Chapter 22

Transparency and Market Discipline: Post–Basel Pillar 3

Daud Abdullah (David Vicary)

1. INTRODUCTION

In the wake of the financial crisis that started in 2007, there have been significant developments in the global financial services industry. In particular, the world economies were hit by a major global financial crisis, by most accounts the worst since the Great Depression, which was triggered by the subprime crisis in the United States. According to the Federal Deposit Insurance Corporation (FDIC), the regulator for the banking industry in the United States, prior to the financial crisis, from 2000 to 2007, a total of 27 banks had failed. Since then, however, a further 412 banks had folded between 2008 and November 2011—a staggering 15-fold increase! The root causes of these failures have been well documented by The Financial Crisis Inquiry Report1 released in January 2011, which, while beyond the scope of the present chapter, is essential reading in order to be able to see the fuller picture.

How did the Islamic financial services industry perform during the financial crisis? Recent studies seem to suggest that, under specific conditions, Islamic banks performed better than their conventional counterparts during and post–financial crisis.2 To date, at least three Islamic banks across the globe have failed. Ihlas Finans House of Turkey was shut down in 2001 due to issues relating to liquidity; Albaraka International Bank in the United Kingdom was closed in 1993 in the aftermath of the Bank of Credit and Commerce International (BBCI) and ING Baring banking collapses (as well as for other regulatory reasons); and Bank Al Taqwa was shut down in 2001 by the Bahamas authorities, also for regulatory reasons. The closures of all of these banks were independent of the recent financial crisis.

In the wake of the crisis, financial regulators and authorities across the globe have struggled either to tighten existing laws or to enact new ones governing financial institutions, with some taking remedial action more quickly than others. All of these efforts were made with the objectives of enhancing transparency and promoting greater market discipline towards providing a sound and stable financial services industry. The markets need certainty, and the consumers need to feel confident about the markets.

The author is of the opinion that good standards of transparency and market discipline are closely interlinked with good standards of corporate governance. As most of you will be aware, there are many areas of similarity, with regard to corporate governance, between conventional and Islamic financial institutions. You will also be aware that there are some specific corporate governance issues that pertain only to Islamic banks. I do not intend to revisit the subject of corporate governance in any great detail during this chapter, merely to stress the importance of building a firm base of governance in order to help achieve good levels of transparency and market discipline.

It would be as well, in the context of this chapter, to give some insight as to the guiding principles of market discipline applicable to financial institutions in general. Probably there is no better source than members of the Basel Committee themselves, who opine, with respect to conventional banking, that:

The purpose of Pillar 3—Market discipline is to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). The Committee aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. The Committee believes that such exposures have particular relevance under the Framework, where reliance on internal methodologies gives banks more discretion in assessing capital requirements.

In principle, banks’ disclosures should be consistent with how senior management and the board of directors assesses and manages the risks of the bank. Under Pillar 1, banks use specified approaches/methodologies for measuring the various risks they face and the resulting capital requirements. The Committee believes that providing disclosures that are based on this common framework is an effective means of informing the market about a bank’s exposure to those risks and provides a consistent and understandable disclosure framework that enhances comparability.3

In a nutshell, then, the purpose of Pillar 3 is to focus on two key areas: first, to reinforce market discipline through enhanced disclosure, which includes the capital adequacy calculations; and second, to instil market discipline to reinforce minimum capital requirements, to impose incentives for banks to behave prudently, and to promote safety and soundness in banks and financial systems. These principles have been reiterated for application to Islamic banks by the Islamic Financial Services Board’s Guidance on Disclosures to Promote Transparency and Market Discipline for Institutions Offering Islamic Financial Services (December 2007)—see Section 3. Under no circumstances should Pillar 3 be seen as a way to get the market to do the supervisor’s job or, indeed, to get the market to police the supervisors. Let me leave that thought with you there, and I shall return to it later in this chapter.

Section 1 has provided a quick introduction, briefly covering the principles underlying transparency and market discipline as documented in Pillar 3. The rest of this chapter proceeds as follows: Section 2 discusses the compliance status of Pillar 3; Section 3 has been expanded with the inclusion of the role of the Islamic Financial Services Board (IFSB) in view of the significant contributions it has made towards the achievement of a sound and stable Islamic financial services industry; Section 4 provides the conclusion.

