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so, some Islamic banks did collapse in the turmoil. Investment Dar in Kuwait, Amlak and Tanweer in Dubai, the Islamic Bank in Qatar, the Gulf Finance House in Bahrain, and the Islamic Bank of Emirate all came to grief in one way or another in 2009. The crisis originated in the conventional finance market, and had a variety of causes; the main ones were the race for credit creation in the banking system; the corporate lever- age lure; the expansion of secondary mar- kets; heightened speculation; and the reck- less fiscal policies of the U.S administration. All these problems are the result of faulty market incentives.


Fortunately, the Islamic financial system has not yet developed enough connectivity with these mainstream maladies to have mould- ed all its methods on them. It is outside the scope of this paper to give a detailed analy- sis of the causes of the current global finan- cial meltdown. Two characteristics of the conventional financing systems are relevant, as they often bring financial institutions to their knees as has happened recently: credit creation and speculation, especially in the bubble-rich derivative markets.


Commercial banks are able to create an in- verted credit pyramid, because they do not give credit (loan) granted to a client across the counter: he must deposit it in his ac- count with the bank. Thus, loans necessitate deposits. The average cash withdrawn daily by the clients from their accounts is normally a small fraction of the total deposit, in cash or credit. This allows banks to generate a spiral of credit through an operator: the mul- tiplier. It is easy to understand the working of this credit pyramid. If we state that the legal tender or base money in an economy, people deposit $M in banks; from their ac- counts people withdraw an average fraction of F to meet their daily needs; meanwhile the central bank of the country wants com- mercial banks to maintain a fraction of R of all deposits as a reserve. M then becomes the credit multiplier, as shown in this equa- tion:


M = I/F [1- R] To illustrate the equation further: imagine that from the base money in an economy people kept $50m in bank; that they with- draw on average an F = 0.1 fraction daily from their accounts; and the central bank of the country requires commercial banks to maintain with it a minimum reserve ra- tio of R = 0.05. The credit multiplier M will then be 9.5. The $50 million cash deposit with the bank will enable it to have depos- its worth $475 million. From that amount, if we take out cash deposits, the remaining $425 million will consist of loan deposits which the bank has generated. The interest received on this amount, minus the part of


it payable for cash deposits and other oper- ating expenses, will all belong to the bank. Banking is therefore an exceedingly lucra- tive business. Bank owners reap handsome leverage benefits. So do businesses taking loans from banks, as the rates of interest are usually much lower than the returns which the loans provide. They are tempted to finance even long- term projects from short-term loans, because in good times easy renewals can convert these into long- term funding. Leverage gains tend to make businesses over-adventurous; ut continued inflation ultimately causes the credit balloon to burst, economies to fail, and unemploy- ment to spread.


Banks, businesses and societies all suffer in a crisis. Governments become hostage to big business. Large banks cannot be allowed to fail; rescue packages and bailouts involv- ing trillions of dollars have become the order of the day. Barry Ritholtz in his forthcoming book, Bailout Nation, puts the estimate of United States rescuing costs until now at $4.6165 trillion; and calls this figure a “con- servative” estimate. The current credit crisis bailout, he notes, comprises the largest out- lay in American history.


This seems to lay bare the latest axiom of capitalism: Profits are private, losses pub- lic. Islamic banks are not yet part of this dynamic, because unlike their conventional counterparts they do not indulge in multiple credit expansion. The expansion of credit, and the consequences which I have ex- plained above, bring us to my second point. Mounting loans in current crisis fuelled the expansion of the derivative markets, and in turn experienced Derivatives draw their value mostly from the worth of an underlying asset: a security, commodity, or other finan- cial instrument. Futures, forwards, options, and swaps are the most common types of derivatives.


Markets for derivatives have their advan- tages, the most considerable being risk miti- gation, but lately they have become unregu- lated dens of high risk credit bets; derivate markets can cook up any kind of leverage de- vice, including caps, collars and floors, in or- der to “bet the hell out of virtually anything”. Some 25 years ago, the derivatives market was small and domestic. Since then it has grown impressively – around 24% per year during the last decade – into a sizeable and truly global market. Today, it has assumed a global worth of US $1.14 quadrillion (1 quad- rillion = 1000 trillion). In the year 2009, it was worth more than - almost 20 times - the entire GDP of the world. The expansion of the derivatives market has been exponential - interestingly, more so after the events of 9/11 2001. It may not be strictly practical to apply responsibility to this growth in deriva-


tives to the setting in motion of the global meltdown, which was the most intense and of the longest duration than any recession since the Great Depression of the 1930s; but such speculation is certainly fascinat- ing experts. Initially, some jurists - Hashim Kamali in particular- claimed scope in law for the creation of derivatives in the area of Islamic finance as well; a few were in fact launched. However, it is currently argued that derivatives are un-Islamic for a variety of reasons; mainly because they consist of bets on bets on debts on debts. One opin- ion is that “regulations and prosecutions are needed to punish and deter present and fu- ture self-paid corporate crooks looting and draining other people’s pensions and sav- ings.”


Concluding Remarks In the piece above I have discovered the po- tentialities of Islamic finance from a hitherto unexplored angle: the adoption of the short- term financing structure used by convention- al banks to meet the essentially long-term objectives of Islamic economics. It is true that the structure-objective mismatch has in some measure facilitated the expansion and growth of Islamic finance, but on a more important level, it has forced Islamic finance into convergence and competition with the matured conventional system. Competition between these grossly unequal sectors is like the competition of the pond, where the big fish always swallows up the smaller ones. That process is happening now: the unidirec- tional convergence of Islamic finance seems to be leading to its eventual submergence within the conventional system.


For the present, it is neither expedient nor possible to indulge in substantive structural changes in Islamic finance, but it is not too late to initiate some sideways diversions. Even if Islamic finance continues to operate within the existing framework, there is much that can be done to make the industry meet the ends which it was initially intended to serve. Indeed, some policy measures have already been initiated in that direction. How- ever, the decisive question still remains: for whom does the bell of Islamic finance toll? I take the view that Islamic finance was con- ceived to serve the interests of unmah; it is not necessary or desirable to sacrifice that objective at the altar of globalisation. Oth- ers can of course benefit from the system, if they so desire, following the Islamic norms. It is from this perspective that I venture be- low some observations for the consideration of scholars and of policy makers.


• One reform called for by the Islamic system is the separation of short-term from long-term financing. Experience shows the difficulty in handling the two efficiently under the same organisa-


2011 February Global Islamic Finance 27


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