1.1 DEFINITION OF “FINANCIAL CRISIS”
Goldsmith has succinctly defined the term ‘financial crisis’ as a “sharp, brief, ultra-cyclical deterioration of all or most of a group of financial indicators”, such as short-term interest rates, asset prices, corporate insolvencies and the meltdown of financial institutions. A ‘financial crisis’ leads to catastrophic turmoil in financial markets that puts constraints on the flow of credit to families and businesses and which in result adversely affects the “real economy of goods and services”. During a financial crisis, investors abruptly suffer significant losses to their investments and financial institutions significantly lose values of their products.
1.2 THE ROOT OF THE CRISIS
The conventional explanation of the crisis involves finding its roots in the property market bubble, principally, the US housing market and “subprime mortgages”, which were surprisingly popular in the period between 2002-2007. They were “lair loans”, also known as “no-doc”, “low-doc” or “stated income” loans. These loans required the borrowers to provide very little or no documentation to prove their incomes. Instead, financial institutions were readily providing those borrowers with loans merely based on their stated incomes. These loans were primarily designed for people who were not eligible for normal loan products, such as the self-employed or those with little or no credit history. Undoubtedly, coupled with low interest rate, lenders were incentivised to issue as many mortgages as possible. Consequently, during the US housing boom of 2006-07, these loans accounted for 40 per cent of newly issued mortgages.
1.3 RESIDENTIAL MORTGAGE-BACKED SECURITY (RMBS) AND COLLATERALISED DEBT OBLIGATIONS (CDOs) AND CREDIT DEFAULT SWAP (CDS)
Two major financial instruments that paved the way for subprime mortgages to enter into global financial markets were residential mortgage-backed securities (RMBSs) and collateralised debt obligations (CDOs).
Most residential mortgages in the period of housing boom were bundled and packaged into pools which were later sold to special purpose vehicles (SPVs) for the purpose of securitisation. These were known as “residential mortgage-backed securities (RMBSs)”. The SPVs purchased these securities and sold them to investors as “tranched bonds” which were backed by the cashflows of mortgage pools.
The RMBSs were divided into different slices (or tranches), which were known as collateralised debt obligations or CDOs. They ranged from the most senior tranches, which received AAA rating from at least two credit-rating agencies, to subordinate tranches – rated as AA, A and BBB – the lowest and below which there was a very low level of unrated “equity”. The senior tranches of RMBSs were liquid and frequently traded up until the financial crisis, even though during that period they were exclusively backed by subprime mortgage pools. The senior tranches had prioritised claim on the cash flows and therefore were chosen by “conservative investors” such as insurance companies and pension funds.
The whole purpose of bundling up several mortgage loans and their cash flows was to provide securitisation and distribute the risks of the loans widely. However, in years leading up to the financial crisis, over half of the CDOs were exposed to subprime mortgages. Consequently, the securitisation process failed catastrophically and hence this type of bonds was dubbed as “economic catastrophe bonds”.
There is a particular financial product that gave the lenders an illusion of insurance on their debt default which is known as “credit default swap” or CDS. This product allows the lender to shift and transfer the risk of credit default to another entity. The buyer of the swap is required to pay a percentage of the face value of the bond or other credit obligation as if paying a regular insurance premium. In return, the seller is obliged to reimburse the difference between the face value of the bond and its market value, should the debt default. The CDS was considered to be the first cost-efficient way to short sell CDOs, although it was later called a “ticking time bomb”.
1.4 HOW THE CRISIS UNFOLDED
The many different mechanisms to make mortgage finance widely available led to an unprecedented surge in housing prices which doubled in the five years ending June 2006. Then the prices started to go down and many borrowers began to default on their mortgages. Consequently, companies that had heavily invested in the housing market began to declare huge losses. In 2008, the US government was forced to take over two financial federal giants, Fannie Mae and Freddie Mac, as they had invested several hundred billion dollars in sub-prime mortgage backed securities. Since then, financial giants one after another became on the verge of bankruptcy.
Meanwhile, corporations became uncertain about other companies’ proportion of exposure to subprime mortgage-backed securities. This led financial institutions to become unsure about which institution will be the next victim of the crash. Consequently, banks became reluctant to lend to each other and the inter-banking interest rate shot up to an unprecedented level. Both long term and short-term debt markets became dry. All of this had an immediate “knock-on effect” on the supply of credit to the financial industry and the world economy became plagued with its biggest recession since the Great Depression of 1930.
The effect of the global economic meltdown was felt on both sides of the Atlantic as well as in other developed countries. Non-US banks had also invested in the subprime market. Their governments had to also come to their rescue and bail them out.
