Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 2

Banking and the Risk Environment

Brandon Davies

1. THE GLOBAL RISK ENVIRONMENT

We live in interesting times. The global economy has changed significantly in the last decade. Emerging market economies have increased their share, for much of that time, of a rapidly expanding global economy, from around 25 percent to around 50 percent of global GDP (measured at purchasing power parity).

Growth has not, however, been evenly distributed. Developed economies that have been globally dominant in both economic and political terms for much of the period since World War II have increasingly suffered, since the turn of the millennium, from low rates of economic growth. This has been especially true since they entered a recessionary period, which we may date from the collapse of the U.S. investment bank Lehman Brothers in 2007.

The collapse of Lehman Brothers itself was consequential upon the collapse of the U.S. mortgage-backed securities (MBS) market. This collapse brought about a general reduction in the supply of liquidity across the interconnected banking systems of many developed economies, as banks restricted their lending to each other, fearful of which banks might be exposed to the very large credit losses from their holdings of MBS and other similar collateralised debt obligations (CDO).

As a number of very large international banks suffered from both high credit losses and illiquid markets, they were unable to fund their balance sheets and had to be funded and recapitalised ...