Dr. Zeti Outlines Roadmap for the Future of Islamic Finance at the World Bank Seminar

Dr. Zeti's clarion call was for the Financial Stability Board (FSB) of the International Monetary Fund (IMF) to engage with the prudential standard setting entities for Islamic finance, not only to raise awareness of whether the new standards being introduced can be applied to Islamic finance and whether modifications need to be made, but also to see whether there are any unintended consequences.

            "Equally important is for there to be recognition of the standards that have been issued for Islamic finance specifically by the Islamic Financial Services Board," she explained.

            Indeed, the IDB member countries are poised to establish a Financial Stability Forum (FSF) to promote stability in the Islamic financial system. This is a strong recommendation amongst others in a Report that will be submitted to the IFSB Council in November 2009 by the Taskforce on "Islamic Finance and Global Financial Stability" that was established in 2008 by the IDB in collaboration with the IFSB, industry leaders and international experts.

            The Islamic FSF will mirror the activities of the IMF's FSB which was set up at the behest of the G20 Summit. The FSB framework to strengthen the international regulatory standards is important because it will form the basis by which assessments will be made by multilateral agencies such as the IMF.

            The Governor also confirmed that "substantive progress has been achieved by the Taskforce on recommendations on the effective implementation and enforcement of the prudential standards, the supervisory framework, the strengthening of the financial safety net mechanisms and the development of an effective crisis management and resolution framework for the global Islamic finance industry."

            IDB and IFSB in addition also set up a Liquidity Management Task Force earlier this year whose mandate is to enhance the efficiency of Islamic financial institutions (IFIs) in managing national and cross-border liquidity.

            Dr. Zeti advised that apart from the risk of contagion effects from the global financial crisis, Islamic finance "will also be affected by the second round effects arising from slower economic growth and the reduction in global liquidity. In such an environment, a well functioning liquidity management infrastructure to enhance the capacity of IFIs to effectively manage their liquidity positions, is essential."

            Dr. Zeti identified several key challenges facing the Islamic finance. These include:

              a.. the need for a comprehensive legal, regulatory and supervisory framework to meet the present challenges, and its regular adaptation to keep pace with the evolution and transformation of the financial system;
              b.. the need for an integrated crisis management framework to ensure that any emerging crisis in the Islamic financial system will be promptly and efficiently managed;
              c.. the need for institutional arrangements for resolution of troubled international IFIs;
              d.. the enhancement of the risk management capability of IFIs, through additional capital requirements to cushion the inventory risks of underlying assets and equity positions that are embedded in partnership contracts, therefore bringing the capital requirements closer to the true economic risks in the portfolio of the IFIs;
              e.. the need for a mechanism for cooperation between regulators across jurisdictions for resolution and for containing potential systemic risks beyond the national boundaries; and
              f.. mutual recognition of financial standards and products across jurisdictions.
            Malaysia, she advised, has already a comprehensive legal, regulatory and supervisory framework for Islamic finance which is further supported by a financial safety net framework that encompasses the lender of last resort facility and a deposit insurance system.

            The growing role and relevance of Islamic finance in the global financial system will not only increase its potential to contribute to global financial stability, but also towards strengthening global economic growth. As the world seeks solutions to the current global financial crisis, a general consensus is emerging that financial services needs to return to its basic functions - to provide financial services that adds value to the real economy.

            In fact, explained Dr. Zeti, "these are the very elements that are espoused in the Shariah principles that underpin Islamic finance and which explains its resilience during this international financial crisis. The challenge before us is to build a new financial architecture that would allow for more efficient functioning of not only financial intermediation within national economies but also across borders. Islamic finance, with its emphasis on a strong linkage to productive economic activity, its in-built check and balances and its high level of disclosure and transparency offer this prospect."

            Dr. Zeti stressed the importance of innovation, which remains crucial to product development although unfettered financial innovation can become a major source of instability in the financial system. In Islamic finance, financial innovation must be tested against the 'Maqasid al-Shariah' (objectives of the Shariah), where the primary objective is the realisation of benefit to the people. This demands the internalisation of Shariah principles in Islamic financial transactions, both in form and substance.

            "Indeed in the area of Shariah, there has already been progressive convergence of Shariah views and rulings, and the mutual recognition of financial standards and products across jurisdictions. As this continues to occur, it would be a major driver towards greater convergence and harmonization. This has been facilitated through greater engagement among the regulators, practitioners and scholars in Islamic finance across jurisdictions. This interface is important given the common interest of global financial stability," she explained.