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Financial Stability

Dr Dadang Muljawan

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The basic concepts

The basic concepts

Contents of discussion

Sources of funds

Sources of funds

Financing products

Financing products

Other servicesOther services

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B

IntroductionIntroduction1

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I. IntroductionB

- Mobilize public funds

- Optimize resource allocation process

- Promote product innovation and flexibility

- Promote fair competition in the Islamic financial industry

- Facilitate the transactions of goods and services

- Provide adequate customer protection

- Promote good governance and risk management

A sound and efficient Islamic financial system is capable to:

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I. IntroductionB

Stability and

robustness

Internal factors External factors

- Currency volatility

- Price volatility

- Fraud

- Inefficiency

- Illiquid market

- No safety net

- Panic

- Imported inflation

Sources of instability

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I. IntroductionB

Stable and robust Islamic financial system requires:

- Strong institutions and markets

- Efficient infrastructure

- Supporting policies

- Crisis management protocol

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B

The pillarsThe pillars2

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II. The pillarsB

Strong Islamic financial institutions and markets

Islamic bankingIslamic banking

Zakat institution

Zakat institution

TakafulTakaful

Micro financeMicro

finance

Islamic pawn house

Islamic pawn house

Finance co’y

Finance co’y

Capital Market and

Money market

Capital Market and

Money market

Competence, GCG and risk management, information system, market structure, supervision and

customer protection

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II. The pillarsB

1 Improving level of competence- Develop standard for training to promote technical competence (in terms of financial and sharia aspects), integrity, and business ethics and sharia principles for the players as and supervisors.

- Certification program for Islamic financial professionals

- Regular review on the materials of the training and certification program.

Strong Islamic financial institutions and markets

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II. The pillarsB

2 Good governance and risk management

- The implementation of good governance principles for the Islamic financial institutions.

- Standard guidance for governance, risk management and business continuity plan which adopts the international accounting standards and IFSB prudential standards.

- Periodical review to adopt any developments including products and regulatory approach.

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II. The pillarsB

3 Information system- The information system should be capable in

providing accurate and timely information covering Islamic financial subsectors whenever required. The development of the informational system is aimed at promoting efficiency and accuracy of the financial authority when making strategic decisions. This information exchange would also improve the capability of the system to conduct surveillance activities comprehensively.

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II. The pillarsB

4 Market structure- The capability of the Islamic financial institutions

to play significant role in financial intermediation and risk management is also affected by the soundness, efficiency and liquidity of the market. The development process should be able to consolidate the development plan of each sector and focus on the financial deepening that maximizes the benefits of the financial system to the real economic development program.

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II. The pillarsB

5 Regulation and supervision

- The development of the supervisory system should accomodate the need for cross-sectorial supervisory capability supported by appropriate system and man-power.

- Information exchange program among financial authrities is very important, particularly as a foundation for establishing an early warning system that is capable of foreseeing potential disturbance to the financial system.

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II. The pillarsB

6 Customer protection- Customers and investor protection program is

aimed at minimizing the vulnerability to any financial disturbance caused by unverifiable information or destructive rumors.

- Transparency and financial performance are mutually reinforcing.

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B

InfrastructureInfrastructure3

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III. Efficient infrastructureB

1 Deposit insurance- Deposit insurance plays a very fundamental role

in maintaining public confidence high by providing a certain level of deposit repayment guarantee, particularly to the retail depositors, in the case of bank closure.

- Public may not get well informed about the difference between underlying transactions applied in the deposit products and the investment products.

- Operationally, the deposit insurance company should take part in the supervisory activities to ensure systemic stability.

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B

2 Payment system- A reliable and efficient payment system plays an

important role to support development in an Islamic financial market and, subsequently, the economic development by facilitating financial transactions among the economic players.

- The sistem designed should be able to minimize risks resulted from the settlement process such as liquidity risk, credit risk, Herstatt risk and systemic risk.

