<>Such growth rates are providing opportunities to new players. Britain, for example, is making a bid to become a leading market for Islamic finance in Europe, introducing a new tax regime for alternatives to conventional securitisations, such as sukuk – securities that comply with Islamic law.Yet, how readily Islamic finance can be fitted into the international regulatory framework constructed for conventional products, markets and banking remains unclear. What seems certain is that continued rapid growth is going to compel regulators to grapple with these questions.
A series of regulatory initiatives is underway to establish principles for the supervision of this market, and a number of multilateral institutions, including the IFSB, are seeking to establish global principles for its regulation. Regulators in the Middle East and Asia, notably Bahrain, Dubai and Malaysia, are also working hard to establish ground rules for the supervision of Islamic banks and capital markets within their own countries. This can be very challenging for the regulators who operate in countries where a dual banking system, including conventional and Islamic banks, operates. Indeed even within Islamic finance and banking there is a lack or harmonisation over definitions and standards making cross-border comparisons of different financial institutions very challenging for regulators. The need for more uniform principles is urgent, say proponents of a more harmonised global Islamic finance industry.
“There is a general market desire to move towards standard market practices and to generate as much consensus as possible for the Shariah supervision of Islamic financial services,†says London-based Ruari Ewing, primary markets advisor at the International Capital Markets Association, the self-regulatory organisation and trade association representing the financial institutions active in the international capital markets worldwide. “This seems to be filtering down,†he adds, “to the national level where we are beginning to see some regulators working to establish a level playing field between Islamic and conventional products within national law.â€
In addition, responding to the growing involvement of international banks and investors in Islamic finance, regulators in non-Islamic countries are looking at ways to shoehorn the supervision of this market into their existing regulatory frameworks. Since 2004, Britain’s Financial Services Authority (FSA) has had oversight of the first Islamic bank in Europe, the Islamic Bank of Britain. Authorisation of this bank was followed by the establishment in Britain of the first standalone Islamic wholesale bank in Europe, the European Islamic Investment Bank, in 2006.
Defining Sharia law
The distinguishing feature of Shariah (Islamic) law is that risk in trade and business must be shared. The law bans speculative activity meaning that interest, or riba, is prohibited. Business deals are also, usually backed by assets. For example murabaha, salam and istisna contracts are based on the sale or purchase of an asset, while ijara (leasing) contracts are based on selling the benefits of such an asset. Musharakah and mudaraba are profit-sharing transactions (see box).
Investment in certain business activities, such as alcohol, tobacco, pornography, armaments and gambling is also forbidden on ethical grounds. “Ultimately Shariah is part law and part ethics,†says Michael McMillen, partner at Dechert law firm in New York and an internationally recognised expert in Islamic finance. “A lot of this is a matter of personal belief and religious principles and it is debatable how much you can standardise this.â€
This is not stopping the regulators trying to do so. To police this growing market a number of multilateral regulatory institutions have sprung-up, of which the leader is the IFSB. Created in 2002 the IFSB’s key objective is maintaining the stability of the Islamic financial services industry, including banking and capital markets. It works in conjunction with other regulatory bodies to provide guidance on Islamic investment products and is the multilateral body charged with addressing the issue of Basel II – the new capital standard for banks that is now starting to be implemented around the world – and Islamic banking.
The IFSB is emphasising to both banks and regulators worldwide that Basel II compliance is possible for Islamic banks. “We do not attempt to reinvent the wheel for Islamic finance as a niche system, rather, we complement the work of the Basel Committee, architect of Basel II, by catering for the specificities of Islamic banks,†the IFSB’s Rifaat told a seminar on Islam and the global economy, held last June in Wellington.
Philip Smith, senior director in Fitch Rating’s financial institutions group in London, agrees that despite the differences in approach between Islamic and conventional banking there is enough common ground for Islamic banks to fulfil Basel II capital adequacy standards. “For our own part we can’t see any reason why Islamic banks and financial products cannot be accommodated into our existing rating scale and methodology,†he says. “Islamic finance is certainly more asset-based but essentially the risks are the same although there are certain differences in product structures and risk profile, and you must be sensitive to this.â€
In a bid for further clarity and standardisation, at the end of last year the IFSB published a document setting out seven guiding principles of prudential requirements in the area of corporate governance for institutions offering Islamic financial services, excluding insurance. These principles offer guidance for the general governance of these institutions, the rights of investment account holders, compliance with Shariah rules and principles and transparency in the reporting of investment accounts.
No single model
That IFSB report says: “We share the opinion of the OECD [the Paris-based policy body for developed nations] and the Basel Committee that there is no ‘single model’ of corporate governance that can work well in every country. Each country or even each organisation should develop its own model that can cater for its specific needs and objectives.â€
It continues: “Despite undergoing a very rapid development in recent decades it should not be forgotten that the Islamic financial services industry is still in its infancy. Any rigid, rule-based approach adopted in haste may jeopardise the potential and healthy growth of this market.â€
So, the IFSB has been cautious in setting down basic principles for governing Islamic banks. In December 2005 the Board adopted two standards; (1) the Guiding Principles of Risk Management and (2) Capital Adequacy Standard for Institutions (Other Than Insurance Institutions) Offering Only Islamic Financial Services. These guidelines outline how Shariah financial risks should be defined and measured and have been designed to closely adhere to the basic principles of the Basel Committee.
