Lessons from the global financial fiasco

[Naveed Yaseen]

By M Iqbal Patel
THE developing countries like Pakistan can learn a number of lessons from the global financial turmoil, the worst since the Great Depression.

The regulators in US, Pakistan, the banks and financial institutions relied heavily on ratings given by the credit agencies. In the US, the banks extended housing finance on the basis of ratings given to the borrowers by these agencies. And yet the borrowers failed to repay their loans. The credit agencies were criticised for their failure to carry out their obligations towards the banks.

William Rutledge, executive vice-president of the Federal Reserve Bank (FRB), criticised rating agencies for failing to adequately identify risks in sub-prime mortgages. He said that the US financial regulatory structure has been shown to have some major weaknesses. Many mortgage-backed securities that had been given credit rating of triple-A suffered losses. He advised the investors not to solely rely on rating agencies which, he emphasised, should also come under more scrutiny of the American regulators.

The European Commission has called for clampdown on credit rating agencies. Leading rating agencies — Moody’s Standard and Poor’s and Fitch — have come under fire for being too slow to alert investors to the danger of high risk subprime mortgage loans.

Tougher rules for rating agencies are being considered. These are: (i) rating agencies should be banned from doing consultancy work on concerns over potential conflicts of interests. (ii) They may be required to disclose how they make ratings (iii) They should be disallowed to rate a security in the absence of sufficiently reliable information (iv) They may be required to have on their boards at least three independent directors whose pay is not tied to business performance, (v) internal reviews of rating quality and (vi) publication of annual transparency reports. Markets Commissioner Charlie McCreevy said that these very exciting rules are necessary to restore the confidence of the market in ratings business in the European Union.

The regulators in Pakistan have also lessons to learn: that ratings given by the credit agencies should not always be taken on their face value; there should be a system to scrutinise these ratings. The regulations governing the rating agencies should have provision for punishment, penalty etc in case the wrongly assigned credit rating. Similarly, the banks and financial institutions should not rely on the rating blindly but they should have a system to confirm its correctness.

Financing policies: The financial crisis developed in the US may be attributed to mortgage loans given by banks at low rate of interest and on easy repayment terms. It created intense competition among the banks that started to lend to the borrowers who could not afford to purchase mortgages and lacked creditworthiness. Subsequently, the borrowers could not afford the increase in interest rate and began to default in repayment of their loan instalments. Gradually, the banks felt liquidity crisis

A similar situation is visible in our banking system. The facility of credit cards, auto financing or consumer financing has been extended on simple documentation without scrutinising borrower’s credit worthiness. And intense competition among the bankers has led to lowering of their scrutiny standards. The banks should learn lesson from the US credit crisis and review their credit policy accordingly to prevent their down fall.

Over the past few years, the banks encouraged consumer financing instead of the industry which should have brought economic development, employment and self-reliance. The State Bank of Pakistan has recognised that rapid credit growth has resulted in high credit risks. Initially, the banks may earn profit from consumer financing but they will face similar credit crisis like the one that cropped up in the US. In order to avoid a repeat of like subprime crisis in Pakistan, the State Bank should tighten consumer financing standards.

Western financial system: The European and other countries seem to agree that present US financial turmoil has established that it is the unbridled capitalist system that has caused the global financial crisis. There is consensus to create a new financial architecture. The bailout package approved by the US Congress was with a view to averting a collapse of capitalism. The economic discipline developed in the West over last two centuries poses certain problems. The pursuit of efficiency and optimal allocation of resources have become the central problems.

In addition, the system lacks equally important factors such as equality and justice; there are adverse social and ecological consequences of economic efforts. All these factors have weakened the link between wealth and well-being. Finally money, which was primarily a medium of exchange, has become a medium of speculative business activity.

The most important ingredient in the making of the existing financial system is the institution of interest that has played a crucial role in this transformation. Consequently, the economic system of West has failed to address the problems of mankind. It leads to the concentration of wealth in a few hands, widening the gap between rich and poor. This crisis thus provides an opportunity to the Muslim countries to offer the western world the Islamic financial system to replace capitalism.

The Islamic Financial System: The Muslim countries should seize the opportunity and present the Islamic economic system as a substitute for capitalism. The Islamic financial system provides for right of private property, freedom of enterprise, market mechanism and profit motive which are all integral parts of the Islamic economic system like in capitalism. The fundamental difference between the two systems is that Islam eliminates interest from its financial system which is cornerstone of capitalism. But this does not involve any denial of profitability to capital or its right to enjoy a fair return. Capitalism allows predetermined fixed return on capital without sharing the risk of the business while Islam entitles capital to a return based on actual productivity. Islamic economy is primarily an equity based one, not riddled with debts.

http://www.dawn.com/2008/12/22/ebr13.htm