For quite a while now there has been talk of Somaliland instituting a legislative bill with respect to the establishment of banking institutions in the country. Accordingly, the time has come for Somaliland to establish a supervisory and regulatory agency that carries out the prudential and systemic regulation of financial institutions. Yet, how that legislation is drafted makes all the difference in the world.
This entry speaks to the necessity of a strong regulatory framework and highlights some of the major decision points we stress that Members of Parliament should be keeping in mind when they debate this legislation which is on the agenda for the upcoming sessions in the House of Representatives. In particular, this article layout a framework for the guiding principles in the regulation of financial institutions and some of the problems the oversight of these institutions is designed to address.
Regulatory Regime is Instrumental in the Financial Sector
A properly structured and functioning financial sector has the potential to expedite Somaliland’s developmental agenda by ensuring economic growth through the supply and efficient allocation of credit. Further, a functioning and integrated financial sector has the potential to enhance the scope and strength of Somaliland’s monetary policy thus improving its ability to combat inflationary forces and stimulate economic growth.
Financial sectors are composed of a regulatory framework such as legislative bills, regulatory bodies that govern the provision of financial products, and financial institutions (i.e. a central bank and commercial banks). In this article, the term ‘financial institutions’ refers to deposit taking institutions, this includes for instance banks, investment firms and financial planning firms.
Despite the fact that Article 5 of the Constitution stipulates that the laws of the country should be grounded in Sharia, the successful implementation of dual banking system (composed of both conventional and Islamic financial institutions) in Malaysia and Indonesia is worth noting and highlights the potential for a dual system to exist in a largely Muslim society.
Those nations have not found that the presence of a dual banking system violates Sharia principles. A dual banking system has several advantages, namely that it fosters a highly competitive banking sector which breeds innovation and consumer satisfaction, hence it can theoretically stimulate a higher degree of economic growth than a banking system which allows only one of the major types of financial institutions (conventional or Islamic).
Rationale for the Regulation of Financial Institutions
The recent financial crisis and ongoing European sovereign debt crisis has highlighted the growing importance of the stability of the financial sector and the need for policy makers to consider the systemic impact that failures in the financial sector can have on the overall well being of the economy. While financial institutions in the developing world were not directly associated with the recent and ongoing global financial crisis, they have suffered through indirect channels (i.e. contraction of remittances or reduction in foreign direct investments).
Moreover, financial crisis have taken place in developing countries in the past. A study conducted by IMF in 1996 entitled Bank Soundness and Macroeconomic Policy (available here), details the various crisis and measures taken by 133 IMF member countries who have undergone some form of a financial crisis.
Prudential and System Regulation
The regulation of financial institutions by governments or institutions at arm’s length of the government is premised on two fundamental principles:
• The need to protect depositors and policy holders (investors)
• The need to avoid systemic failure in the financial sector
These two principles highlight the fact that the case for the oversight of financial institutions rests on prudential and systemic regulation.
Prudential regulation refers to the idea that there exists information asymmetry between depositors and financial institutions. Namely, most consumers are not experts in the field of financial products and thus not in a position to judge the safety of financial institutions.
The systemic concerns underpins the second fundamental principle and posits that it is best to guard against systemic failure in the financial sector in which case the social costs of a systemic failure to the system may outweigh the private costs of such a failure. This was the economic and policy justification used by the Obama administration when it pushed for legislation that “bailed out” large US banks in 2008/2009 – despite the general idea prevalent within the US that the government should stay out of private enterprise.
A systemic failure can occur for instance if suddenly the majority of depositors in financial institutions withdraw or demand their deposits (bank runs) or contagion caused by linkages (i.e. European sovereign debt crisis). In cases of drastic systemic failure, efforts to restore systemic stability and confidence in the banking sector may require expenditure of public funds (bailouts) or stagnate economic growth (liquidity crisis). Accordingly, a systemic failure can pose disruptions to the nation’s payment system (both internally and externally), and disrupt both economic growth and poverty reduction goals.
Risks and Challenges to Conventional and Islamic Financial Institutions
Financial institutions such as banks accrue earnings primarily through financial intermediation, which can entail substantial risk. Traditionally financial institutions in the business of financial intermediation made their profits from the income spread of their assets and liabilities as well as from user fees. Accordingly they often faced market risk resulting from the business cycle, credit risk from defaults and interest rate risk from changes to the expected rate.
