Financial Turmoil Challenges Islamic Financial System

FINANCIAL TURMOIL CHALLENGES ISLAMIC FINANCIAL SYSTEM <!--[if gte mso 10]> FINANCIAL TURMOIL CHALLENGES ISLAMIC FINANCIAL SYSTEM By M. Iqbal Patel, Chartered Accountant, Karachi The recent worst financial turmoil since Great Depression in the world's super power United States is preceded by rising housing prices and rapid expansion of credit. It has now set for a sharp economic downturn or recession. Similar banking crisis were cropped around the globe over past 30 years. The present financial turmoil has not shaken the economy of US only but it has shaken the economy of West and European countries too. It exacted a heavy economic toll as the investors wrestled a crisis of confidence and global credit is choked off. Failure of Capitalism.---The present US financial turmoil has provided the fiercest critics a golden opportunity to launch fresh attacks on its financial system. According to Venezuela's Hugo Chavez, it is the capitalist system that has caused the financial crisis in the US and the country should come up with a new constitution it was capitalism that caused the ruin in US. The British Prime Minister Gordon Brown called on world leaders to create a new financial architecture to reflect the global reach of economic and banking, in much the same way that the current international economic system was set up at a conference in 1944. French President Nicholas Sarkozy called the free enterprise system "crazy." The US presidential John McCain called it corrupt. The EVP of FDR said that US financial structure has been shown to have some major weaknesses and it is an incredible learning experience and will take years before there could be changes in our financial architecture and before we have a stronger and more resilient system. European leaders called on for a new world order to prevent future financial crises, as growing signs of global recession damped optimism over government efforts to bail out banks. Germany joined France calling for international summit this year to draw up a new world financial system. British Prime Minister and German Chancellor Angela Merkel backed a proposal by French President to hold a meeting to revamp financial structure set up at the Bretton Woods conference in 1944. Challenges to the Muslims.---Thus there is general consensus among US, Europe and other countries of the world that their financial system has failed to address their financial problems and suffering from the weaknesses. All of them are in search of a financial system which resolves their financial difficulties. French President speaking after a meeting of 27 EU leaders in Brussels said that we will be defending a common position, a vision, for restructuring our financial system. Although the European countries, US and other countries are talking for united action to restructure the world financial system but it is difficult that they achieve their objective in view of different ideologies and perceptions of each of them. For instance Brown has opposed the financial system set up at Breton Wood's Conference (BWC) in 1944. He has urged the adoption of his four-point agenda to strengthen global co-operation and build a new global financial architecture for the years ahead--a new Breton Woods, which recognizes the globalization of financial risk in the responsibilities of global institutions. Whereas the financial system emerged in BWC has complete support of US. Similarly France also favours revamping of financial system of the Bretton Wood. Thus these economic powers are divided on form of new financial system, has, therefore, provided the Muslim block with an opportunity to boost its influence on international stage and offer Islamic economic system to the world as the solution of their financial crisis. This challenge expects coordination and unity among the Muslim countries because a disorderly attitude will create obstructions to achieve this opportunity. Sheikh Yusuf al-Qaradwi, an influential Sunni, Qatar-based cleric, called on Muslims to take advantage of the turmoil to build an economic system compatible with Islamic principles. He said that the collapse of the capitalist system is because it based on usury, interest and paper which is not based on goods traded in the market. It shows that Islamic economic philosophy is holding up. A meeting may be called of the Heads of Muslim countries, on the line of the meeting held of G-20, and offer the Islamic financial system to the world as a solution of the present financial crisis facing the world-over. Islamic Financial System.---Islamic teaching is not confined to some moral teachings or some rituals or some modes of worship. The Quran and Sunnah are the primary sources of Islamic Sahria which .provides to the people world over basic guidelines, principles and commands of social disciplines, economic, parting ways with the integral linkage with other disciplines of the life. Islamic economics system is rooted in the values and principles with an approach to the fundamental economic problems of mankind. An approach of a Muslim is that Allah Almighty, the Creator of the universe, has provided guidance to the mankind through His revelations sent down by His prophets who shall be followed in letter and spirit. The Islamic economic system addresses basic economic problems of mankind from moral and socially responsible perspective, and reintegrates economics with ethics so that efficiency and equity become elements of a composite reality. The end product of all economic activity in the Islamic State is the betterment and well-being of the people. The politico legal framework and the socio-economic policies must ensure that the system of production of national wealth and its distribution is geared towards the maximum happiness of the maximum numbers of the country. Concentration of wealth within fewer hands, monopolies and cartels in the industrial and commercial enterprises are repugnant to the Islamic spirit of equality and universal well-being. Islamic financial system abolishes interest.