Malaysia
Publication of Financial Sector Assessment Program Documentation—Detailed Assessment of Basel Core Principles for Effective Banking Supervision

The Bank Negara Malaysia (BNM) employs a well-developed risk-focused regulatory and supervisory regime. Despite this, a clear gap exists in the application of the supervision and regulation regime to financial holding companies. BNM is to be commended for its thoughtful and comprehensive self-assessment and efforts to help draft legislative changes and to make administrative changes to address the areas of improvement revealed by the self-assessment. Improvements should be made in the transparency of elements of BNM’s supervisory expectations, its domestic coordination and information-sharing arrangements, and legal protection for staff.

Abstract

The Bank Negara Malaysia (BNM) employs a well-developed risk-focused regulatory and supervisory regime. Despite this, a clear gap exists in the application of the supervision and regulation regime to financial holding companies. BNM is to be commended for its thoughtful and comprehensive self-assessment and efforts to help draft legislative changes and to make administrative changes to address the areas of improvement revealed by the self-assessment. Improvements should be made in the transparency of elements of BNM’s supervisory expectations, its domestic coordination and information-sharing arrangements, and legal protection for staff.

I. Summary, Key Findings and Recommendations

A. Summary

1. BNM employs a very well developed risk-focused regulatory and supervisory regime, consisting of a hands-on and comprehensive program of onsite supervision and extensive off-site macro—and micro—surveillance that is well integrated with its on-site supervision. BNM has in place a Supervisory Risk-based Framework that provides a strong structure for supervisors to carry out consistent and effective supervision across BNM’s portfolio of regulated firms, both through individual firm supervision and through horizontal or thematic reviews. Decision-making within this structure, as to onsite reviews to be conducted and special off-site surveillance work is carried out by teams of supervisors headed by a Relationship Manager (RM). The supervision work carried out by the RM and his/her team is supported by micro-surveillance personnel, a macro-surveillance unit and a Specialized Risk Unit (SRU). A careful system of checks and balances has been implemented, involving vetting of ratings and other supervisory products through at least one, and sometimes two, layers of independent panels within the Supervision Department. Ratings and supervisory recommendations/remediation requirements are conveyed effectively to banking institutions in writing, and through extensive interaction with the Board and senior management; necessary remediation is followed through on in a highly disciplined way.

2. BNM supervisors are guided and assisted by a generally well articulated set of risk management and internal control expectations, specified higher than international minimum capital requirements, a comprehensive liquidity risk framework, and effective coordination and information sharing with foreign supervisory authorities. While some improvements (as detailed below) can be made, BNM has a generally appropriate array of guidelines and supervisory expectations covering overall risk management and most of the individual risk areas, as well as internal audit, compliance, and control functions. The BNM’s capital framework is generally speaking in line with, and in many instances stricter than, international standards, although not covering financial holding companies and with some minor differences from the international standards. The liquidity framework is a multi-level approach to ensuring good liquidity in normal and high stress times (also not applicable to financial holding companies). BNM has an impressive network of formal and informal coordination and information sharing arrangements with foreign supervisors, and has been active in hosting and attending supervisory colleges and in conducting its own overseas examinations.

3. Despite this strong performance, and as suggested above, a clear gap exists in the application of the supervision and regulation regime to financial holding companies. Six of the eight large domestic banking groups have parent financial holding companies (FHCs), and the current legislative framework does not by its terms apply to those firms on a parent only or consolidated basis. Many of the affiliates of the bank are regulated by the BNM, but some (such as asset managers) are not. The BNM has been creative by imposing conditions on the FHCs incident to approval of their investments in their banks, covering the nomination of their directors and CEO, acquisitions of shares of other companies, the issuance of capital instruments, and more generally complying with BNM guidelines. BNM has also used legislative authorities applicable to affiliates of banks to apply reporting and examination requirements to the FHC and its subsidiaries. Through these means, the BNM has been able to significantly reduce the existing gap, but not to completely eliminate it. No consolidated capital ratios apply to the FHCs; the liquidity framework does not apply on a consolidated basis; and stress testing expectations are not generally applied on a consolidated basis. As noted below, a proposed legislative change would address many of these issues.

4. Some improvement opportunities exist in the regulatory framework, as more detailed regulation would be useful on interest rate risk in the banking book, credit concentrations, country risk, operational risk and in the requirement for banking institutions to have a separate, independent risk unit. IRRBB and operational risk management requirements are generally in place and adhered to, but the release of more detailed regulation and supervisory expectations is currently underway. The BNM is planning to strengthen its regime for credit concentrations. The full implementation of Pillar 2 will also further strengthen the oversight of IRRBB and credit concentration risk. While country risk appears to be properly identified, assessed and reported to the BNM, more rigorous and comprehensive regulation should be considered. Although all of the domestic banking groups currently have independent risk units, there is no regulatory requirement to have them.

