shamshad akhtar : building an effective islamic financial system speech by dr shamshad akhtar, governor of the state bank of pakistan, at the global islamic financial forum, governor ’ s : financial regulators forum in islamic finance, kuala lumpur, 27 march 2007. * * * surge in capital from oil rich economies may have spurred the activity in islamic finance ( if ) but one should not assume that this phenomenon will be the sole catalyst to promote growth in if industry. the primary driver of if growth will be the effectiveness with which this industry is consistently, persistently and substantively nurtured, groomed and developed and how successful the industry is in maintaining its robustness, soundness and governance as it grapples with some of the fundamental issues and challenges facing the industry in its evolving and growth phase. what is comforting and encouraging that islamic world has collectively launched if with a fair degree of commitment and fervor backed by adequate capital base. the process has been further supported by the right mix and blend of institutional frameworks that have led to gradual development of internationally accepted architecture for regulatory and accounting frameworks for islamic industry. there is further an intensive effort underway to aggressively explore and exploit the virtues and benefits of this discipline. as one unfolds the mysteries of islamic tenets and ethical spirit in finance, it offers opportunities for financial innovation and flexibility to structure different types of financial products which, among others, would allow for a shift from debt based financial system more to equity and partnership based. what is further amazing is ifs has promising potential to channel wealth by offering alternate avenues for saving and investment, while dealing with the problems of financial exclusion by extending riba free services to devout muslims. critical driver for effective development of if industry, its growth and sustainability will depend on the ability of the system to offer clients comfort that these financial services do conform to the shariah injunctions and principles. it is this value addition that will help enhance the outreach and appeal to the larger muslim population base in particular rural and poor that suffers from financial exclusion. it is equally critical that the if emerges as a robust, competitive, efficient and well diversified segment of financial industry to be able to compete with the long standing conventional industry. to evolve and develop a strong, healthy and competitive system, if industry has to ( i ) further explore the depth and breadth of if systems in order to fully unleash its uniqueness and potential, ( ii ) develop and implement policies and regulatory framework

, istisna, musharaka etc. ) the risk is the expected variance in the measure of profit distribution between iah and bank. ifis have to recognize that this uncertainty or mudarabah risk can arise from a variety of factors both systemic as well as bank specific. risk mitigation for iah can be achieved through use of profit equalization reserves ( per ), investment risk reserves ( irr ) and by variation in modarib ’ s share. 2 at the same time regulatory regime, needs to offer perspectives on risk determination and capital assignments for the high exposures ifi ’ s face because of their excessive reliance on murabah and other trade and sales based transactions backed which are prone to higher degree of volatility and appropriate weights have to be assigned for both associated commodity pricing and counter party risks. while adopting a suitable risk mitigation technique, comprehensive and transparent disclosure of “ … … risk profile, risk - return matrix, and internal governance is critical. among others, this requires coordination of supervisory disclosure rules, and accounting standards, and proper differentiations between consumer friendly disclosures to assist iahs and market - oriented disclosures to inform markets. ” 3 in this regard, ifsb guiding principles on risk management has served a good purpose. they provide guidance for different risks to which if industry is exposed and offers guidance on the methodology for credit risk, market risk, liquidity risk, operational risk, equity investment risk and rate of return risk for different types of financial transactions. we are in the process of adapting these guidelines for islamic banking institutions in pakistan. finally, as the if industry diversifies, it will face increasingly more diverse range of risks associated with investment banks, mutual insurance ( takaful ), and investment companies. islamic banks, however, remain the core of the industry in many countries and offshore financial centers and account for the bulk of financial transactions and their soundness would remain a key concern for systemic stability. in islamic banking, the management of risks becomes more challenging due to its peculiar risk characteristics in line with the requirement for compliance to shariah principles. while the basel ii initiatives on the identification of credit, market and operational risks can be assimilated into islamic banking, the initiatives have to be complemented with consideration of the other dimensions of risks that are inherent in the if transactions. fourth, for effectiveness of if development, it is desirable that eventually model legislation is developed for ifs to recognize different institutions and products. this