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

Abstract

The article 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 Long-Term Capital Management (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 spill-over 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 restrictions on the sale of debt, short sales, excessive uncertainty (gharar), and gambling (qimar), which Islamic finance stands for, can help inject greater discipline into the system and, thereby, substantially reduce financial instability.