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European Passport for Islamic Banks:
Regulators’ Concern
M. Fahim Khan1
The present form of Islamic banking is not very different in
substance from the conventional interest-based banking. This
is not by choice. Since the Islamic banking has to operate
within the European institutional framework, necessary
modifications are made in the concept and operational
modalities of Islamic banking to conform to the prevailing
institutional framework, which is basically geared towards
promoting, regulating and monitoring the conventional
interest-based banking. In this perspective, introducing
Islamic banking is no more a serious regulatory challenge in
Europe. It is also evident from the fact that conventional
institutions are entering the Islamic financial market
easily without leaving their own conventional (interest
based) business. They are doing this in several ways. They
are opening subsidiaries to do Islamic finance business
only. They are opening Islamic windows, carrying out
conventional and Islamic business under the same roof,
utilizing the certificate of Shari'ah scholars about the
1 Author is currently chairman, Riphah Centre for Islamic Business and Finance, Riphah International University, Islamabad. Email: [email protected]
Shari'ah compatibility of their Islamic operations. They are
selling Islamic products exactly similar to those of Islamic
banks on the backing of their Shari'ah consultants. This is
all happening within the conventional systems of banking
regulations and supervision.
It cannot, however, be denied that the Islamic banking may
require not only a higher degree of monitoring, supervision
and regulations but also a different type of regulatory
framework than what exists for the existing conventional
banking institutions, in case they want to use their
distinct Islamic products. Two areas need attention from the
regulatory authorities in this respect. These are:
1. Risk Management
2. Corporate Governance
Risk management is an issue for regulatory authorities even
for the conventional banking institutions because these
institutions handle other people’s money, which cannot be
subjected to bearing risk. Despite that banking institutions
guarantee the principal and a fixed return determined in
advance, regulatory authorities still monitor the financial
institutions’ operations. Regulatory authorities remain
vigilant so that the banking institutions do not make
adverse selection while choosing their clients for deploying
depositors’ fund or make weakly secured (also called
subprime) loans, as this may lead to the failure of banking
institutions and ultimately cause depositors to suffer a
loss on their deposits. Also the failure of a bank may lead
to a contagion effect and may cause a run on the banking
system and hence putting the entire financial system at
stake. European union of course would not like to take this
risk if permission of Islamic banks to operate in European
Union can lead them to such situation. This apprehension is
not unfounded.
This apprehension arises out of a unique a unique and
distinct feature of Islamic banking that the European
regulatory authorities have never dealt with in the context
of their banking system. The unique feature relates to the
fact that depositors give the Islamic banks their
willingness to bear the risk of loss if it arises out of the
investments made from their deposits. According to Islamic
law, no one can make its money grow without letting it go
through real economic activity and without being willing to
bear the risk of loss associated with the activity. This
willingness of depositors to bear risk, in order to earn a
Shari'ah permissible return on their deposits, generates a
distinct and very important regulatory issue. The
depositors’ willingness to bear the risk may lead the
banking institutions to use the depositors’ money for more
risky economic activities exposing depositors’ money to
bearing the risk more than the depositors would like to
bear. This calls for the attention of regulatory
authorities. Regulatory authorities would like to make sure
that banking institutions are not only doing enough to
manage risk but also they are not taking the risks beyond
what depositors are willing to afford. This is indeed a
complex issue, but definitely not beyond the capacity of
regulatory authorities.
The willingness of depositors to bear the risk on investment
of their deposits raises another important issue for the
regulatory authorities. The issue arises out of the fact
that banks may choose such risky activities to invest
depositors’ money that may benefit the owners/shareholders
of the banking institutions rather than the providers. This
is the issue of corporate governance, which is also on the
agenda of the regulatory authorities. This too will be a
complex issue for the regulatory authorities monitoring
Islamic financial institutions.
Both these issues, risk management and corporate governance,
in respect of Islamic banking become more sensitive in the
context of European union in view of the fact that
regulatory officials are not trained to understand and deal
such operational peculiarities of Islamic banking
institutions. How to understand what risks are necessary to
fulfill Shari'ah compliance and what are not necessary is a
complex issue unless there is complete awareness of the
concept and philosophy underlying the operational details of
Islamic banking institutions.
