A roadmap for the Islamic financial industry

1. A roadmap for theIslamic financial industry Sami Al-Suwailem Islamic Development Bank COFFIS Conference Paris, France Rabie II, 1433H - February, 2012

2. Lessons from the Crisis • “We cannot afford to keep stumbling from one crisis to the next.” We have to build “a new global financial market architecture” Angela Merkel, Chancellor, Germany • “Fundamental reforms of the international prudential framework for banks are urgently needed” Financial Services Authority, UK • “What we need is a new paradigm” Jean-Claude Trichet, President, ECB

3. Types of Risk • Risk might be exogenous (earthquakes, tsunamis, etc.) • It also might be endogenous, arising from the actions and decisions of agents • Financial crises are largely endogenous • Endogenous risks are twice as costly as exogenous risks • We need to build the Islamic financial industry to be resilient to both types

4. Cost of Financial Crises Average cumulative loss of real GDP • With financial stress = 14% • Without = 5% Average recession period • With financial stress = 27 months • Without = 12 months

5. Trends in Financial Industry • Homogeneity • Indebtedness • Shortsightedness

6. Homogeneous Industry • Before the crisis conventional financial industry was practically homogenous: • Mergers and acquisitions • Deregulations • No more borders • The industry became highly concentrated and highly inter-connected • Top 10 banks control 50% of industry in 2003 vs. 25% in 1990 • About 70% of the financial sector’s activities were within the sector not for the end user,

7. Heavy Indebtedness • Every dollar of financial sector profits was supported by: • 13 dollars of debt in 1975-1980 • 33 dollars of debt in 2002-2007 • For the nonfinancial business sector: • 9 dollars in 1975-1980 • 13 dollars in 2002-2007 • For every dollar borrowed by households and nonfinancial business, financial sector borrowing quadrupled during 1978-2007

8. Short-Sightedness • 25% (or $1 trillion) of liabilities of major investment banks was rolled-over on daily basis • Shadow banking system in 2007 exceeded commercial banking: $10.5 trillion vs. $10 trillions • System is vulnerable to bank-runs without commercial banking regulation • Overlooking the shadow system by regulators was a “fundamental failure” (Lord Turner)

9. Risk Concentration • Homogenous industry is vulnerable to shocks • When a shock hits, the entire industry moves in lockstep • Liquidity evaporates when every one wants to sell at the same time • Homogeneity leads to heavier reliance on short-term debt—the industry becomes fragile • Maturity mismatch creates high endogenous risks • Recurrence of financial crises

10. Diversity • Diversity makes the system resilient to external shocks • Diversity creates complementarity and thus improves productivity and healthy innovation • Liquidity = Diversity

11. Resilience • Industry shall be less dependent on debt • Must better align maturities of assets and liabilities • Together, the industry becomes resilient to both exogenous and endogenous risks

12. Islamic Finance • Integrated with real economy • Debt is tamed with economic output • Diversity of economic activities is reflected in financial activities • Institutional structure should be adapted to the nature of IF

13. Islamic Financial Industry • Commercial banks 74% • Investment banks 10% • Sukuk 10% • Investment funds 5% • Takaful accounts for 1% (IFSL, 2010)

14. IFI Architecture • IFI should follow new trends in international financial architecture • The industry should be structured according to the ability to absorb risk • At one end is equity: maximum shock-absorbing ability with highest value created • At the other is short-term debt: minimum shock-absorbing ability with lowest value

15. Integrated Value Chain • Equity markets • Venture capital • Leasing • Long- and medium-term debt • Short-term debt and money markets • Overnight repos • …

16. Value Chain Low shock-absorbance & value Money markets Long and medium-term debt Leasing (real estate, machinery, …) Equity (stock markets, venture capital, …) High shock-absorbance & value

17. A Roadmap for IFI • Put primary emphasis on equity and leasing segments • Banks need to be supplemented by other specialized finance to function productively • Misplaced order results in unfair demands and unrealistic expectations

18. How to Create Boundaries? • No diversity without boundaries • Not all boundaries create diversity! • Boundaries must be economically viable not arbitrary • Natural boundaries: • Economic activities • Regulatory boundaries: • Time-horizon (long-term, medium-term, short-term)

19. Time Horizon • The most critical dimension is time-horizon • Reason: maturity mismatch creates endogenous fragility of the financial system • Aligning assets and liabilities is essential for avoiding systemic risks • Setting boundaries based on time-horizon of aligned assets and liabilities • Balance-sheets must be “balanced”

20. Maturity-Matching Borders Long-term assets & liabilities Short term assets & liabilities

21. Two Birds with One Stone! • By preserving boundaries between financial institutions, diversity is protected • By choosing boundaries based on asset-liabilities harmony, systemic fragility is minimized • Together, both endogenous risk and exogenous risk are better neutralized

22. Conclusion • IFI needs to be build on high equity and high risk-absorbing base • The industry has to be well diversified and integrated • Creating boundaries based on maturity-matching could help achieve diversity and stability

23. Thank you!