Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 4

Risk in a Turbulent World: Insights from Islamic Finance1

Sami Al-Suwailem

1. INTRODUCTION

Despite the remarkable technological advances that humanity enjoys in our age, financial instabilities have been on the rise since the 1970s. The steady improvement in the stability of the real economy in the past few decades was accompanied by rising frequency and severity of financial crises (IMF 2007, ch. 5; 2009a, ch. 3). “The fact that the total risk of the financial markets has grown in spite of a marked decline in exogenous economic risk to the country is a key symptom of the design flaws within the system,” noted Richard Bookstaber, Senior Policy Adviser to the Financial Stability Oversight Council in the United States (Bookstaber 2007, 5).

Further, recessions that precede banking and financial crises are more costly to the economy and have a longer negative impact than ordinary recessions. It takes on average four years for the economy to recover from a recession accompanied by a banking crisis, but only one year to recover from an ordinary recession (Reinhart and Rogoff 2009). Furthermore, cumulative loss in GDP in case of financial crises on average is 14 percent, compared to 5 percent in absence of crises (IMF 2008, ch. 4).

Islamic finance is characterised by the view that finance needs to be anchored in the real economy, which distinguishes it from conventional finance just as significantly as the well-known prohibition of interest. The basic principles nonetheless ...