1. Sau Ngan Wong, Senior Counsel, Finance and Markets Global Practice
Regulation and Supervision of sukuk markets Abu dhabi, UAE 20 April 2015
Sau Ngan Wong, Senior Counsel,
Finance and Markets Global Practice
The World Bank Group

2. Agenda - IOSCO report on Islamic capital markets - Distinct features of Sukuk regulatory framework - Relevant standards issued by IFSB on Sukuk - Shariah governance framework - Regulation of non-sovereign primary issuance of Sukuk - Regulation of secondary market of Sukuk - Examples of country approaches to regulation of Sukuk - Key challenges to regulation & supervision of Sukuk markets

3. IOSCO Islamic Capital Market (ICM) Taskforce Report 2004
Islamic Capital Market (ICM) constitutes a segment of the wider global securities market, the regulatory health and proper functioning of which falls within IOSCO’s objectives
A capital market with a sound regulatory framework and appropriate supporting infrastructure must first be present in order to nurture and support an ICM component
While conventional principles of securities regulation may be applied to ICM, there may be, in certain instances, a need for more specific guidelines to be introduced to ensure that the unique aspects of ICM products are appropriately regulated
There is no need to formulate separate regulatory principles for ICM. By extension, IOSCO’s objectives and principles of securities regulation can be applied to ICM
Reaffirmed in Analysis of Application of IOSCO’s Objectives and Principles of Securities Regulation for Islamic Securities Products 2008

4. Universal principles of securities regulation equally apply to ICM & Sukuk
Protection of
Investors
Products and services must be true to label
Leverage on existing legal and regulatory infrastructure wherever possible
Additional disclosures where necessary
Opportunities for regulatory arbitrage must be minimized
Trust in the system to be safeguarded
Benchmark against international standards
Standards of documentation
Governance structures & practices
Levels of transparency & disclosures
Ensuring markets are fair, efficient &
transparent
Reduction of systemic risks

5. Fair, efficient & transparent framework applicable to Sukuk markets...
Investors
Issuers
Conducive regulatory framework that ensures:
Fairness
Efficiency
Transparency
Investors’ protection
Market returns
Liquidity
Timely access to relevant information
Expeditious issuance process
Lower funding cost
Ability to borrow long
Clear and consistent rules

6. Firewalls for Infrastructure Consumer protection & fair dealing
Distinct features of Sukuk regulatory framework…
Corporate
Governance
Governance principles peculiar to Islamic finance
Fiduciary duties as Mudharib i.e. fund manager
Shariah Governance
Risk Management
Unique risks e.g. Shariah risk, rate of return risk,
Displaced commercial risk & equity investment risk
Capital Adequacy
Standard
Risk profiles & exposures determined based on underlying Shariah contracts
Separate accounting, clearing and settlement system
Separate prudential requirements – liquidity, single customer limit
Firewalls for Infrastructure
As the domestic Islamic banking industry progresses into a more advanced stage of development, the Islamic banking industry is also witnessing significant developments shaping its financial regulatory infrastructure on both the domestic and international front.
Domestic Prudential Regulation
On the domestic front, these developments include the emergence of a different set of regulatory guidelines for Islamic banking operations, encompassing corporate governance, standard calculation of rate of return to depositors, financial disclosure, Shariah governance, Islamic money market and capital adequacy.
Consumer protection & fair dealing
Transparency and disclosures
Dispute resolution mechanism
Rate of return framework

7. Adapt existing sound practices to address Islamic Finance
characteristics to minimize regulatory arbitrage…
Capitalize on strength of conventional regulatory system
Gradual establishment of Islamic finance regulatory framework
Conventional regulatory infrastructure already in place & proven effective
Leverage on existing framework to address similar risks in Islamic finance
Islamic finance/Sukuk are governed by similar regulatory framework as in conventional banking
Corporate governance
Capital adequacy
Liquidity management
Financial transparency & market discipline
Risk management and auditing
Modify existing framework to address salient characteristics of Islamic finance
Establish Shariah compliance & governance mechanism
Adoption of international Islamic prudential standards issued by Islamic Financial Services Board - to addresses unique characteristics of Islamic financial transactions 7

8. …and streamlined with Islamic Financial Services Board (IFSB) standards for international regulatory harmonization
Relevant Standards issued by IFSB to Sukuk
Islamic Financial Services Board (IFSB) was established in 2002
Significant progress in addressing regulatory framework for Islamic financial institutions
Promote international convergence of standards
Provide platform for knowledge sharing
191 members to date, including 54 regulators
Capital Adequacy Standard (Dec 2005)
Guiding Principles on Risk Management (Dec 2005)
Guiding Principles on Corporate Governance ( Dec 2006)
Transparency & Market Discipline (End-2007)
Supervisory Review Process (End-2007)
Capital Adequacy Requirements for Sukuk,
Securitization & Real Estate Investment (1/09)
Guiding Principles on Governance for Islamic Collective Investment Scheme (1/09) 8

