Regulatory Supervisory Issues Regulators Perspective Seminar

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Regulatory & Supervisory Issues – Regulators Perspective Seminar on Islamic Finance Banca d’ Italia Regulatory & Supervisory Issues – Regulators Perspective Seminar on Islamic Finance Banca d’ Italia 11 th November 2009 Muhammad bin Ibrahim, Assistant Governor 1 1

Part I • Global Development • Islamic Finance in Malaysia Part 2 • Regulatory Part I • Global Development • Islamic Finance in Malaysia Part 2 • Regulatory and Supervisory Issues - Shariah Governance - Risk Management - Islamic Deposit Insurance - Cross-border Supervision 2 2

Islamic finance… fastest growing segment in global financial system… Islamic Assets under Management USD Islamic finance… fastest growing segment in global financial system… Islamic Assets under Management USD 750 billion & expected to hit USD 1 trillion by 2010 Average growth rate of 15 -20% p. a. USD 300 billion Islamic Mutual Funds Average growth rate of 23% p. a. USD 7. 2 billion Takaful Contributions Growth rate of 13% p. a. Global Market Capitalization of Dow Jones Islamic Index USD 10 trillion Shariah Compliant Global Funds 680 funds Global Outstanding Sukuk USD 107 billion Average growth rate of 22% p. a. Number of Islamic Financial Institutions (IFIs) > 600 IFIs in the world Sources: Mc. Kinsey, The World Islamic Banking Competitiveness Report 2007 -08 & 2008 -09; Price. Water. House. Coopers, Islamic Finance News, IFSB & National Authorities; Islamic Banker Research Group; Islamic Finance & Insurance & Investor Offshore Review Enormous potential in Islamic Finance… 3

Rapid development of Islamic banking & finance have contributed to diversity in industry structure… Rapid development of Islamic banking & finance have contributed to diversity in industry structure… Various jurisdictions have their own Islamic banking & finance model to meet local requirement Attributes Adopting countries § Full transformation of financial system in accordance with Shariah § Iran, Sudan § A comprehensive Islamic financial system co-exist with conventional system § Malaysia, Bahrain, Pakistan & UAE § Islamic products mainly offered by conventional banks through “windows”. § UK, Hong Kong § Lack of supporting infrastructure (e. g. Islamic money market & capital market) may constraint product offering Single Islamic Financial System Dual Financial System Conventional Banks with Islamic Windows 4

Malaysia has developed a comprehensive dual financial system… Dual financial system • • Constituents Malaysia has developed a comprehensive dual financial system… Dual financial system • • Constituents of Malaysian financial system Conventional banking Insurance Money market Capital market Malaysian Financial System • • Islamic banking Takaful Islamic money market Islamic capital market Central Bank Act 1958 (CBA) Conventional Financial System Legal Governance Main Regulatory Authorities • • • BAFIA 1989 Insurance Act 1996 Loan Local Act 1959 Treasury Bills Local Act 1946 Capital Market & Services Act 2007 Islamic Financial System • • Islamic Banking Act 1983 Takaful Act 1984 Government Funding Act 2005 Capital Market & Services Act 2007 • Bank Negara Malaysia – regulate & supervise both conventional & Islamic FIs • Securities Commission – regulate capital market & Islamic capital market Central Bank of Malaysia Act 2009: “The financial system shall consist of conventional & Islamic financial system”… demonstrated Government’s commitment… Sources: Bank Negara Malaysia, Securities Commission FIs – Financial Institutions 5

Malaysia… several notable achievements… Sukuk market (Islamic bonds) • World’s largest sukuk market ± Malaysia… several notable achievements… Sukuk market (Islamic bonds) • World’s largest sukuk market ± USD 66 bil or 58% of total outstanding bonds) • Accounted 62% of total global sukuk outstanding • Islamic banking Comprehensive system (17 Islamic banks, 3 International Islamic banks) • Takaful (8 takaful operators, 4 retakaful operators, 1 international takaful operator) • Shariah governance Comprehensive Shariah Governance framework Well established infrastructures • Regulation & supervision Capital adequacy, deposit insurance framework, risk-based supervisory framework, liquidity, disclosures & transparency Sources: Bank Negara Malaysia, Securities Commission • Sukuk issuance covers all sectors of the economy • Contributes to overall economic growth • Sukuk as new asset classes • Fund Management (8 Islamic fund management companies, 144 Islamic unit trust funds) • Islamic money market Total annual money market transactions: exceeded RM 1 trillion • Dispute resolution - Judicial system – dedicated high court - Kuala Lumpur (KL) Regional Centre for Arbitration – dedicated rules for Islamic finance arbitration; - Financial Mediation Bureau • Human capital development Total solution approach for human capital development 6

