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1 1 Regulatory & Supervisory Issues – Regulators Perspective Seminar on Islamic Finance Banca d’ Italia 11 th November 2009 Muhammad bin Ibrahim, Assistant.

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Presentation on theme: "1 1 Regulatory & Supervisory Issues – Regulators Perspective Seminar on Islamic Finance Banca d’ Italia 11 th November 2009 Muhammad bin Ibrahim, Assistant."— Presentation transcript:

1 1 1 Regulatory & Supervisory Issues – Regulators Perspective Seminar on Islamic Finance Banca d’ Italia 11 th November 2009 Muhammad bin Ibrahim, Assistant Governor

2 2 2 Part I Global Development Islamic Finance in Malaysia Part 2 Regulatory and Supervisory Issues -Shariah Governance -Risk Management -Islamic Deposit Insurance -Cross-border Supervision

3 3 Islamic finance… fastest growing segment in global financial system… Islamic Assets under Management USD750 billion & expected to hit USD1 trillion by 2010 Average growth rate of 15-20% p.a. Islamic Mutual Funds USD300 billion Average growth rate of 23% p.a. Takaful Contributions USD7.2 billion Growth rate of 13% p.a. Global Market Capitalization of Dow Jones Islamic Index USD10 trillion Shariah Compliant Global Funds 680 funds Global Outstanding Sukuk USD107 billion Average growth rate of 22% p.a. Number of Islamic Financial Institutions (IFIs) > 600 IFIs in the world Sources: McKinsey, The World Islamic Banking Competitiveness Report & ; PriceWaterHouseCoopers, Islamic Finance News, IFSB & National Authorities; Islamic Banker Research Group; Islamic Finance & Insurance & Investor Offshore Review Enormous potential in Islamic Finance…

4 4 Rapid development of Islamic banking & finance have contributed to diversity in industry structure…  Full transformation of financial system in accordance with Shariah  A comprehensive Islamic financial system co-exist with conventional system  Islamic products mainly offered by conventional banks through “windows”.  Lack of supporting infrastructure (e.g. Islamic money market & capital market) may constraint product offering  Iran, Sudan  Malaysia, Bahrain, Pakistan & UAE  UK, Hong Kong AttributesAdopting countries Dual Financial System Single Islamic Financial System Conventional Banks with Islamic Windows Various jurisdictions have their own Islamic banking & finance model to meet local requirement

5 5 Conventional banking Insurance Money market Capital market Islamic banking Takaful Islamic money market Islamic capital market Malaysian Financial System Dual financial system Conventional Financial SystemIslamic Financial System Islamic Banking Act 1983 Takaful Act 1984 Government Funding Act 2005 Capital Market & Services Act 2007 BAFIA 1989 Insurance Act 1996 Loan Local Act 1959 Treasury Bills Local Act 1946 Capital Market & Services Act 2007 Legal Governance Main Regulatory Authorities Central Bank Act 1958 (CBA) Bank Negara Malaysia – regulate & supervise both conventional & Islamic FIs Securities Commission – regulate capital market & Islamic capital market Constituents of Malaysian financial system Central Bank of Malaysia Act 2009: “The financial system shall consist of conventional & Islamic financial system”… demonstrated Government’s commitment… Malaysia has developed a comprehensive dual financial system… Sources: Bank Negara Malaysia, Securities Commission FIs – Financial Institutions

6 6 World’s largest sukuk market ± USD66bil or 58% of total outstanding bonds) Accounted 62% of total global sukuk outstanding Malaysia… several notable achievements… Sukuk market (Islamic bonds) Sukuk issuance covers all sectors of the economy Contributes to overall economic growth Sukuk as new asset classes Comprehensive system Islamic banking ( 17 Islamic banks, 3 International Islamic banks) Takaful ( 8 takaful operators, 4 retakaful operators, 1 international takaful operator) Fund Management ( 8 Islamic fund management companies, 144 Islamic unit trust funds) Islamic money market Total annual money market transactions: exceeded RM1 trillion Well established infrastructures Shariah governance Comprehensive Shariah Governance framework Regulation & supervision Capital adequacy, deposit insurance framework, risk-based supervisory framework, liquidity, disclosures & transparency Dispute resolution - Judicial system – dedicated high court - Kuala Lumpur (KL) Regional Centre for Arbitration – dedicated rules for Islamic finance arbitration; - Financial Mediation Bureau Human capital development Total solution approach for human capital development Sources: Bank Negara Malaysia, Securities Commission

