I believe that banking institutions are more dangerous to our liberties than standing armies.
Attributed to Thomas Jefferson1
When I sat down to write this book, it had always been my intention to make the connection between the global credit crisis and the dominance of the ‘financial’ economy over the ‘real’ economy. In other words, creating financial instruments – the derivatives we read about earlier – that provided exposure to different types of investments without actually investing in those assets created an economy powered by pieces of paper. Like a game of musical chairs, when the music stopped and underlying assets were no longer performing to expectations, suddenly investors found themselves without a chair. It’s not surprising that many outside the industry see the financial economy as a giant Ponzi scheme.
I haven’t set out to describe in detail the events and causes of the financial crisis of late 2007 onwards, nor do I suggest that Islamic finance in its contemporary form would have prevented the crisis in the first place, or indeed be the definitive solution to recovery. There are many excellent narratives of the events that led to the collapse of major banking institutions and subsequent government interventions, and the reader may wish to develop his or her understanding of these events.2 These events provide a context for the challenges that faced the Islamic finance industry during this crisis, and the role that it may play in preventing future crises.
What are the origins of the credit crunch? To help us answer this question, I turn to an irreverent and anonymous cartoon that circulated the internet in 2008, entitled ‘The Subprime Primer’, and I paraphrase it below, though I regret being unable to unearth the author in order to credit him or her:
At Ace Mortgage Brokers (‘We Make Your Dreams Come True’), a customer walks in and declares his wish to buy a house.
‘But I haven’t saved any money for a downpayment and I don’t think I can afford the monthly payments’, he says. ‘Can you help me?’
The mortgage broker is bullish. ‘Sure, since the value of your house will always go up, we don’t need downpayments any more! And we can give you a really low interest rate for a few years and raise it later.’
‘Sounds good’, says the customer. ‘But there’s one thing: my employer might not verify my employment. Is that a problem?’
‘Not at all. Here, take a look at the “Liar’s Loan” and you can verify your own employment and income.’ The broker hands over a brochure with a smile and a wink.
The customer is delighted. ‘Wow, you’re willing to finance me?’
‘Well, we don’t actually lend you the money’, explains the broker. ‘That’s the bank’s problem. As long as they lend you money, we get commission.’
A few weeks later, at the First Bank of Bankland, Inc, (‘We Don’t Waste Your Time with Due Diligence’), the head of loans has a problem. The new mortgages file doesn’t look too hot and he’s worried about the credit risk on his books. ‘These crappy mortgage loans are really stinking up my office. I’ll sell them to the smart guys in New York and they can do their magic on them.’
Over in New York, at the Stearns Brothers Investment Bank of Wall Street (‘So Sharp, We Cut Ourselves’), the stinking mortgages are attracting flies.
‘Who’s gonna buy this crap, boss?’ asks one of the smart guys.
The boss is very smart. ‘We create a new security using these mortgages as collateral. Let’s call it a CDO, short for collateralized debt obligation. We sell the CDO to investors and promise to pay them back as mortgages are paid off.’
‘But crap is crap, isn’t it? I don’t get it’, says the junior investment banker.
‘Sure, individually, these loans stink’, explains the boss. ‘But if we pool them together, only some of them will go bad, thus spreading out the risk. Since housing prices always go up, we have very little to worry about. To categorize the risk, let’s cut up the loans into three pieces or tranches: the Good, the Not-So-Good, and the Ugly. If some mortgages fail, we’ll pay investors holding the Good tranche first. Then we’ll pay the Not-So-Good holders, then the Ugly.’
‘Oh, so you mean we’ll pay the highest interest rate to investors in the riskiest Ugly tranche, and the lowest rate to the least risky Good tranche.’
‘Yes, and I have an even cleverer idea’, continues the boss. ‘We buy bond insurance for the Good tranche. The rating agencies will give it a great rating, somewhere between A and AAA. The Not-So-Good will get rated B to BBB. We won’t bother rating the Ugly tranche.’
‘Boss, you’re a genius. You’ve created AAA and BBB securities out of a stinking pile of crap. So, who do we sell to?’