5. Improvements should be made in the transparency of elements of BNM’s supervisory expectations, its domestic coordination and information sharing arrangements and legal protection for staff. BNM should increase the transparency of the criteria it applies for new licenses and for acquisitions. The BNM will further enhance transparency by wider public consultation on proposed policy measures in accordance with the Policy Development Framework. Feedback from market participants reflected a need for clearer communication of external auditors’ supervisory expectations to banks, particularly in case these go beyond the usual audit procedures. Hence, assessors recommend the BNM more clearly communicate to banks its supervisory expectations in case there are required additional procedures in addition to the normal audit procedures. BNM’s MOU with the Securities Commission should be modified to make it much more directed to consolidated supervision, and an MOU with the Cooperatives Commission (SKM) should be negotiated. Finally, it should be clarified that legal protection for BNM’s staff should not depend on the person’s employment status at the time of the lawsuit; former employees should be explicitly included. Consideration should also be given to include a provision in law permitting the BNM to indemnify these persons for their legal costs in the event they are sued.

6. BNM is to be commended for its thoughtful and comprehensive BCP self-assessment (self identifying many of the areas for improvement needed cited above) and its strong efforts to help draft legislative changes and to make administrative changes to address the areas of improvement revealed by the self assessment. Moving forward, BNM is seeking enhanced legal powers under new financial services legislation to enable full application of supervision and regulation of FHCs (including the capital framework). The proposed new legislation, the Financial Services Act (FSA) will, at such time as it is enacted, further define the specific objectives of financial regulation and supervision by BNM as the supervisory authority for the banking sector. In addition to the existing power to initiate criminal processes, the proposed FSA will empower BNM to impose civil and administrative penalties in the event of non compliance with legal provisions. BNM is also in the process of addressing gaps in its regulatory framework. The assessors recommend taking this opportunity to introduce more clarity on what regulatory requirements “must” be observed rather than “should” be met.

7. The increasing sophistication of Malaysian banks’ risk management processes and the ongoing implementation of complex regulatory approaches (Basel II Pillar II and ICAAP) will put increased demands on staffing. BNM currently has a relatively small cadre of specialized risk personnel in the SRU, who, in addition to performing model reviews, only occasionally carry out on-site visits to respond to specific request from relationship managers for technical assistance. As BNM moves forward with implementing the advanced approaches, including dealing in the coming period with recovery and resolution planning, the need for specialized risk personnel will increase overall, and the value they would contribute in making sure banking organizations implement the changes effectively, argues that more of their time be spent in the field in carrying out on-site reviews and direct engagement with banking institutions. This practice could be integrated gradually in the supervision framework, for example by requiring the participation of a risk specialist as the risk profile of the banking institution increases.

8. There are some broad policy issues on the relationship between BNM and MOF, and between BNM and the Malaysia Deposit Insurance Corporation (PIDM) that should be reviewed. The assessors found some instances in the legal framework where the Minister could interfere with BNM’s independence. For example, Section 70 in BAFIA allow the Minister at any time to direct the Bank to make an examination of the books or other documents, accounts and transactions of any licensed institution if he has certain suspicions with regard to a banking institution. Other examples include the use of the word “bank”, “banking” or any derivatives of this word by companies with the explicit approval of the Minister. Furthermore, Section 73 of BAFIA authorizes BNM to direct institutions to take corrective actions, but only with the concurrence of the Minister remove and/or appoint new officers and directors. In practice, however, the assessors have not come across evidence of Government interference which would seriously compromise the independence of the BNM and note that the proposed FSA seeks to provide for greater independence in supervisory decisions by BNM. A new Strategic Alliance between BNM and PIDM was agreed while the BCP review was taking place; how effective the arrangement is should be reviewed over time to ensure that when Malaysia may need to deal with a problem bank, the coordination is effective. How the assessment of the viability of an institution is to be made (and how transparent the criteria should be) and how the framework could be applied to FHCs are among the major policy issues to be considered.

B. Introduction

9. This assessment of the current state of compliance with the BCPs in Malaysia has been undertaken as part of a joint IMF-World Bank Report on the Observance of Standards and Codes (ROSC) mission.1 The assessment was conducted from 4 April till 20 April 2012. It reflects the banking supervision practices of the Bank Negara Malaysia (BNM) as of the end of March 2012 for the supervision of commercial banks.

C. Information and Methodology used for the Assessment

10. The assessment is based on several sources: (i) a detailed and comprehensive self-assessment prepared by the BNM ; (ii) detailed interviews with the BNM staff; (iii) review of laws, regulations, and other documentation on the supervisory framework and on the structure and development of the Malaysia financial sector; and (iv) meetings with individual banks, the banking association and an external auditor.