---The Islamic financing may have prevented a majority of the mess created by the conventional banking and financial institutions. The Islamic finance prevents the kind of disaster that is currently gripping world markets. The root cause of the present crisis is the element of interest which has basis in western economy. Islamic law prohibits the payment and collection of interest, which is seen as a form of gambling so highly complex instruments such as derivatives and other creative accounting practices are banned. The Islamic financial system requires the transaction must be backed by real asset and not shady repackaged sub prime mortgage and because risk is shared between the bank and the depositor thereby there is an incentive for the, both the banks and financial institutions and the depositors/borrowers to ensure that the deal is sound. The abolition of interest is one of the pillars of the Islamic economic system. The Quran through its numerous injunctions has condemned all riba-based dealings and the transactions compared with other economic systems of the world. It absolute emphasizes on the removal of all riba-related modes and practices such as corruption, exploitation, usury and unequal exchanges. By eliminating riba in all dealings in business, governance, trade and industry, Islam presents a viable, equitable and just economic system as a vehicle for growth of economy for entire humanity to enjoy common well-being. On the contrary the western financial system is entirely based on interest. That is why almost all the countries of the world used the interest as lever and have reduced the rate of interest to attract the customers and try to keep a credit crisis from tipping the economy into deep recession. Moreover, present financial crisis cropped up due to increase in rate of interest on housing loans which resultantly hardened the repayment term and consequently it caused default in repayment of housing loans which spread financial crisis world over. This scenario confirms the Islamic philosophy true that the economic peace in the world depends on the elimination of interest. It offers resolution of the present financial crisis. Interest is the root cause of the economic maladies of the world. The concept of interest is disputed by some segment of the society on the ground that profit earned from exchange of money for money is just as profit derived from buying and selling of goods or services so when profit from trade is halal, the interest should be halal too. According to them that since both activities aimed at earning profit, their governing injunction should also be one and the same. Their argument is baseless. In fact Allah Almighty's injunction about prohibition of interest is in the interest of the people and society as a whole. It would be appropriate to discuss the some of the reasons for abolition of interest from Islamic financial system. Firstly the wealth collected through earning of interest may in beginning increase faster and higher but generally in long run it does not survive as it is observed that millionaires and capitalists have become insolvents and paupers sooner or later. Moreover, increase in wealth through earning of interest, deprives the interest-earners from comfort, honour, real peace and happiness he always remains in distress condition. Further the interest results in the gain of some individuals at the cost of the whole community in a way that the people deposit their money into the banks who in return pay them interest at very low rate compared to rate of interest charged by them on the loans given to the borrowers. Further generally it has been the practice of the banks to pay loans to the big businessmen or group of companies who has resources to offer securities for mortgage etc. Thus money of small deposit holders is transferred to the persons who are already millionaire. Thereby business gets monopolized by some big capitalists. Thereby great injustice is inflicted on the poor/medium class of the community who are reduced to economic slavery of big capitalists. Moreover, through the help of the banks, more and more businesses are established by the capitalists, who capture the markets and the goods produced by them is sold at high prices, they hoard the goods in order to create shortage of the goods in the market with a view to enhance the prices, making thereby the business profit fairly widespread which badly affect the whole country. Whereas in case of loss sustained by them, they failed to repay loan amount to the bank, the bank writes of their debt at the cost of the depositor's money and the whole community is to suffer. Whereas in case of profit in the business, the bank earns interest at a fixed rate on the amount borrowed from it; but the community is not benefited from their huge profit earned by them out of investment of money of the depositors. Thus the conventional banking encourages concentration of wealth in the hands of few capitalists through unjust profiteering from investment of national wealth in their business which is highly injurious to the economic health of the country. The Islamic economic system aims at to eliminate the concentration of wealth in few hands through abolishing interest from the banking business on one hand and conduct business on the basis of joint partnership, just sharing of profit or loss of the business. In Islamic financial system the bank will advance or give loan to the borrower at a stipulated proportion of profit actually earned by the borrower, and must share loss also in the same proportion in case he sustained the loss in the business. Thus loss is restricted to an individual only. The Islamic financial system excludes interest from financial activities and substitutes it with the concept of profit and loss sharing. The Islamic finance principle provides that the financier should share profit actually earned as well as loss actually incurred by the debtor. In case of greater profit earned by debtor, the bank will share greater profit from it who will give handsome return to the depositors. Thereby the businessmen would not secure greater profit exclusively for themselves but the common depositor will be benefited. Similarly in case of loss, the bank and the depositors will share it. Thereby the banks will no need bail out package from the government in case of they have to bear a greater loss. Thereby the community is not affected and is saved from the crisis. The Islamic banking system has been tested throughout world. It has largely been escaped the fallout from the global financial crisis, because the Islamic finance rules forbid the sort of risky business. Thus outlook for Islamic-financing is bright and will likely take the lead in terms of providing funding for the major projects. The Morgan Stanley reported that Pakistani full-fledged Islamic banks have dominated the Islamic financial markets. He estimated that the Islamic financial assets are to cross $ trillion by 2010. He reported that in comparison with conventional banks, Islamic banks have superior asset quality, sustained over an extended period. Islamic instruments of financing.