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Impact of Financial Crisis on Islamic Banks

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Chapter - 1

Background / Introduction of recent financial crises and Islamic banking system

The credit crunch is widely blamed upon the sub prime crisis which originated in America, where banks offered housing loans to those known in the industry as ninjas (no income, no job, no assets). Such people often had poor financial track records. However these loans were subsequently repackaged into financial products known as ‘collaterised debt obligations' (CDOs). They were then mixed in with ‘prime loans' and sold on to other banks via the wholesale market. In theory, this trading in debts was meant to spread the risk of bad loans amongst many different banks, thereby reducing risk. In fact, it lead to the ‘sub prime' problem infecting not just the banks that offered the dodgy loans in the first place, but a far, far greater number of banks who bought the ‘toxic' loans via the wholesale markets. The knock-on effect of this was for banks to suddenly become unsure of the value of their ‘toxic' assets and as a result to stop lending each other money, or to lend money only at much higher rates. As a result the London Interbank Offered Rate (LIBOR) shot up to unprecedented levels, which in turn massively increased the cost of providing loans to the general public according to Khan (2008).

The Western perspective also argues that this initial problem with sub prime debts triggered a secondary problem whereby banks which relied for cash flow principally on accessing funds from other banks via the wholesale market, suddenly found they could no longer borrow enough money to meet their cash flow requirements This is what led to the crisis with collapse of 150 year old Lehman Brothers and take over of Merrill Lynch by Bank of America, which, more than any other bank relied on the wholesale market rather than its own depositor funds to meet the bank's day-to-day cash requirements Khan (2008).

According to Bashir (2008) the paralysis in interbank lending led in turn to banks drastically reducing the money they lent to customers, as well as dramatically raising the cost of existing loans. This in turn substantially reduced demand for property and led to the ongoing crash in the property market. This is now feeding back to create a yet bigger problem for the banks because property is what they mostly hold as collateral for all the debts people owe them. Evidently this collateral is now worth a lot less than a year ago, and this will inevitably lead to a much higher rate of loan defaults and repossessions Bashir (2008).

Having covered a secular analysis, we now turn to Islam, which proposes a very different explanation for these problems.

According to Haddad (2008) Islam does not consider money to be a commodity, which can be traded at a profit, that is to say a transaction that is interest (or usury) based. Thus the reality of negating this Islamic consideration provides us with the first part of the problem. Interest, known as Riba in Arabic, is one of the major violations of God's law, and when it spreads through society becoming an established norm without any condemnation nothing can be expected but divine wrath.

Islamic banks do not borrow or lend on international money markets because interest is not allowed, traditionally they have a larger proportion of their assets in reserve accounts with central banks. Islamic banking is based on the principles of risk sharing between depositor and investor in theory, meaning that customers practice greater oversight of an Islamic bank's lending performance. Shariah law stipulates that Islamic securities should be asset-based, which means that a trader must own the asset being traded. This, in turn, proscribes most forms of futures trading, as goods that the seller does not own or will not deliver cannot be the subjects of an Islamic contract. Practices such as short selling, consequently, are not a feature of Islamic Banking according to Haddad (2008).

According to Siddiqi (2009) Islamic finance is growing in various parts of the world. It has moved from a mere theoretical concept to a practical reality. Islam not only prohibits dealing in interest but also in liquor, pork, gambling, pornography and anything else, which the Shariah (Islamic Law) deems Haram (unlawful). Islamic banking is an instrument for the development of an Islamic economic order. The core principles of Islamic economics system are justice, equity and welfare. Islamic economics seeks to establish a broad based economic well being with full employment and optimum rate of economic growth, it will bring socio economic justice and equitable distribution of income and wealth. Islamic economics will also ensure the stability in the value of money to enable the medium of exchange to be a reliable unit of account and a stable store of value Siddiqi (2009).

According to Bagsiraj (2009) in the Islamic economy, Islamic banks act as venture capital firms collecting people's wealth and investing it in the economy, then distributing the profits amongst depositors. Islamic banks act as investment partners for those who need money to do businesses, becoming part owners of the business. The banks should only be able to recoup their original capital by selling their share of the mortgage/business at the prevailing market value. As real partners, Islamic banks should have no objection to owning real assets and hence should be ready to share the consequential risk. This scheme, although seemingly inconsequential, could constitute a major relief to Islamic banks' clients, as they would no longer live under the burden of debt and fear of repossession Bagsiraj (2009).

Further more, according to Siddiqi, (2009) Islam neither endorses the capitalist nor the communist financial model. However, both the capitalist and socialist systems share certain elements with Islam, such as encouraging people to work, to be productive and earn as much as they can. Islam promotes an awareness of the hereafter in the hearts and minds of believers and instructs them not to be overcome by greed or excessively attached to money. The Islamic economic and financial system is based on a set of values, ideals and morals, such as honesty, credibility, transparency, clear evidence, facilitation, co-operation, complementarities and solidarity. These morals and ideals are fundamental because they ensure stability, security and safety for all those involved in financial transactions. Islamic Shariah prohibits economic and financial transactions that involve lying, gambling, cheating, gharar (risk or uncertainty), monopoly, exploitation, greed, unfairness and taking people's money unjustly Siddiqi, 2009.

The aim of this research is to examine the extent to which the Islamic banks have been affected by the recent financial crisis in contrast with its conventional counterpart.

Chapter - 2

Literature review

1.1 Detailed history of credit crunch: According to BBC website a credit crunch is an economic condition in which loans and investment capital are difficult to obtain. In such a period, banks and other lenders become wary of issuing loans, so the price of borrowing rises, often to the point where deals simply do not get one. When a National Public Radio journalist asked the famous economists Nouriel Roubini, Kenneth Rogoff, and Nariman Behravesh, their reaction on the monthly report that was just released by the U.S. Department of labor, their answers were “Its worse then anybody had anticipated”; “Its pretty disastrous”, and “I am shocked” Langfitt (2007). Before the report was published, the economic forecasters view was that the report would show the U.S economy increased about 100,000 jobs in August. Instead there was a net loss of 4,000 jobs; there was no growth for the first time in four years. U. S Department of Labor (2007).

