Tariqullah Khan
Regulatory Approaches to
Islamic BankingWhy each approach is the
right approach?
Financial Engineering Approach
Policy Developme
nt Approach
Regulatory Approaches to
Islamic Banking
Bank NegaraSaudi Arabian Monetary Agency
❶ ❷H
ybri
d Ap
proa
ch
Saudi Arabia MalaysiaBahrain
Central Bank
❸
Financial Engineering ApproachThe❸
Principles
❶Bank
deposits shall always be treated as loans
In Shariah
loans cannot
earn income
Repayment of
principal is
guaranteed
Repayment of
principal is NOT
guaranteed
No profit sharing
investment deposits (PSIAs)
could be allowed
PRINCIP
LE
Financial Engineering Approach
❷ Shariah
supervision is a matter of clients’ satisfaction & not
a concern of regulators
Banks may
voluntarily have
Shariah Boards
but Central
Banks do not need to have Shariah Boards
PRINCIP
LE
Financial Engineering Approach
❸No income earning
deposits. Instead of PSIAs banks shall offer
Islamic mutual funds
Hence Islamic contracts like Istisna’, Ijarah and Murabahah will be written only on the financing side of the balance sheet
PRINCIP
LE
Financial Engineering Approach
Pros &
cons
Financial Engineering Approach
Pros: Systemic Safety
Banking instabilities are caused by the instability of deposits and pressure on bank capital
❶By not allowing PSIAs, Islamic
banking specific deposit instability
is ruled out
Pros: Systemic Safety
❷Islamic mutual funds as an alternative to PSIAs are more transparent and more risk spreading
As compared to PSIAs mutual funds will have lesser pressure on Bank capital
❸Pros: Systemic Safety
Islamic financial contracts will only be used on asset side and not on the funding side
As compared to funding side risks, asset side risks have lesser severe implications for banking stability
Pros: Wide applicability
Financial Engineering Approach is widely applicable worldwide as it Doesn’t recognize any special risks
of Islamic banking doesn’t treat enforcement of
Shariah supervision as a regulatory requirement;
Islamic banking can be introduced within the existing legal, tax and regulatory framework with some minor adjustments
Cons & Pitfalls
The unique funding side, asset side and systemic risks characteristics of Islamic banking are not recognizedShariah compliance is a non-enforceable
matter and hence the genuine benefits of Islamic banking will not be available;
Overtime the Islamic financial products may degenerate and converge into the conventional products;
Banks offering Islamic financial services will be bound to compete in a field designed and maintained for conventional banks
Cons: Preconditions for application
Neutrality of LawsTaxes &Regulation
In Saudi Arabia where the approach is applied there are no significant taxes to date; other countries have to ensure tax neutrality;
Issues of accounting treatment of Islamic financial contracts need resolution;
Issues of regulatory capital charges and risk weighting of contracts need resolution too
Policy Development ApproachThe
④ Principles
PRINCIPLE❶Regulators must recognize all the funding side, asset side and systemic characteristics and risks of Islamic banking and adapt the relevant international standards accordingly
Hence Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is tasked for adapting International Accounting Standards and Islamic Financial Services Board (IFSB) tasked for adapting standards of Basel Committee for Banking Supervision
Policy Development Approach
PRINCIPLE❷
Policy Development Approach
Deposits can be based on interest free loan contract (current accounts) as well as on profit and loss sharing contract (profit sharing investment accounts (PSIAs)
Allowing PSIAs makes the business model of an Islamic bank different from a conventional bank. It introduces important withdrawal risk due to fiduciary issues and due to rate of return considerations. Risk sharing by PSIA holders with shareholders introduces incentive issues and banking stability. IFSB standards deal with such issues.
PRINCIPLE❸
Policy Development Approach
Shariah non-compliance could cause systemic instability and hence Shariah compliance must be enforced by regulators
To enforce Shariah compliance by financial institutions regulatory authorities need to have their own central Shariah Supervisory Boards
PRINCIPLE❹Legal, tax, regulatory and supervisory authorities shall provide policy support and leveled playing field to Islamic financial services recognizing its special infrastructural needs
Policy Development Approach
Government through policy support to provide essential financial infrastructure to support Islamic financial services
Legal, tax, regulatory and supervisory infrastructure
Transparency infrastructure
Safety net infrastructure
Systemic liquidity infrastructure
Unique risks of Islamic banks RecognizedI. Fiduciary risk:
Withdrawal risk due to Shariah non-compliance
II. Displaced commercial risk: Withdrawal risk due to rate of return differential
III. Income impurity risk
I. Transformation of risks at different stages of contracts
II. Bundled nature of risks
III. Willful default
IV. Contract specific structural risks
I. Non-existence of Islamic banking specific financial
infrastructure – LLR, deposit
protection, systemic liquidity, access to financial markets
II. Conflict of contracts with different legal jurisdictions
Funding Side
Unique Risks
Asset Side
Unique Risks Unique Risks
Systemic Side
Policy Development Approach
Pros&
Cons
Policy Development Approach
Pros: Offers Genuine Policy Support
Recognizes the benefits of Islamic banking as a business model for the society and economy and provides policy support for its development and sustainability as such ❶
Pros: Recognizing uniqueness of Islamic banking
Recognizes the unique features and risks of Islamic banking on the funding side, asset side and systemic side which is a precondition to develop a competitive and sustainable Islamic banking system ❷
Pros: Adapting International Best Practice Standards
Supports the adaptation of international best practice standards of capital adequacy, risk management, governance, financial reporting, transparency, which is precondition for global credibility of Islamic banking ❸
Pros: Facilitates to build the required financial infrastructure
Supports the creation of enabling environment for Islamic banking such as: legal, regulatory and supervisory framework, deposit protection, lender of last resort facility, systemic liquidity and transparency infrastructure ❹
Pros: Supports financial inclusion
Recognizes the need to integrate Zakah, Awqaf and general philanthropy in the financial system to provide microfinance and enhance financial inclusion❺
Cons: Limitations on global application
The existence of the financial engineering approach in several countries shows that there are limitations in applying the policy development approach and that is actually so
It is actually the policy development approach
but the central regulatory authority NOT having its own Shariah
supervisory board
The Hybrid Approach
The approach exists in the GCC countries
Because, in regulation there should not be a
“one size fit for all” approacheach approach is a
right approach