Wherever Islamic banking is available on the globe, the
tools to regulate conventional financial institutions are
being used for the regulation of Islamic financial
institutions too. This puts the Islamic financial
institutions, when competing with the conventional
institutions, at disadvantage. The Challenge for the
regulatory authorities is to understand the peculiarities of
operational modalities of Islamic financial institutions and
develop a distinct regulatory mechanism that would be more
relevant and friendlier to the concept of Islamic finance.
Encouraging Islamic banking institutions in Europe would be
a welcome step in the interest of making the financial
system socially more inclusive. The absence of the Islamic
financial institutions keeps a large part of the Muslim
population and their economic and financial activities in
European out side the formal financial system.
This article discusses the nature of these issues and how to
take care of them so that Islamic banking institutions’
entry to European Union is facilitated without putting the
objectives and principles of European financial system at
stake.
Risk Management
In the context of allowing Islamic banking in the European
Union, the European regulatory authorities need to worry
about those dimensions of risk that arise out of the
particular nature of contractual relationships with the
clients on assets side as well as liabilities side. The
distinct dimensions of risk in Islamic banking emerge from
following sources:
1) Contractual relationship with the depositors
2) Choice of the modes of financing
3) Risk taking as a part of investing in a real sector
activity
The other dimensions of risk that are common with the
conventional banking do not need to be discussed here as
Islamic banks are equally amenable to any such regulations
and prudent rules that regulatory authorities prescribe for
conventional banking institutions from time to time.
Risks arising out of the contractual relationship with the
depositors: The contract of depositors with the Islamic
banks requires the willingness of depositors to share the
loss of the bank, in case the eventuality arises. The
depositors, thus, are neither guaranteed any predetermined
rate of return nor are guaranteed their full amount of
deposits. The depositors will get back the principal amount
of their deposit and return on their deposits only if bank
makes a profit. If bank bears a loss then the depositors
will get their money back after adjustment of the losss.
Banking laws in Europe may not authorize an institution to
take deposits without guaranteeing principal amount of
deposits and without guaranteeing some return on the
deposits. Presently, Islamic banks have only one choice to
comply with the law. They can offer the guarantee and leave
it to the depositors whether or not they want to invoke the
guarantee. If this is the case, no challenge is posed to
regulatory authorities to devise extra regulations and
prudent rules to protect the depositors’ money. Even if
banking laws allow the Islamic banks not to provide the
guarantees, to comply with the Shari'ah principles, even
then this does not pose a problem for the regulatory
authority, which is concerned with the stability of the
banking institutions. Since the depositors are willing to
bear the losses of the bank, there is no chance of
liabilities exceeding the assets. It can be noted that in
conventional banking any shock on assets side of immediately
creates imbalance in assets and liabilities because
liabilities remain fixed. In case of Islamic banks,
liabilities are linked with the performance on the asset
side and any loss on asset side reduces the liabilities too
to the same extent. Hence, the stability of Islamic banks is
not at stake because of the peculiar contractual
relationship between depositors and Islamic banks.
With respect to the stability, a concern can be raised in
the light of an IMF study claiming that small Islamic banks
are more stable than small conventional bank but large
Islamic banks are not as stable as the large conventional
banks2. “Plausible explanation for the contrast between the
higher stability in small Islamic banks and the relatively
lower stability in larger entities is that it is
significantly more complex for Islamic banks to adjust their
credit risk monitoring system as they become bigger. For
example, the PLS modes, used by Islamic banks, are more
diverse and more difficult to standardize than loans used by
commercial banks”3. If this is true then this is something
that the regulatory authorities can take care of as part of
their normal duties. It does not require any special
concern.
There is, however, a serious issue that arises out of the
contractual relationship of Islamic banks with their
depositors, when they offer risk-bearing savings account to
make profit for the depositors. This adds a new dimension in
the context of managing risk that regulatory bodies may get
more concerned with. This relates to the risk management
relating to managing the profit-sharing Investment Account
(PSIA). The depositors who want to earn a return on their
2 Martin Čihák and Heiko Hesse IMF Working Paper No. 08/16, "Islamic Banks and Financial Stability: An Empirical Analysis," http://www.imf.org/external/pubs/ft/survey/so/2008/RES051908A.htm3 (http://www.imf.org/external/pubs/ft/survey/so/2008/RES051908A.htm).
deposits have to open profit sharing investment accounts.
