RISK-BASED SUPERVISION IN INSTITUTIONS OFFERING
ISLAMIC FINANCIAL SERVICES (IIFS)
February 02-05, 2015
Kuwait City, Kuwait
L01: Core Principles for Islamic Financial Institutions
Presented by:
Jamshaid Anwar Chattha, CIFP
AGENDA
BCBS CORE PRINCIPLES – OVERVIEW AND APPROACH
IFSB CORE PRINCIPLES – OVERVIEW AND APPROACH
IFSB WORKING PAPER ON EVALUATION OF CORE PRINCIPLES
DISCUSSION ON ADDITIONAL PROPOSED CORE PRINCIPLES
CONCLUSION
2
BCBS’S CORE PRINCIPLES –
Strengthening the Banking Supervision
1997 Core Principles
• BCBS’ Core Principles for
Effective Supervision issued
for the first time in September
1997.
• Assessment Methodology was
issued in 1999.
• Considered de facto minimum
standards for the banking
system’s sound prudential
regulation and supervisory
practices
2006 Core Principles
2012 Core Principles
• In 2006, the BCBS revised its
original Core Principles along
with its assessment
methodology.
• The revision was undertaken in
relation to (i) the treatment of
Basel II.
• Significant changes to the
2006 Core Principles due to
Global Financial Crisis
(2007/2008).
• In December 2011, the BCBS
issued the revised Core
Principles and the
methodology for public
consultation. Accordingly, final
version of the “Core Principles
for Effective Banking
Supervision” was issued in
September 2012.
• In total there were 29 Core
Principles.
• In total there were 25 Core
Principles.
Note: Each Principle is supported by assessment criteria, divided between essential criteria (ECs) and additional criteria (ACs)
3
BCBS’S CORE PRINCIPLES –
Strengthening the Banking Supervision (2)
Comparison between the 2006 and 2012 Core Principles
Items
Core Principles 2006
Revised Core Principles 2012
Number of Core Principles
25 Core Principles
29 Core Principles
CP1: Responsibilities, objectives and
powers
Supervisory Powers,
Responsibilities and Functions
CP1: Objectives, independence,
powers, transparency and
cooperation
CP 2: Independence, accountability,
resourcing and legal protection for
supervisors
CP 3: Cooperation and collaboration
Not Available in 2006
Prudential Regulations and
Requirements
CP 22: Accounting and disclosure
CP 14: Corporate governance
CP 27: Financial reporting and external
audit
CP 28: Disclosure and transparency
Assessment methodology
Separate from the Core Principles
Impeded within the same document
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BCBS’S CORE PRINCIPLES –
Strengthening the Banking Supervision (3)
Basel Core Principles 2012
A. Supervisory powers, responsibilities and functions
CP 1
Responsibilities, objectives and powers
CP 2
Independence, accountability, resourcing and legal protection for supervisors
CP 3
Cooperation and collaboration
CP 4
Permissible activities
CP 5
Licensing criteria
CP 6
Transfer of significant ownership
CP 7
Major acquisitions
CP 8
Supervisory approach
CP 9
Supervisory techniques and tools
CP 10
Supervisory reporting
CP 11
Corrective and sanctioning powers of supervisors
CP 12
Consolidated supervision
CP 13
Home-host relationships
B. Prudential regulations and requirements
CP 14
Corporate governance
CP 15
Risk management process
CP 16
Capital adequacy
CP 17
Credit risk
CP 18
Problem assets, provisions and reserves
CP 19
Concentration risk and large exposure limits
CP 20
Transactions with related parties
CP 21
Country and transfer risks
CP 22
Market risks
CP 23
Interest rate risk in the banking book
CP 24
Liquidity risk
CP 25
Operational risk
CP 26
CP 27
CP 28
CP 29
Internal control and audit
Financial reporting and external audit
Disclosure and transparency
Abuse of financial services
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BCBS’S CORE PRINCIPLES –
Strengthening the Banking Supervision (4)
Assessment Methodology - BCPs Four-grade method
• Compliant – A country will be considered compliant with a Principle when all
essential criteria applicable for this country are met without any significant
deficiencies….
