But these are good arguments only for those in receipt of the tax rebates or the state subsidies. As a policy matter, they are distortions to risk-taking. Using them to support lower capital ratios is to argue that three wrongs make a right. Even without further regulatory reform, a case could be made for reconsidering risk-taking distortions directly, such as the tax advantage of debt. The effects of removing that tax subsidy could be potent. Basel III will lower banks’ required debt-to-asset ratio by around 3 percentage points. Given estimated tax elasticities, a similar change could be achieved by lowering the tax shield on debt by as little as 5 percentage points. There are two ways in which the playing field between debt and equity could be levelled: removing the tax deductibility of debt interest – for example, through a system of comprehensive business taxation; or allowing firms to deduct from profits an allowance for corporate equity – for example, as recently proposed in the Mirrlees Report (2011). The latter approach already operates in Belgium, Brazil and Latvia. There is of course a third way – do both. That would tilt the financing playing field through its axis, favouring equity over debt. In public finance theory, a non-neutral tax system can be justified when externalities are at play. Bank leverage has negative externality-like properties because of the deadweight costs of default and the growth-sapping effects of debt overhang. Both these externalities have been evident recently.

Being smaller and relatively young, Islamic finance currently offers fewer product choices for consumers and less comprehensive risk management options for institutions. Cross-border investment flows are also constrained by differing interpretations of permissible transactions under  2  BIS central bankers’ speeches  Shariah principles. The isolated pools of Islamic liquidity in each market restrict opportunities for more efficient allocation of capital across consumers, industries, and jurisdictions. Islamic finance must become more integrated with the global financial system. The industry must expand beyond its traditional markets to include a wider range of financial institutions, investors and consumers. This means Islamic finance must strike roots in the key international financial centres of the world. These centres can contribute to Islamic finance in several ways. First, market liquidity. The broad and deep investor pools in international financial centres offer an opportunity to channel non-traditional sources of funds into Islamic finance. In Singapore, for instance, several local and foreign issuers have successfully tapped the capital markets using Islamic instruments. The demand comes from not just Singapore but a diverse group of international investors across Asia and Europe. Many of them are conventional investors, attracted by the credit quality and yields. Second, capabilities in global financial markets. Islamic finance should leverage on the capabilities and strengths offered by conventional financial markets in international centres, to augment the range of Shariah-compliant products. Take for example the market for Real Estate Investment Trusts, or REITs.