Credit Default Sharing Instead of Credit Default Swaps: Toward a ...

JOURNAL OF ECONOMIC ISSUES Vol. XLVIII No. 1 March 2014 DOI 10.2753/JEI0021-3624480101

Credit Default Sharing Instead of Credit Default Swaps: Toward a More Sustainable Financial System Nader Naifar Abstract: The central cause of all recent financial crises (including the Asian financial crisis, the European debt crisis, and the subprime mortgage crisis) was the debt crisis. The primary objective of this study is to examine the principles of risksharing promoted by Islamic finance as a possible reform of or complement to the current financial system. The secondary objective of this paper is to explain how and why the famous credit default swaps (CDSs) markets expanded and why they contributed to the recent financial crisis. In addition, I propose a new financial instrument to hedge default risk (credit default sharing) based on the principles of risk-sharing and Islamic insurance, takaful (sharing responsibility and mutual cooperation), as a substitute for CDSs. I explain that credit default sharing can reduce counterparty risk, improve banks’ monitoring incentives, reduce systemic risk and contagion in financial systems, and eliminate “empty creditors.” Keywords: counterparty risk, credit crisis, credit default swap, financial stability, Islamic finance, “originate and distribute” model, risk-sharing, systemic risk, takaful JEL Classification Codes: G01, G18, G32

The financial crisis of 2007–2008, also known as the global financial crisis and the subprime crisis, started with the collapse of two Bear Stearns hedge funds and peaked with the default of the U.S. investment bank Lehman Brothers. Atif Mian and Amir Sufi (2009) show that mortgage credit-underwriting standards were relaxed from 2001 to 2005 with a significant number of high-risk borrowers. Relaxed standards were associated with increased mortgage lending, growing housing prices, and an increase in defaults. As I (Naifar 2011) argue in a previous publication, the main problem facing financial institutions which have either invented subprime loans or purchased subprime asset-backed securities is that the decline in housing prices contributed to

Nader Naifar is an associate professor of finance in the Department of Finance and Investment of the College of Economics and Administrative Sciences at Al Imam Mohammad Ibn Saud Islamic University (IMSIU), Riyadh (Saudi Arabia). This paper was financially supported by SABIC chair for Islamic Financial Markets Studies at IMSIU. The author thanks the editor of this journal, Professor Mohammad Al-Suhaibani, and an anonymous referee for constructive comments and suggestions that improved the quality of this article.

1 ©2014, Journal of Economic Issues / Association for Evolutionary Economics

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the extraordinary increase in subprime and Alt-A mortgage defaults. Several important credit default events occurred during the subprime crisis: namely, the bankruptcies of Lehman Brothers (on September 15, 2008), Washington Mutual, Circuit City, Chrysler, and General Motors. The acquisition of Bear Stearns by JPMorgan Chase in May 2008, the takeover of mortgage giants Fannie Mae and Freddie Mac, and the bailout of American International Group (AIG) injured the confidence of investors and creditors. Barry Eichengreen et al. (2012) argue that the decision to let Lehman Brothers fail — which damaged the global economy and created a financial tsunami — was a critical mistake. The recent financial crisis was not purely a debt crisis (especially after finding fault and error with the work of C.M. Reinhart and K.S. Rogoff 2009). The crisis has also illustrated the critical need for better mechanisms of regulation, supervision, and systemic liquidity management. In the aftermath of the subprime crisis, the enormous increase in sovereign debt has emerged as an important negative effect because public debt dramatically increased in an effort by the U.S. and the European Union (EU) governments to reduce the accumulated growth in private debt in the years preceding the subprime crisis. With respect to the issues of EU member nations, the problem is not so much “too much debt” as it is design flaws of the European monetary mechanism. More specifically, the basic design flaw is to have a common currency or treasury without political and fiscal integration. The global financial crisis and the recent Euro crisis have raised concerns over the use of CDSs. Rama Cont (2010) argues that the effect of CDSs markets can contribute positively or negatively to financial stability depending on how counterparty risk is managed in these markets. Non-standard contract CDSs markets in which protection sellers may lack sufficient liquidity resources and capital could amplify contagion. According to Anne-Laure Delate, Mathieu Gex, and Antonia López-Villavicencio (2012), budget deterioration increases risk and simultaneously raises the bond spread and the insurance cost priced in the sovereign CDSs premium. A CDS is a contractual agreement to transfer the credit exposure of fixed income products between parties. The CDSs, initially intended to be an instrument for hedging and managing credit risk, has been condemned during the recent financial crisis as being detrimental to financial stability. CDSs were supposed to protect lenders against default risk. Instead, they provided a false sense of protection that helped propagate the credit crisis. In addition, CDSs played a prominent role in the bankruptcy of Lehman Brothers, the collapse of AIG, and the sovereign debt crisis of Greece, and have been pinpointed during the recent crisis as being detrimental to the stability of financial systems. As risk-sharing financial instruments gain wide acceptance, a financial system founded on risk-sharing principles will become the basis for a sustainable financial system. According to Hossein Askari (2012), excessive leverage, combined with an inherent mismatch in assets and liabilities, exposes institutions to unsupportable risk and threatens the overall soundness of the financial system. Firms in emerging markets and developing countries must avoid debt-creating flows and adopt financing systems founded on risk-sharing promoted by Islamic finance instead of risk-shifting as a basis for sustainable finance. The central piece of Islamic finance is really risk-sharing

