Islamic Finance and Penetration of Financial Services

Transcription

1 Islamic Finance and Penetration of Financial Services Wafik Grais Keynote Address Seminar on Comparative Supervision For Islamic and Conventional Finance Beirut December 7-8, 2004 Excellencies, Honorable Guests, Ladies and Gentlemen It is a great pleasure for me to be here today and address this seminar. National supervisors and international assessors are increasingly facing the issue of the adequacy of their instruments and approaches to Islamic finance. This seminar, led by the IFSB, and hosted by the Central Bank of Lebanon is a good opportunity to focus on the challenges Islamic finance poses to supervisors. I would like to thank Professor Rifaat Abdel Karim, and the IFSB for the initiative to allow us to consider these issues in the next two days. I would like also to thank his Excellency, Governor Salameh, and the Central Bank of Lebanon, for the gracious offer to host this conference, here in Beirut, a city that is a symbol of how determination and hope can overcome adversity. The importance of bank supervision was highlighted by the Basel Committee on Banking Supervision, in its work on the Basel II accord for the regulation and supervision of major international banks, approved earlier this year. Similarly market and regulatory developments in the last two years have brought focus to the issue of supervision of Islamic finance, in particular. More than a year ago, Professor Rifaat Abdel Karim brilliantly presented the case for differential regulation of 1

2 conventional and Islamic finance, at a panel discussion at the Dubai Annual Meetings of the IMF and the World Bank. Meanwhile, the IFSB has been hard at work to develop practical rules addressing identified differences. Also in the meantime, Islamic finance has continued its market penetration from Indonesia to the UK and the US, as well as its expansion notably in Takaful, and domestic and international capital markets. Equally national regulators have put in place regulations to govern Islamic finance activities. Here, in Lebanon, law 575 of February 2004, and related executive regulations have been issued. They provide rules for the licensing of Islamic financial institutions, the nature of deposits, distribution of revenue as well as the conduct of Murabaha transactions, a dominant asset class. All these developments are bound to impact the business of supervision. They highlight the timeliness of the topics that will be discussed in this seminar. It should be an important milestone in sharpening the outstanding issues. I propose to share with you two thoughts on the role Islamic finance could play in increasing the penetration of financial services. The first thought is its potential contribution to improving access to financial services and larger social inclusion, for the more than 1.2 billion worldwide Muslim community. The second thought is the critical complementary role of effective supervision and sound corporate governance to the realization of that potential. 2

3 Finance, Development and Access Let me start with three observations related to increased penetration of financial services. The first observation is that it is by now well established that an effective financial system can make a sizable contribution to national prosperity. A 2001, World Bank monograph with the telling title Finance for Growth reports on the evidence collected to that effect. Further evidence is provided by more recent work that attributes 25% of the growth rate of Thailand over 20 years to increased penetration of financial services. 1 The second observation is that in many developing countries, the penetration of financial services remains limited. For example, in Morocco and Yemen, the share of people having a bank account is reported to be less than 20% and 10% respectively. Similarly, the penetration of insurance services remains well beneath the world average. The share of premia in GDP in 2000 was less than 3% in most of the Middle East and North Africa countries, while the world average was at about 8%. In contrast, South Africa, and the UK had penetration rates of 17%, and 16%, respectively. The third observation is that it appears that many members of the Muslim community may refrain from accessing conventional financial services in order not to breach their religious beliefs. Accordingly, the limited penetration of financial services could well be 1 Gine and Townsend (2004), Wealth Constrained Occupation Choice and the Impact of Financial reforms on the Distribution of Income and Macro Growth. 3

4 due to this attitude, as well as to the limited development of conventional finance, in a number of countries. Combined, these three observations prompt one to ask whether increased availability of Islamic financial services would increase the penetration of financial services, and consequently economic growth, and social inclusion. The answer to this question is relevant to the focus of financial development policies for many countries. A substantiated analysis of the issue needs to be developed. There are some, however, who would argue that policy makers attention should not be diverted from the development of conventional financial services. In their view, conventional finance is likely to deliver superior efficiency as it need not accommodate constraints Islamic finance needs to observe. A systematic analysis of the comparative efficiency of the two modes of financial intermediation could help shed light on this issue.---- I understand that the Islamic Development Bank research institute may be looking at it---. In considering the relative efficiency of both modes of financing, it may be useful however to keep in mind two points The first one is that the benchmark, against which one needs to measure the impact of increased penetration of Islamic financial services. This benchmark may be no or less financial services, rather than a fully developed set of 4

