Global Financial Crisis and Islamic Banking

· Economics

Several months ago, I published a post on the “Global Financial Crisis and Islamic Banking” on my blog: Science, Politics and Art. This post has been on the website of “Islamic Banking, Masterclass for Islamic Banks Board of Directors” for several months and has been frequently visited. I therefore assume that it correctly reflects the essentials of Islamic Banking and its success. Consequently, I publish it here as a knol. It does not claim to deal with all aspects of Islamic Banking.


The Global Financial Crisis and Islamic Banking

Wednesday, 15 October 2008

Some of my earlier posts have cast doubt on the validity of free market fundamentalism:  don’t worry, leave it to the market it will sort itself out! The fewer restrictions, the better! Any external interference with markets is harmful!

But are free markets (as practised in today’s capitalist world) really a universal and universally accepted mechanism driving economic progress?

Medieval Christian ethics did not accept usury, which is the basic tool of capitalism. Max Weber, in a famous essay, traced the origin of capitalism back to the Protestant ethic, especially its Calvinist (Pietist) variety. Islam still does not accept usury. So, how does the Islamic approach to finance do in the modern world?

Loretta Napoleoni: Rogue Economics. Capitalism’s New Reality. Allen&Unwin 2008 discusses the essentials of the Islamic banking system, which is based on sharia law and  best developed in Malaysia. Its essentials are prohibition of any kind of “speculation” and of interest charges. “Immoral” investments such as in casinos are also forbidden. Islamic banks have to make a profit. They do this by buying assets on behalf of the customer, who has to repay the “loan” and a fee for using the asset. When the “loan” is paid off, the asset’s ownership is transferred to the borrower. The advantage of this arrangement is that the bank shares not only the profit but the risk as well. For that reason, it will also have a very close look at the potential borrowers. For example, take as an example the case of a person or persons who want to buy a factory. They approach an Islamic bank which, after a thorough personal check, agrees to support the purchase. It buys the factory on behalf of the customer(s). Since it bears part of the risk, it has to make sure that this risk is not excessive. – In toto, partnership (sharing risk and profit) and avoidance of excessively risky investments are characteristic of Islamic banking.

Napoleoni discusses the Asian financial crisis of the nineties. Several countries (Thailand, South Korea, Indonesia, Philippines) decided to accept financial support from the IMF and its restrictive conditions, which resulted in a worsening of the crisis. Malaysia, blaming international speculators for the crisis, refused to take the offer and relied on Islamic banking instead. It was the only country which survived the crisis without much damage.

In a recent article in the Sydney Morning Herald (October 11-12, 2008), Clancy Yeates (“Islamic finance rides the storm”) shows that the story is being repeated. Whereas we in the West are in a severe global crash, “the Dow Jones’s Islamic financial index rose 4.75 per cent in the most recent September quarter and lost a modest 7 per cent in the previous year”.

What does this teach us? I would say that, beside the immense debts accumulated particularly in the US,  the almost unrestricted speculation (which is often connected with accumulation of debt) is at least to a large degree responsible for the present meltdown.

A propos speculation: The US-magazin Fortune reports that Credit Default Swaps (CDS’s) have doubled annually over the last decade. Trading in CDS’s is completely non-transparent, therefore the CDS volume can only be estimated. Such estimates arrive at US$ 54.5 trillion (compared with the global GNP of US$ 54.3 trillion). What would be the result if sellers default on their payments?

(Wikipedia: “A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the “buyer” makes periodic payments to the “seller” in exchange for the right to a payoff if there is a default or credit event in respect of a third party or “reference entity”.)


Copyright note

This knol was first published as a post on my blog: Science, Politics and Art and pasted from there onto the  website of Islamic Banking by the managers of that website.



Loretta Napoleoni (2008). Rogue Economics. Capitalism’s New Reality. Allen&Unwin.

Max Weber (1934). Protestantische Ethik und der Geist des Kapitalismus. The Protestant Ethic and “The Spirit of Capitalism” (Penguin Books, 2002) translated by Peter Baehr and Gordon C. Wells.

Clancy Yeates (2008). Islamic finance rides the storm. Sydney Morning Herald (October 11-12, 2008).

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