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Would having an Islamic Economy prevent balance sheet recessions?

Bashaar Yousuf Karim
By Bashaar Yousuf Karim
4 months ago
Dear Editor.I would be grateful if you would consider my article for publication on the Islamic Markets website. It examines the potential impact of an Islamic Economy on balance sheet recessions. I am an 'A'-level economics student in Guildford, Surrey, UK.With many thanks.Best wishesBashaar Yousuf Karim

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  1. Would having an Islamic Economy prevent balance sheet recessions ? Bashaar Yousuf Karim Upper 6th Form, Royal Grammar School, Guildford, Surrey, UK Introduction: 34 million - the increase in unemployment (ILO, 2011); 47-84 million trapped in poverty (World Bank, 2013); $14.5 trillion worth of the world’s companies decimated, suicide and drug abuse rates increased (UN, 2011): such were ramifications of the 2008 Great Recession, with after-effects still being felt to some extent today. These consequences, coupled with the cyclical nature of recessions, emphasise how imperative it is to find adequate preventative strategies. In this article, I will discuss how implementation of an Islamic economic system could prevent such a catastrophe. Using the 2008 Great Recession as an example, I will discuss how the underlying principles of Islamic finance could prevent balance sheet recessions. Currency crises are also important triggers of recessions, as illustrated by the 1997 Asian Financial Crisis. However, for brevity, I will address this in a future article. Balance Sheet Recession and limitations of conventional responses A balance sheet recession occurs when both individuals and firms accrue a large amount of private sector debt. Accordingly, firms no longer focus their attention on investment and profit but rather on deleveraging as a means of minimizing the debt, whereas consumers focus on saving to pay off their debt rather than spending, both of which contribute to decline in economic growth. As debt-financed asset bubbles burst, the value of those assets depreciates inordinately, however the liabilities incurred in the acquisition of the asset remain, subjecting individuals or firms to the spectre of negative equity. Thus, to regain financial health and credit ratings, to avoid the notion of bankruptcy or just because consumers lack confidence in the economy, these agents will concentrate on paying off their debt/and saving wherever possible, to rehabilitate their “balance sheets” (Koo, 2012). Thus, this process of deleveraging and saving diminishes aggregate demand and so economic growth declines. In most instances, due to this process, the economy enters a deflationary spiral; this is because even in the presence of zero percent interest, net savings and deleveraged sums are leaked and unable to enter the real economy, and so the economy contracts in absence of any real sufficient demand (Balance Sheet Recessions – World Policy). This type of recession is important to consider, because usual remedies such as monetary policy changes may be ineffective. The lowering of interest rates has no real effect, partly due to lack of confidence in the economy but more so that agents are looking to reduce their negative equity, and so taking a loan and so more debt is counter-intuitive. Although some may be enticed by low interest rates, and arguably are not looking to deleverage, they are still unable to borrow due to a lack of lenders. Essentially, the lenders themselves are repairing their own “balance sheets”, but also they may have little confidence that the
  2. recipient will not default on the loan . Altering interest rates has little effect on increasing demand, due to potential reduced liquidity left in the banks as they may have incurred a ‘Bank Run’ as many withdraw simultaneously to balance their books, and so banks do not have the ability to lend out either. However, the most important reason why lowering interest rates may not work is due to the lack of credit available because the banks “themselves face solvency challenges, trading losses, rising loan defaults and non-performing loans. Thus they hold on to more of their own capital as excess reserves rather than lending it” (Balance Sheet Recessions – World Policy). Another monetary policy response introduced in response to the liquidity trap is quantitative easing (QE). Richard Koo, an expert on balance sheet recessions, claims that injecting liquidity into the economy via QE is not an effective means to boost consumer spending because availability of credit is still sparse as banks are still averse to lending. Koo argues that although initial use of QE is necessary to aid the banks with their own liquidity strife, any further QE may not significantly induce wealth effects on consumption and does not increase investment. He continues to say that the QE “will lead to an asset bubble and they squeeze bank earnings by twisting the term structure of interest rates.” However, not all economists fully concur