The forecasters were not done getting it wrong, however, after publication of the jobs data, a number of them predicted the news would bolster the U.S. stock market, because they argued, the employment report practically guaranteed that the Federal Reserve would cut interest rate on September 18, Instead, investor panic over the employment report caused the market, which had been volatile during most of the summer, to quickly lose about 2% on all major indices as per Whalen (2007). The Federal Reserve did eventually cut rates as expected, but it took a number of reassuring comments by U.S. central bank governors on September 10 to calm Wall Street's fears according to Monica (2007). What is now clear is that most economists underestimated the widening economic impact of the credit crunch that has shaken U.S. financial markets since at least mid-July 2007.

According to Times online (2009) years of lax lending inflated a huge debt bubble as people borrowed cheap money and ploughed it into property. Lenders were free with their funds, especially in the US, where billions of dollars of so-called Ninja mortgages - no income, no job or assets - were sold to people with weak credit ratings (called sub-prime borrowers).

The informal notion was that if they ran into trouble with their repayments rising house prices would allow them to re mortgage their property as per times online (2009). It seemed a good idea when Central Bank interest rates were low; the trouble was it could not last. Interest rates hit rock bottom in America in 2004 at just 1 per cent, but in June that year they began to rise Bernank (2006). As interest rates jumped, US house prices started to fall and borrowers began to default on their mortgage payments sparking trouble for us all BBC websites (2009).

According to Mullan, 2008 easy money conditions made funds available to finance millions of US ‘sub prime' borrowers, less well-off people who in earlier times would not have been seen as credit-worthy enough to get a plastic card never mind a home mortgage. These extra homebuyers helped reinforce the pre-existing rise in property prices, producing price hikes in many regional markets across the US. By summer 2007, the market had turned - house prices were falling and default levels were raising Mullan, 2008.

When the sub prime crisis hit, liquidity froze in the wholesale money markets, not just in the US but also across the Western world nytimes (2008). Following the common pattern of all credit crises, at a certain point - never precisely predictable, because of the ‘elastic' nature of credit - debt becomes too extended for some borrowers when their circumstances change, default levels begin to grow, and the upward spiral of credit expansion and asset price appreciation turns into its unwelcome opposite Mullan, 2008. Just as mortgage issuance and rising US house prices fed on each other for several years, so now price falls and mortgage foreclosures reinforce each other BBC websites (2009).

The difference with the credit crisis this time is that the necessity for writing off the bad debts spreads far beyond the original lenders, the banks and the other institutions, which issued the sub prime mortgages, repackaged the debts and sold them on elsewhere into the financial system the process of passing on debt from one institution to another has long been a feature of the financial markets, this activity became so frequent that the terminology of ‘securitization' became commonplace, as bank lending was repackaged and sold on as bonds or securities, the same underlying value of a piece of financial paper (or electronic account) becomes reproduced often multiple times elsewhere in the financial system Economichelp.org (2008).

In essence, such loans are resold as assets to others so that the same underlying value becomes used many times over, is what the credit system has been about since its early days. This time, in fact since the 1980s, the scale and scope of the repackaging of debt was simply more extensive than ever Mullan (2008). Hence the emergence of trading in ‘derivatives' - instruments derived from the original credit note - that dominates modern financial markets trading. More recently, over the past few years, this practice spawned a number of new acronyms which have been a feature of the terminology for today's crisis: ABSs (asset-backed securities, with the ‘assets' often being those home mortgages); CDOs (collateralised debt obligations); and SIVs (structured investment vehicles - these are the alternative secondary financial bodies which invested in the new mortgage-backed financial instruments) according to Mullan (2008).

1.2 Causes of credit crunch

Inaccurate Credit ratings: According to Acharya, Viral, Bharath, and Srinivasan, (2007) The Collateralized Debt Obligations (CDO) market has grown substantially since 2001 with issuance volume reaching $551.7 billion in 2006. While securitization makes financing more accessible for firms and households1, it also presents regulatory challenges, as rating agencies and institutions struggle to keep up with the rapid pace of financial innovation on Wall Street.

According to Coval, Jurek, and Stafford (2008) Since summer 2007, both academics and practitioners have blamed complex CDOs for being, in part, responsible for the current sub prime crisis and credit crunch. While more than 85% of the dollar value of CDO securities issued was rated AAA by either Moody's or Standard and Poor's (S&P), 3 several major banks and financial institutions eventually had to write-off substantial portions of their balance-sheets related to investments in CDOs, largely those backed by sub prime mortgages. In 2007, Moody's downgraded $76bn in CDO securities and another $150bn remained on credit watch as of January 2008. Downgrades in November 2007 alone numbered 2,000 and many downgrades were severe, with 500 trenches downgraded more than 10 notches.4 The ensuing confusion about the true value of these complicated securities and the extent of exposure by financial institutions, incited a credit crunch with effects beyond sub prime mortgage related investments.

In another words the securities, especially the now-notorious C.D.O.'s, for (collateralised debt obligations) were probably too complex for anyone's good. Investors placed too much faith in the rating agencies which, to put it mildly, failed to get it right. It is tempting to take the rating agencies out for a public whipping. But it is more constructive to ask how the rating system might be improved. That's a tough question because of another serious incentive problem. Under the current system, the rating agencies are hired and paid by the issuers of the very securities they rate which creates an obvious potential conflict of interest.

The following figure shows the typical collateralised debt obligations (CDO) structure and CDO issuances over time respectively:

1.3 Sub prime market collapse:

According to Khan (2008) As the housing sector continued to inflate due to the appetite for housing by Americans, the sub prime sector continued to also grow. Commercial banks entered what they considered a buoyant market that could only raise, many Americans refinanced their homes by taking out second mortgages against the added value to use the funds for consumer spending. The first sign that the US housing bubble was in trouble was on the 2nd April 2007 when New Century Inc the largest sub rime mortgage lender in the US declared bankruptcy due to the increasing number of defaults from borrowers. In the previous month 25 sub prime lenders declared bankruptcy, announcing significant losses, with some putting themselves up for sale.

