The current global financial crisis stems from the absence of adequate market discipline, and Islamic finance can help fix it by injecting a greater discipline into the system, an expert at the Islamic Development Bank said.

Speaking at an international gathering here Saturday, Umer Chapra from the Bank's Islamic Research and Training Institute said the global financial system lacks discipline because the reward and punishment mechanism in the banking system was not working.

Under current practices, banks are allowed to sell debt, transferring the risks of default to the purchasers, and use the proceeds to make more loans to increase their profits. After selling the debt, banks have no relationship with the debtors.

In such a system, the banks have no incentive to make a proper assessment of the debtors in the first place, and have no interest if the debtors are able to pay off all their debt.

Added to this is the introduction of derivatives like credit default swaps which make it possible for lenders to insure themselves against the risk of default.

This innovation might not cause any harm if the sellers of the swap (hedge funds) made some sort of risk assessment and sold the swaps to the actual lending banks, Chapra said.

The problem is they sold the swaps to a large number of institutions and individuals who were willing to bet on the default of the debtor.

As a result, the amount of derivatives is getting bigger and bigger. According to the Bank for International Settlements (BIS), outstanding derivatives rose to US$683.7 trillion as of June 2008, more than 12 times the world's combined gross domestic products of $54.3 trillion in 2007.

"It's OK when the economy is booming. But when the economy is going down, defaults increase, and it's just not possible to recover the investment," Chapra said.

Therefore, he said, the way to address the current crisis is to restore market discipline through a reward and punishment system. Banks making good loans must be rewarded through profits, while those making bad or excessive loans must be punished through losses or even bankruptcy.

In that sense, Chapra said, Islamic finance offers some solutions to the current problems through its risk-sharing principles. It introduces greater discipline into the financial system by requiring financier to share the risk.

Islamic finance links credit expansion to the growth of the real economy and minimizes speculation and gambling by allowing credit primarily for the purchase of real goods and services.

It requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby insuring that the creditor evaluates the risk more carefully.

"Thus, we can see that the Islamic financial system has the potential of minimizing the severity and frequency of financial crises by getting rid of the major weakness of the conventional system: market indiscipline," he said.

Bank Indonesia deputy governor Muliaman Hadad agreed and said that Islamic finance proved to be more resilient to crisis, at least in Indonesia.

"The Indonesian Islamic banking industry, in particular, has proved its robustness against both this current financial disturbance and the 1998 financial crisis," Muliaman said.

The problem is Islamic finance in Indonesia is still very small, compared to the whole financial system in the country. Currently the industry, at around US$5 billion, accounts for only 2.5 percent of the national banking industry.

The good news is that the industry is growing rapidly, at a rate of 40 percent annually in the last four years.

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