Since the 1980’s the emergence of secondary markets (i.e. derivatives market), new financial products, globalization and securitization have provided financial institutions with risky new opportunities to generate more wealth. Consequently, banks and their subsidiaries (i.e. investment and financial planning firms) have begun to engage in activities that are outside the scope of their traditional activities. Both conventional and Islamic banks can be exposed to some if not all of the following risks:
• Liquidity risk
• Capital risk
• Interest risk
• Foreign exchange risk
• Actuarial risk
• Operational risk
• Market risk
• Sovereign risk
Islamic banks (as detailed in our Islamic Finance series which begins here) are premised on the Islamic economic model as dictated by the Quran and Sunnah which provide for the values and principles that are to guide the dealings and relationships of individuals in economic matters. It is often cited that one of the main defining features of the Islamic economic model is the prohibition of interest or riba. While Islamic banking is an growing field within Islamic and non-Islamic countries, in particular Britain, their share of the global financial market is still smaller than to that of non-Islamic financial institutions.
Within nations where a dual banking system exists such as Malaysia, Islamic banks have taken to increasing diversifying financial products and activities in order to to compete with conventional banks for market share. However, the designation of a particular financial product as being in compliance with the values and principles of ‘Sharia’ in terms of how it is structured requires the opinion of scholars. This is where we can expect some of the risks common to Islamic banks to arise.
The risks and challenges that are unique to Islamic banks that are discussed here do not necessarily represent the full spectrum of the risks that Islamic banks may face. These risks however serve to highlight the potential for a discrepancy in the activities and products Islamic banks are engaged in and their compliance with the principles of Sharia.
Accordingly, a discrepancy between the financial institutions status as being in compliance, can both distort the risk assessment of their balance sheet and thus the need to take prudential measures and it can also be misleading to consumers. Differences in opinions of Sharia scholars, and changes during the financial products lifecycle can be sources of such a discrepancy. Therefore this poses a challenge to the supervisory and regulatory agency in terms of protecting consumers.
The issue of contract and documentation risk is one that is much more pertinent to Somaliland, where secure definitive documents that attest to one’s identity and enforcement channels such as individual credit scores are not as developed. Thus risks that emanate from defaults and missed payments to the banking institutions may be heightened and will need to be taken into account in the feasibility evaluations of banks, with regards to how they go about ensuring a level of documentation and probability of repayments (i.e. requirement of collateral).
Further, the need for trained professionals and scholars in the field of Islamic banking is a recurrent issue that many institutions face in the field of Islamic banking and one that exasperate the aforementioned risks.
It is important to note that there some potential adverse effects that an overly prescriptive regulatory framework can have on the financial sector. Moreover, it is important such regulatory frameworks be structured in a manner that promotes due diligence on the part of the shareholder and consumers of financial institutions. In this regard, there is widespread agreement a principles-based approach to regulation rather than rules based approach is the better method.
This is because strict rules regarding what specific activities or products to engage in for instance can stifle financial innovation and foster ‘creative compliance’. On the other hand a principles based approach to regulation promotes dialogue between financial institutions and regulators, and puts pressure on management and board of directors to meet a set of standards. In that regard it allows for a degree of flexibility in terms of financial products and activities and places responsibility for the safety and soundness of individual financial institutions on management.
However, for principles-based regulation to work properly, the set of standards to abide by should be broad enough to encourage flexibility and innovation, and be backed up a set of clearly stated severe penalties for financial institutions found to be in non-compliance.
Guidelines for Somaliland Financial Institutions Regulatory Agency
The mechanisms whereby a regulatory regime ensures that financial institutions are taking into account the various risks they may be exposed to, may include investigative work by the regulatory agency with regards to the accounting measures of financial institutions, governance mechanisms and compliance regarding standards.
For instance the Basel Committee on Banking Supervision (BCBS) is a global forum for banking regulators that acts as a ‘standard-setting’ agency for the supervision and regulation of banking institutions. The latest round of talks referred to as Basel III at BCBS has resulted in an agreed upon set of guidelines for banking regulators. These standards speak to the ability of banks to absorb shocks to their funds as a result of ‘financial and economic stress’. Some of their publications include a liquidity coverage ratio for specific scenarios so as to ensure a level solvency.
In addition, where Islamic Finance is concerned there are extensive guidelines and best practices which have been adopted by the Islamic Financial Services Board (IFSB). The IFSB is an international body of the heads of Islamic finance regulatory bodies from the primary nations leading the development of Islamic finance.
The main gist of this article is to underscore the importance of having a financial sector framework that facilitates and promotes the emergence of financial institutions that are conducive to the developmental goals of Somaliland and that makes it easier for its business community to engage with the international community through formal financial channels.
By Hassan (Watershed legal service)