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Islamic Banking: Can it Save Us from Crises?

Asli Demirgüç-Kunt's picture

Pundits in the financial press have been asking an intriguing question: if too much debt and insufficient equity was partly responsible for the financial crisis, might Islamic banking be part of the solution? After all, Islamic principles require that financial transactions cannot include interest rate payments on debt, but rather have to rely on profit-loss risk-sharing arrangements (as in equity). For example, demand deposits that do not pay interest are fine, but savings deposits generally participate in the profits of the bank since these cannot accrue interest. Lending also generally follows a partnership model where the bank provides the resources and the client provides effort and expertise, and profits are shared at some agreed ratio. So can the heightened risk-sharing required by Sharia curb excess risk-taking by banks?

In practice Islamic scholars have also developed products that resemble those offered by conventional banks, replacing interest rate payments and discounting with fees and contingent payment structures. Nevertheless, Islamic banking still retains a strong element of equity participation. How does this affect bank risk-taking? Conceptually, the answer is not immediately clear. On the one hand, the equity-like nature of savings instruments may increase depositors’ incentives to monitor and discipline banks. On the other hand, if deposit instruments are equity-like, banks’ incentives to monitor and discipline borrowers may also be reduced since banks no longer face the threat of immediate withdrawal. Similarly, the equity-like nature of partnership loans can reduce the important discipline imposed on entrepreneurs by debt contracts.

The Challenges of Bankruptcy Reform

Leora Klapper's picture

The 2008 financial crisis precipitated a global economic downturn, credit crunch, and reduction in cross-border lending, trade finance, remittances, and foreign direct investment, which all adversely affected businesses around the world. The increase in the number of distressed firms has made policymakers more concerned about the effectiveness of existing bankruptcy regimes, including both the laws that address reorganization and liquidation, as well as improved enforcement of laws in court.

In a recent paper with Elena Cirmizi and Mahesh Uttamchandani, my co-authors and I summarize the theoretical and empirical literature on designing bankruptcy laws; discuss the challenges of introducing and implementing bankruptcy reforms; and present examples of the most recent reforms in this area from around the world. As policymakers use the current recession as an opportunity to engage in meaningful reform of the bankruptcy process, it is important to assess experiences from previous crises.

Reforming Global Finance: What is the G20 Missing?

Franklin Allen's picture

Editor's Note: Professor Franklin Allen came to the World Bank on October 27 to give an FPD Chief Economist Talk on the topic of Reforming Global Finance: What is the G20 Missing? Please see the FPD Chief Economist Talk page to download a copy of his presentation and watch a video of his Talk.

The recent financial crisis clearly had more than one cause. My view is that the most important one was a bubble in real estate prices, not only in the US but also in a number of other countries such as Spain and Ireland. It was the bursting of this bubble that has led to so many problems in the world economy. A significant part of this is a direct effect on the real economy rather than an effect transmitted through the financial system. For example, Spain had one of the best regulated banking systems and its banks did much better than in other countries. Yet with a doubling of its unemployment rate to 20 percent, its real economy has been devastated. In contrast countries like Germany that did not have a real estate bubble but had much larger drops in GDP have not suffered nearly as much. Germany's unemployment rate is now lower than at the start of the crisis.

Credit Where Credit is Due: Partial Credit Guarantee Schemes in the Middle East and North Africa

Roberto Rocha's picture

Editor's Note: The following post was submitted jointly by Youssef Hassani, Economist, MENA, Zsofia Arvai, Senior Financial Economist, MENA, and Roberto Rocha, Senior Adviser, MENA.

Many countries in the Middle East and North Africa (MENA) region have established partial credit guarantee schemes (PCGs) to facilitate SME access to finance. These guarantee schemes can potentially play an important role, especially in a period where MENA governments are still making efforts to reduce risks for lenders by improving the effectiveness of credit registries and bureaus and strengthening creditor rights. However, the contribution of credit guarantee schemes to SME finance depends largely on their design. 

Well designed schemes may be able to achieve significant outreach and additionality, i.e. benefit a significant number of SMEs that have substantial growth potential but are effectively credit constrained due to lack of credit information and collateral. In some countries PCGs have also played an important capacity-building role. By contrast, poorly designed guarantees schemes may have a limited development impact by providing guarantees to firms that are not credit constrained. PCGs may also accumulate losses by providing overly generous and underpriced guarantees, and ultimately become a burden to public finances.

The Chrysler Effect: The Impact of the Chrysler Bailout on Borrowing Costs

Deniz Anginer's picture

Did the bailout of Chrysler by the U.S. government overturn bankruptcy law in the United States?

Almost two years ago, the outgoing Bush and incoming Obama administrations announced a series of steps to assist Chrysler, the struggling automaker, in an extraordinary intervention into private industry. The federal government intervened in Chrysler’s reorganization in a manner that, according to many analysts, subordinated the senior secured claims of Chrysler’s lenders to the unsecured claims of the auto union UAW. As one participant interpreted the intervention, the assets of retired Indiana policemen (which were invested in Chrysler’s secured debt) were given to retired Michigan autoworkers.

Critics claim that the bailout turned bankruptcy law upside down, and predicted that businesses would suffer an increase in their cost of debt as a result of the risk that organized labor might leap-frog them in bankruptcy. A long-standing principal of bankruptcy law requires that a debtor’s secured creditors be repaid, in full, before its unsecured creditors receive anything.

