The document discusses the global financial crisis and opportunities for Islamic finance. It notes that pre-crisis leverage built up vulnerability, and deleveraging during the crisis triggered fire sales and exacerbated problems. While Islamic finance principles call for greater stability, currently it only represents a small share of the global market. However, there may be positive ideas from Islamic finance that could inform Western policies to enhance stability.

1. Presentation to the
Global Islamic Finance Forum:
Internationalization of Islamic Finance: Bridging Economies
Mahmoud Mohieldin*
Managing Director
The World Bank
Public Lecture 2:
Enhancing the Islamic Financial System
in a Decade of Increasing Internationalization
Kuala Lumpur, Malaysia
September 20, 2012
*Disclaimer: The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors
of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work.

2. Key questions
 What is the current landscape of the global financial system?
 Are there any feasible alternatives?
 Where is Islamic finance today?
 What role can Islamic finance play in economic
development?
 Where are the key opportunities?
 What are the main challenges?
 What is the contribution of the World Bank?
Introduction
2


3. Leveraging and Vulnerability
3

 Pre-crisis leverage build up in the US and Europe
Source: World Bank FinStats Database.
-10%
-5%
0%
5%
10%
15%
2002 2003 2004 2005 2006 2007 2008 2009 2010
Private credit to GDP Growth
EU JP UK USA
40%
50%
60%
70%
80%
90%
100%
110%
120%
130%
140%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Loan to deposit ratio
EU JP UK USA

4. Leveraging and Vulnerability
4

 Positive Feedback Loop: Leverage Boosted Economic
Growth and Ample Liquidity, but Fostered Latent
Risks
 Negative Feedback Loop:
Deleveraging Triggers Fire Sales
and Exacerbates Funding and
Solvency Problems
Asset prices
fall, diverge
from
fundament
als
Volatility
and VaR
metrics
increase
Profits and
equity fall;
demand for
higher
capital and
haircuts
Weaker
solvency;
increased
moral
hazard
Evaporatin
g funding
Asset fire
sales and
precaution
ary savings
Sources: FSA (2009); FSB (2009); Brunnermeier (2009), Adrian
and Shin (2008); Kyotaki and Moore (2005); World Bank staff
When the bubble bursts:
Synchronized reduction of
balance sheets (deleveraging)
triggers credit crunch

5. Leveraging and Vulnerability
5

 Developed Market Equity Markets and Global Banks
Deteriorated Significantly During the Recent Crises
0
50
100
150
200
250
300
350
400
Jan05
Jul05
Jan06
Jul06
Jan07
Jul07
Jan08
Jul08
Jan09
Jul09
Jan10
Jul10
Jan11
Jul11
Jan12
Jul12
BasisPoints
Average CDS price of 16 globally active retail banks
0
20
40
60
80
100
120
140
160
180
Jan05
Jul05
Jan06
Jul06
Jan07
Jul07
Jan08
Jul08
Jan09
Jul09
Jan10
Jul10
Jan11
Jul11
Jan12
Jul12
Index(1/1/05=100)
Developed market equities (10 countries)
LessVulnerable
Developed market equity indices boomed before the crisis but
collapsed post Lehman…
…and global bank default risk went up significantly
and increased further due to deepening Euro crisis
Lehman
Start mortgage crisis LehmanStart mortgage crisis
Escalating
Euro crisis
Source: World Bank Global Financial Stress Watch.

6. Leveraging and Vulnerability
6

96.4
53.0 53.0 28.1
109.0
56.7 56.7
29.1
0.0
50.0
100.0
150.0
200.0
250.0
300.0
Scenario 1 Scenario 2 Scenario 3 Scenario 4
Impact on emerging market credit due to Euro zone
deleveraging as a result of the EBA capital shortfall (€bn)
LAC
Middle East
Asia
CIS
CEE
Africa
Scenario 1 Scenario 2 Scenario 3 Scenario 4
Fraction of shortfall reached via deleveraging (%) 100% 100% 50% 50%
Fraction of deleveraging via loans (%) 100% 50% 100% 50%
Source: World Bank Global Financial Stress Watch.
 Threat of deleveraging and the global real economy

7. Financial Stability Matters
7

 Global Financial Development Report 2013:
Rethinking The Role of the State:
Notes: Average values for 2008-2010. Simple (unweighted) averages across country groups.
0 corresponds to a historical low of the proxy variable, and 100 corresponds to a historical high.
For the explanation of individual proxy variables for financial depth, access, stability, and efficiency,
see Chapter 1 and Čihák, Demirgüç-Kunt, Feyen, and Levine (2012).
Source: World Bank Global Financial Development Report 2013.

