Zeti Akhtar Aziz: Islamic finance - financial stability, economic growth
and development
Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia (Bank Negara
Malaysia), at the Islamic Development Bank (IDB) Prize Lecture on "Islamic finance -
financial stability, economic growth and development", Jeddah, 27 November 2013.
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It is my honour to be invited to deliver this lecture on Islamic Finance: Financial Stability,
Economic Growth and Development, here in Jeddah. I wish to thank the Islamic
Development Bank for the invitation. The Islamic Development Bank has been pioneering
and instrumental in the development of Islamic finance and has been an inspiration in driving
its progress and evolution. It is indeed a privilege for me to be part of this journey, and to
have witnessed the increasing dynamism of the Islamic financial industry amidst a highly
challenging economic and financial international environment.
Global financial and economic adjustments
My remarks today will focus on the relevance of Islamic finance in modern market
economies, taking into account the knowledge that we have today about the vulnerabilities of
finance, its causes and its wider economic ramifications. Five years on after the global
financial crisis erupted, the most pressing challenge confronting the world economy
continues to be securing financial stability and generating growth and employment. While
regulatory reforms both at the global and national levels have been extensive to strengthen
financial systems, there has been less progress on the recovery in growth. While conditions
in the world economy have improved, the growth prospects going forward is expected to
remain modest for an extended period of time.
Several important lessons have emerged from this recent global financial crisis. The first
relates to the exponential expansion of the financial system which did not commensurate
with the expansion in economic activity. This resulted in a significant disconnect between the
financial sector and its role in serving the economy. A number of factors contributed to the
weakening of the link between financial intermediation and productive economic activity.
Deregulation had opened up new opportunities for financial institutions to expand the scope
of their activities. Increased competition, reinforced by advances in technology intensified the
pace of innovation. And, the extended period of low interest rates in an environment of low
inflation also prompted greater risk taking which in turn contributed to the significant build up
of financial imbalances.
The role of leverage in the global financial crisis, both in the public and private sectors, was
also a particularly important contributing factor. It has also become a factor that is now
holding back growth. At the height of the global financial crisis, the total leverage in the major
industrial economies increased significantly. In the US, private sector leverage alone had
reached over 200 percent of GDP in 2008. Other reports place the average debt level to
GDP of major advanced economies at over 300 percent in 2010. The current process of
deleveraging in the private sector remains incomplete, while pressures on fiscal sustainability
in these economies also continue to weigh on confidence and growth. Significant challenges
continue to be faced in the implementation of the structural adjustments which in turn is
affecting the process of fiscal consolidation. This has further restrained the policy flexibility to
support growth. The extraordinary and exceptional monetary measures taken by central
banks in these economies have provided support to their economies, but they have also
come at a cost to savers with growing risks of market distortions and financial imbalances the
longer these measures are held in place.
In efforts to build stronger defences against a repeat of the events that precipitated the 2008
global financial crisis, the global regulatory reform agenda has placed significant focus on
addressing elements of the regulatory and supervisory systems that allowed the build-up of
excessive leverage. These elements include the unfettered innovation by financial institutions
and the prevailing incentive system. Financial engineering had led bankers and investors to
lose focus on their risk exposures when they failed to understand the increasingly complex
products that purported to reduce the risks. The weak regulatory regime and supervision also
failed to rein in such unbridled innovation. Misaligned incentives then fuelled excessive risk
taking both at the institutional and individual levels. The inadequate financial buffers held by
banking institutions against risk, a growing disconnect between the creation of credit and its
use for productive economic activity and a highly interconnected system of financial
intermediation ultimately combined to give rise to risks that disrupted credit flows to the
economy. Over time, these trends were substantially amplified.
The global reform agenda has made important progress in efforts to reduce the fragility of the
financial system and to strengthen its resilience. Substantial work has already been
advanced and largely completed on the development of global liquidity standards, the
adoption of leverage ratios, and the significantly strengthened capital regulations which are
important components of the reform effort. Greater focus has also been placed on strong
supervision, effective resolution regimes and arrangements for the oversight of systemically
important financial institutions. While the effective implementation of these reforms is crucial,
the world continues to seek more enduring solutions that will place financial institutions firmly
back in the service of society. In some countries, fundamental structural changes are being
pursued to reduce the complexity of banking and to protect banking services from such
higher risk-taking activities. The challenge however, is how this might be achieved in a
sustainable manner without undermining growth and development, and erasing the important
efficiencies in financial management.
