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Islamic finance and financial stability apex forum

Islamic finance and financial stability joint forum of finance ministers and central bank governors as apex architectural body for Islamic finance

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Islamic finance and financial stability apex forum

  1. 1. Islamic Finance and Financial Stability Tariqullah Khan, Professor Hamad bin Khalifa University Tariqullahkhan.me A note on the gaps existing in Islamic financial architecture
  2. 2. Several studies conclude that Islamic finance, because of its inherent risk sharing and risk spreading features will enhance financial stability Such conclusions are in fact similar to theoretical works in conventional finance which argue that if such and such conditions are met financial stability can be enhanced However, financial crises reoccur because the theoretical conditions of stability are not met in practice. Therefore, the practice of Islamic finance may be far from its ideal architectural principles and hence Islamic finance may not promote financial stability or may even cause instability Like conventional finance Islamic finance may lead to financial instability The 5 channels of financial instability that may also exist in Islamic finance
  3. 3. The 5 channels of financial instability that may also exist in Islamic finance Channel One: Excessive credit creation and leverage Channel Two: Trading in future expectations Channel Three: Unstable funding sources Channel Four: Rigidities of financial infrastructures Channel Five: Structural Risk of the Opaque Products
  4. 4. 7% interest 10% interest 5% interest 15% interest BANK Murabahah for asset $100 Tawaruq $100 Tawaruq $100 Tawaruq $100 Tawaruq $100 Tawaruq 20% interest Crisis Channel 1: Credit creation and excessive leverage $100 $100 $100 $100 $100 $100
  5. 5. Excessive credit creation and leverage Scenario-1: Lending being as the core commercial activity of banks, credit creation is primarily based on ratings and credit risk and interest rates that different borrowers have to pay causing unbridled leverage subject to reserve requirments. Scenario-2: If we make genuine Murabahah as the core business of banks, financing cannot get out of the real economy. In this scenario, we can benefit from the advantages of the fractional reserve banking system but at the same time also avoiding the excessive and unhealthy credit creation by banks. Scenario -3: But if we make non-genuine Murabahah like Tawaruq as the core business, this scenario prevails which is almost similar to Scenario -1, where financing gets out of the real economy. The excessive leverage channel to financial crisis is open for Islamic finance through Tawaruq
  6. 6. Crisis Channel 2: Trading in future expectations 516.4 683.8 604.6 582.6 Jun-07 Jun-08 Jun-09 Jun-10 BIS reported total OTC derivative contracts outstanding (trillion US $) FX 9% interest rate derivatives 72% Equity 1% commodity 0% credit 5% others 7% June 2008 FRAs 12% Interest rate swaps 78% options 11% Jun-2008 Of all BIS reported derivatives (US$ 684 trillion in June 2008) 72% were interest rate derivatives of which 78% were fixed-to-floating rate swaps. Islamic finance has also created an exact replica of the fixed-to-floating rate swaps known as “profit-rate- swaps” The derivatives’ channel to financial crisis is open for Islamic finance through “Islamic” derivatives
  7. 7. Crisis Channel 3: Instability of funding sources 0 2 4 6 8 10 12 14 16 18 Sample of Islamic Banks Average US GSSBs Average non-US GSSBs EU 28 Banks Source: IFSB “Islamic Financial Services Industry Stability Report 2015” *GSSB – Global Systemically Significant Bank % tier 1 capital adequacy ratios 0 5 10 15 20 25 Sample of Islamic Banks US GSSBs Non US GSSBs % balance sheet leverage multiples % of PSIAs in the funding of Islamic banks 0 5 10 15 20 25 2012 2013 2014 Islamic retail banks Islamic wholesale banks Liquid assets as % of total assets
  8. 8. Rigidities of financial infrastructures The IFSB’s Islamic Finance and Financial Stability Reports address what the IFSB is doing in setting standards. The report doesn’t address the actual implementation of these standards. 1. In fact the prudential standards of IFSB, and the Shariah and accounting and auditing standards of AAOIFI are not under implementation except for a few countries. 2. PSIAs as the core deposits of Islamic banks are not uniformly treated in different jurisdictions 3. The relevant two prudential reserves, respectively for “displaced commercial risks” (profit equalization reserve) and for “commercial risks” (investment risk reserves) are not established 4. Instead of taking and managing PSIA related risks since the financial crisis Islamic banks are either avoiding PSIAs or placing the PSIA funds into lowest risk commodity Murababahs 5. Disputes among key architectural players about foundational principles; example Tawaruq, Promise, Ee’na, sale of debts, etc
  9. 9. Promise to repurchase the Sukuk assets at the initial price is not permissible “Sukuk and their Contemporary Applications” open source document 2007 by Muhammad Taqi Usmani, President of the AAOIFI Shariah Council Promise to repurchase the Ijarah Sukuk assets at the initial price is permissible AAOIFI Sukuk Resolution 2008 “The issuer or the partner or the agent must not undertake any of the following: Purchase of sukuk or their assets in their nominal value or for a prefixed price so that it ensures the capital. ------------------- The decisions issued by the Board come into effect from the time of its issuance and do not affect the previous contracts and from among them are the sukuk”. Resolution No. 188 (2012) of OIC Fiqh Academy on the subject of Sukuk OIC Fiqh Academy Disputes and Structural Risks of Opaque Products
  10. 10. “Prospective Holders should note that different Shariah advisers, and Saudi courts and judicial committees, may form different opinions on identical issues and therefore prospective Holders may wish to consult their own legal and Shariah advisers to receive an opinion if they so desire.”
  11. 11. Sukuk Structural Risk – bundled nature of credit, price and return risk Sukuk Credit risk Interest rate risk Asset price risk Bond Equity Consequence of disputes and noise between Shariah scholars
  12. 12. Financial Crisis Channels Is this crisis channel open in Islamic finance? Excessive credit creation and leverage Yes, the crisis channel is wide open through Tawaruq in which no party is genuinely interested in selling and buying assets. Trading in future expectations Yes, the door is opening through the growing R&D efforts and emergence of “Islamic” derivative products and markets. Unstable funding sources Yes, but not wide open – capitalization and liquidity situation of Islamic banks is better but because of withdrawal risk, profit sharing investment deposits are perceived to be more unstable as compared to the interest-based term deposits. Rigidities of financial infrastructures Yes, the crisis channel is open because neither prudential standards of IFSB nor Shariah standards and financial transparency standards of AAOIFI are practiced. Nor there is a mechanism for Islamic financial sector assessment in place. Structural Risk of the Opaque Financial Products Yes, the crisis channel is widely open because of the disputes between Shariah academies and boards on even basic architectural issues. Summary of crisis channels
  13. 13. How to enhance financial stability through Islamic finance? Strengthen Islamic finance architecture Islamic Finance Stability Board By establishing an apex
  14. 14. Finance Ministers; Central Bank Governors; Islamic Bankers; Sukuk Issuers and dealers Investors “Independent” scholars The key architectural players are actually
  15. 15. Looking ahead an Apex Islamic Finance Stability Joint Forum is the need to avoid structural risks of industry Finance Minsters of OIC Countries Central Bank Governors of OIC Countries Head Office Istanbul, Turkey