In the aftermath of the global financial crisis, structural reforms to the global financial architecture are, not surprisingly, under way to improve the resilience of the global financial system so that it can better withstand future cases of economic and financial stress.
In his recent speech at Mansion House in London, UK Chancellor of the Exchequer Alistair Darling highlighted four lessons that needs to be learnt from the global financial crisis. These included: Transparency is paramount; solutions to the global financial and economic crisis must be international and not national given the global nature of banking and movements of capital; there should not only be a focus on preventing future failures but also in a greater preparedness in case a crisis happens despite efforts of the major G20 economies; and there needs to be an overhaul of financial regulation globally to pre-empt system-wide risks.
At an Islamic capital markets conference in London last week, exchequer secretary to the Treasury, Sarah McCarthy-Fry confirmed that “the UK will continue to pursue a regulatory framework that is an international benchmark, and a consistent, politically neutral legal system that is widely used and understood globally. These will form the foundations of confidence for doing business with the UK and in investing in the UK.”
In an increasing globalized financial system, Islamic finance, despite the fact that it has been less affected systemically by the global crisis because of the proscription on investing in debt-backed derivatives, is no exception. Indeed, the Jeddah-based Islamic Development Bank (IDB), the multilateral development bank of the Muslim world, and the Kuala Lumpur-based Islamic Financial Services Board (IFSB), whose mandate is to introduce prudential and supervisory standards for global Islamic finance, established a taskforce headed by Zeti Akhtar Aziz, governor of Bank Negara Malaysia, in global financial stability and Islamic finance aimed at examining the key elements in Islamic finance that contribute to its viability, resilience and financial inclusion, and the building blocks in the development of the Islamic financial architecture to further strengthen the resilience of the Islamic financial services industry.
Globally, the emerging framework for financial stability which the IMF is spearheading at the request of the G20 economies, says professor Rifaat Abdel Karim, secretary-general of the IFSB, has already seen three emerging features. The IMF’s Financial Stability Forum has been transformed into a Financial Stability Board with a broader mandate to promote financial stability. The new framework focuses on building a stronger and better capitalized financial system concentrating on strengthening prudential oversight of capital which includes capital buffers to deal with cyclical problems; and strengthening liquidity and risk management. It also involves the proposed creation if a “supercop” — a global systemic risk regulator.
Speaking in London at a conference on the “Emerging Financial Stability Framework” organized by the IFSB, the IDB and its research arm, the Islamic Research and Training Institute (IRTI) earlier this month, Abdel Karim warned that despite the fact that the IFSB has spent the last seven years toward developing in highlighting the importance of a sound financial stability in the Islamic finance industry, there is still much work to be done. “We need to expedite the development of a systemic liquidity infrastructure for the Islamic financial services industry, as this constitutes one of the key prerequisites for sustaining financial stability. We need to step up our efforts to foster the development of liquid sovereign Sukuk markets, Islamic interbank money markets and more efficient tradable Shariah-compliant financial instruments.”
According to the IFSB, there are also unresolved legal issues surrounding the development of trust laws and securities laws to facilitate the operations of special purpose vehicles (SPVs) in Islamic asset securitization. Similarly, imitation by the Islamic finance sector of conventional products potentially exposes the sector to the same risks and destabilizing forces as in the conventional financial system.
Professor Volker Nienhaus, principal of Marburg University in Germany and a seasoned researcher in Islamic finance, stressed that much of the financing provided by Islamic banks is short-term. “Proponents of an Islamic system propagate profit-and-loss-sharing modes of financing as the ‘true’ Islamic alternative. Such modes, however, are difficult to apply in short-term financing and applied to medium to longer term financing, they usually imply a considerable maturity mismatch,” explained Nienhaus.
He warned that without an efficient interbank market and without support by central banks, “market forces have driven Islamic banks toward an increasingly sophisticated replication of conventional banking techniques. There is obviously a trade-off between efficiency and distinctiveness of Islamic finance. Given the conceptual preference for profit and loss or risk sharing, much more fresh thinking and radical innovations are needed in order to engineer efficient instruments for participatory financing.”
The lack of an Islamic interbank or global liquidity system is impacting on the operations of Islamic financial institutions in both Muslim and non-Muslim countries. Islamic banks have hardly any liquid assets they can hold on to in many markets because of a lack of high quality Sukuk assets; and there is no basis for placement of short-term assets with central banks for reserve and other requirements because there are very often no Shariah-compliant papers or instruments to invest in.