Khan (2008) also highlights the crisis that then spread to the owners of collateralized debt who were now in the position where the payments they were promised from the debt they had purchased was being defaulted upon. By being owners of various complex products the constituent elements of such products resulted in many holders of such debt to sell other investments in order to balance losses incurred from exposure to the sub prime sector or what is known as ‘covering a position.' This second round of selling to shore up funds and meet brokerage margin requirements is what caused the collapse in share prices across the world in August 2007, with the market getting into a vicious circle of falling prices, leading to the further sales of shares to shore up losses. This type of behavior is typical of a Capitalist market crash and is what caused worldwide share values to plummet.

What made matters worse was many investors caught in this vicious spiral of declining prices did not just sell sub prime and related products; they sold anything that could be sold. This is why share prices plummeted across the world and not just in those directly related to sub prime mortgages Khan (2008). International institutes who poured their money into the US housing sector realized they will not actually receive their money that they loaned out to investors as individual sub prime mortgage holders were defaulting on mass on such loans this resulted in all those who took positions in the housing sector not being able to pay the institutes they borrowed money from. It was for these reason central banks across the world intervened in the global economy in an unprecedented manner providing large amounts of cash to ensure such banks and institutes did not go bankrupt Khan (2008).

According to bbc.co.uk the European Central Bank, America's Federal Reserve and the Japanese and Australian central banks injected over $300 billion into the banking system within 48 hours in a bid to avert a financial crisis. They stepped in when banks, such as Sentinel, a large American investment house, stopped investors from withdrawing their money, spooked by sudden and unexpected losses from bad loans in the American mortgage market, other institutions followed suit and suspended normal lending. Intervention by the world's central banks in order to avert crisis cost them over $800 billion after only seven days.

2.1 Islamic Banking:

The beginning of Islamic Banking: The earliest writings on the subject of Islamic banking and finance date back to the forties of the twentieth century Nejatullah (1981) and the earliest practice can be traced to early sixties Mahmud (1995). The literature showed ambivalence between the model of an intermediary designed after conventional commercial banks and one like an investment company serving individuals seeking profits as well as the community needing development. Models of commercial banking based on two-tier Mudaraba came from economists aspiring to build an alternative to a system of banking and finance hinged on interest. Some of them placed the issue in the larger context of the struggle between capitalism and socialism in which Muslim intellectuals projected Islam as having a different approach resulting in a distinct economic system with its own financial institutions. Community initiatives looked forward to something workable while avoiding interest.

The nineteen-sixties saw the establishment of an interest-free bank in Karachi, that of Tabung Haji in Malaysia, and saving-investment banks in Mit Ghamr in Egypt, that were based on sharing profits and avoided interest. Only Tabung Haji survived, Haji (1995), thanks to its roots in the community, its narrow focus, official blessings and clear structure as a business. Early in the nineteen seventies came the Dubai Islamic Bank, taking deposits in current as well as investment accounts and engaging in profit-making activities directly as well as through working partners. The Islamic Development Bank, which started operations in 1975, was designed to serve Muslim countries and communities by arranging finance for trade and development on non-interest bases. By late nineteen-seventies there were half a dozen more banks in the private sector in Egypt, Jordan, Kuwait, and the Gulf. The following decade saw a rapid expansion bringing the number of banks to dozens by the end of the decade. To banks were now added non-bank financial institutions, like investment companies and insurance companies IAIB (1997).

According Mohammad (1970) till the end of the nineteen-seventies, largely a plea for replacing interest in bank lending by profit sharing. This would change the nature of financial intermediation, making the fund owners as well as the financial intermediaries share the risks of enterprise with the fund users. Early literature's main emphasis was on fairness. Making the fund-user-entrepreneur bear all the risks of business and allowing fund owner and bank claim a predetermined return was regarded to be unjust. The environment in which productive enterprise was conducted did not guaranty a positive return, so there was no justification for money capital claiming a positive return irrespective of the results of enterprise, it was argued. Hadi (1973), Nejatullah (1968). It was also argued that most, though not all, the other problems of capitalism were rooted in the practice of lending on interest. Among these problems were unemployment, inflation, poverty amidst plenty, increasing inequality and recurrent business cycles Mohammad (1955), Ala (1961), Mahmud (1972),

According to Mohammad (1970) abolishing interest and replacing it by profit sharing could solve these problems. It was not until the next decade that Islamic economists were able to fortify these claims by sophisticated economic analysis, especially at the macroeconomic level. The focus at this stage was largely on pointing out the deficiencies of capitalism and linking them to the institution of interest, among other things. With this went the arguments showing that it was possible to have banking without interest and that it would not adversely affect savings and investment Ala (1961), Ala (1969) Iqbal (1946), Nejatullah (1969).

Hasan (2005) The most significant development during the late nineteen-seventies and early eighties was the advent and proliferation of Murabahah or cost-plus financing. What the businessman got from the Islamic bank under this arrangement is the commodity he needed purchased by the bank at his request, with the promise to purchase it from the bank at a price higher than its purchase price, to be paid after a period of time. Each Murabahah transaction created a debt. Compared to funds supplied on a profit-sharing basis, funds invested in Murabahah transactions were safe. Within a couple of years of the introduction of Murabahah in late nineteen seventies, it conquered the landscape of Islamic finance, assigning Mudarabah or profit-sharing to a corner accounting for less than ten percent of the operations. Security of capital invested rather than magnitude of returns to capital ruled the roost, insofar as the fund owners were concerned. However, the proliferation of Murabahah did give a big boost to Islamic finance during the coming decades. Their total number by year 2004 may have exceeded 200, spread over more than fifty countries.

Archer and Karim (2002) the seventies also saw Pakistan officially committing to interest-free Islamic banking, followed by Iran and Sudan in the eighties. Meanwhile Malaysia developed a new approach of introducing Islamic banking and finance under official patronage, while the main system continued along conventional lines Indonesia followed in early nineties. This pattern later became the model for certain countries in the Gulf, like Bahrain, Qatar and the UAE. With the spread of Islamic financial institutions across the globe and enlargement of the size of funds managed by them, came the involvement of big players in the international financial arena like Citibank, HSBC and ABN AMRO according to Archer & Karim (2002).