11. The assessment was performed in accordance with the guidelines set out in the Core Principles (CPs) Methodology.2 It assessed compliance with both the “essential” and the “additional” criteria, but the ratings assigned were based on compliance with the “essential” criteria only. The Methodology requires that the assessment be based on the legal and other documentary evidence in combination with the work of the supervisory authority as well as its implementation in the banking sector. The assessment of compliance with the CPs is not, and is not intended to be, an exact science. Banking systems differ from one country to the next, as do their domestic circumstances. Furthermore, banking activities are changing rapidly around the world, and theories, policies, and best practices of supervision are swiftly evolving. Nevertheless, it is internationally acknowledged that the CPs set minimum standards.

12. This assessment is based solely on the laws, supervisory requirements, and practices that were in place at the time it was conducted. However, where applicable the assessors made note of regulatory and supervisory initiatives which have yet to be completed or implemented. In this respect, the proposed adoption of the Financial Services Act will be a notable development which could remedy many of the areas for improvement highlighted by the assessors.

13. The assessment team enjoyed excellent cooperation with its counterparts and, within the time available to perform their work, reviewed all the information provided.

D. Institutional and Macro-prudential Setting, Market Structure Overview

14. The financial system—both banking and non-banking—is concentrated. The onshore banking sector—with assets of some 200 percent of GD—comprises nearly 50 percent of financial sector assets (Islamic banks are around 20 percent of the banking sector) and Labuan OFC banks an additional 3.2 percent. The top 5 domestic banking groups comprise nearly 62 percent of total banking system assets. The banking sector’s asset quality remained healthy with steady improvement in gross NPL ratios from 3.6 percent in 2009 to 2.7 percent in 2011. Total provisions (general and specific) were 99.4 percent of NPLs in 2011; NPLs net of specific provisions stood at 1.8 percent in 2011, below the 5-year average of 2.3 percent. Banks remain well capitalized with system-wide risk-weighted capital ratio and core capital ratios at 15.6 percent and 13.6 percent respectively in 2011.

15. Non-bank credit intermediation is sizable, at some 90 percent of GDP. This is accounted for predominantly by the state-run Employee Provident Fund (33 percentage points, including substantial government bond holdings), insurance companies (15 percentage points), and DFIs (16 percentage points). The bond market has doubled over the past 10 years to Malaysian ringgit (RM) 851 billion as at November 2011. Some 40 percent of bonds are issued by the ‘private sector’; this includes government-linked companies that are counted in private sector (in official statistics, ‘public’ covers central government and the BNM only). The EPF and insurance companies invest the majority of their portfolios in the domestic bond market, in both government and private debt securities.

16. DFIs provide credit via direct lending to targeted sectors such as agriculture, SMEs, infrastructure, maritime, export-oriented sector, high-technology and capital-intensive industries. The asset quality of these institutions seems to have deteriorated from 2009 to 2010 with gross impairment ratio rising 2.3 percentage points to 9.0 percent, but provision coverage remained comfortable at 80 percent. They are well capitalized with Leverage Ratio (Total Shareholders’ Funds-to-Assets) of 13.9 percent in 2010. In addition, the DFIs’ gross impairment ratio reduced to 7.3 percent in 2011.

17. There is a small financial sector in Labuan. Entities operating in Labuan benefit from tax advantages (very low financial sector income tax, no stamp duty). As at end of 2011, there were 60 approved banks with 57 in operations. Of these, 25 percent of the banks are part of Malaysian financial groups, and are subject to consolidated supervision by BNM. Operations of these entities in Labuan are almost entirely back-office; customer relations, dealing operations, risk management and loan decisions are all handled from the respective head-offices in Kuala Lumpur. In addition to banks, there are insurance entities, leasing companies and trust companies operating from Labuan. In recent times, reinsurance activities (including Islamic insurance, known as ‘takaful’) have grown with many Labuan-based reinsurers having a global scope of operations.

18. The financial system seems adequately positioned to withstand spillovers from an escalation in global financial stress. The more recent uncertainties emanating from the Eurozone debt crisis have resulted in a tightening of global USD liquidity; but the impact on local banks is manageable. A global liquidity squeeze would not be expected to create severe deleveraging pressures in Malaysia. Portfolio outflows associated with a sell-off in local bond and equity markets, as in 2008–09, would unlikely have systemic implications. Nevertheless, financial turbulence would affect growth through confidence and credit channels (and thus, indirectly, trade). Moreover, contagion from a hard landing in China’s economy, or from an escalation of the current Eurozone crisis, could be significant.

