Top-notch recognition for Islamic finance

MUSHTAK PARKER, reports on an industry very much on the up

These are exciting times for the estimated $2.2 trillion global Islamic financial industry.

First, it was the Basel Committee for Banking Supervision, which in 2013 okayed for the first time qualifying Sukuk to be included in the High Quality Liquid Assets (HQLA) universe under its Liquidity Coverage Ratio (LCR) standard, which officially comes into effect in 2017 but which has been introduced by some Muslim countries in 2015.

In the past few months, however, the global recognition of Islamic finance has taken some giant leaps forward especially at the International Monetary Fund (IMF) and its associated World Bank, and in the Group of 20 (G20) countries, which brings together the developed countries and the important emerging nations, including Saudi Arabia, Indonesia and Turkey.

A potential game changer could be the inclusion of Sukuk as a tool for infrastructure financing and Islamic finance on the official agenda of the G20 Summit, which will be held in Antalya, Turkey, in November.  Indeed, Saudi Arabia, Indonesia and host Turkey, have been working closely with the Islamic Development Bank (IDB) in Jeddah and the IMF to push the Sukuk agenda at the G20.

Turkey also hosts the G20 presidency in 2015; Indonesia co-chairs the G20 Investment & Infrastructure Working Group, and Malaysia is an Observer representing the ASEAN group of countries.

Indeed the G20 commissioned the IMF to do a study on the suitability of Sukuk as an asset-based and asset-backed financing instrument for infrastructure especially in emerging countries, where the estimated spend over the next decade totals in excess of $5 trillion.

The IMF in the study titled Islamic Finance: Opportunities, Challenges, and Policy Options and published in April did conclude that while Sukuk are seen as well-suited for infrastructure financing because of their risk-sharing property, the supply of Sukuk falls far short of demand and, except in a few jurisdictions, issuance takes place without a comprehensive strategy to develop the domestic market.

“National authorities should, therefore, focus on developing the necessary infrastructure, including promoting true securitisation and enhanced clarity over investors’ rights, and on stepping up regular sovereign issuance to provide a benchmark for the private sector. Increased sovereign issuance should be underpinned by sound public financial management,” emphasised the IMF.

The study further concluded that Islamic finance has the potential for further contributions in fostering greater financial inclusion, especially of large underserved Muslim populations; in providing support for small-and-medium–sized enterprises (SME), as well as investment in public infrastructure, because of its emphasis on asset-backed financing and risk-sharing features; and in posing less systemic risk than conventional finance because of its risk-sharing features and prohibition of speculation.

However, says the IMF, for this potential to be realised, and to allow this industry to develop in a safe and sound manner, a number of regulatory and macroeconomic challenges will need to be addressed.

The IDB is also concluding a cooperation agreement with the IMF for the latter to provide technical assistance to countries interested in developing Islamic financial services, including Sukuk, in their jurisdictions.  Indeed the Fund has published four major papers on Islamic finance thus far this year, in addition to a blog.

Turkey at the same time hosted a meeting of G20 finance ministers and Central Bank governors in Istanbul in February during which extensive discussions took place on instruments such as equity financing and Sukuk.  The meeting urged regulators to include Sukuk in their monetary policy frameworks.

Thus, perhaps not surprisingly, Islamic finance featured in the main schedule of the IMF/World Bank spring meetings in Washington DC in April, when Dr Ahmed Muhamed Ali, president of the IDB, Ali Babacan, deputy prime minister of Turkey, Dr Zeti Akhtar Aziz, governor of Bank Negara Malaysia (the central bank), Pierre Gramegna, finance minister of Luxembourg, and Min Zhu, deputy managing director of the IMF, discussed unlocking the potential of Islamic finance especially in supporting financial stability and funding infrastructure.

