zeti akhtar aziz : islamic finance – financial stability, economic growth and development speech by dr zeti akhtar aziz, governor of the central bank of malaysia ( bank negara malaysia ), at the islamic development bank ( idb ) prize lecture on “ islamic finance – financial stability, economic growth and development ”, jeddah, 27 november 2013. * * * it is my honour to be invited to deliver this lecture on islamic finance : financial stability, economic growth and development, here in jeddah. i wish to thank the islamic development bank for the invitation. the islamic development bank has been pioneering and instrumental in the development of islamic finance and has been an inspiration in driving its progress and evolution. it is indeed a privilege for me to be part of this journey, and to have witnessed the increasing dynamism of the islamic financial industry amidst a highly challenging economic and financial international environment. global financial and economic adjustments my remarks today will focus on the relevance of islamic finance in modern market economies, taking into account the knowledge that we have today about the vulnerabilities of finance, its causes and its wider economic ramifications. five years on after the global financial crisis erupted, the most pressing challenge confronting the world economy continues to be securing financial stability and generating growth and employment. while regulatory reforms both at the global and national levels have been extensive to strengthen financial systems, there has been less progress on the recovery in growth. while conditions in the world economy have improved, the growth prospects going forward is expected to remain modest for an extended period of time. several important lessons have emerged from this recent global financial crisis. the first relates to the exponential expansion of the financial system which did not commensurate with the expansion in economic activity. this resulted in a significant disconnect between the financial sector and its role in serving the economy. a number of factors contributed to the weakening of the link between financial intermediation and productive economic activity. deregulation had opened up new opportunities for financial institutions to expand the scope of their activities. increased competition, reinforced by advances in technology intensified the pace of innovation. and, the extended period of low interest rates in an environment of low inflation also prompted greater risk taking which in turn contributed to the significant build up of financial imbalances. the role of leverage in the global financial crisis, both in the public and private sectors, was also a particularly important contributing factor. it has also become a factor that is now holding back growth.

activities in which the expansion or contraction of credit is dependent on developments in the real sector. this would provide a restraint on financial engineering and innovation as financial transactions need to be supported by real assets, thus aligning innovation to productive economic activities. as a result, the dangers of unbridled innovation are also substantially reduced. the move to embrace the risk - sharing dimension of islamic finance also presents new opportunities for financial management. the profit sharing and risk - sharing characteristics of islamic financial transactions strengthen the incentives for islamic financial institutions to undertake the appropriate due diligence on the transactions to ensure that the profits are commensurate with the risks assumed. the explicit risk - sharing element between the financier and customer instils greater discipline and responsibility, given the obligation and economic incentives created for participants to the contract to evaluate the risk profile of the product or investment proposition, the underlying trends in earnings and cash flows, and its income - producing potential. such a process strengthens safeguards against the widespread mispricing of risks. the strong incentives for financial institutions to understand the nature and level of risk and leverage that is embedded in the islamic financial instruments would in turn lead to more responsible innovation. this ensures that the products offered are aligned in delivering real benefits for the investors. reinforced by a combination of stronger governance, enhanced transparency and more robust risk management, the trust - based relationship that underpins islamic finance is therefore strengthened, thereby promoting overall confidence in the intermediation process. more recently, in this decade, the greater use of equity - based models has been most evident in the sukuk market, with shariah structures evolving from predominantly lease - based ( ijarah ) and mark - up sale ( murabahah ) structures to profit and loss sharing partnerships ( musharakah ), as well as convertible and exchangeable trusts. the evolution of assetbacked and asset - based sukuk provides further options for investors to diversify their portfolio. asset - backed sukuk, has profit and loss sharing elements that thus offers investment sustainability. the possibility of a default is minimised, as investors of assetbacked sukuk are not guaranteed to receive income or capital gains, and profits are paid by the issuers only when the underlying assets earn profits. risk - sharing transactions and undertakings under the participatory finance models in islamic finance also enhances prospects for increasing financial inclusion and in bringing the financially unserved into the economic mainstream. in