Zeti Akhtar Aziz: The nature of risks involved in dealing with OTC financial derivatives Keynote address by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the 4th Banking and Financial Law School Seminar, Kuala Lumpur, 19 February 2004. *  *  *  It is my great pleasure to be here at this 4th Banking and Financial Law School in light of developments in the global and domestic financial markets. We are in a period of great change. As the pace of globalisation intensifies the global environment has been marked by greater volatility and uncertainty. As a consequence we are often dealing with probabilities. The process of globalisation has resulted in international capital movements and developments in the global financial, and regulatory arena that have had significant implications on domestic financial institutions. There is therefore a need for a global perspective in effectively managing these risks. The universal application of ISDA Master Agreements is a demonstration of the need for globally oriented solutions. This morning my remarks will focus on the need to appreciate the nature of risks involved in dealing with OTC financial derivatives, both by the market and the regulators. I will also touch briefly on the opportunities emerging in terms of developing derivatives within Islamic banking and finance. Financial institutions, as the linchpin for the process of financial intermediation, have a crucial role in facilitating the flow of capital to areas where it can be most productively used.
On a preemptive note, in response to a series of derivative debacles that was sparked off by the Barings crisis in 1994, Bank Negara Malaysia has taken steps to enhance prudential regulations on the derivatives business of banking institutions. In 1996, the Guideline on Minimum Standards on Risk Management Practices for Derivatives was issued to provide a framework that outlines the minimum risk management standards for the derivatives business of banking institutions. It requires banks to ensure that risk management controls and procedures are in place before engaging in derivatives business. The guidelines also ensure that derivatives can be offered to customers for hedging purposes only. In May 2003, as a step towards a more liberalized financial market, banking institutions are allowed to embed derivatives into investment instruments to enhance yields. The investment has to be principal protected, and may be offered to high net worth or corporate clients and for a minimum transaction amount of one million Ringgit. As part of the prudential requirements, no leveraging is allowed on the structure. Gradual liberalization allows the banking industry and the regulator to work in a collaborative manner in developing an innovative yet stable financial system. In the context of the significant growth in OTC derivatives, both in the domestic market as well as the global market, there is therefore an important need for prudential management in derivatives since speculation would itself introduce risks into OTC derivatives market and could deter the principal objectives of risk diversification and risk management.