The organisation, nevertheless, that is spearheading this behind-the-scenes engagement with the likes of the Basle Committee, the IMF/World Bank Group and the G20 is the Islamic Financial Services Board (IFSB), the multilateral prudential and supervisory standard setting body that sets the rules for the global Islamic financial industry.

Thanks to the relentless work by the IFSB since its establishment in 2003 by a group of central banks, including the Saudi Arabian Monetary Agency, Central Bank of Kuwait, Central Bank of Bahrain, Central Bank of Qatar, Bank Negara Malaysia, Banque centrale du Luxembourg and the IDB, in the adoption of more than 20 Standards and Guidance Notes, the Islamic finance industry is in danger of no longer being marginalised in the international financial system and even in the G20/FSB (Financial Stability Forum) of the IMF’s global financial reform agenda.

Indeed the council of the IFSB at its 26th Meeting, held in Jakarta, Indonesia in early April, approved the adoption of the board’s latest Standard on Core Principles for Islamic Finance Regulation (CPIFR)(Banking Segment), known as IFSB-17, which will be under further scrutiny at the board’s upcoming 12th annual summit scheduled to be held in Almaty, Kazakhstan, towards the end of May.

This Standard has been developed with the participation of IFSB member regulatory and supervisory authorities (RSAs), the Basel Committee and the IMF and aims to complement the Basel Core Principles (BCP) in assessing the strength and effectiveness of regulation and supervision by RSAs – in countries with a significant Islamic banking industry.

For the conventional sector, such assessment is carried out by the respective regulatory and supervisory authorities, peer reviews and by third parties, including by the IMF/World Bank as a part of their Financial Sector Assessment Programme (FSAP).

The IMF/World Bank has completed more than 84 FSAPs in several MENA and IFSB member countries, including Saudi Arabia and Malaysia, which, in certain cases have included an assessment of the Islamic banking, capital market and insurance sectors. However, many FSAP reports have either not reviewed Islamic finance sectors at all or identified the absence of applicable Core Principles for Islamic finance as a major hurdle for not performing a regular assessment.

Jaseem Ahmed, the secretary general of IFSB, who is a seasoned development banker having served the Asian Development Bank in a senior capacity for many years, is in no doubt why the CPIFR are so important to the development of the next level of the Islamic banking system.

“With the fast growth of the Islamic finance industry in many parts of the world, and associated increase in number of institutions and sophistication in the variety of products and services offered, many jurisdictions find it challenging to fully appreciate the underlying risks in the products and operations offered by these institutions and their impact on the stability and resilience of the overall financial system,” he explains.

IFSB-17, according to him, is also a progression to the next level of financial sector supervision, whereby the Core Principles provide a high-level framework that not only covers the prudential regulation aspects related to risk management, corporate governance and transparency of institutions but also the more fundamental issues such as responsibilities, powers and legal protection of the supervisory authority itself.

The issuance of IFSB-17 is, in fact, the culmination of the phased developments made by the Basel Committee for Banking Supervision, which has been issuing standards on various aspects of the regulation and supervision of internationally active banks since 1974.

Thus instead of a piecemeal approach to financial regulation, a core principles framework, emphasises Ahmed, provides guidance on the necessary elements required in a supervisory regime in order to establish a financial sector that is sound and able to withstand system-wide shocks emanating from within and outside the jurisdiction.  The CPIFR specifically also helps to make Islamic finance part of the global surveillance framework, primarily carried out by the IMF/World Bank FSAP.

Similarly, consumer protection, linkage with the real sector and enhancing financial inclusion are well accounted for in the Core Principles framework.

In some respects, the Core Principles especially if applied through the FSAPs apart from IFSB’s own efforts, says Ahmed, has the potential to be the great equaliser for the supervision of Islamic banks especially in the Gulf Cooperation Council (GCC) states, the rest of the MENA region and in Asia.

In the past regulation and supervision of Islamic banks in various jurisdictions have been at best mixed and haphazard.  This is improving following the introduction of IFSB standards.  The Core Principles, however, have the embedded potential to greater transparency and consistency by way of providing support to cross-border growth and resilience of the industry.

