Economic Crisis: How can Islamic Finance Help?
The Global Financial Crisis has triggered an unprecedented wave of action calls from various financial institutions, reserve banks, economists and bankers across the World. The European Sovereign Debt Crisis has increased the urgency of this call of action. How do we prevent such an event occurring in the future?
It is critical and fundamentally important that we determine the primary causes of the crisis. It is an undeniable fact that the fundamental cause of the crisis was excessive and imprudent lending by the banks and financial institutions. Over leveraging, deceptive brokerage, derivatives, mezzanine financing and deregulation all played a role in the crisis.
The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "The crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels."1
While economists are struggling with solutions and mechanisms to avert the possibility of a future meltdown, they have failed to realize that the inherent structure and system of the conventional economic system is flawed.
Islam provides the solution in establishing a just and equitable economic system. Classical Shariah Law has addressed the concepts of financial schemes, equity funds, cession, surety, collateral, debentures, future sales, etc.
The Shariah provides various solutions to contemporary and modern day economics. One of the key elements of an Islamic Economy is that of asset financing. Islamic Finance is backed by physical goods and services while conventional institutions merely deal in financial papers and debt financing. Islam does not consider money as an object of trade. Money is merely a medium of exchange having no intrinsic utility. Much of the global crisis was caused through the sale of debt in the form of derivatives, CDO’s, CDS’s, etc. This would have never happened in an ideal Islamic Economy.
The most ideal forms of Islamic Financing are the profit and loss sharing modes of Mudaraba (Commenda) and Musharaka (Equity Partnership). In both cases, both the transacting parties share in the profits according to any mutually agreed upon ratio. In the case of Mudaraba, the financier bears the loss while both the parties share the loss according to total the amount of financing in the case of Musharaka.
We must continue searching for the solutions and answers through Shariah in realizing a just and equitable economic system.