University of Hertfordshire

Attiya Shafaq 26/07/11 1
School of Law
UNIVERSITY OF HERTFORDSHIRE
SCHOOL OF LAW
Dissertation (MLAW0141)
AUTHOR - Miss. Attiya Shafaq
DATE - 27th September 2010
Thesis Supervisor - Professor Bill Davies
SCHEME - LLMF1
Islamic Financial System
Rescue to the Global Financial Crisis
A Study on the Origin of Subprime Mortgage Crisis and rescue offered by Islamic Financial
System
Attiya Shafaq
Shafaq 1 26/07/2011
In the name of Almighty Allah the most Merciful and most Gracious
“THE MOST WORTHY OF EARNINGS ARE THOSE OF THE MERCHANT, WHO, IF THEY ARE SPOKEN TO, DO NOT LIE, IF
THEY ARE TRUSTED, DO NOT BETRAY, IF THEY PROMISE, DO NOT FAIL, IF THEY BUY, DO NOT CONDEMN, IF THEY SELL,
DO NOT EXTOL, IF THEY OWE, DO NOT DELAY AND IF THEY ARE OWED, DO NOT PRESS.”
(PROPHET MUHAMMAD PEACE BE UPON HIM)
“Islamic financial system carrying the elements of morality and ethics”
Dedication
To
Pakistan
May Allah protect Pakistan and bestow upon me the opportunities to be the part of her
development, prosperity and a bright future ahead Inshalla (amen).
And a very humbly dedication to my mentor, Late Principal of Kouser Public Haripur Agha Ge
(May his soul rest in peace)
His strong and fearless character building enabled me today to create opportunities through
my struggles and tough times.
Praise is to Allah.
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Preface
I would first like to acknowledge my colleagues’ Barrister Asghar Khan Senior Legal
Advisor and Mr. Safeer Ahmad Senior Financial Analyst in PPIB Pakistan for their
intellectual motivation in introducing me to the fascinating world of finance which
gave rise to this research. I would gratefully like to acknowledge my tutor Professor
Christopher Kirkbride for inspiring discussions during course work and guidance
during this thesis that deepened my interest in the subject.
Further, I direct heartily gratefulness to my Thesis Supervisor Professor Bill Davies
for his availability, productive guidance, supervision and continuous collaboration and
help in suggesting and sharing new aspects and analyses on financial system.
Moreover, I must not forget to thank particularly my teacher and distinguished Islamic
Financial Analyst and Scholar very humble Dr. Muhammad Tahir Mansoori Sahab
from International Islamic University Islamabad Pakistan, for his efforts in helping me
in revising every aspect from the very basic principles to complexities of Islamic
finance and I especially want to thank him for his frequent recommendations not to
hesitate in contacting him when ever I required his analysis or suggestions on
aspects of Islamic Finance. I would like to express my thanks to my colleagues Mr.
Hamza Syed (Syeds Solicitors Birmingham) for proof reading parts of this written
material and giving me constructive criticism and useful suggestions.
I would also like to acknowledge the efforts of my family and friends through
out, special thanks to my grandmother Mrs. Asmat Nisa whose precious
lifelong efforts are momentum to bring me to this conceiting stage and for
strengthening my way till here. May Allah bless and grants them a long and
healthy life.
In the end I want to offer my immense gratitude to Miss Ramla Kanwal
“Without you it was impossible for me to come this far”.

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The responsibility for any mistakes and for the ideas expressed herein is mine alone.
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Abstract
Subject Tutor: Professor Christopher Kirkbride

Thesis Supervisor: Professor Bill Davies
Discussant: Attiya Shafaq
The severity of the Subprime mortgage crisis has traumatised the foundations
of the conventional financial system and has led to the search for cure of
losses suffered and reforms against such crisis in future. During this crisis we
have witnessed the impacts of irregularities done and insufficient monitoring
of the complex financial products in the financial market. Standard regulations
in the loan industry under conventional financial system proved to be
insufficient to tackle this crisis. During Subprime mortgage crisis, when the hot
real estate markets were converting into foreclosure capitals, Islamic financial
market was impervious from its impacts. This thesis focuses on the point of
view of the author that the fundamentals of conventional financial system
resulted in degeneration of an artificial economy. Elements of interest, debt
trading, speculation and uncertainty fuelled the voracity of the entities.
Imperative doctrine and mechanism of conventional financial system is
against the fundamentals on which the principles of Islamic financial system
rest upon, therefore, proving them to be two alternative financial systems; we
see that main features, which are prohibited in Islamic financial system, are
the primary postulates of conventional financial system. As by following the
principles of Islamic finance, there is no prospect for any kind of transactions
involving interest, gambling and practice of speculation. Hence, the adoption
of Islamic finance would have prevented the occurrence of the crisis on the
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first place. This system mitigates the risk at the levels of institutions in such a
way that makes sure the real economic activity should be the main player,
supervising the financial activity. Under Islamic Financial System transactions
involving interest or a commodity which are not owned or possessed can’t be
transacted unless some kind of risk is born by the parties. Similarly debt is
based on some real underlying asset it can’t be backed by some artificial
financial arrangement. We know that interest in its nature creates artificial
money supply which is not backed by real assets; as a result Interest allows
the money to circulate and grow in large amount which ultimately becomes
unpayable. Compounding interest, mere speculation, gambling and debt
trading were the active causes of Subprime mortgage crisis. Securitisation
instruments were not backed by the real assets consequently this created an
economic bubble which ended up with the default of securitised debts. Unlike
conventional financial system, Islamic financial system focuses more on
productivity rather than credit worthiness. In the view of the author The worse
part of this situation is that we are trying to fix the damage caused by the
crisis on the same fragile foundations that basically caused the Subprime
crisis, instead of trying to avoiding those principal and foremost causes giving
rise to these economic failures. The focus of this work is that Islamic financial
system can not only be developed and used to mitigate the losses suffered as
a result of Subprime mortgage crisis, but can successfully replace the
conventional financial system and is capable of transmitting better economic
results on longer terms.
Attiya Shafaq.
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Table of Contents
1. Introduction
1.1 Thesis Structure……………………………………………………………....06
1.2 Research Hypotheses …………………………………………………….....06
1.3 Structural differences of Conventional and Islamic Financial System…..06
2 Subprime Mortgage Crises

2.1 What was the U.S. Subprime Mortgage crisis…………………………….20
2.2 Key features of the financial crisis …………………………………………22
2.3 The Worst Crisis since the 1930s …………………………………………23
2.4 Islamic Mortgage System …………………………………………………..28
3 Instruments involving Mortgage Structure

3.1 Securitisation…………………………………………………………………32
3.2 Bonds………………………………………………………………………….34
3.3 Derivatives…………………………………………………………………….36
4. Case Law……………………………………………………………………….52
5. Concluding Remarks
5.1 Conclusion…………………………………………………………………….61
A. References……………………………………………………………….76
B. Diagrams…………………………………………………………………88
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1. Introduction
In the Introduction there is a brief description on the opus of the thesis, the idea behind its
structure and statement of purpose is presented, along with enlightening the importance of
this subject following the describing of the main structural difference of conventional and
Islamic financial systems.
1.1 Thesis Structure
This work identifies the main causes of the crisis leading to the failure of
conventional financial system and studies the main structural difference of
conventional and Islamic financial systems. The dissertation focuses on US
Subprime mortgage crises, the role of Instruments involving mortgage
structures and different aspects of securitisation involved. This dissertation is
an attempt to look into the core of this financial crisis and hit upon the ways
out of this crisis according to the principles of Islamic financial system.
1.2 Research Hypotheses
Islamic financial system deals with financial transactions approved by Shariah
laws. In the view of the author, this system can not only be developed to
replace the present conventional financial system but can also be used to fix
and improve the conditions caused by the current Subprime mortgage crisis.
1.3 Structural differences of Conventional and Islamic Financial System

Just after the Asian financial crisis, the boom and bust1 of US housing market
hit the economy with the Subprime mortgage crisis exposing the pervasive
weaknesses2 in the structural and regulatory framework of conventional
1
By Mark Zandi, Chapter 10, “Boom, Bubble, Bust, and Crash” Financial Shock: A 360 look at the Subprime
Mortgage Implosion, and How to Avoid the Next Financial Crisis, available online on http://books.google.com/books?
id=hXzUAnhEuzYC&pg=PA1&source=gbs_toc_r&cad=4#v=onepage&q&f=false, last seen on 19th July 2010.
2
Subprime mortgage crisis, Available online on wikipedia.org, last seen online on 10th July 2010.
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financial system. Recently due to the globalisation, state ownership has been
reduced, labour market and welfare state institutions have been weakened
and legal regulation has been dropped in favour of codes of conduct and so-
called self regulations of the markets. Under the same effects of globalisations
and expansion of the financial institution across the boarders the financial
sector has been actively de-regulated at the unambiguous behest and with
the help of substantial political donations of financial institutions, which are
now holding out their hand for state support.3 Earlier crises, particularly the
US banking and economic devastation of the 1980s and early 1990s and
subsequent Latin American and Asian events, suggested a large number of
warning signs for identifying such crisis, ranging from
• Fast growth by acquiring larger or failing institutions,
• Heavy reliance on non-retail funds and inadequate liquidity;
• Dependence on excessive leverage,
• Concentration of assets,
• Risky, exotic and cross-border loans to
• Weak managements in the financial systems,
but unfortunately we learnt no lesson from the above indications 4. In the view
of the author the worse part of this situation is that instead of avoiding
foremost causes that gave rise to these economic failures, we are trying to fix
the damage caused, on the same fragile foundations that basically caused the
Subprime crisis.
3
Watt, “The economic and financial crisis in Europe: addressing the causes and the repercussions”, European
Economic and Employment Policy Brief No 3-2008, available online on http://www.etui.org/research/about/Staff/Watt-
Andrew, last seen on 18th July 2010.
4
By Gillian G.H. Garica, “Ignoring the lessons for effective prudential supervision, failed bank resolution and
depositor protection”, Journal of Financial Regulation and Compliance, 2009, available online at WestLaw.Uk, last
seen on 9th July 2010.
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There is a fundamental and conceptional difference in the structure and
working of Islamic and conventional financial systems. Unlike conventional
financial system, Islamic financial system conceptionally focuses more on
productivity rather than credit worthiness. Similarly Interest is prohibited in its
totality under Islamic financial system. There is no approach that one can use
or get any benefit from interest or instruments which are the result of Interest
based transactions, whereas, we know that, the development and progress of
conventional financial system is widely based on the instruments and
transactions involving interest. High and compounding interest rates are
nothing except getting unjustifiable advantages from the people who need
financial help to progress in their respective fields. Interest (Riba) through its
mechanism drives the poor into more scarcity and automatically creates more
affluence for the affluent. Islamic financial system focuses on the equal
distribution of wealth resulting in no huge difference of benefits obtained by
both the parties in a transaction. This system carries a unique aspect of the
elements of morality and ethics in its profound foundations. In the current
crisis we have seen that the impact of the crisis on a regular and common
consumer is more than the big titans in their individuality, who still managed to
get their share of money some how or escaped through government
interventions but the unsecured common people suffered the most who were
either dragged into this crisis due to excessive speculation and default of
companies or as a result of increased rates of interests on their mortgages,
which they were unable to pay. The voracity of “Entities” is more responsible
for the crisis than the “Individual” activity. The default of these entities resulted
the individuals to loss their jobs and their economic situations to go worse.
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The system seemed playing games to get the least penny under the trance of
voracity. Trade in artificial economy made the product of transactions so
unpredictable that it appears that in order to prevent loose in a transaction you
need a “God” to set in the end of every transaction to save and protect your
assets and monies invested.
Investment decisions coupled with numerous factors like a self-regulated
Subprime market and the complex structured finance products were the most
prominent elements increasing the effects of this financial crisis. 5
Through past crisis it is easy to understand that for a stabilised economy,
credit and debt have proved to be detrimental. For avoidance of further crisis
it is important that the corporations have a financial structure that is
depending more on equity base and internal funding rather than depending on
leveraged system, followed by a proper and regulated supervision. There are
no doubts that a conventional financial system dominated by interest-based
debt transactions is nothing but fragile and instable.
Mohsin Khan (1986) suggests that: “Based on principles of equity
participation, Islamic banking may well prove to be better suited to adjusting to
shocks that result in banking crises and disruption of the payment mechanism
of the country. In an equity-based system that excludes predetermined
interest rates and does not guarantee the nominal value of deposits, shocks
to asset positions are immediately absorbed by changes in the value of
shares (deposits) held by the public in the bank [;] therefore, the real values of
assets and liabilities of banks in such a system would be equal at all points in
time.” (Khan, 1986) 6

5
ICMR IBS Center for Management Research, case study on “The US Housing Market and the Subprime Mortgage
Crisis (B): Impact on the US Economy”, available online www.icmrindia.org, last seen on 10th August 2010.
6
By Tony Ciro and Michael Longo, “The global financial crisis: causes and implications for future regulation: Part 1”,
Journal of International Banking Law and Regulation, 2009, available online on westlaw.uk, last seen on 14 July
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In the wake of the September 11 terrorist attacks in the United States,
Impetus of cheap global debt was created, as central banks and governments
all over the world feared great depression. To avoid these nightmares central
banks pumped much needed liquidity into the system and aggressively
lowered interest rates. This was to stimulate demand and avoid an ugly
contraction. In order to avoid a massive collapse in demand and industrial
production following the terrorist attacks in the United States. But the financial
system was set onto a definite collision course later on, which we now know
to be the Subprime mortgage crisis. It took about seven years of cheap
floating debt to expose serious weaknesses in conventional financial markets.
The world was saved from a significant global recession in 2001 which
reemerged with added steam of impacts of speculation in derivative market in
late 2007-2009.7 Sakti (2009) affirmed that the volume of transactions in the
world money markets which consist of currency speculation and derivative
market transaction amounted US$ 1.5 trillion in a day, while in very contrast,
the transaction volume in the world real sectors amounted only US$ 6 trillion
in a year. This non-productive activity for real economy was indeed alarming
that had every opportunity to bring the real economy on its knees and was an
open invitation for long term crisis.8 After the Asian financial crisis, another
major financial crisis that hit the global economy was US Subprime mortage
crisis, which exposed pervasive weakness in the revailing financial system
and regulatory framework.
2010., also see http://www.iiu.edu.my/iaw/SHPhDHTMLfiles/Chp_05%20The%20Need%20for%20Islamic

