Issues and Challenges 379
EXPANDING SCOPE OF FINANCIAL INTERMEDIATION
A fi nancial intermediary transforms savings into investment and, in the
process, creates additional value by reducing search, monitoring, and trans-
action costs, as well as diversifying and/or hedging risks, thereby allowing
more effi cient utilization of resources. A fi nancial intermediary performs
these functions through the design and utilization of instruments or prod-
ucts intended to achieve a specifi c objective. The nature of fi nancial inter-
mediation in Islamic fi nance is distinct from conventional fi nance in several
ways, the most critical being that a fi nancial intermediary in the Islamic
system plays multiple roles. Whereas organized markets — such as money,
capital, and derivative markets — complement the role of a conventional
fi nancial intermediary, in the Islamic system an intermediary is expected
to undertake some of these functions. In other words, an Islamic fi nancial
system has more common features with “bank - centered” fi nancial systems
such as those of Japan and Germany than with the “market - centered” sys-
tems of the US and the UK (Iqbal 2005; Iqbal and Mirakhor 2007).
At present, fi nancial intermediation in Islamic markets is very restricted.
It is limited mainly to commercial banking activities, with the gradual intro-
duction of investment banking services. Within commercial banking, there
is more emphasis on trade fi nancing and some leasing - based assets that are
of short - term maturity and often illiquid. In the case of investment banking,
the menu of products and services is even more limited and is often targeted
at high - net - worth individuals.
IFIs have to expand the scope of their activities to provide a wider range
of products and services in the areas of corporate fi nance, risk management,
SME fi nancing, and wealth management. Research has shown that during
early phases of development where capital markets are not well developed,
fi nancial intermediaries play a critical role in providing fi nancial services to
the corporate sector. In the absence of liquid Islamic capital markets, they
will have to become the main source of fi nancing. Furthermore, the simple
availability of fi nancing will not serve this purpose; the mode of the service
will have to be improved. The fi nancing would have to be cost - effective,
fl exible, and client - oriented. Financial intermediaries must understand the
needs of corporate sector clients to develop customized solutions that can
make them competitive in the market.
Major structural changes in the role of fi nancial intermediaries are
required in the area of risk management. Their role in developing a risk man-
agement infrastructure should be twofold: fi rst, to develop and apply risk
management techniques for their own portfolios; and, second, to offer
risk management services to their clients. Risk management tools expand
the role of a fi nancial intermediary that can offer innovative products and
risk management services to the client, and can also manage its own expo-
sure more effi ciently and in a cost - effective manner. Managing fi nancial risk
also creates profi table opportunities for fi nancial intermediaries in several