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and the majority of emerging countries in Asia are actively considering risk-sharingbased instruments through Islamic finance (e.g., Islamic bonds, or sukuk) as a possible alternative. This paper reviews the recent financial crises with a special focus on the subprime crisis, examines the principles of risk-sharing promoted by Islamic finance, and studies its implications on sustainable financing. The paper then explains how CDSs markets expanded and why they contributed to the recent financial crisis. Finally, the paper develops a new financial instrument for hedging default risk (credit default sharing) based on the principles of risk-sharing and takaful as a substitute for CDSs. The remainder of the paper is organized as follows. Section two presents the principle of risk-sharing promoted by Islamic finance. Section three presents CDSs contracts and studies the contribution of this instrument to the credit crisis and financial instability. Section four provides the structure of the new financial instrument credit default sharing, and discusses the possible contribution of this instrument to financial stability. The article ends with a conclusion. Essential Principles of Islamic Finance Islam is not only a divine service, like Judaism and Christianity, but also involves a code of conduct that regulates and organizes humankind in both spiritual and material life (Presley and Sessions 1994). Islam is a system of believes that covers not only man’s relationship with God, but also offers Muslims rules that regulates their entire way of life. Islamic law, sharia, is the moral code and religious law of Islam. Islam comprises a set of principles and doctrines that guide and regulate a Muslim’s relationship with God and with society. Islamic law is based upon four main sources. The first source is the Quran (regarded by Muslims as the direct words of God, as transmitted by the prophet Muhammad). Whereas the Quran itself does not address certain matters directly or in detail, Muslims use the second source of Islamic law, sunnah or hadiths (the traditions or known practices of the prophet Muhammad) to guide them. In the cases where Muslims have not been able to find clear guidance in the Quran or hadiths, the consensus of the community is regarded as the third source of Islamic law (or at least the consensus of the religious scholars within the community). In this situation, judges may use analogy, reasoning, and interpretation as a source of Islamic law. Islamic finance functions in compliance with the rulings and principles of sharia. The central feature of Islamic finance is the prohibition of payment or receipt of interest, riba. The best definition of riba is the prohibition of charging interest when lending money and of any added amount of money that is unjustified (such as a penalty). I notice a parallel between John Maynard Keynes’s thinking on interest and the institution of riba. As Keynes (1936, 375) posits, [i]nterest today rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst

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Nader Naifar there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital.

Based on Islamic principles, all profits should match work effort. Islamic principles permit instead for the replacement of interest by a return that is dependent upon the profitability of the underlying investment. Lending money by charging interest permits the lender to increase his capital without any effort because money by itself does not create value added. The lender does not receive profits for offering money unless he or she shares in the provision of the enterprise, and profits must be variable (not fixed or guaranteed). In addition, Islamic finance prohibits investing in transactions involving gambling, alcohol, and drugs, and transactions including uncertainty about the subject matter and contract terms (or gharar). There is a prohibition on the sale of objects, whose existence or characteristics are not certain, and on contractual terms that are ambiguous. In addition, contracts with uncertain fundamental terms regarding price, time, delivery, and each party’s obligations and rights are prohibited under sharia. Furthermore, under Islamic law, the transfer of debt and, therefore, the buying and selling of debt are prohibited. The sale of an asset followed by a buy-back of the same asset at an increased price is also not permitted under sharia. Islamic finance precludes the assumption of excessive risk by prohibiting excessive debt instruments. Various sharia-compliant financing and investment structures have been developed. The most commonly used structures are murabaha (cost-plus financing at an agreed profit margin), mudarabah (a special kind of partnership), musharaka (sharing and participation), and ijara (leasing). Murabaha is the most common forms of Islamic financing. It is a contract of sale in which a commodity is sold for profit. The commodity is delivered immediately and the price to be paid for the item includes a mutually agreed margin of profit payable to the seller. In murabaha agreements, the market cost price (true cost) of the item is shared with the buyer at the time of concluding the sale. Mudaraba is another form of Islamic financing, and it is considered a type of trading partnership in which capital is contributed by a capital provider and labor from an entrepreneur. The profit is shared between them. If there is a loss, it is borne by the capital provider. Another kind of equity-participation financial instrument used in Islamic finance is based on a musharaka contract. In its simplest form, a musharaka agreement is a partnership arrangement between two or more parties, where each partner makes a capital contribution to the partnership in the form of cash or in-kind contributions. All partners are obligated to contribute capital to the venture. These contributions can be subject to profit-sharing in a ratio mutually agreeable to all the investing parties. Finally, an ijara contract (Islamic leasing) is an agreement in which a party leases physical assets or property to another party who receives the benefits associated with ownership of the asset against payment of predetermined rentals. Islamic finance is one of the fastest growing segments of the global financial industry. The overall size of the Islamic financial industry increased from $80 billion