7 7 7 Part I Global Development Islamic Finance in Malaysia Part 2 Regulatory and Supervisory Issues -Shariah Governance -Risk Management -Islamic Deposit Insurance -Cross-border Supervision

8 8 Shariah Governance  Shariah compliance: apex of Islamic financial system  How to ensure comprehensiveness of Shariah compliance (that cover both ex-ante & ex-post aspects of all financial transactions)? Risk Management  In addition to traditional banking risks, there are risks peculiar to Islamic banking - e.g. rate of return risk, displaced commercial risk (DCR), inventory risk & equity investment risk  Do Islamic bank regulators & supervisors have sufficient capacity & capability to look into these peculiar risks ? Deposit Insurance  Deposit insurance was introduced in conventional banking system to instil public confidence & maintain financial stability  Is it necessary to introduce Islamic deposit insurance for Islamic banking institutions that operate in dual financial system?  What is the effective mechanism to introduce Shariah-compliant Islamic deposit insurance in an entrenched conventional banking system? Cross-Border Supervision  Effective cross border supervision of Islamic banking & finance is instrumental in ensuring financial stability  Are Islamic banking’ supervisors ready to implement effective cross- border supervisory collaboration?  How to ensure Islamic banks which operate across multiple jurisdiction adhere to the common principles of strong governance & risk management? Regulatory & supervisory issues in Islamic banking & finance…

9 9 Malaysia’s experience:  Proper governance provides multi-layer assurance on Shariah compliance 1.Shariah Advisory Council given legislative stature as highest authority for Shariah matters in Islamic finance 2.Institutionalise mutual respect by recognising differences of Shariah interpretations in various jurisdiction 3.Accountability of Shariah committee of IFIs on decision, views & opinions related to shariah matters 4.Board & senior management with sufficient expertise & capability in dealing with issues specific to Islamic financial transactions 5.Emphasise the function of Shariah review & Shariah audit to provide check & balance 6.Timely disclosure on fatwa rulings Shariah Governance: A credible Shariah structure that promotes integrity and confidence… * IFI- Islamic Financial Institution Shariah as overarching principle in Islamic finance Shariah Compliance Functions :  Shariah Review  Shariah Audit BOARD MANAGEMENT SHARIAH COMMITTEE

10 10 Risk Management: Equity investment transactions that involves profit risks sharing require distinct risk management & governance… An illustration: Assets Liabilities  To manage risks associated with Mudharabah (profit-sharing) & Musharakah (partnership) contracts, equity-based transactions  Allow appointment of Board representatives on entities involved in such transactions  Board to ensure IBIs have sufficient understanding & expertise on Musharakah & Mudharabah transactions  Establishment of dedicated talent & oversight committee/ unit, e.g. in-house property development/ research department for property investment & development activities  To safeguard interest of Investment Account Holders (IAH)  Board’s fiduciary responsibilities in protecting depositors, particularly investment account holders (IAH)  Need to acknowledge IAHs’ right (1) to monitor the performance of their investments & the associated risks, (2) put into place adequate means to ensure that these rights are observed & exercised such as through sufficient disclosures Malaysia’s experience: In view of high risk nature of Mudharabah & Musharakah, BNM has issued specific guidelines on Musharakah & Mudharabah to provide guidance to IBIs IBIs – Islamic Banking Institutions