III. Efficient infrastructure

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B

3 Fatwa resolution- fatwa resolution is very essential to maintain

public confidence through providing legal certainty to the players. In some countries that operates Islamic financial institutions, fatwas have been compiled and standardized to improve efficiency.

III. Efficient infrastructure

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B

Supporting policiesSupporting policies4

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IV. Supporting policiesB

1 Monetary policy

The monetary policy is made to provide clear signals to the market by using conventional as well as sharia compliant instruments.

2 Fiscal policyThe government can also participate in the development of Islamic finance by a regular issuance of Islamic government securities or sukuk locally and internationally.

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B

Crisis management protocol

Crisis management protocol5

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V. Crisis management protocolB

Financial policies should be set based on two possible condition: normal business and during the period of crisis. - The CMP serves as the anticipatory action to

maintain the operational soundness of the financial system even if it operates under a significant financial pressure so that the intermediary function can always be performed.

- The CPM should promote possible prompt corrective actions to stabilize the system whenever necessary.

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BBusiness continuity plan (BCP) – The financial authorities require the Islamic financial institutions to have business continuity plan to anticipate significant financial disturbance. The BCP should also be supported by qualified human resource and adequate information technology that allows the management to take right actions whenever necessary. Framework for coordination – Setting up a solid legal foundation for the coordination activities among the parties involved in the CMP decision making process. This includes procedures for decision making process, roles and responsibilities, flows of information and sets of possible prompt corrective actions to be taken during the crisis.

V. Crisis management protocol

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B

Early warning system – The information system that is capable to indicate financial turmoil is very essential in the implementation of CMP. Accurate information about the market allows the authority to define the critical period based on the thresholds set by the financial stability committee and decide the actions to be taken. Stress test – The financial authority may require the financial institutions and also themselves to conduct stress test. Proper stress test can improve mutual understanding among the market participants and regulator. It also allows them to regularly identify weak areas that need to be improved.

V. Crisis management protocol

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B

Solvency regimeSolvency regime6

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BVI. The solvency regime

At product levelAt product level

Sharia contractsSharia contracts

Expected residual value

Expected residual value

Types of claimsTypes of claims

Accounting standards

Accounting standards

Classification of financial products that are compliant to fatwas issued

Classification of financial products that are compliant to fatwas issued

Accounting treatments leading

to the sound financial practices

Accounting treatments leading

to the sound financial practices

Financial classification

describing the types of claims and

possesion of the assets

Financial classification

describing the types of claims and

possesion of the assets

The basis for further calculation like risk

management

The basis for further calculation like risk

management

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BVI. The solvency regime

Risk management

Risk management

Expected lossExpected loss

Objectives

Objectives Micro:

Operational sustainability

Micro:Operational sustainability

Macro:Minimizing potential systemic

costs

Macro:Minimizing potential systemic

costs

Deposit insurance

Deposit insurance

Fiscal constraints

Fiscal constraints

Cost minimizingCost minimizing

Exit policyExit policy

Networth levelNetworth level

At institution and macro levelAt institution and macro level

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BVI. The solvency regime

At institution and macro levelAt institution and macro level

0))((lim

tANetWorthNWt

A

dtCCMint

MBO )1(

where , CBO, CM and represent the potential of having a bail-out, the cost resulted from a bail-out process,a maintenance cost and discount rate respectedly. The first operator expresses the expected bail-out cost; whilst, the second operator expresses the present value of the expected menyatakan maintenance cost drawn from t to infinity. The supervisor selects the independent variables that are considered influencing the two possible events :(x1,...xn-1,xn). It is assumed that the operational sustainability of Bank A is higher than Bank B if A>B.

The networth and optimal stopping time:

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Read! In the Name of your Lord, Who has created (all that exists),Has created man from a clot.Read! And your Lord is the Most Generous,Who has taught (the writing) by the pen,Has taught man that which he knew not.

B

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