Financial Stability: Lessons from Indonesia's Islamic Banking FSAP

In the complex world of global finance, stability is paramount. But how can countries ensure their financial systems are robust enough to withstand shocks and support economic growth?

Enter the Financial Sector Assessment Program (FSAP), a comprehensive and in-depth analysis of a country's financial sector.

This article delves into the FSAP process, its significance, and draws valuable insights from Indonesia's recent assessment, with a special focus on its growing Islamic banking sector.

What is the Financial Sector Assessment Program?

The FSAP is a joint initiative of the International Monetary Fund (IMF) and the World Bank. Launched in 1999 in the wake of the Asian financial crisis, it serves as a critical tool for evaluating the stability and development needs of a country's financial sector. The program aims to:

1. Identify strengths and vulnerabilities in financial systems
2. Determine how key risks are being managed
3. Ascertain the sector's ability to absorb shocks
4. Assess the financial sector's contribution to economic growth and development

Why Does the IMF Conduct FSAPs?

The IMF's involvement in FSAPs stems from its mandate to ensure the stability of the international monetary system. By conducting these assessments, the IMF:

1. Helps prevent financial crises by identifying systemic risks early
2. Promotes the development and implementation of sound financial sector policies
3. Enhances the global financial architecture by encouraging adherence to international standards
4. Facilitates cross-country analysis and early warning systems for global financial instability

The FSAP Process: A Closer Look

An FSAP typically involves several key steps:

1. Preparation: The IMF team gather data and information about the country's financial sector.
2. On-site Assessment: Experts conduct in-depth discussions with various stakeholders, including regulators, financial institutions, and policymakers.
3. Risk Analysis: The team performs stress tests and examines the interconnectedness of financial institutions.
4. Evaluation of Standards: The country's adherence to international standards and codes is assessed.
5. Recommendations: Based on the findings, the team provides recommendations for enhancing financial stability and development.
6. Follow-up: The IMF may provide technical assistance to help implement recommendations.

Indonesia's FSAP: A Comprehensive Case Study in Islamic Banking

Indonesia's 2023 Financial Sector Assessment Program (FSAP) provides a unique and invaluable case study in the evaluation of Islamic banking within a dual banking system. As the world's largest Muslim-majority country with a rapidly growing Islamic finance sector, Indonesia's experience offers critical insights into the challenges and opportunities of integrating Shariah-compliant banking into a modern financial ecosystem.

Contextual Framework

Before going into the specifics, it's crucial to understand the context:

• Islamic banking assets in Indonesia grew at 13.6% year-on-year, reaching 7.3% of total banking assets by July 2023.
• The sector comprises 13 full-fledged Islamic commercial banks, 20 Islamic windows, and 171 Islamic rural banks.
• Indonesia has a strong national commitment to Islamic banking development, as evidenced by the Indonesia Islamic Economic Masterplan 2019-2024 and the strategic plan for 2023-2027.

FSAP Methodology for Islamic Banking

The FSAP for Indonesia's Islamic banking sector was done based on its application of the Core Principles for Islamic Finance Regulation (CPIFR) by IFSB, focusing on five additional core principles (ACPs) specific to Islamic banking:

1. Treatment of Profit-Sharing Investment Accounts (PSIA) and Investment Account Holders (IAHs)
2. Shariah governance framework
3. Equity investment risk
4. Rate of return risk
5. Islamic windows operations

This approach allowed for a nuanced evaluation that respected the unique characteristics of Islamic finance while maintaining the rigorous standards of the FSAP process.

Key Findings and Analysis

The FSAP for Indonesia's Islamic banking sector focused on five additional core principles (ACPs) specific to Islamic banking in the Core Principles for Islamic Finance Regulation (CPIFR). Here's a detailed analysis of the findings and recommendations for each principle:

1. Shariah Governance Framework (CPIFR 16)

Observations:

• Foundational aspects of Shariah governance are in place, including the role of the National Sharia Board (DSN) in issuing fatwas.
• The Otoritas Jasa Keuangan (OJK) has a dedicated Islamic Banking Department for regulation and supervision.
• A new draft Shariah governance regulation is being developed.

Analysis:

• The existing framework provides a basis for Shariah compliance, but there are gaps in oversight and accountability.
• The dual role of OJK in regulation and development may lead to potential conflicts of interest.

Recommendations:

• Strengthen the Shariah Supervisory Board (SSB) evaluation process, incorporating formal fit and proper assessments.
• Assess SSB's collective knowledge and effectiveness as a whole, not just individual contributions.
• Clarify oversight responsibilities and accountability lines between the Board of Commissioners, Board of Directors, and SSB in the new Shariah governance regulation.
• Require Islamic banks to establish a transparent process for resolving differences between management and SSB.
• Enhance supervisory capacity to conduct effective Shariah risk supervision, including taking a holistic view of Shariah non-compliances.
• Implement horizontal thematic reviews on Shariah governance and material Shariah contracts application.
• Finalize and implement the new Shariah governance regulation by the first quarter of 2024.

2. Treatment of Investment Account Holders (CPIFR 14)

Observations:

• 82% of total deposits in the Islamic banking system are under Mudharabah contracts, treated as principal-guaranteed deposits.
• The Financial Sector Omnibus Law (FSOL) recognizes "investment" as a separate category from "deposits".