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in 2000 to $1.1 trillion at the end of 2011 (Baig 2012). According to the recent Global Islamic Finance Report (GIFR 2013), the global Islamic finance market value crossed $1.63 trillion, with its growth rate estimated to be around 20.4 percent per annum. The increase of money in the Middle East, reflecting the growth of the oil industry, has had a positive impact on the Islamic banking industry. The principle players of Islamic finance in the modern world are the Middle East, Malaysia, Iran, Indonesia, Brunei, Singapore, North America, Pakistan, Bangladesh, Southwest Africa, and the U.K. The shared Islamic financial system displays inherent resistance to the recent global financial crisis. According to Khawla Bourkhis and Mahmoud Sami Nabi (2011), Islamic banks were more profitable than conventional banks. In the 2007–2008 period of the subprime crises, large Islamic banks remained more profitable than large conventional banks. However, Islamic banks became less profitable in 2009 when the crisis subsided. In addition, Khawla Bourkhis and Mahmoud Sami Nabi (2011) show that Islamic banks were more resistant to the crisis than conventional banks only during the first period of the financial crisis: namely, 2007–2008. However, Islamic banks were indeed impacted during the second period because of their higher exposure to real estate and their limited reliance on risksharing instruments. According to Baig (2012), many factors related to the Islamic banking industry helped contain the adverse impact on their profitability. In particular, these included smaller investment portfolios, lower leverage, and adherence to sharia principles. In addition, Islamic financial institutions are based on ethical principles and take into account the social implications of a business transaction, thereby serving the greater community interests. “Originate and Distribute” Model, CDSs, and the Recent Financial Crisis The dominance of the “originate and distribute” (OD) model over the past years led to a significant growth of the structured finance market. The OD model has presented numerous benefits to the financial system. However, the level of innovation and complexity in structured finance instruments has also increased the challenges to appropriate risk assessment and valuation by investors, thus raising financial stability concerns. One of the most important changes in the lender-borrower relationship during the past few years has been the creation and subsequent development of the credit derivatives market, particularly CDSs. CDSs as but one component of the newage system of securitization, or OD model, has gradually supplanted traditional, “relationship” banking. In this section, I present the main characteristics of CDSs, evaluate the OD model carried out from an Islamic finance perspective, and discuss the contribution of CDSs to the recent financial crisis. What Is a CDS? The most widely traded credit derivative product is CDS, which is a contract between two parties — the protection buyer and the protection seller. Through the CDS, the protection buyer is being compensated for the loss generated by a credit

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event in a reference instrument. If the buyer owns the reference entity, the CDS act as a hedge against default. The protection against default was the initial motivation for introducing CDSs. A default is often referred to as a credit event and includes such events as failure to pay, restructuring, and bankruptcy. Generally, the protection seller compensates the buyer for the difference between the face value of the debt and its market value following the occurrence of a credit event. The protection buyer pays the protection seller a premium in basis points of the notional amount. The premium paid to the protection seller is called the CDS spread and reflects both the probability of default and the loss, given a default. There is no limit to the notional amount of CDSs that can be traded. As a result, the number of CDSs contracts linked to a company’s debt may exceed the number of bonds available to settle the contracts. Figure 1 presents the cash flow structure in a CDSs transaction: Figure 1. Common CDSs Transaction