‘Well, the SEC [the US Securities and Exchange Commission] won’t let us sell this to orphans and widows’, says the boss, clearly frustrated, ‘so we’ll have to go to our sophisticated institutional clients. Insurance companies, banks, pension funds for small villages in the English countryside, school boards in Kansas. Anyone looking for a high-quality safe investment.’
‘Who’s gonna buy the Ugly piece, boss?’
‘We keep it for ourselves’, says the boss. ‘We’ll pay ourselves a handsome interest rate.’
‘This is great, boss. But even though the mortgages are collateral for an entirely new security, it’s still on our balance sheet, right?’
‘Don’t be stupid. The accountants will let us set up a shell company in the Cayman Islands to take ownership of the mortgages. We move the crap off our balance sheet onto theirs. It’s called a Special Purpose Vehicle or SPV.’
Over at the Office of the Czar of Accounting (‘The Finest Box Tickers in the Land’), an investor and concerned citizen is demanding that the Czar forces financial institutions to show greater transparency and openness in their financial reporting. But the Czar is in the middle of a fiendishly difficult sudoku puzzle and waves the concerned citizen away.
At the Crinkley-on-the-Wold Village Pension Fund in rural England (‘Safer than Geoffrey Boycott’s Forward Defence’), the fund manager has a problem. ‘I say, old boy’, he says to his contact at Stearns Brothers. ‘What is going on here? We’re not receiving our monthly payments!’
‘Sorry, bud, it’s really crazy round here. The mortgagees are not paying up so the CDO is struggling’, replies the investment banker.
‘You mean the AAA piece, the “Good” one? We’re supposed to be paid out first!’ exclaims the incredulous fund manager.
‘It seems the loans are worse than we originally thought and there’s very little cash coming in. Frankly we’re as disappointed as you are.’
‘You told me the housing prices would always go up and borrowers could always refinance!’
‘Yeah, bad assumption. My bad. Sorry.’
‘And the AAA rating from the rating agencies?’
‘Their bad.’
‘What about the insurers?’
‘They don’t have enough money to cover this mess. Their bad.’
‘What do I tell my villagers?’
‘Your bad.’
The cartoon may have been overly simplistic, but it contained some considerable truth. At the point at which French investment bank BNP Paribas identified in August 2007 that three of its funds could not value assets within them owing to a ‘complete evaporation of liquidity’,3 in a clear sign that banks were refusing to do business with one another following a slowdown in the US housing market and increasing default rates on US subprime loans, the authorities began to mobilize their resources to prop up the financial system. At first, the European Central Bank pumped €95 billion into the banking market to improve liquidity, then followed up with a further €109 billion a few days later. The US Federal Reserve, the Bank of Canada and the Bank of Japan also began their own interventions.
Whilst the Fed cut its bank lending rate, warning that the credit crunch could be a risk to economic growth, the rate at which banks lend to each other rose to its highest level in nine years: banks started to worry about being repaid by other banks, or urgently needed funds themselves. By September 2007, Northern Rock, the fifth largest British lender, had approached the Bank of England for emergency support in its capacity as the ‘lender of last resort’. Northern Rock’s mortgage lending relied heavily on the capital markets, rather than savers’ deposits, for funding and this funding was now drying up. The day after this information became public, depositors withdrew £1 billion, the largest run on a bank in more than a century, forcing the British government to step in to guarantee depositors’ savings.
By October, Swiss bank UBS announced US$3.4 billion of losses from subprime investments, and its chairman and chief executive stepped down. Merrill Lynch’s chief executive also resigned after revealing a $7.9 billion exposure to bad debt. These numbers seemed like small fry over the next six months as Citigroup was to reveal losses of $40 billion.
By December, central banks around the world engaged in a concerted effort to stabilize the global economy by offering billions of dollars in loans to banks, including a $500 billion package from the European Central Bank to assist commercial banks over the Christmas period. Though the Fed and the Bank of England repeatedly cut rates, global stock markets continued to fall, and the first monoline insurance company, MBIA, announced a major loss, blaming exposure to the US subprime sector. Companies like MBIA specialize in insuring bonds, guaranteeing to repay loans in the event the borrower collapses, and now ratings agencies would look to downgrade these previously AAA-rated bastions.