“The focus on enhancing market discipline through greater transparency to the investors and other stakeholders supports the objective of a resilient financial sector.  RSAs would also greatly benefit from the Core Principles framework by applying a globally consistent framework for the supervision of a financial sector that has been suitably modified to address the specific nature of operations of the international Islamic financial services industry,” he adds.

The adoption of Core Principles for Banking will impact on all business lines, products and assets classes, including trade finance, real estate, cash management and SME finance.  However, bankers have emphaised the potential impact of additional costs through the increasing compliance, anti-money laundering, capital adequacy and liquidity ratios regimes that have been introduced as part of the global financial reform agenda.

On the issue of compliance cost and impact on line of products and asset classes, Jaseem Ahmed is adamant that while there are always some additional costs to the financial institutions when a new regulatory regime is implemented, these costs are counterbalanced by the reduced risks and vulnerabilities for the overall financial system.

He warns, though, that studies post the financial crisis have shown that the cost of the failure of systemically important financial institutions are enormous, which could pose serious repercussions for the economic stability not only of a country, region but also of the global economy.

The emphasis of the CPIFR is on reducing concentration risk, which may have some impact on the Islamic bank’s exposure to the real estate sector, for example.  Islamic banks especially in the GCC states of Saudi Arabia, Kuwait, Qatar and the UAE have been repeatedly reminded of their over exposure to the real estate sector which during a downturn did badly affect such banks.

Similarly, focus on managing the risks of investment account holders, says Jaseem Ahmed, may require some additional investment in the IT infrastructure.  A focus on infrastructure elements such as Shariah-compliant deposit insurance could also pose additional cost to the Islamic financial institutions individually and the financial system as a whole.

At the regulatory level, there might be some associated costs to the RSAs for capacity building of their staff, improved monitoring and information systems and other infrastructures.  Thus being compliant with Core Principles is also expected to result in reduced cost of recovering an insolvent Islamic financial institution, since supervisors will be able to identify and control various risks at an early stage, promoting a timely corrective action.

He remains confident that in the near future the application of the FSAP in IFSB member countries will cover both the conventional and Islamic financial sector as matter of routine.  Needless to say, FSAPs can be preceded or complemented by a range of other “surveillance” activities, including those by individual RSAs or by third parties through peer reviews and Article IV Consultations of the IMF/World Bank.

Similarly, the new framework outlined by the Financial Stability Board (FSB), which is agreed by the G20 nations, stipulates a peer review two-to-three years subsequent to each FSAP conducted for a jurisdiction.  These peer reviews are conducted by a team consisting of selected representatives from other G20 RSAs.

A number of recent FSAP reports have acknowledged that a separate assessment for respective Islamic finance sectors could not be conducted as available assessment methodology does not distinguish between conventional and Islamic markets.

This was the driving force behind drafting and adopting IFSB-17, which aims to help bridge this gap.

“For the assessment modalities of the new Core Principles, we anticipate that all the available mechanisms would be utilised, though that would largely depend on the jurisdiction specific requirements and marked conditions.  While the involvement of the IMF and WB in the preparation of IFSB-17 provides necessary impetus, ultimately it is the decision of the management of these institutions to permit the formal use the document in the FSAP process,” explains Jaseem Ahmed.

While the FSAP is not a frequent phenomenon for most of the non-G20 jurisdictions, many of the IFSB member jurisdictions have either never participated in an FSAP or have undergone such a review only once in last five years or so.

As such, the IFSB is confident that all the options for assessment will be explored by its member countries that could include, among other things, the establishment of regional groups and peer review teams.

This assessment, asserts Ahmed, “would be beneficial for the jurisdictions that are new to Islamic finance as well as those which have some experience in supervisory this industry.  Similar to conventional Core Principles, the IFSB-17 has been envisaged to be applicable to all jurisdictions regardless of the level of development or sophistication of the markets and the type of products or services being offered and supervised.

