Supervisory Review Process Risk-based Supervision in Institutions offering Islamic Financial Services (IIFS) 2-5 February 2015 Kuwait city, Kuwait Abdullah Haron 1

2 Agenda Principles of supervisory review process in IIFS Scope and application of the principle in various jurisdictions Specific elements of the supervisory review process relating to IIFS

Principles of SRP in IIFS Why there is a need for a specific review process for the IIFS?  The operations of IIFS are significantly influenced by the Sharī`ah rules and principles governing their structure and activities. It is desirable because there are risks specific to the IIFS Shari`āh non-compliance risk Fiduciary risk Rate of return risk Displaced commercial risk Profit equalisation and investment risk reserves Limited hedging instruments  Apart from the risks to which the conventional institutions are traditionally exposed, the reputational risk is of particular concern to supervisory authorities. 3

Principles of SRP in IIFS (cont’d) International Standards: Basel II Pillar 2 has four principles Bank Develop capital assessment and measure Supervisory authority Evaluate the quality of banks’ internal capital assessment procedures Impose capital requirement in excess of the minimum capital adequacy requirement Intervene at an early stage to prevent capital from falling below regulatory level 4

Principles of SRP in IIFS (cont’d) What all these principles mean to the authority supervising IIFS?  The review process has to be adapted to take into account specific features of IIFS  Apart from the elements mentioned in the Basel II Pillar 2 above, the elements in the review process shall complement the IFSB’s standards on capital adequacy, risk management, corporate governance, transparency and market discipline. 5

Principles of SRP in IIFS (cont’d) What is the supervisory review process for the IIFS?  In addition to ensuring that the IIFS have sufficient capital to support all the material risks to which the business exposes them, the supervisory authority shall satisfy itself as to the adequacy of various compliance aspects, including the Sharī`ah rules and principles, linking to the capital requirements, risk management, governance structure, transparency and market discipline 6

Framework for SRP (cont’d)  It is important to note the notion of balance between the three pillars (minimum capital adequacy requirements, supervisory review process, transparency and market discipline) in the regulation of IIFS and the supervisory review programme employed in this context.  The supervisory authorities will have to exercise judgement regarding the appropriate weights and balance to be given in the application of qualitative and quantitative measures in their policies on capital adequacy, risk management, corporate governance and disclosure requirements. 7

Pillar I Minimum Capital Requirements Pillar I Minimum Capital Requirements Pillar II Supervisory Review Process Pillar II Supervisory Review Process Pillar III Transparency & Market Discipline Pillar III Transparency & Market Discipline QUANTITATIVE Capital Requirements Credit Risk Market Risk Operational Risk QUANTITATIVE Capital Requirements Credit Risk Market Risk Operational Risk QUALITATIVE Regulatory Framework Internal Capital Adequacy Assessment Process (ICAAP) Risk Management Supervisory Framework Risk matrix/profile Evaluation of internal systems QUALITATIVE Regulatory Framework Internal Capital Adequacy Assessment Process (ICAAP) Risk Management Supervisory Framework Risk matrix/profile Evaluation of internal systems QUALITATIVE Disclosure System of Banks: Transparency for market participants concerning the bank’s risk position Enhanced comparability of banks QUALITATIVE Disclosure System of Banks: Transparency for market participants concerning the bank’s risk position Enhanced comparability of banks Framework for SRP (cont’d) 8 QUANTITATIVE Definition of Capital Liquidity Systemic Risk and Interconnectedness QUANTITATIVE Definition of Capital Liquidity Systemic Risk and Interconnectedness Basel III related

Full Fledged IIFS; Islamic Window Dual System Prescribe additional requirements in order to address elements that are specific to Islamic finance. Specify the requirements of making Shari'ah Boards at the institution level. Subject the IIFS to comply with other international standards etc. Prescribe additional requirements in order to address elements that are specific to Islamic finance. Specify the requirements of making Shari'ah Boards at the institution level. Subject the IIFS to comply with other international standards etc. Let the industry and institution decide itself what Shari'ah compliance mechanism they want to choose. Leave the decision of acceptability or otherwise to the customers. Let the industry and institution decide itself what Shari'ah compliance mechanism they want to choose. Leave the decision of acceptability or otherwise to the customers. Supervisory Approaches to regulate IIFS Industry Driven “Regulatory” Driven 9

Framework for SRP Supervisory review process Financial (Capital Adequacy) Governance and risk management Disclosures Basic conditions for the effective functioning of The IIFS supervisory authority The IIFS sector { Preconditions Regulatory Requirements Supervisory Action Adapted from IAIS Framework for Supervisory Review Assessment 10

Approach of SRP Adapted from IAIS Framework for Supervisory Review Assessment While the primary responsibility for compliance with applicable Shari'ah rules rests with the management of IIFS, supervisory authorities have to satisfy themselves that IIFS have an appropriate control environment, with policies and procedures in place to ensure compliance. 11