• Largely compliant – A country will be considered largely compliant with a
Principle whenever only minor shortcomings are observed that do not raise any
concerns about the authority’s ability and clear intent to achieve full compliance
with the Principle within a prescribed period of time….
• Materially non-compliant – A country will be considered materially noncompliant with a Principle whenever there are severe shortcomings, despite the
existence of formal rules, regulations and procedures, and there is evidence that
supervision has clearly not been effective…..
• Non-compliant – A country will be considered non-compliant with a Principle
whenever there has been no substantive implementation of the Principle, several
essential criteria are not complied with or supervision is manifestly ineffective..
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Balance Sheet of an Islamic Bank
Need for Core Principles
One Stop
Shopping
Bank
ASSETS
Cash & cash equivalents
Current accounts
Sales receivables
Other liabilities
Investment in securities
Equity of Profit Sharing
Investment Accounts
(PSIA)
Buying physical assets
before selling
Investment in leased assets
Direct equity investment
Investment in real estate
Equity investment in joint ventures
Leasing and trading in
real estate
Fund management
Investment in Sukuk
LIABILITIES
Profit Sharing Investment
Accounts (PSIA)
Equity investment in capital ventures
Inventories
Profit equalization reserve
Other assets
Investment risk reserve
Fixed assets
Owners’ Equity
Off-balance sheet assets
IFSB’S WORK ON CORE PRINCIPLES –
Strengthening the Islamic Banking Supervision
Note: The ED-17 is being finalised by the IFSB after the public consultation period, which ended on 05 January.
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OVERVIEW OF THE WORKING PAPER
Evaluation of Core Principles Relevant to Islamic Finance Regulation
BCBS’s Core Principles for Effective Banking Supervision
IAIS’s Core Principles
IOSCO’s Objectives & Principles of Securities Regulation
Core Principles for Deposit Insurance
Principles for Financial Market Infrastructures
Principles for the Supervision of Financial conglomerates
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IFSB CORE PRINCIPLES
Objectives
The main objective of the CPIFR is to provide a set of core principles for the regulation and
supervision of the IFSI, taking into consideration the specificities of the IIFS in the banking
segment, the lessons learned from the financial crisis, and complementing the existing
international standards, principally the BCBS’s Core Principles for Effective Banking
Supervision (the Basel Core Principles, abbreviated here to BCP).
In particular, the objectives of the CPIFR include:
1. Providing a minimum international standard for sound regulatory and supervisory
practices for the effective supervision of the IIFS;
2. Protecting consumers and other stakeholders by ensuring that the claim to Shari’ah
compliance made explicitly or implicitly by any IIFS is soundly based;
3. Safeguarding systemic stability by preserving the linkages between the financial
sector and the real economic sector which underlie Islamic finance; and
4. Ensuring that IIFS act in accordance with their fiduciary responsibilities in all their
operations, especially in regard to investment account holders (i.e. PSIA).
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IFSB CORE PRINCIPLES
General Approach of the CPIFR
The Draft Mentioned that:
Section
1:the
Introduction
 Many of
BCPs are equally applicable to both conventional and Islamic
banking (though the details of their application may differ).
 These BCPs have been incorporated into the CPIFR essentially unchanged, in
order to produce a single, complete, set of principles. Where this has been done,
the relevant BCP number is cited immediately after the CPIFR number.
 Several other BCPs have been modified to deal with the specificities of Islamic
finance, generally at the level of assessment criteria rather than the Principle itself.
 One, BCP 23, has been replaced (by CPIFR 26), and four further Principles have
been added. These deal comprehensively with certain topics of particular relevance to
Islamic finance.
 Where related topics are dealt with in different Principles, the relationship has
generally been indicated by a cross-reference rather than by repeating or
restating material.
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IFSB CORE PRINCIPLES
General Approach of the CPIFR
• Each 1:
CPIFR
is supported by assessment criteria. These are divided
Section
Introduction
between essential and additional criteria. For the purposes of
assessments, the essential criteria are the only elements on which to gauge
full compliance with a Core Principle.
• By and large, the compliance grading will be based on the essential
criteria; the assessor will comment on, but not grade, compliance with the
additional criteria unless the jurisdiction undergoing the assessment has
voluntarily chosen to be graded against the additional criteria too.
