Zeti Akhtar Aziz: Ensuring stability in the Islamic financial system
Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the 3rd Annual Islamic
Finance Summit, London, 13 January 2004.
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I. Introduction
"In its nascent history spanning three decades, Islamic banking and finance has undergone rapid
growth and transformation. From an industry striving to fulfil the religious obligations of the Muslim
community, it is now a multi-billion dollar industry driven by well-defined business considerations and
profit optimisation, whilst steadfastly upholding the Islamic principles. Indeed, this progress has been
achieved against a challenging global financial and economic environment. The further development
of Islamic finance requires for it to be endowed with the right pre-requisites that will ensure the
evolution of an intermediation system that is viable, resilient and sustainable. Of essence, is the
timeliness to develop an Islamic financial industry that is comprehensive and sound, that promotes
financial stability and growth through the robustness of its regulatory framework, the dynamism of its
inter-connected markets, the strength of its financial infrastructure and the responsiveness and
sophistication of its products and services."
It is my honour to be invited to speak before this distinguished audience at this 3rd Annual Islamic
Finance Summit organized by Euromoney. In the development of the Islamic financial system,
significant attention has been given to ensuring financial stability. Several initiatives have been taken
to promote financial stability in the Islamic financial system and thereby strengthen its foundations. My
address this morning will focus on these initiatives. Allow me to also take this opportunity to share with
you Malaysia's experience in this endeavor.
II. Current trends in the international financial landscape
The international financial landscape is constantly being reshaped and transformed by the rapid pace
of globalisation, financial liberalisation and the advances in technology. Globalisation has manifested
itself with the geographic expansion and consolidation of financial establishments beyond national
boundaries and the massive flow of financial resources across borders. This has unleashed a greater
volume of resources through the financial system, increasing the importance of the financial sector.
These trends have been reinforced by the advances in technology, which has radically changed the
way we do business and the structure of markets and their dynamics in the national and global
economy. This has resulted in an environment in which businesses, markets and economies are
becoming internationally more integrated and inter-dependent.
Financial liberalisation and deregulation of the financial services industry has also resulted in
increased competition and the proliferation of new financial products and services. Also, the business
operations of global financial conglomerates now span over multiple jurisdictions. Against these
developments, regulators have reassessed existing prudential rules and have adopted a consolidated
supervision framework to prevent regulatory gaps that could become a source of systemic concern.
While deregulation of the financial sector has expanded the range of opportunities, it has also
increased the incidence of instability in the financial markets. Heightened uncertainties and greater
volatility in financial markets have required greater attention on building more robust risk management
capabilities. Greater investments have gone towards refining risk quantification techniques to enhance
the overall risk management framework. There is also greater emphasis on risk management in the
new international regulations such as in the Basel II capital framework. Maintaining relevant financial
data and information has also become more important, and has resulted in large investments to
enhance data mining and IT capability.
While the global financial markets have become increasingly sophisticated, unstable market conditions
and the failure of large financial institutions have prompted more stringent regulatory requirements and
increased transparency. The message is that integrity and transparency is critical for financial
institutions to gain public and investor confidence. In response to a number of high-profile corporate
failures, there has also been a review of international accounting standards and practices to address
inadequacies in the existing standards. In some countries, independent oversight committees/public
boards have been formed to establish auditing standards and to impose new rules on auditing quality
control and auditor independence. The trend is, therefore, towards improving the value of financial
reporting and increasing the overall level of transparency.
The 1997 Asian financial crisis also resulted in a reexamination of policies and practices. This has
prompted extensive financial restructuring and reform to strengthen domestic financial systems. Five
years after the crisis, the financial systems in East Asia have emerged significantly strengthened and
demonstrated greater resilience.
III. Pre-requisites to a stable Islamic financial system
Despite a more challenging environment, the development of Islamic finance as a viable form of
financial intermediation has moved forward. It is while Islamic finance is still at its early stage of
development that the opportunity has been taken to strengthen its foundations and put in place the
pre-requisites that will pave the way for its development and safeguard the stability of the system.
Not only has closer attention been given to the supervisory, regulatory and legal dimension but also to
the development of the financial infrastructure and the markets as well to institutional development. In
essence, the prudential regulatory design has been complemented by concurrent efforts to develop
Islamic financial markets, the Islamic institutions and the financial instruments. Allow me to highlight
the key areas that are important to this objective.
