Zeti Akhtar Aziz: Towards the positioning of Islamic finance as an integrated
component of the International Financial System
Opening speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the 5th Annual
Islamic Finance Summit, London, 24 January 2006.
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It is my great pleasure to be here in London to speak at this 5 th Annual Islamic Finance Summit
organised by Euromoney. Islamic finance has made significant breakthroughs to now gain a place in
today's challenging global environment with its international dimension now becoming increasingly
more significant. It has now evolved to become an integral part of the international financial system. As
this international financial integration process intensifies, it will not only increase the potential for
Islamic finance to contribute towards enhancing the prospects for more balanced global growth
through fostering greater trade and wealth creation, but also through facilitating greater diversification
of risks, it will contribute towards increased global financial stability.
Rapid Evolution of the Global Islamic Financial Services Industry
As recent as five years ago, the development of Islamic finance was still regarded as an infant industry
striving to prove its viability and competitiveness in the global financial environment. At that time, the
growth of Islamic finance was mainly organic and largely concentrated in countries where the Muslim
population was significant. Islamic finance was also for the most part governed by conventional
regulatory and accounting standards. In addition, the divergence of views on some of the outstanding
issues called for greater harmonization. Indeed, there was also some apprehension amongst the
regulatory authorities, consumers, business communities and investors on the future potential of
Islamic finance.
Notwithstanding this, over the recent five years, there has been a rapid evolution and expansion of the
industry. Today, Islamic finance has been recognised as a viable and competitive form of financial
intermediation not only in Muslim countries but also outside the Muslim world and offering a wide
range of financial products and services. Licences are being issued to facilitate the establishment of
Islamic banks including in the industrial economies in Western jurisdictions. There are also an
increasing number of international conventional banking institutions offering Islamic financial products
and services through dedicated subsidiaries or branches as well as through window arrangements. In
addition, countries that have pockets of Muslim population, in particular, in the Asian region are now
exploring the prospect of providing access to Islamic financial services to promote greater inclusion.
These trends have not only been in terms of numbers of Islamic financial institutions, but also in terms
of institutions with larger size of capital and a more established operational governance framework
including risk management. Islamic financial institutions that previously operated only in their own
domestic jurisdictions have also begun to venture abroad to tap new growth opportunities in other
regions and forge greater cross-border linkages.
In the Islamic capital markets, there has been a growing interest in the issuance of Islamic sukuks by
both sovereigns and multinational corporations. At the international level, the issuance of the first
sovereign global Islamic sukuk by the Government of Malaysia in 2002 has been followed by a series
of other issues. Corporations and multilateral development institutions have also embarked to issue
Islamic financial instruments resulting in an increase in the range of products in the international
capital market. Islamic sukuks have now breached the USD15 billion mark. The Islamic sukuks have
attracted a broad range of investors. In 2004, to deepen our capital market further, Malaysia liberalized
our exchange administration rules to allow multinational corporations and multilateral agencies to raise
ringgit denominated papers in our domestic bond market. Multilateral financial institutions including the
International Finance Corporation and the World Bank have since issued Islamic based
ringgitdenominated instruments. We welcome the origination and issuance of Islamic financial instruments to
be issued in Malaysia.
The growth in Islamic asset and wealth management has also been phenomenal arising from the
diverse and innovative structures of Islamic investment funds, including Islamic hedge funds. It is
estimated that more than 250 Shariah-compliant mutual funds are currently managing approximately
USD300 billion in assets. Shariah-compliant screening techniques have been able to improve
riskadjusted returns on Islamic investment funds which in turn have led to its adoption in improving the
risk-adjusted returns of conventional equity funds. Benchmark indices such as the Dow Jones Islamic
Market Indexes and the Financial Times Stock Exchange Global Islamic Index Series in the
international equity market and the listing of Islamic financial instruments on international exchanges
have all contributed to enhance the depth of the Islamic financial markets as an attractive asset class
for investment.
On the regulatory front, the standardised international rules and regulations for the Islamic financial
institutions now being issued by the Islamic Financial Services Board (IFSB) will be important in
effectively ensuring the stability and soundness of the system. Two important standards, the standards
for capital adequacy and risk management have been approved by the Council of the IFSB in 2005.