11 11 Risk Management (cont…) Displaced Commercial Risk & Rate of Return Risk: How to mitigate the risk that depositors might not receive expected return? Islamic Banking Institution’s Profit PER OR Rate not competitive (rate < market) PER Islamic Banking Institution’s Profit Profit surplus competitive (rate > market) Excess save as PER for rainy days PER is written back Other possible solutions: (1) Minimise dependency on long-term fixed return assets in managing return to investors/depositors & introduce floating rate financing e.g. Ijarah (leasing) based contract (2) For banks that do not adopt PER, there is a possibility of confidence crisis / run on the banks (should they cannot react to the expectation of depositors) - continuous monitoring is important to minimise the risk. An increase in benchmark rates: -  Effect : Investment Account Holders (IAH) have expectation of a higher Rate of Return (RoR).  Problem : Assets funded by IAH are mostly long term & fixed rate – hence, cannot be repriced higher until those assets mature  Solution (1): Islamic bank has to give up some portion of its return in order to pay a competitive rate to IAH & prevent them from leaving the bank (risk of flight to quality or liquidity risk)  Solution (2): Apart from the Bank foregoing their portion of profits in ensuring competitive returns, Bank could adopt Profit Equalisation Reserve (PER) as a mechanism to smoothen income & to minimise displaced commercial risk (DCR)

12 12 Deposit Insurance in Islamic Finance… Depositors Islamic Banks 1.Deposit money 2.Contribution (premium paid by Islamic bank) 3.Provide coverage when bank fails (3 rd party guarantee with fee) Malaysia Deposit Insurance Corporation Separate & Equitable Principles  Islamic deposit covered separately from conventional  All coverage limit – similar to conventional  Up to RM60k per depositor per member institution (covers 90% of total depositors)  Funded by contribution (premium) collected from Islamic banks  Pooled contribution (funds) managed separately  Invest in Shariah compliant instruments  Separate deposit premium assessment system for Islamic & conventional  Separate supervisory assessment for Islamic & conventional banking institutions (inc windows)  Separate payment in event of failure Islamic deposit insurance funds used only for Islamic banks  Deficit contribution – can raise funds from government based on Shariah principles Separate management of funds Equivalent Coverage Limit Separate Premium Assessment Separate Payout Malaysia’s Experience:

13 13 Cross-border supervision: As Islamic financial institutions going global, supervisory issues require cross-border initiatives… Understanding of supervisory philosophy & objective with regard to Islamic financial system within jurisdictions Common understanding among supervisors especially on specific risks emanating from Islamic finance operations Clarity of responsibilities of home & host supervisory authorities – Mutual respects of Shariah view? UNITY IN DIVERSITY Easy access to relevant information Cross border supervisory issues are generally similar to conventional banking. The differences lies in detailed application of Islamic banking & finance model HOME HOST

14 14 Understand the Fundamental  Shariah as the backbone of Islamic banking & finance  Specific approach must be taken to ensure adherence to Shariah principles  Understand the industry in which the Islamic banking & finance exist  Tailor-made the regulatory & supervisory approach to the nature of the financial system  Full commitment on effort to resolve emerging system-wide issues  Identify the pre-requisite for an Islamic financial institutions -Human capital -Infrastructure -Capacity & capability  Balancing the need for prudential regulation & strategic aspiration  Recognise the unique structure of Islamic banking & finance  Acknowledge the distinctive risks associate with Islamic banking finance Appreciate the Uniqueness Recognise the Environment Acknowledge the Challenges In essence, to ensure Islamic banking regulation & supervision is effective, the following elements should be considered..

15 15 Disclaimer: While every care is taken in the preparation of this presentation, no responsibility can be accepted for any errors. Copyright: All or any other portion of this presentation may be reproduced provided acknowledgement of the source is made. Notification of such use is required. All rights reserved.  - Bank Negara Malaysia  - Malaysia International Islamic Financial Centre (MIFC)  Islamic Money Market  - Malaysian Government Securities Market  - Securities Commission Malaysia  - Malaysia Deposit Insurance Corporation Informative websites: “Malaysia, a vibrant Islamic financial hub, shapes the future of Islamic finance through innovation and thought leadership to enable the collaboration with global talents and leading players”


