A ROADMAP FOR THE

ISLAMIC FINANCIAL INDUSTRY

Sami Al-SuwailemIslamic Development Bank

COFFIS Conference Paris, France

Rabie II, 1433H - February, 2012

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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

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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

Cost of Financial Crises

Average recession periodWith financial stress = 27 months

Without = 12 months

Average cumulative loss of real GDP

With financial stress = 14%Without = 5%

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Trends in Financial Industry Homogeneity Indebtedness Shortsightedness

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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,

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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

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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)

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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

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Diversity Diversity makes the system resilient to

external shocks Diversity creates complementarity and

thus improves productivity and healthy innovation

Liquidity = Diversity

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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

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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

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Islamic Financial Industry Commercial banks 74% Investment banks 10% Sukuk 10% Investment funds 5% Takaful accounts for 1%

(IFSL, 2010)

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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

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

Value Chain

Long and medium-term debt

Leasing (real estate, machinery, …)

Equity (stock markets, venture capital, …)

Money markets

High shock-

absorbance & value

Low shock-

absorbance & value

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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

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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)

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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”

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Maturity-Matching Borders

Short term assets & liabilities

Long-term assets & liabilities

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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

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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

THANK YOU!