“Preserving financial stability in the Islamic financial system extends beyond the regulatory framework to the building of an intermediation system that is robust and resilient, that is efficient and competitive and that is able to contribute to the growth process. Islamic finance has evolved to become a dynamic industry that has extended beyond domestic borders to become an integral component of the international financial system. Indeed, amidst the changing global financial landscape, the Islamic financial industry has demonstrated its ability to operate in an increasingly more challenging and competitive environment. The challenge before us is to maximise the potential and the seamless opportunities Islamic finance accords. Each component – the financial infrastructure, the institutions, the legal, regulatory and supervisory framework and the Shariah infrastructure all have an important role in the progressive development of the Islamic financial system. The strengthening of these respective components will provide the foundations on which future sustainable progress and expansion can be realised.”

It is my honour to be invited to speak before this distinguished audience at this conference organised by the Islamic Financial Services Board on approaches to regulations of the Islamic financial services industry. While the rapid expansion of Islamic finance has been achieved in an environment of financial stability, the regulatory and supervisory agenda continue to be an important priority. Todays increasingly challenging environment of heightened risks have prompted reassessments of existing prudential rules and supervisory approaches amongst regulators to develop a dynamic regulatory and supervisory framework to achieve financial stability in all areas of the financial services sector. No less attention has been given to these issues in Islamic finance. Indeed, the work that is being undertaken by the IFSB to develop prudential, regulatory and supervisory standards and core principles that are in compliance with Shariah rules and principles represents a breakthrough in the regulation and supervision of the Islamic financial services industry.

My remarks today will focus on regulatory approaches adopted for Islamic banking institutions that take into consideration the context of the varying customer-banking institution relationship based on the contracts entered into that is inherent in the Islamic financial transactions. These considerations are essentially required to take into account the Shariah governance which reinforces the efforts to achieving the stability and soundness of the Islamic financial system. My presentation will also touch on areas of challenges in the formulation of the regulatory approach that arise from the multi-facet role performed by the Islamic banking institutions, and for systems in which Islamic finance operates side-by-side with the conventional financial system.

Objective and Regulatory Philosophy

In designing and implementing financial regulation for Islamic banking institutions, the challenge is to formulate a framework that not only takes into account the unique characteristics peculiar to Islamic banking business, but that does not put Islamic financial institutions at a comparative disadvantage and affect their competitiveness and growth potential in the overall financial system. Imperative is that the regulatory requirements need to be consistent with the injunctions of Shariah. Secondly, it needs to take into account the multi-faceted role performed by the Islamic banking institutions. Thirdly, in a dual financial system where Islamic financial institutions operate in a system side-by-side with conventional banks, including that where conventional banks may offer Islamic banking products and services through Islamic banking windows, the regulatory approach adopted needs to provide a level playing field.

Islamic banking institutions in most jurisdictions have to a large extent been governed by the same regulatory framework that is applied to conventional banking operations reinforced by the compliance to the Shariah framework. However, as the conventional banking framework is premised on an interest-based debtor-creditor relationship, the regulatory framework for conventional banking is built to assess and mitigate risks arising from loan-based financial transactions. Islamic banking is different in term of its underlying philosophy on the prohibition of interest. This in turn shapes the nature of the financial transactions that has its own risk characteristics. The specific risks associated in Islamic banking activities therefore needs to be identified to ensure its prudential regulation is adequately addressed.

It is within this context of diversity of systems and players that the regulatory approach adopted needs to ensure harmonisation and a level playing field for a competitive and robust financial system. Efforts towards achieving this objective will include the elements of greater transparencies and disclosure, a strong legal and judiciary system, reinforced by strong Shariah governance. It is in this aspect that the IFSB assumes a key role in developing prudential standards aimed at addressing issues peculiar to Islamic banking and identifying the gaps on existing regulatory and prudential standards. The IFSB represents an important catalyst that will contribute to enhancing the resilience of Islamic financial institutions in the global financial system and that will strengthen the foundation for the progress in the development of the global Islamic financial landscape.

