Zeti Akhtar Aziz: Regulatory and governance for Islamic finance
Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the Brunei
Darussalam Islamic Investment Summit 2013 "Regulatory and governance for Islamic
finance", Bandar Seri Begawan, Brunei, 19 June 2013.
* * *
It is my great pleasure to be here in Brunei Darussalam to speak at this Islamic Investment
Summit 2013. My remarks today will discuss the current landscape of Islamic finance in Asia
in the context of the growing role of Asia in the global economy, and the important priorities
for Islamic finance to strengthen its prospects for future growth and stability.
Asia and the global economy
The global economic landscape is now significantly evolving as it progresses towards a new
more multi-polar world. This is being shaped by the increasing contribution of emerging
economies to global economic growth, with some of the most vibrant and dynamic emerging
economies being in the Asian region. In 2012, the Asian region contributed 56% to global
growth. This advancement takes place at a time when the world economy continues to be
significantly challenged by the lingering effects of the 2008 global financial crisis, with a
sustainable economic recovery yet to be secured.
Asia's growth trajectory has been underpinned by several favorable fundamentals, which will
continue to support its prospects for growth going forward. Asia is a highly diverse region in
terms of its economic and demographic structure, market size, stage of development, and
political systems. This provides immense opportunities for the region to leverage on its
complementarities to boost economic growth.
Being the most populous region in the world, Asia's favourable demographic structure,
comprising a significant young population and a rising middle income segment, constitutes a
huge and growing consumer market. The unlocking of this potential growth has also been
advanced through wide ranging policy initiatives to promote higher consumption demand.
The measures have essentially aimed at strengthening the social welfare system through
increased arrangements for healthcare and retirement, and improving the macroeconomic
environment and reducing the income gap. These measures collectively seek to support
domestic drivers of growth thus making the development process more inclusive and
sustainable.
In parallel with these measures is the drive towards urbanization and the infrastructure
development in the region. The Asian Development Bank has estimated that Asia needs to
invest a total of USD8 trillion to fund infrastructure development such as rail networks,
airports, power networks and water treatment plants in the current decade to 2020. These
investments, reinforced by the growing consumer market, have become an important driver
of private investment activity. This trend is also well supported by the growing and resilient
financial systems in the region.
Intra-regional trade activity is also rapidly increasing, signifying the deepening of economic
ties within the region. Intra-regional trade in East Asia has expanded from an average of 44%
of total trade in 1995, to 50% in 2010. Similarly, intra-regional investment activities have
been on a rising trend. More recent efforts have focused on strengthening regional financial
integration which is aimed at promoting the more efficient intermediation of funds in Asia.
The strengthening of domestic demand and the greater regional financial and economic
connectivity within Asia has also enhanced the resilience of the region.
Islamic finance in the evolving new frontier in Asia
Given that Islamic finance is a form of financial intermediation that is closely linked to the real
economy arising from its requirement that financial transactions needs to have an underlying
economic transaction, its accelerated growth and dynamic expansion across the financial
landscape in Asia brings with it the tremendous potential to reinforce the transformative trend
that is characterizing the region. With greater liberalization, Islamic finance is increasingly
supporting regional and international trade and investment flows, intermediating significant
cross border financial flows. With its internationalisation, Islamic finance has become an
increasingly more important channel for the efficient allocation of Asia's surplus funds
towards productive investments in the region. This trend is also contributing towards the
strengthening of global financial and economic linkages, particularly between Asia and the
Middle East.
The vast population in Asia and the growing middle-income group, combined with high
savings rates in the region have substantially heightened the demand for a wider spectrum of
financial products and services. These trends have increased the opportunities in retail and
investment banking, takaful, and fund and wealth management businesses in the region. An
area that Islamic finance has a major potential role is in the reorientation towards achieving a
more inclusive and sustainable growth - an important post-crisis development agenda.
Serving the small and medium-size enterprises (SMEs) presents huge potential for Islamic
financial institutions, particularly those with the capability to deploy innovative equity-based
structures and alternative forms of financing, such as private equity and venture capital.