%20Accounting-PF2-Estab%20of%20isl%20org.htm,
7
ibid
8
Sakti, Ali.(2009), "Islamic Economic: Challenges and Opportunities of Monetary Authority in the Global Financial
Crisis" Paper presented on Public Lecture Series held by Centre of Islamic Economics and Business, Faculty of
Economics, University of Indonesia, Depok, Indonesia, February 18, 2009.
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A successful diminishing of the national boundaries by the financial system is
the result of high demand and interaction between different parts of the world.
Global markets have invented several ways to meet the demand of these
financial transactions . In Chapters a head we will discuss in detail that, in
process of alligning financial products with investers individual risk for more
appitite of returns complex structured financial products were created, which
were difficult to be understood by the consumers using them ultimately
making the underlying risk to become more intricative. Under the impact of
growing economy and companies revenue reaching all time high the every
day consumer engaged themselves in different financial transaction for
facilitating themselves, like mortgage loans. Because of the effects of
compounding interest(Riba), speculation (Maisar) and Uncertainties (Garar) in
the transaction, this situation ended up with the rising interest rates with
declining house prices which seriously effected US mortgage borrowers,
causing the default of several borrowers as they fail to make payments on
their mortgage loans. As, the crisis intensified, increasing numbers of
delinquencies leading to foreclosures, and in repossessions. As this system
was running on debt based economy, and financial institutions, instead of
depending on deposits, were taking loans from the international secondary
market for their rapid growth. And secondary mortgage market itself came
under the effects of this crisis as well, with the spreading panic in the financial
market and beyond sub prime securities. The counter party risk dried up the
liquidity in the credit market, as financial institutions became increasingly
reluctant in lending each other. 9
9
ICMR IBS Center for Management Research, case study on “The US Housing Market and the Subprime Mortgage
Crisis (B): Impact on the US Economy”, available online www.icmrindia.org, last seen on 10th August 2010.
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Over the years the regulatory response in the US has been to expand and
extend systematically important financial institutions by sponsored safety nets,
including explicit deposit insurance and implicit government guarantees for
too-big-to-fail organisations. As the benefit of the perception that some
financial organisations were too big to fail the financial organisations received
implicit subsidies. The rational was to protect de jure uninsured depositors
and other stakeholders against some or all of the risk of loss because of the
fear that their failure would cause havoc to the real economy. Examples
include The Northern Rock, The Bear Stearns Companies, Inc., Federal
National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage
Corporation (Freddie Mac), American International Group, Inc. (AIG),
Citigroup, Inc etc. These subsidies or Injections of capital into the largest
banking organisations was massive wealth redistribution from taxpayers to
debt holders of these financial institutions. 10
Although realisation of an inadequate legal and regulatory mechanism and
failure of prevailing belief in the self controlling and correcting power of
markets resulted in a subsequent pattern of government interventions into
financial markets supplemented by temporary legislation but if we closely look
at all these financial initiatives and structures, they are based on the same
principles which resulted in the present financial crisis. These initiatives serve
to foster the purpose of business rescue rather than to provide an effective
harbour for financial rescue for the system as a whole which could prevail on
the long term basis. In recent times we have seen a very strong support and
very serious official concerns to save the “Too Big to Fail” gigantic
10
By Elijah Brewer and Ann Marie Klingenhagen, “Be careful what you wish for: the stock market reactions to bailing
out large financial institutions: evidence from the USA”, Journal of Financial Regulation and Compliance
2010
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organisation. In the view of the author the recent times call for correcting the
existing mechanism of financial institutions under which they are operating
their financial transactions. Instead of focusing on rescue of companies in
distress, we need to focus on the basics of this mechanism that ultimately
engaged this distress. Short term incentives can not provide us with the long
term advantages; instead they will lead us to impacts which wouldn’t be
different from what we are facing today. Why are we thinking about saving the
reckless acting voracious gigantic organisation? The time is to correct the
foundations of financial system and start thinking about the benefit of the
common depositor. Imprudent lending transaction by banks resulted in
unavoidable default and the crash on capital market leading to crisis on
banking and real economy. Islamic finance, which prohibits the practice of
Riba (Interest), Gharar (ambiguity), and Maysir (Speculation), may act as
powerful medicine to heal this crisis. In practice a feature which is prohibited
in Islamic financial system is a mechanism working in conventional financial
system. Causes of current crisis comprises of those vital differences which
are present in one system and absent in the other system. Islamic financial
system comprises of an inherent risk management tools to prevent such
situations and crisis. It establishes a distinctive system for protecting not only
the individual investors but also the financial institutions from any potential
risks in the market.11 Unlike conventional financial system the concept of
lending is backed by more carefully structured underlying asset and preferred
instrument to protect these investments is real estate. Islamic financial system
promotes that returns must be an outcome of productive financial activities
11
By Rasem N. Kayed and M. Kabir Hassan, “Islamic finance for a global solution-II”, available online on
http://www.thefinancialexpress-bd.com/2009/08/02/75038.html, last seen on 17th August 2010.
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based on the doctrine of profit-and-loss-sharing transactions. They are strictly
prohibited from investing in or dealing with financial transactions and activities
that involve elements of interest (Riba), uncertainty (Gharar), and speculation
(Maysir). Islamic financial system not only discourages any kind of investment
in businesses that are linked to illegitimate activities under Islamic law and
12
paying or receiving any predetermined fixed rate of return on borrowing.
Under Islamic financial system real trade is the primary function of the
financial markets. Islamic finance is based on equity rather than debt, and
lending transactions are founded on the concept of real assets backing for
example the mortgage loans under Islamic financial system would have been
backed by solid and real asset structures. From the standpoint of Islamic
jurisprudence (fiqh al-muamalat), the unfettered use and trading of
instruments used in conventional financial system are not encouraged as they
easily involve excessive uncertainty (Gharar), speculative behaviour (Maysir),
or the trading of debts (bay al-dayn) three main concepts that contravene
fundamental principles of Islamic law.
Islamic financial system is seen as equipped with inherent features that not
only survived financial crisis inherently but also have ability to prevent such
crisis from developing. The blow of the crisis on the Islamic financial system
was minimal as they were not caught by toxic assets due to avoidance of
interest and their disinclination to exploit sophisticated financial instruments.
However, we must realise that a sound financial system is the corner stone on
which economy is built. While we are adopting various solutions to correct this
abortive financial system we should make sure that these recovery plans are
based on a stable and thoroughly managed financial principles which have

12
ibid
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the potential of fulfilling the core functions of a financial system in an economy
and which is shock proof from long term devastating impacts of such failures
in case if they occur.13
Mirakhor (1990) constructed a model that demonstrated that a fully equity-
based system has desirable features that improve the shock-absorption
adjustment capacity of the economy; that is, such a system is more stable
than a debt-based system, as it adjusts rapidly to shocks. The model in
Mirakhor’s paper assumed only two assets: money and shares, Mirakhor’s
model derived a rate of return from the real sector, thus providing an
interactive process between the financial sector and the real sector which
provided the rate of return to the former sector. The equilibrium conditions in
the short and long run for both closed- and open-economy models were
derived. The paper then examined the stability of the equilibrium and the
process of adjustment of the system to shocks. In summary, standard
economic analysis can demonstrate the stability of an Islamic financial system
and its resilience to shocks. The insight in the wake of this conclusion is that,
unlike a debt based system, there is a one-to-one mapping of the financial
structure onto the underlying real sector assets. There is neither the problem
of mismatching household savings and finance for investment, nor of
mismatching maturities. Risks of loss are shared between the surplus fund
holder and the entrepreneur. There is no opportunity to expand credit and
leverage beyond what can be supported by the real sector output (Krichene
and Mirakhor, 2008). While, the informational problems that are the trait of
debt based system do not exist in the case of share contracts; thus, risk-
13
By Roman Tomasic, “Creating a template for banking insolvency law reform after the collapse of Northern Rock:
Part 1”, Insolvency Intelligence 2009
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sharing, equity-based financing is more proficient. Scholars have argued that
it is the predominance of debt (Diyan) that is responsible for the inherent
instability of a debt-based market economy. What that is required for a truly
Islamic financial system, is not only the prohibition of elements of speculation,
uncertainty and interest, but the institutional framework within which the
system has to operate. Without the institutional foundation Islamic finance
becomes indistinguishable from a conventional system, with financing being
provided through sharing, rather than debt contracts. Douglass North calls it
the institutional scaffolding which Islamic jurisprudence provides for the
strengthening and the stability of its economic and financial system. The
elements of this “scaffolding” come directly from the Qur’an, with additional
clarification and operationalisation from Prophet Muhammad (PEACE BE UPON
HIM). This framework includes, inter alia, sanctity of contract (explicit and
implicit); property rights; trust; rules of behaviour in governance; existence of
markets; rules regarding the allocation, production and distribution of
resources, income and wealth; rules governing the behaviour of market
participants; and rules regarding post-market distribution. This strongly rules-
based framework based on faithfulness to contracts and a strong prohibition
against taking interest, lying, cheating and other fraudulent activities, makes
the financial system more desirable, transparent, efficient and trouble-free.
We know crises are prevalent to a financial system that is debt denominated.
Without much consideration to activities in the real sector, contracts are made
on the basis of money, which creates an incentive structure for the rapid
expansion of credit and debt, through leverage, and the emergence of asset
price bubbles. Under this system the market players are “merchants of debt”.
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These “merchants of debt” increase leverage, through financial innovation,
expand credit as with the rising asset prices inn the market, their profit
expectations also rise with every around of transaction. The fragility of this
system increases, as this practice also encourages their clients to lean the
financial structures more and more towards debt. Under this fragile financial
system some debt obligation become invalidated as the prices of assets in a
market reach a limit or increase and interest rates are so high that there is a
fear of inflation. This default of few larger debt obligations under complex and
interrelated market acts as a contamination and creates panic in the financial
market. The result is a “rolling bubble”, and each bubble is larger and packed
with a greater force than the one before it. Soros advocates that this causes
the emergence of an immense size “super bubble” within which smaller
bubbles are created and then busted. Such was the case in the US mortgage
market as bubbles rolled from emerging markets debt, to the dotcom, real
estate and commodities markets. At each turn, bailouts, low interest rates,
inflow of funds from emerging markets and financial innovations created a
powerful source of funds in search of yield, which poured into new asset
classes. According to a view, these results of crisis were predictable and
predicted, as financial fragility (greater reliance on debt) was reinforced. Asset
price increase is a natural response of the market to investment opportunities,
and bubbles are the result of an overly enthusiastic response of market
participants to profit opportunities. (Sooner or later, bubbles will disappear.) 14
Islamic finance derives its key strength from its inherent underlying principles.
Islamic financial transactions must be along with an underlying asset that has
14
By Dr. Abbas Mirakhor, “The Recent Crisis: Lessons for Islamic Finance”, available online on
http://www.ifsb.org/otherdoc.php, last seen on 10th August 2010.
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a potential of real and productive economic activity to generate legitimate
returns and assets15, thereby ascertaining a secure association between the
economic and financial transactions and productive flows of the operation.16
Islamic financial system can not only be developed to replace the present
conventional financial system but can also be used to fix and improve the
conditions caused by the current Subprime mortgage crisis.
In next chapters, we will have a detail discussion on causes and nature of
Subprime mortgage crisis.
2. Subprime Mortgage Crises
In this chapter Subprime mortgages crisis is elaborated and the alternative system offered by the
Islamic financial system is argued.
A remarkable and rapid growth of capital market has successively diminished
the national boundaries. To meet the demand of these transactions, market
has invented various ways to align financial products with their respective
15
By Dr Zeti Akhtar Aziz, at the Seminar on Islamic Finance: During and After the Global Financial Crisis – "Islamic
finance and global financial stability", Istanbul, 5 October 2009. available online on
http://www.scribd.com/doc/22025051/Dr-Zeti-Akhtar-Aziz-Islamic-finance-and-global-financial-stability , last seen on
10th August 2010.
16
IFSB-IRTI-IDB Islamic Finance and Global Stability Report. Available online on http://www.ifsb.org/otherdoc.php
last seen on 10th August 2010.
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risks. This alignment of financial products with investor’s risks and more and
more appetite of return paved a way to create complex structure of financial
products. The crucial refund policies allowed the credit rating agencies to
award the investment institutions the same grade as they gave to the banks
that backed them.These complexities made such structures difficult to be
understood by the consumers using them, ultimately this lack of
understanding shaped the risk of such products and their underlying assets
dangerously complicated in their understanding and impacts. Everyone
involved, from banks to borrowers to investors, convinced themselves that
they were taking little, if any, risk.17
Under the brunt of rapidly growing economy and the company revenues
reaching their all time high, every day consumer of financial products engaged
himself in a lot of different financial schemes and mortgage loans were one of
those methods adopted by them. From this superficial flourishing scenario of
an artificial economy, a point came when economic bubble bursted. This
bursting of bubble effected the interest rates on mortgages by pushing them
high against the decreasing value of the under lying assets. This unbalance
situation appeared, when supply crossed the level of demand, which
consequently brought a dramatic rise in the rate of delinquency and the
default of Subprime-mortgage loans in US economy, as borrowers were not
able to meet the mortgage payments required because of higher interest
rates. These mortgage loan defaults resulted credit crisis which ultimately
created panic in the credit market.18
2.1 What was the U.S. Subprime Mortgage crisis?

17
By David Henry, “Banking: This Disaster Was Guaranteed”, Magazine Content by Bloomberg Businessweek, Available
online, www.businessweek.com, last seen on 14th August 2010.
18
By Anna Gustavson and Staffan Unge, Unfolding the Subprime Crisis; A Study on the Origin of a Global Crisis, August 2008,
available online on Westlaw UK
Attiya Shafaq
Shafaq 21 26/07/2011
The U.S. mortgage market on the bases of its credit rating was divided into
Prime and Subprime segments. The borrowers who were unable to meet the
required prime criteria were classified as Subprime borrowers. Subprime word
refers to the mortgages given to less than creditworthy borrowers. Initially the
Subprime loans had low interest rates for the first two or three years. Through
low interest rates, there was increased supply of money in the market, and
with additional money floating in the market the banks were in charge to lend
this money in the market to earn extra revenue.19 There were mainly two
types of mortgages working in the market, fixed-rate mortgages and
adjustable-rate mortgages. In fixed-rate mortgage arrangements a fixed
interest payment based on the principal was due on a regular basis. In
adjustable-rate mortgage arrangements interest was set to LIBOR index plus
a certain margin in basis points. Until the interest rate was low these
Subprime mortgage borrowers were able to pay these adjustable rate
mortgages, but when the interest rates increased they became unable to pay
their mortgages. The deterioration in the Subprime mortgage market for the
most part is linked to the defaults on adjustable-rate mortgage arrangements
by these Subprime borrowers.20One of these mortgages was interest only
loans where for couple of years the borrowers were to pay only interest rate
without the principal amount kicking in. The ability to engage in mortgage
loans was dependent on the value of the underlying collateral, i.e. the house.
The lenders of the primary mortgage market include mortgage banking
companies, saving banks and housing finance agencies. Mortgage banking
companies relied on secondary market funding in order to originate more