The Returns to Better Management

David McKenzie's picture

How much does management matter for economic performance? Despite a large industry of business schools, consulting firms, and airport books purporting to teach you the secrets of good management over the course of your next flight, the answer until very recently has been “we don’t know”. In a recent review, Chad Syverson goes as far as to say “no potential driving factor of productivity has seen a higher ratio of speculation to empirical study”.

Together with colleagues from Stanford and Berkeley, I have been working for the last couple of years to try and understand how much management matters by means of a randomized experiment among textile factories in India. In common with most firms in developing countries, the firms (with 300 workers on average) we were working with did not collect and analyze data systematically in their factories, had few systems for regular maintenance and quality control, had weak human resource systems for promoting and rewarding good performers, and had little control over inventory levels.  The result was a high level of quality defects, large stockpiles of unorganized inventories, and frequent breakdowns of machines. 20 percent of the labor force was occupied solely in checking and repairing defective fabric (see picture).

The Impact of the Crisis on New Firm Registration

Leora Klapper's picture

With millions around the globe feeling the impact of the financial crisis and slower economic growth and job losses, it is important to understand regulatory and policy constraints on entrepreneurs wanting to start a formal business. Entrepreneurial activity is the basis of sustainable economic growth, and the first step for entrepreneurs joining or transitioning to the formal sector is the registration of their business at the registrar of companies. For evidence of the economic power of entrepreneurship we need look no further than the United States, where young firms have been shown to be an important source of net job creation, relative to incumbent firms (Haltiwanger, et al.).

To measure entrepreneurial activity, we’ve constructed with support from the Kauffman Foundation the World Bank Group Entrepreneurship Snapshots (WBGES) – a cross-country, time-series dataset on new firm registration in 112 countries. The main variable of interest is “Entry Density”, defined as the number of newly registered limited liability firms as a percentage of the working age population (in thousands). We employ annual figures from 2004 to 2009 collected directly from Registrars of Companies and other government statistical offices worldwide. Like the Doing Business report, the units of measurement are private, formal sector companies with limited liability.

FDI in Southern Africa: Microeconomic Consequences and Macro Causes

Foreign direct investment (FDI) can theoretically reduce income gaps between developing and advanced economies. In a neoclassical world, with perfect capital mobility and technology transfer, capital readily flows from rich to poor countries, seeking higher returns in capital-scarce economies. The real world differs starkly from the theory.

Even though southern African countries (the Southern African Development Community, SADC hereafter) are poor on average, per capita FDI inflows are a meager 36.6 U.S. dollars per year (in 2000 value), which is about 18 percent of average per capita FDI in non-SADC countries and 58 percent of the average level for similar-income economies. Moreover, within SADC, country differences are huge: FDI per capita ranges from single digits (Malawi, Zimbabwe, Madagascar, Democratic Republic of Congo, and Tanzania) to 10-30 dollars (Mozambique, Zambia, Mauritania, and Swaziland), to 50 to 100 dollars (Lesotho, South Africa, and Angola), and to 167 dollars in the outlier in this region, middle-income Botswana. And even within this region there is a positive relationship between average income and FDI per capita, a pattern that holds for the world as a whole. Thus, any hope of relying on FDI as a supply-side remedy to catapult poor countries onto a development fast track is not likely to materialize soon.

Financial Access and the Crisis: Where Do We Stand?

Asli Demirgüç-Kunt's picture

Do you wonder how the recent global crisis affected access to financial services? Well I do, and a report by the World Bank Group and CGAP just provided the answer: Data show that even as countries were suffering because of the financial crisis, access to formal financial services grew in 2009.  Indeed, the number of bank accounts grew world-wide, while at the same time the volume of loans and deposit accounts dropped. The physical outreach of financial systems— consisting of branch networks, automated teller machines (ATMs), and point-of-sale (POS) terminals—all expanded.

That’s a relief. Readers of this blog know by now that I am a strong believer in expanding access. Lack of access to finance is often the critical element underlying persistent income inequality as well as slower growth. But the recent global financial crisis has led us to question many of our beliefs and re-opened old debates. It also exposed an important tension between access and stability. Were we wrong to emphasize access in the light of what happened?

Corruption and Finance: Are Innovative Firms Victims or Perpetrators?

Asli Demirgüç-Kunt's picture

Designing policies that promote innovation and growth is key to development. In many countries there is also considerable corruption, with government officials seeking bribes and many firms underreporting their revenues to the state to evade taxes. Might there be a set of reforms that allow policymakers to kill two birds with one stone, both reducing corruption and boosting innovation? New research suggests financial sector reform may be able to play this role.

In a recent paper with co-authors Meghana Ayyagari and Vojislav Maksimovic, we look at corruption—defined as both bribery of government officials and tax evasion—and how this is associated with firm innovation and financial development. Using firm-level data for over 25,000 firms in 57 countries, we investigate whether firms are victims, who pay more in bribes than they gain by underreporting revenues to tax authorities, or perpetrators, who gain more by avoiding taxes than they lose in paying bribes.

Of particular interest is the effect of corruption and tax evasion on innovative firms. Specifically, we explore the following questions: