Eurozone Predicament – Could Shariah Based Finance Avert the Crisis?

The Eurozone crisis is caused by fractional reserve banking and interest based lending and borrowing. 

A very strong statement/accusation but I will stand by it and I am sure I’m not the only one with that view. In fact, any financial or economic crisis will have roots in the fiat monetary system and lending with interest.

The beginning of the 21^st century saw low interest rates and easy credit fuelling a borrowing binge. This spree caused prices of assets, real estate in particular, to soar. Rising prices ‘invited’ a new group of investors into the market – the speculators, and their presence made things even worse. Banks too made things worse by lending to people who were not really credit worthy or lending to people amounts beyond their ability to repay.

Similarly, in the Eurozone, countries which are not creditworthy were allowed to borrow beyond their means, often hiding behind the credit strength of stronger countries;, in this case, Germany. These governments took advantage of the opportunity and cashed in on the cheap funding to finance everything from infrastructure to social benefits.

Everyone seemed to forget that what goes up must come down; the economy is no exception.

In 2008, everything collapsed. The US housing bubble burst and the whole world followed suit. House prices crashed, banks went bust, stock markets crashed, pension funds lost money, unemployment rose and everything fell apart.

Now everyone is poorer.

Let’s try to imagine if things were done according to Shariah rules. Profit and loss sharing (PLS); a ban on speculative activities and prohibiting the creation and trading of ‘gharar’ and ‘maisir’ infested financial instruments would almost certainly prevent the bubble from appearing in the first place. If the bubble doesn’t exist, it cannot burst.

Imagine if businesses carried out investments on a PLS basis where returns on investment (i.e. cost of funds) matches the actual returns of the investment and not burdened by movements in the rate of interest. The problem with interest based bank lending is that it does not care how much the business is making (or losing); all it wants is their money back plus interest. PLS on the other hand is directly linked to demand and supply and the real economy; when times are good, partners have more to share but when times are bad all partners share the smaller pie (or absorbs the losses). It all boils down to the intention of the investor (lender, in conventional terms); adopting PLS means riding the waves of the economy, insisting on interest based lending could mean not getting anything if the economy crashes.

Imagine if properties are acquired on a (pure) diminishing partnership basis. The buyer (borrower, in conventional terms) and financier jointly purchase a property which the buyer rents at the market rental rate. Being a joint owner, part of the rental is attributable to the buyer him/herself which is then used to purchase equity in the property from the financier. If times are bad, the buyer can choose to only pay the portion of the rental owed to the financier and if times are good, he/she can choose to buy more equity in the property. The rental is market determined and not influenced by movements in interest rates.

Investment bankers are smart people. They are so smart they come up with all kinds of solutions to earn themselves a commission and bonus. However, some of these solutions may only be good for the banks and not for the customers. In most of the solutions, the element of gharar and maisir are clearly present. To make matters worse, some of the instruments can be used to speculate and gamble. These are the recipes for disaster and are exactly what mortgage-backed securities (MBS) and collateralized debt obligations (CDO) are.   The U.S. Senate's Levin–Coburn Report asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." Shariah based finance would not have allowed such instruments to flourish (although I personally know of some bankers who wanted to create a “Shariah compliant” CDO!).

Therefore, I conclude that the Eurozone crisis (and the global financial meltdown of 2008) was created by;

1. Fiat money;
2. Interest based lending;
3. Unjust and unethical business practices (lending to those who can’t afford, selling potentially worthless credit notes etc.)
4. Gharar; and
5. Masir.