Since its creation in the mid-1990s, as a means to transfer credit exposure for commercial loans, the CDSs market has experienced dramatic growth, approximately doubling in size each year between 2002 and 2007, and reaching a peak of $62 trillion in 2007. Despite a significant contraction and recession after the 2008 global financial crisis, the CDSs market is still valued at $30 trillion — more than double the total capitalization of all U.S. stock markets. The notional amount of outstanding CDSs decreased by 19 percent in the first six months of 2009, from $38.56 trillion to $31.22 trillion. The notional amount of outstanding CDSs was $26.3 trillion in mid2010, which marks a decrease of 13.7 percent from $30.4 trillion at the end of 2009. The notional amount of outstanding CDSs was valued at $26.93 trillion at mid-2012, according to a Bank for International Settlement report (BIS 2013). CDSs have several advantages for portfolio managers, including mitigating concentrations of credit risk, promoting diversification, enhancing trading liquidity, and signaling creditworthiness. Many studies on credit risk management have concentrated on estimating default probabilities from corporate bond data and exploring the determinants and the dynamics of the term structure of credit spreads. Prior empirical research has been conducted on single-name CDSs products. Francis A. Longstaff, Sanjay Mithal, and Eric Neis (2005) explore the notion that a significant


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part of the bond spread is the result of illiquidity, making bond prices not a good proxy for credit risk. Roberto Blanco, Simon Brennan, and Ian W. Marsh (2005) argue that CDSs spreads are more sensitive to firm-specific factors than bond spreads. Carol Alexander and Andreas Kaeck (2008) argue that credit spreads, inferred from corporate bond prices, are affected by tax considerations and illiquidity. The Real Problems of OD Model Securitization was a crucial underpinning of the development of the OD model. In this model, banks do not hold the loans they originate, but repackage and securitize them. This model allows the originating financial institution to achieve better risk-shifting with the rest of the economy. Conventional securitization in the OD model involves interest-bearing debt. Investors would typically hold (secured) contingent claims on the performance of securitized assets that entitle them to receive both predetermined interest and repayment of the principal amount. Previous literature has documented several positive and negative effects of the loan sales market for banks as well as borrowers. The benefits of the OD model include a reduced cost of capital (Gupta, Singh and Zebedee 2008), increased access to debt capital (Drucker and Puri 2008), and information effects associated with a positive stock price effect (Gande and Saunders 2012). The negative effects of the OD model include a negative long-run performance for all firms that borrow in the syndicated loan market (Billett, Flannery and Garfinkel 2006). In addition, Antje Berndt and Anurag Gupta (2009) show that the OD model presents problems of moral hazard and adverse selection. Banks that sell loans would have a reduced incentive to engage in costly screening and monitoring of borrowers. In addition, they would have an incentive to sell the loans of borrowers about whom they have negative private information, unobservable to outside investors. They also show that the OD model of bank credit may not be entirely “socially desirable,” since it negatively impacts the long-run performance and valuation of borrowers. Amiyatosh Purnanandam (2011) argues that the OD model of lending has resulted in the origination of inferior quality loans. This effect was predominant among banks with relatively low capital and banks with lesser reliance on demand deposits. According to Purnanandam (2011), banks with higher OD participation have higher mortgage default rates in the later periods. These charge-offs are concentrated in banks that are unable to sell their OD loans after the disruption in the mortgage market. As the above literature attests, the existing structure of the OD model is continuing to be questioned at the highest level of the intellectual and political discourse. The OD model, coupled with the easy global money and credit conditions that have existed over many years, advances in structured finance, and a persistent rise in risk-taking and financial leverage contributed to the recent financial crisis. Banks with important involvement in the OD model had incentives to issue inferior quality mortgages. This allowed them to gain from origination fees without bearing the credit risk of borrowers. When the secondary mortgage market came under stress, banks with high OD loans were stuck with relatively inferior quality mortgage loans.