2. COMPLIANCE WITH PILLAR 3

What, then, is required of banks to comply with the requirements of Pillar 3? The requirements may be summarised under the following headings in this section:

  • Level of Disclosure
  • Frequency of Disclosure
  • Disclosure Templates
  • Basic Principle of Disclosure

2.1 Level of Disclosure

With regard to the level of disclosure, it is mandatory for all banks to disclose at the standard or basic level. Additional mandatory disclosures will be required for those banks taking advanced approaches.

2.2 Frequency of Disclosure

Disclosure should be made every six months via sources that are set by the respective national supervisors. Qualitative disclosures should be made annually. In situations where information on risk exposure is prone to rapid change, disclosure should be made on a quarterly basis. All information provided is subject to verification.

2.3 Disclosure Templates

Templates have been suggested as a means to ensure comparability between banks.

2.4 Basic Principle of Disclosure

Disclosure should be consistent with how senior management and the board of directors assess and manage risks.

Thirteen tables are prescribed in Pillar 3 relating to market discipline and the respective aspects of qualitative and quantitative exposures for each table:

1. Scope of application: Gives details on the qualitative and quantitative disclosures required. This allows the market to assess how Basel II applies to a banking group and how the various entities within the group are treated for capital adequacy purposes.
2. Capital structure: Summary information on the terms and conditions of the main features of all capital instruments. Disclosure about the amount, components, and features of capital provides market participants with important information about a bank’s ability to absorb financial losses. Information on the terms and conditions of capital instruments provides additional background on the loss-absorbing capacity of capital instruments and provides a context for the analysis of the capital adequacy of the bank.
3. Capital adequacy: A summary discussion of the bank’s approach to assessing the adequacy of its capital to support current and future activities. Capital requirements for credit risk, equity exposures in the internal ratings-based (IRB) approach, market risk, operational risk, and the total and Tier 1 capital ratio. To provide market participants with a link between the disclosure of capital and risk exposure and assessment, it is important that a bank publishes information about its capital adequacy based on Basel II. Under Pillar 2 it is recommended that all banks have an internal process for assessing their capital adequacy and for setting appropriate levels of capital. This process should be objective and overseen by senior management, and all banks should be able to demonstrate that the results of their internal processes are credible and reliable. Information provided about a bank’s capital allocation process assists market participants in gaining a better understanding of the risks and rewards inherent in the bank’s activities.
4. Credit risk: General disclosures for all banks from both a qualitative and quantitative perspective. This section sets out general credit risk exposures for all banks, regardless of which regulatory capital assessment technique they use. The aim is to give an overview of the size and nature of the bank’s credit risk exposure and to provide the context for information on how a bank assesses and manages that risk.
5. Credit risk: Disclosures for portfolios subject to the standardised approach and supervisory risk weights in the IRB approaches. This allows the market to assess asset quality by providing a breakdown of the bank’s exposures in the standardised framework. Furthermore, this provides market participants with a sense of the suitability of the standardised approach for the particular institution (that is, that the resulting weights for capital purposes properly reflect the exposure of the underlying asset) and provides a basis for comparative analysis of banks.
6. Credit risk: Disclosures for portfolios subject to IRB approaches. This disclosure regime is intended to enable market participants to assess the credit risk exposure of IRB banks and the overall application and suitability of the IRB framework, without revealing proprietary information or duplicating the role of the supervisor in validating the detail of the IRB framework in place.
7. Credit risk mitigation: Disclosures for standardised and IRB approaches. Basel II recognises an enlarged range of credit risk mitigation techniques for regulatory capital purposes. The disclosure regime is intended to allow market participants to assess the types of mitigation employed and their impact on risk and regulatory capital levels.
8. Securitisation: Disclosure for standardised and IRB approaches. In order to gain preferential capital treatment with respect to asset securitisation, a bank must disclose information about the size, type, and features of securitisations to allow market participants to assess the resulting impact on the bank’s risk profile.
9. Market risk: Disclosures for banks using the standardised approach. The disclosure regime for the standardised approach is based on the capital charge as a proxy for the risk indicator, allowing a comparison between different types of risks and between different institutions.
10. Market risk: Disclosures for banks using the internal models approach (IMA) for trading portfolios. The disclosure regime for the IMA is based on the value-at-risk (VaR) concept, the common metric in internal market risk models. Market participants can judge the exposure to market risk and verify the results of the model, in broad terms, compared to the actual outcomes. The qualitative disclosure of portfolios covered by the IMA allows market participants to evaluate the sophistication of the bank’s risk measurement and management based on the qualifying criteria for the IMA.
11. Operational risk: This is an important feature of Basel II. The metric to assess exposure, across all capital calculation types, is the capital charge itself. The disclosure of the regulatory capital approach that a bank qualifies for—basic indicator, standardised, or advanced measurement approach—provides useful information to market participants about the quality of risk identification, measurement, monitoring, and control as incremental standards apply to each of the three capital assessment techniques.
12. Equities: Disclosures for banking book positions. Note that for Islamic banks, equity positions in the banking book include assets resulting from financings made by the bank based on musharakah or mudarabah contracts.
13. Interest rate risk in the banking book (IRRBB): Interest rate risk in the banking book does not attract a minimum regulatory capital charge in Pillar 1, but is rather dealt with under Pillar 2—the supervisory review process. This places considerable importance on the disclosure of comparable information by banks to allow market participants to assess the current and potential level of interest rate risk in the banking book, the means by which the bank identifies, measures, monitors, and controls the risk, and the results of this process. For Islamic banks, there is no IRRBB as such, but there is rate of return risk which is a major factor in displaced commercial risk. Rate of return risk, insofar as it contributes to displaced commercial risk, is therefore dealt with under the Islamic Financial Services Board’s (IFSB’s) Capital Adequacy Standard (Pillar 1).

