Abstract

Although there are differences between Islamic banking and "conventional" banking, there are some
fundamental principles that apply equally to both. In particular, rigorous risk management and
sound corporate governance help to ensure the safety and soundness of the international banking
system. In the light of the growing importance of Islamic banks and Sharia-compliant financial
innovation, the increasing integration of Islamic financial services into global financial markets serves
to strengthen this point.

The Basel II framework improves the risk sensitivity and accuracy of the criteria for assessing banks'
capital adequacy. This framework is fundamentally about stronger and more effective risk
management grounded in sound corporate governance and enhanced financial disclosure, the
importance of which has been underscored by the recent problems that have arisen in the banking
industry worldwide. The guidance provided by the Islamic Financial Services Board (IFSB) is a useful
contribution to the realisation of these global goals. It will support the establishment of resilient
financial market infrastructures and sound and robust core Islamic financial institutions operating
according to safe and sound risk management practices.

Full speech

Introduction

Good morning. I am pleased and honoured to address the 2nd Islamic Financial Services Board
Forum today. As the General Manager of the Bank for International Settlements, I am particularly
pleased to be here today to discuss Islamic finance and its growing importance in the global financial
system. But let me start by commending Professor Rifaat Ahmed Abdel Karim of the Islamic Financial
Services Board and Josef Tošovský of the BIS Financial Stability Institute for putting together such a
comprehensive programme. It is entirely appropriate that the IFSB and the FSI should join forces to
organise this conference. After all, the IFSB's mission is to promote the soundness and stability of
the Islamic financial services industry. It does so by issuing global prudential standards for the
industry. Likewise, the FSI's mission is also to promote sound supervisory standards and practices
globally.

BIS and BCBS support for the IFSB

As an associate member of the IFSB, the BIS has been actively supporting the IFSB's mission and
initiatives since the Board began operations in 2003. The Basel Committee on Banking Supervision,
which is hosted by the BIS, is increasingly looking beyond its membership to enhance cooperation
with non-member countries and organisations with related interests and similar goals. The
Committee's outreach to non-member countries is part of an initiative to promote the development
of sound supervisory practices and to accommodate the growing importance and sophistication of
non-member banks.

The BIS and the Basel Committee have been strong supporters of the IFSB through participation in
IFSB working groups, such as the capital adequacy group, and by providing speakers for conferences
and other events. I believe that the active and productive dialogue between the Basel Committee
and the IFSB will continue to benefit both of our organisations. Professor Rifaat and members of the
Basel Committee's Secretariat have recently held fruitful discussions, and continue to strengthen the
cooperation between the IFSB and the Committee.

In my remarks today, I will not address the specifics of Islamic finance and how it differs from
conventional banking. Instead, I would like to focus on two elements of banking supervision that
Islamic and conventional banking have in common. That is, appropriate levels of risk management
and corporate governance, which help to ensure the safety and soundness of the international
banking system.

Growth in Islamic finance

As I am sure you heard yesterday and will also hear today, there has been significant growth in
Islamic financial services in recent years and there is every reason to expect that this growth will
continue at a rapid pace. Clearly, there is expanding demand for these products, and a closely
associated desire on the part of banks, including non-Islamic banks, to provide Islamic financial
services.

Although it is still modest in size relative to conventional retail banking, Islamic retail banking is
rapidly becoming more visible. This is particularly true in the Middle East and Asia Pacific regions,
where a number of Islamic banks and banking units have been opened in recent years. There are
also Islamic banks and asset managers in key international financial centres of the United Kingdom
and the United States.

The growth in Islamic finance is also visible in the expanding range of services and products that
comply with the basic precepts of Sharia law. One example is the burgeoning global market interest
in Islamic bonds - Sukuks - many of which are increasingly being issued and bought outside the
Islamic world. This suggests that non-Islamic investors in general are becoming comfortable with
Sukuks. The broadening appeal of Islamic finance is also evident in the move by large international
banks and other private sector financial institutions to provide Islamic financial services. This
includes the establishment of exchange-traded funds that are screened to ensure their conformity
with Islamic investment principles, as well as offering "takaful" - or Islamic insurance.

Although the elements that are usually emphasised at conferences like this are differences between
Islamic banking and "conventional" banking, there are some fundamental principles that apply
equally to both. For example, I can point to the necessity of strong corporate governance, rigorous
risk management and sound capital adequacy requirements as essential ingredients to ensure the
safety and soundness of any financial system. The increasing integration of Islamic financial services
into the global financial fabric only strengthens this point.

What about risk management and corporate governance?

The issuance of the revised Basel II framework for bank capital adequacy not only improves the risk
sensitivity and accuracy of the criteria for assessing capital adequacy, but it is fundamentally about
stronger and more effective risk management grounded in sound corporate governance and
enhanced financial disclosure. I should acknowledge that the special features of Islamic banking may
not always be adequately addressed by broad international standards for conventional banking
contained in the Basel II framework. Nonetheless, the IFSB considers carefully the global banking
standards that have been and are being developed for conventional banking. The IFSB's capital
adequacy standard, for instance, draws to a large extent on Pillar 1 of the Basel II framework (the
minimum capital adequacy requirements). It has also released an exposure draft on the supervisory
review process (consistent with the principles of Basel's Pillar 2) and another on disclosure and
market discipline (Pillar 3).