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The growing emphasis on ethics and morality in economic and financial transactions highlights the structural problems undermining the confidence in the OD model and, in turn, the pressing need for more durable alternatives. An alternative to the OD model is the Islamic finance model that works on the basis of risk-sharing instead of risk-shifting. Lending transactions under Islamic finance are based on the concept of asset-backing and specific credit participation in identified business risk. Lenders (i.e., investors) and borrowers (i.e., entrepreneurs) share the risk of an investment on agreed terms, and divide any profits between themselves based on the share of funding or ownership of the asset by each party. Profits must not be guaranteed and can only accrue if the investment itself yields income. Since most Islamic financial instruments are based on the concept of asset-backing, the economic concept of asset securitization is particularly agreeable to the basis of Islamic finance. Islamic securitization, via sharia-compliant investment certificates, has grown into a notable segment of global structured finance over the last few years. Islamic securitization transforms bilateral risk-sharing between borrowers and lenders into the market-based refinancing of one or more underlying Islamic finance transactions. According to A.A. Jobst (2009), securitization under sharia bars interest income and must be structured in a way that rewards investors for their direct exposure to business risk. The Contribution of the CDSs to the Credit Crisis The CDSs are considered as a component of the OD model. In principle, CDSs should make financial markets more efficient and improve the allocation of capital. Yet, many observers agree that CDSs have contributed to the recent financial crisis. CDSs were supposed to protect lenders against default risk. Instead, they provided a false sense of protection that helped propagate the credit crisis. Christopher Brown and Chung Hao (2012) argue that CDSs are implicated in the subprime crises because a large market for securities collateralized by subprime mortgages and consumer debt could not have materialized if hedge funds and other holders of these instruments lacked a means of hedging default risk. CDSs reduce the incentives of banks to be cautious regarding credit quality. Thus, banks become more indifferent to risk. Creditors may not be as attentive in monitoring borrowers once they hedge their credit exposures using CDSs contracts. A.C. Morrison (2005) argues that because CDSs can undermine bank monitoring, borrowers may inefficiently switch to bond financing. CDSs can weaken bank monitoring and, therefore, reduce welfare. Using a model with banking and insurance sectors, Franklin Allen and Elena Carletti (2006) show that credit risk transfer can lead to contagion between the two sectors and increase the incidences of financial crises. According to R.M. Stulz (2010), the separation of risk-bearing and funding made possible by CDSs can also create problems with the incentive to monitor and resolve situations of financial distress. Thus, a bank that made an important loan to a firm and simultaneously buys CDSs protection against a default event of that loan has diminished incentives to monitor the loan. The seller of


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protection (who guarantees the creditworthiness of the debt security) cannot monitor the firm’s debt because it has no contractual relationship with the firm. In addition, banks can borrow more money and increase the amount of loans to firms because they can hedge their risk exposure to such firms by using CDSs. Beverly Hirtle (2008) argues that greater use of CDSs protection leads to an increase in bank credit supply and to improved credit performance. A.B. Ashcraft and J.A.C. Santos (2009) show that the use of CDSs protection has led to an improvement in borrowing terms, primarily for safety and transparency. Such improved access to capital may increase borrowers’ financial flexibility and resilience to financial distress. Another related study addresses CDSs and empty creditors. As H.T.C. Hu and Bernard Black (2008, 682) argue, “[e]ven a creditor with zero, rather than negative, economic ownership may want to push a company into bankruptcy, because the bankruptcy filing will trigger a contractual payoff on its credit default swap position.” Following Patrick Bolton and Martin Oehmek (2013), creditors with CDSs protection not only have lower incentives to monitor the debtor, but also have a lower interest in sustaining the debtor and helping him or her avoid default by rolling over debt, granting new financing, or agreeing to voluntary debt restructuring. According to David Mengle (2009), empty creditors hedge their exposures and are indifferent to a firm’s survival. Bolton and Oehmke (2011) formally modeled the empty creditor problem. Credit insurance with a CDSs instrument affects the borrower-lender relationship in the event of financial distress because it separates the creditor’s control rights from his or her cash flow rights. Hu and Black (2008), Alexander Yavorsky (2009), M.G. Subrahmanyam, D.W. Tang, and S.Q. Wang (2012) have raised concerns about the possible consequences of such a separation, arguing that CDSs may create empty creditors (holders of debt and CDSs) who no longer have an interest in the continuation of the borrower, and may push the borrower into inefficient bankruptcy or liquidation. An investor might prefer to drive the firm into bankruptcy, and thus trigger payments under the CDSs contract, rather than work out a restructuring plan. According to Bolton and Oehmke (2011), projects that can be financed in the absence of CDSs may obtain more efficient financing because the presence of CDSs lowers the borrower’s incentive to efficiently renegotiate down payments for strategic reasons. In addition, CDSs protection is fairly priced and correctly anticipates creditors’ potential value-destroying behavior after a nonpayment. Thus, creditors have an incentive to over-insure, which results in inefficient empty creditors who refuse to renegotiate with lenders to collect payment on their CDSs protection. Alessio Saretto and Heather E. Tookes (2013) argue that borrowers with traded CDSs take on more leverage than borrowers without them. Most of the CDSs payouts go to “naked” counterparties. A naked CDSs position is a short position that is not hedged by the underlying credit risk. For example, if a person has a short position on a bond through a CDSs contract, he or she does not actually own the bond. Then, that person obtains profits if the price of CDSs protection on the bond increases, which usually means that the underlying bond is more likely to default than when the person opened up the CDSs trade. In other words, the buyer of protection by CDSs contract may have a “naked” position in

