Islamic Finance and Financial Policy and Stability an Institutional Perspective

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Islamic Financial Services BoardInaugural Lecture

26 March 2007Kuala Lumpur

Islamic Finance and Financial Policy and Stability:an Institutional Perspective

by

Datuk Seri Panglima Andrew ShengAdjunct Professor, University of Malaya, Kuala

Lumpurand Tsinghua University,

Beijing

Yang Berhormat Tan Sri Dr Zeti Akhtar Aziz, Governor, Bank NegaraMalaysia and Chairman, IFSB,The Honourable Josef Tosovsky, Chairman, Financial StabilityInstitute,Professor Rifaat Ahmed Abdel Karim, Secretary General, IFSB,Tan Sris, Datuks,Distinguished Guests,Ladies and Gentlemen,

I. Introduction

I am very honoured to be invited to the Islamic Financial StandardsBoard (IFSB) Inaugural Lecture. I should begin by congratulatingTan Sri Governor Dr Zeti Akhtar Aziz on her appointment as theChairman of the IFSB and Professor Dr Rifaat on his leadership ofthe IFSB to new heights of achievement.

Islamic Finance has grown by leaps and bounds since the early1960s, when Malaysia first pioneered Islamic banking, insuranceand then other financial services through the Pilgrims ManagementFund and then the Islamic Banking Act in 1983 and Takaful in 1984.It is not my place to celebrate the achievements of Islamic financial

markets, but rather I hope to contribute in a small way how oneshould think about the development of Islamic financial institutions

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and markets within the whole context of financial policy andstability.

I am speaking here today as a Professor, no longer as a practicingregulator1. The advantages are obvious - one has a greater degree

of academic freedom to profess, to confess and to digress. Before Iprofess on the important but boring subject of Financial Policy andStability, let me confess and digress a bit.

I would be the first to confess that I know little about IslamicFinance. My shallow reading of the literature leads me to concludethat there is much to be learnt and understood about one of thefastest growing segments of global markets. Some Westernbankers categorize this phenomenon as the equivalent of financialinnovation, as if insurance, which meets the specific needs of aparticular class of customers, is financial innovation. Since IslamicFinance meets the financial needs of a particular class of customers,indeed 1.3 billion of the Islamic faith in the world or 20% of worldpopulation, it is as much mainstream as non-Islamic Finance.

It is also not my place to debate the interpretation of Syariah Law inIslamic Finance, for which I am neither qualified nor do I have anyparticular insights. From the first issue in 1999, the International Journal of Islamic Financial Services had an interesting andcontroversial debate on whether there is utility in using theempirical approach of Western economic literature in understanding

Islamic Financial Markets2

. This was quickly rebutted by MohammadZiaul Hoque and MA Choudhury3 who felt that copying by Islamiceconomists and finance researchers from and of the premises ofWestern paradigms is not merely a fiasco; it is a non-starter for atruly Islamic economic, social and scientific thinking.Unfortunately, this is also not helpful, since it assumes that little ofWestern thinking can be used.

Since I come from the practical world where Islamic Finance isalready an increasingly accepted form of finance in Westernmarkets, the doctrine that one discipline is not helpful in thinking

about the other discipline cannot be intuitively or in practice right.Let me be bold enough to try to bridge the divide by narrowing thedebate to where there may be common elements in currenteconomic thinking and practice. This is in the area of institutionaleconomics that is being led by Nobel Laureate Douglass North and

1I am grateful to Prof. Rifaat, Josef Tosovsky, Gavin Bingham, John Pang and GLTan for very insightful and helpful comments. All errors and mistakes are myown.2Humayon Dar and John Presley (1999), Islamic Finance: A WesternPerspective, International Journal of Islamic Financial Services, Vol.1, Number 1.3

Mohammad Ziaul Hoque and Masudul Alam Choudhury (2003), Islamic Finance:A Western Perspective Revisited, International Journal of Islamic FinancialServices, Vol.5, No. 1.

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others. The new body of thinking is less a theory of what happensin the real world, but a way of thinking about how the real worldevolves.

Let me start with where I think Islamic Finance differs from the

mainstream neo-classical model that underpins current Westerneconomic theory. The work of El-Hawary, Grais and Iqbal4 (2004)on regulating Islamic Financial Institutions views the Islamicfinancial system as grounded in four basic principles:

a) risk-sharing terms of financial transactions need to reflecta symmetrical risk/return distribution for eachparticipant to the transaction;

b) materiality a financial transaction needs to have amaterial finality, that is it is directly orindirectly linked to a real economic transaction;

c) no exploitation a financial transaction should not lead tothe exploitation of any party to the transaction;and

d) no financing of sinful activities such as the production ofalcoholic beverages.

