Key Policy Issues and Policy Priorities to Support Stability

The previous sections of this chapter (3.1—3.5) have described a range of qualitative and quantitative information and techniques that can be used to identify potential strengths

• Another specific risk inherent in IIFS stems from the special nature of investment deposits, whose capital value and rate of return are not guaranteed. This condition increases the poten­tial for moral hazard and creates an incentive for risk taking and for operating financial institu­tions without adequate capital.

• Finally, Islamic banks can use fewer risk-hedg­ing instruments and techniques than do con­ventional banks and can operate in an environ­ment (a) with underdeveloped or nonexistent interbank and money markets as well as govern­ment securities and (b) with limited availability of, and access to, lender-of-last-resort facilities operated by central banks.

The above risk factors have historically forced IIFS into holding a comparatively larger proportion of their assets in reserve accounts with central banks or in correspondent accounts than do conventional banks, and those risk factors have also led to reli­ance mostly on sales-based facilities on the asset side rather than PLS modes. This situation has affected their competitiveness and has increased their vulner­ability to external shocks, with potential systemic consequences. Sundararajan and Errico (2002) pro­vide suggestions on how to address the risks inherent in Islamic banking.[2]

Box 3.3 Stability Issues in Islamic Banking


Unique risks in Islamic finance arise both from con­tractual design of instruments that are based on Sharia Principles and from the overall legal, governance, and liquidity infrastructure governing Islamic finance. The following lista summarizes the features that need to be taken into account when assessing stability in a financial system that includes (or is based on) institu­tions offering Islamic financial services (IIFS).

• Profit-and-loss-sharing (PLS) modes of financing shift the direct credit risk from banks to their investment depositors, but they also increase the overall degree of risk of the asset side of banks’ balance sheets because they make IIFS vulner­able to risks normally borne by equity investors rather than by holders of debt. In particular, operational risk is crucial in Islamic finance. It arises from (a) the fact that the administration of PLS modes is more complex than conventional financing (which also makes standardization of the products more difficult to achieve) and (b) the fact that IIFS often have no or limited legal means to control the agent-entrepreneur. Non – PLS modes of financing are less risky and they more closely resemble conventional financing facilities, but they also carry special risks that need to be recognized.

• Sales-based methods of financing often bundle commodity price risks, operational risks, and credit risks in complex ways, making it difficult to price risks.


a. This subsection is based on Sundararajan and Errico (2002).

b. For more on regulatory and risk management issues in Islamic banking, see exposure drafts of various prudential standards in the Web site of the Islamic Financial Services Board (http://www. ifsb. org), an international organization that was established to promote good regulatory and supervisory practices and to develop international prudential standards for institutions offering Islamic financial services.


and vulnerabilities in the financial system. Once weaknesses have been identified, the next issues to consider are how this information can be used to help maintain financial stability and how policies can be enacted or changed to minimize the risks to financial stability. The responses to those issues are multifaceted and depend on the nature of the vulnerabilities that have been identified.

Vulnerabilities and the corresponding policy actions can be categorized into four key areas:

• Macroeconomic (such as aggregate imbalance in payments to nonresidents)

• Institutional (relating to weaknesses in particular institutions or classes of institu­tions)


• Regulatory or supervisory (relating to the design and implementation of regula­tions and prudential standards)

• Structural (relating to the operational infrastructure of markets, settlement sys­tems, and safety nets)

The mix and the timing of policy tools need to be appropriate for the vulnerability addressed. For example, if rapid credit growth were mainly a result of macroeconomic imbal­ances, it would need to be addressed primarily by macroeconomic stabilization policies, while prudential tools would play only an auxiliary role. Conversely, if a vulnerability were mainly a result of weaknesses in banking supervision and regulation, then using macroeco­nomic policies would be second best should reforms of supervision and regulation turn out to be insufficient or slow to yield results. Weaknesses such as these should be addressed in a timely manner through improved prudential supervision and oversight, effective surveil­lance of individual institutions and markets, and development and maintenance of a robust financial infrastructure. Macroeconomic policy adjustments, even when they are second best, could be crucial, for example, to limit inflationary pressures, credit growth, or bubbles in certain sectors that could substantially affect the financial sector. In addition, by them­selves, policies to develop institutions and markets (e. g., money or government securities market development) and to build infrastructure (e. g., design a large value payment system) pose additional financial and macroeconomic risks, which need to be managed through prudential policies and macro-policy adjustments, as further discussed in chapter 12.

The calibration of policies can take into account information obtained from the quan­titative macroprudential tools, in particular, stress tests. For example, in the context of macroeconomic policies, stress tests or sensitivity calculations can provide an assessment of how a certain interest-rate and exchange-rate policy mix can affect the financial sector and of what the resulting effect on the economy as a whole would be. Similarly, in the context of regulatory policies, simulations can be used to assess what the effect would be of an envisaged policy change (e. g., an increase in the rate of providing loans) on the health of the financial system. In the context of supervision, stress-test results can be used to direct supervisory attention to those groups of institutions that pose the greatest risk for the system as a whole. Similarly, evolution of financial soundness indicators and information from macroprudential surveillance may call for more intensive supervision in specified areas (e. g., market risks or country risks).

An assessment of the overall stability of the financial system is based on combining the analysis of risks and vulnerabilities with the assessment of various financial policy responses and policy frameworks. If the potential vulnerability to plausible shocks were not high or if the policy framework and policy responses—as seen, for example, from stan­dards assessments—were considered appropriate, then the system would be judged stable. The stability considerations would typically dictate that a range of prudential and market development policies be given high priority.

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