E. Preconditions for Effective Banking Supervision

Soundness and sustainability of macroeconomic policies

19. Malaysia recovered strongly from the fallout from the global financial crisis, but growth has started to slow more recently. Growth reached 7.2 percent in 2010, but momentum is beginning to ease against the backdrop of a weakening external environment. In particular, the growth of manufacturing exports has slowed, although commodity exports have remained resilient. Growth was 5.1 percent in 2011; latest IMF staff projections suggest it will slow to 4 percent in 2012. Inflation remains contained and the rapid post-crisis buildup in public debt has leveled off. Capital inflows, which had rebounded strongly after the Lehmans’ collapse in 2008, have been scaled back. Inflows were robust through H1 2011, led by bond inflows, which increased steadily since 2008. However, foreign investors subsequently scaled back their exposures, mainly in equity markets and BNM bills, prompting a depreciation of around 8 percent against the U.S. dollar since the beginning of August. The depreciation was less severe than in some other open Emerging Market economies in part owing to foreign exchange intervention. BNM only intervenes in the domestic foreign exchange market to prevent extreme movements in the Ringgit exchange rate, with no particular level for the Ringgit in mind. Overall, foreign investor holdings comprise some 21 percent of the domestic bond market and 23 percent of the equity market.

A well developed public infrastructure

20. The legal framework in Malaysia is based on a common law legal system. Law are enforced through a single structured judicial system consisting of superior and subordinate courts whose decisions are enforceable, with avenues for appeal consistent with common law systems.

21. In addition to the court system, alternative mechanisms for resolving disputes and debts also exist that allow judicial resources to be conserved, while expediting case disposals. These include:

  • Arbitration, which is governed by the requirements of the Arbitration Act 1952, or the Kuala Lumpur Regional Center for Arbitration (KLRCA) Rules which are modeled after the UNCITRAL Arbitration Rules of 1976, revised in 2010;

  • The Financial Meditation Bureau (FMB), an independent body, helps settle disputes between consumers and financial service providers, including banking institutions. The FMB handles a wide scope of disputes at no cost to the consumer. Decisions are binding on the financial institution but not the consumer who may choose to have further recourse through the court system;

  • The Corporate Debt Restructuring Committee (CDRC) which provides a platform for corporate borrowers and their creditors to work out feasible debt resolutions with the CDRC mediating between companies and their lenders;

  • The Credit Counseling and Debt Management Agency allows individuals needing assistance in managing their personal debt to enroll in its Debt Management Program which facilitates the rescheduling or restructuring of such credit facilities.

22. Pursuant to the Companies Act 1965, companies are required to prepare their accounts based on approved accounting standards issued by the Malaysian Accounting Standards Board (MASB). The financial statements should show a “true and fair” view of the financial positions, financial performance and cash flow of an entity.

23. Public interest entities are required to report their accounts using Financial Reporting Standards set by the MASB, which is in compliance with IFRS both in terms of content and timing of implementation. IFRS is directly transposed into Malaysian FRS, with the text changed only where absolutely necessary. Any changes made are done with the sole objective of enhancing the quality of reporting, and typically deal with only specific issues not dealt with in the IFRS by illustrating or providing additional clarifications for better understanding or making changes necessary to comply with local laws and regulations.

24. Companies’ accounts are required to be audited annually by approved auditors. Reports and the audit procedures performed are in compliance with the National Auditing Standards, which are in full compliance with the International Standards on Auditing. Membership of the Malaysian Institute of Accountants is a pre-requisite for employment in Malaysia as a professional accountant or auditor and all members are required to comply with the MIA By-Laws on Professional Ethics.

25. The Malaysian Electronic Clearing Corporation, (MyClear), a wholly owned subsidiary of BNM, operates RENTAS (Real Time Electronics Transfer of Funds and Securities), a real time gross settlement system for interbank funds transfer, a securities settlement system and a scripless securities depository for all unlisted debt instruments. Rentas is also linked with the USD Clearing House Automated Transfer System in Hong Kong to mitigate for settlement risk for Ringgit and USD FX transactions. The link allows the simultaneous settlement of Ringgit in Malaysia and USD in Hong Kong as well as settlement for USD denominated securities deposited with Rentas during Malaysian business hours.

26. The credit information services industry in Malaysia consists of agencies from both the public and the private sector. The Centralized Credit Reference Information System (CCRIS) is operated by BNM. It collects and disseminates credit information from and to participating financial institutions. The credit reports contain factual information, including outstanding loan obligations with no thresholds, conduct of accounts, and repayment behavior of the individual. No opinion is expressed about the information supplied in the report. Private sector credit reporting agencies include Credit Bureau Malaysia Sdn. Bhd. (CBM), RAM Credit Information Sdn. Bhd (RAMCI), Financial Information Services Sdn. Bhd (FIS) and CTOS Sdn. Bhd. Private sector credit agencies will be regulated from this year by the Registrar of Credit Reporting Agencies under the Credit Reporting Agencies Act 2010.