19
By David Waring, “2008 US Subprime Crisis Intro and Background” available online on
www.informedtraders.com. Last seen on 11th August 2010.
20
Is the 125 Percent Home Equity Loan Right for You? Available online on MortgageLoan.com. (Fri, 06/16/2006).
Attiya Shafaq
Shafaq 22 26/07/2011
mortgage loans. In the secondary market there were several government-
sponsored enterprises that facilitated funding in order to keep interest rates
low on house purchases. Fannie Mae, Freddie Mac and Ginnie Mae were that
operated in the secondary market, providing primary lenders with liquidity.
These enterprises bought these mortgage loans from the primary lenders and
sold them to institutional investors after repacking them into securities. 21 Their
credit ratings provided guidance for the lenders to evaluate a person’s credit
risk as it measured the borrower’s probability of delinquency and default. The
main aspects considered when determining credit quality were the
characteristics of the borrower, of the collateral, and of the loan. 22 The refund
policies, technically known as "liquidity puts," were crucial. They allowed the
credit rating agencies to bestow on the investments the same grade they gave
the banks that backed them.These complexities made such structures difficult
to be understood by the consumers using them and this lack of understanding
shaped the risk of such underlying assets dangerously complicated in their
impacts.23So in the same way these government-sponsored enterprises also
decided the criteria for lending money on these credit ratings. As the prime
segment had become saturated mortgage lenders looked for alternative
customers in new markets. Instead of entering new geographic markets, the
lenders detected a great opportunity by approaching the Subprime segment.
Credit innovations done by these enterprises allowed Subprime borrowers to
engage in a wider range of mortgage products, this extra risk conceded by
these Subprime borrowers, resulted in a higher interest on Subprime
21
By Anna Gustavson and Staffan Unge, Unfolding the Subprime Crisis; A Study on the Origin of a Global Crisis,
August 2008
22
Fair Isaac Corporation (2007), Understanding Your FICO Score.
23
By David Henry, “Banking: This Disaster Was Guaranteed”. Magazine Content by Bloomberg
Businessweek, Available online, www.businessweek.com, last seen on 14th August 2010.
Attiya Shafaq
Shafaq 23 26/07/2011
mortgages. These Subprime mortgagers thought that there income was
sufficient when it was only covering the expected interest ignoring the other
expenses for instance mortgage insurance, closing fees, instalments, and tax.
These total expenses had tendency of going up to three times as high as the
interest expenses, hence, mortgage lenders allowed loans that unfamiliar
Subprime borrowers could not afford.24
2.2 Key features of the financial crisis
Under the U.S. mortgage market the underlying asset was ring-fenced, i.e. the
house was the only collateral backing the mortgage, therefore, a borrower
who faced default on the payment could only offer the underlying house to the
lender, while, the foreclosure of the property cancelling the borrower’s debt,
even if the value of the asset doesn’t correspond to the outstanding debt of
the lender. So U.S. mortgage borrowers made deals by turning in houses of
less value than their actual loans. This system supported the speculative
house ownership, since the borrower may transfer the ownership to the bank
and move if the value of one property is reduced. 25 While under the Islamic
financial system debt payment is the agreed payment between the borrower
and the lender which was agreed when terms of debts were being initialised,
there is no concept of compounding interest. But on extreme levels if a
borrower defaults on the payments, the individual is personally responsible for
the whole debt, if the foreclosed value of the asset doesn’t correspond to the
outstanding debt of the lender, other assets of the borrower may be
24
August 2008
25
August 2008
Attiya Shafaq
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confiscated, This consequently results in individual loss instead of institutional
and systematic damage of the system as a whole.
Another very important aspect of the U.S. mortgage market was that it offered
high loan-to-value (LTV) ratios to borrowers. There was no regulation
regarding LTV ratios, meaning that the loans may exceed the value of the
underlying collateral like there were few loans that were allowing a LTV of 125
percent.26
2.3 The Worst Crisis since the 1930s
The present worldwide financial crisis that began with the crisis in the
mortgage markets in the United States is categorised as the worst financial
crisis since 1930s. This fiscal tightening momentum and tremendous losses
during this crisis turned investment managers to focus on “Return of Capital”
rather then “Return on Capital”. Investors began to realise the riskier nature of
these securities. The insurance for covering default risk became very costly
as asset backed securities were difficult to sell in turn. The financial
institutions that depended on the markets for funding also got adversely
affected. Commercial banks lacked necessary funds to provide new loans as
they depended on short-term commercial paper which they could no longer
obtain and the Investment banks needed short-term paper in order to buy
asset-backed securities defaulted on their payments.27 Financial system
witnessed a jargon of problems that trigger a deeper session of turmoil like
companies that needed credit to survive being shut down, rise of number of
bankruptcies, no new businesses or jobs openings, leaving many people
without jobs and growing up unemployment rates. In the US there was
26
By: MortgageLoan.com Is the 125 Percent Home Equity Loan Right for You? (Fri, 06/16/2006).
27
“The sub prime Mortgage Crisis explained”, available online on www.stock-market-investors.com, last seen on
18th August 2010.
Attiya Shafaq
Shafaq 25 26/07/2011
increase of 25,000 jobless claims to 471,000 in the week ending May 15.28 All
that made it harder to borrow money to buy a house hard to find the funding to
build a factory or renovate and buy new equipment for an existing one.
This recent crisis that began in the financial sector and moved to the real
economy is the result of motives to achieve economic stability in short-run.
This motive indeed causes instability in the long-run since debt mount up to
29
unsustainable levels causing rise of interest rate in future. As stated earlier,
the subprime mortgage crisis refers to real estate crisis triggered by a
dramatic rise in mortgage delinquencies with major adverse consequences for
banks and financial markets around the globe and in USA. This crisis was
fuelled by Subprime lending, a phenomenon that eventually led to the
exporting of the crisis to markets in Europe and Asia. Voracious bank
executives, dishonest mortgage brokers and many other structural conditions
have been blamed for the present financial meltdown. Impact of ignoring the
account of “Systematic Risk” on the part of Credit rating agencies by blessing
the apparently low risk securities with AAA rating can’t be ignored, as in
principal the securitisation of these mortgages did not provide any protection
30
against the systematic risk. A brief over view of that mortgage structure is
as follow:
In first step an individual got a mortgage from a broker, who sold that
mortgage to a bank,
The banks in turn sold that mortgage to an investment firm on Wall Street.
Thousands of such mortgages were collected in one big pool by these firms,
28
By Annalyn Censky, Surprise jump in jobless claims, May 20, 2010, available online on
http://money.cnn.com/2010/05/20/news/economy/initial_claims/index.htm, last seen on 18th August 2010.
29
“The Credit Crisis Credit Crunch”, available online on www.stock-market-investors.com, last seen on 14th August
2010.
30
Neil Seitz, James Gilsinan etc, ”Bank integrity: the case of Subprime lending”, Company Lawyer, 2009, available
online on http://www.westlaw.co.uk, last seen on 12th August 2010.
Attiya Shafaq
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which were receiving a monthly income that was supposed to continue for the
life of these mortgages. These were security backed mortgages and seemed
as safe investments by both US and global investors. These Subprime
mortgages were pooled together and often were broken down, grouped,
packaged and repacked with other mortgages of the same type. And as a last
step these firms pooled together these mortgages as securities and
sold/resold the shares of that income to willing investors. Features of
diversification, liquidity and smoothing out of particular risk of defaulting or
bankruptcy crafted them as wonderful low risked financial vehicles. In
presence of huge demand of these financial assets and absence of not many
who could actually provide such assets, speculative bubbles appeared and
became a part of the supply response of these financial assets. 80 % of
security based US market and excess of capital and liquidity in the financial
market globally pushed an enormous amount of capital into the US mortgage
market. 31 Global and US based banks and investors bought such securities
thinking that they are safe ultimately leveraging them (Invested more capital
than they actually had).
The qualification guide lines adopted by the banks to lend money were pretty
tight in past. They refused to those who have no income or poor credit history.
But new development in economic sector caused the instigation of generating
higher returns and created a corridor for high risk borrowers to mortgage at
the significantly higher mortgage rates.
Thus, on one hand these financial instruments and vehicles were serving as a
great solution to meet the demand of assets in the market and on the other
31
“What caused the current financial crisis”, available online on www.stock-market-investors.com, last seen on 27th
August 2010.
Attiya Shafaq
Shafaq 27 26/07/2011
hand the yield on such securitised Subprime mortgages was also higher.
Ultimately the economy absorbed an enormous amounts of these instruments
and securities and as a result this Subprime lending by banks caused 5
million people to become homeowners from tenants, resulting low rents and
high house prices till they reached untenable heights relative to rents in
contrast to the stock market, as the assets prices attain height in the real
estate market, more assets were created through construction. By 2006,
between 63 and 81 per cent of Subprime loans were originated from

32
mortgage brokers and other wholesale lenders. But this designed plan
Collapsed. 33
In reality the fact was that this boom was not based on a real economic
activity but on a series of inflated debts. The banking institutions had
employed increasingly sophisticated financial engineering techniques to
repackage mortgages into complex structured securities; such financial
innovations were not supported by proportionate development to their
governance processes and risk management infrastructure and practices.34
The halt in rise of housing prices and no increase in average household
income in 2006 made this housing bubble more evident as many Subprime
mortgage lenders began declaring bankruptcy around March 2007. Because
of the losses in the Subprime mortgage markets international financial system
witnessed a triggered surprising turmoil with amazing speed even to those
financial institutions that had no direct exposure to the Subprime mortgage
32
Mark Fox and H. Lane David,” Lessons from the US Subprime mortgage crisis”, Journal of International Banking
Law and Regulation, 2008
33
What Caused the Current Financial Crisis? Available online at http://www.stock-market
investors.com/stock-investment-risk/what-caused-the-current-financial-crisis.html. Last seen on 14th
July 2010.
34
Islamic Finace and Global Stability, Available online on http://www.ifsb.org/docs/IFSB-IRTI-IDB2010.pdf, last seen
on 19th August 2010.
Attiya Shafaq
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market and shake in confidence of many financial institutions and the stock
market grounding systemic weakness across financial sectors. The share
prices for large, small, and investment banks all significantly dropped and lost
about a third of their value creating distrust among the banks and as a
consequence interbank lending was disrupted. This catastrophe that struck
the heart of the macro economy is the result of unruly desires of ravenous
capitalists.35
At this point the Subprime crisis turned into a credit crisis. A credit crunch,
credit squeeze or credit crisis is a reduction in the general availability of loans
or credit or a sudden tightening of the conditions required to obtain a loan
from the banks. The “credit crunch” of 2007-2008 can be seen as a product of
the explosive modification of debt that has occurred in recent years. This
modification has, moreover, combined with a globalisation of the credit
markets to produce not only a lending crisis but also a set of daunting
challenges for those concerned with corporate rescue.36
2.4 Islamic Mortgage System
The World Economic Forum’s Financial Development Report 2008 has
endorsed a view that: “These crises [currency crises, sovereign debt crises,
systemic banking or financial crises, systemic corporate crises, systemic
household debt crises] are often preceded by asset bubbles and the credit
bubbles that feed them… However, many asset bubbles have been
associated with episodes of easy monetary policy and excessive credit
growth. The perverse interaction between easy money, asset bubbles, credit
growth, and leveraging that feed asset bubbles has been observed in many
35
By Asharq Al-Awsat, “The Mortgage Crisis – An Islamic View”, available online on
http://knol.google.com/k/lahem-al-nasser/the-mortgage-crisis-an-islamic-view/jzg9so45w3jo/4#, last seen on 14th
August 2010.
36
Vanessa Finch, “Corporate rescue in a world of debt”, Journal of Business Law,2008
Attiya Shafaq
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episodes. The initial trigger for a bubble may (but not necessarily) be a period
of easy money with relatively low real interest rates. Such a low cost of capital
and easy liquidity may lead to an initial increase in the asset price above its
fundamental value. Since asset purchases are often financed by credit, the
initial increase in the asset prices allows borrowers to borrow more as the
asset price rise increases the value of collateral that can be used to increase
leverage. With higher asset prices, the collateral value of borrowing to finance
further asset purchases is higher, with increased leverage allowing additional
asset purchases that further increases the collateral that then allows further
borrowing and leveraging, entering into a vicious circle… Thus, easy money
and easy credit may be an initial trigger of a process of asset bubbles and
excessive leveraging of the financial system and of the private non-financial
sector (Roubini, 2008, pp. 34-35).”37
As a result of bad investment decisions and financial bets on” risky Subprime
loans” on July 17, 2007, two hedge funds of Bear Stearns collapsed.38 The
following news was the start of a sequence of devastating declarations issued
by the banks and other financial investment institutions and companies about
losses associated to Subprime mortgages.39The declining U.S. housing
prices, unprecedented foreclosures, and unexpected performance of complex
financial products backed by Subprime loans ended up in a global credit
crunch and in order to defuse the effects of economic meltdown, several
37
Research paper by Rafe Haneef, a Research fellow of International Shariah Research Academy for Islamic
Finance.
, “Reshaping the Islamic finance industry applying the lessons learnt from the global financial crisis”, available online
on www.isra.com , last seen on 23rd May 2010.
38
CNBC.com, Two Bear Stearns Hedge Funds 'Essentially Worthless': CNBC, July17, 2007, available online on
http://www.cnbc.com/id/19807752.
39
See Bankrate.com, Subprime Mortgages,May1,2006,http://www.bankrate.com/brm/green/mtg/basics2-4a.asp
Attiya Shafaq
Shafaq 30 26/07/2011
Central Banks overnight slit the lending rates and injected in extra cash into
the economy.40
Under the same effects as a consequence of drying up of money market, the
European Central Bank provided 94.8 billion euros of liquidity of one-day
funds to money markets on August 9, 2007. In September 2007, the Bank of
England, gave an emergency monetary support to British mortgage lender
Northern Rock, that was flickered by a classic bank run and by March 2008,
major banks and insurers across the globe forecasted over $150 billion of
write-downs and losses suffered as a result of financial crisis originated by
Subprime mortgage transactions.41
According to the senior financial analyst Khairul Nizam from Accounting and
Auditing Organisation for Islamic Financial Institutions (AAOIFI) in this chaos,
Islamic economic and monetary market remained intact and Islamic
investment institutions have been protected from the credit crunch that world
was facing as a result of financial crisis. This is because trading of Subprime
mortgages is against the principles of Islamic financial system, so they were
not allowed to step into these transactions.42According to Khairul Nizam, as
the Subprime mortgages are not traded on the principals of Islamic financing
their exposure in the Islamic financial market was non existent. So rather than
credit issues, because of the issues of fundamental structures of these
40
By Nickolas C. Jensen, CPA, “Avoiding another Subprime mortgage bust through greater risk and profit sharing
and social equity in home financing: an analysis of Islamic Finance and its potential as a successful alternative to
traditional mortgages in the US”, available online on http://www.ajicl.org/AJICL2008/Jensen.pdf, last seen on 10th July
2010. also see
41
By Tanya Azarchs, Subprime Writedowns: Is the Worst Over?, BUSINESS WEEK, Mar. 13,2008, available online on
www.businessweek.com, last seen on 23rd May 2010.
42
Kippreport, Islamic Banks ‘Are Safe From Credit Crunch’, Oct. 7, 2007, available at www.kippreport.com , See
also N.C. Aizenman, A Higher Law for Lending; Business is up at Islamic finance firms, which don't charge interest
and weren't part of the mortgage debacle, WASHINGTON POST, May 13, 2008 (“The mortgage industry may be in
meltdown, but at least one class of lender appears to be flourishing: Islamic Finance”).
Attiya Shafaq
Shafaq 31 26/07/2011
transactions the Islamic banks were suppose to stay away from these kind of
dealings.
Thus, Islamic financial institutions escaped the credit crunch by managing to
entirely avoid the Subprime lending market as a result of fundamental
differences between the two systems. Islamic financial institutions are
forbidden from dealing in Subprime mortgages for various reasons: firstly, a
traditional mortgage basically is based on lending at interest and thus is
barred due to containing interest or Riba; secondly, because there is a huge
uncertainty or excessively risky elements involved, a Subprime mortgage is
prohibited because of the involvement of Gharar (Ambiguity) or Maysir
(Gambling).43Risk management is one of the fundamentals of Islamic financial
system. Under this system on one hand there is no profit allowed unless
equivalent liability of loss is taken into consideration and on the other
exposing one’s wealth to unnecessary risk without bringing real economic
activity in motion is also prohibited.
In alternate to the conventional mortgage system Islamic finance adopts a
system which signifies the mechanism of three contracts:
1. A Partnership contract between the bank and the client in buying the
said commodity for example a House.
2. The Ijara (Lease) contract, where bank earns profit by renting or
leasing the said house to the client, and
3. The third contract is where client or partner will buy bank’s share or unit
in the partnership on predetermined price and contract between the
parties. The working mechanism of this system is as follows:

43
Nickolas C. Jensen, CPA, “Avoiding another Subprime mortgage bust through greater risk and profit sharing and
social equity in home financing: an analysis of Islamic finance and its potential as a successful alternative to
traditional mortgages in the United States”, available online on the web site of University of Arizona,
www.law.arizona.edu, last seen of 23rd May 2010.
Attiya Shafaq
Shafaq 32 26/07/2011
In the following example:
• B stands for the bank and
• P stands for the person who wants to buy a House or is a partner of the
bank in the said transaction
Step 1: B and P jointly buy a house, or only B buys a house and becomes the
joint owner or a sole owner of the house respectively.
Step 2: Then a term is agreed let us say 30 years. Now for that term P who is
joint owner of property with B will live in that house and will pay rent to B for
his part of share in house. For example if B’s share of money was 70% in
buying that house then P will pay for that 70% of the share to B and not for
the 30% i.e. his ownership. With this rent that P will pay to B, P will pay B an
amount/equity to buy the share of the house. By this way B’s equity will keep
decreasing and P’s ownership in the house will keep increasing. Through this
variable shared equity plan, steadily as the payments are made, the
proportion of the house owned by B will shift completely to P. Briefly house is
bought on instalment from the bank on a mark up determined by the bank and
the purchaser, until the purchaser pays off. The difference between the
transaction made by the conventional bank and this transaction is that bank
buys house for you and you pay the bank for it, but in a loan transaction under
conventional banking you take loan from bank and you pay back money to the
bank on some interest rate. Summarising the above description, mortgage
financing under Islamic financial system basically involves three contracts
namely:
• Partnership Contract (Musharaka)

Attiya Shafaq
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Two partners share the capital and buy a house or any commodity they
want to buy
• Lease or Rent Contract (Ijara)
As bank is not living in the house, so partner living in the house will be
paying the rent. Or in other words the bank will lease the property to the
partner or client.
• Buying Of the Share (Baye)
The partner or client will be having an option of buying pre determined
share portion from the bank’s portion every month, until the client buys all
the shares of the house. In this kind of financing there is no involvement of
Interest, Gharar which are prohibited under Islamic Shariah in their totality.
Asharq Al-Awsat in his article “The Mortgage Crisis – An Islamic View” states
that this crisis and other analogous to it highlight the ingenious of Islamic
financial system and the wisdom in prohibiting these types of transactions
which involve gambling, interest and uncertainty. He stress that such a crisis
puts a huge burden on those in charge of Islamic banking to invent Islamic
banking tools based on the rules of Islamic finance away from cloning and
reproducing existing conventional banking tools, in order to provide effective
solutions to this economy which has been sent reeling due to its dependence
on human trial and error. He further states that this crisis has broken many of
the beliefs of economic moderation that US has endorsed through the years
just as it also demonstrated that leaving everything to the regulations of the
market without control and oversight leads to catastrophes striking the heart
of the macro economy as a result of the unruly desires of voracious
capitalists. In his view, today the entire world has fallen victim due to the
Attiya Shafaq
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gambles of some Wall Street traders. There is no better way to portray the
root cause of this crisis than with the term ‘gambling,’ which was practiced by
numerous parties starting with the monetary policy makers that are
represented by the Federal Reserve Board, financial institutions, brokers and
borrowers.44
3. Structure of Securitisation in Islamic and Conventional

