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Regulatory approaches to Islamic banking

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Financial Engineering Approach, Policy Development Approach and Hybrid Approach to Regulating Islamic Banking

Published in: Economy & Finance, Business
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Regulatory approaches to Islamic banking

  1. 1. Tariqullah Khan Regulatory Approaches to Islamic Banking Why each approach is the right approach?
  2. 2. Financial Engineering Approach Policy Development Approach Regulatory Approaches to Islamic Banking Bank NegaraSaudi Arabian Monetary Agency ❶ ❷ Hybrid Approach Saudi Arabia MalaysiaBahrain Central Bank ❸
  3. 3. Financial Engineering Approach The ❸ Principles Governments to treat Islamic financial services as a matter of financial engineering and product development by service providers
  4. 4. ❶ Bank deposits shall always be treated as loans No profit sharing investment deposits (PSIAs) could be allowed Financial Engineering
  5. 5. 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 Financial Engineering
  6. 6. ❸ No 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 Financial Engineering
  7. 7. Pros & cons Financial Engineering Approach
  8. 8. Pros: Systemic Safety Banking instabilities are caused by the instability of deposits and pressure on bank capital ❶ By not allowing PSIAs, Islamic banking specific deposit instability is ruled out
  9. 9. Pros: Systemic Safety ❷ Islamic 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
  10. 10. ❸ Pros: 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
  11. 11. 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
  12. 12. Cons & Pitfalls The unique funding side, asset side and systemic risks characteristics of Islamic banking are not recognized Shariah 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
  13. 13. Cons: Preconditions for application Neutrality of Laws Taxes & 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
  14. 14. Policy Development Approach The ④ Principles Governments to provide policy support & levelled playing field to develop Islamic financial services in an orderly and resilient manner
  15. 15. PRINCIPLE ❶ Regulators 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
  16. 16. PRINCIPLE❷ Policy Development 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.
  17. 17. PRINCIPLE❸ Policy Development 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
  18. 18. PRINCIPLE❹ Legal, tax, regulatory and supervisory authorities shall provide policy support and leveled playing field to Islamic financial services recognizing its special infrastructural needs Policy Development 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
  19. 19. Unique risks of Islamic banks Recognized I. 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
  20. 20. Pros & Cons Policy Development Approach
  21. 21. 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
  22. 22. 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
  23. 23. 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
  24. 24. 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
  25. 25. Pros: Supports financial inclusion Recognizes the need to integrate Zakah, Awqaf and general philanthropy in the financial system to provide microfinance and enhance financial inclusion ❺
  26. 26. 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
  27. 27. 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 Qatar & Bahrain
  28. 28. Hybrid Approach: Core principles Current Account Owners Equity Equity of Profit Sharing Investment Accounts (PSIAs) PSIAs allowed but treated as deposits with full coverage of protection by shareholder’s equity for calculation of capital adequacy PSIAs are not perceived to be a source of systemic stability, hence Central Shariah Board not needed All Islamic banks in the jurisdiction should have a shared Shariah Board.
  29. 29. Hybrid Approach: Pros & Cons Policy Development Approach Hybrid Approach Financial Engineering Approach ConsPros Pros & Cons
  30. 30. Because, in regulation there should not be a “one size fit for all” approach each approach is a right approach

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