Effective market discipline

27. As public interest entities, banking institutions in Malaysia are subject to Financial Reporting Standards (FRS) established by the Malaysian Accounting Standards Board which are in compliance with the IFRS. Banking institutions are also subject to additional transparency and disclosure requirements established by BNM which include:

  • The Guidelines on Financial Reporting to Banking Institutions which set out the minimum disclosure requirements relevant to users of financial statements to assess the nature and extent of the risks associated with the operations of banking institutions.

  • Pillar 3 disclosure requirements under Basel II which provide additional transparency and disclosure on risk management practices and the capital adequacy of banking institutions. This includes quantitative and qualitative disclosures with respect to credit risk, operational risk, and interest rate in the banking book.

28. Mechanisms for providing an appropriate level of systemic protection (or public safety net).

Crisis management

29. The Central Bank of Malaysia Act (CBA) empowers BNM with a broad range of powers to avert or reduce risks to financial stability. These include intervention and resolution measures, including powers to reduce systemic risks that emanate from both regulated and non regulated entities and to stem institutional or market liquidity shocks. While efforts are underway to establish a structured and formal framework for crisis management, individual elements of the crisis management framework are already in place:

  • BNM assumes responsibility for addressing financial stability concerns given its mandate, powers and responsibilities set forth in the CBA, and its role as the central bank and supervisory authority for banking and insurance sectors, and the payment system. Within BNM, these functions are led by the Financial Stability Committee (FSC), which serves as BNM’s internal high level forum responsible for discussing risks to financial stability and deciding on the appropriate policy responses.

  • The CBA empowers BNM to enter into arrangements with other supervisory authorities to coordinate financial stability measures. BNM engages with other regulatory authorities such as the Securities Commission Malaysia and the Malaysian Deposit Insurance Corporation (PIDM) on a regular basis and collaborates with these agencies particularly in the areas of surveillance and supervision to facilitate the timely implementation of pre-emptive responses to systemic risk.

Deposit insurance

30. The PIDM is a statutory body established in 2005 under the PIDM Act 2005. Under the Act, the PIDM is to administer and provide deposit insurance to protect depositors against the loss of part or all deposits as well as a takaful and insurance benefits system to protect owners of takaful certificates and insurance policies in the event of a failure of a member institution. The deposit insurance system provides coverage for conventional and Islamic deposits, for all type of depositors, whether business or individuals. The maximum limit of coverage is RM 250,000 per depositor per member institution (namely commercial and Islamic banks). This includes both the principal amount of a deposit and the interest/return. By law, all commercial banks under the Banking and Financial Institutions Act 1989 (BAFIA) and Islamic banks licensed under Islamic Banking Act 1983 (IBA) including foreign owned banking institutions are member institutions of PIDM. Member institutions to PIDM are subject to a differential premium system, whereby annual premium charged are linked to certain risk and financial parameters of members institutions, thus providing incentives for member institutions to adopt sound risk management practices.

Liquidity support

31. BNM has at its disposal a broad range of tools to allow for the effective containment of institutional or market liquidity shocks to prevent such shocks from

32. threatening systemic stability. In addition to the operational standing facility framework that allows banking institutions to obtain overnight liquidity from the BNM to satisfy temporary liquidity needs, BNM has broad powers to provide liquidity assistance to any financial institution through a broad range of instruments. BNM is also empowered to enter into arrangements with other central banks to provide liquidity assistance to subsidiaries or branches outside Malaysia of any financial institution established in Malaysia.

33. The development of a more formal and structured emergency funding liquidity assistance framework that institutionalizes sound practices ensuring continued efficacy of the lender of last resort function of BNM and better aligned operational, governance and accountability mechanisms, in line with the new requirements under the CBA is underway. These include strengthened internal arrangements for the coordination of viability assessments of institutions requiring liquidity support, more formalized operating procedures for the provision of liquidity support as well as predefined features of the lending arrangements (e.g., acceptable collateral, interest rates).

Islamic Banking in Malaysia

Islamic banking refers to a system of banking that complies with Islamic law or Shariah law. Malaysia has recorded robust growth in Islamic banking assets. Total assets in the Islamic banking sector (including DFIs) increased by 23.8% to RM 434.6 billion to account for 22.4% of total banking system assets as at end-2011. In Malaysia, Islamic banking is mostly conducted through separately incorporated banks – the 16 Islamic banks include ten which are domestically owned and six which are foreign owned. Licensed banks or licensed investment banks are also given the flexibility to operate an Islamic banking window, subject to meeting applicable standards and guidelines to ensure that the Islamic banking window operations are fully Shariah compliant – to date there are three commercial Islamic banking windows and seven investment banking windows.

