Rasheed Mohammed Al-Maraj: Inaugural Plenary Session - "Regulatory
perspectives"
Speech by His Excellency Rasheed Mohammed Al-Maraj, Governor of the Central Bank of
Bahrain, at the 16th World Islamic Banking Conference - Session 1: Inaugural Plenary
Session: "Regulatory perspectives", Manama, 7 December 2009.
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Your Excellencies, Distinguished Guests, Ladies and Gentlemen: "Salaam Alaikum"
It is a pleasure to have the opportunity to welcome you once more to the World Islamic
Banking Conference. The 2009 Conference is the sixteenth to be held in Bahrain, and the
WIBC has firmly established itself as a landmark event in the calendar. I would like to
congratulate the organisers on having assembled such a strong list of speakers at this year's
event, which I am sure will be the best yet.
Let me begin by thanking the many distinguished speakers who will be appearing during the
Conference, as well as the event organisers and sponsors. Collectively, your contributions
are the reason for the success of this event. It also gives me great pleasure to welcome back
His Excellency Heng Swee Keat, Managing Director of the Monetary Authority of Singapore.
Your presence at the World Islamic Banking Conference for the second year in succession is
an indication of the increasingly strong ties between Bahrain and Singapore, and of the
important role that Singapore can play in helping to develop the international presence of the
Islamic financial industry. I should also like to welcome the other speakers in this Session,
His Excellency Aset Issekeshev, the Minister of Trade & Industry from the Republic of
Kazakhstan, and His Excellency Khalid M. Al-Aboodi, the Chief Executive Officer and
General Manager of the Islamic Corporation for the Development of the Private Sector, part
of the Islamic Development Bank Group. We are greatly pleased to have you with us today
as well.
When the World Islamic Banking Conference took place a year ago, it was overshadowed by
the events that followed the collapse of Lehman Brothers. For a time it seemed that no
financial institution was so large or so strong that the threat of its failure was unthinkable.
There was wide-spread risk aversion in the financial markets. Interbank markets froze and
many banks found it difficult to fund their positions. For a time it seemed that the world
financial system was teetering on the brink of total collapse.
The nightmare scenario that seemed to be unfolding before our eyes was averted by the
timely and effective intervention of governments around the world. Banks were recapitalized,
blanket guarantees of deposits were issued, and central banks provided liquidity in unlimited
amounts. These measures were sufficient to stave off catastrophe. Although in Bahrain we
did not consider it necessary to resort to some of the extraordinary measures adopted
elsewhere, the central bank took a number of policy actions to ensure the continued smooth
functioning of our financial markets.
Although Bahrain has not been as badly affected by the crisis as some other financial
centres, there is no room for complacency. As 2009 has unfolded, the impact of the crisis on
the level of real economic activity has become more apparent. This has fed through to rising
credit losses and reduced profitability at many banks. Reduced investor appetite for risk has
also had an impact on those banks that follow an "originate to distribute" model, especially
those that have funded real estate developments through distributing shares to investors in
Special Purpose Vehicles.
More challenging economic conditions affect the Islamic financial industry just as much as
the conventional one. As a result, it is essential that the Islamic financial industry recognizes
that the crisis has lessons which apply to them as well as to conventional financial
institutions.
The first lesson that the industry might usefully learn is the importance of avoiding what might
be termed "straight line thinking". This is the tendency to assume that what held true of
recent years will hold true in future as well. For example, the fact that the economy has
grown for the last five years at the rate of six or seven percent, leads to the conclusion that it
will continue to grow at the same rate indefinitely in the future. As a result, banks and other
financial institutions build their business plans and expansion strategies around the
assumption of an indefinite period of strong economic growth. These business plans or
strategies then tend to come unstuck when growth falls short of expectations as in the past
year.
"Straight line thinking" has resulted in poor decision-making throughout the financial industry.
Later in this Conference we will hear from Professor Nassim Nicholas Taleb whose book, the
Black Swan, has deservedly attracted wide attention for showing the fallacies behind this
kind of reasoning. Nonetheless, because the Islamic financial industry is a relatively young
one, with many institutions that have not yet experienced a full business cycle, "straight line
thinking" seems to have been particularly prevalent in this sector of the industry. In future
Islamic financial institutions will need to adopt more conservative assumptions in their
business plans and strategies and to stress test them against outcomes which may not be as
optimistic as those they originally assumed.
Closely related to "straight line thinking" is the tendency to be carried away on a wave of
euphoria. When markets are booming, when every day there seems to be an announcement
of a major new project or deal, it is tempting to be carried along by this psychology. Bankers
begin to fear that they are losing out on profit opportunities that are being exploited by their
competitors. They see their rivals' ambitious expansion plans and feel that they must jump on
board the bandwagon. As a result the industry moves as a herd, all galloping in the same
direction at once. Few bother to stop and to consider whether the direction in which they are
heading is one that is leading to a cliff.
