SPEECH: Keynote Address by H.E. Dr. Zeti Akhtar Aziz, Governor, Bank Negara Malaysia at the 7th IFSF
Date posted: 23 April 2013
Date: 7 April 2013
Event / Venue: 7th Islamic Financial Services Forum | Doha, Qatar
Speaker: H.E. Dr. Zeti Akhtar Aziz, Governor, Bank Negara Malaysia
It is my honour to be here in Doha to speak at this 7th Islamic Financial Stability Forum on the "Financial Reforms in Response to the Global Crisis: Lessons for Islamic Finance in Ensuring Financial Stability". The efforts to implement the international regulatory reform to strengthen the global financial system are now well underway. This Forum today provides us with an opportunity to reflect on these reforms and to discuss the lessons that can be drawn in our efforts to ensure the resilience of the Islamic financial industry in this more challenging environment.
Much of the international regulatory reforms have focused on addressing the issues that have contributed to, or that have amplified the global financial crisis. This includes the structural reforms aimed at strengthening the fundamental link between financial systems and the real economy, in particular, to protect insured deposits from excessive risk-taking, over-leverage and unfettered innovation. Leading up to the crisis, banking institutions took on risks that were not sufficiently captured by the prudential regulatory frameworks by the oversight systems. The resulting consequences were compounded by the over-reliance on self-regulation and market discipline to correct distortions which proved to be greatly misplaced. In addition, the incentive and the value systems had become excessively preoccupied with short-term gains. In response to these issues, the existing prudential regulatory framework has been strengthened, notably through the Basel III reform package and reforms to compensation practices. The reforms have also focused on addressing gaps in the regulatory framework with the growing significance of non-bank and shadow banking activities. This has also been reinforced by moves to strengthen the macro-prudential orientation of regulation to complement micro-prudential supervision to manage the risks arising from the interdependencies within the financial system.
The cross-border dimension of finance has also raised new challenges particularly in the area of resolution, leading to efforts through the Financial Stability Board to develop effective resolution regimes to resolve systemically important financial institutions in an orderly manner. A continuing challenge for the global reform agenda however, has been the need to address issues that are national in nature but that are global in scope for the financial institutions and markets. This has increased the need for clear mandates and effective coordination arrangements between national authorities, both within jurisdictions and across borders.
Regulatory reforms to strengthen the global financial system
With the focus of the advanced economies shifting to achieving a durable recovery, maintaining the momentum in the implementation of the global regulatory reforms has, become more challenging. Following the series of financial meltdowns and disruptions experienced during the recent global financial crisis, the Islamic financial industry has fared relatively well. In this challenging environment, Islamic finance has experienced vibrant growth. Strong growth has been recorded in several countries during these six years, with total Islamic banking assets growing at a compound annual growth rate of more than 40 percent. While there are certainly wide ranging lessons that Islamic finance can draw from the global financial crisis, there may also be lessons that Islamic finance can offer in evolving financial systems that will effectively serve the economy.
The strong performance of Islamic finance has been underpinned by its inherent strengths. In encouraging business and trade activities that generate fair and legitimate profit, Islamic finance is subject to an explicit requirement of materiality and validity of transaction. This requirement ensures the channelling of funds into real business activities, thus reinforcing the link between financial and productive flows. This reduces the risks associated with highly leveraged activities. The practice of risk sharing in Islamic finance also strengthens the incentives for the Islamic financial institutions to conduct the appropriate due diligence, reinforced by high standards of disclosure and transparency, and more prudent risk management practices. This in turn raises the bar for governance practices in Islamic financial institutions.
These foundations in Islamic finance have also been reinforced by the global efforts to strengthen the international financial architecture of Islamic finance. The Islamic Financial Services Board (IFSB), since its establishment in 2002, has been at the forefront of the international efforts to increase regulatory cooperation and encourage uniformity of regulatory frameworks and enhanced monitoring of financial risks in the different jurisdictions in the Islamic financial system. The IFSB has introduced prudential standards for the Islamic financial services industry – in the areas of capital adequacy, risk management, corporate governance and Sharī`ah governance. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has also to date contributed to the issuance of more than 80 standards in the areas of Sharī`ah, accounting, auditing, ethics and governance for the international Islamic financial industry.