In addition to the above, the Basel Committee’s more recent pronouncements place some emphasis on liquidity risk. The International Accounting Standards Board’s IFRS 7, Financial Instruments: Disclosure also sets out some disclosure requirements regarding liquidity risk, as does the IFSB’s Guidance on Disclosures to Promote Transparency and Market Discipline for Institutions Offering Islamic Financial Services.

While there may be a need to change some of the details in Pillar 3 to adapt to the requirements of Islamic banks, the general direction and relevance of these essential elements of market discipline cannot be denied. They will therefore be generally applicable to the world of Islamic finance. However, like everything else, there are potential benefits and drawbacks to their implementation. In particular, I would draw your attention to the need for a sense of balance between the regulators and the market. Section 3 discusses the Guidance (or Standard) issued by the IFSB pertaining to transparency and market discipline for Institutions Offering Islamic Financial Services (IIFS).

3. TRANSPARENCY AND MARKET DISCIPLINE: SPECIFICITIES OF ISLAMIC FINANCE

This chapter focuses on transparency and market discipline, in tandem with Basel Pillar 3. In particular, this chapter relies heavily on IFSB-4: Disclosures to Promote Transparency and Market Discipline for Institutions Offering Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds).4

The Standard is designed to specify principles to be followed by IIFS as well as the regulatory agencies in achieving transparency and promoting market discipline. The IFSB Standard has been developed for various types of stakeholders of the IIFS and complemented by the observance of the international standards and best practices. Exhibit 22.1, for example, summarises the similarities between the Basel Pillar 3 Transparency and Market Discipline and that of the IFSB’s Standard.

EXHIBIT 22.1 The IFSB and Basel Pillar III Standards

Source: IFSB, IDB, and IRTI. 2010. Islamic Finance and Global Financial Stability, 60.

image

The essence of the Standard is the importance of disclosure in promoting market discipline, as well as providing investor protection and creating investor confidence. Thus, to achieve this mandate, the Standard is applicable to both the IIFS and the Islamic window operations offered by conventional banks involved in managing funds in the form of restricted investment accounts. The Standard draws upon the specific features of the IIFS that are absent or not captured in the existing guidelines and principles relating to bank transparency and bank governance issued by the Basel Committee on Banking Supervision, and disclosure standards (Pillar 3) contained in the new Basel Capital Accord. The Standard also builds on the standards for Collective Investment Schemes (CIS) and on international accounting and auditing standards.

