• Book Title:
 Islamic Finance Writings Of Sundararajan
  • Book Author:
Harinder S KohliJaseem Ahmed
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This book has been compiled by us to honor Dr. Venkataraman Sundararajan’s numerous contributions to the development and mainstreaming of Islamic finance during the past twelve years.

Rajan—as he was known to most of his friends—was both a friend and colleague. We had the privilege to watch him from very close quarters as he produced some of his best work on Islamic finance, as he interacted with the leading figures in the field, as he advised the senior-most policy makers in their quest to both deepen and expand Islamic finance in individual countries, and as he helped them, as a group, in their quest to make Islamic finance instruments and institutions more compatible with the fast-evolving regulatory and supervisory framework of the overall global financial system.

As Abbas Mirakhor notes in his tribute in this book, Dr. Sundararajan respected, and accepted as legitimate and viable, the premises and objectives that underpin Islamic finance. He recognized that Islamic finance was not simply a Shari’ah-compliant version of conventional finance. It is a distinct approach, based on universal values that require special attention to its risk management and infrastructure needs.

 From this perspective he took great satisfaction in the growth of Islamic finance without ever losing his singular focus—which was on the stability, soundness, and resilience of Islamic Financial Institutions (IFIs) and of Islamic financial systems.

His contributions in these areas were seminal and were informed by the deep study of the fundamentals of Islamic finance, by his immense knowledge and experience in monetary policy, and in financial and capital markets issues acquired through a long and distinguished career at the IMF.

Only a person of his towering intellect, intimate knowledge of the financial systems throughout the world, ability to understand the often very different perspectives and constraints of various parties, uncanny ability to find pragmatic solutions to bridge ideological divides, and boundless energy could accomplish this.

Rajan left behind a vast quantity of papers and reports on most key aspects of Islamic finance. Many of the papers are seminal in nature. Hence our decision to compile this book to honor Rajan by bringing together in one volume Rajan’s selected writings on key aspects of Islamic finance. We faced a formidable challenge in selecting the writings that would go in this volume. We ultimately settled on eight major papers that, in our view, are the most representative of the breadth and variety of his writings. We had to leave out a number of other papers also worthy of wider publication in order to limit the size of this volume to a reasonable length.

The chapters in this book span twelve years of his work, between 1998 and 2010. They demonstrate not only Dr. Sundararajan’s long-standing commitment to help develop Islamic banking, but also how Islamic finance itself has evolved rapidly over this period. During this period, Islamic finance became a global phenomenon on the back of two distinct developments. First, there was a rapid growth of assets. The most recent estimates from the Kuwait Finance House suggest that this was at a rate of about 14 percent per annum on a cumulative or compound basis. The growth rate was even higher in the period 2006–09, reaching about 28 percent per annum. As a result, global Islamic finance assets were estimated to be over USD 1 trillion in 2009 (80 percent is accounted for by the banking sector).1 Second, Islamic finance has been transformed. From what a few decades ago consisted principally of retail banking, today it is an industry that encompasses commercial banking, takaful, fund management, sukuk, and much more. Alongside these developments, there is a widening of its geographical coverage as a result of an increased interest in Islamic finance from nontraditional markets—particularly in Europe, but also in Asia. It can no longer be said that Islamic finance is a marginal part of the global financial system, concentrated only in the Middle East and Southeast Asia. On the contrary, Islamic finance has gone global.

1 These figures come from Bank Negara Malaysia (BNM) Governor Zeti’s speech on October 26, 2010, “Enhancing the Resilience and Stability of the Islamic Financial System; Global Islamic Finance Forum 2010.” See

The overarching commonality of all Islamic finance issues discussed in this book stem from core principles drawn from Islamic law, or the Shari’ah, which govern all Islamic finance transactions and activities. These core principles include ethical principles of justice, fairness, transparency, and the public interest. Second, riba, or a predetermined and guaranteed rate of return or interest, is prohibited. Third, gambling is prohibited and preventable, and uncertainty and ambiguity in contracts must be avoided. Fourth, the requirement that finance must be linked to a productive activity—a requirement that essentially stipulates that finance is an instrument, and only an instrument—to the underlying objective of creating lawful, productive economic activities.

