National and Global Islamic Financial Architecture:
Problems and Possible Solutions for the OIC Member Countries
6
1. Introduction
The financial sector performs various functions that facilitate the efficient functioning of the
economy and promote economic growth. Levine (1997: 689) identifies the functions of a
financial system as “the trading of risk, allocating capital, monitoring managers, mobilizing
savings, and easing the trading of goods”. 1 For the financial sector to contribute to growth and
mitigate risks, however, the industry itself has to be resilient and be able to reduce its own
vulnerabilities. The global financial crisis (GFC) highlights the vulnerability of the financial
sector and its detrimental impact on output and welfare with the monetary cost of the crisis
estimated to be as high as USD 15 trillion (Yoon 2012).2 Given the complexity and dynamism
of modern financial products and markets, appropriate institutions are needed to reduce the
risks and vulnerabilities that can potentially lead to harmful and costly economic downturns.
This would require certain architectural institutions and policies that foster a stable and
efficient financial sector that effectively promote economic development.
Financial transactions are legal constructs with contracts that usually have the realization of
their outcomes in the future. The theoretical basis of the need for a sound institutional
environment facilitating economic and financial development lies in New Institutional
Economics which asserts that institutions such as laws, the executive, legislature, judiciary, etc.
provide the formal rules that enforce property rights and promote economic activities
(Williamson 2000). An institutional framework introduces first order economizing in the
economy by providing supporting rules of the game that enables the production and exchange
of goods and services in an orderly manner. For example, organization, financial institution,
tax, and contract laws are relevant to the construction of financial transactions. Specifically,
organizational law determines the types of organizations that can be formed and banking law
specifies the legal requirements to establish and operate banks. Tax laws relevant to the
financial sector are related to income (profit), transactions (capital gains and stamp duties)
and goods and services (value-added tax). Contract law provides the principles and basis of
conducting transactions. While ‘law and finance’ literature assert that legal institutions have
an influence on financial development, the ‘political institutions and finance’ strand maintains
that ‘political institutions’ that protect property rights are also important determinants of
financial and economic development.3 Recognizing this, various international organizations
such as International Monetary Fund, World Bank, Basel Committee for Banking Supervision,
etc. are developing various institutional standards, tools, and policies necessary for a sound
framework for the development of the financial sector.
The role of the financial sector in promoting development depends on both demand and supply
side factors. On the supply side, the financial sector has to be inclusive and provide various
financial services to all segments of the population including the poor. On the demand side, two
broad types of markets can be identified: domestic and international. An issue on the demand
side in Muslim countries relates to voluntary exclusion whereby a large segment of the
1 Similarly, Merton and Bodie (1995) identify six functions of financial system as managing risks, transferring economic
resources, dealing with incentive problems, pooling of resources, clearing and settling payments (to facilitate trade) and
providing price information.
2 Researchers from the Federal Reserve Bank of Dallas estimate the losses from GFC in the US to be in the range of USD 6 to
USD 14 trillion. See Atkinson et. al. (2013).
3 For the former literature see La Porta et. al. (1997 &1998) and for the latter see Acemoglu and Johnson (2005)