1. Introduction (includes main objective of your report, what makes your report interesting and section planning of your report)
The aim of this report is to find out what are the effects of 2008 financial crisis to the global market. Besides, this report also talk about how the Islamic and conventional banking system affected by the 2008 crisis. A financial crisis is a circumstance in which the value of financial institution drops rapidly. A financial crisis is regularly connected with a panic or a run on the banks which lead to investors pull back their investments with the expectation that the value of those assets will drop if they remain at financial institution. The 2008 financial crisis started in the United States real estate market in 2007. The crisis spread over the world and harmed the economies of numerous countries including US and reached a new level in September 2008 as several prominent US- based financial institutions collapsed, for example Lehman Brothers and AIG. There are few causes that lead to the financial crisis in 2008. Furthermore, the cause of the financial crisis is also due to the US investors loss confidence in the value of subprime mortgages lead to the liquidity risk, this resulted in United States Federal Bank inject a lot of capital into the financial markets. By mid 2008, the crisis had compounded as the stock markets around the world crashed and turned out to be very unstable.
2. Discuss on the main causes of financial crisis.
2.1 US government policy
First of all, in 1992, the US government began to introduce a new loaning approach to increase “the homeownership rate of low and moderate Americans”, traditional underwriting benchmarks such as up-front payment were relaxed and a second market called subprime mortgages was created. Besides that, following the burst of the dot com bubble in 2001 and the recession that resulted the Federal Reserve engaged in expansionary monetary policy, this implies that the government is slashing the interest rate to 1% from 2001-2004. (Bartmann, 2016) Because of the low interest rates, the demand for the mortgage loans increased as people saw the opportunity to own a house. During the time, housing price grew unexpectedly due to various factors such as over generous loan, persistently low interest rates. Between 2004 to 2006, the Fed raised interest rates seventeen times, increase the interest rates from 1% to 5.25%.
2.2 Subprime mortgages
Subprime mortgage played a very crucial role in the crisis. US banks began to issue subprime mortgages to borrowers with no proof of income and employment to create more mortgages in the market. (Dirnhofer,2012) Bank ensured low interest rates, diminishing up-front payments which allowed more middle class to borrow money to purchase the house they normally couldn’t afford. This action lead to the housing market in the US suffered enormously as a lot of property holders with adjustable-rate mortgages who had taken out subprime loans discovered that they were unable to meet their mortgage repayments as interest rates rose. (Davies, 2017) With an extensive number of borrower defaulting on loans, banks were faced with a circumstance where the repossessed house and land was worth less on the present market than the bank had loaned out initially.
According to the graph above, in 2006, there was a sign that the economy is in trouble, that is the time when the housing prices began to fall. The realtors thought the overheated housing market would come back to sustainable level. The realtors didn’t realize there were an excessive number of property holders with questionable credit. The financial sector created an own market to trade these mortgages. (Amadeo,2016)
2.3 Investment bank and rating agencies
To acquire profit, US banks sold these mortgages, called mortgage backed securities to investment banks and investors globally. Mortgage backed securities were bundles of mortgages and very profitable. Thus, a new financial derivative called collateralized debt obligation (CDO) was created by investment bank. US investment bank paid rating agencies to give high ratings triple “AAA” to their CDO which contain high default risk. Investors believed the rating agencies and felt secured by the rising house prices in the market.
Therefore, it created a ticking time boom before the entire financial market was ready to explode.
3. Discussion on how the banking system is affected by the crisis. (Hint: financial crisis may affect banking industry both domestically and internationally.
The crisis of 2008 has adversely impact on the performance of banking industry. Before the 2008 financial crisis, regulations passed in the US had forced the banking industry to allow more loan for people to buy houses. There are a lot of people who borrowed money to buy houses that were much more costly than their ability to meet their mortgage responsibilities. Besides that, the banks had loaned significantly more than the value of their reserves and not able to sell repossessed houses to recover their loans. This eventually led to the fall of the banking system due to a mountain of debt. The cracks in the US housing sector and banking system started to appear.
Besides that, numerous foreign banks purchased collateralized US debt as subprime mortgages loans that were re-bundled into collateralized debt obligations and sold to financial institutions around the world. Some borrowers began to default on their mortgages as adjustable-rate mortgages rates started to increase in mid 2007, the US bank and foreign bank started to lost money on the loans. Bank began to stop lending to each other, and it became harder for people to get loan.
Besides that, according to the table above prepared by Dr. Smita, many markets reported fall in the growth of bank credit. Return on assets is an indicator of banking system’s profitability. From the table above, it indicates the changes during 2007-2012. At first, it was reducing but starting to improve by 2010.
