GLOBALIZATION OF ISLAMIC FINANCE: STATE STREET ISLAMIC FINANCE CONGRESS BOSTON 6 OCTOBER 2008

October 9, 2008 at 2:48 pm | Posted in Development, Economics, Financial, Globalization, Islam, Research, World-system | Leave a comment

Keynote address by Dr Zeti Akhtar Aziz

Governor of the Central Bank of Malaysia at the State

Street Islamic Finance Congress 2008

“Islamic Finance: A Global Growth Opportunity Amidst

a Challenging Environment”

Boston, 6 October 2008.

Zeti Akhtar Aziz: Islamic finance – a global growth opportunity amidst a challenging environment

Keynote address by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the State Street Islamic Finance Congress 2008 “Islamic Finance: A Global Growth Opportunity

Amidst a Challenging Environment”, Boston, 6 October 2008.

* * *

State Street Islamic Finance Congress 2008

Globalisation of Islamic finance

This decade has witnessed the rapid evolution of Islamic finance. This has resulted in the

dramatic transformation of the industry, from being focused on retail financing to providing an

extensive spectrum of financial products and services, from being focused on the Muslim

community to having an extended reach that serves the non-Muslim community, from being

governed by conventional regulatory and accounting standards to having promulgated its

own standards and finally from being domestic centric to becoming increasingly

internationalised. The Islamic financial services industry has during this decade transitioned

into a dynamic, fast growing and competitive form of financial intermediation servicing the

global community.

It is my honour and great pleasure to be here in Boston to participate in this inaugural State

Street Islamic Finance Congress. With the recent evolution and expansion in Islamic finance,

it has now emerged as a viable new asset class for investors and a competitive form of

financing for businesses. It has therefore, not only allowed for the further diversification of

risks, but, the resulting higher level of foreign participation and the increased cross border

flows has not only strengthened international financial inter linkages between nations but

also contributed to the more efficient international allocation of resources across borders.

Intrinsic strength of Islamic finance

Islamic finance has, thus far, remained positive, despite the current challenging global

financial environment. The strengths in Islamic finance are derived from the Shariah

principles, the key pillar of Islamic finance that has contributed towards its overall stability

and resilience. The Shariah injunctions require that the financial transactions be

accompanied by an underlying productive activity thus giving rise to a close link between

financial and productive flows.

In addition, under the risk sharing arrangement, the Islamic financial institution will share the

profit or loss incurred by the entrepreneur. Under this arrangement, there is an explicit risk

sharing by the financier and the customer and the real activity is expected to generate

sufficient wealth to compensate for the risks. This arrangement, thus, entails the appropriate

due diligence and the integration of the risks associated with the real investment activity into

the financial transactions. In addition, the Shariah principles also prohibit excessive leverage

and speculative financial activities thus insulating the parties involved from excessive risks

exposures.

The intrinsic principle of profit and risk sharing thus provides an in-built check and balance to

the Islamic financial transactions. Explicit in this arrangement is the element of risk

management and governance practices. Hence, it is a modality in which there is strong

explicit emphasis on the economic viability of the underlying assets and on good

governance, ethics and transparency.

A demand-driven industry with growing potential

This decade has seen the global Islamic finance industry evolve from being faith-based to a

business driven industry for all communities. Its significant similarities to the principles in

BIS Review 121/2008 1

ethical finance and socially responsible investment has been a further factor that has drawn

interest in Islamic Finance. Islamic finance does not only involve the avoidance of riba

(usury) but also extends to issues relating to ethical values, such as fair trade and

environmental protection. This has prompted participation from conventional global players in

Islamic financial activities and in the acquisition of strategic stakes in Islamic financial

institutions.

There is also a growing number of established international financial centres such as

London, Tokyo, Hong Kong and Singapore that have initiated plans for the integration of

Islamic finance into their financial systems. Islamic finance has now become one of the

fastest growing segments in the global financial system. The total Islamic assets under

management by Islamic banks and conventional banks offering Islamic banking services is

reported to exceed USD500 billion. This growth has also been in the other major

components of the Islamic financial system. Islamic mutual funds are estimated to be about

USD300 billion, while global takaful or Shariah-compliant insurance contributions are

estimated to be about USD5 billion.

Strengthening the international infrastructure

Integral to the efforts in the development of Islamic finance has been the development of the

supporting international Islamic financial architecture. The establishment of the Islamic

Financial Services Board (IFSB) in 2002 to set the prudential standards for Islamic finance,

and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

established in 1990 has been key to ensuring the soundness and stability of the Islamic

financial system.

