HLS Paper: The Relevance of Islamic Finance Principles to the Global Financial Crisis

Earlier this month, I spoke at two events – one at the Harvard Law School (HLS) and the other at the Harvard Business School (HBS) – regarding the relevance of Islamic finance principles to the global financial crisis. The topic has been raised by observers in the Muslim world and beyond – including regulators in a number of G20 countries and even commentators at the Vatican.

At the Law School event, organized by Harvard’s Islamic Finance Program, I presented a discussion paper on the theme, followed by comments from three discussants: Prof. Samuel Hayes (Jacob Schiff Professor Emeritus of Investment Banking at HBS), Prof. Roger Owen (A.J. Meyer Professor of Middle Eastern History at Harvard University), and Prof. Baber Johansen (Director of the Islamic Legal Studies Program at HLS).

The paper noted that there are a number of ethical maxims from Islamic finance which address key causes of the crisis. In theory, Islam’s focus on asset-based financing puts natural limits on the level of debt, preventing excessive leverage. The prohibition of the sale of debt (per the majority of Islamic scholars) fosters a more conservative approach to lending in which the party that originates a debt also takes the credit risk therein. Rules requiring financial transparency and disclosure act to prevent opaque securities like the mis-rated “toxic paper” that exacerbated the crisis. Further, Islamic finance offers practical models of ethical supervisory boards with real authority – a potential model for “corporate social responsibility with teeth.”

At the same time, Islamic finance as currently practiced does not offer a fully-developed alternative model to the conventional system. Further – due largely to competitive pressures, regulatory constraints, and customer expectations – Islamic financial practices today often seek to replicate conventional ones as closely as possible. In doing so, they lose several of the benefits and strengths which would come from following the spirit of Shariah maxims more closely. The crisis should, therefore, encourage the Islamic finance industry to re-commit to the spirit of the ethics it was created to serve.

The event was enriched by a lively, interdisciplinary discussion touching on a wide range of topics including ethics vs. regulation, the role of debt in Islam, the standardization of Shariah guidelines, and more.

An excerpt from the discussion paper (which we are currently finalizing to incorporate feedback from the event) is below. A final version should be available on the website of the Islamic Finance Program later this year. If you would like a copy of the final paper when ready, please email islamicfinance@rehmaninstitute.com

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(Excerpt from the discussion paper:

The current global financial crisis is causing a fundamental rethinking of the global financial system. Basic assumptions regarding the role of banks, the responsibilities of regulators, the treatment of customers, and the rules of financial innovation are being examined and revisited. Commentators are deeming the U.S. subprime mortgage crisis as a catalyst for exposing frailties in the current financial system that presented bundles of bad credit as creditworthy investments. Observers expect a “new financial order” to emerge from the crisis, redesigned based on the lessons now being learned.

The Islamic finance sector – itself a new global player – has not been immune from the current crisis. While several aspects of the Islamic banking model inherently provide insulation from the crisis, the financial markets and real economies of the Muslim world are clearly impacted by the global recession. At the same time, many, including the Vatican, see the crisis as reinforcing the relevance and merits of Islamic financial principles – principles worthy of examination by both the global financial community and Islamic bankers themselves. To quote an official Vatican publication, the “ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.”

The pace of global economic decline is the greatest in decades, and will lead to a fundamentally different economic landscape. Governments are actively engaging in interventionist policies in an effort to stimulate aggregate demand. Emerging and newly industrialized economies with fiscal surplus and cash reserves will increasingly be partaking in international collaboration efforts and steering groups. The crisis has the potential to stimulate what many see as a much-needed shift from the Bretton-Woods era of international policy setting, to a forum reflective of the rise of the emerging markets.

Endeavoring to outline key themes on the interplay between the current crisis and Islamic finance principles, this paper is organized in four main sections:

I. Ethical perspectives on the current crisis;

II. Shariah maxims and the causes of the crisis;

III. Practices of Islamic financial institutions in light of Shariah maxims; and

IV. Practices from the Islamic finance sector relevant to addressing the crisis.

The paper seeks to provide a framework for – and help generate – robust discussion among seminar participants. It identifies themes for exploration, each of which can be explored more deeply in the ensuing discussion.

end of excerpt)

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