Without Restriction or Loss of Profit

by Rifaat Ahmed Karim

Rifaat Ahmed
Abdel Karim
Secretary-General Islamic Financial Services Board

The recent global financial crisis has brought significant changes to the international financial landscape. Major regulatory reforms are now underway to bolster the resilience of the international financial system in order to prevent a re-occurrence of a crisis on such a scale. The crisis has also heightened the interest in Islamic finance as a form of financial intermediation that can promote financial stability.
The initial resilience demonstrated by the institutions offering Islamic financial services (IIFS) against the first wave of the financial shock provides some indication of this resilience of Shariah-compliant finance. This is due, in part, to the Shariah requirement of direct links between financial activities and the real sector, the prohibition of speculation and interest-based debt structures, as well as the promotion of high ethical standards in business conduct. In addition, Islamic finance makes no use of derivative instruments such as credit default swaps and does not permit the sale of debt. Moreover, the ‘originate-to-distribute’ model of debt securitisation has no place in Islamic finance. These ‘stability-protecting’ characteristics of Islamic finance offer an opportunity for countries in Europe venturing into Islamic financial services, such as Italy, to reap the benefits of not only enhancing wealth creation but more importantly, to achieve it within the context of greater financial stability. However, these benefits can be achieved only if the jurisdictions opening the door to Islamic financial services are willing to develop their financial system architecture so as to accommodate the specificities of Shariah-compliant finance. This applies, inter alia, to the regulatory and supervisory framework, the relevant parts of the legal framework, the liquidity framework (interbank market and lender of last resort facilities), the crisis management and resolution framework as well as the accounting, auditing and disclosure framework.
Today, I will share with you some of the challenges faced by the Islamic Financial Services Board (IFSB) in drafting and issuing standards and guidelines dealing with these specificities. On the regulatory front, the IFSB has issued a set of prudential and supervisory standards, which constitute the equivalent of Basel II in Islamic finance – covering capital adequacy (including capital adequacy standards for Sukuk securitisations and real estate investment, and prudential limits on the latter), risk management, corporate governance, and transparency and market discipline. In addition, the IFSB has issued standards on Shariah governance and the governance of Islamic investment funds. […]
One of the challenging aspects of Islamic financial services relates to the unique funding structure of IIFS. The on-balance-sheet funding structure of IIFS in almost all countries is composed mainly of current accounts and unrestricted profit-sharing and loss-bearing investment accounts (UPSIA), and in most IIFS these investment accounts constitute the major source of funding (although one may note an increasing use of Murabahah accounts payable as a form of term deposit). […]
In developing the IFSB capital adequacy framework, a different type of difficulty arose, namely how the credit and market risks arising from the assets financed by UPSIA are to be allocated between the IIFS’s own capital and that of the UPSIA. […]
To address this situation, the IFSB has introduced a method of calculating the capital adequacy ratio (CAR) of an IIFS in a manner that takes account of DCR. […]
Since from a strictly contractual point of view PSIA bear their own risk of loss, logically central banks would not be expected to have the same concern for protecting the capital of PSIA holders as they would for that of depositors. […]
However, given that in general, UPSIA are provided as a Shariah acceptable substitute for conventional interest-bearing deposits, a central bank may have a concern for systemic risk in connection with UPSIA comparable to that with conventional deposits. […]
The risk of being unable to pay competitive returns has been referred to by the IFSB as rate-of-return risk (an analogue of ‘interest rate risk in the banking book’ conventional banks), and may entail withdrawal risk which in turn may threaten the bank’s solvency and trigger systemic risk. […] Hence, a regulatory issue arises when supervisory authorities, in particular in Western markets such as Europe and North America, require IIFS to treat unrestricted PSIA as (in substance) capital certain. […]
One possible solution to this regulatory issue is to establish a separate legal entity for undertaking the fund management activities of the IIFS. This entity can be established as either a subsidiary of the Islamic retail bank or a fellow subsidiary of a holding company. […]
The development of Islamic financial services also creates challenges on the legal front. The IFSB has been organizing a series of annual Legal Seminars as part of the efforts to promote awareness on some of the legal complexities in the Islamic financial services industry. […]
The interface between existing civil law systems that govern banking and finance practices generally, and Shariah rules and principles that govern Islamic financial contracts specifically, raises numerous legal complexities that need to be addressed. Islamic finance transactions are typically governed by national (secular) commercial law (either statute or common law) and not Shariah law. This exposes the IIFS to legal risks. We have recently experienced some litigation cases in which the courts’ decisions were based on conventional banking laws and the reference to Shariah in the governing provision was not enforceable as it was not sufficiently explicit to be regarded as part of the contract[…]
A particular risk is that of a legal hiatus where there is a conflict between the Shariah rules applicable to the contract and the applicable secular law, and it is clear that the contracting parties expected the Shariah rules to be followed. […]
Challenges on the legal front also relate to the issue as to whether the existing legal systems, whether common law jurisdictions or codified systems, adequately address such matters as asset recovery and the arrangements for dealing with distressed assets, insolvency and liquidation of Islamic banks and insurance undertakings and other insolvency issues arising from Shariah-compliant financial operations, with particular reference to the rights of PSIA holders and Takaful policyholders. […]
The IIFS would also be exposed to a number of risks in jurisdictions with established insolvency rules that are not tailored to deal with insolvency issues in Islamic financial transactions. The specificities of Islamic finance must also be accounted for in the accounting, auditing and disclosure framework for the IIFS.
The IFSB standard on transparency and market discipline requires disclosures from a prudential perspective that would assist market forces to enhance the stability and soundness of the Islamic financial services industry. These disclosure principles are designed to enable market participants generally, and PSIA in particular, to assess key information on the IIFS which includes, inter alia, its capital structure, capital adequacy, investment accounts, including specific disclosures on unrestricted investment accounts and restricted investment accounts, risk management, the extent of risk-sharing and displaced commercial risk borne by shareholders, the practice of smoothing returns on PSIA as well as key aspects of general and Shariah governance arrangements. […]
In response to the global financial meltdown, the IFSB, together with the Islamic Development Bank (IDB) Group, has established a Task Force on Global Financial Stability and Islamic Finance. […]
In conclusion, first is the importance of incorporating the specificities of Islamic finance in all aspects of the financial architecture in order to reap the benefits offered by Islamic finance in terms of sustainable growth with financial stability. Second is the regulatory benefit of separating the commercial banking and fund management activities of IIFS in order to permit the banking activities, narrowly defined to exclude offering PSIA, to be regulated as banks with due regard for issues of systemic risk and financial stability as viewed by the supervisory authorities.
Third is the importance of having an appropriate framework within the constitutional setup to ensure the enforceability of Islamic financial contracts in the courts that would give due recognition to the Shariah rules and principles when these are explicitly set out in contracts and clearly reflect the intentions of the contracting parties, and allow the resolution in such cases of any conflicts between Shariah rules and principles and the secular law.