basel iii impacts on ifsi and role of the ifsb by abdullah haron
TRANSCRIPT
Islamic Financial Services Board
Basel III: Impacts on the IIFSpand the Role of the IFSBBriefing/Workshop on Islamic LiquidityBriefing/Workshop on Islamic Liquidity
Management & Capital Market5-6 May 2012
Abdullah HaronAbdullah HaronAssistant Secretary General
About the IFSB
Introduction
• Based in Malaysia officially inaugurated on 3 November 2002 andBased in Malaysia, officially inaugurated on 3 November 2002, and started its operation on 10 March 2003
• Serves as an international standard-setting body of regulatory and supervisory agencies that have vested interest in ensuring thesupervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry, which is defined broadly to include banking, capital market and takaful
• To this end the work of the IFSB complements BCBS IOSCO andTo this end, the work of the IFSB complements BCBS, IOSCO and IAIS
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About the IFSB cont’d
Objectives
• Develop standards & recommend its implementationDevelop standards & recommend its implementation• Provide guidance on effective supervision and regulation & develop
risk management & disclosure criteria• Establish cooperation with standard international setting bodies &• Establish cooperation with standard international setting bodies &
member countries• Enhance & coordinate initiatives to develop instruments and
procedures for efficient operation and risk managementprocedures for efficient operation and risk management• Encourage cooperation among member countries• Facilitate capacity building and development of human capital• Undertake research• Establish database• Miscellaneous objectives agreed by the General Assembly
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j g y y
About the IFSB cont’d
187 members from 43 jurisdictionsj
By organisational demarcationBy membership type
2727
2626
Regulatory / supervisory authorities
Inter-governmental Associate MemberAssociate Member
Full MemberFull Member 5353
882626
134134
organisations
Financial institutions and professional firmsObserver MemberObserver Member
Associate MemberAssociate Member 88
126126Membership as at March 2012
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AgendaB k d R l t F k• Background: Regulatory Framework
• Basel III Framework: An overview
• Nature of the regulated IIFS
• Impacts of Basel III to IIFS
• The Role of the IFSB• The Role of the IFSB
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Background: Regulatory Framework
Background: Regulatory Framework
AAOIFI: CAR AAOIFI: CAR --excludes risks borne excludes risks borne
IFSB: capital based on IFSB: capital based on the adaptation of Basel II the adaptation of Basel II
standardized formula standardized formula --excludes risks borne by excludes risks borne by the PSIAthe PSIA (standard and(standard and
IFSB: special issues in IFSB: special issues in capital adequacy on capital adequacy on
securitization and realsecuritization and real
2010201019881988 19961996 20062006
by PSIAby PSIA the PSIA the PSIA (standard and (standard and supervisory discretion)supervisory discretion)
securitization and real securitization and real estateestate
G30 recommendations 1994G30 recommendations 1994Basel risk management guidelines for derivativesBasel risk management guidelines for derivatives
2010201020062006
Basel risk management guidelines for derivatives Basel risk management guidelines for derivatives Minimum requirements for trading activitiesMinimum requirements for trading activitiescredit risk treatmentcredit risk treatment
CapitalCapital00--8% based 8% based
di i kdi i k
Capital based Capital based on credit riskon credit risk
on credit riskon credit riskequivalentsequivalents
(also to cover other (also to cover other risks)risks)
-- Standard method Standard method -- Int. rating based Int. rating based
methodmethodAs well as op risk and As well as op risk and
Market risk chargesMarket risk charges
MR StandardMR Standardor Model *3plusor Model *3plus
plus specific riskplus specific riskBasel IIIBasel III
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Market risk chargesMarket risk chargesplus specific riskplus specific risk
Background: Regulatory Framework cont’d
Supervisory review processSupervisory
Supervisory review processAction
Financial(Capital Adequacy)
Governance and Risk management
DisclosuresRegulatoryRequirements
Basic conditions for the effective
The IIFS supervisory authority{P diti the effective functioning of The IIFS sector{Preconditions
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The IFSB standardsIt i i t t t t th ti f b l i thIt is important to note the notion of balance in the regulatory requirements of IIFS and the supervisory review programme employed in this context.