I look at the differences between traditional free markettransactions and Islamic transactions much more simply and

practically. My favourite quote of the Prophet on the business oftrade is: the most worthy of earnings are those of the merchant,who, if they are spoken to, do not lie, if they are trusted, do notbetray, if they promise, do not fail, if they buy, do not condemn, ifthey sell, do not extol, if they owe, do not delay and if they areowed, do not press. In other words, the philosophy of Islamicfinance carries an embedded element of morality or ethics. Incontrast, the neo-classical underpinnings of the Western marketeconomy are often offered up as a normative science that issupposed to be totally objective or value-free. This is of course nottrue, since many of the assumptions in neo-classical theory are

heavily value loaded5.

Indeed, in its most extreme form, the neo-classical framework ofperfect information, perfect competition and zero transaction coststhat instantly clears all markets at an equilibrium price, includingthe price of money, has little room for institutions nor morality,except the further assumption that all market actors are perfectlyrational and has only self-interest. This framework is so dominant in

4Dahlia El-Hawary, Wafik Grais and Zamir Iqbal, Regulating Islamic Financial

Institutions: The Nature of the Regulated, World Bank Policy Research WorkingPaper 3227, March 2004.5 I am grateful to Gavin Bingham for pointing this out.

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the doctrine of free markets that the main policy implication isgetting prices right, which implies that interest rates, exchangerates and commodity prices would clear all markets with minimalgovernment intervention. Since the Islamic religion rejects thetaking of interest or riba, it is small wonder that some Islamic

economists reject the idea that the neo-classical framework canapply to Islamic economics and finance.

As someone who has applied economic theory to practice over 30years, I have never failed to be amazed that every neo-classicaleconomist acknowledges the real world has imperfect knowledge,imperfect competition and high transaction costs, and yet, in amagnificent leap of faith, assumes that the neo-classical model canyield very useful policy application for the real world. Unfortunately,the model has been sold to many naive developing countryeconomists who try to apply it in practice, often with disastrousoutcomes. This is exactly what Keynes meant when he said that,Practical men, who believe themselves to be quite exempt fromany intellectual influences, are usually the slaves of some defuncteconomist6.

The policy recommendation of getting prices right implicitlyassumes that there is an institutional or infrastructure for pricediscovery, with high search costs, information asymmetry and theexistence of incomplete contracts. The real world is an institutionalworld, in which the neo-classical model is more like a doctrine that

corresponds to an extremely special, limiting case of a moregeneral theory of markets7.

Thanks to the work of Douglas North and others, we are finallyemerging into an area of theory of institutions that actually helps usto understand the real world better. It will also help us understandthat Islamic finance and markets face the same institutionalconstraints and challenges as any other group of institutions with itsown class of products or services.

Organizations, as defined by North, are groups of individuals bound

by some common purpose to achieve objectives8. All economiesand markets are path dependent, based on initial conditions shapedby geography, demography, history and culture. Differentinstitutions and organizations evolve differently in response tochanges in environment (competition/warfare, globalization, globalwarming etc) and to social beliefs about how to respond to these

6John Maynard Keynes, The General Theory of Employment, Interest andMoney, Macmillan, 1942, pp 3837 John Roberts, Perfectly and Imperfectly Competitive Markets, in The New

Palgrave Dictionary Dictionary of Economics, Macmillan, 19878 Douglass C North (1990), Institutions, Institutional Change and EconomicPerformance, Cambridge University Press,

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changes. Institutions affect the performance of the economy bytheir effect on the costs of exchange and production. The majorrole of institutions in a society is to reduce uncertainty byestablishing a stable (but not necessarily efficient) structure tohuman interaction9.

The insight that members of organizations are bound by sharedbeliefs and values is crucial to an institutional view of the real world.There is no such thing as a value-free world, because in such aworld by Norths definition, there are no institutions. Competition,which is key to rise and fall of institutions, is not just competitionbetween people, but really the competition of ideas, values andbeliefs. This must be true irrespective of creed, religion, culture oreven lifestyles.

II. Financial Policy and Stability some definitionalthoughts

To sum up so far, the commonality between Islamic Finance andcurrent non-Islamic Finance is the existence of financial markets asinstitutions and the desire for stable financial markets that protectthe valuable savings of the people, irrespective of faith or religion.

