The ongoing financial crisis (credit crunch) is considered the greatest depression to beat the global economy since the Great Depression. This crisis is in reality as a result of failed morality, greed, exploitation as well as corruption. It is a result of failed communication and lack of relationship between the investment originators who did not explain the potential risks associated with transactions to the investors and borrowers. The credit crunch is bound to bring a prolonged period of global economic downturn. It is therefore very important to establish ways of curing the situation and preventing similar crises in future. The first step is establishing the cause of the credit crunch. The impact of the credit crunch on Islamic banking sector has been minimal. This is in part due to the intrinsic principles that govern this sector. It is worth to study the principles Islamic finance and establish the part they played in protecting these institutions from collapsing. It is also worth to explore how Islamic Financial institutions have been performing during the credit crunch as compared to conventional banking institutions. The paper will establish whether the mode of operation of Islamic finance has the potential to cure the current credit crunch and prevent future crises.
This study is important as there is need to prevent similar crises in future because of its impact on the global economy. The credit crunch has resulted to collapse of many financial institutions globally. The global equity markets have also sharply declined. The need to minimize the current global economic downturn and prevent future crises is inherent. Understanding the concept of Islamic finance, performance of these institutions and the impact of the credit crunch is the only way of establishing whether they could be used as a solution.
Relation to Previous Research
1. Principles of Islamic Finance and Sharia law
Islamic finance principles seek to promote greater justice within the human society. These principles are derived from the Shunnah as well as the Holy Quran. Islamic finance which is based on Sharia law encompasses Islamic banking and Islamic insurance. These principles include transparent dealings that are fair. The principles emphasize on profit as well as risk sharing and entrepreneurship between the financer and the investor (Abdouli 1991). They also prohibit against receiving as well as giving of interest as it is believed that money should not be used as an asset to earn a surplus of and on itself (Iqbal Mirakhor 2007). It is believed that in addition to free and pure returns, capital should also be used top realize social as well as ethical purposes, something that lacks in conventional finance. In Islam, disclosure of information and contractual obligation are a sacred duty as such, the risk of asymmetric information is reduced. Islamic finance does not fund business activities that violate Sharia law such as gambling, casinos and bars amongst others (Usmani, 2002). The principles also prohibit against business activities that involve speculation and uncertainty in the terms of contract (Choudhury Harahap 2009).
Islamic banking includes all the activities that are known as banking activities only that borrowing and lending are not on the basis of interest (Ayub 2007). Prohibition against interest (Riba) is considered the basic principle of Islamic bank practice. This principle is based on the guidance that is the foundation of the Islamic religion (Usmani 2002). Islamic banks adopt the concept of participation in the enterprise where investor funds are subjected to a risk on profit and loss sharing basis. Islamic financing, unlike conventional banking does not exhibit speculative schemes. Diversification, careful investment policies as well as proper management is conducted by Islamic financial institutions before investing clients money. As a result, Islamic financial institutions manage resources and perform better than conventional institutions (Wit Meyer 2010).
According to scholars, one of the main reasons as to why Islamic banks were not affected by the credit crunch which hit conventional banks that involved themselves in toxic assets is that Sharia law strictly prohibits interest (Daft 2008).
Sharia law which characterizes Islamic banking encourages equality and fairness amongst all members of the society by stressing religious, social and ethical factors. According to its teachings, Muslims have a responsibility to the poor and God has appointed them to maintain a balance in the world.
2. Most Commonly used Islamic Financing Modes
There are various modes of Islamic financing. Murabaha, Musharaka and Mudaraba are however the ones that are most commonly used. Murabaha is asset based while the Musharaka and Mudaraba are equity based (Ayub 2007).
Musharaka arrangements are similar to those used in conventional banking in that the investor is allowed to set any kind of profit ratio of their investment. The difference is that in the event loses occur, each of the partners incurs loss according to the ratio of their investment (Ayub 2007). Musharaka and Mudaraba are best used in cases where the return on investment can be correctly predicted. Unlike in conventional banking, Murabaha loans in Islamic banking are not considered loans as interest is not charged on them. Rather, they are viewed as a contract of sale between financial institution and its client. Many Islamic banks prefer Murabaha as the mode of financing because of the simplicity of its model and its advantages over the equity based modes.
