Credit default swaps (CDS) are the instruments a lender institution buys at a price in order to shift the risk of default in repayment of its loan from the borrowers to the institution selling the CDS.
It is important to note that the risks attached to each outstanding loan are idiosyncratic. However, the seller of CDS undertaking to pay for all defaulters at all times and under any circumstances has no scientific basis to measure the enormous risk it is exposing itself to. This boils down to the fact that such a blind sale of CDS is greed-oriented, rather than being a disciplined approach.
On the other hand, the lender institution purchasing CDS feels secure for its outstanding loan portfolio and this sense of false protection pushes it to go all out giving more and more loans, thereby continuing to enhance its loan book. This, at times, is done even by compromising on the institution’s own policies and procedures to meet the ambitious loan growth targets.
This was how, many western banking experts believe, the seed of the financial crisis was sown. The institutions having regularly bought CDS went aggressive in lending and when the time came for cashing in on the CDS, the seller institutions such as Lehman Bros and others could not endure the pressure of meeting with piled up financial commitments since they never factored in their business model that a time may come when all claims could be lodged at the same time.
Risk management in Islamic finance
The old conventional banking adage of ‘knowing your borrower’ was folded in the face of voracity since the risk was no more borne by the lender but shifted to CDS sellers. This opened the door for maneuvering the practices to lend to anyone and everyone. Even the small earners were made to enter the mortgage trap to buy their own homes which they could have never dreamed of in their lifetime – only to be evicted later.
The Shariah approach to risk management, on the contrary, is realistic and prudent. First of all, Shariah principles do not allow shifting the risks in a financial transaction. Secondly, the transactions involving excessive risks are outlawed in Shariah finance since they are akin to gambling which is forbidden.
Moreover, as opposed to a fixed interest rate system for conventional banking deposits, in Islamic finance the additional wealth created with the application of the original deposit amount is shared between both parties, such as the fund manager (bank) and the fund provider (depositor).
The Shariah approach being pro-business, the motive of parties entering into an Islamic investment contract (such as Mudarabah, Musharakah or Wakalah) is always to make profits for mutual benefits. As such, the money must not be lost except in extraordinary circumstances or due to the utter negligence of either of the contracting parties.
Another fascinating aspect providing protection to the investor from within the Shariah nominate contract is the definition of profit – which is ‘what exceeds the original capital’. Therefore, a fund manager in a Mudarabah contract, a managing partner in a Musharakah contract and the investment agent in a Wakalah contract (where the agent is entitled to an incentive) cannot claim to share the profit unless it is evident that the original capital remains intact at the time of profit distribution.
As such, in Islamic finance, the fear of losing the original capital works to counterbalance the ambition for gain, providing a vigorous internal control system by default. When a system allows shifting the risk at a price, this fear factor becomes inoperative for the buyer of CDS.
Moreover, it is worse when the governments intervene on the pretext of ‘too big to fail’. Such an approach is heavily tilted toward the rich and leads to greater inequality as it protects the lenders but leaves the borrowers to fend for themselves. In other words, it is in fact privatizing gains and socializing pains since the profits go to the corporations whereas losses are borne by the taxpayers.
Sometimes I ponder would it not have been much better if, instead of pumping money in trillions into the same financial institutions that had caused mayhem, the US government should have utilized the money toward buying the subprime mortgages from banks and allowed the hapless homeowners to continue to live in their properties with mortgage payments diverted to the government in a stretched program.
Perhaps this could have averted the massive housing bubble we saw in the US during 2007-10 and helped to reduce the magnitude of the crisis. I wish I had the hotline working with Ben Bernanke, the chairman of the Federal Reserve during the times of turmoil.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the projects advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected]