16 May 2007 — David Knott, DFSA Chief Executive, Speech at the IFSB Submit
Address by David Knott, Chief Executive,
Dubai Financial Services Authority (DFSA)
at the IFSB Summit
16th May 2007
Having listened already to four excellent sessions on various aspects of cross-sectoral supervision, it is difficult to think that there is much left to say. But I congratulate the organizers for highlighting this issue and for posing the questions they have. I believe that the answers adopted will impact fundamentally on the future success of markets in this region, both conventional and Islamic.
The question of cross-sectoral supervision is confronting, implying as it does a need to critically examine existing regulatory mechanisms and structures. Having come from a country where this was done in the late 1990s I can confidently say that this is no academic debate. It’s strategic; it’s political; and it can get personal.
By cross-sectoral supervision, I am referring to the supervision of those financial institutions who offer any combination of banking, securities or insurance products.
In the more advanced capital markets, a new approach to the regulation of such financial conglomerates became a hot topic of debate in the 1990s. Many countries accepted that the traditional approach of regulating the financial sector along institutional lines required review. Separate regulators for banking, securities and insurance had become difficult to sustain when the financial institutions themselves were operating across most, if not all, of those business lines. I’ll return to this international experience shortly, but we should perhaps start by asking whether there is a problem that needs fixing in this region, especially in the context of Islamic Finance.
I think we would all agree that financial conglomeration is not yet a burning issue for most emerging markets. But it is equally clear that as our regional financial markets acquire greater sophistication and are opened up to increased competition through public policy reforms, issues of cross-sectoral regulation and supervision will become more acute.
We already have some cross-sectoral activity in this region, including in the areas of banking and funds management; in the distribution by banks of insurance and investment products; and the provision of financial advice. From those activities alone we can easily identify a range of regulatory issues that might include capital adequacy; operational risk; conduct of business rules; disclosure standards; governance and investor protection. In some cases the cross-sectoral issues may be imbedded in the financial products themselves. For example, in the insurance sector (whether conventional or Takaful) a product may be viewed for one purpose as an insurance policy but for another purpose as an investment product. Another example may be a PSIA which may raise issues of capital adequacy but also important issues of investor protection and conduct of business.
It is generally accepted that regulatory fragmentation and markets fragmentation are already issues of significance in the Middle East. The question is whether the growth of Islamic Finance (and, for that matter, conventional finance also), will be constrained unless this is addressed? Some may argue that this is not yet a sufficiently serious issue to justify correction. Others may reply: "Why wait until the problem becomes even harder to resolve?" A recent industry survey by McKinsey suggests that this is a legitimate question to ask.
If one looks at the London market over the past decade it is clear that policy and strategy have driven growth and competitive success. Part of that policy and strategy has been legislative and part regulatory. In my view, one of the key planks of this policy was the creation of the Financial Services Authority, an integrated cross-sectoral financial services regulator. That policy was driven by a recognition that having separate regulators according to whether the institution called itself a bank a securities firm or an insurer was no longer consistent with the way business was conducted in the market. The inefficiencies of having overlapping regulators applying different solutions for the same or similar problems not only constrained business but resulted in increased transaction costs and compliance costs. The creation of the FSA was one of the first actions of the Blair Government and it was controversial. But you would be hard pressed to find anyone in the UK financial services sector today who would want to return to the past. By contrast, you would quickly find large numbers of industry participants in the United States who would readily trade their diversified and complex regulatory structure in return for integrated cross-sectoral regulation.
It is no surprise to me to see the UK aspiring to prominence as an Islamic Finance market, and I believe that their cross-sectoral regulatory structure gives them a competitive advantage over the fragmented models that generally prevail in this region. However, I should point out that the Dubai Financial Services Authority has adopted the UK regulatory model.
I am not saying that this is the only way to address cross-sectoral supervision. The Australian model, for example, is somewhat different, dividing regulatory responsibility on functional grounds between prudential risks and market conduct risks. The key point, however, is that over the past 10 years at least 19 jurisdictions have moved from institutional-based regulation to a fully integrated model.
Several other jurisdictions are actively moving in that direction (e.g. Switzerland). The new-found emphasis of banking regulators on governance (traditionally a province of securities regulators) and introduction of MiFID in Europe will add further impetus to this trend.
Let me now say something about the DFSA’s own experience and approach to cross-sectoral issues in Islamic Finance.
