Islamic Financial Services Board
Transparency and Market Discipline –
A Direct Comparison to Basel II
Disclosures to Promote Transparency and Market Discipline
(TMD) For Institutions Offering Islamic Financial Services
(IIFS) (Excluding Islamic Insurance (Takaful) Institutions
and Islamic Mutual funds)
Presented by Dr. V.Sundararajan
Centennial group
.
2nd Islamic Financial Services Forum: The
European Challenge
Dec 5 & 6, 2007
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Islamic Financial Services Board
Outline
ƒ Definition & aspects of Transparency & Market
Discipline
ƒ Basel II - Pillar 3 Disclosure Categories
ƒ What is common among them?
ƒ IFSB Standard approach for IIFS Disclosures
to promote Transparency
ƒ Summary and conclusion
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What is Transparency?
• Generally, transparency refers to accountability
as well as the legal and accounting
infrastructure for economic decisions
• From operational perspective of a supervisory
authority, transparency is characterised by an
environment in which the information disclosed
is;
• Comprehensive, Material, Reliable, Comparable,
Relevant & Timely, and Accessible to all
stakeholders and to the market at large (IFSB’ TMD 2006)
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Market Discipline
• Market Discipline refers to those environmental
features which provide incentives for financial
institutions including IIFS to limit excessive risktaking and to pursue good governance;
• In response to the disclosure of material information,
there are prompt adjustments in either prices or
quantities of financial positions in the institutions/IIFS
• Requires a set of mechanisms through which markets
can penalize the excessive risk-taking or inadequate
transparency
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The Basel II Pillars of a
Sound banking system
Pillar
1
Minimum
Capital
Requirement
Pillar
2
Pillar
3
Effective
Supervision
Transparency
and
disclosures
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Pillar 3 –
Market Discipline
provides Specific Templates
on level of consolidation
,capital, risk exposure,
risk assessment process,
asset securitization &
capital adequacy to
complement Pillar 1 & 2
12/6/2007
6
How does IFSB fill the gap in TMD?
IFSB TMD
Enables market participant to complement & support the
implementation of IFSB’s Capital Adequacy, Risk Management,
Supervisory Review, and Corporate Governance Standards.
Facilitates access to relevant, reliable, and timely information by
market participants generally, & by IAH in particular thereby
enhancing their monitoring capacity.
IIFS disclosures can be seen as Pillar 3 plus IAH & other IIFS–
specific disclosures. TMD provides detailed guidance on the
disclosures (qualitative and quantitative) which are consistent
with International Standards without conflicting with them.
Transparency and Market Discipline – A Direct
Comparison to Basel II
IFSB- TMD
Basel II- Pillar III
Purposes –Pillar III
•
To complement the
minimum capital
requirements
(Pillar I) and the
supervisory review
process ( Pillar II)
Both aim at
strengthening
the market
environment
for bankingindustry and
complementing
their existing
standards
Purposes – IFSB TMD
•
•
To specify the key
principles and
practices for IIFS in
making disclosure to
achieve
transparency and
promote market
discipline
Need for
Transparency as a
Shari’ah
consideration
based on principles
of justice & fairness
Transparency and Market Discipline –
A Direct Comparison to Basel II
• What is common among them ?
• Both IFSB and Basel II aim at creating a banking-industry
market environment that induces banks to self-maintaining
capital adequacy and self-satisfying the supportive
supervisory requirements through the disclosure of relevant
information.
• To create a market discipline , relevant information is
determined by a materiality test and both use qualitative and
quantitative format for disclosure reporting
• The where, how, how often and the extent of coverage of
qualitative information of disclosure is left to the discretion of
management under the prevailing authority of supervisors.
• General considerations about TMD remain same with slight
change in scope of application. (See next slide)
( Supervisory authorities normally have the power and ability to enforce
the necessary disclosures)
Transparency and Market Discipline –
A Direct Comparison to Basel II
IFSB TMD
•
Basel II-Pillar III
Scope of Application
• Fully-fledged IIFS (other than
Takaful institutions & Islamic
mutual funds)
• Islamic funds managed by
IIFS in the form of restricted
investment accounts (that are
not offered as units or shares)
• Fully consolidated basis at the
holding company level within
group or subgroup of IIFS
• Islamic window operations of
conventional banks (with both
asset & funding facilities)
•
Scope of Application
• Top consolidated level of the
banking group to which this
framework applies.
