First International Labuan Islamic Finance Conference The Evolution of the Global Islamic Capital Market Environment 6-7 July 2004 Convention Hall, Financial Park Complex Labuan, Malaysia The Role of Regulatory Bodies in the Development of the International Capital Market By Andrew Sheng Chairman Securities and Futures Commission Hong Kong Distinguished Guests, Ladies and Gentlemen, I am most grateful to the LOFSA Chairman, Tan Sri Dato Sri Dr. Zeti Akhtar Aziz and Cik Rosnah Omar, Director General, for the honour to participate in this historic first International Labuan Islamic Finance conference. I am delighted to share this platform also with my old friend, Dato Mohd Nor, Chairman of the Malaysian Securities Commission. As Malaysia was one of the first countries to promote Islamic finance, this conference marks a time when the enormous potential of Islamic financing is becoming recognized globally. The World Bank estimates that there are approximately 240 Islamic financial institutions, with combined assets in excess of US$200 billion in more than 48 countries 1, witnessing tremendous expansion of Islamic financing and innovation, particularly in the last 10 years. Demographics alone a total Islamic population of over 1 billion and increasing accumulation of wealth mean rising potential demand. Many conventional global money centre banks and fund managers are beginning to offer Islamic financial products. 1 Regulating Islamic Financial Institutions The Nature of the Regulated Policy Research Working Paper 3227, Dahlia El-Hawary, Wafik Grais, Zamir Iqbal, Financial Sector Global Partnerships Department, The World Bank, March 2004 1
This international attention has attracted studies by the international financial institutions, such as the World Bank, IMF and IOSCO, on the implications of Islamic financing activities in the global landscape. What role, then, can the securities regulator play in the future and direction of Islamic capital markets? I cannot claim any expertise on Islamic financing, but in my capacity as Chairman of the Technical Committee of IOSCO, let me offer some personal views on this question. IOSCO principles 2 IOSCO is the international forum for global securities regulators, comprising 174 members. Since 1998, IOSCO has developed a set of Core Principles for all members to follow, founded on three key objectives: - (a) (b) (c) Investor protection and transparency. A fair, efficient and transparent market. Reduction of systemic risk. IOSCO is rapidly implementing these Core Principles throughout its membership, particularly through its Self-Assessment programmes. The Malaysian Securities Commission is a member of IOSCO and a leading player in IOSCO s fact-finding study on Islamic capital markets. In May, at the IOSCO Annual Meetings in Amman, we approved the publication of the Islamic Capital Market Fact Finding Report 3. Basic principles of Islamic finance In applying the principles of regulation to Islamic financing, the regulator must confront the question of its role in the difficult area of Syariah interpretation. While recognizing the importance of Islamic financial products and financial services practices being in compliance with the requirements of Syariah, I should make clear that IOSCO has no view regarding compliance with religious or other precepts beyond the matters of regulatory policy set out in its principles. However, IOSCO clearly recognizes the importance of furthering the application of the IOSCO Principles in the context of the development of Islamic capital markets. A recent World Bank study suggests that Islamic financing is grounded on 4 basic principles that may be described roughly as follows: - 2 Objectives and Principles of Securities Regulation, International Organization of Securities Commissions, May 2003. This is available at http://www.iosco.org 3 Islamic Capital Market Fact Finding Report Report of the Islamic Capital Market Task Force of the International Organization of Securities Commissions, forthcoming 2
(a) Risk-sharing financial transactions must have terms that reflect a symmetrical risk-return distribution to each party to the transaction. (b) Materiality a financial transaction must have material finality that is linked to a real economic transaction. (c) No exploitation a financial transaction should not lead to exploitation of any party to the transaction e.g. gambling. (d) Prohibition against financing of activities that are non-halal 4. The first three principles are quite consistent with IOSCO Core Principles, whilst the fourth is subject to Syariah interpretation. IOSCO is aware that regulators and/or practitioners involved in Islamic capital markets may wish to consider international best practices in relation to the Syariah certification process but recognizes that it is for religious councils, not securities regulators, to interpret Syariah standards. Securities regulators in Islamic capital markets should work with the relevant religious bodies and other industry bodies such as the Islamic Financial Services Board to develop process and structure to manage the Syariah aspects. As regulators, our focus is to ensure that our issuers, regulated intermediaries and our financial products adhere to and comply with IOSCO principles. Additionally, for regulators involved in Islamic capital markets, they individually may wish to have in place a framework that assures Syariah-compliance. In addition, securities regulators involved in Islamic capital markets would benefit in having a high level of international cooperation and dialogue, a fundamental IOSCO Objective and Principle which IOSCO encourages all its members to attain. How far can Islamic capital markets be regulated within the IOSCO principles? The survey conducted by the IOSCO Islamic Capital Market Task Force, which reported in May 5 showed that most respondents agree that the objectives and principles of securities regulation can be applied to Islamic financial activities. But the Report also found that there are areas where we need more clarity and consistency in the application of securities regulation to Islamic capital market activities 6. 4 Regulating Islamic Financial Institutions The Nature of the Regulated Policy Research Working Paper 3227, Dahlia El-Hawary, Wafik Grais, Zamir Iqbal, Financial Sector Global Partnerships Department, The World Bank, March 2004, pages 5 and 6 5 Islamic Capital Market Fact Finding Report Report of the Islamic Capital Market Task Force of the International Organization of Securities Commissions, forthcoming 6 Ibid, pages 51, 52 and 71 3
