The recent crisis: lessons from Islamic finance
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Two alternative explanations of the financial crisis have emerged. One relies on deviations from the efficient capital market hypothesis - emergence of bubbles and informational problems - to explain the causes of the crisis. An alternative explanation views financial crises as internally generated instability episodes that inevitably arise from the basic debt-credit interest rate relations. Based on a number of assumptions, theory has demonstrated the inherent stability of Islamic financial system. However, in practice the assumptions of theory are not met and, therefore, such stability cannot be taken for granted. For one thing, theory, inter alia, assumes a 100 percent reserve banking system. Moreover, Islam provides an institutional scaffolding (behavioral rules) as support for its economic and financial systems. This paper contends that the recent global financial crisis holds valuable lessons for the operation of existing Islamic finance. One such lesson is that in the absence of the institutional framework appropriate for its operation. Islamic finance requires a regulatory supervisory framework much stronger than exists in the dominant system. In particular, such a framework has to be unified, uniform, and multinational in its design and implementation. Such a regulatory-supervisory system is far more important to the Islamic Financial system in its present stage of evolution than in the dominant system because the reputational risks of failure of a few Islamic finance institutions anywhere can pose far greater systemic risk and reputational damage than similar failure in the dominant system.
Mirakhor, A. & Krichene, N. (2009). The recent crisis: lessons from Islamic finance. Journal of Islamic Economics, Banking and Finance, 5 (1), pp. 9-58.
Islamic Bank Training and Research Academy (IBTRA)