking system” (Yellen, 2009). Thus, the securitization process did not make new instruments safer, as was suggested by the rating agencies, because they were basically credit-debt instruments closely correlated with movement in prices of underlying assets, i.e. houses. iii. Monetary policy and low interest rates It is believed that “abnormally low interest rates” over a prolonged period prior to the crisis combined with excessive and easy monetary policy paved the way for the emergence of the crisis (Bordo, 2008; Kashyap et al., 2008; Taylor, 2008; Yellen, 2009). Low interest rates made mortgage payments cheaper, which in turn increased demand for homes, leading to higher house prices. In addition, existing home owners, lured by the lower interest rate, started to refinance their existing mortgages to cash out as much as and as fast as possible. iv. Credit growth and predatory techniques by lenders According to the Bank for International Settlements (BIS), the fundamental cause for the current global financial crisis lies in “excessive and imprudent credit growth over

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a long period” (BIS, 2008, p. 143). As a direct result of the exceptional boom in credit growth over the years, financial institutions searching for higher and higher profits adopted predatory lending, increasingly non-transparent instruments and off-balance-sheet operations to avoid capital and liquidity regulation (Aziz, 2008; Financial Stability Forum (FSF), 2008, pp. 1 and 5; Mirakhor and Krichene, 2009). Although default cases were on the rise in 2006, banks did not slow down on lending.

376 v. The complexity and mispricing of the risks of new products The decade prior to the crisis was marked by financial engineering and innovation of new products. Although financial innovation can contribute to the growth of the economy and benefit the society, it could also cause enormous damage as it creates new instruments whose risks are less understood, assessed and regulated (Ahmed, 2009; Hassan and Kayed, 2009b; Kashyap et al., 2008). Owing to the increased complexity of financial products and markets, regulators, supervisors and market participants in general failed to effectively evaluate the inherent risks (Ahmed, 2009; Mirakhor and Krichene, 2009). Some would say that the crisis was not due to the complexity of the new products as much it was due to mispricing of the risks of these products (Mizen, 2008, p. 532). Be that it as it may, the crisis exposed the inadequacy of the risk management practices of many financial institutions (Ahmed, 2009; Aziz, 2008; Bernanke, 2009; FSF, 2008, p. 7; Mirakhor and Krichene, 2009; Trichet, 2009). vi. Liquidity, leveraging and the fear of contagion The current crisis also revealed the importance of liquidity risk management and leveraging (Aziz, 2008; Bernanke, 2009; Mersch, 2009; Mirakhor and Krichene, 2009; OECD, 2009). Liquidity risk management is important due to its role in maintaining institutional and systemic resilience in the face of shocks and, conversely, due to the system-wide contagion caused by liquidity shock to a single institution (Basel Committee on Banking Supervision, 2008, p. 1; FSF, 2008, p. 16). Once the US financial crisis began, the panic spread worldwide. The resulting uncertainty and lack of liquidity made banks more averse to risk, as they were afraid of contagion (Hassan and Kayed, 2009b). Furthermore, with the complexity and opacity of credit instruments, the interbank market froze, forcing financial institutions into deleveraging (Bordo, 2008; Mirakhor and Krichene, 2009, p. 28; Sarkar, 2009, September). vii. Regulatory and supervisory failures Lack of both supervision and regulation of the financial sector played an important role in the crisis (Ahmed, 2009; Hassan and Kayed, 2009b; Mirakhor, 2009a; Mirakhor and Krichene, 2009; Truman, 2009a). This led to the growth of unregulated exposures, which further led to excessive risk-taking and weak liquidity risk management (Aziz, 2008; FSF, 2008, p. 9). It is now evident from the crisis that the regulatory and supervisory frameworks of leading economies were incomplete and inefficient (Jordan and Jain, 2009, October). viii. Transparency and disclosure The complexity of the new products and the lack of transparent information sent wrong signals to market players, leading to underestimation of the risks involved.

This led to overleveraging and excessive borrowing. Once market confidence was shaken, panic in the market became inevitable since no one had a clear idea of the depth of the problems (Aziz, 2008; OECD, 2009, p. 36). Lack of market clarity as an underlying cause of the crisis led the FSF to conclude that sound disclosure – among other things – is an essential part of market confidence and effective market discipline (FSF, 2008, p. 22).

