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Inaugural Lecture
26 March 2007
Kuala Lumpur
by
Yang Berhormat Tan Sri Dr Zeti Akhtar Aziz, Governor, Bank Negara
Malaysia and Chairman, IFSB,
The Honourable Josef Tosovsky, Chairman, Financial Stability
Institute,
Professor Rifaat Ahmed Abdel Karim, Secretary General, IFSB,
Tan Sris, Datuks,
Distinguished Guests,
Ladies and Gentlemen,
I. Introduction
Islamic Finance has grown by leaps and bounds since the early
1960s, when Malaysia first pioneered Islamic banking, insurance
and then other financial services through the Pilgrims Management
Fund and then the Islamic Banking Act in 1983 and Takaful in 1984.
It is not my place to celebrate the achievements of Islamic financial
markets, but rather I hope to contribute in a small way how one
should think about the development of Islamic financial institutions
1
and markets within the whole context of financial policy and
stability.
2
others. The new body of thinking is less a theory of what happens
in the real world, but a way of thinking about how the real world
evolves.
Let me start with where I think Islamic Finance differs from the
mainstream neo-classical model that underpins current Western
economic theory. The work of El-Hawary, Grais and Iqbal 4 (2004)
on regulating Islamic Financial Institutions “views the Islamic
financial system as grounded in four basic principles:
4
Dahlia El-Hawary, Wafik Grais and Zamir Iqbal, “Regulating Islamic Financial
Institutions: The Nature of the Regulated”, World Bank Policy Research Working
Paper 3227, March 2004.
5
I am grateful to Gavin Bingham for pointing this out.
3
the doctrine of free markets that the main policy implication is
“getting prices right”, which implies that interest rates, exchange
rates and commodity prices would clear all markets with minimal
government intervention. Since the Islamic religion rejects the
taking of interest or riba, it is small wonder that some Islamic
economists reject the idea that the neo-classical framework can
apply to Islamic economics and finance.
6
John Maynard Keynes, “The General Theory of Employment, Interest and
Money”, Macmillan, 1942, pp 383
7
John Roberts, “Perfectly and Imperfectly Competitive Markets”, in The New
Palgrave Dictionary Dictionary of Economics, Macmillan, 1987
8
Douglass C North (1990), “Institutions, Institutional Change and Economic
Performance”, Cambridge University Press,
4
changes. “Institutions affect the performance of the economy by
their effect on the costs of exchange and production. The major
role of institutions in a society is to reduce uncertainty by
establishing a stable (but not necessarily efficient) structure to
human interaction”9.
The starting point of financial policy and stability is that both are
means to an end, namely, the desire in the end that we will all live
in a prosperous, peaceful and just society.
9
Douglass North (2005) Understanding the Process of Economic Change,
Princeton University Press.
5
spending considerable time figuring out what is the right policy,
forgetting that the best policy is the one that can actually be
implemented. Moreover, without the right institutional framework,
many ideal policies cannot be implemented at all, or at least,
implemented with tragic results. I need not remind friends here
that raising interest rates in an overleveraged environment would
only send the economy into a tailspin, instead of bringing an
economy back to its zero two-gap equilibrium.
6
and the International Financial Institutions (IFIs) have learnt and
progressed significantly in their ability to assess and monitor
financial stresses and strains. Gary Schinasi has encapsulated the
view of the IFIs in the following three Pillars of Financial Stability
(Figure 1).
Figure 1:
Pillar I –
• Macro prudential analysis, including stress testing,
scenario analysis, and analysis of financial soundness
indicators and of macro financial linkages
• Analysis of financial sector structure, including analysis of
efficiency, competitive-ness, concentration, liquidity, and
access
• Assessment of observance and implementation of relevant
international standards, codes, and good practices in the
financial sector
• Analysis of specific stability and development issues
tailored to country circumstances (e.g., role of public
financial institutions, effect of dollarization, reasons for low
access or underdeveloped securities markets, etc.
Pillar II –
• Financial system supervision and regulation to help
manage the risks and vulnerabilities, protect market integrity,
and provide incentives for strong risk management and good
governance of financial institutions.
• Good practices in most areas of financial system supervision
and regulation are reflected in various international standards
7
and codes and the related assessment methodologies; for
some areas of supervision and regulation such as
microfinance institutions, agreed international standards do
not yet exist.
Pillar III –
• Legal infrastructure for finance, including insolvency
regime, creditor rights, and financial safety nets
• Systemic liquidity infrastructure, including monetary and
exchange operations; payments and securities settlement
systems; and microstructure of money, exchange, and
securities markets
• Transparency, governance, and information
infrastructure, including monetary and financial policy
transparency, corporate governance, accounting and auditing
framework, disclosure regime and market monitoring
arrangements for financial and non-financial firms, and credit
reporting systems
Whilst the FSAP process is very useful to the IFIs to assess financial
capacity, and to some extent it helps the developing country under
surveillance to understand its weaknesses and areas of
vulnerability, very little work at the theoretical and practical front
exist to help emerging markets build their financial infrastructure or
markets effectively11.