Analysis:

• Current practices diverge from the risk-sharing principle fundamental to Islamic finance.
• The treatment of profit-sharing accounts raises concerns about Shariah compliance and introduces Displaced Commercial Risk (DCR).

Recommendations:

• Align the use of profit and loss sharing Shariah contracts with their intended purpose and substance.
• Develop internal supervisory guidance to streamline evaluation of income smoothing practices by Islamic banks.
• Prescribe formal guidance on the fiduciary duties of Islamic banks towards their investor customers.
• Develop subsidiary legislation to provide clarity on the treatment of "investment" accounts upon liquidation or resolution.

3. Equity Investment Risk (CPIFR 24)

Observations:

• The FSOL expands Islamic banks' ability to participate in non-financial activities.
• Current regulations focus on equity participation in financial activities (35% threshold of total bank capital).

Analysis:

• The expansion aligns with Islamic principles of linking finance to the real economy but introduces new risks.
• The current regulatory framework may not adequately address risks associated with non-financial equity investments.

Recommendations:

• Specify prudential limits on equity participation in non-financial activities to mitigate concentration and contagion risks.
• Finalize and implement the new Risk Management regulation by the first quarter of 2024 to align with CPIFR 24.

4. Rate of Return Risk (CPIFR 26)

Observations:

• The Risk-Based Bank Rating (RBBR) framework includes elements of Rate of Return (ROR) risk.
• There's limited supervisory capacity to assess Islamic banks' ROR risk management capabilities.

Analysis:

• ROR risk is unique to Islamic banking and critical for maintaining competitiveness with conventional banks.
• The lack of specialized supervisory expertise may lead to inadequate risk assessment.

Recommendations:

• Enhance monitoring of ROR risk through more regular assessments of financial instruments' features and behavioral maturity.
• Strengthen supervisory evaluation of Displaced Commercial Risk.
• Upskill supervisors with technical expertise to assess Islamic banks' capacity to manage ROR risk, with support from Risk Specialists.
• Finalize and implement the new Risk Management regulation by the first quarter of 2024 to align with CPIFR 26.

5. Islamic Windows Operations (CPIFR 32)

Observations:

• Regulations for Islamic windows have been updated, including increased minimum capital requirements.
• There's a push for "spin-offs" to create full-fledged Islamic subsidiaries.
• Liquidity Coverage Ratio (LCR) is not applied at the Islamic window level.

Analysis:

• The regulatory approach to Islamic windows reflects the challenges of operating a dual banking system.
• The spin-off policy aims to strengthen the Islamic banking sector but may pose operational challenges.
• Current practices may not fully ensure the segregation of Islamic and conventional funds.

Recommendations:

• Clarify regulations on preventing withdrawal of funds from Islamic windows that would leave them unable to meet capital adequacy and liquidity requirements.
• Conduct early and close engagement between supervisors and Islamic windows subjected to "spin-off" to mitigate residual risks.
• Clarify the scope and application of OJK's broad powers under Article 61 of the 2023 regulation on Islamic windows.
• Apply LCR at both entity and Islamic window levels to align with the principle of segregation of Shariah-compliant assets and funds.
• Clarify treatment of Islamic windows' assets and liabilities in the event of liquidation/resolution of the host conventional bank.

Overarching Themes

1. Regulatory Alignment: There's a need to ensure coherence between Islamic banking regulations and the fundamental principles of Islamic finance, particularly in areas like profit-sharing accounts and equity investments.
2. Supervisory Capacity: Across all principles, there's a recurring recommendation to enhance supervisory expertise in Islamic banking-specific areas.
3. Risk Management: The unique risks in Islamic banking, such as equity investment risk and rate of return risk, require specialized regulatory and supervisory approaches.
4. Transparency and Accountability: Clearer delineation of responsibilities and decision-making processes, especially in Shariah governance, is emphasized.
5. Timely Implementation: The recommendations stress the importance of finalizing and implementing new regulations, particularly in Shariah governance and risk management, by early 2024.

These findings and recommendations provide a roadmap for strengthening Indonesia's Islamic banking sector, addressing both the technical and philosophical challenges of integrating Islamic finance principles into a modern regulatory framework. The insights gained from this FSAP are valuable not only for Indonesia but also for other jurisdictions developing or refining their Islamic banking sectors.

Conclusion and Global Implications

Indonesia's FSAP offers a wealth of insights for the global Islamic finance community:

1. It demonstrates the feasibility of applying international assessment standards (CPIFR) to Islamic banking systems.
2. The assessment reveals the practical challenges of adhering to Islamic finance principles within a modern, dual banking framework.
3. Indonesia's innovative approaches, particularly in Shariah governance and liquidity management, provide potential models for other jurisdictions.
4. The FSAP highlights the critical need for specialized supervisory capacity in Islamic banking, a lesson applicable to all countries developing this sector.
5. It underscores the importance of aligning product structures with fundamental Islamic finance principles to maintain the integrity and distinctiveness of the Islamic banking sector.

As Islamic finance continues to grow globally, the lessons from Indonesia's FSAP will undoubtedly inform regulatory approaches and industry practices far beyond its shores, contributing to the evolution of a more resilient and authentic Islamic financial system worldwide.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

Think About It

Now that you've learned about Indonesia's banks, here's something to think about:

In your country, Do you see any challenges or good ideas related to Islamic Banking?

Share your thoughts in the comments. Your experience can help others learn!

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