Transcript

Transcript of a Conference Call on Islamic Finance Discussion Note titled “Islamic Finance: Opportunities, Challenges, and Policy Option”

April 7, 2015

Christopher Towe, Deputy Director, Monetary and Capital Markets Department (MCM)
Prasad Ananthakrishnan, Deputy Division Chief, Middle East and Central Asia Department (MCD)
Mohamed Norat, Senior Economist, MCM
Wafa Amr, Senior Communications Officer, Communications Department

MS. AMR: Good morning. Thank you all for joining us this morning. This is a conference call on the Islamic Finance paper discussion note, Islamic finance, opportunities, challenges and policy options. I have with me most of the authors.

I'm pleased to introduce Mr. Chris Towe, Deputy Director of the Monetary and Capital Markets Department and Marco Pinon, Advisor in MCM. Mr. Prasad Ananthakrishnan, Deputy Division Chief, Middle East and Central Asia Department and Mr. Mohammed Norat, senior economist in MCM Department.

Mr. Towe will first give a short presentation on the paper and then, we'll open the floor for questions.

MR. TOWE: Thank you, Wafa. Just again, my name is Christopher Towe. I'm a Deputy Director in the Monetary and Capital Markets Department. The first thing I thought would be useful to do this morning is really just to give you an overview of why we're issuing this staff discussion note.

And in that context, I would say that at least one goal is to provide us an opportunity to recognize the Fund's very long involvement in the area of Islamic finance. And indeed, over the last several decades, the Fund has provided significant contributions to the theory and empirical analysis of Islamic finance. We've provided training and technical assistance to our members in such areas as regulation and supervision of Islamic banks, monetary policy implementation in the presence of Islamic finance and the development of Sukuk markets.

And we have worked closely with key Islamic finance standard setters and other important stakeholders to assist them in the development of international standards for Islamic institutions. However, our interest in this area has grown in recent years and this reflects the very rapid growth of the industry. This growth is documented in our staff discussion note which flags the growing reach of the industry not just in the Middle East but in Asia and Africa and as well as the considerable interest in Sukuk issuance by financial centers such as the U.K., Luxembourg and Hong Kong.

And this growth has put an even greater premium on the Fund's ability to provide consistent policy advice to our member in the context of our regular surveillance, our financial stability assessments and our technical assistance. So the second purpose in issuing the staff discussion note is to crystallize the work and policy messages that we have developed in recent years in response to the rapid growth of Islamic finance and provide a platform for our continued work in this area.

So what are the key messages in our paper? First, we see Islamic finance offering considerable promise. It has the potential to foster more inclusive growth by increasing access to banking services to Muslim populations that may not be willing to or able to use conventional banks. It has the potential to foster growth-enhancing investments by enabling easier access to financing for SMEs in public infrastructure. And it has the potential to improve financial stability because Islamic finance is asset-backed, reduces leverage and requires risk sharing between borrowers and lenders.

But the second message is that for these benefits to materialize there are important policy issues that will need to be tackled. Let me enumerate. First, there is a need to tailor regulations to specifics of Islamic banks and for greater consistency of regulation and supervision. Islamic standard setters, including the IFSB, have done an impressive job in establishing the rules of the road.

But our analysis suggests that these standards are not being applied consistently. And this could either stifle the development of Islamic finance or encourage its growth in a manner that creates systemic vulnerabilities.

Second, we see important gaps in the instruments that central banks have to manage liquidity for Islamic banks. This reflects the underdevelopment of Sharia compliant money markets and Sharia compliant central bank liquidity management tools. And this handicaps Islamic banks forcing them to maintain higher levels of liquidity than they may need and handicaps the ability of central banks to operate monetary policy and meet their inflation and growth objectives.

Third, financial safety nets have not been well designed to take into account the specificities of Islamic finance. Both deposit insurance and lender of last resort facilities in many jurisdictions do not take into account the specific needs of Islamic banks. And this means that countries may not have the tools available to respond to shock to individual institutions or the capacity to avoid them spilling over to the entire system.

