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The Islamic Perspective on Debt and the Current Banking Crisis: Lessons and Cautionary Tales
Michael Gassner
Head of Islamic finance, strong in compliance and Sharia-compliance, board experience and educator
May 21, 2023
Dear Readers,
In a recent lecture to students in Zurich, I touched an important aspect of Islamic finance – the cautious approach towards debt. This perspective sheds light on the risks associated with interest-driven debt accumulation and provides valuable insights into the current banking crisis. Drawing parallels to historical crises and offering guidance for private investors, this blog post aims to explore the Islamic viewpoint on debt and its relevance to the prevailing financial landscape.
The Islamic View on Debt:
Islam perceives debt with caution, recognizing its potential to create unsustainable financial burdens. The Quran prohibits the charging of interest on money, and emphasizes fairness, justice, and ethical conduct in financial transactions. One of the most known and least understood interventions in the traditions.
Interest on Interest and Unsustainable Debt Piles:
One of the critical concerns highlighted in the lecture was the concept of interest on interest, which leads to the accumulation of unsustainable debt piles. When debt grows exponentially due to compounding interest, individuals, businesses, or even entire economies can find themselves trapped in a cycle of indebtedness that becomes increasingly difficult to overcome. This notion can be seen as a cautionary tale for the current banking crisis: In the order of revelation, the Quran prohibited interest on interest first, and only in another step ended charging interest generally. Exponential growth of debt is never sustainable and must be limited. As an explanation to mainstream economists: Islam allows return on capital in different forms, just not on money triggering the interest on interest problem.
Historical Banking Crises: Lessons Learned:
The lecture drew attention to past banking crises to provide context for the current situation. The savings and loan banking crisis of the 1980s, triggered by the raising of interest rates, demonstrated the dangers of volatile lending practices and excessive risk-taking. Similarly, the solvency-type financial crisis of 2008 has not yet fully evolved, raising concerns about potential triggers such as corporate real estate issues or developing world debt pressures.
The Normalcy of Bank Failures and Mergers:
It is important to remember that bank failures and crises are not uncommon occurrences. Throughout history, numerous banks have merged or closed due to various economic factors. Such events, while challenging, are part of the natural cycle of the financial industry. Understanding this cyclical nature can help investors gain a more realistic perspective and make informed decisions. Do not be surprised, if a few dozen banks will fail till year end, openly or silently due to mergers. This is not “the end of the world”. More serious would be, that the corporate real estate refinancing needs are not met, or sovereign debt defaults of developing countries. Either could trigger a deeper recession.
In light of the lecture, private investors were advised to approach their finances with prudence and foresight. Building and maintaining an emergency fund in the form of cash and gold was emphasized to safeguard against unexpected economic downturns. Furthermore, the suggestion to invest in companies and properties aimed to ensure the retention of value despite inflation, with the hope that these investments will weather financial storms and remain resilient.
Creating a More Resilient Economy: Exploring Alternative Solutions
In addition to discussing the Islamic perspective on debt and the current banking crisis, the lecture in Zurich also touched upon potential solutions to build a more resilient economy that is less prone to such crises. It emphasized the need to reconsider the promotion of debt as a global policy in taxation and regulation and proposed alternative instruments to mitigate risks and ensure stability. Let’s delve into these solutions in more detail.
Ending the Promotion of Debt:
The lecture underscored the importance of reevaluating the prevailing global policy that promotes debt. In many financial systems, debt is incentivized through taxation and regulation, encouraging excessive borrowing and contributing to the fragility of economies. To create a more resilient financial system, it is crucial to rethink these policies and explore alternative approaches that discourage the over-reliance on debt.
Corporate Allowance for Equity:
One proposed solution highlighted in the lecture is the implementation of a corporate allowance for equity. This instrument would incentivize businesses to rely more on equity financing rather than debt. By providing tax incentives or exemptions for equity investments, companies would be encouraged to seek funding through equity partnerships or profit-sharing arrangements, aligning their interests with those of investors and reducing the risks associated with debt-based financing.
Cap on Interest Deductibility:
To address the issue of interest-driven debt accumulation, the lecture suggested the implementation of a cap on interest deductibility. This measure would limit the amount of interest expenses that businesses can deduct from their taxable income. By curbing the excessive deductibility of interest payments, this approach encourages businesses to rely less on debt financing, reducing the vulnerability to unsustainable debt piles and potential crises.
Insurance Model for Deposit Protection:
The lecture proposed an alternative model for deposit protection, shifting from the traditional Basel risk-weighting approach to an insurance-based system. Rather than relying solely on risk-weighted assets to determine the level of deposit protection, an insurance model would pool funds from financial institutions to create a comprehensive protection mechanism – at a market-based price, rather than preferring debt over equity in a calculatory model. This approach would provide greater stability and reassurance to depositors, mitigating the risk of bank runs and bolstering confidence in the financial system.
Full Reserve Monetary System:
Another alternative solution discussed in the lecture was the concept of a full reserve monetary system. This system advocates for a separation between commercial banking and money creation, requiring banks to hold full reserves for all customer deposits on current accounts. By limiting the ability of banks to create money through fractional reserve lending, this approach aims to prevent excessive credit expansion and reduce the risks associated with a debt-fueled economy and makes bank runs plainly unnecessary.
Conclusion:
The lecture in Zurich shed light on the Islamic perspective on debt and its cautionary stance on interest-driven lending. The lecture aimed to provide valuable insights into the current banking crisis by analysing historical banking crises and offering guidance for private investors and policy makers:
Private investors should approach financial matters with wisdom and to learn from past experiences, understanding that bank failures and crises are part of the ebb and flow of the financial world. By staying informed and making prudent investment choices, individuals can navigate challenging economic times while preserving and growing their wealth.
Policy makers should strive to create a resilient economy. The lecture emphasized that moving towards a more resilient economy requires reevaluating the current approach to debt promotion and exploring alternative solutions. Instruments such as the corporate allowance for equity, a cap on interest deductibility, an insurance-based deposit protection model, and a full reserve monetary system were presented as potential measures to mitigate risks and build a more stable financial system. By embracing these alternative approaches, policymakers and regulators can strive for a more sustainable and resilient economy, reducing the likelihood of future banking crises and their far-reaching impacts.
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Published by
Head of Islamic finance, strong in compliance and Sharia-compliance, board experience and educator
source https://www.linkedin.com/pulse/islamic-perspective-debt-current-banking-crisis-lessons-gassner/
Categories: Economics, Economy, Europe, Europe and Australia, Islamic Banking, Islamic Books, Islamic Finance, Switzerland