Transparency and market discipline: basel pillar 3

1. Transparency and market discipline: basel pillar 3 Chapter 19: Islamic finance the regulatory challenge Daud Abdullah (David Vicary) By: Cheah Ping Yean & raja shahridatuldewa

2. AGENDA • INTRODUCTION • COMPLIANCE WITH PILLAR 3 • MARKET DISCIPLINE IN ISLAMIC BANKING • CONCLUDING REMARKS

3. 1. INTRODUCTION • a) Transparency and market discipline are closely intertwined with corporate governance • b) Basel Pillar 3 • i) Guiding principles of market discipline • ii) Complement Pillars 1 and 2 • iii) Disclosure of information, consistent with how the bank’s risks are measured (inclusive of capital adequacy calculation) • b) By doing this, market discipline is reinfoced, and banks are incentivised to behave prudently. • c) END Goal – a sound and safe financial system

4. 2. How to comply with pillar 3? • Level of disclosure • Frequency – disclosure every six months • Templates – to compare between banks • 4 requirements

5. 2. How to comply with pillar 3? (Con’t) • IV. Basic principle of disclosure (13 tables on info disclosure) • 4 requirements Credit risk mitigation techniques disclosured Securitization – Size type and features disclosed Market risk – compare different types of risks and institutions Market risk – IMA * approach for trading of portfolios Operational risk – disclosure of regulatory capital approach Equities – disclosure of banking book positions Interest Rate Risk in the Banking Book (For IFIs, there is a rate of return risk) Qual’tv and quan’tv info Capital structure info (analyse capital adequacy of bank) Capital allocation process info (Pillar 2) Overview of size and nature credit risk exposures Portfolios subject to standardised approach (IRB) and supervisory risk weights Portfolios – IRB approaches *IRB – Internal Rating Based; IMA – Internal Models Approach

6. Market discipline in Islamic banking (IB) What is market discipline? • It refers to the use of market as a means of governance, as a complement to regulation and supervision. The benefits and drawbacks are:

7. Conditions for effective market discipline • Andrew Crocket, former Bank for International Settlements (BIS) general manager developed conditions for effective market discipline which are also applicable to IBs. • These are: • Information – market participants must have sufficient information to reach informed judgments • Ability – market participants must have ability to process information correctly • Incentive – market participants must have the right incentive to act upon information • Mechanism – market participants must have the right mechanism to exercise discipline.

8. Conditions for effective market discipline, cont’d • While all four prerequisites need to be developed, the author has focused on the first two building blocks in this article. • Information • Pressing need to develop informational infrastructure to promote transparency to understand the operations of IFIs. • Transparency facilitates decision making, hence improves allocation of resources (ii) Ability • Market participants (eg analysts, brokers, ratings agencies, etc) need to have the ability to process correctly information provided by Islamic finance industry to enable the industry reached the required critical mass and eventually to be rated. • Easier to develop market discipline in countries with significant market penetration such as S. Arabia (20%), Kuwait (16%), Qatar(13%), Malaysia (12%), Bahrain (10%) and UAE (7%).

9. Transparency: A Virtuous Cycle Standards Transparency Regulatory Information Disclosure Regulation and Enforcement Good Corporate Governance Voluntary Information Disclosure As market discipline develops, the market demands more information • Other Factors • Risk Management • Product Development • Skilled workforce • Marketing • Efficiency • Industry Infrastructure Industry Growth Attract Market Participants and Maintain Confidence Virtuous Cycle of Transparency – a cycle that embraces all aspects of regulation, disclosure, transparency, corporate governance, market discipline and the growth of Islamic banking industry.

10. The Role of regulators Standards Transparency Regulatory Information Disclosure Regulation and Enforcement Good Corporate Governance Voluntary Information Disclosure As market discipline develops, the market demands more information • Other Factors • Risk Management • Product Development • Skilled workforce • Marketing • Efficiency • Industry Infrastructure Industry Growth Attract Market Participants and Maintain Confidence Standards setting – regulators develop coherent regulatory disclosure requirements which are useful both on national and international basis. Enforcement – at country level whereby central bank enforce regulations by monitoring the implementation & compliance of IFIs to the disclosure requirements. Vigilance – regulators need to be vigilant about –ve signals sent by the market as early warning distress in individual FIs.

11. Criteria for good information disclosure Standards Regulatory Information Disclosure Transparency Regulation and Enforcement Voluntary Information Disclosure Good Corporate Governance As market discipline develops, the market demands more information • Other Factors • Risk Management • Product Development • Skilled workforce • Marketing • Efficiency • Industry Infrastructure Industry Growth Attract Market Participants (ratings agencies, analysts and institutional investors) and Maintain Confidence Criteria for good information disclosure by IFIs – quantitative & qualitative useful, accurate, complete and credible.

12. Criteria for good information disclosure, cont’d • Good information disclosure by IFIs both quantitative and qualitative that meets the criteria of useful, accurate, complete and credible • Useful – it depends on what the market discipline aims for e.g.: • Satisfactory financial performance - IFIs have to provide financial statements and comparative analysis (e.g. changes in financial statement’s items over several accounting periods to detect trends in the operations and results) • Good risk management – provide information on how it manages risk exposures • Shariahcompliance – show Shariah certification in annual reports and accounts and highlighting Shariah review program • Resolution of conflict regarding Investment Account Holders (IAH) – due to the fiduciary role, IFIs need to provide information to both assets allocation and profit allocation.

13. Criteria for good information disclosure, cont’d • Accurate, Complete and Credible – to meet these criteria, all of the previously mentioned information need to be applied. • Good information disclosure lends itself to enhancing transparency in the marketplace.

14. The role of market participants Standards Transparency Regulatory Information Disclosure Regulation and Enforcement Good Corporate Governance Voluntary Information Disclosure As market discipline develops, the market demands more information • Other Factors • Risk Management • Product Development • Skilled workforce • Marketing • Efficiency • Industry Infrastructure Industry Growth Attract Market Participants and Maintain Confidence Disciplining institutions – Reward & punish IFIs based on information disclosure to motivate good behavior among IFIs. Reward good IFIs by placing funds with them and punish those IFIs that did the opposite thing. Soliciting information – market relays the information needed and over time IFIs develop potential for voluntary information disclosure as market demand increases.

15. conclusion • Islamic Finance industry has the products and infrastructure to compete with conventional institutions. • Growth rates in some markets outstripped conventional markets • To move forward, standard setters and regulators need to work together to build strong and practical corporate governance framework. • Good corporate governance framework promotes transparency via information disclosure by institutions that must be credible to inspire confidence and promote market discipline.

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