GREATER TRANSPARENCY

2.8 GREATER TRANSPARENCY

Transparency of banks through the provision of correct information about important financial variables and other institutional and administrative factors which have a bearing on the soundness of a bank, is vital for not only protecting the interests of depositors and other concerned parties but also systemic stability. It is, therefore, the core principle of international accounting standards. Its importance increases even further in the risk-sharing nature of Islamic finance, because of the need to enable the shareholders and the depositors to monitor the affairs of the bank and thereby help inject greater discipline. It is necessary, therefore, to enhance transparency and comparability of banks through suitable Transparency of banks through the provision of correct information about important financial variables and other institutional and administrative factors which have a bearing on the soundness of a bank, is vital for not only protecting the interests of depositors and other concerned parties but also systemic stability. It is, therefore, the core principle of international accounting standards. Its importance increases even further in the risk-sharing nature of Islamic finance, because of the need to enable the shareholders and the depositors to monitor the affairs of the bank and thereby help inject greater discipline. It is necessary, therefore, to enhance transparency and comparability of banks through suitable

2.8.1 Capital Quality

The need for transparency about banks' capital structures arises due to the fact that banks' tier-1 or core capital may be increasingly diluted by tier-2 or supplementary capital (and in some countries also by tier-3 capital). To ensure that this dilution does not erode the core capital, the BCBS makes two recommendations. First, banks should appropriately and timely disclose i) the amount of tier-1 and tier-2 capital with their detailed components; ii) deductions from tier-1 and tier-2 capital; iii) amount of tier-3 capital, if any; and, iv) the total capital base of the bank. Second, banks should appropriately disclose the loss absorbing capacity of capital instruments, including: i) maturity of instruments; ii) level of seniority; iii) dividend deferrals’ and iv) status and characteristics of derivative-like instruments, etc.

It is highly relevant to note that the capital of Islamic banks consists so far of only shareholders’ equity and is, therefore, primarily core capital which is not diluted in any way. Even if the AAOIFI’s recommendation regarding investment deposits is accepted, no complications would be introduced because of the absence of preference shares and subordinated debt. However, if Islamic banks induct new types of capital into their capital structure in the future, they should fully adopt the international exposure and transparency requirements.

2.8.2 Accounting Standards

Effective market discipline also requires an appropriate and standardised accounting framework and disclosure policies with respect to assets, liabilities and income statements of banks. The special accounting requirements of Islamic modes of finance also need to be specified in detail. The way in which profits are calculated and distributed by Islamic banks is also not clear. Therefore a number

of papers have urged these banks to adopt uniform and transparent standards. 57

2.8.3 Risk Exposure

56 Market discipline elements and guidelines are elaborated in i) BCBS, Enhancing Bank Transparency, 1998; ii) BCBS, Sound Practices for Loan Accounting and Disclosure; 1998;

BCBS, Best Practices for Credit Risk Disclosure, 1999; and (iii) BCBS, Pillar-III: Market Discipline, 2000.

57 See, for example, Iqbal et. al., 1998.

To strengthen market discipline, banks must release both qualitative and quantitative, information on their risks and risk management policies. Banks can strengthen market discipline only if there is a timely release of information about all risks, including credit risks, liquidity risks, and market risks. This is a highly challenging area for Islamic banks. Two factors need to be given special consideration in determining the risk profile of Islamic banks. One of these reduces the risk while the other raises it. The one that reduces the risk is absence of the use of derivative instruments by them. Their risk exposure is hence not as complicated as that of conventional banks which use derivatives to a very large extent, but make a limited disclosure of this, thus raising concerns about the high level of systemic instability. The factor that raises the risk is the use of modes and mechanisms which are new and risk-sharing. Thus these banks need to adopt conscious policies and mechanisms to decompose their risks, adopt suitable measures to manage them and provide suitable timely disclosures about their risks and the manner in which they deal with them.

2.8.4 Capital Adequacy Measures

Market discipline can also be strengthened if capital ratios and the way these are calculated are transparent and released timely. The implementation of this recommendation of the BCBS is extremely important for Islamic banks. As of now, most Islamic banks do not generally disclose information about their capital adequacy policies and ratios. We therefore recommend that Islamic banks adopt

a clear and uniform capital adequacy standard as capital is critically important for averting, or significantly reducing, shocks and for stabilising the banks after a shock. Islamic banks must at least initiate a policy with regard to the standardised approach, the internal ratings-based approach and the models-based approach as outlined earlier in the paper. Given the present infrastructural and technical capabilities of Islamic banks, which are at best very modest by international standards, it is prudent to adopt the standardised approach but, at the same time, initiate work on building capacity to adopt the more sophisticated internal ratings- based and models-based approaches.

The non-exposure of Islamic banks to derivatives makes their case much less complicated, but the non-existence of appropriate methods and mechanisms to deal with credit risks, market risks, liquidity risks and operational risks creates initial difficulties. It is therefore imperative that these banks adopt suitable policies and provide sufficient disclosures in this regard while calculating their capital adequacy ratios. As indicated earlier, many factors affect the capital adequacy of The non-exposure of Islamic banks to derivatives makes their case much less complicated, but the non-existence of appropriate methods and mechanisms to deal with credit risks, market risks, liquidity risks and operational risks creates initial difficulties. It is therefore imperative that these banks adopt suitable policies and provide sufficient disclosures in this regard while calculating their capital adequacy ratios. As indicated earlier, many factors affect the capital adequacy of

changes in the capital structure of banks. 58 This recommendation is also equally relevant for Islamic banks.

2.8.5. Facilitating the Supervisory Review Process

All the previous suggestions, if adopted by banks, will facilitate not only market discipline but also the supervisory review process, i.e., the second pillar of the New Framework. There is hardly any information available on the allocation of various components of Islamic bank’s funds, investment deposits, current accounts and shareholders’ capital. Some studies are very critical of this phenomenon and recommend a compartmentalised allocation of not only these funds, but also the different maturities of investment deposits along with the investment activities of similar maturities. Such strict compartmentalisation may not be feasible, and may even be counter-productive, as it is against the basic principle of bundling and packaging of funds. However, a reasonable record and disclosure of the allocation of these funds can facilitate supervisors in comparing the bank’s soundness in its peer group. Thus Islamic banks need to prepare such information and make suitable disclosure of these. In this regard the Bahrain Monetary Agency (BMA) has adopted a conscious policy which can be reviewed

and replicated by other supervisory authorities. 59