Fifth, there is an emphasis on the concept of partnership—and on equity-based, profit/risk-sharing transactions, as the ultimate bases for economic activities and investment. These are powerfully appealing and immutable principles for Muslims, but they also resonate with growing numbers of non-Muslims who participate in Islamic finance today.

A major part of Dr. Sundararajan’s work addresses the complex range of risks that arise in Islamic finance requiring a strong transparency and disclosure regime, and robust corporate governance systems. These risks span mudarabah risk in the banking system accounts—which arises from the participatory element in Islamic finance, credit-risk embodied in sales-based contracts, principally of the murabahah or commodity- based type, as well as other distinctive risks faced by Islamic finance. As he stressed, at the aggregate level, the key risk is mudarabah risk in the banking system arising from the variability in bank profits and the manner and in which these are shared with Investment Account Holders (IAH). His major contribution in this area was to make more transparent the risks being borne by IAHs—through disclosure and reserving policies that were issued as standards and guidance notes by the Islamic Financial Services Board (IFSB), an institution in the establishment of which he participated.

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Reflecting on the fact that murabahah and other sales-based contracts dominate the asset side of Islamic financial institutions, he was convinced that enhanced transparency and risk management capabilities would inevitably see a greater ability and willingness by the IFIs to engage in the profit- and loss-sharing activities that would drive productive investment. His technical papers were designed to hasten this process along and contributed significantly to enhancing capabilities for integrated risk management to control different types of risks faced by the IFIs, as well as to improved approaches to disaggregated risk measurement needed to price specific contracts and facilities.

As an early advocate of a multipronged approach to risk management, it can be said that he anticipated some of the lessons from the Global Financial Crisis. Thus, he stressed the importance of careful attention to measurement and disclosure of the unique risks in Islamic finance, supported by enhanced data collection and surveillance capabilities. He was amongst the first to suggest the need for greater regulatory coordination in Islamic finance.

In the last five years of his life he concentrated on helping to develop some of the critical missing pieces needed to strengthen the resilience and stability of Islamic finance, beginning first with his work on liquidity management in 2005 and concluding in 2010 with his participation in the work of two path-breaking Task Forces, both of which were chaired by Governor Zeti Akhtar Aziz of BNM. The IFSB High Level Task Force on Liquidity Management recommended the establishment of an international facility to issue short-term sukuk for liquidity management purposes; and the Task Force on Islamic Finance and Global Financial Stability, jointly formed by the Islamic Development Bank (IDB), the Islamic Research and Training Institute at the IDB, and IFSB, produced the first Islamic Finance Global Stability Report in April 2010 and saw the establishment of the Islamic Financial Stability Forum. It is safe to say that the work of each of these Task Forces culminated in landmark developments that are helping shape the global architecture of Islamic finance while spurring greater cross-border cooperation and consultation.

Both endeavors were close to Dr. Sundararajan’s heart and to his professional interests. Dr. Sundararajan’s work with IFSB in preparing the Technical Note on liquidity management identified key impediments to liquidity management by IFIs resulting from the inadequate supply of short- term Islamic financial instruments. This constituted a critical hindrance to the development of efficient interbank markets and money markets. This work also served to focus attention on the systemic risks to Islamic financial systems from this missing piece of institutional and market infrastructure, a message that resonated powerfully with the onset of the Global Crisis. The Technical Note paved the way for the recommendations of the High

Level Task Force, resulting in the establishment of the International Islamic Liquidity Management Corporation (IILM) in Kuala Lumpur, Malaysia, in October 2010. The IILM, with thirteen founding members, including eleven central banks, and two multilateral development institutions, will issue Shari’ah-compliant financial instruments to facilitate more effective liquidity management by IFIs as well as by central banks. The IILM is, thus, poised to enable the Islamic finance industry to strengthen its capacity to respond to a liquidity crisis while also enhancing cross-border linkages between Islamic capital and securities markets. Sadly, Dr. Sundararajan was not alive to see this milestone event to which he had contributed.

