John B. Taylor
Under Secretary of the Treasury for International Affairs
Keynote Address at the Forum on Islamic Finance
May 8, 2004
I thank the Islamic Finance Project for inviting me and for, once again, leading efforts to organize this excellent conference. I would also extend a warm welcome to all of you here. I know you will enjoy hearing from my esteemed colleague, Dr. Ahmad Mohamed Ali from the Islamic Development Bank. Harvard University continues its fine tradition of providing a strong platform to generate critical thinking to inform academics and policymakers on Islamic finance through its series of Islamic Finance Forums and through the Islamic Finance Project here at Harvard Law School.
I appreciate the opportunity to speak to you today on a topic that is very important to us in the Bush Administration, and, in particular, the U.S. Treasury. Islamic finance over the last several years has expanded throughout the world, not just in the Middle East, but in Asia, Europe and the United States. The global Islamic finance industry has grown significantly over the last 10 years and today assets are in the range of $200-$300 billion.
Though small compared to the whole global financial system, Islamic finance is growing and is already playing a significant role in the financial systems in the Middle East. We have seen a growth in product innovation, an increase in the number of financial institutions offering Islamic finance products, and an expansion beyond the Islamic countries to the UK, Switzerland, the United States, and elsewhere. With these developments, we need to deepen our understanding and awareness of Islamic finance, to protect its unique role to honor its traditions, and to ensure sound regulatory frameworks and suitable jurisprudence that allow for efficient financial intermediation.
The Bush Administration places significant importance on promoting strong vibrant financial sectors, including Islamic finance, as an integral component of advancing economic growth in emerging markets. This year, for example, we in the U.S. Treasury have been working with our G7 colleagues and Finance Ministers from the Middle East and North Africa to advance economic growth and financial sector development. These are key objectives for the G8 Summit which the United States is hosting in Sea Island, Georgia, in June. We have created a Partnership for Financial Excellence, which represents a hallmark bilateral initiative with the region that reinforces financial sector growth. This initiative targets technical assistance and training on key needs in regional finance ministries, central banks, and commercial banks. We are working with the Federal Reserve and other U.S. financial regulatory bodies and counterparts in the Middle East and North Africa to design a training program for regional bank supervisors on best practices for bank regulation and supervision. We will also be providing targeted technical assistance to governments in the areas of public finance, debt management, and financial institution strengthening.
We at the U.S. Treasury have recently deepened our engagement in Islamic finance in a number of ways.
In April 2002, inspired by a terrific briefing on Islamic finance at Citibank’s facility in Bahrain, I hosted the “Islamic Finance 101 Conference” in Washington, D.C., which was the first conference on Islamic finance for U.S. government officials and financial regulators to raise awareness of the global Islamic finance industry.
In September 2003, Randy Quarles, Assistant Secretary of the Treasury of International Affairs, spoke about our involvement in Islamic finance at the First International Islamic Finance Conference in Washington, D.C.
Also in September, Secretary Snow and I attended the Second International Islamic Finance Conference in Dubai. We had a remarkable opportunity to sit down with Islamic bankers to discuss the real issues they face.
And today, I am pleased to announce today that the U.S. Treasury is launching an Islamic Finance Scholar-in-Residence program to generate more awareness and catalyze deeper policy discussions on Islamic finance domestically and internationally. We will be hiring as our first Scholar-in-Residence a noted Islamic finance expert. We intend for this scholar to work with us and others in Washington, D.C. on public policy issues related to the role and importance of Islamic finance. This new position will provide an opportunity to engage with key policymakers from the U.S. regulatory bodies and members of Congress, on comparing and contrasting Islamic finance and conventional banking, and promoting international standards. The first person to occupy this new position will be Dr. Mahmoud El-Gamal of Rice University. We look forward to his arrival in Washington, D.C. later this month.
In reviewing the agenda for today’s conference, I was struck by some very interesting new areas for further research in Islamic finance. As this industry evolves, a range of new Shari`a compliant products are emerging. Some examples are the government and corporate bonds – so-called sukuks – which have seen an increase in issuances over the last few years, and the development of repo facilities, which allow for open market operations in Islamic finance banks and help in the development of a global Islamic money market. The Islamic Development Bank (IsDB) is also financing infrastructure-development projects using new mechanisms that rely on the depth and innovation in the sukuk market. Islamic finance securitization has also been growing both in the United States and abroad. Freddie Mac has been offering mortgage backed-securities as a financing option to the Muslim community in the United States.