As interest in Islamic finance grows, the importance of the IFSB's role increases. The importance of
the fundamental elements of banking - conventional or Islamic - cannot be emphasised enough.
Topics such as corporate governance, risk management and capital adequacy are key elements that
underpin sound financial practices. The guidance provided by the IFSB in these areas helps to ensure
that there are resilient financial market infrastructures and robust core financial institutions
operating according to safe and sound risk management practices. It is important that the same
degree of supervisory oversight is applied to Islamic financial institutions, to ensure the continuing
acceptance of their instruments and services in international marketsand conventional banking
systems. In addition, the guiding principles and standards developed by the IFSB are assisting
supervisors globally to better understand and supervise institutions providing Islamic financial
services.

This is why I am particularly pleased to see the issuance by the IFSB, over the last couple of years, of
its capital adequacy standards and guiding principles on corporate governance and risk
management. The issuance of these prudential standards and guiding principles helps to enhance
the soundness and stability of the Islamic financial services industry and helps fill an important niche,
as will the recent exposure draft on market discipline.

The importance of robust risk management systems and corporate governance cannot be
overstated. Many of the recent problems that have arisen in the banking industry worldwide, such
as losses due to accounting improprieties, low underwriting standards and inappropriate valuation
methodologies - particularly when applied to complex financial instruments, are primarily due to
poor corporate governance and inadequate risk management. Given these shortcomings, what then
are the implications for banks and supervisors?

Risk management

First and foremost, with respect to risk management banks must have policies and procedures in
place that enable them to identify, measure, control and report all material risks. Bank management
is primarily responsible for understanding the nature and degree of the risks being undertaken by
the institution. This was not necessarily the case with respect to subprime residential mortgages,
mainly packaged by conventional banks in the United States, which were then securitised and resold
as mortgage-backed securities and collateralised debt obligations. Investors at large, and the
managements of even some of the largest internationally active banks, did not fully appreciate the
risk inherent in the subprime mortgages embedded in the structured securities they had purchased.
Instead, many relied too heavily on the credit ratings that the specialised credit rating agencies
established for the various branches of the resulting structured products. While Basel II provides a
better framework for supervisors to focus discussions with banks on the robustness of their risk
measurement and management of complex financial instruments, banks' risk management systems
need to be constantly adapted to better address the effects of innovation in the financial markets
and increased complexity and opacity of financial activities in which banks are engaged. While
weaknesses in these areas have focused on conventional banking instruments and institutions,
Islamic instruments are not immune to them.

Strong risk management is a critical component of a bank's ability to withstand adverse conditions.
And this is certainly as important for Islamic banks as for other types of financial institutions. One
element that is essential is comprehensive stress testing that can capture the effects of a downturn
on market and credit risks, as well as on liquidity. This helps ensure that banks have a sufficient
capital buffer to carry them through difficult periods. In the events of last summer and this autumn,
it became clear that many banks' stress tests did not anticipate the degree and breadth of illiquidity
that resonated throughout the credit markets. Stress tests must consider the effects of prolonged
market tensions and illiquidity, and must reflect the nature of institutions' portfolios and realistic
assumptions about the amount of time it may take to hedge out risks or manage them in severe
market conditions.

Corporate governance

The necessity of a robust corporate governance framework has long been recognised by bank
supervisors around the world. Indeed, supervision would not be possible without sound corporate
governance in place. Over the years, experience has highlighted the need for banks to have the
appropriate levels of accountability, as well as sufficient checks and balances. In general, sound
corporate governance effectively addresses the manner in which the decision-making process in the
organisation is structured, the respective responsibilities and accountability of senior management
and the board of directors, and the control functions that ensure the accuracy of the monitoring
processes.

Of course, when supervisors review an institution's risk management system and corporate
governance framework, they must consider the system's appropriateness in relation to the bank's
size, its risk exposures and the nature and complexity of the financial instruments it deploys.

Market disclosure

I have already noted the IFSB's exposure draft on disclosure and market discipline that was released
for comment late last year. This interest in promoting increased transparency and market discipline
is especially important, particularly given the recent difficulties experienced by banks and investors
alike with respect to complex structured products. Much of the current turmoil in the credit markets
has related to questions about the soundness of certain types of collateralised debt obligations
(CDOs) and asset-backed commercial paper. These problems might well have been avoided or at
least mitigated if there had been greater transparency both about the products themselves and the
commitments made by the banks that originated them. Again, this problem has thus far been
concentrated in conventional banks in the key financial countries. A crucial area where more
transparency has proved necessary has been in the exposures of some large financial institutions to
CDOs of securities backed by subprime mortgages in the United States.

Basel II and the IFSB's exposure draft on transparency both seek to raise the bar on the quality of
financial disclosures by providing clearer industry benchmarks. Enhanced financial disclosure that
improves the transparency of banks and complex structured products, valuation, and the
measurement of risk exposure can certainly help to improve overall risk management. In addition,
requiring enhanced qualitative disclosures will permit all banks to put their quantitative disclosures
into better context and assist them in explaining their approach to risk management.

Conclusion

Let me conclude by emphasising that rigorous risk management and sound corporate governance
are key elements of any bank's ability to understand and manage its risks. With the growing
importance of Islamic banks and Sharia-compliant financial innovation, it will be increasingly
important to ensure sound Islamic financial institutions going forward. Supervisors must work
together to encourage all banks to improve their risk management systems, controls and
transparency. Such improvements will help ensure the stability and soundness of the international
banking system. Thank you very much.

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