Let me try and identify these areas and consider how standards can be developed to ensure no lapses in investor protection. Financial reporting Financial reporting represents a good example of this. As Islamic financial products and services differ from conventional financial products and services in terms of philosophical basis and structure, financial institutions face a challenge to produce a "true and fair" view of Islamic financial transactions. Accounting problems exist because existing accounting standards, such as the International Accounting Standards ("IAS"), were developed based on conventional institutions and conventional product structures and so do not adequately account for Islamic financial transactions which are based on a different philosophy and Syariahcompliant structures. The relevant IOSCO Principle on accounting and auditing relates to: Comparability and reliability of information Internationally acceptable standards Quality of accounting and auditing standards The IOSCO Report finds that Islamic financial institutions generally apply IAS for financial reporting. At the same time, there are initiatives among individual jurisdictions to develop accounting standards for Islamic capital market transactions, benchmarked against international standards such as IAS. 7 As you are aware, the AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) is developing accounting standards appropriate to Islamic finance that are benchmarked against IAS. Presently, these standards are mandatory in Bahrain, Sudan, Jordan and Qatar. In Malaysia, the Malaysian Accounting Standards Board is developing its own standards for domestic Islamic financial institutions that take into consideration the standards of AAOIFI and IAS 8. There are two issues which securities regulators in Islamic capital markets need to consider. First, given the various initiatives in developing standards, there would be a need to ensure convergence of the standards so that financial information released by Islamic financial institutions globally is comparable. It is encouraging that the survey finds a convergence of 7 Ibid, page 59 8 Ibid, page 59 4
views on this point in order to facilitate the development of globally accepted and tradable Islamic products and services 9. Second, Islamic capital markets have to individually consider whether they wish the auditors of Islamic financial institutions to have the added responsibility to ensure Syariah-compliance. It is noted that the AAOIFI has issued auditing standards of Islamic financial institutions. Investor protection In the context of disclosure, therefore, the key question appears to be: what is material to an ethical or Islamic investor who is looking to invest in Syariah-compliant products? (a) (b) He has religious and social views so first and foremost, he would want to know how the issuer or operator ensures that the product/transaction is (and continues to be) Syariahcompliant. Then, as with conventional products, he would need to know, what are the risks and rewards of the investment, and how does it compare with other financial products? The relevant IOSCO principle states - "Investors should be provided with the information necessary to make informed investment decisions on an ongoing basis. The principle of full, timely and accurate disclosure of current and reliable information material to investment decisions is directly related to the objectives of investor protection and fair, efficient and transparent markets." Accordingly, our role as a securities regulator would be to ensure transparency, so that the investor would have all the material, relevant and timely access to information that enables him or her to make an informed investment decision: - (a) (b) (c) (d) what governance procedures are in place to ensure the product is and remains Syariah-compliant, and what are the responsibilities, if any, of Syariah advisors or committee to their customer; how returns are calculated, by comparison with other Syariah and conventional analogues; what risks are involved in such products, including counterparty or credit risks, and what might be charged by the intermediary for its services. 9 Ibid, page 60 5
An issue raised by the study is whether it is desirable to develop best practices or specific regulatory guidelines to ensure that disclosures made in the offer document accord the investor with full information regarding the Syariah compliance of the investment as a means of complying with IOSCO s Objectives and Principles relating to disclosures 10. The Report notes that while non-financial statement disclosures are still voluntary, the trend is towards more of such disclosure so that the investor receives adequate information. Hence, it is up to the individual securities regulator to consider encouraging such disclosure to meet the specific investment needs of investor groups, be they ethical investors or Islamic investors. As in the case of the accounting standards, the Syariah-compliance standards would have to be worked out institutionally in different jurisdictions on how these standards can be monitored and enforced. Different jurisdictions may have different institutional arrangements to carry out these functions or they may engage in dialogue with other jurisdictions that have an Islamic capital market or provide Islamic financial services with a view to harmonizing these standards. Concluding remarks Clearly, Islamic capital markets are a vibrant and growing segment of the global capital market. Securities regulators in Islamic financial markets, and markets that provide both Islamic and conventional financial services, may play some part, to a larger or lesser extent, in the evolution of Islamic financial institutions, the availability of Syariah-compliant financial products and the development of a liquid secondary market in Islamic financial products. It is also clear that there would be advantages in benchmarking standards for Islamic financial institutions to accepted international best practices and international accounting principles, as it would promote investor confidence. Confidence is the cornerstone of markets and would facilitate the growth of Islamic capital markets, the potential of which is relatively untapped compared to conventional capital markets. It is encouraging that several Islamic international organizations are considering regulatory and accounting issues relevant to Islamic finance. These initiatives should contribute to narrowing the present gap in international dialogue on capital market issues, and contribute to common standards that strengthen the architecture of Islamic financial markets. 10 Ibid, page 57 6
IOSCO is not able to participate in many aspects of these deliberations where it has no expertise. What IOSCO is able to contribute is in respect of its core expertise, by providing views or sharing experience in relation to issues such as investor protection and international enforcement cooperation, and in market regulation. This historic first International Conference on Islamic Finance will help to educate us all on evolution of Islamic capital markets and financial services. We all stand to learn considerably from the experience of others. There is no question that we are all here to promote the interest of investors, to provide them with a better choice in terms of the financial products available to them. And we are here to develop financial markets that are efficient, transparent and firmly and fairly regulated in the interests of all investors and market participants, wherever they may be. Thank you. 7 July 2004 7