Financial Systems
In this chapter the basic features of securitisation used in Islamic and Conventional financial system is
presented in respect to the structures of bonds and derivatives.
Over the years securitisation has developed into a significant financing tool,
offering credit to both the public and the private sectors. There are various
kinds of products in the financial market used for the purpose of securitisation.
The key motivation for the employing the tools of securitisation include
cheaper funding, regulatory capital relief, arbitrage and balance sheet
considerations. 45 We have discussed in previous chapters that due to the non
performance of the loans financial institutions were strapped into liquidity
problems. This issue diverted the financial institutions to relay on the bond
44
By Asharq Al-Awsat, “The Mortgage Crisis – An Islamic View”, available online on
http://knol.google.com/k/lahem-al-nasser/the-mortgage-crisis-an-islamic-view/jzg9so45w3jo/4#, last seen on 14th
August 2010.
45
By Jan Job de Vries Robbe and Reviewed by Marek Dubovec, Publication Review, “Securitisation Law and
Practice in the Face of the Credit Crunch”, Journal of International Banking Law and Regulation,2010, Available
online on Westlaw.UK, last seen on 1st September 2010
Attiya Shafaq
Shafaq 35 26/07/2011
market to support their financing needs instead of looking for bank loan
financing and equity financing for required funds. A bond is kind of a loan or a
debt security. In conventional bond structure the issuer of the bond is like
debtor and the holder of the bond is like a creditor. The bond issuer owes the
holder a debt and pays the holder of the bond fixed interest, until the date of
maturity when the principal amount is due. We have discussed in the
previous chapters that interest and debt based transaction in there nature
lead to inequity and instable economic situations. And their malfunctioning
can be termed as a major element attracting the crisis over the years.46 Bonds
are termed as a source of external funding for the issuer to finance his long
term financial projects. Bond holders have a creditor stake in the company for
a definite term.47
Sukuk (plural of Sakk), commonly referred to as “Islamic bonds”, are
proportional undivided ownership rights in tangible assets, or a pool of assets,
or in the assets of a specific project or investment activity. Sukuk are used in
Islamic financial sector as alternate of conventional notes. Sukuk have
developed as one of the most significant mechanisms for raising finance in
the international capital markets used by Islamic financial institutions as an
alternative to syndicated financing48 as a proportionate interest in the well
defined pool of specific assets to yield income and capital interest.
The funds raised through the issuance of Sukuk are applied to investment in
specified and particular assets rather than for general or undetermined
46
By Ben s. Bernanke, “Nonmonetary effects of the financial crisis in the propagation of the great depression”, The
American Economic Review, Vol. 73, No. 3 (Jun., 1983), pp. 257-276
47
By Zariyawati Mohd Ashhari, Loo Sin Chun and Annuar Md Nassir , “Conventional vs Islamic Bond
Announcements: the effects on shareholders’ wealth”, International Journal of Business and Management, vol. 4, No.
6, June 2009. Available online on http://www.ccsenet.org/journal/index.php/ijbm/article/viewFile/1238/2142, last seen
on 10th September 2010.
48
By Shariq Nisar, “Islamic bonds (Sukuk): its introduction and application”, available online
http://www.financeinislam.com/article/8/1/546, Last seen on 23rd May 2010
Attiya Shafaq
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purposes. Identifiable assets provide the basis for Islamic bonds. Since the
Sukuk are based on the real underlying assets, income from the Sukuk
relates to the purpose for which the funding was used. The Sukuk certificate
represents a proportionate ownership right over the assets in which the funds
are being invested. The ownership rights are transferred, for a fixed period
ending with the maturity date of the Sukuk, from the original owner (the
originator) to the Sukuk holders.
The process of issuing Sukuk involves the following steps:
1. Origination of assets from Shariah compliant assets.
2. Transfer of the assets to a Special Purpose Vehicle (SPV) which
issues after packaging them into securities (Sukuk); and
3. Issuing of these securities to investors.
The main difference between the both Islamic and conventional bonds is that
issuance process of Islamic bonds should be approved by Shariah principles
while the issuance process of the conventional bonds only requires the
acceptance or approval of securities commission. Conventional bonds are the
debt of the issuer while on the other hand Sukuk is the like an undivided
ownership share in specific assets. So the owner of the bond has an
ownership claim on the specific assets. 49But in case of conventional bonds it
is the creditors’ claims on the borrowing entity and in some cases liens on
assets as well. Conventional bondholders do not have any responsibilities for
the circumstances of the issuers, while the Sukuk holder has a responsibility
for defined duties relating to the underlying assets. Sukuk structures have real
assets at their core and their structure is based on assets, equity and it could
49
“Capital adequacy requirements for sukuk, securitisations and real estate investment”, January 2009, available
online on www.ifsb.org, last seen on 12th July 2010.
Attiya Shafaq
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be debt based as well while the conventional bonds are based by large on
loans. And ultimate users of Sukuk bonds are both Islamic and conventional
investors but Islamic investors can not use the conventional bonds as their
trading is against the principles of Shariah laws. 50
Conventional bonds as we know are the sale of debt, which is prohibited
under Islamic financial system.
Derivatives
“A Zero Sum Game of Small Investments with Large Consequences’’
For many around us “Casino type trading” is and was considered more than a
threat to the financial system. This breed of synthetic products was identified
as “Financial Weapons of Mass Destruction”51 and for this indistinguishable
rationale Alexander Lamfalussy cautioned against the use of derivatives that
enhance instability and increase systematic risks against the backdrop of
global markets.52 In the global economy, flexibility and innovational
methodologies of derivatives makes them very dominating among other
assets in respect of growth and popularity.53
Derivatives are useful alternatives for holding the underlying commodity or
financial asset. They are being used on a large magnitude in financial markets
by individuals (for leveraging or gearing), by institutional investors (for asset
allocation strategy), by corporate treasurer (for hedging exposure and for
enhancing yields) and by banks /other financial intermediaries (for their
50
Information available online on “Islamic Interbank Money Market”, http://iimm.bnm.gov.my/index.php?ch=1&pg=42
last seen on 3rd September 2010.
51
Warrant Buffet called synthetic products “Financial Weapons of mass destruction” in 2003
52
Liberals and Democrats workshop, February 27th , 2008, “Financial Crisis: its causes and what to do about it?”
available online on http://www.alde.eu/fileadmin/webdocs/key_docs/Finance-book_EN.pdf, last seen on 20th May
2010.
53
By Sami Al-Suwailem, "Hedging in Islamic finance, Occasional paper no. 10," (Jeddah: Islamic Research and
Training Institute, 2006).
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strategic risk management features and for hedging etc). 54 As compare to the
amount of money needed to buy an actual commodity or financial asset they
require a relatively small amount of capital to trade.55
Derivatives became an enigma due to the development of a complexity over
their basic working, purpose and mechanics. They were created to manage
risk and enable hedging, but the troubling part is that they are largely used for
speculation, against their projected purpose.56 The current financial crisis is
largely blamed on the speculative usage of derivatives. According to OCC
only 2.7% of total derivatives are used by end users, (i.e. corporations
assumed to hedge their risks); while the remaining 97.3% is used by dealers
(OCC 2005)57 concluding hedgers as minorities while the speculators an
obvious majority working in the financial market. The three main users of
derivative products are as follows:
Hedgers – They use futures to lock in an acceptable margin between their
purchase cost and their selling price. Hedgers make purchases and sales in
the futures market for the purpose of establishing a known price level for
something they later intend to buy/ sell in the cash market to protect
themselves against the risk of an unfavourable price change in the interim. 58
Speculators – they trade in derivative market with a higher than average risk
in return for a higher than average profit potential especially with respect
54
Workshop on “Derivatives- Pakistan Perspective” organised by Total Biz Solution, available online on
www.mfaridalam.com, last seen on 21st May 2010
55
By Hans R. Stoll and Robert E. Whaley, "The new option markets," in Futures markets: their economic role, ed.
Anne E. Peck, (Washington, D.C.: American Enterprise Institute for Public Policy Research, 1985) Robert C. Merton,
"Financial innovation and the management and regulation of financial institutions," Journal of Banking and Finance
19, no (1995)
56
By Adam Tickell, "Unstable futures: controlling and creating risks in international money," Socialist Register,
(1999). http://socialistregister.com/socialistregister.com/files/SR_1999_Tickell.pdf.
57
By Sami Al-Suwailem, "Hedging in Islamic finance, Occasional paper no. 10," (Jeddah: Islamic Research and
Training Institute, 2006).
58
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to anticipating future price movements, in the hope of making quick, large
gains.59
Arbitragers – in the hope of profiting from the price differential, they purchase
securities from one market for their immediate resale in the new market. It is
basically speculation about the differences in prices of commodities and
assets in different markets.
Islamic Financial System introduced different contractual structures
(described above) in which derivatives can be formulated. But the main
principle around which they all are developed is the same as prescribed by
Shariah laws i.e. there is a freedom of contract under Islamic Financial
System transactions but it should be free of
(i) Interest,
(ii) Uncertainty and
(iii) Gambling
(iv) Underlying asset must exist that
(v) Must be owned by the party willing to sell and
(vi) Must be envisaged to be delivered.60
Islamic derivatives advocate fairness and risk sharing between parties under
ethical investment and substance contract. The terms on which transaction
will take place should be known, any operation apart from it for example
(i) Where time of delivery is not known, or
(ii) where there is ambiguity in presence of some transactional product
or
(iii) There is excess of inequality, or
59
Definition of Speculator , available online on www.investopedia.com last seen on 29th May 2010
60
“Infusing Shariah into Derivatives” www.islamicfinanceasia.com/2_fea-infusing.php
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(iv) Delay in delivery of dissimilar products etc these operations are not
permitted under ISLAMIC FINANCIAL SYSTEM.
Derivatives issued and formulated under ISLAMIC FINANCIAL SYSTEM are
for sole purpose of hedging as there is no speculation allowed under ISLAMIC
FINANCIAL SYSTEM. These derivatives are risk management structures to
manage currency risk in a global trend and yield curve risk movement to
determine the cost of the production. Islamic derivatives are new and are
subject to new changes and developmental issues. The economic effect of
both conventional and Islamic derivatives is the same except that Islamic
derivatives can only be used for hedging and covering risk and not for
speculation and hence deemed to be more restrictive for the impacts that
caused current global crisis.
A derivative is a unique value holder; a financial instrument independent from
the underlying asset from which it derives its value. It is an independently
tradable entity with referable value to its underlying asset.
Types of conventional derivatives include;
1. Forwards,
2. Futures,
3. Options and
4. Swaps.
5. Naked Short Sale
In order to create hybrid instruments these forms are usually combined
together with traditional securities, loans and bonds.
The Forward contracts are customised, simplest in form and risk-exposed
contracts for future trade which are undertaken between two parties with
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diametrically opposing needs to complete a transaction at a future date at a
price that is determined today. Their prices are determined by negotiation so a
party in a better bargaining position may be able to exploit the situation in their
favour. This transaction bears a counterparty risk, i.e. the risk to one party for
the default of other.
The Futures contract is a standardised exchange-traded, daily-settlement
contract with respect to contract size, maturity, product quality and place of
delivery where physical delivery hardly ever takes place. These contracts
carry fair prices which arrive at by the interaction of many buyers and sellers
against exploitations. Unlike forwards they manage to avoid a number of
problems like multiple coincidences and Counterparty risk, as the exchange or
the clearing house itself is the guarantor for each trade by being the buyer to
each seller and the seller to each buyer .61 Exchange minimises its risk of
default by ‘Margining’ and ‘Marking to Market’ methods. Under Margin Call
each party deposits initial deposits/margins, then the party whose position is
losing, pay up as the loss occurs. Marking to market refers to the ‘gain or loss
in each contract position’. The above mentioned gain or loss is determined by
change in the price of the futures or option contracts at the end of each
trading day by adding or subtracting from each account balance.62
An Option entitles the holder the right (not an obligation) to buy or sell the
underlying asset at a predetermined exercise price anytime before maturity
against a premium.
There are three types of options:
1. A Call Option,
61
By Biyathulla Ismath Bacha, “Financial derivatives markets and application in Malaysia” (Serdang: Penerbit
University Putra Malaysia, 2001).
62
M.H Kamali, "Commodity futures: an Islamic legal analysis," Thunderbird International Business Review 49, no. 3
(2007).
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2. A Put Option and a
3. Double Option
A Call Option provides the holder a right to buy and a Put Option provides the
holder a right to sell the underlying asset at a predetermined price, while a
Double Option is a right of the holder, either to buy from or sell to the grantor
a specified underlying asset at a predetermined price during a fixed period.63
In futures and forwards there will be an obligation to exercise the contract,
unless the holder reverses his position before maturity. Inactivity will cause
him to pay compensation or deliver the commodity, however, for options no
such obligation exists at maturity, inactivity will just cause the option contract
to expire and the premium paid will be lost.64
Swap is a multiple of forwards with periodic settlement of contractual
agreements, based on a predetermined notional amount of the underlying
asset in which two parties agree to exchange payments over a period of
time.65 For instance interest-rate swaps and currency swaps, they control
effective management of both balance sheets and risk profiles. 66 In Swap
Contracts two parties exchange benefits (cash flows) resulting from a given
asset or liability. This is very much like a specialized, time limited barter
arrangement. For example, two firms, one with a loan on a fixed interest rate
over ten years and the other with a similar loan on a floating interest rate over
the same period, may agree to take over each other’s interest obligations, so
63
M. H. Kamali, "Islamic commercial law: an analysis of options," The American Journal of Islamic Social Sciences
14, no. 3 (1997).
64
F. Black & Scholes, M., "The pricing of options and corporate liabilities," Journal of Political Economy (1973); J.
Cox, Ross, S., Rubenstein, M., "Option pricing: a simplified approach," Journal of Financial Economics 7, no. (1979).
65
By C. A. Rusinko & J. O. Matthews, "Evolution of a technological community: a case study of financial derivatives,"
Journal of Engineering and Technology Management 14, no. 3-4 (1997).
66
By Yusuf Talal DeLorenzo, “The Total Returns Swap and the "Shariah Conversion Technology" Stratagem”,
available online on www.failaka.com, last seen on 27th May 2010 also see
http://www.allenovery.com/AOWEB/AreasOfExpertise/Editorial.aspx?
contentTypeID=1&contentSubTypeID=7944&itemID=55092&countryID=18674&aofeID=302&prefLangID=411.
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that the first firm pays the floating rate and the second pays the fixed rate. If
one is careful with regards to
Interest (Riba) on physical trades, these contracts can be islamically justified
and could be used regularly in the commodities swap markets.
Alternatives to conventional derivatives Islamic finance system have
developed Islamic derivatives that comply with the rules of Shariah. Their
structure uses a combination of different contracts. These instruments may
include the following contractual structures;
1. Salam
2. Istasnah,
3. Urbun,
4. Wa’ad
5. Jialah
6. Bai bil-Wafa
7. Bai bil-Istighlal
8. Bai Sarf
9. Murabiha contract
10. Islamic Swap etc
A brief summary of the most commonly used Islamic financial derivatives are:
Salam is a clearly beneficial transaction to the seller where two parties agree
to carry out a sale or purchase of an underlying asset at a predetermined
future date and fully cash paid price. So before the performance of transaction
on the part of a seller is reached, price is determined at a lower than the
prevailing spot price for today. The customised nature of Salam makes it
closer to Forward contracts. Thus Salam carries the same problems of