In a dual financial system in which conventional and Islamic financial products are offered in parallel, a critical aspect of the regulatory framework is the consistency of rules and regulations across both sectors to eliminate possibilities for regulatory arbitrage. At the same time, there is a need to reflect the differences in the nature of risk inherent in Islamic financial products and services.

The regulatory framework for Islamic banks encompasses standards which are equally applicable to commercial or investment banks and standards which are modified or distinct to cater for risks specific to Islamic banking business. Shariah requirements are observed in the formulation of these standards through active involvement of the Shariah unit and consultation with the Shariah Advisory Council on Islamic Finance established under the Central Bank of Malaysia Act 2009 (SAC) on any matters requiring ascertainment of Islamic law.

The supervisory approach and practices for Islamic banks at the BNM are very similar to commercial banks. The only major difference is that, in accordance with the risk based supervisory framework, an additional operational risk i.e. that of Shariah compliance, is assessed for Islamic banks. This risk is analyzed in two ways; first, as a compliance risk embedded in every significant activity, second as an overarching operational risk for the whole bank. To assist with the specific detailed aspects of the assessment, a team of Shariah officers including a Shariah compliance expert employed in the BNM Specialist Risk unit provides input on specific matters with recourse to the SAC on need basis.

From a legal perspective, the Islamic banks are governed by a separate Act namely the Islamic Banking Act 1983 (IBA). In some areas, the IBA provides less legislative authority than the more recent Banking and Financial Institutions Act 1989 (BAFIA) which governs the commercial banks. The authorities’ state that effective implementation of a comparable prudential framework has been conducted through guidelines issued pursuant to the general power to issue guidelines under IBA and setting clear supervisory expectations on Islamic banks. There remain some areas where the legal and regulatory requirements as well as the powers of the BNM are not formalized in the IBA for Islamic banks. Although the assessors have not focused on Islamic banking, the BNM is confident that in practice it ensures consistent rules and regulation across both sectors.

For example

  • The lack of explicit power for the BNM to revoke licenses for Islamic banks; The IBA does not have a provision that allows the MOF, on recommendation of the BNM, to revoke a license granted when BNM has been provided with false, misleading or inaccurate information in connection with the application or after the grant of a license. Instead BNM may rely on contravention of any provision of the IBA, more specifically the provision relating to submission of document or information to the Minister upon any license application, for revocation.

  • Unlike BAFIA, there is no specific share ownership threshold driving the need for an application in the IBA, however by regulation BNM has imposed the same 5% threshold.

  • The IBA does currently not require external auditors to report matters of material significance to the supervisor, for example failure to comply with the licensing criteria or breaches of banking or other laws or other matters which they believe are likely to be of material significance to the function of the supervisor.

  • The lack of explicit power to obtain information from the holding companies of Islamic banks. Section 41 of IBA only allows the BNM to request information from subsidiaries. Hence, the BNM can currently not conduct any examinations of holding companies or require holding companies, controllers or significant owners or any group or related entities to provide information to BNM for supervisory purposes. In practice however, this legal gap does not impede sound supervision by the BNM as most Islamic banks are held directly by a regulated banking institution. That said, one Islamic bank is not part of a commercial banking group and is held by a holding company and the BNM is of the opinion that it has been able to obtain relevant information relating to the holding company from the Islamic banks.

  • The lack of power for the BNM to access auditors’ working papers. In practice however the BNM has not yet used this power for commercial banks.

  • Where the law provides for certain decisions to be referred to the MOF, BAFIA explicitly provides that decisions by the MOF should be made upon the recommendations of BNM. The MOF is further required under the law to consider the interests of the public and the promotion of a sound financial system in reaching a decision. This is currently not explicitly available under the IBA.

Further enhancements are envisaged under the FSA to streamline legal and regulatory requirements and powers of BNM in regulating the Islamic financial sector alongside the conventional financial sector. Major parts of the IFSA, for instance licensing, regulation and supervision of financial groups and examination powers, contain mirror provisions to the FSA to ensure consistency of rules and regulation across both sectors and eliminate potential regulatory arbitrage (about 75% of the provisions in IFSA are the same as in the FSA). In addition, the proposed new legislation for Islamic finance seeks to provide greater visibility to Shariah compliance and the effective implementation of Shariah governance by Islamic financial institutions, thus ensuring a coherent regulatory framework. Among others, proposed provisions have been put forward to allow the Bank to specify standards on Shariah matters, including rules relating to Shariah governance, principles and practices of Shariah in relation to the business and affairs of an Islamic institution, as well as requirements for Shariah compliance audits. In line with Shariah requirements, the proposed new law will also clarify the nature of Shariah contracts employed in conducting Islamic banking business and the process and priority of payments in the event of a winding up of a financial institution involved in Islamic financial business.

