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The Financial Sector Crisis and Islamic Banking

The international financial crisis began over a year ago, and has intensified over past few months.

The International Monetary Fund has already warned that this credit crisis will result in losses of over trillion dollars and that it may worsen especially after the 150-year-old US financial giant Lehman Brothers been declared bankruptcy, not to mention the sale of financial services firm Merrill Lynch to the Bank of America.

Islamic banks are unaffected by the sub prime mortgage crisis; rather many non-Muslims are turning to Islamic banking as customers spooked by turmoil in the Western banking system feeling Islamic banks as a safe haven because these are immune against such crisis due to inherent business ethics within Islamic banking.

There are mainly two important reasons for insulation of Islamic banks under this current credit crisis as compared to the interest based banks and financial institutions. The first is liquidity problem due to inter banks lending, merger and resales of debted companies with their assets in the money markets. The second problem is realted to the rating the asset values mortgaed against debt finances by the credit rating agencies.

Principally Islamic banks are custodians and cannot tarnsfer public deposits to other banks without permission of the depositors. Inter bank liquidity transfer on debt finance basis is not permitted in Islam, which counters liquidity realted problems in the market.

Under Islamic banking, since equity finance does not mortgage assets to grant debt finance, but analyze cost projected yield on projects needing finance, the credit / equity finances remains unaffected with changes in assets values. There are so many internal and external factors affecting the asset values of stocks, bonds and securities which are prime components for credit rating system for Interest based lending; so it is not easy for the banks and even for credit rating agencies to evaluate the exact credit risk. The credit rating under Islamic Finance has nothing to do with up and rise in asset values, instead it depends on actual business. Thus there is no fear of sub prime mortgage under Islamic banking principles, and it thus reduces the throat cut competition in financial sector to get more credit shares. This principle in fact tends to provide stability in the financial market.

Islamic banking interestingly helps the weaker and even the weakest section of the society through various ultra modern financial products. Under Islamic banking credit in terms of equity finance, business finance, trade finance and leasing is provided by investors / banks to the borrowers with a condition that financial risk is borne by investors. This helps the poorer and vulnerable to get credit at no risk, but definitely requires other credibility like strong business proposal, sound projects, rational approach, skill and technical art to attract the financer. Under Islamic finance, genuine business proposals fetch credits with no risks and irrational projects finds difficult to get finances. This raises entrepreneurship skill within the economy helping inclusive growth because financial resources is well shared among haves and have nots with financial risk on financers and other risks on borrowers of funds.

The credit rating under Islamic banking and finance evaluates real term business potential and growth trends, instead of evaluating manipulated asset values which has caused recent damages to the credit market. Thus the regulators and credit rating agencies should now adopt principles of Islamic banking to safeguard the financial sector from any more turmoil.

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