The international community, including many emerging countries, is still deliberating on the necessary financial reforms at both the national and international level to pre-empt the type and scale of the global crisis that the world has been witnessing over the last year or so. There remain serious differences over a number of issues although on the fundamental issue of promoting financial stability and resilience, there is a poad consensus.

However, the lessons learnt thus far and the new challenges that emerged from the global financial and economic crisis are also relevant to the global Islamic finance industry, which needs to ensure not only its resilience but how it might contribute to global financial stability.

This was the poad consensus at the recent Bank Negara Malaysia (BNM) high level conference on financial stability which was held at Sasana Kijang Auditorium in Kuala Lumpur. The conference was held in conjunction with the 15th Islamic Financial Services Board (IFSB) council meeting and the 3rd IFSB public lecture on financial policy and stability delivered by Abbas Mirakhor, the former executive director of the International Monetary Fund.

To operate successfully, emphasized Mirakhor, a market needs rules to allow information to flow unhindered; trust to be established; coordination, cooperation and competition to take place among market participants; transaction costs and costs to third parties to be minimized; contracts of exchange that promote risk sharing to promote in turn "the unity of mankind" with equity participation being the ideal instrument of risk sharing.

The ultimate aim is to have an ideal Islamic financial and economic system which requires a poad consensus of their institutional structures; social consensus on implementation and the political will and commitment to implementation. In the absence of the ideal, Muslim countries need to "embark on a well designed program of transition to the ideal system." This means strengthening the legal, regulatory and enforcement infrastructure of the financial system. "This is necessary so the result of the financial system's interactions with the real sector of the economy converge to those that would be expected from an ideal Islamic financial system."

Mirakhor also urged the reduction of reliance on interest-based debt contracts especially for the external and public borrowing requirements of Muslim governments; educating market players and investors in best practice in equity investments; and investing in human capital by strengthening the caliber of business and law schools.

Conference host, BNM governor, Zeti Akhtar Aziz, emphasized that Islamic finance does have a potential role in contributing not only to global financial stability but also toward a more balanced global growth.

"Islamic finance, with its emphasis on a strong linkage to productive economic activity, its inbuilt check and balances and its high level of disclosure and transparency offers this. At the center of this recent global financial crisis was the peakdown in governance that led to indiscriminate lending, excessive risk-taking and overzealous financial innovation. This is avoided in Islamic finance with the requirement that Islamic financial transactions must have an underlying economic activity and that the process of innovation and formulation of Islamic financial products and services must be done carefully and in accordance with Shariah," explained Zeti. But she warned that there is a risk of contagion effects arising from financial and economic disruptions that emanated from the conventional markets. The correction of asset prices and the economic contraction following this international global financial crisis has been on an unprecedented scale. Islamic finance is therefore confronted with the risks associated with these second round effects that need to be managed. An important aspect that needs to be urgently addressed in the Islamic financial industry is the need to enhance the ability of Islamic financial institutions to manage liquidity. This requires the development of Shariah compliant financial instruments that facilitate this and a well internationally functioning market infrastructure to facilitate cross border management of liquidity, so that liquidity risks are effectively managed.

Integral to the efforts in the development of Islamic finance, is also the strengthening of the regulatory and supervisory framework which must also remain relevant to the rapidly changing Islamic financial landscape, advised Zeti.

The G20 has launched an ambitious agenda to reform financial regulations, which include key main areas namely, (1) the strengthening of international frameworks for prudential regulation, (2) the review of the scope of regulation, (3) the revision of accounting standards; and (4) more effective oversight of the credit rating agencies as well as strengthening risk management. These areas should also be looked at in Islamic finance, which has also to deal with additional issues of harmonized regulation. Zeti called on the new global Financial Stability Board, managed by the IMF, to give due recognition to Islamic finance given its increasing importance in the international financial system and its potential role in contributing to global financial stability.

Muhammed Al-Jasser, governor of the Saudi Arabian Monetary Agency (SAMA), said that the stability of the financial system was critical to a healthy economy. Generally speaking, he added, "Financial stability encompasses the safety and soundness of financial institutions and the stability of the overall financial system. But this does not mean that the central bank and supervisory authorities must prevent the failure of every institution to achieve financial stability. The central banks must set clearly defined objectives. The ultimate objective should be to promote a resilient financial system and reduce the systemic risks that may be created by failure of a systematically important institution."

professor Rifaat Abdel Karim, secretary-general of the IFSB, suggested six key building blocks to promote the resilience and stability of the Islamic financial services industry. These include effective implementation and enforcement of a set of robust and consistently applied prudential standards for risk management and supervision; ma robust liquidity management infrastructure both at the monetary policy and exchange and securities levels; the strengthening of the financial safety net mechanisms; the development of a reliable crisis management and resolution framework which includes bank insolvency laws; closer cooperation among policymakers and financial supervisors; and macrop-rudential surveillance and financial stability analysis.

Andrew Sheng, chief adviser to the China Banking Regulatory Commission, maintained that ultimately the defense against excessive greed and speculation in the financial system must be good value systems. In this regard, Islamic finance is equity based and also ethically based. Islamic finance, he added, recognizes that the relationship between borrower and lender is really between an investee and investor -- losses by the investee dynamically pass to the investor. Hence the relationship is one of trust and mutual partnership. "What remains to be seen is whether the tools of preventing moral hazard under Islamic finance can be more effective in practice compared with current non-Islamic finance. The true challenge to Islamic finance is therefore the evaluation of the trustworthiness and value system of investors and the due diligence undertaken by the investor according to Islamic principles. This is still evolving," he said.&M.p.

By Mushtak parker

© Arab News 2009