8. Financial Stability Matters
8

 Global Financial Development Report 2013:
Rethinking The Role of the State:
…. and financial systems before and during the crisis
Financial Institutions Financial Markets
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
Average2008-2010
Average2000-2007
Stability
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
Average2008-2010
Average2000-2007
Depth
Source: World Bank Global Financial Development Report 2013.

9. Some Reflections on the Global Financial Crises …
9

… countries stepped up efforts on
macroprudential policy, crisis
resolution, and consumer protection
However, not clear whether incentives
for market discipline improved (deposit
insurance coverage increased during the
crisis, further eroding incentives to
monitor, while some elements of
disclosure and quality of information
improved)
A recent survey suggests further scope
for improving disclosures and
monitoring incentives
…weaker regulation and
supervision practices
(e.g., less stringent definitions of
capital, less stringent provisioning
requirements, greater reliance on
banks’ own risk assessment);
…. and less scope for market
incentives
(e.g., more generous deposit
insurance coverage, lower quality
of publicly available financial
information)
Crisis hit countries had…
Source: World Bank Global Financial Development Report 2013.
After the crisis…

10. Some Reflections on the Global Financial Crises …
10

Source: World Bank Global Financial Development Report 2013.
Needed: balance among the state’s roles
Promoter / owner and guarantor / regulator and supervisor / overseer
Right balance depends on a number of factors (including the level of development)
Leads to trade-offs
Direct interventions during the crisis:
Evidence that some worked … partly, in the short run….
…. but also robust evidence on potential longer-term harmful effects
… as crisis subsides, need for rebalancing towards less direct involvement
Overarching theme: role of incentives in finance
the challenge for the state's involvement is to better align private incentives with public interest
without taxing or subsidizing private risk-taking

11. Some Reflections on the Global Financial Crises
…Seeking Islamic Finance Solutions?
11

“The Islamic financial system has so far been able to gain a very small share of the
global financial market and, even if it operates perfectly as desired by the Shari‘ah,
it may not be able to create a significant impact on the international financial
system in the near future.” Umer Chapra, October 2008
However, he emphasized that the only option for further development of Islamic
Financial Services is to explain the system rationally and implement it seriously
and sincerely to enhance effectiveness and promote financial health and stability.

12. Some Reflections on the Global Financial Crises
…Seeking Islamic Finance Solutions?
12

“Yet perhaps scholars who argue that Islamic financial systems’prohibition on
interest generates massive inefficiencies ought to be looking at these systems for
positive ideas that Western policymakers might adopt. ….. In the meantime, the IMF
and the G-20 can help by finding better ways to assess the vulnerability of each
country’s financial structure – no easy task, given governments’immense cleverness
when it comes to cooking their books. Policymakers can also help find ways to reduce
barriers to the development of stock markets, and to advance ideas for new kinds of
state-contingent bonds, such as the GDP-linked bonds that Yale’s Robert Shiller has
proposed. (Shiller bonds, in theory, pay more when a country’s economy is growing
and less when it is in recession.)” Kenneth Rogoff, Project Syndicate, March 2011

13. 13

 Strengthening financial stability:
o Encourages its banks to have greater capitalization.
o Consistent evidence of higher capitalization of Islamic banks.
o Eliminates pure debt securities from the financial system.
o Calls for bank deposits to be collected on a profit/loss- (PLS)
sharing basis rather than fixed predetermined liabilities.
o Ensures a close link between the real economy and financial sector.
o Affirms property rights and contract enforcement (honoring of debt
obligations).
o Emphasizes principles of morality and ethics in business conduct.
o Advocates the sharing of risk and reward between the rich and
poor.
The Role of Islamic Finance in Development

14. Islamic Finance Today
14

0
200
400
600
800
1000
1200
2006 2007 2008 2009 2010
US$billions
Global Shariah-Compliant Financial Assets
Banking Assets (1) Sukuk Outstanding (2) Assets Under Management (3)
Sources: (1) Deutsche Bank 2010;(2) International Islamic Financial Markets database, March 2012; and (3) Ernst and Young 2011a.

15. Islamic Finance Today
15

19%
10%
33%
21%
27%
43%
24%
9%
5%
19%
13%
17%
32%
15%
Malaysia Indonesia Turkey Saudi Arabia UAE Qatar Median
Growth of Islamic Banking and Conventional Banking Assets in Selected Countries (2006-2010)
Islamic Banking Conventional Banking
22%
10%
31%
13%
20%
48%
21%
9% 4%
19% 14% 19%
26%
17%
Malaysia Indonesia Turkey Saudi Arabia UAE Qatar Median
Growth of Islamic Banking and Conventional Banking Deposits in Selected Countries (2006-2010)
Investmetns: Islamic Banking Deposits: Conventional Banking
Source: Deutsche Bank 2011, 8.

