Transparency, Transparency and Transparency Can we learn from the Islamic system and avoid credit crunch

What is the underlying problem?
In short,
• Financial institutions are holding a large volume of securities of falling and doubtful value, and which imply large losses for them.
• There are further losses from having insured asset values through credit default swaps and other derivative instruments
• Trading is not-so-transparent over-the-counter markets
• There are also massive speculation
Even if a bank knows that its own balance sheet is intact, it cannot be sure that its counterparty is in the clear (or in some way exposed to a third party with problems). In this hot environment of distrust and capital shortage, standard macroeconomic policy instruments are blunted and a strategy that relies mainly on liquidity provision by central banks while essential will not suffice.
What more must be done?
First, as some governments have concluded, the fragility of public confidence has now reached a point that some explicit public guarantee of financial system liabilities is unavoidable. This means not only retail bank deposits but probably also inter-bank and money market deposits, so that activity may restart in these key markets. Of course, such a step would need to be temporary, and include safeguards against the risk-taking that comes with such guarantees, such as heightened supervision and limits on deposit rates offered.
Second, the state needs to take out troubled assets and force the recognition of losses. Asset purchases must be done transparently at fair market value. The reasons are not moralistic, though there is such an imperative, but pragmatic. If prices are inflated, then banks will inevitably have to make good the losses that fall on the taxpayer – in the US case, they would have to issue shares to the government, thus diluting other shareholders. But losses deferred to the future prevent new private capital from flowing into banks. If such capital is to be attracted, it is better to pay a lower price now, recognise losses, and give banks an upside if the implied loss turns out to be smaller.
Third, private money is scarce in today’s environment, and loss recognition alone may not be sufficient to induce fresh injection of private capital. One strategy that has worked in past crises is to match new private capital subscriptions with state capital, which imposes a market test for the use of public funds.
Fourth, a high degree of international co-operation has become urgent. Unfortunately, recent measures have been taken with national interests in mind, and not enough has been done to prevent unintended “beggar-thy-neighbors” consequences that only exacerbate problems for others. If one country credibly offers a blanket guarantee (say, Ireland), investors may move out of countries that do not (say, the UK). If asset purchase schemes are very different, institutions will go to the most generous buyer. Financial institutions now span many countries and credible rescue plans must be consistent across many jurisdictions. More fundamentally, and looking beyond the immediate crisis, it is clear that the international community needs to work to close the many loopholes in the global regulatory architecture that allowed financial institutions to minimise capital even as they concentrated risk.
Fifth, it is now becoming clear that emerging market countries are likely to be hit hard by financial turmoil, despite stronger fundamentals and policy frameworks. Lest a sudden stop of capital bring their progress to a sudden halt or, worse, bring down their financial systems, some form of large and rapid financing should be kept ready. There should be no doubt that the Fund is prepared to deploy its emergency procedures and flexibility in rapidly approving high access financial programmes, based on streamlined conditionality that focuses on crisis response priorities.
As bleak as the situation now looks, I am convinced that there is a way out of our shared predicament. The trick is to get policymakers around the world to pull in the same direction.
Public assistance must protect the taxpayer
Government intervention in business usually has unintended consequences. The results of regulation are often disappointing but the scope and scale of regulation nevertheless expand. Regulation works best when it is narrowly focused on defined objectives. We now regulate airline safety, not the airline business, since prudential supervision of the industry created elaborate panoply of controls that came to serve only the interests of established operators, and often not even them.
When governments intervene in the banking crisis, their objectives should be equally narrowly focused and on what matters to the public, not what matters to the banks. We have no reason to care whether the inter-bank market is functioning well, nor should it be a policy objective to revive the issue of mortgage-backed securities. The inter-bank market was many times larger than needed to secure its economic function, and the residential mortgage-backed securities market should probably never have come into existence: banks will be sounder and their lending decisions wiser if the loans they underwrite are on their own balance sheets.
However it feels on Wall Street and Canary Wharf, this is not the worst economic crisis since the Great Depression. Today’s problems are not only created by financial markets but largely confined to them. Compared with the wreckage of Europe’s physical infrastructure in the 1940s, or the threats to living standards and social order from oil shortages and accelerating inflation in the 1970s, these perturbations are minor. The greatest threat to the non-financial sector is the effect on business and consumer confidence that comes from apocalyptic headlines.
The travails of the banking system matter less to the public than to bankers, but they do matter. The payments system is an essential utility; companies and individuals must be able to receive cash and pay invoices. The most feared event is a recurrence of March 1933 with customers unable to use their cheque-book and locked out of their banks. But the central banks of the world have now flooded the system with liquidity and if your bank cannot pay your bills, it is because it is short of assets, not because it is short of cash.
The next public objective is to reassure those who are rightly uninterested in studying the impenetrable accounts of banks to make sure their savings are safe. The deposit protection measures that are in place – implicit or explicit – are more or less enough to do this. Despite panicky headlines, the volume of retail deposits that have been withdrawn from big banks are a small percentage of the total.
The largest problem for the real economy, beyond the crisis of confidence, is the difficulty, though not impossibility, that good borrowers find in obtaining credit. This is not because banks do not have sufficient cash. It is partly because they are short of capital. But even better capitalised banks are reluctant lenders. The main cause of the credit shortage is an overdue fit of prudence.
Another lesson from experience of government intervention is that temporary public assistance to get companies over a bad patch is rarely either temporary or effective. When government funding comes in, other funders move out. Things are almost always worse than management admits, or perhaps knows. When the share price or the credit default swap rate has told a different story from the one senior executive tells, the market has generally been a more reliable predictor than the trading statement.
Even large-scale recapitalization of banks will not ease the pressure on lending much, but it will do so a bit and is certainly the measure most likely to have an effect. All other measures take us down a road whose destination is not clear but certainly distant. Since there are fine ongoing retail and corporate businesses in the banking sector, the idea of separating the good banks from the bad banks makes sense. The scale of necessary recapitalisation may imply a public contribution. But Mr. Paulson got it the wrong way round. If taxpayers are called on for cash, they should enjoy the major equity stake in the good bank and leave the value of bad banks behind with the shareholders.
Islamic system may have the answer to the Risk management in Banks
Important features of risks in Islamic banking
Islamic banking rests on participation and thus is based on sharing profit and loss as partners, so the funding and return on a project is not only on the amount and duration of the borrowing but also on the purpose and performance. The stress is on equity financing rather than debt financing. This changes the canvas of the risks. In conventional finance the canvas of the risk is narrower and carries only a financial dimension. In the case of Islamic finance, the canvas of risk is bigger and covers many extra elements due to participation, purpose, and other restrictions attached to capability of payment.