The Islamic Finance Global Stability Report, which was issued in Khartoum, Sudan, a few days before Dr. Sundararajan’s untimely demise, presents a comprehensive overview of the global financial architecture— and the cooperation and collaboration mechanisms among IFSB members—needed to promote a competitive, resilient, and stable Islamic finance industry. The Islamic Financial Stability Forum that resulted from this Report, and the IILM, provide Islamic finance with a wider range of tools and instruments, as well as a road map leading toward a vision of an integrated and sound global Islamic financial industry.

Intended Audience and Organization of the Book

The chapters in this book are a blend between those of interest to the general public interested in knowing the basics of Islamic finance, policy makers responsible for setting policies and standards at the national or regional/global levels, and experts in Islamic finance working on the more complex issues relating to their stability and compatibility with the conventional financial system.

The book is accordingly structured into three parts. Part I is meant for the general reader as well as casual students of finance and provides an overview of the basic principles and practices of Islamic finance and how they differ from conventional finance. Part II is aimed at the senior policy makers and comprises of four chapters each of which addresses a major policy issue. The chapters appear in the chronological order in which they were written. And Part III, of interest to experts on Islamic finance, consists of three chapters that address complex technical issues that became of paramount importance as the Islamic finance industry grew in size and complexity and the countries tried to make it more compatible with the conventional global financial system and its governance. Again, the chapters in this part appear in the order in which they were written.

By putting the chapters in the chronological order in which they were written, the book follows the evolution of Islamic banking and finance during its most critical years as well as the resulting changing focus of Rajan’s work. As the size and importance of Islamic finance grew, the primary policy focus within the Islamic countries moved from the initial creation of the basic Islamic finance instruments and institutions to the more complex issues such as risk management and compatibility with the mainstream global financial system. This structure also demonstrates that throughout this twelve-year period, Rajan’s writings were geared toward providing analytic foundation and pragmatic solutions to the fast-changing policy and institutional issues confronting the regulatory and supervisory authorities at the time.

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In these works, Dr. Sundararajan dispassionately identified relevant issues and weaknesses in the field of Islamic banking and finance at various stages, and then developed tools and methodologies to address them so as to allow the industry to develop on a sound and sustained basis. As a consummate international civil servant, Rajan could draw great satisfaction that, as a result of his writings and face-to-face dialog, the responsible organizations and authorities—both national and multilateral—accepted most of his findings and adopted his proposals. Consequently, it is perhaps fair to say that Rajan played an important role in shaping the evolution of Islamic finance during the past decade.

The chapters that follow this introduction are self-contained. We will also like to encourage the readers to learn directly from Rajan’s own words, instead of filtering his work through a long introduction by the editors. Accordingly, we will keep the remaining section brief by limiting our introduction to a short description of what each of the three parts and the chapters therein cover.

Part I, as mentioned, consists of the first chapter of the book, “Current Developments and Key Issues in Islamic Finance.” It was written in 2007 and provides a very useful overview of Islamic finance. The chapter goes on to describe its basic foundations and core principles and key features. It then goes on to describe the structure, size, and expanding scope of the Islamic Financial Services Industry’s (IFSI) five distinct categories:

(i) Islamic banking, (ii) Islamic capital markets, (iii) takaful or Islamic insurance, (iv) Islamic nonbank financial institutions (e.g., leasing), and

(v) Islamic money markets. It also traces the history of standard setting bodies and the likely challenges in the future development and supervision of IFSIs. This chapter highlights the cross-sectoral nature of Islamic finance which renders the design of any financial instruments, products, and services more complicated (e.g., the combined features of deposits, or loans, and of mutual funds, or equities, requires the close cooperation between banking and securities regulators).

Part II of the book includes four chapters meant for senior policy makers and regulators in countries with Islamic finance. They were written between 1998 and 2008. Islamic finance instruments and institutions are subject to a unique set of risks based on contractual forms that are derived from Shari’ah principles.