The two standards have taken into account the aspects of risks associated with the different contracts
in Islamic banking business. Proper assignment of capital charge on profit-sharing arrangement and
the introduction of profit equalization and investment risk reserve are risk-mitigating elements to
ensure the soundness in Islamic banking business. The on-going work in the area of supervisory
review process, market discipline, corporate governance and transparency will complete the range of
the prudential and supervisory standards of Islamic financial institutions. The increased participation in
the IFSB from across the globe reflects the growing interest of the global financial community to be
involved, at the onset, in the development of regulatory standards in Islamic finance. In addition to
these developments, regulatory and legal reforms are also being undertaken in a number of
jurisdictions to accommodate the unique characteristics of Islamic financial transactions to support the
progressive development of Islamic finance.
Following these institutional enhancements, the significant growth of Islamic financial markets and the
development of the supporting financial infrastructure, the international financial architecture for
Islamic finance has been strengthened considerably. Established international financial centers have
now included the development of Islamic finance as part of their agenda. Also emerging on the
horizon are new Islamic financial centers in which innovative and competitive Islamic financial services
industry is evolving. With the supporting comprehensive Islamic financial infrastructure in place in
Malaysia and the diversity of Islamic financial players following the recent increased liberalization in
the Islamic finance sector, Malaysia is positioning itself as an international Islamic financial center.
Key Challenges Ahead
While Islamic finance has made significant strides, there are key challenges that needs to be
addressed for Islamic finance to sustain its development in the global financial system. My remarks will
focus on four of these challenges.
The development of robust Islamic financial system at the national level
Firstly, there is the challenge to develop a robust Islamic financial system at the national level. The
level of development of Islamic finance across jurisdictions varies significantly. While in some, Islamic
finance is at an advanced stage of development, in others, more meaningful progress is yet to be
made. To foster greater international linkages and cross-border transactions, the level of development
of Islamic finance needs to reach a certain threshold of development and sophistication. It requires the
development of a robust Islamic financial system which encompasses both the banking and the
nonbank Islamic financial intermediaries, the Islamic financial markets, offering the range of Islamic
financial products that is supported by a developed Islamic financial infrastructure.
The formulation of the ten-year masterplan for the Islamic financial services industry by the Islamic
Development Bank and the Islamic Financial Services Board, marks an important step in setting the
blueprint for leading the development of Islamic finance in a systematic and synchronized manner
across jurisdictions to achieve the common goal of a vibrant and comprehensive Islamic financial
services industry. Malaysia had five years ago launched our own Financial Sector Masterplan which
includes the strategic direction for the development of Islamic finance forward in Malaysia. It has now
culminated in the progress that Malaysia has achieved today.
Malaysia has now evolved a comprehensive domestic Islamic financial system that is diversified in
terms of its institutions, markets and players. The strategy has been to institute the entire financial
system chain to ensure the smooth functioning of the system. The initiatives include building the
required financial institutions including, the Islamic banking institutions, the takaful industry, the
nonbanking institutions and developing the Islamic money and capital markets. These respective
components have recently been progressively liberalized to become internationally more integrated.
The supporting financial infrastructure includes a robust regulatory and supervisory framework
reinforced by the legal and Shariah framework, the payment and settlement systems, the development
of the pool of talent and the mechanism for the liquidity operations of the Central Bank as part of its
monetary policy.
The development of efficient and active international Islamic financial markets
The second challenge is to advance further the development of an efficient and active international
Islamic financial market. Well-developed international Islamic financial markets enhance the liquidity of
the instruments and risk management capacity of the players. This would promote the efficient
functioning of the markets and thus facilitate capital flows and thereby strengthen global integration.
Coordinated initiatives are therefore essential to foster the development of an efficient and vibrant
international Islamic financial market. Sustainable supply of sukuks on a regular basis needs to be
ensured. The participation of issuers including multilateral organizations, governments and
multinational corporations would contribute to this process. In Malaysia, the domestic bond market
now accounts for 80% of GDP. Of this, 44% of the papers are Islamic based.
