1. An overview of the IFSB’s framework on (a) Guiding principles of risk management (b) Capital adequacy standard for institutions (other than insurance institutions) offering Islamic financial services (IIFS) ABDULLAH HARON Project Manager Islamic Financial Services Board (IFSB) abdullah@ifsb.org IRTI-The World Bank GLDN Video Conference Lecture 23 May 2006

2. I slamic F inancial S ervices B oard 2 Agenda  Objectives of the IFSB  An overview of the IFSB’s guiding principles of risk management and Capital Adequacy Standard (CAS) for IIFS  Experience in the development of the standard and expected challenges in its implementation process

3. I slamic F inancial S ervices B oard 3 Objectives of the IFSB  Article 4 of the Articles of Agreement outlines the objectives of the IFSB, which include, among others :  To promote the development of a prudent and transparent Islamic financial services industry by introducing new, or adapting existing, international standards consistent with Shari’a principles, and recommend them for adoption.  To provide guidance on the effective supervision and regulation of institutions offering Islamic financial products and to develop the criteria for identifying, measuring, managing and disclosing risks, taking into account international standards for valuation, income & expense calculation and disclosure.

4. I slamic F inancial S ervices B oard 4 Status of development of the IFSB standards Standard on/Guiding PrinciplesCommencement of preparation* Issuance of framework Risk ManagementJuly 2003Standard issued in December 2005 Capital AdequacyJuly 2003Standard issued in December 2005 Corporate GovernanceMay 2004Exposure Draft (ED) issued in December 2005 Supervisory Review ProcessApril 2005Expected ED to be issued in 2007 Transparency & Market DisciplineApril 2005Expected ED to be issued in 2007 Note : * corresponds to the date of the 1 st meeting of the Working Group

5. I slamic F inancial S ervices B oard 5 Guiding Principles of Risk Management High level overview

6. I slamic F inancial S ervices B oard 6 High level overview of Guiding Principles of Risk Management  Approach  Key objective  Guiding principles for the management of risk on specific features of IIFS products and services, amongst others: Equity investment risk Rate of return risk –Displaced commercial risk Operational risk –Sharī`ah compliance risk –Fiduciary risk

7. I slamic F inancial S ervices B oard 7 Approach (1)  Rather than prescriptive procedures, the approach that has been taken by the IFSB is principle-based approach, applied to accommodate continuous improvement in the infrastructures, methodologies and system as theory and technology permit

8. I slamic F inancial S ervices B oard 8 Approach (2)  In identifying the risks to which IIFS are exposed, as an initial step is to identify inherent risks which include the following two risks: primary risks, i.e. the exposures deliberately entered into for business reasons when an IIFS decides to offer a certain type of service; and consequential (or operational) risks, i.e. the exposures that are not actively taken but which are incurred as a result of business undertaken by the IIFS

9. I slamic F inancial S ervices B oard 9 Key objective of Guiding Principles of Risk Management (1)  The IIFS are expected to view the management of these risks from a holistic perspectives  The guiding principles define a common terminology of key risk categories to which IIFS are exposed, acting as a common language for further development of regulatory financial requirements and seen as a stimulant to the progress of risk management practices required in Islamic financial services industry:

10. I slamic F inancial S ervices B oard 10 Key objective of Guiding Principles of Risk Management (2) For example, the rate of return risk (as opposed to interest rate risk) is essentially the risk with regard to the result of an investment at the end of the investment-holding period. We cannot exactly predetermine such results Displaced commercial risk could be the consequence of the rate of return risk whereby IIFS may be under market pressure to pay a return that exceeds the rate that has been earned on assets financed by IAH

11. I slamic F inancial S ervices B oard 11 Key objective of Guiding Principles of Risk Management (3) At present, in many jurisdictions, the consequence of the rate of return risk is considered as part of the strategic risk, hence is left to the individual IIFS to decide. In some jurisdictions, guidelines on the rate of return risk including on the use of profit equalisation reserve (PER) exist.