16. Islamic Finance Today
16

Malaysia
63%
United Arab
Emirates
16%
Saudi Arabia
8%
Bahrain
4%
Indonesia
3%
Others
2%
Qatar
2%
Pakistan
1%
Kuwait
1%
Cumulative Sukuk Issuances (1996-2010)
0
100
200
300
400
500
600
700
800
900
0
10
20
30
40
50
60
2006 2007 2008 2009 2010
US$billions
Global Sukuk Issuances (volume and number)
Sovereign Quasi Sovereign
Corporate Number of Sukuk Issuances
(right side vertical axis)
Source: Islamic Finance Information Services Database, October 2011.

17. 17

 Enhancing financial inclusion
0.61%
0.79%0.78%
0.97%
0.92%
1.19%
Deposits: Value as
percentage of GDP
Loans: Value as
percentage of GDP
OIC countries
Developing
countries
Low-income
countries
Limited scale of Microfinance deposits and loans
The Role of Islamic Finance in Development
Economic development and growth, along with social
justice, are the foundational elements of an Islamic
economic system.
• Zakat
• Sadaqat
• Qard-al-Hassan
• Waqf
Distributive
and Re-
Distribution
Institutions
• Small-Medium Enterprises
(SME)
• Micro-Finance (MF)
• Micro-Insurance (Micro-
Takaful)
Risk-Sharing
or Hybrid
Alternatives
Source: Mohieldin et al., 2011.

18. Opportunities
18

 Commodity boom
 Quality improvements
 Islamic finance windows at conventional financial
institutions
 Shariah compliant indexes

19. Opportunities
19

 The commodity boom has generated surpluses in some Muslim countries that
need to be allocated through financial intermediaries and sovereign wealth funds.
0
100
200
300
400
500
600
700
800
UAE
China
Singapore
China–HongKong
Australia
Kuwait
Russia
Algeria
Norway
SaudiArabia
Azerbaijan
Brunei
SouthKorea
Ireland
Kazakhstan
Libya
Qatar
Malaysia
SouthKorea
US–Alaska
USD billion Assets of Top 20 Global SWF
0
20
40
60
80
100
120
0
50
100
150
200
250
300
350
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
US$ / BarrelUSD billion
Current Account of GCC Vs. Oil Prices
Current Account Balance (a)
(left scale)
Crude Oil-Brent Dated Free
on Board U$/Barrel (b) (right
scale)
Source: Sovereign Wealth Funds Institute, March 2012 Source: (a) Institute of International Finance database, April 2012, (b) Reuters.

20. Opportunities
20

 Quality improvements
o Quality has improved substantially over the years.
o New instruments have been developed.
o Islamic finance is increasingly being seen to offer
practical alternatives to conventional instruments for
savers and investors.

21. Opportunities
21

 Conventional financial institutions are offering Islamic
windows
o Over the past three years, ten major international
conventional financial institutions have opened Islamic
finance windows.
o This translates into Islamic finance products potentially
being available in an additional 44000 outlets/branches
across more than 70 countries.

22. Opportunities
22

 Shariah compliant indexes
0
20
40
60
80
100
120
140
Selected S&P – Shariah Compliant Stocks Indices
S&P DEV EX IS PROP HTL/RSRT & ENT $ - PRICE INDEX
S&P DEV EX IS PROP OFFICE SP-EQ $ - PRICE INDEX
S&P DEV EX IS PROP RETAIL-EQ $ - PRICE INDEX
0
500
1000
1500
2000
2500
3000
3500
Selected Dow Jones – Shariah Compliant Stocks
Indices
DJ ISLAMIC EUROPE TITANS 25 - PRICE INDEX
DJ ISLAMIC TECHNOLOGY - PRICE INDEX
DJ ISLAMIC US LARGE CAP - PRICE INDEX
Source: Reuters

23. Opportunities
23

 Potential for Stronger OIC Integration in the Global Economy:
Source: The World Bank – DECPG database
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Merchandise exports within OIC
% of total OIC exports
0%
2%
4%
6%
8%
10%
12%
14%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Total OIC Merchandise exports
% of world exports

24.  Improving regulatory oversight
 Rebalancing tax treatment
 Strengthening insolvency frameworks
 Promoting standardization
 Ensuring adequate liquidity for long term financing
 Establishing sound risk-management practices
Key Challenges
24


25.  Improving regulatory oversight:
Key Challenges
25

o Progress needs to be made on improving the regulatory framework
and strengthen regulations.
o International experience points to two approached:
 Minimal alterations: United Kingdom
 Dual approach: Bahrain and Oman
o Consensus remains to be established on a widely accepted and
comprehensive risk based supervisory approach , essential for
mitigating the risk of systemic failures.

