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Comparative Analysis of Islamic Banking Supervision and Regulation

DevelopmentMuhamed Zulkhibri

Islamic Development Bank

All findings, interpretations, and conclusions are solely of the authors’ opinion and do not necessarily represent the views of the Islamic Development Bank.

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Presentation outline

Inflation

Cost push inflation

Cost push inflation

Inflation

The Paper

Recent Development in Islamic Finance Industry

Review of Law and Legislation

Approach to Regulation and Supervision

Shari’ah Regulation and Governance

Conclusion

Recommendations

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The paper

Motivation:Rapid development but lack of coherent legal framework

Lack of uniformity in specific forms of Islamic principles

Difficult to generalize Islamic banking in practice

Objective:Review the legal and regulatory framework

Compare the legal and regulatory framework

Focus on 11 IDB member and 2 non-member countries

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Recent Developments

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Rapid development in Islamic financial industry

Source: Bank Negara Malaysia, IFSB-IDB-IRTI, various

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Total assets of the industry has exceeded US$800 billion

Table 2. Islamic finance by country* (Banking, takaful, fund & other assets, US$bn)of which Number

2009 Banks Takaful Inv.firms Others of firmsIran 314.9 310.92 3.67 0.31 --- 22S.Arabia 138.2 136.01 2.2 --- 0.03 25Malaysia 102.6 96.69 3.8 --- 2.15 39UAE 85.6 84.18 1.4 0.03 0.01 22Kuwait 69.1 56.32 0.14 12.63 --- 37Bahrain 44.9 42.71 0.42 1.73 --- 34Qatar 34.7 32.4 0.4 1.87 0.01 18Turkey 22.6 22.56 --- --- --- 4UK 19.0 18.95 --- --- --- 22Bangladesh 9.4 9.17 0.15 0.05 --- 16Sudan 9.3 9.06 0.2 --- --- ---Egypt 7.2 7.21 0.01 --- --- 3Indonesia 7.2 6.84 0.38 --- --- 26Pakistan 6.2 6.2 --- --- --- 23Syria 5.5 5.53 --- --- --- 3Jordan 5.0 4.8 0.08 0.16 --- 10Brunei 3.3 3.31 --- --- --- 6Other countries 10.3 9.46 0.49 0.06 0.3 38Total 895.0 862.32 13.34 16.84 2.5 348*Includes only those firms submitting data to the Banker's surveySource: The Banker, 2010

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How do Islamic financial infrastructure keep-up with the development pace?

6/10/2012 Source: Khan , T (2009) 8

However, there are gaps remained in Islamic financial architecture developmentAreas of Standards Key Agency(s) in the International

Financial ArchitectureCorresponding Agency(s)

in Islamic Finance1. Accounting International Accounting Standards Board

(IASB), International Federation of Accountants (IFAC), Committee on Banking Supervision (BCBS)

AAOIFI

2. Anti-Money Laundering / Combating the Financing of Terrorism

Financial Action Task Force (FATF)

Auditing International Federation of Accountants (IFAC)

AAOIFI

3. Banking Committee IFSB4. Corporate Governance OECD, Basel Committee, World Bank AAOIFI and IFSB

5. Data Dissemination IMF6. Fiscal Transparency IMF

7. Insolvency and Creditor Rights Systems

World Bank, United Nations Commission on International Trade Law (UNCITRAL), International Bar Association (IBA)

Not yet addressed but especially critical for Islamic financing as it is based on risk sharing

8. Insurance Regulation International Association of Insurance Supervisors (IAIS)

Not yet addressed but within the mandate of IFSB

9. Monetary & Financial Transparency Policies

IMF

10. Payments Systems Committee on Payment and Settlements Systems (CPSS)

11. Securities Market Regulation International Organization of Securities Commissions (IOSCO)

Not yet addressed but within the mandate of IFSB

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Product development - slow pace of innovation

Great need to continue to innovate for further growth

Shortage of product in the area of risk and liquidity management

Sufficient (short- and medium-term maturities), but not for maturities at the extreme

Lack of national/international supporting commercial framework

Application of derivatives, hedging and securitization remained controversial

Figure 3. Sukuk Global Issuance (US$bil)

Sources: Zawya Sukuk Monitor, Islamic Financial Information Service, 2011

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Lack of comprehensive development

Cro

ss B

orde

r an

d G

loba

l D

evel

opm

ent

Nat

iona

l Dev

elop

men

t

Institutional Development

Legal, Regulation and

Shar’iah

Knowledge, Education and

Expert

Product and Market

Supporting key initiatives of legal and regulatory framework are key to robust development

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A Review of Law and Legislation

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Islamic banking laws and structure varies across jurisdictions

Countries whose constitution requires the banking system to be fully Islamic:

Iran, Sudan, Pakistan (1985-2001)

Countries having specific enabling Islamic banking legislation:

Malaysia, Brunei, Indonesia

Countries that has no specific enabling legislation but have specific regulation and/or provisions under general financial market regulation for Islamic finance:

UAE, Saudi Arabia, Kuwait, Pakistan (since 2001), Jordan, Bahrain, Singapore, UK.

