The growing importance of Islamic finance in the global financial system

Remarks by Mr Malcolm D Knight, General Manager of the BIS, at the 2nd Islamic Financial Services Board Forum, Frankfurt, 6 December 2007.

Abstract

Although there are differences between Islamic banking and "conventional" banking, there are some fundamental principles that apply equally to both. In particular, rigorous risk management and sound corporate governance help to ensure the safety and soundness of the international banking system. In the light of the growing importance of Islamic banks and Sharia-compliant financial innovation, the increasing integration of Islamic financial services into global financial markets serves to strengthen this point.

The Basel II framework improves the risk sensitivity and accuracy of the criteria for assessing banks' capital adequacy. This framework is fundamentally about stronger and more effective risk management grounded in sound corporate governance and enhanced financial disclosure, the importance of which has been underscored by the recent problems that have arisen in the banking industry worldwide. The guidance provided by the Islamic Financial Services Board (IFSB) is a useful contribution to the realisation of these global goals. It will support the establishment of resilient financial market infrastructures and sound and robust core Islamic financial institutions operating according to safe and sound risk management practices.

Full speech

Introduction

Good morning. I am pleased and honoured to address the 2nd Islamic Financial Services Board Forum today. As the General Manager of the Bank for International Settlements, I am particularly pleased to be here today to discuss Islamic finance and its growing importance in the global financial system. But let me start by commending Professor Rifaat Ahmed Abdel Karim of the Islamic Financial Services Board and Josef Tošovský of the BIS Financial Stability Institute for putting together such a comprehensive programme. It is entirely appropriate that the IFSB and the FSI should join forces to organise this conference. After all, the IFSB’s mission is to promote the soundness and stability of the Islamic financial services industry. It does so by issuing global prudential standards for the industry. Likewise, the FSI’s mission is also to promote sound supervisory standards and practices globally.

BIS and BCBS support for the IFSB

As an associate member of the IFSB, the BIS has been actively supporting the IFSB’s mission and initiatives since the Board began operations in 2003. The Basel Committee on Banking Supervision, which is hosted by the BIS, is increasingly looking beyond its membership to enhance cooperation with non-member countries and organisations with related interests and similar goals. The Committee’s outreach to non-member countries is part of an initiative to promote the development of sound supervisory practices and to accommodate the growing importance and sophistication of non-member banks.

The BIS and the Basel Committee have been strong supporters of the IFSB through participation in IFSB working groups, such as the capital adequacy group, and by providing speakers for conferences and other events. I believe that the active and productive dialogue between the Basel Committee and the IFSB will continue to benefit both of our organisations. Professor Rifaat and members of the Basel Committee’s Secretariat have recently held fruitful discussions, and continue to strengthen the cooperation between the IFSB and the Committee.

In my remarks today, I will not address the specifics of Islamic finance and how it differs from conventional banking. Instead, I would like to focus on two elements of banking supervision that Islamic and conventional banking have in common. That is, appropriate levels of risk management and corporate governance, which help to ensure the safety and soundness of the international banking system.

Growth in Islamic finance

As I am sure you heard yesterday and will also hear today, there has been significant growth in Islamic financial services in recent years and there is every reason to expect that this growth will continue at a rapid pace. Clearly, there is expanding demand for these products, and a closely associated desire on the part of banks, including non-Islamic banks, to provide Islamic financial services.

Although it is still modest in size relative to conventional retail banking, Islamic retail banking is rapidly becoming more visible. This is particularly true in the Middle East and Asia Pacific regions, where a number of Islamic banks and banking units have been opened in recent years. There are also Islamic banks and asset managers in key international financial centres of the United Kingdom and the United States.

The growth in Islamic finance is also visible in the expanding range of services and products that comply with the basic precepts of Sharia law. One example is the burgeoning global market interest in Islamic bonds – Sukuks – many of which are increasingly being issued and bought outside the Islamic world. This suggests that non-Islamic investors in general are becoming comfortable with Sukuks. The broadening appeal of Islamic finance is also evident in the move by large international banks and other private sector financial institutions to provide Islamic financial services. This includes the establishment of exchange-traded funds that are screened to ensure their conformity with Islamic investment principles, as well as offering “takaful” – or Islamic insurance.

Although the elements that are usually emphasised at conferences like this are differences between Islamic banking and “conventional” banking, there are some fundamental principles that apply equally to both. For example, I can point to the necessity of strong corporate governance, rigorous risk management and sound capital adequacy requirements as essential ingredients to ensure the safety and soundness of any financial system. The increasing integration of Islamic financial services into the global financial fabric only strengthens this point.

What about risk management and corporate governance?

The issuance of the revised Basel II framework for bank capital adequacy not only improves the risk sensitivity and accuracy of the criteria for assessing capital adequacy, but it is fundamentally about stronger and more effective risk management grounded in sound corporate governance and enhanced financial disclosure. I should acknowledge that the special features of Islamic banking may not always be adequately addressed by broad international standards for conventional banking contained in the Basel II framework. Nonetheless, the IFSB considers carefully the global banking standards that have been and are being developed for conventional banking. The IFSB’s capital adequacy standard, for instance, draws to a large extent on Pillar 1 of the Basel II framework (the minimum capital adequacy requirements). It has also released an exposure draft on the supervisory review process (consistent with the principles of Basel’s Pillar 2) and another on disclosure and market discipline (Pillar 3).