I now come to the objectives of sound financial policy and stability,which I am sure my good friend Josef Tosovsky will speak withgreater authority. What I shall attempt is to re-interpret

development economics through the lens of an institutionalframework, drawing upon recent evolution in both theory andexperience. I hope that those who wish to build strong, vibrant andinnovative Islamic financial markets and institutions will find thisframework useful.

The starting point of financial policy and stability is that both aremeans to an end, namely, the desire in the end that we will all livein a prosperous, peaceful and just society.

In definitional terms, policy is a wish whereas stability is a condition.

The reason why these two terms are often linked together is alsoproof that practical central bankers automatically link monetarypolicies with financial stability with its institutional context. Forexample, one of the objectives of Bank Negara Malaysia that isenshrined in the central bank law is to promote monetary stabilityand a sound financial structure in Malaysia.

Indeed, many economists tend to see policy as an end in itself,

9 Douglass North (2005) Understanding the Process of Economic Change,

Princeton University Press.

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spending considerable time figuring out what is the right policy,forgetting that the best policy is the one that can actually beimplemented. Moreover, without the right institutional framework,many ideal policies cannot be implemented at all, or at least,implemented with tragic results. I need not remind friends here

that raising interest rates in an overleveraged environment wouldonly send the economy into a tailspin, instead of bringing aneconomy back to its zero two-gap equilibrium.

What Douglass North has reminded us brilliantly, is that economicchange is a process that is path-dependent. In order to get policiesto work effectively, we often have to build the institutional buildingblocks, which implies that there is a policy objective or vision, anarchitecture and a sequential path towards a situation or outcomewhere we can attain our objectives. Because we are bound in reallife by many constraints, our existing institutional framework, ourculture, resources and internal and external vested interests, wecannot move from point A to point B without some process ofchange, either through deliberate policy, accident, crisis orspontaneous order.

In short, the common element behind policy and stability isgovernance, because both policies and institutional stability must bemanaged. At least if you wish to have good policy outcomes andsound institutional stability or resilience, you must have goodgovernance. These do not come by accident. This must be true

irrespective whether you are dealing with Islamic Finance or Non-Islamic Finance.

Andrew Crockett rightly defines Monetary stability refers to thestability of the general price level; financial stability to the stabilityof the key institutions and markets that go to make up the financialsystem10. Gary Schinasi defines financial stability as the financialsystem satisfying three conditions: efficiency, ability to assess andmanage risks and ability to withstand shocks.

So, drilling deeper down to the meaning of financial policy and

stability, we find that good financial policy and financial stability arenecessary but not sufficient conditions for economic growth,prosperity and equity. Simply put, the necessary condition forsustainable financial stability and real sector growth is goodgovernance.

This is the 10th Anniversary of the Asian Financial Crisis, in theaftermath of which the global financial architecture has changed

10Andrew Crockett, Why is Financial Stability a Goal of Public Policy?FederalReserve Bank of Kansas City, Fourth Quarter 1997

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and the International Financial Institutions (IFIs) have learnt andprogressed significantly in their ability to assess and monitorfinancial stresses and strains. Gary Schinasi has encapsulated theview of the IFIs in the following three Pillars of Financial Stability(Figure 1).

Figure 1:

Source: International Monetary Fund (2005).

Since the crisis, the IMF/World Bank has already produced aHandbook on Financial Sector Assessment Programme (FSAP), thattries to achieve an integrated analysis of stability and developmentissues using a wide range of analytical tools and techniques thatinclude the following:

Pillar I

Macro prudential analysis, including stress testing,scenario analysis, and analysis of financial soundnessindicators and of macro financial linkages

Analysis offinancial sector structure, including analysis ofefficiency, competitive-ness, concentration, liquidity, andaccess

Assessment of observance and implementation of relevantinternational standards, codes, and good practices in thefinancial sector

Analysis of specific stability and development issuestailored to country circumstances (e.g., role of publicfinancial institutions, effect of dollarization, reasons for lowaccess or underdeveloped securities markets, etc.

Pillar II

Financial system supervision and regulation to helpmanage the risks and vulnerabilities, protect market integrity,and provide incentives for strong risk management and goodgovernance of financial institutions.

Good practices in most areas of financial system supervisionand regulation are reflected in various international standards

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and codes and the related assessment methodologies; forsome areas of supervision and regulation such asmicrofinance institutions, agreed international standards donot yet exist.