12. I slamic F inancial S ervices B oard 12 Features addressed by the Guiding Principles of Risk Management (1)  Inclusion or introduction of principles for equity investment risk and rate of return risk, along with other risk categories similar to those in Basel standards such as credit, market and operational risks.  These additional risk categories take into account specific risk profiles of the profit-sharing and loss-bearing nature of Mushārakah or Mu ḍ ārabah financing.  The context of operational risk category (which comprises documentation, internal controls and legal risks) has also been extended, to include greater emphasis on Sharī`ah compliance and fiduciary risks whereby IIFS are liable for negligence and misconduct.

13. I slamic F inancial S ervices B oard 13 Features addressed by the Guiding Principles of Risk Management (2)  Apart from equity investment and credit risks, market (price) risk and risks arising from the interaction between assets and sources of funds are equally important aspects of the risk profile of IIFS as a result of the profit- sharing nature of investment accounts.  The Guiding Principles stipulate high-level principles, among others, on some pre-conditions necessary for IIFS when managing the expectations of IAH. For example, by requiring IIFS to put in place an appropriate framework for managing displaced commercial risk, where applicable and appropriate mechanisms to safeguard the interests of all fund providers where funds of IAH and shareholders are commingled.

14. I slamic F inancial S ervices B oard 14 Fifteen guiding principles of risk management for IIFS covering:  General Requirement for an Effective Risk Management Processes  Credit Risk  Equity Investment Risk  Market Risk  Liquidity Risk  Rate of Return Risk  Operational Risk

15. I slamic F inancial S ervices B oard 15 Capital Adequacy Standard (CAS) High level overview

16. I slamic F inancial S ervices B oard 16 High level overview of Capital Adequacy Standard  Approach  Key objective  Principles for the measurement of capital adequacy standard on specific features of IIFS products and services Credit (including exposures made under profit sharing modes that are not made for trading) Market Operational Profit sharing investment account (PSIA)

17. I slamic F inancial S ervices B oard 17 Approach  Since the structure and activities of IIFS are influenced by the Shari`āh rules and principles, the approach undertaken by the working group is analysing the intrinsic characteristics of each contract. For this reason, the CAS is structured in a matrix format  The CAS does not represent an exhaustive list of products Principles for minimum capital adequacy requirements for credit and market risks arising from a given type of financial instrument Financing and investment instruments

18. I slamic F inancial S ervices B oard 18 Key objective of Capital Adequacy Standard  The standard on Capital Adequacy sets out a common structure for the assessment of IIFS capital adequacy requirements, which will support transparency and consistent methodology for all IIFS This will bring the benefits of a common approach without compromising Sharī`ah rules and principles by substantially enhancing the transparency of true obligations within IIFS operations

19. I slamic F inancial S ervices B oard 19 Key objective of Capital Adequacy Standard (2) Recognition of investment account holders (IAH) as partners in IIFS operations should result in a more effective use of capital. According to the Quantitative Impact Study (QIS) conducted by the IFSB last year, the capital base of IIFS is more than sufficient to meet their true liabilities, in contrast to critics about them being undercapitalised The standard promotes a level playing field at a global level as far as common assessment is concerned especially for the minimum capital requirement in respect of both credit and market risks arising from each financing mode at different stages of a contract

20. I slamic F inancial S ervices B oard 20 Principles for the measurement of capital adequacy requirement (1)  IIFS are required to use the substance of the Sharī`ah rules and principles governing the contracts to form the basis for an appropriate treatment in deriving their minimum capital adequacy requirements  Capital adequacy requirements vary according to the transformation of risks at different contract stages

21. I slamic F inancial S ervices B oard 21 Features addressed by the Capital Adequacy Standard  Catering for specific structure and contents of Sharī`ah compliant products & services (which are either asset-based, profit-sharing or sukūk) but not specifically addressed by Basel standards. For example, in Murābahah or Ijārah, rather than lending money, an IIFS has to acquire a physical asset and then sell it back on credit or on lease. The risk to which the IIFS is exposed transforms from the market risk of physical assets at the time of acquisition to credit risk at the time of sale on deferred payment or on lease. In measuring the capital adequacy of these contracts, the physical assets are risk-weighted not only by bucketing them according to different risk categories but also by differentiating them according to various stages of contracts.