The decrease in housing values immediately purged the reserves of the bank, leading to the fall of the bank such as AIG, Merrill Lynch. From the graph above showed that the lending of the US banks fall, private sector credit from commercial banks declined from annual rates of 8% from 2003 through the first quarter of 2008 to just over 2% before the end of 2008, it showed negative growth for the first time in the decade. In September 2008, the US government and Fed stabilized the financial markets by purchasing the troubled assets and equity from the banks to decrease uncertainty in the markets. The plan was called the Troubled Asset Relief Program (TARP). The Capital Purchase Program which is under TARP, 9 major banks gained a capital injection of one hundred and forty-five billion dollars. The Citigroup also received a 2nd round of government assistance, in the early 2009, bank of America also given additional government support. (Silvio & Hoda, 2011)
For instance, the bank of England still look for the way to strengthen their balance sheets by reducing lending, so creating an extreme credit crush. This had adverse impact on lenders which found out bank finance hard to get. The squeeze on bank credit continued despite the deep cuts in the bank rate and forecasts for GDP growth were declined to 4.0 %, the economy was going for a severe recession. (Nicholas, 2009)
4. Discuss how the Islamic banking system can be an alternative to mitigate the severity of crisis
Islamic banking is characterized as banking system which takes the lead on the principle of Islamic law (Shariah). From the perspective of the Islamic Shariah, transactions involving interest are restricted. In addition, they cannot deal with transaction that the subject is invalid. Islamic banking is another option other than conventional banking that is available to any individual who looks for an alternate way to deal with financial services. It was designed for Muslim and non- Muslims community who wish to operate financially in accordance with Shariah Law. (Banking association South Africa, 2014)
4.1 Risk sharing
A financial crisis would not occur if the requirement of Shariah were appropriately implemented such as the issue of risk sharing. If conventional bank were required to share the profit and losses of their clients, regardless of whether in business investments or mortgages, they would be significantly more careful while choosing which to invest. Islamic bank provides accounts which offer profit and loss instead of traditional accounts which given interest rates. With Islamic banking, the risks are shared between the bank and the client. (Iqbal & Llewellyn, 2002) This is due to their financial returns would depend on the performance of the projects. In contrast with conventional banking which risk are not shared, the risks are carried by the client. In the Islamic economy, the bank act as venture capital firms collecting individual’s money and invest in the economy and then giving out the profits among depositors. The bank also act as an investment partners for individual who require cash to do businesses, becoming part owners of the business. This is because the risk sharing principle is considered very important in Islamic banking, it encourages investors to invest their money and become partners in a business instead of becoming creditors. However, risk sharing does not prevail in the current world. The aim is often the opposite because businesses and conventional bankers like to increase excessive risk, and then protect themselves from to increase their return on capital.
4.2 Prohibition of Interest
The recent global financial crisis has influenced the conventional banking system around the world. The global financial crisis has also affected on the Islamic banking system but performance of Islamic banks during 2008 financial crisis is better than conventional banks. The risk in Islamic banks is less than conventional bank is due to its advantage of interest free. (Shafique, Faheem, Abdullah, 2012) Riba is the meaning of charging of any interest, which means money earned on the lending out of money itself. The ban on paying or getting fixed interest is because of the Islamic principle that money is just a medium of trade, a way for defining the value of a thing and has no value in itself. Thus, it ought not to be permitted to give rise to more money through fixed interest installments by just put in a bank or lend to others. (Institute of Islamic banking and insurance) But, international economics also very depend on interest rates. The foreign debt is one of the primary issues that caused the plague economies. For example, corrupt leader can often acquire cash without limitations, and international financial institutions lend it without reservations since interest ensures a return on capital. (Mohammed, 2014)
5. State your recommendations supported by justifications as to which banking system is safer for the banking industry.
As a result, due to the 2008 financial crisis conventional banks are heavily impacted. Even though Islamic bank also affected by the crisis, the performance of Islamic banks is better than conventional banks during the crisis. (Parashar & Venkatesh, 2010) Additionally, a study showed that even Islamic banks suffer in term if leverage, capital ratio and ROE, despite these information, the performance of Islamic banks from 2006 to 2009 is still better than conventional bank. (Beck, Asli., Kent, & Quarda, 2010) Furthermore, according to the study of Tabash and Dhankar (2014), the data published by Islamic Finance Service Board on Islamic Financial Services Industry Report 2014 demonstrate a solid growth of 38.4 percent during 2004 to 2011. The 2008 financial crisis prompted difficulties in numerous conventional banks across the world. However, Islamic banks were insulated from the crisis as they run by the Shariah concepts. (Mamiza, 2016)
The chart above describes the total assets of conventional and Islamic bank percentage to the UAE’s GDP in 20007-08. The graph shows conventional banks total assets declined from 109.7 percent to 106.3%. But, Islamic banks are facing an increase in its total asset from 18 percent to 19.7 percent. The increase in Islamic banks total asset to UAE GDP is a little bit but it is critical in the specified years because a lot of conventional banks encountered a decline in their total asset to the UAE GDP.
Another significant factor that Islamic banking is better than conventional banking is because of the investors of Islamic banking are informed by the bank what the bank does with their money and they know where the money is invested. Moreover, Islamic banks prohibited interest rates at all level of financial transactions and promote risk sharing between the bank and client. Islamic banks are less competitive in compare with conventional banking. The profitability of Islamic banks significantly increases but still low when compare with conventional bank. However, Islamic banks have less financial risk due to the higher capitalization. A lot of banks were benefited from Islamic banks after the financial crisis to deal with the crisis for restoration of their financial stability. (Ariss, 2010)