In February 2008, the British government announced that Northern Rock would be nationalized; a month later, distressed US investment bank Bear Stearns was acquired by JP Morgan for a paltry $240 million, where only a year earlier it had been worth $18 billion. Shortly afterwards the International Monetary Fund warned that the contagion of the credit crunch was spreading from subprime mortgages to commercial property, consumer credit and corporate debt.
Rights issues – that is, asking shareholders to subscribe for new shares – and other capital-raising exercises were announced by Royal Bank of Scotland, UBS and Barclays, and by September the US government had stepped in to aid the country’s two largest lenders, Fannie Mae and Freddie Mac, both owners and guarantors of $5.3 trillion worth of home loans – simply too big to be allowed to fail. US Treasury Secretary Hank Paulson stated that the two institutions’ levels of debt posed a ‘systemic risk’ to financial stability and that without action the financial position of the two firms would rapidly deteriorate.
Almost immediately afterwards, on 15 September 2008, Lehman Brothers became the first major bank to collapse since the crisis began. Days earlier, it had posted a loss of $3.9 billion for the three months to August and had been frantically searching for a buyer, but to no avail. Simultaneously, Merrill Lynch was agreeing to a takeover from Bank of America. The next day, the US Fed announced an $85 billion rescue package for the country’s largest insurance company, AIG, in return for an 80 per cent stake.
But the largest bank failure was yet to happen: on 25 September, the mortgage lender Washington Mutual, with $307 billion of assets, was closed down by regulators and sold to JP Morgan Chase. Around the world, governments were bailing out their financial champions and guaranteeing depositors’ savings at the expense of the taxpayer. The US House of Representatives passed a $700 billion government plan to rescue the US financial sector, even using some of the money to support the three big car manufacturers, General Motors, Ford and Chrysler. In Michael Moore’s documentary film, Capitalism: A Love Story (2009), he described the bailout as a ‘financial coup d’état’, with particular venom directed at the investment bankers turned politicians and senior civil servants, now apparently bailing out their buddies with little thought to moral hazard.
British taxpayers also felt the pain, with £37 billion injected into Royal Bank of Scotland, Lloyds TSB and HBOS as part of a £50 billion rescue package. Around the world, the US jobless rate rose to a sixteen-year high, the Bank of England’s base rate dropped to its lowest level in its 315-year history, Chinese exports registered their biggest decline in a decade, and world economic growth fell to its lowest rate since the Second World War. The effects of the crisis will be felt for generations to come.
Did Islamic investments and institutions survive? Did they thrive in the vacuum left by conventional financial services? Let’s first take a look at what industry analysts tell us about the conventional financial services industry.
In a fictional narrative produced in 2011 by the consulting firm Oliver Wyman, ‘The Financial Crisis of 2015’ reconstructs the events of 2011 to 2015 through the eyes of a senior investment banker who witnesses a cyclical repeat of the credit crisis that gripped the world only a few years earlier. The narrative contends that there are three potential reasons for a financial crisis to re-emerge: the resurgence of shadow banking, the formation of emerging markets asset bubbles, and sovereign debt restructurings in developed markets. In other words, the growth of hedge funds, irrational exuberance in emerging markets and a change in developed nations’ debt obligations could result in a perfect storm. ‘Shadow banking’, that enormous sector of finance that exists outside the purview of mainstream banking regulators and out of mind of the general public (like hedge funds), was projected to be subject to greater scrutiny by policymakers and regulators. Despite this, the report surmised that the world of structured investment vehicles, credit hedge funds, asset-backed commercial paper conduits and securities lenders would remain on top in the game of regulatory cat and mouse. The amount of risk warehoused in the global financial services industry would continue to get squeezed across from the carefully monitored banking industry into the murkier world of the shadow banking sector. New, stricter, regulatory regimes would fail to persuade, threaten or penalize the financial sector into behaving more prudently and responsibly.