9. strict adherence to Shariah principles…
Shariah Governance plays an important role in instilling & shaping sound governance practices ….
Ensures compliance with Shariah rules & principles
Importance of
Shariah governance
Ensure strict Shariah-compliance
Instill public confidence
Shariah Governance
Fiduciary duties in Islamic banking transaction
Normal
Corporate
Governance
Promote financial stability
Principles of Islamic finance place great emphasis on strong corporate governance values & structure, transparency, disclosure of information &
strict adherence to Shariah principles… 9 9

10. An example of Shariah Governance Framework Model
as overarching principle in Islamic finance
BOARD RISK MANAGEMENT COMMITTEE
BOARD Overall oversight on Shariah governance structure & Shariah compliance
BOARD AUDIT COMMITTEE
Accountability
SHARIAH COMMITTEE
Oversight accountability on Shariah related matters
Oversight
MANAGEMENT
Ensure executions of business & operations are in accordance with Shariah principles
Provide necessary support to the Shariah Committee
Support
Support
Shariah Risk Management Control Function
Identify, measure, monitor, report & control Shariah non-compliance risk
Shariah Review Function
Review business operations on regular basis to ensure Shariah compliance
Shariah Research Function
Conduct in-depth Shariah research prior to submission to the Shariah Committee
Shariah Audit Function
Provide independent assessment & objective assurance designed to value add & improve IFI’s compliance with Shariah
Check & Balance
Check & Balance
Shariah Compliance and Research Functions

11. Proper Sequencing of Regulatory Policies
The 5 Pillars
Establish reliable and efficient benchmark yield curve
Introduce efficient & facilitative issuance process for Sukuk
Widen issuer and investor base
Improve liquidity in the secondary market
Facilitate introduction of risk management instruments

12. Regulation of primary issuance of non-Sovereign Sukuk
Regulation of primary issuance mechanism
Public offer – most stringent regulation via prospectus & other disclosures
Private placement
Hybrid offering
Conditions for exemption from public offering disclosure requirements
Distinction between retail and professional investors
Definition of a “professional” investor
Different approaches to levels of regulatory approval depending on whether –
exempt market or not
classification of types of investors

13. Regulation of secondary market trading of Sukuk
Transferability of Sukuk instruments & conditions for trading
Distinction between retail and professional investors, if different from primary issuance
Restrictions on transfer of non-listed or non-public Sukuk
Relevant listing requirements for Sukuk on the stock exchange
Access to pre-trade and post-trade information
Ongoing disclosures
Investment framework for pension funds, NBFIs etc
“Suitability” test for different categories of investors

14. International experience points to two approaches – some examples:
Different country approaches to regulation & supervision of Sukuk…
International experience points to two approaches – some examples:
Minimal alterations: United Kingdom, Singapore
Parallel approach: Malaysia, Bahrain and Oman

15. Country approach in regulating & supervising Sukuk markets: Malaysia
Ensure base-line application of rules governing disclosure, investor protection, fair and orderly market
Introduce legislative changes to remove impediments and to provide certainty
Issue legally binding guidelines, rulings and requirements where necessary to cover –
Product regulation
Intermediation services
Shariah governance
Adopt market-based approach by requiring disclosure rather than merit assessment relating to product offerings
Remove tax impediments (to achieve level playing field) and introduce temporary incentives where appropriate

16. Country approach in regulating & supervising Sukuk markets: Malaysia
Ensure base-line application of rules governing disclosure, investor protection, fair and orderly market
Introduce legislative changes to remove impediments and to provide certainty
Issue legally binding guidelines, rulings and requirements where necessary to cover –
Product regulation
Intermediation services
Shariah governance
Adopt market-based approach by requiring disclosure rather than merit assessment relating to product offerings
Remove tax impediments (to achieve level playing field) and introduce temporary incentives where appropriate

17. 1: General Regulatory Requirements 2: Shariah-specific Requirements
Malaysia: 2 Tier Approach to regulation of ICM/Sukuk products ensure investors receive same degree of clarity, certainty & protection
1: General Regulatory Requirements
Applicable to both conventional & Islamic products
Prospectus
Trust Deeds
Eligible Issuers
Mandatory rating
2: Shariah-specific Requirements
Applicable to Islamic products & Sukuk
Approved Shariah principles
Shariah Adviser
Utilization of proceeds

18. Two-tier Shariah assurance supported by Shariah governance structure
Proper governance provides assurance on Shariah compliance & confidence on IF operation:
SAC’s legislative stature as highest authority for Shariah matters in Islamic finance is accorded under the Central Banking Act.
Shariah committee of IFIs are fully accountable on decision, views & opinions related to shariah matters
Board & senior management with sufficient expertise & capability in dealing with issues specific to Islamic financial transactions
Emphasise the function of Shariah review & Shariah audit to provide check & balance
Shariah Committee member of another IFI within the same industry shall not be appointed – avoid conflict of interest & maintain info confidentiality
Institutionalise mutual respect by recognising differences of Shariah interpretations in various jurisdiction
Shariah parameters provide guidance on main features, principles & rulings of Shariah contracts
Shariah as overarching
principle in Islamic finance
Shariah Advisory Council (SAC)
Management
Board
Shariah Committee
Shariah Compliance Functions :
Shariah Review
Shariah Audit
Shariah Governance Framework
Shariah Parameters
Shariah Resolutions & Rulings 18

