L01: Core Principles for Islamic Financial Institutions Presented by: Jamshaid Anwar Chattha, CIFP...

L01: Core Principles for Islamic Financial Institutions

Presented by: Jamshaid Anwar Chattha, CIFP

RISK-BASED SUPERVISION IN INSTITUTIONS OFFERING ISLAMIC FINANCIAL SERVICES (IIFS)

February 02-05, 2015Kuwait City, Kuwait

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

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AGENDA

CONCLUSION

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


• 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.

• In total there were 25 Core Principles.


• 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.

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Note: Each Principle is supported by assessment criteria, divided between essential criteria (ECs) and additional criteria (ACs)

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Items Core Principles 2006 Revised Core Principles 2012

Number of Core Principles 25 Core Principles 29 Core Principles

Supervisory Powers, Responsibilities and Functions

CP1: Objectives, independence, powers, transparency and cooperation

CP1: Responsibilities, objectives and powers

CP 2: Independence, accountability, resourcing and legal protection for supervisors

CP 3: Cooperation and collaboration

Prudential Regulations and Requirements

Not Available in 2006 CP 14: Corporate governance

CP 22: Accounting and disclosure

CP 27: Financial reporting and external audit

CP 28: Disclosure and transparency

Assessment methodology Separate from the Core Principles Impeded within the same document

Comparison between the 2006 and 2012 Core Principles

BCBS’S CORE PRINCIPLES – Strengthening the Banking Supervision (2)

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Basel Core Principles 2012A. Supervisory powers, responsibilities and functionsCP 1 Responsibilities, objectives and powersCP 2 Independence, accountability, resourcing and legal protection for supervisorsCP 3 Cooperation and collaborationCP 4 Permissible activitiesCP 5 Licensing criteriaCP 6 Transfer of significant ownershipCP 7 Major acquisitionsCP 8 Supervisory approachCP 9 Supervisory techniques and toolsCP 10 Supervisory reportingCP 11 Corrective and sanctioning powers of supervisorsCP 12 Consolidated supervisionCP 13 Home-host relationshipsB. Prudential regulations and requirementsCP 14 Corporate governanceCP 15 Risk management processCP 16 Capital adequacyCP 17 Credit riskCP 18 Problem assets, provisions and reservesCP 19 Concentration risk and large exposure limitsCP 20 Transactions with related partiesCP 21 Country and transfer risksCP 22 Market risksCP 23 Interest rate risk in the banking bookCP 24 Liquidity riskCP 25 Operational risk

CP 26 Internal control and auditCP 27 Financial reporting and external auditCP 28 Disclosure and transparencyCP 29 Abuse of financial services


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 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 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 BankNeed for Core Principles

ASSETS

Cash & cash equivalents

Sales receivables

Investment in securities

Investment in leased assets

Investment in real estate

Equity investment in joint ventures

Equity investment in capital ventures

Inventories

Other assets

Fixed assets

LIABILITIES

Current accounts

Other liabilities

Equity of Profit Sharing Investment Accounts (PSIA)

Profit Sharing Investment Accounts (PSIA)

Profit equalization reserve

Investment risk reserve

Owners’ Equity

One StopShopping

Bank

Buying physical assets before selling

Direct equity investment

Leasing and trading in real estate

Fund management

Off-balance sheet assets

Investment in Sukuk

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Note: The ED-17 is being finalised by the IFSB after the public consultation period, which ended on 05 January.

IFSB’S WORK ON CORE PRINCIPLES – Strengthening the Islamic Banking Supervision

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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

OVERVIEW OF THE WORKING PAPER

Evaluation of Core Principles Relevant to Islamic Finance Regulation

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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).

IFSB CORE PRINCIPLES Objectives

Section 1: Introduction

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The Draft Mentioned that:

Many of the 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.

IFSB CORE PRINCIPLES General Approach of the CPIFR


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• Each CPIFR is supported by assessment criteria. These are divided 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.

IFSB CORE PRINCIPLES General Approach of the CPIFR


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Background – The Need for Core Principles

Main Premises and Objectives

General Approach of the CPIFR

Scope and Application of the CPIFR

Implementation Date

Structure of the CPIFR

IFSB CORE PRINCIPLES SECTION 1: INTRODUCTION

SECTION 2: PRECONDITIONS FOR EFFECTIVE SUPERVISION OF IIFS


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The preconditions include:

•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.