First, effective regulatory and supervisory framework
The hallmark of a well-developed financial infrastructure is an effective legal, regulatory and
supervisory framework which would underpin the stability of the financial system. The regulatory and
supervisory function is an indispensable and vital component of the financial infrastructure. For the
Islamic financial system, this framework also needs to be consistent with the requirements of the
Shariah principles, including the establishment of a Shariah council, which provide assurance that the
strategic direction, the formulation of policies and the conduct of financial transactions are in
compliance with the Shariah principles. This would need to be supported by an efficient court system
that can effectively deal with all Islamic banking and finance cases, whose decisions are enforceable
over the range of financial issues such as contracts, bankruptcy, collateral and loan recovery all of
which are essential for businesses to operate. The legal framework should also deal with supervisory
issues, including the relevant regulatory agencies involved in the supervision of Islamic financial
institutions and encompass the licensing and conduct of Islamic banking business. The relevant
agencies should have clear responsibilities and objectives to ensure effective financial supervision.
While the conventional banking system is guided by the Basel core principles which outlines the
minimum requirements for the supervisory regime, these principles need to be reviewed from the
perspective of Islamic banking, taking into account the unique characteristics and risks involved in
Islamic banking and its products and services.
A fundamental issue is the setting of prudent and appropriate minimum capital adequacy requirements
for Islamic banks. Such requirements need to reflect the risks that the banks undertake. The
framework devised would need to incorporate fundamental Islamic concepts. The principle of
Mudharabah, for example, creates a class of depositors that can also be construed as
quasi-shareholders. Similarly, risk weights assigned to individual asset components need to reflect the
nature of inherent risks involved. It is not as straightforward as a debtor-creditor relationship in
conventional banking but also needs to include other inherent risks arising from the
investor-entrepreneur relationship that is inherent in Islamic banking.
Islamic banking operations therefore need to be governed by its own standards and best practices in
parallel with the international best practice. The establishment of the Islamic Financial Services Board
(IFSB) in 2002 as an international prudential standard-setting body to promulgate the international
regulatory and supervisory standards for Islamic financial institutions is aimed towards achieving this
objective. In this regard, the IFSB has already made progress in developing the prudential standards
on the capital adequacy and risk management framework. These standards are expected to be
completed in 2005. In addition, the IFSB will commence work on developing standards on corporate
governance.
At present, some countries have adopted the Basle Accord standards in their regulatory and
supervisory framework for their Islamic banking industry. However, these standards do not adequately
address the requirements of Islamic banking operations and transactions, resulting in gaps in the
standards. Therefore, these gaps will be taken into account with respect to the capital treatment and
risk associated for the different types of Islamic financial contracts to truly reflect their features and
characteristics.
While certain products in Islamic finance by their nature may not attract capital, the Islamic financial
institutions need to have a more rigorous risk management systems in managing the funds placed
under this arrangement. In this regard, the risk management standard needs to specifically address
this concern. The Islamic financial institutions can expect to be better regulated and supervised
following the adoption of the standards to be issued by the IFSB. The IFSB will also have a prominent
role in facilitating the streamlining of the standards covering the cross-border supervision issues
including the home-host supervisor issue.
Since its establishment just over a year ago, the IFSB has attracted a wide participation. To-date,
there are 13 full members, 3 associate members and 20 observers in the IFSB. This encouraging
development demonstrates the keen interest towards the orderly and sound development of Islamic
banking and finance. The wider participation which also includes several international and regional
multi-lateral agencies will facilitate the consultation process and the adoption of these standards.
Another important role to be played by IFSB is in the harmonization of the different Shariah
interpretations towards a more universally accepted practice. These positive developments are
expected to bring about a more robust regulatory and supervisory framework for the Islamic financial
institutions to promote financial stability in the system.
Second, existence of strong corporate governance
It is also recognised that good corporate governance reinforces sound regulation and supervision. It
contributes towards maintaining market confidence, and strengthening transparency and
accountability. Its emphasis is to be value-oriented and promote fairness and justice with respect to all
stakeholders of the banking institution. For corporate governance to work, good corporate practices
need to be instilled and embedded in all aspects of the operations and at all levels within the
organisation.
Indeed, Islam strongly advocates all forms of positive governance. These values and ethical conduct
have already been in built and are inherent in the community. Islamic corporate governance serves
through its underlying principles of economic well-being of the Ummah, universal brotherhood, justice,
accountabilities and equitable distribution of income. Therefore, while the virtues of Islam have always
advocated good corporate governance, the challenge to us lies in its application. For Islamic banking
institutions, good corporate governance should have already been embedded in all aspects of their
operations.
