11th divider - prudential regulation and supervisory framework · prudential regulation and...

Prudential Regulation and Supervisory FrameworkImplementation of Principle-Based Regulation White Box: Prudential Standards Issued in 2007Risk-Based SupervisionEnsuring a Cohesive Prudential and Supervisory FrameworkImplementation of Revised Capital Adequacy Frameworks Priorities in 2008 White Box: Distinct Features of Islamic Financial Transactions: Perspective on Musharakah Mutanaqisah (Diminishing Partnership)

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11th divider - Prudential Regulation and Supervisory Framework

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11th divider - Prudential Regulation and Supervisory Framework

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Maintaining a robust, effective and efficientregulatory and supervisory framework remained akey priority for Bank Negara Malaysia in 2007.Given the continuing evolution of the financiallandscape as well as the greater volatility in thefinancial markets, the Bank remained focused onensuring that its prudential regulations andsupervisory framework are responsive to changingeconomic conditions in maintaining the resilienceof financial institutions, while providing aconducive environment for financial innovationand growth.

The Bank is responsible for the regulation andsupervision of commercial banks, investmentbanks, Islamic banks, insurance and reinsurancecompanies as well as takaful and retakafuloperators. Since 2002, the Bank also assumedresponsibility for the regulation and supervision ofsix development financial institutions which arecharged with specific mandates within the broaderfinancial sector. The Bank also regulates insurancebrokers, loss adjusters, money brokers andpayment system operators which are covered inthe chapters "Market Conduct and EnhancingFinancial Capability" and "Payment andSettlement Systems".

The evolution of the regulatory andsupervisory framework in the recent period hasbeen cognisant of the fundamental changes to thefinancial landscape, characterised by the followingtrends:• the increasing diversity of the financial sector

which has seen the emergence and moresignificant presence of new players in themarket such as investment banks, privateequity firms, boutique investment advisors aswell as new international players in Islamicfinance;

• increasing linkages between the banking,insurance and capital market sub-sectors as aresult of financial conglomeration and with it,greater financial innovation at a much fasterpace than previously experienced;

• the significant growth of Islamic bankingwhich now accounts for 15.4% of the assetsof the banking system, which has furthercontributed to the increasing level of productsophistication and innovation;

• the growing importance of market-basedfinance, with the capital markets assuming amore significant role in the financing ofeconomic activities. This in turn, has resultedin banking institutions shifting more towardstreasury-based activities while stimulating thegrowth of the derivatives market; and

• the growing volume of cross-border capitalflows with greater global financial integrationboth in terms of the increased foreignparticipation in the Malaysian financial sectorand the increased regional expansion bydomestic players.

In adapting to these new trends, the Bank’sapproach to regulation and supervision hasfocused on three main complementary strands:• firstly, achieving an optimal balance between

principle-based and rule-based regulation toappropriately reflect the greater complexityand diversity of the financial sector, whilehaving the agility to continuously adapt tochanging economic and market conditions;

• secondly, the implementation of an enhancedrisk-based supervisory framework with moregranular assessments of individual institutions’unique risk profiles and risk managementcontrol functions, thus ensuring thatsupervisory attention continues to beproportionately focused on financialinstitutions that are of higher risk; and

• thirdly, strengthening the conditions foreffective market discipline to play a moreimportant role in ensuring sound financial andbusiness practices by financial institutions.

Progress achieved on each of these strandshas also resulted in the closer alignment of theBank’s regulatory and supervisory framework withinternational standards and guidance issued by theBasel Committee on Banking Supervision, theInternational Association of Insurance Supervisorsand the Islamic Financial Services Board.

IMPLEMENTATION OF PRINCIPLE-BASEDREGULATIONPrinciple-based regulations have gained greaterprominence within the prudential framework.Under a more principle-based regulatory regime,prudential standards issued by the Bank have

Prudential Regulation and Supervisory Framework

Financial Stability and Payment Systems Report 2007

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Since 2001, more than 50 prudentialstandards have been developed or reviewed undera more principle-based regulatory approach. In theprocess, a majority of prescriptive limits andregulatory requirements or restrictions have beenreplaced with broad principles that emphasise theresponsibility of the board and seniormanagement to manage risks in a mannerappropriate to the circumstances and exposures ofa particular institution. Among the regulatoryprescriptions that have been abolished under themore flexible, principle-based regulatory regime

progressively shifted towards establishing highlevel principles, in place of detailed prescriptions,which frame the Bank’s supervisory expectationsregarding sound financial and business practices.This shift is not synonymous with less supervisionor regulation, but aims to achieve greater focus onan institution’s ability to effectively manage itsrisks instead of a mechanical compliance withdetailed rules. This, in turn, would result in aregulatory framework that is more robust againstthe vagaries of changing market conditions, whileaddressing the limitations of a "one-size-fits-all"rule-based regulatory system through anappropriate differentiation between institutionsaccording to their size, complexity and risk profile.Financial institutions have considerable flexibilitywithin this framework to determine the mostappropriate means by which the Bank’ssupervisory expectations can be met in a way thatis also in line with the institution’s own strategicobjectives and business models. The Bank believesthat ultimately, this approach is more sustainableover time in reinforcing financial stability andpromoting a more competitive financial system.

The implementation of a more principle-basedregulatory regime for the financial sector inMalaysia remains at a relatively early stage. Whilecommitted to this process, significant attentioncontinues to be directed at strengthening thepreconditions necessary to support the movetowards a more principle-based regulatoryframework without compromising financialstability outcomes. This is reflected in the clearemphasis placed on corporate governance overthe recent few years, beginning with substantiverevisions to the Bank’s prudential standards oncorporate governance. The new standards focus inparticular on the role of the board and seniormanagement in ensuring a sound riskmanagement and internal control environmentwithin financial institutions. These standards setout the Bank’s expectations regarding effectiveboard compositions that include strongindependent members, the presence of relevantcompetencies on the board and seniormanagement team, transparent board processesand clearly delineated accountabilities foroperating and internal oversight functions.

The Bank’s supervisory processes have alsoconcurrently been enhanced to ensure thatdirectors and chief executive officers of financialinstitutions fulfil fit and proper criteria on an

ongoing basis. In addition to supervisory reviewscarried out to check the suitability of proposedchief executives and directors prior to theirappointments, the Bank also engages morefrequently with the board and senior managementof financial institutions, either individually orcollectively, on key strategic and risk developmentsaffecting the institution. This has facilitated moreeffective assessments of how the board and seniormanagement are discharging their responsibilitiesin practice, while providing deeper insights intopotential governance issues within an institution.

