ISWGNA Task Force on Islamic Banking Islamic Finance

ISWGNA Task Force on Islamic Banking Islamic Finance in Policy and Surveillance Russell Krueger Economic and Social Commission for Western Asia (ESCWA) Beirut October 24 – 26, 2017 o 7

Overview of Lecture I. State of the Art – Statistical initiatives related to Islamic banking and finance II. Statistical perspectives on Islamic finance in surveillance III. Islamic finance statistics in future surveillance 1

State of the Art: Initiatives related to statistical coverage of Islamic banking and finance Recent pickup in research and initiatives related to Islamic banking and finance - IFSB programs have a central place in these initiatives (PSIFIs, Compilation Guide, Capital Markets, Takaful) o o o IMF – Substantial increase in focus on Islamic finance IMF meetings on macroprudential analysis and indicators and Compilation Guide (April 2017) IMF WP/17/161 “Basel Compliance and Financial Stability: Evidence from Islamic Banks” July 2017 n Comparison of Basel Core Principles in bolstering financial stability in conventional and Islamic banks n Econometric study of individual bank indicators similar to PSIFIs UN Statistical Division project on Islamic finance in the SNA SESRIC “Developing Islamic Financial Industry Database of OIC Member Countries” Mugla, Turkey 24 Sept. 2017

IMF Focus on Islamic Finance o IMF: Substantial increase in focus on Islamic finance n n n n 2015 IMF Director Christine Legarde announced Islamic Finance will be part of surveillance IMF Working Group on Islamic Finance, including External Advisory Group Paper “Ensuring Financial Stability in Countries with Islamic Banking” (January 2017) First comprehensive statement of IMF policy on Islamic Finance “IMF Executive Board Adopts Decisions to Strengthen the Financial Stability in Countries with Islamic Banking” (February 2017) Participation in PSIFI Task Force IMF Staff Note “Use of Supervisory Standards in Financial Sector Assessment Program” Forthcoming in 2019 – Comprehensive Surveillance Review as opportunity to increase involvement in Islamic finance

IMF “Ensuring Financial Stability in Countries with Islamic Banking” – January 2017 o o o IMF review of financial stability issues for Islamic banks Eight countries – Bahrain, Djibouti, Indonesia, Kenya, Kuwait, Malaysia, Nigeria, Pakistan Some conclusions and recommendations n Strong regulatory and institutional framework and level playing field are needed for sound and stable growth – allows normal expansion of market n Flexibility in approaches to IB has fostered greater acceptance of IB principles n Licensing requirements have not been effectively used to ensure that IBs have key structures that support supervision n Licensing process must require proof of a robust Shari’ah governance framework and internal controls n Windows must provide proof of systems and procedures to separate IB activities from conventional ones n Greater consistency is needed in capital adequacy requirements including by applying IFSB standards n Regulations do not fully account the different credit risk and provisioning requirements between debt-based products (Mudarabah, Ijarah) and risk-sharing products (Musharakah and Mudarabah)

Ensuring Financial Stability in Countries with Islamic Banking – more conclusions o Centralized Shari’ah boards that help standardize industry practices and improve consumer perceptions have been established in only a limited number of countries Consumer protection frameworks have focused more on improving disclosure but, they often are not anchored in laws or regulations need greater protection of IAHs interests Liquidity management frameworks need strengthening Need further development of Shari’ah-compliant capital and interbank markets Adapt central bank monetary operations and Lender of Last Resort framework. Promote regular sovereign issuance of tradable Sukuk with different maturities Develop resolution frameworks and Shari’ah compliant deposit insurance schemes o Need legal clarity on treatment of investment accounts in bankruptcy o o o “It is recommended that countries with dual banking systems compile separate aggregate data for IBs, in addition to standard monetary statistics, to allow monitoring of specific indicators for the IB system such as growth in financing (credit) and sources of funding (deposits). ”