Fourth, more needs to be done to provide an enabling environment for Sukuk markets which still remain relatively shallow and illiquid. This reflects legal gaps as well as a lack of standardization of the instruments including with regard to Sharia governance and compliance. What are needed are more concentrated efforts by country authorities to establish more regular issuance and provide greater clarity about investor rights.

Fifth, it will be important for jurisdictions to develop and adapt macro prudential tools and frameworks to Islamic institutions. The good news is that many of the approaches that are already applied in conventional systems can be used for Islamic finance but they still will need to be fine-tuned in a number of dimensions including to take into account the fact that Islamic institutions typically have a higher concentrations of loans to households and real estate.

Six, Islamic finance also has important implications for tax policy. This means the tax systems which typically favor debt versus equity-based finance will need to be adapted since otherwise Islamic finance will be at a competitive disadvantage.

Last but not least, there is a need for consumer and investor protection frameworks that take into account the specifics of the Islamic finance industry. This will require governance and transparency arrangements for Islamic banks and improvements in legal frameworks governing Sukuk.

So in summary, the message is that we see enormous potential for Islamic finance to foster inclusive growth and to help support financial stability. But for it to achieve this potential policies need to be in place that take full account of the specificities of the industry so as not to unduly handicap its growth but also to ensure that the potential risks it poses are properly addressed.

Before closing let me also say that I'm pleased to say that our work in this area will continue. At our spring meetings next week, a high level seminar will take place entitled Islamic Finance: Unlocking its Potential and Supporting Stability. And speakers will include IMF Deputy Managing Director Min Zhu, Governor Zeti from Malaysia, Finance Minister Babacan from Turkey, Dr. Ali Madani president of the Islamic Development Bank and Finance Minister Gramegna from Luxembourg.

We are also planning with the Kuwaiti authorities a global conference on Islamic finance in November of this year. A series of working papers that provide in-depth analysis and which underpinned our policy conclusions will also be issued and consolidated into a volume. And, of course, our regular policy dialogue with our member countries, our financial stability assessments, our technical assistance and training will all benefit from the work that has been undertaken over the last year and the continued efforts that we would make in this area.

So with that, let me close and take any questions that you may have.

MS. AMR: Please identify yourself and the organization you are working for.

QUESTIONER: I was curious about this point that you made in the paper about the industry, the Islamic finance, whether it might pose less of systemic risk than conventional finance at least in principle?

So I was hoping that you could elaborate on that aspect of -- because what does Islamic finance need to do further to make that statement perhaps a bit more concrete? Because it seems that what you're saying is that the industry is almost there in terms of, at least, conceptually it can provide sort of a -- it has this ability to provide sort of systemic economic benefit in the economy. But it seems really it's not there yet. So I was hoping that you could sort of elaborate on what the industry might need to do to get there?

MR. TOWE: I think for Islamic finance to achieve the promise that we see it having, to reduce systemic risk, I think that the key criteria are that it has to be truly asset-based and the requirements for risk sharing that underlie Islamic finance have to actually be applied in practice and not just in principle.

So where we see that as being important to promote is in the context of regulation and supervision in particular and again, our take on the standards that have been designed including by the IFSB, the Islamic Financial Services Board, all serve those objectives. But where we see concern or where we do have some concern is that the application of those standards, within jurisdictions and across jurisdictions is not wholly consistent. And this is particularly prevalent in jurisdictions where Islamic finance is relatively nascent or is relatively young, if you like, is still growing.

And many regulatory and supervisory systems have not taken into account the growth of the industry and the specific nature of Islamic finance, including with regard to capital requirements, including with regard to the development of liquidity frameworks and including with regard to the development of Sharia compliant money markets. So those are the some of the areas where we see as critical but let me ask if my colleagues have any context for that.

MR. NORAT: That's a very good question and it's something I think the staff discussion notes is particularly aware of. And in the context of the staff discussion note, within it I think you have some of the contents of an answer there for yourself.