Following increased liberalisation, the role of Islamic finance is now becoming significantly more globalised. This trend has resulted in a strengthening of global financial and economic linkages, particularly among the emerging economies. Total global asset size of the Islamic financial system has now surpassed the 1 trillion US dollar threshold. This trend has not only supported domestic demand but has also facilitated the greater trade and investment flows across borders. With increased globalisation and greater international integration of Islamic finance, the risks associated with the contagion effects from external developments are however, also correspondingly higher. This necessitates the current framework for regulation and supervision of Islamic finance to be broadened to address the new challenges that have emerged. In this respect, lessons can be drawn from the recent international financial reforms to address the international dimension of finance, both for the financial institutions and the financial markets. Equally important is the governance structure and practices for the effective coordination of efforts to secure financial stability within the national and international financial system.
Key dimensions for improved regulation and increased regulatory oversight for Islamic finance
Let me touch on key dimensions of financial regulation that have been the focus of the recent global regulatory developments, and which have a particular significance for Islamic finance. The first aspect relates to the effective implementation of the international regulatory and supervisory standards and best practices to secure financial stability while promoting more consistent regulatory and supervisory frameworks across borders. In Islamic finance, these standards have taken into account the distinct characteristics and specificities of Islamic finance and the unique combination of risks associated with Sharī`ah-compliant financial business.
Several jurisdictions have already commenced the implementation of the cross-sectoral prudential standards that have been issued by the IFSB. The effective implementation of the IFSB standards in the different jurisdictions would also chart the path for greater harmonisation of prudential standards that promotes the soundness and stability of Islamic financial institutions. A survey conducted by the IFSB in 2011 indicated that nine countries have implemented the various standards issued by IFSB and 18 countries are expected to implement them within the next five years. The next stage is to ensure consistent implementation of these standards to obtain greater certainty in the regulatory treatment of Islamic financial transactions. Greater global cooperation and collaborative action is vital to this process. It would enhance regulatory harmonisation and promote the full adoption of the IFSB standards. This would reduce the opportunity for regulatory arbitrage arising from cross-sectoral differences and cross-border differences, including the differences arising from the regulation of conventional and Islamic financial sectors.
Fundamental to the application and enforcement of these standards is a clear understanding and interpretation of the standards across jurisdictions. This needs to be supported by capacity building to enhance jurisdictional preparedness prior to the implementation of the standards. Post implementation, a transparent and credible assessment process can be developed to assist jurisdictions in evaluating their level of compliance with the international standards and to make recommendations for improvements. These developments would over time, lead to the strengthening of the domestic regulatory framework to be in line with the IFSB standards, alongside the core principles and standards adopted by the Basel Committee, IAIS and IOSCO. Indeed, with the growing global significance of Islamic finance, the assessments such as by the IMF-World Bank Financial Sector Assessment Program (FSAP), would be incomplete without an assessment of the regulatory and supervisory system for Islamic finance. Going forward, the implementation and compliance of the IFSB standards at the national level should form part of the FSAP assessments.
The second aspect is the importance of the macroprudential dimension of financial regulation in preserving financial stability. New or strengthened mandates for macroprudential policies are being established in a growing number of jurisdictions, with central banks and other financial authorities now being vested with the powers and tools to manage excesses and imbalances in the financial system. Post-crisis, there has been greater attention to the role of macro-prudential measures to complement micro-surveillance and supervision. This involves the incorporation of horizontal assessments of risks across institutions, sectors and national borders, including the risks in asset markets.
The global financial crisis has also demonstrated the need for central banks and other regulatory authorities to have the means for addressing risks from the shadow banking system. For some jurisdictions, this segment has grown to be even larger than the traditional banking sector. While entities in this sector have an important role, in complementing banks and other regulated financial institutions in supplying credit and liquidity to the economy, their activities, if not adequately regulated, may have a disruptive impact on the overall financial system. Surveillance and monitoring frameworks are therefore being significantly enhanced to better capture the risks and vulnerabilities emerging from areas beyond the traditional perimeters of regulated financial institutions and markets. This is of particular importance in the context of Islamic finance. In this respect, there is a particular need for heightened surveillance over real estate and commodity markets. Also important is a greater understanding of the inter-relationships between the financial and the real sector, including the potential for the second round effects that are transmitted within and across sectors of the economy.