The Islamic banks thus have authorization from the
depositors to invest their deposits in risk bearing
activities. This suits Islamic banks because they do not
bear any risk in investing these deposits in risky projects
because under the contract (which is called Mudarabah
Contract) bank does not bear any loss that may arise from
the investment of the deposits in risky projects. Depositors
will bear all the loss (the amount of their deposit will be
reduced to the extent of their deposits. Though Islamic
banks would not like to be unscrupulous in managing the risk
bearing deposits because if they end up making a loss on
PSIAs, they will lose their clients who are the major source
of their funds and hence of profit to their share holders.
Yet it cannot be denied that PSIAs potentially do entail
displaced commercial risks for Islamic banks. It is the
existence of this type of risk that necessitated the
enforcement of Glass Steagall Act. The regulatory bodies may
need to formulate not only rules and legal provisions to
stop Islamic banks from speculating on commodity and real
estate prices but may also require different set of
prudential rules to discourage the Islamic banks getting
into risky activities.
Risks arising out of choice of modes of financing
Islamic banks have to make sure that the money passes
through a real activity to justify a return on the use of
their money. There can be several ways to deploy depositors’
money in real economic activities. Islamic banks have to
choose mode of financing that will involve a real activity
(rather than simply advancing money to the clients). Towards
this end, Islamic banks can make a choice from a variety of
modes of financing. These modes of financing4 are either in
the nature of
1) Direct investment with the clients (Called Mudarabah or
partnership between labor and capital and Musharakah
partnership in business, also called profit/loss
sharing-PLS- modes of financing) or
2) Doing Trade directly or indirectly for the clients
(called Bai’ Mujjal bi Thaman Aajil or markup based
trade financing and Bai’ Salam or purchasing foreign
delivery by making advance payment).
3) Leasing assets, directly or indirectly for the clients
(called Ijarah or leasing based modes of financing)
The risk profile of these different types of modes of
financing can be seen in the following table.
Table
4 See Khan and Khan (1), for details of these modes in terms of their counter parts in the contemporary world of trade, finance and investment
Comparison of theNature of the Return of Funds Supplier
and Cost Paid by the Fund User
Return to theFund Supplier
Payments madeby the Beneficiary
Whether the two will be different or same
Profit/loss sharing Based Finance
Uncertain Uncertain Same
Mark-up BasedTrade Financing
Fixed and known in advance
Fixed and known in advance
Same
Salam (Advanced payment) Based Financing
Uncertain Uncertain Different
Istisna BasedFinancing
Uncertain Fixed and known in advance
Different
Leasing Uncertain Fixed and known in advance
Different
The profile shown above is, in theory. The Islamic banks,
however, had been able to develop documentation such that
almost all modes of finance they use yield almost fixed
return known in advance. Hardly, any regulatory challenge
arises in such practice of Islamic banks. If Islamic banks
choose to operate Islamic modes of finance in substance, not
merely in form, then the adoption of Profit/loss sharing
(PLS) based, Leasing based, Istisna based and Salam based
modes of finance, may pose substantial challenge for the
regulatory bodies. This challenge, however, will arise only
if the regulatory bodies are willing to give a chance to
Islamic banks to do Islamic banking in real substance and
spirit5 to show what difference the new paradigm makes on
the frontier of their financial system. This will be a
matter of choice for the regulatory authorities.
Risk taking as a part of undertaking real sector activity
According to Islamic law, financing can earn return only if
it passes through real activity. In other words financing
has to be either a part of a trade or leasing or direct
investment in equity of a business. This takes the concept
of Islamic banking closer to what is known in Europe as
universal banking which has been considered as exposing the
banking institution to get involved in speculative and risky
activities in trading, leasing and stock market activities.
So far Islamic banks are avoiding getting involved directly
in real activity. They are depending on trading based modes
of financing methods where client seeking financing is
required to make the purchase on behalf of the bank and then
to repurchase it from the bank, getting the repurchase
5 The PLS modes of financing are considered reflecting the true spirit of Islamic finance. See M. Fahim Khan, Comparative Economics of Islamic Financing Techniques, Islamic Research and Training Institute,Islamic Development Bank, Jeddah.
financed by the bank. This may have implications but not for
regulators seeking stability of banking institutions, as
discussed earlier. Now that Universal banking is gaining
support in Europe and regulators are already dealing with
the issue, Islamic banking itself does not pose any new
issue.