3 The Credit Crunch
The twentieth century economy initially moved towards regulation (tight government control) and then slowly moved away towards deregulation as the economy became more liberalised. The current financial crisis and credit crunch is as a result of lack of government control. In the midst of this crisis, the Islamic financial industry has remained strong and continued to record positive growth even as its counterpart conventional institutions collapse. The implications are that Islamic finance is well equipped to prevent the development of such crises.
The credit crunch has caused constraints to the flow of capital and credit to businesses and families globally. The effect on the real economy is also adverse as investors lost considerable amount of their investments unexpectedly. Most of the financial institutions and in particular the conventional institutions have lost considerable proportion of their value (Hargreaves 2010).
Prior to the crisis, financial institutions operated in an environment that was deregulated. There was also a shift in products as the financial institutions became innovation driven and took to creating complex instruments that were opaque (Kling 2010). Financial institutions moved from using depositors and borrowers as sources of funds to capital markets creating new risks that could not be understood at the time as old relationships broke down and new ones were created. Engagement of the banks such as Lehman Brothers in sub-prime lending was the main cause of the credit crunch (Kling 2010). Lehnman Brothers is one of the major financial institutions that were pushed into bankruptcy by the credit crunch due to excessive engagement in subprime mortgages (Matt 2007). Deregulation encouraged risk-taking as the institutions became excessively profit motivated. The derivatives which were complex securities and securitisation also contributed to the new risk profile and ultimately the depression.
Most people view the global financial crisis of lack of morality, exploitation, corruption and greed which are absent in Islamic finance (Matt 2007). Lack of communication and breakdown in relationship between the investors and the investment originators is viewed to be another cause. Islamic banks did not rush to exploit the complex financial instruments. Financing in Islamic law is founded on asset backing as a concept where real estate is the most preferred instrument in protecting investments (Various authors, 2009). According to the Islamic theory of finance, a crisis of capital market and the banking crisis would never have occurred if the all banking institutions adopted the principles of Islamic finance which discourage capitalism as they prohibit riba, maysir and gharar (Wilson 1997). Islamic finance is also regulated by sharia law which prevents these institutions from engaging in practices that are risky to investors and the economy (Wit Meyer 2010).
Islamic finance as a service sector is said to be growing at an impressive rate of double digits. Though this growth is most significant in Arab Muslim markets, the potential of these institutions have had impact beyond the Islam markets to non-Islam and non-Arab markets. Alexakis Tsikouras (2009) attribute this growth to the increased engagement in Islamic finance by credit rating agencies and Western regulators. Wilson (1997) explains that the demand for ethical investment products has been increasing since the 1970s, contributing to the growth of Islamic finance which offers ethical investment. A research conducted by Khan Bhatti (2008) shows that Islamic finance has made improvements and breakthroughs to become an alternative that is truly viable as well as competitive to conventional systems globally. Though institutions that practice Islamic banking have obtained booming markets in South East Asia and the Middle East, Islamic finance has also gone global. This study found that product innovation as well as sophistication, soaring oil prices worldwide, advancements in information and technology and the attitudes of conventional regulators which have been receptive to Islamic banking are the main factors that have contributed to the growth of Islamic banking (Daft 2008).
HSBC Amanah is one outstanding example and evidence of how well Islamic finance is doing and how the credit crunch has had no major direct impact on the industry. This bank has successfully established itself within the Middle East and has branched out to other countries outside the region including the US, UK and Turkey amongst several others (Zawya 2008). HSBC continues to enjoy growth and expansion in spite of the credit crunch.
