LONDON: Zeti Akhtar Aziz, governor of Bank Negara Malaysia, the central bank, last week called on Muslim and other interested countries to build linkages between them to strengthen the infrastructure, regulatory regime, supervisory and legal framework, and crisis management capabilities of the global Islamic finance industry.
Zeti emphasized at a banking conference in London last week that "the global financial crisis has highlighted several structural weaknesses and imbalances in the international financial system. Whilst Islamic finance is not insulated from the effects of the current environment, the Shariah principles and values that underlie Islamic finance provide an important underlying foundation."
Kuala Lumpur believes that the Malaysia Islamic Finance Center (MIFC) and London can pave the way toward bridging Islamic financial markets between the East and the West, as part of the next phase of development of the global economic and financial system.
With total global Islamic financial assets now estimated at $700 billion in 2007, the Islamic financial industry offers a wide range of complex and sophisticated Islamic financial products and services. Of significance, according to Zeti, is their greater integration into the international financial system. But she warned that "as it becomes part of the financial globalization process, Islamic finance has however become increasingly exposed to the systemic implications of external developments...its potential for sustaining financial stability and... how robust is the industry to external shocks."
Malaysia is by far the most holistic and systemically-developed Islamic finance market in the world. As at the end of 2008, the share of Islamic banking assets in the total banking sector, according to the latest Bank Negara statistics, reached 16.7 percent as compared to 6.9 percent in the year 2000. Similarly the growth rate of Takaful averaged 23 percent per annum in the last five years with family and general Takaful accounting for 11 percent and 7 percent, respectively of the overall insurance sector. Malaysia also remains the world's largest Sukuk market, accounting for more than 37 percent of global Sukuk issuances in 2008.
Zeti highlighted the intrinsic strengths of the Islamic finance system - Shariah injunctions require that Islamic financial transactions are supported by an underlying economic activity. In essence, Islamic financial transactions need to be accompanied by business and trade activities that generate legitimate profits. This ensures the funds are channeled into productive economic activity. This results in a close link between financial and productive flows, which in turn, shields the Islamic financial system from excessive leveraging, imprudent risk taking and speculative activities.
The risk sharing requirement necessitates Islamic financial institutions to institute strong risk management practices that involve the appropriate due diligence on the economic viability of the business activity or of the underlying asset. This is reinforced by the explicit requirements of transparency and disclosure. The intrinsic principle of profit and risk sharing and the upholding of the universal values of justice and fairness thus provides implicit in-built checks and balances in the system. Embedded in this arrangement is also ethics and good governance.
However, potential risks may nevertheless arise when the economic environment and conditions in the financial markets turn adverse or when the Shariah principles are violated. The risk of the former will be greater for those Islamic financial institutions that have pursued aggressive investment strategies during periods of strong growth. In the current global financial crisis, the initial tightening of liquidity and the subsequent breakdown of the functioning of the financial markets precipitated stress and insolvency in the financial sector. The credit crunch that followed, has resulted in catastrophic damage to the global economy. Second round effects will be felt as the economic contraction produces further strain on the financial sector. The Islamic financial system will not be immune to these developments.
Zeti identified several conditions for Islamic financial institutions to cope with the vagaries of the current global down market. An essential requirement is a well functioning liquidity management framework, because the absence of a well developed money market would inhibit the capability of Islamic financial institutions to effectively manage funding of Islamic financial transactions. Facilities for adjusting portfolio balances in a Shariah-compliant manner are crucial in ensuring liquidity risks are effectively managed. Indeed Malaysia has its Commodity Murabaha Program (CMP), which is managed by Bank Negara and the Securities Commission and serves as an effective short-term money market. The CMP, which is flexible and can accommodate transactions in different commodities and currencies, more importantly has taken on an international dimension. Several GCC (Gulf Cooperation Council) banks have signed up to the CMP.
A major deficiency in the global Islamic finance market is the lack of an international Islamic inter-bank money market - a sort of a lender of last resort.
The Jeddah-based Islamic Development Bank may be considering setting up such an institution with a possible subscription of $10 billion - a sort of International Islamic Inter-bank Bank (IIIB) that would effectively serve as an Islamic Bank for International Settlement, and Islamic BIS.
Another requirement is a comprehensive prudential regulatory regime. The Islamic Financial Services Board (IFSB) was established in 2002 to set prudential standards for Islamic finance. Bank Negara believes that the adoption of the IFSB standards across jurisdictions will be key in promoting and enhancing the soundness and stability of Islamic financial services industry.
There is also a need to ensure the supervisory and legal infrastructure remain relevant to the rapidly changing Islamic financial landscape. In Malaysia, she reminded, "These efforts are also supported by a comprehensive financial safety net that includes a deposit insurance scheme and a resolution mechanism, so that not only are depositors protected, but it also allows for prompt, effective and least cost resolution of the financial system."
At the same time, the absence of an Islamic benchmark has exposed Islamic finance to "displacement risk" due to changing monetary conditions in which it co-exists with the conventional system. This fundamental issue has to be addressed to reduce the vulnerabilities of the Islamic financial sector to changing economic environment.
Similarly, the Islamic finance sector still lacks strong corporate governance, which could expose it to similar risks as in the conventional system. The good news for the sector is that greater intra-regional cooperation has fostered closer linkages amongst regulators across jurisdictions and the convergence of standards in the supervisory and regulatory approaches.