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CDSs when it offers payment from the protection seller to the protection buyer, even when the buyer is not a holder of debt referenced in the CDSs contract. Yeon-Koo Che and Rajiv Sethi (2011) show that the effect of the naked CDSs position may then be to drive up the cost of borrowing for firms, as more and more optimists reduce their positions in the corporate debt market to speculate in the CDSs market. As with other over-the-counter (OTC) derivatives, CDSs are exposed to counterparty risk, and they facilitate speculation involving negative views of a firm’s financial stability. Traditionally, CDSs have been traded in the OTC market, meaning that buyers and sellers independently negotiate terms and settle contracts. CDSs contracts are generally considered a zero-sum game within the financial system, as there is a buyer for each seller of CDSs contracts. Counterparty risk exposure affects CDSs spreads and can be important in the case where the default dependence structure between the protection seller and the underlying entity is significant. Because credit events for reference entities occur suddenly (reference entities jump to default), counterparty risk is important in CDSs transactions. Moreover, the risk is significant if the protection seller has insufficient reserves to cover CDSs payments in the case of a credit event. CDSs protection sellers such as AIG and Ambac faced downgrades of their ratings because of large mortgage defaults and increases in their potential exposure to CDSs payment losses. AIG had CDSs that insured $440 billion of the MBS (mortgage -backed securities) and obtained a government bailout. In addition, no central clearinghouse existed to pay CDSs in the event that a party to CDSs proved unable to honor its obligations under the instrument’s protection contract. The bankruptcy of Lehman Brothers in September 2008, as a major CDSs dealer, aggravated the market’s perception of counterparty risk. Furthermore, CDSs can be used to hedge risks and to speculate, and it then presents a source of systemic risk. Systemic risk is generally defined as the probability that the financial system is incapable of supporting economic activity. In other words, systemic risk refers to the possibility of propagating default among other financial institutions during a short period of time. According to a European Central Bank report (2009), a number of structural features in the CDSs market contribute to transforming counterparty risk into systemic risk. First, most of the CDSs market remains concentrated in a small group of dealers with large exposure. Second, the interconnected nature of these dealers can result in large trade replacement costs for market participants in the event of dealer failures. Third, many banks appear to have become net sellers of standard single-name and index CDSs contracts, which implies exposure to market risk. Many observers focused on counterparty risk on credit derivatives and CDSs that caused a worse credit crisis. Credit derivatives greatly expose financial institutions to credit risk. The failure of a financial institution to honor its payments may cause other financial institutions to fail as they experience losses on their exposures, and this contagion may cause a collapse of the financial system. Philippe Jorion and Gaiyan Zhang (2007) analyze the intra-industry information transfer effect of credit events as captured in CDSs and equity markets. They find that contagion is reliably associated with industry characteristics. Moreover, contagion effects are better


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captured by the CDSs market than the equity market. When Lehman Brothers failed to reach a deal with any of a number of possible buyers and investors, consequently collapsing on September 2008, several firms and financial institutions became financially weaker. This caused a contagion effect of Lehman Brothers’ failure through losses on credit derivatives contracts because of the collapse of counterparties. The financial system bears systemic risk as a result of the interconnectedness of the CDSs market. Credit Default Sharing: A New Financial Instrument This section presents a new financial instrument for hedging default-risk credit-default sharing based on the risk-sharing principles. The concept underlying this instrument is based on the combination of the most important characteristics of CDSs (hedging default risk) with the principles of Islamic cooperative insurance (takaful) and the laws and regulations governing the protection of many of the world’s financial markets (clearinghouse or central counterparty). In addition, this section presents the possible implications of credit default sharing on financial stability compared with CDSs. Risk-Sharing Principles At their root, all recent financial crises are debt crises. Excessive leverage, combined with a very poor regulatory framework, exposes corporations to unsupportable risk and threatens the overall soundness of the financial system. The more debt-based the financial structure, the more unstable the financial system. According to Abbas Mirakhor (2009), an economy in which the financial system is dominated by highly leveraged institutions where the objective of every transaction is money-now-for-more-money-later, and where transactions are supported by interest rate-based debt contracts, financial institutions become “merchants of debt.” An alternative to the current financial system must be founded on risk-sharing instead of risk-shifting as a basis for sustainable finance. In this section, I study the principles of risk-sharing promoted by Islamic finance to reform or complement the current financial system. The governance structure in Islam differs from common corporate governance practices in its standardization of rules, which must obide by sharia rules. Effectively, the governance structure should meet the expectations of Muslim investors by providing financing modes that are compliant with sharia. The association between risk-return, the notion of profit and loss-sharing, and partnerships inherent in Islamic contracts are central to Islamic finance. To enhance corporate governance, regulators must adopt policies and practices that eliminate moral hazard, excessive debt creation, and leverage. Corporate governance requires a reduction in debt financing and leverage in favor of the expansion of risk-sharing-based instruments. Insurance in Islamic finance also differs from common insurance practices, and is based on the principle of takaful and cooperation. Islamic insurance, takaful, has emerged as a complementary Islamic banking system throughout the world. The