As for the emerging markets, to where many institutions might end up migrating in order to escape constricting regulatory environments, an asset bubble would form. Western banks would lend to emerging markets’ banks and governments in order to generate a positive margin over the rising costs of funds in their home markets, moving down the credit spectrum to increase their yield – in other words, riskier loans with higher interest rates. Favourable demographics and increased liberalization of such markets, catalysed by cheap money, would lead to rising commodities prices and consequent strong incentives to launch expensive development and infrastructure projects. An overemphasis on commodities-related activities such as mining would create a massive oversupply relative to demand from the real economy, and governments would spend beyond their means in the comfort of their unrealistic asset valuations. Western banks would build concentrated credit exposures in these markets, and previously risk-averse banks would feel pressured into acquiring previously downsized banks.
Rampant inflation in China as a result of dramatic rises in commodity prices and loose Western monetary policy would lead to a raising of Chinese interest rates and an appreciation of its currency. The Chinese economy would slow and global demand for commodities be profoundly affected. The commodities crisis of 2013 (remember this is a fictional scenario postulated in 2011) would render expensive commodity exploration projects half finished, just as the tumbleweeds had blown through real estate developments around the world only five years earlier. (In this respect at least, the consulting firm’s fictional scenario turned out to be partially right, with a Chinese slowdown leading to reduced demand for raw materials and a consequent correction in commodity prices.)
Finally, the developed world’s sovereign debt mountain would reach a crisis point. Heavily indebted US, UK and European nations would experience rising long-term sovereign bond yields as their solvency rapidly deteriorated. Their debt burdens would become unserviceable, forcing restructuring and bailout money from healthier nations, leading to the biggest post-war rebalancing of economic and political power.4
A far-fetched scenario? Not according to some of the more introspective observers in the Islamic finance industry. To them, the modern obsession with growth, and leverage to achieve that growth, is fundamentally philosophically at odds with the notion of creating a harmoniously balanced society, leading as it does to repeated cycles of debt-fuelled lunacy. Like a long-suffering father bailing out his alcoholic son’s gambling debts, governments have become accustomed to entertaining moral hazard by subsidizing risk taking by their financial institutions.
This observation is not exclusive to observers from the Islamic world. In Oliver Wyman’s report, the projected scenario contends that speculative investors will head for the exits at the first sign of trouble when the Chinese economic juggernaut applies the brakes, leading to the next global financial crisis. One of their suggestions to avoid this ‘avoidable history’, as they call it, is to stop the subsidization of risk taking by governments. They contend that market failure is commonly caused by governmental distortion of prices, often by way of taxes or subsidies.
Governmental policies causing market failure is an interesting observation for our purposes, because tax legislation has been one of the primary reasons why both lenders and borrowers turn to debt financing instead of equity financing. Though the report goes on to discuss implicit government support for bank creditors – in the form of reducing risk premia on banks’ debt funding – a primary reason why an entity would wish to finance itself with one form of capital over another is largely distorted by the unequal tax treatment of debt versus equity. Interest repayments on debt are typically tax deductible, dividends on equity shares are not. Governments incentivize us to use leverage to grow, instead of to seek equity investors, who typically focus on long-term strategic issues with a view to growth, not merely payback. In addition, the acceptance of an economic system that allows banks to maintain low reserve ratios is anathema to the real economy perspective of Islamic finance, where the offer of finance by one party to another does not create wealth in and of itself.
Other types of governmental price distortion include the effects of quantitative easing, the printing of money, which can help to cause the formation of bubbles. In our discussion on the nature of money in Chapter 2, we heard from Justice Mufti Muhammad Taqi Usmani at Davos. His vision of an Islamic economy leads to the suggestion that a just economy could not be based on an interest-bearing fiat currency. Fiat money – that is, money that has value established by decree – is based on faith in the government issuing the money rather than on a physical commodity such as gold.