Islamic Window to Islamic Subsidiary

Badr, Emirates Islamic Bank, First Gulf Bank, RHB Islamic Bank, ABN AMRO, HSBC Amanah, AFFIN Islamic, Arab Banking Corporation

Conventional Banks to Islamic Banks

Bank Aljazira, Sharjah Islamic Bank, Dubai Bank, Kuwait International Bank, Bank Muamalat, Meezan Bank, Kauthar Bank

New Islamic Banks NOOR Islamic Bank, Albaraka Banking Group, Alinma Bank, Kuwait Finance House, The Bank of Khyber, Asian Finance Bank

ISLAMIC BANKING STRUCTURE

Pure Banking System

Dual Banking System

Parallel Banking System

Table 5. Overview of Type of Islamic Banking System and Banks

ISLAMIC BANKING SYSTEM

Specific Law

Using law as

conventional

banks

Law & Legislation

Specific Rules

Using rules as

conventional

banks

Prudential Framework

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Variation in law and regulationsMalaysia Iran Bahrain S. Arabia Pakistan Turkey Indonesia Sudan Kuwait UAE Jordan S’pore U.Kingdom

Type of Islamic Financial System

Dual Pure Parallel Parallel Pure Parallel Dual Pure Parallel Parallel Parallel Parallel Parallel

Specific enabling legislation for banking

Yes No No No No No No Yes No No No No No

Specific provisions for Islamic banking under general legislation

Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes No No

Specific regulation for Islamic banking

Yes Yes Yes No Yes No Yes Yes Yes Yes Yes Yes Yes

Specific provision for Islamic banking under general regulation

Yes No Yes No No No Yes Yes No No Yes No No

Specific enabling legislation for capital market

No No No No No No No No No No No No No

Specific provisions for Islamic capital market under general legislation

Yes No No No No No Yes Yes No No Yes No No

Specific regulation for Islamic capital market

Yes No Yes No No No Yes Yes No No Yes No No

Specific provision for Islamic capital market under general regulation

Yes No No No Yes No Yes Yes No No Yes No No

General legislation and regulation applicability and enforceability

Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes

Shari’ah Authority in Central Bank or Financial Institutions

SAC/SC CoG NSB/SSC No SB/SA No SSB HSSB SSB HSA/SSA SB SA SA

Applicable Shari’ah Standards (Final Authority)

SAC CoG NSB No SB No NSB SB SSB NSB SB No No

Applicable Accounting Standards

National

AAOIFI#

National AAOIFI

AAOIFI IFRSIFRS

AAOIFI# National

National

AAOIFI# AAOIFI IFRS IFRS AAOIFI IFRS National

Tax Rules Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes

Regulatory and Supervision Authority

Bank Negara

Malaysia

Central Bank of

Iran

Bahrain Monetary Authority

S. Arabia Monetary Authority

State Bank of Pakistan

Central Bank of Turkey

Bank Indonesia

Bank of Sudan

Central Bank of Kuwait

DFIC, Central Bank of

UAE

Central Bank of Jordan

Monetary Authority Singapore

Financial Services Authority

Note: 1/ See Appendix 1 for details of the legislations and regulatory frameworks. SAC is stand for Shari’ah Advisory Council; SC is stand for Shari’ah Committee; HSA is standfor Higher Shariah Authority; SB is stand for Shari’ah Board; SA is stand for Shari’ah Advisor; SSC is stand for Shari’ah Supervisory Committee; SSA is stand for Supervision Shari’ah Authority; HSSB is stand for Higher Shari’ah Supervisory Board; CoG is stand for Council of Guardian; NA is stand for Not Applicable; AAOIFI stands for Accounting and Auditing Organisation for Islamic Financial Institutions; IFRS stands for International Financial Reporting Standards; # indicates authority has issued guidelines.