Based on the Bank’s ongoing supervisoryassessments, the effectiveness of board oversightand senior management has, on the whole,continued to improve. More specifically, aheightened awareness of risk with clear strategiesfor managing key risks, enhanced disclosures,closer scrutiny of management by the board andprompt actions to detect and remedy internalcontrol deficiencies have been evident amongfinancial institutions. Financial institutions whichdid not meet the Bank’s supervisory expectationswere required to maintain a higher proportion ofindependent directors, or replace board membersor chief executives who no longer fulfilled the fitand proper criteria. These developmentsunderpinned the presence of stronger governancestructures within institutions and supported thegrowing momentum towards principle-basedregulations in more recent periods.

The shift towards moreprinciple-based regulations isnot absolute, but rather aimsto strike an optimal balancebetween principle-based andrule-based regulations.


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are the individual counter limits imposed oninvestments in shares by banking institutions,restrictions placed on credit facilities to connectedparties, prescribed scenarios for stress testing andprior notification requirements for the introductionof new products.

The shift towards more principle-basedregulations is not absolute, but rather aims tostrike an optimal balance between principle-basedand rule-based regulations in order to preserve asound prudential framework at the differentstages of development of the financial sector.Prescriptive rules and requirements are accordinglyretained in specific areas. For example, baseline, orPillar 1, capital adequacy requirements for the

Prudential Standards Issued in 2007

(i) Guidelines on Investment inShares and Interest-in-Shares(issued in February 2007)

(ii) Guidelines on Stress Testing(issued in March 2007)

(iii) Guidelines on the Role of theAppointed Actuary for TakafulOperators(issued in March 2007)

(iv) Property Development andProperty Investment Activitiesby Islamic Banks(issued in March 2007)

(v) Revised Risk-Weighted CapitalAdequacy Framework(issued in April 2007,implementation from January2008)

■ Provides greater flexibility for banking institutions toundertake equity-related activities according to theinstitution’s internal risk management policies.

■ Introduces a more robust stress test regime by givingfinancial institutions greater flexibility in designing their stresstest framework that would be most appropriate for theirbusiness profile, while encouraging financial institutions tobetter understand the risk drivers of their institution.

■ Sets out the expected quality of actuarial investigationsinto the financial condition of family takaful funds by,among others, setting out:• the qualifying criteria for the appointment of

appointed actuaries; and• their responsibilities to continuously evaluate the

financial well being of the family takaful business,having due regard to certificate holders’ reasonableexpectations and developments in the business thatmay impact the financial condition of the funds.

■ Sets out the duty of the boards of Islamic banks to ensurethat adequate governance, sound internal controls and astrong risk management infrastructure are in place tosupport Islamic banks’ direct participation in propertydevelopment and property investment activities which isallowed under the Islamic Banking Act 1983.

■ Sets out the methodologies for quantifying theminimum regulatory capital requirements for credit,market and operational risk for conventional bankinginstitutions.

banking and insurance sectors which are afundamental cornerstone of the prudentialframework remain largely prescriptive in nature.The Bank considers certainty and consistency inthis particular area essential to maintainconfidence in the financial system and avoidmaterially distortive competitive effects in thesystem. Regulatory reporting requirements havealso remained prescriptive to facilitate the Bank’smicro- and macro-surveillance functions. Whereappropriate, the Bank has retained prudentiallimits as well – for example, on exposures to singlecounterparties – in certain areas as a minimumsafeguard against excessive risk-taking. Morespecific prudential requirements have alsocontinued to serve a useful purpose in achieving


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(vi) Risk-Based CapitalFramework for Insurers(issued in April 2007,implementation fromJanuary 2009)

(vii) Valuation of Liabilities forMortgage Reducing TermTakaful (MRTT)(issued in April 2007)

(viii) Capital AdequacyFramework for Islamic Banks(issued in June 2007,implementation fromJanuary 2008)

(ix) Guidelines on CreditTransactions and Exposureswith Connected Parties(issued in August 2007)

(x) Policy on Musharakah andMudharabah Contracts(issued in September 2007)

(xi) Guidelines on SingleCounterparty Exposure Limit(concept paper issued inSeptember 2007)

■ In October 2007, the market risk component wasincorporated in the framework with enhanced guidanceon trading book governance and the provision forbanking institutions to adopt the Internal ModelsApproach, subject to the Bank’s approval.

■ Replaces the existing solvency framework with theparallel run commencing from June 2007.

■ Sets out more transparent and risk-adjusted capital andvaluation requirements that address all major financialrisks of insurers.

■ A similar framework for takaful operators is beingdeveloped, with a concept paper expected to bereleased in 2008.

■ Specifies the minimum valuation requirement based on thenet premium valuation method to be adopted by takafuloperators in determining the reserves that must be providedfor to meet future liabilities under MRTT contracts.

■ Sets out the capital adequacy requirements for Islamicbanks covering credit, market and operational risks,which are consistent with the Capital AdequacyStandards issued by the Islamic Financial Services Board.The framework addresses risk characteristics unique toIslamic finance contracts.

■ Introduces specific capital requirements for inventory andcommodities risks to reflect exposures to pricefluctuations associated with the ability of Islamic banksto undertake the sale and purchase of assets.

■ Provides greater flexibility for banking institutions toextend credit in the ordinary course of business toconnected parties (previously prohibited) based on arm’slength principles and subject to sound risk managementpractices and concentration limits.

■ Sets out the Bank’s expectations regarding keygovernance, risk management and internal controlfunctions to support the sound conduct of investmentand financing transactions based on musharakah andmudharabah contracts.

■ Strengthens the prudential requirements for controllingconcentrated exposures to single names in line withinternational standards and best practices.

■ Proposed changes include the requirement to observethe limits on a consolidated basis, greater considerationof interconnected exposures based on financial andcommercial interdependence, refinements to the basisfor the computation of limits, and the application ofpermitted credit risk mitigation techniques to reduceexposures to a particular counterparty.


