The impact of the global financial crisis on Islamic banking

The global financial crisis (GFC) has provided an opportunity to test a number of well-known hypotheses about the relative advantages of conventional banks and those following Islamic principles. In particular, it has been hypothesized that Islamic banks should be more stable in that they do not use some of the more exotic products that were the subject of major losses in the United States. Furthermore, since they practise risk sharing through joint stakes in projects rather than simply charging interest on debt finance, it has been suggested that they ought to be less prone to failure in a downturn because the value of their liabilities will be reduced at the same time as asset values fall. Hence, the pressure on capital to cover losses should be smaller than in the commercial banks. However, the argument is not one way because at the same time Islamic banks are forgoing the opportunity to use a number of well-known derivative products that help manage risk. The net effect is therefore more debatable. Our chapter examines four phases in the global financial crisis. In the analysis, we find that experience is not well aligned with the theoretical expectations, in part because Islamic banks have tried to emulate the effect of conventional instruments and designed shariah-compliant products that have similar effects, hence reducing the potential degree to which the two sets of banks are different.