According to the Mufti, the credit crisis can be distilled into four basic causes: money is no longer a medium of exchange; the sale of intangible contracts (the modern derivatives industry) has ballooned out of control; the sale of debt is not considered objectionable; and the sale of assets one does not own caused a spiral of collapsing prices.5
He no longer appears to be alone in his views. Western commentators have started to question the way in which the world’s financial institutions do business. Riots and protests from Athens to London to Wall Street suggest that the general public – the holders of low- and middle-income jobs, mortgage payers – agree and demand change. Some are also starting to question our established conceptions of leadership. Are the mistakes that have been made in recent years that led to the global financial crisis a result of the manner in which we collectively view risk, and appoint our leaders to chase that risk?
Jeremy Grantham, the chief investment strategist at US fund management company Grantham Mayo Van Otterloo, certainly believes so. In his letter to the firm’s investors in autumn 2008, he identified what he believed was the underlying cause of the global financial crisis. He contended that his firm knew dozens of people who saw the crisis coming, who had good historical data, were thoughtful and intuitive. He described them as right-brained: given to developing odd theories, taking their time to sift through and ruminate on mountains of data. They considered outlier events, the ones the financial services industry believed couldn’t possibly happen. They were introspective, reflective and patient, but their personality traits are not generally considered those of natural leaders. In contrast, said Grantham, not one of the bosses of the bulge bracket investment banks, nor US Treasury Secretary Hank Paulson, nor the chairman of the US Federal Reserve Ben Bernanke, saw the crisis coming. Grantham writes:
I have a theory that people who find themselves running major-league companies are real organisation management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained – but we end up with an army of left-brained immediate doers.
So it’s more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four dozen-odd characters screaming about it are always going to be ignored.6
Today’s CEOs and political leaders have been picked for their left-brainedness: focus, persuasiveness, political acumen, energy, decisiveness. Patience does not figure. If they do not act decisively and immediately, they would not hang around in their jobs for too long. Their job performance is measured on a quarterly basis and their career risk is high. If the herd is piling into financing real estate development projects, or collateralized debt obligations of mortgage-backed securities, then so must they, or they risk being thrown out onto the street. Investment banking does not reward thinkers. It rewards doers.
So what has all this got to do with Islamic finance? Let’s return to the scene at the Godolphin Ballroom in the Emirates Towers Hotel on that muggy summer night, where our derivatives trader turned Islamic finance evangelist, Tarek El Diwany, was in full flow.
‘The seventeenth-century goldsmith banker had realized the incredible opportunity presented to him in the behaviour of his customers’, explained El Diwany. The gold deposit receipt presented to the depositor by a trusted goldsmith would increasingly be accepted in the marketplace by merchants selling goods and services to those holding the paper receipts. As a result, depositors sought redemption of their gold receipts in ever decreasing numbers, gradually dispensing with the need to frequently withdraw gold. The goldsmith was no longer the manager of a gold vault, instead he now offered to lend paper receipts, instantaneously created in the back office. Paper money was born.
‘Naturally, many businessmen wanted to join in this new game of banking’, said El Diwany, describing the fractional reserve banking system, an evolution of the argument of goldsmith bankers that they need not keep the same amount of gold in their reserves as the amount of paper money they lent out. Since the majority of depositors did not come back to the bank to claim their gold in any given period, one could safely issue paper receipts in excess of the amount of gold in the vaults. Bankers thus created multiple legal claims of ownership for every gold coin in their safe keeping. Now the reserve ratio was born.
So notes had become legal tender instead of gold and were lent in the inter-bank market for banks to fulfil day-to-day activities. Every time a bank made a loan, the supply of money circulating in the economy increased. El Diwany put forward the argument that reducing debt would merely cause a reduction in the money supply and lead to recession. ‘Pay your debt, or lose your job, that’s the choice.’
He illustrated the point by way of an example.7 Imagine there is one bank in the economy, holding $10 of cash in its vault as its start-up capital. Customers A and B are issued with cheque books. A buys goods from B for $100 and pays by cheque. B deposits the cheque at the bank, leaving A with an overdraft and B with a credit for $100.
