Keynote Address to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Conference

Keynote Address to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Conference
Bahrain, December 14, 2009

AAOIFI – World Bank Annual Conference on Islamic Banking and Finance
James Adams
Vice President, East Asia and Pacific Region, World Bank

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Excellencies, distinguished guests, ladies and gentlemen:

I would like to express my sincere gratitude to the Secretary General of AAOIFI, Dr. Mohamad Nedal Alchaar, and the staff of AAOIFI for organizing this important conference.  I would also like to thank Minister Shaikh Ahmed Bin Mohammed Al Khalifa and Governor Rasheed Mohammed Al Maraj for hosting us here in Manama.  The World Bank is pleased to be a co-sponsor of this conference for the third year and it is my personal honor to be a keynote speaker here again. 

Before I get started, I want to first congratulate the class of graduates from the Certified Sharia Advisor and Auditor and Certified Islamic Professional Accountant programs.  You should all be proud of this achievement.  Accounting is the fundamental building block of the financial system, which is why such programs as the CSAA and CIPA are so important, and I have no doubt that all of you have bright career futures ahead of you. 

The World Bank recognizes Islamic finance as an important segment in the financial sector.  The large attendance at this conference is a testament to the broad agreement to this view and recognition that Islamic finance is positioned for continued growth.

Many observers have commented that the prospects for Islamic finance are even greater now than before in the wake of the current financial crisis.  The reasons given are that Islamic financial institutions do not rely on major leverage, they do not invest in complex structured financial products or derivatives, and thus far, they have not developed complicated corporate forms – all of which played a role in the downfall of many large financial institutions worldwide. 

Sharia structures have been viewed by many as inherently safer given the fundamental requirement that finance should be linked to the assets being financed. In addition, Islamic banks have the ability to pass through negative shocks to their assets along to their depositors, which are de facto investors in the bank.  This also has the effect of giving more incentives to depositors to ensure that the banks are well-managed and this may be all the more true because in most cases, there is no deposit insurance. 

However, Islamic financial institutions and products are exposed to a range of risks, some of which are coming to the fore now.  I would like to take this opportunity to raise some questions to help focus our minds on the agenda of this conference.  Let me concentrate on four areas – liquidity management, corporate governance, resolution of failed institutions, and access to finance. 

I’ll start with an area that cuts across many sessions of the conference – liquidity management.  We know that one of the key triggers of the collapse of many major financial institutions during this global crisis was the freezing of liquidity in the major conventional financial markets.

But, we know less about how the Islamic financial markets would react to a similar liquidity event.   The Islamic money markets are evolving, but this seems to be an area of critical importance given the rapid growth in the industry.  The development of Islamic money market and Islamic Government financing instruments will be a first order priority in the coming years. 

The second area of importance is that of corporate governance.  The governance practices of Islamic financial institutions have evolved significantly and new standards on corporate governance were adopted last month by the Islamic Financial Services Board.  However, a number of specific governance challenges are still faced by Islamic financial institutions.  One “big picture” issue on corporate governance is a lack of cross-border harmonization of corporate governance standards, which we at the World Bank are beginning to engage on.  Another issue includes the role, structure, composition, independence, and functioning of the Sharia board and its relationship with the board of directors and other control structures.  Also, there is an issue related to the fact that investment account holders essentially bear the same risk that shareholders do, but do not have the same representation.   Therefore, it is becoming essential to get a better understanding of the risks related to governance of Islamic financial institutions today and how corporate governance standards can be strengthened given the unique features of the Islamic industry. 

The third area that is increasingly important is preparation for bank failures and resolution in the Islamic finance industry.  Islamic banks are exposed to a variety of risks if problems arise. 
One issue is that the lack of standardization of many Islamic financial products makes the process of managing the workout of problem assets and institutions quite complex.  In addition, the uncertainty on the claims on the underlying assets and differences in interpretation across jurisdictions can potentially complicate resolution procedures.  Thankfully, there have been very few failures of Islamic banks to date.  But, there is a need to better understand the prospects for resolution if and when there are failed institutions in the Islamic finance industry.  This understanding should also include how the regulatory authorities and the court systems will respond.

The final issue I will touch on is access to finance.  Although 44 percent of all conventional microfinance clients reside in Muslim countries, Islamic microfinance loans represent a very small fraction of the entire microfinance sector – less than 3 percent.  There are some positive examples, including Indonesia, where Islamic banks have rapidly expanded access to microenterprises while maintaining relatively strong financial performance.  In fact, lending by the rural Islamic banks in Indonesia represents over 62 percent of the total microfinance loans worldwide.  So, the potential is clearly there, but it is not yet being fully realized.  This is a central development issue for us at the World Bank and we are now trying to understand why access to finance through Islamic financial institutions been relatively limited.  This may be due to a lack of awareness by potential customers, regulations that may hinder the development of small-scale finance products, a lack of cost efficient structures, and other reasons.  We are now doing a pilot study in Indonesia to find some answers from this experience.

I do not have the solutions to these four issues.  But, I expect that all of you will address these challenges over the next two days here in Bahrain.  And, the World Bank will be an active partner in this pursuit. 

Broadly speaking, the objective for the World Bank’s engagement in Islamic finance is to supplement our efforts in promoting overall financial sector stability and improving access to finance.  We will not take the lead in this area, but instead we aim to work closely with many of you – the experts in the various technical areas of Islamic finance.  We hope to make future contributions in the areas of corporate governance, accounting, insolvency, financial stability, liquidity management, and access to finance issues – many of the topics of this conference. 

We look forward to working with you on these important issues and I know that this will be a very productive two days.  I am looking forward to the active discussions and debates and I thank you for your time and attention.