5 conventional financial services. Indeed if it proves to be true that many do not have recourse to conventional finance because of their religious beliefs, no matter the availability of conventional finance, the penetration of financial services would remain limited, with corresponding negative implications for growth. The second point is that over time there may well be convergence between Islamic and conventional modes of financing. Such convergence would come from a combined effect of a strive for market innovation, efforts at enhancement of financial stability, and requirements of social inclusiveness in both Islamic and conventional finance. Islamic finance can be expected to continue pursuing market innovations and improvements in the regulatory framework governing its operations. Regulators, market participants and Sharia scholars are deploying significant efforts to overcome features of Islamic finance that constrain its efficiency, without tampering with its fundamentals. Market developments from the Gulf, to East Asia in the last few years are a witness to these creative efforts. I have alluded to them earlier. While the progress achieved in product innovation and market development, may have been uneven as Stefan Ingves mentioned, further efficiency improvements can be expected to continue. Development of 5

6 markets that can facilitate risk management and permit long term financing are critical in this respect. Convergence may well also be the outcome of public and corporate policy concerns of promoting more socially inclusive economic growth. The increasing concern of conventional finance with social inclusion does indeed converge with the tenets of Islamic finance. Promoting socially inclusive conventional finance will need naturally to rely on market innovations, but also pro-active public and corporate policy that do not ignore efficiency. Prevailing public policy considers socially inclusive finance as conducive to healthier and more stable societies. Indeed consumer, housing or SME finance are considered instrumental in giving a stake in social development to a broad spectrum of people and empowering them to seek a better future for themselves and the societies they live in. Promoting more socially inclusive finance will need to avoid falling again in the traps of financial repression. Protecting the vulnerable from exploitative abuse of debt contracts by the unscrupulous is a conventional finance goal that deserves greater attention than it has hitherto been accorded in financial sector policy for developing countries. Over time these concerns may blur some of the differences between Islamic and conventional finance. 6

7 Convergence may well also be the outcome of public and corporate policy concerns of promoting maintaining financial stability and public confidence. These concerns may lead to cross-fertilization between Islamic and conventional finance. They will require constant improvements in risk management practices, stringent fiduciary standards and close compliance monitoring in both systems. They should also lead each system to research and adapt features in the other that contribute to stability and confidence. An example of such cross fertilization is a recent paper with the revealing title: Remedy for Banking Crises: What Chicago and Islam Have in Common. 2 There, the authors argue that both Islamic finance and a narrow banking based system provide more stability to a banking sector than a conventional banking system. Be it as it may, on this particular point, this work illustrates well the potential of cross-fertilization and enlargement of common grounds between Islamic and conventional finance in achieving greater financial stability and increasing public confidence. Further work in this spirit should be encouraged. 2 Garcia,V.F., Fretes Cibils, V., Maino, R. Remedy for Banking Crises: What Chicago and Islam Have in Common, Islamic Economic Studies, Vol. 11, No 2, March

8 Regulation. Supervision and Sound Corporate Governance Let me now turn to the second thought I wanted to share. It is related to financial stability and public confidence. Islamic finance, like conventional finance needs to promote public confidence in its operations if it is to mobilize deposits in a sustainable way and develop a healthy business. Regulation, supervision and risk management should contribute significantly in this respect and help the industry establish a track record. Indeed these are issues that brought us together here today and many of them were outlined by Stefan Ingves. I would like to focus however on the complementary role of sound corporate governance and two challenges it presents for businesses offering Islamic financial services. While views may differ on what constitutes sound corporate governance, there can be agreement that it can create accountabilities, transparency and balance of power within the firm, which discourage deviations from virtuous behavior. 3 Thus sound corporate governance can facilitate supervision, in addition to enhancing business performance for Islamic and conventional finance businesses alike. 3 The OECD offers a definition of corporate governance along the lines that it is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. 8