As we all know, however, the process of replication or mimicking conventional banking instruments certainly does not mean that the replicated Islamic products are identical to their conventional counterparts. Dr. El-Gamal will be discussing this in his talk tomorrow on the “Limits of Shari’a Arbitrage and the Unrealized Potential of Islamic Finance”. Deposit taking at fixed terms is a highly different business than taking equity participations, leasing, or profit sharing. And it is simpler and relatively more straightforward. Because of the transformation costs, complex Islamic financial products appear to be inherently less transparent and less efficient than conventional ones. This may have the undesirable effect of making Islamic finance a less attractive practice in the longer run. Dr. El-Gamal’s calls for a fundamental paradigm shift in the development of Islamic finance to reduce complexity and increase competitiveness are thought-provoking and worthwhile to consider.
The replication and transformation of conventional financial products into their corresponding Islamic finance analogues have important implications for the regulation and supervision of Islamic financial institutions.
First, the various lending structures generate different risk and balance sheet exposures for Islamic banks that need to be carefully monitored and managed. For example, while only a few Islamic financial products generate different liquidity profiles from conventional products, the lack of uniformity of standards for “Islamic banking” practices across Islamic countries makes it difficult to apply the same prudential regulatory standards (e.g., capital adequacy requirements) across the board. This calls for more harmonization of Islamic banking practices, which in turn calls for harmonization of Shari`a standards at the national and international levels.
Second, the treatment of profits/losses will have consequences for the balance sheet structure and will require particular adjustments to meet minimal prudential requirements. For example, in mudaraba transactions, the bank bears full financial responsibility for any losses but shares relative profits with the client. Any losses stemming from uncollateralized equity financing may require higher loan loss provisioning and additional capital. Mudaraba transactions are essentially investment partnerships in which all the capital is provided by the financial institution while the business is managed by the entrepreneur/client. Profits are shared in pre-agreed ratios, and losses are borne by the bank (which is passed on to the depositors).
Third, disclosure requirements may need to be comprehensive and more frequent to inform investors of the investment techniques, so they can make decisions based on their risk preference. Maintaining clear transparency and ensuring adequate disclosure of financing mechanisms are important steps towards building the necessary foundation for Islamic finance. And with respect to firms in which financial institutions take stakes, greater transparency, along with strengthened corporate governance, are necessary.
As part of the international effort to design a regulatory framework for Islamic finance, regulators need to factor in the differences in these forms of finance and have at least minimal standards or benchmarks to gauge compliance and assess risks. There needs to be some level of consistency in regulatory treatment across the board, subject to the particular country’s legal and regulatory regime. Malaysia and the GCC countries have been making notable progress on developing Islamic banking laws. Recognition and enforcement of these laws by the relevant national regulators would set the stage for making true progress on establishing internationally-accepted regulatory standards. Equally important is ensuring strong anti-money laundering oversight for these transactions targeted mainly at preserving the integrity of and bolstering investor confidence in Islamic finance.
Today’s conference will set the stage for a lively exchange on these important issues. Looking ahead, there is much that remains to be accomplished. We welcome the work of the Islamic Financial Services Board (IFSB) in Malaysia and the Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFI) in Bahrain that is looking at formulating standards for Islamic financial institutions, for example in corporate governance, accounting and capital adequacy. We look to see how policy makers mainstream their approach to Islamic finance in countries where this industry has grown significantly. The IMF as part of its overall financial surveillance work – particularly in the context of its Financial Sector Assessment Programs (FSAPs) and its Reports on Standards and Codes (ROSCs) -- should explore what, if any, systemic implications Islamic finance can have on the overall financial systems in the relevant countries, and it should also consider how its surveillance instruments can be better aligned with monitoring Islamic Finance. The World Bank through its financial sector work can enhance the effort to develop international regulatory frameworks and explore how Islamic finance can have a positive development impact in communities. International standard-setting bodies, such as IOSCO and BIS, have a role to play, first in understanding the basic implications of Islamic finance, and secondly to take into account implications of Islamic Finance on the implementation of existing standards. I hope that the international institutions, like the IMF, WB and the IsDB, work closely with national authorities to factor in a country’s monetary policy framework and the capacity of the country’s regulators who will eventually have to implement the standards developed by those bodies. These are but a few examples on the regulatory front.
In conclusion, developments in Islamic finance are of great interest to us at the U.S. Treasury and we look forward to the lively discussions on new product development and differentiation and on recent legal and regulatory issues that have emerged as the Islamic finance industry grows. As with conventional financing, Islamic financing will benefit from transparency, good governance and an internationally-accepted regulatory framework that will govern this important form of financing. I hope today’s discussions will help inform these debates and contribute to the overall effort to raise awareness and promote action among key policy makers.
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