with Koo’s analysis (Balance Sheet Recessions – World Policy). Essential concepts and principles of Islamic Finance As highlighted above, conventional responses to such catastrophic recessions are relatively ineffective. This illustrates that vital changes are needed in an economy run on the intangible, hence: Islamic Finance. The desiderata of Islamic Finance are derived from the Holy Quran and Sunnah, and should follow the maxims entailed in Sharia law. The first is the prohibition of “Riba”, literally meaning excess, but more commonly associated with usury (meaning lending at excessive rates). Riba al-nasi’ah refers to the interest on loans - prohibition of fixing in advance of a positive return on a loan as a reward for waiting; Riba al-fadl is the excess over and above the loan paid in kind. It lies in the payment of an addition by the debtor to the creditor in exchange of commodities of the same kind (Prohibition of Riba, Maysir and Gharar - Financial Islam - Islamic Finance). Muslims derive these principles from the Quran which states that, ‘Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, "Trade is [just] like interest." But Allah has permitted trade and has forbidden interest.’ (Surah Baqarah - Quran, Chapter 2). Prohibition of usury in Islamic Finance, is considered mainly to ensure that the poor are not exploited via having a more equitable transaction in terms of risk and to ensure unrepayable debt is not incurred. In conventional banking, profit and thus money is the primary objective which can lead to outcomes listed above. But axioms regarding money in Islam are: that money has no intrinsic value or usufruct and its purpose is simply for the facilitation of exchange. It is, put simply, a means to an end and not the end itself. Thus, money should not have any self-enhancing characteristic, thus it is prohibited to earn money out of nothing, commonly displayed as interest. Investment in Islam should be done with intention of not only improving one’s own standards but also improving the standards of others.
  3. Sharia law also condemns the use of Gharar , which in context of finance, means prohibition of any transaction involving deceit, risk, fraud, uncertainty, and hazard that might lead to destruction or loss. It aims to ensure protection of parties in a transaction by promoting transparency and diminishing any information gaps and bounded rationality regardless whether they be intentional or driven by ignorance. To elaborate on further, Sharia law also prohibits any form of gambling in a transaction, Maysir and Qimar. Maysir refers to easy accumulation of wealth by chance and Qimar is where one gains via chance at the expense of another. These principles avoid excessive speculation, relying instead on the intricate analysis of data, which requires aptitude and investment, deemed necessary to make a transaction honest and ensure that a transaction is completed with necessary due diligence. The requirements for a transaction to be Halal (permissible) are as follows: 1.The asset, which is being sold or leased must be real, and not imaginary or notional; (a transaction must be asset-based and not intangible), examples of a real asset are oil, machinery even bonds but imaginary assets can be deferred financing costs and discount allowed in the issue of shares. 2. The seller or lessor must own and possess the goods being sold or leased; 3. The transaction must be a genuine trade transaction with full intention of giving and taking delivery; and 4. The debt cannot be sold and thus the risk associated with it must be borne by the lender himself. (Muhammad b. Ismail al-Bukhari, Sahih al-Bukhari, Kitab al-Buyu, Date Unknown) The 2008 Global Recession The initial trigger appeared to have been the subprime mortgage crisis. The demand for such sub-prime mortgages caused the formation of an asset bubble which is a typical pre-requisite for a balance sheet recession. The purported intention of banks in dealing with subprime mortgages was that they could assume, in the very likely event that the buyer defaulted, very good collateral in the properties themselves, since the value of the asset (the property) was constantly rising. Often these mortgages would have low initial interest rates to entice buyers, however the rate could quadruple after this initial ‘teaser’ rate changed. These types of loans gave buyers no flexibility or protection for unforeseen circumstances, and so lead more people to default on their loans. In addition, even for those who were not subprime borrowers but who wanted to access and/or increase their equity with their homes, as house prices were rapidly increasing, the cost to increase equity would rise also, meaning they would have to refinance with more loans with significantly higher interest rates. By this mechanism, normal borrowers had now become subprime borrowers, which in a stable market would not be too much of an issue (more on this later). Clearly the vulnerability of these customers to rising interest rates would not arise in a Riba-free financial system.