Asia is also now becoming a primary force for the global Sukuk market, with 68% or
USD120 billion of the total sukuk outstanding in 2011 originating from the region, thereby
providing an important investor base for sukuk issuance from different parts of the world.
Whilst Malaysia has evolved a vibrant sukuk market, more Asian countries have turned to the
sukuk market for financing large-scale projects including for infrastructure development.
Several countries in the region are currently reviewing their legislation and taxation to enable
debut sukuk issuance. The Asian sukuk market has also been progressive in the innovation
frontiers. There has also been a growing trend for multi-currency sukuk issuances. This
provides greater prospects for tapping a wider pool of investors, including from the
Middle East and Europe.
In Malaysia and more recently, in Indonesia, Sukuk issuances have also aimed at retail
investors. This is to take advantage of the high levels of surplus savings in Asia, whilst
providing wider investment options to retail investors that have traditionally invested in bond
funds and unit trusts. The trend for greater regional economic and financial integration will
also provide substantial opportunities for Islamic financial institutions to facilitate the
integration process in the region and with other parts of the world, and thus have a greater
role in financing Asia's future growth.
Priorities for strengthening financial stability and growth
Let me turn to the priorities for strengthening financial stability and growth. Whilst there
needs to be continued efforts at the national level to develop the institutional foundations for
Islamic finance that will foster effective and efficient financial flows, and ensure that financial
stability is preserved, the new wave of internationalization for Islamic finance requires
increased collaboration across jurisdictions to strengthen the international financial
infrastructure of Islamic finance. Going forward into the future, this will be particularly
important given that the international environment has become more challenging. This is to
ensure that the greater internationalization of Islamic finance takes place in an environment
of financial stability.
At the national level, the first priority relates to trend for the domestic Islamic financial system
to become more integrated allowing for risks to be rapidly transmittal across the financial
system. This requires the development of enhanced regulatory, supervisory and legal
frameworks that are also adaptive and effective to the innovative dynamics and unique mix of
risks in Islamic finance. Fundamental to this is the implementation of the international
regulatory and supervisory standards and best practices for Islamic finance. The Islamic
Financial Services Board (IFSB) has introduced prudential standards for the Islamic financial
services industry - in all key areas of capital adequacy, risk management, corporate
governance and Shariah governance. Their implementation would in turn promote more
consistent regulatory and supervisory frameworks across borders.
Importantly, the adoption of these international prudential standards which are aligned to the
core principles and standards adopted by the Basel Committee, the International Association
of Insurance Supervisors (IAIS) and the International Organization of Securities
Commissions (IOSCO), would serve to minimise the opportunity for regulatory arbitrage
arising from cross-sectoral and cross-border differences, whilst ensuring that the regulatory
requirements that are distinct for Islamic finance are effectively addressed. A survey
conducted by the IFSB in 2011 indicated that 9 countries have implemented the standards
issued by the IFSB and that 18 countries are expected to implement them within the next five
years. Their consistent implementation will be vital. This harmonization will also facilitate
consistent participation in Islamic finance across borders and contribute towards global
financial stability.
Whilst micro-supervision is an integral part of the toolkit for ensuring financial system
stability, the recent global crisis highlighted the need for it to be complemented by
macroprudential surveillance and measures. This dimension of prudential regulation involves
the incorporation of horizontal assessments of risks across institutions, sectors and national
borders, including the risks in asset markets. This is to address systemic risks and to take
into account the interconnectedness within the financial system. This is particularly relevant
for the Islamic financial services industry given the close link of Islamic finance with the
real economic sector through the various modes of Islamic financing contracts. In
particular, heightened surveillance is needed over developments in the real estate and
commodity markets. Equally important is a greater understanding of the inter-relationships
between the financial and the real sector, including the potential for second round effects that
are transmitted across sectors of the financial system and the economy.
