Finance & Banking



Islamic finance, after four decades of progress and development, is no longer “swimming against
the tide”. The founder of one of the largest Islamic banks in the world, Sheikh Ahmed Al-Yasin (Rahimahum Allah), famously used this phrase in the mid-1970s, to describe the challenge of establishing an Islamic bank at a time when there was virtually no Islamic finance model to emulate or learn from.

Empirical evidence shows varying degrees of implementation of Islamic finance regulations issued by the three relevant international standards-setting bodies – Malaysia-based Islamic Financial Services Board (IFSB), and Bahrain-based, Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the International Islamic Financial
Market (IIFM) – across the jurisdictions.

In general, the regulatory issues addressed in the reforms by these three bodies provide both opportunities and challenges to the Islamic financial services industry (IFSI). For example, the IFSB – which complements among others,
the work of the Basel Committee on Banking Supervision (BCBS) – has, as of June 2019, issued 22 Standards and Guiding Principles, six Guidance Notes and two Technical Notes since its inception in 2002. It also has a strong
membership of 76 regulatory and supervisory authorities (RSAs) from jurisdictions in which Islamic finance is practised. However, according to the respondents of the IFSB’s Standards Implementation Survey of 2018, RSA respondents indicated that only 36% of the overall IFSB Standards and Guidelines (SAGs) have been implemented. This is a 2% reduction from 2017 (IFSI Stability Report, 2018). The respondents also indicated that 44% of the IFSB SAGs are being considered for implementation. This considerably low implementation rate highlights two significant challenges for
supervisors regulating Islamic finance. First, a lack of consistent implementation produces huge regulatory gaps among countries, and second, evolving and emerging issues create an issue of priorities and brings more challenging conditions for supervisors and Islamic banks.

Many of the regulatory reforms in recent years have addressed issues of risk management, corporate governance, enhanced capital requirements, stress testing, macroprudential measures, risk-based supervision, FinTech and RegTech, IFRS 9, de-risking, consumer protection and insolvency regime, among others. No doubt, the global financial system has been strengthened by these reforms, and efforts are continuing by the international organisations mandated with the task to maintain the industry’s soundness and stability. The key issues that remain are what do these reforms mean for RSAs regulating Islamic finance, and how far has the IFSI come in addressing these regulatory issues. These are the
questions this article aims to explore.

Key Regulatory and Supervisory Issues – what they hold for Islamic finance

Risk Management

Since the IFSB issued its Guiding Principles of Risk Management (IFSB-1) in 2005, there have been a lot of improvements and enhancements in risk management guidance, regulations and practices in the conventional space. Although IFSB is yet to update IFSB-1, it has taken into account some updates in other SAGs such as IFSB-13 (Stress
Testing), IFSB-16 (Supervisory Review Process), IFSB-17 (Core Principles), and most recently ED-23 (that is the revised IFSB-15 on Capital Adequacy requirements). ED-23 proposes a modified definition of operational risk to accommodate
new emerging risks such as cybersecurity risk together with internal loss multiplier, and credit risk weights adjustments for the treatment of individual exposure.

Stress testing has been the core of risk management discussions post-GFC. In this regard, IFSB-13 provides useful recommendations to the RSAs for Islamic banks. The only issue, which seems to be of significance, is the IFSB’s inability to decouple the updates to stress testing from the conventional templates such as those from IMF. The IFSB should issue its own (separate) templates reflecting Islamic banks’ balance sheets and specificities, which would ensure it remains relevant and usable should there be any revisions in the IMF templates. Specific guidance on this would be helpful to the supervisors.

Corporate Governance

Recent research by the IMF offers a granular look at the progress of the banking sector regulations and supervision since the GFC in the context of the 29 Basel Core Principles (BCPs). It shows that across the financial sector, two of the most problematic areas are corporate governance and regulatory oversight. The BCBS has issued two revisions of its Corporate Governance Principles requirements and updates since 2010, which are equally applicable to Islamic banks. The IFSB issued its Guiding Principles on Corporate Governance (IFSB-3) in 2006 and has yet to be revised, though revision is planned under the
IFSB’s SPP 2019-2022. This prolonged delay
in addressing the new requirements for Islamic
banks puts significant pressure on supervisors as
to what guidance is to be applied, given that the
IFSB has not endorsed the changes by the BCBS.