WP comparing Islamic and conventional banks o o o IMF WP/17/161 “Basel Compliance and Financial Stability: Evidence from Islamic Banks” (July 2017) Role of Basel Core Principles in bolstering financial stability in conventional and Islamic banks Econometric study of individual bank indicators similar to PSIFIs – capital, liquidity, cost to income, assets size, assets growth, noninterest/nonfinancing income Mixed results – Cases where Islamic banks reacted the same and cases where Islamic reacted differently – identifies areas for investigation Potential research agenda comparing BCPs and CPIFRs

Islamic finance in the SNA o UN Statistical Division project on Islamic finance in the SNA n Krueger “Some notes on Islamic finance in the SNA” n Covers Islamic bank income statement and balance sheet, measurement of production of Islamic banks, classification of Islamic financial institutions, distributions to IAH, and PSIFI structural data o 3 -day meeting of experts in Beirut in October o UN meeting in December to develop policy on Islamic finance in national accounts n Potentially affects macroeconomic statistics for all countries with Islamic banking

IMF “Use of Supervisory Standards in Financial Sector Assessment Program” (June 2017) o o o New statement on use of supervisory standards in FSAP assessments Staff consulted with the supervisory bodies: BCP; Insurance Core Principles – ICP; Principles of Securities Regulation – IOSCO FSAP have voluntary assessment reports on adherence to these principles; These serve as benchmarks for “Focused Reviews” on deficiencies identified Use a macrofinancial approach that combines quantitative and qualitative criteria Although standard are to be assessed as coherent wholes, in each certain “Base Principles” such as capital adequacy are emphasized Statement does not cover Islamic finance principles, but should and countries might request assessment reports: n IFSB-15 CPIFR, IFSB-8 Guiding Principles on Governance of Takaful, IFSB-19 Guiding Principles on Disclosure Requirements for Islamic Capital Market Products

IMF Meetings on Macroprudential Indicators o Two meetings April 26 – 28 at IMF on macroprudential analysis and indicators n Users’ Perspectives on Financial Soundness Indicators Policy officials and researchers that covered nature of macroprudential risks, use of indicators in policy and surveillance, and future directions. n FSI Reference Group Meeting of FSI Reference Group to discuss issues related to draft FSI Compilation Guide and future directions of work

Some results of meetings o o o “FSIs are the core measure of the condition of the financial system. ” FSIs in macroprudential analysis, early warning systems, and surveillance Linkages between FSIs and other analytic tools – including use in flow of funds analysis and sectoral balance sheets Concentration and Distribution Measures (CDM) Recognition and valuation of impaired assets Use in FSAP and Surveillance Major conclusions and recommendations are in separate slideshow “Results of IMF Meetings on Macroprudential Analysis”

SESRIC Islamic Finance Database o “Developing Islamic Financial Industry Database of OIC Member Countries” Mugla, Turkey 24 Sept. 2017 o Statistics compilers from central banks, national statistical offices, insurance supervisors, securities supervisors, international organizations o Review of current activities and roadmap for Islamic Finance data

New Research: Basel Core Principles impact on Islamic and conventional banks o o o IMF WP/17/161 “Basel Compliance and Financial Stability: Evidence from Islamic Banks” July 2017 Econometric review of soundness of 761 Islamic and conventional banks in 19 countries Whether compliance with BCP affects Islamic bank stability differently than conventional banks’ → Mixed results – Cases where Islamic banks reacted the same and cases where Islamic reacted differently Tested at individual bank level many of the same variables used in core PSIFIs – capital, liquidity, cost to income, assets size, assets growth, noninterest/nonfinancing income Dependent variable is “Z-index” of profitability (return on assets) and capital strength (equity to assets) Independent variables included FSAP evaluation of adherence to BCP, individual bank accounts, country macroeconomics and institutional features

Basel Core Principles impact on Islamic and conventional banks o o o o o Overall results – Adherence to BCP highly significant for conventional bank soundness; Significant but less so for Islamic banks “BCP compliance is the main factor driving the Z-score of both bank types through incentives to hold higher capital ratios in a strong regulatory environment” Compliance “discourages excessive risk taking, which is inversely correlated with higher profits and volatile earnings” Most important variable was capital strength Rate of growth of total assets is negatively associated with Z-score, reflecting weak screening standards and less monitoring incentives Islamic bank liquidity ratios have a negative effect on bank profits but positive effect on capital, netting to insignificant effect on Z score The cost to income ratio has negative effect, “suggesting that managerial inadequacies reduce bank profitability and increase risk” Significant negative association for conventional banks between BCP compliance and proxies for credit risk, but only limited for Islamic banks Banks are more stable in countries with better GDP growth, higher mineral rents, lower oil-industry rents, and lower inflation Institutional and regulatory factors are important determinants of soundness of Islamic banks