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concept of takaful implies compensation and sharing responsibilities in the community. Conventional insurance involves elements prohibited by Islamic law, such as uncertainty (gharar), gambling, and interest (riba). Islamic insurance generally uses contracts based on joint-venture partnerships. The strong condemnation of interest by Islamic law led Muslim thinkers to explore ways to finance firms and investors on an interest-free basis. In Islamic financial markets, sukuk (or Islamic bonds) are the fastest growing part of Islamic finance. The investment concept of sukuk was created in the last few years as an alternative to interest-bearing instruments — namely, conventional bonds. In the case of sukuk, it is important that investors have direct access to a proportion of the underlying asset. The features of sukuk securities are similar to those of a conventional bond, which has a fixed-term maturity and is tradable based on normal yield prices. However, major differences include the fact that conventional bonds that yield fixed interest rates are prohibited under sharia law. A basic principle of sukuk is highlighted in the sharing of profits and losses among parties in a business transaction. As the discussion so far attests, Islamic finance reduces debt financing and promotes direct asset financing which allows for risk-sharing instead of risk-shifting. Structure of Credit Default Sharing In simple terms, credit default sharing is a financial contract between cooperative banks for hedging default risk based on the principles of risk-sharing and takaful, which means guaranteeing one another. Banks are both buyers and sellers of protection. I present the main steps of credit default sharing transactions below: Step 1: Some cooperative banks organized in a country constitute a guaranty fund that represents all cooperative banks. The resources of the constituted fund are from the cooperative banks’ donations, margin calls, and investment returns of surplus cash-savings. Step 2: Each bank pays a variable sum of money in the form of a donation depending on the degree of risk in each bank’s portfolio (without recovery). The guaranty fund also functions as a clearinghouse that becomes the counterparty to all trades. The fund can select credit (through a screening process), as well as diversify and manage the credit risk of the total credit portfolio through membership criteria based on minimum capital requirements for cooperative banks (in the form of a donation). Step 3: The guaranty fund prevents cooperative banks from facing additional exposures to the total credit portfolio and special margin calls depending on the degree of risk. The guaranty fund may adjust collateral requirements several times daily to account for changes in the parties’ creditworthiness. Margins are requested to absorb short-term losses and first losses in the case of default. All cooperative banks pay an equally fixed sum of money to cover losses in the case of default. The amount of equally fixed sums of money is determined by the amount of expected losses in the case of default (loss given default) divided by the number of all cooperative banks. In


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the case of credit risk reduction, the amount of margin available is invested in a shortterm horizon or refunded to banks according to the credit default-sharing contract. Step 4: Even with continual collateral adjustments and margin calls, guaranty funds sometimes have difficulty collecting sufficient collateral to account for “jump-todefault risk.” In the case of large losses not covered by margin calls, cooperative banks contribute to the guaranty funds with additional payments in accordance with the principle of takaful (and not according to the risk of their position). The act of sharing responsibility and cooperation between all banks helps reduce extreme risks, contributes to overall financial stability, and decreases systemic risk by immunizing each bank from the others’ default. Computing an appropriate additional payment for bank members should be based on loss given a default and a default dependence structure between all names in the total credit portfolio using Archimedean copula functions. In case of a default, no payment will be made by the guaranty fund. Figure 2 illustrates the main steps of the “credit sharing transactions”: Figure 2. Credit Default Sharing Transaction