If B were to withdraw his money, the bank would not be able to redeem the deposit since it only has $10 in its vault. If B buys goods from A for $100, the $100 of money would disappear in B’s account. Money created by the bank is destroyed in the act of repaying a bank loan. Thus bank money is fundamentally different in nature to commodity money: gold coins, for example, would continue to exist after the act of repayment.
Let’s go back to A’s overdraft of $100. At an interest rate of 20 per cent, A would need to pay $120 back to the bank in a year. Since there is only $110 of money in existence – that is, $100 of bank-created money and $10 cash in the vault – A cannot repay the money unless he borrows it from the bank (creating new bank money and merely deferring the problem), or the state creates new ‘state money’ (cash issued by the state, such as, say, welfare payments), or A sells goods or services to the bank in return for bank money.
‘Much of the effort of society to produce is in fact an effort to obtain sufficient money to repay debts owed to banks’, concluded El Diwany. He described the monetary system as being responsible for ‘forcing unnecessary and sometimes aggressive forms of economic growth on the world’, fuelled by long-term increases in debt.
When in late 2007, the problems of Northern Rock became public knowledge, memorable images were broadcast around the world, the very definition of a run on the bank, as customers flocked to their local provincial high street, queues snaking for blocks out of the branch doors in locations around the UK. If the photos had been in black and white and the customers had worn flat caps, you would be hard pressed to know it wasn’t the Great Depression of the 1930s.
If the bank’s customers all asked for their money back at the same time, and the inter-bank market slammed the door on an institution, what then? In Northern Rock’s case, the Bank of England stepped in with £20 billion of what was described as taxpayers’ money, though El Diwany contended that this was in fact ‘new money, created in a few keystrokes by the Bank of England’ and backed by the taxpayer if Northern Rock could not repay the bank.8 The consequences of a wider bank run would clearly be an economic catastrophe.
Should the legal privilege to create money be removed from private hands? What about government hands? Do we trust our political leaders not to issue money for their political advantage? Islamic economics experts suggest a gold-based currency: its quantity is finite and it has intrinsic value. This argument has not been restricted to Islamic commentators, though. Even America’s founding fathers saw the benefit of throwing off the yoke of enslavement to private banks, with Thomas Jefferson variously attributed as having written:
If the American people ever allow [private] banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their Fathers conquered9…I believe that banking institutions are more dangerous to our liberties than standing armies…The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.10
Whilst it is difficult to establish the outright veracity of the above quotations (since they were printed many years later), Jefferson was one of a number of early American presidents distressed by the greed of money manufacturers, arguing that the Republic and the Constitution were in constant danger from the so-called ‘money power’, an elite who manipulated the political power of the state to gain a monopoly over money issue.11 Andrew Jackson, having struggled to demand the withdrawal of government deposits from the privately owned Bank of the United States, arguing that debt from private monopoly was being wielded as a political weapon, passionately addressed the American public some years after Jefferson, in 1837:
The distress and alarm which pervaded and agitated the whole country when the Bank of the United States waged war upon the people in order to compel them to submit to its demands cannot yet be forgotten. The ruthless and unsparing temper with which whole cities and communities were oppressed, individuals impoverished and ruined, and a scene of cheerful prosperity suddenly changed into one of gloom and despondency ought to be indelibly impressed on the memory of the people of the United States. If such was its power in time of peace, what would it have been in a season of war, with an enemy at your doors?…if you had not conquered, the government would have passed from the hands of the many to the few, and this organised money power, from its secret conclave, would have dictated the choice of your highest officials and compelled you to make peace or war, as best suited their wishes.12
Jackson had earlier argued that ‘the only currency known to the Constitution of the United States is gold and silver. This is consequently the only currency which that instrument delegates to Congress the power to regulate.’13 No doubt Jackson would have considered today’s US Federal Reserve, a private bank-owned monopoly, to be unconstitutional.
