The Islamic financial system
period of economic slowdown. There is, hence, a call for a new architecture that would helpminimize the frequency and severity of such crises in the future.Primary cause of the crisis : It is not possible to design a new architecture without firstdetermining the primary cause of the crisis. The generally recognized most important cause of almost all crises has been excessive and imprudent lending by banks over a long period. This isclearly acknowledged by the Bank for International Settlements (BIS), which states as much inits annual report (released on 30th June 2008).This raises the question of what makes it possible for banks to resort to such an unhealthy practice which not only destabilizes the financial system but is also not in their own long-runinterest. There are three factors that make this possible. One of these is inadequate marketdiscipline in the financial system resulting from the absence of profit-and-loss sharing (PLS).The second is the mind-boggling expansion in the size of derivatives, particularly credit defaultswaps (CDSs), and the third is the ‘too big to fail’ concept, which tends to give an assurance to big banks that the central bank will definitely come to their rescue and not allow them to fail.The false sense of immunity from losses that all these factors together provide, has introduced afault line in the financial system. Banks have not, therefore, undertaken a careful evaluation of the loan applications. This has led to an unhealthy expansion in the overall volume of credit, toexcessive leverage, and to an unsustainable rise in asset prices, living beyond means, andspeculative investment. Unwinding later on gives rise to a steep decline in asset prices, and tofinancial frangibility and debt crises, particularly if there is over-indulgence in short sales. JeanClaude Trichet, president of the European Central Bank, has rightly pointed out that ‘a bubble ismore likely to develop when investors can leverage their positions by investing borrowed funds’.