LONDON, 31 May 2004 — While regulators of the thirteen or so leading industrial countries move closer toward the final draft text of the new Basel II Capital Accord, the new set of risk-based regulations for international banking especially for capital and credit requirements, due to be adopted at end 2006, the banking regulatory challenges for the leading member countries of the Islamic Development Bank (IDB) are equally challenging, if not more.
Some of the outstanding issues in Basel II remain. These include the capital treatment of credit cards, a major issue especially for the banking majors in markets such as North America where they have huge exposure to such credit risk; the assessment of operational risk; and the "own credit standing" accounting item which is still a point of contention between the Basel Committee and the IAS (International Accounting Standards).
Malaysia, not surprisingly, is the first and only IDB-member country to have announced a plan of implementation of Basel II. The first phase will begin in January 2008, and the second phase in 2010. In the first phase, Malaysian banks will adopt the "Standardized" approach for operational risk at supervisory discretion. Bank Negara Malaysia, the central bank, in fact in October 2002, conducted a study to ascertain the impact of Basel II on the local banking industry using the "Standardized" approach.
Bank Negara acknowledges that Basel II imposes many supervisory challenges. As such, as a pre-requisite for effective supervision, the central bank is providing continuous training and exposure to key staff to keep abreast with the developments globally to ensure that Malaysia is at par with international best practice. At the same time, it is also a requirement for senior risk management staff at all the 10 banking groups in the country to similarly be trained as a precursor to effective implementation of Basel II at their institutions.
This dual banking model is now becoming the standard for many of the IDB-member countries. In the GCC, almost all the countries follow a de facto dual banking model. The main exception is Saudi Arabia, where only one general banking law exists, which does not distinguish conventional banking from Islamic banking. In other countries such as Pakistan, where previously the unilateral "Islamization" of the banking system was introduced, and subsequently failed, the dual banking model is now officially adopted, according to a recent confirmation by Dr. Ishrat Hussein, governor of the State Bank of Pakistan.
Dr. Zeti Akhtar Aziz, governor of Bank Negara Malaysia, who was earlier this year voted the "International Central Banker of the Year 2003" by "The Banker", published by the Financial Times Group, outlined the Bank Negara regulatory ethos for Islamic banking at a conference in London in mid-May 2004. "The challenge," she stresses, "is to formulate a framework that not only takes into account the unique characteristics peculiar to Islamic banking business, but that does not put Islamic financial institutions at a comparative disadvantage and affect their competitiveness and growth potential in the overall financial system." However, these regulatory requirements must also comply with Shariah injunctions and must take into account the multi-faceted role performed by Islamic banks.
The Islamic Financial Services Board (IFSB), the multi-national prudential and supervisory standard-setting body established in December 2002 in Kuala Lumpur, is working on issuing a capital adequacy standard for Islamic banks (among others such as corporate governance and risk management standards) perhaps before the end of 2004. But how these square with the proposed Basel II Accord will only become clear once the standards are published and adopted.
"Of equal importance," adds Dr. Zeti, "is the need to ensure that there is no opportunity for regulatory arbitrage in banking practices that makes one system more superior to the other in terms of product pricing. The Malaysian experience has a further variant of the dual banking model where conventional banking institutions are able to offer Islamic banking products and services."
The Malaysian dual banking model seems to be working very well. During the Asian financial crisis in 1997-1998, the Islamic financial system in Malaysia showed its resilience to market vulnerabilities. It is also steadily increasing its market share of the total banking system - the market share of Islamic banking deposits of the total deposits of the Malaysian banking system is about 10.8 percent for end 2003. Bank Negara has a 20 percent target of market share by 2010, which Islamic bankers stress is eminently achievable and on track.
Indeed in Malaysia Islamic banks not only have to observe international banking regulatory and supervisory standards, but also additional requirements such as a minimum Islamic banking fund for Islamic banking operations; maintaining an internal separation of accounting books; disclosing the fair and true value of the Islamic banking operations in the form of balance sheet and profit-and-loss statements as part of notes to the accounts in the main financial statements of the banking institutions.
This stresses Dr. Zeti is to duly reflect the different risks and unique characteristics inherent in Islamic banking as compared to conventional banking. And where, Islamic banking operates on a window basis, the existence of a "firewall" is to ensure the strict compliance to Shariah principles.
The $64 million question is how many of the IDB-member country regulators and supervisors are indeed fully equipped with this supervisory oversight infrastructure?
