Assalamu’alaikum warahmatullahi wabarakatuh and a very good morning to all of you.
My remarks today will be exploratory in nature, focusing on some thoughts on how we can address the concept of cross border connectivity in Islamic finance. I will have some suggestions to make on practical measures that can be taken to strengthen this connectivity by both the private sector and policy makers. I will also share some thoughts on the role that stock exchanges can play in this connection. Although I will stress the central importance of common, international standards for prudential supervision and regulation in fostering connectivity, needless to say, I am not in a position to offer settled conclusions on the broader topics that are relevant and which represent a work in progress by the wider Islamic finance community and industry. I will begin with some remarks on the global economy.
Global economic turbulence. At this time of great turbulence in the global economy we cannot afford to be complacent about the likely global impact of an intensification of the Eurozone crisis. Economic deterioration in the Eurozone could lead to substantial instability if European and American banks de-leverage, as they did in 2008 when financial contagion spread globally. European banks, UK banks, and those from the US continue to have a presence in Asia and the Middle East, so downside risks are significant if there are severe stresses to global inter-bank markets.
However, there are also factors which could partially buffer Asia and also the Middle East from these knock-on effects. First, turning to Asia, many foreign banks in Asia rely on a local depositor base which is likely to impede deleveraging. Second, there is decreasing reliance on the transatlantic economies for direct and indirect financing of Asia’s non-financial private sector, and greater reliance on financing from within the region. Thus, since 2009, according to a recent study by the BIS, domestic credit expansion in Asia has been driven principally by domestic funding sources, pointing to another factor that is contributing to resilience in Asian economies. Finally, if we anticipate not the worst case, but an intermediate one, an orderly withdrawal by euro banks could offer opportunities for Asian banks, including Islamic banks, to expand their market share. This also applies to the Middle East. I will not elaborate on a worst case scenario which, we must hope, will not take place.
Resilience of Islamic finance. For Islamic finance, which has been resilient through the crisis, strong, well capitalised Islamic banks and development of broader Islamic financial markets and financial institutions are essential to sustaining its resilience.
The strength of Islamic banks lies in their reliance on a committed domestic depositor base and, most of all, in their conduct in which they have demonstrated adherence to a set of principles that have shielded them from exposure to toxic assets and to excessive risk taking. Islamic banks are better capitalised and less leveraged than their western counterparts thus giving them more space to absorb downside risks. These factors will help to sustain Islamic finance, or at least to provide it with substantial buffers, in the event of de-leveraging by European and US banks. But it will also be important to develop broader Islamic financial markets, in particular capital markets and Takāful. The development of these markets will not only contribute to promoting shared prosperity, but will further contribute to the resilience of Islamic finance.
It is therefore important to distinguish between the immediate global economic turbulence, and the prospects and longer term goals of Islamic finance. Today, the Middle East, Africa and Asia share a common challenge in the short term – to manage the spillovers from the Eurozone crisis. Over the longer term, however, these regions, and the countries within them, will benefit from a shared goal – that of cooperation in advancing economic growth and social justice through Islamic finance.
Collaboration and cooperation among national economies in which Islamic finance participates carries significant benefits in terms of developing domestic financial and capital markets. But it also contributes towards becoming significant players at the global level – through scale and depth of markets achieved by the collective action that creates greater cross border connectivity of Islamic finance.
Connectivity and Islamic finance. Let me now turn to this issue, and do so by posing two related questions. First, what does connectivity mean in terms of links through Islamic finance between the regions, and in particular between Asia and the Middle East? Second, how is this goal of connectivity to be further advanced – or rather, through what combination of domestic and international measures should we be focusing on?
Let me propose a relatively simple way of thinking about connectivity: it is a state of the world in which issuers and investors are enabled to issue or invest anywhere within a defined regional economic sphere.