Key Principles of SRP Adapted from IAIS Framework for Supervisory Review Assessment While the primary responsibility for compliance with applicable Shari'ah rules rests with the management of IIFS, supervisory authorities have to satisfy themselves that IIFS have an appropriate control environment, with policies and procedures in place to ensure compliance. SUPERVISORY REVIEW PROCESS First Principle IIFS’s Own Assessment of Capital Adequacy in relation to their risk profile and a strategy of maintaining their capital level Banks must be able to demonstrate that chosen internal capital targets are well founded and that these targets are consistent with their overall risk profile and current operating environment Rigorous, forward-looking stress testing that identifies possible events or changes in market conditions that could adversely impact the bank should be performed. Bank management clearly bears primary responsibility for ensuring that the bank has adequate capital to support its risks. Five main features of a rigorous process: Board and senior management oversight, Sound capital assessment, Comprehensive assessment of risks, Monitoring and reporting and internal control review 12

Key Principles of SRP (cont’d) Adapted from IAIS Framework for Supervisory Review Assessment SUPERVISORY REVIEW PROCESS Second Principle  Supervisory Review of institutions’ internal capital adequacy assessments ensuring compliance with regulatory capital ratios and action in case of not compliance Third Principle  Capital above Regulatory Minima and Supervisors should have ability to require IIFS to hold capital in excess of the minimum. Fourth Principle  Supervisory Intervention at an early stage to prevent capital from falling below the minimum levels- Rapid remedial action if capital not maintained or restored intensifying the monitoring of the bank restricting the payment of dividends requiring the bank to prepare and implement a satisfactory capital adequacy restoration plan, and requiring the bank to raise additional capital immediately. 13

Key Principles of SRP (cont’d) Adapted from IAIS Framework for Supervisory Review Assessment SUPERVISORY REVIEW PROCESS Fifth Principle  Supervisory authorities need to pay attention to the Investor Protection Issues raised by the IIFS’ role as managers of funds placed with them by the IAH.  IAH’s investment risk is similar to that of the shareholders of IIFS who bear the risk of losing their capital as investors in the IIFS the IIFS have a fiduciary duty to the IAH to uphold their interests no less than those of the IIFS’s own shareholders acknowledging the IAH’s right to access all relevant information in relation to their investment accounts. This would assist the IAH in making an informed decision on their selection or choice of the investment accounts in which to place their funds with the IIFS 14

Scope and Application Adapted from IAIS Framework for Supervisory Review Assessment  While the primary responsibility for compliance with applicable Sharī`ah rulings rests with the management of IIFS, supervisory authorities have to satisfy themselves that IIFS have an appropriate control environment, with policies and procedures in place to ensure compliance.  The supervisory authority may consider developing a set of guidelines when reviewing the operations of IIFS, including evaluating their management systems for investment programmes and asset allocation practices in order to safeguard various stakeholders’ interests, particularly those of the IAH.  The supervisory review process culminates in a formalized and structured supervisory strategy, which staff will follow when conducting off-site surveillance and on-site examination. 15

Scope and Application (cont’d) Adapted from IAIS Framework for Supervisory Review Assessment  Sometimes, IIFS are setting up branches and subsidiaries in other countries, and investing in activities not traditionally undertaken by conventional financial intermediaries (e.g. real estate development), or undertaken by the latter only through subsidiaries (e.g. asset management, collective investment schemes). In this context, and where separate supervisory agencies are responsible for certain regulatory requirements, coordination and cooperation among these authorities are expected in order to ensure effective consolidated supervision and stability of the financial system. 16

Key Elements in the SRP  Regulatory capital requirements  Internal capital adequacy assessment process (ICAAP)  Governance and risk management  Related party transactions  Securitisation risk and related off-balance sheet exposure  Transparency and market discipline  Consolidated and home-host supervision  Islamic window 17

Additional Specific Issues in the SRP  Risk concentration  Assessment of the rate of return risk in the banking book  Counterparty credit risk  Liquidity risk  Sound stress testing practices  Reputational risk  Shari`ah-compliant hedging techniques  Valuation practices  Supervisory transparency and accountability 18

For the Purpose of the Discussion Adapted from IAIS Framework for Supervisory Review Assessment 19 Risk Matrix for IIFS

For the Purpose of the Discussion (cont’d) Adapted from IAIS Framework for Supervisory Review Assessment 20  How do we apply key elements and specific risks of IIFS in the context of supervisory review process? How are they to be included? What should be addressed separately?

Pre-conditions for Effective Supervision  In jurisdictions where IIFS operate alongside conventional institutions, the supervisory authority needs to recognize the requirement for a framework that is both consistent with Islamic precepts and able to meet internationally acceptable prudential requirements.  It is necessary that banking or other specific laws relating to IIFS define in detail the permissible activities of the IIFS. 21

Pre-conditions for Effective Supervision (cont’d)  Insofar as IIFS cannot obtain funds from conventional lender of last resort facilities or discount windows, because these involve the payment of interest, contingency plans to obtain funds (Sharī`ah- compliant financial instruments) are highly desirable and are feasible.  The fact that capital and return on investment for profit-sharing investment accounts (PSIA) depend on the IIFS’s profits indicates that transparency is even more crucial in the IFSI than in the conventional sector. Applicable international accounting and auditing standards are the underlying supports for risk management, control systems and market discipline. 22

Thank you for your attention Reference: IFSB standards 23