9 Corporate governance should be a significant pillar, complementary to supervision, in any framework aimed at enhancing financial stability. From a perspective broader than finance, one can think of Hirschman s point that under any economic, social, or political system, individuals, business firms, and organizations in general are subject to lapses from efficient, rational, law-abiding, virtuous, or otherwise functional behavior. 4 Conventional or Islamic finance businesses alike are susceptible of featuring such unrestrained, inefficient and dysfunctional behavior. There are cases of distress of conventional and Islamic financial businesses witness to that effect. By providing a ruleof-law government for the firm that stresses accountability, transparency and balance of power, corporate governance can constrain such behaviors and mitigate the risks they represent. Accordingly sound corporate governance supports supervision. Supervision can indeed best function when the supervised have developed a 'Law habit', that is a tendency to respect the rules of the game, without the constant intervention of a supervisory watchdog. Thus adopting and practicing sound corporate governance arrangements, Islamic financial businesses can contribute to efficient supervisory activity, in addition to enhancing their competitive potential. They face two particular challenges however. The first one stems from the emphasis Islamic finance appears to place on stakeholder value, and the associated difficulty of designing corporate governance arrangements that incorporate incentives that would induce managers to internalize all stakeholders 4 Hirschman, Albert, O., Exit, Voice and Loyalty: Responses to Decline in Firms, Organizations and States, Cambridge, Massachusetts, Harvard University press,

10 interests. Mission statements of businesses offering Islamic financial services emphasize the primacy of serving stakeholders interests though they do not ignore shareholders value. Pursuing stakeholders value entails multi-dimensional business objectives, likely to be more difficult to capture in measurable and monitorable indicators. Consequently the design of non-biased incentives for managers presents yet unresolved challenges. In contrast, conventional shareholding corporations emphasize shareholders value. Though, they do not ignore stakeholders interests, they are likely to perceive them more as constraints to their overarching objective. As monitorable indicators of shareholders value may be more readily available, the design of managers incentives for businesses with such objective has appeared a more tractable problem than for those emphasizing less easily measurable stakeholders value. A second corporate governance challenge of businesses offering Islamic financial services relates to the mobilization of deposits through risk-sharing, profit and loss, investment accounts. It is well known by now that unrestricted investment account holders are stakeholders sharing risks and benefits with shareholders. They do not however have a voting right or exercise control on management. Compounding the issue, a large number of businesses offering Islamic financial services have concentrated ownership or are state-owned. Such concentration is susceptible of producing biased decisions. 5 As a result, investment account holders find themselves in the situation of principals who delegate to other principals, that may have conflicting interests, the responsibility of selecting, and monitoring their agent. 5 Tirole, J. (1999), Corporate Governance Centre for Economic Policy Research, Discussion paper no

11 Solutions to these two issues are not straightforward. While improvements can be brought to current arrangements to mitigate some of the associated risks, regulators may need to engage in a strategic rethinking of the institutional arrangements that would be most appropriate for businesses that engage in offering Islamic financial services. The shareholder limited liability corporation may be adapted to certain circumstances such as corporate, investment or project financing. Other forms, such as cooperatives and credit unions can be appropriate for retail community banking where stakeholders concerns matter significantly. A strategic review of the various forms of corporate arrangements could provide useful guidance for developing licensing policies. Similarly a thorough review of the intrinsic features of the investment account as a financial product could help clarify its market relevance. In particular a sharp focus on its deposit versus investment features could be helpful in designing resource mobilization products that respond to depositors/investors risk appetite. In the meantime ongoing efforts to enhance the soundness of current corporate governance arrangements should help mitigate some of the risks. Final Remarks I am confident that the seminar discussions will shed light on the regulatory and supervisory challenges raised by the growth of businesses offering Islamic financial 11

12 services. We will all be looking forward to the outcome, as they would affect a sector generating high expectations as it has put human welfare and compassion at the center of its concerns. The soundness and credibility of its activities are therefore critically important, with consequences that may well be broader than financial performance. Thank you 12