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     May 1, 2010
Islamic finance - steady amid chaos

Reviewed by Robert E Looney

In 1936 in the depths of a world-wide economic depression, John Maynard Keynes described the decline of the world's financial markets as a result of playing at a casino: "Short-term speculation with little regard to fundamentals." A cursory examination of the current global financial crisis suggests little has changed since Keynes' day - the conventional financial system, despite various patches and fixes over the years, is still prone to periods of extreme instability and abuse.

Unfortunately, the economics profession has provided little in the way of constructive input in re-designing a more stable financial architecture. Mainstream neo-classical equilibrium economic


analysis has not systematically incorporated elements that would account for the conventional system's instability, let alone provide a framework for predicting the occasional bouts of extreme instability.

Liberal-minded neo-Keynesians have done a bit better in identifying some important precursors of the crisis, in particular, the destabilizing role of huge private sector financial deficits in countries with large external deficits, such as the US. The Keynesian view certainly played a big part in the post-crisis response (fiscal stimulus) of many developed and emerging countries.

On the conservative side, monetarists certainly raised doubts about the Federal Reserve's abnormally low interest rates and expansive monetary creation in the years preceding the crisis. Yet, at best, this line of analysis does not go very far beyond the warning of an impending bubble and likely bout of inflationary pressures.

No doubt a leading monetarist, Milton Friedman, if alive today, would reaffirm a firm belief in Say's Law of the smooth functioning of unimpeded (free) markets. Those going down this road contend the current financial instability is wholly the fault of too much government. As Friedman often observed, "The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy". Lax money and credit policy of US Federal Reserve under Alan Greenspan would be the focus of his ire today.

Monetarist offshoots such as the Rational Expectations School, while producing good explanations of the stagflation experience of the 1970s, have not been able to systematically incorporate irrational behavior into their models. The lemming or investor-herd mentalities observed in recent years remain well beyond their comprehension.

As Martin Wolf of the Financial Times has noted, of the Western interpretations of the global financial crisis, it appears those economists working in the Austrian tradition were more nearly right than anybody else. In particular, they have argued that: central bank inflation-targeting is inherently destabilizing; that fractional reserve banking creates unmanageable credit booms; and that the resulting pattern of investment, linked not to the marginal efficiency of capital but rather to financial returns, explains the subsequent financial crash.

The best non-Western explanation of the global financial crisis is presented in the book under review, The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future by Hossein Askari, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor. However, this book is much more than just an alternative explanation of the current depressed state of the world economy - it is an elegant, sophisticated assessment of Islamic finance as a viable, realistic alternative to the current conventional system. Perhaps to the surprise of many, the author's assessment finds a number of similarities between the core elements of Islamic finance and that of the Austrian School.

Certainly Islamic finance and banking institutions are thriving relative to conventional finance. The Banker's 2009 survey of Islamic finance found the volume of sharia-compliant assets of the Top 500 grew by an extremely healthy 28.6%, rising to US$822 billion from $639 billion, in 2008 (forecasts are that this figure will top $1 trillion in 2010). At a time when asset growth in the Top 1,000 world banks slumped to 6.8% from 21.6% the previous year, Islamic institutions were able to maintain the 28% annual compound growth achieved in the past three years.

The industry also continued to expand, with 20 new entrants bringing the number of sharia-compliant institutions to 435, with a further 191 conventional banks having sharia windows. The Islamic banking geographies are stretching beyond the existing strongholds of Iran, Saudi Arabia, Bahrain, Malaysia and the UAE to Europe, South Africa, Kenya and Indonesia.

Advocates claim Islamic finance has been immune because sharia-compliant institutions are focused on the fundamentals, with simple products bearing robust mechanisms for risk mitigation. Market analysts have stressed the correlation between asset quality in Islamic institutions and their conservative approach to risk as an insulating factor. Many conventional bankers contend the success of Islamic finance in riding out the financial storm can be attributed to the fact it is underpinned by tangible assets such as real estate.