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forwards like double coincidence and negotiated price but counter party risk is
avoided under the transaction as buyer can take guarantee or mortgage as
security against default.67
Note: It is similar to a conventional forward contract with a distinction of full
payment in cash to help needy farmers and small businesses with working
capital financing, whereas, prohibiting the partial payment as it would signify
the use of credit. The subject matter of Salam has to possess defined and
clearly specified qualities. If the commodity is destroyed, seller can buy the
same from anywhere he wants for the buyer (avoiding the element of
‘Gharar’).
Salam contract is used for financing the agricultural sector and by banks to
purchase a good and then resale through a parallel Salam.68
Under Istasnah contract, a buyer contracts with a manufacturer a needed
product under specifications upon agreed and fixed price. Unilateral
cancellation of the transaction is possible by either party before production
begins. Unlike the Salam Contract neither time of delivery or payment in
advance is made.
Under Urbun, the buyer who intends to buy a certain commodity in the future
pays a predetermined amount to the seller as a down- payment. If the buyer
purchases the commodity, the down- payment is counted towards the total
price for the commodity. If buyer decides not to buy the commodity, the down-
69
payment is forfeited to seller. By virtue of holding equal and opposite option
positions on the same strike price, both parties are obliged to honour the
67
68
By Beata M. Paxford, “Derivatives -An Islamic Finance Perspective”, available online on www.sailanmuslim.com,
last seen on 29th May 2010.
69
ibid
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terms irrespective of changes in asset value. The sequence of periodic and
maturity-matched put-call combines with a zero-cost structure and preserves
equitable risk sharing consistent with Islamic financial system entrepreneurial
investment. Unlike in conventional options, there are no unilateral gains from
favourable price movements in the range between the current and the
contractually agreed repayment amount. Any deviation of the underlying asset
value from the final repayment amount constitutes shared business risk in
existing or future assets.70
Note: urban looks as if it is parallel to an option contract yet there are serious
differences between them. As under profit and risk sharing principal both
parties are required to bear the risk of the transaction as the seller may not
sell and the buyer may forfeit his down-payment consequently putting the
burden of risks on one party is strictly prohibited. The purpose of Urbun is to
secure future purchase of the commodity, unlike option the total price of the
commodity is known to the parties at the time contract is entered into and the
client does not need to bet on future price of the commodity. The down
payment in the transaction is treated as a guarantee showing a serious
intention to buy the commodity and latter as compensation to the seller in
case the buyer withdraws from the purchase. This payment is counted
towards the total price of the commodity upon purchase. While in an option
contract the seller sells his right (in the context of Ikhtiyarat) against his
property to buyer for a premium, as he is buying an “Opportunity” from seller
to entitlement him to have first right to purchase underlying asset for an
agreed price on an agreed term in the future.
70
By Andreas A Jobst, “Derivatives in Islamic Finance”, available online on www.eurekahedge.com, last seen on
24th May 2010
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Waad is a unilateral and legally binding promise and in the context of a classic
Murabiha sale resembles a conventional 'sale and deferred payment' model.
Waad is morally binding and may be enforceable at court, if:
(a) If it is a unilateral promise, binding only one of the parties to the Murabiha;
and
(b) The promise has caused the promisee to incur some liabilities. 71 The
Accounting and Auditing Organization of Islamic Financial Institutions
(AAOIFI) has endorsed the extension of the Waad to currency exchange
transactions within an Islamic framework .72 The Wa’ad can be used to
structure an FX (i.e. currency) option. In this regard, Shariah distinguishes
between the “creation” of an option and the “trading” of an option. The
creation of an option for genuine trade hedging purposes is broadly viewed as
permissible, as it reduces uncertainty (Gharar) and is therefore regarded as
contributing towards the public good (Maslaha). However, the trading of an
option without any accompanying purchase or sale of underlying tangibles
and undertaken solely with the objective of making a speculative gain is
regarded as impermissible as this is looked upon as increasing Gharar. The
currency option is conceptually accepted by many scholars and the promisor
may be eligible to receive a fee for facilitating the transaction. The cash-flows
under an FX option using a Wa’ad emulate the cash-flows under a
comparable conventional FX option.73
71
Resolution numbers 2 and 3 of the Fifth Conference of the Islamic Fiqh Academy (Kuwait), as cited in Deutsche
Bank Academic Paper, Pioneering Innovative Shariah Compliant Solutions, available online on www.db.com , last
view on 20th May 2010
72
By Muhammad Al Bashir Al Amine, “Risk Management in Islamic Finance: An analysis of derivatives instruments in
commodity markets, Brill's Arab & Islamic Laws series (2008).
73
By Priya Uberoi, Rahul Chatterji and Dany Bidar, “Promises on the Horizon: An Introduction to the Wa'ad”,
available online on Allen and overy.com, last seen on 21st May 2010.
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Jialah contract is essentially an Istasnah but applicable for services as
divergent to a manufactured product.
Under Bail bil-Wafa seller sells an asset to a buyer who pledges to sell back
the asset to the original owner at a predetermined future date making it a
fusion of sale and pledge (the pledge being to sell back to the owner and not
to a third party).
Note: This transaction is very near to repurchase agreement as the buyer has
rights to benefits from ownership of the asset. A repo is equivalent to a cash
transaction combined with a forward contract. Except that the resale price and
original purchase prices must be the same.
Under the transaction of Bai bil-Istighlal the buyer promises to resell at a
predetermined future price and to lease the asset to the seller in the interim
period. It is a convenient mean to provide short or medium term financing.
The bank first purchases the asset and then leases it the customer before
finally reselling it to the customer.
The Istijrar Contract embedded options that could elicit if an underlying
asset’s price exceeds certain bounds. It involves two parties;
• A buyer which could be a company seeking short term working
capital to finance the purchase of a commodity approaches a
bank.
• The bank purchases the commodity at the current price and
resells it to the company for payment to be made at a mutually
agreed upon date in the future.74
74
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Islamic banks are increasingly looking for ways in which to hedge their
exposures i.e. mismatches between underlying portfolio payments and
payments due from an originator, lender or project company in securitisations,
loan structures and project financings.75This agreement is a customised and
privately negotiated hedging tool that confirms to the principles of Islamic
finance. It is designed for use with Shari’ah-compliant hedging transactions
that use murabaha contracts. This document is prepared to give the industry
access to a framework of document which is neutral in terms of treatment to
both the trasacting parties and strictly comfirms to Shariah principles and will
provide the critical frame work for the growth and evolution of Shariah
compliant hedging instrument.
Under this agreement two types of transaction can take place;
• In which the parties agree that they will enter into at a future date or
• the transactions which one party undertakes pursuant to a wa’ad, to
enter into at a future date at the election of the other party.
The agreement to enter into such transactions is referred to as a DFT terms
agreement. Which will be confirmed by a DFT terms confirmation. Until they
are entered into, DFT do not constitute transactions for the purpose of the
agreement and are therefore treated differently from concluded transactions
(most notably in relation to close-out). However, once entered into, DFT
constitute transactions for the purposes of the Agreement.76
Islamic Profit Rate Swap (IPRS) and the Islamic Cross Currency Swap (ICCS)
are most commonly used swaps. IPRS is used to swap or exchange floating
75
By: Priya Uberoi and Nick Evans, “Derivatives and Structured Finance”, available online on Allen and overy.com,
last seen on 21st May 2010.
76
By Yusuf Battiwala, “ISDA/IIFM Tahawwut Master Agreement”, available online on Allenovery.com, last seen on 5th
July 2010.
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payment obligations with fixed payment obligations while ICCS is used to
hedge against fluctuations in currency rate (by swapping or exchanging a
series of profit payments in one currency for another).
The common underlying Islamic contracts used by the banks in Islamic swaps
are commodity Murabiha and Waad. Other common uses of Islamic
derivatives are for foreign currency exchange purposes. For the purposes of
hedging the exchange rate prices, Islamic banks enter into transactions to
exchange different currencies at a future date but at a rate decided today. The
Islamic contracts that are used to support these transactions are the Waad,
commodity Murabiha and also Bay-Mu’ajjal.77
Swap transactions under Islamic finance are traded bilaterally and combine
opposite maturity matched Murabaha contracts with immediate (or periodic)
transfer of similar assets and delayed payment of the sales price (inclusive of
a premium payment for the use of the asset until the maturity date). The basic
structure matches two commodity Murabaha sale contracts that generate
offsetting cash flows in opposite currencies with maturities desired by the
contracting parties. As explained by Andreas Jobst who considered the case
of a Malaysia-based Islamic bank that raises revenue in Malaysian Ringgit but
faces payments in US dollars over a certain period of time. To eliminate this
foreseeable currency mismatch, Andreas Jobst explains, the bank could
substitute its future outflows in US dollars for outflows in Malaysian Ringgit by
entering into a CCS with a US dollar-paying counterparty. Under this contract,
the Malaysia-based Islamic bank purchases an amount of commodity A on a
Murabaha basis (i.e. against future instalments) denominated in Malaysian
77
By Riyazi Farook, “Derivaties and Islamic Finance”, available on www.islamicfinancingandbanking.blogspot.com
last seen on 21st May 2010
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Ringgit and sells it forward against payment in US dollars. 78 Simultaneously, a
GCC-based Islamic bank buys an amount of commodity B, also under a
Murabaha agreement, but denominated in US dollars and sells it forward
against payment in Malaysian Ringgit. By combining the two Murabaha
contracts, each denominated in a different currency, each party will be able to
receive cash flows in the desired currency. Finally, both banks sell their
particular products in order to recover their initial expense, where the fair
value of each commodity (A and B) should wash out at the prevailing
exchange rate.79
A profit rate swap is best analogised to a conventional interest rate swap.
Under the profit rate swap, the parties enter into Murabaha contracts to sell
Shariah-compliant assets to each other for immediate delivery but on deferred
payment terms. A term Murabaha is used to generate fixed payments
(comprising both a cost price and a fixed profit element) and a series of
corresponding reverse Murabaha contracts are used to generate the floating
leg payments. The cost price element under these Murabaha contracts is
fixed but the profit element is floating. This structure, in effect, is not dissimilar
to the "parallel loans" structure. It should be noted that a profit rate swap may
also be structured as a series of Wa’ad whereby each party undertakes to the
other to "swap" relevant fixed and floating rate payments at some particular
point of time in the future.
Under a conventional interest rate swap the parties agree to exchange
periodic fixed and floating payments by reference to a pre-agreed notional
78
By Andreas Jobst, “Risk Management of Islamic Finance Instruments”, QFINANCE the ultimate financial resource,
available online on http://www.qfinance.com/financial-risk-management-best-practice/risk-management-of-islamic-
finance-instruments?page=4, last seen on 12th August 2010.
79
By Andreas A. Jobst and Juan Sole, “The governance of derivatives in Islamic finance”, Journal of International
Banking Law and Regulation, 2009, available online on westlaw.uk
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amount. As with many conventional derivative products, a conventional
interest rate swap, is prohibited Islamic Financial System because of the
overarching requirements for a transaction for a number conditions for
example,
(i) Riba – the receipt and payment of interest (the effective exchange
of interest payments being fundamental to an interest rate swap);
(ii) Gharar - Identifiable object characteristics (“quantity and quality”) of
a bona fide trade and/or certainty about delivery results--in order to
avoid Gharar. uncertainty in the principal terms of a contract (for
example price, quantity or material characteristics of any asset sold
and hence under a conventional interest rate swap the agreement
to make future payments linked to a floating rate); and
(iii) Maysir - gambling or speculation in contracts (and accordingly,
conventional contracts of insurance and particular futures and
options contracts viewed as akin to gambling are prohibited).
(iv) Price certainty and balance between borrowers (protection
buyers) and lenders (protection sellers)
(v) Asset ownership and prohibition of both short selling and leverage
(under funding)
Islamic financial system arranges the transaction in such a way that the
parties gain the benefit of the positive risk sharing and management solutions
that derivatives can offer but without breaching the fundamental prohibitions
as discussed above (by using reciprocal Murabaha transactions).80
80
By Andreas A. Jobst and Juan Sole, “The governance of derivatives in Islamic finance”, Journal of International
Banking Law and Regulation, 2009, available online on westlaw.uk
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4. Case Study
In this chapter some case law is presented to show how the reckless transaction of “Too Big
to Fail” caused the crisis. In the view of the author by protecting “Too Big to Fail”, we are
failing the system on longer terms, actually if we closely look at the history of these crisis,
such incentives are causing the happening of such crisis once in every decay, not to mention
that it takes another decay to recover from its lose before another episode of a further crisis,
that proves to be more detrimental to economy than the previous one. The time has come
when we have to decide to stop giving pain killers and cure the disease. Death of one culprit
system will act as deterrent for the rest.
The challenges posed by the current global financial crisis, both economic
and social, have highlighted the need for well thought out policy responses
that reach beyond the national sphere to promote cross-border co-operation
and the international regulation of financial markets. The globalised economy
of the 21st century has diminished the supremacy of national authorities,
acting alone, to exercise effective regulatory control and oversight over global
markets. It is the improvements in communication and mobility that have
intensified social, economic and political mobilisations across national
boundaries, driven by international institutions and international corporations
and apparently facilitated by legal regulation.81
81
Journal of International Banking Law and Regulation, 2010, Available online on Westlaw.uk, last seen on 1 st
September 2010.
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Some highlights of the Subprime mortgage crisis are as follows with detail
case study of few of them like Northern Rock and Bear Stearns etc.
Bail out of Fannie Mae and Freddie Mac: On September 7th, The U.S. Fed
had to seize the nation’s two largest mortgage companies, Fannie Mae and
Freddie Mac. In an extraordinary intervention, FED provided financial aid of
$100 billion to each company, to backstop capital shortfalls. The two
institutions owned or guaranteed $5.4 trillion in loan products, or about half of
the U.S. mortgage market. Because of their size and importance for the
economy as a whole, the U.S. Federal Reserve was forced to bailout these
institutions, to avert a total collapse of the financial system. Investors feared
that the take-over could lead to a default of up to $500 billion in CDSs.
Lehman Brothers “failing to become too big to fail”: At the same time as the
bailout of Fannie Mae and Freddie Mac, the investment banks Lehman
Brothers, Merrill Lynch and the insurance company AIG struggled after losing
more than half of their market values. As Lehman was approaching
bankruptcy, speculation arose that the government would not intervene this
time and come to Lehman’s rescue, as they previously had done with Bear
Stearns six months earlier (through the merger with J.P. Morgan). September
14th became an historical day in modern financial markets when Lehman
Brother failed to get the desirable government intervention and filed for
bankruptcy and liquidation, after all attempts to find a buyer had failed.82 On
the same day it was announced that Merrill Lynch agreed to be bought by
Bank of America for $50 billion. In the financial turmoil, the Dow Jones
Industrial average fell 504 index points, the largest drop since the 9/11
82
By Richard Swedberg , “The Structure of Confidence and the Collapse of Lehman Brothers”, CSES Working Paper
Series,Paper#51,Available online on
http://www.economyandsociety.org/publications/wp51_Swedberg_LehmanBrothers.pdf
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terrorist attacks. With record low levels of consumer confidence, October
2008, was the most volatile month in Wall Street history. S&P500 posted its
worst month since the 1987 crash and consumer spending fell for the first
time in 17 years.83
The collapse of Bear Stearns84 caused a lot of employs to loss their jobs. We
have discussed in previous chapters that compounding interests, speculation
and gambling involved in the transactions, hidden risk in pool of mortgages,
mortgage backed securities and collateral debt obligations, gave rise to
Subprime mortgage crisis. Bear Stearns was the major player in mortgage
back securities not only for securitising the debt but also in repackaging those
mortgages and selling them in the market. They were holding these pools of
debt on their books as a very concentrated part of their business. Bear
Stearns in attempts to make money and to show credit worthiness adopted a
pattern by which they were taking short term low interest rate loans from
international market and buying longer term debts on high rate of interest from
the whole sale markets and were earning their profit from the differences
between the two interest rates. To meet their financial obligations of long term
loans, they had the facility of refinancing these loans as well. But when the
short term low interest rate loans become unavailable they were consequently
unable to buy long term debt from international market giving rise to another
classy example of bank run. run on bank is a situation where depositors rush
to the banks to take their money out as the Bear Stearns was investment
83
Just How Bad Was October 2008? 1st November 2008, available online on
th
http://bigpicture.typepad.com/comments/currency/ last seen on 14 August 2010
84
By Axel Jacobsson Philip Nordenström; Reviewing the financial crisis; A descriptive analysis of the turmoil in
financial markets 2007-2009, 2009
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bank so institutions rushed to take their money out. Bear Stearns was also
the second largest prime broker in US financial market making them to “too
big to fail”. We know that the Institutions trade through their credit lines. They
go to the institutions they want to trade with and show their credit worthiness
by showing their financial statements and put up collaterals to secure the
credit line given to them. As institutions trade with multiple firms because
different brokers and banks provide different and better trading package
prices due to competition between them in the market. So instead that these
institutions go to each of them separately and form trade relationships with
them individually, a prime broker establishes a counter party relationship
between them. The main thing that these financial institutions have to do is to
engage themselves with a prime broker and prime broker (Bear Stearns) will
approach these counter party, so basically such trade relationship between
the two financial institutions is through a prime broker. Similarly Bear Stearns
was trading link between financial institutions as their prime broker, making
him too big to fail because the failure of Bear Stearns was equivalent to the
default of all the financial institutions that were trading through Bear Stearns.85
. Further, Subprime lending by investment banks grew from $18.5 billion in
1997 to $56 billion in 2000. Because Subprime loans were bundled and sold
to many large investment banks like Bear Stearns, when the housing bubble
burst, these banks and the investors lost large amounts of money. This in turn
threatened trust in the whole financial system. Ultimately tax payers got stuck
with the problem caused by the voracity of these entities, giving rise to moral
hazards. This is a situation which can not arise if they know that government
85
By David Waring, “2008 US Subprime Crisis Intro and Background” available online on www.informedtraders.com.
Last seen on 11th August 2010
Attiya Shafaq
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will not help or back their reckless behaviour. By helping such institutions
government make the possibility of such incidents to happen more often as in
the back of their mind they know Federal Reserve or government is there to
bail them out of such troubles. Such bailout plans are serving as
encouragement and support to reckless behaviour of voracious financial
institutions. Although the rational behind the government intervention was that
without the help of bail outs and liquidity support, the whole economy will fail
putting serious and negative economic impacts on common citizen. Such
policy decisions sow the seeds for more future crisis and the subsequent
world wide financial trauma. This practice can be termed as providing backing
of unacceptable risk taking and reckless financial transactions, and give rise
to ignore and create excuses for skipping the principles of moral hazard. This
indeed encourages the seed of predatory lending and pursuit of unacceptable
risk to blossom into the carnivorous plants of financial melt down 86
Due to the uncertainty and crisis, Fed-sanctioned rescue of Bear Stearns
unveiled a new £50 billion that later extended to £200 billion, “Special Liquidity
Scheme” under which it swapped Treasury bills for securities backed by
mortgages.87
Nationalisation of Northern Rock: The recent financial turmoil that started in
the summer of 2007 recapped that the crisis and the bank runs are an
important feature of our financial landscape.88 Northern Rock used to be a
building society, mainly based in the north east of England. In 1997 it was
86
By Ellen Harshman. Muhammed Islam and Fred Yeager, “Bank integrity: the case of Subprime lending”, Comp.
Law. 2009, 30(9), 271-276, available online on westlaw.uk, last seen on 20th September 2010.
87
By Maximilian J.B. Hall, “The sub-prime crisis, the credit crunch and bank "failure": an assessment of the UK
authorities' response”, Journal of Financial Regulation and Compliance, 2009, available online on westlaw.uk, last
seen on 20th September 2010.
88
By Lindgren, Garcia and Saal (1996) show that during the period 1980-96, of the 181 IMF member countries, 133
have experienced significant banking problems. Such problems have effected developed, as well as developing and
transitional countries. Also, see Dell’Ariccia, Detragiache and Rajan (2007) for an analysis of real effects of banking
crises.
Attiya Shafaq
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“demutualised”, converted into a public limited company, and authorised to
carry on business as a bank under the Banking Act 1987. On its
demutualisation, shares were issued to its existing depositors. Its core
business remained residential mortgage lending. Under the trance of growing
economy Northern Rock tried to expand rapidly and soon grew to become the
eighth largest UK bank by market capitalisation and fifth largest UK mortgage
lender covering 20% of UK mortgage market. Unlike the norms of traditional
banking system, Northern Rock was expanding not by deposits but they
financed a large part of its expansion and loan book by borrowing money from
the international wholesale money market. This allowed the company to
achieve high levels of growth; but by 2007 global financial markets became
severely disrupted due to credit crunch, and one consequence was that
banks’ ability to raise funds from the international wholesale money markets
was greatly constrained as US market dried up, which means that banks were
not ready to trust each other, and were not willing to lend each other any
more. So they were unable to borrow and went short of liquidity. The
difficulties had begun to arise earlier in the year. By August 2007 the
wholesale money markets had largely closed down. Depositors were worried
what will happen to their deposits and income.89
On Friday 14 September 2007, the first day branches opened following the
news, many customers queued to withdraw their deposits; It was estimated
that £1 billion was withdrawn by clients that day, about 5% of the total bank
deposits held by Northern Rock.90 On Monday 17 September 2007, as worried
89
SRM Global Master Fund LP, Rab Special Situations (Master) Fund ltd, Dennis Grainger & Others Vs. The
Commissioners of her Majesty's treasury, Neutral Citation Number: [2009] EWCA Civ 788, Case No: C1/2009/0453,
C1/2009/0446 & C1/2009/0469, Date: 28/07/2009.
90
"Rush on Northern Rock continues". BBC News. 2007-09-15. available online on
http://news.bbc.co.uk/1/hi/business/6996136.stm. Also see
http://pandapedia.com/wiki/Nationalisation_of_Northern_Rock
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savers continued to flock to some Northern Rock bank branches to withdraw
their savings, it was reported that an estimated £2 billion had been withdrawn
since the bank applied to the Bank of England for emergency funds. By early
afternoon in London, Northern Rock's shares, which had lost 32% on the
previous Friday, fell a further 40% from 438 pence to 263 pence. 91The events
surrounding the collapse of Northern Rock are its excessive reliance on
trading debt, which drove the bank into the arms of the Bank of England in
September 2007 in search of an emergency liquidity lifeline and subsequently
led to a nationwide deposit run on the bank.92The failure of Northern Rock
stands as a “tipping point” in the credit crisis93 a year later the collapse of
Lehman Brothers in the United States was another such point.94 When
Northern Rock failed it had been the fifth largest mortgage lender in the
United Kingdom.95 Its collapse in September 2007 sent shock waves through
banking, regulatory and political circles as it was the first run on a British bank
in over 140 years. The subsequent injection of public funds into Northern
Rock by the Bank of England and its nationalisation in February 2008
reflected a dramatic change in the landscape of British banking.96United
Kingdom has spent a huge lion's share on nationalising Northern Rock to
support the banking system, and to provide a credit guarantee scheme of
approximately £300 billion to encourage banks to lend more.97