Capital Adequacy Requirements (CAR)

These have been a central element of the BCBS’s
response to the GFC. Post-GFC issuances of
Basel 2.5 and Basel III have primarily focused
on the numerator of the CAR that is, improving
the quality and quantity of the regulatory capital
together with systematic measures. While these
reforms have helped to strengthen the global
banking system, a major gap remains in the
regulatory framework – i.e. the way in which risk weighted assets (RWAs) are to be calculated due
to the complexity and opaqueness of internal
models, the degree of discretion in modelling risk
parameters, and the use of national discretions.

In response to this, the Basel III reforms,
finalised in 2017 and 2018, focus primarily on
the denominator of the CAR (i.e. credit, market,
and operational risks) and seek to restore the
credibility of RWA calculations by enhancing the
robustness and risk sensitivity of the standardised
approaches for credit and operational risks. The
IFSB has focused significant efforts on CAR,
ensuring a level playing field for the IFSI. It has
revised IFSB-2 (issued in 2007), introducing IFSB15 in 2013, and ED-23 in 2019, which is basically
a revised IFSB-15.

These revisions are not without challenges as
supervisors who have started implementing the
IFSB Capital Adequacy framework have a puzzling
choice to make – do they start from the beginning
or from the most recent update. The former is
easier to implement, while the latter without the
former would not constitute best practices, nor
can be practical and robust. In this scenario, the
recommended approach would be to give Islamic
banks adequate transitioning arrangements to
allow them time to cope with, and adopt the
latest changes and relevant internal requirements.

Complementing Microprudential Approach with Macroprudential Measures

Typically, prudential supervision has mainly
focused on assessing whether individual financial
institutions meet the statutory requirements in
terms of solvency, liquidity and operations. One
crucial lesson from the GFC was that individual
institutions’ compliance does not guarantee
financial system stability. In this respect, a
new consensus has emerged that alongside
monetary policy and microprudential supervision,
macroprudential regulation and supervision are
also needed to maintain financial stability and to
address systemic risk.

In dual banking systems, where both conventional
and Islamic banks operate side by side, there is still
scant understanding of how best to structure the
supervisory approach within the macroprudential
policy framework, which requires distribution
of responsibilities between the different actors
responsible for these domains. While the BCBS
has published guidance for supervisors, the
IFSB is yet to issue any specific guidance on
the macroprudential measures and supervision
catering to Islamic banking specificities.

This could include developing and operationalising
a rigorous analytical framework with clear criteria
for risk identification and prioritisation for RSAs
for Islamic banks. It is equally important to identify
and calibrate the tools and instruments suitable
for Islamic banks. The questions could be: how
should the macroprudential policy framework be
structured for measuring and monitoring systemic
risk for Islamic banks, which instruments should
be used, how, and under what conditions? In
this context, perhaps an IFSB SAG on macroprudential measures and supervision can provide
guidance to the RSAs

De-risking and AML/KYC

De-risking refers to the phenomenon of financial
institutions terminating or restricting business
relationships with clients to avoid, rather than
manage, risks as identified in the Financial Action
Task Force on Money Laundering’s (FATF) riskbased approach. This is a new phenomenon for
Islamic banks globally due to strict compliance to anti-money laundering (AML) and know-yourcustomer (KYC) principles, where recently many
Islamic banks have been fined by their regulators
for AML/KYC non-compliance.

A 2019 IFSB-AMF joint study noted that AML/
KYC Principles are equally applicable to Islamic
banks. This is one area where RSAs will not have
much difficulty in ensuring a level-playing field.
De-risking brings candid concerns of instability
in the financial sector due to the fear of building
up of illicit markets and financial exclusion, thus
undermining the integrity of the entire financial
sector. De-risking measures by banks have the
potential to turn legitimate businesses into a
more-risky, less-regulated and/or unregulated
alternatives such as Hewala (i.e. an informal system
for transferring money without money movement)
and shadow banking (i.e. credit intermediation
involving entities and activities outside of the
regular banking system).

