IFSB-IRTI IDB report on financial stability

The IFSB-IRTI-IDB paper on financial stability within the Islamic financial industry provides a good overview of the development of Islamic finance over the past forty years and provides eight "building blocks" for the Islamic financial industry. Before getting to those building blocks with my thoughts, there was one passage of the report which I think is a clear description of the areas of the financial crisis that the Islamic financial industry was able to avoid followed by the a description of how the industry was affected. A lot of ink has been spilled over the past two years claiming that the Islamic financial industry is immune from crisis and was not affected by the most recent crisis. Besides being flatly untrue, it leads to a dangerous level of complacency about the real risks that the Islamic finance faces. Having a report issued by three large multi-lateral institutions face up to these challenges and recognize the harm the credit crisis did to the Islamic finance industry (albeit far less damage than was absorbed by its conventional counterpart) is refreshing. The report describes:

"Islamic financial institutions, which are subject to Shari’ah regulations, are forbidden from investing in such derivative instruments and therefore did not have exposure to such derivatives. Also the holding of shares or the investment in conventional financial institutions which are involved in usury or riba’ are not permitted. The combination of these factors minimised the impact of the financial crisis on Islamic financial institutions. However, the subsequent tightening of liquidity and credit in the global financial markets did adversely impact all financial institutions in general, including Islamic financial institutions. As the financial crisis become prolonged, the global recession, the collapse in commodity and oil prices, and the sharp erosion of asset values that followed, affected the performance of the Islamic financial institutions." (p. 28)

The key part of this summary is that "the subsequent tightening of liquidity and credit in the global financial markets did adversely impact all financial institutions in general including Islamic financial institutions. As the financial crisis become prolonged, the global recession, the collapse in commodity and oil prices, and the sharp erosion of asset values that followed, affected the performance of Islamic financial institutions".

Moving on through the report to the eight building blocks. I will give my thoughts on each building block although I would recommend reading at least this part of the report, which begins on page 43 of the PDF. The report ends with a suggestion of the creation of an Islamic Financial Stability Forum.

• Building block 1: Develop cross-sectoral prudential standards. There has been much talk of developing a set of global standards in Islamic finance so this section is not new. However, it provides a focus on covering all aspects of Islamic finance including banking, investment and takaful. The standards for takaful are noted as being especially deficient. Takaful is still dwarfed by the other areas of Islamic finance, particularly banking, in its development so it is not surprising that its prudential standards development is also lagging behind banking. One of the most important areas where I think regulation should focus most in takaful is in the investment of the premiums. There are currently far to few sukuk or other fixed income products to even accommodate the industry's current size. As it grows, this deficiency will grow. The role of prudential standards is to ensure that the takaful funds do not become too exposed to real estate and equities. However, the regulation has to avoid being too constrictive, which could hurt the growth of takaful. That being said, if a large proportion of takaful funds are invested in equities, the next large decline in equities could leave takaful funds holding assets below their needs in terms of meeting claims, which could spark a crisis in confidence among consumers of takaful, which would set the development back significantly.
  
• Building block 2: Develop liquidity management tools. This is one of the areas where I have been most concerned and I have written extensively about this risk area for Islamic finance. The lack of a lender of last resort is particularly troubling because it creates a situation where a liquidity problem (not having enough liquid resources to meet depositor withdrawals) can turn into a solvency problem (where institution's assets fall below its liabilities due to its need to sell assets at fire sale prices to meet depositor withdrawals). It is heartening that there are more liquidity management tools being developed (UAE, Pakistan and privately within the UK) to complement a few countries which have taken the lead in this area (Bahrain and Malaysia).
  
• Building block 3: Developing a lender of last resort and depositor insurance. Most of the inter-bank financing (either murabaha or wakala) works most of the time. However, as the recent financial crisis demonstrates, these markets can freeze up when they are most needed, which creates liquidity problems for institutions that can morph into solvency problems. There is an additional problem where Islamic banks' depositors are not insured. The lack of deposit insurance can make an inter-bank money market freeze up worse if depositors 'run' on the bank. The lack of funding in inter-bank markets forces Islamic banks to sell assets at whatever price they can get. As I mentioned above, this can turn a liquidity crisis into a solvency crisis.
  
• Building block 4: Develop crisis management tools. This building block is one that is very similar across conventional and Islamic finance. What should be done with institutions that become undercapitalized, particularly when there are large institutions or a large number of institutions that are undercapitalized? The common aspects of liquidation (who has priority over whom?) and recapitalization (including from the sovereign) raise additional issues relating to Shari'ah-compliance. As important as this building block is, I think it is among the most difficult because every crisis is different and there are so many factors (legal regimes, economic characteristics, etc.) that could impact the specific response so that planning in advance is nearly impossible except on the most general points.
  
• Building block 5: Transparency of accounting, auditing and disclosure. This is an area where, in contrast to building block four, there is already an institution in place that can take the lead in this development. There is also a global standard (Basel 2 and the to-be-released Basel 3) that applies to all financial institutions. These are clearly not adequate on their own and will have to be incorporated within other prudential standards for Islamic financial institutions (if an apple is rotten, no amount of auditing or disclosure about the apple will make it any less rotten). However, greater auditing and disclosure can bring problems to the fore earlier which can in some cases make them easier to deal with than if they are hidden until the market sniffs them out.
  
• Building block 6: Macro-prudential supervision. This is the section of the report which received the most attention. The risks to the Islamic financial system do not come just from one institution. As mentioned above, the risk that liquidity dries up in inter-bank lending can bring down even the healthiest Islamic banks. However, when it comes to monitoring systemic risks and remedying them, there are issues with: who will do it? how will they spot systemic risks? what can they do once they spot a risk? how will they enforce their decisions across multiple countries and regulatory systems?
  
• Building block 7: Strengthen ratings of Islamic finance. This is an issue that has been significant in the conventional industry as well. However, within the Islamic finance industry, it takes on another dimension. As much as the products used by Islamic financial institutions are designed to replicate conventional financial products, they do have unique risks that ratings agencies may or may not be incorporating into their ratings. Is a AAA sukuk different from a AAA bond? In many ways, this discussion is a replication of the arguments about whether the AAA rating on CDOs and other mortgage securitizations was used identically to the same rating on a corporate bond. Different products (conventional and Islamic) have different risks so forcing them into the same ratings scale may lead to situations where a AAA sukuk performs far differently than a AAA rated bond would. Avoiding this situation before there is another financial crisis is imperative.
  
• Building block 8: Capacity building. The Islamic financial industry has to continue growing the number of skilled individuals to allow for this growth to continue without overstretching its human capital resources. I don't have much to comment on this except that I agree.