The increased cross-border reach of Islamic finance has also underscored the importance of
enhanced cross-border collaboration among the supervisory authorities. Information-sharing
and effective coordination among supervisors will enable a complete understanding of the
entire risk spectrum of the risk taking activities undertaken across jurisdictions by the Islamic
financial institutions. This is especially important in crisis situations, given the serious
ramifications of a delayed or ineffective response to cross-border contagion. Robust
institutional arrangements are therefore vital to improve the efficiency of the supervisory
processes and to allow for the early detection and management of cross-border transmission
of risks arising from group-wide activities.
Another key area is the evolution of the legal framework for Islamic finance. This is to provide
greater certainty and to build public confidence in the system as a whole. This necessitates a
legal framework that enforces end-to-end Shariah compliance in the Islamic financial
services industry - through provisions and mechanisms that unambiguously define the
conduct and governance of Islamic financial institutions. It needs to recognize the distinct
elements in Islamic finance and identify risks and challenges associated with the different
Islamic contractual arrangements and the instruments for the appropriate regulatory
treatment of the Islamic financial transactions. There is also a need for court recognition and
acceptance of the Islamic contracts within the common and civil law systems, with a
consistent approach of interpreting the rights of the contracting parties based on Shariah
principles. This will lend certainty and predictability to the financial transactions and is
particularly important in evolving legal frameworks that are facilitative of cross-border
transactions as Islamic financial activities continue to venture beyond domestic borders.
In Malaysia, the new legal framework for Islamic banking and takaful that will come into force
this year, will pave the way for the development of an end-to-end Shariah compliant
regulatory framework for the conduct of Islamic financial operations. This new framework
provides clarity on the fundamental requirements of Shariah that must be adhered to for the
contractual arrangements between the financial institution and the customer to remain
enforceable. The framework also outlines the operational requirements for the effective
application of Shariah principles in the conduct of Islamic financial institutions. This aims to
strengthen the risk management practices beyond the traditional credit, market and liquidity
risks, to also include inventory risk, ownership risk and Shariah compliance risk. The
legislation also provides for the resolution of Islamic financial institutions to be in line with
distinctive elements of the relevant Islamic contracts, thus improving the legal and procedural
aspects for the orderly resolution of Islamic financial institutions.
Another important area of priority is to achieve the further harmonization and mutual
recognition of Shariah interpretations across jurisdictions. The progressive harmonization will
be a major driving force for the internationalization of the Islamic financial system. The
reduced uncertainty from differences in Shariah interpretations will also contribute to
safeguarding financial stability. The continuous and constructive engagement amongst
scholars, regulators and practitioners within and across the regions will pave the way for
greater understanding and mutual respect for the Shariah views. This also needs to be
supported by in-depth research and greater transparency on Shariah rulings and resolutions.
The International Shari'ah Research Academy for Islamic Finance (ISRA), through its
Shariah research undertakings and activities in promoting constant engagement among
international scholars, has been at the forefront in driving progressive harmonization of
Shariah at the regional and international levels. Its annually organized Muzakarah
Cendekiawan Shari'ah Nusantara has emerged as an important platform for greater
consensus to be forged among the Shariah scholars in the Nusantara.
Finally, is the imperative for a robust liquidity management infrastructure for Islamic finance,
both at the national and international levels. This is vital not only to ensure the resilience and
stability of the Islamic financial system but also to reduce the cost of intermediation.
Cross-border liquidity risk management in the Islamic financial system still remains a
significant challenge, with the lack of short-term Shariah compliant instruments in
international currencies. The global efforts to strengthen the liquidity arrangements for the
international Islamic financial system will be an important breakthrough in facilitating more
efficient cross-border liquidity management by Islamic financial institutions, thereby meeting
the challenges of the trend of greater internationalisation.
Conclusion
Let me now conclude. The growing role of the emerging economies as an anchor to global
growth in particular, in Asia, represents a major shift in the global economic landscape. In
this environment, Islamic finance is well-positioned to assume a much larger role as a
competitive form of financial intermediation for supporting economic activity, and as a
channel for enhancing greater global connectivity. Efforts to strengthen the foundations for
Islamic finance to ensure its continued resilience amid the more challenging environment
must remain a priority going forward into the future. Indeed, our commitment to act guided by
this foresight will strengthen the prospect for Islamic finance to realize its potential in the
region and beyond.