Islamic Finance and the New Financial System. Alrifai Tariq
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since we had to follow Islamic finance guidelines in all of our investments, the leverage we secured from the United States had to comply with Shariah guidelines. This attracted both curiosity and interest on the part of U.S. lenders; some of them liked the concept and were interested in working with us, while others felt it was too strange and foreign and had no interest in our enterprise. I'll explain more about the differences between Islamic finance and conventional finance in Part II of this book. Needless to say, without equity from Bahrain, and without leverage from U.S. firms, we could not invest.
By 2008, we had built a team of eight people and invested in five companies worth more than $300 million, in both equity and leverage financing. For the most part, our parent bank was pleased with our achievements but, at the same time, was under increasing pressure from shareholders to use more of the bank's capital for investments in the Middle East. We were asked to start reducing our reliance on equity from Bahrain and consider sourcing both equity and leverage financing from the United States. This made the events of September 15, 2008, particularly worrisome for us.
The news on CNBC was grim. The Dow Jones Industrial Average had already lost more than 700 points in early trading, and all other markets were sinking fast. The news driving this was the announcement that Lehman Brothers, one of Wall Street's oldest and largest banks, had filed for bankruptcy protection. This seemed to come out of nowhere. When I went home the previous Friday evening, all was well. By Monday morning, all of a sudden Lehman was going out of business. How could this be happening?
I remembered that in March 2008, Bear Stearns, another one of Wall Street's oldest and largest firms, collapsed and was forced to merge with JPMorgan in a Federal Reserve brokerage bailout deal. Back then, the bank's failure didn't cause such ripples through the market. What had changed now?
In the days following September 15, global credit markets froze and major financial institutions around the world were on the brink of failure. The United States, along with regulators and governments from around the world, agreed to pump trillions of dollars into the global financial industry to save it from the worst financial crisis in recent history.
The global financial crisis of 2008 shocked everyone. Much of the world was caught off guard because of its severity and reach. Now, nearly six years since the crisis began, the world is still reeling from its effects. Global growth has not returned to the level it had reached before the crisis, developed countries are saddled with debt, and unemployment rates have yet to recover to what they were at precrisis levels. Much of Europe, as an example, has been seesawing in and out of recession, just as Japan has for the past two decades.
Never in our lifetime have we experienced such a severe recession. Governments and central bankers around the world have not been able to cure the economy of its ills, even after unprecedented government bailouts and central bank money printing.
The events of 2008 caught me and my colleagues off guard as well. We had worked in finance and banking for our entire careers, yet we failed to see this crisis coming. It hit all of us very hard – especially me. In 2006, I got caught up in the housing market. The pressure was on to buy a house before prices rose to an unaffordable level. At that time, the thought of paying rent was crazy because home prices were rising steadily, so owning a home became the best tool for building wealth. The housing market in Chicago was one of the hottest markets in the country. Quality single-family homes in Chicago were hard to find and not cheap. I decided to bite the bullet and “invest” in a new development. To avoid a big mortgage, I decided to make a large down payment (25 percent), since I wanted to build equity fast. I went with a conventional jumbo mortgage. To most financial experts, this was considered to be an excellent and conservative financial move. By the summer of 2009, I had lost my job at the firm and my 25 percent equity in the house went to zero.
So, yes, I was hit especially hard by the financial crisis. The bulk of my savings that was my home equity simply disappeared. The shock of losing my savings as well as my job led me to start asking myself questions, beginning with: How could I let this happen to me and my family? How could I not see this coming? Why didn't the experts in the field, along with all the economists and analysts, tell us about this? I spent the next five years reading, researching, and learning in order to figure out what had happened and how I could protect myself from future financial crises.
Much of what I learned I will share with you in this book. The book is divided into three parts. Part I talks about the financial system and financial crises. It also discusses the financial crisis of 2008 and the solutions that were applied. Part I ends with a discussion of the root causes of financial crises and why the next one will be worse than the last one. Part II is an introduction to Islamic finance. For those of you who are familiar with this industry, it will be nothing new. For those of you who are not familiar with Islamic finance, this will give you a good overview of its principles and practices. You will also see that some of the key principles of Islamic finance are based on sound financial and economic principles. We can all learn from this regardless of our differing faiths. This is not a religious book by any means; it's a book on financial crises and how to prevent them from happening again, for everyone's benefit. Part III outlines some practical solutions the finance industry can take from Islamic finance and apply to building a better system.
As we shall see, identifying the core problem is easy, but the solution is painful. Governments and central bankers do not have the will to take the necessary steps to fix the core of the problem, which is simply the ever-increasing mountain of debt in the world. The cure, therefore, is to reduce the level of debt, which then creates an entirely new set of problems and challenges.
We are now at the stage where the next financial crisis will put too much stress on our current system. As such, governments, economists, and central bankers will need to develop a new system to address the issues of the current one.
Islamic finance might seem like an odd place to look for ideas for a new global financial system, but, as we shall see, many of its key elements are based on sound economic principles. Global leaders may not know they are adopting Islamic financial principles when designing the new system, because they will be looking to build a system that will help protect us from the ills of the current one. Islamic finance has some of the answers to this problem.
Part I
Financial Crises and the Current Financial System
Chapter 1
A Brief History of Financial Systems and the Birth of Money
Most of us know very little about our financial system and its history. Even though I had worked in the banking and finance industry for close to two decades, I knew very little about the financial system's history until I started doing my research. I was surprised to learn that our current financial system is only about 43 years old. I knew that the world had been using paper currencies for hundreds of years and that, before this, coins were used, mainly gold and silver. However, the circumstances for the shift from coin to paper as well as the shift to fiat currency were all new to me.
What I came to realize was that our financial system moves in cycles much like an economy does. It goes through periods of growth and expansion and then decline. There have always been crises in financial systems. No financial system has ever been perfect and free of flaws. Crises can be sparked by many factors – wars, speculation (bubbles), runaway government borrowing and spending, and government mismanagement of the economy or its currency.
To understand where we are and where we are heading, we must first understand where we have been, beginning with the history of money and financial systems. Literally hundreds of books have been written on early currencies and financial systems. This topic alone deserves time to explain in detail. However, to keep focused on the topic of this book, I will attempt to summarize the evolution of currencies and financial systems in this chapter.
Early Financial Systems and Currencies
Financial systems existed long before gold and silver were used as a medium of exchange. One of the earliest forms of money was cattle and other animals, which were used as a medium of exchange and a store of value as early as 9000 BCE.1 Animals were used as payment under Roman law, whereby fines were paid in oxen and sheep.
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