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Opinion: Financial stability issues and challenges – Islamic finance

By Tan Sri Dr Zeti Akhtar Aziz

OVER the recent decade,  had achieved remarkable growth and development.


The continued success and viability of Islamic finance will also depend critically on ensuring focus on preserving financial stability. While contractual relationships and obligations may be different under Islamic finance, thus requiring different risk governance arrangements and skill sets, both conventional and Islamic financial institutions are exposed to similar risks including credit, market, liquidity and operational risks. For these reasons, the relevance of reforms to strengthen capital and liquidity buffers such as that under Basel III also extends to Islamic financial institutions and their universal implementation is important to avoid competitive distortions and regulatory arbitrage.

Beyond prudential standards however, ensuring strong adherence to shariah principles is central to delivering the financial stability benefits that were found wanting in conventional financial systems prior to the global financial crisis. In addition, the agenda to promote fair, responsible and professional conduct by Islamic financial institutions and more empowered consumers must be equally advanced. In Malaysia, the new legal framework for Islamic banking and takaful that recently came into force is set to pave the way for the development of an end-to-end shariah compliant regulatory framework, reinforcing the effective application of shariah principles in the conduct of Islamic financial institutions.

It is encouraging to see that substantive progress has been made in respect of the development of prudential standards for Islamic financial institutions and the cooperation arrangements that are taking place to facilitate the implementation of these standards at national levels. Since its establishment in 2002, the Islamic Financial Services Board (IFSB) has introduced prudential standards for the Islamic financial services industry in the areas of capital adequacy, risk management, corporate governance and shariah governance.

Nine countries have implemented these standards and 19 more are expected to implement them within the next few years. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has also contributed to the issuance of more than 80 standards in the areas of accounting, auditing, governance, ethics and shariah for the international Islamic financial industry.

Further progress on two fronts remains important. The first is to continue to evolve a more refined distinction within prudential and financial reporting frameworks to reflect the different nature and profile of risks under risk-sharing contract arrangements. The second is the need to accelerate efforts to further strengthen the infrastructural underpinnings for the development of the overall Islamic financial system. While the broad regulatory principles and standards developed in the aftermath of the global financial crisis can be applied to most Islamic finance transactions, a broad-brush application of these rules would limit the ability of Islamic financial institutions to implement the more unique risk-sharing contract arrangements. The stage of development of the overall financial system in which Islamic finance operates must also be considered to ensure that the effective application of global standards can be achieved without unintended consequences, given the prevailing associated constraints. Islamic banks today continue to be confronted with limitations in the availability of a sufficiently deep and diverse pool of shariah compliant instruments – in both domestic and international currencies – in which they can invest. Under the strengthened international capital and liquidity standards, this can result in higher costs of compliance, inefficiencies in funding structures and increased risks of funding mismatches.

Strengthening prudential standards alone would therefore be an incomplete response to building a strong foundation for the future of Islamic finance. Beyond the more stringent capital and liquidity standards, a further response to strengthen the global Islamic financial system should therefore also include measures to strengthen the infrastructural underpinnings and building blocks of the industry. It is equally important that initiaves such as the establishment of the International Islamic Liquidity Management Corp (IILM) to support cross-border liquidity management by Islamic financial institutions, continue to be pursued. The recent sukuk issuance by IILM represents a major breakthrough in global cooperation on Islamic finance which has made available short-term US dollar shariah compliant instruments in the global market to Islamic financial institutions to facilitate more efficient management of their cross-border liquidity requirements.

As Islamic finance further evolves and advances, more fundamental questions on the framework for financial stability in the context of Islamic finance will need to be addressed. At a national level, such questions will include the relevance and design of financial safety nets such as deposit insurance and lender of last resort facilities in an Islamic financial system. To a large extent, these safety nets have in mind the traditional roles played by conventional banks – the acceptance of deposits which are payable on demand and which enjoy principal protection for the depositors. In a risk and profit sharing model with participatory or equity-based contracts that support ventures involving entrepreneurship endeavours, savers and fund providers stand to bear the losses in such ventures, similarly to gaining profits from such ventures. A main challenge would be in structuring financial safety nets which honour the true nature of Islamic contracts, while preserving confidence in the financial system given the entrenched expectations of consumers. Consumer protection and education initiatives are also essential to further deepen the understanding and awareness of consumers on the associated risks and rewards in the Islamic financial contracts. In addressing these questions, there is much to be gained from sharing experiences and strengthening cooperation in research initiatives.

At the global level, the framework for financial stability in the context of Islamic finance needs to interface with the arrangements that exist for the conventional financial systems. As conventional frameworks for financial stability are being strengthened and in some areas being fundamentally revisited, it is timely to take the opportunity to elevate the level of engagement and coordination between global standard setting bodies in international standard setting and implementation activities. Closer coordination will be increasingly important to avoid fragmentation in regulatory frameworks and improve the surveillance of risks to global financial stability. As lessons from previous crises should teach us, we would be well served to ensure that the growth of Islamic finance – on a global scale – is well supported by the strengthening of our collective capacity to understand, monitor and manage the attendant risks.

Tan Sri Dr Zeti Akhtar Aziz is the governor of Bank Negara.

This an excerpt from her Islamic Development Bank Prize Lecture entitled “Islamic Finance: Financial Stability, Economic Growth and Development” delivered in Jeddah on Nov 27, 2013.

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