The supervisory authorities will have to exercise judgement regarding the appropriate weights and balance to be given in the application of qualitative and quantitative measures in their policies on capital adequacy riskmeasures in their policies on capital adequacy, risk management, corporate governance and disclosure requirements.
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Development of the IFSB standards
Standard Commencement of preparation
Issuance
Risk management 2003 2005Risk management 2003 2005
Capital adequacy 2003 2005
Corporate governance 2004 2006
Transparency & market discipline
2005 2008
Supervisory review process 2005 2008Supervisory review process 2005 2008
10Note : * corresponds to the date of the 1st meeting of the Working Group
Development of the IFSB standards cont’d
Standard Commencement of preparation
Issuance
Special issues in capital 2006 2008Special issues in capital adequacy
2006 2008
Governance of investment fund 2006 2008
G f T k f l t 2006 2009Governance of Takaful operator 2006 2009
Sharī`ah governance 2007 2009
Conduct of business 2007 2009Conduct of business 2007 2009
Solvency for Takaful 2008 2010
Liquidity risk 2010 2012Liquidity risk 2010 2012
Stress testing 2010 2012
11Note : * corresponds to the date of the 1st meeting of the Working Group
Development of the IFSB standards cont’d
Standard Commencement of preparation
Issuance
Risk management in Takaful 2011 2013 (ED)Risk management in Takaful 2011 2013 (ED)
Revised capital adequacy standard
2011 2013 (ED)
Revised supervisory review 2012 2014 (ED)Revised supervisory review process
2012 2014 (ED)
12Note : * corresponds to the date of the 1st meeting of the Working Group
Basel III Framework:An Overview
Basel III Framework: An Overview
Basel III: Capital and Leverage•More restrictive definition of capital•More demanding capital ratios, bigger capital buffers•Higher capital charges for counterparty risk•Formal leverage ratio
The Global Reform Agenda
Microprudentialg
Basel III: Quantitative Liquidity Standard•Liquidity Coverage Ratio: to survive 1-month stress•Net Stable Funding Ratio: to require longer term
Reform Agenda
•Net Stable Funding Ratio: to require longer term funding sources
Systemic Risk•SIFIs Too big too fail
Macroprudential
SIFIs Too big too fail•Surcharges•Levy and resolution funds•OTC derivatives and central clearing•Non-bank financial institutions
Compensation, Cross Border Resolution, Countercyclical Provisioning, Accounting
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Basel III Framework: An Overview cont’dCapital Leverage Ratio Liquidity Ratio
1a. Increased quantity
•Rise in the overall capital ratios
•Forward looking provisionsf
Liquidity coverage ratio•High quality liquid assets to cover a 30 day stress
Leverage ratio•Includes both on-balance sheet and adjusted off-
2. Enhanced risk coverage and new capital standards for
counterparty credit risk
3. Leverage ratio 4. Liquidity ratio
•Additional requirements for systemically important institutions
cover a 30 day stress scenario
Net stable funding ratio•Measure of structural liquidity
•Based on a long term (1
sheet and adjusted offbalance sheet assets
•A minimum threshold of 3%Credit risk Market risk
Higher capital requirements•Trading book exposures•Securitization exposures1b. Capital buffer
•Based on a long term (1 year) funding requirement
Monitoring metrics•Contractual maturity mismatch1c. Increased quality
Counterparty credit risk•CVA risk•Wrong way risk•Move towards central
•ResecuritizationCapital conservation
Procyclical adjustment
•Concentration of funding•Available unencumbered assets
•Market related monitoring tools
Tier 1: Tighter eligibility standards
To be phased out:•Capital instruments other than common equity
Move towards central counterparties
Tier 2: Simplified
•Intangibles•Deferred tax assets•Other items
Tier 3: Abolished
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Basel III Framework: An Overview cont’dHigher Minimum Capital Adequacy Requirements
2 5%2 5%
11.75% 2.5%2.5%
11.875% 2.5%2.5%
13%
2.5%2.5%
13%