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(xii) Corporate GovernanceStandards for LicensedIslamic Banks(issued in September 2007)

(xiii) Guidelines on Introductionof New Products(issued in November 2007)

(xiv) Appointment of ExternalAuditors(issued in November 2007)

(xv) Guidelines on RiskGovernance(concept paper issued inDecember 2007)

(xvi) Policy on the Recognitionand Measurement of ProfitSharing Investment Accountsas Risk Absorbent(issued for implementationfrom January 2008)

■ Outlines the broad principles and minimum standardsfor sound corporate governance which addressmanagement oversight, accountability, audit andtransparency.

■ Strengthens the Shariah compliance frameworkthrough requirements for the establishment of aShariah committee, Shariah internal audits andenhanced disclosures relating to Shariah matters in theannual report.

■ Introduces a more efficient regulatory process for theoffering of new products by banking institutions anddevelopment financial institutions.

■ Institutions are now allowed to offer new products inthe market immediately upon submission of requiredinformation to the Bank (thereby replacing the former21-day prior waiting period for supervisory reviews),subject to meeting the Bank’s supervisory expectationsset out in the guidelines.

■ A similar system will be introduced for insurers in 2008.

■ Addresses the responsibility of financial institutions inevaluating the integrity, objectivity and professionalcompetence of external auditors appointed under therelevant financial sector legislation.

■ Outlines high level principles on risk managementgovernance for the board and senior management aswell as supervisory expectations regarding the riskmanagement control functions of banking institutions,insurers and takaful operators.

■ More specific risk management guidelines on credit,market and operational risks are concurrently beingdeveloped to provide further guidance on supervisoryexpectations in each risk area, with the concept papersexpected to be released in 2008.

■ Islamic banks that satisfy the minimum requirements ofthe framework would be allowed to deduct the creditand market risk-weighted assets funded by profitsharing investment accounts from the total risk-weighted assets for the computation of the risk-weighted capital ratio, in recognition of the effectivetransfer of risks from the Islamic banks to theinvestment account holders.

The Shariah Advisory Council of the Bank also issues pronouncements on Shariah matters to beobserved by financial institutions regulated by the Bank. Please refer to the box on "ShariahPronouncements in 2007".


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certain minimum standards of sound managementin certain sectors which are less developed interms of risk management sophistication (e.g.development financial institutions), where specificguidance remains necessary to build capabilities(e.g. valuation standards for takaful funds), or toaddress present and emerging risks (e.g. specificrequirements that may be imposed underconditions of distress).

To reinforce the dynamic nature of the balancebetween principle- and rule-based regulations, theBank will continue to enhance the structure of theprudential framework to provide greater clarity onthe interplays between the regulations issued bythe Bank. The priority will be towards developing acomprehensive set of general prudential standardswhich establish high level principles covering thekey risk management control functions thatshould exist within all financial institutions. To thisend, significant efforts have been taken in recentyears to review and develop standards in the areasof board oversight, senior management, internalaudit and risk management, which would providethe overarching prudential framework for allregulated financial institutions.

The overarching framework will becomplemented by more specific prudentialstandards that address the Bank’s supervisoryexpectations regarding the management ofsignificant activities undertaken by financialinstitutions. These may be specific to therespective banking, insurance or takaful sectors,and may include appropriate prudential limits andmore detailed requirements prescribed by theBank. Over time, the Bank expects to evolve amore cohesive and consistently expressedprudential framework that:(i) addresses all the main elements of effective

risk management control functions which areapplicable across all significant activities offinancial institutions (general standards);

(ii) is appropriately tailored, while avoiding anyoverlaps, to specific areas of activity (specificstandards); and

(iii) provides for regulatory prescriptions whereneeded as minimum prudential safeguards.

The Bank generally expects that financialinstitutions would require some time to adapt to amore principle-based regime. Going forward, thepace of transition toward a more principle-basedregime will depend on several key factors. The first is

a corresponding change in the behaviours offinancial institutions from a focus on compliance-based outcomes, to one that focuses on the effectivemanagement of risks by institutions in an integratedmanner. Greater reliance will be placed on boards toset the "tone at the top", while ensuring that thereis broad-based engagement within the organisationsacross various levels and functions in setting riskstrategy, establishing acceptable levels of risk-takingand defining accountabilities. Following from this,the Bank will expect financial institutions to have thenecessary processes, systems and expertise effectivelyin place to support sound operating decisions andjudgements, thus maintaining financial stabilityunder the more principle-based regime.

For institutions to operate with a reasonabledegree of certainty as to acceptable practices undera less prescriptive framework, there is also a need forgreater dialogue between the Bank and the industry,particularly in the initial stages of transition, to builda common understanding of the range of acceptablepractices and approaches which would satisfy theregulatory principles established by the Bank. TheBank will continue to actively engage the industry onthis front, while ensuring consistent supervisoryassessments and actions to reinforce good practices.

The Bank further envisages significant scope forthe key industry associations and relatedprofessional bodies to play a more active role inpromoting dialogue within the industry andproviding industry-specific guidance on howprinciples promulgated by the Bank may be appliedin practice. These entities include the Association ofBanks in Malaysia, the Malaysian InvestmentBanking Association, the Life Insurance Associationof Malaysia, the General Insurance Association ofMalaysia, the Actuarial Society of Malaysia, theMalaysian Takaful Association, the Association ofIslamic Banking Institutions Malaysia and theprofessional accounting bodies. While the Bankencourages the development of useful guidance bythe industry, individual financial institutions willremain responsible for ensuring that the applicationof such guidance provided by the industryadequately addresses the institution’s own riskexposures, having regard to the specificcircumstances under which the institution operates.

RISK-BASED SUPERVISIONA risk-based approach to supervision has beenadopted by the Bank since 1997. In 2004, anenhanced risk-based supervisory framework (RBSF)


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was implemented for insurers and takaful operators,followed progressively thereafter by the adoption ofthe framework for banking institutions anddevelopment financial institutions. The RBSF furtherstrengthens the Bank’s risk and impact-focusedapproach to supervision, underpinned by morecomprehensive and holistic risk assessments ofindividual financial institutions under the purview ofthe Bank. It is applied to all financial institutionsregulated by the Bank, thereby ensuring that similarrisks are addressed in a consistent manner across thefinancial sector. The framework also facilitates theappropriate concentration of supervisory attentionon institutions that are of higher risk. Supervisoryresources and activities are thereby more efficientlyand effectively managed, with greater scrutiny onweaker and systemically important institutions.

