Aurora Borealis
1 April 2015 CFA Institute Journal Review

Why Economists (and Economies) Should Love Islamic Finance (Digest Summary)

  1. Vipul K. Bansal

Carrying debt is generally seen as a poor choice in a risky, uncertain world where the costs of default are high. The leveraged state of many households, financial institutions, and governments is undesirable and preventable. According to the authors, Islamic finance principles have the potential to decrease the incidence of systemic financial crises and to reduce their costs. Excessive and unsustainable debt should be restructured by converting all or part of it into risk-sharing equity-like products.

What’s Inside?

The high level of debt and low level of equity was very costly during the financial crisis that occurred between 2007 and 2010. The equalization of excessive debt is highly beneficial to all sectors of the economy. The authors suggest that Islamic finance principles should be applied, particularly encouraging a strong preference for profit-, loss-, and risk-sharing arrangements. They suggest that excessive debt should be converted into risk-sharing instruments and that the application of Islamic finance principles can help reduce systemic financial crises and their associated costs. The authors also advocate for the recapitalization of banks through mandatory debt-to-equity conversions.

How Is This Research Useful to Practitioners?

Seven years after the start of the recent financial crisis, the world economy is still suffering from it. The authors suggest that too much debt was the problem and that the solution is less reliance on debt and more reliance on equity. They believe that Islamic finance principles can be helpful because they are based on the concept of sharing profit and loss and the prohibition of charging interest. As a result, equity-type instruments are preferred in Islamic finance. They suggest that restructuring excessive debt into risk-sharing products can be instrumental in regaining sustained growth, especially in European economies. This restructuring also has the potential to prevent future financial crises. It can replace the incentive structures for excessive risk taking and expand the capacity of the economic system to respond to shocks.

The authors believe that all sectors of the economy, sovereign debt, public debt, and even household debt should be converted into equity-like instruments. For example, a household and a bank could be joint owners of a property and share in the profit or loss on the property. The authors also discuss ways of equitizing public debt.

How Did the Authors Conduct This Research?

The authors use data from the OECD, Citi Research, the International Monetary Fund, and other national sources. They show that there was a significant increase in the gross debt of households, nonfinancial corporations, and governments in 26 advanced economies between 1995 and 2011. They also present data that show the sharp increase in the gross debt by sector for the advanced economies as well as gross debt as a percentage of GDP for the nonfinancial sector for selected countries. There was a constant increase in debt from 1980 to 2012.

Abstractor’s Viewpoint

The authors point out that the high amount of private and public debt has made financial crises worse. They propose the application of Islamic finance principles as a way of solving many economic problems. Mandatory conversion of debt into equity-like instruments would be highly desirable. This study should be very useful for policymakers.

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