By contrast, the European Central Bank defines connectivity – or cross border integration of financial markets – very precisely and strongly in terms of a set of markets and market participants who are governed by a single, harmonised set of rules and regulations. There are benefits to harmonised regulations of financial markets, supplemented by mutual recognition as the case may be, but in practical terms most jurisdictions outside of Europe are not ready to adopt the ECB and the European view of market integration and connectivity as immediate practical goals. But we can achieve an intermediate level of integration through greater cross border access that is facilitated with a view towards achieving the less stringent form of connectivity that I have suggested.
Framed in this way, the issue of connectivity for Islamic finance revolves around a set of questions of which the principal are as follows: how can we facilitate cross border fund raising, cross border product distribution, and cross border access by financial intermediaries, in a way that ensures investor protection and financial market stability?
As we address these issues collectively, it will be fruitful to aim for something that is likely to be feasible. What is needed, in short, is a set of practical measures that lead to cooperation mechanisms that help to progressively address impediments to greater cross border financing and investments.
In fact Islamic finance is already contributing to greater connectivity, especially between Asia and the Middle East, through increased levels of cross border financing and investment. In particular, there is strong evidence of an investor base developing in both regions willing and able to finance carefully prepared الشريعة-compliant investments in infrastructure. The surge in Sukūk financings in 2011, and the continuation of this phenomenon in 2012, reflects this development. The scope for the expansion of these financial and real investments is enormous between these regions but will need concerted efforts by public and private sectors to create the conditions needed to sustain it. Let me touch on a few challenges that lie ahead and indicate also, what can be done at both the national and regional levels through international cooperation.
A key challenge is that despite sustained growth of Islamic finance, this has principally been in the banking sector. Islamic capital markets are still relatively underdeveloped, in both Asia and in the Middle East, with the principal and well known exceptions in Southeast Asia and in the GCC.
Broadly speaking, Islamic capital markets are typically small and illiquid and there is often an absence of a wide investor and issuer base. The critical factor is that where Islamic capital markets have failed to exhibit stronger growth it is often because of a domestic and national focus that has not been able to adequately reap the benefits from greater cross border access. A similar situation exists in many stock markets which are also small and domestically focused. There are exceptions of course, and considerable change is taking place in terms of outward orientation. But where these conditions exist the relatively small market capitalisation of Islamic finance results in illiquid markets and exchanges with high transaction costs.
The domestic orientation of capital markets typically reflects the state of broader economic development and is not necessarily the result of policy inadequacy. But the lack of liquidity and small investor and issuer base pose challenges to further deepening of Islamic finance and will require resolute policy action at both the domestic and international front. The key is to sequence reform measures so as to evolve towards a greater cross border orientation. The critical challenge is to maximise the synergies between domestic and external markets. These synergies are considerable and involve a two way interaction between domestic and international markets.
Most of us would agree that greater cross border connectivity can help strengthen financial intermediation and risk management, attract more capital and help improve liquidity, and reduce operating costs for market players hence improving their competitiveness. But it will also be important to strengthen domestic risk management capacities in tandem with opening up of markets.
Hence, domestically, the priority in many jurisdictions is to further liberalise national markets and strengthen capacities of domestic issuers and investors to manage risks, thereby enabling them to compete effectively both domestically and internationally. Once this is achieved, providing greater cross border access to issuers and investors will contribute to widening the domestic investor base and range of market products.
In terms of strategic priorities to achieve greater cross border connectivity, let me mention three. First, to benefit from the synergies between domestic and international capital markets will require a sequenced strategy over the medium term that focuses on adoption and implementation of common international standards for prudential supervision and regulation. This is essential towards achieving inter-operability between financial systems and between financial intermediaries across borders.
There is clearly a need for further work in defining standards related to issuers, investors and capital market intermediaries. This is a task to which the IFSB has turned and we intend to address this as part of our medium term strategy – the IFSB’s Strategic Performance Plan for the period 2012-2015. The issuance of standards and guiding principles along these lines will help to provide a common framework based on either harmonisation principles across borders, or on mutual recognition, or as is most likely, a combination of both.