Part I • Global Development • Islamic Finance in Malaysia Part 2 • Regulatory Part I • Global Development • Islamic Finance in Malaysia Part 2 • Regulatory and Supervisory Issues - Shariah Governance - Risk Management - Islamic Deposit Insurance - Cross-border Supervision 7 7

Regulatory & supervisory issues in Islamic banking & finance… Shariah Governance § Shariah compliance: Regulatory & supervisory issues in Islamic banking & finance… Shariah Governance § Shariah compliance: apex of Islamic financial system § How to ensure comprehensiveness of Shariah compliance (that cover both ex-ante & ex-post aspects of all financial transactions)? Risk Management § In addition to traditional banking risks, there are risks peculiar to Islamic banking - e. g. rate of return risk, displaced commercial risk (DCR), inventory risk & equity investment risk § Do Islamic bank regulators & supervisors have sufficient capacity & capability to look into these peculiar risks ? Deposit Insurance § Deposit insurance was introduced in conventional banking system to Cross-Border Supervision § Effective cross border supervision of Islamic banking & finance is instil public confidence & maintain financial stability § Is it necessary to introduce Islamic deposit insurance for Islamic banking institutions that operate in dual financial system? § What is the effective mechanism to introduce Shariah-compliant Islamic deposit insurance in an entrenched conventional banking system? instrumental in ensuring financial stability § Are Islamic banking’ supervisors ready to implement effective crossborder supervisory collaboration? § How to ensure Islamic banks which operate across multiple jurisdiction adhere to the common principles of strong governance & risk management? 8

Shariah Governance: A credible Shariah structure that promotes integrity and confidence… Malaysia’s experience: § Shariah Governance: A credible Shariah structure that promotes integrity and confidence… Malaysia’s experience: § Proper governance provides multi-layer assurance Shariah as overarching principle in Islamic finance MANAGEMENT BOARD SHARIAH COMMITTEE Shariah Compliance Functions : § Shariah Review § Shariah Audit * IFI- Islamic Financial Institution on Shariah compliance 1. Shariah Advisory Council given legislative stature as highest authority for Shariah matters in Islamic finance 2. Institutionalise mutual respect by recognising differences of Shariah interpretations in various jurisdiction 3. Accountability of Shariah committee of IFIs on decision, views & opinions related to shariah matters 4. Board & senior management with sufficient expertise & capability in dealing with issues specific to Islamic financial transactions 5. Emphasise the function of Shariah review & Shariah audit to provide check & balance 6. Timely disclosure on fatwa rulings 9

Risk Management: Equity investment transactions that involves profit risks sharing require distinct risk management Risk Management: Equity investment transactions that involves profit risks sharing require distinct risk management & governance… An illustration: § To manage risks associated with Mudharabah (profit-sharing) & Musharakah (partnership) contracts, equity-based transactions - Allow appointment of Board representatives on entities involved in such transactions - Board to ensure IBIs have sufficient understanding & expertise on Musharakah & Mudharabah transactions Assets Liabilities - Establishment of dedicated talent & oversight committee/ unit, e. g. in-house property development/ research department for property investment & development activities § To safeguard interest of Investment Account Holders (IAH) - Board’s fiduciary responsibilities in protecting depositors , particularly investment account holders (IAH) - Need to acknowledge IAHs’ right (1) to monitor the performance of their investments & the associated risks, (2) put into place adequate means to ensure that these rights are observed & exercised such as through sufficient disclosures Malaysia’s experience: In view of high risk nature of Mudharabah & Musharakah, BNM has issued specific guidelines on Musharakah & Mudharabah to provide guidance to IBIs – Islamic Banking Institutions 10

