Regulation of Islamic Financial Institutions 311
BANK SUPERVISION AND MARKET DISCIPLINE
Basel I was an early attempt to defi ne the framework for ensuring fi nancial
stability, but it was a simplistic approach that focused mainly on capital
requirements. Increased market volatility and rapid development and the
introduction of innovative products into the fi nancial markets, together
with a series of fi nancial crises spreading from one continent to another,
soon exposed the weakness of Basel I. The fi nancial crisis in East Asian
countries in 1997 and that in Eastern Europe in 1998 were evidence of the
increased complexity of risks faced by international banks and highlighted
the need for improved transparency, governance and supervision of fi nan-
cial institutions.
In light of these factors, in June 2004 the BCBS issued a Revised
Frame work (Basel II) which, in addition to capital adequacy (Pillar I),
deals with the principles of the enhanced supervisory review process
(Pillar II) and effective use of market discipline (Pillar III). While the
new framework aims to provide a comprehensive approach to measuring
banking risks, its fundamental objectives remain the same as those of the
1988 Accord: to promote the safety and soundness of the banking system
and to enhance the competitive equality of banks. All three pillars are
mutually reinforcing and no one pillar should be viewed as being more
important than another.
The message of Basel II is that a robust fi nancial system infrastructure
and adequate macro prudential surveillance are the prerequisites for effec-
tive supervision and risk management. Several recent studies by the World
Bank and the IMF have highlighted the signifi cance of having the appro-
priate balance of prudential supervision and market discipline in Islamic
fi nance, and the related implications for the organization and fi nancial
stability of the industry. These studies stress the importance of disclo-
sure and market discipline in Islamic fi nance, because the different nature
of the risks of IFIs and their limited capacity for risk mitigation expose
them more than the conventional fi nancial institutions. This exposure is
further enhanced by the inadequacies of its fi nancial infrastructure, mani-
fest in such things as a low level of transparency, the absence of deriva-
tive instruments and markets, and a weak insolvency and creditor - rights
regime. Weak disclosure and low market discipline also call for active
supervision.
While understanding the risks and the allocation of capital under
Pillar I is a critical step, the core elements of supervision (Pillar II) and
market discipline (Pillar III) are equally or more important. A well -
designed capital requirement standard cannot be made effective in the
absence of strong and prudent supervision. Therefore, the strengthening
of the existing supervisory framework to achieve full compliance with the
core principles of Basel is highly desirable for IFIs, particularly in relation
to the disclosure requirements on risk exposures and risk management
processes.