The fact that Islamic banks may be carrying out more risky
operations on the money of the depositors than conventional
banks do, may be true in theory but the practice of last
more than 35 did not show as a norm. There are only one or
two such instances and those too were not the result of
policy but of unscrupulous management. In general, Islamic
bank do not pose any serious challenge to the regulatory
bodies, even if they are allowed to get into universal
banking. They have been found amenable to suggestions to
reduce risks inherent in their operations. Since they are
competing with the conventional banks, their survival
requires being prudent so that they do not take risks more
than what conventional banks are taking.
Corporate Governance
Though the regulatory authorities in Europe are fully aware
of this issue, particularly in view of the current global
financial crisis yet Islamic banking raises one unique
aspect of corporate governance that is new for the
regulatory authorities in Europe. As already mentioned, the
commitment of Islamic banks to provide Islamically
acceptable modes of finance require a totally different
approach on the part of the regulatory authorities than what
they are faced with in the context of conventional banking.
The sources that generate new issue for governance are also
the sources that generate new issues for risk management.
Taking care of governance will take care of the interest of
the depositors as well. Before discussing what can be done
to ensure good governance in Islamic banking let us see the
sources that create new aspects of the governance to be
faced by regulatory bodies in Europe.
The new issue for corporate governance also arises from the
contractual relationship with the depositors according to
which depositors stand committed to share the profits with
the banks and bear loss of their deposits if eventuality
arises.
Islamic banks offer two types of profit-sharing
investment accounts (PSIA) to the depositors:
a) Restricted Profit Sharing Investment Accounts.
b) Unrestricted Profit Sharing Investment Accounts.
The deposits received under the restricted accounts are
used in pre-specified projects using pre-specified modes.
For such accounts, Islamic banks have succeeded in
developing products that will ensure a return to the
depositors varying only in a very narrow range and almost
non-existing possibility of loss. Thus, despite being
profit-loss sharing accounts, the depositors can have their
deposits in Islamic banks with same risk profile that a
client of conventional bank will get on their savings
account. Whether Islamic banks will be able to provide same
return profile as conventional banks provide to their
depositors is an empirical question. Such accounts thus
pose no risk management issue and no corporate governance
issue significantly different from what is involved in
conventional banking institution.
Unrestricted profit-sharing investment accounts, however, is
an Islamic banking product that offers major and most
complicated regulatory challenge. This is an account where
the depositors authorize bank to invest their deposits in
any investment that banks find suitable and the depositors
agree ex-ante to share the profits/losses arising from these
investments. The spirit of Islamic banking requires
increasing the share of such accounts in mobilizing
resources. It is the existence of these accounts that
distinguish the Islamic banking insititutions from
conventional banking institutions.
Islamic Bank use the deposits of account holders in
investments selected by the bank and account holders will
not have any say in this choice. The possibility of moral
hazard may arise in the use of depositor’s money, which
arise when deposits may be used more in the interest of the
bank management and equity holders than in the interest of
depositors. When bank is making good profits, no corporate
governance issue arises with respect to the interest of the
depositors. Depositors share the profits made by the bank as
the shareholders do. But when banks incur loss on the use of
the deposits, the entire loss is passed on to the
depositors. Here the governance issue comes. There will be
temptation on the part of the management of bank to use the
depositors’ money to increase profits of equity holders who
determine the emolument of the managers. Islamic banking
provides this opportunity. Since Islamic banks are free to
choose where to invest, they may investment in high-risk
high-return projects without caring for the risk-return
preference of depositors. Investing depositors’ money in
high-risk/high-return projects means that if there is high
return, both depositors and equity holders will get higher
return but if the investment ends up incurring loss then the
entire loss will be passed on to the depositors.
Islamic banks have not been able to develop a mechanism of
internal controls strong enough to take care of the interest
of investment account holders vis-à-vis the interests of
shareholders and bank management. In the disciplined
financial and investment environment of Europe, will this
issue be a serious challenge to the regulators?
This governance issue may not be resolved simply by
regulations. There are aspects that relate to ethical
issues also in this respect. Protection of interests of
PSIAs, without adversely affecting the performance of
Islamic banks, will require strict adherence to a carefully
designed code of ethics. Islam gives its own code of ethics
to take care of governance issues. The current practice of
Islamic banking, however, does not have a mechanism to
ensure adherence of Islamic ethics in the conduct of Islamic
banking business.