19. Key Challenges to regulation & supervision of ICM/Sukuk
Bringing regulatory framework and oversight in line with international best practices
Rebalancing tax treatment
Strengthening insolvency frameworks
Promoting standardization
Ensuring adequate liquidity for long term financing
Establishing sound risk-management practices

20. Rebalancing tax treatment
Conventional debt often receives advantageous tax treatment (encouraging leverage), while some Islamic finance products face double taxation.
Examples of Malaysia and Thailand took steps to ensure that Islamic financial transactions operate on a level playing field:
In Malaysia, this principle has extended to ensuring that profits, asset transfers, and expatriation of profits by foreigners are treated equally, whether occurring under conventional or Islamic financial contracts.
In Thailand, a package of proposed tax changes for Sukuk issuances is making its way through the legislative process to address the main hurdles faced by Sukuk issuers.

21. Promoting standardization
Lack of standardization and cohesion, especially in Sukuk products, hinders the growth potential of Islamic finance
The industry would benefit from more widely accepted benchmarks and indices.
Innovation and knowledge sharing between various market players are essential to facilitate the standardization and unification of global markets for Islamic financial products.

22. Need to strengthen insolvency frameworks…
More work is needed to ensure convergence between best insolvency practices on the conventional and Shariah-compliant sides.
The need to establish reliable mechanisms for dealing with Sukuk defaults, and addressing adverse outcomes, with special adaptations for risk sharing.
Setting up these mechanisms requires the specification of parties’ rights under Shariah-compliant finance, especially in the case of cross-border transactions.

23. THANK YOU

24. Sau Ngan Wong, Senior Counsel, Finance and Markets Global Practice
THANK YOU
Sau Ngan Wong, Senior Counsel,
Finance and Markets Global Practice
The World Bank Group

25. II. Capital adequacy RWA 6 : Sukuk B
Sukūk is certificates that represent the holder’s proportionate ownership in an undivided part of an underlying asset where the holder assumes all rights and obligations to such asset ultimate customer.
Externally Rated Sukūk
Applicable risk weight will be based on the ECAI ratings in accordance with the Standardised Approach
Non Rated Sukūk
Applicable risk weight will be based on the underlying contract or on that of the issuer if there is recourse to the issuer

26. II. Capital adequacy RWA 6 : Sukuk B
Sukūk is certificates that represent the holder’s proportionate ownership in an undivided part of an underlying asset where the holder assumes all rights and obligations to such asset ultimate customer.
Externally Rated Sukūk
Applicable risk weight will be based on the ECAI ratings in accordance with the Standardised Approach
Non Rated Sukūk
Applicable risk weight will be based on the underlying contract or on that of the issuer if there is recourse to the issuer

27. II. Capital adequacy RWA 5 : Mudharabah B
Muḍārabah Investment in Project Finance
Prior to certification where funds are already advanced by the IIFS to the Muḍārib :
- Risk weight is based on the rating of either the ultimate customer or the Muḍārib
- Otherwise, 400% RW is applied to unrated Muḍārib.
After certification where amount receivable by the IIFS from the Muḍārib in respect of progress payment due to the Muḍārib from the ultimate customer:
- Risk weight is based on the credit standing of the ultimate customer on the amounts receivable by the IIFS from the Muḍārib
- Otherwise, 100% RW for unrated ultimate customer.

28. II. Capital adequacy RWA 5 : Mudharabah B
Private commercial enterprise to undertake a business venture (other than (1))
Simple risk-weight method:
The RW shall be applied to the exposures (net of specific provisions) based on equity exposures in the banking book. The RW under the simple risk-weight method for equity position risk in respect of an equity exposure in a business venture shall entail a 400% for shares that are not publicly traded.
However, funds invested on a Muḍārabah basis may be subject to withdrawal by the investor at short notice, and in that case may be considered as being as liquid as shares that are publicly traded. The applicable RW in such a case is 300%.
Slotting Method expertise.

29. II. Capital adequacy RWA 5 : Musharakah B
1. Private commercial enterprise to undertake trading activities in the foreign exchange, share and/or commodity
- The RW of a Mushārakah that invests in quoted shares shall be measured according to the equity position risk approach where positions in assets tradable in markets will qualify for treatment as equity position risk in the trading book, which would incur a total capital charge of 16% (equivalent to 200% RW).
- The capital charge can be reduced to 12% (equivalent to 150% RW) for a portfolio that is both liquid and well-diversified, subject to meeting the criteria as determined by the supervisory authorities