26.  Rebalancing tax treatment:
Key Challenges
26

o Conventional debt often receives advantageous tax treatment (encouraging
leverage), while some Islamic finance products face double taxation.
o Malaysia and Thailand took fundamental steps to ensure that Islamic financial
transactions operate on a level playing field:
 In Malaysia, this principle has extended to ensuring that profits, asset transfers,
and expatriation of profits by foreigners are treated equally, whether occurring
under conventional or Islamic financial contracts.
 In Thailand, a package of proposed tax changes for Sukuk issuances is making
its way through the legislative process to address the main hurdles faced by
Sukuk issuers.
 “Real Estate Certificates” in Belgium offers interesting possibilities to develop
the issuance of Sukuk with a clear defined tax regime.
 Japan passed legislations in 2011 to encourage Sukuk issuances, knowledge
sharing is key to boost this new market.

27.  Strengthening insolvency frameworks:
Key Challenges
27

o More work is needed to ensure convergence between best insolvency
practices on the conventional and Shariah-compliant sides.
o The need to establish reliable mechanisms for dealing with Sukuk
defaults, and addressing adverse outcomes, with special adaptations for
risk sharing.
o Setting up these mechanisms requires the specification of parties’
rights under Shariah-compliant finance, especially in the case of cross-
border transactions.

28.  Promoting standardization:
Key Challenges
28

o Lack of standardization and cohesion, especially in sukuk products,
hinders the growth potential of Islamic finance
o The industry would benefit from more widely accepted benchmarks
and indices.
o Innovation and knowledge sharing between various market players
are essential to facilitate the standardization and unification of global
markets for Islamic financial products.

29.  Ensuring adequate liquidity for long term financing:
Key Challenges
29

o The divergence between fully guaranteed Sukuk by sponsors, partially
guaranteed Sukuk, and those that are not covered by any guarantee.
o Uncommon and poor understanding of various Sukuk structures limits
diversification and hinders growth potentials of the industry.

30.  Establishing sound risk-management practices:
Key Challenges
30

o Basel III compliance and concerns about liquidity risk management
need to be addressed.
o Relying on equity-based finance, Islamic banks incur a higher cost
of capital, since by definition they hold more equity than
conventional banks.
o More work is needed to find a greater convergence on the rules
governing risk weighting and the treatment of investment accounts
in Islamic banks.

31.  Joining other MDBs in tapping Islamic financial markets
 Insolvency and Corporate governance frameworks
 Knowledge sharing and capacity building
Contribution of the World Bank
31


32.  Tapping Islamic financial markets
Contribution of the World Bank
32

o Financial products include the Multilateral Investment Guarantee Agency’s
(MIGA) transaction in Indonesia in FY11, using a murabaha instrument
involving exposure of some US$450 million to improve the quality of the
mobile network and increase population coverage.
o MIGA also provided US$ 427 million in guarantees supporting the
construction of the Doraleh Container Terminal in Djibouti in 2007.
o The International Bank for Reconstruction and Development (IBRD)
launched a five-year RM760 million Islamic bond in 2005.
o International Finance Corporation (IFC) recently issued a US dollars-
denominated 100 million - non-amortizing – Sukuk issue with a five-year
maturity against a portfolio of leases which was well-received in the market.

33.  Insolvency, Corporate governance and Liquidity:
Contribution of the World Bank
33

o Collaborating with IFSB to establish widely accepted Principles for Effective
Insolvency and Creditor Rights Systems – the essentials of an effective
insolvency regime.
o The World Bank is in the process of finalizing the Supplemental Corporate
Governance Guidelines for Islamic financial institutions .
o The World Bank is currently discussing potential areas of collaboration with
International Islamic Liquidity Management Company (IILM) to foster
liquidity.

34.  Knowledge sharing and capacity building.
Contribution of the World Bank
34

o Islamic Development Bank
o IFSB
o AAIOFI
o Collaboration with research centers and universities, including:
 INCEIF
 Oxford Center for Islamic Studies
 Harvard – Islamic Finance Project – Islamic Legal Studies Program

35.  Within a relevant framework of regulations, standards and
corporate governance, Islamic finance, based on its main
principles and through continued investment in human
capital can play an ever-more important role in ensuring
broadened financial access to support sustainable
development.
Conclusion
35


36. Thank You
36