The RBSF is a dynamic supervisory tool thatidentifies and assesses the emerging risks in afinancial institution based on an in-depthunderstanding of the institution, the industry andenvironment in which it operates, and factors thatcould adversely alter the risk profile. A key outputof the RBSF is an assessment (known as thecomposite risk rating) of an institution’s ability tomeet its obligations to depositors, creditors andpolicyholders on a continuing basis, includingunder stress conditions. The composite risk rating(CRR) is derived from an assessment of the risksinherent in an institution’s significant activities, theoverall quality of its operational management andrisk management control functions to mitigate theinherent risks, and the extent of capital andearnings support available to the institution toabsorb unexpected losses (Chart 4.1). The CRRprovides the basis on which the Bank determinesthe appropriate level of intensity of supervisionover a particular institution and supervisoryactions, including the imposition of additionalcapital requirements, that need to be taken toaddress residual risks. The CRR is also a factorconsidered by the Malaysia Deposit InsuranceCorporation in the application of the differentialpremium charges on member banking institutionsfor deposit insurance.

The RBSF further strengthensthe Bank’s risk and impact-focused approach tosupervision, underpinned bymore comprehensive andholistic risk assessments ofindividual financial institutions.

* For Islamic banks

Identify SignificantActivities

Assess theInherent Risks

Assess theOperational

Management

Assess the RiskManagement Control

Functions

· Credit · Board of Directors · Market · Liquidity · Senior Management

· Operational· Information

· Risk Management

Technology

· Internal Audit

· Strategic

· Compliance

· Insurance &

· Information &

Takaful

Communication

· Equity Investment*· Rate of Return*

Composite Risk Rating

RISK-BASED SUPERVISORY FRAMEWORK

Business linemanagers responsiblefor day-to-dayoperations

Assessment of Capital & Earnings

Significant activities couldinclude any line of business,unit or process having asignificant potential impact onthe institution's earnings andcapital positions as well asthe achievements of theirstrategic plans.

Chart 4.1 Supervisory Framework under RBSF


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In implementing the RBSF, the Bank has alsoenhanced its supervisory documentation to ensurethat supervisory assessments are well-supported,and provide a clear trail of risk issues, developmentsand actions taken in relation to each individualinstitution. Greater integration between the Bank’smacro-surveillance and supervision functions wasalso achieved with enhanced two-way flows ofinformation that provided supervisors with up-to-date developments of emerging risks within thebroader financial system that could impact the riskprofile of individual institutions, while institution-specific insights from supervisors contributedtowards a deeper understanding and more effectivemonitoring by the Bank of potential risks tofinancial stability.

Under the RBSF, greater reliance is placed onan institution’s internal oversight functions toidentify emerging risks and safeguard aninstitution’s financial condition. To support suchreliance, the Bank has continued to regularlyengage the board and senior management as wellas those principally responsible for internal audit,risk management, compliance and managementinformation support within institutions, on riskissues concerning the institution. Greater relianceis also placed by the Bank on the work of externalauditors and actuaries appointed by financialinstitutions. In this connection, the Bank hasregular discussions with external auditors andactuaries to enhance awareness and clarity of theBank’s expectations of their roles, and the degreeof reliance placed on their work for supervisorypurposes.

ENSURING A COHESIVE PRUDENTIAL ANDSUPERVISORY FRAMEWORKThe framework for prudential regulation andsupervision is both interdependent and mutuallyreinforcing. In implementing the RBSF and more

Greater integration betweenthe Bank’s macro-surveillanceand supervision functions wasalso achieved with enhancedtwo-way flows of informationthat provided supervisors withup-to-date developments ofemerging risks.

The RBSF is centrally supported by "relationshipmanagers" in the Bank whose primaryresponsibilities are to carry out supervisoryassessments of institutions, conduct ongoingsupervisory reviews, recommend appropriateinterventions and maintain open lines ofcommunication with the institutions to ensure thatdevelopments – both internal and external to theinstitutions – are quickly identified and factored intosupervisory assessments on a continuing basis.

Based on the Bank’s supervisory assessmentsunder the RBSF, the vast majority of financialinstitutions remained in a healthy position as atend-2007, with the capacity to manage theincreased risks associated with the more volatileexternal environment.

During the year, the Bank continued tostrengthen the supporting structure, processes andcore capabilities required to effectively implementthe RBSF through:• the institution of a quality assurance

framework which provides for more rigorousinternal processes to promote accurate riskassessments and feedback across the Bank’ssupervisory departments, as well as timely andeffective interventions. Among other things,the framework provides for internal peerreviews of supervisory assessments to validatethe judgements exercised by relationshipmanagers in respect of individual institutions.These panel reviews ensure that supervisoryassessments are appropriate, having regard tothe supervisory expectations established inguidelines issued by the Bank, the institution-specific exposures and risk managementpractices, and assessments of otherinstitutions with similar risk profiles;

• significantly strengthened technicalcapabilities residing in specialised risk (credit,market, operational and insurance) andeconometrics units established within theBank. These units are staffed by qualifiedsupervisors and subject matter experts whoprovide key support to the relationshipmanagers on more technical aspectsassociated with statistical modelling, complexrisk assessments and the evaluation of internalrisk models; and

• improved supervisory information systems andinfrastructure with enhanced capabilities tosupport more efficient supervisoryassessments.


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principle-based approach to regulation, significantattention is directed at ensuring the effectiveintegration of the regulatory and supervisoryprocesses to achieve a coherent framework thatcontributes to financial stability.

to financial institutions under the Bank’s purviewto ensure an enabling legislative framework that issupportive of the more principle-based regulatoryapproach as well as risk-based supervision. Morethan 166 provisions of the Banking and FinancialInstitutions Act 1989 and the Insurance Act 1996were reviewed with the aim of:• aligning the legal provisions with the more

principle-based regulations and developmentsin international supervisory standards;

• ensuring that the Bank will have the necessaryauthority to act under the risk-based approachto supervision when necessary;

• enhancing cross-sector consistency;• enhancing clarity of the law; and• reducing the administrative burdens on

financial institutions where appropriate.

