Global financial crisis: How it all began Otherwise referred to as 'credit crunch', 'credit crisis', 'sub-prime mess' et cetera, the roots of the global financial crisis can be traced back to the United States sub-prime (riskiest category of consumer loans) debacle, which occurred in 2007-08. First, there was an economic boom, especially in the real estate sector whereby a large number of long term substandard loans were granted by banks, resulting in excessive credit expansion. These loans were financed hugely by short-term borrowings.Second, poor corporate governance and lack of transparency among major financial conglomerates had intensified the financial meltdown. Risks management of major banks broke down, while compensation structures of financial executives were merely based on short-term performances. Third, little global coordination between national regulators also prolonged the financial turmoil. This is probably due to rising protectionism policies of several countries in a bid to uphold their citizens' welfare first. Lastly, accounting policies delayed the recognition of the losses and almost successfully obscured the size and magnitude of losses incurred.The results were incredibly staggering between mid 2007 and end of 2008, Americans lost more than a quarter of their net worth. Housing prices had dropped by 20 per cent from their 2006 peak, with future markets signaling a 30-35 per cent potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 per cent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Altogether, these losses total a staggering $8.3 trillion.The crisis then began to affect the financial sector in February 2007, when HSBC, the world's largest (2008) bank wrote down its holdings of subprime-related Mortgage Backed Securities (MBS) $10.5 billion, the first major sub-prime related loss to be reported. In 2007 only, at least 100 mortgage companies either shut down, suspended operations or were sold.Going by all relevant literature, the sub-prime crisis actually became global, largely because of financial instruments such as securities where banks pool their various loans into sellable assets, thus off-loading risky loans onto others. The security buyer gets regular payments from all those underlying loans which were mostly mortgages; the banker off-loads the risk. Several individuals, companies and even countries unwittingly became holders of these risky securities.To put it all in general perspective, the value of world's companies wiped out was estimated to be a whooping $14.5 trillion as at 2009, dwarfing the Gross Domestic product (GDP) of the world's largest economy (USA) at $13.8 trillion, during the same period.Another lesson learnt during this financial debacle was that contrary to opinions in some economic quarters, each domestic financial sector is to some extent, correlated with the rest of the world. As such, policy actions in a financial system positively or adversely affected the entire global financial landscape.Below is an overview of the chronicle of events between 2007 and 2010Islamic banking is based on Islamic law (Shariah). It follows the Shariah called fiqh muamalat (Islamic rules on transactions). The rules and practices of fiqh muamalat came from the Quran and the Sunnah, and other secondary sources of Islamic law such as opinions collectively agreed among Shariah scholars' (ijma '), analogy (qiyas) and personal reasoning (ijtihad).The most common Shariah concepts in Islamic banking are as follows:Wadiah (Safekeeping)Wadiah means custody or safekeeping. In a Wadiah arrangement, you will deposit cash or other assets in a bank for safekeeping. The bank guarantees the safety of the items kept by it. This concept, which is normally used in deposit-taking activities, custodial services and safe deposit boxes, works as follows: You place money in a bank and the bank guarantees to return the money to you.You are allowed to withdraw the money any time. Bank may charge you a fee for looking after your money and may pay hibah (gift) to you if it deems fit.Hibah (Gift)This refers to a payment made willingly in return for a benefit received. An example relate to savings operated under Wadiah, banks will normally pay their Wadiah depositors hibah although the accountholders only intend to put their savings in the banks for safekeeping.Mudharabah (Profit sharing)Mudharabah is a profit sharing arrangement between two parties, that is, an investor and the entrepreneur. The investor will supply the entrepreneur with funds for his business venture and gets a return on the funds he puts into the business based on a profit sharing ratio that has been agreed earlier. The principle of Mudharabah can be applied to Islamic banking operations in two ways: between a bank (as the entrepreneur) and the capital provider, and between a bank (as capital provider) and the entrepreneur. Losses suffered shall be borne by the capital provider.-You supply funds to the bank after agreeing on the terms of the Mudharabah arrangement.-Bank invests funds in assets or in projects.-Business may make profit or incur loss.-Profit is shared between you and your bank based on agreed ratio.-Any loss will be borne by you. This will reduce the value of the assets/ investments and hence, the amount of funds you have supplied to the bank.Bai' Bithaman Ajil- BBA (Deferred payment sale)This refers to the sale of goods where the buyer pays the seller after the sale together with an agreed profit margin, either in one lump sum or by installment.- You pick an asset you would like to buy.- You then ask the bank for BBA and promise to buy the asset from the bank through a resale at a mark-up price.- Bank buys the asset from the owner on cash basis.- Ownership of the goods passes to the bank.- Bank sells the goods, passes ownership to you at the mark-up price.-You pay the bank the mark-up price in installments over a period of timeMurabahah (Cost plus)As in BBA, a Murabahah transaction involves the sale of goods at a price which includes a profit margin agreed by both parties. However, in Murabahah, the seller must let the buyer know the actual cost of the asset and the profit margin at the time of the sale agreement.Musyarakah (Joint venture)In the context of business and trade, Musyarakah refers to a partnership or a joint business venture to make profit. Profits made will be shared by the partners based on an agreed ratio which may not be in the same proportion as the amount of investment made by the partners. However, losses incurred will be shared based on the ratio of funds invested by each partner.Ijarah Thununa Bai' (Hire purchase)Ijarah Thumma Bai' is normally used in financing consumer goods, especially motor vehicles. There are two separate contracts involved:Ijarah contract (leasing/renting) and Bai contract (purchase). The contracts are made one after the other. You pick a car you would like to have. You ask the bank for Ijarah of the car, pay the deposit for the car and promise to lease the car from the bank after the bank has bought the car.-Bank pays the seller for the car.-Seller passes ownership of the car to the bank.-Bank leases the car to you.-You pay Ijarah rentals over a period.-At end of the leasing period, the bank sells the car to you at the agreed sale price.Mrs Bello is of the ING Investment Management, Atlanta Georgia, United States of America.(To be continued)
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