A model to reanchor finance to the real economy
While the global financial stability efforts have made progress in generating an enabling
environment for a new equilibrium of financial stability, a key consideration as we move
forward is the need to redefine the fundamental character of modern finance and how it
would interface and interact with the economy and the broader society. New considerations
that prioritise justice and fairness, sustainability and inclusion have also become essential
underpinnings of such a financial ecosystem. The recalibration of finance should aim to serve
the needs of the real economy and more importantly the broader society. This would
generate positive externalities that would in the medium term lead to more sustainable
financial systems, and in turn contribute positively to growth and development.
A core underpinning of Islamic finance is the tenet that requires Islamic financial transactions
to be supported by genuine productive economic activity. Islamic finance is also a financial
regime that places emphasis on risk-sharing, thereby strengthening further the link of finance
to the real economy. Thus, it provides a greater understanding on the fundamental
relationship between the financial sector and the real economy. The concept of risk-sharing
in finance is not new. While risk-transfer activities currently dominate the conventional
financial systems, risk-sharing in the form of equity has long been a cornerstone of capital
markets with vibrant stock exchanges. Techniques used by venture capital financiers also
have similarities to risk-sharing contracts in Islamic finance. The development towards a
more equity-based financial system where risk-sharing takes place reduces the over-reliance
on debt funding, thus avoiding excessive debt and speculation and thus financial system
fragility. In Islamic finance, this is further reinforced by Shariah principles that strongly
discourage excessive debt given its detrimental effects on society.
The use of risk-sharing transactions and undertakings under participatory finance models in
Islamic finance thus offers the potential to reinforce the links between finance and the real
economy. The contractual arrangements between the financier and the entrepreneur place
strong emphasis on the value creation and economic viability of the enterprise. This results in
a close link between the growth of the financial sector and real sector activities in which the
expansion or contraction of credit is dependent on developments in the real sector. This
would provide a restraint on financial engineering and innovation as financial transactions
need to be supported by real assets, thus aligning innovation to productive economic
activities. As a result, the dangers of unbridled innovation are also substantially reduced.
The move to embrace the risk-sharing dimension of Islamic finance also presents new
opportunities for financial management. The profit sharing and risk-sharing characteristics of
Islamic financial transactions strengthen the incentives for Islamic financial institutions to
undertake the appropriate due diligence on the transactions to ensure that the profits are
commensurate with the risks assumed. The explicit risk-sharing element between the
financier and customer instils greater discipline and responsibility, given the obligation and
economic incentives created for participants to the contract to evaluate the risk profile of the
product or investment proposition, the underlying trends in earnings and cash flows, and its
income-producing potential. Such a process strengthens safeguards against the widespread
mispricing of risks. The strong incentives for financial institutions to understand the nature
and level of risk and leverage that is embedded in the Islamic financial instruments would in
turn lead to more responsible innovation. This ensures that the products offered are aligned
in delivering real benefits for the investors. Reinforced by a combination of stronger
governance, enhanced transparency and more robust risk management, the trust-based
relationship that underpins Islamic finance is therefore strengthened, thereby promoting
overall confidence in the intermediation process.
More recently, in this decade, the greater use of equity-based models has been most evident
in the sukuk market, with Shariah structures evolving from predominantly lease-based
(Ijarah) and mark-up sale (Murabahah) structures to profit and loss sharing partnerships
(Musharakah), as well as convertible and exchangeable trusts. The evolution of
assetbacked and asset-based sukuk provides further options for investors to diversify their
portfolio. Asset-backed sukuk, has profit and loss sharing elements that thus offers
investment sustainability. The possibility of a default is minimised, as investors of
assetbacked sukuk are not guaranteed to receive income or capital gains, and profits are paid by
the issuers only when the underlying assets earn profits.
Risk-sharing transactions and undertakings under the participatory finance models in Islamic
finance also enhances prospects for increasing financial inclusion and in bringing the
financially unserved into the economic mainstream. In many IDB member countries, studies
have shown that economic development is constrained by the lack of access to finance,
given that only about 30 percent of the adult population use formal financial intermediaries.
Greater outreach to small and medium enterprises (SMEs) and microenterprises can be
achieved through the wider application of equity-based structures in financing for SMEs and
Islamic microfinance given their strong emphasis on promoting entrepreneurship and
valuecreating activities. This contributes towards the overall objective of generating inclusive
growth that enhances the prospects for job creation. Integration with other financial products
such as microtakaful and social welfare arrangements such as endowment (waqf) can also
provide a total financial solution for the lower income groups and small businesses.
Risk-sharing in Islamic finance also extends to the creation of a more equitable and just
distribution of wealth. Redistributive instruments such as obligatory alms giving (zakat),
endowment (waqf) and charity (sadaqah) complement risk-sharing financing tools to form
part of a comprehensive approach to address poverty and promote social justice within the
community, aspects that are important in increasing the potential for a more balanced
economic growth.