2.5%2.5%
13%
2.5%2.5%
13%14%
12%Counter Cyclical Buffer
Higher Minimum Capital Adequacy Requirements
2.5%2.5%
11.125%
1.25%1.25%
2.5%2.5%
1.85%1.85%
2.5%2.5% 2.5%2.5% 2.5%2.5% 2.5%2.5%
ed A
sset
s
10%Capital Conservation Buffer
4%4% 3.5%3.5% 2.5%2.5% 2%2%
8% 8% 8% 8%2%2%
0.625%0.625%
2%2% 2%2% 2%2% 2%2% 2%2% 2%2%
% o
f Ris
k W
eigh
t
8%
6%
Other Capital
2%2%
3 5%3 5%
1%1%
4%4%
1.5%1.5%
4.5%4.5%
1.5%1.5%
4.5%4.5%
1.5%1.5%
4.5%4.5%
1.5%1.5%
4.5%4.5%
1.5%1.5%
4.5%4.5%
1.5%1.5%
4.5%4.5%
1.5%1.5%
4.5%4.5%
1.5%1.5%
4.5%4.5%
1.5%1.5%%
4%
Other Tier I Capital
Tier I Common Equity
2%2%
3.5%3.5%
2%
0%
Equity
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 20222010
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Basel III Framework: An Overview cont’dTimelineTimeline
2011 2012 2013 2014 2015 2016 2017 2018 2019Minimum common equity capital ratio 3.50% 4.00% 4.50% 4.50% 4.50% 4.50% 4.50%
Capital conservation buffer 0 625% 1 25% 1 875% 2 50%Capital conservation buffer 0.625% 1.25% 1.875% 2.50%Minimum common equity plus capital conservation buffer 3.50% 4.00% 4.50% 5.125% 5.75% 6.375% 7.00%
Phase in of deductions from CET1 (inc. amounts exceeding the limit for DTAs, MSRs and 20% 40% 60% 80% 100% 100%
financials)
Minimum Tier 1 capital 4.50% 5.50% 6.00% 6.00% 6.00% 6.00% 6.00%
Minimum total capital 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%
Minimum total capital plus 8 00% 8 00% 8 00% 8 625% 9 25% 9 875% 10 50%conservation buffer 8.00% 8.00% 8.00% 8.625% 9.25% 9.875% 10.50%
Capital instruments that no longer qualify as non-core Tier 1 or Tier 2 capital
Phased out over 10-year horizon beginning 2013
Leverage ratio Supervisory monitoring Parallel run 1 January 2013 – 1 January 2017 Disclosure starts 1 January 2015 Migration to Pillar 1 Disclosure starts 1 January 2015
Liquidity coverage ratio Observation period begins
Introduce minimum standard
Net stable funding ratio Observation
period Introduce minimum
begins standard
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Basel III Framework: An Overview cont’d
Increase quantity of capital
Better quality of capital
Global Capital Framework
Capital Impact Equity capital to increase by 25%- 40%* or more, banks will need to look at ways to
optimize the use of capital Additional Tier 1 capital need is almost 60% of the current Tier 1 outstanding capital The deferred tax assets change and the new capital instruments will have significant tax Better quality of capital
New leverage ratio
Risk Coverage
g p gimplications
Fall in ROE is 3.7% when not considering impact of NSFR and 4.3% when considering its impact on NSFR
Cost of capital may increase as debt is replaced by equity Restructuring of balance sheet to dispose phased out capital instruments and optimize
Risk CoverageIncreasing capital charges
Counterparty credit risk
usage of capital
Global Requirements for Liquidity Buffers
Liquidity coverage ratio
Net Stable funding ratio
Monitoring liquidity risk
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Basel III Framework: An Overview cont’d
Increase quantity of capital
Better quality of capital
Global Capital Framework
Better quality of capital
New leverage ratio
Risk CoverageRisk CoverageIncreasing capital charges
Counterparty credit risk
Global Requirements for Liquidity Buffers
Liquidity coverage ratio
Liquidity Impact Additional 40% requirement for liquidity over the liquidity buffer held currently Require an additional increase of 10 – 15% of stable funding over the currently available
stable funding Liquidity risk stress testing and reporting pose challenges for many banks
Net Stable funding ratio
Monitoring liquidity risk
Liquidity risk, stress testing and reporting pose challenges for many banks Impact on income as bank invests in more liquid investments and curtailed loans maturity
to match available stable funding Increased cost of liquid funds as demand increases and high interest costs of holding
stable funds
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Basel III Framework: An Overview cont’d
Increase quantity of capital