Thus, the type and mix of risks that are embedded in individual Islamic products and financing facilities, and the arrangements to share risks (e.g., with IAHs), pose very unique risk management challenges. In particular, the nature of the specific risks that Islamic banks face, together with the many different ways available to them to provide funds through the use of permissible Islamic modes of financing—both profit-and-loss-sharing (PLS), and non-profit-and- loss-sharing (non-PLS)—raise a host of issues in risk measurement, income recognition, adequacy of collateral, and disclosure standards. Hence, innovative solutions and an appropriate adaption of available risk management frameworks are needed.

Chapter 2 was written in 1998 and addresses one of the most vexing policy challenges faced by the monetary authorities, financial sector regulators and supervisors with budding financial systems as to how to carry out their responsibilities while promoting Islamic finance. The chapter is entitled “Monetary Operations and Government Debt Management under Islamic Banking.” It focuses on three critical issues:

(i) issuance of government securities under Islamic finance principles; (ii) recent developments in monetary instruments under Islamic banking; and

(iii) issues in institutional arrangements for monetary operations. While several financial instruments suitable for Islamic commercial banking or for funding specific projects have been developed, progress in developing instruments for noninflationary financing of government deficits and for market-based monetary management has been less satisfactory. There have, however, been significant efforts by both the central banks (money market) and securities commissions (capital market) to strengthen the regulatory foundations to issue diverse Shari’ah-compliant financial instruments—ranging from short-term papers to long-term sukuk. It should be noted that this chapter was reportedly influential in helping early movers like Sudan to satisfy international institutions while allowing them to follow Islamic finance principles.

Chapter 3, written in 2002, addresses another central policy issue—risk management—faced by both national and international policy makers as Islamic finance grew into an important part of financial systems in many countries in the Middle East, Africa, and parts of Asia. Its title “Islamic Financial Institutions and Products in the Global Financial System: Key Issues in Risk Management and Challenges Ahead” describes very well its coverage.

The chapter starts by describing the special risks surrounding Islamic banking and then goes on to suggest ways to manage these risks, including by strengthening the regulatory and disclosure framework. It ends with Rajan’s views on the key challenges that lay ahead at that time (as of 2002).

Chapter 4 was written three years later (in 2005) and comes back to the issues concerning risk measurement and disclosure. Perhaps reflecting the fact that regulators were beginning to focus more on the issue of risk at the individual institutional level, this chapter (“Risk Measurement and Disclosure in Islamic Finance and the Implications of Profit Sharing Investment Accounts”) proposes a specific approach to measure the actual sharing of risks between shareholders and profit-sharing investment account (PSIA) holders, based on the value-at-risk (VAR) methodology.

It outlines overall risks of an Islamic bank and possible approaches to risk mitigation, and a possible disclosure regime for Islamic banks. Finally, given its primary audience, the chapter closes with the following key policy conclusions: (i) the appropriate management of PSIAs, with proper measurement, control, and disclosure of the extent of risk sharing with investment accounts holders, can be a powerful risk mitigant in Islamic finance; and (ii) supervisory authorities can provide strong incentives for effective overall risk management and transparent risk-sharing with PSIAs.

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The last chapter of Part II is Chapter 5, titled “A Note on Strengthening Liquidity Management of Institutions Offering Islamic Financial Services:

The Development of Islamic Money Markets.” Written in 2008, this chapter demonstrates how the focus of policy makers and of Rajan’s policy advice evolved with the rapid development of Islamic financial institutions.

By 2008, he had linked the long-term growth and prosperity of Islamic finance institutions with the development of broader Islamic finance markets, in this case, the need to make money markets consistent with Islamic principle in order to provide adequate liquidity to individual institutions.

This chapter discusses the following: the rationale for Islamic money markets development; an overview of factors affecting the money markets including legal and Shari’ah issues; structure and instruments of Islamic money markets and the role of monetary operations; and importance of coordinating monetary operations, public debt, and financial management (a topic first visited by him in his 1998 paper).