Rules/RegulationsIDB Member Countries Non-Member Countries

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Implications: Need to have a clear and specific legislative mandate

• Legal framework contain provisions relating to licensing and permissiblemodes of financing

• Clear provision for enterprise to call themselves Islamic banks, collect depositsand carry-out banking practices on the basis of Islamic principles

• Clear legislative power and enforceability to address compliance of Islamicprinciples i.e Civil court vs. Shari’ah court

• Resolve conflict between Islamic laws and common/civil laws

• A clear and specific point of reference with respect to different fatwas i.eShari’ah board

• Integrating ruling within the conventional banking framework andaccommodating Shari’ah reference in conventional legal documents

• Need to develop uniform prudential and best practices standards that aretailored to the specific characteristics

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Approach to Regulation and Supervision

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Islamic bank - different from conventional?

Significant deviation of the structure of assets

Choice and application of accounting policies

Practice and principles -the status of investment accounts (PSIA)

Governance rights granted to investment account holders.

Table 8. Two Windows Balance Sheet of Islamic Financial Institutions

Liabilities Assets

The mix of contracts on the liability side

A wider variety of assets andfinancing mixes. Products can beeither PLS based, or based on mark-up pricing

Demand deposit: Guaranteed but no return at all, the purpose is amanah (safekeeping)

Equity based PLS of Mudarabah and Musharakah , holding of equityof companies

Investment deposit (PSI account): Not guaranteed, no fixed return

Sales based assets throughMurabahah , Ijarah , Salam andIstis'na

Quasi-equity nature of investment deposit (account) due to PLS system

Murabahah trade financing

Shareholders’ equity Fee-based services

Reserves: Profit equalization reserves, investment risk reserves

Presence of risk sharing andabsence of interest

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Stylised facts about Islamic banking regulationSingle regulatory framework applies to both conventional and Islamic banks

Some follow the national and international accounting standards: IAS and AAOIFI

Some follow IFSB for prudential, regulatory and disclosure standards

Central banks are their main regulators and supervisors

Safety net arrangement implementing Islamic deposit insurance

Lack of cross border cooperation between different authorities

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Emergence of Islamic Deposit InsuranceTable 9. Islamic Deposit Insurance in the IDB Member Countries

Malaysia Iran Bahrain S. Arabia Pakistan Turkey Indonesia Sudan Kuwait UAE Jordan S’pore U.Kingdom

Year of establishment

2005 not available 1993 not available Implementing 2005 2005 1996 2008 2010 2000 2006 2001

Governance Structure

government-owned deposit

insurer with specific

legislation

implicit scheme

government-owned entity

without specific legislation

implicit scheme

not available

government-owned entity

without specific

legislation

government-owned entity

without specific

legislation

government-owned deposit

insurer with specific

legislation

central bank with specific

legislation

implicit scheme

government-owned entity with specific legislation

government-owned entity

without specific

legislation

privately-owned entity with specific legislation

Mandatory membership

not available not available not available not available not available × × ×

Separation of Islamic premiums from non-Islamic premiums

not available not available not available not available × × not available not available not available not available × ×

Management of fund according to Shariah principles

not available not available not available not available × × not available not available not available × ×

Similar coverage limit for Islamic and conventional deposits

not available × not available not available not available not available not available × ×

Similar premium rates for Islamic and conventional deposits

not available not available not available not available not available not available

Coverage limitMYR 60,000

(USD 17,150)not available

75% up to a maximum of BHD 15,000

(USD 39,800)

not available not availableTRY 50,000

(USD 30,000)

IDR 100 million (USD

10,000)

SDG 4,000 (USD 2,000)

for investment

and SDG 3,000 (USD 1,500) for current

100% not availableJOD 50,000

(USD 14,085)SGD 20,000

(USD 14,000)GBP 35000

(USD 56,000)

Source: Central bank websites, International Association of Deposit Insurers

FeaturesIDB Member Countries Non-Member Countries

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National regulatory framework and international best practices

National Regulation

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Shari’ah Regulation and Governance

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Stylised facts on Shari’ah regulation and governance

Exposed to “Shari’ah arbitrage” - seek to find the opinion that suits their objectives

Different institutions have different governance models to measure and monitor compliance

AAOIFI established a standard requiring Islamic financial services to have its own Shari’ah supervisory board

Shari’ah boards exist in all individual Islamic banks with some Shari’ah scholars sit on the SSBs of more than one financial institution

The backbone of Islamic finance and need for a standardized Shari’ah regulation and supervisory framework

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Regulating Shari’ah Governance