Similar to the regulations and supervision in stocks and
securities market, Islamic banking industry also requires
more emphasis on developing a system of checks and balances
in respect of fiduciary responsibility with respect to use
of PSIAs. This system has yet to be developed and
implemented as a means to improve the image of the Islamic
banks.
Another issue relating to governance arises on account
of ensuring Shari'ah compliance in the use of different
modes of financing. There is diversity of opinion among
Islamic jurists in the application of Shari'ah rules and
there is flexibility in Islamic system in adopting the
jurist opinion that suits. Islamic banks to enhance their
profits rather than satisfy depositors’ preference for any
particular jurist opinion are utilizing this diversity and
flexibility. Furthermore, since the Islamic banking industry
is still developing, Islamic banking institutions do not
like to reveal all details of their products to avoid free
rider problem. The banks therefore are not very transparent
in declaring all such details that will satisfy account
holders that their religious concerns are being respected in
deploying their funds. Transparency in business deals is
essential ethical requirement in the Islamic system but
maintaining transparency, however, is not simple in view of
the diversity of opinion in religious perceptions of what is
Islamic and what is un-Islamic. This would require a
religious board to specify clear rules and ethical standards
to make the appropriate declarations. The significance of
this issue from the regulators point of view is that if
Islamic banks lose the confidence of their depositors and
fail to establish that they are using the depositors’ money
in Shari'ah compatible way to the satisfaction of the
depositors, the depositors will withdraw their deposits and
the banks will become immediately insolvent. Depositors stay
with Islamic banks only for the satisfaction of Shari'ah
compatibility, otherwise conventional banks are more
convenient, less costly and better equipped to serve their
clients because of their size and experience. This
possibility of losing the confidence of the clientele makes
the Islamic banks vulnerable. A fatwa (verdict) from a
religious scholar enjoying the trust and confidence in the
community can destabilize an Islamic bank. This would be a
genuine concern for the regulatory authority. This concern
becomes more serious when they find that there is no central
Shari'ah body where they could get advice on issues arising
out of diversity of juristic opinions on the application of
Islamic law in developing Shari'ah compatible banking
products. The solution for the problems arising out
diversity of Juristic opinion does not lie in the banking
laws. The solution is in developing independent body that
would set standards for the application of Shari'ah rules
and adherence to ethical standards for Islamic financial
institutions. This will be a self-sustaining body
collectively supported by the Islamic financial institutions
and Islamic businesses in the community. Certification from
this body can be the basis of ensuring stability of Islamic
banks on Shari'ah grounds6.
Another source of generating governance issue is the item of
Reserves in the balance sheet of Islamic bank. This is
similar to the Reserves in the balance sheet of a
conventional bank with only one distinction. Islamic banks
like to keep part of the bank’s profit (before sharing it
with the depositors) as “Profit-Equalization Reserve”.
Islamic banks intend to use these reserves to smooth out
wide fluctuations in the return on profit sharing investment6 See M. Fahim Khan, “Setting Shari'ah Standards for Shari'ah Application in Islamic Finance Industry”, Thunderbird International Business Review, Special Issue, 2006
account. They use the reserves to compensate the depositors
for abnormal decline in profits in any year. Some
prudential and ethical standards are needed to ensure that
no moral hazards takes place on this account and that the
depositors are not compensated from what is genuinely due
for other depositors, or reserves are not used to the
benefit of shareholders what is genuinely required to be
distributed to the depositors.
Islamic banks are not insensitive to governance issue. There
is effort on their own part to show good governance and
hence improve their national and global image. Some of their
efforts are described below:
1. Banks adopt two approaches towards investing the
Investment Accounts. They make PSIA to earn almost
fixed-return, no-risk account by investing in the fixed
return modes of financing and if still there is some
risk of loss the shareholders are willing to bear it
from the reserve account of the bank. The governance
issue of benefitting shareholders at the cost of
deposit holders is diffused to a great extent.
2. Capital adequacy requirements, asset-liability
management and product pricing policies are being
adopted to make the operations not only transparent but
also to build up cushion to fall back on in case of any
unexpected shock.