17 17 Pakistan Hong Kong  Aims to become Islamic finance gateway to China  Plans to issue sovereign sukuk  Hang Seng Islamic China Index Fund in 2007 UK  Gov’t sets an objective to ‘entrench London as a global gateway for Islamic finance  5 FSA-approved Islamic banks and Takaful operators  Plans to issue sovereign sukuk, amend tax law on IF UAE Japan Law passed allowing banks to do Islamic finance France  Passed rules/regulations to support Islamic finance activities  In process of licensing Islamic banks  Made fiscal & legal adjustment for IF transaction i.e. taxation guidelines on sukuk & murabaha Singapore  Established first Islamic bank  Introduced tax neutrality for Islamic finance  Aspiring to be centre for Islamic finance  Launched Islamic ETF South Korea Parliament expected to pass the law related to offering of tax waiver on foreign investors’ interest income from sukuk issued Thailand Qatar Sudan Indonesia Kuwait Germany  Saxony-Anhalt state issued government sukuk  First Islamic bank to operate in 2010 Emerging interest on Islamic finance as viable alternative to the global financial system … Saudi Arabia Bahrain Malta  Plans to position as Islamic finance hub for the Mediterranean Jordan  Plans to tap sukuk market to finance its deficit Turkey  Announced IFC Istanbul in Sep ’09 with focus includes interest- free financial business Brunei Aim to become Islamic financial services hub for Asia Muslim-majority countries offering Islamic finance (IF) Non-muslim countries starting to offer IF

18 18 Instituting a comprehensive Islamic financial system in overall financial system in Malaysia… 58% of outstanding private debts are Sukuk Global leader in Sukuk - 62% of total outstanding sukuk globally 87% permissible counters Capital Market Islamic inter-bank money market Diverse short-term Islamic money market Instruments Money markets 8 approved Islamic fund management companies 35 fund management companies with Islamic mandate 149 Islamic Unit Trust funds Fund Management Shariah Shariah Advisory Council Shariah Committee members requirements at Bank level Shariah Parameters Shariah Governance Islamic Banking Act Takaful Act Government Funding Act Capital Market Services Act Deposit Insurance Act Guidelines & Policies Legal & Regulatory Judicial system – dedicated high court on Islamic Finance KL Arbitration Centre Financial Intermediation Bureau Dispute Resolutions 17 Islamic Banks 10 Islamic windows 6 DFIs offering IBs 3 International IBs 14 International Currency Business Units Islamic Banking 8 Takaful operators 3 re-takaful operators 1 International Takaful Operators 5 International Currency Business Units Takaful International Centre for Education in Islamic Finance (INCEIF) Islamic Banking & Finance Institute (IBFIM) International Shariah Research Centre (ISRA) Advisory (e.g. KPMG,Deloitte) Human Capital Shariah & Legal infrastructure Diversity of players supported by Human Capital & Advisory Institutions Comprehensive Capital & Money markets

19 19 Rapid development of Islamic banking business have also contributed to the diversity in industry structure… Various jurisdictions have their own Islamic banking model to meet local requirement  Full transformation of economic system in accordance with Shariah led to existence of single banking system  Country: Iran, Sudan and Pakistan  A comprehensive Islamic banking system co-exist with conventional system  Country: Malaysia, Bahrain, Kuwait, Qatar and UAE  Islamic products offered by conventional banks through “windows”.  Lack of support infrastructure (e.g. Islamic money market & capital market) may constraint product offering  Country: Singapore and UK Single Islamic Banking System Dual Banking System Conventional Banks with Islamic Windows


