The growing importance of Islamic finance in the global financial system
The growing importance of Islamic finance in the global financial system
Remarks by Mr Malcolm D Knight, General Manager of the BIS, at the 2nd Islamic Financial Services Board Forum, Frankfurt, 6 December 2007.
Abstract
Although there are differences between Islamic banking and
“conventional” banking, there are some fundamental principles that apply
equally to both. In particular, rigorous risk management and sound
corporate governance help to ensure the safety and soundness of the
international banking system. In the light of the growing importance of
Islamic banks and Sharia-compliant financial innovation, the increasing
integration of Islamic financial services into global financial
markets serves to strengthen this point.
The Basel II framework improves the risk sensitivity and accuracy of
the criteria for assessing banks’ capital adequacy. This framework is
fundamentally about stronger and more effective risk management grounded
in sound corporate governance and enhanced financial disclosure, the
importance of which has been underscored by the recent problems that
have arisen in the banking industry worldwide. The guidance provided by
the Islamic Financial Services Board (IFSB) is a useful contribution to
the realisation of these global goals. It will support the
establishment of resilient financial market infrastructures and sound
and robust core Islamic financial institutions operating according to
safe and sound risk management practices.
Full speech
Good morning. I am pleased and honoured to address the 2nd Islamic
Financial Services Board Forum today. As the General Manager of the
Bank for International Settlements, I am particularly pleased to be
here today to discuss Islamic finance and its growing importance in the
global financial system. But let me start by commending Professor
Rifaat Ahmed Abdel Karim of the Islamic Financial Services Board and
Josef Tošovský of the BIS Financial Stability Institute for putting
together such a comprehensive programme. It is entirely appropriate
that the IFSB and the FSI should join forces to organise this
conference. After all, the IFSB’s mission is to promote the
soundness and stability of the Islamic financial services industry. It
does so by issuing global prudential standards for the industry.
Likewise, the FSI’s mission is also to promote sound supervisory
standards and practices globally.
As an associate member of the IFSB, the BIS has been actively
supporting the IFSB’s mission and initiatives since the Board began
operations in 2003. The Basel Committee on Banking Supervision,
which is hosted by the BIS, is increasingly looking beyond its
membership to enhance cooperation with non-member countries and
organisations with related interests and similar goals. The
Committee’s outreach to non-member countries is part of an initiative to
promote the development of sound supervisory practices and to
accommodate the growing importance and sophistication of non-member
banks.
The BIS and the Basel Committee have been strong supporters of the
IFSB through participation in IFSB working groups, such as the
capital adequacy group, and by providing speakers for conferences
and other events. I believe that the active and productive dialogue
between the Basel Committee and the IFSB will continue to benefit
both of our organisations. Professor Rifaat and members of the Basel
Committee’s Secretariat have recently held fruitful discussions,
and continue to strengthen the cooperation between the IFSB and the
Committee.
In my remarks today, I will not address the specifics of Islamic
finance and how it differs from conventional banking. Instead, I
would like to focus on two elements of banking supervision that
Islamic and conventional banking have in common. That is, appropriate
levels of risk management and corporate governance, which help to
ensure the safety and soundness of the international banking system.
As I am sure you heard yesterday and will also hear today, there has
been significant growth in Islamic financial services in recent
years and there is every reason to expect that this growth will
continue at a rapid pace. Clearly, there is expanding demand for these
products, and a closely associated desire on the part of banks,
including non-Islamic banks, to provide Islamic financial services.
Although it is still modest in size relative to conventional retail
banking, Islamic retail banking is rapidly becoming more visible.
This is particularly true in the Middle East and Asia Pacific
regions, where a number of Islamic banks and banking units have been
opened in recent years. There are also Islamic banks and asset
managers in key international financial centres of the United
Kingdom and the United States.
The growth in Islamic finance is also visible in the expanding range
of services and products that comply with the basic precepts of
Sharia law. One example is the burgeoning global market interest in
Islamic bonds – Sukuks – many of which are increasingly being issued
and bought outside the Islamic world. This suggests that non-Islamic
investors in general are becoming comfortable with Sukuks. The
broadening appeal of Islamic finance is also evident in the move by
large international banks and other private sector financial
institutions to provide Islamic financial services. This includes the
establishment of exchange-traded funds that are screened to ensure
their conformity with Islamic investment principles, as well as
offering “takaful” – or Islamic insurance.
Although the elements that are usually emphasised at conferences like
this are differences between Islamic banking and “conventional”
banking, there are some fundamental principles that apply equally to
both. For example, I can point to the necessity of strong corporate
governance, rigorous risk management and sound capital adequacy
requirements as essential ingredients to ensure the safety and
soundness of any financial system. The increasing integration of
Islamic financial services into the global financial fabric only
strengthens this point.
The issuance of the revised Basel II framework for bank capital
adequacy not only improves the risk sensitivity and accuracy of the
criteria for assessing capital adequacy, but it is fundamentally
about stronger and more effective risk management grounded in sound
corporate governance and enhanced financial disclosure. I should
acknowledge that the special features of Islamic banking may not
always be adequately addressed by broad international standards for
conventional banking contained in the Basel II framework. Nonetheless,
the IFSB considers carefully the global banking standards that have
been and are being developed for conventional banking. The IFSB’s
capital adequacy standard, for instance, draws to a large extent on
Pillar 1 of the Basel II framework (the minimum capital adequacy
requirements). It has also released an exposure draft on the
supervisory review process (consistent with the principles of Basel’s
Pillar 2) and another on disclosure and market discipline (Pillar
3).