Basel Core Principles impact on Islamic and conventional banks - Some takeaways o o o Provides micro-level analysis of the mechanisms underlying numerous PSIFIs BCPs are applied to all banks – Are BCPs properly attuned to Islamic banks? IFSB’s CPIFR only created in 2015 – Would application of these principles over time produce better results? n o Researchers looking forward to IFSB data collection in 2017 on application of CPIR Next steps n n n Explore the effect of CPIFRs on the stability of Islamic banks and compare effect of BCPs Identify which BCP and CPIFR (especially the specific Islamic principles) are responsible for significant effects on bank stability Proposal – Examine full range of PSIFIs at the bank level.

II. Statistical perspectives on Islamic finance in surveillance How do Islamic financial statistics fit into surveillance of financial soundness? o From a statistical perspective…. n n n o o Availability of statistics on Islamic finance is a precondition to understand its roles within the finance sector and full economy. Focus on the whole banking sector can obscure key information about both the conventional and Islamic components Analysis operates at different levels – granular data on individual banks, macroprudential data on subsectors and peer groups (such as PSIFIs), and sector wide macrostatistics PSIFIs for the first time allow analysis of behavior of the Islamic subsector within the financial system and how the overall picture is affected Compilation of national accounts measures of Islamic finance is an additional step that would enhance the analysis

Analysis of Islamic finance data is just beginning o o o PSIFI data are new and are not yet regularly included in surveillance In time, understanding will increase about the behavior of the Islamic banking subsector and how the subsector interacts with the rest of the economy The patterns revealed differ by country Topical coverage of PSIFIs will expand (capital markets and nonbank financial institutions) to support surveillance of the full financial sector Capacity building in surveillance of Islamic finance is needed, both in countries and in international institutions

Countries with significant Islamic banking o In some countries, Islamic banking is large enough to likely affect overall surveillance n n n o Southeast Asia – Bangladesh, Brunei Darussalam, Indonesia, Malaysia Middle East – GCC countries, Jordan In other countries, it is an empirical question whether the Islamic banking sector is large enough to affect overall surveillance – Turkey, Egypt, Iraq, etc. Within the Islamic banking sector, unique conditions might prevail that should be separately analyzed. That is, Islamic banking can be analyzed as a separate “peer group”. n However, Islamic banking, as a peer group, has special features that present a steep learning curve for surveillance teams

III. Islamic finance statistics in surveillance o o o Surveillance refers to regular reviews of financial and macroeconomic conditions to analyze current conditions and structural/legal situations, and recommend policy actions and development programs IMF Article IV consultations are annual reviews of monetary, financial, and general macroeconomic conditions and policies. PSIFIs should be part of surveillance of financial systems, but only beginning to be used Parallel national accounts data lag – limits analysis of interactions with full economy and policy implications Directions ahead are uncertain. Learn as you go, and make adjustments as relevant. However, PSIFI data are now available – time is ripe for systematic review of the role of Islamic banking

Partial isolation of Islamic banking o o Islamic banks’ activities are “Sharī’ah-compliant” – They are constrained to act within a restricted pool of Sharī’ah-compliant financial instruments and institutions. Islamic banks have a client base that prefers dealing with Islamic banks. Conventional banks organize Islamic financial activity into “Windows” that are separated to various degrees from their parents – varies by country. Depending on the degree of isolation, surveillance results might vary for the Islamic subsector