The Islamic Banking Act 1983 and Takaful Act1984 have also been concurrently reviewedtogether with an exercise to update andstrengthen these respective legislations. The Bankexpects to complete the legislative process toeffect these amendments in 2008.

To ensure the efficiency and integrity of theprudential framework, the Bank made furtherprogress in efforts to rationalise and update theprudential framework across the industriesregulated by the Bank, as well as in relation to thecapital market intermediaries regulated by theSecurities Commission. During the year, the Bankcompleted an exercise to identify divergentregulatory requirements in common areas ofactivity involving its regulated institutions,reviewed 18 regulatory requirements andidentified a further 14 areas for review in 2008.

The Bank continued to obtain relevant inputfrom the financial industry and other keystakeholders to maintain a robust framework thatis reflective of changing market realities and isimplementable in practice. During the year, sixconcept papers were issued to the industry, withanother eight in the final stages of completion forexpected issuance within the first half of 2008.Responses received from stakeholders continuedto provide important insights into the efficiencyimplications of proposed policies, consistencyacross industries as well as their likely impact onbusiness and financial activities. Whereappropriate, policies were modified to addresssignificant issues raised.

In line with the transition from a "one-size-fits-all", compliance-focused regulatory regime, toone that is more differentiated according to riskand more reliant on the exercise of supervisoryjudgements, enhanced processes have beenadopted to further integrate critical supervisoryinputs into policy thinking and formulation.Specifically:• prudential policy priorities are confirmed

against key risks to financial stabilityhighlighted through supervisory observationsand assessments;

• policy development is jointly approachedbetween the regulatory and supervisoryfunctions of the Bank, thus allowing forbroader-based assessments of proposedpolicies while ensuring a commonunderstanding of the specific outcomes ofprudential policies. This, in turn, facilitatessupervisory assessments of individualinstitutions under the RBSF that will bealigned with, and reinforce, the supervisoryexpectations set out under the principle-basedregulations; and

• the exercise of sound supervisory judgement isfurther reinforced through the inclusion ofstaff involved in policy development in thesupervisory review panels and interventiondeliberations. This further contributes towardsensuring that supervisory assessments andinterventions are appropriate, having regardto specific outcomes intended by theprudential standards issued.

During the year, the Bank also completed anassessment of revisions to the legislation applied

Significant attention is directedat ensuring the effectiveintegration of the regulatoryand supervisory processes toachieve a coherent frameworkthat contributes to financialstability.


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The Bank remained mindful of the trade-offbetween the benefits and costs of regulation. Asin previous years, a large part of feedback receivedduring the consultation process highlighted theconcerns of institutions regarding practicalimplementation issues. The Bank held dialogueswith the industry and individual institutions tounderstand these concerns more fully and developimplementation solutions that appropriatelybalanced the costs of implementation with risks tofinancial stability. In an environment of increasedvolatility and competition, however, financialinstitutions clearly recognised the urgent need toenhance risk management systems andgovernance structures within their organisations.

Outside the Bank, closer coordination withother regulatory and supervisory agencies was alsoachieved with the conclusion of formalagreements with the Securities Commission andthe Malaysia Deposit Insurance Corporation thatclearly set out the roles, responsibilities andcooperation arrangements aimed at minimisingregulatory overlaps and inconsistencies. Thearrangements have continued to work well inenhancing regulatory efficiency and facilitating thesharing of information between agencies whereappropriate. The Bank also signed a Memorandumof Understanding with the State Bank of Vietnamto facilitate greater cross-border supervisorycollaboration.

IMPLEMENTATION OF REVISED CAPITALADEQUACY FRAMEWORKSDuring the year, substantial progress was achievedin final preparations for the implementation of therevised capital adequacy frameworks for bankinginstitutions and insurers. The revised frameworkswill align regulatory capital requirements moreclosely with the specific risk profiles of individualinstitutions and adopt underlying valuations thatare consistent with international financialreporting standards.

Revised Risk-Weighted Capital AdequacyFramework (Basel II) for Banking InstitutionsThe revised risk-weighted capital adequacyframework (Basel II), which is applicable tocommercial banks and investment banks, becameeffective from 1 January 2008 for a total of 27banking institutions that are adopting the simplerapproaches, namely the Standardised Approachfor credit risk and either the Basic Indicator,Standardised or Alternative StandardisedApproaches for operational risk. The remainingseven banking institutions (including four locally-incorporated foreign banking institutions) havebeen allowed to remain under the existing capitaladequacy framework (Basel I) until their migrationto the more advanced Internal Ratings-Based (IRB)approaches for credit risk under Basel II from 1January 2010. The option for direct migrationwhich is intended to minimise the cost of Basel IIimplementation, was granted only to bankinginstitutions that had met preconditions set by theBank, such as the availability of resources andexpertise to meet the supervisory expectationsunder IRB approaches as well as the ability todemonstrate a high level of commitment anddiscipline in implementation preparations.

With respect to Islamic banks, 10 out of 12Islamic banks have adopted the revised frameworkfor Islamic banks (Capital Adequacy Framework forIslamic Banks or CAFIB) which specifies thestandardised approach to capital computations,while reflecting the differences in the underlyingcontracts and incorporating specific elementspeculiar to Islamic banking such as the capitalrequirements for inventory risks as well as thetreatment of profit sharing investment accounts. Theremaining two Islamic banks have been allowed tomigrate directly to the IRB approach in January 2010.

The Bank anticipates that most bankinginstitutions would experience only modest

At the regional level, supervisory cooperationthrough the various regional groupings of whichthe Bank is a member, such as the ExecutiveMeeting of East Asia and Pacific Central Banks(EMEAP) and South East Asian Central Banks(SEACEN), deepened further. Cooperationfocused in particular on facilitating theimplementation of Basel II within the region aswell as strengthening the regional frameworksfor macro-surveillance and crisis management.During the year, the Bank also maintained itscommitment to strengthen the region’s influencein the development of international standardsthrough its participation in various workinggroups, and by providing feedback on more than15 draft standards and surveys issued by theinternational standard setting bodies.

Supervisory cooperation at theregional level deepenedfurther.