Risk Management (cont…) Displaced Commercial Risk & Rate of Return Risk: How to mitigate Risk Management (cont…) Displaced Commercial Risk & Rate of Return Risk: How to mitigate the risk that depositors might not receive expected return? An increase in benchmark rates: § Effect : Investment Account Holders (IAH) have expectation of a higher Rate of Return (Ro. R). § Problem : Assets funded by IAH are mostly long term & fixed rate – hence, cannot be repriced higher until those assets mature § Solution (1): Islamic bank has to give up some portion of its return in order to pay a competitive rate to IAH & prevent them from leaving the bank (risk of flight to quality or liquidity risk) § Solution (2): Apart from the Bank foregoing their portion of profits in ensuring competitive returns, Bank could adopt Profit Equalisation Reserve (PER) as a mechanism to smoothen income & to minimise displaced commercial risk (DCR) Rate not competitive (rate < market) Profit surplus competitive (rate > market) PER Islamic Banking Institution’s Profit Excess save as PER for rainy days OR Islamic Banking Institution’s Profit PER is written back Other possible solutions: (1) Minimise dependency on long-term fixed return assets in managing return to investors/depositors & introduce floating rate financing e. g. Ijarah (leasing) based contract (2) For banks that do not adopt PER, there is a possibility of confidence crisis / run on the banks (should they cannot react to the expectation of depositors) - continuous monitoring is important to minimise the risk. 11

Deposit Insurance in Islamic Finance… Malaysia’s Experience: 3. Provide coverage when bank fails (3 Deposit Insurance in Islamic Finance… Malaysia’s Experience: 3. Provide coverage when bank fails (3 rd party guarantee with fee) 1. Deposit money Depositors Islamic Banks 2. Contribution (premium paid by Islamic bank) Malaysia Deposit Insurance Corporation Separate & Equitable Principles Separate management of funds § Funded by contribution (premium) collected from Islamic banks § Pooled contribution (funds) managed separately § Invest in Shariah compliant instruments Equivalent Coverage Limit § Islamic deposit covered separately from conventional § All coverage limit – similar to conventional § Up to RM 60 k per depositor per member institution (covers 90% of total depositors) Separate Premium Assessment § Separate deposit premium assessment system for Islamic & conventional § Separate supervisory assessment for Islamic & conventional banking institutions (inc windows) Separate Payout § Separate payment in event of failure Islamic deposit insurance funds used only for Islamic banks § Deficit contribution – can raise funds from government based on Shariah principles 12

Cross-border supervision: As Islamic financial institutions going global, supervisory issues require cross-border initiatives… 1 Cross-border supervision: As Islamic financial institutions going global, supervisory issues require cross-border initiatives… 1 Understanding of supervisory philosophy & objective with regard to Islamic financial system within jurisdictions 2 Common understanding among supervisors especially on specific risks emanating from Islamic finance operations Easy access to relevant information 3 HOME HOST 4 Clarity of responsibilities of home & host supervisory authorities – Mutual respects of Shariah view? UNITY IN DIVERSITY Cross border supervisory issues are generally similar to conventional banking. The differences lies in detailed application of Islamic banking & finance model 13

In essence, to ensure Islamic banking regulation & supervision is effective, the following elements In essence, to ensure Islamic banking regulation & supervision is effective, the following elements should be considered. . Understand the Fundamental Appreciate the Uniqueness Recognise the Environment Acknowledge the Challenges § Shariah as the backbone of Islamic banking & finance § Specific approach must be taken to ensure adherence to Shariah principles § Recognise the unique structure of Islamic banking & finance § Acknowledge the distinctive risks associate with Islamic banking finance § Understand the industry in which the Islamic banking & finance exist § Tailor-made the regulatory & supervisory approach to the nature of the financial system § Full commitment on effort to resolve emerging system-wide issues § Identify the pre-requisite for an Islamic financial institutions - Human capital - Infrastructure - Capacity & capability § Balancing the need for prudential regulation & strategic aspiration 14

Informative websites: § http: //www. bnm. gov. my - Bank Negara Malaysia § http: Informative websites: § http: //www. bnm. gov. my - Bank Negara Malaysia § http: //www. mifc. com - Malaysia International Islamic Financial Centre (MIFC) § http: //iimm. bnm. gov. my - Islamic Money Market § http: //bondinfo. bnm. gov. my - Malaysian Government Securities Market § http: // www. sc. com. my - Securities Commission Malaysia § http: //www. pidm. gov. my - Malaysia Deposit Insurance Corporation “Malaysia, a vibrant Islamic financial hub, shapes the future of Islamic finance through innovation and thought leadership to enable the collaboration with global talents and leading players” Disclaimer: While every care is taken in the preparation of this presentation, no responsibility can be accepted for any errors. Copyright: All or any other portion of this presentation may be reproduced provided acknowledgement of the source is made. Notification of such use is required. All rights reserved. 15




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