Better quality of capital
Global Capital Framework
Implementation issues and Operational costsBetter quality of capital
New leverage ratio
Risk Coverage
Additional costs of implementation of systems for Basel III compliance is estimated to be between 30 – 50% of outlays for Basel II implementation
Interdependence and complexity in designing systems to capture granular data for modeling and stress testing
Drafting and incorporating new risk management policies and processes Increased operational costs of monitoring reporting and being compliant by 2012Risk Coverage
Increasing capital charges
Counterparty credit riskStrategic implications Restructuring or disposals of some business units to optimize usage of capital Inability to provide full-fledged services or products (trading, securitization) due to
increasing capital charges and restrictions which can be up to a factor of 10 for
Increased operational costs of monitoring, reporting and being compliant by 2012
Global Requirements for Liquidity Buffers
Liquidity coverage ratio
c eas g cap ta c a ges a d est ct o s c ca be up to a acto o 0 osecuritization
Pressure to increase lending spreads leading to possible loss of valuable customers
Risk of falling below shareholder ROE expectation Growth can take a backseat with increased capital, liquidity and leverage
Net Stable funding ratio
Monitoring liquidity risk
requirement
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Nature of the regulated IIFSNature of the regulated IIFS
Stylised Balance Sheet of an IIFS
ASSETS
Cash & cash equivalents
LIABILITIES
Current accountsq
Sales receivables
Investment in securities
Investment in leased assets
Other liabilities
Equity of Profit Sharing InvestmentInvestment in leased assets
Investment in real estate
Equity investment in joint ventures
Equity of Profit Sharing Investment Accounts (PSIA)
Profit Sharing Investment Accounts (PSIA)
Equity investment in capital ventures
Inventories
Other assets
Profit equalization reserve
Investment risk reserve
Fixed assets Owners’ Equity
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Risks: IIFS vis-à-vis conventional banks• Unlike the predominantly borrowing and lending operations• Unlike the predominantly borrowing and lending operations
performed by conventional banks, the stylized balance sheet of an IIFS suggests that its business activities resemble a “one-stop shopping” model.resemble a one stop shopping model.
• The nature of risks to which an IIFS is exposed is not necessarily the same as those of a conventional bank.y
• IIFS do not have the option to sell at a discount or to repackage and sell off their financial assets (e.g.
i bl ) i i hi h hi hreceivables) as securities, which represent a high percentage of total assets, in order to take the risk off their balance sheet.
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T f Ri k D fi iti
Risks: IIFS vis-à-vis conventional banks cont’dType of Risks Definition
Equity Investment Risk
The risk arising from entering into a partnership for the purpose of undertaking or participating in a particular fi i l b i ti it d ib d i thfinancing or general business activity as described in the contract, and in which the provider of finance shares in the business risk. This risk is relevant under Muḍārabah and Mushārakah contracts.a d us ā a a co ac s
Rate of Return Risk The potential impact on the IIFS’ returns caused by unexpected change in the rate of returns.
Displaced The risk that the IIFS may confront commercial pressureDisplaced Commercial Risk
The risk that the IIFS may confront commercial pressure to pay returns that exceed the rate that has been earned on its assets financed by investment account holders. The IIFS forgoes part or its entire share of profit in order t t i it f d id d di d th fto retain its fund providers and dissuade them from withdrawing their funds.
Sharī`ah Noncompliance Risk
Risk arises from the IIFS’ failure to comply with the shariah rules and principles
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Noncompliance Risk shariah rules and principles.