While an important function of regulation is to work against the herding mentality which has
been a feature of financial markets from their very beginning, the primary responsibility for
questioning the direction of travel must be with the industry itself. It is the job of prudent
bankers to raise awkward questions about the sustainability of their bank's business model
and their ability to generate profits in the long-run and not just in the short-term. It is also
worth remembering the words of Warren Buffet that he is fearful when others are greedy, and
greedy only when other are fearful.
Thirdly, the crisis has also illustrated the importance of good liquidity risk management. Prior
to the crisis, bank management paid too little attention to liquidity risks. They were reluctant
to invest in safe, but low yielding liquid assets at a time when much better investment returns
could be earned from other financial instruments. They also assumed that it would be
possible for them to exit their positions at any time, without considering the possibility that all
other financial institutions would be trying to do the same thing at the same time.
The regulators of conventional banks have now recognised the importance of liquidity
adequacy in parallel to capital adequacy. New international standards are being developed
on liquidity and several regulators, such as the UK's FSA, have already put forward their own
proposals for enhancing liquidity standards. As you are no doubt aware, the CBB recently
published a draft Consultation Paper on liquidity standards for conventional banks and were
are currently considering similar proposals for Islamic financial institutions.
Liquidity management has, of course, been a long-standing issue for Islamic financial
institutions. We recognise that there is a relative lack of Sharia-compliant high quality liquid
instruments that could be used to meet a stock of liquid assets test. As you know, the CBB
has undertaken a number of initiatives in recent years to assist the Islamic financial sector to
overcome this difficulty. Nonetheless, although recognizing that the problem is a difficult one,
the management of Islamic financial institutions have a responsibility to ensure that they take
appropriate steps to limit the risk of illiquidity to their institutions.
Prudent banking requires management to consider risk adjusted profitability. For example,
putting a large proportion of the bank's assets into potentially profitable, but also highly
illiquid, real estate development projects may fail to achieve an appropriate risk reward
tradeoff. If a bank has put all of its assets into long-term illiquid assets, it may show high levels of
profitability for a few quarters, but it is unlikely to remain in business for very long.
Finally, let me turn to the role of the Boards of Directors and of senior management. The
financial crisis involved failures of corporate governance at many different levels. There is a
common pattern behind many of the failed financial institutions of the last 18 months. In
many cases, the Chief Executive was a dominant figure who made sure that he alone took all
important decisions. There was no culture of open debate and discussion within the
institutions, with the result that members of the Board of Directors did not feel able to
challenge the Chief Executive's decisions. Many bank Boards lacked banking experts.
Individuals were recruited to the Board of banks for their connections rather than for their
knowledge of the banking industry and the ability to ask the right kind of questions.
Boards of Directors also failed in their fiduciary duty to consider the interests not just of
shareholders, but also of creditors and depositors. Banks are not like other corporations
where directors need to consider only the interests of shareholders. Banks have a special
position of trust in that they are charged with looking after other people's money. This means
the interests of creditors and depositors need to have equal weight with those of
shareholders in the decisions taken by the board of directors. Recognition of the directors'
fiduciary responsibilities is, therefore, an essential element of corporate governance for
banks.
This observation applies with special force to the Islamic financial industry. The fiduciary duty
of the Board of Directors of an Islamic financial institution does not only relate to the interests
of shareholders, depositors, and other creditors, but also to investment account holders who
bear many of the same risks as shareholders, but who lack the same control rights. Boards
of Directors and management therefore have a fiduciary duty to consider the interests of a
wide range of stakeholders. It is essential that Sharia-compliant institutions reflect this
requirement in their corporate governance arrangements.
The four issues that I have mentioned today - avoiding "straight line thinking", avoiding
herding behaviour, managing liquidity risks, and high standards of corporate governance -
are not the only lessons that can be learned from the financial crisis. However, I believe that
these lessons are the ones of greatest relevance to the Islamic financial industry, and ones
that it needs to give especially careful attention to in reforming its own practices.
While the financial crisis will result in regulatory changes which will apply to conventional and
Islamic banks alike, the primary responsibility for ensuring sound and prudent banking
practices must reside with the owners and managers of the banks themselves. Post-crisis
reform needs to begin with the industry examining carefully its own practices and considering
whether they meet the standards that its various stakeholders have a right to expect. Only by
doing so will it be able to sustain the public trust which is an essential component of a
successful financial industry. As the financial crisis has shown, there is little point in pursuing
short-term profitability if the long-run result is a loss of public trust in the industry itself.
On that note I should like to thank you for your attention and to wish this Conference every
success.