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increases in their regulatory capital requirementsfollowing the adoption of the revised capitalframeworks, based on results from the parallel runexercise in 2007. While the revised frameworksintroduce a new operational risk charge, theanticipated additional capital requirements areexpected to be partly mitigated by savings on thecredit risk capital charge derived from the lowerrisk weights applied for residential mortgages andretail exposures. In this connection, there has beengreater emphasis for banking institutions toimprove the collection of data on operationallosses. While this is not a pre-requisite for theimplementation of the Basic Indicator Approachunder the revised frameworks, the Bank views thecollection of loss data as critical in allowingbanking institutions to better understand theiroperational risk profiles as a basis for thedevelopment of enhanced operational riskmanagement capabilities.

For some institutions, the ability to quantifythe effects of comprehensive credit risk mitigationtechniques used, and the holdings of a significantportion of investment-grade debt securities, wouldgenerate further capital savings. The parallel runcalculations also indicated a minimal impact oncapital arising from the revised requirements formarket risk which, among other things,incorporate a new capital requirement forcommodity risk positions and recognise offsettingliability positions in the trading book. For Islamicbanks, the inclusion of physical assets as eligiblecollateral and the recognition of profit sharinginvestment accounts as a risk absorbent under therevised framework would also allow for additionalcapital relief.

internal risk modelling and analytical capabilities.The Bank will monitor these preparations closely toensure that these banking institutions remain ontrack to comply with the IRB approaches by 2010.

Risk-Based Capital (RBC) Framework forInsurersThe Risk-Based Capital (RBC) framework was issuedto the insurance industry in April 2007. Theframework provides for regulatory capitalrequirements that are more sensitive to theunderlying risk exposure of insurers, compared tothe existing solvency requirements. This allows formore flexible investment rules, while introducingrevised valuation requirements that are marketconsistent. All insurers are currently conducting aparallel run exercise in preparation for the effectiveimplementation of the framework in January 2009.

While the Bank anticipates some increase incapital requirements among several insurers, theparallel run exercise indicated that the majority ofinsurers would be able to comfortably meet theminimum regulatory capital requirement. Whileinsurance risk contributed most significantly to theoverall regulatory capital requirement, market riskalso represented a significant source of risk for lifeinsurers, mainly associated with equity exposuresand interest rate mismatches.

Most banking institutionswould experience only modestincreases in their regulatorycapital requirements followingthe adoption of the revisedcapital frameworks.

The majority of insurers wouldbe able to comfortably meetthe minimum regulatorycapital requirement.

For banking institutions that have been allowedto migrate directly to the IRB approaches,significant attention and resources have beendirected towards the proper construction of riskand data management systems and infrastructuralenhancements, as well as strengthening the

The adoption of market consistent valuationsof assets and liabilities may also result in someincreased volatility in the financial results ofinsurers. For life insurers in particular, theinsufficient volume of long-term debt instrumentsin the domestic market currently, coupled with theprevailing low interest rate environment, hascontinued to place some pressure on guaranteedbusiness, resulting in higher exposures to asset-liability mismatch risks. However, most insurersshould experience only modest increases involatility as asset positions adjust proportionatelyagainst corresponding liability positions.

PRIORITIES IN 2008Bank Negara Malaysia’s regulatory andsupervisory priorities in 2008 will continue to


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focus on strengthening the Bank’s capabilitiesand capacity to respond pre-emptively toemerging risks in the financial system. This wouldinclude:• ensuring that regulatory requirements

continue to remain appropriate over time andin relation to the changing environment, aswell as clearly setting out the Bank’ssupervisory expectations with regard to themanagement of key risks;

• ensuring, through vigilant supervision, thatinstitutions are adequately managing theirrisks in practice in line with the supervisoryexpectations of the Bank; and

• continuously building capacity within the Bankto support both of these activities.

The implementation of the revised capitalframeworks for the banking and insuranceindustries will remain a key priority in 2008.Banking institutions which have been grantedapproval to adopt the IRB approaches for creditrisk will be required to submit their internalmodels to the Bank for review before the modelscan be used to determine regulatory capitalrequirements. Significant supervisory resourceswill be devoted to the review and validation ofthese models ahead of the 2010 deadline forimplementation of the IRB approaches. The Bankwill also continue to closely monitor thequantitative impact of regulatory capitaladjustments within institutions and across theindustry for both banking institutions adoptingthe standardised approaches and insurersapplying the RBC framework on a parallel runbasis in 2008. The Bank expects to providegreater clarity to the industry on its approach tothe determination of additional capitalrequirements under the supervisory assessmentprocess (Pillar 2) for specific institutions, as wellas advance forward its work on marketdisclosures to reinforce sound financialmanagement (Pillar 3). Remaining

implementation and calibration issuessurrounding the revised frameworks will also beresolved. The Bank further intends to initiatework to develop an equivalent RBC frameworkfor the takaful operators.

Other priorities for the Bank in 2008 are thecompletion of reviews of the relevant financialsector legislation to reinforce the Bank’s newapproaches to regulation and supervision;development of a revised and more cohesivecompendium of risk management standards; andpreparations for the implementation ofinternational financial reporting standards onfinancial instruments and insurance contracts.The Bank also expects to engage the industry onthe proposed approach to the supervision offinancial groups, focusing in particular on theapplication of the revised capital adequancyframeworks and the RBSF in the context offinancial groups.

Another priority will be in the area ofcorporate governance. While the Bank does notenvisage substantive changes to its current set ofprinciples applicable to financial institutions,further efforts will be taken to harmonisestandards across institutions regulated by the Bankand, to the extent appropriate, with the updatedrequirements under ongoing reforms to theCompanies Act 1965 and developments innational codes of corporate governance. The Bankalso expects to take forward initiatives in the areaof directors’ education which are aimed atsupporting effective board functions.

Shariah Pronouncements in 2007

The Shariah Advisory Council (SAC) is the sole authoritative body on Shariah matters pertaining toIslamic banking, takaful and Islamic finance. Its jurisdiction covers all financial institutions regulatedand supervised by Bank Negara Malaysia. As the reference body and advisor to the Bank on Shariahmatters, the SAC is also responsible for validating all Islamic banking and takaful products to ensurecompatibility with Shariah principles.

The implementation of therevised capital frameworks forthe banking and insuranceindustries will remain a keypriority in 2008.