The IFSB and AAOIFI have had an important role in the harmonisation of prudential and

accounting standards across the different jurisdictions. They are also instrumental in

instituting international best practices in the global development of Islamic finance. The

Islamic financial institutions are also subject to the requirements on anti-money laundering

and anti-terrorist financing.

Opportunities through greater international financial integration

The globalisation of Islamic finance has gained significant momentum in this recent five

years. While the early development of Islamic finance was domestic centric, its

internationalisation is now manifested by increased cross border flows, greater participation

in international Islamic financial markets, the increased presence of financial institutions in

new jurisdictions and more recently, the increased number of Islamic financial institutions

which have shareholders from multiple jurisdictions.

Greater financial integration has essentially been facilitated by the more rapid pace of

liberalisation that has been supported by the progress that has been achieved in the

development of the international Islamic financial infrastructure. This trend has also been

prompted by the need for greater diversification of risks in the management of funds. In the

current international financial environment, this trend has become more pronounced

prompting investors to consider other asset classes and markets that provide stability. Thus

far, the global financial crisis has had limited direct effects on Islamic finance. While Islamic

finance by its very nature only engages in transactions that have underlying tangible

productive activities, the slower overall growth and the increased uncertainties have affected

pricing and activity in certain market segments. However, this in part reflects the shift in

activity from the financial markets to the Islamic financial institutions.

The scope of Islamic financial business has now expanded to more sophisticated financial

products in response to the changing global customer base. Such Shariah-compliant

products include private equity, project finance, the origination and issuance of sukuk, as well as fund, asset and wealth management products. The sukuk market in particular, has

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become an important avenue for international fund raising and investment activities. This

market has expanded by an annual growth rate of 40%. The year 2007 saw an exceptional

growth of the global sukuk market which expanded by more than 70%. New issues during

the year reached a record high to about US$47 billion and the outstanding global sukuk

market has now surpassed the US$100 billion mark. Up until August this year, it has held its

ground with a total global issuance now exceeding US$14 billion, and is expected to exceed

USD200 billion in 2010. This growth is spurred in part by the growing funding requirements in

emerging market economies, in particular, in Asia and the Middle East. This is reinforced by

the continued confidence of investors in the Islamic financial instruments.

Malaysia’s Islamic finance journey

Let me now turn to Malaysia’s journey in the development in Islamic finance. Islamic finance

in Malaysia first started as a strategy for greater financial inclusion, so as to have a greater

outreach to the underserved segment of society to basic banking and insurance products

that are compatible with Shariah principles. After three decades, the Islamic financial industry

in Malaysia has evolved as an integral and competitive component of the overall financial

system that operates in parallel with the conventional financial system.

The Malaysian Islamic financial system is founded on three major strategies. Firstly, the

Islamic financial system has been evolved as a comprehensive financial system that is

diversified in terms of its institutions, markets and players. The Islamic financial system

comprises the Islamic banking institutions, the takaful industry, the non-banking institutions

and the Islamic money and capital markets. The supporting financial infrastructure includes

the robust regulatory and supervisory framework that is reinforced by the legal and Shariah

framework, the payment and settlement systems and the mechanism for the liquidity

operations by the Central Bank.

The assets of the Islamic banking system now comprise 16% of the market, while the takaful

sector has garnered 7% market share. Significant progress been achieved in particular in the

Islamic capital market where the outstanding amount of Islamic private securities amounted

to USD79 billion or 54.3% of the total outstanding private securities in the market. The

number of Shariah-based unit trust funds have also increased to 136 with a net asset value

of over USD5.2 billion while 85% of the listed Malaysian stocks are Shariah-approved

counters.

The second strategy is to accord greater emphasis on the enabling environment for

increased innovation in the Islamic financial industry. The product range in Islamic finance

has now expanded into a broad spectrum of innovative instruments, including investment

and equity linked products based on musyarakah, mudarabah and ijarah. These products are

competitive both in terms of product structure and pricing. The enhanced depth of the Islamic

financial markets, in particular, the sukuk market, has increased the attractiveness of the

Islamic financial instruments as an asset class for investment.

