A. Prudential Standards and The Challenge of Implementation
MAS – An Appreciation. Let me begin with some words of appreciation about the Monetary Authority of Singapore, which has been a member of the IFSB Council since it joined the institution in 2005.
MAS brings an exceptional set of experiences, skills and knowledge to the IFSB and, indeed, to Islamic finance.
Let me highlight this point in relation to the immense challenge ahead for the IFSB in terms of further enhancing its strategy to support implementation of its standards.
This was the focus of the IFSB’s most recent Islamic Finance Stability Forum held in Brunei on 27 March this year, where the Managing Director of MAS, H.E. Mr. Ravi Menon provided insightful comments on the IFSB presentation.
The presentation, which was made by ASG Zahid Ur Rehman Khokher and myself, sought to draw lessons from the IFSB’s two Implementation Surveys of 2011 and now 2013.
The MD shared with us, and with other members of the IFSB Council, perspectives based on his experience as a member of the Financial Stability Board (FSB) Plenary and FSB Steering Committee.
The MD is of course also the Chair of FSB’s Standing Committee on Standards Implementation (SCSI).
The discussion at the IFSB Stability Forum highlighted the similarities as well as the differences in the objectives of the FSB and the IFSB in promoting implementation. For example, the FSB has developed assessment methodologies that allow for evaluating the consistency of national implementation with international standards. This key set of capabilities is under preparation at the IFSB, and we hope to see a convergence over time in the use made of these capabilities.
This is not so “dissimilar”, but rather points to differences that reflect different starting points. The FSB is focused on promoting soundness and stability in the aftermath of the global crisis. At the IFSB, where we share this FSB focus, we also have a broader objective – that of promoting the sound growth of Islamic finance through consistency in treatment across jurisdictions.
Perhaps the key difference between the two organizations is in the nature of the challenges faced by IFSB member jurisdictions in the adoption of IFSB standards. This is in view of the very considerable limitations in capabilities, and the demanding reform agenda ahead for many IFSB member jurisdictions, involving changes needed to the legal and regulatory framework to facilitate Islamic finance.
The depth of these challenges will require an approach from the IFSB that will be different in some respects from the FSB. At the FSB the emphasis is placed on peer pressure to obtain adherence to a set of timetables for the adoption of Basel standards.
For the Islamic finance industry, given the nature of the challenges faced, reliance on peer pressure alone may not be effective. There is the need also for the provision of substantial technical assistance, combined with opportunities for the sharing of experiences between nations.
This feedback from the Stability Forum in Brunei underscores a key finding of the IFSB Implementation Surveys, which consistently ranks the provision of TA as of the highest priority in addressing implementation challenges.
In commenting on IFSB’s work supporting implementation of its standards, Mr. Menon also noted that both the FSB and IFSB face resource constraints and could learn from each other. There were many other insights provided by MAS at the Stability Forum, as well as by other IFSB Council Members, and we plan on issuing a publication of the discussion and points raised sometime later this year.
Let me conclude this section of my remarks by thanking MAS and its MD.
At the IFSB we look forward to further participation by MAS on a range of issues relevant to Islamic finance. In particular, we look toward further insights from MAS, drawing upon its FSB experience, in helping to strengthen our various work programs that support implementation of IFSB standards, and the building of regulatory capabilities amongst our member jurisdictions.
B. Capital Structure and Liquidity Framework
Let me now turn to some key developments in the global regulatory architecture – in particular in relation to the capital and liquidity framework – and draw some implications for Islamic finance.
As indicated in our Surveys and research, and as reported in the IFSB Islamic Financial Services Stability Report 2014, IIFS have capital levels that are of high quality in that they are principally in the form of Tier 1 common equity which is the most loss absorbent type of capital. This suggests strong prospects for resilience.
In addition, the average capital adequacy levels indicate they are above the regulatory minimum stipulated by Basel III, and, above the average levels observed in conventional banks. This also is encouraging.
Finally, Islamic banks tend to be quite liquid.
These three characteristics of Islamic finance are, prima facie, suggestive of an industry that is experiencing high and sustained growth on the back of a capital and liquidity structure that is robust.
At the same time, I would like to point to the need for vigilance and a pro-active stance towards vulnerabilities and exposures which could be heightened by the kind of growth that we are seeing in the industry. Thus, there is some evidence of a decline in capital levels in Islamic banks and this is something that will bear further scrutiny and observation.
Capital structure.
The high reliance on Tier 1 common equity capital reflects the limited supply of Sharī`ah-compliant securities that would meet Basel III requirements for Additional Tier 1 capital, as well as for Tier 2 Capital.
The key issues are in relation to loss absorbency of capital – first, while the bank is still a “going concern”, and second, under Tier 2 capital, at the point of non-viability. The purpose of Tier 2 capital is to provide additional protection to shareholders once the bank is determined to be a “gone-concern”.
Basel requirements for AT 1 and for Tier 2 capital are quite stringent. The Sharī`ah requirements for these kinds of capital are, perhaps, more stringent even than Basel, especially in relation to issues such as conversion of Tier 2 capital at the point at which a bank becomes non-viable.
The IFSB’s recently issued Revised Capital Adequacy Standard –IFSB 15 -has proposed a number of structures: for example, Mushārakah Sukūk can be eligible for AT1 capital, subject to a determination of their Sharī`ah compliance by the relevant authority.