21 21 AssetsLiabilities Inventory Real estates/Automobiles Asset-backed Transactions Murabahah (cost plus) / Ijarah (leasing) / Istisna’ (manufacture) / Salam (forward delivery) Demand Deposits Wadiah (Safe custody) / Qard (Loan) Profit Sharing Transactions Mudharabah (profit sharing & loss bearing) /Musharakah (profit & loss sharing) Fee Based Services e.g. Qadr Hassan (Benevolent Loan) Investment Accounts Mudharabah (profit sharing) Equity Specific Investment Accounts Mudharabah (profit sharing) Profit Equalisation Reserves Islamic Rate of Return Management (Asset Driven) Return on AssetsInvestment Returns Islamic banking institution’s balance sheet…similar in terms of products but different in terms of contractual relationship…  The investors-entrepreneur relationship changes the way Islamic banks operate: – Investors (IAH) bear fully the investment risk (while the bank is only exposed to negligence risk). IAH could therefore determine the investments/assets profile of the banks – Islamic banks have greater fiduciary duty to protect IAH’s investment Level of funding from IAH is the most significant differentiating factor To minimise Shariah & legal risks of various contracts - understanding Shariah requirements are essential when drafting legal documentations…

22 22 Formulation of separate guidelines* to reflect distinct features of Islamic finance… Corporate Governance Guidelines  Board & senior management oversight  Governance principles peculiar to Islamic banking Capital Adequacy Standards  Capital adequacy framework based on IFSB* Capital Adequacy Standard  Risk profiles & exposures determined based on underlying Shariah contracts PSIA Risk Absorbent Framework  Assets funded by PSIA does not require capital if comply with certain requirements Shariah Governance Guidelines  Governance of Shariah Committee of Islamic Financial Institutions (IFIs)  Duties & responsibilities of IFIs in ensuring Shariah compliance Guidelines on Financial Disclosure  Comprehensive guidelines as a basis for disclosure and presentation of reports and financial statements Rate of Return Framework  Standardise method on calculation of rate of return for Islamic banking Islamic Money Market Guidelines  Policies governing Islamic Money Market Operations Firewalls for Islamic window operation  Segregation of funds, separate accounting, clearing & settlement system Musharakah & Mudharabah  Policies & regulatory provisions that govern the exposure of IBIs under Musharakah and Mudharabah contracts. Property Development & Investment Activities  Policies relating to property development & property investment activities by Islamic BankingInstitutions (IBIs) # IFSB- Islamic Financial Services Board* Note: Selected BNM Guidelines which can be downloaded at … and streamline with International Standards (IFSB#) Selected BNM Guidelines

23 23 Manage risks peculiar to Islamic financial transactions requires different approaches & mindset…  Bringing capital requirement closer to true economic risk of the Islamic banks  Optimise benefit from the more advanced capital measurement approach which promotes better risk management practices [e.g. Internal ratings based approach] International best practices for an effective risk management process Shariah non- compliance risk Shariah non- compliance risk Market risk Credit risk Equity investment risk Equity investment risk Liquidity risk Liquidity risk Rate of return risk Rate of return risk  Avoid dependency on long-term fixed return assets in managing return to investors/depositors  Product development to diversify returns profile  Enhance liquidity management capabilities & increase availability of Shariah-based Islamic financial market instrument  Explore behavioural model to adequately reflect liquidity risk profile of Islamic products

24 24 Credit risk Ownership risk (Inventory Risk) EVENT RISKS Receiving asset Sell the asset Ownership by the Bank Payment installments at Selling Price Maturity date Capital adequacy standard addressed peculiar risk on Islamic finance incl. inventory & transformation of risk… Risk transformation at different stages of Shariah contracts, bringing capital requirement closer to their actual risk profile…

25 Concept of risk management in Islam  Text in Quran Further he said: "O my sons! Do not enter the capital of Egypt by one gate: but go into it by different gates. However know it well that I cannot ward off you Allah’s will for none other than He has nay authority whatsoever. On Him do I put my trust and all who want to rely upon anyone should put their trust on Him alone." (Surah Yusuf: Verse 67)  Hadith from Prophet Muhammad S.A.W Prophet Muhammad noticed a Bedouin leaving his camel without tying it and he asked the Bedouin “Why didn’t you tie down your camel?” The Bedouin answered, “I put my trust in God.” Muhammad replied, “Tie your camel and put your trust in God.” Text in Quran Hadith from Prophet Muhammad S.A.W

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