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ix. The role of rating agencies Rating agencies were assumed to play the role of guardians of the market. They were thought to be market-filters, making sure that full and accurate information are available to the market. However, credit rating agencies were consulted, for a fee, on design and structuring of new products by those who participated in the packaging and distribution of complex credit-derivative instruments. This created competition between rating agencies that led to a deterioration of credit standards (Mirakhor and Krichene, 2009, p. 26).

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x. The effect of financial globalization Although the current financial crisis started in the USA, the negative effects were felt all over the world. Financial integration and the internationalization process that had begun in earnest in the second half of the 1980s picked up accelerated momentum in the 1990s, creating strong international linkages. These linkages, unfortunately, were mostly reliant on investment – through financial intermediaries, banks and “shadow banks” – in credit-derivatives, particularly subprime instruments. Once the housing credit market collapsed in the USA, panic spread rapidly, paralyzing the international financial market (Aziz, 2008; Jones, 2009; Jordan and Jain, 2009, October; Truman, 2009b; Yellen, 2009, May). The IFI: stability and resilience The Islamic financial system refers to financial activities that are guided by the teachings of the Shari’ah (Islamic law), which strictly prohibits the payment and receipt of interest. Moreover, not only must investment activities be in line with the ethical principles of the Shari’ah, they should also take into consideration public interests (masa¯lih). Today Islamic finance attracts both Muslim and non-Muslim market participants (Monger and Rawashdeh, 2008). The worldwide market for Shari’ah-compliant Islamic financial products is estimated to be between US$800 billion and $1 trillion. According to London-based IFSL (McKenzie, 2010, January), Shari’ah-compliant assets grew to $951bn by the end of 2008, up 25 percent from $758bn in 2007, and up about 75 percent from $549bn in 2006 (KFH Research, 2009). IFI is growing at 15-20 percent per annum – a growth rate that far exceeds that of the conventional financial industry. The evidence shows that IFI was somewhat more resilient to the global financial crisis. It is even argued that if the principles of Islamic finance had been followed, the financial crisis would have been prevented (Ahmed, 2009; Hassan and Kayed, 2009a). Nevertheless, some impact has been felt within the industry, revealing some vulnerabilities that need to be urgently addressed in order to sustain the growth of IFI (KFH Research, 2009). The true reason for IFI’s insulation from the crisis lies in the fundamental prohibitions of the Shari’ah against riba (interest) and gharar (unnecessary ambiguity) on the one hand and the limited sophistication of Islamic finance on the other.

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Furthermore, the impermissibility, therefore unavailability, of financial derivatives, such as CDOs and CDSs, within the Islamic financial system may have been an important contributor to shielding the system from experiencing the deeper impact of the crisis. This resilience to the current global financial crisis has attracted attention to Islamic finance. For example, the Vatican has called for reliance upon Islamic finance principles in financial dealings (Totaro, 2009). The crisis has offered an opportunity to consider the lessons resulting from this painful experience in order to strengthen Islamic finance. Abdulla Al Awar, CEO of the Dubai International Financial Centre Authority (DIFC), pointed out that “[p]erhaps now is the opportunity for Islamic Finance to come out from the shadows of conventional finance and provide financial products in line with Shari’ah to an investor base that is currently unsatisfied and unsure of the conventional financial system” (Zawya, 2009). Ebrahim (2004) suggests that IFI rushed into the next phase of its development, characterized by innovation and expansion of products, without having fully prepared the necessary ground and without having solidified its foundation. This may prove detrimental to the future development of IFI. Many share the view that IFI is currently only a subset of the conventional financial system and that it is converging towards the conventional system. These critics suggest that the products of IFI are but blurred copies of conventional products (Ahmed, 2009; Brant, 2009; Hassan and Kayed, 2009b). Because of its similarities to the conventional financial system, IFI contains flaws resembling those underlying the current global financial crisis and, as such, is vulnerable to its own crisis (Ahmed, 2009). These flaws include weakness in the regulatory/supervisory system, opaqueness of products, concentration of the risk of these products in banks and financial institutions and limited risk-sharing characteristics of the products developed thus far. Implications for the IFI In its current nascent stage, IFI can learn lessons from the crisis and correct its present weaknesses. Some of the lessons include. i. The role of debt and interest-like instruments According to Minsky (2008), the underlying reason for financial instability is debt (Mirakhor and Krichene, 2009). Abstinence from riba (interest) and interest-rate-debt-based instruments by Islamic financial institutions are reasons why the global financial crisis had limited effect on IFI. Keynes considered that capitalism suffers from two “evils”. First, it cannot create full employment on its own without government intervention. Second, income and wealth would be maldistributed. He believed that the interest rate mechanism was the “villain of the piece”. Without it there would be stability in the market and the surplus income would be directed to investment activities (Mirakhor and Krichene, 2009). The most important lesson of this financial crisis for IFI “is to reduce over-reliance on debt-based instruments and to introduce more risk-sharing instruments” (Mirakhor, 2009a). One of the most serious problems of the conventional system and a major lesson of the crisis is the “decoupling” of the financial system from the real sector of the economy. Just before the crisis hit, it was estimated that in 2007 the total available financial instruments (mostly derivatives) represented 12.5 times the total global GDP. An inverted colossal pyramid of debt was created on a much smaller base of real sector activities which, ultimately, have to be relied upon to validate the debt created. This is an incredibly valuable lesson for Islamic finance as it continues to innovate liquid,