According to Vogel and Hays (1998) in the development of theory of Islamic finance and banking, the late seventies and the eighties saw many significant contributions. Murabaha or cost plus financing, acknowledged only grudgingly in documents such as the Islamic Ideology Council of Pakistan Report on Elimination of Interest from the Economy, earned full recognition as well as respectable rationale. The controversy around its legitimacy, its efficacy hardly had any impact on the speed with which it conquered the landscape of Islamic finance. Practitioners of Islamic finance report they tried to push through sharing based Finance but the results were not encouraging Attiyah (2007).

The laws of the land did not (may be, could not) offer the financier same protection from false reporting of profits by the users of funds, even against outright fraud and deception, not to speak of delay in payment, as was offered to borrowers in a lending contract. There seemed to be no room for collaterals. On top of all this there were projects to be financed that simply defied profit-sharing finance, like long term municipal plans to lay sewage-pipes in a city. In this case, returns to the finance would accrue over many decades in the future while costs had to be met in the present. In the absence of a market on which shares could be floated, even medium term Mudarabah bonds designed to finance development of WAQF property did not succeed Khairallah (1994).

Recourse to trade based modes of finance became necessary. This happened with privately established Islamic banks in the Gulf area as well as with the Islamic Development Bank. By the early nineteen-eighties, Murabahah had become the dominant mode of Islamic finance everywhere. As pointed out above, early theory had failed to pay due attention to trade based modes of finance and to the issue of capital protection. Murabahah seemed to fill the gap. According to Khairallah (1994) the macroeconomic implications of Islamic banking were still being worked out on the assumption that it would be largely based on profit sharing. It was argued that financial intermediation based on profit sharing rather than lending will contribute to greater stability in the economic system in general and the financial markets in particular. It was also argued that such a system would be more efficient than the conventional system Khairallah (1994).

2.2 An overview of Islamic Banking and Financial products:

The earliest Islamic financial product to appear on the scene was investment deposit with an Islamic bank or investment certificate issued by an Islamic investment company IIBI (1995).

Both were based on profit-sharing/ Mudarabah between the depositor/certificate holder (Rabbal-mal) and the bank/investment company (Mudarib). The next to appear were based on sale. Murabahah is sale with a mark-up on purchase price, payment being deferred. Ijarah is sale of usufruct of an equipment or real estate owned by the seller. Murabahah proceeds on the basis of a purchase order by a client who commits to buy the commodity involved. Originally introduced as contracts between two parties both Ijarah and Murabahah ended up in the form of securities. Bypassing controversies around operating leases versus financial leases Nejatullah (2005b)

The market seized upon Sukuk. Ijarah bonds are investment certificates indicating ownership of a real asset subject to a lease contract yielding predetermined rent yields, they are very popular in the Gulf, unlike the Sukuk based on Murabahah receivables that are considered valid only in Malaysia. Adam and Thomas (2004).

Other sale-based modes in Islamic finance are Salam and Istisnaa Islamic banks started by using them as bases for extending finance to agriculture and industry respectively. As they had no interest in taking possession of the commodities or the manufactured goods involved, there was usually a parallel contract reversing the flow so that the bank ended up with cash, larger in amount than that paid by it in the first contract. In their more developed forms, the Islamic financial market now has Sukuk based on Ijarah, Salam and Istisnaa. The buyers of Sukuk periodically get a predetermined income over and above the privilege of redemption at par on maturity, as in case of conventional bonds.

According to (http://www.bankislam.com.my) there are efforts to develop secondary markets on which these Islamic bonds could be traded. If and when these efforts succeed, the same markets could handle variable return Mudarabah bonds or Sukuk based on Mudarabah/musharakah. The big difference would be in there being no guaranteed value on redemption as these investors are vulnerable to losses too, unlike those who invest in fixed income Sukuk mentioned earlier. We have to examine, first how trade based modes of finance got in, and second, how bond-like Sukuk were constructed. Later on, we go on to economics: the impact of fixed income financial products on an economy aspiring to be Islamic.

Malaysia introduced sale of debt (Bay Al-Dayn) in Islamic finance. It also brought in Inah, a way of obtaining cash now against a larger amount of cash to be paid after a period of time, on the basis of sale contracts on deferred prices followed by buyback contracts at lower cash prices. The first Islamic bank to come up in Malaysia, Bank Islam Malaysia Berhad, started its operations in 1983. It is now marketing about 50 innovative and sophisticated Islamic banking products and services, comparable to those of their conventional counterparts (http://www.bankislam.com.my).

A second Islamic bank, Bank Muamalat Malaysia Berhad commenced operations in 1999. The Central Bank of Malaysia also decided to allow the existing banking institutions to offer Islamic banking services using their existing infrastructure and branches. The long-term objective of BNM is to create an Islamic banking system operating on parallel lines with the conventional system' This involves some interaction between the two systems, which is overseen and organized by the central bank, Bank Negara Malaysia, which has in-house National Shariah Advisory Council. An Islamic Inter-bank Money Market launched in 1994 plays a significant role in this regard (http://www.bnm.gov.my).

There is also Mudarabah Inter-bank Investment facilitating interaction between deficit and surplus Islamic banks. The backbone of the whole structure seems to be the Government Investment Issue (GII). It was originally based on ‘the Shariah contract of Qard Hasan, the holder being given back only what he/she gave. ‘Any return on the loans (if any) is on the absolute discretion of the government'. But, in 2001, the basis of Government Investment Issue (GII's) issuance was further enhanced to accommodate the need to develop further the secondary market activities of the Islamic money market. An alternative concept of GII based on Sell and Buy Back Arrangement was introduced in June 2001. Under this arrangement, the Government will sell its identified assets at an agreed cash price to the buyer and subsequently buy back the same assets from the buyer at an agreed purchase price to be settled at a specified future date (http://www.bnm.gov.my).

Saleem (2006) says besides complying with the prohibitions against interest and the financing of forbidden activities, Islamic banking products are based on the concept of property exchange, profit and risk sharing, and certainty. Uncertainty (gharar) is not permissible, and contracts for banking services must clearly define the responsibilities and rights of the customer and bank as to the ownership of property, fees, and risk sharing.

2.3 Istisna'a

The Istisnaa the second kind of sale where a commodity is transacted before it comes into existence. This allows the Bank to order for the goods or equipment required for a construction project according to the choice of the client and delivers them to the client. The client agrees to pay in installments at specified dates. There are two sub types of Istisnaa contracts, which are classified based on the commodity bought or sold Saleem (2006).