As interest in Islamic finance grows, the importance of the IFSB’s role increases. The importance of the fundamental elements of banking – conventional or Islamic – cannot be emphasised enough. Topics such as corporate governance, risk management and capital adequacy are key elements that underpin sound financial practices. The guidance provided by the IFSB in these areas helps to ensure that there are resilient financial market infrastructures and robust core financial institutions operating according to safe and sound risk management practices. It is important that the same degree of supervisory oversight is applied to Islamic financial institutions, to ensure the continuing acceptance of their instruments and services in international markets and conventional banking systems . In addition, the guiding principles and standards developed by the IFSB are assisting supervisors globally to better understand and supervise institutions providing Islamic financial services.

This is why I am particularly pleased to see the issuance by the IFSB, over the last couple of years, of its capital adequacy standards and guiding principles on corporate governance and risk management. The issuance of these prudential standards and guiding principles helps to enhance the soundness and stability of the Islamic financial services industry and helps fill an important niche, as will the recent exposure draft on market discipline.

The importance of robust risk management systems and corporate governance cannot be overstated. Many of the recent problems that have arisen in the banking industry worldwide, such as losses due to accounting improprieties, low underwriting standards and inappropriate valuation methodologies – particularly when applied to complex financial instruments, are primarily due to poor corporate governance and inadequate risk management. Given these shortcomings, what then are the implications for banks and supervisors?

Risk management

First and foremost, with respect to risk management banks must have policies and procedures in place that enable them to identify, measure, control and report all material risks. Bank management is primarily responsible for understanding the nature and degree of the risks being undertaken by the institution. This was not necessarily the case with respect to subprime residential mortgages, mainly packaged by conventional banks in the United States, which were then securitised and resold as mortgage-backed securities and collateralised debt obligations. Investors at large, and the managements of even some of the largest internationally active banks, did not fully appreciate the risk inherent in the subprime mortgages embedded in the structured securities they had purchased. Instead, many relied too heavily on the credit ratings that the specialised credit rating agencies established for the various branches of the resulting structured products. While Basel II provides a better framework for supervisors to focus discussions with banks on the robustness of their risk measurement and management of complex financial instruments, banks’ risk management systems need to be constantly adapted to better address the effects of innovation in the financial markets and increased complexity and opacity of financial activities in which banks are engaged. While weaknesses in these areas have focused on conventional banking instruments and institutions, Islamic instruments are not immune to them.

Strong risk management is a critical component of a bank’s ability to withstand adverse conditions. And this is certainly as important for Islamic banks as for other types of financial institutions. One element that is essential is comprehensive stress testing that can capture the effects of a downturn on market and credit risks, as well as on liquidity. This helps ensure that banks have a sufficient capital buffer to carry them through difficult periods. In the events of last summer and this autumn, it became clear that many banks’ stress tests did not anticipate the degree and breadth of illiquidity that resonated throughout the credit markets. Stress tests must consider the effects of prolonged market tensions and illiquidity, and must reflect the nature of institutions’ portfolios and realistic assumptions about the amount of time it may take to hedge out risks or manage them in severe market conditions.

Corporate governance

The necessity of a robust corporate governance framework has long been recognised by bank supervisors around the world. Indeed, supervision would not be possible without sound corporate governance in place. Over the years, experience has highlighted the need for banks to have the appropriate levels of accountability, as well as sufficient checks and balances. In general, sound corporate governance effectively addresses the manner in which the decision-making process in the organisation is structured, the respective responsibilities and accountability of senior management and the board of directors, and the control functions that ensure the accuracy of the monitoring processes.

Of course, when supervisors review an institution’s risk management system and corporate governance framework, they must consider the system’s appropriateness in relation to the bank’s size, its risk exposures and the nature and complexity of the financial instruments it deploys.

Market disclosure

I have already noted the IFSB’s exposure draft on disclosure and market discipline that was released for comment late last year. This interest in promoting increased transparency and market discipline is especially important, particularly given the recent difficulties experienced by banks and investors alike with respect to complex structured products. Much of the current turmoil in the credit markets has related to questions about the soundness of certain types of collateralised debt obligations (CDOs) and asset-backed commercial paper. These problems might well have been avoided or at least mitigated if there had been greater transparency both about the products themselves and the commitments made by the banks that originated them. Again, this problem has thus far been concentrated in conventional banks in the key financial countries. A crucial area where more transparency has proved necessary has been in the exposures of some large financial institutions to CDOs of securities backed by subprime mortgages in the United States.

Basel II and the IFSB’s exposure draft on transparency both seek to raise the bar on the quality of financial disclosures by providing clearer industry benchmarks. Enhanced financial disclosure that improves the transparency of banks and complex structured products, valuation, and the measurement of risk exposure can certainly help to improve overall risk management. In addition, requiring enhanced qualitative disclosures will permit all banks to put their quantitative disclosures into better context and assist them in explaining their approach to risk management.

Conclusion

Let me conclude by emphasising that rigorous risk management and sound corporate governance are key elements of any bank’s ability to understand and manage its risks. With the growing importance of Islamic banks and Sharia-compliant financial innovation, it will be increasingly important to ensure sound Islamic financial institutions going forward. Supervisors must work together to encourage all banks to improve their risk management systems, controls and transparency. Such improvements will help ensure the stability and soundness of the international banking system. Thank you very much.