3. Diversity in Fiqh opinion also has been a potential
source of malpractice on account of corporate
governance. The diversity can potentially be used (and,
in some cases, has actually been used) by the Islamic
banks to increase share holders’ profits rather than
providing the products to satisfy clientele for fulling
their commitment to adhere to Islamic principles in
financial prinicples in lettr and spirit. It is
generally believed that Shari’a Supervisory Board (SSB)
are being used by Islamic banks as an effective organ
ensuring good governance in Islamic banks. But
regulatory body become cautious when seeing SSB taking
decisions which are the prerogative of the management.
Decision making is prerogative of management. Sharing
this prerogative with SSB may generate issues with the
regulating and monitoring agencies such as the central
banks reponsible for overseeing the performance of the
banking industry. This would be a genuine concern of
the regulators in Europe. They would like to be clear
about who is taking the decisions in the Islamic
banking institutions. The Islamic banks, however, have
taken several steps during last decade to clearly
delineate the role of their Shari'ah scholars or
shariah services board in the line of authority
responsible for managing the Islamic banking
operations.
4. Still another area where Islamic banks have made
substantial improvement in their governess structure in
Islamic financial institutions relates to improving
transparency in financial reporting. About two decades
earlier, Islamic banking institutions had no specific
system of financial reporting to provide adequate
information to their PSIA holders with respect to the
revenues and expenses and profit sharing ratios making
up the profit in their investment account. This
information asymmetry made regulatory authorities
rightly concerned about moral hazards on the part of
the banks as well as on the part of their clients with
whom they invest the money of PSIA holders. The
financial reporting system on this account, however,
has improved substantially over time and is still
improving improving. The emergence of institutions like
Accounting and Auditing Organization for Islamic
financial institutions (based in Bahrain) and the
Islamic Financial Services Board (based in Malaysia)
are helping Islamic banks in improving their financial
reporting and transparency and hence improving their
governance structure. The Islamic banks are working
hard to adopt standards for financial reporting that
may meet the requirements of European regulatory
authorities.
5. The solution to governance issue relating to Islamic
banking operations lies to a large extent in the
institutionalization of Islamic business ethics which
specifically aim at not only removing information
asymmetry between banks and the depositors by making it
religious obligations to be transparent to the maximum
possible extent, but also ensuring not to usurp
property of others. There are specific verses in the
Quran. “And do not eat one another's wealth wrongly
[2:188]. “O you who have believe, do not consume one
another's wealth unjustly but only in [lawful] business
by mutual consent. And do not kill yourselves [or one
another” [4:29]. These verses comprehesively prohibit
bad governance and moral hazard. How to
institutionalize such moral values is the issue that
Islamic Financial Institutions are seriously trying to
grapple on priority to minimize the interference of
regulatory authorities to check their governance
standards.
Role of Shari'ah Scholars in Ensuring Good Governance
A Shari'ah scholar or a team of Shari'ah scholars engaged by
Islamic bank has a vital role in the contemporary practice
of Islamic banking. There are following dimensions for this
role. First dimension is related to assuring the clients
that the operations of Islamic bank conform to Islamic law.
Only Shari'ah scholars have the authority to give this
certificate. If a Shari'ah scholar declares that the
management of the bank has violated the Shari'ah in preparing
any product or in conducting any business, it would quickly
lose the confidence of the majority of its investors and
clients.
Second dimension relates to overseeing the operations
whether or not they strictly adhere to Islamic law as the
Shari'ah scholars advised. The third dimension relates to
the adherence to Islamic code of morals and ethics. There is
a specific system of ethics and morals given by Islam for
running a business or a commercial institution. Shari'ah
scholars will identify the practices of Islamic banks, which
are ethically and morally unsound. In this role, Shari'ah
scholars help not only minimizing the transaction costs,
possibility of moral hazards and making adverse selection
but also will help in identifying the situations leading to
bad governance.
There are two points that may be kept in view about the role
of Shari'ah scholars and Shari'ah boards of individual
banks.