One of the challenges of implementing this Standard is the nonbinding nature of all the IFSB’s Standards, Technical Notes, and Guidance Notes in various jurisdictions. (The same applies, in principle, to the pronouncements of the Basel Committee and other international standard-setting bodies that rely on national regulators for enforcement.) Thus, the effectiveness of the implementation of these Standards may vary from country to country. However, this particular Standard is not in conflict with the existing international accounting standards and other relevant national standards.

The objectives of the Standard are:5

  • To enable market participants to complement and support, through their actions in the market, the implementation of the Islamic Financial Services Board’s capital adequacy, risk management, supervisory, and corporate governance standards; and
  • To facilitate access to relevant, reliable, and timely information by market participants generally, and by investment account holders (IAH) in particular, thereby enhancing their monitoring capacity.

To achieve transparency and market discipline, the financial market needs a well-functioning infrastructure, as illustrated in Exhibit 22.2.

EXHIBIT 22.2 The Infrastructure for an Effective Transparency and Disclosure Regime for IIFS6

image

3.1 The Islamic Financial Services Board’s Disclosures in Achieving Transparency and Creating Market Discipline

The IFSB Standard on Transparency and Market Discipline can be divided into five broad categories, and for each of these categories there could be Qualitative and/or Quantitative Disclosures. The categories are:

Financial and Risk Disclosure Principles

IIFS must establish internal disclosure policies with regard to the nature of disclosures it will make and the internal controls over the disclosure process. This process must identify the appropriateness and the frequency of the disclosures. The Standard provides guidelines on “comply and explain” basis on the following items:

a. Corporate information. An IIFS must provide the summary of the corporate information, indicating whether it is a stand-alone IIFS or an Islamic window, and the bases of consolidation for financial reporting and for regulatory purposes.
b. Capital structure, including equity of unrestricted IAH. The Standard recommends for the IIFS to disclose total and Tier 1 capital by the top consolidated entity, equity of unrestricted IAH, and the related prudential reserves of the IAH. Items recommended to be disclosed include: the amount of Tier 1 capital, the total amount of Tier 2 and Tier 3 capital, total eligible capital, the amount of unrestricted IAH funds, and profit equalisation reserve (PER) and investment risk reserve (IRR).
c. Capital Adequacy. It is very important to note that there exist clear distinctions between the IIFS and conventional banks in determining the capital adequacy requirements:
i. The financing arrangements, under the IIFS, are either asset based or profit- and loss-sharing (musharakah) contract, or profit-sharing or loss-bearing (mudarabah) contract.
ii. The funding for the IIFS that is raised through unrestricted investment accounts is in a form of equity. Thus, the underlying assets involved under the Shari’ah-compliant financing contracts may be exposed to market (price) risk, as well as to credit risk in respect of the amount due from the counterparty.

Disclosures for IAH

An IIFS obtains funds from the IAH under the profit-sharing and loss-bearing mudarabah contract. It is recommended for the IIFS to disclose specific policies, procedures, product design/type, profit allocation basis, and differences between restricted and unrestricted IAH.

The profit-sharing investment accounts (PSIA) are very similar to the collective investment schemes (CIS), thus the available international standards, guidelines and discussions on risk disclosures by the CIS, and on the role of investor education in the effective regulation of the CIS and CIS operators, can be replicated in designing policies for the IIFS.

The disclosures are recommended by the IFSB Standard to be made as part of the periodic external financial reporting process (marked “F”) or as part of product information published in connection with new products or changes in existing products (marked “P”). The disclosures can be classified by the following:

a. Disclosures applicable to investment accounts (both unrestricted and restricted IAH).
b. Disclosures specific to unrestricted investment accounts.
c. Disclosures specific to restricted investment accounts.

