Shamshad Akhtar: Building an effective Islamic financial system
Speech by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the Global Islamic
Financial Forum, Governor's: Financial Regulators Forum in Islamic Finance, Kuala Lumpur,
27 March 2007.
* * *
Surge in capital from oil rich economies may have spurred the activity in Islamic Finance (IF) but one
should not assume that this phenomenon will be the sole catalyst to promote growth in IF industry.
The primary driver of IF growth will be the effectiveness with which this industry is consistently,
persistently and substantively nurtured, groomed and developed and how successful the industry is in
maintaining its robustness, soundness and governance as it grapples with some of the fundamental
issues and challenges facing the industry in its evolving and growth phase.
What is comforting and encouraging that Islamic world has collectively launched IF with a fair degree
of commitment and fervor backed by adequate capital base. The process has been further supported
by the right mix and blend of institutional frameworks that have led to gradual development of
internationally accepted architecture for regulatory and accounting frameworks for Islamic industry.
There is further an intensive effort underway to aggressively explore and exploit the virtues and
benefits of this discipline. As one unfolds the mysteries of Islamic tenets and ethical spirit in finance, it
offers opportunities for financial innovation and flexibility to structure different types of financial
products which, among others, would allow for a shift from debt based financial system more to equity
and partnership based. What is further amazing is IFs has promising potential to channel wealth by
offering alternate avenues for saving and investment, while dealing with the problems of financial
exclusion by extending riba free services to devout Muslims.
Critical driver for effective development of IF industry, its growth and sustainability will depend on the
ability of the system to offer clients comfort that these financial services do conform to the Shariah
injunctions and principles. It is this value addition that will help enhance the outreach and appeal to the
larger Muslim population base in particular rural and poor that suffers from financial exclusion.
It is equally critical that the IF emerges as a robust, competitive, efficient and well diversified segment
of financial industry to be able to compete with the long standing conventional industry. To evolve and
develop a strong, healthy and competitive system, IF industry has to
(i) Further explore the depth and breadth of IF systems in order to fully unleash its uniqueness
and potential,
(ii) Develop and implement policies and regulatory frameworks for IF which are complementary
to conventional banking system but which are tailored to capture the different types of risks
associated with IF,
(iii) Recognizing that IF offers an opportunity to diversify financial system to more equity based
and better risk sharing instruments than offered by conventional system thereby helping the
overall financial system to evolve in a more balanced way, and
(iv) Better understand and appreciate the richness of IF which advocates a different liability and
asset approach that once effectively acknowledged and applied will offer wide range of
opportunities for financial innovation key to the further development and diversification of
overall financial system.
It is the recognition and implementation of the above goals and objectives that will the lay foundation
for an effective financial system. I will now dwell on some of the key preconditions which are critical for
laying the foundation for an effective IF system.
First, it has to be recognized that depending on their circumstances, regulators have adopted
varying approaches to develop IF system. At this stage, it is too early to pre-judge which
approach and model will be effective but success would be contingent on how effectively these
institutions are nurtured and supervised. In some jurisdictions regulators have allowed dual
systems whereby it issues some additional policies and regulations for IFIs over and above the
prudential regulatory framework for conventional banks. Within this category there are variations with
regard to role of regulator in Shariah compliance. Some countries have declared the entire financial
system to be Islamic and in others no distinction is made between Islamic or conventional financial
systems, and the decision to establish Islamic bank is with the owners, e.g. Saudi Arabia and UAE. As
distinct from these, there is now a wave across developed financial systems, such as U.K and
Singapore, to introduce specific legislation and regulations to facilitate IF transactions.
Depending on regulators' adopted policy stance, approaches to issuance of licensing and role of
regulator in Shariah compliance varies significantly. For instance, some regulators issue standard form
of banking license (e.g. Saudi Arabia) for both Islamic and conventional institutions, while others issue
separate Islamic banking licenses (e.g. Malaysia).
When regulators apply the same criteria and due diligence for licensing both IFIs and conventional
institutions, they strengthen the competitive forces. Use of a separate licensing criterion should be
applied carefully; because relatively lax criterion for IFIs will lower industry standards and
result in a protected non-competitive class of institutions.