F. Main Findings

Objectives, Independence Powers, Transparency, and Cooperation (CP 1)

34. Laws are in place and the role of BNM and other authorities is clearly defined. The statutory responsibilities and objectives of BNM are stated in the CBA and BAFIA, supported by internal governance arrangements. The adoption of the new Policy Framework will increase the transparency in policy activities. Governance arrangements (including operational procedures) and the roles/responsibilities of various functions within the BNM have yet to be more explicitly defined. The BNM is well funded and its staff has credibility based on their professionalism and integrity.

35. The assessors found some instances in the legal framework where the Minister could interfere with BNM’s independence. In practice, however, the assessors have not come across evidence of de facto government or industry interference. It would provide greater legal certainty regarding the independence of the BNM if these provisions were removed and the independence of the BNM were formally grounded in the law.

36. Legal protection for bank supervisors is in place and as a matter of practice the employees costs of defending actions made while discharging their duties in good faith would be borne by the BNM. Some enhancements could be made to the current arrangements. Ideally, the CBA should specifically state that the legal protection provided to the BNM employees is not limited in time (i.e. provides protection beyond the termination of appointment or employment). Also, at the minimum, it is necessary that protection against incurring the costs of defending the actions of supervisors is stated clearly and explicitly (at least at the level of internal procedures), including the financing of any expenses since the start of the legal proceedings.

37. BNM has a good framework for information sharing with foreign supervisors, but domestic information sharing arrangements could be improved. The MOU with the SC should be expanded to cover more than the investment banks that the SC and BNM co-regulate (i.e. to include asset management companies), and provide for the SC to share information with BNM on entities supervised by them that are part of FHCs and for BNM to alert the SC on supervisory developments in the broader banking group that could affect those institutions regulated by the SC. Information sharing with the SKM could also be formalized. Finally, the BNM should consider entering into MOUs with countries of major new entrants (e.g., Japan).

CP 2-5 Licensing and structure

38. The Malaysian banking law appropriately defines and controls the business of banking, with Bank Negara strongly overseeing the evolution of the banking structure, with some areas of needed concurrence (e.g., license approval) from the Minister of Finance. BNM has presented publicly long term plans for banking and financial structure that have guided ongoing decision-making—as the country responded to the Asian banking crisis of the 1990s by consolidating banks into the current eight large banking groups that dominate the domestic market, and as the country looks forward over the next decade. Since that consolidation, the structure has been kept relatively stable with no new licenses for conventional commercial banks granted from 1970 until 2009; consistent with the long run plan to encourage the development of the Islamic banking sector, a number of Islamic bank licenses have been granted since 2004. The licensing and acquisitions that have occurred in recent years have been reviewed by BNM to ensure they are appropriate from a safety and soundness viewpoint and contribute to the development of the Malaysian banking market. There has been, however, little public transparency on the criteria used, as BNM has chosen to share expectations only directly with the applicants. Improving transparency and ensuring that appropriate focus is given to shareholders of banks in addition to the applicant banks are areas where improvements can be made.

Prudential Regulation and Requirements (CPs 6-18)

39. The BNM has set prudent and appropriate minimum capital adequacy requirements but the scope of application of capital requirements should be widened to include the financial holding company. Banks are well capitalized with strong system-wide risk-weighted capital ratio and core capital ratios. The BNM has accredited ten banks to adopt the Basel II foundation IRB approach for credit risk and two banks to adopt the standardized approach for operational risk. The BNM does not have the power to include the financial holding company in the scope of application of capital adequacy requirements, though the draft FSA, if enacted, would remedy this gap. Basel III implementation is planned in accordance with the international timetable.

40. BNM issued comprehensive guidelines specifying the requirements and regulatory expectations for banking institutions to have in place an effective system for management of problematic assets and processes to ensure the adequacy of provisions and reserves. In the event that BNM has supervisory concerns over banking institution’s asset quality and adequacy of provisions, BNM has the power to require banks to increase the level of provisions and reserves as well as banking institutions financial strength via higher minimum capital requirements. The regulations as well as the supervisory framework cover the overall credit risk process in terms of identification, management and mitigation.

41. The assessors identified several other areas for strengthening of prudential regulation. More detailed regulation and supervisory expectations in the area of interest rate risk in the banking book, credit concentrations, operational risk and country risk are recommended. Also, the BNM should formally require banks to have a separate and independent risk management unit. The BNM has recently released prudential regulations covering Pillar 2 and many banks are making good progress towards their implementation. That said, full implementation is required to further strengthen oversight of interest rate risk in the banking book and credit concentrations.