---Islamic commercial law has designed commercial financing system based of the concept of profit and loss sharing. These systems are Musharikah and Mudarabah. In the sectors where these financing systems are not workable or feasible, the other financing systems in Islamic financial framework are Murabahah, Ijarah, Salam or Istisna. Rescue Plans.---The banking credit crises thus emerged, resulted in collapse of many banks which have shattered confidence in the banks across the Unites States and Europe, needing support from governments or outside investors. The US Congress approved financial bailout package of $700 bin. for US banks as efforts to head off a spreading global financial crisis hung in the balance despite great concern expressed by almost over 200 US's leading economists who believed that the bailout plan is a subsidy to the investors at the taxpayers expense and desperately is short-sighted. Further it pledged to pump $250 bln into its banks to buy preferred shares in qualifying financial institutions, though government's this plan of owning a stake in any private US company is objectionable to most Americans, yet the alternative of leaving businesses and consumers without access to financing was an unacceptable. France used two entities to help banks with one offering 320 bln euros to guarantee bank landing the other 40 bln euros fund to take stakes in companies. British Prime Minister, Gordon Brown announced that the Bank of England to increase short term liquidity loans from 100 bln pounds to at least 200 bin pounds under the special liquidity scheme; he offered support the banks in raising additional capital by investing directly through preference shares or ordinary shares and to provide guarantee at least 250 pounds to allow banks to raise their own money in the market and to resume normal lending. Interest cut.---The credit crisis, which began with failing US mortgages, mushroomed into a worldwide rout as the depositors and the investors lost confidence in the financial system of the West. Since the Western financial system based on interest, the countries in Europe and Asia used interest as a lever to save the banks from collapse. South Korea cut interest rates. The Bank of Japan cut interest rates for the first time in seven years in a move that followed a rate cut in US by FDR. Similar reduction in interest rates followed by almost by every country. Collective Actions.---There are a number of lessons to be learnt from the episode for developing countries such as Pakistan in general and Muslims in particular. Firstly the US, European countries and all developed countries were united. The French Prime Minister, Francois Fillon said only collective action could solve the financial crisis. He said the world is on the edge of the abyss because of an irresponsible system. British Prime Minister, Gordon Brown said only by global action can we fully restore the confidence that is needed and build the international financial order. Chinese Premier Wen Jiabao said overcoming the crisis requires global action and a joint response Contrary to this if we look at the issues confronting to Pakistan in particular and Muslim ummah as whole, the Muslims have not taken united stand to fight against the injustices and discrimination meted out the Muslims, especially since the cataclysm of 9/11, has and discrimination meted out the Muslims, especially since the cataclysm of 9/11, has radicalized the western perception of Islam and the Muslims. A religion of peace and tranquillity that Islam inherently is in its pristine sense is, regrettably, associated with violence, bloodletting and terrorism, Islam, today, is stuck in the western mind as religion which has a zero tolerance for other religions and their followers. It is the high time that we all Muslims collectively categorically make clear to the world that the western perception of Islam and Muslim is not correct. We have to establish our values transparently and remove confusion about them. Credit agencies.---Today the financial system and economy has greater reliance on the credit rating granted by the world known credit agencies. The role of these credit agencies exposed as despite their rating to the borrowers, they proved defaulters. Commenting on the issue, William Rutledge, the Executive, Vice-President of the Federal Reserve Bank, criticized ratings agencies for failing to adequately identify risks in sub-prime mortgages. He said that the US financial regulatory structure has been shown to have some major weaknesses. Many mortgage-backed securities that had been given triple-A credit ratings took losses. He further advised that the investors should move away from relying on ratings agencies. He emphasized that these credit agencies also come under more scrutiny by US regulators after they underestimated the risk of failing sub-prime mortgage loans The European Commission, has also called for clampdown on credit rating agencies. Leading rating agencies Moody's standard and Poor's and Fitch have come under fire for being too slow to alert investors to the dangers. The regulators in Pakistan, the banks give considerable weight to the rating granted by the credit agencies, all of them have food of thought on the role of these credit agencies. Bank's financing policies.---The banks have started to issue credit cards, auto financing and consumer financing on simple documentation are all without scrutinizing credit worthiness of the borrowers. Further intense competition among the bankers has deteriorated their scrutiny standards. The banks should learn lesson from the credit crisis of US and review their credit policy accordingly. The State Bank of Pakistan has recognized that rapid credit growth in recent year has resulted in high credit risk. The data released by SBP showed that during March, 08, quarter non-performing loans (NPL) bin increased from Rs.214 bin to Rs.232 bin. NPL of consumer sector increased from 3.2% to 4.6% at the end March, 08 than in March, 07. Trying to avoid a repeat of prime crisis, the US banks have been tightening credit card lending standards especially in state such as California and Florida that were hardest hit by the housing downturn. The bank was doing its best to modify the terms of credit card agreements where it sees danger. In addition, the number of credit card offers sent by mail has declined to its lowest point in over three years.