Second, for long term sustainability and confidence of IF sector, it is critical that clients and
Islamic banks effectively and fully exploit Islamic financial intermediation potential and
process based on Shariah principles. Profit sharing is the cornerstone of Islamic financial
intermediation process, be it fund raising or funds used or lent among the depositors, banks and the
businesses. Lack of appreciation of this and reluctance of banks to experiment and expose
themselves to different types of transactions and risks has delayed proper application of IB and as
such prevented the desired level of portfolio diversification that IB theoretically have potential for.1
On liabilities side, while money deposited as amanah is repayable on demand and is backed by 100%
reserve requirement, the money held under investment account holders (IAHs) on profit and loss
sharing basis and deployed in riskier businesses is not guaranteed and is not strictly a liability. This,
however, is not fully recognized by ordinary customer thereby serving as a limitation to business
expansion and also carries unintended consequences for IAHs who may not appreciate the risks they
are exposed to.
While IFIs are now recognizing this liability distinction more and more, the problem emerges more on
asset side. As businesses have evolved, IFIs have ended up largely depending on less risky trade and
commodity financing which typically are of shorter maturity even though the IF allows for financial
intermediaries to structure various transactions (including Musharakah, Mudarabaha, and Ijarah etc.)
that allow adequate flexibility for portfolio and maturity diversification. However, high dependence on
Murabahah and on short term transactions has limited the asset diversification potential of IFI and their
portfolio ends up resembling conventional fixed income securities in terms of their risk-return profile.
Islamic banks have been thus far less open to adoption of some profit-loss sharing instruments (i.e.
musharaka or mudarabah) because of bank's low appetite for risk, the associated costs of monitoring
such transaction, lack of transparency in markets within which Islamic banks are operating and the
reluctance of the depositors/IAHs to take risks.
Furthermore, in contrast to conventional banks who are obligated to offer fixed return to depositors,
irrespective of the actual return on assets, IF inherently and potentially helps in asset: liabilities match
in the balance sheet. All profits and losses on asset side are expected to be shared by the participants
and there are no guaranteed returns to depositors or investors. Thus far IFIs have not fully exploited
these real distinguishing characteristic and features of IF that assign it distinct edge and advantage
relative to conventional banks. Despite the flexibility of the IF system, there is often lack of clarity and
lack of differentiation between depositors and investors (i.e. those serving as equity holders or
partners in businesses) nor is there full appreciation of the profits and loss sharing arrangements that
are typically backed by "pass through" arrangements for the stakeholders. Consequently, the IFIs
continue to observe asset-liability mismatches even when there are Islamic products/structures
available to address these. Continued partial and adhoc applications of IF-system relative to what it
offers theoretically will hinder the effective development of IF system and over the period carries the
risks of eroding confidence in the system.
Third, to enhance effectiveness of IF it is important that IFIs recognize that the wide array of
Islamic financial products do offer opportunities for asset and risk diversification both for the
banks balance sheets and that of financial system at large. Proper application of IF alters
inherently the balance sheet risks and has potentially inbuilt risk mitigation. On one hand, it brings to
forefront different characteristics and types of risks, while making the risk identifiable and transparent.
On the other hand, it provides a better framework for risk sharing and mitigation.
What is critical for effective development of IF that both regulatory and supervisory regime recognizes
the risk profile of IF and provides adequate guidance on exposures, risk weights and capital to be
assigned so that there is uniform application of these standards by industry. There are several aspects
that can be discussed and debated in this area, but I will offer only few perspectives:
The regulatory regime should be open to providing adequate incentives for risk and profit sharing and
the IF industry needs to adopt more conformed standards to enhance system predictability and
stability, while promoting greater awareness among fund suppliers about the terms and conditions of
profit sharing under different contractual arrangements. For instance as illustrated and well articulated
in one of the recent papers of V.V. Sundarajan (2007): for an IAH who largely provides funds on a
mudarabah basis and the IFI which invests these funds (often commingled with shareholders' and
other funds) in various IF contracts (like salam, murabaha, ijara, istisna, musharaka etc.) the risk is the
expected variance in the measure of profit distribution between IAH and bank. IFIs have to recognize
that this uncertainty or Mudarabah risk can arise from a variety of factors both systemic as well as
bank specific. Risk mitigation for IAH can be achieved through use of profit equalization reserves
(PER), investment risk reserves (IRR) and by variation in modarib's share.2
At the same time regulatory regime, needs to offer perspectives on risk determination and capital
assignments for the high exposures IFI's face because of their excessive reliance on Murabah and
other trade and sales based transactions backed which are prone to higher degree of volatility and
appropriate weights have to be assigned for both associated commodity pricing and counter party
risks.
