In addition, it recommends the establishment of an Islamic Financial Stability Forum (IFSF) which would essentially "be a broad-based and constructive strategic platform for IFSB members to achieve the primary objective of building cross-border dialogue in efforts to promote financial stability within the Islamic financial system."
However, it seems that the objective of the IFSF will be confined to facilitating better understanding of emerging developments in the Islamic financial system and their implications for national and global financial stability. It would also have the "potential to promote collaboration and cooperation in remedial policies to prevent, contain and manage emerging issues in Islamic finance."
This latter aspiration could be difficult to achieve in the short term, simply because Islamic finance systems in most of the IDB member countries are either fragmented or non-existent. The overwhelming number of IDB member countries, do not have a systemic approach to Islamic finance. The approach at best is ad hoc or piecemeal.
Malaysia by far has the most advanced and holistic Islamic financial system. If there is a criticism, the Malaysian government for the last 30 years may be perceived of too much hand-holding or patriarchy of its Islamic finance industry. Some would like to see a cost benefit analysis of the Malaysian government's investment in its Islamic finance industry over the last three decades to see to what extent the Malaysian taxpayer is getting value for money.
Many key IDB members are living in denial about their Islamic financial industries. Saudi Arabia and Libya, for instance, do not have enabling legislation which recognizes the special characteristics of Islamic financial institutions in their banking legislation. Instead they insist on either authorizing Islamic banks under general banking laws or, in the case of Libya, merely allowing Islamic financial products according to their perceived risk characteristics under the Central Bank of Libya rules. Both countries have emphatically ruled out introducing stand-alone Islamic banking enabling laws. How then can an IFSF promote remedial policies and collaboration when the very systems in place differ so radically?
This is one key feature which the report should have stressed above all.
The report, presented at the inaugural financial stability forum organized by the IFSB recently in Khartoum, was produced by a task force on Islamic finance and global financial stability, in response to the recommendations of the Forum of the Global Financial Crisis and its impact on the Islamic financial industry, which was organized by the IDB Group in October 2008.
The task force, chaired by Zeti Akhtar Aziz, governor of Bank Negara Malaysia, the central bank, includes an international group of eminent scholars, practitioners and Islamic finance experts. "As Islamic finance extends its reach to serve the global community and becomes an integral part of the global financial system," explained Zeti in the report, "it will however be increasingly tested by risks and developments in the international financial system. The Islamic financial services industry is also entering into a fundamentally different environment that will be significantly influenced by the international regulatory reform that is being undertaken in the post crisis era. For the Islamic financial services industry to thrive in this new environment and to transition to the next level of development and trend toward greater international integration, its level of resilience needs to be strengthened further".
Ahmad Mohamed Ali, president of the IDB Group, similarly warned in the report that "the global financial crisis has demonstrated that we face common challenges. In joining and sharing lessons with international organizations, we can work toward avoiding such financial crises in the future. We believe that there is much that Islamic finance can contribute to this process."
The report identifies three key areas of priority that warrant greater policy attention to further strengthen and enhance the entire Islamic finance ecosystem.
These include: i) strengthening the infrastructural building blocks of the Islamic financial services industry (IFSI) to further enhance the industry's resilience; ii) accelerating the effective implementation of Shariah and prudential standards and rules to facilitate the creation of a more stable, efficient and internationally integrated IFSI; iii) and creating a common platform for the regulators of the Islamic financial services industry to enhance constructive dialogue.
In addition the report suggests eight "building blocks" aimed at further strengthening the Islamic financial infrastructure at the national and international levels to promote resilient and efficient Islamic financial system.
These include: i) the development of a set of comprehensive, cross sector prudential standards and supervisory framework covering Islamic banking, Takaful and capital market which takes into account the specificities of the IIFS; ii) the development of a robust national and international liquidity infrastructure, which encompasses the potential for monetary policy and money market operations, and which is important not only to reduce the cost of intermediation, but also to influence the level of liquidity in the financial system; iii) the strengthening of the financial safety net mechanism, namely, lender of last resort (LOLR) facilities and emergency financing mechanisms as well as deposit insurance, all of which need to be compatible with Shariah principles; iv) the development of a reliable crisis management and resolution framework in addition to financial safety nets, which includes bank insolvency laws and the arrangements for dealing with non-performing assets, asset recovery and bank restructuring, as well as bank recapitalization. An integrated crisis management framework is essential to ensure that any emerging crisis in the Islamic financial system will be promptly managed; v) the introduction of accounting, auditing and disclosure standards for IIFS and their counterparties, supported by adequate governance arrangements, which would enhance financial reporting to facilitate the effective monitoring and assessment of Islamic financial institutions; vi) the development of the macro prudential surveillance framework and financial stability analysis, which is an integral part of the strategy to strengthen the resilience of the Islamic financial system and to minimize the risks of financial fragility and to complement traditional micro prudential supervision of individual institutions; vii) to review the rating process for Islamic institutions or instruments by re-examining and improving the related core processes to encourage greater transparency on the risks involved; and viii) the need for international Islamic supra-nationals and developmental bodies to consider more involvement in capacity building to promote global financial stability. Islamic finance is an industry that is dynamic and complex with rapid product innovation.
The report raises several other key issues including that of harmonization of prudential standards, and the development of innovative, diversified and universally-acceptable Islamic financial instruments across jurisdictions. This, says the report, "is essential as varying interpretations of Shariah in key issues in different countries or markets add to the complexity when cross-border transactions are involved. Mutual recognition of financial standards and products across jurisdictions would facilitate the integration of Islamic finance across the world and in bridging the global markets."
The task force also urges the development of a more inclusive system, within a broader Islamic financial ecosystem. In reality this means to impact Islamic finance much more on the real economy and not just high net worth individuals and institutional investors so as to help toward economic development, social improvement, financial inclusion and poverty alleviation.
Perhaps equally importantly, the report's clarion call for constructive dialogue among the regulators of the international Islamic financial system may be the most difficult to achieve. It is the political will and support of governments that is crucial. There are several cases in IDB member countries where regulators are very proactive supporters of Islamic finance but this is tempered by the cynicism and inertia of their political masters especially ministries of finance. In the odd case the opposite is also true.
The report rightly berates the apparent failure of the rating agencies to assign accurate ratings on new, complex securities, before the onset of any crisis, and advises them to adopt a more holistic rating process, encompassing the fiduciary aspects and credit risk while giving due consideration to the transparency and visibility of the underlying transactions and the quality of the management. They also need to fully appreciate the unique features, characteristics and risk profiles of Islamic institutions and instruments.