2.4 Ijarah

Islamic Investment's ‘Ijarah' is the process by which (Usufruct of a particular property is transferred to another person in exchange for a rent claimed from him/her). It is the equivalent of ‘Leasing' in commercial banking. This allows the Bank to order for Capital assets required for the customer against a rental agreement with him. The title remains with the Bank until the maturity of the lease, but the lease uses the equipment during the lease period. On maturity the asset belongs to the Bank Saleem (2006).

2.5 Murabaha

Murabaha contract revolves around the purchase of an asset by the Bank and the onward sale of the same by the Bank to a customer. The purchase may involve commodities, homes, real estate, vehicle, etc. The Bank makes a profit on the transaction, which is the difference between the price, which it pays to the supplier of the goods, and the price at which it sells the commodity to the customer. This mark-up will be agreed between the Bank and the customer in advance. The financed amount and profit are due and payable on terms agreed between the two parties. The Shariah principles require that goods have to be purchased, owned by the Bank and therefore, the Bank bears all the risks related to the unforeseeable events (goods damage, war, customer bankruptcy) until the goods are sold to the customer Saleem (2006).

2.6 Musharaka

Musharaka contract revolves around partnership, normally of a limited duration, formed to finance a project. The Bank enters into a partnership with a client in which both share the equity capital. Net profit will be divided according to the equity shareholding, regardless of the management fees Saleem (2006).

2.7 Mudaraba Investments

Mudaraba allows customers to invest funds in Mudaraba transactions, which will have to be invested by the Bank using Islamic Investments. The funds taken from the Customer are then given to the dealers who will make the necessary investments using all or part of the funds in one or more IS contracts respectively i.e. the customer's funds can be used along with bank's funds to make an IS Contract. Depending on the profit the dealer generates from the IS contract, he will then give a rate for the customer's funds (which normally is lower than the rate of the profit made on the IS Contract). Therefore, the Customer's investment becomes a normal deposit with the Bank with a profit (interest) rate and Maturity date (the final Sell payment date of the IS contract) associated with it. The customer can do the following things with his Mudaraba investment: On the maturity date customers can take back his Capital & Profit i.e. let the contract mature. Customers can take back his profit at maturity and roll the capital over for an additional time period. Customers can ask the bank to add the profit to the capital and roll over the whole amount for an additional time period. The Mudaraba contract can be ‘early matured' i.e. the customer can come to the Bank and ask them to break the investment. In that case the profit is calculated up to the date on which the customer asks the bank to ‘break' the investment Saleem (2006).

2.8 Tawarruq

This product is designed for a Bank customer to get an immediate liquidity facility applying Islamic Shari'a Rule. With this product the Bank will own a position in a precious metals or any asset which can be sold in the market by the client them self. In Tawarruq procedure, a customer can keep his asset or liquidate it to a broker by the Bank arrangements. Tawarruq is used also to cover drawings required by the customer on demand Saleem (2006).

2.9 Current Accounts

Accounts are Shari'a compliant with no “Riba” with prevention of debit balance situation. All other features associated with a Current Account are available. Charges for services provided can be automated or applied manually Saleem (2006).

2.10 Post Dated Cheques

Post Dated Cheques (PDC) where unlike conventional PDCs the discounting of a PDC is based on a pre-determined profit. All other PDC processing is based on the UAE conventional banking applications Saleem (2006).

2.11 Hajj Loans

Islamic Banking provides for lending to Pilgrims who wish to attend the Hajj. The loan is profit free and can be repaid in installments or as a bullet single repayment. To support such lending, should the Bank so require, a documentary evidence workflow can be provided. An example would be sight of Air Tickets to allow the Loan to be drawn Saleem (2006).

2.12 Qard Hasan Finance

These loans are profit free and are given to customers on a hardship and/or charitable basis and are normally sourced from the Bank's own funds. Automated charges relating to the loans can be charged and if documentary evidence workflow is required to support the loan, this can be provided. An example would be sight of a medical bill for a loan to cover treatment Saleem (2006).

2.13 Past Due Debt Processing

Any indebtedness where any loan from an Islamic product is not repaid at the correct time either in part, as an installment or whole. The profit calculation ceases at the point of past due but does allow the charging of ‘fees' for costs incurred by the bank to affect a recovery Saleem (2006).






· Retail Banking

· Retail banking

· Project Financing

· Syndication

· Retail banking

· Project Financing

· Syndication

· Equity

· Ijarah (Leasing agreement)

· Retail banking

· Project Financing

· Syndication

· Equity

· Ijarah (Leasing agreement)

· Sukuk (Bonds)

· Structured products

· Retail banking

· Project Financing

· Syndication

· Equity

· Ijarah (Leasing agreement)

· Sukuk (Bonds)

· Structured products

· Wealth management

2.14 Evaluation of Islamic Banking:

Sources: Islamic Banking - A $300 Billion Deception by Dr. Muhammad Saleem Paperback - 31 Jan 2006)

Chapter -3

Impact of Financial Crises on Conventional Banks =====================================================================

Though many financial institutions have been affected by the recent financial crises across the globe, but we will focus on two of the highly affected Banks namely Lehman Brothers Holdings Inc. and Merril Lynch.

1.1 History of Lehman Brother Holdings Inc.

According to Harvard Business School Library (2002) In 1844, Henry Lehman immigrated from Rimpar, Germany, to Montgomery, Alabama where he established a small shop selling groceries, dry goods, and utensils to the local cotton farmers. By 1850, his two brothers, Emanuel and Mayer, had joined him in the business, and they named it Lehman Brothers. After Henry Lehman's death in 1855 at the age of 33, the two younger brothers headed the firm for the next four decades. During their tenure, only family members sons, brothers, and cousins were permitted as partners. This was a policy that continued until the 1920s. Soon after its founding, Lehman Brothers evolved from a general merchandising business to a commodities broker that bought and sold cotton for the planters living in and around Montgomery, Alabama. "King Cotton" dominated the economy of the southern United States in the 1850s.

