Interview with Prof Aly Khorshid

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The Global Financial Crisis: Islamic system may have some answers

The current financial crisis has highlighted the critical importance of ensuring that a firm’s senior managers have a transparent and robust oversight of capital, liquidity and risk management. This article outlines the principles that all institutions should be upholding right now.

Whether we consider recent events from the vantage point of the sub-prime mortgage industry’s losses, the proliferation of sophisticated financial products, or the collapse in confidence in investment and commercial banks taking place at the moment, the scale of the crisis is substantial. We all know about the sub-prime crisis and the world as we know it is changing in its aftermath. The entire global economic system is interconnected – what affects one nation touches others? If the troubled country is the US, it reaches everywhere and if the crisis is great enough, the disease may be fatal and human wreckage catastrophic. This is precisely the current dilemma that world leaders and financial experts are currently scrambling to figure out. They are desperate to contain, and not sure what, if anything, can work. The lingering question is: how did this happen and why?

Q: What is the underlying problem?

A: Financial institutions are holding a large volume of securities of falling and doubtful value, and which imply large losses for them. There are further losses from having insured asset values through credit default swaps and other derivative instruments Trading is not-so-transparent over-the-counter markets. There is also massive speculation. Even if a bank knows that its own balance sheet is intact, it cannot be sure that its counterparty is in the clear (or in some way exposed to a third party with problems). In this hot environment of distrust and capital shortage, standard macroeconomic policy instruments are blunted and a strategy that relies mainly on liquidity provision by central banks while essential will not suffice.

Q: Where did it start?

A : The financial crisis that has taken the world by storm despite efforts by the US government to keep dishing out rescue plans and joint actions with other central banks to inject massive sums of money into the markets. No one seems to be able to tell when the crisis will actually retreat, but one thing is sure: it has displayed the trend of further propagation, as evidenced by the spread of its fallout to financial institutions in Europe calling for similar rescue packages. The root cause, to some extent, reflects the laxity with which the US was regulating the disbursement of sub-prime mortgage loans, as well as the derivatives that evolved from them.

The financial institutions of many countries in particular developed and emerging economies, were lured in by such derivatives, which explain the wide reach of the latest crisis. As liquidity began to disappear in the asset-backed securities markets, counterparties became increasingly risk averse, making funding extremely difficult to obtain and creating uncertainties about valuation and creditworthiness that persist to this day.

The collapses of Lehman and many other financial institutions in the last few weeks have put a great deal of strain on the system. And when you have a system that’s already under stress, that strain is hard to take. Failure to do so could usher in a period in which the ongoing deleveraging process becomes increasingly disorderly and costly for the real economy’.

Q: What more must be done?

A: First, as some governments have concluded, the fragility of public confidence has now reached a point that some explicit public guarantee of financial system liabilities is unavoidable. This means not only retail bank deposits but probably also inter-bank and money market deposits, so that activity may restart in these key markets. Of course, such a step would need to be temporary, and include safeguards against the risk-taking that comes with such guarantees, such as heightened supervision and limits on deposit rates offered.

Second, the state needs to take out troubled assets and force the recognition of losses. Asset purchases must be done transparently at fair market value. The reasons are not moralistic, though there is such an imperative, but pragmatic. If prices are inflated, then banks will inevitably have to make good the losses that fall on the taxpayer – in the US case, they would have to issue shares to the government, thus diluting other shareholders. But losses deferred to the future prevent new private capital from flowing into banks. If such capital is to be attracted, it is better to pay a lower price now, recognise losses, and give banks an upside if the implied loss turns out to be smaller.

Third, private money is scarce in today’s environment, and loss recognition alone may not be sufficient to induce fresh injection of private capital. One strategy that has worked in past crises is to match new private capital subscriptions with state capital, which imposes a market test for the use of public funds.

Fourth, a high degree of international co-operation has become urgent. Unfortunately, recent measures have been taken with national interests in mind, and not enough has been done to prevent unintended “beggar-thy-neighbours” consequences that only exacerbate problems for others. If one country credibly offers a blanket guarantee (say, Ireland), investors may move out of countries that do not (say, the UK). If asset purchase schemes are very different, institutions will go to the most generous buyer. Financial institutions now span many countries and credible rescue plans must be consistent across many jurisdictions. More fundamentally, and looking beyond the immediate crisis, it is clear that the international community needs to work to close the many loopholes in the global regulatory architecture that allowed financial institutions to minimise capital even as they concentrated risk.