In regards to the work that Islamic financial standard setters are doing with conventional standard setters, what we have seen is the development of adapted principles set out by conventional standard setters but applied to the specificities for Islamic banks. And specifically, an example of that is the recent work that the Islamic Financial Services Board has undertaken with various national central banks, the IMF, the World Bank, the Asian Development Bank and its core principles working group and Islamic financial regulations.

And that working group has or is about to issue a document which adopts the core principles essentially and adopts them by taking into account some of the specificities of the banking model that's apparent for Islamic institutions. And that's important because what we see, and Chris has mentioned this, that the application of the regulation supervision across jurisdictions is not consistent and these core principles provide at least a coherent framework for national jurisdictions to think about applying regulatory and supervisory components which will enhance the regulatory environment for Islamic financial institutions. And to be on a par in terms of robustness and financial stability and macro development services with that for conventional banks.

And that is important because in many institutions you have conventional banks operating with Islamic banks. So having a consistent standard which Islamic banks can refer to will be a great help in that regard.

In addition, also, I think some of the other additional stability elements that Chris mentioned for Islamic institutions are that on the balance sheet side, we see a great proliferation of these profit-sharing investment accounts. Now, these are what you would call in the modern terminology bail-in-able accounts, i.e. accounts which are -- which these profit-sharing investment account holders obtain profits and losses.

And so, in the event of a loss, we're not talking about risk transference which we see apparently in the conventional system, in our conventional finance system but a situation of a risk sharing, a real risk sharing and that's important because ultimately, when times are good, profits that flow from Islamic bank activity generate quite substantial returns. But equally, when times are not so good, we want an opportunity or a framework which allows losses to be shared in a way that doesn’t come to investors in a surprising kind of way in a crisis situation.

So those profit sharing investment systems allows those loss absorption. Now, the question of whether those are just conceptual, what you've seen is that certainly the profit sharing investment accounts don't form a large part of Islamic banks' balance sheets over the last couple of years. But what we've seen especially in the last two of three years, we've seen the growth of these profit sharing investment accounts from being around two to three percent of Islamic banks' balance sheets to around 15-20 percent and growing in many jurisdictions like the GCC, the MENA region, Asia and also in other jurisdictions outside of that.

So we've seen an element of moving towards a more fully risk-based Islamic financial system which is a good sign. And we've seen evidence of that also from this last two publications of Islamic Financial Services Board and in their global financial stability report. They've identified that some of these standards that Islamic Financial standards have provided are starting to be slowly adopted even though it's still a work in progress. It's an encouraging sign and we see jurisdictions around the world trying to adopt consistent standards.

And that's important because as Islamic finance, Islamic banking grows across borders, a consistent framework with regards to risk sharing, profit sharing investment accounts, capital determination with Islamic banks, liquidity instruments are what constitutes high (inaudible) liquid assets, all of those issues and Sharia governance in particular, is applied on a consistent basis across jurisdictions.

So we're seeing some positive developments in that regard. I'll transfer over to my other colleagues who may want to contribute.

MR. Prasad: I just wanted to add that macro prudential policy can also play a very important role in strengthening financial stability. By and large the instruments that are used for conventional banks are applicable even to Islamic finance. But the special characteristics of Islamic finance and the unique risks that some of the Islamic banks face would need some fine-tuning in the macro prudential policy framework.

For instance, there are challenges arising from the the way Sharia is interpreted across jurisdiction. Then there are certain non-financial subsidiaries that operate under the main umbrella of Islamic banks. There could also be a lack of high quality instruments that constrain liquidity management in Islamic finance and also the risk sharing characteristic of Islamic gives rise to special challenges in the the way capital has to be imposed on these banks.

So all these things would require some fine-tuning of macro prudential policies, and macro prudential coordination is more important here, since cross sectoral and cross-jurisdictional issues are of a greater relevance in the formulation of macro prudential policy framework. . Thank you.

MS. AMR: Thank you all for joining. Please don't hesitate to call me or contact me if you want any further questions.