Lessons Islamic finance can learn from current crisis

By Habib Toumi, Bureau Chief
Published: November 25, 2008, 23:15

Manama: The Islamic financial industry must remember the importance of risk diversification, good liquidity management, and sound corporate governance if it is to continue to enjoy a framework for stability against the background of global financial turmoil, the governor of Bahrain Central Bank has warned.

“Although the Islamic financial services industry has been insulated to-date from the effects of the global financial crisis, there are many lessons that Sharia-compliant institutions can learn,” Rasheed Al Maraj said at the opening session of the 2008 World Islamic Banking Conference.

“Until very recently, many commentators and analysts believed that the economies of the GCC were an oasis of calm in the ongoing global financial turmoil,” said Al Maraj.

However, since the collapse of Lehman Brothers in mid-September, it has become clear that no part of the world can be immune to the present crisis. We have seen a vastly changed financial landscape, and there is little doubt that the availability of funds and the costs of borrowing are being affected in all parts of the world,” he added.

In recent months, as the global financial crisis has deepened, many commentators have pointed out that Islamic financial institutions have escaped relatively unscathed from the severe downturn.

Post mortem

However, the fact that Sharia-compliant institutions have avoided significant losses resulting from the global financial crisis does not mean that there are no lessons they can learn from the fallout.

“Many conventional banks believe that lending to sub-prime borrowers represented a viable new business line in which there would be an appropriate risk reward trade-off,” Al Maraj said.

“The first movers in this market might have found a profitable niche. But once many banks tried to become players in the same market, credit standards became lax and loans were made to borrowers who had little chance of repaying them. Although some banks recognised the risks, they did not do enough to mitigate them at a sufficiently early stage.”

According to the governor, the sub-prime episode provides an illustration of the herding instinct which has been a recurrent feature of financial markets since their very beginning.

Some banks discover a profit opportunity, other banks follow, and before long the oversupply of credit has led to losses.

“Newer entrants to the industry have merely tended to copy the strategies they see being successfully pursued by their more established rivals,” he said. “As a result, the industry’s assets have become heavily weighted towards the property sector. Events in other parts of the world have recently reminded us that this sector can and does experience significant cycles of activity.

“The industry needs to develop a greater diversity of business models, more diverse and stable income sources, and more robust risk management and stress testing techniques.,” he added.