  4. Moreover , the process of securitization exacerbated the likelihood of a recession. One buys a mortgage from the bank, then the bank immediately sells it on the secondary market to e.g a hedge fund. Hedge fund then sells mortgage-backed securities, derivatives, and collateralized debt obligations (CDO), which were a mix of prime and subprime debt which made it possible for mortgage originators to pass the entire risk of default of even subprime debt to the ultimate purchasers who would have normally been reluctant to bear such a risk. Mortgage originators had, therefore, less incentive to undertake careful underwriting (Mian and Sufi, 2008). The mortgage-backed security is a bundle of mortgages the price of which is based on the value of the mortgages that are used for collateral; these are also sold to investors. This process as highlighted above means that risk of the transaction is no longer of concern to the banks and hedge funds, and the onus is now on the investors. Investors, to offset the risk had insurance known as Credit Default Swaps (CDS). Therefore, these derivatives enticed a plethora of investors, including pension funds and banks. These derivatives, since they were backed by insurance and real estate was incredibly profitable, and in order to maximise this newfound profit, the subprime mortgage market expanded markedly. This process of selling on debt clearly does not achieve the criterion 4 stated above for the transaction to be “halal”(due to them not taking responsibility for that potential of default on that debt but simply passing it on). In addition, the principle of Gharar is also compromised, in that there was insufficient clarity to the buyers of exactly what this secondary debt entailed. The cause of the asset bubble here may have been that huge demand for these ‘protected’ derivatives and the mortgages (whether prime or subprime) drove the price through the roof. Investors felt that they were insured by CDS and that the real estate market was very secure - prices had only increased in recent times. This induced an iconic ‘momentum-trade sentiment,’ which forced prices to go up. The bubble developed to such an extent, not only due to Keynesian ‘Animal Spirits’ like behaviour (both by investors in the derivatives but also those purchasing property simply as speculative investment), but also because they considered the bubble either was not present, could not burst or they were immune to any risk from any market collapse, perhaps because they were insured by CDS. This bubble was also facilitated by the large amount of liquidity in the system, due to the “Fed” dropping interest rates to 1%, rendering bonds ineffective and effectively beautifying these derivatives. The potential impact of Islamic finance on the 2008 Global Recession The first premise to address when considering whether Islamic Finance would prevent a balance sheet recession, is the formation of the asset bubble. As mentioned earlier, in order to invest, suitors must not commit any form of Gharar. Arguably this was committed both by consumers of the mortgages themselves, and also by firms investing in the derivatives. Whilst one could argue that consumers were somewhat “coerced” into these transactions by deceitful ‘teaser’ rates and packages, they also did not fulfil their responsibility to scrutinise the transaction to a sufficient degree. In being enticed by the beauty of bigger and better homeownership, or even a first home for some, they experienced cognitive overload and did not fully consider the risk in the deal. Had consumers not fallen for this temptation to such an extent, then there would not have been such a huge demand for these subprime mortgages, which lead to and sustained the growth of the asset bubble. In addition, many consumers,
  5. spurred on by fear of missing out as house prices rose (Animal Spirits) bought properties as a means of investment thus accelerating the price of the assets. Moreover, shallow materialism seems to be a primary objective of human performance, with maximisation of profits and wealth a means of achieving it, which was the underlying motif in the actions of the hedge funds, private investors and banks themselves during this time. The idea of making profits is of course not haraam, but when achieved at the expense of social welfare and justice it then becomes impermissible. Arguably, this mindset of myopic profiteering, clouded their judgement and enabled them to be serial committers of Gharar and Maysir, as they did not consider the wider implications of their actions and did not consider the risk involved, since they were making profits. In addition, it explains why they relentlessly demanded the sale of these mortgages