GUEST COLUMN -
By Muhammed Tariq -
The Royal Decree issued by His Majesty Sultan Qaboos authorising use of Shari’a compliant means of finance has provided a unique opportunity to the financial services sector and people of Oman at large. Islamic Finance is practiced in many jurisdictions and a closer look at country experiences reveals that countries with a robust Islamic ecosystem (an appropriate framework to provide a level playing field to Islamic finance from a legal, regulatory, prudential supervision, accounting and tax perspective) have been more successful in this space. While Oman is new to Islamic finance, it can benefit from experiences of other jurisdictions.
Different countries use different methods and approaches to identify monitor, quantify and mitigate banking risks. These approaches, however, have one important theme in common; i.e. a risk based, formal and systematic supervision.
Although there are many risks which are common to Islamic and conventional banks, the embodied features of risk and profit-and-loss sharing in Islamic banking create a unique set of risks associated only with Islamic banks. This necessitates a regulatory framework that is able to respond to such risks.
A practical example
In 2004 when Islamic Bank of Britain was being established, one of the main issues that arose was relating to the definition of “deposit”. In UK, a deposit is defined as a “sum of money paid on terms under which it will be repaid either on demand or in circumstance agreed by parties”. The capital protection embedded in the legal definition and ensured through various regulatory monitoring tools including deposit insurance scheme, is in direct contrast with “Mudaraba” deposits which carry a theoretical risk of capital loss.
A regulatory regime targeted to protect a capital guaranteed deposit is clearly incapable of dealing with a deposit that carries an investment level risk.
Risk of Shari’a compliance
An Islamic bank’s success resides in its claim of being Shari’a compliant. It is acknowledged that there is diversity of opinion on what constitutes Shari’a compliance. A regulator needs to see the basis on which the Islamic bank claims to be Shari’a compliant. In most jurisdictions, regulators do not look at this aspect, mainly due to religious sensitivity and stature of the scholars providing guidance to banks. However, of-late certain initiatives have been taken in different jurisdictions to regulate and govern the activities of Scholars to ensure that appropriate safeguards are in place with regard to conflict of interest, commercial expediency and market pressure to innovate. In some jurisdictions, the Central banks have created their own panel of Shari’a scholars to ensure consistency of Shari’a interpretation within the system.
In the absence of robust Shari’a compliance process, there is significant reputational risk converging into withdrawal risk whereby depositors may decide to move to other banks and jurisdictions. Nevertheless, regulators have to provide an environment that creates a balance between innovation and credibility.
A case for disclosure and transparency
The risks and rewards of products offered by Islamic banks are significantly different and require much more transparency when these are being offered to customers. Most customers are ignorant of the risks features emanating from product structures, and complain of improper sale when they incur losses.
The concept of treating the customers fairly and providing them sufficient disclosure fits naturally with the principles of Shari’a, however, regulators need to ensure commercial expediency on the part of the banks does not result in un-informed decisions by the customers.
Monitoring Islamic bank’s assets
The composition of assets held by Islamic banks pose significant problems for regulators, on two counts a) liquidity risk b) concentration risk.
Islamic banks have struggled for a long time to develop Shari’a compliant substitutes for two instruments widely used to manage short term liquidity namely inter-bank deposits and government treasury bills / short term notes.
Shari’a does not permit sale of debt at profit and hence it is not possible for Islamic banks to liquidate their financing receivables to generate short term liquidity. Hence, short term commodity Murabaha and Tawarruq (reverse murabaha) are currently being used to manage this risk. However, both solutions have their Shari’a issues.
The regulator needs to take cognizance of this problem while determining minimum liquidity requirements because Islamic banks cannot be treated at par with conventional banks in this matter. A higher liquidity threshold, is expected to spark the debate about liquidity vs profitability.
In 2002, a Liquidity Management Centre was established in Bahrain which is owned by Islamic banks operating in the GCC and supported by Central Bank of Bahrain with a view to enable Islamic financial institutions to manage their liquidity mismatch through short and medium term liquid investments. A similar initiative has recently been taken by Islamic Financial Services Board (IFSB) in setting up of International Islamic Liquidity Management Corporation based in Malaysia.
Concentration risk arises from trade based financial instruments where the bank takes exposures to commodities and properties to generate profit. A market dislocation, as experienced very recently, tends to expose Islamic banks to significant risks and regulators need to think about a mechanism to manage this concentration risk.
This implies that, due to rules around distribution of profit arising from separate pools of assets, the bank may not be able to pay competitive rates of return as compared to conventional banks. This creates an incentive for depositors to seek withdrawal, creating a systemic risk. It is not uncommon that shareholders forgo their profit to prevent such withdrawals. The regulators need to consider whether a mechanism is in place to ensure that any act of shareholders or depositors does not create systemic risks resulting in financial instability.
Contracts and their enforceability
The legal system within which Islamic banks operates creates many regulatory challenges. While products structures may comply with Shari’a principles and rights and obligations are appropriately defined, it is the enforceability of these rights and obligations that may come under question.
From a regulators perspective, if an asset represented on the balance sheet of an Islamic banks is not backed by an enforceable right, it cannot be considered for solvency purposes. This issue was highlighted in a very famous case of Shamil Bank of Bahrain vs Beximco Pharmaceuticals Ltd in 2004, where a UK court did not allow the case to be heard under Shari’a law and cited the diversity of interpretation of Shari’a as one of the reasons. There are a number of initiatives under way to ensure standardisation of documentation across jurisdictions to achieve some level of regulatory comfort from these contracts.
The accounting challenge
The accounting for Islamic financial instruments has been a subject of long and heated debate. IFRS specialists insist on treating Islamic contracts on the basis of their commercial substance rather than legal form, while religious scholars have long disagreed with lack of acknowledgement of Shari’a compliant structures. The Accounting and Auditing Organisation for Islamic Financial Institution offers an alternate, however this lacks a wider recognition at this stage. The regulators in general have glued on to IFRS except in a few jurisdictions, where modified IFRS frameworks have been enforced.
Edward Kane’s concept of a “regulatory dialectic” may be most useful in the context of Islamic banking. This refers to a dynamic interaction between the regulated and the regulator, where there is continuous action and reaction by all parties in a kind of strategic game.
(The writer is a partner at KPMG Lower Gulf and Heads the Islamic Financial Services team. He can be contacted at: email@example.com)