With total assets reaching $1.8 trillion, the Islamic financial industry does not require change but it requires both a transformation and a new mindset, Rasheed M. Al-Maraj, Governor, Central Bank of Bahrain, told the global audience at the World Islamic Banking Conference kicked off on Monday.
“In common with the financial industry in general, the Islamic financial industry continues to undergo significant change. This is partly due to the continuing developments required in the industry as it comes to terms with rebuilding customer confidence, which was so badly damaged by the global financial crisis. In addition, the industry needs to come to terms with the need to make significant changes to the traditional business model, which has primarily been based on investment in real estate,” Al Maraj said.
Titled ‘Improving the Enabling Infrastructure to Create Stronger Islamic Financial Institutions: Key Chold the allenges for International Financial Reform’ the WIBC 2012 attracted over 1200 delegates from across the world.
“Perhaps the most important subject in the global financial industry at present is the proposed implementation of Basel III. Although it is impossible to discuss all of the changes in the time available to me, you know the primary intention is to mitigate the risks of a repeat of the current financial crisis. The detail has yet to be finalised, but there is no doubt that it will have a huge influence on the fundamentals of the global banking industry and the wider economic environment.
“One of the major changes arising from Basel III is the definition of eligible Tier 1 capital. Going forward this will primarily consist of common shares and retained earnings. Critically the quality and quantity of Tier 1 capital will be significantly increased. The ultimate result will be a higher Capital Adequacy Ratio.
“Further substantial improvements to the risk management frameworks of banks will be required. The methodology underpinning value-at-risk calculations will be strengthened, and the output from these calculations will be scrutinized in far more detail by a wide stakeholder audience.
“Regulators will be required to improve their supervisory review processes, and in so doing these will become increasingly stringent. Whereas in the past jurisdictional judgement has played a prominent role in the implementation of regulation, this will be largely replaced by reforms which will be consistent in the manner in which they aim to strengthen regulation, and raise the resilience of individual banking institutions to periods of stress. These reforms will also have a macro-prudential focus, and will address system-wide risks that can build up across the banking sector, thereby ultimately amplifying these risks over time.
“In tandem with Basel III, accounting rules are changing. Moreover, the way in which banks can remunerate staff, and the level of remuneration they can provide, will be subject to increasing regulation. The CBB has already published papers detailing what policies and practices will be considered as acceptable. The public and other stakeholders have spoken clearly on this subject, and their opinions that the current levels of remuneration are extreme reflect the view that they are also unsustainable.
“All of this will change the way banks do business. Islamic banks must prepare now for these changes, or risk being left behind.
“The headline challenges arising from Basel III are not new, but they are becoming increasingly time-critical at various levels. At the foundation level, there are simply too many small to medium sized Islamic financial institutions. The risks inherent in that scenario are clear – Islamic banks cannot play with the big boys. Smaller banks will find it very difficult to combine the increased capital requirements with the ability to participate in the market.
“The larger and often more lucrative deals are even now frequently beyond the reach of Islamic banks and without major changes this will become more acute. Leaving aside the debate about the quality of assets, the importance of holding a larger amount of liquid assets cannot be ignored, and small banks will find this almost impossible.
“There are a number of steps which need to be taken to achieve this. The first is to build a range of Islamic institutions which are well capitalized, continuously highly profitable, and which have a balance sheet size which places them within the top ten in their sphere in the world.
“There are various options which can be implemented to achieve this aim, and by way of example I outline two below.
“Acquisitions and mergers have been discussed many times, but this has been a slow and cumbersome path. It is no longer appropriate to have only small, local, financial institutions which are fundamentally and practically restricted in terms of the markets in which they can compete and the deals they can underwrite. Personal interest and a local or regional mindset must be replaced with a ‘big picture’ mentality; a mentality which emphasizes and works towards the global contribution Islamic institutions can make for the benefit of all.
“However, institutions are impotent if they do not have the correct leadership supported by appropriate numbers of well-trained, experienced, and respected individuals. A first-class corporate governance framework is essential, and it must be continuously implemented in practice. Inspirational leaders are absolutely essential. Each leader must exude credibility with the stakeholders and wider community. They need to act responsibly at all times.
“A further challenge is that the business model has to change. I have spoken before about the over-reliance on a model built on real estate. A business model has to adapt to the changing environment in which it operates. If the Islamic financial industry is to be successful at each stage of any economic cycle, the model needs to implement and demonstrate diversity in the asset portfolio. This in turn needs to be coupled with investment in a much wider range of economic sectors.
“Moreover, the range of available products must be increased in line with Shari’a principles. They must be competitively priced and marketed such that they appeal to the broadest possible community of clients.
All of the above must be underpinned by a risk management framework which recognizes that to properly service the demands of the client base the institution has to have an appropriate risk appetite. The risk appetite should also reflect the discrete elements of the client base, taking account of the needs of the retail customer as well as the various requirements of the investors and other stakeholders.
“Many will ask – what has Bahrain done to turn these desires into reality? Firstly, the CBB has successfully worked with many stakeholders to encourage and facilitate mergers. This year, one of our Islamic banks successfully completed the acquisition of a conventional bank. Moreover, within the next few weeks three of our Islamic banks will merge to become one. Shortly after that we anticipate the merger of two other banks. We continuously work quietly and effectively behind the scenes to influence, persuade, and guide licensees to grow and develop. This is only the beginning of what we consider to be an essential ingredient in the transformation of Islamic finance.
“On a parallel front, the CBB works closely with a plethora of industry stakeholders with the aim of developing and expanding the range of products and services which can be made available. We reach out to licensees; industry bodies; standard setters; and of course Shari’a Boards through consultation papers and face-to-face meetings. We encourage and facilitate constructive dialogue aimed at transforming the industry.
“We are tireless in our pursuit of improving regulatory standards. The Rulebooks are continuously refined to reflect market and other changes. We actively participate with other financial regulators and such bodies as the IIFM, AAOIFI, IFSB, and the Basle Committee for Banking Supervision.
“I recognize the challenge in the ideas I have put forward here today. Some may consider them to be controversial, and I understand that there are many different ways of addressing a situation. My aim has been to provoke thought and action which is designed to encourage the growth of this important part of the financial industry. This is a time of great opportunity, I urge you to embrace the challenges.”