Key Policy Issues and Policy Priorities to Support Stability
The previous sections of this chapter (3.1—3.5) have described a range of qualitative and quantitative information and techniques that can be used to identify potential strengths
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• Another specific risk inherent in IIFS stems from the special nature of investment deposits, whose capital value and rate of return are not guaranteed. This condition increases the potential for moral hazard and creates an incentive for risk taking and for operating financial institutions without adequate capital. • Finally, Islamic banks can use fewer risk-hedging instruments and techniques than do conventional banks and can operate in an environment (a) with underdeveloped or nonexistent interbank and money markets as well as government securities and (b) with limited availability of, and access to, lender-of-last-resort facilities operated by central banks. The above risk factors have historically forced IIFS into holding a comparatively larger proportion of their assets in reserve accounts with central banks or in correspondent accounts than do conventional banks, and those risk factors have also led to reliance mostly on sales-based facilities on the asset side rather than PLS modes. This situation has affected their competitiveness and has increased their vulnerability to external shocks, with potential systemic consequences. Sundararajan and Errico (2002) provide suggestions on how to address the risks inherent in Islamic banking.[2] |
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• Regulatory or supervisory (relating to the design and implementation of regulations and prudential standards)
• Structural (relating to the operational infrastructure of markets, settlement systems, and safety nets)
The mix and the timing of policy tools need to be appropriate for the vulnerability addressed. For example, if rapid credit growth were mainly a result of macroeconomic imbalances, it would need to be addressed primarily by macroeconomic stabilization policies, while prudential tools would play only an auxiliary role. Conversely, if a vulnerability were mainly a result of weaknesses in banking supervision and regulation, then using macroeconomic policies would be second best should reforms of supervision and regulation turn out to be insufficient or slow to yield results. Weaknesses such as these should be addressed in a timely manner through improved prudential supervision and oversight, effective surveillance of individual institutions and markets, and development and maintenance of a robust financial infrastructure. Macroeconomic policy adjustments, even when they are second best, could be crucial, for example, to limit inflationary pressures, credit growth, or bubbles in certain sectors that could substantially affect the financial sector. In addition, by themselves, policies to develop institutions and markets (e. g., money or government securities market development) and to build infrastructure (e. g., design a large value payment system) pose additional financial and macroeconomic risks, which need to be managed through prudential policies and macro-policy adjustments, as further discussed in chapter 12.
The calibration of policies can take into account information obtained from the quantitative macroprudential tools, in particular, stress tests. For example, in the context of macroeconomic policies, stress tests or sensitivity calculations can provide an assessment of how a certain interest-rate and exchange-rate policy mix can affect the financial sector and of what the resulting effect on the economy as a whole would be. Similarly, in the context of regulatory policies, simulations can be used to assess what the effect would be of an envisaged policy change (e. g., an increase in the rate of providing loans) on the health of the financial system. In the context of supervision, stress-test results can be used to direct supervisory attention to those groups of institutions that pose the greatest risk for the system as a whole. Similarly, evolution of financial soundness indicators and information from macroprudential surveillance may call for more intensive supervision in specified areas (e. g., market risks or country risks).
An assessment of the overall stability of the financial system is based on combining the analysis of risks and vulnerabilities with the assessment of various financial policy responses and policy frameworks. If the potential vulnerability to plausible shocks were not high or if the policy framework and policy responses—as seen, for example, from standards assessments—were considered appropriate, then the system would be judged stable. The stability considerations would typically dictate that a range of prudential and market development policies be given high priority.
