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Islamic Finance: An Alternative Financial Model

By Ahmad Mohamed Ali, president, Islamic Development Bank

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There is much to be learned from the central principles of risk sharing and adhering to ethical values offered by the Islamic finance model.

There are signs that the global financial crisis is subsiding. The unprecedented fiscal stimulus packages applied by the G20 countries have curtailed the sharp fall in gross domestic product in the first quarter of 2009. Economic recovery is, therefore, in sight. Economic growth in the G20 countries is expected to turn positive during 2010. The global financial crisis has, however, adversely affected the export prospects of developing countries.

It has either dried up external financing, or made it more costly, thus making it harder for them to attain the targets set in the Millennium Development Goals. Under these challenging conditions, scaled-up lending by multilateral development banks has helped developing countries to avert a disruptive crisis in the balance of payments and to continue funding critical projects in their public investment programmes.

Since November 2008, the Islamic Development Bank (IsDB) has participated actively in the work of the ‘G20 Working Group 4: The World Bank and Other Multilateral Development Banks’ by frontloading already-approved development assistance and identifying programmes for additional financing. This helped the IsDB garner support during its 34th annual meeting, held in June 2009, for adopting the board of governors’ Ashgabat Communiqué to support the IsDB Group in its programme to mitigate the impact of the global economic crisis on member countries. In this context, the bank announced a two-fold increase of its ordinary capital resource operations from 15 per cent per annum to 30 per cent per annum over the three years from 2009 to 2011.

The IsDB will also rapidly disburse financing for programmes and projects in member countries in order to assist them in partially alleviating the tighter external financing conditions they encounter. This will help lay the foundations for economic recovery.

Given the scale of the global financial and economic crisis, G20 leaders and policymakers have responded forcefully with macroeconomic stabilisation measures. However, some of the key structural issues, involving addressing the toxic assets and the financial sector, have not been fully resolved. The virulence of the financial crisis was due to its extensive global reach and the epic magnitude of losses to which it led.

From the perspective of Islamic finance, the origination-distribution of risky assets through complex products and multiple layering created an illusion of economic progress. It in turn only benefited a few. Between 1975 and 2007, the debt of the financial sector in the United States grew at an annualised rate of 185 per cent, while that of the business sector, which is a major source of wealth creation, grew at only 34 per cent. It is, therefore, not surprising that during the same period the corporate profits of the US financial sector jumped by more than 20 times, while those of the non-financial sector increased by less than nine times. The hard lesson is that there is an urgent need to introduce a new set of regulations that could inextricably link the activities and growth of the financial sector to the performance of the real economy.

Over the years, the IsDB has supported and contributed to the establishment of an Islamic financial architecture. It is working with infrastructure institutions in the Islamic financial services industry to motivate and enhance the links between Islamic financial institutions and the real economy. The relationship between them is affected by the fact that Islamic financial institutions work within the global financial system.

On 29 October 2008, the lsDB organised a brainstorming session of leading bankers and economists from around the world. This led to the establishment of the Task Force on Islamic Finance and Global Financial Stability, chaired by the governor of Bank Negara Malaysia. The task force has, inter alia, examined the key elements of Islamic finance that can lead to the reform of the global financial system and build a resilient financial system, which can help prevent the recurrence of financial crises.

A major lesson of the current financial crisis is that the new international financial architecture should explicitly foster greater responsibility and accountability in the system by injecting greater market discipline. The central feature of Islamic economics and finance is, accordingly, strict adherence to Shariah principles, which reflect universal ethical values and the creation of a strong link between the financial and the real sectors. Islamic financial institutions are therefore not merely the agents for the collection of ‘spread’ in the context of debtor-creditor relationship. This prohibition of interest, or riba, helps build such a discipline into their operations.

The intrinsic feature of Islamic finance is the participatory finance model in which both the financiers and business partners share in the ex-post outcome of risk and reward. Mainstreaming this feature of Islamic finance carries the potential of contributing to the promotion of market-based discipline and stability in the global financial system. Participatory financial intermediation will help in controlling leverage and the resulting excessive credit expansion. It will also, in turn, help bring about realistic pricing of assets and liabilities. Islamic contracts are generally asset based and activities transacted must comply with Islamic law.

The G20 reform agenda for international financial architecture proposes a host of regulations and assessments for the ‘too big to fail’ global financial institutions. Yet regulation of such financial institutions alone cannot counterbalance the incentives for socialisation of losses and privatisation of gains. Simply put, the ever-leveraged model of financial intermediation in a globalised world has proved disastrous.

The crumbling of ethics in the financial sector, explosion of little understood and risky debt instruments, and excessive leverage and speculation that have so unsettled financial markets, all need to be addressed. The Islamic tenet of risk sharing combined with the adherence to universal ethical values, restrictions on the sale of debt and its further securitisation can enhance the soundness and stability of institutions as well as the market, and thereby reduce the emergence of asset bubbles. A model of balanced financial and economic growth, which is at the heart of Islamic economics and finance, is necessary for achieving sustainable growth with financial stability.

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