1. The Shari'ah scholars are hired by Islamic banks to
help them develop products that are not only Shari'ah
compliant but also make the Islamic banks compete with
conventional banks. They, thus, play the role of
financial engineers for which they are not properly
qualified. They are qualified to supervise, monitor and
help regulatory bodies to keep Islamic bank on the
track it has adopted for its operations which is to
conduct their business according to Islamic law. They
are on pay roll of Islamic banks and hence issue of
conflict of interest may exist. They are often
criticized that being on pay role of Islamic banks they
may be unable to play an objective role in ensuring the
adherence to Shari'ah principles and code of ethics in
the bank employing them7.
2. Diversity of opinion on the application of Shari'ah
gives Islamic banks to choose scholars of their own
choice that may help them in preserving the form of
their products that can earn more profits to them in
the name of Shari'ah rather than preserving the spirit
and substance of Islamic law which is the concern of
the clients of the banks. Benefitting from Shari'ah
scholars’ ability to exploit diversity of opinion in
Islamic juristic literature for increasing profits of
Islamic banks may prove to be counter productive, if
their clientele becomes dissatisfied with the
operations of Islamic banks. This may have serious
7 They place excessive emphasis on contract forms rather than thesubstance, thus sacrificing economy and efficiency to preservation of form. (Mahmoud A el- Gamal, Islamic Finance: Law, Economics and Practic, Cambridge University Press, Cambridge, New York, 2006
repercussions on the long run stability of Islamic
banks. An organization known as Auditing and Accounting
Organization of Islamic Financial Institutions (AAOIFI)
based in Bahrain is carrying out the functions in the
dimensions mentioned above. Another body known as
Islamic Financial Services Board (IFSB) consisting of
the regulatory authorities where Islamic banking exists
is working on developing standards for various
dimensions of Islamic banking operations, corporate
governance, market discipline, risk management being
some of the areas where IFSB has completed the work on
setting standards. However, neither the accounting and
auditing standards set by AAOIFI nor the operational
standards set by IFSB are binding on Islamic banks. If
a body can be developed in Europe to set standards on
Shari'ah application and operational modalities of
Islamic banks and to certify the adherence to these
standards, much of the burden of regulatory authorities
with respect to supervising Islamic banks may be
reduced. The help from the Jeddah based Islamic
Development Bank that played a catalytic role in the
establishment of AAOIFI and IFSB can be solicited to
establish such a Shari'ah regulatory body.
Institutional Infrastructure
As mentioned earlier, most Islamic banks have operated inenvironment, which are conducive to protection and
promotion of conventional interest based banks. Islamic banks cannot benefit from this. The infrastructural institutions to give support to Islamic banking operations and products are non-existent. For example, interbank market is nonexistent for Islamic banks. Shari'ah compatible money market though is developing butis still extremely in formative stage. There are not enough instruments to meet the contemporary financing needs of Muslims to be met from money market. Shari'ah compatible government securities are not available even in Muslim countries. There is limited availability of andaccess to lender-of-last-resort facilities of central banks. Lack of institutional infrastructure to give support to Islamic banks, however puts them in disadvantaged position while managing risk and achieving good governance in competition with the conventional banks whohave strong infrastructure to facilitate their efforts inthese two directions. Development of such infrastructure for Islamic banking institutions, however, is a matter oftime and the market share that Islamic banks carry in thefinancial market of a country. If regulatory bodies in Europe are convinced of the usefulness of the concept of Islamic banking, then the Islamic banks need to be given opportunity to exist and grow and steps need to be taken for infrastructural institutions to emerge for the support of Islamic financial institutions. The infrastructural institutions will emerge in a disciplinedmarket like that of European union more easily to lead and force the Islamic banks to adopt best practices.
Significance of Prudential Regulations
The need and significance of prudential regulations in the
context of allowing Islamic banks in a country or region
like European Union is more pronounced on two accounts.
Firstly, all aspects of Islamic banking practice cannot be
legislated as large part of it depends on good perception of
and commitment to religious spirit of the concept. This can
be assured more by prudential rules than by the legislative
procedures. If Islamic banks deviate from the religious
spirit of the concept of Islamic finance they will lose the
roots in their clientele and hence will lose stability.
Secondly, the corporate governance issue is an issue that
can best be handled by adherence to relevant ethical and
moral norms. Islamic system of life has a strong system of
business ethics specially referring to good governance.