Turning to Tier 2, subject to Sharī`ah compliance, capital instruments could be issued in the form of Mudhārabah or Wakālah Sukūk in which the underlying assets would be convertible into common equity. However, the trigger points for conversion would need to be specified ex ante.
Finally, on the subject of time frames for the adoption of the proposed capital structure for Islamic finance, the IFSB has proposed a timeframe that is aligned with that of Basel.
These recommendations are designed to ensure, to the extent that this possible, that there is in place a level playing field with conventional banks. We also recommend comparable time lines for the gradual adoption of macro-prudential features of the new regulatory requirements, in particular for the Capital Conservation Buffer which, it is recommended, commence from 1 January 2016.
Liquidity Structure
As I have mentioned, Islamic banks appear to be quite liquid. However, the fact that many Islamic banks appear to be flush with cash is in fact a symptom of continuing shortcomings in the liquidity management infrastructure, across jurisdictions and regions.
To put things in context, in terms of liquidity management the IFSB’s Technical Note of 2008 had shown that efficient money markets for Sharī`ah compliant instruments were in an under-developed state, with limited availability of instruments and indeed, a small size of the IIFS.
These two factors limited the liquidity in money markets. In particular, while a number of initiatives were underway at the time in terms of compensating balances between banks, or placement of funds on a Mudharabah basis, amongst other measures, in general most IIFS solved their liquidity problem by maintaining a larger amount of cash with the central bank than their conventional counterparts.
There has indeed been much progress on this front, but the underlying challenges remain across a range of jurisdictions, and many IIFS continue to maintain liquidity in the form of cash.
In the IFSB’s dialogue with the BCBS in 2012, prior to the rules issued by BCBS on the new liquidity framework in January 2013, we had stressed the importance of providing to Islamic finance jurisdictions the same flexibility accorded to Emerging Markets and Developing Economies (EMDEs), in which a broadly similar set of issues and constraints feature. In recognising these issues, the BCBS has developed a framework for Alternative Liquidity Arrangements (ALA), that would be applicable in those jurisdictions that did not have the range and depth of financial markets observed in advanced economies. This is an ongoing dialogue with the BCBS, which has provided important flexibility to Islamic finance in its initial document on liquidity coverage.
The key questions now are the preparedness of the IIFS in adopting the new regulatory ratios proposed by BCBS. The final rules for the Liquidity Coverage Ratio (LCR) were announced in January 2013, to be fully implemented by early 2019. The BCBS will also be issuing a document on the Net Stable Funding Ratio (NSFR), to be adopted by 2018.
To prepare the ground for a considered regulatory response to these developments, in June 2013, the IFSB undertook a survey to seek the opinions of the regulatory and supervisory authorities and IIFS with regards to the Basel III Liquidity Framework. We also conducted a Quantitative Impact Study (QIS) to collect primary data to ascertain the current status of the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR).
The findings of the survey identified a number of significant challenges.
These include (i) insufficient Sharī`ah-compliant instruments that meet the Basel requirements for market-related characteristics, namely active and sizeable markets, and low volatility and flight to quality, (ii) difficulty for IIFS in obtaining Sharī`ah-compliant high quality liquid assets (HQLA) that meet the stress scenario characteristics stipulated by Basel, and (iii) the small number and size of assets, which are insufficient to meet LCR requirements.
To provide guidance to supervisory authorities of the IFSI on the application of the LCR for the IIFS in their jurisdictions, the IFSB has commenced work to prepare a Guidance Note on Quantitative Measures for Liquidity Risk Management in IIFS.
The Guidance Note, which is expected to be issued in 2015, establishes a minimum level of liquidity for IIFS for both full-fledged IIFS and Islamic windows of conventional banks on an individual and a consolidated basis. The parameters of the LCR in the Guidance Note are built upon BCBS proposals with a number of additions and adjustments to meet the specificities of IIFS. In addition, although the LCR should be applied consistently across the jurisdiction for the IIFS sector, regulatory and supervisory authorities may modify or exclude some of its components, taking account of specific economic conditions and the business model of IIFS in their respective jurisdictions.
C. Conclusion
Ladies and Gentlemen,
Two years ago at this very same event, in his keynote address, the Managing Director of MAS characterised Singapore’s role in Islamic finance in the following words:
“Financial centres like Singapore serve as intersecting nodes where Islamic financial institutions collaborate with their conventional partners to jointly grow the industry”.
The phrase ‘intersecting nodes” was well chosen, since it best describes the networks that characterise financial as well as trading relations.
This is indeed a natural role for Singapore to play in Islamic finance, as a nodal point of intersection, given the depth of its experience in facilitating global trade and financial flows.
And finally, the idea of “intersecting nodes” refers also to the world of ideas and knowledge, and to the beneficial cross fertilisation that takes place as a result of the sharing of experiences. I tried to illustrate this idea at the beginning of my speech, with the reference to the role that MAS is playing in the IFSB. But it has a wider relevance, and embraces all of us at this Conference, and those beyond, who will follow its results with great interest.
Thus, this Conference also serves as an intersecting node, one that draws in a global audience, and which serves as an expanding source of creative ideas. On that point, let me conclude my remarks today by wishing you a productive and fruitful day of deliberations.
Thank you.
