300 AN INTRODUCTION TO ISLAMIC FINANCE
Mitigation of Systemic Risk
Another rationale for regulation, linked to the notion of public good, is that
it is a pre - emptive measure to avoid or mitigate any systemic risk that can
lead to a contagious collapse of the fi nancial system. Such mitigation can
reduce the fi nancial distress and social costs associated with the failures.
Banks are particularly vulnerable to such collapses because of the nature of
their business; that is, illiquid assets fi nanced by liquid liabilities. Therefore,
the objective of prudential regulation is the mitigation of the risk of disruption
of the normal business performed by the fi nancial system in payments or
the provision of liquidity. Such systemic risks could be the outcome of a
spillover from distress in one institution unable to honor its commitments,
undermining confi dence in the system. It could also be the result of a failure
in the payments system itself — either of its material infrastructure or of the
mechanisms and instruments to exchange liquidity.
Protection of Public Resources
Another view of fi nancial regulation is that the existence of an explicit or
implicit safety net, notably in the form of deposit insurance, creates a con-
tingent government liability. The existence of such a commitment of public
resources entails both the right and the duty of the public authority to regu-
late activities that may endanger these resources. This view is not unrelated
to the public-good view, as the existence of deposit insurance is itself a pub-
lic service. The existence of any safety net or deposit insurance also creates
a moral hazard, as it reduces the incentive for depositors to impose market
discipline on banks with regard to their risk taking. Regulation is one of the
means to check such moral hazard.
Integrity of Fiduciary Contracts
Another perspective on regulation is provided by a focus on the fi duciary
nature of the business of fi nance. The role of regulation is seen here as the
provision of suffi cient checks and balances to mitigate the risk of the inter-
mediary failing the trust of its stakeholders. These are generally seen as the
depositors, but also include small shareholders, which underlines the impor-
tance of sound corporate governance.
In the light of this rationale, Chapra and Khan (2000) suggest four rea-
sons for the regulation of IFIs:
i) Systemic considerations, particularly the need to maintain an orderly
payments system and ensure the development of the economy.
Maintaining orderly payments is clearly in the nature of a public
good which needs to be protected. Whether IFIs operate according to
core principles or follow prevailing practices, regulation to mitigate the
risks of disruption in payments can be justifi ed.