• The CPIFR are neutral with regard to different approaches to
supervision of IIFS, so long as the over-arching objectives are
achieved. They are not designed to cover all the needs and circumstances
of every banking system.
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IFSB CORE PRINCIPLES
SECTION 1: INTRODUCTION
Background – The Need for Core
Section
1: Introduction
Principles
Main Premises and Objectives
General Approach of the CPIFR
Scope and Application of the CPIFR
Implementation Date
Structure of the CPIFR
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SECTION 2: PRECONDITIONS FOR EFFECTIVE
SUPERVISION OF IIFS
The preconditions include:
Section 1: Introduction
• sound and sustainable macroeconomic policies;
• a well-established framework for financial stability policy
formulation;
• a well- developed public infrastructure;
• a clear framework for crisis management, recovery and resolution;
• an appropriate level of systemic protection (or public safety net);
and
• effective market discipline.
In principle, the broad preconditions are equally relevant for the IFSI; however, they need
to be properly adapted to provide a basis for effective supervision of Islamic financial
services institutions. Additional considerations, where appropriate, are added within the
preconditions.
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SECTION 3: ASSESSMENT METHODOLOGY
FOR CPIFR
Use of the methodology
Section
1: Introduction
Assessment
of compliance
Practical considerations in conducting an assessment
Assessment Methodology
• Compliant – A jurisdiction will be considered compliant with a Principle when all
essential criteria applicable for this jurisdiction are met without any significant
deficiencies….
• Largely compliant – A jurisdiction will be considered largely compliant with a
Principle whenever only minor shortcomings are observed that do not raise any
concerns about the authority’s ability and clear intent to achieve full compliance with
the Principle within a prescribed period of time….
• Materially non-compliant – A jurisdiction will be considered materially non-compliant
with a Principle whenever there are severe shortcomings, despite the existence of
formal rules, regulations and procedures, and there is evidence that supervision has
clearly not been effective…..
• Non-compliant – A jurisdiction will be considered non-compliant with a Principle
whenever there has been no substantive implementation of the Principle, several
essential criteria are not complied with or supervision is manifestly ineffective.
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Appendix A: Mapping the BCPs –
The CPIFR Approach
BCP’s
Supervisory powers, responsibilities and functions
CP 1: Responsibilities, objectives and powers
CP2: Independence, accountability, resourcing and legal protection for supervisors
CP3: Cooperation and collaboration
CP4: Permissible activities
CP5: Licensing criteria
CP6: Transfer of significant ownership
CP7: Major acquisitions
CP8: Supervisory approach
CP9: Supervisory techniques and tools
CP10: Supervisory reporting
CP11: Corrective and sanctioning powers of supervisors
CP12: Consolidated supervision
CP13: Home-host relationships
Prudential regulations and requirements
CP14: Corporate governance
CP15: Risk management process
CP16: Capital adequacy
CP17: Credit risk
CP18: Problem assets, provisions and reserves
CP19: Concentration risk and large exposure limits
CP20: Transactions with related parties
CP21: Country and transfer risks
CP22: Market risk
CP23: Interest rate risk in the banking book
CP24: Liquidity risk
CP25: Operational risk
CP26: Internal control and audit
CP27: Financial reporting and external audit
CP28: Disclosure and transparency
CP29: Abuse of financial services
Additional Core Principles
Treatment of PSIA/IAHs
Sharī`ah governance framework
Equity investment risk
Rate of return risk [Replacing CP23]
Islamic windows operations
CPIFR Approach - Revised CPs in the form of
CPIFR Reflecting the Specificities of IIFS
Retained unamended: CPIFR 1
Retained unamended: CPIFR 2
Retained unamended: CPIFR 3
Amended: CPIFR 4
Retained unamended: CPIFR 5
Retained unamended: CPIFR 6
Amended: CPIFR 7
Retained unamended: CPIFR 8
Amended: CPIFR 9
Amended: CPIFR 10
Amended: CPIFR 11
Amended: CPIFR 12
Amended: CPIFR 13
Amended: CPIFR 15
Amended: CPIFR 17
Amended: CPIFR 18
Amended: CPIFR 19
Amended: CPIFR 20
Amended: CPIFR 21
Amended: CPIFR 22
Retained unamended: CPIFR 23
Amended: CPIFR 25
N/A But CP23 replaced with CPIFR 26
Amended: CPIFR 27
Amended: CPIFR 28
Amended: CPIFR 29
Retained unamended: CPIFR 30
Amended: CPIFR 31
Retained unamended: CPIFR 33
New: CPIFR 14
New: CPIFR 16
New: CPIFR 24
New: CPIFR 26
New: CPIFR 32
16
Head-to-Head comparison:
Core Principles
Total
Principles Total ECs Total ACs
Core Principles
BCBS
IFSB
Replaced:
New
Principles
Part A: Supervisory Powers
Part B: Prudential Regulation
Part A: Supervisory Powers
Part B: Prudential Regulation
13
16
13
20
29
231
16
33
305
14
BCP 23 (Interest rate risk, EC4, AC 2) with CPIFR26 (EC9, AC2)
CPIFR 14: Treatment of IAHs
CPIFR16: Shari'ah Governance Framework
CPIFR 24: Equity Investment Risk
CPIFR 32: Islamic "windows" Operation
Total ECs Added
13
15
8
11
74
What does
this mean to
supervisory
authorities?