Closely linked to the corporate governance issue is the role of market discipline. Central to the
effectiveness of the corporate governance arrangements is the empowerment of shareholders. This
would mean providing the conditions under which shareholders have both the incentive and the
means to act to discipline Management. The market for corporate control is an important way in which
shareholders exercise, in effect, an ultimate discipline over bank Management on the premise of
allocating capital where sound management is practised.
Third, greater transparency and disclosure of information
Transparency and disclosure is essential particularly in a rapidly changing environment. While the
comprehensive and timely availability of financial information will increase market discipline, the
disclosure of information needs to be complemented with the ability of the market players to analyse,
and appropriately interpret the information.
Closely related to this issue is the need to strengthen the framework for consumer protection to
provide an avenue for redress due to lack of transparency. This is even more relevant in the
multi-facet role played by the Islamic financial institutions in dealing with Islamic banking customers as
the Islamic financial transaction is not merely based on the lender and borrower relationship as is the
case in conventional banking. The move towards the adoption of the supervised market approach
requires continuous efforts to enhance product disclosures and to elevate the level of financial literacy
of consumers.
To further enhance transparency in the conduct of banking institutions, proper accounting standards
need to be in place to reflect the true and fair value of banking operations that would lead to greater
accountability and responsibility on the part of the banking institution. Accurate financial reporting
requires a body of financial accountants that are well-versed in Shariah principles to ensure that the
accounts are not only drawn in accordance with the international accounting standards but are also in
line with Islamic principles. This is to enable the investors and supervisors to obtain the true and fair
assessment of the Islamic institution's financial condition and the profitability of the business.
Transparency and disclosure is even more crucial in Islamic banking where the concept of
mudharabah (profit-sharing) entails an investor-entrepreneur relationship and is a significant element
in sourcing of funds.
The establishment of the Accounting and Auditing Organisation for Islamic Financial Institutions
(AAOIFI) has made a significant contribution in formulating and issuing accounting and auditing
standards for Islamic financial institutions. The standards issued by AAOIFI have contributed towards
improved quality of financial statements and reporting methodology of Islamic financial institutions.
AAOIFI has also issued standards on the role of the Shariah committee as well as the code of ethics
that should govern the accountants and auditors of Islamic financial institutions. Efforts by AAOIFI
have also accelerated the pace of transparency and corporate governance of Islamic financial
institutions.
Fourth, risk management framework
Emphasis on improved corporate governance goes hand in hand with the need for improvements in
risk management standards. Sound risk management practices will minimise adverse consequences
faced by financial institutions during periods of uncertainty. Robust internal controls to provide
qualitative standards are also necessary to complement the quantitative analysis of risk to provide a
check and balance in the overall risk management practices.
Effective risk management systems is central to supervisory efforts. The risk management system in
Islamic institutions need to be able to address the unique characteristics and attributes associated with
Islamic financing operations involving financial contracts and instruments which may give rise to other
risks besides credit risk. The risk management infrastructure needs to be in place to facilitate the
identification, measurement, monitoring and control of all inherent risks present in all the various types
of financing so that the specific risks involved may be 'unbundled'. The complexities of the respective
risks in the Islamic financial instruments therefore need to be fully explored and quantified to provide
for their effective assessment and management.
In the area of Islamic banking, the requirement to manage the risks becomes more important because
of the unique peculiarities in the contracts. Basel II has, to a certain extent, incorporated some aspects
in the identification of risks, in particular the credit, market and operational risks that can be
assimilated by the Islamic banks in terms of its product offering. However, further refinement will have
to be done by the Islamic financial specialists to assess the appropriateness of the capital definition in
particular as outlined by the Basel committee. One of the considerations that need to be addressed in
assessing the risks associated with the Islamic bank is with regard to the capital charge on its
investment accounts. Basel II does not address this unique feature in its framework. Assets that are
funded by monies in the investment account may not require the capital charge for the purpose of
capital adequacy measurement except in the case of misconduct and negligence. Similarly, if the
Islamic banking institutions were to be more engaged in the profit-sharing arrangement in its
balance-sheets, it will require the Islamic bank to have a more rigorous risk management assessment
and monitoring mechanism. This is an area that is being addressed by the Islamic Financial Services
Board in the drafting of the standard on the overall risk management framework for the Islamic
financial community that takes into account this unique requirement of Islamic banking.
