The Islamic finance system, which introduces greater discipline into the economy and links credit expansion to the growth of the real economy, is capable of minimizing the severity and frequency of financial crises, says Umer Chapra, a well-known Saudi economist and winner of the King Faisal International Prize for Islamic Studies. "Islamic finance can also reduce the problem of sub-prime borrowers by providing them loans at affordable terms. This will save billions of dollars that are spent to bail out the rich bankers," said Chapra, who at present works as adviser at the Islamic Research and Training Institute of the Islamic Development Bank. Chapra estimated the derivatives market at $600 trillion, more than 10 times the size of the world economy.
"No wonder George Soros described derivatives as hydrogen bombs while Warren Buffett called them financial weapons of mass destruction," he pointed out. The derivatives include credit default swaps (CDS) worth $54.6 trillion. The Islamic economist described the present global financial crisis as the worst in four decades. "There is a lurking fear that this might be only the tip of the iceberg. A lot more may come if the crisis spreads further and leads to a failure of credit card institutions, corporations, and derivatives dealers," he warned.
Chapra urged Muslims to establish a genuine Islamic finance system with proper checks and controls, adding that such a move would encourage others to embrace it. The Islamic system does not allow the creation of debt through direct lending and borrowing. It rather requires the creation of debt through the sale or lease of real assets by means of its sales- and lease-based modes of financing such as murabaha, ijara, salam, istisna and sukuk. He said the conditions set by the Islamic system would help eliminate most of speculative transactions. "Financing extended through the Islamic products can expand only in step with the rise of the real economy and thereby help curb excessive credit expansion," he said.
Chapra emphasized the significance of the condition that prevents a creditor from transferring the risk to someone else by selling the debt. "This will help eliminate a great deal of speculative and derivative transactions where there is no intention of giving or taking delivery.
"In the Islamic system, credit is primarily for the purchase of real goods and services which the seller owns and possesses and the buyer wishes to take delivery. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully," he explained. He said excessive and imprudent lending by banks was the main cause of the current global crisis. Chapra said the subprime mortgage crisis in the US was also the result of excessive and imprudent lending. "Securitization or the originate-to-distribute model of financing has played a crucial role in this. Mortgage originators collateralized the debt by mixing prime and subprime debt. By selling the collateralized debt obligations (CDOs), they passed the entire risk of default to the ultimate purchaser. They had, therefore, less incentive to undertake careful underwriting."Consequently a number of banks have either failed or have had to be bailed out or nationalized by governments in the US, the UK, Europe and a number of other countries.