Retail Investor-Oriented Disclosures for IAH

The IIFS is recommended to publish a simplified and uncomplicated financial/annual report for the retail investors. While some of these disclosures might require great detail, they must be presented in nontechnical language. Items proposed by the Standard to be included in the risk-return characteristics of products, such as the restricted and unrestricted PSIA, are:

a. For the unrestricted PSIA, the extent to which the IIFS is committed by its policies to maintaining the IAH’s investors’ capital intact and to paying a competitive rate of return by accepting displaced commercial risk (DCR).
b. The management fees as a percentage of the total investment profit.
c. IAH’s right to withdraw funds during the term of the mudarabah contract.
d. The extent of management’s right to appropriate the IAH’s share of investment profits in order to build up PER and/or IRR.
e. Investment and asset allocation policies for IAH funds.
f. For the unrestricted IAH, the extent of any sharing of profits from the IIFS’ provision of fee-based banking.
g. The availability of personal banking and investment advisory and financial planning services for the benefit of the IAHs.
h. Complaints procedures available to dissatisfied IAHs.

Risk Management, Risk Exposures, and Risk Mitigation

The purpose of this disclosure is to ascertain the nature of risk to which the IIFS is exposed and the techniques it uses to identify, measure, monitor, and control those risks.

The Standard provides several key financing risks as well as specific risks faced by the IIFS. It is recommended that for each area of risk, the IIFS describes: the risk management objectives, policies, and practices; the structure and organisation of the relevant risk reporting and measurement systems; the measures and indicators of risk exposures; policies for hedging and/or mitigating risk; strategies and processes for monitoring the continuing effectiveness of risk management tools; and techniques such as hedging and other risk mitigants.7

a. Credit risk. This refers to the exposure to the likelihood that the counterparty will fail to meet its obligations in accordance with agreed terms. This definition is applicable to the IIFS both in terms of managing the financing exposures of receivables such as murabahah, diminishing musharakah, and ijarah contracts, as well as to working capital financing such as salam, istisna’a, or mudarabah contracts. It also includes non-traded equity instruments such as mudarabah and musharakah contracts.
b. Credit risk mitigation. The IIFS is recommended to make disclosures on credit risk mitigation. These include, among others, the disclosure on the nature of the collateral used and other Shari’ah-compliant risk mitigation techniques.
c. Liquidity risk. This refers to the potential loss to the IIFS arising from its inability either to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses.8 The IIFS must provide a summary of liquidity risk management framework for current account, unrestricted investment accounts, and restricted investment accounts.
d. Market risk. This refers to the risk of losses in both on-balance sheet and off-balance sheet positions arising from movements in market prices—for instance, fluctuations in values in tradable and marketable instruments (including sukuk), in investments in lease assets, and in off-balance sheet individual portfolios (such as restricted investment accounts). The risk arises from the current and future volatility of market values of specific assets and of foreign exchange rates.9
e. Operational risk. This refers to the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events, including losses resulting from Shari’ah–non-compliance and the failure in fiduciary responsibilities of the IIFS towards different fund providers. Failure of these controls may affect the soundness of the IIFS’s operations and its reliability of reporting.10
f. Rate of return risk. This refers to the possible impact on the net income of the IIFS arising from the impact of changes in the market rates and relevant benchmark rates on the return on assets and on the returns payable on funding.11
g. Displaced commercial risk. It refers to the magnitude of risks that are transferred to shareholders in order to cushion the IAH from bearing some or all of the risks. The risks arising from assets managed on behalf of the IAH are effectively transferred to the IIFS’s own capital because the IIFS follows the practice of foregoing part or all of its share of profit as the mudarib12 on such funds, when it considers this necessary as a result of commercial pressure in order to increase the return that would otherwise be payable to the IAH.13
h. Contract-specific risk. Each type of Islamic financing asset is exposed to a varying mix of credit and market risks. Thus, the IIFS is recommended to disclose its policy on relative shares of various Shari’ah-compliant financing contracts and capital allocation for various types of Shari’ah-compliant financing contracts. The IIFS is to disclose total risk weighted assets (RWA) classified by type of Shari’ah-compliant financing contract.14

General Governance and Shari’ah Governance Disclosures

Other than for the purpose of establishing general and Shari’ah governance processes, structure, and function of such governance in an IIFS, the primary objective of the disclosures is to ensure transparency regarding the status of Shari’ah compliance.

