Zeti Akhtar Aziz: The changing landscape of financial
regulation - implications for Islamic finance
Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the
7th Independence Federal Savings Bank (IFSB) summit on Global Financial Architecture,
Manama, 4 May 2010.
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It is my pleasure to be here on the occasion of the 7th IFSB Summit on Global Financial
Architecture: Challenges for Islamic finance. I am honoured to be invited to speak on the
ongoing regulatory and supervisory reforms being undertaken following the recent
international financial crisis, focusing on its implications for Islamic finance particularly in the
context of strengthening the financial stability of the Islamic financial system.
It was exactly 10 years ago in a speech here in Bahrain when I reflected on then the
remarkable achievements of Islamic banking and highlighted that while the amount of funds
managed in the Islamic financial system was only a fraction of the total assets of the
international financial system, it represented that portion of financial activities that was truly
supported by underlying productive capacity that generated growth of economies across
continents, and that, it was this form of financial activities that we should encourage, as
opposed to the financial flows that were destabilising and destructive.
Today, it is precisely this element in Islamic finance amongst others, that are highly relevant
to the discussions on the reform of the national and international financial system so that we
have a system of financial intermediation that is stable, sustainable and contributes to global
growth. In ten years now Islamic finance has experienced accelerated growth and the
financial landscape has undergone a major transformation with great progress achieved on
many fronts. The transformation is particularly evident in three dimensions, firstly, Islamic
finance has evolved into a complete and competitive form of financial intermediation,
effectively serving consumers and businesses, both Muslims and non-Muslims. Islamic
finance has become a competitive form of intermediation with several established
conventional players now entering the Islamic finance industry, resulting in more diverse
Islamic financial institutions with wide spectrum of product range.
Secondly, this recent decade has also seen significant milestones being achieved in the area
of the international Islamic financial infrastructure of Islamic finance since the establishment
of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in
1990. In 2002, the Islamic Financial Services Board (IFSB) was established as an
international prudential standard setting body for Islamic finance. The IFSB with a
membership of now 50 regulatory authorities has since developed a number of standards
ranging from capital adequacy requirements to standards for governance and risk
management, taking into account the specificities of Islamic finance. There have also been
notable achievements in the area of talent development with the proliferation of programmes
and certifications which have focussed on Islamic finance offered by several major
institutions of higher learning, professional entities, training agencies and industry groups
around the world. More recently, platforms for greater engagement among practitioners,
scholars and regulators have further added to international collaboration in Islamic finance.
And finally, the evolution of Islamic finance in this decade has been marked by its
international dimension in which it is becoming an increasingly important part of the global
financial landscape. The development of Islamic finance in emerging economies also reflects
the changing global pattern of financial and economic integration. This is taking place with
the strengthening of financial and economic linkages between Asia and the Middle East and
the increased activity of Islamic finance beyond the traditional Muslim countries including the
more established financial centres. Cross-border transactions are growing as more issuers
consider Islamic finance as an attractive alternative means for raising capital, whilst investors
are also increasingly considering it as a new asset class in their investment universe. This
internationalisation and sustained global expansion of Islamic finance has taken place
despite the more challenging environment presented by the global financial crisis,
demonstrating the resilience of Islamic finance as a stable form of financial intermediation.
Global financial regulatory reforms
Ladies and gentlemen,
Much has been said and written about the causes of the global financial crisis. Efforts are
now underway to address many of the shortcomings in the financial infrastructure that have
contributed to the crisis. With the worst of the crisis now seemingly over, attention has turned
to strengthening the global financial system. There is now an even greater need to restore
confidence in the integrity of the global financial system given the loss of trust between
society and the financial sector particularly in advanced economies . At the core of this
reform agenda is the development of a new financial regulatory framework that would be
more effective, one that is premised on greater emphasis on ethics, fairness, and
accountability and that promotes global economic, social and environmental sustainability. It
also needs to be anchored on a sensible balance of supporting growth while maintaining
financial stability , and one founded on greater international coordination of regulatory
approaches and supervisory oversight with a crisis management framework that will reduce
systemic risk, and the severity of any such future financial crises.
