Rasheed Mohammed Al Maraj: Islamic finance and the financial crisis
Keynote address by His Excellency Rasheed Mohammed Al Maraj, Governor of the Central
Bank of Bahrain, at the AAOIFI-World Bank Annual Conference on Islamic Banking and
Finance, Manama, 14 December 2009.
* * *
Distinguished Guests, Ladies and Gentlemen:
On behalf of the Central Bank of Bahrain, I would like to welcome you to the 11th Annual
AAOIFI-World Bank Conference on Islamic Banking and Finance. I should especially like to
thank the many distinguished speakers who will participate in this Conference, as well as the
event organisers and sponsors. Particular thanks are due to Mr. James Adams, Vice
President, East Asia and Pacific Region, World Bank who has travelled to Bahrain to be with
us today. We are grateful to the World Bank for their continued support of this important
event.
Looking back on the 12 months that have passed since the last AAOIFI-World Bank
Conference, it is striking how profound have been the changes in the financial landscape
since then.
The last time this Conference took place it was under the shadow of the bankruptcy of
Lehman Brothers. This had cast a dark cloud over the world financial system and the global
economy. For a period of several weeks it had appeared that no institution was so strong, or
so large, that the prospect of its failure was unthinkable. There was widespread risk aversion
in financial markets and the reluctance of banks to lend to each other risked creating a
vicious downwards spiral. The interbank markets were frozen. Banks that were unable to
raise wholesale funding were forced to cut back on their lending. This reduced the availability
of credit to otherwise sound borrowers. Rising default rates then in turn fed the perception
that lending banks were at risk. And so the cycle took another downward turn.
In response to this downward spiral many governments - especially in the advanced
economies - took a series of extraordinary measures, including the provision of liquidity in
unprecedented amounts, the provision of recapitalization support, and Government
guarantees of deposits. These measures have been successful in breaking the psychology
that led to the vicious downward spiral. Although the global economy has not yet fully
recovered, the signs of recovery are there and the situation is immeasurably better than
12 months ago.
There are many who might say that the events in the global financial system have little
relevance to Islamic finance. Many in the Islamic finance industry point out that it has been
sheltered from the impact of the crisis in part because the Shari'a prohibits the excess
leverage and speculative financial activities that were at its root. They also take comfort from
the fact that many participants in conventional finance, as well as regulators, and
policymakers have begun to ask whether there are lessons to be learned from the principles of
Islamic finance which might help avoid future crises.
Recent events have certainly created a great opportunity for the Islamic financial industry. At
the same time, however, there is no room for complacency and if the industry is to make the
most of the opportunity that has now arisen it will need to ensure that the lessons of the crisis
are fully learned.
Some of these lessons are quite general and apply equally to conventional and to Islamic
finance. Central bankers and regulators have learned that they must pay more attention to
risks that are common throughout an entire sector of the industry. These risks might not be
immediately apparent from reviewing the balance sheet or financial statements of an
individual institution.
An example of such a risk is when all banks assume that they can exit their speculative
positions at the same time. This requires them to assume that financial markets will always
remain as liquid as they are in normal times. But if every financial institution is operating on
the same assumption, then the point at which everyone tries to rush to the exit will be the
point at which financial markets cease to function. There will be only sellers and no buyers.
This is what happened in conventional finance when banks invested in structured financial
instruments like CDOs and CLOs which they then found they couldn't sell at any price.
Now some people might believe that because Islamic financial institutions cannot invest in
CDOs and CLOs, they must be immune to this problem. But think about the exposure of
many Islamic banks to the real estate market. It might be a reasonable assumption for an
individual institution that it could exit profitably a property development that it is funding. But
when many other institutions are making similar assumptions about the projects they are
funding, the industry as a whole may find it difficult to exit its investments without substantial
losses or within a reasonable time-frame.
A further lesson of the crisis is specific to the work of the accounting standard setters and
thus to AAOIFI. This lesson relates to the importance of disclosure and transparency. Good
disclosures ensure that risks can be clearly identified and that market counterparties are able
to form a considered view of the value of financial instruments and investments.
The financial crisis involved multiple failures of disclosure and transparency. For example,
conventional banks moved assets to Structured Investment Vehicles (SIVs) or "conduits"
which did not form part of their normal financial reporting or disclosures. Because these
entities were regarded as off-balance sheet they were opaque both to regulators and to the
counterparties of the banks that sponsored them.
Similarly, as we now know, the risk disclosures of various structured financial instruments
were inadequate to permit purchasers of those instruments to perform a proper assessment
of the risk/reward trade-off. Many investors purchased assets which they believed to have a
very different risk profile than turned out to be the case.
Again, there are parallels with Islamic finance. The use of off-balance sheet special purpose
vehicles has been a feature of the financing model of many Islamic banks. We need to
consider whether this gives rise to the same problem of a lack of transparency that arose
with off-balance sheet SIVs. Similarly, accounting standards for Islamic finance need to keep
pace with financial innovation. There is a lesson in the failure of the accounting of
conventional instruments to keep pace with industry developments.
As the G20 leaders recognised in their recent summit meeting, enhanced accounting and
disclosure standards must be a key component of the response to the financial crisis. They
have commissioned the international standard setting bodies, such as the International
Financial Standards Board (IFSB) and from the US Financial Accounting Standards Board
(FASB), to review the lessons of the crisis and to amend their accounting and disclosure
frameworks accordingly. AAOIFI will have important work to do in ensuring that the
framework of transparency and disclosure of Islamic financial institutions will match the
enhanced standards that are likely to be forthcoming for conventional finance. I encourage
AAOIFI to follow these developments closely and to work on producing revised and new
accounting standards to match changes in the field of conventional finance.
The changes that are likely to result from the global financial crisis, including in the
accounting and auditing profession, will provide the background to the professional careers
of the students whose success we have gathered to recognise today.
I would like to offer my congratulations to these students who have successfully completed
the "Certified Shari'a Adviser and Auditor", and "Certified Islamic Professional Accountant"
programmes. Both are challenging courses of study. To complete them successfully has
required hard work and commitment. It is an achievement to be proud of, and one that I am
sure will serve you in good stead as you further develop your professional careers.
Let me conclude by wishing the graduating students all the best in their future careers, and to
wish all the participants in this Conference a very rewarding and stimulating two days.