However, these guidelines have their limitations. “What cannot be overlooked is the fact that Basel II, despite its principle-based approach, was not designed for Islamic institutions or institutions offering Islamic products. It does not recognise the different risks emanating at various stages of an Islamic financial transaction’s lifecycle,†says John Tattersall, head of financial services regulatory practices at the professional services firm PriceWaterhouseCoopers, in London.
The Board, Tattersall says, has drawn up principles based on the standardised approaches to Basel II for both credit and operational risk. “What we must now see is more thinking about how these practices can be expanded to include the more advanced approaches to measuring risk under Basel II, in particular, the internal ratings-based approach for credit risk and the advanced measurement approach for operational risk. This is the next challenge for the IFSB,†he says.
Specificially, more work is needed to clarify the types of risks faced by Islamic banks and fit them into the Basel context. This includes rate of return, withdrawal, liquidity, transparency and Shariah risk. The latter fits under the operational risk umbrella and refers to the risk that a product is not Shariah-compliant and will not be approved by Shariah-scholars. The IFSB is also working to produce more detailed guidelines on pillars 2 and 3 of Basel, namely the supervisory review function and information disclosure to enhance market discipline.
Another regulatory institution seeking to establish global principles for Islamic finance is the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), (see box, page 18). This organisation has taken the lead in establishing accounting, auditing and banking practices appropriate for Islamic financial institutions. AAOIFI standards for accounting and reporting are processed in a manner similar to international accounting standards, except that they are modified to comply with Shariah principles.
Farmida Bi, partner at law firm DentonWildeSapte in London, says the Organisation is playing a key role in the harmonisation of Islamic financial services. “AAOIFI is a member of the standards advisory council of the IASB and maintains close links with the International Monetary Fund, the Washington agency, and other global bodies to ensure that its standards are comparable. Increasingly in the market you hear people refer to AAOIFI standards and there is no doubt they are expanding their ambit in Islamic financial services supervision.â€
According to Bi, the countries already following or basing their regulation on AAOIFI standards are Bahrain, Sudan, Jordan, Malaysia, Qatar, Saudi Arabia, the UAE (specifically Dubai), Lebanon and most recently Syria.
It is hoped that the work of the IFSB and the AAOIFI will complement each other and that closer collaboration will establish firm international standards that represent both the Asian and Gulf face of Islamic finance, although this remains a tricky and controversial area. “Make no mistake about it there is rivalry between the Far East and the Middle East over who owns the Islamic principles and rules for governing Islamic financial services,†says PWC’s Tattersall.
Bi agrees: “We would like to see national Shariah boards established which could meet international needs to create global standards. However this is a tall order when you consider the philosophical differences of the main four schools of Shariah thought.†These four main schools of Sunni Islam – Hanafi, Maliki, Shafi’I and Hanbali – share most of their rulings although some take a more literal approach to the texts while others allow for looser interpretations. The other major school of thought is Jaafari, followed by most Shia Muslims.
The Bahrain banking regulator has been very proactive in promoting itself as a key supervisor of Islamic finance and has set a deadline for all banks under its jurisdiction to be Basel II compliant by the end of 2008. The Central Bank of Bahrain (formerly known as the Bahrain Monetary Agency) was the first central bank and financial services regulator to develop a comprehensive regulatory framework for Islamic banks back in 2001. The CBB claims that Bahraini Islamic financial institutions are subject to a regulatory standard that is comparable to that in the conventional sector and is accepted as such by the major international regulatory bodies. Meanwhile, both Dubai and Malaysia, which have a well-established framework for supervising both Islamic and conventional banks, are also confident that their banking sectors will meet Basel II requirements in a timely fashion.
FSA’s steep learning curve
In Europe, Britain’s FSA has been busy trying to overcome a number of issues specific to the supervision of Islamic banks. “It has been a steep learning curve for us as regulators and we are still running to keep up with developments in the Islamic market. However in each instance we have found a way to work with Islamic banks on a ‘no obstacles but no special favours’ basis,†says David Holt, manager of wholesale banks and investment firms, Middle East, at the FSA in London.
This includes establishing the treatment of deposits in Islamic banks. Under British law a bank must offer a guarantee to repay the total sum of the deposit, whereas under Shariah law the bank and depositor agree to share profits and losses. The solution that the FSA put in place is that depositors are legally entitled to ask for their money back but if they wish to follow Shariah principles they can just ask for a share of the profit/loss.
The FSA also had to decide on its supervisory stance towards an Islamic banks’ Shariah supervisory board. It decided that the Shariah board did not have a sufficiently managerial role to require personnel to be approved by the regulator.
