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The Global Financial Crisis: Can Islamic Finance Help Minimize the Severity and Frequency of Such a Crisis in the Future?

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The Global Financial Crisis: Can Islamic Finance Help Minimize the Severity and Frequency of Such a Crisis in the Future?
October 21, 2008

THE GLOBAL FINANCIAL CRISIS: CAN ISLAMIC FINANCE HELP MINIMIZE THE SEVERITY AND FREQUENCY OF SUCH A CRISIS IN THE FUTURE? by M. Umer Chapra*

(A paper prepared for presentation at the Forum on the Global Financial Crisis to be held at the Islamic Development Bank on 25 October 2008)

___________________
* The author is Research Adviser at the Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB). This paper is a revised and updated version of the keynote Forum lecture delivered by him at the inaugural session of the Eighth Harvard University Forum on Islamic Finance held on 19-20 April 2008 in the Harvard Law School. The views expressed in this paper are his own and do not necessarily reflect those of IRTI or IDB. He is grateful to Shaikh Muhammad Rashid for the excellent secretarial assistance he has provided. He is also grateful to Bashir Khallat, Acting Director of IRTI, for the encouragement and support he has provided and to his colleagues, Drs. Sami alSuwailem, Tariqullah Khan and Salman Syed Ali for their valuable comments on an earlier draft.

ABSTRACT The paper tries to determine the primary cause or causes of the financial crises that have plagued almost every country around the world over the last three decades. Of particular significance are the 1998 LTCM breakdown and the prevailing subprime mortgage crisis in the United States which is more severe than any in the past and has had devastating spillover effects worldwide. It argues that one of the major causes of these crises is the lack of adequate market discipline in the financial system. This leads to excessive lending, high leverage and ultimately the crisis. Unwinding gives rise to a vicious cycle of selling that feeds on itself and leads to a steep decline in asset prices accompanied by bank failures and economic slowdown. Risk-sharing along with the availability of credit for primarily the purchase of real goods and services and



References: International Monetary Fund (September 1998), World Economic Outlook (Washington, DC: IMF). Islamic Horizons, International Monetary Fund, (December 1998), World Economic Outlook, and International Capital Markets (Washington, DC: IMF)

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