Institute of Islamic Banking and Insurance“Resilience and Stability of the Islamic Financial System – An Overview” by Noureddine Kirchene and Abbas Mirakhor presented at the seminar held on 3. January 2. 00. 9 on . Representing the collapse of trillions of fictitious credit derivatives and the meltdown of uncontrolled credit growth, the scope of the crisis and its intensity only kept worsening and could reach unmanageable size . Most of the derivatives are over the counter (OTC). Contrary, to exchange transactions (futures contracts, options, stocks), there is no centralized clearing institutions for credit derivatives. Reform efforts will seek to establish clearing facility for credit derivatives in order to be able to quantify them.
The philosophical foundation of an Islamic financial system goes beyond the interaction of factors of production and economic behavior. The Islamic financial.
It has crippled the financial system of many advanced countries, and has claimed long established banking institutions that were deemed too big too fail. Large bailouts by governments and massive liquidities injections by central banks have only fanned more the flames. Capital markets have frozen, leading in turn to unexpected crash in stock markets, wiping out trillions of dollars in share values and in retirement investment accounts. Economic uncertainty has never been as high.
Has the crisis been correctly tackled or has it only been made worse? In view of incredibly high liquidity injection by major central banks, has money supply become out of control? How long the crisis will last? How many sectors and countries will it affect? What will be its impact on growth and employment?
What will be its fiscal and inflationary cost? Will inflation finally run out of control? Company Of Heroes Game Of The Year Edition Cracker more. While precise answers are not possible, the present crisis has already slowed down economic growth in many industrial countries, triggered food riots and energy protests in many vulnerable countries, increased unemployment, and imposed extraordinary fiscal costs.
Notwithstanding its far reaching and devastating consequences, the crisis has made the quest for financial stability a pressing and fundamental issue in economics and finance. Financial instability has been a recurrent phenomena in contemporary economic history, affecting countries with varying intensity. The most enduring crisis was the Great Depression 1. Eminent economists who lived through the Great Depression fought very hard to establish a banking system, based on some pillars of Islamic finance, capable of preserving long- term financial stability. Their proposals became known as the Chicago Reform Plan, as they were elaborated by economic professors at the University of Chicago . Professor Irving Fisher from Yale University was a strong supporter of the Plan.
His book, 1. 00% Money, was an attempt to win support among academics and policy makers for the Plan. The Chicago Plan basically divides the banking system into two components: a warehousing component with 1.
What transpired from the Chicago Plan and subsequent literature was that only a financial system along Islamic principles is immune to financial instability. Financial stability is a basic concept in finance. It applies to a household, firm, bank, government, or a country. It is an accounting concept conveying notions of solvency, or equilibrium. For a given entity, financial stability can be defined as regularly liquid treasury position, whereby the sources of funds exceed uses of funds. The sources of funds are diverse and include income streams (salaries, transfers, taxes, interest income, dividends, profits, etc.), borrowing or loan recovery, and sales of real and financial assets.
The uses of funds include current expenditures (including interest payments), capital expenditures, purchase of assets, lending or debt amortization. Accounts are separated into income or current accounts, and balance sheet or capital accounts. Financial stability means that the consolidated account tends to be regularly in surplus . Each account is composed of two components: a current account component and a capital account component. The overall balance of the consolidated account should be sustainable for financial stability to be maintained over time. It can be associated with notions of default, arrears, or insolvency.
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It manifests itself through a regularly deficient treasury position, whereby the sources of funds fall short of uses of funds or payments obligations. When financial instability persists, access to borrowing becomes unavailable. The entity facing financial instability may have to recapitalize, liquidate assets, restructure liabilities, seek a bailout, or may be subject to merger or liquidation. In banking, stability means that assets and liabilities maturities are matched, assets preserve their values and do not depreciate, and the amount of IOUs is fully backed by gold or warehouse deposits that served for issuing these IOUs. Over issues of gold or warehouse certificates, bank notes, or scriptural money may cause instability in case of a run from domestic or international depositors . Similarly, the US suspended gold standard in August 1. The amount of claims may exceed largely the stock of gold or merchandise; in these conditions, conversion may be suspended, bankruptcies may happen, or IOUs may be devalued.