91
Northern Rock besieged by savers, http://newsvote.bbc.co.uk/1/hi/business/6997765.stm Also see
92
By Maximilian J.B. Hall, “The sub-prime crisis, the credit crunch and bank "failure": an assessment of the UK
authorities' response”, Journal of Financial Regulation and Compliance,2009,
93
M. Gladwell, the Tipping Point (London: Abacus, 2008).
94
BBC News, “Q&A: Lehman Brothers bank collapse”, September 16, 2008, available at
http://news.bbc.co.uk/1/hi/business/7615974.stm[Accessed March 31, 2009].
95
See further R. Tomasic, “Corporate rescue, governance and risk-taking in Northern Rock” (2008) 29 Company
Lawyer 297 (Part 1) and (2008) 29 Company Lawyer 330 (Part 2).
96
By Roman Tomasic, “Creating a template for banking insolvency law reform after the collapse of Northern Rock:
Part 1”, Insolvency Intelligence, 2009
97
Almunia, European Commissioner for Economic and Monetary Policy, “The crisis and Beyond: What Priorities for
European Financial Markets?” 2nd Financial Centre Meeting, Frankfurt, March 5, 2009, available online
www.mondovisione.com Last seen on 1st September 2010
Attiya Shafaq
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The U.K. bank Northern Rock became the first high-profile casualty of the
global financial crisis of 2007-2008 when it suffered its depositor run in
September 2007. Its high leverage coupled with reliance on institutional

98
investors for short-term funding. When the de-leveraging in the credit
markets began in August 2007, Northern Rock was uniquely vulnerable to the
shrinking of lender balance sheets arising from the tick-up in measured risks.
Financial regulation that relies on risk-weighted capital requirements is
powerless against such runs. The Northern Rock case also offers lessons
concerning the economics of short-term debt.99 Its problems stemmed from
macroeconomic causes, risk management, credit rating agencies, corporate
governance, regulatory and supervisory failures and global institutional
weakness.100
Financial economists had learned many lessons from past crises in both
developed and emerging economies on how to identify problem financial
institutions.101 The causes of the Subprime crisis were related to two
dimensions of the structured-finance market: poor investment analyses and
transaction motivated by the desire of maximum returns based on
fundamentals of compounding interest and the quality of Subprime mortgage
loans. As stated in previous chapters that the complex structures of financial
instruments made the assessment of risk complicated for sellers, investors,
98
By Tanju Yorulmazer, “Liquidity, Bank Runs and Bailouts: Spillover Effects during the Northern Rock Episode”,
Federal Reserve Bank of New York, 1st February 2008, available online on http://ssrn.com/abstract=1107570 , last
seen on 1st September 2010.
99
By Hyun Song Shin, “Reflections on Northern Rock: The Bank Run That Heralded the Global Financial Crisis”,
Journal of Economic Perspectives, Vol. 23, No. 1, winter 2009. also see http://www.aeaweb.org/articles.php?
doi=10.1257/jep.23.1.101
100
Journal of International Banking Law and Regulation, 2010, Available online on Westlaw.uk, last seen on 1 st
September 2010.
101
By Gillian G.H. Garcia, “Ignoring the lessons for effective prudential supervision, failed bank resolution and
depositor protection”, Journal of Financial Regulation and Compliance, 2009. also see
http://www.emeraldinsight.com/fwd.php?oldurl=%2FInsight%2FviewContentItem.do%3FcontentType%3DArticle
%26contentId%3D1800811&newurl=%2Fjournals.htm%3Farticleid%3D1800811%26show
%3Dabstract&statuscode=301
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and rating agencies, leading to the poor investment analysis. With new and
complex high-yield structures sellers were satisfying the investor demand,
however they were unaware of the behaviours of these new products and at
the same time investors were relying upon inaccurate credit ratings and
assumptions on the performance of these financial instruments102. Overall, the
misjudgements causing the Subprime crisis also relate to lack of regulation in
the Subprime market, combined with complex financial engineering. These
underlying conditions generated securities backed by low-quality mortgage
loans not known to investors as they were unaware of all the risk factors these
financial instruments were carrying.103
102
Brunnermeier, Markus K. (2008), “Deciphering the 2007-08 Liquidity and Credit Crunch”. Journal of Economic
Perspectives (forthcoming).
103
Is the 125 Percent Home Equity Loan Right for You? MortgageLoan.com (Fri, 06/16/2006).
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5. Concluding Remarks
In this chapter finial analysis of the thesis is made.
Let us recap the previous chapters; we had cheap global debt searching for
high returns. This search was channelled into a deregulated market by the
innovations of complex financial instruments based on the fundamentals of
interest, uncertainty and speculation. The Subprime mortgage crisis was the
result of a market that was too much involved in debt rather than equity based
transactions. Use of faulty financial models, equally faulty credit ratings and
the effects of securitisation of financial instruments which were not accurately
reviewed for their risk coupled with debt and compounding interest on such
financial transactions gave an open invitation to a devastating Subprime
mortgage crisis. And when all these rudiments combined together under the
effects of globalisation in financial market, we were in the middle of a classic
panic which influenced the financial markets through out the globe. The
Subprime mortgage crisis exposed vulnerability of various regulatory
frameworks operating in the financial market. Without vigorous financial and
economic conditions in the financial market, contagious risks are very
common, and market expansion in such circumstances is a definite threat to
the stability of real economy.104 More than three trillion dollar bail out and
liquidity injections to a dying economy did not come out of blue there are
104
By Tony Ciro and Michael Longo , The global financial crisis: causes and implications for future regulation: Part 1,
Journal of International Banking Law and Regulation, 2009
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number of causes and Islamic economists frequently linked the results of
compounding interest rate, Imbalance between the equity and debt based
transactions, excessive expansions of the firms through debt borrowings, and
inadequate regulations in the financial market to the Subprime mortgage
crisis.105 Taxpayer money was injected as capital into major financial
organisations by governments as an attempt to reinstate the consumers’
confidence in the banking system. Robert Priester, head of department of
Banking Supervision and Financial Markets observed; “… Crisis was due to
the combination of three levels:
First level: ... Sub prime loans in US were regulated by institutions which were
not regulated by the Fed and lending conditions were based on the unrealistic
projection on real estate prices evaluation and completely over looked the
borrower’s repayment capacity.
Second level: CDOs were not easily understood…and
Third level: Imprudent behaviour of the banks…”106 On one hand banks were
selling money (when there was no actual money in existence) and Assets
(before their existence); while on the other hand they allowed the debt to grow
unchecked. This unchecked excessive and imprudent lending worsen by
excessive derivative and speculative transactions on the capital market and
resulted in unavoidable default causing the capital market to crash, further
destabilising banking market which brought another episode of financial crisis
harming real economic sector.
105
The TARP was created under the Emergency Economic Stabilization Act of 2008 which passed by an Act of the
United Congress and signed into law by US President George W. Bush on October 3, 2008.
106
2010.
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Edward Estlin once said "I'm living so far beyond my income that we may
almost be said to be living apart." and this was what exactly happening in our
real economy. Wolfgang Munchau in Financial Times describes this too much
involvement of financial market in debt base financing as “… The US market
was overprized with 40 to 50%. People took loan after loan and you have
reports that people in US having 25 credit cards, taking mortgages that are 20
times more than their incomes, 130% of the Value of the house…” 107
Current Subprime crisis can be evident as a crisis of failed morality , that
innovated financial relationships created by voracity of “investment
originators” and ended up on exploitation of “investors”, who where unaware
of the risk they were investing in. As a consequence we have witnessed a
sharp decline in equity markets through out the globe, collapse of numerous
financial institutions and rescues by central banks and governments by
investing trillions of tax payers money on bailouts, liquidity injections, and by
reducing interest rates in order to Increase liquidity and avoid recession to
revive the financial market and to restore assurance in the monetary system.
108
Under the pressure of reviving economy government supported the “Too Big
to Fail”, and one after another the major financial institutions received
government assistance. There is a famous Arabic proverb which says:
“Whoever is secure from punishment may do what he pleases”. This really fits
well on such voracious organisations. This chance of receiving regulatory
forbearance is making big organisations to go beyond the boundaries of
prudent financial transactions and pushes them to the limits of recklessness.
107
Ibid.
108
Islamic Economics and Finance available online on http://www.financialislam.com. Last seen on 17th August 2010.
Attiya Shafaq
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“With big position comes a big responsibility” but these organisations used
this position to black mail governments for their voracious and self-interested
drives, as if governments let them fail they fear that there failures would
cause havoc to the real economy.109 These organisations assumed their
immunity from losses on two assumptions.
1. First that the “Indispensable and Unavoidable Collaterals” stand in front
for managing the risk of default.
2. And then comes the “Too Big To Fail” concept that protects and
ensures their survival and proved to be encouraging reckless
behaviour and negligence to undertake a careful evaluation of loan
applications eventually resulting in unhealthy expansion in the overall
volume of credit, to excessive leverage, and above all unsustainable
speculative investment that gives rise to financial fragility and debt
crises and builds instability into the fiscal structure.110 False sense of
immunity and assurance against losses provided bankers with such a
safety net which is like incentive to take greater risk than what they
otherwise would in normal circumstances. Because as soon the big
banks and borrowers are threatened by the default they are
immoderately bailed out by IMF or central banks or the governments.
This kind of free subsidy proved to be very harmful for the financial
system this is “Rewarding Greed and Stupidity” not the “Ingenuity of
the Market” against the norms of moral hazards.111
109
By Elijah Brewer and Ann Marie Klingenhagen “Be careful what you wish for: the stock market reactions to bailing
out large financial institutions: evidence from the USA”, Journal of Financial Regulation and Compliance, 2010
110
By M. Umer Chapra, The Global Financial Crisis: Some Suggestions for Reform of the Global Financial
Architecture In The Light Of Islamic Finance” available online on http://www.scribd.com/doc/29417966/The-Global-
Financial-Crisis also see
http://www.mihe.org.uk/mihe/upload/documents/Seminar/IslamciEconomicsLecture/Lec3/lec3.doc
111
Video on “the causes of U.S mortgage crisis”, available online on http://al-azmah.com/en/?p=39 , last seen on 17th
August 2010.
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Islamic financial system on the other hand strikes a balance between flexibility
and oversight. Such situations of credit crunch could not happen under
Islamic financial system because this system is based on partnership between
the client and the banks or a social commitment within the Islamic banking
and financial market. The financial crisis has proven very clearly that the
apparent strength of modern financial markets was illusionary. The happy-go-
lucky mood vanished instantly, with the write down of losses accompanied by
the sackings of executives followed by more rigorous lending for the real
victims of the credit crunch. Moreover, this crisis has stunned the economies
through out the globe. The modern financial system differs from Islamic
financial system in many critical respects.112 One thing is very apparent that
the elements which caused the global crisis are the elements completely
prohibited under Islamic financial system. In principle impacts and causes of
the present catastrophe were not different from other significant crisis, as
economic and monetary crises are not strange to financial history. From the
Mexican currency crisis (1994) to Asian currency crisis (1997), Russian
sovereign default (1998) and LTCM bailout (1998) till devastating dot-com
(2000), and very recent housing (2006) and commodity bubble burst (2008)
they always have showed indicating signs of the bigger problems ahead
influencing the world economy at large.113The panic that began in US
mortgage sector rapidly spread through out the globe. Since the experience of
Great Depression 1930, the Subprime mortgage crisis has exposed the world
economy to a worse and very long period of economic slowdown. This default
112
Dr. Abul Hassan,The Global Financial Crisis and Islamic Banking, http://www.islamic
foundation.org.uk/IslamicEconomicsPDF/Hassan-financialcrisis-if.pdf
113
Islamic finance provides way out of economic crisis, available online on
http://www.sundayszaman.com/sunday/detaylar.do?load=detay&link=176182
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and failure of financial market has brought down a notable spill in economic
progress.114
Mainly this time, the credit risk assumed by lenders in US on Subprime clients
was overlooked. The transactions were not balanced between debt and equity
based financing. Stress of financial market on debt based transactions
ultimately ended up in entering into a recession spreading the economic
slowdown and panic through out the globe. People acquired debt, which they
were unable to pay back. Debt was not the problem; the crunch was caused
by the compounding interest which people were unable to pay. There is
nothing wrong in borrowing money; the problem comes when there is too
much money borrowed by the borrowers on interest rate (which is not fixed).
As stated earlier after the Great Depression in 1930s the current financial
crisis is the greatest one that hit the world economy making the speculative
114
2010.
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explosion a reality. Charlie McCreevy Commissioner for the Internal Market
and Services, European Commission in his speech states that “the only way
to prudently lend money is on the basis of a realistic assessment of the
capacity of the borrower to repay- not from crystal ball gazing about the
prospects of finding some one to refinance but from the borrower’s
sustainable cash flows. In the US much of the market moved towards the
assumption that one could indefinitely rely on mortgage refinancing with
increase debt on the back of rising asset values and an environment of
permanently low interest rates… fragility of this system became clear once
falls in US house prices were followed by inevitable high default levels among
over leveraged borrowers. Exposure to these losses was transmitted partly
via the securitisation markets to financial intuitions around the world, trading
of these underlying financial instruments on over the counter markets made
these loses hard to locate… . As market confidence fell, problem started to
appear in other credit markets and default spread to higher quality segments
of the US market, to credit card debt and to car loans.” 115
In the monetary world maximisation of income and wealth is the highest
measure of human achievement and banks also wish to maximise their profits
by extending more credit resulting in high profits. It is high leverage which
enables excessive lending. M. Umer Chapra, who is a research adviser at the
Islamic Research and Training Institute (IRTI) of the Islamic Development
Bank (IDB) states that excessive lending, however, leads to an unsustainable
and shaky boom in asset prices, followed by an artificial rise in consumption
115
By Charlie McCreevy, European Commissioner for Internal Market and Services, Speech at the "International
Financial Crisis: Its causes and what to do about it?" workshop of the Alliance of Liberals and Democrats for Europe
(ALDE) European Parliament, Brussels, 27 February 2008, available on line on
http://europa.eu/rapid/pressReleasesAction.do?reference=SPEECH/08/111&format=HTML&aged=0&language=EN,
last seen on 10th august 2010.
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and speculative investment. The higher the leverage the more difficult it is to
unwind it in a downturn. And this unwinding gives rise to a vicious cycle of
selling that feeds on itself and leads to a steep decline in asset prices followed
by a serious financial crisis, particularly if it is also accompanied by
overindulgence in short sales.116
Almost all crises are the result of excessive and imprudent lending by banks117
that can not only damage its own long-run interest structure but can blow-off
the balance of whole economic system. Mr. Bernanke, Chairman of the Board
of Governors of the Federal Reserve System, stated in one of his speeches
that “far too much of the lending in recent years was neither responsible nor
prudent. ...in addition, abusive, unfair or deceptive lending practices led some
borrowers into mortgages that they would not have chosen knowingly”.118
As stated earlier that the interest on lending operations is the major source of
profit in the conventional financial system by banks, but the bad episode of
loss starts when banks are unable to recover these loans with interest. Hence
it is very prudent to think that banks would carefully analyse their lending
operations to avoid loss. But during the current crisis we have witnessed that
the excessive and imprudent mortgage lending by financial institutions for
example financial institutions like Washington Mutual to many high-risk home
purchasers boomed the defaults of Subprime mortgages in the US. i.e.
116
By M. Umer Chapra, “Global Financial Crisis: Could Islamic Finance Solve the Problem?”, available online on
http://www.islamonline.net/servlet/Satellite?c=Article_C&pagename=Zone-English Living_Shariah
%2FLSELayout&cid=1262372073198, last seen on 14th august 2010.
117
The Bank for International Settlements (BIS) in its 78th Annual Report released on 30 June 2008 by stated that the
fundamental cause of today’s problems in the global economy is excessive and imprudent credit growth over a long
period (p.3).
118
By M. Umer Chapra, The Global Financial Crisis: Some Suggestions for Reform of the Global Financial
Architecture In The Light Of Islamic Finance” available online on http://www.scribd.com/doc/29417966/The-Global-
Financial-Crisis, also see http://www.isdbforum.org/Subjects/Islam_and_the_Financial_Crisis/umerchapra1.pdf last
seen on 12th August 2010.
Attiya Shafaq
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1. The lenders paid certain amount of service fees to Washington Mutual
in return of the sale. Mutual securitised this lending and sold to
mortgage guarantee institutions (Fannie Mae and Freddie Mac) to earn
more funds.
2. The guarantors pooled and packaged the mortgages into instrument
called Mortgage backed Securities (MBS).
3. MBSs were sold to the Wall Street. After that, the Wall Street re-
packaged the MBS into another derivative instrument called as
Collateralized Debt Obligations (CDOs) and sold them to some
investment banks, e.g. Lehman Brothers.
4. The investment banks mixed prime and Subprime debt to pass the
entire risk of default of even Subprime debt from mortgage originators
and sold the instruments to the ultimate purchasers who due to this
disguise packaging could not see the inherent risk of the financial
instrument they bought against their default.

