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Sami Al-SuwailemIRTI, IDB

Safar 1430 ± February 2009

Global FinancialCrisis:

Causes and Remedies

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Overview� Worst in 100 years� Capital Markets lost $30-35 trillions this year 

� Real estate lost $30-35 trillions²total $60 trillions� Financial institutions lost $3+ trillions� Central banks injected $8+ trillions since start� For comparison: Insured catastrophe losses

(earthquakes, tsunamis, man-made disasters) 1970-

2007: $745 billions

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Root Causes� Excessive leverage� Excessive speculation

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Debt

Wealth

Inverted Pyramid

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Unsustainable System� Debt accumulates faster than wealth� Minor shocks make the system crash

� Financial fragility� Crashes needed to ³clean up´ the system� Then debts start to accumulate again faster than

wealth� Recurrent crashes

� Very costly system

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Sources of Danger � Riba: usury and interest on loans� Gharar : gambling and wagering

� Prohibited by all Divine revelations

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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

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Debt in the US

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Figures� Average growth annual rate for 

o debt: 39%,o GDP: 21%,o M2: 19%

� Debt-GDP ratio grew from 1.3 to 2.2� Debt-M2 ratio grew from 2.2 to 4.2� Unsustainable system

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Imbalance sheets� Borrowing short and lending long causes financial

fragility

� By end of 2006, investment banks were rolling over 25% of their liabilities d aily � Extreme mismatch of assets and liabilities� ³The original sin´

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Derivatives� Caused more imbalances, thus made the system

overall more risky� Derivatives themselves are imbalanced²even more

than underlying assets and liabilities

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Gharar � High risk transactions� Zero-sum games that create no wealth

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Toxic Assets� By definition, they are more likely to lose� Meet classical definition of g harar � Cannot be allowed in Islamic finance

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Zero-sum games� Derivatives by definition are zero-sum transactions� Make the system more risky

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Derivatives

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Credit Default Swaps� Semi-insurance contract� Why to insurance subprime?

o Upfront feeso Rising house priceso Large markets for risk trading

� Size of CDS: $62 trillions in 2007� Naked CDS: ~80% of the market

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CDS

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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

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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

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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

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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 

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Ineffective Policy� ³Privatization 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

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Search for New Paradigm� Jean-Claude Trichet, President of the European

Central Bank: ³What we need is a new paradigm´� Angela Merkel and Nicola Sarkozi: New economic

order 

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Islamic Economics� Universal principles� Solid economic ground� Tested financial instruments

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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 thanconventional finance

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Safety Net� Non-profit safety-net is integral to economic

activities:o Forbearanceo Zakato Interest free lendingo Other social activities

� Cycles in an Islamic economy are bounded

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Economics Cycles

Unregulated creditexpansion

Regulated creditexpansion

Forbearance enacted

No forbearance

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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

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Interest-free Lending� Commercial banks face difficulties lending during

crises� Non-profit institutions serve social objectives� A complementary channel for lending

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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

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Moral Hazard� Conventional safety net causes moral hazard� Financial systems become more risky� Islamic safety net minimizes moral hazard:

o Directed to the needy²No ³too big to fail´o Not guaranteed²they are privateo Wrongdoer s are not rewarded!

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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