In the wake of the 2008 financial melt-down, bankers and regulators appeared to start talking seriously about adopting the more stable and transparent principles of Islamic finance, as opposed to the harum-scarum and frequently dishonest manipulations of the conventional financial markets. Yet in the past 18 months, the focus on the widespread use of the ethical precepts of Islamic finance appears to have disappeared, except where it can be used to drum up business in the Muslim world. London now fancies itself as the leading center for Shariah-compliant finance, claiming to have overtaken Kuala Lumpur.
This is not the only cause for concern. Banking regulators in US and Europe are busy trying to ensure there will be no repeat of that systemic failures that brought Western economies at least to the brink of disaster. Meanwhile, investors seem intent on repeating the insane behavior that cost them billions only a few years ago.
The banking part of the piece is easy to understand. The North American and European banking systems only survived thanks to colossal injections of tax payer cash. After the collapse of Lehman brothers and the enforced takeover of Bear Stearns and other vulnerable financial institutions, politicians swore that they would change the rules, so that no bank could be ‘too big to fail.” A key part of the fix was supposed to be the break-up of banking operations. A core retail function would gather deposits and turn them into loans. Meanwhile, the higher-risk investment banking function, whose previous dubious, if not criminal practices nearly destroyed the whole financial system, would sit in a stand-alone part of the bank. If its speculative deals came unstuck, then it would be the investment banking division that went bust. The retail part of the bank, ring-fenced from the loss, would carry on with its customers’ deposits entirely safe.
This completely sensible division was what existed in the US, thanks to the post-Depression Glass-Steagall legislation of 1933. In the UK, the division had always existed. What were then called “Merchant banks” regarded themselves as altogether a cut above the mundane retail bankers.
Unfortunately today’s financial behemoths continue to fight a series of rearguard actions. The latest, in response to their being ordered to hold more protective capital, is to threaten that the extra costs will be passed on. As if bank customers expected anything less.
But it is not the obduracy of the banks that ought to be causing most concern. It is the way that those who control trillions of dollars of funds are once more piling in to high risk investments. The level of risk supposedly dictates the level of return. There is an irony here because many governments sustained their banks by moving the cost of money to historic lows. This enabled banks to rebuild their shattered balance sheets by taking advantage of a healthy spread between what money cost them and what they charged their borrowers.
Unfortunately, those low interest rates have not been good enough for fund managers seeking to outdo each other in profitability. Thus sometime struggling companies have been issuing junk-grade bonds offering generous terms, in return for a lack of the normal covenants that might protect an investor. International fund managers have been snapping up these generally short to medium term investments. Their belief is that they will be able to re-sell profitably or cash out at maturity, before the company or indeed, the wider economy, goes bad.
As if this were not bad enough, banks are once again “slicing and dicing” and bundling up different securities into investment products that are so unnecessarily complex, they are extremely difficult to analyse and price. However, because they offer a good return, they are finding an eager market. By some measure, the issuance of these risky securities has now passed pre-collapse levels.
It seems barely credible that in their frantic search for return, so many apparently sane institutional investors should have strayed back into the self-same risky asset classes that brought ruin to so many just six short years ago. With China hovering on the brink of its own deep financial crisis, the potential for early disaster for investors in junk securities is all to clear.
Islamic finance may not, as some critics complain, yet have the full set of tools to make it real challenger to the brutal, high-speed investment status quo. Nevertheless, this high-principled approach to channelling money productively stands in stark contrast to the “absolutely anything for a buck” stance of Western investors, who are surely heading for another, and perhaps even harder fall.
