If you have any doubt that Islamic finance is creeping into the mainstream global financial system where it matters, albeit cautiously and perhaps in some instances even apologetically, then you should have been in Istanbul last week. Perhaps Turkey may not be perceived as the natural bedfellow of the Islamic finance industry, but contrary to popular misconception, next year will be the 30th anniversary of the introduction of the special decree (No. 831/7506 of 16 December 1983 issued by the Council of Ministers) allowing the establishment of Special Finance Houses (the euphemism for interest-free Islamic banks). Armed with the ambition of transforming Istanbul into a regional and international financial center (and no financial center these days can be complete without also offering an Islamic banking and investment proposition) and with the sovereign debt chaos emanating from the West European continent, Turkey like several other countries is seeking alternatives to the unbridled market capitalism responsible for the near meltdown. They want alternatives that connect finance with the real economy and with productive activities whether in the form of external borrowing requirements; better managing of both micro and macro economic policies; the financing of infrastructure and development; the financing of the private sector including small-and-medium-sized enterprises; a resilience to future financial and economic shocks and a contribution to financial stability and GDP growth. In fact Turkey experienced its own financial crisis in 2001 and the lessons learnt then have stood it in good stead. As the Turkish Minister of International Development Dr. Cevdet Yilmaz stressed in Istanbul, not a single Turkish bank has gone bust since the onset of the 2008 financial crisis. Perhaps it is no coincidence that the World Bank Group has been actively engaging with the Islamic financial system through its links with the Islamic Financial Services Board (IFSB), which held its 9th Annual Summit in Istanbul last week, and with the Islamic Development Bank Group. Equally important, the International Monetary Fund (IMF) is now including adherence to IFSB prudential and supervisory standards in its Financial Sector Assessment Program (FSAP), primarily in jurisdictions where such standards have actually been adopted. Dr. Mahmoud Mohieldin, Managing Director of the World Bank, in his keynote speech to the IFSB Summit, could be forgiven for adopting a “carrot-and-stick” approach to the Islamic finance industry. “While several features of Islamic financial institutions have enabled them generally to fare better than their conventional counterparts these past few years, there is no room for complacency. Several key areas that connect with current global reform trends need urgently to be addressed,” he advised. These include regulatory oversight, corporate governance and insolvency frameworks. While begrudgingly acknowledging that the basic principle of risk sharing and the strong linkages between the real sector of the economy and financial sector protected Islamic financial institutions from the worst effects of the crisis, and that as business partners, financial institutions are more likely to assist borrowers in working through bad times, thus lowering the pressure to sell assets at “fire-sale” prices and therefore reducing the probability of contagion to the rest of the financial system, Dr. Mohieldin returned to form, warning that despite the remarkable expansion of the Islamic finance industry, it remains a relatively small one accounting for a mere one percent of global financial assets. While market depth and scalability are indeed immediate challenges for the Islamic finance industry as Dr. Mohieldin suggests, he fails to offer any glimmer of hope of how the very ethos of Islamic financial intermediation can be worked into the very global reforms that the IMF's Financial Stability Forum and the Basel III provisions purport to offer. Such recognition transcends mere market size or growth. Nevertheless, the World Bank is right in terms of regulatory oversight to urge the need for uniform enforcement of key regulatory prudential and supervisory rules across jurisdictions. “We need to achieve a common understanding of risk-sharing for Islamic finance globally, and how rules would work, in practical terms on specific transactions, across jurisdictions,” he added. The current environment, he suggested, presents a good opportunity to bring Islamic finance into the broader debate on the strengthening of the financial system. For example, Basel III poses challenges for Islamic banks operating internationally and in jurisdictions that do not have regulations geared towards the industry. At the same time, some have argued that Islamic banks are already ahead of Basel III rules in many ways, holding more equity and with a greater emphasis on common equity. The reality is that the increase in banks' capital quality, consistency and transparency under Basel III do not affect Islamic banks because the Hybrid and Tier III capital that are affected by the changes have not played a significant role in their capital structures. The capital structure of the majority of IFIs is dominated by Tier I capital and common equity. In Tier II capital, the issue is how IFIs will meet Shariah requirements before meeting the regulatory requirements for instruments such as subordinated debt, hybrid capital, convertible contingent capital (CoCos) and Sukuk that can be considered as capital. On the other hand, liquidity is one area where Islamic banks are likely to be significantly affected, principally due to the lack of liquid Islamic instruments. Good and effective corporate governance is an essential component of Islamic financial principles, although in practice there remains significant challenges, especially in the Shariah Governance process including the Shariah Supervisory Boards (SSBs). An important new suggestion from Dr. Mohieldin is worth considering. That is to enhance the effectiveness of SSBs “by shifting their emphasis from reviewing Shariah compliance to serving as the fiduciary guardians of the customer's rights, as quasi-outsiders who are providing independent validation, in some ways analogous to external auditors”. Indeed, the World Bank considers this a “priority area” and is in the process of finalizing its “Supplemental Corporate Governance Guidelines for Islamic Financial Institutions”. Given the few Sukuk defaults including exposure to the SAAD Group and Al-Gosaibi Sukuk, and the actions in the London High Court and in Malaysia over the last few years, insolvency regimes, including effective insolvency and creditor rights, are a key priority. The World Bank proposes the establishment of “a coherent system of insolvency rules and principles which are consistent with the Shariah and are benchmarked against international best practices.” Dr. Mohieldin is confident that Islamic finance can contribute meaningfully to financial stability through its demonstration effect on risk sharing and keeping its “own house in order”. Indeed recent empirical research at the World Bank suggests that Islamic financial institutions fared better through the crisis that gripped the world starting in 2008, than conventional counterparts. Similarly, Islamic finance can play a key role in financial inclusion which is high on the agenda of inter alia the G20 and G24 forums. The World Bank recently launched its Global Findex which collects comparable cross-country data on financial inclusion. The results are staggering – some 2.5 billion people are unbanked, including about 75 percent of the world's poor. Dr. Mohieldin reaffirmed the World Bank's commitment to play a positive role in the growth of the Islamic finance industry which focuses primarily on knowledge sharing, support for the development of standards and rules, and executing transactions through its financing programs. The Bank's Islamic Economics and Finance Working Group seeks to provide support to the industry in capacity building and knowledge management; engagement on policy directions in market development, regulation, standard setting and new financial products; diagnostic and analytical work in Islamic finance; and technical assistance on issues relating to legal, regulatory and institutional frameworks as well as compliance with standards. To date, the World Bank has issued a RM750 million Sukuk in Malaysia; its private sector funding arm, the International Finance Corporation (IFC) has issued a US$100 million Sukuk Al Ijara against assets in the GCC region; and its Multilateral Investment Guarantee Agency (MIGA) structured a US$450 million Murabaha facility for a mobile phone company in Indonesia to improve the mobile network and to increase population coverage; and MIGA underwrote US$27 million in guarantees to support the construction of the Doraleh Container Terminal in Djibouti. __