Fifth, it is now becoming clear that emerging market countries are likely to be hit hard by financial turmoil, despite stronger fundamentals and policy frameworks. Lest a sudden stop of capital bring their progress to a sudden halt or, worse, bring down their financial systems, some form of large and rapid financing should be kept ready. There should be no doubt that the Fund is prepared to deploy its emergency procedures and flexibility in rapidly approving high access financial programmes, based on streamlined conditionality that focuses on crisis response priorities.

As bleak as the situation now looks, I am convinced that there is a way out of our shared predicament. The trick is to get policymakers around the world to pull in the same direction.

Public assistance must protect the taxpayer

Government intervention in business usually has unintended consequences. The results of regulation are often disappointing but the scope and scale of regulation nevertheless expand. Regulation works best when it is narrowly focused on defined objectives. We now regulate airline safety, not the airline business, since prudential supervision of the industry created elaborate panoply of controls that came to serve only the interests of established operators, and often not even them.

When governments intervene in the banking crisis, their objectives should be equally narrowly focused and on what matters to the public, not what matters to the banks. We have no reason to care whether the inter-bank market is functioning well, nor should it be a policy objective to revive the issue of mortgage-backed securities. The inter-bank market was many times larger than needed to secure its economic function, and the residential mortgage-backed securities market should probably never have come into existence: banks will be sounder and their lending decisions wiser if the loans they underwrite are on their own balance sheets.

However it feels on Wall Street and Canary Wharf, this is not the worst economic crisis since the Great Depression. Today’s problems are not only created by financial markets but largely confined to them. Compared with the wreckage of Europe’s physical infrastructure in the 1940s, or the threats to living standards and social order from oil shortages and accelerating inflation in the 1970s, these perturbations are minor. The greatest threat to the non-financial sector is the effect on business and consumer confidence that comes from apocalyptic headlines.

The travails of the banking system matter less to the public than to bankers, but they do matter. The payments system is an essential utility; companies and individuals must be able to receive cash and pay invoices. The most feared event is a recurrence of March 1933 with customers unable to use their chequebook and locked out of their banks. But the central banks of the world have now flooded the system with liquidity and if your bank cannot pay your bills, it is because it is short of assets, not because it is short of cash.

The next public objective is to reassure those who are rightly uninterested in studying the impenetrable accounts of banks to make sure their savings are safe. The deposit protection measures that are in place – implicit or explicit – are more or less enough to do this. Despite panicky headlines, the volume of retail deposits that have been withdrawn from big banks are a small percentage of the total.

The largest problem for the real economy, beyond the crisis of confidence, is the difficulty, though not impossibility, that good borrowers find in obtaining credit. This is not because banks do not have sufficient cash. It is partly because they are short of capital. But even better capitalised banks are reluctant lenders. The main cause of the credit shortage is an overdue fit of prudence.

Another lesson from experience of government intervention is that temporary public assistance to get companies over a bad patch is rarely either temporary or effective. When government funding comes in, other funders move out. Things are almost always worse than management admits, or perhaps knows. When the share price or the credit default swap rate has told a different story from the one senior executive tells, the market has generally been a more reliable predictor than the trading statement.

Even large-scale recapitalization of banks will not ease the pressure on lending much, but it will do so a bit and is certainly the measure most likely to have an effect. All other measures take us down a road whose destination is not clear but certainly distant. Since there are fine on going retail and corporate businesses in the banking sector, the idea of separating the good banks from the bad banks makes sense. The scale of necessary recapitalisation may imply a public contribution.

Q: Where does We Stand Now?

A: The current upheaval in the global financial markets has caused more mayhem in a month than the world has seen in its entire economic history. The financial market turmoil has not yet come to an end. In fact, over the past few weeks, it has intensified yet again. Larger financial institutions have failed or had to be taken over by others, while a number of markets have exhibited increased volatility and reduced liquidity. In particular, significant tensions persist in global money markets, where market liquidity is strained and term interest rates are elevated. Meanwhile, volatility has increased in other global financial markets, particularly for equities and commodities.

Central banks have provided liquidity to help to stabilize conditions In addition, public authorities have announced a number of measures and initiatives to address problems within stressed markets and troubled individual institutions. Nevertheless, international money markets remain under stress. Too much volatility is, to a large extent, a reflection of the urgent need to control investors’ ‘animal spirits’ through the appropriate market and institutional framework.

