Rasheed Mohammed Al Maraj: Relevance of international standards to
the Islamic financial industry
Speech by HE Rasheed Mohammed Al Maraj, Governor of the Central Bank of Bahrain, at
the 13th AAOIFI - World Bank Annual Conference on Islamic Banking and Finance,
Manama, 23 October 2011.
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Your Excellencies, Distinguished Guests, Ladies and Gentlemen:
On behalf of the Central Bank of Bahrain, it gives me great pleasure to welcome you to the
13th AAOIFI - Annual World Bank Conference on Islamic Banking and Finance.
I should especially like to thank the many distinguished speakers who will participate in the
Conference, as well as the event organisers and sponsors. Particular thanks are due to the
World Bank for its continuing support. Mr. James Adams, Vice President, East Asia & Pacific
Region of the World Bank has again travelled to Bahrain participate in this Conference. It is a
pleasure to have you with us.
As in previous years, the Conference agenda deals with a wide range of topics, all of which
are important to the future development of the Islamic financial services industry. However, in
my remarks this morning I intend to focus on a theme that two of the sessions have in
common: the relevance of international standards to the Islamic financial industry. This
theme is explored both in session one, which considers the risks associated with using
International Financial Reporting Standards by Islamic financial institutions, and in session
five which is concerned with the potential risks and difficulties in the implementation of Basel
III in Islamic banks.
The question asked by both of these sessions is: How relevant are international standards to
the Islamic financial industry? In many ways the Islamic financial industry faces different
issues to those that the international standards have been designed to address. For
example, the principle of risk sharing is at the core of the Islamic financial industry. It
changes the nature of the risks faced by Islamic financial institutions and their customers.
Unlike ordinary depositors, the holders of unrestricted investment accounts in theory share
some of the risks that in a conventional institution would be borne exclusively by the
shareholders of the bank.
However, it is possible to concentrate too much on the differences and not enough on the
similarities. While the principles of Islamic finance are very different to those of conventional
finance, Islamic financial institutions are still subject to same kinds of risks and to the same
laws of economics as are conventional ones. The differences between the two types of
financial structure should not blind us to the issues that are common to both.
Let me give some examples.
Basel III requires conventional banks to hold a stock of high quality liquid assets that can be
used to meet unexpected deposit outflows. These instruments include highly rated paper
issued by sovereigns and by corporates.
The regulators of the conventional industry have focused on the issue of liquidity because,
pre-crisis, conventional banks increasingly relied on their access to short-term interbank
markets to fund relatively long-term assets. Borrowing short to lend long is, of course,
fundamental to the business of banking. Even so, there comes a point of which the degree of
maturity mismatching is no longer prudent, and we saw with conventional financial
institutions that the boundary between prudent and imprudent business conduct had been
crossed.
If we look at the trends in Islamic banking in the years prior to the crisis, we can see that
there are important similarities between the practices of Islamic financial institutions and
those of conventional ones. Just like conventional institutions, Islamic financial institutions
increasingly funded long-term assets with short-term funding. Although the assets and
liabilities were structured in a Sharia-compliant manner, the degree of maturity mismatching
was just as great as was practiced by conventional institutions. In some cases where the
asset involved a long-term development project, the degree of maturity mismatching was
significantly greater than that practiced by conventional financial institutions.
The conventional financial industry received a wake-up call during the crisis concerning the
importance of understanding, monitoring and controlling liquidity risks. The Islamic financial
industry must recognise that it also needs good liquidity risk management. However, Islamic
financial institutions find it difficult to manage their liquidity risk given the relative lack of
short-term money market instruments in which they can invest. The CBB has been at the
forefront of innovation in assisting Islamic financial institutions to manage their liquidity, but
more still needs to be done both by regulators and the industry.
So, does Basel III offer a solution? Obviously, Islamic financial institutions cannot invest in
interest-based products. This makes the specific liquidity requirements of Basel III difficult to
apply to them. There is also the complication that the outstanding stock of Sukuk is not
sufficiently large to enable all Islamic financial institutions to meet a liquidity ratio comparable
to that mandated under Basel III. Finally, the markets for Sukuk are not always as liquid as
those for conventional government bonds and therefore even if an Islamic financial institution
invests in them it might not always be able to find a ready buyer when the need occurs.
These are genuine practical difficulties in applying Basel III to Islamic financial institutions.
Even so, they should not get in the way of recognizing the important principle that Islamic
financial institutions need to take liquidity risk just as seriously as conventional firms need to
do. They need to make sure that they keep maturity mismatching to prudent limits. There
needs to be a debate about what sort of limits would be prudent. But there is no doubt that
limits are needed.
Another issue that Basel III seeks to address is to ensure that banks have sufficient capital to
be able to absorb losses on an on-going basis. Standard setters have focused not only on
the amount of capital but also on its quality. In the simplest terms, the financial crisis
revealed that too many conventional banks had capital that would only absorb losses if the
bank went into liquidation. It was not capable of absorbing losses on an on-going basis.
Basel III sets out to ensure that bank capital has a stronger ability to absorb losses before a
bank goes into liquidation.
It has often been argued that Islamic financial institutions need a different capital structure to
conventional ones. Their account holders can expect to share in the risks to which the firm is
exposed. This means that, in principle, they should expect to share in losses as well as
profits. But a similar assumption was made about investors who held the subordinated debt
issued by conventional banks. When those banks failed, instead of taking their share of
losses, subordinated debt holders were often protected by the terms of the bail-out.
So, what applies in theory does not always apply in practice. This means that the regulators
of Islamic financial institutions also need to pay careful attention to the ability of capital
structures to absorb losses on an on-going basis. It has become clear as a result of the
financial crisis that the predominant form of bank capital needs to be equity. From an Islamic
industry perspective, this has the great advantage that equity is without a doubt
Shariacompliant.
Finally, on the subject of international financial reporting standards, it is important to
remember that transparency and consistency in the valuation of assets is every bit as
important to Islamic financial institutions as to conventional ones. In fact, it is even more
important. Because investment account holders are in principle exposed to similar kinds of
risks as the holder of bank equity, it is important that Islamic financial institutions can present
their financial results in a clear and understandable form which is comparable between
institutions. IFRS may not be the right solution in all circumstances. AAOIFI has done a lot of
immensely important work over the years in adapting international standards to the needs of
the Islamic financial industry. However, the need to adapt international standards to the
needs of the Sharia-compliant industry should not mean that the important underlying
principles of transparency and comparability become neglected.
Recognition that international standards are relevant to the Islamic financial industry, even if
they should not be blindly copied, will go a long way towards ensuring that the industry has
the strong foundations on which to build for the future. Securing strong foundations for the
industry is in the interests of everyone involved it, especially those who are just beginning
their careers.
This brings me to the second purpose of our meeting today. I would like to congratulate
those students who have successfully completed the "Certified Sharia Adviser and Auditor",
and "Certified Islamic Professional Accountant" programmes. To have mastered these
challenging courses of study has required hard work and commitment from you. It is an
achievement that you can be proud of, and one that I am sure will serve you well throughout
your professional career.
Let me end by wishing all the graduating students a long, successful, and rewarding career. I
also wish all the participants a successful Conference and hope that you will have many
stimulating and fruitful discussions over the course of the next two days.
Thank you for your attention.