“It aims to help jurisdictions with nascent Islamic finance sector to promote consistency in terms of implementing prudential standards through identifying the gaps and issues in supervisory practices, legal framework and regulations”.

Like most Standards in the financial sector, the IFSB ones are implemented on the basis of voluntary adoption by its member countries.  The culture of voluntary adoption, however, in the IDB-member countries, including in the GCC and MENA region, is at best ordinary.  The board has over the last few years taken this challenge seriously and its implementation strategy, which is based on the Basle Committee’s one, has led to the adoption of “an extensive programme of facilitating the implementation of the IFSB Standards in place”.

This includes an increasingly popular technical training process involving officials from member country RSAs.

The IFSB also conducts three annual “train-the-trainers” workshops dedicated for the staff of RSAs supervising Islamic banking, Takaful (insurance) and Islamic capital market sectors.  These workshops will be used as a main tool to support the RSAs in implementing the various principles included in IFSB-17, as well as the IFSB’s other Standards.

Recently, the IFSB has also commenced preparation of e-learning modules for its various standards, funded by the Asian Development Bank. “The IFSB-17 is being prioritised for the preparation of e-learning module, which will provide another outreach mechanism and capacity building tool to reach out to a wider audience of the IFSB members who are not able to participate in the FIS workshops,” explains Jaseem Ahmed.

However, he admits that IFSB-17 is not a typical standard on a particular area of supervision; rather it provides an overarching framework.  Thus its implementations is much more challenging than a standard or a guiding principle.

Therefore, the IFSB sees the implementation of IFSB-17 in member jurisdictions as a longer-term engagement with the RSAs, which goes beyond workshops or e-learning modules.

The IFSB is already providing technical assistance to a select number of member RSAs and this, according to Ahmed, will be beefed up to support the jurisdictions in the implementation of IFSB-17.

The secretariat is also deliberating on alternative ways of delivering technical assistance as outlined in its new Strategic Performance Plan 2016-2018, which involve “de-grouping” of an IFSB standard such that implementation is prioritised for a particular principle, or group of principles, rather than on the whole standard.

Another consideration in the implementation of IFSB-17 is whether a jurisdiction has so-called “pre-conditions” or “necessary elements” in its supervisory framework. These infrastructure components are largely institutional in nature, which are increasingly viewed as an essential component of both Islamic financial market development

However, warns the IFSB, these preconditions need to be an overall financial system stability. These preconditions relate to macroeconomic policies; framework for financial stability policy formulation; public infrastructure; framework for crisis management, recovery and resolution; systemic protection or public safety net; and effective market discipline.

According to Ahmed, there are particular issues in relation to recovery and resolution in Islamic finance, including, for example, the correct contractual treatment of individual account holders, Sukuk issued as capital instruments and the rights of their holders, and priorities among creditors of a failed Islamic financial institution that has defaulted.

The major differences between the Core Principles for Islamic Finance compared to those for conventional finance cannot be ignored.  The very faith-based specificities of an Islamic system of financial intermediation make its stand out from the interest-based conventional system – interest or riba being anathema and, therefore, proscribed under Fiqh Al Muamalat (Islamic Law relating to Financial Transactions).

It is inevitable that the drafters of IFSB-17 benchmarked it against the BCPs for conventional finance to the extent possible.

To help them distinguish between the Islamic and conventional requirements, the IFSB Working Group conducted a survey among the RSAs that supervise the Islamic banking sector.  A total of 28 jurisdictions participated in the survey, which identified a number of areas in which existing Core Principles are either silent or deal inadequately with the unique nature of supervisory practices and underlying risks facing Islamic banks and the sector as a whole.