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The high ratings and higher yields on CDOs, made it easier for mortgage
originators to pass the risk of default to the ultimate purchasers. Unscrupulous
lenders also used deceptive tactics to sell adjustable rate mortgages (ARMs)
to promote the sale of debt to unsophisticated borrowers. Loan volume
accordingly gained greater priority over loan quality and the amount of lending
to Subprime borrowers and speculators increased steeply. This bundle of
doughy debt became structured investment vehicle (SIV). In the end they
structured no risk but crisis. This camouflage created uncertainty in creditors
and they sought for protection against default by buying derivatives like Credit
Default Swaps (CDSs). They paid premium to hedge funds for the
compensation they will receive in case the debtor defaults. An additional
dilemma was that the hedge funds not only sold these CDSs to creditors, but
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also to a large number of others who were willing to bet on the default of
these debtors, and those speculators further resold such instruments ahead.
Consequently, the default of hedge funds and investment banks to pay such
promised incentives to the instrument buyers brought them to unavoidable
bankruptcy and those buyers to extremely high investment losses.119
The lack of transparency in the financial market also played its part as the
inadequate information led to adverse selection of transactions. Assessments
that were based on complex modelling did not provide a clear picture of tail
risks or liquidity risk and this put creditors to have a heavy reliance on rating
agencies. Credit rating agencies were providing triple AAA rating to the
institutions in deception or due to lack of understanding about the nature of
the new financial instruments, what ever the reasons were they were acting
recklessly by playing with the life time wealth of the people by putting very
little of their own in this zero sum game. The set-up was so unclear that After
August 2007 when London market went down a well know city firm Lake
Street Global Market issued a statement saying: “Market participant don’t
know whether to buy on rumor or sell on news, do the opposite do both or do
neither depending on which way the wind is blowing.”
This brings us to a conclusion that the current financial crisis is self created by
the market system under the huge influence of voracity. Advocates and the
opponents of both who believe in government intervention and free market
economies have failed to deliver a practical long-term solution to the crisis.
The break down of old relationships of depositors and borrowers for sources
of funds moved to capital markets through Securitisation process. This
119
By Miranti Kartika Dewi, Islamic Finance: A Therapy for Healing the Global Financial Crisis, available online on
http://cgfs.hu.edu.jo/confernce%20papers/Miranti%20Kartika%20Dewi%20(%20Islamic%20Finance_%20A
%20Therapy%20for%20Healing%20the%20Global%20Fin%20Crisis).PDF , last seen on 10th August 2010.
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ultimately created a web of Innovation driven new risks by creation of complex
and opaque financial instruments of hedging and speculation for transfer of
risk that were not well understood by the investors resulting in crisis of
financial markets. This phenomenon on one hand caused the financial
institutions to suddenly lose significant proportion of their value and on other
unexpectedly affected the Investors to lose substantial amount of their
investments. This created a constraint on the flow of credit to families and
businesses, bringing adverse effects on the real economy. Conventional
financial system promoted derivatives to transfer one kind of risk, but created
newer risks through complex securities which being novel in their nature were
difficult to assess. Investors were unable to know the exact nature and
inherent risks of assets underlying these securities due to lack of
transparency. All this defacing of financial system was originated by excessive
profit-motives driving the creation of complex instruments and deregulation of
financial market which brought the nightmares of default and crisis into a
reality.120
The situation of misunderstanding the complexity of new financial instrument
was not limited to the common consumer but many members of financial
institutions boards have proved to be too ignorant and incompetent to serve
as directors. Like consumers using them the originators originating these
financial instruments were also unable to understand leverage or the implicit
risks behind these derivatives. For example a well known Swiss bank which
prompted for the government aid had only one member on board with
experience in derivatives, similarly the Lehman Brother’s financial board
120
By Kabir Hassan, The Global financial crisis and the Islamic Finance Solution,
http://www.sesric.org/imgs/news/image/Presentation-FinCrisisAndIFSolution.pdf
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included the head of US Red Cross and a well known Broadway play writer…
experience in derivatives and risk was sacrificed at the expense of diversity.121
The financial sector became too removed from the real world economy.
Islamic financial system can make a valuable contribution in overcoming the
losses of present crisis.122 Its techniques, if applied and executed properly can
create a much closer nexus between the asset, the customer and the
financier. This system prohibits the creation of debt through direct lending and
borrowing, hence prohibiting excessive leverage, which was one of the root
causes of the present crisis. The creation of debt, through the sale or lease of
real assets (via the Murabahah, Ijarah, and Salam or Istasnah modes of
financing) is very suitable mode of financing to be used as a rescue method.
As these transactions are based on the principles which prohibit compounding
interest, sale of debt, speculation and uncertainty in financial transactions.
The crisis has proven that Islamic financial system is a credible alternative
system that is free of the major weaknesses found in the conventional system.
Islamic financial system not only encourages the equity based financing
against debt based financing but under this system the due to its inherent risk
structure the market risk can not be over stretched like we have seen during
the present crisis as result of conventional financing.
121
Ignacio de la Torre, The role of derivatives in the credit crisis, http://al-azmah.com/en/?p=24
122
Dr M. Umer Chapra, “The global financial crisis: Can Islamic finance help minimise the severity and frequency of
such a crisis in the future?” (A paper prepared for presentation at the Forum on the Global Financial Crisis at the
Islamic Development Bank on 25 October 2008) available online on http://www.isdbforum.org/presentationPapers/5-
M_Umer_Chapra.pdf , last seen on 10th August 2010.
Attiya Shafaq
Shafaq 74 26/07/2011
The current crisis shows the soundness of a trade and investment-based
financial system, which is firmly present in the foundations of Islamic financial
system. The strengths of Islamic finance are derived from its adherence to
ethical finance and socially responsible investment.123 In the view of the
author, “although Islamic financial system is new and obviously requires time
to develop against its rival, but indeed provides perfect set of basic principals
on which new alternate financial instruments can be developed to avoid
further crisis. A prudent and rational solution for further avoidance of financial
crisis is not possible without following the basic guidelines advocated by
Islamic financial system.”
THE WORD LIMIT FOR THIS COURSEWORK IS: 15,000 WORDS
123
Islamic finance provides way out of economic crisis, http://www.sundayszaman.com, 25th May 2010
Attiya Shafaq
Shafaq 75 26/07/2011
A. Reference
Detail reference of resources used in the thesis is given in the following section
BIBLIOGRAPHY
E. Books
1. Mark Zandi, Chapter 10, “Boom, Bubble, Bust, and Crash” Financial Shock: A
360 look at the Subprime Mortgage Implosion, and How to Avoid the Next
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finance”, Journal of International Banking Law and Regulation, 2009,
available online on westlaw.uk

Attiya Shafaq
Shafaq 76 26/07/2011
 Andreas A Jobst, “Derivatives in Islamic Finance”, available online on
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Management 14, no. 3-4 (1997).

Attiya Shafaq
Shafaq 77 26/07/2011
 David Waring, “2008 US Subprime Crisis Intro and Background” available
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%2FLSELayout&cid=1262372073198, last seen on 14th august 2010.
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minimize the severity and frequency of such a crisis in the future?” (A paper
prepared for presentation at the Forum on the Global Financial Crisis at the
Islamic Development Bank on 25 October 2008) available online on

Attiya Shafaq
Shafaq 78 26/07/2011
http://www.isdbforum.org/presentationPapers/5-M_Umer_Chapra.pdf , last
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stock market reactions to bailing out large financial institutions: evidence from
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 Hyun Song Shin, “Reflections on Northern Rock: The Bank Run That
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markets: their economic role, ed. Anne E. Peck, (Washington, D.C.: American
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"Financial innovation and the management and regulation of financial
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Economy”, available online www.icmrindia.org, last seen on 10th August 2010.

Attiya Shafaq
Shafaq 79 26/07/2011
 Islamic Finace and Global Stability, Available online on http://www.Islamic
financial systemb.org/docs/ISLAMIC FINANCIAL SYSTEMB-IRTI-
IDB2010.pdf, last seen on 19th August 2010..
 ISLAMIC FINANCIAL SYSTEMB-IRTI-IDB Islamic Finance and Global
Stability Report. Available online on http://www.Islamic financial
systemb.org/otherdoc.php last seen on 10th August 2010.
 Jan Job de Vries Robbe and Reviewed by Marek Dubovec, Publication
Review, “Securitisation Law and Practice in the Face of the Credit Crunch”,
Journal of International Banking Law and Regulation,2010, Available online
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Commentary No. 20/9 October
2008,http://new.ceps.eu/system/files/book/1733.pdf
 Kelly, Kate, 2008, Fear, Rumors Touched Off Fatal Run on Bear Stearns,
The Wall Street Journal, May 28, 2008
(http://online.wsj.com/article/SB121193290927324603.html).
 Kippreport, Islamic Banks ‘Are Safe From Credit Crunch’, Oct. 7, 2007,
available at www.kippreport.com , See also N.C. Aizenman, A Higher Law for
Lending; Business is up at Islamic finance firms, which don't charge interest
and weren't part of the mortgage debacle, WASHINGTON POST, May 13,
2008 (“The mortgage industry may be in meltdown, but at least one class of
lender appears to be flourishing: Islamic Finance”).
 Liberals and Democrats workshop, February 27th , 2008, “Financial Crisis: its
causes and what to do about it?” available online on
http://www.alde.eu/fileadmin/webdocs/key_docs/Finance-book_EN.pdf, last
seen on 20th May 2010.
 Maximilian J.B. Hall, “The sub-prime crisis, the credit crunch and bank
"failure": an assessment of the UK authorities' response”, Journal of Financial

Attiya Shafaq
Shafaq 80 26/07/2011
Regulation and Compliance, 2009, available online on westlaw.uk, last seen
on 20th September 2010.
 M. Gladwell, the Tipping Point (London: Abacus, 2008).
 Mark Fox and H. Lane David,” Lessons from the US Subprime mortgage
crisis”, Journal of International Banking Law and Regulation, 2008
 Matsumoto, Gary, 2008, Bringing Down Bear Began as $1.7 Million of
Options, Bloomberg, August 11, 2008
(http://www.bloomberg.com/apps/news?
pid=20601109&sid=aGmG_eOp5TjE&refer=home).
 Maulana TaqiUsmani, What Sharia Experts Say: Futures, Options and
Swaps” (1999) 1(1) International Journal of Islamic Financial Services
 Miranti Kartika Dewi, Islamic Finance: A Therapy for Healing the Global
Financial Crisis, http://cgfs.hu.edu.jo/confernce%20papers/Miranti%20Kartika
%20Dewi%20(%20Islamic%20Finance_%20A%20Therapy%20for
%20Healing%20the%20Global%20Fin%20Crisis).PDF
 Muhammad Al Bashir Al Amine, “Risk Management in Islamic Finance: An
analysis of derivatives instruments in commodity markets, Brill's Arab &
Islamic Laws series (2008).
 M.H Kamali, "Commodity futures: an Islamic legal analysis," Thunderbird
International Business Review 49, no. 3 (2007).
 M. H. Kamali, "Islamic commercial law: an analysis of options," The American
Journal of Islamic Social Sciences 14, no. 3 (1997).
 Neil Seitz, James Gilsinan etc, ”Bank integrity: the case of Subprime lending”,
Company Lawyer, 2009, available online on http://www.westlaw.co.uk, last
 Nickolas C. Jensen, CPA, “Avoiding another Subprime mortgage bust
through greater risk and profit sharing and social equity in home financing: an
analysis of Islamic Finance and its potential as a successful alternative to
traditional mortgages in the US”, available online on