As interest in Islamic finance grows, the importance of the IFSB’s
role increases. The importance of the fundamental elements of banking –
conventional or Islamic – cannot be emphasised enough. Topics such
as corporate governance, risk management and capital adequacy are
key elements that underpin sound financial practices. The guidance
provided by the IFSB in these areas helps to ensure that there are
resilient financial market infrastructures and robust core financial
institutions operating according to safe and sound risk management
practices. It is important that the same degree of supervisory oversight
is applied to Islamic financial institutions, to ensure the
continuing acceptance of their instruments and services in
international markets and conventional banking systems .
In addition, the guiding principles and standards developed by the IFSB
are assisting supervisors globally to better understand and supervise
institutions providing Islamic financial services.
This
is why I am particularly pleased to see the issuance by the IFSB, over
the last couple of years, of its capital adequacy standards and
guiding principles on corporate governance and risk management. The
issuance of these prudential standards and guiding principles helps
to enhance the soundness and stability of the Islamic financial services
industry and helps fill an important niche, as will the recent
exposure draft on market discipline.
The importance of robust risk management systems and corporate
governance cannot be overstated. Many of the recent problems that
have arisen in the banking industry worldwide, such as losses due to
accounting improprieties, low underwriting standards and
inappropriate valuation methodologies – particularly when applied to
complex financial instruments, are primarily due to poor corporate
governance and inadequate risk management. Given these shortcomings,
what then are the implications for banks and supervisors?
First and foremost, with respect to risk management banks must have
policies and procedures in place that enable them to identify,
measure, control and report all material risks. Bank management is
primarily responsible for understanding the nature and degree of the
risks being undertaken by the institution. This was not necessarily
the case with respect to subprime residential mortgages, mainly
packaged by conventional banks in the United States, which were then
securitised and resold as mortgage-backed securities and collateralised
debt obligations. Investors at large, and the managements of even
some of the largest internationally active banks, did not fully
appreciate the risk inherent in the subprime mortgages embedded in the
structured securities they had purchased. Instead, many relied too
heavily on the credit ratings that the specialised credit rating
agencies established for the various branches of the resulting
structured products. While Basel II provides a better framework for
supervisors to focus discussions with banks on the robustness of
their risk measurement and management of complex financial instruments,
banks’ risk management systems need to be constantly adapted to
better address the effects of innovation in the financial markets
and increased complexity and opacity of financial activities in which
banks are engaged. While weaknesses in these areas have focused on
conventional banking instruments and institutions, Islamic
instruments are not immune to them.
Strong risk management is a critical component of a bank’s ability to
withstand adverse conditions. And this is certainly as important
for Islamic banks as for other types of financial institutions. One
element that is essential is comprehensive stress testing that can
capture the effects of a downturn on market and credit risks, as well as
on liquidity. This helps ensure that banks have a sufficient
capital buffer to carry them through difficult periods. In the
events of last summer and this autumn, it became clear that many banks’
stress tests did not anticipate the degree and breadth of
illiquidity that resonated throughout the credit markets. Stress
tests must consider the effects of prolonged market tensions and
illiquidity, and must reflect the nature of institutions’ portfolios
and realistic assumptions about the amount of time it may take to
hedge out risks or manage them in severe market conditions.
The necessity of a robust corporate governance framework has long
been recognised by bank supervisors around the world. Indeed,
supervision would not be possible without sound corporate governance
in place. Over the years, experience has highlighted the need for banks
to have the appropriate levels of accountability, as well as
sufficient checks and balances. In general, sound corporate
governance effectively addresses the manner in which the decision-making
process in the organisation is structured, the respective
responsibilities and accountability of senior management and the
board of directors, and the control functions that ensure the accuracy
of the monitoring processes.
Of course, when supervisors review an institution’s risk management
system and corporate governance framework, they must consider the
system’s appropriateness in relation to the bank’s size, its risk
exposures and the nature and complexity of the financial instruments
it deploys.
I have already noted the IFSB’s exposure draft on disclosure and
market discipline that was released for comment late last year. This
interest in promoting increased transparency and market discipline
is especially important, particularly given the recent difficulties
experienced by banks and investors alike with respect to complex
structured products. Much of the current turmoil in the credit
markets has related to questions about the soundness of certain
types of collateralised debt obligations (CDOs) and asset-backed
commercial paper. These problems might well have been avoided or at
least mitigated if there had been greater transparency both about
the products themselves and the commitments made by the banks that
originated them. Again, this problem has thus far been concentrated
in conventional banks in the key financial countries. A crucial area
where more transparency has proved necessary has been in the exposures
of some large financial institutions to CDOs of securities backed by
subprime mortgages in the United States.
Basel II and the IFSB’s exposure draft on transparency both seek to
raise the bar on the quality of financial disclosures by providing
clearer industry benchmarks. Enhanced financial disclosure that
improves the transparency of banks and complex structured products,
valuation, and the measurement of risk exposure can certainly help to
improve overall risk management. In addition, requiring enhanced
qualitative disclosures will permit all banks to put their
quantitative disclosures into better context and assist them in
explaining their approach to risk management.
Let me conclude by emphasising that rigorous risk management and
sound corporate governance are key elements of any bank’s ability to
understand and manage its risks. With the growing importance of
Islamic banks and Sharia-compliant financial innovation, it will be
increasingly important to ensure sound Islamic financial institutions
going forward. Supervisors must work together to encourage all banks
to improve their risk management systems, controls and
transparency. Such improvements will help ensure the stability and
soundness of the international banking system. Thank you very much.
source:Bank of international settlements website(www.bis.com)
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