The multiple contractual relationship of Islamic banking institutions

A strong regulatory framework must have the important elements of adequate capital standards, effective risk management practices and strong governance. In building a sound prudential framework for Islamic banking, aligning regulatory capital requirements to the underlying risks requires a dichotomisation of the risk intricacies in the Islamic banking asset portfolio.

On the asset side, the Islamic banking institutions enter into different financing modes that have varying risk characteristics, ranging from the low risk sales and lease-based modes to the higher risk equity-based modes of finance. Each of these modes of finance have a distinct intrinsic characteristic dictated by its underlying Shariah principle, and thus entail different risk profiles. An equity-based finance, may for example involve higher risks and therefore attract higher capital requirement. In this regard, the challenge in formulating the risk management infrastructure in Islamic banking institutions lies in having an accurate assessment of the various risk variants underlying the alternative modes of finance to provide for their effective quantification and management.

Similarly, the liability structure of Islamic banks is characterized by two distinct categories of deposits: demand deposits which is not subject to risks associated with banking business and for which the principal is guaranteed, and investment deposits which involves risks and hence, is eligible to share the profits earned from the banking business. Given this liability structure of Islamic banking institutions, the design of the regulatory framework for Islamic banking needs to give emphasis to full financial disclosure, prudent risk management and adherence to Shari’ah principles. This will serve as a firewall to prevent the transmission of risks from investment deposits to demand deposits thus enhancing transparency, depositors’ protection and systemic stability.

Rate of return framework

A further regulatory challenge arises from the liability structure of Islamic banking institution and the determination of a standard rate of return for account holders. Unlike conventional banking where returns are pre-determined, profit-sharing depositors of Islamic banking institutions know their returns at the maturity of the deposits. These returns are subject to the earnings of the assets that is shared between the Islamic banking institutions and the profit-sharing depositors. In the event of loss, the depositor as the capital provider will bear the losses. As the deposits in Islamic banking are for the most part are in the form of profit-sharing deposits, it places a higher degree of fiduciary risk on the management to ensure the funds are utilised in the most efficient manner.

Hence, regulators need to establish an effective rate of return framework to provide standard methodology for deriving the rate of return for depositors. Of equal importance is the need to address the information asymmetry between the Islamic banking institutions and the depositors by enhancing the level of transparency and ensuring that depositors would receive fair returns on their investment. Within the regulatory context, the framework would provide a means of assessing the efficiency of Islamic banking institutions as well as their profitability, prudent management and fairness.

In this regard, Malaysia has introduced the Profit Equalisation Reserve in the rate of return framework. To generate rates of return that are competitive and stable, the Profit Equalisation Reserve acts as a mechanism to mitigate the fluctuation of rates of return arising from the flow in income, provisioning and total deposits. This reserve is appropriated out of the total gross income and is shared by both the depositors and the banking institution. In a dual banking environment, the ability to maximise risk adjusted return on investment and sustain stable and competitive returns is an important element for the development of a competitive Islamic banking system.

Regulatory approach in a dual banking system

In a dual banking environment where Islamic banking institutions are operating side-by-side with conventional banking institutions, it is important to maintain harmonisation of the regulatory infrastructure, thus providing a level playing field for both the Islamic and conventional financial industry. The challenge lies in the development of a rigorous regulatory framework, legal and tax structure that will not position any of the financial players at a disadvantage. Of equal importance is the need to ensure that there is no opportunity for regulatory arbitrage in banking practices that makes one system more superior to the other in terms of product pricing. The Malaysian experience has a further variant of the dual banking model where conventional banking institutions are able to offer Islamic banking products and services.