Methods of Ongoing Banking Supervision (BCP 19-21)

42. BNM supervises the activities of banks with a well-structured risk focused supervisory approach that integrates well on-site supervisory practices, extensive regulatory reporting, and off-site monitoring. BNM’s Supervisory Risk-based Framework provides a strong structure for supervisors to carry out consistent and effective supervision across BNM’s portfolio of regulated firms, both through individual firm supervision and through horizontal or thematic reviews. Decision-making within this structure, as to onsite reviews to be conducted and special off-site surveillance work, is carried out by teams of supervisors headed by a Relationship Manager (RM). The supervision work carried out by the RM and his/her team is supported by micro-surveillance personnel, a macro-surveillance unit and a Specialized Risk Unit (SRU). A careful system of checks and balances has been implemented, involving vetting of ratings and other supervisory products through at least one, and sometimes two, layers of independent panels within the Supervision Department. Ratings and supervisory recommendations and remediation requirements are conveyed effectively to banking institutions in writing, and through extensive interaction with the Board and senior management; necessary remediation is followed through in a highly disciplined way.

43. Emerging global practices are being introduced and BNM has incorporated increasingly sophisticated supervisory techniques and expectations into its risk focused approach. In doing so, there are challenges in ensuring that appropriately specialized supervisory expertise is maintained, and utilized to maximum effect. BNM is moving forward to incorporate Basel II, Pillar 2 and ICAAP expectations, and will soon be looking to address recovery and resolution planning. BNM currently has relatively few specialists in the SRU, and the bulk of the time of those experts is spent in-house, providing guidance to the general supervisors. As BNM has found with model validation requirements, specialized risk people can provide major contributions on-site. Over time, the assessors expect that the cadre of specialized people should be expanded, and more of their time spend in direct interaction with bankers.

Accounting and disclosure (CP 22)

44. The BNM has adequate regulations in place in the area of accounting and disclosure by banking institutions. The BNM approves the external auditors for banks on an annual basis and maintains an ongoing dialogue with them during the course of the audit cycle. Feedback from market participants reflected a need for clearer communication of auditors’ supervisory expectations to banks. Hence, assessors recommend the BNM more clearly communicate to banks its supervisory expectations, particularly in case additional procedures may be required on top of the normal audit procedures.

Corrective and Remedial Powers (CP 23)

45. BNM has broad discretion in the range of remedial actions it can take to address problem situations, which it takes within a well designed early intervention program. BNM’s Supervisory Intervention Guide sets out a clear set of steps to take if a bank’s condition deteriorates and its risk increases, with BNM having the clear power to issue directives to banks to take appropriate remediation actions.

46. A new Strategic Alliance between BNM and the Malaysian Deposit Insurance Corporation (PIDM) was agreed to while the BCP review was taking place, and its effectiveness should be reviewed over time. Among the issues to address over time is how the assessment of the viability of an institution is to be made (and how transparent the criteria should be) and how the resolution framework could be applied to financial holding companies.

Consolidated and Cross-border Banking Supervision (CP 24-25)

47. A clear gap exists in BNM’s legislative authority for the supervision and regulation of financial holding companies. The BNM has been effective in narrowing (but not eliminating) the gap, and the proposed new FSA would address the statutory shortcoming. Six of the eight large domestic banking groups have parent financial holding companies, and the current legislative framework does not by its terms apply to those firms on a parent only or consolidated basis. Many of the affiliates of the bank are regulated by the BNM, but some (such as asset managers) are not. The BNM has been creative by imposing conditions on the financial holding companies incident to approval of their investments in their banks, covering the nomination of their directors and CEO, acquisitions of shares of other companies, the issuance of capital instruments, and more generally complying with BNM guidelines. BNM has also used legislative authorities applicable to affiliates of banks to apply reporting and examination requirements to the financial holding company and its subsidiaries. Through these means, the BNM has been able to significantly reduce the existing gap, but not to completely eliminate it. No consolidated capital ratios apply to the financial holding companies; the liquidity framework does not apply on a consolidated basis; and no stress testing expectations are applied on a consolidated basis. The proposed legislative change, if enacted, would address many of these issues.

48. BNM has a very well developed program of information exchange and supervisory cooperation with an appropriate set of foreign supervisors, although it could make some elements of information exchange globally and domestically more formal. BNM has put in place an extensive set of MOUs and less formal information exchange mechanisms with a relevant set of international supervisors. In addition it has been active in hosting and participating in supervisory colleges and carrying out its own program of overseas examinations. It has also been in the forefront in offering training programs to other supervisors in the region. As a matter of good practice going forward, BNM should, in licensing foreign banks subsidiaries, do a formal independent assessment of consolidated home country supervision and look to enter into MOUs with countries of the major new entrants. BNM’s MOU with the Securities Commission should be modified to make it much more directed to consolidated supervision, and an MOU with the Cooperatives Commission should be negotiated.

II. Detailed Assessment

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