Rasheed Mohammed Al Maraj: Ensuring stability - international
perspectives on creating an effective regulatory framework
Inaugural plenary address by His Excellency Rasheed Mohammed Al Maraj, Governor of the
Central Bank of Bahrain, at the 15th World Islamic Banking Conference 2008, Manama,
24 November 2008.
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Your Excellencies, Ladies and Gentlemen: "Salaam Alaikum"
It is a pleasure to participate in this Opening Session, and to have this opportunity to
welcome you all to the 2008 World Islamic Banking Conference. This is the 15th Conference
of its kind to have been held here in Bahrain, and in July of this year, the first WIBC
European Summit was held in London. The inaugural European Summit was yet a further
indication that Islamic finance is rapidly moving into the financial mainstream.
I should like to 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 reasons for the success of this event. I should also particularly like to
extend a warm welcome to His Excellency Heng Swee Keat, Managing Director of the
Monetary Authority of Singapore. Thank you for being with us today.
The theme of this Session - "Ensuring stability: International perspectives on creating an
effective regulatory framework" - is timely in my view.
Until very recently, many commentators and analysts believed that the economies of the
GCC were an oasis of calm in the ongoing global financial turmoil. However, since the
collapse of Lehman Brothers in mid-September, it has become clear that no part of the world
can be immune to the present crisis. We have seen a vastly changed financial landscape,
and there is little doubt that the availability of funds and the costs of borrowing are being
affected in all parts of the world.
Against the background of this global financial turmoil, it seems a good time to take stock of
the prospects for the Islamic financial industry, and to consider in particular how best to
ensure the stability of the industry in future.
In recent months as the global financial crisis has deepened, many commentators have
pointed out that Islamic financial institutions have escaped relatively unscathed from the
severe downturn which is affecting most conventional financial institutions. This certainly
presents the industry with an opportunity to continue its rapid and successful growth of
recent decades.
However, the fact that Shari'a compliant institutions have avoided significant losses resulting
from the global financial crisis does not mean that there are no lessons that they can learn
from the fallout. Let me mention three in particular which I believe are particularly relevant -
the risks of herding behaviour, the importance of liquidity management, and the importance
of sound corporate governance.
The first example I invite you to consider concerns the belief by many conventional banks
that lending to sub-prime borrowers represented a viable new business line in which there
would be an appropriate risk reward trade-off. The first movers in this market might have
found a profitable niche - but once many banks tried to become players in the same market,
credit standards became lax and loans were made to borrowers who had little chance of
repaying them. Although some banks recognized the risks they did not do enough to mitigate
them at a sufficiently early stage. The reason, as the former head of a major bank remarked
in explaining his bank's sub-prime related write-offs, is that "if the music is playing, you have
to get up and dance."
The sub-prime episode provides an illustration of the herding instinct which has been a
recurrent feature of financial markets since their very beginning. Some banks discover a
profit opportunity, other banks follow, and before long the oversupply of credit has led to
losses.
Although Shari'a compliant financial institutions have been insulated from direct losses
resulting from the recent financial crisis, this does not mean that they are not as much
subject to herding as are conventional financial institutions. As I have pointed out in the past,
newer entrants to the industry have merely tended to copy the strategies they see being
successfully pursued by their more established rivals.
As a result, the industry's assets have become heavily weighted towards the property sector
- real estate, commercial property and construction. Events in other parts of the world have
recently reminded us that this sector can and does experience significant cycles of activity.
We also need to remember that a business model which looks robust in conditions of rising
asset values and abundant liquidity, may not be so in a changed economic environment.
The industry needs carefully to consider the risks of the widespread adoption of the same
business model. Is it that there are genuine profit opportunities that are not being exploited
by their competitors? Or is it instead the consequence of merely deciding to follow the herd?
An important part of the regulator's role is to lean against the tendency towards herding that
seems to be a perennial feature of financial markets. This is not always a popular role but it
is an essential one. For example, by imposing concentration limits, regulators can require
banks to hold a more diversified and therefore less risky portfolio of assets. While we
recognise that there are advantages to banks in developing expertise in particular economic
sectors, there are also significant risks in chasing after the profit opportunities others have
already exploited.
While regulators can help to ensure that financial institutions' risks are well diversified, the
main incentive for risk diversification needs to come from the industry itself. The industry
needs to develop a greater diversity of business models, more diverse and stable income
sources, and more robust risk management and stress testing techniques.
The essential consideration in Islamic finance, as in all forms of finance, is to find the right
balance between business development and risk management.
A second issue brought to prominence by the recent global financial turmoil concerns
financial institutions' liquidity risk management. Conventional financial institutions and their
regulators clearly did not pay sufficient attention to liquidity risks in the run up to the crisis.
Liquidity has been a source of potential risk for the Islamic financial services industry for
some time, particularly given the relative unavailability of short-term, liquid money market
instruments that are Shari'a compliant.
To assist Islamic financial institutions to overcome this problem, the CBB has recently
developed an Islamic Sukuk liquidity instrument. This is a repurchase agreement which has
been designed to enable financial institutions to access short-term liquidity against
Government of Bahrain long- and short-term Ijara Sukuk. Despite this important innovation in
the CBB's standing facilities, there is a continuing need for more depth and liquidity in Shari'a
compliant money markets and the CBB will continue to explore other such initiatives.
A final issue which the recent global financial turmoil has brought to prominence concerns
corporate governance. The experience of the conventional financial sector has been a
reminder that financial institutions need high standards of corporate governance as they are
entrusted with other people's money. While this is true of all financial institutions, the need is
particularly great for those which are Shari'a compliant due to several issues that are specific
to their business model.
Decisions on profit distribution, for example, require the careful balancing of the interests of
multiple stakeholder groups - not just shareholders as in conventional banks, but the
interests of the holders of investment accounts as well. Investment account holders are
exposed to many of the same risks as shareholders, but lack the same control rights - such
as the ability to vote for Board members - that are attached to equity ownership. Balancing
these different stake holder interests, requires the adoption of strong corporate governance
practices, and the standards developed both by AAOIFI and by the Islamic Financial
Services Board, are vital components of the solution.
To conclude, although the Islamic financial services industry has been insulated to-date from
the effects of the global financial crisis, there are many lessons that Shari'a compliant
institutions can learn. The global financial crisis has been a reminder of the importance of
risk diversification, of good liquidity management, and sound corporate governance. These
are all lessons which the Islamic financial industry needs to bear in mind if it is to continue to
enjoy the framework for stability that is essential for its future prosperity.