Askari et al incorporate all of these considerations into their demonstration of the advantages of the Islamic alternative, but they also go several steps further than most previous assessments. Prior examinations of Islamic finance have devoted most of their attention to its ethical side - prohibition of interest and the ban on lending for certain activities - gambling, alcohol production and so forth. As its title suggests, The Stability of Islamic Finance demonstrates, in addition to Islamic finance's usual virtues, its relative stability with regard to the conventional system.

As the authors note (p 209), conventional banks fail to meet inherent stability conditions even in the presence of prudential regulations. First, credit losses from debt default to the depreciation of assets may create a large divergence in relation to the liabilities that remain fixed in nominal value. Second, bank credit has no fixed relation to real capital in the economy and bears no direct relation to the real rate of return. Unbaked credit expansion through the credit multiplier and further leveraging is a fundamental feature of conventional banks. Cash flow could fall short of expectations and force large income losses on banks, especially when the cost of funds is fixed through a predetermined interest rate.

Third, banks caught in a credit freeze, with a drying up of liquidity. may default on their payments. Fourth, banks are fully interconnected with each other through a complex debt structure; in particular, the assets of one bank instantaneously become liabilities of another, leading to fast credit multiplication. A credit crash causes a dramatic contagion and a domino effect that may impair even the soundest banks.

While their analysis is much too rich to detail here, suffice to say they demonstrate that an Islamic system overcomes many of these limitations. In particular, in an economy governed by the principles of Islamic finance, the rate of return on equities is determined by the marginal efficiency of capital and time preference, and is positive in a growing economy. This implies that Islamic banks are always profitable provided that real economic growth is positive. This establishes a basic difference between Islamic banking where profitability is fully secured by real economic growth and conventional banking where profitability is not driven primarily by the real sector.

A critical feature noted by the authors, and one consistent with the Austrian ideal for banking, is the fact that the Islamic system operates on a 100% reserve requirement. In this system, investment banking operates on a risk/profit sharing basis, with an overall rate of return that is positive and determined by the real economic growth rate.

Islamic banks do not create and destroy money; consequently, the money multiplier, defined by the savings rate in the economy, is much lower in the Islamic system than in the conventional system, providing a basis for strong financial stability, greater price stability and sustained economic growth.

In short, the requirements of Islamic finance - lower proportions of debt to equity, a condition that the lender share profits and losses with the borrower, and a focus on transactions based on tangible assets - mean that Islamic banks have not become entangled in the toxic-debt instruments that have laid waste to many of the conventional banking giants.

In sum, The Stability of Islamic Finance has many strengths. Perhaps the greatest one is the ability of the authors to bridge the gap between the conventional and increasingly sophisticated global financial system and that represented by Islamic finance. Previous attempts at contrasting the systems largely failed because authors were strong in one area but lacked the expertise to provide an in-depth critique of the other system. Professor Askari is an acknowledged world-class expert in both systems and combined with his three co-authors anchors an analytical team uniquely capable of integrating the workings of an Islamic system into the increasingly complex global context.

Still, there are many problems confronting a wider based adoption of Islamic financial systems. In addition to the usual West-Islamic differences over interest, ethical roles of business etc, a number of fundamental changes would have to take place in the way Western governments manage their economies. For one thing, the adoption of popular Keynesian stimuluses during recessions would be much more difficult than is currently the case. Central bank discretionary policy would have to be abandoned for strict rules on monetary expansion. Reserve requirements of 100% on banks would fundamentally alter the banking business - the list goes on.

Having shown its inherent advantages over the current system, hopefully the authors will collaborate on a follow-on book detailing how the Islamic financial system can transition outside of its current narrow confines to be a viable alternative to the conventional system.

The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future by Hossein Askari, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor. John Wiley & Sons, Singapore (2010). ISBN: 978-0-470-82519-80. Price US$49.95, 256 pages.

Robert Looney is a professor of national security affairs, and associate chairman of instruction, Department of National Security Affairs, at the Naval Postgraduate School, California.

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