A fundamental pre-requisite is to promote innovation in the development of a broader range of Islamic
financial market instruments. These include instruments with equity ownership features, Islamic
assetbacked securities, inclusion of permissible forms of credit enhancements as well as Shariah-compliant
risk mitigating instruments. The development of an Islamic derivatives market for hedging is required
for market-making activities to support the development of secondary markets. Research and
development therefore need to be intensified. The Shariah fund recently established by Malaysia is to
support research activities in these areas. This initiative is also to facilitate annual dialogues amongst
international Shariah scholars. It is to provide a platform for deliberation on the Shariah compatibility of
newly developed Islamic financial instruments and markets.
A further pre-requisite is to ensure sufficient availability of liquidity to support the intermediation of
funds in the Islamic financial system. The demand for central bank discount window operations is
inevitable. Central banks must therefore have sufficient Islamic financial instruments at its disposal to
manage the liquidity conditions in the Islamic financial system. This is an area that has yet to be fully
developed. In relation to this, Malaysia has developed Islamic monetary instruments that includes both
the government and our own Bank Negara Malaysia Islamic financial instruments. We have also a
dedicated clearing and settlement mechanism to ensure the smooth functioning of the Islamic financial
system. To add to the existing range of Islamic financial instruments, Bank Negara Malaysia will in
February this year issue an Ijarah paper to further meet the requirements of Islamic market players in
the domestic Islamic money market and also for the purpose of conducting monetary policy. Of equal
importance is having in place appropriate regulatory and legal framework to support the development
of Islamic financial instruments and markets to ensure investor protection, uphold market integrity in
addition to containing systemic risks.
The adoption of IFSB standards
The third is to ensure the adoption of the IFSB standards. The standards on capital adequacy and risk
management that have now been approved by the Council of the Islamic Financial Services Board in
December in 2005 is scheduled for implementation in 2007. Islamic financial institutions must
therefore be equipped with the required capacity and infrastructure to capture the respective risk
weights and assign appropriate amount of regulatory capital at each of the different stages of the
Islamic financial transaction. The exclusion of risk-weighted assets funded by the profit-sharing
investment accounts from the calculation of regulatory capital requirement places critical emphasis on
a comprehensive infrastructure in the Islamic financial institutions to clearly segregate the restricted
and unrestricted profit-sharing investment accounts from the non-profit-sharing accounts and
shareholders funds and to track their respective flows in financing and investment transactions.
Strategic investments in the state-of-the-art IT and risk management systems are integral to this
process.
Supervisory authorities need to be equipped with the specialized skills necessary to have the right
assessments on the level of risks that the Islamic financial institutions are exposed to and the
effectiveness of the risk management infrastructure in the Islamic financial institutions in mitigating
these risks.
The development of a sufficient pool of talent in Islamic finance
Finally, the development of a sufficient pool of appropriately skilled Islamic finance practitioners needs
to be accorded the highest priority. The required skill set in Islamic finance is unique. It needs to have
the right blend of knowledge of finance with the understanding of the Shariah as being central. The
Shariah principles must be embedded in each and every operational aspect of the Islamic financial
institution, including in the design of financial products and financing structures, financial contracts and
their execution, liquidity and balance sheet management, risk management as well as asset and
wealth management. The upholding of Shariah principles must permeate from the highest level,
including at the board and senior management levels, which provide the strategic direction for the
Islamic financial institution and to the operational levels. Sound policies and practices premised on
Shariah principles will evolve the Islamic financial system into a financial system that is distinctively
ethical and that which promotes economic justice.
To meet this objective of providing a total talent management solution for the global Islamic financial
services industry and to meet the educational needs of the different levels of Islamic finance
practitioners, including professionals and specialists in Islamic finance, Malaysia is establishing an
International Centre for Education in Islamic Finance (INCEIF). INCEIF will commence operations in
March this year and will offer professional certification programmes in Islamic finance. INCEIF will also
forge strategic alliances with domestic and foreign academic institutions to offer post-graduate
programmes, namely Masters and Doctorates in Islamic Finance with specific areas of specialization.
A professional association for Islamic finance professionals will also be established for the alumni of
INCEIF to keep abreast with the latest developments in Islamic finance.
Conclusion
Building the foundations on which Islamic finance has been able to advance forward has been vital to
its viability, competitiveness and sustainability in this challenging global financial environment. With its
integration into the international financial system, it would strengthen further the global economic and
financial inter-linkages and in so doing would open new frontiers towards achieving more balanced
global growth and greater shared global prosperity.
Thank you.