As large correspondent banks move out of
the higher risk areas, their “risky” customers
(entities and persons) will be forced to enter
into the less-regulated or unregulated channels,
generating potential systemic risks. It is thus
equally important for the IFSB to put efforts into
addressing developments pertaining to issues
faced by Islamic financial institutions in relation
to correspondent banks and de-risking, and
provide detailed guidance on assessments and
implications of “de-risking” in the Islamic finance
context to supervisors.

Technological Transformation and Innovation

The terms FinTech and RegTech are the current
buzzwords and are part of the industry’s new
mantra. RSAs are at the crossroads of this new
paradigm, facing the formidable challenge of
striking a balance between financial stability,
innovation and designing a “fit for purpose”
regulatory and supervisory regime, which
embraces FinTech and RegTech. While the
traditional view of credit underwriting standards
is being transformed in the FinTech space, a key
question is how supervisors will judge the quality
of credit underwriting and the effectiveness of runoff rates in LCR under these new methodologies.

Cyber-security risk is another example directly
relevant for supervisors as more consumers and
businesses rely on digital platforms. An increasingly
IT-reliant banking system exposes it to a growing
and evolving set of operational risks. RegTech –
i.e. use of technology to enhance capabilities of
supervisors – promises to disrupt the regulatory
landscape by providing agility, speed and datadriven outputs to the ever-increasing demands
of compliance within the financial industry.
The supervisory challenge is to conceptualise
and implement the far-reaching possibilities of
RegTech to develop a financial ecosystem, which
is safer, stable and more efficient. The IFSB is yet to issue any specific guidance on a ‘regulatory
sandbox’ approach highlighting the implications
of FinTech and RegTech for supervisors regulating
Islamic banks.

‘Compliance-Based’ to ‘Risk-Based’ Supervision (RBS)

Post-GFC saw supervisors focused on improving
supervision. A recent IMF research highlights
issues of weaknesses in the supervisory approach
and proposes developing forward-looking risk
assessments (such as RBS) of banks’ risk profiles,
and effective approaches to early intervention
and resolution. The RBS is a forward-looking
approach, which evaluates both present and
future risks. This is a departure from the earlier
compliance-focused and transaction-based
approach called “CAMELS” which typically covers
point-in-time supervisory assessments. This
requires supervision to become more risk-based
and forward-looking, and not only monitoring
financial indicators that may, to some extent,
be backward-looking in nature. It also requires
delving into less well-known areas, such as
the business model, culture and conduct, and
governance of an Islamic financial institution.

In many countries, the application of RBS to
Islamic banks is still new and not well-developed.
In many cases, specific tools and methodologies
need to be established to supervise Islamic
banks, which are able to assess their unique
risks (including transformation of risk) and
vulnerabilities. The IFSB is yet to issue any specific
prudential guidance on this. It is important to
highlight that the RBS process focuses heavily
on off-site surveillance and is extremely data and
resource-intensive. In this respect, adequate offsite surveillance tools for the RBS of Islamic banks
should be enhanced.
There is a need to combine the analysis of financial
statements, supervisory reporting and on-site
inspections with stress testing exercises to assess
banks’ resilience under different risk scenarios. It
could mean adjusting rating methodologies, such
as CAMELS, to cater to the peculiar nature of
risks (including transformation and commingling
of risk, and Shari’a governance) in harmony with
the IFSB standards.

It is explicable that the BCBS has required both
approaches (i.e. standardised approach and IRB)
for credit risk measurement since the issuance
of Basel II in 2006. On the other hand, the IFSB
has so far only issued the standardised approach
for credit risk measurement for Islamic banks. The
shift in setting ‘provisions’ to expected credit losses
(ECL) through the implementation of IFRS-9 and
its equivalent AAOIFI FAS-30 has changed the
game for supervisors as most of the jurisdictions
supervising Islamic finance seem to be within the
standardised approach.

At the same time, to implement the ECL approach,
neither Islamic banks nor their supervisors were
prepared in terms of historical loss data collection
for various Shari’a-compliant contracts, probability
of default (PD), and loss given default (LGD) to
name a few. While the implementation of IFRS-9
and its equivalent AAOIFI FAS-30 might be a step
closer to IRB implementation and enhancement
to ICAAP; proper guidance is needed for Islamic
banks on the IRB. The IFSB, with its mandate
on prudential supervision, should issue specific
guidance on the implementation of IFRS-9 and its
equivalent AAOIFI FAS-30.

