In response to the global financial crisis, Islamic finance is expected to contribute to the global agenda of fostering sustainable growth that is firmly anchored to the real economy, Malaysia’s central bank governor Dr. Zeti Akhtar Aziz said.
Islamic finance calls for the banking industry to focus on its core function of providing financial services that add value to the real economy.
The Islamic tenets ensure a close link between financial transactions and the real economy, strongly discourage excessive risk undertakings and prohibit speculative elements, the governor of Bank Negara Malaysia and the IDB Prize Winner in Islamic Banking and Finance 1433H/2012 said on Wednesday.
Dr. Zeti was in Jakarta to deliver an inaugural lecture as part of the IDB Regional Lecture Series on Islamic Economic, Finance and Banking at Bank Indonesia’s headquarters. The lecture was attended by Bank Indonesia Governor Darmin Nasution, director general of the Islamic Development Bank’s Islamic Research and Training Institute Mohammad Azmi Omar, chief commissioner of the Financial Services Authority (OJK) Muliaman D. Hadad, representatives of international organizations, House of Representatives members, religious leaders, senior government officials and financial industry executives.
“These rulings also serve to insulate the Islamic financial system from excessive leverage, which in turn contributes toward promoting financial stability and its long-term sustainability,” Dr. Zeti said during her lecture, “Finance and the Real Economy: Fostering Sustainability”.
She explained that the global financial crisis provided a distinct example of how excessive leverage and exponential growth in financial activities that were detached from the growth trajectory of the real economy could become a source of instability.
In advanced economies, bank balance sheets exploded, growing to multiples of annual gross domestic product (GDP). In Iceland, for example, the three largest banks that were nationalized in early October 2008 had seen their total assets expand from 100 percent of GDP in 2004 to more than 900 percent of GDP as of the end of 2007, while in the United Kingdom, bank assets were more than 500 percent of GDP prior to the global financial crisis.
The sheer size, complexity and leverage in the banking system increased the fragility of financial institutions and limited their ability to absorb even small losses, thereby resulting in widespread and deep economic dislocations.
At the height of the crisis, the size of gross amounts outstanding of over-the-counter (OTC) derivatives globally was estimated at over US$614 trillion, more than 10 times global GDP. Despite its size, the OTC market was opaque and inadequately regulated, making it difficult to quantify the risk that had been assumed by the financial institutions.
Dr. Zeti said that this recent decade had witnessed a dramatic transformation of the Islamic financial landscape, marked by sustained rapid growth and the widening of its geographical reach, resulting in more diverse Islamic financial institutions and the generation of a wide spectrum of innovative products. Islamic finance had also evolved from being domestic-centric to become increasingly internationalized.
“Today, the total global size of the Islamic financial assets is $1.6 trillion,” she said, adding that there were currently more than 600 Islamic financial institutions operating in 75 countries.
She acknowledged that countries hosting Islamic banks needed to adjust their legal, regulatory and supervisory frameworks to accord greater clarity to the appropriate legal and regulatory treatment in order to foster the sound and orderly growth of risk-sharing structures and activities, both in terms of the funding and the assets-side of Islamic banks.
Another important dimension in fostering the further development of risk and profit sharing instruments was the need to ensure the institutional soundness of the Islamic financial institutions and their enhanced ability to assess risks in the real sector.
This underscored the imperative of robust risk management capabilities to manage new risks peculiar to risk and profit sharing contracts and the adoption of strong governance, transparency and disclosure practices within the Islamic financial institutions to meet the due diligence requirements for determining the viability of business and investment proposals, she said.
“Equally important in ensuring the institutional soundness of Islamic financial institutions is the need for robust liquidity management,” Dr. Zeti said.
Today, Islamic financial institutions operating in the different jurisdictions are still confronted with the challenge of managing their liquidity positions effectively, given the limited supply of high quality sharia-compliant liquid instruments being the reason most commonly cited.
The lack of high quality liquidity instruments for Islamic finance not only constrained effective liquidity management, but it also affected the efficient cross-border diversification of financial flows.
Darmin Nasution said in his welcoming remarks that Islamic finance standard setters, such as the Islamic Financial Services Board (IFSB) and the Accounting Auditing Organization for Islamic Financial Institutions (AAOIFI), consistently developed international Islamic finance standards in the areas of risk management, stress testing, accounting and auditing.
“However, the prescribed Islamic finance standards alone will not be sufficient to tackle the current economic and finance conditions that have posed a challenge for the development of Islamic finance,” he said.
He said that to manage the stability of the financial system as a whole, countries needed to strengthen their macro and micro prudential policies.
(The Jakarta Post / 22 Dec 2012)
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