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In 2007, the SAC convened 12 meetings and among its major decisions were:

(i) Application of Ijarah Mausufah fi Zimmah in house financingThe SAC approved the application of ijarah mausufah fi zimmah (forward lease) as a supportingcontract in house financing based on ijarah as the primary contract. The decision bearsparticular significance for the financing of uncompleted assets as it will resolve the issue ofrental payments made for the period commencing from the execution of the contract to thecompletion of the asset. Prior to the decision, rental charges for the period before completionof the asset were not justifiable as the tenant could not enjoy the usufruct during this interimperiod. With the application of the forward lease, however, such payments can be treated asfuture rentals. The decision has been recognised by scholars from different schools of thoughtand will further refine existing contracts incorporating Shariah principles.

(ii) Application of Wakalah bi Istithmar contractThe SAC also approved the application of the wakalah bi istithmar (agency for investment)contract in deposit accounts. This contract involves deposit-taking mobilised through wakalah(agency), in which the funds mobilised are invested in instruments that would generate anagreed minimum rate of return. In contrast to deposits mobilised through wadiah or qardh, thewakalah contract feature would allow Islamic financial institutions to offer additional benefitssuch as takaful coverage with wakalah deposit accounts to enhance the product’sattractiveness to customers. However, the implementation of such contracts must be carriedout prudently to avoid any element of guarantee by the agent on the investment returns. Theresolution by the SAC is expected to further diversify Shariah-compliant products and at thesame time allow Islamic banks to be more creative and innovative in their product offerings.

Recognising the importance of Shariah compliance in Islamic finance, Bank Negara Malaysia, inMarch 2007, published a compilation of resolutions made by the SAC in a book entitled "ShariahResolutions in Islamic Finance". The book is intended to serve as a reference for the Islamic financecommunity, especially Shariah officers and practitioners. To inform the market in a timely manner,the Bank has also disseminated recent resolutions made by the SAC through press releases as part ofits continuing effort to increase transparency and enhance the understanding of Shariah issuesamong market players.

To promote quality research on Shariah compliance while improving regulatory efficiency, thepresentation of Shariah issues and new product proposals by Islamic banks to the SAC are requiredto be submitted in a standard format which incorporates issues, opinions and views of renownedShariah scholars. Institutions offering Islamic products are also required to state clearly the views ofthe institutions’ Shariah committee and the rationale behind such views. This will contribute towardsdeepening the understanding of the issues being discussed, thus promoting sound Shariahresolutions.

The SAC is supported by Shariah research carried out by Bank Negara Malaysia on Shariahaspects of product innovations as well as on immediate and long-term policy issues. In 2007,research undertaken on the application of the wakalah bi istithmar concept in savings depositproducts supported the approval given by the SAC for this product, considered the first wakalah-based savings product in the world. The Bank also conducted research to establish the applicabilityof existing financial reporting principles as a guide to develop Islamic financial reporting standards.Based on the Bank’s research, the SAC pronounced that these principles are consistent with Shariahand can serve as guiding principles to develop similar standards for Islamic financial reporting. TheSAC also highlighted the need for existing financial reporting standards to be enhanced in order tosupport Shariah requirements.

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Distinct Features of Islamic Financial Transactions:Perspective on Musharakah Mutanaqisah (Diminishing Partnership)

"The very objective of the Shariah (Maqasid Shariah) is to promote thewelfare of the people which lies in safeguarding their faith, their life, theirintellect, their posterity and their property. Whatever ensures the safeguard ofthese five serves public interest and is desirable." - Al Ghazali

Islamic finance is founded on Shariah principles which express an explicit intention to meet thefinancial needs of participants with integrity and in a manner that is just, fair, trustworthy andhonest, while ensuring a more equitable wealth distribution. Chart 1 briefly summarises theessential features of Islamic finance.

Chart 1Essential Features of Islamic Finance

� Towards achieving the objectives of Shariah (Maqasid Shariah) � High ethical values - justice, fairness, trust, honesty and integrity

Overarching Principles

� Economically productive underlying activities� Avoidance of interest-based transactions� No involvement in illegal and unethical activities� Genuine trade and business transactions� Avoidance of speculative transactions

Materiality and Validity of Transactions

� Entitlement of profit contingent upon risk taking� Honouring both substance and form of contract

Mutuality of Risk Sharing

Embedded governance Disclosure & transparency requirements

Unlike conventional finance, Islamic finance is governed by Shariah rules that prohibit interest-basedtransactions. Islamic financial transactions are also required to be accompanied by genuine underlyingtrade and business activities that generate fair and legitimate profits. This reinforces the close linkbetween financial and productive flows which underpin Islamic finance, thereby insulating the Islamicfinancial system from risks associated with excessive leverage and speculative financial activities. The risk-and profit-sharing characteristics of Islamic financial transactions (such as in mudharabah andmusharakah contracts) which are clearly defined at the onset, serve as additional in-built mechanismsthat further strengthen incentives for the adoption of sound risk management practices by Islamicfinancial institutions. In particular, these features demand the exercise of appropriate due diligence byIslamic financial institutions and higher standards of disclosure and transparency to be observed which, inturn, act to enforce market discipline and minimise informational asymmetries.

Collectively, these intrinsic features and requirements of Islamic finance act as natural stabilisersand restraints against the risks and excesses associated with excessive leverage, financial speculationand mis-selling that can threaten the effective functioning of financial systems.

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The range of Islamic financial products has broadened considerably in recent years in responseto the more diverse and differentiated requirements of participants. For example, Islamic financingcontracts have expanded from simple-mark up contracts to include those that are equity-based.While Islamic finance has continued to evolve rapidly, the distinct features of Islamic financialtransactions have been preserved in the new innovations in order to ensure that the religious andethical principles of participants are not compromised. This is illustrated in the following example ofmusharakah mutanaqisah, an equity-based contract which has been widely accepted in manyjurisdictions.

A Study on Musharakah Mutanaqisah

Musharakah mutanaqisah can be applied in home financing products. Based on the joint-ownershipconcept, the banking institution and the customer contribute their respective shares of the capitalrequired to acquire the property according to a pre-determined ratio agreed to between them at thebeginning of the contract. The banking institution leases the property to the customer whoundertakes to incrementally acquire the full ownership of the property from the banking institutionover an agreed period. Once the customer has fully acquired the banking institution’s share of theproperty, the partnership comes to an end with the customer becoming the sole owner of theproperty. This contract incorporates elements of both sale and lease (ijarah) contracts, which areintegral in ensuring that no element of riba (interest) is involved in the musharakah mutanaqisahtransaction. The dynamics, at different transaction stages, of a musharakah mutanaqisah contractfor completed property is illustrated in Chart 2.

