Report: Islamic Finance and Global Financial Stability

Islamic Finance and Global Financial Stability: A joint report published by the Islamic Financial Services Board (IFSB), Islamic Research and Training Institute (IRTI) and Islamic Development Bank (IDB)

Report extract:

The global financial crisis of 2008-09 has brought to the forefront issues concerning the stability and resilience of financial systems.At the heart of the crisis is the near-breakdown of the functioning of the financial intermediation process, amid a generalised loss ofconfidence in the financial system.

Many factors have been cited as the cause of the crisis. They include a combination of misalignments in the incentive structure and unbridled financial innovation which led to indiscriminate lending and excessive risk-taking. Other contributory factors include the erosion of sound prudential practices, with banks compromising on underwriting and risk management standards in pursuit of short-term gains and market share. While the banking institutions had employed increasingly sophisticated financial engineering techniques to repackage mortgages into complex structured securities, such financial innovation was not supported by commensurate enhancements to their governance processes and risk management infrastructure and practices.

In the wake of the crisis, the global financial community has intensified efforts to reform the international financial architecture to ensure its stability and resilience in a more challenging environment.The challenge before us is to not only undertake the necessary regulatory reform that will minimise potential risks, but to also build a new financial architecture that will promote greater efficiency in the financial intermediation process, including across borders.

In the search for a new financial architecture, there is a general consensus on the need to return banking to its basic function – to provide financial services that add value to the real economy. This in fact represents the very essence of Islamic finance. These are the very elements found in the Shari’ah principles that form the foundation of Islamic finance. It is these inherent elements that contribute towards the overall stability and resilience of the Islamic financial system. This foundation is further reinforced by the values that are extolled in Islamic finance that are similar to those found in ethical finance and socially responsible investment. The key strength of the Shari’ah injunctions is its emphasis on a strong linkage to productive economic activity, its inbuilt checks and balances and its high level of transparency and disclosure. The Islamic financial services industry has thus been in a relatively stronger position to weather the global financial crisis, demonstrating its robustness as a stable form of financial intermediation. The inherent features of Islamic finance have the potential to serve as a basis to address several of the issues and challenges that have surfaced in the conventional financial system during the current crisis. As the role and relevance of Islamic finance in the global financial system gains significance, it has potential to contribute to greater global financial stability and towards strengthening global growth.

Read the full report here.

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