The drive for innovation has been supported by the investment in human capital

development. A sufficient pool of the talent and expertise has been key to the development

of the Islamic financial hub in Malaysia. The International Centre for Education in Islamic

Finance (INCEIF) was established in 2006. INCEIF which has an international faculty and

students from more than 40 countries is focused on programmes for Islamic finance

professionals and specialists in Islamic finance. The first group of students for the Chartered

Islamic Finance Professional qualification, CIFP, offered by INCEIF, is expected to graduate

at the end of this year after completing a three year programme that includes an internship

with an Islamic financial institution. INCEIF also offers a Masters and PhD Programme in

Islamic finance.

BIS Review 121/2008 3

To promote research in Islamic finance, the International Shariah Research Academy (ISRA)

was established this year to conduct applied Shariah research on the contemporary Islamic

finance issues. ISRA also provides a platform that promotes active engagement and

dialogue among global Shariah scholars that promote mutual respect in Shariah and the

convergence of views from different jurisdictions in the global Islamic financial system.

The third strategy is to promote greater financial integration with the global Islamic financial

system. The Malaysian Islamic financial system has also been progressively liberalised to

allow for increased foreign entry and participation in our financial system, thus facilitating

greater cross border flows and thus strengthening the international financial inter-linkages.

This has taken the form of issuance of new licences and increasing foreign participation in

both Islamic banks and takaful companies to 49%. New licences were also issued to foreign

fund managers and foreign stockbrokers. In this new phase of development for Islamic

finance, Malaysia as an international Islamic financial hub, has increasingly become a

meeting place for businesses from different parts of the world that need to raise funds and for

investors that have surplus funds for investment.

Islamic finance going forward

There is now a strong and growing demand for Islamic financial products in the global

market, far exceeding the current availability of financial products and services being

provided by the Islamic financial institutions. Going forward, there is therefore tremendous

upside potential for Islamic finance.

As the pace of development of the Islamic financial services industry accelerates, the

increasingly more complex and challenging environment will continue to shape the

advancement of the industry. Central to this will be the expansion of the business parameters

and innovative product offerings. For this, there is increased investment in research and

development to yield new instruments and structures to meet the changing requirements of

the international community. An area of focus, in particular, is related to the development of

mechanisms for risk mitigation and liquidity management. Of importance, are the solutions

needed to converge the market requirements and the Shariah compliance.

Increased innovation also calls for greater emphasis on the implementation of best practices

and higher standard of risk management. Vital to this is the implementation of the prudential

standards promulgated by the IFSB. There is also a need to leverage more on IT

applications and the strengthening of management capabilities of the Islamic financial

institutions. Going forward, with the increased awareness and understanding of Islamic

finance, the role of market discipline will become increasingly important in driving Islamic

financial institutions towards ensuring Shariah compliance in the operations, in improving

operational efficiency and in instituting sound and dynamic risk management practices.

The forces of innovation also raise a number of issues concerning the divergence of Shariah

views underlying a number of the Islamic financial transactions. While such a divergence of

opinions in Islamic financial transactions is not a new phenomenon, it has now prompted

increased international dialogue among the Shariah scholars from the different parts of the

world. It is the closer linkages between the global Islamic financial markets and the increased platforms for greater engagement on Shariah issues that will contribute towards promoting an increased common understanding and mutual acceptance on the rules, standards and Shariah views, and for convergence to occur. This would evolve global Shariah standards for the Islamic financial industry.

As Islamic finance continues to internationalise with expanding scale, there will be greater

financial intermediation linkages among the East Asian, West Asian, and the Middle East

regions – creating the “New Silk Road”. While this New Silk Road of financial flows is

enhancing connectivity between Asia and the Middle East, both regions have, as in the case of the old Silk Road, extended the New Silk Road to the rest of the world.

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Global investors and the international financial community have already drawn benefits from the increased diversification of investment activity to the two regions. The expansion of the interlinkages of intermediation to and among these regions would in turn contribute towards a more efficient allocation of capital in the global financial system.

Closing remarks

Against a backdrop of an increasingly uncertain global environment, Islamic finance, as a

form of financial intermediation in the international financial system, has continued to be

viable and competitive. In the coming years, the greater global participation in this

developmental process, both directly and indirectly, would enhance the potential role that

Islamic finance would have in contributing towards greater global financial stability in the

international financial system.

BIS Review 121/2008 5

Keynote address by Dr Zeti Akhtar Aziz

Governor of the Central Bank of Malaysia at the State Street Islamic Finance

Congress 2008

“Islamic Finance: A Global Growth Opportunity Amidst a Challenging

Environment”

Boston, 6 October 2008