As the business grew, a brief partnership was formed with cotton merchant John Wesley Durr to build a cotton storage warehouse, enabling Lehman Brothers to engage in larger sales and trades. A New York office was opened in 1858, giving the firm a stronger presence in the commodities trading business as well as a foothold in the financial community. With much of its operations tied to the southern economy, Lehman Brothers did not escape the hardship of the Civil War. The firm was rebuilt after the war, concentrating its operations in the New York office Harvard Business School Library (2002).

According to lehmanbrothers website (2009) In 1870, Lehman Brothers spearheaded the formation of the New York Cotton Exchange, the first commodities futures trading venture. Mayer Lehman was appointed to its first board of directors. As Lehman Brothers' commodities sales and trading business grew to include other goods, the company also helped to establish the Coffee Exchange and the Petroleum Exchange. Because of its Southern heritage and Northern connections, Lehman Brothers was designated to be the Alabama government's fiscal agent to help sell the state's bonds in 1867. This was no simple assignment, given the credit rating of the Southern states at that time. The firm was also assigned to service the state's debts, interest payments, and other obligations, beginning a long tradition in municipal finance.

Lehmanbrothers website (2009) the rapid development of the railroads helped transform the country from an agrarian to an industrial economy in the years following the Civil War. The boom in railroad construction resulted in tremendous activity on Wall Street, as companies turned to financial markets to raise funds for expansion. Kuhn, Loeb & Co., which merged with Lehman Brothers nearly a century later, was one of the leading financial advisors and underwriters to the railroad industry. The firm was engaged in the financing of the Chicago and North Western Railroad, the Pennsylvania Railroad, the Baltimore & Ohio, and the Great Northern, along with the reorganization of the Union Pacific. Railroad bonds were milestones in the developing capital markets. To raise the huge amount of money needed to fund the industry's expansion, underwriters began reaching beyond their traditional sources of financing. Bonds were structured at affordable prices and sold to individual investors, bringing masses of first-time investors into the market. Noting this trend, Lehman Brothers expanded its commodities business to include the sales and trading of securities lehmanbrothers website (2009).

In 1887 the firm became a member of the New York Stock Exchange, marking the evolution of Lehman Brothers from a commodities business to a merchant-banking firm. The New York office provided the presence to build a securities trading business, and Lehman Brothers aggressively pursued this area. The firm was also becoming more involved in financial advisory, which provided the foundation for developing the underwriting business in the early 1900s.

Lehmanbrothers website (2009) For a 20-year period beginning in 1906, Emanuel's son, Philip Lehman, and Henry Goldman, the dominant partner in the firm of Goldman, Sachs, formed an alliance to fund the emerging retail industry. The two firms jointly underwrote securities issues for some of the most famous names in the retailing industry, including Sears, Roebuck & Co.; F.W. Woolworth Co.; May Department Stores; Gimbel Brothers, Inc.; and R.H. Macy & Co. Robert Lehman, Philip's son, became a partner in the firm during the 1920s and quickly moved into the leadership role. Robert Lehman led the firm from 1925 until his death in 1969, a period of significant growth for the firm. His business philosophy centred on his belief that consumption, not production, would determine America's future prosperity.

According to lehmanbrothers website (2009) to that end, he steered the firm to back emerging industries geared toward mass consumption. His commitment to identifying growth industries led the firm to become active in the financing of airlines and motion picture companies as well as continuing Lehman Brothers' substantial support of the retailing industry According to lehmanbrothers website (2009).

According to guardian.co.uk (2009) Lehman Brothers was an early backer of the entertainment business, advising on the consolidation of the Keith-Albee and Orpheum theatres in the 1920s. This merger created the nation's largest vaudeville circuit, with more than 700 theatres and a seating capacity of 1.5 million. As the motion picture industry developed in the 1930s, Lehman Brothers helped fund Radio-Keith-Orpheum (RKO), Paramount Pictures, and 20th Century Fox. The firm was also interested in the growth of the communications industry in the 1930s, underwriting the first public offering of the leading televised company at that time, Allan B. Dumont Laboratories. In addition, the firm helped fund the Radio Corporation of America (RCA).

Guardian.co.uk (2009) The Depression made it difficult even for strong companies to raise capital during the 1930s. To help mediate risk and encourage investment, Lehman Brothers was one of the first firms to devise a new method of financing known as the private placement. These loans between blue-chip borrowers and private lenders included strict safeguards and restrictions for lender safety, enabling borrowers to raise needed capital and lenders to receive an appropriate return with a tolerable level of risk. Innovative at the time, the private placement is a standard financing technique today. The first half of the twentieth century was also an era of immense expansion in the oil industry. Lehman Brothers became involved, financing Murphy Oil and the Trans Canada pipeline, as well as supporting the oil service business of Halliburton and the development of Kerr-McGee's oil and gas exploration and production business.

http://www.lehman.com/ (2009) Economic expansion in the 1950s was driven by the arrival of electronic and computer technology. Lehman Brothers quickly sought investment opportunities in these areas, helping to launch Litton Industries as well as underwriting Digital Equipment Corporation's first public offering. In the 1960s the firm greatly expanded its capital markets trading capabilities, particularly in commercial paper. This led to the firm's designation as an official dealer for U.S. Treasuries. In the 1960s and 1970s, when many U.S. companies began to expand internationally, Lehman Brothers increased its global presence as well, opening offices in Europe and Asia.

http://www.lehman.com/ (2009) the firm's international stature was further enhanced in 1977 through the merger with the distinguished investment bank, Kuhn, Loeb & Co. As significant advances in electronic technology and computer science contributed to economic expansion during the 1970s, Lehman Brothers sought opportunities in applied science and technology. Among their new investments were future industry leaders such as QUALCOMM, a developer of digital wireless communication systems, and Loral Corporation, a manufacturer of defence electronics. In the 1980s, financial advisory centred on mergers and acquisitions as major corporations moved to expand both domestically and internationally lehmanbrothers website (2009).

According to http://www.lehman.com/ (2009) Lehman Brothers acted as an advisor on several large U.S. and cross-border transactions, including Bendix/Allied, Chrysler/American Motors, General Foods/Philip Morris, and Genentech/Hoffman-LaRoche. The development of personal computers and the elements that made them user-friendly gave rise to a field of related industries in the 1980s, ranging from microprocessors to video games. The fast pace of high-tech research and development enabled tiny start-up ventures with expertise in design, programming, and engineering to become major international corporations seemingly overnight.