and derivatives, which led to acceleration in size of the asset bubble. This situation was exacerbated either or both by a hubris mindset, which was demonstrated by the common belief that the “banks were too big to fail’”. This belief implied that they felt they were immune to or simply just naïve to the ramifications of their actions. With Islamic finance, even if there is a large minority who surrender to profit, the majority who are morally bound to Islamic legislation, will seek to appease God only and as such will take careful consideration of the implications of their transactions. Subprime mortgages would never have been allowed in an Islamic financial system. Although prima face, this is because they are interest-based, there is also more specific reasoning with respect to these particular mortgages. It appeared that the intention of banks in handing out these loans was to target people at high risk of default, and hence develop another route to profit as a by-product of this default. This is clearly a haraam transaction as the banks were looking to maliciously and relentlessly exploit the recipient, and not intending to share any of the risk (as the banks are predetermining the outcome-which is only positive for them and negative for the other) and there is no essence of equity in a profit-loss-sharing (PLS) model agreement. There was a lack of transparency, and in particular the way the consumers were deceptively enticed, tricked and entrapped; in many cases these consumers were already highly vulnerable with low incomes. This approach is the literal antithesis of Islamic economics in which exploitation and profiteering are shunned, and brotherhood and community are promoted. Finally, this form of transaction is contractually contradictory to the maxim that ‘the transaction must be a genuine trade transaction with full intention of giving and taking delivery;’ and would be considered Qimar, in which the banks were speculatively profiting from the deprivation of others. Moreover, the conditions highlighted earlier for a transaction to be halal would also condemn the use of derivatives, CDO and CDS; this is because the purchase of the derivatives highlighted earlier is an exchange of the intangible in which agents do not have any/full control over the asset, and importantly the use of CDO is potentially a mechanism by which banks rid themselves of any risk and so responsibility. CDS may be interpreted as a mechanism by which the investors rid themselves of any risk. This would be considered haraam as it allows them to simply gamble (Qimar and Maysir) “to claim compensation for losses which have been actually suffered only by the principal party and not by them” (Chapra, 2011). This element of risk aversion, and indeed passing on the risk, had catastrophic implications on the
  6. unmonitored rise of the bubble and also when the bubble burst , as it meant there was a mass confusion as to who should pay and to whom payment was due, which exacerbated the downturn itself. Had there been any element of equity and PLS, and even if there had not been but if the lender had simply borne the debt and risk himself, the above would not have happened. This is addressed by the Islamic pre-conditions highlighted earlier, which obviously outlaw the use of short selling, which is commonly associated in accelerating the capitulation of asset prices (as people do not take responsibility but simply ship on the burden of loss). The key with Islamic Finance, is that there must be a direct 1 to 1 correlation and association between the finance and the real economy, there should ideally be symbiotic balance between the two. When the financial economy grows at the expense of the real, often excess debt is created which if it grows above the size of the sector of the real economy, can lead to the creation of debt-induced bubble bursts, and so may lead to huge balance sheet recessions. With regards to 2008, such imprudent lending, and the transactions listed above lead to huge credit expansions and so creation of a debt mountain. The Islamic attitude to debt is that it should ‘not be promoted for nonessential and wasteful consumption and speculative investments’. The Islamic financial system does not allow the creation of debt through direct lending and borrowing, but rather can be created via the lease or sale of real assets, thus any debt created has the same implications on the real economy as it does financially and in addition allows the recipient to be able to pay back the loan within their means (Chapra, 2011). Thus, if one were to adopt this attitude and follow principles regarding halal transactions, i.e. PLS, risk sharing, that debt cannot be sold, and that any