SECTION 3: ASSESSMENT METHODOLOGY FOR CPIFR


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Use of the methodologyAssessment of compliancePractical considerations in conducting an assessmentAssessment 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.

BCP’s CPIFR Approach - Revised CPs in the form of CPIFR Reflecting the Specificities of IIFS

Supervisory powers, responsibilities and functionsCP 1: Responsibilities, objectives and powers Retained unamended: CPIFR 1CP2: Independence, accountability, resourcing and legal protection for supervisors Retained unamended: CPIFR 2

CP3: Cooperation and collaboration Retained unamended: CPIFR 3CP4: Permissible activities Amended: CPIFR 4CP5: Licensing criteria Retained unamended: CPIFR 5CP6: Transfer of significant ownership Retained unamended: CPIFR 6CP7: Major acquisitions Amended: CPIFR 7CP8: Supervisory approach Retained unamended: CPIFR 8CP9: Supervisory techniques and tools Amended: CPIFR 9CP10: Supervisory reporting Amended: CPIFR 10CP11: Corrective and sanctioning powers of supervisors Amended: CPIFR 11CP12: Consolidated supervision Amended: CPIFR 12CP13: Home-host relationships Amended: CPIFR 13Prudential regulations and requirementsCP14: Corporate governance Amended: CPIFR 15 CP15: Risk management process Amended: CPIFR 17CP16: Capital adequacy Amended: CPIFR 18CP17: Credit risk Amended: CPIFR 19CP18: Problem assets, provisions and reserves Amended: CPIFR 20CP19: Concentration risk and large exposure limits Amended: CPIFR 21CP20: Transactions with related parties Amended: CPIFR 22CP21: Country and transfer risks Retained unamended: CPIFR 23 CP22: Market risk Amended: CPIFR 25CP23: Interest rate risk in the banking book N/A But CP23 replaced with CPIFR 26CP24: Liquidity risk Amended: CPIFR 27CP25: Operational risk Amended: CPIFR 28CP26: Internal control and audit Amended: CPIFR 29CP27: Financial reporting and external audit Retained unamended: CPIFR 30CP28: Disclosure and transparency Amended: CPIFR 31CP29: Abuse of financial services Retained unamended: CPIFR 33Additional Core Principles Treatment of PSIA/IAHs New: CPIFR 14Sharī`ah governance framework New: CPIFR 16Equity investment risk New: CPIFR 24Rate of return risk [Replacing CP23] New: CPIFR 26Islamic windows operations New: CPIFR 32

Appendix A: Mapping the BCPs – The CPIFR Approach

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Core Principles Total

Principles Total ECs Total ACs

BCBS Part A: Supervisory Powers 13 29 231 16Part B: Prudential Regulation 16

IFSB Part A: Supervisory Powers 13 33 305 14Part B: Prudential Regulation 20

Replaced: BCP 23 (Interest rate risk, EC4, AC 2) with CPIFR26 (EC9, AC2)New Principles CPIFR 14: Treatment of IAHs 13

CPIFR16: Shari'ah Governance Framework 15CPIFR 24: Equity Investment Risk 8CPIFR 32: Islamic "windows" Operation 11

Total ECs Added 74Of which: 47 are from Four New Principles

Head-to-Head comparison: Core 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.

What does this mean to supervisory authorities?

4.2 CPIFR Related to Supervisory powers, responsibilities and functions

CPIFR 1: Responsibilities, objectives and powersCPIFR 2: Independence, accountability, resourcing and legal protection for supervisorsCPIFR 3: Cooperation and collaborationCPIFR 4: Permissible activitiesCPIFR 5: Licensing criteriaCPIFR 6: Transfer of significant ownershipCPIFR 7: Major acquisitions CPIFR 8: Supervisory approachCPIFR 9: Supervisory techniques and toolsCPIFR 10: Supervisory reportingCPIFR 11: Corrective and sanctioning powers of supervisorsCPIFR 12: Consolidated supervisionCPIFR 13: Home-host relationships

SECTION 4: CRITERIA FOR ASSESSING COMPLIANCE WITH THE CPIFR FOR IIFS

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Please see ED-17 for detail of

these Principles.