While adopting a suitable risk mitigation technique, comprehensive and transparent disclosure of "......
risk profile, risk-return matrix, and internal governance is critical. Among others, this requires
coordination of supervisory disclosure rules, and accounting standards, and proper differentiations
between consumer friendly disclosures to assist IAHs and market-oriented disclosures to inform
markets."3
In this regard, IFSB Guiding Principles on Risk Management has served a good purpose. They
provide guidance for different risks to which IF industry is exposed and offers guidance on the
methodology for credit risk, market risk, liquidity risk, operational risk, equity investment risk and rate
of return risk for different types of financial transactions. We are in the process of adapting these
guidelines for Islamic Banking Institutions in Pakistan.
Finally, as the IF industry diversifies, it will face increasingly more diverse range of risks associated
with investment banks, mutual insurance (takaful), and investment companies. Islamic banks,
however, remain the core of the industry in many countries and offshore financial centers and account
for the bulk of financial transactions and their soundness would remain a key concern for systemic
stability. In Islamic banking, the management of risks becomes more challenging due to its peculiar
risk characteristics in line with the requirement for compliance to Shariah principles. While the Basel II
initiatives on the identification of credit, market and operational risks can be assimilated into Islamic
banking, the initiatives have to be complemented with consideration of the other dimensions of risks
that are inherent in the IF transactions.
Fourth, for effectiveness of IF development, it is desirable that eventually model legislation is
developed for IFs to recognize different institutions and products. This will facilitate
development of contractual frameworks which has its basis on approved legal framework,
which among others will allow for proper enforceability of contract. Strictly speaking even in
Muslim-majority jurisdictions, Shariah compliant IFIs/products and services are not explicitly
recognized in the relevant laws and statutes. As such, interpretation and recognition of financial
products and enforceability of Islamic financial contracts may not be there in the laws and courts which
have traditionally adopted either the common law or civil law framework. For example, whereas
Islamic banks main activity is trading (Murabahah) and participating in equities (Musharakah and
Mudarabah), banking law and regulations in most jurisdictions forbids or allows restricted exposure of
such activities.
To address these issues, some counties have adopted separate Islamic Banking laws (e.g., Kuwait
and Malaysia), while in others IF system is recognized under a section of the existing banking law
(e.g., Bangladesh and Indonesia). Pakistan has also added provisions in relevant banking laws to
support financial institutions involvement in Islamic finance transactions.
Fifth there is need for dispute settlement and conflict resolution mechanism. In line with Islamic
Laws and Statues, an effective Dispute Settlement Institutions that recognizes the intricacies of
Shariah principles and contractual arrangements would be beneficial. Among others, this will facilitate
resolution of disputes associated with cross border contractual arrangements that could involve more
than one jurisdiction each offering their own perspective. Notwithstanding, there is further need for
harmonizing the Islamic rules related to financial dealings. While the courts can not be expected to
change fast, formation of special bench that deals with, among others, Islamic financial transactions
could be a solution. Malaysia has build some legal infrastructure institutions for IF industry and has
dedicated high court judges to oversee litigations related to IF. To complement the court system, the
Kuala Lumpur Regional Centre for Arbitration has been enhanced to deal with disputes on Islamic
banking and finance for both domestic and international cases.
Sixth, essential for effectiveness and sustainability of IF industry is need for encouraging this
segment to enhance corporate governance and ethical standards in banking. In line with the
Shariah rulings, the challenge for IFIs is how to balance the dual objectives of achieving economic
gains, while ensuring compliance with Islamic faith. Compliance with Islamic faith goes beyond the
elimination of Riba to facilitate equitable distribution of economic resources and non-exploitation of any
particular segment of the society. In more concrete terms, IFIs should play a greater role in micro
finance, SME lending, rural development, and in funding more socially responsible schemes. IFSB
should consider working on social responsibility guidelines for IF institutions, which would aim to foster
the larger objectives of equity and non-exploitation.
In conclusion, proper and sequenced development of IF would be critical for this industry to emerge as
an effective channel for both savers and financier's. Collectively continued efforts are warranted to
ensure that we address the issues and challenges raised above so that there is greater national,
regional, and global acceptability and fast integration of IF with conventional industry. Besides the
concerns and proposals suggested above there is need to strengthen capacity in IF both at regulator
and industry level, while promoting financial literacy among public; develop new generation of Shariah
scholars and other academic and special industry experts, and use more effectively standard setters
and private sector to work together to helping align IF industry with appropriate enhancements with
existing international standards to lend more confidence and allow greater international integration.
Finally, most critical is the standardization of Shariah rulings within the same jurisdictions and among
various regions which currently offer divergent views and advice given the beliefs of different schools
of thoughts on same issues.