The subprime mortgage crisis, in the grip of which the USA finds itself at present, is a classical example of excessive and imprudent lending. Securitization or the “originate-to-distribute” model of Banking has played a crucial role in this. The creation of CDOs by mixing prime and subprime debt made it possible for mortgage originators to pass the entire risk of default of even subprime debt to the ultimate purchasers who would have normally been reluctant to bear such a risk. Mortgage originators had, therefore, less incentive to undertake careful underwriting. Consequently, loan volume gained greater priority over loan quality and the amount of lending to subprime borrowers and speculators increased steeply. In addition, abusive, unfair, or deceptive lending practices led some borrowers into mortgages that they would not have chosen knowingly. (Iqbal, 2009) The check that market discipline could have exercised on the serving of self-interest did not come into play. Even the supervisors failed to perform their task effectively by not taking serious notice of the unfair practices at an early stage and nipping them in the bud.
Islamic Banking should, in its ideal form, help raise substantially the share of equity and PLS in businesses. Greater reliance on equity Banking has supporters even in mainstream economics. (Iqbal, 2009)
Greater reliance on equity does not necessarily mean that debt Banking is ruled out. This is because all the financial needs of individuals, firms, or governments cannot be made amenable to equity and PLS. Debt is, therefore, indispensable, but should not be promoted for nonessential and wasteful consumption and unproductive speculation.
For this purpose, the Islamic financial system does not allow the creation of debt through direct lending and borrowing. It rather requires the creation of debt through the sale or lease of real assets by means of its sales- and lease-based modes of Banking (murabaha, ijara, salam, istisna, and sukuk). The purpose is to enable an individual or firm to buy now the urgently needed real goods and services in conformity with his/her ability to make the payment later
The injection of a greater discipline into the financial system may tend to deprive the subprime borrowers from access to credit. Therefore, justice demands that some suitable innovation be introduced in the system to ensure that even small borrowers are also able to get adequate credit. (Cihak, 2008)
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