a. General governance disclosure. The IIFS is recommended to disclose and explain any departure from complying with the applicable financial reporting standards; whether the IIFS complies in full with the IFSB’s Corporate Governance Standard, and to provide explanation on non-compliance; disclosure on consumer/investor education; and disclosure of social functions and charitable contributions of the IIFS, such as sadaqah, qard, and so forth.
b. Shari’ah governance disclosure. Primarily, the IIFS is recommended to provide a statement on the governance arrangement, systems and control mechanisms to ensure Shari’ah compliance and in accordance to the established national and international standards; disclosure of how Shari’ah noncompliant earnings and expenditure occur and the manner in which they are disposed of; disclosure on whether compliance with Shari’ah rulings is mandatory or not; disclosure of the nature, size, and number of violations of Shari’ah compliance during the year; disclosure of annual zakat contributions of the IIFS; and remuneration of the Shari’ah board members.

In strengthening the IIFS in the wake of the recent global financial crises, the IFSB and the Islamic Development Bank (IDB) published a joint report entitled Islamic Finance and Global Financial Stability in April 2010. The report identified the following eight building blocks to strengthen the infrastructure and framework of the Islamic financial services industry.15

1. The development of a set of comprehensive, cross-sectorial prudential standards and supervisory framework covering Islamic banking, takaful and the capital market, which takes into account the specificities of the IIFS.
2. The development of a liquidity management infrastructure.
3. Strengthening of the financial safety net mechanism—lender of last resort (LOLR) facilities and emergency financing mechanisms, as well as deposit insurance that is compatible with the Shari’ah principles.
4. The development of a reliable crisis management and resolution framework—which includes bank insolvency laws and the arrangements for dealing with nonperforming assets, asset recovery and bank restructuring, and recapitalisation.
5. The establishment of accounting, auditing, and disclosure standards for IIFS and their counterparties, supported by adequate governance arrangements.
6. The development of the macroprudential surveillance framework and financial stability analysis as an integral part of the strategy to strengthen the resilience of the Islamic financial system and to minimise the risks of financial fragility.
7. Strengthening rating processes for Islamic institutions or instruments by reexamining and improving the related core processes to encourage greater transparency on the risk involved.
8. Capacity building and talent development—the international Islamic supranational and developmental bodies need to consider more involvement in capacity building to promote global financial stability.

“Market discipline” refers to the use of the market as a means of governance, as a complement to regulation and supervision. The potential benefits and drawbacks of this approach are set out in Exhibit 22.3.

EXHIBIT 22.3 Potential Benefits and Drawbacks of Market Discipline in Islamic Banking

Potential Benefits Potential Drawbacks
  • It can provide Islamic financial institutions with the necessary incentive to properly address relevant corporate governance issues and behave responsibly.
  • Market reactions to early signs of distress in individual institutions provide impetus for the institution to rectify problems, hence preventing possible bank failures.
  • Lower risk premiums in the marketplace resulting from transparency of operations, which is a prerequisite for effective market discipline.
  • Potential time and cost savings for regulators.
  • There may be a conflict of interest between regulators and the market (issue of public versus private interest). For example, markets may react too strongly on institutions in a weakened position, resulting in unnecessary failures, which regulators would prefer to avoid in order to maintain the soundness and stability of the financial sector.
  • Loss of confidence in one bank may cause a “contagion” effect resulting in a systemic event occurring in the banking sector.

I would also like to reiterate some thoughts developed by Andrew Crocket, former Bank for International Settlements general manager, on the conditions necessary for effective market discipline (see Exhibit 22.4). These thoughts are equally applicable to the world of Islamic banking, which is in the context of market discipline, very similar to conventional practices. First, information: market participants must have sufficient information to reach informed judgments. Second, ability: market participants must have the ability to process information correctly. Third, incentive: market participants must have the right incentive to act upon information. Fourth, mechanism: market participants must have the right mechanism to exercise discipline. All four prerequisites will need to be developed in order to achieve effectiveness. However, the focus at this point in time should be on the first two conditions, without which we cannot move on to satisfy conditions three and four. Let me elaborate a little on the first two conditions.