Strengthening supervision, regulation, risk management, accounting and transparency frameworks are of great importance. Several governments have taken decisive action to address credit concerns and central banks have been coordinating action to address liquidity pressures in funding markets. It is extremely important for central banks to strengthen enhanced information sharing and collective monitoring of market developments. Central banks should take steps to strengthen their capacity to counter problems in the international circulation of liquidity.

The US government has stepped up to bailout financial institutions; bailouts are needed in the short run must be targeted at low-income victims of the sub-prime deals. In the longer term, the solution will require leaders to revamp the financial framework and limit risks, including: better financial information; simplified legal contracts and regulations; expanded markets for managing risks; home equity insurance policies; income-linked home loans; and new measures to protect consumers against hidden inflationary effects.

Q: Renewed Focus on Regulation

A: It is important to note that market events over the last couple of months drive home the critical importance of ensuring that a firm’s senior managers engage themselves with regulatory objectives, adjusting approaches to delivery as circumstances change, rather than just focusing mechanically on compliance with prescriptive rules.

More principles-based, outcome-focused regulation is an essential tool both for informing senior management about the objectives of the regulators and for making them accountable for delivery. It is important for boards to recognise that having compensation structures where traders receive immediate reward and do not bear the consequences of losses is a risk to shareholders. The compensation structure should ensure that both employees and shareholders share the risk in good times and bad. Firms should continue to expect increased regulatory attention on their funding and liquidity arrangements and the adequacy of their stress testing. Firms should ensure they can deal with uncertain market conditions and also maintain sufficient focus on other important business, such as the usual controls and regulatory priorities.

Over the coming year, one can expect the regulators to challenge senior management and boards more intensively including a focus on issues, such as:

  • How are they ensuring continued compliance with regulatory principles, especially as market conditions change?
  • The judgments they make on business decisions.
  • Whether they review the consequences of their decisions.
  • When developing and selecting business options, whether they give robust consideration to the risks and impact of those risks if they were to come into effect.
  • As a result, financial institutions must focus on the following principles:
  • Strengthened prudential oversight of capital, liquidity and risk management.
  • Enhancing transparency and valuation.
  • Changes in the role and uses of credit ratings.
  • Strengthening the authorities’ responsiveness to risks.
  • Robust arrangements for dealing with stress in the financial system.
  • Consider the potential for new risks going forward.
  • Increase liquidity buffers.
  • Co-effective firm-wide risk identification and analysis.
  • Consistent application of independent and rigorous valuation practices across the firm.
  • Timing and quality of information flows up to senior management.
  • Breadth and depth of internal communication across the firm.
  • Informative and responsive risk measurement and management reporting and practices.
  • The balance between risk appetite and risk controls.
    • Increase oversight in setting the risk appetite of banks.
    • Take an enterprise-wide view of risk.
    • Set up governance and control mechanisms and frameworks to ensure that any excesses or transgressions are flagged and reported.
  • Regulators expected to take counter-cyclical measures to dampen the credit curve, such as curbing rampant build up of credit during economic boom.
  • Pro-active role of senior management in understanding emerging risk:
    • Role of communication and information flow on risk indicators is critical.
    • Risk measures that reflect the dynamic nature of risks.
    • Qualitative risk indicators that reflect key aspects of risk management practices that cannot be captured by risk measures.
  • Increased role of independent directors in risk oversight and governance.

The regulators’ focus will continue to be ensuring that all firms maintain adequate financial resources, robust funding and contingency plans. The last nine months have highlighted how crucial it is for firms to look closely at the vulnerabilities inherent in their business models and test for extreme events. For instance, recent events have confirmed the importance of firms maintaining adequate liquidity; institutions would be expected to take a comprehensive view of all possible demands on liquidity that could arise from various sources, on balance sheet or off, and develop plans to meet those demands, even in times of stress.

The primary focus, as per the regulators’ view, with regard to liquidity management should be on scenario planning and stress testing. The other aspect is market abuse, which remains a key risk to efficient, orderly and fair markets. Regulators are stepping up their efforts to both help prevent market abuse and to detect and act where abuse has taken place, by strengthening the capacity of their market monitoring department.

Q: What can we learn from the Islamic system?

A: Several factors have contributed to the growth of Islamic banking, but this phenomenal growth is not without concerns. Islamic banking fundamentally is based on few basic contracts, which can be used to create products as desired. The risk profiles of these products reflect the risk profiles of these basic contracts, and are dynamic and complex.

