Transcript Global Financial Crisis: Causes and Remedies by Sami Al Suwailem

Global Financial
Crisis:
Causes and Remedies
Sami Al-Suwailem
IRTI, IDB
Safar 1430 – February 2009
Overview
 Worst in 100 years
 Capital Markets lost $30-35 trillions this year
 Real estate lost $30-35 trillions—total $60 trillions
 Financial institutions lost $3+ trillions
 Central banks injected $8+ trillions since start
 For comparison: Insured catastrophe losses
(earthquakes, tsunamis, man-made disasters) 19702007: $745 billions
Root Causes
 Excessive leverage
 Excessive speculation
Inverted Pyramid
Debt
Wealth
Unsustainable System
 Debt accumulates faster than wealth
 Minor shocks make the system crash
 Financial fragility
 Crashes needed to “clean up” the system
 Then debts start to accumulate again faster than
wealth
 Recurrent crashes
 Very costly system
Sources of Danger
 Riba: usury and interest on loans
 Gharar: gambling and wagering
 Prohibited by all Divine revelations
Riba
 Separates debt creation from wealth creation
 Debt grows faster than wealth
 Debt maturities shorter than assets
 Debt services become unbearable
 Pressure on wealth base accumulates
 Crash is imminent to restore balance
Debt in the US
Figures
 Average growth annual rate for
 debt: 39%,
 GDP: 21%,
 M2: 19%
 Debt-GDP ratio grew from 1.3 to 2.2
 Debt-M2 ratio grew from 2.2 to 4.2
 Unsustainable system
Imbalance sheets
 Borrowing short and lending long causes financial
fragility
 By end of 2006, investment banks were rolling over
25% of their liabilities daily
 Extreme mismatch of assets and liabilities
 “The original sin”
Derivatives
 Caused more imbalances, thus made the system
overall more risky
 Derivatives themselves are imbalanced—even more
than underlying assets and liabilities
Gharar
 High risk transactions
 Zero-sum games that create no wealth
Toxic Assets
 By definition, they are more likely to lose
 Meet classical definition of gharar
 Cannot be allowed in Islamic finance
Zero-sum games
 Derivatives by definition are zero-sum transactions
 Make the system more risky
Derivatives
OTC
OE
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
1998
1999
2000
2001
2002
2003
2004
Global Derivatives Notional Values, $B
2005
2006
2007
Credit Default Swaps
 Semi-insurance contract
 Why to insurance subprime?
 Upfront fees
 Rising house prices
 Large markets for risk trading
 Size of CDS: $62 trillions in 2007
 Naked CDS: ~80% of the market
CDS
70,000
60,000
50,000
40,000
30,000
20,000
10,000
2001
2002
2003
2004
2005
Credit Default Swaps Notional Value ($B)
2006
2007
How CDS Fueled the Bubble?
 Rising home prices encourage insurance
 Insurance encourages lending
 Lending fuels housing demand, which raises prices,
etc.
 Moral hazard and reckless behavior
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Home Prices
220
200
180
160
140
120
100
80
CDS vs. Casino
 CDS: side bets
 CNN: “The largest casino in the world”
 CDS vs. casino:
 CDS not regulated; casino is
 CDS highly interlinked;
 CDS highly linked with outside institutions
CDS and Amplification of Risk
 Side bets magnify risks
 Inter-related financial contracts make the system very
sensitive
 Concentration of risk
 Downturns cause higher counter-party risk
 The result: losses are amplified
Risk in Financial Markets
 Financial risks are mostly endogenous: 70%
 Real sector volatility is decreasing, while that of
financial markets is increasing
 Conventional finance is more risky than natural
disasters
Summary: Causes of Crisis
 Uncontrolled debt financing
 Uncontrolled risk taking
 Both lead to excessive financial commitments and
inverted pyramid of wealth
 They fuel each other
Ineffective Policy
 “Privatization of profits and nationalization of losses”
 Capitalism in during upturns, but communism in
downturns
 Markets on steroids more than 2 decades
 Recovery cannot be brought back using more steroids
 Liquidity trap and the Japanese case
Search for New Paradigm
 Jean-Claude Trichet, President of the European
Central Bank: “What we need is a new paradigm”
 Angela Merkel and Nicola Sarkozi: New economic
order
Islamic Economics
 Universal principles
 Solid economic ground
 Tested financial instruments
Islamic Finance
 Debt creation is integrated with wealth creation
 Excessive risk and zero-sum games are excluded
 Finance is integrated with real transactions
 Since real economy is less risky than financial markets,
Islamic finance is less risky than conventional finance
Safety Net
 Non-profit safety-net is integral to economic activities:
 Forbearance
 Zakat
 Interest free lending
 Other social activities
 Cycles in an Islamic economy are bounded
Economics Cycles
Unregulated credit
expansion
Regulated credit
expansion
Forbearance enacted
No forbearance
Role of Zakat
 Economies now face the risk of deflation
 As prices decline, more incentives to hoard money
 As every one hoards, downturns intensifies
 Zakat: a benevolence tax on hoarded money
Interest-free Lending
 Commercial banks face difficulties lending during
crises
 Non-profit institutions serve social objectives
 A complementary channel for lending
Non-profit Institutions
 For each dollar spent by non-profits, $8 are generated
in direct economic and social returns
 Government support shall be directed towards social
institutions rather than those that caused the crisis
Moral Hazard
 Conventional safety net causes moral hazard
 Financial systems become more risky
 Islamic safety net minimizes moral hazard:
 Directed to the needy—No “too big to fail”
 Not guaranteed—they are private
 Wrongdoer s are not rewarded!
Conclusion
 Roots of danger: riba & maysir
 Both allow mountains of commitments and debt to
accumulate beyond existing wealth
 Fuel each other
 Islamic economics builds a stable system with
bounded cycles