Public Lecture
Dr Abbas Mirakhor
29 September 2009
Securities Commission Malaysia
1997 Asian crisis gave rise to policy recommendations by IMF which included-
• avoid debt dependence
• rely mostly on equity investments
• if must have debt, shld not be more than 25% GDP
• countries’ obligations should not be geared to short term
• must have enough strength in economy
• shld ensure sovereign bonds include certain clauses to ensure risks are shared equally between creditors and debtors
• transparent balance sheet, marked to market financing, not heavily leverage
• domestic institution must be regulated
• shld establish orderly bankruptcy procedures and restructuring mechanism for workouts
• periodic audits of the soundness and stability of the economy, “financial sector assessment report”
Majority of IMF members accepted this, but major economies incl the US did not implement them eg they refused to have financial sector assessment
The recent subprime crisis occurred and 2 possible explanations:-
Conventional and non conventional
Conventional explanation-
1. policy failure
a. to undertake strengthening regulations, lax monetary policies and fiscal policies
b. refusal to deal with asset and actual incentives of policy makers towards highly risky and complex instruments.
c. These are premised on the interllectural idea o the policy maker which drives his policies.
i. In Greenspan’s idea, he believes in “perfect markets”. If this is true, the risks in the economy will be distributed efficiently. 2 issues affect any economy- (a) what is the total aggregate risk in the economy (b) how do you distribute this risk among the participants of the economy. If you believe in perfect markets, you will want as many instruments to spread the risks efficiently;
ii. The idea that the value of the firm relates to its marginal profitability. So it does not matter how it is financed, ie whether debt or equity. MM model. If you believe in this idea, instruments can be derived based on payoff which is interest rate;
iii. EMH- were the prices of the security includes all the information that a decision maker requires. So if the price increases, it means demand increases and later with over demand supply increases which leads to prices falling again. Thus, Asset Bubbles will never occur
d. The conclusion is that Greenspan will never interfere in policy and regulate markets as you don’t believe that either monetary policy or regulatory measure will affect asset bubbles.
e. But in Dec 2008 Greenspan concluded that he was following a flawed model.
2. regulatory failure – hands off policy, segmentation of economy
3. governance failure – internal and external idea that profit seeking did not create a systemic risk – too complex, too big instruments and institutions resulted
4. globalization failure- increase the vulnerability of the world system, becos there was no institution to overlook the global system. An excess in sovereign funds of some countires , invested in the debt instruments of the US – treasury bills – created a huge inflow into the US – no regulation – debt imbalance
Non conventional explanation
• crisis cannot be avoided in a financial capitalist society where it is based on interest and debt contracts
• 2 components to this-
o capitalism is vulnerable and fragile due to the Fractional Reserve banking system (refe Morris Alais or Holbern) – the fragility sets in because once the banks can create credit, they can also create “shadow banking” ie leverages without taking deposits
o this is the money multiplier of the conventional banks and the leverage of the shadow banks. The fragility is due to the ease in contraction and expansion
• so the “Chicago Plan” during the Depression years came about, but was not adopted as the banking lobby was so strong – the suggestion of that school being that the banking system that operates on 100% reserve
• also mismatching – banks borrow short and lend long. If this does not occur, there won’t be ny need for banking deposit insurance. James Token proposed this system which would anchor the market economy
• Keynes says that capitalism and market economies are inherently fragile because the system interferes with surplus / shortfall of supply of funds. Even in a market economy, there can be no perfect balance, cos savers and investors have different motivations. So consumption in 1 period cannot validated investment in a previous period. So you also cannot guarantee full employment situation.There is also rentier class (interest rate system). If you don’t have this class, saving will find its way into a project and the payoff will be the profit. With interest, it creates a wedge in the economy that make the system fragile. So he says get rid of interest and the rentier class.
• Minsky, a student of Keynes – repeated Keynes ideas and he says financing must be done based on equity financing – “Financial Stability Hypothesis” – during prosperity, firms see investment opportunities, use equity to finance it with little debt. When prosperity picks up momentum, the businessman decides that he want to take advantage by undertaking debt in order to grow. Then begins interest payments, asset bubbles leading to financial distress – “rolling bubbles”
• Soros – “super bubble” which takes magnitude fromt eh bursting of smaller bubbles within it.
• So there must be equity financing and risk sharing to stabilize an economy
What are the lessons for Islamic Finance?
Since they exist side by side with conventional system
-how do you cushion the system from price shocks, so that they can adjust very rapidly in such events
-islamic mathematical models of finance before this assumed that they were bank based, but this cannot be relied on to create stability
also regulatory frameworks is important. The major lesson from the crisis is reulation. We are not assured, because there is no quality control. So a stong enough regulation must be in place acceptable in all jurisdiction and an authority with enough mandate to implement. Otherwise the system can be destroyed. – reputationa damage of sukuk failures
with 100% reserve system, there is no money created. Only the State will create money.
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