Heng Swee Keat: Ensuring stability - international perspectives on
creating an effective regulatory framework
Remarks by Mr Heng Swee Keat, Managing Director of the Monetary Authority of Singapore,
at the Inaugural Plenary Session, World Islamic Banking Conference, Bahrain, 24 November
2008.
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Introduction
Good morning, ladies and gentlemen.
I am honoured to speak at this opening plenary, following the keynote remarks by His
Excellency, Governor Rasheed Al-Maraj.
I am also delighted to be in Bahrain, recognised globally as one of the leading centres for
Islamic Finance. Besides having a core of active Islamic financial institutions, Bahrain also
plays host to a number of organisations central to the development of Islamic Finance,
including AAOIFI, the LMC, IIFM and the IIRA, and of course, this WIBC.1 The Central Bank
of Bahrain ["CBB"], a highly regarded regulator, has played a key role in spearheading the
development of Islamic Finance. The CBB has scored many "firsts", including the first central
bank sukuk in 20012 and being the first country to develop and implement regulations
specific to the Islamic banking industry. The CBB has also established the Waqf Fund to
finance research, education and training in Islamic Finance. There is much that the MAS can
learn from the CBB.
The current global crisis - some root causes
The theme of this session - having an effective regulatory framework - is of great relevance
given the on-going financial crisis. The current financial crisis is unprecedented in terms of its
scale, complexity, and speed of transmission. While the series of coordinated actions by
financial authorities and Governments have helped to stabilise the markets somewhat,
sentiments remain fragile, and many of the underlying problems remain.
Many reasons have been offered about the root causes of the current crisis. Let me just
highlight a few of these.
The first is the unprecedented levels of leverage taken on by global financial institutions
coupled with very loose lending standards in the credit markets. Consumers in the US were
also highly leveraged. The high leverage enabled asset values and consumption to be raised
to unsustainable levels. When sentiments finally turned, there was massive deleveraging.
The second is that complexity magnifies risks. The proliferation of complex securities and
derivatives had not diversified risk amongst different counterparties as was originally
intended, but instead increased aggregate systemic risk throughout the financial system. Not
only banks and investment banks were affected but a whole range of players including credit
insurers, hedge funds and investors in asset-backed commercial paper have also suffered
major losses.
The third is the inadequate assessment of risks and compression of yields. Many of the
assessments were based on complex modeling and did not give sufficient regard to the tail
risks in these financial products including the illiquidity risk. In some instances, there may not
have been sufficient diversity of views of the risks and pricing of structured credit, with a
heavy reliance on rating agencies.
Against these key causes, we must include the backdrop of unsustainable macro-economic
imbalances that were building up in the global economy, and policy responses which
effectively allowed yields to fall to very low levels. The aggressive search for returns also led
to severe compression of yields which distorted investor behaviour and long-term valuations.
The interaction of high leverage, excessive complexity and compression of yields meant that
when sentiments turned, the magnitude of price falls across asset classes have been sharp,
and the dynamics of the deleveraging process unpredictable. Financial institutions and
markets have also become so highly interconnected that an event in one area sets off a
chain of events that magnify and exacerbate the initial shocks.
The shocks in the financial markets have now been transmitted to the real economy in the
developed countries. Through both the financial as well as the trade and investment
channels, these shocks are also propagated to emerging economies. The negative feedback
loop between the deterioration in the real economy and sell-offs in financial assets have
added to the uncertainty. It will take some time before the crisis runs its course.
Policy agenda
Our immediate focus must be to limit the damage of the financial crisis on the real economy,
and stop the downward spiral created by the negative feedback loop. Policy measures must
include not just fiscal and monetary policy stimulus, but also an acceleration of structural
changes to correct the underlying imbalances, to put the global economy on a sounder
footing for renewed growth.
There has also been much discussion about regulatory reform. Reform is certainly
necessary, but we must avoid swinging the regulatory pendulum to the other extreme. While
the present system has major flaws, it is not fundamentally broken. Fixing these flaws
demands thoughtful and pragmatic changes at the global level. Piecemeal quick fixes, which
may be logical and perhaps even headline grabbing, may end up creating unforeseen and
unintended consequences. It would be a mistake, for instance, to swing towards overly
prescriptive rules, or to severely restrict all forms of securitisation and financial innovation. As
financial markets are at different stages of development in various countries, we must also
avoid a "one-size-fits-all" approach. Certainly, we will need greater international cooperation,
and the work of bodies such as the IMF, FSF, BCBS, IOSCO, IAIS,3 and initiatives
sponsored by groupings such as the G20 will be important in this reform effort.