Given the scale and magnitude of this recent crisis, the global regulatory reform being
shaped is wide-ranging. Bold measures are being developed in various international forums
with fundamental changes to the current approaches to financial regulatory and supervisory
oversight. Some of these reform proposals have attracted intense international debate
generating divergent views on these issues. A broad consensus however is emerging on the
need to raise both the quantity and quality of regulatory capital, strengthen liquidity rules and
improve market transparency. There also seems to be agreement for the extension of
regulatory tools to address pro-cyclicality in the financial system through the creation of
counter-cyclical capital buffers, dynamic loan-loss provisioning and greater alignment of
incentives with long-term goals. This consensus reflects the objective of avoiding having
incentives that would encourage the material build-up of leverage and the excessive appetite
for risk. Other measures under consideration include the implementation of non-risk-based
leverage limits to contain the build-up of leverage in the banking sector and the strengthening
of the supervisory framework and the arrangements for dealing with oversight on
crossborder financial groups and for resolution.
Implications for Islamic finance
Islamic finance does not exist in isolation and as it becomes an increasingly important
component of the global financial system, it will inevitably be impacted by the changing
global landscape of financial regulation. This is particularly the case as its growth gains
momentum both in terms of number of services providers and in terms of business volume
and as its internationalisation process continues. The global call for improved regulation and
increased oversight will thus intensify the efforts that have already been undertaken to
strengthen the financial regulation for Islamic finance.
Let me now focus my remarks on four major implications of the changing global financial
regulatory landscape for Islamic finance - first, particularly in financial systems in which
Islamic finance is being developed alongside the conventional financial sector in a dual
system environment, (which is the case for most IFSB member countries), there will be a
need to ensure that the reforms are undertaken in parallel. The concern is that there would
be insufficient attention given for Islamic finance and consequently, the tendency for broad-
brush application of regulatory measures intended for conventional finance on Islamic
finance.
In developing the appropriate regulatory framework for Islamic finance, it is not uncommon to
leverage on the established wisdoms of prudential regulation for conventional finance to
achieve regulatory efficiency particularly in a dual system environment. Whilst it may be
envisaged that it is not necessary to reinvent the wheel, it should not override the importance
of addressing the specificities of Islamic finance where necessary. Such a prudential
regulatory design that takes into account the unique mix of risks associated with
Shariahcompliant instruments would enhance the effectiveness of the regulatory outcomes intended
for Islamic finance. Although there is already a broad international consensus on the
prudential areas that need to be enhanced, different regulatory parameters may be
necessary to address the specific risks and unique characteristics of Islamic finance. The
Islamic financial community thus needs to effectively respond to this, by strengthening their
internal capability to make sound assessments on the need for making similar regulatory
reforms that are specifically attuned for Islamic finance to achieve the common objective of
financial stability.
With this in mind, I am pleased to inform you that following the recent completion of the work
by the Task Force on Islamic Finance and Global Financial Stability, that was jointly formed
by the Islamic Development Bank (IDB) and the IFSB in 2009, the Report has now been
released following the endorsement by the IFSB Council in Khartoum, Sudan, in April this
year. The Report examines the conceptual elements inherent in Islamic finance that form the
foundation of its strengths and contribution towards financial stability. The Report also
provides a preliminary assessment on the performance of Islamic finance during this recent
international financial crisis. The final part of the Report outlines eight key recommendations
to further strengthen the foundations of the Islamic financial system in a more challenging
global environment. Although the Islamic financial services industry has generally performed
well in the face of the recent global financial turbulence, there are clear lessons to be learnt
from the crisis. The recommendations were therefore developed upon careful reflection on
the conditions and financial practices that have contributed to the global crisis, as well as the
current direction of the global regulatory reform.
A central theme of the recommendations in the Report is the need for greater collective
efforts to be given to putting in place eight building blocks for strengthening the financial
infrastructure of Islamic finance and its institutional capacity both at the national and
international levels. The building blocks identified in the Report relate firstly to the global
implementation of the IFSB prudential standards; second, the development of systemic
liquidity management infrastructure; third, the establishment of strong financial safety nets;
fourth, putting in place an effective crisis management and resolution framework; fifth,
strengthening the accounting, auditing and disclosure standards; sixth, the development of
an effective macro-prudential surveillance framework; seventh, having in place credible
rating institutions; and eighth, to institute close international cooperation and coordination
among countries in achieving financial stability. This also includes cooperation in the area of
capacity building and talent development. Addressing these eight areas are highlighted in the
Report as being fundamental to ensuring the continued development of a robust and resilient
Islamic financial system, that can effectively preserve financial stability and contribute to
growth and development.