Need for Research
There is no proper educational, research and training
facility preparing concerned officials to develop
methodology and systems to monitor, supervise, and regulate
Islamic financial market. The conventional market has
developed instruments and institutions for risk management
that are not Shari'ah compatible and hence not so relevant
for Islamic finance industry. Islamic finance industry is
not yet mature enough to develop its own methods of risk
management and it does not have the means (because of its
relative size vis-à-vis interest based institutions) to
develop methodology and institutional setup that will help
the industry to have its own mechanism of taking risk and
managing it. Conventional finance industry is better
equipped to manage risk using the institutional arrangements
that they developed.
The entry of Islamic banks in European Union requires
regulatory authorities to research and understand the need
of the Islamic banking industry. The academia and the
research institutions dealing with financial and monetary
system are required to attend to the needs of the Islamic
banking industry in Europe and hence guide regulatory bodies
how and in what directions to regulate the industry.
The Bank of International Settlements has noted the need for
innovations in Islamic banking activities in three
directions: liquidity enhancement, risk transfer and revenue
generation. Islamic banks have to focus on revenue
generation, as it had to compete with conventional finance
and show comparable returns. The need to enhance liquidity,
and hence to move towards greater securitization of assets,
is already recognized as evidenced by the developments in
Malaysia.
An important area for research is integrating Zakah
(obligatory charity) and Waqf (charitable endowments) in the
operations of Islamic banking institutions. At present only
an insignificant fraction of the Zakah payments passes
through Islamic financial institutions. Making Islamic
financial institutions a trustworthy medium to access the
poor and deprived sections of the population meet their
needs from the contributions to Zakah Fund maintained by
Islamic banks will reflect the Islamic financial institution
to be an institution of poor as well. This feature will
attract the, population that pays Zakah, to shift to Islamic
banking institutions as these institutions can help them
discharge their Zakah and similar obligations in a better
way. Islamic financial institutions can also explore the
possibility to include in their activities development of
Awqaf properties and hence contributing to social
development. Securitizing Awqaf properties to mobilize
resources for the development of Awqaf properties and
helping them perform their social development programs is
one example of enhancing the image of Islamic financial
institutions.
All innovations need a base in research and development,
which in turn draw on fundamental research in universities
and laboratories. Islamic finance became a subject of
research in universities in 1980s. The subject is discussed
every year at high profile conferences in Bahrain, Harvard,
and other places. Yet the resources devoted and the
facilities available hardly match the challenges facing the
industry.
Conclusion
Islamic banks need European passport on their own merit.
They are needed tto meet the banking needs of the Muslim
communities and they are also needed for introducing
diversity in the financial system in European Union. The
Islamic institutions will certainly be able to make positive
contribution to the financial system particularly in the
context of the international movement of ethical banking.
There are institutions in Europe that are trying to practise
some sort of “without interest” or zero interest financing.
Islamic banking may provide them a working model. There is
no significant regulatory challenge involved in allowing
Islamic banks to practice in Europe. There are, however, two
areas that require attention of policy makers if they grant
Islamic banks entry into Europe.
1) Facilitating the development of infrastructural
institutions
2) Training the officials of regulating bodies to
understand the Shari'ah background of Islamic banks in
relation to the banking laws in Europe
Institutional Development
Following institutional developments need to be encouraged:
Firstly institutions are required to give access to Islamic
banks to a special inter-bank market that may enable to
acquire liquidity or deploy access liquidity in Shari'ah
compatible way.
Secondly Shari'ah compatible methods need to be developed to
provide effective link with the national central banks to
provide not only support the regular support that is
provided to conventional banks but also to develop external
control of the Islamic banks.
Thirdly, an independent body (on lines of Association of
Investment Management Research-AIMR) consisting of Shari'ah
scholars and finance experts to develop uniform procedures
of internal control and provide training in Shari'ah
diversity in Fiqh opinions and Islamic system of business
ethics. This body will also provide certification adherence
to Shari'ah standards and Islamic ethics, will monitor the
operations of Islamic banks and publish report on state of
adherence to Islamic law and ethics.
Need for Training of officials in regulatory bodies
This is the fundamental conclusion of the paper. If any
European country wants to consider granting license to
Islamic banking, the apprehensions about regulatory
challenge will be substantially alleviated if officials of
regulatory bodies get themselves trained in the Shari'ah and
Fiqh rules underlying the theory of Islamic banking. There
is no shortage of reliable institutions to provide such
training. Islamic Research and Training Institute (IRTI) of