An effective regulatory framework for Islamic finance
The current global crisis has posed a series of extreme stress tests on financial systems and
our regulatory approaches, and offers many important pointers for the development of
Islamic Finance. Allow me to highlight a few.
First, one of the most significant lessons about the crisis is also the most basic, that is,
finance needs to return to its basic function of allocating scarce capital to the most productive
uses, with the capital earning an appropriate risk-adjusted return.
In this regard, the underlying Shariah precept in Islamic Finance of not using capital for
speculation, but to build productive capacity and generate sustainable economic growth,
takes on great relevance. By adhering to this basic precept, I am confident that Islamic
Finance will assume a more prominent role in the coming years.
Second, whatever the forms of intermediation, we must remain focused on the types and
nature of risks, and how these risks are distributed among the players. Before this crisis, the
main focus was on risks posed by hedge funds. As it turns out, a large part of the risks were
sitting in the core banking system, in the form of off-balance sheet items held in SIVs.
Mortgage lenders which originated subprime mortgages were outside the regulatory ambit.
The main lesson here is that we have to examine risks holistically, across the value chain of
activities and across different asset classes and markets, and not be blinkered in pre-judging
where risks sit. For tail risks in particular, the dark corner where we shine the light may not
necessarily be the place where those risks reside.
Many of the risks inherent in Islamic Finance are similar to those of conventional finance,
including credit risks, market risks, market conduct risks, operational and reputational risks.
However, the exposure to those risks could differ between conventional and Islamic finance.
For instance, Islamic banks are generally exposed to substantially more liquidity risk than
their conventional counterparts, as the range of liquid instruments and hedging instruments
are more limited. Islamic banks tend also to be more exposed to the property and
infrastructure sectors, in part because these are the prevalent asset classes in the Gulf and
also in part because Islamic finance has to be based on physical assets. Given the "large
and lumpy" nature of such transactions and the tendency for asset bubbles to build up
quickly, it is a risk that merits special attention.
In addition, there are also risks unique to Islamic Finance such as Shariah-compliance risk. If
products are later found to be non-Shariah compliant, the institutions not only face
reputational damage, but also costly unwinding of such structures, with possible losses to
investors.
The third point is that to achieve a good outcome, an effective regulatory approach needs to
embrace a tripartite approach. Regulators, financial institutions and investors all have a role
to play.
Allow me to share briefly the approach that MAS takes. As a regulator, MAS looks at both the
micro-prudential aspects, looking at the safety and soundness of individual financial
institutions, as well as macro-prudential aspects, looking to see if system-wide risks have
been built up in the aggregate.
In doing this, we adopt a risk-based approach towards supervision and regulation, in order to
promote sustainable development of the sector. For example, we set appropriate limits and
capital charges to address the credit, market and other risks. The standards of governance
and risk management are set at levels commensurate with the activities and the risks being
taken. Sometimes we are accused of being overly conservative, but this prudence has
served us well.
In all instances, we seek to find the right balance between "principles-based" and
"rulesbased" regulation; to avoid being over-prescriptive in rule-making or being over-reliant on
market discipline alone to curb excessive risk-taking. Similarly, market conduct measures
focus on upholding principles of fairness and transparency, for instance, through
requirements on disclosure to investors and a fair-dealing sales process.
The second leg of the tripartite approach is to put the primary responsibility for sound risk
management and oversight of each institution on the board and senior management, which
must set the right tone and culture. The third leg is to promote greater awareness among
investors of their financial needs, encourage financial planning and promote deeper
understanding of the risks and returns of different products, through educational programmes
such as MoneySENSE.4
The fourth pointer from the current crisis is the importance of preventing regulatory arbitrage,
and ensuring a level playing field. With regards to Islamic Finance, in particular, MAS seeks
to ensure a level playing field between the conventional and Islamic financial players. Where
the economic substance and risks are similar, the same regulatory treatment is accorded,
regardless of whether the product is a "conventional" or "Islamic" product. For example,
Singapore-based banks treat murabaha-based5 asset financing as a credit risk exposure to
the customer for the purpose of maintaining regulatory capital. As Islamic Finance grows, our
regulatory framework must continue to evolve to maintain regulatory consistency in
managing the underlying substance of the risks.