short-term, low-risk, debt-like instruments under demand pressure. IFI must find ways and means of innovating more medium to long-term instruments of risk sharing rather than short-term instruments of risk transfer or risk shifting. ii. Human factors One important element that contributed to the crisis, but has been overlooked by most (if not all) authors, is the human factor. After all, financial institutions tend to be controlled by humans who are profit-motivated and greedy in pursuit of their self interest. Despite the fact that most of these individuals are highly educated, they failed to keep the market safe. Although IFI has grown rapidly over the years (and is still growing), this growth has not been accompanied by sufficient development of additional human capital; the industry thus faces a huge shortage of experienced Shari’ah scholars. This is one of the biggest challenges facing IFI today, according to Rosly (2005, pp. 347-9). The challenge becomes more complicated as the scholars have to look into more and more sophisticated contracts and instruments that are being developed by the industry (Sa’Pinto, 2009). Therefore, there is an urgent need for additional well-qualified manpower that will not only be well-versed in the Shari’ah but also equipped with necessary knowledge and skills to carry on the mission and vision of IFI. The establishment by Bank Negara Malaysia (Central Bank) of The International Centre for Education in Islamic Finance (INCEIF) represents a template for the education and training of future leaders in Islamic finance. iii. Financial innovation IFI is, indeed, in need of new products, especially for risk-sharing and risk management. Islam encourages productive and useful innovation in line with Shari’ah principles, both in form and in substance. Currently, Islamic financial institutions concentrate mainly on the innovation of instruments that are vulnerable to risks similar to those of conventional interest-based debt products. They may also have the potential to decouple the financial sector from the real sector of the economy. In that case, the growth of these instruments may reach a point where the underlying real sector activities would be too small relative to the size of these instruments. As such, they may not be able to withstand a shock to the financial sector. This vulnerability is exacerbated by the fact that many (if not all) of these instruments are benchmarked to some internationally accepted interest rate index. Thus, their value could well be affected by changes in the interest rate (Mirakhor, 2009b). In short, although it is a part of the interest-based and debt-driven global financial system, IFI must make extra effort to avoid its flaws. Moreover, it should be kept in mind that there is a difference between Shari’ah contracts per se and the instruments that financially facilitate these contracts. In other words, these contracts are valid contracts from a Shari’ah point of view; however, some of the instruments utilized to finance these contracts may not be fully in line with the Shari’ah, i.e. they may conflict with its objectives while adhering to it sanctioned forms. iv. Risk management Every financial transaction involves a certain degree of risk. In order for any profit to be considered legitimate, from an Islamic point of view, the parties in a transaction must share the risk of that transaction. This is in line with the concept of “no risk, no gain”. In other words, Islam requires risk sharing. However, it does not allow excessive and unnecessary risk taking or transfer of risk to a third party.