Another important dimension of risk-sharing that enhances financial inclusion lies in the
potential for Islamic finance to become a powerful tool that can enhance financial access for
emerging economies, in particular the less developed countries that have been marginalised
by modern finance. Debt financing or risk-transfer activities are heavily dependent on
conventional measures of financial and economic performance. In contrast, equity financing,
with its risk-sharing elements, can provide the required financial solution that is not
dependent on such conventional assessments. This will allow those countries which are less
developed but have assets and resources to access finance. The strong emphasis on
governance and risk management in risk-sharing contracts will also have an important role in
catalysing broad-based improvements in standards of oversight and financial discipline in
these countries as safeguards against irresponsible practices. Taken together, these
elements of Islamic finance offer enormous potential for less developed countries, more so
those that are rich in resources, to mobilise and channel economic resources to finance
growth and development, and significantly raise standards of living for their communities.
In the sukuk market, sukuk structured in profit and loss sharing partnerships (Musharakah)
represents one of the majority in global sukuk issuances and outstanding. The emergence of
sukuk as an alternative fund raising and investment instrument has opened up an important
new source of funding for long term development projects. Many Asian countries have
leveraged on the sukuk market to raise funds for infrastructure development in the
healthcare, transportation, telecommunications and education sectors that contribute towards
generating broad-based growth. There is a seemingly good fit between sukuk and
infrastructure project financing that requires large capital outlays with long gestation periods.
This can significantly benefit IDB member countries which can tap into the sukuk market to
meet the strong current and future demand for infrastructure financing, particularly for
countries that face large funding gaps for infrastructure development. Indeed, it is
encouraging that developing economies in Africa have already begun to leverage on the
sukuk market for infrastructure financing particularly those that have progressed further in
laying the legal groundwork to enable sukuk issuances.
Globally, the performance of the sukuk market has exceeded expectations. From an
outstanding amount of US$33 billion in 2006, the sukuk market has expanded more than
eightfold to US$292 billion by December of 2012. Future growth prospects for the sukuk
market is supported by the positive growth prospects in both the GCC and Asian regions and
the increasing funding needs for infrastructure projects in these regions. In the Asian region,
it is estimated that US$8.3 trillion is required for infrastructure development until the year
2020. Infrastructure spending has also been one of the key drivers of economic growth in the
GCC in the recent decade. In the MENA region, the changing energy landscape towards
more renewable energy and clean, efficient technologies presents significant potential for the
use of sukuk to meet such financing requirements.
With its growing international dimension, Islamic finance has assumed an increasingly
important role in facilitating regional and international trade and investment flows thereby
intermediating significant cross border financial flows. More recently, international financial
centres such as London and Hong Kong have been increasing their connectivity with the
Middle East and Asian regions, two important growth centres in the global economy. The
increased international dimension of the sukuk market, in particular has facilitated the
movement of funds across borders from jurisdictions with surplus funds to regions with
investment opportunities thereby enhancing its potential as a vehicle to foster greater trade
flows and investment and thus facilitating growth and development.
The development of Islamic finance and its risk-sharing and equity financing aspects could
be significantly rewarding for countries that venture into this alternative form of financial
intermediation. However, to fully realise its potential, different elements of the financial
system must evolve in tandem to provide the enabling conditions for this to occur. In such a
system, it is essential for both investors and entrepreneurs to embrace different approaches
in managing risk and return relationships that are embedded in the many variations of
Shariah contracts. It is important that these relationships are well understood by the parties
involved, and aligned with the clear contractual and operational requirements.
Islamic finance: financial stability issues and challenges
It is imperative that the lessons of the global financial crisis are not lost as the growth of
Islamic finance gains further traction. Having already achieved remarkable growth and
development over the recent decade, the continued success and viability of Islamic finance
will also depend critically on ensuring focus on preserving financial stability. While
contractual relationships and obligations may be different under Islamic finance, thus
requiring different risk governance arrangements and skill sets, both conventional and
Islamic financial institutions are exposed to similar risks including credit, market, liquidity and
operational risks. For these reasons, the relevance of reforms to strengthen capital and
liquidity buffers such as that under Basel III also extends to Islamic financial institutions and
their universal implementation is important to avoid competitive distortions and regulatory
arbitrage.
Beyond prudential standards however, ensuring strong adherence to Shariah principles is
central to delivering the financial stability benefits that were found wanting in conventional
financial systems prior to the global financial crisis. In addition, the agenda to promote fair,
responsible and professional conduct by Islamic financial institutions and more empowered
consumers must be equally advanced. In Malaysia, the new legal framework for Islamic
banking and takaful that recently came into force is set to pave the way for the development
of an end-to-end Shariah compliant regulatory framework, reinforcing the effective
application of Shariah principles in the conduct of Islamic financial institutions.
