Islamic Financial System capable of minimising the severity and frequency of financial crises 

Thus we can see that the Islamic financial system is capable of minimising the severity and frequency of financial crises by getting rid of the major weaknesses 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 buyer wishes to take delivery. It also requires the creditor to bear the risk of 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 to them at affordable terms.

Reform of the Conventional Financial System 

Since the current architecture of the conventional financial system has existed for a long time, it may perhaps be too much to expect the international community to undertake a radical structural reform of the kind that the Islamic financial system envisages. However, the adoption of some of the elements of the Islamic system, which are also a part of the western heritage, is indispensable for ensuring the health and stability of the global financial system.

These are:

  • The proportion of equity in total financing needs to be increased and that of debt reduced.
  • Credit needs to be confined primarily to transactions that are related to the real sector so as to ensure that credit expansion moves more or less in step with the growth of the real economy and does not promote destabilising speculation and gambling.
  • Leverage needs to be controlled to ensure that credit does not exceed beyond the ability of the borrower to repay.
  • If the debt instruments, and in particular CDOs, are to be sold, then there should be full transparency about their quality so that the purchaser knows exactly what he is getting into. It would also be desirable to have the right of recourse for the ultimate purchaser of the CDOs so as to ensure that the lender has incentive to underwrite the debt carefully.
  • While there may be no harm in the use of CDOs to provide protection to the lender against default, it needs to be ensured that the swaps do not be come instruments for wagering. Their protective role should be confined to the original lender only and should not cover the other purchasers of swaps who wish to wager on the debtor’s default. For this purpose the derivatives market needs to be properly regulated to remove the element of gambling in it.
  • All financial institutions, and not just the commercial banks, need to be properly regulated and supervised so that they remain healthy and do not become a source of systemic risk.
  • Some arrangement needs to be made to make credit available to subprime borrowers at affordable terms to enable them to buy a home and to establish their own microenterprises. This will help save the financial system from crises resulting from widespread defaults by such borrowers.