Pillar III Legal infrastructure for finance, including insolvency

regime, creditor rights, and financial safety nets

Systemic liquidity infrastructure, including monetary andexchange operations; payments and securities settlementsystems; and microstructure of money, exchange, andsecurities markets

Transparency, governance, and informationinfrastructure, including monetary and financial policytransparency, corporate governance, accounting and auditing

framework, disclosure regime and market monitoringarrangements for financial and non-financial firms, and creditreporting systems

Whilst the FSAP process is very useful to the IFIs to assess financialcapacity, and to some extent it helps the developing country undersurveillance to understand its weaknesses and areas ofvulnerability, very little work at the theoretical and practical frontexist to help emerging markets build their financial infrastructure ormarkets effectively11.

The reason for the lack of practical guidance stems from theunderlying free market philosophy that there should be minimalgovernment interference in the market and the fact that it is veryhard to generalize and design the sequencing of building marketinfrastructure for different countries with different initial conditions.

Karadeg, Sundararajan and Elliot (2003) gave an interesting paperon the proper sequencing of markets (Figure 2). In essence, themost basic markets to be built are domestic money markets,followed by inter-bank and foreign exchange markets, governmentbond markets, corporate bond markets, equity markets and finallyderivative markets. The hierarchy of the markets lies in theknowledge intensity of the product market. Building on this and theDouglass North framework, I shall attempt here to develop a way ofthinking about how to prioritize or sequence the development ofdomestic financial markets and infrastructure. This frameworkwould apply to building Islamic Financial Markets or non-IslamicFinancial Markets. I know I am attempting something that isextremely complex and difficult, but I hope that the way forward willbe worth the effort.

11 See Sheng (2006) and Davis (2007) on the difficulties faced in building Asian

bond markets and using a menu approach.

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Figure 2: Hierarchy of Domestic Financial Markets

We begin by accepting the Douglas North view that institutions areany form of constraint that human beings devise to shape humaninteraction12.

In thinking about an economy as a system comprising institutionsand organizations (of which people form the lowest unit oforganization), we can identify the following eight elements of themarket as an institution of people (participants) and organizations(enterprises) bounded by interaction:-

1. Values, Beliefs and Ownership2. Property rights, resources and transaction costs3. Information, Knowledge, Technology and Wisdom/Experience4. Standards5. Codes, Rules and Laws

12North (1990) differentiates institutions from organizations in the rules of thegame that shape the institutional framework. Pg 4.

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6. Process and Procedures (of change or transaction)7. Structure, architecture or hierarchy (at a point of time)8. Incentives and Governance

Each element is broadly defined and there could be considerable

overlap with other elements of an institution. For example,information is classified according to different standards. Differentstandards embody different values. Rules and Processes bothembody considerable social experience (positive and negative) andalso create different incentive structures, depending whether theyare enforced or not.

(1) Values, Beliefs and Ownership: Every textbook on corporategovernance emphasizes the importance of shared values, missionand beliefs. We also know that no organizational or institutionalreform or change is possible without ownership or a stake in thatorganization. The stake holding could be in a physical property rightownership (such as equity) or simply shared belief (religion,philosophy or culture). Beliefs and Values are often expressed interms of objectives, missions, goals or general principles that areeasily understood. Ownership also means that the approachtowards reform should be inclusive and market participants inreforms must feel that they own the process.

(2) Property Rights, Resources and Transaction Costs:Markets transact or exchange property rights and obligations.

Transactions also cost or expend resources. There are considerablecosts in transactions in terms of search for information, ensuringtrust in transaction and effecting legitimacy in property rights andtheir protection. The efficiency of markets is generally measured bythe least amount of transaction costs available to create themaximum amount of output or value. Market A is more efficientthan Market B if transaction costs are lower, leading to greateroutput. Market A is also more robust or resilient, if the propertyrights are protected with clear and transparent rules that areenforced fairly and at low costs. A primary condition of markets istherefore clearly defined and delineated property rights that are

exchanged and protected at relatively low transaction costs.

(3) Information, Knowledge, Wisdom and Experience: Theimportance of access to reliable, accurate and verifiable informationis now well understood in markets. The fundamental problem of allmarkets is information asymmetry. However, if we dig deeper,information is also a property right with value. The higher the levelof information classification and intensity, the greater is the value ofknowledge. Traditional economics is still not able to cope with howindividuals learn and institutions learn. Information or knowledge

may have little value if it is not owned, experienced or learnt.Wisdom is knowledge plus experience, leading to judgment.