The application of Shariah principles in musharakah mutanaqisah contracts creates distinctrelationships, rights and obligations of the parties to the contracts. As a result, banking institutionsare exposed to both market risk associated with the joint ownership of the underlying asset, as wellas credit risk associated with the obligation on the part of the customer to acquire, and on thebanking institution to sell, its share of ownership in the asset. This distinct risk exposure requires thebanking institution to adopt more robust methodologies supported by reliable and adequate dataand systems that are able to detect and provide best estimates of potential losses arising fromadverse developments in the credit profile of the customer. The risk management processes andinfrastructure of a banking institution offering such a product must also be dynamic in identifying,measuring, controlling and managing all the relevant risks associated with musharakah mutanaqisahtransactions. Chart 3 shows the key risk exposures and risk management practices at the differentstages of a transaction in musharakah mutanaqisah, as well as additional risk mitigants that can beintroduced.

Musharakah mutanaqisah – A form of partnership in which one partnerpromises to gradually acquire the equity share of the other partner until theshare of ownership is completely transferred to the first partner.

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Chart 2 Dynamics of Musharakah Mutanaqisah Contract for Completed Property

Musharakah Mutanaqisah

The SAC in its 56th meeting held on 6 February 2006 has recognised the application of musharakah mutanaqisah as a permissible contract in Islamic muamalat which inculcates the element of sharing in terms of capital and liability between the financier and customer.

Shariah Advisory Council (SAC) Resolutions

TMTarikh Matang

n

% of share ownership of the banking institution in property

(100-x)%, where x = customer’s share

Periodic rental payment (Rental is calculated based on bankinginstitution’s prevailing share)

Lease rental & gradual transfer of banking institution’s ownership

Banking Institution

Customer

0%

TMTarikh MatangT0

Acquisition dateTn TM

Maturity date

T0-TM

Lease rental and gradual transfer of bank’s ownership.

T0

Acquisition of property by both parties.

STAGE OF TRANSACTION

KEY FEATURES

CONTRACTUAL RELATIONSHIP

Diminishing partnership and ijarah (lease).

Transfer of full ownership of the property to the customer.

TM

Full transfer of bank’s ownership to customer.

• Full settlement of the agreed rental.

• Allows early settlement by acquiring bank’s share of ownership.

Banking institution and customer enter into partnership contract to jointly purchase the property based on an agreed share ownership between them in the property.

They are partners/joint owners of the property based on the pre-agreed ratio, e.g. 10% will be paid by customer and the bank will pay the remaining 90%. The parties also agree on profit sharing ratios and the loss will be based on the proportion of each party’s capital contribution.

Under ijarah, customer pays the lease rental and gradually reduces the banking institution’s ownership (rental payment is inclusive of the use of asset and purchase of the banking institution’s share of the asset). The rental rate may be fixed or floating.

Tn – Prepayment / Withdrawals• Customer may opt to make partial prepayments

by acquiring a higher proportion of the banking institution’s ownership.

• Flexibility for customer to withdraw his share by selling off his ownership share to the banking institution.

Tn – Default Event In the event of customer default, the partnership will be terminated. • Without wa’d (purchase undertaking), the asset

will be sold and the proceeds will be divided according to the latest ownership shares of the banking institution and customer.

• With wa’d, the customer is obliged to acquire the banking institution’s remaining share. This creates a debt to be paid by the customer to the banking institution.

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Chart 3Management of Key Risks in Musharakah Mutanaqisah Contracts

TM: Full Transfer of Banking Institution’s Ownership to Customer

Risk ManagementProvide appropriate mechanism to compensate the bank’s loss of future income arising from early settlement.

Risk Management

RATE OF RETURN RISK Potential loss in future income arising from early settlement

T0: Acquisition of Property by Both Parties

1. Ensure comprehensive agreement to cover the rights and obligations under joint ownership.

2. Proper assessment of customer credit profile and valuation of the property.

LEGAL RISK

Enforceability of contract and recognition of beneficial ownership under the law

Pre-agreed rental price based on financial market indicators.e.g. BLR, KLIBOR

Risk Management

MARKET RISK

Arising from the fluctuation of market price (in the case of transactions without wa’d)

T0 – TM: Lease Rental & Transfer of Bank’s

Ownership

CREDIT RISK

Non-payment of rental by the customer1. Incorporation of

purchase undertaking (wa’d) as a risk mitigant (exit strategy) in the event of default. Refer to default scenario for wa’d in Chart 2.

Risk Management

Tn: Customer Default

2. To use security instruments (charge the underlying

property) against the non payment of rental.

The case of wa’d may give rise to arguments that it negates the essence of the partnership contract. However, there are Shariah views allowing the use of wa’d.

To consider other measures that will preserve the essence of the partnership and the virtue of sharing risk.

POSSIBLE ENHANCEMENT

To consider rental rate that is more indicative of the actual rental price while taking into account the competitiveness of the product.


To incorporate elements in the contract that would fully reflect the actual rights and obligations of the co-owners. e.g. maintenance cost and quit rent provisions/clauses.

To apply appropriate financial reporting standards that reflect the Shariah contract.


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Several jurisdictions have also applied specific regulatory requirements to ensure theappropriate management of risks associated with this type of contract. For example, in jurisdictionsadopting capital adequacy frameworks based on the Capital Adequacy Standard issued by theIslamic Financial Services Board, Islamic banking institutions are required to allocate sufficientregulatory capital to cover the exposures to both the price risk based on the proportion owned bythe banking institution in the underlying assets, as well as the credit risk arising from theoutstanding rental payable by the customer. In tandem with the banking institutions’ diminishingshare of ownership in the asset, the capital requirement for the price risk would gradually declineover the period of contract.

With its distinct features, and in-built checks and balances, the development of Islamic financeas a viable form of financial intermediation is expected to contribute towards enhancing financialstability. Moving forward, further product innovations in Islamic finance can be expected. Thisneeds to be supported by further in-depth research on Shariah issues relating to risk mitigation,liquidity management and hedging in order to ensure that the fundamental tenets of Shariahwhich underpin the stabilising factors inherent in Islamic financial transactions, are preserved.

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