Financial Consumer Protection and Insolvency Regime

Both these elements are underdeveloped in the
Islamic finance industry. While some efforts have
been undertaken by the IFSB, it is yet to introduce
specific prudential guidance on these issues.
Consumer protection has gained more attention
in the aftermath of the GFC as consumers face
more sophisticated, unique, and complex financial
products and markets. From a supervisory
perspective, financial consumer protection is
needed to ensure that consumers receive adequate
and easy-to-understand information, are not
subject to unfair or deceptive practices and have
recourse to fair redress mechanisms to resolve

It is, and should be, an integral part of the
legal, regulatory and supervisory framework. A
robust consumer protection regime for Islamic
banking and finance is pertinent. In dual banking
systems, it is quite challenging for the RSA to
implement a consumer protection regime for
Islamic banks in the absence of certain measures for consumer protection in the conventional
system. Seen broadly, measures for financial
consumer protection in a conventional system
are also applicable in Islamic finance with minor
adjustments due to the specificities.

Some issues that require consideration may
include Shari’a-compliance as an essential and
distinguishing product feature, financing business,
deposit business and damage containment
for Islamic banking consumers, and Islamic
specificities in dispute resolution and damage
containment in (near) failure cases. In this context,
in establishing an effective national consumer
protection regime, RSAs should review and assess
their legislative framework (legal, regulatory and
supervisory framework) to see whether it sets
out financial consumer protection objectives and
responsibilities for conduct of business with regard
to Islamic banking products and services and
whether it provides a clear definition of the scope
of consumer protection mechanisms (consumers
vs. retail investors).

Insolvency Regimes

Insolvency regimes also play a key role in the
financial sector. An efficient recovery and
resolution regime, as well as a robust bankruptcy
and/or insolvency procedure, is essential for
maintaining financial stability. The regime should
address and cover the specificities of Islamic
financial institutions. Among them are priority
of claims, asset sale and transfers, the treatment
of assets funded by PSIAs and the rights of
investment account holders, ownership of the
assets jointly funded by PSIA and the institution,
treatment of reserves such as PER and IRR, legal
governance and enforceability of Shari’a contracts
in the resolution regime. A Task Force on this
issue has been set up bu IFSB to develop specific
guidance to the supervisors.


In any banking system, it is vital for supervisors
to promote a level-playing field. This supervisory
role becomes more complicated in a dual-banking
system with a sizeable Islamic banking component
as the regulator is required to supervise two
sets of banking institutions with different risk
characteristics while ensuring a consistent
regulatory regime.

While too many to mention in this article, each
specific risk characteristic of Islamic banks would
ideally require separate guidance from the IFSB,
or relevant standard-setting body, to ease and
support this challenging supervisory role. Effective
regulation and supervision requires continuous
strengthening of regulatory capabilities in line
with the relevant Islamic finance standards, to
ensure the resilience and stability of the overall
financial system.

The implementation of the IFSB prudential
standards is one way forward to achieve
effective supervision of Islamic banking within a
jurisdiction. Regular and consistent application
of the available IFSB prudential standards will
reduce the likelihood of RSAs facing bigger issues
with the supervision of the Islamic banks as new
rules emerge. To succeed in this effort, RSAs need
to be cognisant of the evolving and emerging
regulatory issues, as well as address the lack of
adequate supervisory expertise in Islamic finance.

Requisite continuous training and capacity
development for supervisors is essential to
develop, nurture and equip scarce supervisors to
be effective and efficient in dealing with peculiar
risks of Islamic finance. There is also a strong
need to have a formal unit with a clear mandate
within a central bank or supervisory authority
to formulate and issue Islamic finance-related
policies and regulations, as well as oversee their
implementation in line with the IFSB and AAOIFI
standards. This unit should work closely with
other departments within the RSA in order to
integrate Islamic finance with the overall financial
system. These efforts are crucial to help RSAs
achieve the long-term sustainability of growth,
stability and resilience of Islamic finance.

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