Global Financial Crisis: Ways Out

Global Financial crisis began in the US and especially was caused by some lapses in
the economics, financial, regulatory and supervisory policies in the US and possibly
those in other industrialized countries. Since the world is now integrated, the crisis
has engulfed other developed, developing and underdeveloped countries.

The most important cause of all crises has been excessive and imprudent lending
by banks and financial institutions over a long period. This raises the question of the
question of what makes it possible for banks to resort to such an unhealthy practice
which not only destabilize the financial system but is also not in their own long –run
interest. There are three factors that make this possible.

1. Inadequate market discipline in the financial system resulting from the absence
of profit loss sharing (PLS)

2. The bind boggling expansion in the size of derivatives, particularly credit default
swaps (CDSs)

3. Too big to fail concept, which tends to give an assurance to big banks that the
central bank will definitely come to their rescue and not allow them to fail?

The false sense of immunity from losses that all these factors together provide has
introduced a fault line in the finical system.

Banks have not, therefore, undertaken a careful evaluation of the loan applications.

This has led to an unhealthy expansion in the overall volume of credit, to excessive
leverage, and to an unsustainable rise in asset prices, living beyond means, and
speculative investment.

Jean Claude Trichet, president of the European Central Bank, has rightly pointed out
that a bubble is more likely to develop when investors can leverage their positions
by investing borrowed funds. The situation was so severe that Larry Summers,
former secretary of the US treasury said

“Seven major crises in20 years…… that is not good enough.”

Regarding the theoretical aspect we cannot ignore the fact that central part of
discipline macroeconomics & financial economics are now rightly, being severely re-
examined. There are three main critiques:

1. Macro & Financial economists helped cause the crisis.

2. They failed to spot it
3. 3. They have no idea how to fix it.

In the recent lecture, Paul Crugman, winner of the Noble Prize in 2008, argued that
much of the past 30 years of macroeconomics was “spectacularly useless at best, at
positively harmful at worst.”

On the other we see, Islamic financial institution like Dubai Islamic Bank, Kuet
Finance House have been barely affected.

Theoretically we can see that Islamic financial system is capable of minimizing the
severity & frequency of financial crises by getting rid of the major weakness of the
conventional system. It introduces greater discipline into the financial system by
requiring the financier to share in the risk. It links credit expansion to the growth of
the real economy by allowing credit primarily for the purchase of real goods and
services which the seller owns and possesses, and the by\buyer wishes to take
delivery.

It also requires the creditor to bear the risk of the default by prohibiting the sale of
debt, thereby ensuring that he evaluates the risk more carefully. In addition, Islamic
finance can also reduce the problem of subprime borrowers by providing credit at
affordable terms.
This will save billions that are requires after the crisis to bail out the rich bankers.
These do not, however, help the poor because their home may have already
become subject to foreclosure and auctioned at a give-away price.

It is the oldest debate about the role of the market &state, the role of economists &
politicians, the role of private & public sector.

Too many people equate mistakes made by economists got things wrong then
politicians will do better. Islam told us that everybody has responsibilities and
duties. If we do not perform these duties or ignore these responsibilities, various
types of inconsistencies will arise.

So I think learning the right lessons from the global financial crisis of 2007-09 is a
challenge not only the leaders of the advanced economies & the larger emerging
economies whose policies individually & collectively will determine the evolution of
the global economy & financial system over the next several decades. Learning &
applying the right lessons is also a great challenge for the leaders of smaller
emerging & developing economies that will have to live the consequences. Their
own words should be clear & their policy should be example for all of us. This is
most difficult lessons.