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One of the objectives of the Shari’ah (Maqasid al-Shari’ah) is to protect wealth. As such, risk management is integral part of Maqasid al-Shari’ah. Therefore, developing proper and efficient risk management practices is a very important element of proper and responsible participation in IFI activities[3]. v. The regulatory and supervisory framework Many analysts believe that if an appropriate and effective regulatory and supervisory framework had been in place, the current financial crisis would have had much less devastating effects. Does more regulation and supervision mean a more stable financial system? Not necessarily; there may be a lot of regulation, but if it is not effective it will offer no protection. Based on the post-crisis review of lessons learned, it can be concluded that “the most important lesson of the recent crisis for Islamic finance is an urgent need for the design, development and implementation of a comprehensive, unified, uniform, global and dynamic regulatory-prudential-supervisory framework” (Mirakhor and Krichene, 2009, p. 71). This “properly designed regulatory-prudential-supervisory framework,” the authors argue, is “essential to the orderly development and evolution of Islamic finance” (Mirakhor and Krichene, 2009, pp. 68-9). vi. Transparency and governance It is often argued that Islamic financial institutions are more transparent than their counterparts in the conventional system. Ironically, while information and data on conventional institutions, their structures and practices, are available to the public, information and data on Islamic financial institutions, their product structures and other related issues are difficult, in some cases impossible, to obtain. While this lack of information in the case of Islamic financial products and their structures may be one way by which a bank protects its “intellectual property”, the bank would be better off by greater transparency in its product structure. Transparency would benefit an innovator by causing an increase in market activities as other banks use that product structure (if acceptable), and it would increase trade volume among the banks themselves. This may well lead to improvement of the products needed for the industry to grow further. The proper transparency, disclosure and governance of IFI should become mandatory through appropriate laws and regulation to help improve the quality of products and protect the financial system. Moreover, disclosure and reporting by Islamic financial institutions should comply with the highest international standards and practices for financial and non-financial reporting. Furthermore, this disclosure of the relevant information should be done accurately and in a timely fashion (Khir et al., 2008, p. 312). The governance system of IFI should be far stronger than the conventional one. The reason for it lies in the fact that ethics cannot be separated from the operations of Islamic financial institutions. In other words, Islamic governance is guided by moral principles and is based on maslahah (public interest), whereby all business operations should take into account the social implications of their activities, i.e. public interest comes first (Chapra, 2008; Walsh, 2007). Conclusion Notwithstanding the limited impact of the global financial crisis on IFI, there are many lessons that should be learned from it, and commensurate steps must be taken within IFI

in order to make it more resilient to similar shocks. One of the steps necessary for strengthening the resilience of Islamic finance, according to Bank Negara Malaysia Governor Dr Zeti Akhtar Aziz, is the assimilation of Shari’ah values in the realization of benefits (masa¯lih) to the relevant stakeholders. Islam calls for justice, fairness, cooperation and shared responsibility. Its goals go far beyond monetary indicators and growth as it promotes ethics, responsibility and market discipline (Aziz, 2008; Chapra, 2008). This is an opportune time for IFI to reduce reliance on debt-like products and move closer to equity-based, risk-sharing instruments. However, whatever choice is made by the industry, there is a need for an efficient regulatory and supervisory framework that will stay ahead of the market so as to prevent regulatory arbitrage from making significant inroads in the market (Aziz, 2008; Mirakhor and Krichene, 2009). An effective system of checks and balances has to be constructed that will help avoid making mistakes similar to those which led to the current crisis. In this context, Chapra (2008, p. 2) suggests three critical steps: (1) establishing moral constraints on greed to maximize profit, wealth and consumption; (2) strengthening market discipline that will exercise a restraint on leverage, excessive lending and derivatives; and (3) reforming the system’s structure combined with prudential regulation and supervision to prevent crises, achieve sustainable development and protect social interest. Among the Islamic countries, Malaysia has had by far the greatest success in creating a flexible, innovative environment with the potential to provide both the incentive structure as well as the administrative apparatus to allow steps towards developing new risk-sharing instruments under an effective regulatory structure. The country’s courageous step of unifying the Shari’ah-ruling framework, as well as its long standing commitment to provision of human capital to IFI and its encouragement of innovation, gives it a leadership position that can serve to strengthen the progress of Islamic finance. Notes 1. A subprime mortgage refers to a home loan made to a borrower who does not qualify for a “prime” loan because he or she has a blemished or non-existent credit history. These loans are referred to as “Ninja loans” – no income, no jobs, and no assets (Mirakhor and Krichene, 2009, p. 23; Russell, 2009). 2. Securitization, simply put, is a financial process which allows one asset to be grouped with others to create a marketable security guaranteed by the cash flows. It could also be defined as “Pooling loans for various purposes into standardized securities backed by those loans, which can then be traded like any other security. In sum, the process of converting assets into marketable securities is called securitization” (Lee and Lee, 2006, p. 243). 3. For the discussions on risk management from Islamic perspective please see, for example Ahmed (2009), Iqbal and Mirakhor (2007), Dusuki and Smolo (2009) and Hassan and Kayed (2009b). References Ahmed, H. (2009), “Financial crisis risks and lessons for Islamic finance”, ISRA International Journal of Islamic Finance, Vol. 1 No. 1, pp. 7-32.

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