The reason for the lack of practical guidance stems from the
underlying free market philosophy that there should be minimal
government interference in the market and the fact that it is very
hard to generalize and design the sequencing of building market
infrastructure for different countries with different initial conditions.
11
See Sheng (2006) and Davis (2007) on the difficulties faced in building Asian
bond markets and using a menu approach.
8
Figure 2: Hierarchy of Domestic Financial Markets
9
6. Process and Procedures (of change or transaction)
7. Structure, architecture or hierarchy (at a point of time)
8. Incentives and Governance
10
Consequently, the need for investor and intermediary education is
vital for rational and sophisticated markets. Because of the huge
gaps in information, knowledge and experience with new products,
processes and institutions, risks in new products such as Islamic
Finance are perceived as higher than conventional products that are
already well accepted in financial markets. Mature markets are
those that are experienced in market volatility, whereas emerging
markets are subject to volatility because retail investors (including
new institutional players) are inexperienced and can “herd” or panic
at the slightest shock or surprise.
Although most laws are still local, globalization has created a whole
range of codes, rules and legislative principles that are common for
11
international commerce and trade, bank regulation, market
practices, bankruptcy and insolvency and the like. It is therefore
relatively easy for emerging markets to adopt such international
rules and regulations. For example, in establishing the Qatar
Financial Centre and the Qatar Financial Center Regulatory
Authority, of which I am a Board member, a Court and Appeals
Tribunal was established with renowned international experts to
ensure that the legal framework for operations and transactions in
the Center would operate according to best international standards
and rules.
12
procedures operate through organizational structures. Different
processes require different organizational structure, architecture or
hierarchy. Such structural differences basically represent different
alignments of authority or function within any particular institution
or organization in response to its functional needs. The creation,
removal or re-configuration of organizational or institutional
structure can greatly change not just its behaviour, its efficiency,
but also its robustness (resilience to shocks) and also adaptability to
new environments (innovation).
13
Williamson13 introduced the concept of bounded rationality in his
work on the Transactional Cost Economics for his theory of the firm
and institutions. The concept can be broadened to resource
constraints, information or knowledge constraints, belief constraints
and institutional constraints.
14
government implementation of project led to too much government
intervention in markets. However, it is quite clear that the recent
trend towards public-private partnerships in implementation of
infrastructure projects can yield greater efficiency all round. This
trend is also applicable in financial sector institutional building.
Malaysia was successful in building up Islamic finance because it
allowed non-Islamic financial institutions to promote and develop
Islamic finance products, subject to the necessary syariah
safeguards.
Notice that I have not tried to recommend that one should pick for
priority development product A, institution B or follow model C,
because these tend to be country specific15. Let me elaborate
briefly on each of these steps:-
15
See Davis (2007) for a menu of policy options and choices.
15
• Creation of a financial system that is efficient, transparent, fair
and robust in supporting real sector growth and meeting the
needs of the economy
• Raise the knowledge, skills and management/risk capacity of
the financial system, particularly consumers, investors,
financial intermediaries and regulators
• Delineate, protect and transfer property rights fairly,
transparency and with low costs
• Open to entry, innovation, competition and orderly exit of
market players
• Meeting standards and rules and regulations according to
international standards
• Creation and enforcement of incentives towards lowering
transaction costs, strengthening capacity to manage and
absorb risks and shocks and fair treatment of customers
• Consistent with values of society, e.g. syariah
The FSAP results will form an extremely useful basis for the
consideration of Stage III, the Prioritization of Policies and
Institutional Reforms.
When governments are asked to do too much too fast without the
implementation capacity, the easiest option out is to stay put. The
IFIs should therefore provide technical assistance to set up a
framework to prioritize policies (or to build the institutional
framework to enable implementation of policies).
16
The Constraints are clearly the following:-
•Financial resources
•Information resources (skills availability)
•Ownership (buy in not only by the implementing agency, but
also vested interests and the public generally)
•Political or Bureaucratic Constraints (in the sense that certain
amount of political capital and bureaucratic goodwill will have
to be sacrificed in order to achieve reform).
•Capacity constraint (whether it is possible to assemble a team
that is able to implement, coordinate and push through
reforms)
17
knowledge intensive without building a strong foundation in
their core markets, such as inter-bank, foreign exchange and
government bond markets. The result is that domestic players
are not ready for the next step forward in knowledge intensity
and falter so that derivative markets appear to be much more
fragile and risky than needs to be the case.
18
networks and credibility within the government bureaucracy to
coordinate and ensure that projects move forward without
undue obstacles and foot-dragging.
V. Concluding Remarks
19
society believes is good for them as a group.
References:
20
Framework for Financial Stability”, International Monetary Fund,
1998
Andrew Sheng and Kwek Kian Teng (2007), “East Asian Capital
Markets Integration: Steps Beyond ABMI”, ANU-MOF Conference on
Advancing East Asian Economic Integration, Bangkok, 22-23,
February
21
The East Asian Experience”, Emerging Markets Forum, Jakarta
22