While risk mitigation is desirable in Islamic finance, further improvements need to be made to the
existing risk management framework. New hedging products which are scarce in the market need to
be developed in the quest to seek for compatible risk mitigating products. In accordance with the
principles Islamic the Shariah has allowed the Ummah to undertake juristic reasoning based on
contemporary analysis and logical inference. Indeed, the development of new hedging products is
something that the Islamic financial community can look forward to. In conventional banking, these
instruments are used to mitigate risk. Indeed the Islamic financial community will soon develop such
products for this purpose.
Fifth, effective and dynamic Shariah framework
One of the central issues towards developing a dynamic Islamic financial industry is the Shariah. The
Shariah should always be viewed as an enabler to innovation and creativity, rather than a constraint.
Efforts, therefore, need to be enhanced to fully appreciate and maximise the true potential and wisdom
of the Shariah. The collaboration among the Shariah scholars, practitioners, researchers and
regulators to undertake in-depth studies and research to create new products will provide the
fundamental foundation towards the development of a dynamic Islamic financial system.
Sixth, development of comprehensive legal infrastructure
Another important pre-condition to sustain the continued growth of Islamic banking and finance is a
comprehensive legal infrastructure for legal redress arising from Islamic financial transactions. The
legal infrastructure needs to comprise both effective regulatory and substantive laws as weIl as
appropriate adjudicative fora for parties to resolve disputes relating to Islamic financial transactions. To
address this, efforts are needed to develop a sufficient number of competent lawyers and judges that
are equipped with sound knowledge and expertise in both Shariah and civil laws to deal with such
matters.
Seventh, development of vibrant Islamic financial markets
In the more developed financial centers, the development of inter-related financial markets has
contributed towards the stability in the financial system. This is an area of priority for the Islamic
financial industry. In this regard, the development of a comprehensive Islamic financial system
including the various components of the financial markets would meet the requirements of the various
differentiated groups. The challenge in the Islamic banking industry is, therefore, to steer the
development of an Islamic financial system towards one which is more dynamic and responsive. The
development of an Islamic financial system should include the key components comprising the Islamic
money market and the Islamic equity and debt capital market, given the strong linkages,
inter-dependence and synergies among these components in the system. Of importance is the Islamic
money market to act as a platform to provide a ready source of short-term funding and investment.
Financial instruments and interbank investment will allow surplus banks to channel funds to the deficit
banks, thereby maintaining the funding mechanism necessary to promote stability in the system. The
Islamic money market will also facilitate the conduct of monetary policy.
The Islamic financial system also needs to include the capital market to provide an alternative source
of financing, as well as to create broader and more diverse Islamic financial instruments for investors.
The equity and bond markets will provide a more balanced allocation of financial and economic
resources. This would result in a more efficient distribution of risks within the system, thus creating
stability in the system. The equity and bond markets would also provide an avenue for raising
long-term capital. With a wider spectrum of instruments in the market, fund managers would be able to
manage their portfolios better and spread their risk according to their desired risk tolerance, thereby
contributing toward greater stability.
Complementing these financial markets is the development of non-bank Islamic financial institutions.
Takaful, or Islamic insurance, provides the risk protection to its policyholders and serves as an
important mobiliser of long-term funds. In addition, development financial institutions, savings
institutions and housing credit institutions need to be developed to meet the diversified customer
demands. These specialised institutions will meet the different requirements of the economy.
IV. Malaysia's experience in the development and management of the Islamic finance
The strategy adopted by Malaysia has been to develop a comprehensive Islamic financial system.
Malaysia started with the establishment of one Islamic bank to spearhead the introduction of Islamic
banking products and services, and at the same time, identified the relevant financial segments that
were required to support the expansion of Islamic banking activities. The Islamic financial system in
Malaysia operates in parallel with the conventional system.
Following the establishment of Islamic banking was the establishment of takaful or Islamic insurance
to provide the coverage for Islamic housing mortgages. As these two segments progressed, Malaysia
expanded its implementation approach by allowing the conventional banking institutions to offer
Islamic banking products and services on a window basis. To preserve the integrity of the system,
firewalls between the conventional and Islamic funds were put in place. It was made mandatory for the
Islamic banking operations in these institutions to be separated from the conventional banking
operations, either electronically or through other designated means. This move created more players
in the Islamic financial system and provided the platform for the establishment of a vibrant Islamic
money market. The Islamic money market served as a platform for the Islamic financial institutions to
manage their short-term portfolio adjustments. Recognising the importance of the capital market,
Malaysia initiated the development of a private Islamic financial securities market in the early nineties.