Second, measures are also needed for domestic development of broader Islamic financial markets including the Takāful sector, and its incorporation into the development of pension, social security and insurance mechanisms through the principles of mutual risk sharing. Here too, the IFSB is working to develop a wider range of guiding principles that will provide a common frame of reference to the Islamic finance industry. We have a new set of guiding principles under preparation for risk management in Takāful undertakings which we hope to take to public consultations stage later this year. We also have a number of other guidance notes and standards in mind for stress testing and related measures for this sector during the next three years ahead.
Finally, the strengthening of domestic prudential safeguards and risk management capabilities to manage volatility will, ideally, go hand in hand with stronger cross border cooperation between regulatory and supervisory authorities.
I have suggested earlier that a practical approach is needed to strengthen cross border connectivity in Islamic finance. For the development of this connectivity for capital markets one approach is for the private sector – in particular the stock exchanges in Asia, and those in the Middle East and Turkey, together with their market regulators, to take the first step. In this approach, the way forward would be for the stock exchanges themselves to explore the possibility of link-ups between them. This is of course a process that features as a central objective of the important project launched by the OIC.
It is perhaps time, or perhaps it will be soon, to take advantage of the preparations provided by the OIC project, and the knowledge built up, to begin to forge practical linkages between self selected economies and exchanges, with the full support of policy makers. There are many models for such linkages and they by no means rely on merging of stock markets although this may be an option in some regional contexts. But it is possible to think of a range of linkages including an exchange alliance in which each exchange retains its national and corporate identity whilst benefiting from greater order flow from sharing a common electronic screen. There are other examples, for example the Euronext model of exchange alliance, prior to their merger with the NYSE.
However, much prior work will be needed to explore the options and to identify the minimum needs for commonalities in such areas as governance structures, rule books, and trading systems. Again this is not an insurmountable impediment but it does mean that some exchanges will be better placed to join such an alliance relatively soon, while others strengthen their capabilities prior to joining.
In addition, it will be essential to have regulatory support for this process either in the form of harmonised regulations, or a mix of harmonisation and mutual recognition that facilitates investors and issuers in their cross border activities.
Regulators, and policy makers, need to be closely involved, either in parallel or jointly with the exchanges and the private sector in articulating the objectives and the means to achieve them. It would be advantageous if الشريعة scholars, from each of the regions involved in such an undertaking, also participated at the outset. This would help to ensure that the process is well grounded and representative of the view points, perspectives and interests that are critical to the viability and vigour of Islamic finance.
Conclusion. Greater cross border financing and investment is helping to strengthen Asia’s connectivity to other regions including the Middle East through Islamic finance. We are seeing a proliferation of deal making and opportunity-seeking by the private sector across borders. I have tried to suggest in my remarks today that while the private sector must take the lead in seeking out opportunities, regulatory and policy support is also needed to create a facilitating enabling environment for cross border connectivity through Islamic finance. This will require measures to develop domestic capital markets. At the same time, providing greater cross border access to issuers and investors will strengthen domestic markets by widening the issuer and investor base. National market reforms need to be based on common international standards for prudential regulation and supervision and for transparency and disclosure. The process of widening connectivity can initially be approached on a bilateral basis, and indeed this is taking place through MOUs between regulators and understandings reached between exchanges and other market participants. I have tried to suggest a practical way of transforming bilateral connectivity to a multi-lateral one. There are many challenges and hazards in taking such an approach, in which what has been described as the fragmented islands of Islamic finance are brought together. But the rewards also are great. Islamic finance will be stronger for it and be better placed to contribute to a better world. The IFSB, with its mandate to foster cooperation in the development of the Islamic financial services industry, stands ready to assist such efforts.
I thank you for your consideration and wish you a fruitful and stimulating Conference.