Partial isolation of Islamic banking o To varying degrees, this bifurcates the banking system Transmission of financial impulses into or out from the Islamic banking subsector might be partial, slower, or perhaps even contrary. How is overall monetary or supervisory policy affected? n A smaller subsector will tend to be more concentrated and more volatile, both of which can have soundness implications. n Conventional and Islamic sectors might experience different economic opportunities and risks; types and strengths of economic signals could differ. The two subsectors could be expected to behave somewhat differently n o

Partial isolation of Islamic banking o “Interconnectiveness” will tend to be greater between Islamic banks than with other banks Financial stresses might be more intensely focused within the Islamic banking subsector n Heightened danger of contagion within the sector The pool of Shariah compliant instruments will be relatively small and underdeveloped in some countries n Different liquidity conditions, including less secondary market trading and greater chance of freezes n Greater chance of transmission of impairment costs between Islamic banks n Use of instruments floated in other countries creates currency risk n o

Liquidity issues o o o Islamic banks cannot issue short-term interest bearing instruments to meet liquidity needs - therefore, many hold a large stock of liquid assets (cash) and higher capital to compensate Basel III Liquidity Coverage Ratio (LCR) (CP 13) for liquid assets coverage of net cash outflows over 30 days requires a stock of SC instruments or cash In general, liquid interbank markets are underdeveloped Limited markets for resale of longer term sukuks Limited liquidity management instruments – heavy reliance on Commodity Murabahah, which is often criticized on Shariah compliance grounds and can be costly

Critical Issue: Deepening Sukuk Markets o Underdeveloped sukuk markets is a risk factor for entire Islamic finance subsector n n S&P says complexity of sukuks and market structures have inhibited market o Many small and medium-sized issues with diverse features – limited price discovery information inhibits trading o Over concentration in commodities, real estate, etc. o Many held to maturity, which stunts market trading o Lack of standard documentation o Higher issuance costs o Limited number of local currency issues These create headwinds for Islamic banks, insurers, and funds to find portfolio matches and liquidity of issues to deal with market changes

Building Islamic Financial Markets o o Work to build sukuk capacity is underway on multiple fronts to build critical mass General opportunities for official long-term sukuk programs n n o o Government funding because of lower commodity prices Infrastructure funding (including regional infrastructure projects, such as Asian Infrastructure Investment Bank) Regional development bank and SWF initiatives Inclusion in plans for “One-belt-one-road” to link China with Europe and Middle East Surveillance always reviews overall short-term liquidity, but should give specific focus on Islamic markets Long-term surveillance should highlight development of Islamic securities markets

Possible distortion of accounting results o o o Surveillance relies on accounting data, which need to reflect underlying reality to generate valid models and policy Islamic banking practices were not considered during development of International Financial Reporting Standards (IFRS) IFRS-based accounts for all banks might be distorted by inclusion of Islamic banks; Conversely, Islamic bank data might not be represented well under IFRS. o o o Interest not permitted in Islamic banking No “time value of money” concept (as used in conventional fair value and impairment calculations) Islamic banks have different types of provisions Liability/equity boundary might differ; “Quasi-equity” in Islamic finance Different on-/off-balance sheet boundaries Does the effective degree of distortion significantly differ from the “formal” differences? Empirical evidence is needed.

Capital adequacy ratio o IFSB Capital Adequacy Standard (CAS) has different measure of RWA than Basel CAR: n o o Because investors/depositors carry some risk, RWA denominator for the bank can be lower → CAS ratio will be higher. Islamic banks tend to hold more capital because they have less access to liquidity resources Economy-wide CAR is a mix of conventional and Islamic banks – Because the Islamic banks will tend to have higher capital ratios, is the effective CAR of conventional banks overestimated?

Portfolios of Conventional and Islamic banks differ o Islamic banks emphasize trade instruments and real investments (mortgages, real estate development, project finance, etc. ). n o o Potentially vulnerable to real estate cycle Cannot invest in interest-bearing bonds Often do not hold subordinated instruments Often do not use derivatives The portfolios of the Islamic and conventional banks could respond differently to various shocks

Rapid credit expansion o o Islamic banking has grown rapidly in some countries, and many Islamic banks are relatively new, small, and could have limited experience in credit evaluation and handling adverse situations Very rapid credit expansion frequently precedes financial distress. Annual growth of credit of 10 percent or more is a potential red flag.

