News Column

IFSB Secretary General outlines the challenges facing Sukuk

July 2, 2014

In his Keynote Address at the 2014 London Sukuk Summit, at the Jumeirah Carlton Tower on 18 June, Jaseem Ahmed, Secretary-General, Islamic Financial Services Board, noted that the high growth rate of the Islamic finance industry has led to the emergence of Islamic finance sectors that have attained systemic importance in a number of key economies in Asia and the wider Gulf and Middle East.

He said, "At a benchmark of 20 per cent of total financial sector assets, there are seven national economies in which Islamic finance could be described in this way. At a 15 per cent threshold the number of jurisdictions with systemically important, or sectors that are too big to ignore, rises to 11." Ahmed went on to say, "The second striking aspect of the global IF industry I wish to highlight, one which has major implications for the IFSB's operational strategy, is that rapid growth of Islamic finance is taking place in a group of nations that display wide variation in their market, institutional and policy and regulatory development.

"This stands in stark contrast to the members of the Financial Stability Board, which plays a critical role in the design of the global regulatory architecture. This feature points to an important point of difference to be made about the role that the FSB and IFSB standards play in their respective industries.

"The FSB and the IFSB have a shared goal in promoting the stability and resilience of the global financial system. However, for the IFSB, there is the broader objective of promoting and growing the IF sector through the consistency in treatment across jurisdictions that is provided by its standards.

"For the G20 or FSB group of countries, given their relatively homogeneous state of development and capabilities, the implementation of standards is conducted within a structure that emphasis transparency and accountability through voluntary participation in peer reviews and IMF FSAPs that are then published and publicly disseminated. Peer pressure, and the use of well-developed assessment methodologies are playing an instrumental role in the progress of national implementation of international standards issued under the FSB's direction.

"At the IFSB, we are making progress towards the development of a more systematic framework of our own to support implementation. The starting point of implementation is of course the formulation of a comprehensive range of standards. At present the IFSB has 22 standards and guidance notes (GN) in place. These include five standards produced in the last two years that directly respond to the new Basel III capital and liquidity framework. There are three more standards or GNs under preparation that takes this further, including for liquidity management to which I will be turning shortly. The banking sector, as well as the Takaful sector, has received substantial coverage, and we are bringing capital markets and Sukuk under our focus."

The IFSB Secretary General noted that the key priority is to find the resources and organisational modes and partnerships that help committed jurisdictions to meet the challenges they face, and wish for assistance in addressing.

Liquidity Management and Recent Regulatory Developments

"The drying up of liquidity – both funding liquidity and market liquidity – featured as a critical factor in the breakdown of the global financial system in 2008. This was the major focus of the initial efforts to restore stability in financial markets through the exercise of the lender of last resort function which injected unprecedented liquidity into the global financial system. Subsequently, the Basel III liquidity framework has refined the concept of High Quality Liquid Assets (HQLA) and introduced two measures, the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), amongst others, to bolster this framework. The LCR comes into effect in 2014 but is to be phased in by 2019.

"The two critical aspects of HQLA are in relation to Fundamental characteristics andMarket-related characteristics.

"Fundamental characteristics require that assets should be low risk as reflected in the high credit rating of the issuer or the instruments. The asset should ideally be listed on a national or some regional or international stock exchange to ensure that sufficient information on pricing and trading is available to the public.

"Market related characteristics refer to the requirement that the assets should be traded in markets where there is historical evidence of market breadth and market depth. The asset prices are expected to have remained relatively stable and be less prone to sharp price declines over time, including during stress conditions.

"These are quite demanding requirements, and they underscore the key importance of developing policy frameworks that squarely address them over the medium term. The immediate issue that has featured in the IFSB's dialogue with the Basel Committee is that many if not most Islamic finance jurisdictions will be challenged to provide markets and assets that meet them.

"The IFSB has an ongoing dialogue with the Basel Committee which includes our participation in the BCBS's Consultative Group which meets three times a year. Senior BCBS officials also offer their views and insights to the IFSB in a number of formats, including as members of our Working Groups for standards preparation, from time to time.

"Prior to the issuance of the LCR rules in January 2013, BCBS had requested a Note from the IFSB on the implications of the draft proposals for the IIFS. In our Note, which was submitted in June 2012, we offered a number of perspectives stressing the challenges faced by our jurisdictions in meeting some of the key requirements of the LCR proposals.

"We suggested that jurisdictions in which Islamic finance featured be provided with flexibility at the national level in terms of the instruments and securities to be used. We also suggested that the Alternative Liquidity Arrangements (ALA) framework developed by BCBS for jurisdictions with limited high quality assets, be applied to Islamic finance jurisdictions.