Islamic banking is fundamentally different from conventional banking since Islamic banking does not have interest rates as a variable in the risk equation, it is less risky, since the risks are more dynamic in Islamic banking and they are also generally higher. Islamic system may have the answer to the Risk management in Banks

Q: Important features of Risks in Islamic banking

A: Islamic banking rests on participation and thus is based on sharing profit and loss as partners, so the funding and return on a project is not only on the amount and duration of the borrowing but also on the purpose and performance. The stress is on equity financing rather than debt financing. This changes the canvas of the risks. In conventional finance the canvas of the risk is narrower and carries only a financial dimension. In the case of Islamic finance, the canvas of risk is bigger and covers many extra elements due to participation, purpose, and other restrictions attached to capability of payment.

The most common risks, Credit Risk, Market Risk, Operational Risk and Liquidity Risk, All these risks are basic principals in Islamic banking also. Credit Risk is a risk related to lending portfolio, which does not apply to Islamic banking in the same way as in conventional banking because Islamic banks do not borrow or lend. However, there are different reasons for Credit Risk in Islamic banking such having large amount of liquid for long time.

Market Risk which in conventional banking based on four factors – interest rates, indices, derivatives and commodities – is based on only three in Islamic banking as it excludes interest rates. The Operational Risk is present in both, since it relates to systems, processes, and people. In Islamic banking the additional dimension is Shariah Risk.  Liquidity Risk exists in Islamic banking in the same way as in conventional banking; however the reasons for the Liquidity Risk are different.

Q: Issues Related to Risk Management in Islamic banking?

A: The risks behave differently in Islamic banking as compared to conventional banking. A few points, which should be noted in relation to risks in Islamic banking, are:

  • Credit Risk is apparently higher in Islamic banking due to the non-availability of legal recourse for defaults, thus increasing the chances of defaults.
  • Also, Credit Risk is higher in Islamic banking due to limited access to credit derivatives
  • Market Risk is through commodities, indices and foreign exchange.
  • Operational Risk has another dimension of Shariah Risk, which can be treated differently to Operational Risk.
  • Liquidity Risk is perceivably higher due to non-availability of money markets, limited recourse to overnight borrowing and higher sensitivity of market and clients
  • Moreover, the additional factors such as deficient legal framework, standards, procedures, qualified manpower and qualified government support increases the risk exposures.

Thus risks in Islamic banking are far more complex than in conventional banking and need better understanding and analysis. Because they are more dynamic and are intermingled, they need special treatment. In order to understand the risks in Islamic banking, it is important to understand the structure of contracts in Islamic banking. An analysis on how contracts are structured and how risks exist in Islamic banking contracts is presented in the next section.


For months, economists have debated whether the US is headed towards a recession. The severe liquidity and credit crunch that stemmed from the sub-prime mortgage bust is now spreading to broader credit markets; US$100 barrels of oil are squeezing consumers and unemployment continues to climb. And with the housing market melting down, empty-pocketed Americans can no longer use their homes as ATMs to fund their shopping sprees. It is time to face the truth – the US economy is no longer merely battling a touch of the flu; it’s now in the early stages of a painful and persistent bout of pneumonia.

Countries are watching anxiously and hoping that they don’t experience the same symptoms. In recent years, the global economy has been unbalanced, with Americans spending more than they earn and the country running massive external deficits. When the sub-prime mortgage crisis first hit headlines last year, onlookers hoped that the rest of the world had enough growth momentum and domestic demand to protect itself from the US slowdown. But making up for the slowing US demand will be difficult, if not impossible.

It is important to note that free, flat and liquid markets hold the promise that has been discussed for years: optimal capital allocation, proper risk distribution, leveling of the playing field between large and small investors, and cheap and efficient capital formation. The issue is that several factors need to hold in order for this promise to be realised. Markets need to be free, flat and liquid, and the current crisis shows us that none of these things are really true. Hopefully, regulators and rule-makers everywhere will rise to the challenge.

Islamic banking is fundamentally different from conventional banking since Islamic banking does not have interest rates as a variable in the risk equation, it is less risky, since the risks are more dynamic in Islamic banking and they are also generally higher. Islamic system may have the answer to the Risk management in Banks. The most common risks in banks are the Credit Risk, Market Risk, Operational Risk and Liquidity Risk, All these risks are basic principals in Islamic banking also. Credit Risk is a risk related to lending portfolio, which does not apply to Islamic banking in the same way as in conventional banking because Islamic banks do not borrow or lend.

A basic question, therefore, arises: is the financial system broken, corrupt and in need of reform, or is the system sound, yet subject to external pressures, notably heavy monetary stimulation, with which it could not easily cope? On that diagnosis rests the future of our highly liberalized financial markets.