EXHIBIT 22.4 Developing Market Discipline in Islamic Finance

image
1. Market participants need to have sufficient information to reach informed judgments:
a. There is a pressing need to develop the informational infrastructure of the industry in order to promote transparency to enhance the understanding of the operations of Islamic financial institutions.
b. Transparency facilitates decision making and hence improves the allocation of resources, as it enables us to better understand the intrinsic value of a financial institution.
2. Market participants need to possess the ability to process the information correctly:
a. There is a need to grow the Islamic finance industry, as critical mass is necessary to attract capable market participants, such as analysts, brokers, ratings agencies, and institutional investors, with the ability to process correctly the information provided by the Islamic financial institutions. At this point in time, very few Islamic banks are rated. It is to be hoped that as the market gains critical mass, the value of obtaining an independent rating will also grow.
b. Thus it may, therefore, be easier to develop market discipline in countries with significant Islamic banking market penetration. The global share of Shari’ah compliant assets is as follows: Iran (35.71 percent), Saudi Arabia (13.89 percent), Kuwait (7.33 percent), Qatar (4.82 percent), Malaysia (12.28 percent), Bahrain (6 percent), and the United Arab Emirates (8.66 percent). About 40 percent of the total Shari’ah compliant assets reside in the GCC countries.16

Earlier in this chapter I indicated that I would return to discuss further the purpose of Pillar 3. You will recall that I highlighted that the purpose was not to get the market to do the supervisors’ job and not to get the market to police the supervisors. At this juncture I should like to introduce the concept of a “virtuous cycle of transparency.” This is a cycle that embraces all aspects of regulation, disclosure, transparency, corporate governance, market discipline, and the growth of the Islamic banking industry. Exhibit 22.5 illustrates the cycle.

EXHIBIT 22.5 Transparency: A Virtuous Cycle

image

Let me first examine the role of regulators in this context (see Exhibit 22.6). Initially, standards need to be set. Here we already have Pillar 3 developed by the IFSB. The standards will need to be adopted by the local regulators on a country-by-country basis (central bank or equivalent). In this role of standard setting, the regulator(s) set the wheels of market discipline in motion by developing coherent regulatory disclosure requirements which the markets should find useful, both on a national and international basis. Enforcement would most likely come at the country level, whereby the central bank would enforce regulations by monitoring the implementation and compliance of Islamic financial institutions to the disclosure requirements. The regulator also needs to demonstrate vigilance; in particular, there is a need to be vigilant about negative signals sent by the market, as this may be an early warning of distress in individual institutions. Timely involvement by regulators may help to prevent or minimise the occurrence of bank failures.

EXHIBIT 22.6 The Role of Regulators

image

Let me now examine what constitutes good information disclosure and lends itself to enhancing transparency in the marketplace. The board of directors and senior management of Islamic financial institutions must be committed to providing good information disclosure, both quantitative and qualitative, which meets the criteria of useful, accurate, complete, and credible.

Under the category useful, the information required depends on what the market discipline is aiming to achieve. For example, if the objective were to demonstrate to the market that the bank is performing satisfactorily with adequate profitability, then financial statements and comparative analysis would be useful information. If the objective is to demonstrate good risk management, then information on how the bank is managing its risk exposures is pertinent. If the objective were to demonstrate Shari’ah compliance, then Shari’ah certification in the annual report and accounts as well as a description of the Shari’ah review programme would be of great assistance. If the objective were to demonstrate a resolution of the conflict regarding investment account holders (IAHs) resulting from the dual fiduciary role of the bank, then information pertaining to both the asset allocation and profit allocation of the bank would be extremely useful.

Under the catergories accurate, complete, and credible, it is necessary that the information is all of the foregoing so that the market may be confident in using the information. This may be achieved by means of using external parties—for example, auditors, and ratings agencies—to verify the information provided. In addition, the information should be material, be provided on a timely basis, and be easily available to the public. Here the use of the Internet, by using the bank’s website, is of great importance. Furthermore, the provision of the information should not be unreasonably burdensome to the bank, especially the smaller ones. Finally, the information disclosed should not be, as far as possible, proprietary, which would endanger the competitive position of the bank. In this respect, adequate generic information should suffice (see Exhibit 22.7).