According to theguardian.co.uk (2009) Lehman Brothers bought into these new markets by backing companies like Intel, the company that introduced the world's first microprocessor, raising funds to expand its business to meet the demands of the nascent personal computer market. Advanced research techniques developed during the mid-1980s helped create a new healthcare industry—biotechnology. Lehman Brothers was very active in assisting many new companies in this industry, such as Cetus; obtain the capital base necessary to fund research and development.

In 1984, Lehman Brothers was acquired by American Express and merged with its retail brokerage Shearson to form Shearson Lehman Brothers. American Express began to divest its financial services by business lines in 1992 and eventually, in 1993, the firm was spun off and once again became known solely as Lehman Brothers. In 2000, Lehman celebrated its 150th anniversary as per theguardian.co.uk (2009). The company's World Trade Centre offices were destroyed by the 2001 terrorist attacks, and eventually it moved into its new global headquarters in midtown Manhattan in 2002.

According to newyorktimes.com (2008) Lehman Brothers became entangled in the sub prime mortgage-lending crisis, on Sept. 14, 2008, the investment bank announced that it would file for liquidation after huge losses in the mortgage market and a loss of investor confidence crippled it and it was unable to find a buyer. Lehman's slow collapse began as the mortgage market crisis unfolded in the summer of 2007, when its stock began a steady fall from a peak of $82 a share. The fears were based on the fact that the firm was a major player in the market for sub prime and prime mortgages, and that as the smallest of the major Wall Street firms; it faced a larger risk that large losses could be fatal newyorktimes.com (2008).

Lehman.com (2009) As the crisis deepened in 2007 and early 2008, the storied investment bank defied expectations more than once, just it had many times before, as in 1998, when it seemed to teeter after a worldwide currency crisis, only to rebound strongly. Lehman managed to avoid the fate of Bear Stearns, the other of Wall Street's small fry, which was bought by JP Morgan Chase at a bargain basement price under the threat of bankruptcy in March 2008. But by summer of 2008 the roller coaster ride started to have more downs than ups. A series of write-offs was accompanied by new offerings to seek capital to bolster its finances. Lehman also fought a running battle with short sellers. The company accused them of spreading rumours to drive down the stock's price; Lehman's critics responded by questioning whether the firm had come clean about the true size of its losses. As time passed and losses mounted, an increasing number of investors sided with the critics Lehman.com (2009).

On June 9, 2008, Lehman announced a second-quarter loss of $2.8 billion, far higher than analysts had expected. The company said it would seek to raise $6 billion in fresh capital from investors. But those efforts faltered, and the situation grew direr after the government on Sept. 8 announced a takeover of Fannie Mae and Freddie Mac. Lehman's stock plunged as the markets wondered whether the move to save those mortgage giants made it less likely that Lehman might be bailed out. On Sept. 10, the investment bank said that it would spin off a majority of its remaining commercial real estate holdings into a new public company.

Lehman and Brothers confirmed plans to sell a majority of its investment management division in a move expected to generate $3 billion. It also announced an expected loss of $3.9 billion, or $5.92 a share, in the third quarter after $5.6 billion in write-downs. By the weekend of Sept. 13-14, it was clear that it was do or die for Lehman. The Treasury had made clear that no bailout would be forthcoming. Federal officials encouraged other institutions to buy Lehman, but by the end of the weekend the two main suitors, Barclays and Bank of America, had both said no Lehman.com (2009).

According to McDonald and Robinson (2009) Lehman filed for bankruptcy Sept. 15 one day later, Barclays said it would buy Lehman's United States capital markets division for $1.75 billion, a bargain price. Nomura Holdings of Japan agreed to buy many of Lehman's assets in Europe, the Middle East and Asia. Lehman also said it would sell much of its money management business, including its prized Neuberger Berman asset management unit, to Bain Capital and Hellman & Friedman for $2.15 billion. Lehman's demise set off tremors throughout the financial system. The uncertainty surrounding its transactions with banks and hedge funds exacerbated a crisis of confidence. That contributed to credit markets freezing, forcing governments around the globe to take steps to try to calm panicked markets.

1.2 The following financial figures show how the balance was melting down with the losses.

Lehman Brothers Holdings Inc. cash flow statement as on 31st May 2008.

In Millions of USD (except for per share items)

6 months ending 2008-05-31

3 months ending 2008-02-29

12 months ending 2007-11-30

9 months ending 2007-08-31

Net Income/Starting Line















Deferred Taxes





Non-Cash Items





Changes in Working Capital





Cash from Operating Activities





Capital Expenditures





Other Investing Cash Flow Items, Total





Cash from Investing Activities





Financing Cash Flow Items





Total Cash Dividends Paid





Issuance (Retirement) of Stock, Net





Issuance (Retirement) of Debt, Net





Cash from Financing Activities





Foreign Exchange Effects





Net Change in Cash





Cash Interest Paid, Supplemental





Cash Taxes Paid, Supplemental





Sources: google.com/finance?fstype=ci&q=OTC:LEHMQ

So far we have seen how the Lehman Brothers affected badly by the financial crises now, lets consider what impact it left on yet another largest bank “Merril Lynch”

2.0 History of Merrill Lynch:

According to ml.com (2009) the company was founded on January 6, 1914, when Charles E. Merrill & Co. opened for business at 7 Wall Street in New York City. A few months later, Merrill's friend, Edmund C. Lynch, joined him, and in 1915 the name was officially changed to Merrill, Lynch & Co. At that time, the firm's name included a comma between Merrill and Lynch the newyork times (1915) In 1916; Winthrop H. Smith joined the firm.

According to newyork times (1940) in its early history, Merrill, Lynch & Co. made several successful investments. In 1921, the company purchased Pathé Exchange, which later became RKO Pictures. In 1926, the firm made its most significant financial investment at the time, purchasing a controlling interest in Safeway, transforming the small grocery store into the country's third largest grocery store chain by the early 1930s. Following this investment, the company further increased its investment banking focus by transferring its retail brokerage services to E.A. Pierce. In 1940, the firm merged with E. A. Pierce & Co. and Cassatt & Co. and was briefly known as Merrill Lynch, E. A. Pierce, and Cassatt the newyork times (1940).

