The Global Financial Crisis: Can Islamic Finance Help Minimize the Severity and Frequency of Such a Crisis in the Future?

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October 21, 2008

THE GLOBAL FINANCIAL CRISIS: CAN ISLAMIC FINANCE HELP MINIMIZE THE SEVERITY AND FREQUENCY OF SUCH A CRISIS IN THE FUTURE? by M. Umer Chapra*

(A paper prepared for presentation at the Forum on the Global Financial Crisis to be held at the Islamic Development Bank on 25 October 2008)

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* The author is Research Adviser at the Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB). This paper is a revised and updated version of the keynote Forum lecture delivered by him at the inaugural session of the Eighth Harvard University Forum on Islamic Finance held on 19-20 April 2008 in the Harvard Law School. The views expressed in this paper are his own and do not
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The generally recognized most important cause is, however, excessive and imprudent lending by banks.1 One cannot blame banks for this because, like everyone else, they also wish to maximize their profits in a materialist cultural environment where maximization of income and wealth is the highest measure of human achievement. The more credit they extend, the higher will be their profit. It is high leverage which enables excessive lending. Excessive lending, however, leads to an unsustainable boom in asset prices followed by an artificial rise in consumption and speculative investment. The higher the leverage the more difficult it is to unwind it in a downturn. Unwinding gives rise to a vicious cycle of selling that feeds on itself and leads to a steep decline in asset prices followed by a serious financial crisis, particularly if it is also accompanied by overindulgence in short sales. It is the combined influence of three forces which can help prevent the recurrence of crises. One of these is moral constraints on the greed to maximize profit, wealth and consumption by any means in keeping with the mores of the prevailing secular and materialist culture. The second is market discipline which is expected to exercise a restraint on leverage, excessive lending and derivatives. The third is reform of the system’s structure along with prudential regulation and supervision appropriately designed to prevent crises, achieve

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