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Summary: In part two of our interview, IFSB Secretary General Jaseem Ahmed speaks about the future of Sukuk and how Islamic finance can prepare itself for the possibility of another global financial meltdown

Let's turn our attention to Sukuk. What are some of the main challenges there that you hope to address?

Sukuk of course is, if you like, the star performer of Islamic finance, certainly in terms of the growth phenomenon. It's the fastest growing segment, or was for many years, in Islamic finance, and if we take a backward view, we can see that although there was some fluctuation in Sukuk issuances, on the whole, there has been a very steady increase in Sukuk issuances. It contrasts quite strongly with how the rest of the global economy has performed. In 2007, you saw almost a complete secession of bank lending and credit provision, or indirect financing of investment. As you know, Sukuk are a form of direct issuance. Bank lending is a form of indirect funding for major projects. Thus, this huge increase of Sukuk is partly a result of a changed economic environment. When bank lending is contracting, and when banks are contracting, one traditionally witnesses a direct issuance increase.

The second thing that's happening is that there are fundamental structural changes going on both within the supply and demand side in many countries. On the supply side we are seeing countries making significant gains in terms of the tax and regulatory reforms needed to facilitate Sukuk issuance. On the demand side, we are seeing expanding demand for public infrastructure. There are new countries entering-countries like Turkey and Indonesia that have made progress in preparing the groundwork for Sukuk issuances. Because they made a commitment towards developing their Islamic financial sector in tandem with their conventional sector, so that's another aspect. Countries in the Gulf region are also making progress in some very critical areas which allow them to issue quasi-sovereign Sukuk.

On the issuance side, what is truly remarkable is that if you look at the new public sector infrastructure financing in the Middle East right now, most of it is Sukuk. Of course if there is a contraction of the global economy, things would slow down-we know that. We know the Islamic finance has done very well in terms of stability, but it is not immune to a global economic slowdown. Everything comes to a grind if that happens. But if that doesn't happen, we would see a fundamental shift in the global financial landscape and the emergence of what looks like a new alternative asset class: Sukuk. This certainly is relevant for public sector infrastructure financing by way of taking advantage of this global interest and global investor base.

From a stability perspective, Sukuk are one of the most important instruments from both a funding and a liquidity management perspective. However, there is a need for a wider range of maturities for Sukuk to be issued, especially shorter and medium term Sukuk. We have seen progress in a number of countries but we need to see considerably more progress.

When we look at the liquidity management side, that's where I think there is a long way to go. We've addressed this issue in a number of ways in the last few years. We pointed out in 2008 in our technical note on liquidity management that this was going to be a fundamental challenge to the development of Islamic Finance, and we suggested the public sector had to play a very strong role in providing the instruments and support for market development needed for Islamic finance. We made the point then that there was a need for greater public sector issuances of Sukuk to help develop the yield curve and foster the instruments that banks could use for liquidity management. Sovereign Sukuk would help develop the inter- bank market as well as provide a basis for capital markets and for corporates to issue their own Sukuk. That's still a work in progress.

There are some jurisdictions where we see considerable progress-Malaysia is one country, Bahrain is another, and there are others. The most critical issue from the perspective of the regulatory requirements is that Basel introduces under the new liquidity framework this concept of high quality liquid assets. This is what banks need, but the definition is very hard for our jurisdictions to meet right now. Basel defines "fundamental" and "market" characteristics of HQLA. The fundamental requirements say that your asset must be low risk, sovereign or quasi-sovereign, and it must be listed on a stock exchange, amongst others. This is where we have very few Sukuk that are like that. This responds to the point I made before, which is that we need more frequent and greater volumes of high quality Sukuk issuance, with sovereign issuers stepping in. Here I would like to stress that the market requirements under Basel are even more difficult. The markets must be, according to Basel, markets in which price volatility is constrained, and there is depth, experience of stability through stress conditions, and there are very few markets like that in the markets that offer Islamic finance. That tells us right away that we have a major agenda. But there have been positive developments. The OIC Central Banks have a working group precisely on this, the infrastructure needs and policy structure needs for liquidity management. This group which is led by Bank Negara Malaysia starts with the technical note the IFSB released in 2008. I think this is a very important development. When a sovereign announces they are thinking of issuing Sukuk, we tend to ask, what is the objective? Are you looking at it from the longer term perspective, of developing your inter-bank markets, your capital markets, and to strengthen the ability of your Islamic banks to manage their liquidity? We are very encouraged to see that more and more countries are doing just this.

In my presentation at the GIFF, I drew on the IFSB IFSI Stability Report 2014 to show the 11 or so countries where Islamic finance has more than 15 per cent of domestic financial sector assets. But there are countries that are not on that list that are deeply significant even though their Islamic financial sector is small. These countries are going through very deep-seated reforms to try to develop the preconditions for a full-fledged and resilient industry. So in Turkey, the Islamic finance sector doesn't show up on my graph but the Government has spent a number of years developing their legal and regulatory framework to facilitate its own sovereign Sukuk program, and it has recognized that it's important to prepare the ground for a larger, more resilient banking sector and broader Islamic finance sector this way.