22. I slamic F inancial S ervices B oard 22 Example of RW at different contract stage (1)

23. I slamic F inancial S ervices B oard 23 Example of RW at different contract stage (2)

24. I slamic F inancial S ervices B oard 24 Principles for the measurement of capital adequacy requirement (2)  On basis of either Mu ḍ ārabah or Wakālah contract, credit and market risks of the investment made by the IAH shall normally be borne by themselves, while the operational risk is borne solely by the IIFS (unless proven negligence, mismanagement or fraud)

25. I slamic F inancial S ervices B oard 25 Features addressed by the Capital Adequacy Standard  Recognition of the profit-sharing investment accounts (PSIA) in the Capital Adequacy Ratio (CAR) calculation.  As opposed to the emphasis of Basel II Capital Accord on depositors’ protection, the IFSB Standard on Capital Adequacy stresses the importance of investors’ protection mechanisms (but no guarantee of capital). As such, assets financed by IAH do not affect risk-bearing capital of IIFS since they bear their own commercial risk.

26. I slamic F inancial S ervices B oard 26 Capital Adequacy Standard (CAS) Credit Risk

27. I slamic F inancial S ervices B oard 27 CriteriaBasel II Standardised IFSB CAS Standardised Risk weightCalibrated on the basis of external ratings by the BASEL committee. Vary according to contract stage and financing mode. Treatment of equity in the banking book > 150% for venture capital and private equity investments Simple risk weight method (RM300% or 400%) or supervisory slotting method (RW 90%-270%) Credit Risk Mitigation Techniques Includes financial collateral, credit derivatives, guarantees, netting (on and off balance sheet). Includes hamish jiddiyyah, urbun, PSIA or cash on deposit with IIFS, guarantees, financial collateral, pledge assets Comparison on the approach

28. I slamic F inancial S ervices B oard 28 Principles for the measurement of capital adequacy for credit risk (1)  Credit risk is measured according to the Standardised Approach of Basel II, except for certain exposures arising from investments by means of Mushārakah or Mu ḍ ārabah contracts in assets that are not held for trading  Until adequate historical data are available, the IFSB employs Basel’s risk weights (RW)

29. I slamic F inancial S ervices B oard 29 Individual Claims based on External Assessment Standardised Approach Investment Made Under Profit-Sharing and Loss- bearing Modes Slotting Method Simple Risk Weight Method Risk Weight based on External Credit Assessments (R) Four Categories CRWA = R x Net Exposure* *Amount of exposure less eligible collateral (Net exposure) Measurement of Credit Risk

30. I slamic F inancial S ervices B oard 30 Capital Adequacy Standard (CAS) Market Risk

31. I slamic F inancial S ervices B oard 31 CriteriaBasel II Standardised IFSB CAS Standardised CategoryEquity, FX, Interest rate risk in the trading book, commodity Equity, FX, benchmark risk in the trading book, commodity, Inventory Silver falls under foreign exchange risk Measurement1996 market risk amendments (standardised and internal model) 1996 market risk amendments (standardised measurement method) Comparison on the approach

32. I slamic F inancial S ervices B oard 32 Principles for the measurement of capital adequacy for market risk (1)  Apart from market risk exposures arising from equity, foreign exchange, commodities, the exposures also include trading positions in Sukuk and inventory risk, which results from IIFS holding assets with a view to re-selling or leasing them  In the case of equity investment made by means of Mushārakah or Mu ḍ ārabah contract where the underlying assets are commodities held for trading, market risk provisions for commodities are applicable

33. I slamic F inancial S ervices B oard 33 Principles for the measurement of capital adequacy for market risk (2)  For inventory risk, only simplified approach is applicable

34. I slamic F inancial S ervices B oard 34 Measurement of Market Risk Equity Position/ Sukuk Standardised Approach Market Risk Capital Requirement (MRCR) Foreign ExchangeCommodity/Inventory @ Specific General Market Single Currency Portfolio Maturity Ladder Simplified Forward Gap Basis Directional + + + + + + + ++ MRWA = 12.5 * MRCR @ In case of inventory risk, only simplified approach is applicable

