Islamic finance and financial stability joint forum of finance ministers and central bank governors as apex architectural body for Islamic finance

1. Islamic Finance and Financial Stability
Tariqullah Khan, Professor Hamad bin
Khalifa University
Tariqullahkhan.me
A note on the gaps existing in
Islamic financial architecture

2. Several studies conclude that Islamic finance, because of its inherent risk
sharing and risk spreading features will enhance financial stability
Such conclusions are in fact similar to theoretical works in conventional finance
which argue that if such and such conditions are met financial stability can be
enhanced
However, financial crises reoccur because the theoretical conditions of stability
are not met in practice.
Therefore, the practice of Islamic finance may be far from its ideal architectural
principles and hence Islamic finance may not promote financial stability or may
even cause instability
Like conventional finance Islamic
finance may lead to financial
instability
The 5 channels of financial instability
that may also exist in Islamic finance

3. The 5 channels of financial instability that
may also exist in Islamic finance
Channel One: Excessive credit creation
and leverage
Channel Two: Trading in future
expectations
Channel Three: Unstable funding sources
Channel Four: Rigidities of financial
infrastructures
Channel Five: Structural Risk of the
Opaque Products

4. 7% interest
10% interest
5% interest
15% interest
BANK Murabahah
for asset
$100
Tawaruq
$100
Tawaruq
$100
Tawaruq
$100
Tawaruq
$100
Tawaruq
20% interest
Crisis Channel 1: Credit creation and excessive leverage
$100
$100
$100 $100
$100
$100

5. Excessive credit creation and leverage
Scenario-1: Lending being as the core commercial activity of banks, credit creation
is primarily based on ratings and credit risk and interest rates that different
borrowers have to pay causing unbridled leverage subject to reserve requirments.
Scenario-2: If we make genuine Murabahah as the core business of banks,
financing cannot get out of the real economy. In this scenario, we can
benefit from the advantages of the fractional reserve banking system but
at the same time also avoiding the excessive and unhealthy credit creation
by banks.
Scenario -3: But if we make non-genuine Murabahah like Tawaruq as the core
business, this scenario prevails which is almost similar to Scenario -1, where
financing gets out of the real economy.
The excessive leverage channel to financial
crisis is open for Islamic finance through
Tawaruq

6. Crisis Channel 2: Trading in future expectations
516.4
683.8 604.6 582.6
Jun-07 Jun-08 Jun-09 Jun-10
BIS reported total OTC derivative
contracts outstanding (trillion US $)
FX
9%
interest
rate
derivatives
72%
Equity
1%
commodity
0%
credit
5%
others
7%
June 2008
FRAs
12%
Interest
rate
swaps
78%
options
11%
Jun-2008
Of all BIS reported derivatives (US$ 684 trillion in June
2008) 72% were interest rate derivatives of which 78%
were fixed-to-floating rate swaps.
Islamic finance has also created an exact replica of the
fixed-to-floating rate swaps known as “profit-rate-
swaps”
The derivatives’ channel to financial crisis is open for
Islamic finance through “Islamic” derivatives

7. Crisis Channel 3: Instability of funding sources
0
2
4
6
8
10
12
14
16
18
Sample of
Islamic
Banks
Average
US GSSBs
Average
non-US
GSSBs
EU 28
Banks
Source: IFSB “Islamic Financial Services Industry Stability Report 2015”
*GSSB – Global Systemically Significant Bank
% tier 1 capital adequacy
ratios
0
5
10
15
20
25
Sample of
Islamic Banks
US GSSBs Non US GSSBs
% balance sheet leverage
multiples
% of PSIAs in the funding of
Islamic banks
0
5
10
15
20
25
2012 2013 2014
Islamic retail
banks
Islamic wholesale
banks
Liquid assets as % of total assets

8. Rigidities of financial infrastructures
The IFSB’s Islamic Finance and Financial Stability Reports address what the IFSB
is doing in setting standards. The report doesn’t address the actual
implementation of these standards.
1. In fact the prudential standards of IFSB, and the Shariah and
accounting and auditing standards of AAOIFI are not under
implementation except for a few countries.
2. PSIAs as the core deposits of Islamic banks are not uniformly treated in
different jurisdictions
3. The relevant two prudential reserves, respectively for “displaced
commercial risks” (profit equalization reserve) and for “commercial
risks” (investment risk reserves) are not established
4. Instead of taking and managing PSIA related risks since the financial
crisis Islamic banks are either avoiding PSIAs or placing the PSIA funds
into lowest risk commodity Murababahs
5. Disputes among key architectural players about foundational
principles; example Tawaruq, Promise, Ee’na, sale of debts, etc

9. Promise to repurchase the
Sukuk assets at the initial price
is not permissible
“Sukuk and their Contemporary
Applications” open source
document 2007 by Muhammad
Taqi Usmani, President of the
AAOIFI Shariah Council
Promise to repurchase the
Ijarah Sukuk assets at the initial
price is permissible
AAOIFI Sukuk Resolution 2008
“The issuer or the partner or the agent
must not undertake any of the
following: Purchase of sukuk or their
assets in their nominal value or for a
prefixed price so that it ensures the
capital. -------------------
The decisions issued by the Board come
into effect from the time of its issuance
and do not affect the previous contracts
and from among them are the sukuk”.
Resolution No. 188 (2012) of OIC Fiqh
Academy on the subject of Sukuk
OIC Fiqh
Academy
Disputes and Structural
Risks of Opaque Products

10. “Prospective Holders should note that different
Shariah advisers, and Saudi courts and judicial
committees, may form different opinions on identical
issues and therefore prospective Holders may wish to
consult their own legal and Shariah advisers to receive
an opinion if they so desire.”

11. Sukuk Structural Risk – bundled nature
of credit, price and return risk
Sukuk
Credit
risk
Interest
rate risk
Asset
price risk
Bond
Equity
Consequence
of disputes
and noise
between
Shariah
scholars

12. Financial Crisis Channels Is this crisis channel open in Islamic finance?
Excessive credit creation
and leverage
Yes, the crisis channel is wide open through Tawaruq in which
no party is genuinely interested in selling and buying assets.
Trading in future
expectations
Yes, the door is opening through the growing R&D efforts and
emergence of “Islamic” derivative products and markets.
Unstable funding sources Yes, but not wide open – capitalization and liquidity situation
of Islamic banks is better but because of withdrawal risk, profit
sharing investment deposits are perceived to be more
unstable as compared to the interest-based term deposits.
Rigidities of financial
infrastructures
Yes, the crisis channel is open because neither prudential
standards of IFSB nor Shariah standards and financial
transparency standards of AAOIFI are practiced. Nor there is a
mechanism for Islamic financial sector assessment in place.
Structural Risk of the
Opaque Financial
Products
Yes, the crisis channel is widely open because of the disputes
between Shariah academies and boards on even basic
architectural issues.
Summary of crisis channels

13. How to enhance financial stability
through Islamic finance?
Strengthen Islamic finance architecture
Islamic Finance Stability Board
By establishing an apex

14. Finance Ministers;
Central Bank Governors;
Islamic Bankers;
Sukuk Issuers and dealers
Investors
“Independent” scholars
The key architectural
players are actually

15. Looking ahead an Apex
Islamic Finance Stability Joint Forum
is the need to avoid structural risks of industry
Finance Minsters
of OIC Countries
Central Bank
Governors of OIC
Countries
Head Office Istanbul,
Turkey