exchange must be tangible, then such imprudent lending and credit augmentation should not occur. Accordingly, the insurmountable debt associated with such debt filled asset bubbles should not develop. The final protective measure to reduce the probability of a recession is one of regulation. Regulators in 2007 may have facilitated the rise of such unethical, and dubious practices. Firstly, there was repeal of the Glass-Steagal Act of 1933, which allowed commercial banks to invest in derivative markets. Furthermore, the Commodity Futures Modernization Act exempted CDS and other types of derivatives. Moreover, credit ratings agencies downplayed risks associated with debt securities, consequently increasing their favourability. Investors were misled into having false confidence in the safety of investments, when, they were actually just fruitless mortgage-related securities. As a result, thousands of foreclosures were seen in the Great Recession. However, in Islamic finance, there are two forms of regulation, the first being the internal religious corporate governance known as the Sharia Board, and the second adherence by individuals to Islamic principles based on the strength of their faith. The Islamic banks, via the Sharia Board, have at least 3 scholars trained on transactional and contractual matters according to Islamic jurisprudence. In order for the contracts and transactions to be validated, these must go through a detailed assessment process and be authorised by the Scholars. The other regulator of adherence to Islamic principles by individuals; they are morally bound by Islamic teachings, and also bound by the fear of punishment which is an eternity in hell, for serious misconduct in all matters, including financial – knowing they will held to account by
  7. God as the ultimate regulator . Therefore, at least to some extent one would expect that they would not indulge in the malpractices that caused the crisis. Concluding Remarks Islamic Economics is a theoretically perfect mechanism by which to prevent a balance sheet recession. I recognise that there are issues in implementation; this is addressed in a separate article. I propose that having a global, universally accepted and harmonised regulatory system, is essential in alleviating inefficiencies in Islamic Finance. For example, it should reduce the number of over-complex and laborious transactions which often marginalise stakeholders and compel them to practise conventional techniques with a trivial “Islamic” twist. In order to achieve such a universally accepted system, the Scholars themselves should cast aside any self-righteous pride about what they think is categorically right. They must correspond with one another, which may involve compromise in certain instances, seek to protect the spirit of Sharia and not bicker about infinitesimally small discrepancies. Furthermore, we must take responsibility of the maintenance of societal welfare and ensure our own individual aspirations do not transgress into myopic hedonism. I agree with Muhammad Umer Chapra, that as Economists we must put less importance on value-neutrality and more importance on normative ethical standards as the foundations of our policies. These ethical standards, these principles, may be Islamic, but they do not have to be, they simply must seek to meet humanitarian goals, and if they do, they are inherently likely to be Islamic. This, for example, is seen even in our modern secular society with the UN Principles for Responsible Investment, which are very similar to Islamic Principles for investment. This provides clear illustration of how Islamic principles can be implemented in a secular society. Bibliography Surah Baqarah. Holy Quran, Chapter 2. Balance Sheet Recessions – World Policy (no date). Available at: (Accessed: 5 September 2019). Chapra, M. U. (2011) The Global Financial Crisis: Can Islamic Finance Help?, Islamic Economics and Finance. doi: 10.1057/9780230361133_5. Hussain, M., Shahmoradi, A. and Turk, R. (2015) WP/15/120 An Overview of Islamic Finance An Overview of Islamic Finance 1. doi: 10.1142/S1793993316500034. Irfan, H. (2015). Heaven's Bankers: Inside the Hidden World of Islamic Finance. Harry N. Abrams, New York. Koo, R. (2012) The Escape from Balance Sheet Recession and the QE Trap, The Escape from Balance Sheet Recession and the QE Trap. Wiley. doi: 10.1002/9781119198895. Mian, A. R. and Sufi, A. (2008) ‘The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis’, SSRN Electronic Journal. doi: 10.2139/ssrn.1072304.
  8. Muhammad b . Ismail al-Bukhari. Sahih al-Bukhari. Date Unknown Prohibition of Riba, Maysir and Gharar - Financial Islam - Islamic Finance (no date). Available at: (Accessed: 9 September 2019).