Kuala Lumpur, 21 April 2016 – The Islamic Financial Services Board (IFSB) organised the 8th Public Lecture on Financial Policy and Stability, on 11 April 2016 in Cairo, Egypt. This Lecture series was held as part of the IFSB Annual Meetings and Side Events 2016, which was hosted by the Central Bank of Egypt.
Dr. Sami Al-Suwailem, Head, Financial Product Development Center, Islamic Development Bank delivered an engaging lecture themed Morality, Rationality and Financial Stability.
In his lecture, Dr. Sami Al-Suwailem presented a literature review on how the assumption of rationality, as one of the main pillars of the neo-classical economic theory, is incompatible with achieving the objective of a stable financial system. On the contrary, he emphasised that in order to secure the stability in the current financial system, notions of morality, risk-sharing and integration of financial transactions to the real sector activities must play a greater role. Dr. Sami delineated in his lecture the nature of stability and the concept of ‘endogenous risk’ and how they relate to the important findings of the latest economic theory on the behavior of economic agents and markets.
In elaborating on the “nature of stability”, Dr. Sami observed that “stability is a public good which is generated through coordinated collective action of the community”. Essentially, stability as a public good is secured when everyone in the society complies with the rules and laws, where even a deviation from a small minority of the community from these rules would result in instability. He noted that while compliance with rules is the rational behaviour at the group level, an individual might be compelled to deviate from the norm as long as others continue to follow them. However, he reiterated that this behaviour gives rise to a contradiction – a rational agent always prefers to diverge from the applicable rules and norms to gain from this behavior. He cited Climate Change and the Global Financial Crisis as the most pronounced examples of this agent and group rationality conflict. In the case of the Global Financial Crisis, he underlined that the “banks own collective actions precipitated the events they should have feared”.
He also explicated his thoughts on “endogenous risk” and pointed out that, as opposed to many of the natural catastrophes, the level of the risk in financial system is the by-product of the market players’ behaviour in the sense that the “activities of ‘economic agents’ influence the level of risk, and simultaneously the level of the risk influence the agents’ activities”. He highlighted that market prices play an important role on the formation of the endogenous risks due to the fact that the prices give signals about the market behaviour, while the price mechanism also acts as a tool to direct the same behaviour. He quoted the example of “minority game” in which traders want to be ahead of the crowd so as to gain, and where this behaviour almost certainly results in financial instability due to the fact that being ahead of everyone else is practically impossible. He underlined that decoupling of real trade from financial activities, so called financialisation, and speculative behaviour are good examples of the minority game and increasing financial instability.
In the last section of his lecture, Dr. Sami talked on morality and the concepts of risk-sharing and the integration of financial transactions to the real sector activities. He proposed that these concepts – which are in conflict with the rationality notion – are the main solutions of the financial instability. On morality, he stressed that while laws and regulations are important, they require moral responsibility of the market players to be truly effective. In elaboration, risk-sharing disciplines incentives and helps control the thrust towards fragility, which leads to the fact that risk absorbance is necessary to build a resilient financial system. He also added that equity, as an important risk-sharing instrument, becomes less expensive and less risky as the share of the equity in the system increases. Finally, he stated that integrating finance with real transactions, which is one of the main pillars of Islamic finance, restrains speculation from taking over real trade.
A question and answer session followed the Lecture. Responding a question on the importance of standards for Islamic finance, Dr. Sami observed that while behavioral finance literature emphasises rationality of the economic agents, regulation should aim to find ways to balance the incentives as emotions and morality play key role in market behaviour. On another question related to the entrepreneurs’ preferrence of debt over equity due to cost considerations, he responded that equity is just one of the risk-sharing instruments. Other risk-sharing instruments, such as Muḍārabah and Mushārakah could be less costly compared to the debt if properly structured, noting that it is time to develop such risk-sharing instruments to meet the demands of the entrepreneurs. One participant inquired on what policy action would be required to bring morality into business action, given the global taxation rules favour the use of debt over equity. Dr. Sami responded that a focus on tertiary education would be important for future generations as the economics taught at universities does not take morality and other realities into account.
On a separate note, Dr. Sami also observed that latest developments in the global regulatory landscape in the form of Basel III has provided an opportunity for greater convergence of the principles of Islamic and conventional finance, since Basel III provisions for capital instruments promote risk-sharing between issuers and investors. He further noted that proper implementation of profit-sharing contracts will increase its usage in over time.
The full document of the Public Lecture will be published on the IFSB website (www.ifsb.org) in due course.