• Disclosures related to
individual banks within the
groups would not generally be
required to fulfill the
disclosures requirements as
set out in the standard
What makes them different ? Let us see next slide
Shari'ah
governance
disclosures
Capital
adequacy
differs as UIAH as
source of funding,
requires specific
disclosure
Treatment of
IAH
and Retail Investor
Oriented
disclosures
TMD draws
on principles from
ISOCO-CIS,
AAOIFI,
IFRS
IFSB -TMD
as Pillar III
equivalent
Equity of
IAH
in Capital
Structure and
disclosures
Focus on
Additional risk
disclosure such as
DCR & Rate of
Return Risk
Introduces
Role of Islamic
Windows
disclosures
Islamic Financial Services Board
Necessary Conditions for Effective
Transparency
• Infrastructure for an effective disclosure regime
•
•
•
•
•
Accounting & auditing standards
Corporate governance framework for IIFS
External Credit Assessment Institutions (ECAI)
Investor education programme
Supporting environmental factors
• Availability of markets in which IIFS issue instruments
• Market microstructure for price discovery
• Legal & institutional arrangements for insolvency, investor
rights, investor protection & asset recovery etc.
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Disclosures relative to IAH
• Disclosures related to the rights to profits and
associated risks with simplified disclosure format
• Qualitative disclosures on products & product
design, redemption procedures, principles of
allocation of assets, investment policy and
commingling policy
• Disclosure of industry or IIFS-specific policies on
maintaining reserves (PER/IRR) to ‘manage’ payouts
to IAH
• Standard draws on CIS disclosure practices
endorsed by IOSCO and requires consistency of
disclosures with those of CIS
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Retail Oriented Disclosures for IAH
• Supervisors shall encourage simplified disclosures
• Non-technical presentation of risk-return
characteristics, management rights to appropriate
IAH’s share of investment, asset allocation policies
• Penalty in early withdrawal, management fees,
expenses & taxes, historical returns, complaints
procedure to dissatisfied IAH
• Availability of personal banking and investment
advisory for the benefits of IAH with degree of
independence in recommending products
• True, factual, and well-balanced statements, not
projections or estimates of future performance
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Investment Accounts
(Both Unrestricted and Restricted IAH)
General Qualitative Disclosures
F P
1. Written procedures and policies including:
• variety of investment products from IIFS;
• characteristics of investors;
• purchase, redemption and distribution procedures;
• experience of portfolio managers, investment advisors
and trustees;
• governance arrangements for the IAH funds; and
• strategy for trading and origination of assets
2. Investment and management of IAH funds
√
√
√
√
3. Product information and the manners
4. Bases of allocation of assets, expenses and profit in relation
to IAH funds
√
5. Policies governing the management of both unrestricted and
restricted IAH funds, which cover the management of the
investment portfolios, establishment of prudential reserves,
and the calculation, allocation and distribution of profits
√
√
Investment Accounts
(Both Unrestricted and Restricted IAH)
General Quantitative Disclosures
[1]
F
6. PER / PSIA*100 by type of IAH.
√
7. IRR / PSIA*100 by type of IAH.
√
8. ROA = NI[1] / TA[2]
√
9. ROE = NI[3] / SHE
√
10 Profit Dist / PSIA*100 by type of IAH
√
11. Financing to PSIA*100 by type of IAH.
√
Before distribution of profit to unrestricted IAH
[2] Assets financed by shareholders’ equity and minority interests,
Unrestricted IAH, and current accounts and other liabilities.
[3] After distribution of profit to IAH
P
√
Islamic Financial Services Board
Rate of Return Risk
• 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 ROA and
on the returns payable on funding
• This impact arises from the unrestricted IAH funds
being invested in fixed-return assets such as
Murabahah
• The greater the absorption of risks by IIFS (known as
DCR) , the greater the likely magnitude of the rate of
return risk
• An IIFS shall make disclosures , both qualitative and
quantitative , of factors that cause rate of return
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Displaced Commercial Risk (DCR)
• 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 (e.g.