"I am pleased to report that the flexibility that we requested for Islamic finance features in the final LCR rules issued by the BCBS.

"Within this context, at this stage, we are preparing a Guidance Note that will address the LCR requirements, which we hope to release in Exposure Draft form by the end of 2014. This GN will draw upon a Survey of RSA's and IIFS and a Quantitative Impact Study that have been completed by the IFSB. Our research and deliberations to date suggest that most IIFS will be able to meet the LCR requirements. However, there are a number of constraints to meeting the criteria for HQLA as a result of which liquidity is found to be held chiefly in the form of cash in many IIFS, with the exception of a small number of jurisdictions.

"There are two distinct elements of the liquidity management infrastructure for Islamic finance that constitute continuing challenges. First, the high reliance on cash reflects an inefficient allocation of resources that puts Islamic banks at a disadvantage in relation to the conventional banking system. This is the result of a continuing absence of the liquid markets, in particular for inter-bank markets, in which highly rated securities can be traded. In addition, the scarcity of Shari`ah compliant securities that meet liquidity needs also leads to buy and hold strategies that limits trading. Second, two other major elements of the liquidity framework – the lender of last resort and the deposit insurance scheme – have yet to be developed in the majority of Islamic finance jurisdictions. This also leads to holding of liquidity in cash.

"First, the IFSB will provide guidance on the types of Shari`ah compliant securities that would meet the requirements of the LCR, in the first instance. Sukuk issued by Sovereign and quasi-sovereign entities, and by multilateral development banks and other international institutions, are likely to feature prominently. We hope to issue this GN in 2015.

"Second, subject to the issuance of the final BCBS document on the NSFR, which is expected later this year, we will be seeking the IFSB Council's approval to prepare a similar GN for the NSFR.

"Third, the IFSB has launched a research program that is studying issues and constraints in relation to the development of Shari`ah compliant financial safety nets. We have completed the first working paper on the SLOLR which is now on our website. We are also launching in 2014 a related study on Shari`ah compliant deposit insurance schemes. These two studies, and the overall research program, will form the basis of further deliberations for specific guidance to be provided in this critically important area.

"Fourth, and finally, The IFSB's initial assessment of the liquidity management framework in Islamic finance, incorporated in the Technical Note on Liquidity of 2008, remains substantially valid in the policy directions that it laid out. We noted the lack of well suited money market instruments and interbank markets, and the insufficient use of securitization techniques. The absence of money markets reduced the incentives to securities assets and manage risks by trading in such assets to match maturity and risks on the balance sheet.

"In particular, we stressed the critical importance of Government issuances of Shari`ah compliant securities, of which Sukuk is a prime example, in sufficient volumes and range of maturities which would serve to help address these constraints and lead to the development of liquid markets and instruments for liquidity management purposes and other purposes… A comprehensive and integrated approach in the development of Shari`ah compliant money and securities markets will be important for those jurisdictions that wish to encourage the development of a strong and vibrant Islamic banking sector.

"For jurisdictions in which these Shari`ah compliant markets and instruments are still not fully developed, and in which an Islamic banking sector either already features or is likely to be introduced, the ALA framework provides an alternative approach. One such alternative is the use of central bank 'committed facilities' which can be provided at a fee.

"Finally, on this subject, although there are significant hurdles ahead before we can say that a robust liquidity management framework is in place for Islamic finance, there are also encouraging developments. Indeed, a number of countries have launched their sovereign Sukuk programs with this in mind. Some of the recent additions to this group of countries are developing the capacity to fully integrate Islamic finance into their government public expenditure programme. This would set the stage for a progressive mitigation of the current constraints on the liquidity framework.

"Another significant development is the establishment by the OIC Central Banks of a WG on liquidity management, which is drawing on the IFSB's 2008 Technical Note to develop a comprehensive approach to this subject.

Challenges for the future

"Despite the truly remarkable growth of the Sukuk market, shortage or unavailability of Shari`ah-compliant securities/Sukuk in many jurisdictions compels Islamic financial institutions to maintain a higher level of cash and non-earning liquid assets than conventional institutions.

"In those jurisdictions where Shari`ah-compliant securities/Sukuk are available, the lack of an active trading or repurchase (repo) market remains an ongoing problem. More generally, in the majority of jurisdictions there is a lack of a Shari`ah -compliant Lender of Last Resort (SLOLR) scheme to protect IIFS' soundness and stability in situations of serious liquidity stress.

"On the other side of the balance sheet, in most jurisdictions deposits and profit sharing investment accounts (PSIA) are not covered by a reliable Shari`ah-compliant deposit insurance scheme. All these factors affect the performance and competitiveness of Islamic financial institutions vis-À-vis conventional financial institutions in such jurisdictions."

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Source: CPI Financial

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