The company became the first on Wall Street to publish an annual fiscal report in 1941. Also in 1941, Fenner & Beane joined the firm, and the name became Merrill Lynch, Pierce, and Fenner & Beane. After Edmund Lynch's death in 1952, the company changed its name to Merrill Lynch & Co. and was officially incorporated. On December 31, 1957, The New York Times referred to that name as a sonorous bit of Americana and said After sixteen years of popularising, Merrill Lynch, Pierce, Fenner, and Beane is going to change it and thereby honour the man who has been largely responsible for making the name of a brokerage house part of an American saga, Winthrop H. Smith, who had been running the company since 1940.

newyork times (1940) the merger made the company the largest securities firm in the world, with offices in over 98 cities and membership on 28 exchanges. At the start of the firm's fiscal year on March 1 1958, the firm's name became Merrill Lynch, Pierce, Fenner & Smith and the company became a Big Board member of the New York Stock Exchange The New York Times (1957).

Merrill Lynch rose to prominence on the strength of its brokerage network (15,000+ as of 2006), totalmerril.com (2009) sometimes referred to as the "thundering herd", that allowed it to place securities it underwrote directly as per Perkins (1999) In contrast, many established Wall Street firms, such as Morgan Stanley, relied on groups of independent brokers for placement of the securities they underwrote Chernow (1990) Until as late as 1970, it was known as the "Catholic" firm of Wall Street Stewart(1992).

According to Perkins (1999) the firm went public in 1971 and has since become a multinational corporation with over US $1.8 trillion in client assets, operating in more than 40 countries around the world. In 1978, it significantly buttressed its securities underwriting business by acquiring White Weld & Co., a small but prestigious old-line investment bank. Merrill Lynch is best known for its Global Private Client services and its strong sales force. On November 1, 2007, Merrill Lynch CEO Stanley O'Neal left the company, after being criticized for the way he handled the firm's risk management and the subprime mortgage crisis, which resulted in about US $2.24 billion in unexpected losses, and for discussing in public the possible merger with Wachovia banking corporation, without being authorized by the board to do so. He left Merrill Lynch with about US $161 million worth of stock options and retirement benefits. John Thain, CEO of the New York Stock Exchange, succeeded him as CEO on December 1, 2007. On January 17, 2008, Merrill Lynch reported a $9.83 billion fourth quarter loss incorporating a $16.7 billion write down of assets associated with subprime mortgages. On April 17, 2008, Merrill Lynch reported a net loss of $1.97 billion for the first quarter of 2008 newyorktimes (1940).

According to ml.com (2009) Merrill responded to its losses by raising capital through the sale of preferred shares, however experts suggest that such a strategy may pose a risk to the company's credit rating which could cause an increase to the company's borrowing costs. On January 22, 2009 John Thain resigned as CEO of the company after it was disclosed that he had rushed to pay out $3-4 billion dollars in fourth quarter bonuses to Merrill employees by the end of 2008, just prior to Bank of America's acquisition of the company became final. Thain allegedly did not disclose the bonus payouts to Bank of America negotiators. Bank of America has recently asked the United States Treasury for an additional $20 billion in emergency capital, primarily in order to cover losses at its Merrill Lynch subsidiary nytimes.com (2009).

Thain was also named as a co defendant in a class-action lawsuit filed by shareholders against Bank of America and Merrill Lynch on January 22, 2009. The suit alleges that Bank of America CEO Ken Lewis, ex-Merrill Chief Financial Officer Nelson Chai, ex-Merrill Chief Accounting Officer Gary Carlinand, and Thain failed to warn shareholders of the magnitude of Merrill's losses prior to the Bank of America acquisition nytimes.com (2009).

2.1 Following financial figures show how the balance was melting down with the losses.

Financial data of Merrill Lynch for year ending December 2007 - 2005

(Dollars in Millions, Except per share amount)

2007 (52 Weeks)

2006 (52 Weeks)

2005 (52 Weeks)

Results of Operations

Total Revenue




Less Interest Expense




Revenue, Net of Interest Expense




Non-Interest Expenses




Pre-Tax (Loss)/Earnings from continuing operations

- 12,831.00



Income Tax (Benefit)/Expense

- 4,194.00



Net (Loss)/Earnings from Continuing Operations

- 8,637.00



Pre-Tax Earnings from Discontinued Operations




Income Tax Expenses




Net Earnings from Discontinued Operations




Net (Loss)/Earnings Applicable to Common Stockholders

- 8,047.00



Financial Position

Total Assets




Short-Term Borrowings








Long-Term Borrowings




Junior Subordinated Notes (related to trust preferred securities)




Total Stockholders Equity)




Common Share Data

(In thousands, except per share amount)

(Loss)/Earnings per Share:

Basic (Loss)/Earnings Per Common Share from Continuing Operations

- 1,073.00



Basic Earnings Per Common Share from Discontinued Operations




Basic (Loss)/Earnings Per Common Share

- 9.69



Diluted (Loss)/Earnings Per Common Share from Continuing Operations

- 10.73



Diluted Earnings Per Common Share from Discontinued Operations




Diluted (Loss)/Earnings Per Common Share

- 9.69



Weighted-Average Shares Outstanding:









Shares Outstanding at Year-End




Book Value Per Share




Dividends Paid Per Share




Financial Ratios

Pre-Tax Profit Margin from Continuing Operations




Common Dividend Payout Ratio




Return on Average Assets




Return on Average Common Stockholders Equity from Continuing Operations




Other Statistics

Full-Time Employee





Non- U.S.








Financial Advisors




Client Assets (Dollars in Billions)




Note: N/M = Not Meaningful

Sources: Merrill Lynch Annual Report-2007

Lets consider the other major conventional banks losses below.

2.2 Other major sub prime losses due to credit crunch as on June 2009

According to thebanker (2009) the impact of the crisis on bank profits of the listed banks plunging 85.3% from $780bn to $115bn and return on capital sinking from 20% in 2008s ranking to a paltry 2.69% The shocking 85.3% collapse in profits reveals the full extent of the carnage in the global banking system. After four years of

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