credit and market risk) to which they are
contractually exposed in a Mudarabah contract
• Disclosure of aggregate Mudārabah profits, the
Mudarib share, IAH share and profit distributed to
IAH together with movements in PER & IRR
• The proportion of RWA funded by IAH that is
included in total RWA for capital adequacy
purposes, as approved by supervisor, and the
rationale. see DCR disclosure table
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Displaced Commercial Risk (cont’d)
• IIFS policy on DCR, including framework for
managing risk-return expectations of IAH &
shareholders;
• In order to minimize the adverse impact of income
smoothing for PSIA on shareholders’ returns
(DCR) and meet potential but unexpected losses
that would be borne by the IAH, the IIFS can set
up prudential reserves (PER and IRR)
• Policies on Profit Equalisation Reserves (PER)
and Investment Risk Reserve (IRR) used to
smooth or enhance periodic payouts to IAH and to
mitigate DCR – see following slides
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Displaced Commercial Risk (cont’d)
• Reserves:
• Profit equalization reserve (PER)
ƒ Is the amount appropriated out of gross income
of Murābahah income, before allocating the
Mudarib’s share, in order to smooth returns paid
to the IAH and the shareholders
• Investment risk reserve (IRR)
ƒ Is the amount appropriated out of IAH’s income
after deduction of the Mudarib’s share of
income in order to cover any future losses on
investments financed by PSIA (NB PER may not
be used to cover losses)
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Contract- Specific Risks
• Each type of Islamic Financing asset is exposed
to a varying mix of credit and market risks
because of the holding of assets as part of
Islamic financing. This mix varies according to
stage of contract.
• Hence, the need for monitoring the total
exposure in each type of financing asset and the
corresponding capital charge
• An IIFS shall make disclosures , both qualitative
and quantitative , of contract-specific risks
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General and Shari’ah
Governance Disclosures
• Disclosures of general and Shari’ah governance are
designed to provide information on the structure and
functioning of such governance in an IIFS
• Objective of these disclosures is to ensure
transparency regarding Shari’ah compliance by IIFS
• These disclosures are consistent with International
Standards such as Principles of Corporate Governance
by the OECD, Enhancing Corporate Governance for
Banking Organisations by the BCBS.
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General and Shari’ah Governance
Disclosures (cont’d)
• The IFSB’s Corporate Governance Standard deals
with four areas;
• General governance
• Rights of IAH
• Compliance with Islamic Shari’ah rules and
principles
• Transparency of financial reporting in respect of
investment accounts
• Some countries have national Shari’ah authority
that issues the fatawa, while in other countries,
each IIFS has a Shari’ah board which issues
fatawa
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Islamic Windows Disclosures
• Definition of window under this standard….
• As a part of conventional financial institution (may be branch
or dedicated unit ) that provides both fund management
(investment accounts) financing and investment that are
Shari'ah compliant.
• This standard applies to fully-fledged windows, i.e. with
Shari’ah compliant funds invested in Shari’ah compliant
assets, subject to materiality criteria
• Asset side only “windows" shall disclose risk management,
risk weightings, and their treatment in capital adequacy of
the institutions
• Shari’ah oversight arrangements of windows to be disclosed
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TMD implementation Issues and
Challenges
• Impact of guarantee schemes such as deposit
protection, risk absorption by shareholders with the
perception of principal protection with PER and
IRR, weaken incentives to monitor IIFS
• Market overreactions when IIFS in weakened
position , reaction through interbank linkages
• safety nets and liquidity facilities, emergency lending
• The cost involved in public disclosure
• Incremental cost of developing , implementing and
maintaining a system to generate required disclosure
• Accounting and auditing systems that safeguard
the accuracy of disclosure
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TMD implementation Issues and
Challenges (cont’d)
• A weak information environment and a situation of
system-wide risk exposures will limit the capacity to
identify relative performances of banks, and market
discipline cannot work
• Market discipline requires a broader policy response,
going beyond prudential controls on individual IIFS, to
foster a stronger information environment
• A stronger information environment provides incentives
for voluntary disclosures and use of ECAI and other
information intermediaries
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Summary & Conclusion
• IFSB TMD Standard complements BCBS Pillar 3 and
International Financial Reporting Standards by
• Plugging gaps in financial disclosure requirements with
respect to specificities of IIFS
• Adding requirements for ‘consumer friendly’ retailoriented disclosures re products and services on offer
• TMD Standard is concerned with disclosure but not
with accounting issues of the classification, recognition
and measurement of financial statement elements –
• Effectiveness requires adequate supervisory
transparency and macro transparency
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