The last of many populist presidents to fight against the money monopoly, Abraham Lincoln faced a heavy burden financing the Civil War from a banking system under private control. A shortage of coins meant the private banks were unwilling to finance the Union Army, and so Lincoln presented to Congress a bill in 1862 to make United States notes full legal tender, thus enabling the Federal Government to print sufficient paper to finance the war. Not surprisingly, the issue of paper money by the government was opposed by banking interests, and they argued that they be allowed to act as agents of the government in issuing money, thus rendering the state a perpetual borrower in thrall to the private money monopoly.
In the end, it didn’t matter. By 1913, the Federal Reserve Act was signed into law and the private banks had triumphed. Now the laws of nations across the world permit and encourage money creation by the banking system, and its lending at interest, increasing indebtedness. The banking system will continue to benefit from a society that cannot repay its debt, and debt will continue its inexorable march upwards as a proportion of GDP. El Diwany argued that in previous centuries Western nations had often avoided interest-based debt in order to build their infrastructure, with the hospitals and universities of England financed by donations and endowments. In contrast, today’s massive infrastructure projects such as the Channel Tunnel toil under the debilitating effects of debt service. El Diwany clicked on the next slide of his presentation to illustrate the stark contrast in quality of modern infrastructure, its cost base burdened by debt: a picture of St Pancras Station in London, its fine craftsmanship evident in the brickwork and masonry, juxtaposed against an extension to the station made of prefab panels.
Another click on his laptop and another photograph, this time the rural charm of the English village of Kelvedon, before a house-building firm changed the face of the village by borrowing such a huge amount of debt that rather than make incremental changes to the village, it turned it into a characterless housing estate. Knowing that it could employ leverage at a lower rate of interest than the rate of return on its investment had spurred on its greed to the detriment of what once had made that village unique. One more click and a photograph of a giant out-of-town shopping centre in north London, where at least five of its clothing retailers are owned by the same family-owned investment vehicle of one private individual. El Diwany comments:
House-building firms, out-of-town supermarkets, enormous shopping malls whose clothing stores are owned by the same man, these are all fuelled by leverage. Employment becomes more common than self-employment. Small businesses disappear. Product choice and variety decline as fewer producers dominate the market. Local communities lose control over their affairs as distant centres of influence grow in power.
He painted a grim picture, although some of the harder bitten bankers and lawyers in the audience rolled their eyes. Was there any intellectual credibility to this doctrine of anti-globalization? Was El Diwany identifying with the mass of disorganized and misinformed protest on Wall Street, aimlessly railing at big corporations and government control? Or was he perhaps identifying with America’s founding fathers, who foresaw a future of enslavement to debt?
In Austrian economist Eugen von Böhm-Bawerk’s theory of time preference he proposed that money available today is worth more than money available tomorrow, simply because individuals prefer to consume now and not later. Thus one may consider having $100 today as the equivalent of having $110 in a year’s time, and therefore be willing to borrow $100 today from a bank in return for a repayment of $105 in a year. Although a theory that had much credibility in the nineteenth and early twentieth centuries, few economists questioned the central assumption that consumption today is better than consumption tomorrow. To illustrate the point, El Diwany asked his audience whether it was better to consume one breakfast every day or all seven of the week’s breakfasts on one day.
A further argument was put forward. Consumption today can deny consumption in the future. If one decides to take a holiday now, in one year’s time one may feel it would have been better to wait a year to take the holiday. Thus consumption in one year may have been preferable to consumption today. El Diwany illustrated the point with an environmental example using a tool employed by corporate financiers to calculate the mathematical value of a business opportunity: the discounted cash flow methodology. Let’s imagine a farmer is faced with a choice: either he can produce a sustainable level of output at 100 units of profit per year, or through an intensive pattern of farming, produce 150 units of profit per year but only for fifteen years, after which the land becomes desertified.