In Malaysia, the Islamic financial system operates in parallel with the conventional system. The system has remained competitive and resilient as demonstrated by its growing market share and its ability to withstand adverse development. Their resilience to market vulnerabilities was demonstrated during the 1997-1998 Asian currency crisis. While the Islamic banking institutions observe similar international standards prescribed in the banking regulatory and supervisory framework and are subject to the same supervision by the Central Bank, the Islamic banking institutions are required to observe additional requirements, including observing minimum Islamic banking fund for its Islamic banking operations and maintaining an internal separation of accounting books. Further steps have been taken to require the banking institutions to disclose the fair and true value of the Islamic banking operations in the form of Balance Sheet and Profit and Loss Statements as part of the Notes to the Accounts in the principal financial statements of the banking institutions. This is to duly reflect the different risks and unique characteristics inherent in Islamic banking as compared to conventional banking. Where Islamic banking operates on a window basis, the existence of a firewall is to ensure the strict compliance to Shariah.

Whilst the appropriate regulations and standards are vital to mitigate the risks involved, of equal importance is the oversight and monitoring of the Islamic banking institutions through effective supervision by the regulatory authority to ensure that the prudential requirements are observed. Lack of oversight, inadequate check and balances, and over exposure to risks are amongst the factors that may result in vulnerabilities to the system. The best of regulations and financial safety nets would not be able to avoid such vulnerabilities if early warning systems are not in place. To effectively perform the supervisory functions, there has to be an understanding and appreciation of Islamic banking business and operations. Supervisors therefore need to be fully equipped with the required knowledge and skills to be able to identify the risks involved in various Islamic banking transactions to effectively conduct supervisory oversight of Islamic financial industry.

Enhancing Shariah framework and governance

A distinct feature of Islamic banking vis-à-vis conventional banking is the requirement to set up a Shariah advisory committee within the Islamic banking institutions. The establishment of Shariah advisory committee is important to serve as a check and balance to ensure that the management and operations of the Islamic banking institutions does not deviate from the Islamic principles in the formulation of their policies. Integral to this process is to achieve “unity in diversity” of the interpretations of Shariah injunctions in the realm of finance. In this regard, the IFSB has an important role to strengthen the current initiative to achieve a greater degree of convergence and harmonisation.

Strong adherence to the Shariah is also enforced through guidelines and procedures to ensure its compliance amongst the Islamic banking institutions. Procedures for decision-making by the Shariah advisory committee of the Islamic banking institutions therefore need to be clear and transparent. The role and responsibility of the committee therefore needs to reflect their responsibility and accountability to the management and the public. Their position is comparable to the auditors of the Islamic banking institutions. Hence, the financial reporting by an Islamic banking institution is required to provide the necessary disclosure to report on the conformity of its operations with the Shariah principles. These will promote the foundations for building public confidence and assurance that the Islamic financial products are Shariah compliant.

To enhance the Shariah framework in Malaysia, the Shariah advisory council at the central bank acts as a sole authority on all Shariah matters pertaining to Islamic banking and finance. Being an apex body, the council standardises Shariah ruling on similar issues to provide greater certainty and confidence to the financial institutions and to the investors and consumers. To strengthen the Shariah and legal framework, the Malaysian Judiciary has set up a dedicated High Court to adjudicate cases involving Islamic banking and takaful in accordance with the existing Malaysian civil laws. Any dispute, within or outside the court system that calls into question issues concerning Shariah is referred to the Shariah advisory council for guidance and clarification. Alternatively, disputes may also be referred to the arbitration centre for resolution. In this connection, Malaysia will enhance the Regional Centre for Arbitration in Kuala Lumpur to serve as a platform to deal with dispute cases on Islamic banking and finance, and to extend these services beyond our borders.

Conclusion

The challenge to develop regulatory standards that remain true to Islamic core principles is an important element in the development and growth of the Islamic financial services industry. The development of an Islamic financial system that is able to contribute towards stability and balanced global growth needs for its development to be achieved in the context of a rigorous and robust legal, regulatory and supervisory regime. This is reinforced by effective supervision, strong Shariah framework and an efficient judiciary system that promotes confidence and soundness in the Islamic financial system. It is with the combined commitment and concerted efforts by regulators, the industry and market participants that these goals can be achieved.