The most common risks, Credit Risk (CR), Market Risk (MR), Operational Risk (OpRisk) and Liquidity Risk (LR) . All these risks are basic principals in Islamic banking also .

Credit Risk, conventionally a risk related to lending portfolio, exists in Islamic banking in the same way as in conventional banking. It refers to the non-performance of the counterparty as per the agreed terms. However, the reasons for the origin of the Credit Risk are different in Islamic banking.

Market Risk which in conventional banking based on four factors – interest rates, indices, derivatives and commodities – is based on only three in Islamic banking as it excludes interest rates.

The Operational Risk is present in both, since it relates to systems, processes, and people. In Islamic banking the additional dimension is Shariah Risk.

Liquidity Risk exists in Islamic banking in the same way as in conventional banking; however the reasons for the Liquidity Risk are different.
Issues Related to Risk Management in Islamic banking
The risks behave differently in Islamic banking as compared to conventional banking. A few points, which should be noted in relation to risks in Islamic banking, are:
• Credit Risk is apparently higher in Islamic banking due to the non-availability of legal recourse for defaults, thus increasing the chances of defaults.
• Also, Credit Risk is higher in Islamic banking due to limited access to credit derivatives
• Market Risk is through commodities, indices and foreign exchange.
• Operational Risk has another dimension of Shariah Risk, which can be treated differently to Operational Risk.
• Liquidity Risk is perceivably higher due to non-availability of money markets, limited recourse to overnight borrowing and higher sensitivity of market and clients
• Moreover, the additional factors such as deficient legal framework, standards, procedures, qualified manpower and qualified government support increases the risk exposures.
Thus risks in Islamic banking are far more complex than in conventional banking and need better understanding and analysis. Because they are more dynamic and are intermingled, they need special treatment. In order to understand the risks in Islamic banking, it is important to understand the structure of contracts in Islamic banking. An analysis on how contracts are structured and how risks exist in Islamic banking contracts is presented in the next section.

Islamic banking Contracts and Risk Management
The trade policies in the countries practicing Islamic banking consisted of non-recognition of interest in business dealings and non-participation in prohibited activities (Usury). Hence Islamic banking contracts were structured with the objective of equitable distribution in mind, avoiding exploitation of the poor and non-recognition of interest as a factor. Trade practices were very similar all over the world as far as basic trade conditions are concerned.

There is also a stress on clarity of the terms of contract to avoid speculation, all goods and services which are not owned by the contracting party cannot be a part of the contract.

Can we learn from the Islamic system?
Several factors have contributed to the growth of Islamic banking, but this phenomenal growth is not without concerns. Islamic banking fundamentally is based on few basic contracts, which can be used to create products as desired. The risk profiles of these products reflect the risk profiles of these basic contracts, and are dynamic and complex.

Islamic banking is fundamentally different from conventional banking and it is suggested that since Islamic banking does not have interest rates as a variable in the risk equation, it is less risky, since the risks are more dynamic in Islamic banking and they are also generally higher.

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