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Consequently, the need for investor and intermediary education isvital for rational and sophisticated markets. Because of the hugegaps in information, knowledge and experience with new products,processes and institutions, risks in new products such as Islamic

Finance are perceived as higher than conventional products that arealready well accepted in financial markets. Mature markets arethose that are experienced in market volatility, whereas emergingmarkets are subject to volatility because retail investors (includingnew institutional players) are inexperienced and can herd or panicat the slightest shock or surprise.

Investment in education in people (investors, market professionalsand regulators) in new products is therefore a key building block ofnew markets. In this regard, the establishment of the InternationalCenter for Education in Islamic Finance is clearly an important stepin the building of sound Islamic Financial Markets.

(4) Standards: Standards of measurement, behaviour, conductand operations are also a vital part of human interaction. Commonlanguage, for example is a standard that facilitates communications.The importance of international accounting and auditing standardsonly came to light after the Asian crisis and the Enron failure. Today, the Financial Stability Forum has already adopted corestandards in areas ranging from monetary and fiscal disclosure tocorporate governance. The creation of the Islamic Financial

Services Board and the Association and Auditing Organization forIslamic Financial Institutions (AAOIFI) to introduce standards forIslamic finance and accounting and auditing clearly wouldcontribute to greater use of Islamic Finance as it becomesstandardized, saving considerably in transaction costs, consistencyand transparency.

(5) Codes, Rules and Laws: Human interaction, exchange andtransactions clearly need codes, rules, laws and meta-rules. Codesrefer to informal standards of conduct that carry informal sanctions,but are largely a matter of self-discipline. Rules and laws are

formalized standards of behaviour that are enforced by third-partiesor the government and may even carry criminal sanctions. Meta-rules actually are cultural codes of behaviour or beliefs that areembedded in the rules. For example, syariah law over-rides theconventional business codes in Islamic Finance transactions. Animportant institutional development in all markets is the creation ofindependent dispute resolution and rule interpretation mechanisms.These can range from arbitration panels to independent judiciariesor religious authorities, such as syariah courts.

Although most laws are still local, globalization has created a wholerange of codes, rules and legislative principles that are common for

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international commerce and trade, bank regulation, marketpractices, bankruptcy and insolvency and the like. It is thereforerelatively easy for emerging markets to adopt such internationalrules and regulations. For example, in establishing the QatarFinancial Centre and the Qatar Financial Center Regulatory

Authority, of which I am a Board member, a Court and Appeals Tribunal was established with renowned international experts toensure that the legal framework for operations and transactions inthe Center would operate according to best international standardsand rules.

(6) Process and Procedures: are methods by which change ininstitutions or transactions in property rights are effected.Processes and procedures can be informal or totally formalized.Processes and Procedures can be highly specialized and knowledgeintensive, with considerable cumulated technology and institutionalexperience and wisdom embedded in them. Simple processes maybe easy to build and use, but they may not contain sophisticatedcontrol mechanisms that are needed to handle high turnover andmaintain a robust system needed in modern financial systems.Moreover, processes and procedures are not simply silo (orvertical) processes that operate to complete a single function (suchas share trading), but can be extremely complex, co-coordinating or(horizontal or cross-cutting) operating systems that manage severaldifferent specialized processes. Familiar examples are theWindows or Mac OSX systems that manage the separate software in

a computer, or a central coordinating office to manage the differentfunctional departments within a single ministry.

The emergence of IT and its formalization of process and procedurehave made clear that the model of IT process application can beapplied not only at the level of a single firm, but across wholemarkets and sectors. There are already system standards, inter-connectivity and inter-operability to enable this networking ofsystems. Unfortunately, policy makers who are usually economistsand lawyers are not usually well attuned to the application ofinstitutional change management on a macro-scale.

Because processes and procedures have become more and morecomplex and knowledge intensive, embedding standards, rules andchecks and balances are necessary and this would require operatorsor people with higher and higher skills. We can think of this asincreasing the level of knowledge intensity (or technology) in humansociety. Societies advance because of their adaptive efficiency orthe way they learn and adapt to new internal or external challengesthrough new processes and procedures, and if necessary, newinstitutional structures.

(7) Structure, architecture or hierarchy: Processes and

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procedures operate through organizational structures. Differentprocesses require different organizational structure, architecture orhierarchy. Such structural differences basically represent differentalignments of authority or function within any particular institutionor organization in response to its functional needs. The creation,

removal or re-configuration of organizational or institutionalstructure can greatly change not just its behaviour, its efficiency,but also its robustness (resilience to shocks) and also adaptability tonew environments (innovation).