EXHIBIT 22.7 Criteria for Good Information Disclosure

image

Let us now take a look at the role of the market participants in this “virtuous cycle of transparency” (see Exhibit 22.8). Here I see two main roles. First, there is the role of disciplining institutions, where each market develops a reputation for rewarding and punishing institutions based on information disclosed to provide an incentive for good behaviour. Reward good institutions by giving them good ratings and placing funds with them, and punish deviant institutions by doing exactly the opposite.17

EXHIBIT 22.8 The Role of Market Participants

image

Second, there is the role of soliciting information, whereby the market relays the information needs to the financial institutions. Over time, as market discipline develops, the potential for voluntary information disclosure, based on market demand, also increases.

4. CONCLUDING REMARKS

The Islamic finance industry has already demonstrated that it has the products and infrastructure to compete with conventional financial institutions. Annual growth rates are significant; in many markets, they are far outstripping the growth of conventional banking. However, further growth may be hampered if standard setters and regulators do not grasp the opportunity to move the industry forward by working together in implementing a strong and practical corporate governance framework, incorporating elements of global best practices.18

To date, the overall performance of the IIFS during and post financial crises, namely the Asian Financial Crisis of 1997–1998 as well as the subprime and global financial crises, is encouraging. As noted by the Governor of the Central Bank of Malaysia, Tan Sri Dr. Zeti Aktar Aziz, “the global financial crisis has had limited direct effects on Islamic finance. While Islamic finance by its very nature only engages in transactions that have underlying tangible productive activities, the slower overall growth and the increased uncertainties have affected pricing and activity in certain market segments. However, this in part reflects the shift in activity from the financial markets to the Islamic financial institutions.”19

As discussed previously, a good corporate governance framework will promote transparency via information disclosure by institutions that must be credible. This will help to inspire confidence in the marketplace, promote market discipline within the industry, and ultimately serve as a catalyst to grow the industry and take it to the next level. Long journeys start with small steps, and we do not have a moment to lose!

NOTES

1. Released by the U.S. Financial Crisis Inquiry Commission on 27 January 2011.

2. See for examples, Parashar, S.P., and J. Venkatesh (2010). “How Did Islamic Banks Do During Global Financial Crisis?” Banks and Bank Systems 5(4), pp. 54–62; and Hasan, M., and J. Dridi (2010). The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study. IMF Working Paper no. WP/10/201.

2. Bank for International Settlements (June 2006). Basel Committee on Banking Supervision. Part 4: The Third Pillar – Market Discipline, in International Convergence of Capital Measurement and Capital Standards, p. 226.

4. The IFSB-4, www.ifsb.org/standard/ifsb4.pdf.

5. IFSB-4, Disclosures to Promote Transparency and Market Discipline for Institutions Offering Islamic Financial Services (Excluding Islamic Insurance (Takāful) Institutions and Islamic Mutual Funds), 2007, 1.

6. Ibid., 30–34.

7. Ibid., 16.

8. IFSB-1, Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering Only Islamic Financial Services (IIFS). December 2005, 6, www.ifsb.org/standard/ifsb1.pdf.

9. Ibid., 19.

10. Ibid., 25.

11. Ibid., 23.

12. In a mudarabah contract, the mudarib is the entrepreneurial partner who uses the capital belonging to the rabbul-mal as the capital provider.

13. IFSB-2, Capital Adequacy Standard for Institutions (other than Insurance Institutions) Offering only Islamic Financial Services. December 2005, 19, www.ifsb.org/standard/ifsb2.pdf.

14. IFSB-4, 26.

15. See Islamic Finance and Global Financial Stability, 41–48.

16. The Banker, Top 500 Islamic Financial Institutions 2011 (www.thebanker.com/Reports/Special-Reports/Top-500-Islamic-Financial-Institutions-2011), and author’s own estimate.

17. It should be noted that IAH would have a very limited role in disciplining Islamic banks (see Archer, S. and R.A.A. Karim, “Corporate Governance, Market Discipline and Regulation of Islamic Banks,” The Company Lawyer 27, no. 5 (2006), 134–145.

18. The IFSB has already started this process by issuing its various standards, guiding principles etc.

19. Governor’s Keynote Address at State Street Islamic Finance Congress 2008, Boston USA—“Islamic Finance: A Global Growth Opportunity Amidst a Challenging Environment.” Boston, October 6, 2008, www.bnm.gov.my/index.php?ch=9&pg=15&ac=285.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
3.138.117.75