Professional Documents
Culture Documents
Isl Banks Regulation and Supervision - Cunning Ham
Isl Banks Regulation and Supervision - Cunning Ham
January 2004
Contact Phone
London
Andrew Cunningham 44.20.7772.5454
How to include Islamic financial institutions within the global regulatory system has long been one of the key chal-
lenges for Islamic finance, but the issue has taken on a degree of urgency with the approach of the Basel 2 capital
accord. Although there is much more to global financial regulation than the Basel 2 – recent initiatives on money laun-
dering and enhanced financial disclosure come to mind – Basel 2 occupies the centre stage. “Pillar 1” of the new regu-
lations will set new benchmarks for the management of credit and operational risk, offering incentives – effectively in
the form of lower regulatory capital requirements – for those who are able to demonstrate advanced risk management
practices.
The Basel accord aims to be wide enough and flexible enough to encompass the needs of banks worldwide – so
enabling it to be a truly global standard; yet Islamic bankers fear that their particular financial instruments are not rec-
ognised in the accord. They point to the hybrid nature of many Islamic banking products, which combine several
forms of risk, either simultaneously or sequentially. As a result, they believe, such products cannot be slotted into the
Basel criteria.
The apparent exclusion of Islamic finance from this important new accord has strengthened the hand of those
who would like see Islamic institutions establish a parallel regulatory architecture which explicitly caters for Islamic
financial instruments. They argue – convincingly – that some regulatory organisation has to understand the risk profile
of Islamic banks and set common standards by those banks may then be judged; and if Basel does not, then Islamic fin-
anciers will have to do it themselves.1
But the prospect of Islamic banks being excluded from the Basel framework and adhering instead to another dis-
crete system clearly raises many questions, not only for Islamic banks which hope to continue operating in global mar-
kets, but also for western banks which hope to maintain their current business relationships with Islamic financial
institutions.
The purpose of this paper is to consider the practicalities of integrating Islamic banking into a global regulatory
system. It does so by way of three framing questions:
• Is it desirable to integrate the regulation of Islamic financial institutions into a single global system?
• Is it possible to do so?
• What are the impediments to the creation of a single global system in which Islamic banks will want to be
included?
1. The creation in 2002 of the Islamic Financial Services Board (IFSB) was a significant development in this respect. The Board is based in Kuala Lumpur.
Is it desirable to integrate the regulation of Islamic financial institutions into a single global
system ?
2. Shari’a is the corpus of Islamic law. Riba’ is sometimes translated as “interest” and sometimes as “usury”, but in practice it refers to the charging of interest. Riba’ is
explicitly condemned in the Quran, the principal source of Shari’a.
3. For the avoidance of doubt, this paper is not arguing that tier one regulatory ratios ought to be a major consideration for credit officers; merely citing it as an example
of a ratio which often is used in this way. In Moody’s bank rating methodology, regulatory capital ratios are not considered a leading indicator.
4. Figures on the top 1000 banks are taken from The Banker magazine, London, July 2003.
5. Figures on Gulf banks are taken from Middle East Economic Survey, Nicosia. 15 September 2003.
ISLAMIC BANKERS HAVE NOT OBJECTED TO OPERATING UNDER SINGLE REGULATORY STRUCTURES
In addressing the second of the three framing questions, the point of departure is again to consider how Islamic bank-
ers themselves act, and what they say. In practice, Islamic banks appear happy to operate as part of a single regulatory
framework, albeit one which recognises the important differences between Islamic and conventional banks. All banks
in Bahrain are regulated and supervised by the BMA. The BMA has a department dedicated to Islamic banks, just as it
has separate departments which focus on insurance and mutual funds. But there appear to be no calls from Islamic fin-
anciers in Bahrain to take the regulation and supervision of Islamic banks out of the purview of the BMA.
In Malaysia, which runs parallel Islamic and conventional banking systems, Islamic banks are inspected by the
same officials who inspect conventional banks. Again, there appear to be no calls from Islamic bankers in Malaysia for
supervision of Islamic banks to be done by a discrete team of inspectors specialised only in Islamic matters.
So there is strong evidence that Islamic bankers do not object to operating under a single regulatory and supervi-
sory regime, provided that the particularities of Islamic finance are recognised.
ACTUAL REGULATORY/SUPERVISORY PROBLEMS WHICH HAVE ARISEN AT ISLAMIC BANKS HAVE NOT
BEEN CONNECTED TO THE ISLAMIC NATURE OF THOSE BANKS
If we look at real examples of Islamic banks which have encountered difficulties, it is hard to argue that those difficul-
ties were due to a lack of understanding by regulators of the nature of Islamic finance. Conversely, it is hard to argue
that those problems would have been avoided if regulators had had a greater appreciation of the particularities of
Islamic finance.
Dubai Islamic Bank (DIB) had to be recapitalised in 1998 following the discovery of unusual transactions in its
accounts. At the time, it appeared that some senior executives of the bank had acted beyond their powers, and as a
result incurred large losses for the bank. This problem had nothing to do with the fact that DIB was an Islamic, rather
than a conventional bank – it lay in a lack of controls at the bank, and the desire of certain executives to exploit that
lack. Conventional banks are equally exposed to this risk, and there are many examples where they have suffered losses
in exactly the same way as DIB.
Many Islamic banks suffered losses arising from their exposure to Bank of Credit and Commerce International
(BCCI), which was closed by regulators in 1990 and subsequently found to be insolvent. Yet many conventional banks
also had material exposure to BCCI. Again, we cannot attribute the losses suffered by Islamic banks to the fact that
they were Islamic. The problem can be classified as one of over-exposure to a single counterparty, and also a lack of
appreciation of the credit quality of BCCI.
Kuwait Finance House (KFH) suffered following the collapse of Kuwait’s Souq al-Manakh in 1982, but so did
every Kuwaiti bank. The weaknesses in KFH’s balance sheet following 1982 were the same in nature as those affecting
all Kuwaiti banks. The fact that KFH was an Islamic bank did not make it any more or less vulnerable to the Manakh
crash and its aftermath.
THE ACTIVITIES OF ISLAMIC FINANCIAL INSTITUTIONS DIFFER FROM THOSE OF CONVENTIONAL BANKS
– BUT BY HOW MUCH ?
Islamic financiers argue that the instruments which they use are fundamentally different from those employed in con-
ventional finance, and that they therefore require a separate regulatory and supervisory structure.
Certainly, services offered by Islamic financial institutions are very different from those used by conventional
banks. A crucial difference lies in the frequent requirement for Islamic banks to take legal title to underlying assets at
some point during the financing process -- a risk to which conventional banks only face in specific circumstances. (For
example, when an Islamic bank provides finance to an importer, it will generally own the goods being imported at
some stage during the transaction. A conventional bank would not.) Islamic banks are also constrained in their ability
to charge for late payments, or even, in some circumstances, to pursue debtors.6
6. It is not being argued here that Islamic financing is inherently more risky than conventional financing: there are times when it may be more risky and there are times
when it may be less so. The point being made is that Islamic banks are subject to some different risks.
7. Shari’a boards comprise religious scholars and their task is to ensure that all the institution’s business conforms to the shari’a.
Special Comments:
Analysing the Creditworthiness of Islamic Financial Institutions, November 1999 (# 50620)
Culture of Accounting: What are the real constraints for Islamic Finance in a Riba-based global economy? January
2001 (# 63369)
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