The structure or hierarchy of financial markets is important becauseit is not necessarily true that one should build a market fromscratch. For example, trying to build a corporate bond marketahead of a strong government bond market is likely to lead tounsatisfactory outcomes, since the corporate bond market needs agovernment benchmark yield-curve to price itself correctly.Moreover, evaluating corporate credit risk requires quitesophisticated credit rating and corporate governance rules to be inplace.

(8) Incentives and Governance: Finally, I group incentives andgovernance together since whether governance is effective in theend depends ultimately whether the incentive structure is enforcedeffectively. Administration, coordination, implementation,enforcement, planning, design and management are all part of thefunctions of governance but they all operate to shift incentives in a

manner that determines the ultimate outcome of institutionalefficiency, robustness and fairness.

The above brief summary of an institutional framework of marketsindicate that even the simplest of financial markets carry extremelycomplex elements of beliefs, architecture, processes and incentivesthat ultimately shape its outcome.

I therefore conclude that the neo-classical framework of thinkingabout emerging markets as incomplete contracts, incompleteinformation and incomplete markets is too simplistic and naive to be

of real use in the real world. It detracts from the need tounderstand that markets are scale-free, dynamic and ever evolvingand that in terms of efficiency, robustness and justice, it is notobvious that our present system is second best or third-best relativeto any other system that carries different values and standards.

III. Bounded Constraints

Understanding that information is not costless, resources are notinfinite and competition is neither perfect nor fair means that

behaviour in real life is bounded by different constraints. Oliver

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Williamson13 introduced the concept of bounded rationality in hiswork on the Transactional Cost Economics for his theory of the firmand institutions. The concept can be broadened to resourceconstraints, information or knowledge constraints, belief constraintsand institutional constraints.

In other words, neo-classical thinking can easily mislead a policymaker to think that almost everything needs to or can be done andthat options to reform and change are infinite. This belief was soembedded in IFI thinking that as many as 100 loan conditionalitieswere included in IFI loans to developing countries, when in practice,the implementation capacity of the country for that project may notbe more than three to five.

In reality therefore, building or reforming financial institutions aresubject to huge bounded constraints, like a linear programmingmodel, so that the number of options for change and reform ishighly limited. Under such circumstances, an emerging market thattries to develop a new market, such as Islamic Finance, would befaced with restricted options under limited resources. Thesedevelopments are not random walks, and therefore there must be astructured way of thinking how to sequence and prioritize changeand reform.

The common sense approach is to focus and prioritize, but commonsense is not too common and in reality, the vested interest and

institutional inertia to change could be so strong that even focusand prioritization would not work.

As I mentioned elsewhere14, we need a strategic approach towardmarket reforms and institution building. Given the fact thatdeveloping economies have turned from net importers of capital tonet exporters of capital, there is much less of a resource constraintthan before. Technology for trading, clearing and settlementsoftware and hardware that make up important marketinfrastructure is also readily available for purchase off-the-shelf.Global standards have also been determined, including the codes,

rules and standards of behaviour in markets. There are manyconsultants who have proven experience in building specificmarkets and products, including complete trading and payment andclearing systems.

Unfortunately, planning has become such a dirty word under thefree market influence that many developing countries havedowngraded their planning and implementation capacity within theirgovernment bureaucracy. Part of this was due to the fact that

13

Oliver E Williamson (1985), The Economic Institutions of Capitalism, The Free Press, New York.14 Andrew Sheng (2006), The Art of Reform, Finance and Development,International Monetary Fund, May

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government implementation of project led to too much governmentintervention in markets. However, it is quite clear that the recenttrend towards public-private partnerships in implementation ofinfrastructure projects can yield greater efficiency all round. Thistrend is also applicable in financial sector institutional building.

Malaysia was successful in building up Islamic finance because itallowed non-Islamic financial institutions to promote and developIslamic finance products, subject to the necessary syariahsafeguards.

Given the complexity of markets, one easily forgets that marketsand institutions are all about people, and that the biggest constraintthat is stopping markets from growing faster is in reality the humancapacity constraint. In this regard, the policy maker faces the sameproblem that corporate marketing strategists face in opening up anew product or market. I now turn to the process to managepolicies and institution building.