Of which: 47 are from Four New Principles
Note: The comparison, as presented above, of IFSB ED-17 with respect to the BCPs is provisional as
ED-17 is yet to be issued as final document by the IFSB Council.
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SECTION 4: CRITERIA FOR ASSESSING
COMPLIANCE WITH THE CPIFR FOR IIFS
4.2 CPIFR Related to Supervisory powers, responsibilities and
functions
CPIFR 1: Responsibilities, objectives and powers
CPIFR 2: Independence, accountability, resourcing and legal protection for
supervisors
CPIFR 3: Cooperation and collaboration
CPIFR 4: Permissible activities
Please see
CPIFR 5: Licensing criteria
ED-17 for
CPIFR 6: Transfer of significant ownership
detail of
CPIFR 7: Major acquisitions
these
CPIFR 8: Supervisory approach
Principles.
CPIFR 9: Supervisory techniques and tools
CPIFR 10: Supervisory reporting
CPIFR 11: Corrective and sanctioning powers of supervisors
CPIFR 12: Consolidated supervision
CPIFR 13: Home-host relationships
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SECTION 4: CRITERIA FOR ASSESSING
COMPLIANCE WITH THE CPIFR FOR IIFS
4.3 CPIFR Related to Prudential regulations and requirements for IIFS
CPIFR 14: Treatment of investment account holders (IAHs)
CPIFR 15: Corporate governance
CPIFR 16: Sharī`ah governance framework
CPIFR 17: Risk management process
CPIFR 18: Capital adequacy
CPIFR 19: Credit risk
CPIFR 20: Problem assets, provisions and reserves
CPIFR 21: Concentration risk and large exposures limits
CPIFR 22: Transactions with related parties
CPIFR 23: Country and transfer risks
CPIFR 24: Equity investment risk
CPIFR 25: Market risk
CPIFR 26: Rate of return risk
CPIFR 27: Liquidity risk
CPIFR 28: Operational risk
CPIFR 29: Internal control and audit
CPIFR 30: Financial reporting and external audit
CPIFR 31: Transparency and Market Discipline
CPIFR 32: Islamic windows operations
CPIFR 33: Abuse of financial services
Please see
ED-17 for
detail of
these
Principles.
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SECTION 4: CRITERIA FOR ASSESSING
COMPLIANCE WITH THE CPIFR FOR IIFS
Additional Proposed Principles for IIFS
CPIFR 14: Treatment
of Investment
Account Holders
CPIFR 16: Shari’ah
Governance
Framework
CPIFR 26: Rate of
Return Risk
CPIFR 24: Equity
Investment Risk
CPIFR 32: Islamic
“windows”
operations
Note: Due to the relevance and time limitation, only these five Principles are discussed
in this presentation. Please refer to ED-17 for more detail.