Windows could present various issues o o Conventional banks often engage in Islamic banking in separately organized “windows” IFSB collects separate data on windows because their structure and behavior can differ from standalone Islamic banks. n n o Capital and liquidity support from parent bank – in some countries windows do not carry own capital Possibly greater cross-border transactions than standalone banks Financing policy directed by parent Danger of double accounting of windows’ activity within Islamic subsector and conventional subsector Data for standalone Islamic banks and windows can differ which can complicate analysis

IFSB Islamic Financial Services Industry Stability Report o o Annual review of financial stability issues for Islamic finance Good general overview of Islamic finance for surveillance purposes Reports initially based on survey data for Islamic banks; now based on PSIFI data. Data indicate that overall Islamic banking has recovered well from the GFC n n n Generally high capital and consequently moderate leverage Adequate profitability Limited nonperforming financing Substantial growth, but slowdown in 2016 Possible use of SDRs to compile global measures of Islamic financial activity

IMF Article IV Consultations o o Annual or semiannual reviews of economic conditions and policy options Initial collection of data and information on market, policy, legal, and infrastructure conditions n n o o o Recommend including PSIFIs as part of the data collection Include PSIFIs in Integrated Monetary Database (IMD) for each country Visit by IMF team for discussions with authorities Detailed report written with policy recommendations Discussed by IMF Board, and reports published Can become the main tool for surveillance of Islamic finance IMF would need to build staff capabilities to understand analyze Islamic finance National authorities should proactively assist IMF staff in understanding Islamic banking and how it operates in their country.

Financial Soundness Assessment Program (FSAP) o o o The IMF/World Bank FSAP undertakes periodic in-depth examinations of soundness conditions in countries n Required for G-20 countries (Indonesia, Saudi Arabia, Turkey) and incorporated into Article IV n Can focus on medium- and longer-term development of Islamic financial markets Specialists in each topic visit countries and prepare detailed reviews Islamic finance special features (interconnectiveness, size, niche market, complexity, evolving market structure) suggest that it deserves inclusion in future FSAPs in at least 8 to 10 countries PSIFI indicators provide initial indications of the importance and potential risks of Islamic finance that can help prioritize such work FSAP structure permits creation of specialized teams well-qualified to review Islamic finance – can help develop analytical models for soundness of the subsector The PSIFI Compilation Guide now in preparation will be an important resource to increase understanding of Islamic finance and the use of PSIFIs.

Islamic banking within a broad context o o o PSIFIs cover a subsector of the full banking sector Islamic banking should be analyzed on its own ground, but also in terms of how it relates to the broader financial sector (WP/17/161) Because PSIFIs are likely to differ from FSIs for the entire banking sector, approximate implicit indicators for conventional banks might need to be estimated. Windows could be a complication – treated like Islamic banks, but could be double counted because they are also included in conventional banks’ consolidated financial accounts Ideally, separate peer groups could be compiled for Islamic banks, windows, and conventional banks (either with or without windows). This would probably require input from national compilers.

Future expanded coverage of Islamic Finance o o o Current PSIFIs cover key indicators and structural information for Islamic banks and windows Compilation of full income statements and balance sheets for Islamic banking subsector is now beginning PSIFI program will expand to cover insurance and capital markets n n o o o Broad international recognition of need for full financial sector coverage This will permit a more comprehensive view of how Islamic finance as a whole can affect financial soundness Parallel development of national accounts data is needed IFSB and country compilers will need to develop methodologies Deepened links with international organizations active in these fields is likely to develop in the future

A last word o o o A balanced approach to the soundness situation of Islamic finance is needed It exhibits some unique types of risk However, there are offsetting sources of strength – strong capital, less exposure to volatile financial instruments, etc. . Useful to expand comparisons at bank level of Islamic and conventional banks (WP/17/161) Islamic finance deserves special attention in FSAP and Article IV surveillance to reveal both potential weaknesses and strengths There is much to be learned and ultimate directions are uncertain – the PSIFI program now provides new information about the subsect and permits the analytical process to begin.