Risks: IIFS vis-à-vis conventional banks cont’dOverall IIFS have been well capitalised since theyOverall, IIFS have been well capitalised since they
started their operations. Tier 1 and total capital requirements currently stand at 8% and 12% respectively.respectively.
• IIFS have non-financial assets in their balance sheets
C it l h ith t t i t i k–Capital charges with respect to inventory risk
• Majority of Islamic banks assess their credit risks by applying the standardised approachapplying the standardised approach
–Lack of data and smaller sample size
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Risks: IIFS vis-à-vis conventional banks cont’d• IIFS enjoy additional buffer through loss sharing nature of• IIFS enjoy additional buffer through loss sharing nature of
Muḍārabah contract – the risks of assets funded by the PSIA under the Muḍārabah contract are excluded from the calculation of CAR.calculation of CAR.
• The IIFS could use Investment Risk Reserve (IRR) and Profit Equalisation Reserve (PER) to protect the PSIA q ( ) pinvestors from financial risks.
• The IIFS will bear losses for the risks arising from li i d i i i h PSIAnegligence or misconduct on its part in managing the PSIA
– operational risk.
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Impact of Basel III on IIFSImpact of Basel III on IIFS
Impacts of Basel III to IIFS
Increase quantity of capital
Better quality of capital
Global Capital Framework
Current ScenarioBasel III approaches to enhance the quality of capital. The enhancement changes the
demographic of debt based capital to one of equity. IIFS already have a higher proportion of equity as capital.Basel III covers buffer capital ratios introduced via the Capital Conservation Buffer andBetter quality of capital
New leverage ratio
Risk Coverage
Basel III covers buffer capital ratios introduced via the Capital Conservation Buffer and Counter Cyclical Capital Buffer. The IIFS have introduced Investment Risk Reserve and Profit Equalisation Reserve.
Capital ImpactRequire IIFS to hold much more of the best form of capital while some of the existing capitalRisk Coverage
Increasing capital charges
Counterparty credit risk
Require IIFS to hold much more of the best form of capital while some of the existing capital will cease to count.Deductions from capital will increasingly be made from core tier 1.Dividends and bonuses will be constrained to boost core tier 1.IIFS will have to hold purer liquidity in larger amount and match closely between their lending
and deposit base.
Global Requirements for Liquidity Buffers
Liquidity coverage ratio
pA large part of the IIFS’ profits over the next decade will go into the new standing funds.
Leverage RatioPSIA cannot be included in additional Tier1 capital because they do not meet the criteria set
out by the Basel III.Net Stable funding ratio
Monitoring liquidity risk
out by the Basel III.Assets financed by the PSIAs are excluded from the exposure measure because the PSIAs
are not included in the Tier 1 capital.Generally, IIFS are not highly leveraged due to the strict prohibition of 33% debt to equity
ratio.In summary, no noticeable impact on IIFS positions.y, p p
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Impacts of Basel III to IIFS cont’d
Increase quantity of capital
Better quality of capital
Global Capital Framework
Better quality of capital
New leverage ratio
Risk Coverage Current ScenarioRisk CoverageIncreasing capital charges
Counterparty credit risk
Current ScenarioLiquidity has been a major issue in Islamic finance due to the nature of Islamic financial
instruments and contracts which tend to be short to medium term given the lack of depth in the long-term liquidity market.Challenges also include a) lack of appropriate standardised liquidity instruments, b) limited
capability to transfer fund across borders, and c) reliance on retail funding which locks the
Global Requirements for Liquidity Buffers
Liquidity coverage ratio
p y ) gIIFS to domestic markets.
Liquidity Requirement ImpactHighly rated Sukuk are considered to meet the stock liquidity requirements.Th d t i t i t k f t th t b t d i t h i th i d t
Net Stable funding ratio
Monitoring liquidity risk
The need to maintain a stock of assets that can be turned into cash requires the industry stakeholders to collaborate with one another.Treatment of PSIA and other sources of funds with respect to the run-off in the calculation of
liquidity ratio.The role of rating agencies will play a role in determining sukuk rating.