1.5 WHO IS TO BLAME AND WHY
There is no doubt that the crisis was not caused by a single player. Various players have contributed to it. The complex financial instruments developed by the then financial institutions led to various complications, such as lax risk management practices, under-pricing of risk, leverage/under capitalization, risk transfer, creation of new risk, difficulty in assessing risk, break-down of the relationship between lenders and borrowers, excessive risk taking at the originator level, and no control over underlying assets.
The principal players who should take the responsibility for causing the economic crash have been identified as, firstly, the US Federal Reserve for its policy of easy money; secondly, the US Government for encouraging banks to expand subprime mortgages and its failure to adequately regulate the circulation of those toxic loans; thirdly, the rating-agencies for providing AAA rating to those toxic mortgages; fourthly, the bankers who promoted and resold subprime mortgages; and, finally, the borrowers themselves, despite being aware of their inability to make the mortgage payments.
However, rather than putting the blame on specific actors for their specific actions, it is imperative to look at the conventional market as a whole. It does not seem implausible to suggest that there were four major factors, which still continue to exist, that have significantly contributed to the recent crisis. Unless these problems are resolved, there is no guarantee that another crisis will not unfold again.
These factors are as follows. First, diverting money from its objective of being a medium of exchange to using it as an object of trade and essentially treating it like a commodity has enabled individuals and corporations to make money out of money. This greed-oriented activity has turned the whole conventional economy into a “balloon of debts over debts”. Second, a proliferation of derivatives has also significantly led to the worsening of the crisis. Thus, a former derivatives trader, Professor Frank Partnoy, has described derivatives as the root cause of the crisis. Third, sale of debts via mechanisms such as MBSs (Mortgage-backed securities) and CDOs etc has undoubtedly led to the birth of the crisis. Finally, short sales in stocks and commodities have exacerbated the crisis by making speculation disastrous and significantly disrupting the smooth operation of commercial activities.
As all of the above activities are forbidden under Islamic financial law, it is, therefore, not surprising that when the conventional financial institutions were suffering from major setbacks, Islamic financial institutions (IFIs) remained star performers. Although the tightening of liquidity and the fall in commodity and oil prices had an impact on IFIs, however, the fall in IFI’s market value in comparison to Standard and Poor’s 500 (S&P 500) were 10 per cent less.
Taking a holistic approach to the various causes of the crisis outlined above reveals two phenomena that permeated throughout, i.e. risk-shifting or risk-transferring and making profits without having any real asset. Moreover, it is an undeniable fact that conventional financial institutions have always tried to adopt methods that would shield themselves from the risk of loss and transfer that risk to their clients and accountholders. Thus, the recent crisis has led certain people who were disillusioned by this fact to search for alternative ways of finance.
Islamic finance has characteristics and features that ensure sharing of risks and rewards, in addition to being backed by real assets. Therefore, it will not be unjustified or too bold to contend that if Islamic finance is given sufficient opportunities to thrive, the world may well be saved from another financial crisis.
*Prepared by Abdullah Fahim (as part of the LLM Dissertation)
Alimiyyah, (Jamia Islamia Birmingham), LLB (University of Birmingham), LLM in Corporate Law (University College London), Imam & Khateeb (Masjid Taqwa, Birmingham, United Kingdom)
 RW Goldsmith, ‘Comment on Hyman P. Minsky, “The financial instability hypothesis” (1982) In Financial crises, theory, history and policy, ed. CP Kindleberger and JP. Laffargue. Cambridge University Press 42.
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 Richard A Brealey, Stewart C Myers and Franklin Allen, Principles of Corporate Finance (McGraw Hill 2017) 374.
 Alrifai (n 4)
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 Ronald J Gilson and Reinier Kraakman, ‘Market Efficiency after the Financial Crisis: It’s Still a Matter of Information Costs’ (2014) 100 Virginia Law Review 313, 333.
 Brealey, Myers and Allen (n 6) 623.
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 Joshua D Coval, Jakub W Jurek and Eric Stafford, ‘Economic Catastrophe Bonds’ (2009) 3 American Economic Review 628, 228.
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 ibid, 375.
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 Brealey, Myers and Allen (n 6) 375.
 Kayed and Hassan (n 2) 554.
 Brealey, Myers and Allen (n 6) 375
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 Muhammad Taqi Usmani, Causes and Remedies of the Recent Financial Crisis from an Islamic Perspective (Turath Publishing 2014) 41.
 ibid, 43.
 Vince LaPietra, ‘Wall Street bilks Main Street’ (2009) The Advocate USD Law 19, 22.
 Usmani, Causes and Remedies (n 26) 43.
 Baroness Warsi, ‘The Future of Islamic Finance in a Global Economy’ Foreign and Commonwealth Office (7 June 2013) <https://www.gov.uk/government/speeches/the-future-of-islamic-finance-in-a-global-economy> accessed 26 July 2018.
 Elaine Housby, Islamic and Ethical Finance in the United Kingdom (Edinburgh University Press 2013) 5.