IV. Process of Financial Policy and Institutional Reform

At the risk of sounding like a management consultant, the processthat incorporates the eight key institutional elements discussedabove comprises several structured stages as follows:-

Clarify Principles and Objectives

Stock-take or Diagnostic of Existing Conditions, benchmarked

against international standards, codes and rules, andInstitutional Gaps

Prioritization according to Bounded Constraints

Pick one or two Quick-wins, plus Killer Application that iseither vital building block or stumbling block to marketdevelopment

Create Implementation Team to deliver Quick Wins and KillerApplications

Implement with Allies and Partners in Transparent, Open,Inclusive manner

Evaluate Results against Principles and Objectives and moveonto next phase.

Notice that I have not tried to recommend that one should pick forpriority development product A, institution B or follow model C,because these tend to be country specific15. Let me elaboratebriefly on each of these steps:-

(i). Principles and Objectives: I assume that the principles andobjectives of the financial policy and institutions reform wouldroughly include the following:-

15 See Davis (2007) for a menu of policy options and choices.

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Creation of a financial system that is efficient, transparent, fairand robust in supporting real sector growth and meeting theneeds of the economy

Raise the knowledge, skills and management/risk capacity of

the financial system, particularly consumers, investors,financial intermediaries and regulators

Delineate, protect and transfer property rights fairly,transparency and with low costs

Open to entry, innovation, competition and orderly exit ofmarket players

Meeting standards and rules and regulations according tointernational standards

Creation and enforcement of incentives towards loweringtransaction costs, strengthening capacity to manage and

absorb risks and shocks and fair treatment of customers Consistent with values of society, e.g. syariah

(ii). Stocktaking and Diagnosis: Most countries would alreadyhave undergone an FSAP or at least an FSAP Self Assessment andtherefore should have a reasonable assessment of the quality of thethree Pillars of Macro-prudential Policies, Supervisory Conditions andInfrastructure Conditions. The IFIs and countries should not treatFSAPs as a box-ticking exercise to quibble over whether this or thatcondition is compliant, partly compliant or non-compliant. Thecountry should use the FSAP as a useful tool to (a) Know yourbusiness (b) Know your counterparties (or peer competitors (c)Know your risks and (d) Know yourself.

The FSAP results will form an extremely useful basis for theconsideration of Stage III, the Prioritization of Policies andInstitutional Reforms.

(iii) Prioritization of Policies and Institutional Reforms

When governments are asked to do too much too fast without the

implementation capacity, the easiest option out is to stay put. TheIFIs should therefore provide technical assistance to set up aframework to prioritize policies (or to build the institutionalframework to enable implementation of policies).

Since decision making under uncertainty is bounded by information,resource, political and bureaucratic constraints, this part of theexercise is in fact the most difficult but the most necessary. Oncethe gaps and weaknesses in policies, standards, laws andinstitutions are identified under FSAP or its equivalent, there shouldbe a Gap-Analysis matched with a Constraint-Analysis and an

Institutional Analysis.

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The Constraints are clearly the following:-

Financial resources

Information resources (skills availability)

Ownership (buy in not only by the implementing agency, butalso vested interests and the public generally)

Political or Bureaucratic Constraints (in the sense that certainamount of political capital and bureaucratic goodwill will haveto be sacrificed in order to achieve reform).

Capacity constraint (whether it is possible to assemble a teamthat is able to implement, coordinate and push throughreforms)

The Institutional Analysis, broadly based on work by GeoffreyLamb16 in the 1980s and probably largely forgotten by many IFIs,identifies four key questions in assessing the institutional side of

policy making:-

1. What are the key components of policy decision-making? Which functions belong where and what ismissing?

2. Which institutions control critical aspects or phases ofthe policy process? This identifies where thebottlenecks or weak points are in the policy formulationand implementation process and addresses thegovernance of policy formulation and implementation.

3. How can different policies be managed in ways, which

are less institutionally intensive or demanding? This isthe clearest statement of the high transaction costs ofpolicy formulation and implementation.

4. How can policies and projects be formulated andimplemented together and in consultation with theprivate sector to ensure that there is ownership, skills,transparency and efficiency? This is the inclusiveaspect of governance.

The choice or options clearly must be benchmarked against the

principles and objectives enunciated at the start of the process.In general terms, I would personally suggest that the prioritiesof policies are those that generally reduce transaction costs inthe financial sector, protect property rights and add toknowledge intensity.