Sharia-compliant home finance in Britain provides a good illustration of how regulation has been adapted to level the playing field between conventional and Islamic products. Salem Patel, specialist in the financial services division at consultancy firm Accenture in London, says that when the Bank of Kuwait first launched the Manzil Home Finance Product in Britain in 1996, consumer take-up was slow as the product was very expensive compared with a conventional mortgage. “This was because stamp duty had to be paid twice, once when the bank bought the home from the vendor, and then again when the bank sold the house to its customer. This anomaly was removed by government legislation in 2003, and more providers such as Lloyds TSB and HSBC quickly entered the market. Consequently, Sharia-compliant mortgages have become far more competitive and sales have rapidly increased,†he explains.
Britain’s regulators are also looking at ways to boost participation in the Sukuk (Islamic bond) market, says Patel. The International Islamic Financial Market (IIFM) has estimated that $150bn worth of Sukuk will be issued by 2010, with the overwhelming majority of issuance coming from the Middle East and South East Asia. “The growth and popularity of Sukuk in other parts of the world has forced regulators to examine whether existing regulation has hindered companies from issuing Sukuk in Britain,†he says. Obstacles caused by the country’s tax legislation were addressed in the March budget when Britain’s finance ministerr Gordon Brown confirmed that Sukuk would receive the same tax relief as conventional bonds.
Focus on capital markets
Attention is also being given by the IFSB to the development and regulation of Islamic capital markets. “The [Board] has done a phenomenal job in developing core principles for the world’s regulators to use as guidance for the supervision of Islamic banking and more work is being done in this area. However, as that process matures we are seeing them add capital markets to the agenda. This will be a focus area for this year,†says Dechert’s McMillen. Items under consideration include how to develop and use existing legal frameworks for Islamic finance, securities regulation, trust law, insolvency laws, and the role of the shariah boards across jurisdictions.
McMillen, who is working with the IFSB and the Madrid-based International Organisation of Securities Commissions (an umbrella body for over 100 national regulators) on this topic, says they are initially focusing their research on five countries all operating with different securities laws for Islamic products. These are Saudi Arabia, United Arab Emirates, Singapore, Malaysia and Pakistan. “You have five different jurisdictions each with different securities laws governing Islamic and conventional capital market products. Every individual country has different methodologies and different degrees of specificity for regulating their market,†he says. “Each of these illustrates issues that need to be addressed in the formulation of an effective legal framework for Islamic finance.â€
He says that the plan, as with banking regulation, is to try and establish some core principles and definitions for Islamic finance that can then be interpreted and applied by national regulators.
Islamic finance institutions
• Islamic Financial Services Board (IFSB)
Set-up in 2002 in Kuala-Lumpur, the IFSB’s key objective is maintaining the stability of the Islamic financial services industry, including banking and capital markets. The IFSB is the multilateral body charged with addressing the issue of Basel II and Islamic banking.
• Accounting and Auditing Organisation for Islamic Financial Institutions
Set-up in 1990, the Bahrain-based AAOIFI is a regulatory institution seeking to establish global principles for Islamic finance. It has taken the lead in establishing accounting, auditing and banking practices appropriate to Islamic financial institutions.
•International Islamic Financial Market
The IIFM is a Bahrain-based body established in 2002. It aims to develop primary and secondary market for Islamic financial instruments.
• International Islamic Rating Agency
This Bahrain-based agency also operates at an international level establishing credit, Shariah-compliant and corporate governance ratings for Islamic financial institutions. • Liquidity Management Centre
The Bahrain-based Centre has been set up to develop an active secondary market for short-term Shariah-compliant treasury products.
Islamic finance products
• Murabahah (cost plus) – a contract for purchase and resale that allows the customer to make purchases without having to take out a loan and pay interest. A bank purchases the goods for the customer, and re-sells them to the customer on a deferred basis, adding an agreed profit margin. The customer then pays the sale price for the goods over instalments, effectively obtaining credit without paying interest.
• Salam (deferred delivery sale) – a purchase contract with deferred delivery of goods(opposite to Murabaha), usually used for commodity finance. It is similar to a forward contract where delivery is in the future in exchange for spot payment.
• Istisna (predelivery financing and leasing) – an instrument used to finance long-term projects. It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment, and future delivery. Often used for financing the manufacture or construction of houses, plants, projects, and building of bridges, roads, and highways.
• Mudarabah (profit/loss sharing) – a contract between two parties, one who provides the funds and the other who provides the expertise and who agree to the division of any profits made in advanceThe profit-sharing continues until the loan is repaid.
• Musharakah (joint venture) – where parties agree to the sharing of profits and losses in the joint business. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions.
• Sukuk (Islamic bond) Fixed-income, interest-bearing bonds are not permissible in Islam so Sukuk are securities that comply with the Islamic law and its investment principles, which prohibit the charging or paying of interest.
• Ijarah (leasing) – involves a contract where the bank buys and then leases an item – perhaps a consumer durable – to a customer for a specified rental over a specific period. The duration of the lease, as well as the basis for rental, are set and agreed in advance.
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