Discounted cash flow is a simple piece of maths that determines which projects to invest in by attributing greater importance to profits closer to day zero than those in the future, and the contrast between near-term and long-term profit is determined by a ‘discount rate’. This discount rate is usually the opportunity cost of capital, in other words the rate foregone by investing in the project rather than investing in, say, tradeable securities on a stock exchange.14 Thus, in our example above, if the farmer uses a discount rate of 10 per cent – representing the rate he would normally earn by investing elsewhere – he would quickly discover under the discounted cash flow methodology that he should adopt the highly intensive process that will ultimately desertify his land.15
In this case, modern financial analysis has defeated common sense. It is impossible to maintain perpetual growth for ever because the planet will not sustain it. A modern obsession with GDP growth as the only objective measure of the health of humanity forces us to consider ourselves failures when our nation achieves less than a 5 per cent per annum growth rate. And when we fail to achieve these numbers we mobilize sheer physical force. Early stock markets in Britain and Holland traded the shares of East and West India companies, who were themselves engaged in both military and trading ventures; ventures that were ostensibly private and profit seeking, but which governed exploited far-off populations as an arm of an overseas conqueror. For post-industrial Europe, capitalism has invariably meant a perpetual state of war.
El Diwany poses the question: ‘Do we not have a duty to future generations in the decisions we make today?’ He responds: ‘By and large, Western financial economics answers “no” to this question, and interest is the reason.’ Suddenly, El Diwany no longer sounded like the lunatic that his left-brained critics painted him to be. Though much of the audience were already sympathetic to his views, none of the small core of conventional bankers and lawyers present felt that he had spoken anything but common sense. Perhaps there was a point to Islamic banking, after all, and provided the industry found the courage to plough its own path, perhaps there was a chance it might have a workable solution to the adverse effects of modern globalization.
Did Islamic financial institutions thrive during the global financial crisis? Not really. Subject to the same regulatory and legislative constraints, and plugged into a global economy from which they cannot decouple, they suffered their own slowdown in tandem with the rest of the world’s banking institutions. However, they at least managed to avoid the excesses of gorging on increasingly intangible derivative instruments, though much of this may be attributed to their general lack of sophistication rather than their lack of want. Hedge funds, collateralized debt obligations, structured investment products – these products were largely absent from their shelves. However, many such institutions were overexposed to shares on local stock markets in the Middle East and bricks and mortar, particularly in the Dubai bubble. Those who had put all their eggs in one basket suffered the most. To their credit, any lending activities they had undertaken in the boom years at least correlated with the real economy. For those who had not employed commodity murabaha transactions as a proxy for loan financings, they at least owned real estate through sale and leaseback (ijara) contracts.
* * *
By way of conclusion, let us return to the Landmark Hotel in London in February 2010. The Euromoney Annual Islamic Finance Summit is in full swing and the first panel session of the two-day conference has begun. At the Annual Heads of Islamic Finance Panel Discussion, six senior bankers are quizzed by the moderator, a transparent PR exercise to satisfy egos and justify the budgets each banker has expended on sponsoring this annual jamboree.
‘Has the global financial crisis been an opportunity missed for Islamic finance?’ asks the moderator. At first the responses are, predictably, platitudinous nonsense. Of course not, say the bankers. The industry has grown by x per cent, y number of new institutions have been formed, z number of new funds. Our products are even more innovative than ever, we invest more in talent creation, our value add to our clients puts us at the top of our industry.
But two of the bankers disagree. ‘Why do we use numbers of institutions and awards won as a measure of success in our industry?’ says one.
‘What about the man in the street?’ says the other. ‘Why do Islamic finance products have to be about financing luxury residential developments in central London for ultra high net worth individuals? What about pension funds, retail home financing products, mutual funds, venture capital for small and medium enterprises? We missed a trick. We missed the chance to tell the world that Islamic finance can achieve something that conventional finance could not: real economy transactions leading to real wealth distribution. Ethical finance.’
The head of an Islamic institution sitting in the next chair bristles. ‘I fundamentally disagree with this gentleman’, he fumes. ‘In the last twelve months, we have demonstrated significant progress in this industry. My firm has invested billions in prime luxury real estate in London and the Middle East, including a Sharia-compliant commodity murabaha financing which has helped us to win the industry’s leading awards.’
The left-brained rule the world.