“The working group assessed the relevance of the BCPs and their associated methodology for application to Islamic finance, and retained them in their entirety where this seemed appropriate, whilst providing additional guidance where this was relevant.  Each of the BCPs has been examined individually, and where needed, appropriate wording was introduced to reflect the unique features of Islamic finance,” explains Ahmed.

With the result, four additional Core Principles were introduced, while one existing Core Principle was replaced in its entirety.  Thus, against the 29 Core Principles issued by the Basel Committee, the IFSB-17 includes 33 Core Principles.

The new or replaced Core Principles include the treatment of investment account holders, Shariah Governance framework, equity investment risk and regulation of Islamic window operations.  The Core Principle, which has been replaced in full, is the one that in Basel focuses on interest rate risk, which is not applicable to Islamic finance. This now deals with rate of return risk in the banking book.

According to Ahmed, the additional Core Principles are fundamental in the Islamic finance Regulation and Supervision process:

1. i) The regulation of profit sharing investment accounts (PSIA) poses a number of challenges for a banking supervision regime that has evolved primarily for an interest-based banking sector where the funding side is denominated by debtor-creditor relationship between a bank and its depositors. The new Core Principle (CPIFR 14) stipulates that the supervisory authority is expected to determine how investment account holders are treated in its jurisdiction, and how various implications of the profit sharing contract are considered in the regulatory framework.
2. ii) The new Core Principle on the Shariah governance framework (CPIFR 16) requires supervisory authorities to determine the general approach and lay down key elements of the Shariah governance framework in their jurisdictions. These elements include an effective independent oversight of Shariah compliance over various structures and processes in the Islamic financial institutions, which is commensurate and proportionate with the size, complexity and nature of its business. Moreover, the supervisory framework is expected to ensure that issuance procedures of relevant Shariah pronouncements/resolutions and their dissemination to the operational staff is formalised.  It also foresees the existence of an internal Shariah compliance review/audit function for verifying that Shariah compliance has been achieved.  The Principle further anticipates that a formal assessment of the effectiveness of a Shariah board is conducted on a periodical basis, and of the contribution by each member to the effectiveness of the Shariah board.

iii)            Equity investment risk and rate of return risk are other areas where supervision of the Islamic financial institutions has distinctive characteristics.  The presence of profit sharing contracts on both the asset and liability sides of the Islamic financial institution’s balance sheet requires particular attention from supervisory perspective.  The new CPIFR 24 deals with asset side risk and mentions that supervisory authorities should ensure the presence of adequate policies and procedures including appropriate strategies, risk management and reporting processes.  In addition, an Islamic financial institution should be able to demonstrate the appropriateness of its risk management framework and valuation methodologies as well as define and establish the exit strategies in respect of its equity investment activities.

1. iv) The new principle on rate of return risk in the banking book (CPIFR 26) addresses the liability side of the balance sheet, which not only expects the supervisory authorities to ensure that IIFS have adequate systems to identify, measure, and mitigate rate of return risk with a consideration of their risk appetite and risk management capabilities, it also stipulates that capacity of an IIFS to manage this risk and any resultant displaced commercial risk should be evaluated on a continuous basis.
2. v) Supervision of Islamic “window” operations is another unique feature. Such windows are now operating in a large number of the IFSB member jurisdictions.  Supervisory practices for regulating these entities vary considerably across jurisdictions, which raise a number of issues on consolidation, capital adequacy treatment, transparency and disclosures, Shariah governance as well as comingling of funds.  While many considerations for their supervision are essentially similar to fully-fledged IIFS, other issues need a careful policy stance and supervisory capacity to deal with them adequately. Therefore, supervisory authorities should not only define what forms of Islamic “windows” are permitted in their jurisdictions, they should also satisfy themselves that the institutions offering such windows have the internal systems, procedures and controls to provide reasonable assurance on the adequacy of Shariah governance framework, risk management practices, segregation of funds and disclosures to stakeholders.  All these points are covered in new CPIFR 32. n