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Credit Default Sharing and Financial Stability This section presents the possible implications of credit default sharing on financial stability compared with CDSs. Credit default sharing can eliminate the empty creditor problem caused by CDSs (Bolton and Oehmke 2011; Hu and Black 2008). Creditors protected by CDSs have little incentive to participate in out-of-court restructurings of firms that have fallen on hard times, even when continuation is optimal. The incentives for restructuring are even lower if creditors are over-insured and then their protection reward exceeds the maximum amount that they can receive during restructurings. However, credit default sharing based on a risk-sharing principle increases incentives to exert monitoring efforts to reduce default risk, because losses from defaults will be supported by all cooperative banks. Moreover, margin calls improve incentives for monitoring and mitigating risk. CDSs contracts, which provide a form of insurance against losses, pay off only as long as the seller of protection itself is solvent. CDSs markets suffer from counterparty risk created by their trading partners’ potential default. However, according to J.C. Kress (2011), trading partners are not always able to fulfill their contractual commitments. That is, bankruptcy or illiquidity may prevent the protection seller from satisfying the contract. Credit default sharing transactions mitigate counterparty risk because it requires cooperative banks to post collateral through a guaranty fund, and contribute to the fund through donations and daily margin calls. This collateral is intended to minimize losses sustained by the banks. In addition, the principle of takaful, founded on the cooperative principle and mutual help, eliminates the counterparty risk in credit default sharing transactions. The global financial crisis has also revealed that CDSs markets increase systemic risk in the financial system. The default of Lehman Brothers created a potential systemic risk because market participants and investors did not expect this bankruptcy. An increase in systemic risk in the financial sector should escalate the default risk of each institution, expanding the CDSs spread. One way to mitigate systemic risk is to impose capital requirements. In the case of credit default sharing, requiring the cooperative banks to hold capital in proportion to their hedging activities, counters the hidden leverage embedded in these activities. The presence of the guaranty fund (which represents all cooperative banks) minimizes risks to the financial system by reducing interconnections and dispersing losses. Margin calls and extra capital requirements strengthen the balance sheet of the guaranty fund for a given amount of hedging. The systemic benefits of the guaranty fund are manifest, but one anticipates that some readers will consider the downsides of the guaranty fund, which are primarily concentrated risks and posing threats to financial stability. By contrast, credit default sharing is based on risk-sharing and takaful, which serve as a guarantee for one another. Each of the cooperative banks pools resources and efforts to alleviate the losses of participants within the group. Thus, as the overall discussion suggests, credit default sharing can eliminate “empty creditors,” reduce counterparties, improve a bank’s incentive for monitoring, and reduce contagion and systemic risk in financial systems.


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Conclusion The emergence of Islamic finance as a new paradigm in financial systems has been met with widespread indifference by many western economists. However, the recent financial crisis appears to be a moment of epochal change, and the current financial system has been seriously questioned. The existing system is inherently unstable because it is preeminently a debt- and interest-based system, creating excessive debt and leverage through the credit multiplier. Whereas many papers exist that discuss how the subprime mortgage crisis has had wide-ranging effects on the housing market, the economy, regulators, central banks, stock markets, and exchange rates movements, little research has been conducted on policies and regulations adopted in the aftermath of the crisis. An alternative to the current system is the Islamic finance model that reduces debt financing and promotes equity- and risk-sharing-based instruments instead. The Islamic practice, which conducts finance in compliance with the rulings of Islamic law, is not only a fast-growing field, but also has now officially moved into mainstream financial markets. In this paper, I attempted to introduce policy-makers, regulators, and supervisors to the principles of risk-sharing and takaful promoted by Islamic finance as a possible reform of, or complement to, current financial systems and efficient financial markets. Financial institutions in emerging and developed markets must avoid “risk-shifting” instruments and adopt hedging instruments that allow for risk-sharing and mutual cooperation. To enhance the financial market stability and to reduce systemic risk, regulators must adopt policies and practices (i) that eliminate moral hazard as well as excessive debt creation and leverage, and (ii) that provide efficient insurance to match market needs and ensure financial stability. In this paper, I explained how the (in)famous CDSs markets expanded and why they contributed to the recent financial crisis. In addition, I proposed a new financial instrument for hedging default risk (credit default sharing) based on the principles of risk-sharing and mutual cooperation as a substitute for CDSs. I also argued that credit default sharing can reduce counterparty and systemic risks, improve a bank’s incentive for monitoring, and consequently increase welfare, reduce contagion in financial systems, and eliminate empty creditors. Whereas the future remains uncertain, an analysis of past financial crises provides a crucial insight for policy-makers into strategies for shaping that future. References Alexander, Carol and Andreas Kaeck. “Regime Dependent Determinants of Credit Default Swap Spreads.” Journal of Banking and Finance 32, 6 (2008): 1008-1021. Allen, Franklin and Elena Carletti. “Credit Risk Transfer and Contagion.” Journal of Monetary Economics 53, 1 (2006): 89-111. Ashcraft, A.B. and J.A.C. Santos. “Has the CDS Market Lowered the Cost of Corporate Debt.” Journal of Monetary Economics 56, 4 (2009): 514-523. Askari, Hossein. “Islamic Finance, Risk-Sharing, and International Financial Stability.” Yale Journal of International Affairs 7, 1 (2012): 1-8.

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