When Dr. Zeti speaks, you should be listening

A few quotes and thoughts on Dr. Zeti Akhtar Aziz's speech at ISRA. 

Increased liberalisation and greater foreign participation in the Islamic financial markets are reinforcing this trend and resulting in increased cross border financial flows. This is contributing to increased international financial and economic linkages between nations, particularly among emerging economies.

The development of more cross-border financial flows by Islamic financial institutions is a big positive, and makes sense since Islamic finance is supposed to be focused on facilitating economic activity.  The European debt crisis, which has led to significant fall-off in import demand (not to mention the continuing slow growth elsewhere in the developed countries, means that developing countries are going to have to both focus on their domestic markets and other trading partners as sources of demand for their products.  If Islamic finance can provide financing for the trade flows--which should be a good fit with the products used in the Islamic finance industry, it will be beneficial.  The one area where it may be difficult for Islamic finance is where floating currencies are involved, since it is more difficult to hedge against fluctuations of currencies. 

These developments [the establishment of AAOIFI and the IFSB] have been particularly important to the recent intensification of the internationalisation of Islamic finance which in turn contributes towards building bridges and forging greater linkages among a wider range of economies.

 In this respect there is still more progress to make, since there remain concerns about the regulation of Shari'ah scholars, and no similar body to AAOIFI and IFSB to provide international Shari'ah scholar oversight, although it is being discussed. In one respect IFSB is much further along than AAOIFI in providing transparency in the regulatory standards under which Islamic financial institutions must abide, because it publishes its standards online, whereas AAOIFI does not.  Dr. Zeti does not mention this explicitly, but does highlight the need for: "greater leverage on technology for the active dissemination of information at real time further facilitates the harmonisation process."

She then moves on to globalization in Islamic finance:

In the recent years, the intermediaries have also gained scale and the financial markets have gained depth and maturity.

I would take issue to some degree with Dr. Zeti regarding the depth and maturity of Islamic finance markets, although from her perspective as the central bank governor in Malaysia, she does deserve a pass on this issue.  The Islamic finance market in Malaysia has developed considerable depth and maturity, enough so that it is attracting attention from companies in the GCC (mostly banks), who have looked east to tap more liquid markets, even though it exposes them to currency fluctuations (some of the banks are using the Ringgit markets to avoid currency risk where they have subsidiaries operating in the local Malaysian market). 

However, even some GCC markets have showed they are maturing as the prospect of default by Dana Gas on their $1 billion sukuk attracted some media coverage, but not the same level of concern as when Nakheel was seen at risk of defaulting on its sukuk (a key difference of course is that Dana Gas is a private company while Nakheel's first sukuk was backed by Dubai World, a quasi-sovereign entity). 

The speech shifts into high gear from here, when Dr. Zeti warns that " Its resilience during the global financial crisis should not result in complacency."  This is an important point and mirrors what the IFSB said in response to claims that Islamic finance was immune from financial crisis.  There is a consensus now which disputes the optimistic claims that Islamic finance was not touched by the financial crisis because its structure is fundamentally different than the conventional financial industry. 

It was not necessarily the complex products (CDO, CDS, etc) that ultimately led to the major bank failures, but was instead a failure in the markets of their assets, and doubts about their value, combined with the inherent leverage of the products themselves which dried the market up and took away the ability to use their assets as collateral in repo markets to meet liabilities as they came due.  A dramatic fall in the value of a firm's assets, whether those are complex derivatives or equity-based products, will lead counterparties to question the solvency of any financial institution, Islamic or conventional.

This lack of confidence will spread at a speed in direct proportion to the levels of leverage employed in the balance sheet, and the degree to which the bank is subject to possible liquidity crunches either from depositors with current accounts or other counterparties providing short-term debt.  The inability to access liquidity and the inability to roll over maturing short-term debt (a drying up of interbank liquidity) led to the conventional banks' failures during the financial crisis and could lead to a similar failure in the Islamic finance market as well since it was the liquidity, not the toxic assets, that were the ultimate reason for the failure.

Islamic finance remains vulnerable to a liquidity crisis because 1) there is limited inter-bank lending, 2) nearly no interbank repo, and 3) few options for the central bank to act as lender of last resort (except ad hoc means like the wakala deposits the UAE Central Bank placed with Islamic banks during the crisis).  The lesson from the financial crisis is that when an asset price falls that triggers a fall in the value of your assets and questions about your solvency, the line between survival and failure is the degree to which the financial institution is leveraged (where the debt acts to magnify losses, just as it does profits) and the degree to which you rely on short-term financing (either deposits or inter-bank financing).  Higher leverage and greater liquidity needs lead to a greater likelihood of failure.

Dr. Zeti then goes to highlight the linkage between Islamic finance and socially responsible investing (which I have highlighted before on this blog):

First is the need to highlight with greater clarity the value proposition of Islamic finance so as to ensure that it remains a form of financial intermediation that serves the real economy and that it will continue to be a benefit to society. This requires the development of financial products and services that manifests the value propositions of Islamic finance, and that such products are marketed with simplicity so as to facilitate a greater understanding of the main benefits of the products. In relation to this, Islamic finance presents significant appeal to the growing Socially Responsible Investment (SRI), sustainable investments and ethical finance. This is particularly relevant in the context of the recent global financial crisis. It [the financial crisis] has brought to the forefront the need for the financial system to be linked to the economy and for the need for greater and improved levels of transparency, fairness, ethics and social responsibility in modern finance.

Beyond financial returns, SRI also accords primary consideration to the impact on economic activity and on the broader society, thereby incorporating the important dimensions of environmental sustainability, social responsibility and governance. This is in close parallel with the inherent principles of Islamic finance, in which financial transactions must be underpinned by real economic activities, and its operations are guided by the principle that money should also be used to create social good.

Then she moves on to another favorite topic of mine, Islamic microfinance and a focus on making Islamic finance inclusive:

The second imperative is for the outreach of Islamic finance to be inclusive and to be accessible to all, particularly the lower income groups and small businesses. An important agenda in the global economy is to achieve a more balanced growth with reduced income disparities. Financial services has a tremendous role in contributing towards a more equitable economic growth and a more sustainable development. In relation to this, Islamic financial institutions need to strive to enhance the access of their financial services to all segments of society. This imperative translates into the need and demand for more Islamic microfinancial products. In emerging as a new market niche, Islamic microfinance would meet the differentiated demands of low income communities and provide support to entrepreneurial activities. Its strong value proposition reinforced by financial inclusion would result in significant potential to uplift the economic performance and development. Furthermore, Islamic microfinance, if supported by microtakaful, has the potential to provide a more comprehensive, sustainable and accessible financing and protection solution for the lower income groups and small businesses.

I have said it before and I will say it again, Dr. Zeti's speeches are almost always required reading and she has a knack for making important points rather than repeating the same platitudes that are too frequently repeated.  This should be commended, and also serve as a reminder that when Dr. Zeti speaks, you should be listening.