Saturday, April 10, 2010

Islamic finance and financial stability

The Islamic Financial Services Board meeting recently saw the launch of the IFSB-IRTI-IsDB report on financial stability in the Islamic finance industry. I have not had a chance yet to read the report, but my initial impression of their effort is supportive. It recognizes that the global financial crisis did impact the Islamic financial system and can provide lessons as institutions grow larger. There have been many times, most recently a couple weeks ago where I question whether too big to fail is not a problem that could afflict Islamic finance. I argued (and still maintain) that because the industry is concentrated in small countries in the Gulf, a big institution (like the planned Islamic mega bank or institutions like Dubai World, which is not an Islamic financial institution, but has received significant Shari'ah-compliant funding) could endanger the financial stability of the country it is based in. This problem is heightened because there are no Shari'ah-compliant options for 'lender of last resort', the role the US Federal Reserve played to keep healthy banks from being destroyed as global liquidity dried up. The potential problem does not end there. There is inter-bank funding occurring (although not generally overnight funding which caused virtual runs on conventional institutions) and so one bank's trouble spills over to other banks with exposure to the troubled bank. If a few large lslamic banks became insolvent, it is likely that their debt would be held on other banks' balance sheets and the writedown of the insolvent bank's debts held by other banks could put stress on the solvency of the other banks. This could be heightened if this caused retail banking customers to withdraw their money, which could cause a liquidity squeeze that would put the previously healthy banks at risk of insolvency. With that rather gloomy (although relatively unlikely) prospect in mind, I think it is a good thing for the establishment of an Islamic Financial Stability Forum, which was recommended in the report.

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