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Impacts of Basel III to IIFS cont’d
Increase quantity of capital
Better quality of capital
Global Capital Framework Tier 1 is already
the case of IIFS
Tier 3 is limited inBetter quality of capital
New leverage ratio
Risk Coverage
Tier 3 is limited in IIFS
PER and IRR playRisk CoverageIncreasing capital charges
Counterparty credit risk Leverage is already low in IIFS
PER and IRR play similar role in forward looking provision and
counter cyclical capital
Global Requirements for Liquidity Buffers
Liquidity coverage ratio
already low in IIFS
Shari`ah compliant I t t
Net Stable funding ratio
Monitoring liquidity risk
Instruments
Establishment of the IILM
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The Role of the IFSBThe Role of the IFSB
The Role of the IFSB
Against the backdrop of the global financial crisis and economic downturn, regulatory authorities have focused on securing financial stability and rebuilding the trust of various stakeholders in the industry.
Basel Committee addresses the weaknesses through both micro and macro prudential measures in its current work.
Micro Macro
Task 2: Improve the coverage of risk
Task 1: Introduce a leverage ratio
Task 2: Introduce measures to raise capital in d ti th t th b d d i
Task 1: Raise the quality of capital
Task 3: Require much higher levels of capital to absorb the types of losses associated with the crisis
T k 4 I t d l b l li idit t d d t
good times so that they can be drawn down in periods of stress to reduce procyclicality
Task 3: Require globally systemic banks to have additional loss absorbanccy
Task 4: Introduce a global liquidity standard to supplement the capital regulation
y
Task 5: Introduce stronger supervision, risk management and disclosure standards
The Role of the IFSB cont’dThe IFSB issued two new guiding principles on: 1)The IFSB issued two new guiding principles on: 1)
Liquidity Risk Management and 2) Stress Testing for institutions offering Islamic financial services (IIFS).
–The liquidity risk management endeavors to delineate a set of guiding principles for the robust management of liquidity risk by IIFS and its vigorous supervision and monitoring by supervisory authorities taking intomonitoring by supervisory authorities, taking into consideration the specificities of IIFS and complementing relevant existing and emerging international standards and best practicesinternational standards and best practices.
–The stress testing aims to provide a set of guiding principles intended to complement the existing p p p ginternational stress testing framework.
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The Role of the IFSB cont’dThe IFSB has formed a working group last year aimingThe IFSB has formed a working group last year, aiming
to revise the existing IFSB standards on capital adequacy including sukuk, securitisation, real estates
–Not to put IIFS at a disadvantageous position;
–Provide guidance on capital adequacy treatment of j Sh i’ h li t d tmajor Shari’ah compliant products;
–Offer enough flexibility;
–Address the peculiarities of IIFS with respect to various components of eligible capital, while taking into account the prevailing experiments by some IIFS to raise capitalthe prevailing experiments by some IIFS to raise capital through innovative Shari’ah compliant structures; and
–Promote robust risk management
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Promote robust risk management.
The Role of the IFSB cont’dThe IFSB is working on revising the IFSB 5 in order toThe IFSB is working on revising the IFSB-5 in order to
ensure that the review process covering IIFS will be consistent with those for conventional institutions and relevant to the current state of the industry, whilerelevant to the current state of the industry, while catering for the specificities of Shari’ah-compliant financial transactions. In this respect, the working group will consider:
– the specificities of the IIFS (through reviewing the feedbacks in the IFSB workshops, seminar etc);
– the lessons learned from the financial crisis; and
– the existing international standards on supervisorythe existing international standards on supervisory review process such as that of the BCBS and EBA.
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Th k f tt tiThank you for your attention
References1. M. Hasan, “Impact of Basel III on Islamic Banks”, IMF-STI Seminar on Islamic Banking, Oct 20112. KFH Research Limited, “Basel III Impact on Islamic Banking”, Islamic Finance Research, Aug 20113 S Srivastava “Introduction to Basel III” IFSB Seminar on Risk Mitigation and Enhancing Financial3. S. Srivastava, Introduction to Basel III , IFSB Seminar on Risk Mitigation and Enhancing Financial
Stability in Islamic Finance: Contingent Capital and Takaful, Jan 2011