The Islamic financial system today has emerged as an important component of the overall Malaysian
financial system that contributes to the growth and development of the Malaysian economy.
Malaysia has also adopted legal reform, self-regulation and measures to encourage market-based
regulation. New measures have been introduced to further improve the level of governance among
banking institutions. This includes reviewing the responsibility and accountability of the Board and
Management as well as requiring for the setting up of various Board committees. In the case of
Malaysia, the High Court of Malaysia has dedicated high court judges to preside on litigated cases
over matters relating to Islamic banking and finance. To undertake a holistic legal review, the Central
Bank of Malaysia has set up a Law Review Committee to review the common law-based domestic
legislations to assimilate the Shariah principles with the aim of removing any impediments to ensure
the unhindered and efficient functioning of the Islamic banking and financial system. The Central Bank
Act has also been amended to provide for the establishment of a Shariah Advisory Council at the
Central Bank as the sole authority and reference on all Shariah matters pertaining to Islamic banking
and finance.
The successful integration of these core components to become a comprehensive Islamic financial
system has contributed towards a more active domestic Islamic financial intermediation process.
To-date, Islamic banking has mobilised assets amounting to RM76 billion or 10 percent of the market
size, of which approximately 70 percent of the Islamic banking assets were generated by the
conventional banks with Islamic windows. In the takaful sector, the four takaful operators registered a
total of RM4 billion in terms of assets. Significant progress was achieved in the area of Islamic money
and capital market where the volume traded in the Islamic money market reached RM340 billion, while
the outstanding amount of Islamic private securities was amounted to RM75 billion or 44 percent of the
total outstanding private securities. In the stock market, more than 80 percent of the counters in the
Kuala Lumpur Stock Exchange are Shariah-permissible counters. This year the Islamic banking sector
will be liberalised to include up to three foreign Islamic banking institutions as the system becomes
more integrated with the global financial system.
V. Positioning the Central Bank to meet the challenges ahead
My remarks on pre-requisites to a stable and comprehensive financial system would not be complete
without a few words on the role of the central bank. To stay at the forefront in dealing with the new
challenges and to effectively perform our responsibilities, the Central Bank's efforts have also been
focused on strengthening its capacities and capabilities.
Central Banks in emerging market economies have a much broader mandate than our counterparts in
the more advanced and mature economies. Of importance, is our developmental role in charting the
development of the financial system, institutional development and the overall economic management.
This is over and above the objectives of achieving monetary and financial stability and ensuring the
sound and efficient functioning of the payments system. The Central Bank also has the important role
of developing the financial infrastructure, developing the financial markets, the legal framework and
driving the institutional development. In Malaysia, our vision of the development of the financial sector
over the next ten years is outlined in our Financial Sector Masterplan. The plan includes the strategic
direction and strategies for the development of the Islamic financial sector.
Finally, greater cooperation among the regulators is necessary in order to ensure that the Islamic
financial system is not subject to vulnerabilities and abuses. In this respect, sharing of information
among the regulators including across borders is important especially in a more globalised and
liberalised environment where financial transactions and activities have become more complex and
globalised. In this regard, there is a greater need for regulators to continuously exchange views and
share information on key issues and developments faced in their own financial jurisdictions.
Another important aspect is in regard to the development of the international Islamic financial market.
Although this market is to be driven by the market players, a greater role is expected from the
regulators and central banks to support its expansion. In this respect, the encouraging support shown
by various regulators and central banks in making the launching and issuance of the sovereign sukuk
papers a success represents an important progress that has been achieved. These initiatives will bring
about a more coordinated effort in achieving market development and stability.
VI. Conclusion
Our quest to develop a dynamic Islamic financial system is to achieve the ultimate objective for Islamic
finance that contributes significantly toward the overall development of our economies. This is
achieved through the intermediation process to facilitate trade, business and investment. This will
facilitate the integration of the Islamic financial system as a viable component of the global financial
system.
It is the ability of the Islamic financial industry to build institutional capacity, intensify the collaborative
efforts to strengthen the effectiveness of the Islamic financial infrastructure, and the acceleration of its
global integration that will provide the synergies and opportunities for the Islamic financial industry to
evolve into an important component of the international financial system that can contribute to greater
global financial stability and enhance the prospects for a more balanced global growth.