Attiya Shafaq
Shafaq 81 26/07/2011
http://www.ajicl.org/AJICL2008/Jensen.pdf, last seen on 10th July 2010. also
see www.law.arizona.edu, last seen of 23rd May 2010.
 Priya Uberoi and Nick Evans, “Derivatives and Structured Finance”, available
online on Allen and overy.com, last seen on 21st May 2010.
 Priya Uberoi, Rahul Chatterji and Dany Bidar, “Promises on the Horizon: An
Introduction to the Wa'ad”, available online on Allen and overy.com, last seen
on 21st May 2010.
 By Richard Swedberg , “The Structure of Confidence and the Collapse of
Lehman Brothers”, CSES Working Paper Series, Paper # 51,Available online
http://www.economyandsociety.org/publications/wp51_Swedberg_LehmanBr
others.pdf
 Resolution numbers 2 and 3 of the Fifth Conference of the Islamic Fiqh
Academy (Kuwait), as cited in Deutsche Bank Academic Paper, Pioneering
Innovative Shariah Compliant Solutions, available online on www.db.com ,
last view on 20th May 2010
 Rasem N. Kayed and M. Kabir Hassan, “Islamic finance for a global solution-
II”, available online on http://www.thefinancialexpress-
bd.com/2009/08/02/75038.html, last seen on 17th August 2010.
 Roman Tomasic, “Creating a template for banking insolvency law reform after
the collapse of Northern Rock: Part 1”, Insolvency Intelligence 2009
 Research paper by Rafe Haneef, a Research fellow of International Shariah
Research Academy for Islamic Finance, “Reshaping the Islamic finance
industry applying the lessons learnt from the global financial crisis”, available
online on www.isra.com , last seen on 23rd May 2010.
 Roman Tomasic, “Creating a template for banking insolvency law reform after
the collapse of Northern Rock: Part 1”, Insolvency Intelligence, 2009
 R. Tomasic, “Corporate rescue, governance and risk-taking in Northern Rock”
(2008) 29 Company Lawyer 297 (Part 1) and (2008) 29 Company Lawyer
330 (Part 2).

Attiya Shafaq
Shafaq 82 26/07/2011
 Riyazi Farook, “Derivaties and Islamic Finance”, available on
www.islamicfinancingandbanking.blogspot.com last seen on 21st May 2010
 Shariq Nisar, “Islamic bonds (Sukuk): its introduction and application”,
available online http://www.financeinislam.com/article/8/1/546, Last seen on
23rd May 2010
 Sami Al-Suwailem, "Hedging in Islamic finance, Occasional paper no. 10,"
(Jeddah: Islamic Research and Training Institute, 2006).
 Shin, H.S. (2009), “Reflections on Northern Rock: the bank run that heralded
the global financial crisis”, Journal of Economic Perspectives , Vol. 23 No. 1,
pp. 101-19.
 Sakti, Ali.(2009), "Islamic Economic: Challenges and Opportunities of
Monetary Authority in the Global Financial Crisis" Paper presented on Public
Lecture Series held by Centre of Islamic Economics and Business, Faculty of
Economics, University of Indonesia, Depok, Indonesia, February 18, 2009.
 Sami Al-Suwailem, "Hedging in Islamic finance, Occasional paper no. 10,"
(Jeddah: Islamic Research and Training Institute, 2006).
 Tanya Azarchs, Subprime Writedowns: Is the Worst Over?, BUSINESS
WEEK, Mar. 13,2008, available online on www.businessweek.com, last seen
on 23rd May 2010.
 Tony Ciro and Michael Longo, “The global financial crisis: causes and
implications for future regulation: Part 1”, Journal of International Banking
Law and Regulation, 2009, available online on westlaw.uk, last seen on 14
July 2010., also see
http://www.iiu.edu.my/iaw/SHPhDHTMLfiles/Chp_05%20The%20Need
%20for%20Islamic%20Accounting-PF2-Estab%20of%20isl%20org.htm
 “The sub prime Mortgage Crisis explained”, available online on www.stock-
market-investors.com, last seen on 18th August 2010.
 The Bank for International Settlements (BIS) in its 78th Annual Report
released on 30 June 2008 by stated that the fundamental cause of today’s

Attiya Shafaq
Shafaq 83 26/07/2011
problems in the global economy is excessive and imprudent credit growth
over a long period (p.3).
 Tony Ciro and Michael Longo , The global financial crisis: causes and
implications for future regulation: Part 1, Journal of International Banking Law
and Regulation, 2009, last seen on 1st September 2010.
 Tony Ciro and Michael Longo, “The global financial crisis: causes and
implications for future regulation: Part 2”, Journal of International Banking
Law and Regulation, 2010, Available online on Westlaw.uk, last seen on 1st
September 2010.
 Tanju Yorulmazer, “Liquidity, Bank Runs and Bailouts: Spillover Effects
during the Northern Rock Episode”, Federal Reserve Bank of New York, 1st
February 2008, available online on http://ssrn.com/abstract=1107570 , last
seen on 1st September 2010.
 Vanessa Finch, “Corporate rescue in a world of debt”, Journal of Business
Law,2008
 Watt, “The economic and financial crisis in Europe: addressing the causes
and the repercussions”, European Economic and Employment Policy Brief No
3-2008, available online on http://www.etui.org/research/about/Staff/Watt-
Andrew, last seen on 18th July 2010
 Workshop on “Derivatives- Pakistan Perspective” organised by Total Biz
Solution, available online on www.mfaridalam.com, last seen on 21st May
2010
 Yusuf Battiwala, “ISDA/IIFM Tahawwut Master Agreement”, available online
on Allenovery.com, last seen on 5th July 2010.
 Yusuf Talal DeLorenzo, “The Total Returns Swap and the "Shariah
Conversion Technology" Stratagem”, available online on www.failaka.com,
last seen on 27th May 2010 also see
http://www.allenovery.com/AOWEB/AreasOfExpertise/Editorial.aspx?
Attiya Shafaq
Shafaq 84 26/07/2011
contentTypeID=1&contentSubTypeID=7944&itemID=55092&countryID=1867
4&aofeID=302&prefLangID=411.
 Zariyawati Mohd Ashhari, Loo Sin Chun and Annuar Md Nassir ,
“Conventional vs Islamic Bond Announcements: the effects on shareholders’
wealth”, International Journal of Business and Management, vol. 4, No. 6,
June 2009. Available online on
http://www.ccsenet.org/journal/index.php/ijbm/article/viewFile/1238/2142, last
seen on 10th September 2010.
Legislation
Cases
 SRM Global Master Fund LP, Rab Special Situations (Master) Fund ltd, Dennis
Grainger & Others Vs. The Commissioners of her Majesty's treasury, Neutral Citation
Number: [2009] EWCA Civ 788, Case No: C1/2009/0453, C1/2009/0446 &
C1/2009/0469, Date: 28/07/2009
Other Written Sources
 BBC News, “Q&A: Lehman Brothers bank collapse”, September 16, 2008,
available at http://news.bbc.co.uk/1/hi/business/7615974.stm[Accessed March
31, 2009].
 CNBC.com, Two Bear Stearns Hedge Funds 'Essentially Worthless': CNBC,
July17, 2007, available online on http://www.cnbc.com/id/19807752.
 CNBC.com, Two Bear Stearns Hedge Funds 'Essentially Worthless': CNBC,
July17, 2007, available online on http://www.cnbc.com/id/19807752.

Attiya Shafaq
Shafaq 85 26/07/2011
 “Capital adequacy requirements for sukuk, securitisations and real estate
investment”, January 2009, available online on www.Islamic financial
systemb.org, last seen on 12th July 2010
 Just How Bad Was October 2008? 1st November 2008, available online on
http://bigpicture.typepad.com/comments/currency/ last seen on 14th August 2010
 Islamic finance provides way out of economic crisis,
http://www.sundayszaman.com, 25th May 2010
 Ignacio de la Torre, The role of derivatives in the credit crisis, http://al-
azmah.com/en/?p=24
 Kabir Hassan, The Global financial crisis and the Islamic Finance Solution,
http://www.sesric.org/imgs/news/image/Presentation-FinCrisisAndISLAMIC
FINANCIAL SYSTEMolution.pdf
 Northern Rock besieged by savers,
http://newsvote.bbc.co.uk/1/hi/business/6997765.stm Also see
 "Rush on Northern Rock continues". BBC News. 2007-09-15. available online on
http://news.bbc.co.uk/1/hi/business/6996136.stm. Also see
 Tanya Azarchs, Subprime Writedowns: Is the Worst Over?, BUSINESS WEEK,
Mar. 13,2008, available online on www.businessweek.com, last seen on 23rd May
2010.
Other Sources
 http://al-azmah.com/en/?p=39
 http://www.alde.eu/fileadmin/webdocs/key_docs/Finance-book_EN.pdf
 http://books.google.com/books?
id=hXzUAnhEuzYC&pg=PA1&source=gbs_toc_r&cad=4#v=onepage&q&f=false
Attiya Shafaq
Shafaq 86 26/07/2011
 http://www.bankrate.com/brm/green/mtg/basics2-4a.asp Bankrate.com, Subprime
Mortgages,May1,2006
 http://europa.eu/rapid/pressReleasesAction.do?
reference=SPEECH/08/111&format=HTML&aged=0&language=EN speech by
Charlie McCreevy European Commissioner for Internal Market and Services
 http://www.emeraldinsight.com/fwd.php?oldurl=%2FInsight
%2FviewContentItem.do%3FcontentType%3DArticle%26contentId
%3D1800811&newurl=%2Fjournals.htm%3Farticleid%3D1800811%26show
%3Dabstract&statuscode=301
 http://www.financialislam.com.
 http://www.islamonline.net/servlet/Satellite?c=Article_C&pagename=Zone-
English-Living_Shariah%2FLSELayout&cid=1262372073198,
 http://iimm.bnm.gov.my/index.php?ch=4 last seen on 3rd September 2010
 http://www.islamonline.net/servlet/Satellite?c=Article_C&pagename=Zone-
English-Living_Shariah%2FLSELayout&cid=1262372073198
 http://www.isdbforum.org/Subjects/Islam_and_the_Financial_Crisis/umerchapra1.
pdf
 http://www.scribd.com/doc/29417966/The-Global-Financial-Crisis
 http://www.mihe.org.uk/mihe/upload/documents/Seminar/IslamciEconomicsLectur
e/Lec3/lec3.doc
 http://www.mortgageloan.com/125-percent-home-equity Is the 125 Percent Home
Equity Loan Right for You? (Fri, 06/16/2006).
 http://news.bbc.co.uk/1/hi/business/6996136.stm
 http://newsvote.bbc.co.uk/1/hi/business/6997765.stm
 http://pandapedia.com/wiki/Nationalisation_of_Northern_Rock
 http://www.sundayszaman.com/sunday/detaylar.do?load=detay&link=176182
 http://www.stock-market-investors.com
 "Rush on Northern Rock continues".

Attiya Shafaq
Shafaq 87 26/07/2011
 www.allenovery.com
 www.isdbforum.org/presentationPapers/5-M_Umer_Chapra.pdf
 www.Islamic financial systemb.org
 www.investopedia.com Definition of Speculator , available online on last seen on
29th May 2010
 www.islamicfinanceasia.com/2_fea-infusing.php“Infusing Shariah into Derivatives”
 www.stock-market-investors.com “The Credit Crisis Credit Crunch”, available
online on, last seen on 14th August 2010.
 www.stock-market-investors.com, “What caused the current financial crisis”,
available online on last seen on 27th August 2010.
 www.wikipedia.org.com Subprime mortgage crisis, last seen online on 10th July
2010.
Attiya Shafaq
Shafaq 88 26/07/2011
B. Diagrams
Diagames describing differnt effects of subprime morgages crisis, Islamic financial system
and conventional finacial system are presented

Attiya Shafaq
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Attiya Shafaq
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Diagram showing impacts of recession

Attiya Shafaq
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Banks
Imprudent
Leverage Sale of debt
lending activity
Damaged the long term Knocked off the balance in

interest structure financial system
Securitisation
Under the
Derivatives environment of High
demand of profit and
deregulation
Lending institutions
Pooled together
Mortgages
Pooled together to
Mortgage guarantee institutions
form new
Mortgage backed securities
instrumentt
Pooled together to
form new
Collateral debt obligations Stock exchange
instrument
SPC
Bonds
Investment Banks
Rating Agencies rate the bond

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Attiya Shafaq 26/07/11 1

AUTHOR - Miss. Attiya Shafaq

DATE - 27th September 2010

Thesis Supervisor - Professor Bill Davies

Islamic Financial System

Rescue to the Global Financial Crisis

“Islamic financial system carrying the elements of morality and ethics”

intellectual motivation in introducing me to the fascinating world of finance which

during this thesis that deepened my interest in the subject.

Further, I direct heartily gratefulness to my Thesis Supervisor Professor Bill Davies

hesitate in contacting him when ever I required his analysis or suggestions on

aspects of Islamic Finance. I would like to express my thanks to my colleagues Mr.

material and giving me constructive criticism and useful suggestions.

out, special thanks to my grandmother Mrs. Asmat Nisa whose precious

In the end I want to offer my immense gratitude to Miss Ramla Kanwal

“Without you it was impossible for me to come this far”.

Subject Tutor: Professor Christopher Kirkbride

have witnessed the impacts of irregularities done and insufficient monitoring

of the complex financial products in the financial market. Standard regulations

in the loan industry under conventional financial system proved to be

view of the author that the fundamentals of conventional financial system

resulted in degeneration of an artificial economy. Elements of interest, debt

trading, speculation and uncertainty fuelled the voracity of the entities.

Imperative doctrine and mechanism of conventional financial system is

against the fundamentals on which the principles of Islamic financial system

rest upon, therefore, proving them to be two alternative financial systems; we

the primary postulates of conventional financial system. As by following the

principles of Islamic finance, there is no prospect for any kind of transactions

involving interest, gambling and practice of speculation. Hence, the adoption

supervising the financial activity. Under Islamic Financial System transactions

involving interest or a commodity which are not owned or possessed can’t be

based on some real underlying asset it can’t be backed by some artificial

financial arrangement. We know that interest in its nature creates artificial

unpayable. Compounding interest, mere speculation, gambling and debt

trading were the active causes of Subprime mortgage crisis. Securitisation

conventional financial system, Islamic financial system focuses more on

a result of Subprime mortgage crisis, but can successfully replace the

conventional financial system and is capable of transmitting better economic

results on longer terms.

2 Subprime Mortgage Crises

3 Instruments involving Mortgage Structure

1.1 Thesis Structure

conventional financial system and studies the main structural difference of

conventional and Islamic financial systems. The dissertation focuses on US

Subprime mortgage crises, the role of Instruments involving mortgage

structures and different aspects of securitisation involved. This dissertation is

out of this crisis according to the principles of Islamic financial system.

1.2 Research Hypotheses

Islamic financial system deals with financial transactions approved by Shariah

1.3 Structural differences of Conventional and Islamic Financial System

weaknesses2 in the structural and regulatory framework of conventional

the help of substantial political donations of financial institutions, which are

subsequent Latin American and Asian events, suggested a large number of

warning signs for identifying such crisis, ranging from

• Fast growth by acquiring larger or failing institutions,

• Heavy reliance on non-retail funds and inadequate liquidity;

• Dependence on excessive leverage,

• Risky, exotic and cross-border loans to

• Weak managements in the financial systems,

There is a fundamental and conceptional difference in the structure and

working of Islamic and conventional financial systems. Unlike conventional

financial system, Islamic financial system conceptionally focuses more on

productivity rather than credit worthiness. Similarly Interest is prohibited in its

based transactions, whereas, we know that, the development and progress of