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SECTION 4: CRITERIA FOR ASSESSING
COMPLIANCE WITH THE CPIFR FOR IIFS
CPIFR 14: Treatment of investment account holders (IAHs) - The supervisory
authority determines how unrestricted investment account holders (UIAHs) are treated in
its jurisdiction. The supervisory authority also determines the various implications
(including the regulatory treatment, governance and disclosures, and capital adequacy
and associated risk-absorbency features, etc.) relating to IAHs within its jurisdiction.
CPIFR 16: Sharī`ah governance framework – The supervisory authority determines
that IIFS have a robust Sharī`ah governance system in order to ensure an effective
independent oversight of Sharī`ah compliance over various structures and processes
within the organisational framework. The Sharī`ah governance structure adopted by an
IIFS is commensurate and proportionate with the size, complexity and nature of its
business. The supervisory authority also determines the general approach to Sharī`ah
governance in its jurisdiction, and lays down key elements of the process.
21
SECTION 4: CRITERIA FOR ASSESSING
COMPLIANCE WITH THE CPIFR FOR IIFS
CPIFR 24: Equity investment risk - The supervisory authority satisfies itself that adequate
policies
and1:
procedures
including appropriate strategies, risk management and reporting
Section
Introduction
processes are in place for equity investment risk management, including Mudārabah and
Mushārakah investments in the banking book (i.e. financing on a profit-and-loss sharing
basis), taking into account the IIFS’s appetite and tolerance for risk. In addition, the
supervisory authority also ensures that the IIFS have in place appropriate and consistent
valuation methodologies; define and establish the exit strategies in respect of their equity
investment activities; and have sufficient capital when engaging in equity investment
activities.
CPIFR 26: Rate of return risk - The supervisory authority determines that IIFS have
adequate systems to identify, measure, evaluate, monitor, report and control or mitigate rate
of return risk in the banking book on a timely basis. These systems take into account the
IIFS’s risk appetite, risk profile and market and macroeconomic conditions. The supervisory
authority also assesses the capacity of an IIFS to manage the rate of return risk and obtains
sufficient information to assess its IAHs’ behavioural and maturity profiles.
22
SECTION 4: CRITERIA FOR ASSESSING
COMPLIANCE WITH THE CPIFR FOR IIFS
CPIFR 32: Islamic “windows” operations - Supervisory authorities define what
Section
1: Introduction
forms
of Islamic
“windows” are permitted in their jurisdictions. The supervisory
authorities review Islamic windows’ operations within their supervisory review
process using the existing supervisory tools. The supervisory authorities in
jurisdictions where windows are present satisfy themselves that the institutions
offering such windows have the internal systems, procedures and controls to
provide reasonable assurance that (a) the transactions and dealings of the
windows are in compliance with Sharī`ah rules and principles; (b) appropriate risk
management policies and practices are followed; and (c) the institution provides
adequate disclosures for its window operations.
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CPIFR 14: Treatment of Investment
Account Holders(IAHs)
1. How UIAHs are treated by the IIFS in the jurisdiction
2. Consistency of risk disclosures with the prudential treatment of IAHs
3. Treatment of IIFS in all capital adequacy matters.
4. Contractual agreement between the IIFS as Muḍārib or Wakīl and the IAHs, and
declared policies for the use of smoothing mechanisms such as PER or IRR.
5. Level of competence necessary to fulfil fiduciary duties as Muḍārib or Wakīl.
6. Formal guidance for IIFS to ensure their fiduciary duties towards their IAHs.
7. Existence of various practices of smoothing the profit payout to IAHs that are
employed due to various internal and regulatory considerations.
8. In real estate, prudential limits on the percentage of funds of UIAHs, and resources
and capabilities for undertaking real estate investment.
9. Stress testing and Governance Committee
10. Robust Methodology for DCR measurement.
11. Continuing disclosures to IAHs.
12. Separate accounts for RIAHs
CPIFR 14: Treatment
of Investment
Account Holders
13. Contractual rights of the parties during insolvency.
24
CPIFR 16: Shari’ah Governance
Framework
1. Products and services comply with Shari`āh rules and principles
2. Not allowed to represent itself as “Islamic”, without having such a governance
CPIFR
14: Treatment of
structure, policies and procedures.
Investment Account
3. SSB ofHolders
an IIFS plays a strong and independent oversight role.