4.3 CPIFR Related to Prudential regulations and requirements for IIFS

CPIFR 14: Treatment of investment account holders (IAHs)CPIFR 15: Corporate governanceCPIFR 16: Sharī`ah governance frameworkCPIFR 17: Risk management processCPIFR 18: Capital adequacyCPIFR 19: Credit riskCPIFR 20: Problem assets, provisions and reservesCPIFR 21: Concentration risk and large exposures limitsCPIFR 22: Transactions with related partiesCPIFR 23: Country and transfer risks CPIFR 24: Equity investment riskCPIFR 25: Market riskCPIFR 26: Rate of return riskCPIFR 27: Liquidity riskCPIFR 28: Operational riskCPIFR 29: Internal control and auditCPIFR 30: Financial reporting and external audit CPIFR 31: Transparency and Market DisciplineCPIFR 32: Islamic windows operationsCPIFR 33: Abuse of financial services


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Please see ED-17 for detail of

these Principles.

Additional Proposed Principles for IIFS

CPIFR 16: Shari’ah Governance Framework

CPIFR 14: Treatment of Investment Account Holders

CPIFR 24: Equity Investment Risk

CPIFR 26: Rate of Return Risk

CPIFR 32: Islamic “windows” operations

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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.

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: Sharīàh governance framework – The supervisory authority determines that IIFS have a robust Sharīàh governance system in order to ensure an effective independent oversight of Sharīàh compliance over various structures and processes within the organisational framework. The Sharīàh 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 Sharīàh governance in its jurisdiction, and lays down key elements of the process.

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Section 1: IntroductionCPIFR 24: Equity investment risk - The supervisory authority satisfies itself that adequate policies and procedures including appropriate strategies, risk management and reporting 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.

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Section 1: IntroductionCPIFR 32: Islamic “windows” operations - Supervisory authorities define what 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)

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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

13. Contractual rights of the parties during insolvency.

CPIFR 14: Treatment of Investment

Account Holders

CPIFR 16: Shari’ah Governance Framework

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CPIFR 14: Treatment of Investment Account

Holders

1. Products and services comply with Shari`āh rules and principles

2. Not allowed to represent itself as “Islamic”, without having such a governance structure, policies and procedures.

3. SSB of an IIFS plays a strong and independent oversight role.

4. Sharīàh governance system in place with TOR, operating procedures and line of reporting.

5. Key members of its Sharīàh governance system fulfil acceptable “fit and proper” criteria.

6. IIFS comply at all times with the Sharīàh rules and principles as determined by the relevant body in the jurisdiction.

7. Have in place an appropriate mechanism for obtaining rulings from Sharīàh scholars, applying Fatāwa and monitoring Sharīàh compliance.

8. Requirement and criteria for the establishment of an SSB.CPIFR 16: Shari’ah

Governance Framework

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CPIFR 16: Shari’ah Governance Framework (2)

CPIFR 14: Treatment of Investment Account

Holders

9. SSB is provided with complete, adequate and timely information prior to all meetings and on an ongoing basis on any product or transaction.

10. Sharīàh governance system to cover the relevant ex-ante and ex-post processes.

11. Sharīàh board has free access to the internal Sharīàh compliance unit/department (ISCU) and internal Sharīàh review/audit unit/department (ISRU).

12. Issuance procedures of relevant Sharīàh pronouncements, an internal Sharīàh compliance review, and an annual Sharīàh compliance review/audit.

13. IIFS facilitates continuous professional development of persons serving on its Sharīàh 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 Sharīàh 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

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1. IIFS define and set the objectives of, and criteria for, investments using profit-sharing 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.

9. Appropriate scenarios into their stress-testing programmes.

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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

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We will discuss this topic in detail on Last day.

Definition and Types of Islamic windows operation

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

Prudential surveillance of Islamic windows - On-site supervision and

off-site surveillance

Transparency and Disclosure requirements

Liquidation issues – home/host cooperation

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Thank You Jamshaid Anwar Chattha

Central Bank of [email protected]

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.

mailto:[email protected]

L01: Core Principles for Islamic Financial Institutions Presented by: Jamshaid Anwar Chattha, CIFP...

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