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Islamic Finance as a Solution for Systematic Failures of Current Economic System

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  • Are the financial crises unforeseen events or inevitable results of mainstream economic policy?
  • Are they “Black Swan” or white swan?
  • The subprime crisis is the last in a long line of financial crises and bubbles.

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Are Financial Crises Exogenous or Endogenous in the Current Economic System?

January 25, 2024

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Black or White?

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  • The former CEO of Citigroup (at the time the biggest bank in the world), Charles Owen, said before the crisis:
    • “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
  • “He kept on dancing until the music did eventually stop in November 2007, and at that point he lost his job. Had he stopped dancing to the music of risk four years earlier, when he became CEO, I doubt that he would have survived that long.”

Mervyn King, The End of the Alchemy

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Are the Financial Crises Unexpected ?

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  • There is a consensus about the main reason for the global financial crisis Excessive Borrowing which can stem from:
    • extraordinarily high liquidity,
    • reckless lending practices, and
    • the rapid pace of financial engineering, which created complex and opaque financial instruments used for risk transfer
  • The question is whether these factors ultimately cause financial crisis are endogenous to mainstream economic policy implementation.

January 25, 2024

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The Main Assumption: The Excessive Borrowing is the Primary Reason of Global Financial Crisis

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High Liquidity

Financial Instruments used for Risk Transfer

Excessive Borrowing

Global Financial Crisis

January 25, 2024

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The Way to the Global Financial Crisis

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Excessive Borrowing

Demand Factors

Hedge-Speculative-Ponzi Financing

“Expenditure Cascade” Inequality

Shareholder Capitalism

A rising tide lifts all boats

Piketty

r>g

Supply Factors

Highly Profitable

Low Cost of Fund

Fractional Reserve Banking

Fiat Money and QE Policies

Saving Glut

Deregulation

Low Risk

Risk Transfer Through Financial Engineering

Too Big To Fail

FDIC

January 25, 2024

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Supply and Demand Factors

Making Excessive Borrowing Endogenous to the Current Economic System

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25 January 2024

Increasing Inequality

The Demand Factors for Excessive Borrowing

Inequality

Mainstream Thought about Inequality

(Rising Tide Lifts all Boats)

Piketty’s r>g

Demand for Debt

Shareholder Capitalism

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25 January 2024

  • Bankers, Minsky (1992) warned about the threat of financial innovations.
  • Financial institutions, and financial agents are all characterized by Minsky (1992) as debt merchants.
  • Appropriate financial instruments (f.e trunches of MBS) accompanied with deregulation policies, it become possible to transfer the risk of high level of debt.

Hedge-Speculative and Ponzi Financing

  • With the optimistic expectations supported by the Great moderation period, the demand for the hedge financing easily transformed to speculative and finally ponzi financing as claimed by Minksy’s Financial Instability Theory

The Demand Factors for Excessive Borrowing

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Money Supply Determined by the Profit Motive of Banks

The Supply Factors for Excessive Borrowing

  • Fractional reserve system gives banks a magic like power to create credit-based money which is PRACTICALLY constrained ONLY by the bank’s risk and return tradeoff.
  • Risk part of the money generating transactions can be hedged or transferred with financial instruments in the era of deregulation. (CDOs, MBS, insured by AIG in case of default, worst case scenario TBTF)
  • The money generating power of banks are PRACTICALLY only determined by their profit motive.
  • Long story short : The system gives banks a great opportunity to

“Socializing the risk of credit supply while privatize the profit of credit supply”

If this is MAGIC.

How about this?

Monetary Base Money (M0) vs Credit Base Money (M2)

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Islamic Finance, in Theory

Islamic Finance, in Practice

Conventional Banking

January 25, 2024

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Which Islamic Finance? In Theory or in Practice?

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Islamic Finance

In Practice

No Conceptual Difference from traditional finance

Driven by the ambition of businessmen to get the same financial services as from conventional banks, but in a shari‘a-compliant form

The adaptation and application of traditional banking instruments to sharia rules

In Theory

Wealth Distribution

Risk Sharing

January 25, 2024

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Which Islamic Finance? Theorical or Practical?

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January 25, 2024

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Islamic Finance Before and After 2008 Financial Crisis

Before 2008 Financial Crisis

Complement of Conventional Banking System

ISLAMIC FINANCE in PRACTICE

Giving the same services of conventional banks but in a sharia-compatible way.

After 2008 Financial Crisis

Substitute of Conventional Banking System

ISLAMIC FINANCE in THEORY

Does Islamic Finance have the same structural problems ending with repeated financial crises?

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Islamic Economy as a Solution For Systematic Failures

The Magic of Islamic Finance:

Profit and Loss Sharing

Equity-Based vs Debt Based Money Supply

Money supply will not be as high as in conventional banking system, if debt-based money replaced by equity-based money in which risk cannot be transferred and loss is shared.

Collateral and Derivatives vs. Quality and Performance of Projects

The link between real economy and finance will be reestablished in the Islamic Finance. In the PL world, the lender will be much more careful to finance the project, because it will not be the collateral or derivative instruments which prevents lender to lose but the quality and performance of the financed project. Profit and Loss

Inequality vs Fair Distribution

The concepts like “Finance for Finance”, “Too Much Finance” will be less likely to occur, therefore, the real sector will receive a higher share of total income generated.

PL Sharing reduces speculative demand for money thereby the speculative demand for assets which is on of the main factors of wealth inequality

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Excessive Borrowing

Demand Factors

Hedge-Speculative-Ponzi Financing

Equity Financing

Inequality

Stakeholder Capitalism

Zakat, Zuckman, Saez and Piketty

r>g is not possible

Against Concentration Wealth

Supply Factors

Highly Profitable

Low Cost of Fund

100 % Reserve Banking

Saving Glut is a response for speculative attacks

Active Role in Market Failures

Low Risk

Prohibition of Debt Transfer

Risk Sharing-Equity financing

January 25, 2024

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Islamic Finance as a solution for Systematic Failure

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  • As explained by Molyneux (2016), the idea of elimination of a fractional reserve banking system is based on the view that financial crises are directly caused by banks' ability to create credit well beyond the direct control of the central bank and the protection afforded by the lender-of-last resort facility.
  • The economic experience of the last 40 years shows that excessive borrowing is the common characteristics of the mainstream economic system.
  • Excessive borrowing is a result of supply and demand factors:
    • while supply factors are driven by fractional reserve banking and risk transfer, the demand factors are driven by inequality and stagnant income level.
  • In Islamic finance where Profit and Loss Sharing is the main actor non of the demand factors could become as threatening level as it is in conventional banking system.

January 25, 2024

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Conclusion