4. Sharī`ah governance system in place with TOR, operating procedures and line of
reporting.
5. Key members of its Sharī`ah governance system fulfil acceptable “fit and proper”
criteria.
6. IIFS comply at all times with the Sharī`ah rules and principles as determined by
the relevant body in the jurisdiction.
7. Have in place an appropriate mechanism for obtaining rulings from Sharī`ah
scholars, applying Fatāwa and monitoring Sharī`ah compliance.
8. Requirement and criteria for the establishment of an SSB.
CPIFR 16: Shari’ah
Governance
Framework
25
CPIFR 16: Shari’ah Governance
Framework (2)
9. SSB is provided with complete, adequate and timely information prior to all
meetings and on an ongoing basis on any product or transaction.
CPIFR 14: Treatment of
10. Sharī`ah governance system to cover the relevant ex-ante and ex-post
Investment Account
processes.
Holders
11. Sharī`ah board has free access to the internal Sharī`ah compliance
unit/department (ISCU) and internal Sharī`ah review/audit unit/department
(ISRU).
12. Issuance procedures of relevant Sharī`ah pronouncements, an internal
Sharī`ah compliance review, and an annual Sharī`ah compliance review/audit.
13. IIFS facilitates continuous professional development of persons serving on its
Sharī`ah board, as well as its ISCU and ISRU.
14. Formal assessment of the effectiveness of an IIFS’s SSB as a whole and of
the contribution by each member to the effectiveness of the Sharī`ah board.
15. Supervisory authority has the power to have full access to the SSB and
relevant staff and records in order to monitor compliance with relevant laws
and regulations.
CPIFR 16: Shari’ah
Governance
Framework
26
CPIFR 24: Equity Investment Risk
1. IIFS define and set the objectives of, and criteria for, investments using profitsharing instruments (e.g. Mudārabah and Mushārakah investments)
2. Proper infrastructure and capacity are in place to monitor continuously the
performance and operations of the entity in which IIFS invest.
3. IIFS ensures that its valuation methodologies are appropriate and consistent,
and measures to deal with the risks associated with potential manipulation of
reported results.
4. An IIFS defines and establishes general criteria for exit strategies in respect of
its equity investment activities.
5. Authority sets rules or guidelines for measuring, managing and reporting the risk
exposures when dealing with non-performing investments.
6. Specific guidance on the slotting method.
7. Systematic process to regularly review policies and limits.
8. Policies on stress testing for equity exposures.
CPIFR 24: Equity
Investment Risk
9. Appropriate scenarios into their stress-testing programmes.
27
CPIFR 26: Rate of Return Risk
1. Have an appropriate rate of return (ROR) risk strategy and ROR risk
management framework.
2. IIFS’s strategy, policies and processes for the management of ROR risk have been
approved, and are regularly reviewed, by the IIFS’s board.
3. Authority assesses the capacity of IIFS to manage the ROR risk, including IAHs’
behavioural and maturity profiles.
4. IIFS are aware of the factors that give rise to ROR risk.
5. Authority ensures that IIFS consider ROR risk when setting and reviewing
business and product strategies, and assess its impact on their balance sheet
structure.
6. IIFS’ policies and processes establish an appropriate and properly controlled
ROR environment.
7. Authorities obtain sufficient and timely information.
8. An appropriate framework for managing DCR
CPIFR 26: Rate of
Return Risk
28
CPIFR 32: Islamic “windows”
operations
CPIFR 32: Islamic
“windows”
operations
We will discuss this topic
in detail on Last day.
Definition and Types of Islamic
windows operation
Liquidation issues –
home/host cooperation
Transparency and Disclosure
requirements
Prudential surveillance of
Islamic windows - On-site
supervision and off-site
surveillance
Internal controls - Shari’ah
compliance and accounting
systems
Regulatory capital
requirements – RWAs Vs.
Deduction Method
Liquidity risk management at
parent level and entity level,
through Shari'ah-compliant
way
29
30
Thank You
Jamshaid Anwar Chattha
Central Bank of Kuwait
janwar@cbk.gov.kw
Disclaimer: The views expressed in the presentation are of the presenter and do not represent
the views of the Central Bank of Kuwait. The material presented in the workshop is for
information only for participants.
31