International collaboration
The fifth and very crucial point that emerges from the current crisis is the importance of
international collaboration. As Islamic Finance grows, cross border transactions will multiply.
We must therefore take an international perspective in preventing and resolving problems
right at the outset. Allow me to suggest three areas where regulators can work closely.
The first area is that legal, regulatory and supervisory frameworks that are developed should
be based on internationally recognised principles and standards. The work done by
international standard-setting bodies such as the IFSB, IDB, AAOIFI and IIFM6 is instructive
in this regard. For example, "The Ten Year Framework and Strategies" co-issued by the
IFSB and IDB is a thoughtful blueprint. AAOIFI has also produced standards in areas such
as accounting, auditing, ethics, Shariah compliance and governance. Today, the applications
of Shariah precepts differ somewhat in certain areas. It will eventually be desirable to have
some standardisation to enhance consistency and to remove one source of regulatory risk.
However, our goal should be to achieve a gradual harmonisation of standards and
approaches to regulation, rather than immediate convergence. Even in conventional finance,
regulatory approaches and standards differ across different jurisdictions. A flexible,
riskbased approach will also allow continued innovation to take place, while ensuring the
resultant risks are appropriately managed.
Second, we need to develop a wider range of tools to detect and mitigate risks. In
conventional finance, work is underway in reviewing shortcomings in capital adequacy and
liquidity management in the Basel II framework, as well as the provision of clearing and
settlement infrastructure for derivatives. For Islamic Finance, we need to continue to develop
instruments that help to mitigate risks. Bahrain's initiative in developing the Liquidity
Management Centre7 is an excellent example of such an effort.
In this regard, I am pleased to announce that the Monetary Authority of Singapore is now in
the final stages of setting up a sukuk issuance facility. I had announced, at this May's Islamic
Financial Services Board Summit, Singapore's plan to set up a facility to provide
Shariahcompliant regulatory assets to these financial institutions as part of our efforts to promote the
growth of Islamic Finance in Singapore.
The sukuk structure is based broadly on the Al-Ijarah structure, or the sale-and-leaseback of
an underlying property. Sukuk issued by the facility will be given equal regulatory treatment
as Singapore Government Securities, or SGS, and returns will be tied to the risk-free yield of
SGS of equivalent tenor. The facility is open to all financial institutions that plan to or are
currently carrying on Shariah-compliant financial services in Singapore. We are issuing on a
reverse enquiry basis, which means we can size and time the issuance according to the
needs of the financial institutions. A number of financial institutions have already expressed
interest and we expect the first issue to take place at the start of next year. We invite eligible
and interested financial institutions to approach MAS as we work towards a formal launch.
Last but not least, efforts to further international collaboration will need to be supported by a
solid platform for co-operation and information sharing amongst regulators. Formal
agreements between regulators on the scope of cooperation and information sharing will be
helpful in this regard. Singapore, as a full member of the IFSB, and a signatory to MOUs with
various GCC countries, is keen to explore further avenues for cooperation and collaboration.
Underpinning all these, of course, is the need to continue to broaden and deepen knowledge
and expertise on Islamic Finance among regulators and industry players. An investors'
education platform to promote risk awareness of Shariah compliant products will also serve
to reinforce market discipline by raising awareness of the characteristics and risks of Shariah
products, as well as boosting demand for such products.
Conclusion - opportunities for Islamic finance
I would like to end on an optimistic note by reiterating the opportunities available in Islamic
Finance. While we must expect the global economy and financial activities to slow in the
coming months, the long-term structural improvements in Asia and the GCC will continue.
Between Asia and the GCC, for instance, total trade grew by 17% annually since 2000 to
exceed US$328 billion in 2006.8 Total cross-border capital flows between Asia and the GCC
are also predicted to increase from US$15 billion at end 2006 to US$300 billion by 2020.9
Even if only half of these projections are realised, growth is still sizeable. It is thus crucial that
we remain focused on enabling long term growth and development even as we tackle the
current crisis.
There are many productive areas for the private sector to work in close partnership. I look
forward to working closely with our colleagues in the Middle East to further promote
cooperation in financial services and Islamic Finance, which will serve as key pillars for
promoting long-term, sustained economic development and cooperation in our two dynamic
regions.
On that note, I would like to thank you all for your kind attention this morning, and I wish
everyone a fruitful conference.