This brings me to the second implication of the changing financial regulatory landscape in
respect of preserving financial stability and the broader agenda of effective and efficient
financial intermediation, taking into consideration the unique considerations in Islamic
finance.
Ladies and gentlemen,
A sustained process of excessive financial deregulation and over reliance on market
discipline particularly in advanced economies which led to a prolonged cycle of optimism and
risk taking has been widely cited as part of the root cause of the recent global financial crisis.
Indeed, the pre-crisis era was a period of exuberance in financial innovation and rapid
development in the conventional financial landscape. Although it was argued that financial
deregulation encourages innovation which in turn result in the more efficient allocation of
resources, the recent crisis has shown that there is a need to balance between market
discipline and regulatory oversight.
Whilst there is general support for the reform measures, there is also concern on the dangers
of over-reaction by policymakers that could undermine the role of financial intermediation,
and adversely affect the ultimate objective of economic growth and development. The
concern is specifically on the unintended consequences of the regulatory reform. Financial
stability is not an end in itself; it is a means towards achieving the ultimate goal of
sustainable growth and shared prosperity. This presents the challenge for policymakers in
finding the appropriate balance between preserving the resilience of the financial system
versus maintaining the ability of the system to perform their intended function of delivering
effective, efficient and innovative financing solutions to customers in the wider economy.
Hence, the concern is that that the regulatory reforms would increase the cost of financial
intermediation. A careful assessment needs to be made of the potential medium and
longterm effects of the proposed reforms on market structures and behaviour. These
considerations are equally relevant in the context of Islamic finance.
The assessment on the aims and relevance of each of the proposed reform measures needs
to take into account the two important considerations in Islamic finance; the need to support
sustainable and responsible innovation, and secondly, to leverage on its inbuilt strengths that
set Islamic finance apart in performing its role in supporting the efficient mobilisation and
allocation of resources to generate real economic activities. Given the damaging effects of
complexity and opacity associated with the recent unfettered innovative activities in the
conventional financial markets, it has resulted in a reassessment of the role and benefits of
financial innovation. In Islamic finance, innovation is key in pushing the frontier of market
development to generate the range of products and services, processes and functions. The
key lies in preserving the benefits of innovative initiatives and activities whilst ensuring that
they do not result in negative externalities.
In considering the relevance of the global regulatory reform to Islamic finance, there is
therefore a need to consider the underlying elements that guide the process towards
sustainable and more socially-responsible financial innovation. This comes in the forms of its
strong paradigm in governance, disclosure and transparency, as well as its emphasis that
innovations are anchored in the objectives of Shariah and thus are for the benefit of the
people. Importantly, Islamic finance has the disposition to facilitate financial deepening
without financial excesses through the fundamental Shariah requirement for Islamic financial
transactions to be supported by an underlying economic activity. Moreover, the profit-sharing
and risk-sharing characteristics of Islamic financial transactions strengthens the incentives
for Islamic financial institutions to undertake the appropriate due diligence on the Islamic
financial transactions to ensure that the profits are commensurate with the risks assumed. T
he Shariah board of Islamic financial institutions additionally serve as a vital institutional
safeguard to ensure that the inherent strengths of Islamic finance are fully realised. This
accommodates innovative activities in a manner that achieves the objectives of protecting
customers and the system on an ongoing basis. Islamic finance is essentially also consistent
with the "equator principles", the voluntary guidelines governing social and environmental risk
in project finance which are increasingly growing in prominence in this post-crisis era as an
integrated approach to sustainable and more responsible banking and finance.
Ladies and gentlemen,
The third implication relates to the mobilisation of stronger international cooperation in the
pursuit to preserve global financial stability, particularly in the light of an enhanced
internationalisation of Islamic finance. This post-crisis era will usher in a new chapter in the
development phase of Islamic finance. The trend of internationalisation can be expected to
be more pronounced. As Islamic finance facilitates greater financial and economic
interlinkages between jurisdictions, this enhanced international dimension will bring about a
new set of challenges presented by the fundamentally different operating environment of
heightened competitive dynamics, greater uncertainty, and more complexity. This will require
greater collaboration and cooperation at the global level in the endeavour to preserve global
financial stability.
The recent crisis has highlighted that financial integration across borders needs to be
accompanied by international cooperation and coordination to prevent regulatory arbitrage
across borders and the risk of implications for contagion. A stronger collective effort needs to
ensure that Islamic finance is subject to consistent, high-quality regulation across borders
through the application and enforcement of the international prudential standards
promulgated by the IFSB. This would reduce the opportunities for regulatory arbitrage, which
in turn, will contribute to a more successful international integration of Islamic finance.