It is encouraging to see that substantive progress has been made in respect of the
development of prudential standards for Islamic financial institutions and the cooperation
arrangements that are taking place to facilitate the implementation of these standards at
national levels. Since its establishment in 2002, the Islamic Financial Services Board (IFSB)
has introduced prudential standards for the Islamic financial services industry in the areas of
capital adequacy, risk management, corporate governance and Shariah governance. Nine
countries have implemented these standards and 19 more are expected to implement them
within the next few years. The Accounting and Auditing Organisation for Islamic Financial
Institutions (AAOIFI) has also contributed to the issuance of more than 80 standards in the
areas of accounting, auditing, governance, ethics and Shariah for the international Islamic
financial industry.
Further progress on two fronts remains important. The first is to continue to evolve a more
refined distinction within prudential and financial reporting frameworks to reflect the different
nature and profile of risks under risk-sharing contract arrangements. The second is the need
to accelerate efforts to further strengthen the infrastructural underpinnings for the
development of the overall Islamic financial system. While the broad regulatory principles
and standards developed in the aftermath of the global financial crisis can be applied to most
Islamic finance transactions, a broad-brush application of these rules would limit the ability of
Islamic financial institutions to implement the more unique risk-sharing contract
arrangements. The stage of development of the overall financial system in which Islamic
finance operates must also be considered to ensure that the effective application of global
standards can be achieved without unintended consequences, given the prevailing
associated constraints. Islamic banks today continue to be confronted with limitations in the
availability of a sufficiently deep and diverse pool of Shariah compliant instruments - in both
domestic and international currencies - in which they can invest. Under the strengthened
international capital and liquidity standards, this can result in higher costs of compliance,
inefficiencies in funding structures and increased risks of funding mismatches.
Strengthening prudential standards alone would therefore be an incomplete response to
building a strong foundation for the future of Islamic finance. Beyond the more stringent
capital and liquidity standards, a further response to strengthen the global Islamic financial
system should therefore also include measures to strengthen the infrastructural
underpinnings and building blocks of the industry. It is equally important that initiatives such
as the establishment of the International Islamic Liquidity Management Corporation (IILM) to
support cross-border liquidity management by Islamic financial institutions, continue to be
pursued. The recent sukuk issuance by IILM represents a major breakthrough in global
cooperation on Islamic finance which has made available short-term USD Shariah compliant
instruments in the global market to Islamic financial institutions to facilitate more efficient
management of their cross-border liquidity requirements.
As Islamic finance further evolves and advances, more fundamental questions on the
framework for financial stability in the context of Islamic finance will need to be addressed. At
a national level, such questions will include the relevance and design of financial safety nets
such as deposit insurance and lender of last resort facilities in an Islamic financial system. To
a large extent, these safety nets have in mind the traditional roles played by conventional
banks - the acceptance of deposits which are payable on demand and which enjoy principal
protection for the depositors. In a risk and profit sharing model with participatory or
equitybased contracts that support ventures involving entrepreneurship endeavours, savers and
fund providers stand to bear the losses in such ventures, similarly to gaining profits from
such ventures. A main challenge would be in structuring financial safety nets which honour
the true nature of Islamic contracts, while preserving confidence in the financial system given
the entrenched expectations of consumers. Consumer protection and education initiatives
are also essential to further deepen the understanding and awareness of consumers on the
associated risks and rewards in the Islamic financial contracts. In addressing these
questions, there is much to be gained from sharing experiences and strengthening
cooperation in research initiatives.
At the global level, the framework for financial stability in the context of Islamic finance needs
to interface with the arrangements that exist for the conventional financial systems. As
conventional frameworks for financial stability are being strengthened and in some areas
being fundamentally revisited, it is timely to take the opportunity to elevate the level of
engagement and coordination between global standard setting bodies in international
standard setting and implementation activities. Closer coordination will be increasingly
important to avoid fragmentation in regulatory frameworks and improve the surveillance of
risks to global financial stability. As lessons from previous crises should teach us, we would
be well served to ensure that the growth of Islamic finance - on a global scale - is well
supported by the strengthening of our collective capacity to understand, monitor and manage
the attendant risks.
Conclusion
In concluding, Islamic finance, through its emphasis on risk-sharing for the attainment of
socio-economic goals based on the objectives of Shariah, provides the discipline that
enhances the prospect of strengthening the link between finance and the real economy, thus
contributing towards overall financial stability. With the global economy now on the recovery
path, Islamic finance offers enormous potential in supporting a more inclusive and
sustainable economic growth. Developing and emerging economies in particular stand to
reap the largest benefits from this potential. To fully realise this potential, regulatory priorities
in strengthening financial stability taking into consideration the specificities of Islamic finance
will ensure its continued resilience and its potential to effectively service the functioning of
economies and the economic wellbeing of societies.