35. I slamic F inancial S ervices B oard 35  The 12.5 conversion factor is the reciprocal of the minimum CAR i.e. 8%, and thus converts the market risk capital charges into equivalents of risk weighted assets as follows:  Hence an asset that attracts a 100% credit risk weight results in a minimum capital requirement (i.e. a capital charge) of 8  An asset that attracts a market risk capital charge of 8 is converted to a risk weight of 8*12.5 = 100  When this 100 is added to the credit risk weighted assets, it can be treated in the same way, resulting in a capital charge of 8  If a supervisor decides to impose a minimum capital requirement different from (e.g. higher than) 8%, the conversion factor should be changed accordingly Market risk weight conversion factor

36. I slamic F inancial S ervices B oard 36 Capital Adequacy Standard (CAS) Operational Risk

37. I slamic F inancial S ervices B oard 37 CriteriaBasel II Standardised IFSB CAS Standardised Gross income Annual average gross income (previous three years) Annual average gross income (previous three years) excluding PSIA’s share of income Comparison on the approach

38. I slamic F inancial S ervices B oard 38 Principles for the measurement of capital adequacy for operational risk  Sharī`ah compliance risk is a type of operational risk facing the IIFS which can lead to non-recognition of income and resultant losses  The extent of losses from non-compliance with Sharī`ah rules and principles cannot be ascertained owing to lack of data Supervisory authorities have discretion to impose a RW higher than 15% as they deem fit to cater for the Sharī`ah compliance risk of a particular IIFS.

39. I slamic F inancial S ervices B oard 39 Measurement of Operational Risk Capital Requirement Basic Indicator Approach Annual Average Gross Income (previous three years) X 15% Gross income is defined as: Net income from financing activities (e.g. selling price less purchase price) which is gross of any provisions and operating expenses; plus Net income from investment activities; plus Fee income (e.g. commission and agency fee) Less: Investment account holders’ share of income Operational Risk Capital Requirement (ORCR) ORW = 12.5 * ORCR

40. I slamic F inancial S ervices B oard 40 Capital Adequacy Standard (CAS) Relating to Profit Sharing Investment Accounts

41. I slamic F inancial S ervices B oard 41 Capital adequacy requirement relating to assets financed by PSIA (1)  The IIFS assumes the role of economic agent or Mu ḍ ārib in placing such funds in income- producing assets or economic activities, and as such is entitled to a share (the Mu ḍ ārib share) in the profits (but not losses) earned on funds managed by it on behalf of the IAH, according to a pre-agreed ratio specified in the Mu ḍ ārabah contract The commercial risk on assets financed by PSIA do not represent risks for the IIFS’s own (shareholders’) capital and thus would not entail a regulatory capital requirement for the IIFS

42. I slamic F inancial S ervices B oard 42 Capital adequacy requirement relating to assets financed by PSIA (2)  This implies that assets funded by either unrestricted or restricted PSIA would be excluded from the calculation of the denominator of the capital ratio

43. I slamic F inancial S ervices B oard 43 Capital adequacy requirement relating to assets financed by PSIA (3) Treatment of equity of investment accounts  Standard formula  100% of credit & market risk of risk-weighted assets financed by IAH is borne by IAH  100% of operational risk of managing these assets is borne by IIFS  Supervisory discretion formula  Some proportion α (decided by supervisor) of credit & market risk of risk- weighted assets financed by IAH is deemed to be borne by IIFS (displaced commercial risk)  100% of operational risk of managing these assets is borne by IIFS

44. I slamic F inancial S ervices B oard 44 Risk-weighted assets that is subject to CAR in Standard Formula RWA of PSIA (CR + MR)

45. I slamic F inancial S ervices B oard 45 CAR Standard Formula Standard Formula ELIGIBLE CAPITAL LESS FUNDED BY PSIA: RWA (CR + MR) TOTAL: RWA (CR + MR) + ORW Example: EL = 8, CRWA = 40, MRWA = 40, ORW = 20 and assets funded by PSIA is 70% of total on- and off- balance sheets 8 / [100 – 56] = 8 / 44 = 18.2% Capital amount of PSIA is not guaranteed by the IIFS and any losses arising from investments or assets financed by PSIA are to be borne by the IAH, unless losses are due to the IIFS’s negligence, misconduct or breach of investment mandate.