Beyond the prudential standards, a higher level of cross-border vigilance is pivotal to allow
for appropriate and decisive actions to be taken pre-emptively to deal with any imminent
financial distress. This underscores the importance of adequate coordination and
cooperation among supervisors across borders in strengthening their responsiveness to risks
associated with markets interconnectedness. In particular, more transparency is essential
towards understanding the ramifications of national actions or inaction and the potential
spillover effects from one country to another, whilst equally important is to recognize that
financial regulation and intervention are subject to country-specific circumstances and hence,
must fall within remit of national autonomy. Regular information exchange and better
coordinated oversight among supervisors to address home-host issues of
internationallyactive institutions, and to identify emerging systemic risks, are thus recognised to be the
important focus of effective cross-border surveillance and crisis management.
Recognising the need to mobilise stronger international cooperation in the pursuit to preserve
financial stability in an increasingly global operating environment, the Islamic Financial
Stability Forum (IFSF) was recently established based on the recommendation of the Task
Force of Islamic Finance and Global Financial Stability. The IFSF is to serve as a strategic
platform for the regulators to deliberate common issues and to collaborate endeavours in
achieving financial stability in the Islamic financial system. This represents yet another
milestone in the development of the institutional infrastructure for Islamic finance,
complementing the important roles and functions of the IDB, the IFSB and the AAOIFI.
As Islamic finance becomes a growing component of the international financial system, it will
become important for the ongoing global engagement by the international community that is
driving the financial reform agenda to be extended to the perspectives of financial stability in
the Islamic financial system. The IFSF would be able to facilitate the process of greater
interface between regulators of conventional and Islamic finance to take place given the
common goal of preserving global financial stability.
Ladies and gentlemen,
Let me now turn to the final point on major implications of the global financial reforms on
Islamic finance - in the area of liquidity risk management. The recent crisis clearly
demonstrated a number of vulnerabilities both in the liquidity risk management in individual
banks, and on a systemic basis. Uncertainty and the lack of transparency over the holdings
of toxic assets led to general reluctance to provide funding to each other, resulting in the
freezing of the wholesale money market in several developed economies. This resulted in
short term liquidity to evaporate affecting participants that were too dependent on the market
for funding. This largely stemmed from poor liquidity risk management practices, and has
now prompted the Basel Committee to develop new proposals for global liquidity
management standards. In the context of Islamic finance, the impact of the proposed Basel
requirement to maintain sufficient cushion of high quality liquid assets needs to be carefully
considered, as the infrastructure and tools for liquidity risk management by Islamic banks is
still in its infancy in many jurisdictions. A very narrow definition of liquid assets that is
currently proposed may exacerbate liquidity risks in many Islamic financial markets in which
Islamic banks compete with conventional counterparts for the limited stock of
shariahcompliant government securities. This will certainly increase compliance cost and render the
market illiquid when the demand exceeds supply, placing Islamic financial institutions at a
disadvantage.
The importance of a robust liquidity management infrastructure for Islamic financial
institutions is well-recognised. The growing internationalisation and cross-border activities in
Islamic finance in recent years further accentuates the importance to enhance the ability of
the Islamic financial system to withstand shocks from externalities. Moreover, access to a
robust liquidity management infrastructure will reduce the cost of intermediation which is an
important enabler for a more efficient and competitive Islamic financial system. Recognising
that liquidity management in the Islamic financial system is still under-developed, a Liquidity
Task Force was established by the IFSB in 2009 with the aim to formulate an institutional
arrangement to address this need. Significant progress has already been made in this
endeavor with several key proposals now at the final stage for operationalisation. When
operationalised, this liquidity mechanism will be another landmark development for Islamic
finance.
Conclusion
The recent global financial crisis has spurred the resolve of the world community to chart a
new course towards greater and lasting social and economic stability with fairness and
accountability. Whilst this presents a unique opportunity for Islamic finance to transition into
the next development stage of greater international integration, there needs to be a higher
level of resilience to withstand the new challenges it will bring. This, in essence, requires the
strengthening of the financial infrastructure to preserve the soundness and stability of the
Islamic financial system. Indeed, our collective will to mobilise a higher level of global
cooperation in promoting this outcome will enhance the prospects of Islamic finance to
contribute towards securing global financial stability and a greater shared prosperity.