Under a fiat money system, the central bank may act as the last resort lender to preserve stability by printing new money which may lead to currency depreciation. The paper reviews in Section II some examples of financial instability, both in distant and recent past and the ordeal that followed this instability. The general pattern was that each episode was preceded by a speculative boom and excessive price volatility in one or many types of assets, which could be common stocks, gold, commodities, land, housing, foreign currencies, or any other asset.
The bursting of the boom caused in turn asset price deflation and banking failure. Each major financial crisis has wiped out real income gains setting real GDP and real per capita income at levels much lower than pre- crisis levels . In Japan, financial instability, caused by the collapse of stock and real estate prices following an asset boom during 1. Credit expansion and abundant liquidity, supported by cheap money policy and low interest rates, lead to speculative booms and asset price bubbles. Financial innovations, Ponzi finance, swindles, and fraud develop during a speculative boom.
During a bubble, many illiquid credit instruments become monetized, for instance through securitization, and fuel further liquidity. Over indebtedness erodes creditworthiness and causes defaults. Sharp credit contraction, deflation of asset prices, and bankruptcies that follow thereafter explain economic recession or depression.
The paper discusses Minsky's hypothesis that in a conventional system stability is unstable and that instability is endogenous to such a financial system which is apparently destined to experience periods of financial instability. However, Minsky's endogeneity analysis, while integrating Keynes' views regarding instability of expectations and Schumpeter's view on creative destruction adapted to financial innovations, is not fully supported by facts. Subsequently, Section IV establishes that, in many episodes of financial instability, monetary policy contributed directly to speculative booms and to their severe deflationary or inflationary consequences. Contrary to Minsky's endogeneity hypothesis, financial instability could have been easily avoided had the central bank acted to pre- empt a speculative boom by precluding risky lending, or had it kept tight control on liquidity creation and credit expansion. By being entrusted with achieving full employment, central banks have relied on interest rate setting for achieving this objective to the neglect of close monitoring of monetary aggregates.
Such mandate of the central bank, besides undermining long- term economic growth, has created an uncertain money framework and has become a source of serious financial instability . The same views were held by Allais (1. Section VI analyzes the mechanics of the credit multiplier. It shows that banks do create money substitutes through issuing liabilities.
Under securitization, the credit multiplier becomes theoretically infinite. If not controlled by the monetary authority, bank money creation can lead to excessive credit and money growth in the economy and become a source of instability. Section VII discusses the main theme of the paper: the stability of the Islamic financial system . Deviations from basic Islamic banking precepts could expose Islamic financial institutions to the same instability as conventional banking.
In many instances, troubled Islamic banks were found to apply the same principles as conventional banking. An Islamic financial system avoids interest and interest- based assets . For instance, if a stock market crash happens and shares drop by 2. Similarly, if the stock price index increases by 5. In the same vein, the construction cost of a house may decrease, due to productivity gains; however, because of speculation, its market price may increase two, three, or fourfold. Mirakhor (1. 98. 8) showed that an Islamic financial system can be modeled as non- speculative equity ownership model that is intimately linked to the real sector and where demand for new shares is determined by real savings in the economy.
All causes of financial instability analyzed in previous sections, namely money creation out of thin air, speculation, and interest- based financial assets are absent in Islamic finance. Banks own directly real assets and operate like an equity holding system.
Savings is redeployed into productive investment with no ex- nihilo money creation. Mirakhor (1. 98. 8) showed that the rate of return on equities is determined in a growth model by the marginal efficiency of capital and time preference and is significantly positive in a growing economy, implying that an Islamic banking is always profitable provided that real economic growth is positive.