46. I slamic F inancial S ervices B oard 46 Capital adequacy requirement relating to assets financed by PSIA (4)  In practice, the IIFS (a) may forgo its rights to some or all of its Mu ḍ ārib share of profits in order to offer its IAH a more competitive rate of return on their funds, or (b) may be treated as constructively obliged to do so by the supervisory authority as a measure of investor protection and in order to mitigate potential systemic risk resulting from massive withdrawals of funds by dissatisfied IAH

47. I slamic F inancial S ervices B oard 47 Total RWARWA funded by PSIA (CR+MR) RWA funded by unrestricted PSIA (CR+MR) RWA of PER and IRR of unrestricted PSIA (CR+MR) (1- α) RWA funded by unrestricted PSIA (CR+MR) RWA funded by restricted PSIA (CR+MR) RWA funded by non-PSIA (CR+MR+OR) Risk-weighted assets that is subject to CAR in Supervisory Discretion Formula α RWA funded by PER and IRR of unrestricted PSIA (CR+MR) α RWA funded by unrestricted PSIA (CR+MR)- excl PER and IRR

48. I slamic F inancial S ervices B oard 48 CAR Supervisory Discretion Formula Supervisory Discretion Formula Applicable in jurisdiction where supervisory authority considers the IIFS is obligatory to smooth income for IAH as part of a mechanism to minimise withdrawal risk and is concerned with systemic risk. ELIGIBLE CAPITAL TOTAL RWA (CR+MR+OR) less RWA funded by restricted PSIA (CR+MR) less (1-  ) RWA funded by unrestricted PSIA (CR+MR) less  RWA funded by PER and IRR (CR+MR) Restricted PSIA (20%) Unrestricted PSIA (50%) All other funds (30%) Total (100%) CRWA8201240 MRWA8201240 ORWA0020 Total164044100 Assume eligible capital = 8,  = 30% and PER and IRR = 10% of unrestricted PSIA

49. I slamic F inancial S ervices B oard 49 ELIGIBLE CAPITAL TOTAL RWA (CR+MR+OR) less RWA funded by restricted PSIA (CR+MR) less (1-  ) RWA funded by unrestricted PSIA (CR+MR) less  RWA funded by PER and IRR (CR+MR) Restricted PSIA (20%) Unrestricted PSIA (50%) All other funds (30%) Total CRWA8201240 MRWA8201240 ORWA0020 Total164044100 8 40+40+20 less (8+8) less (1-30%) (20+20) less 30% (2+2) = 14.60% CAR Supervisory Discretion Formula Cont’d

50. I slamic F inancial S ervices B oard 50 Standard formula Supervisory discretion formula Basel formula Capital adequacy ratio18.2%14.6%8% Comparison of using different formula

51. I slamic F inancial S ervices B oard 51 Challenges in the Implementation

52. I slamic F inancial S ervices B oard 52 Challenges in implementing these standards (1)  In general, both national authorities and IIFS may face some of the following challenges in implementing these standards. On the other hand, the IFSB is not empowered to enforce its proposed standards and guidelines. Therefore, the IFSB relies solely on the voluntary adoption of standards by its members and IIFS i.e. the quality of standards is crucial  The obligation on national authorities to ensure that they have sufficient infrastructures, skills and domestic guidelines in order to effectively supervise IIFS operations. The prerequisites to implement these standards imply sound understanding by supervisors and regulators of the risks involved in Shari’a compliant transactions and how such risks are managed.  Absence of adequate risk-mitigating tools and infrastructure for IIFS or even risk management culture among IIFS. As such, the whole process of assessment and measurement of risks will continue to evolve for quite some time.

53. I slamic F inancial S ervices B oard 53 Challenges in implementing these standards (2)  Assurance that the implementation of these standards will not put IIFS at a competitive disadvantage in particular in terms of huge cost implications, lengthy product development process etc. IIFS should keep in mind that implementing these standards will help them having a better understanding of their risk appetite in sourcing their funds and in pricing new businesses in order to determine risk profiles of their fund providers.  Although enhanced disclosure of information is generally perceived as beneficial by the public, its benefit to IAH, given their level of understanding of their rights and obligations, has yet to be proven.

54. I slamic F inancial S ervices B oard 54 Thank you for your attention