By knowledge intensity, I mean financial products that requirehigher and higher knowledge, skills and experience to create,trade and protect. My own experience with marketdevelopment is that too many emerging markets are impatientand leap straight to derivative markets that are highly

16 Geoffrey Lamb (1987), Managing Policy Change: Institutional Dimensions,World Bank Discussion Papers No. 14

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knowledge intensive without building a strong foundation intheir core markets, such as inter-bank, foreign exchange andgovernment bond markets. The result is that domestic playersare not ready for the next step forward in knowledge intensityand falter so that derivative markets appear to be much more

fragile and risky than needs to be the case.

Technology transfer, particularly in financial products, cannotbe made in isolation, but should be done in stages, building ona solid foundation of highly skilled human resource base.

In my experience, once the constraints analysis has been done,the number of options for policy reform and institutional reformbecomes actually much more limited and manageable.Sometimes, it is necessary to retreat and prepare the groundfor the next advance forward, rather than to be bogged down inturf battles that block advances.

(iv) Quick-Wins and Killer Applications Any reform projectmust have quick-wins and Killer Applications to win credibilityand popular backing. Reforms that end up stalled or take toolong to implement usually end up with implementation fatigueand waning support. The idea that quick successes or low-hanging fruit should be harvested early is well accepted.What is less understood is the need for a Killer Application,which is an IT term for highly successful application that is

immediately popular with the market. The best example is theGoogle search function that made Google successful. The killerapplication would create economies of scale, wide productrecognition and immediate removal of market prejudice andbarriers to further product development.

What is needed is a strategic identification of a product orservice that would be widely acceptable to the market. Inmany ways, the Sukuk bond has such characteristics in IslamicFinance, but we have not had enough critical mass issues withglobal trading on a standardized basis to make a great leap

forward. To complement the strategic identification, sufficientimplementation resources, including management attention,are needed to make the big push in order to get the KillerApplication moving.

(v). Implementation Team - In my experience, any reformproject requires a crack team to design and implement. Theteam should consist of highly experienced staff who havemarket credibility and sufficient confidence to make judgmentson what trade-offs, concessions and tactics should be made at

what time in order to get effective results. The team shouldalso comprise experienced officials who have sufficient

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networks and credibility within the government bureaucracy tocoordinate and ensure that projects move forward withoutundue obstacles and foot-dragging.

(vi) Inclusive Design and Implementation Process All too

often, policies and processes are designed in isolation withouttaking the pulse of the market and finding out what the marketreally wants. Having an inclusive process, whereby the privatesector is brought in early to identify market concerns,perceptions as to why there are barriers to entry, competitionand innovation, and ideas for implementation, is often a secretof success and market confidence. The market appreciates anopen and transparent process of consultation into all newpolicies, standards, rules and possible institutional innovation.Proper feedback will ensure ownership and also knowledgetransfers that benefit both the official and the private sector.

The project team must also articulate clearly to all vestedinterests why each new policy or institutional reform isbeneficial and creates public goods, sometimes at the expenseof private loss. An open and inclusive process breedsownership and reduces resistance to new ideas.

(vii) The Outcome is the Objective - It goes without sayingthat the best policy is the one that is effectively implementedwith good outcomes. Hence, the project team must continually

review its achievements and outcomes against its publishedobjectives and principles. Through this process, the projectteam will be able to identify when and how it could move intothe next phase of policy change and institution building.

V. Concluding Remarks

I apologize for this long and winding digression into theinstitutional elements of financial policy and stability. I havedeliberated not discussed in depth stability issues, because it isin my opinion the natural outcome of good policies and good

governance. To sum up, strong vibrant institutions shouldautomatically create good forms of governance that ensurehigh performance, good conformance with generally acceptedstandards, rules and ethics and also sound robustness andresilience to shocks and risks.

Let me conclude by repeating that economic growth is aprocess of change. Our lessons from development experiencesuggest that the process is not a random walk, or at least itshould not be, but a well trodden, but often forgotten common

sense and pragmatic path of evolution and creative changethat members of that particular institution, organization or

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society believes is good for them as a group.

In this world of different faiths, beliefs and values, it is notalways possible to agree on everything. But the process offinding common elements of policies and institutions whereby

we can all achieve prosperity with efficiency, stability andjustice, should be non-controversial.

It goes without saying that I believe that Islamic Finance willhave a great future because its success in growth will meet thefinancing needs not only of members of the Islamic faith, whichnumber one-fifth of mankind, but also, as we increasinglywitness, the needs of the rest of mankind.

Thank you very much for your patience.

Kuala Lumpur and Beijing,12 March 2007

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Islamic Finance and Financial Policy and Stability an Institutional Perspective

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