I’ll start with the obvious point that while being an integrated cross-sectoral regulator is an advantage, it by no means solves all of the practical problems confronting cross-sectoral supervision. The advantage is having a framework that makes it easier to address those problems with relative consistency and efficiency.
But we still have major international standard setters which essentially approach their role from a single sectoral perspective, which in some respects has not kept up with market changes. The good news is that there has been greater alignment of approach between IOSCO, IAIS and Basel in recent years and that the work of the Joint Forum, which they established to consider cross-sectoral issues, has become more focused and relevant. I believe that an opportunity exists for the Joint Forum to engage more actively with IFSB and the Islamic Finance industry to identify and address some of the specific regulatory issues we have heard about at this summit. I hope this will form part of the Joint Forum’s work program over the next 12 months.
In March 2000 a Joint Forum report highlighted the degree of commonality in certain standards set by IOSCO, IAIS and Basel, most notably licensing, supervision and intervention. Supervision is clearly an area where a cross-sectoral perspective should be adopted to ensure that the risk which an institution poses is adequately identified, measured and mitigated. Indeed that is the approach adopted by the DFSA where common supervisory tools and risk measurement and management structures are in place for conventional firms and Islamic Firms.
Central to that approach is our belief that the regulation of Islamic Finance should be aligned with the regulation of conventional finance to the maximum extent consistent with Shari’a requirements. In our view, that is the surest and quickest way for Islamic communities to participate to their full advantage in mainstream international finance and capital markets. In the regulatory context, that means applying internationally accepted standards and principles, with variations only as required to reflect Shari’a compliance.
Against that background, I want to add my voice to others who have warmly welcomed IFSB’s Exposure drafts on Supervisory Review Process and Market Discipline. The IFSB has recognized that the same levels of customer protection, transparency and disclosure should be provided to customers of both Islamic and conventional Firms; and that a different position is detrimental to the financial stability and reputation of the industry.
At the DFSA we had the advantage of being able to design our regulatory structure on this construct from day one. That has made the task of creating a cohesive and balanced regulatory framework easier than in those jurisdictions where Islamic Finance has had to be bolted on to an existing conventional regulatory regime.
Our framework of regulation will be readily recognizable to the major capital markets, based as it is on principles of IOSCO, Basel, IAIS and FATF. Our general approach to risk, disclosure and conduct applies consistently across both Islamic and conventional finance. Where variations are called for, they are implemented within the context of these generally prevailing principles.
So, for example, although we have specific provisions to deal with PSIAs, (including a Displaced Commercial Risk capital requirement of 35%); and although specific concentration limits and risk weightings may apply to certain Islamic products or businesses — nevertheless, our Risk Assessment Model remains standard across all licensed firms, providing a level playing field and avoiding artificial distinctions or distortions in regulatory outcomes.
The other critical part of our approach to regulating Islamic Finance has been to step back from the direct regulation of Shari’a . We decided that as a risk based regulator our focus should be on the adequacy of the systems and controls that Firms maintain for all their compliance obligations, be they conventional or Shari’a.
In short, we are not there to regulate religious features of Islamic products but rather to ensure that those features are addressed by others under adequate systems and controls.
We do not have our own Shari’a Board as part of the regulatory structure. Instead, we require Islamic Firms (and also conventional firms operating an Islamic window) to appoint a Shari’a Supervisory Board, which must comprise suitably qualified scholars and operate under approved policies and procedures. Some see this as a weakness in our regime compared, for example, to the Malaysian model. I think many in industry would prefer a centralised Shari’a approval structure and I can understand that. However, we believe that our approach responds in a practical way to the circumstances that currently prevail in our region.
In summary, I would say that our experience to date has validated our approach to cross-sectoral issues as well as the advantages of our regulatory model. We have an active dialogue with the industry and contribute to the work of the DIFC Islamic Financial Advisory Council, a group of practitioners and experts established within our financial Centre to promote the further development of the industry. We have also been working on the promotion of cross-border Islamic Finance transactions and recently concluded a mutual recognition agreement with the Malaysian Securities Commission to facilitate the marketing of Islamic Funds between our respective jurisdictions.
In conclusion I leave you with the following key thoughts:
|First||the development of the Islamic Finance sector deserves a more co-ordinated and cohesive regulatory framework than it is getting;|
|Secondly||consumers of Islamic Finance products deserve more transparent product regulation than they are getting; and|
|Thirdly||that both of these concerns will require an increased cross-sectoral approach to the content of regulation and the way it is administered.|