The third aspect of financial regulation is the role of financial safety nets that would promote certainty and public confidence, particularly in times of financial stress and crises. In addition, there is a need for a comprehensive and effective resolution regime. In the conventional system, this is gaining traction at the global level, including instituting changes to the legal framework to support the development of the resolution mechanisms so as to provide timely, effective and cohesive responses to the financial distress during a crisis. Well developed legal frameworks would also secure the appropriate protection of depositors which is critical to preserving confidence in financial institutions and the system as a whole. In Islamic finance, it is important that such legal frameworks provide for court recognition and acceptance of Islamic contracts within the common and civil law systems, with a consistent approach of interpreting the rights of the contracting parties based on Sharī`ah principles. A legal framework that considers the specificities of Sharī`ah contracts would assist in ensuring greater certainty to the legal and regulatory treatment of Islamic financial transactions.
In Malaysia, a new legal framework for Islamic banking and Takāful will come into force this year. It would pave the way for the development of an end-to-end Sharī`ah-compliant regulatory framework for the conduct of Islamic financial institutions. This new framework provides clarity on the fundamental requirements of Sharī`ah that must be adhered to for the contractual arrangements between the financial institution and customer to remain enforceable. The framework also outlines the operational requirements that would support the effective application of Sharī`ah principles in the conduct of Islamic financial institutions. This is to strengthen their risk management practices to address the distinct risks beyond the traditional credit, market and liquidity risks, to also include inventory risk, ownership risk and Sharī`ah compliance risk. The legislation also provides for the resolution of Islamic financial institutions to be in line with distinctive elements of the relevant Islamic contracts, thus improving the legal and procedural aspects for the orderly resolution of Islamic financial institutions.
The fourth aspect is the increasing importance of the cross-border dimension of financial regulation. In the world of conventional finance, there has been an unprecedented intensification of cross-border collaborative efforts in the aftermath of the global financial crisis. Supervisory authorities have significantly increased the focus on developing a more holistic evaluation of risks and vulnerabilities confronting institutions that operate across borders, resulting in the strengthening of these oversight arrangements to manage these risks. In Islamic finance, the close linkages with the real economic sector including across borders that are undertaken through the various modes of Islamic financing contracts can present specific challenges for supervisors to obtain a complete understanding of the entire risk spectrum. Given the added considerations for the supervision of risk taking activities by Islamic financial institutions that are undertaken across jurisdictions, collaboration among supervisory authorities has to become an integral part of the overall supervisory framework. Regular engagement between home and host supervisors to share information and supervisory assessments is particularly important to ensure effective supervisory oversight as Islamic financial institutions become more international in their operations.
Such cooperation is already taking place through various informal arrangements. The growing interconnectedness in the global Islamic financial system however will benefit from having a more structured framework for collaboration among supervisors to improve the efficiency of the supervisory processes and to allow for early detection of cross-border transmissions of risk from group-wide activities. The supervisory college arrangement has for example been particularly useful in facilitating better information flows and coordination between home and host supervisory authorities. Such platforms can also prove useful in evolving the supervisory framework for cross-border operations of Islamic financial institutions. The level of cooperation can also be extended to include arrangements for responding to crisis situations, including to those that concern the resolvability of large and complex Islamic financial institutions.
A strategic platform for constructive dialogue among the regulators of the international Islamic financial system to discuss on risk and vulnerabilities facing Islamic financial institutions can also be part of the structured framework for collaboration. Existing arrangements such as this Islamic Financial Stability Forum can be leveraged upon to serve as this platform, to facilitate better understanding of emerging developments in the Islamic financial system and their implications for national and global financial stability.
Let me conclude my remarks. The effective implementation of the wide-ranging global financial reform measures remains an important imperative to ensure financial stability. Despite its resilience during the recent crisis, aspects of these reforms are equally relevant to Islamic finance so as to avoid the weaknesses that plunged the international financial system into its deepest crisis in decades. Continuous efforts to advance the implementation of the reform measures, particularly the prudential standards for the Islamic financial industry, and to also enhance further the rigour of the monitoring and assessment process would greatly reinforce the foundations for Islamic finance and its prospects for preserving financial stability. At the same time, by upholding the fundamental tenets of Sharī`ah, the true practice of Islamic finance is exemplified, which in turn resonates with the global call for building stable financial systems that will achieve its intended purpose of effectively serving the functioning of economies and the well being of societies.
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