Research Design and Data Collection
This study can be considered a qualitative explanatory study which seeks to explore the performance of Islamic finance in the Middle East by studying the Arab Emirates, Saudi Arabia and Kuwait, and compare it with conventional banking in terms of debt impairment during the credit crunch. The researcher intends to collect data from secondary sources by critically analysing, reviewing and appraising articles on prior studies conducted by other researchers on topics that compare Islamic finance to conventional banking and the impact of the ongoing financial crisis (credit crunch). To compare the impact of the credit crunch on the two types of financial institutions, the researcher will also analyse literature on well performing Islamic financial institutions such as HSBC and conventional banks that were adversely affected by the crunch including Lehman Brothers.
This method was chosen because it is cheaper and faster hence saves on time and financial resources which are very essential in research work. Travelling all the way to the Middle East from the UK to conduct a primary study would require extensive resources which are not available to the researcher at the moment. Reviewing secondary sources will allow the researcher to conduct a more comprehensive study as they will compare information from the various sources before coming up with a conclusion. To choose quality sources, the researcher will analyse the methodologies used by the authors and only pick those whose procedures give reliable and valid information. Use of secondary data also eliminates errors that often occur during sampling and data collection due to researcher based biases.
Data Analysis
Content analysis will be used to analyse the data collected from the chosen secondary sources. This tool analyses data by categorising it according to the emerging themes (Salkind 2006). By so doing, this tool allows the researcher to highlight the similarities in the information from the various sources hence can draw a comprehensive conclusion. The researcher will therefore be able to determine the differences in performance of the two kinds of financial institutions. This tool draws its value from the fact that it makes it possible for the researcher to derive data that is rich, detailed and in-depth from the appraised articles which is the fundamental purpose of qualitative studies.
This study involves studying countries that are far off from the United Kingdom. This presents a problem in accessibility of the subjects hence the need to use secondary sources for data. This method has several advantages. First of all the researcher will require to have access to several databases in order to access a variety of articles to critically analyse before conclusions are drawn. This can be expensive as the researcher will be required to purchase most of the articles particularly those with quality information. Using secondary data is also characterised by other disadvantages which could compromise the validity and reliability of the data. The researcher is for example not able to establish the errors that might have been committed in the primary research. The researchers can also not tell whether the described procedure is the one that was actually followed in study. The implications are that the researcher might use wrong data to draw conclusions which could affect the reliability and validity of the findings of the study.
It is also not easy to determine which theoretical framework to use as the topic is characterised by several theories including that one of amongst several others. The articles to be reviewed as secondary sources of data might also be constructed from different theories which might confuse the researcher as the approaches to the topic will vary depending to the theory being used to guide the study.
This study is also likely to be characterized by ethical issues as it involves using other researchers findings as sources of data. To avoid any issues, the researcher will follow the right procedures in attaining the sources and will reference any information lifted from another so as to give credit back to these authors for their research. The study also seeks to recommend adoption of Islamic modes of financing. This might bring issues particularly for those who are not Muslims as they might feel that they are being forced to comply with Islamic (Sharia) law which is against their religious beliefs. To prevent this, the researcher will advocate for adoption of the modes of financing but not compliance with the principles which are founded on Sharia law.
The challenges associated with using secondary data will affect the reliability and validity of the study. However, validity will be enhanced by using multiple perspectives. Critically appraising as many articles as possible will also reduce this risk. The recommendations might also spark unnecessary debates as non-Muslims might not like the idea of all financial institutions adopting the financing modes of Islamic finance. The recommendations will be framed in a manner that allows readers to be open-minded and understand the impact of the findings on their lives economically.
This paper seeks to discuss the concepts of Islamic finance and compare it to conventional banking practices. The dissertation will focus on the performance of the Islamic sector in the Middle East by studying Saudi Arabia, United Arab Emirates and Kuwait. The impact of the credit crunch on Islamic financial institutions will also be established by studying Islamic banks such as HSBC bank and comparing it to Lehman Brothers, one of the most adversely affected conventional banks by the credit crunch.
According to literature, Islamic banking is a safer and manages resources better than conventional banking that is not regulated. In the dissertation, the researcher will explore this argument and make recommendations as well as a conclusion based on the findings on how the current credit crunch can be managed and future crises avoided.
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