In terms of the specific revisions in the Revised Capital Adequacy Standard (IFSB-15), we looked at the funding side of Islamic banks, and we have made a number of proposals for the Sukuk structures that we think would be adequate. For example, the additional tier one structure; we've suggested a Musha[THORN]arakah structure for that, but it will depend upon the national jurisdiction which structure they choose to meet the Basel III requirements. At the moment, the take-up on that is slowly emerging. We see a lot of interest from regulators and many of our jurisdictions have said they want to implement these latest standards. This is quite unusual- historically the older standards usually get adopted first, but people are reacting to the timeline that Basel has imposed.

"The challenging aspect of the Basel requirements for us is related to concepts like contingent capital, or the trigger points when something is transformed from one class of asset to another. That is challenging because there were Shari'ah issues of uncertainty and complexity that had to be addressed.

On the asset management side and the liquidity management side, Islamic banks tend to have a lot of cash but that is not the most efficient way to manage your liquidity. There is a need now to come up with Sukuk structures that will enable a more productive use of their resources.

At the same time, we will be taking up some of the f lexibility provisions that Basel provides. Basel recognizes there are jurisdictions where the high quality liquid assets don't exist in sufficient quantities, and most of those jurisdictions are emerging markets.

You mentioned that the Islamic Finance world isn't immune to another crash or crisis. How well suited is Islamic finance to another crisis?

"As we discussed before, Islamic finance was not directly implicated in the global crisis for a number of reasons, but it did not escape the sharp slowdown in trade and in the global economy. That affected the whole world, and affected the Gulf especially. There are two things to look at - what are the prospects for Islamic finance if the global economy continues to remain on a subdued path, and what happens if there's another crisis?

"A subdued growth path for developed countries will constrain growth prospects elsewhere but it does not mean that emerging markets will contract in the same way. I think to some extent, emerging markets are on a growth path that will ensure that they are able to expand, not as fast as before, but not as slow as the western countries. I'm not saying there is a delinking of these countries-if Europe and the U.S. both go into a recession, that is a huge loss of aggregate demand for the rest of the world, and it's too much to expect that the rest of the world will find alternative sources of aggregate demand to compensate fully. But I think we can expect countries like China and India to shift towards fostering domestic consumption, which will help to drive growth further. So the challenge for Islamic finance is where that growth will come from, and how it will link up to what looks like continued expansion of emerging markets more broadly. I think that's the real challenge for us-we need to see a greater linkage between Islamic Finance and the drivers of the global economy-trade, manufacturing, etc. That's where the future will be determined-how Islamic finance can integrate itself into the global economy.

Regarding a potential crisis, our countries are much more aware of what can happen in a crisis. The IFSB's focus is now to help our countries build on that awareness. We are looking at things like stress testing. Stress testing is an important mechanism, and can give you an early warning of a potential crisis. Another thing that you can recall is that the financial crisis essentially came to an end after the Federal Reserve announced its stress tests in 2009. That was a very important development. Before that, we had seen in 2007 a massive spike in all of the risk and volatility indicators in the global financial system. It was only after the Fed went through a fairly transparent stress testing exercise that the markets calmed down. By July 2009 financial stress indicators were back to pre-crisis levels. Stress testing is hugely important. This is a very key area of focus for us, and that's why the IFSB will prepare a Technical Note as a follow up on our Standard on stress testing, and we hope through our capacity building exercises and awareness exercises that we will help our member countries to build this very important capability.

In addition, we are also looking at the financial safety net. As you saw during the crisis, the first line of defense as markets collapsed globally was the Federal Reserve stepping in and providing a lender of last resort facility in terms of liquidity - massive, almost limitless liquidity. That is a function that we now understand is absolutely essential to stem crises in the first line of defense. We also saw that an absence of a fully funded and well structured deposit insurance scheme can have particularly adverse consequences. Deposit insurance is an important element in providing the public confidence to prevent bank runs.

These two parts of a financial safety net, LOLR and deposit insurance, are where there is a need to develop Shari'ah-compliant versions. That's where the IFSB has made a commitment to developing the understanding and the knowledge needed. We have issued a working paper on Shari'ah-compliant Lender-of-Last-Resort, and this year we are preparing a similar paper on Shari'ah-compliant Deposit Insurance Schemes and we are working through the Islamic Financial Stability Forum, which is part of the IFSB mandate. This meets twice a year following the Council meetings and it is where the regulatory bodies of IFSB members discuss critical issues. So we are developing these critical competencies to help countries strengthen their capabilities to prevent crises. Stress testing, financial safety nets. Down the road, we need to think in terms of resolution mechanisms. That gives you the full armory of the capabilities that the authorities need to manage a crisis. Our membership is very diverse; we have some of the world's poorest countries in which market and institutional development are limited. But we also have advanced jurisdictions in terms of their capabilities and Islamic financial markets. I think these countries together have the ability to productively share experiences through the IFSB.

Sovereign Sukuk would help develop the inter-bank market as well as provide a basis for capital markets and for corporates to issue their own Sukuk.

The challenging aspect of the Basel requirements for us is related to concepts like contingent capital, or the trigger points when something is transformed from one class of asset to another

We have some of the world's poorest countries in which market and institutional development are limited.

But we also have advanced jurisdictions in terms of their capabilities and Islamic financial markets

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Publication:Islamic Business & Finance
Date:Dec 10, 2014
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