It then goes on to outline possible market microstructure, payment and settlement systems, and foreign exchange markets. As in the case of other chapters in Part II, this chapter ends with a summary of policy issues and strategies for development of Islamic money markets.

The third and last part has three chapters all addressing “technical” issues that came to the fore as Islamic finance took root in more and more countries, and as the Islamic finance community intensified efforts to integrate with the “conventional” global financial system and its governance architecture. To illustrate Rajan’s contributions to the analysis and resolution of these issues, we have selected his papers on reserves in Islamic banks, assessments of IFSIs in World Bank-IMF Financial Sector Assessments (FSAPs), and capital adequacy.

Chapter 6 “Issues in Managing Profit Equalization Reserves and Investment Risk Reserves in Islamic Banks” was written first in 2008. To set the stage, it first describes the relevant accounting definitions and (current) practices. It then lays out the main determinants of profit equalization and investment risk reserves and their relationship to DCR—or Displaced Commercial Risk. Based on this analysis, the chapter draws out the main issues and policy conclusions.

Chapter 7, “Towards Developing a Template to Assess Islamic Financial Services Industry (IFSI) in the World Bank-IMF Financial Sector Assessment Program,” was written in 2009. Rajan was the ideal person to write this chapter. While at the IMF, he was first the key driving force behind the conceptualization and development of the FSAP program, and then in supervising the program for a number of years. He also led a few FSAPs himself. As the program matured, the IMF and World Bank asked him to lead a large team of experts to prepare the manual for use by the staffs of the two institutions.

This chapter combines his intimate knowledge of FSAPs with his deep understanding of IFSI. This template outlined in the chapter should be of practical use for both the Islamic central bank officials and the staff of IMF and World Bank for many years to come. The added value of this chapter is that the discussion is also more broadly applicable to any assessment of microfinancial stability in an Islamic financial sector.

Finally, Chapter 8 discusses the “Supervisory, Regulatory, and Capital Adequacy Implications of Profit-Sharing Investment Accounts in Islamic Finance.” This chapter was jointly written by Simon Archer, Professor Datuk Rifaat Ahmed Adbel Karim, and Rajan. It was first published in 2010 in a journal. It is a seminal piece on the subject. The chapter describes the main types and characteristics of PSIAs under mudarabah contracts. In practice, there is considerable ambiguity in the nature and characteristics of PSIAs in Islamic banks. The nature of PSIAs varies among banks and jurisdictions, particularly regarding the division of risk between the IAH and the bank.

Depending on the extent of investment risks that are actually borne by the PSIAs, these instruments could, in principle, be positioned anywhere on the continuum from being pure deposits (in the conventional sense) to pure investments.

The resulting challenge for IFSIs and their regulators is to assess where on the continuum the PSIAs in a specific bank in a specific jurisdiction lie, and what this implies for the level of risks for shareholders and, hence, for the level of regulatory and economic capital requirements for that bank. The chapter concludes with suggestions for risk-sharing as well as implications of these PSIAs for the supervisory and regulatory authorities—both national and pan-national, such as the IFSB.

We think that this book will serve to highlight how some of the key challenges faced by Islamic finance during the modern phase of its development were addressed through the works of Dr. Sundararajan. Many of these challenges have been addressed in recent years and, as a result, Islamic finance today is a stronger and more resilient industry.

To be sure, many challenges still remain to strengthen Islamic financial systems. In addition, there is the practical issue that Islamic financial systems exist within the framework of a globalized, highly integrated conventional financial system. As the global financial crisis of 2008 has demonstrated, the global system exhibits a high degree of structural fragility that persists—and may do so for some time to come. Enhancing global financial stability is a common objective of both Islamic and conventional finance. For holistic stability to be achieved, it is important that collaboration and understanding between Islamic and conventional financial industries is strengthened. Dr. Sundararajan fully embodied this spirit of understanding, and we sincerely hope that this book helps keep this spirit strong.

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