By Joseph McKinney

Like many students of economics, my intellectual journey began in 2008. After the collapse, confusion prompted countless young adults like me to search the internet, looking for answers. One of the most interesting discoveries I made was the resilience of Islamic finance.

Islamic Finance: Recession Resilient

Despite the anarchy in global banking systems after the 2008 recession, Islamic Finance survived untouched. According to the IMF, “A new IMF study compares the performance of Islamic banks and conventional banks during the recent financial crisis, and finds that Islamic banks, on average, showed stronger resilience during the global financial crisis.” Commentators, like the Economist, began asking questions: What in The Islamic Finance system acts as a bulwark against calamity? What shields Islamic markets from the raging forces of economic disaster?

Statistical Evidence

Ernst & Young, a consultancy and accounting firm, estimates that Islamic banking assets grew at an annual rate of 17.6% between 2009 and 2013, and will grow by an average of 19.7% a year to 2018. According to the Economist, Sharia assets are worth $2 trillion worldwide. But how have they sustained such growth?

Sharia Finance

The principles which enable Islamic finance to weather recessions are set down as Sharia law. These concepts come from the Hadith, a holy book detailing the life of the Prophet Mohamed. First, Sharia financial law asserts that speculation is prohibited. By that, Sharia scholars argue that high risk, high return investments are seen as gambling and are immoral under Sharia law, which is the code of conduct Muslims are bound to follow. Second, Islamic finance prohibits interest, known as Riba. As a consequence, over the last 60 years, Islamic institutions have created as series of new financial instruments that provide capital without using debt or interest.

Mudarabah Contract

A Mudarabah contract is when investors and entrepreneurs share profits for a definite period of time. A Raab ul-Mall (Investor) and Mudarib (Entrepenur) enter into an agreement in which the Raab ul-Mall invests, while the Mudarib runs the company. Sometimes a Raab ul-Mall is an individual; in many cases banks act as Raab ul-Mall. In two-tiered Mudarabahs, banks can work as both Mudarib and Raab ul-Mall. Mudarabah agreements can usually be terminated unilaterally, at any time. Enforcement first comes from the Raab ul-Mall, but if the contract has been irreparably broken, investors may go to a Sharia compliant court, backed by the state.

There are two types of Mudarabah contracts.

1. The rabb-ul-maal may specify a business in which to invest, in which case the mudarib is restricted only to such business as pointed out by Rabb-ul-Maal. This is called restricted Mudarabah or al-Mudarabah al-Muqayyadah.

2. If Rabb-ul-Maal has not specified a business in which to invest, it is considered an unrestricted Mudarabah or al-Mudarabah al-Mutalaqah.

Recession Resistant Finance

There are a couple of reasons why Islamic finance is more stable during recessions.

For example, when using debt instruments, like interest bearing loans, payments are linear and do not change according to company circumstance. For instance, if Bob takes out a loan, and his company goes sour, he will be obligated to pay his debts regardless. However, new companies tend to grow exponentially, rather than linearly. That is because companies tend to earn profit later in their payment schedule, in which profits begin accelerating at an exponential rate. That means at the beginning of a company’s life, there is a mismatch between payment and growth, leading many debtors to increase risk, and possibly default. In contrast, profit sharing like Mudarabah contracts base their payment off success. Consequently, entrepreneurs can focus their capital on business during the crucial beginning months, rather than paying debt with interest.

Islamic finance mainly invests in tangible assets, like oil. Commodities like oil are in limited supply, therefore there is little risk of sudden depreciation. At the end of the day, investors have a good that has intrinsic value. This contrasts with conventional banks that invest in risky derivatives that are not attached to actual, limited goods.

As mentioned above, Islamic finance is inherently less risky because Sharia compliant securities prohibit speculative behavior. Consequently, when conventional banks were trading risky Collateralized Debt Obligations in 2008, Sharia law prohibited Islamic investors from taking on toxic assets. Thus, Islamic finance was largely shielded from the economic crisis.

In that same vein, Islamic finance has a history of 100% reserve banking and a gold standard. 100% reserve banking is a system where a bank holds a 100% of their depositors money. This makes bank runs virtually impossible because every depositor could receive their deposits. However, most Islamic institutions have strayed away from 100% reserves, especially in government influenced markets. But the possibility to have less risky finance is spearheaded by Sharia inspired finance.

Conclusion

Collapse is always at knocking at the door. It is a paradox of civilization that society is both incredibly powerful, yet so fragile. Instead of throwing up hands in defeat, a new era of financial players can analyze the systematic problems by comparing it to others. By using Islamic finance as a case study, experts can more clearly see the results of alternative organization. Moreover, we can derive theories on how Islamic principles foster greater financial prudence. We must not give ourselves the delusion that Islamic finance is a panacea for financial reform. Rather, it is an experiment, playing out before our own eyes.