The Global Financial Crisis and Islamic Finance

Abstract

The conventional view holds that the current global financial crisis was caused by extraordinarily high liquidity, reckless lending practices, and rapid pace of financial engineering which created complex and opaque financial instruments used for risk transfer. There was break down of lender borrower relationship, informational problems caused by lack of transparency in asset market prices, particularly in the market for structured credit instruments. There was outdated, lax or absent regulatory-supervisory oversight, faulty risk management and accounting models; and the emergence of an incentive structure that not only encouraged excessive risk taking but also created a complicit coalition of financial institutions, real estate developers and appraisers, insurance companies and credit rating agencies whose actions led to a deliberate under pricing of risk. Such crisis would not have occurred under an Islamic financial system – due to the fact that most, if not all, of the factors that have caused or contributed to the development and the spread of the crisis are not allowed under the rules and guidance of Shariah. The current global financial crisis is largely seen as a real test of the resilience of the Islamic financial services industry and its ability to present itself as a more reliable alternative to the conventional financial system.

Keywords: Subprime Mortgage, Global Financial Crisis, Islamic Financial System, Profit-and-Loss Sharing (PLS), Financial Stability