An eclectic approach should not be ruled out. (c)  Rules or discretion? As I have said on a previous occasion, we are doubtful that macroprudential instruments could be operated by a rule. To steer the banking system towards increasing its resilience to incipient problems in a stretched sector, a whole series of judgments would have to be made. Whether the rate of credit growth seemed excessive; whether terms were overly lax; or whether the “bubble bursting” would materially damage banks. That would call for assessments of the levels of indebtedness, of banking system exposures, of the broad probabilities of those exposures turning sour, and of whether herding in the market might be driving the system into an ever more precarious position. Rapid growth in debt does not of itself signify over indebtedness; and default does not necessarily materially impair lenders’ resilience. One possible way of thinking about this is that the authorities could be guided by top-down stress tests of the effects on the banking system of various adverse scenarios potentially affecting different groups of borrowers and exposures. In very broad terms, this would be akin to systematically applying Pillar II-type judgments under the Basel regime to banks in general. It would share with the Pillar II element of micro-prudential regulation a focus on circumstances that warranted a capital charge different from the Pillar 1 minimum. But it would differ in a number of important respects. First, the instrument would be applied to all banks in the jurisdiction.

As a result, risk management and wealth creation may, at times, move in different or even opposite directions. Conventional financial instruments also allow for the commoditisation of risks, leading to its proliferation through multiple layers of leveraging and disproportionate distribution. This could result in higher systemic risks, increasing the potential for instability and inequitable concentration of wealth. The intrinsic principle of governance also contributes towards insulating the Islamic financial system from potential risks from excessive leverage and speculative financial activities. The explicit and transparent nature of Islamic financial contracts and the greater disclosure of information are important in contributing to the stability of the system. The focus of Islamic investment also not only involves riba free activities but also extends to include issues related to ethical values and fair trade. The Islamic investment guidelines thus share a number of similarities with socially responsible investment (SRI) principles. New opportunities and linkages offered by Islamic finance Islamic finance is now at the threshold of a new dimension in which it has an increased potential role to strengthen international financial inter-linkages between nations. Islamic finance has the potential to contribute towards the efficient mobilization and allocation of funds across regions. Regions with surplus savings may channel funds to regions with deficit savings and to bring about a more inclusive global financial integration. Financial linkages are now gaining ground as intra-regional financial flows are increasing in significance.