Independent central Shari’ah council commands public confidence and promote harmonisation and uniformity

of Shari’ah interpretations

Table 10. Regulation and Governance of Shari'ah Advisor/Board

CountryReference

TermComposition

Decision Making

Appointment/Dismissal

Fit/Proper Criteria

Higher Authority

Restriction on Sholars

Islamic Rating

External Shari'ah Audit

Malaysia × × ×Iran × × × ×Bahrain × × × × × ×S. Arabia × × × ×Pakistan × × Turkey × × × ×Indonesia × × × × ×Sudan × × × ×Kuwait × × × × ×UAE × × × × ×Jordan × × × × ×Singapore × × × × × × × × ×U.Kingdom × × × × × × × × ×Source: Adapted from Wafik Grais and Matteo Pellegrini (2006), official country websites and central bank annual reports

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Need for a structured Shari’ah compliance process

1) Inception &

Conceptualization

of Islamic Instrument

2) Structuring the Product according to

Shari’ah

3) Legal Documentation

4) Execution and

Implementation of Islamic Instrument

5) Audit and Review

6) Restructuring (if needed)

7) Recovery mechanisms & dispute resolution

Source: Adawiyah (2007)

External and internal audit

Drafting the compliance

manual

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Lessons Learned

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Lessons LearnedRapid development, small global share, diverse stages of maturity

Over-dependence on trade and commodity financing instruments

Reluctant to indulge in PLS instruments (PLS has been marginalised)

Gap between ideal model and practical implementation and gap between applicable law and Shari’ah principles

Policies and tools for regulation are based on conventional business models

Absence of standardisation of ununified Islamic governance model

Lack of Shari’ah consensus hampering innovation and creatingloopholes

Standardisation will not be achieved in near and absolute term

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Recommendations

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What is there for us?

Designing appropriate legal framework for Islamic financial institutions – conform to Shari’ah principles

Implementing the AAOFI, IFSB and Basel III legal and regulatory standards

Centralizing Shari’ah council/committee, supervisor and verdicts

Setting-up Shari’ah compliance audit framework and audit programme

Focus on cluster or regional harmonisation and graduallymoving towards greater harmonisation

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Further Questions

Future sustainability – New business model, bank bail-out?

Shari’ah-compliant or Shari’ah-based

Additional values – social/ethical/moral issues

Different economic outcome?

Discipline and governance

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Thank You

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Applicable law related to Islamic Finance Table 6. Applicable Laws and Legislations for Islamic Banking

Country

Malaysia Islamic Banking Act, 1983

Central Bank of Malaysia Act 2009Banking and Financial Institution, 1989 (S.32; S.124)Government Funding Act, 1983Development Financial Act, 2002 (S. 129)Takaful Act 1984

Iran Usury-Free Banking Operations Law, 1983Bahrain Central Bank of Bahrain, 2006

Central Bank of Bahrain, Rulebook, Manama, 2010: Section CA-3Decree No.64, 2006

S. Arabia Saudi Arabia Banking Law, 1966: Article 10.1Saudi Arabian Banking Law, 1966

Pakistan Banking and Financial Services Ordinance, 1984Banking Control Department Circular No. 13, 1984Modaraba Companies and Modarabas Ordinance, 1980Modaraba Companies and Modaraba Rules, 1981Banking and Financial Services Ordinance, 1984Banking Tribunals Ordinance, 1984Banking Companies Ordinance 1962 (S.32 (1), 2002)Presidential order to the local Council of Islamic Ideology, 1977

Turkey Decree No. 18112, dated 22/7/1983Decree No. 70 for the establishment of banksDecree No. 83/7506 dated 16/12/1983 for the establishment of Special Finance Houses in Turkey

Indonesia Banking Act No.21, 2008

Banking Act No. 23, 1999 (amended Act 3, 2004)

Banking Act No. 72, 1992Banking Act No. 7, 1992 (amended Act 10, 1998)

Laws and Legislations Country

Sudan Comprehensive Peace Agreement (CPA)

Banking Business Regulation Act, 1991Central Bank of Sudan Act 2002 (amended in 2006)

Kuwait Central Bank of Kuwait Law No. 32 1968: Section 10Central Bank of Kuwait Law No. 33 1968 (amended 2003)Central Bank of Kuwait Law, Article 86Central Bank of Kuwait Law, Article 93

UAE Dubai Islamic Finance Centre Islamic Finance Law Federal Law No.5, 1985Federal Law No.6, 1985Federal Law No. 10, 1980Dubai Law No. 9, 2004

Jordan Banking Law No. 28, 2000Singapore MAS Notice 640

MAS Notice 613MAS Notice 626MAS Notice 637MAS Notice 612Banking Act (S. 29)Banking Act (S.33)

U.Kingdom Financial Services and Markets Act 1999

Finance Acts 2007

Finance Acts 2006

Finance Acts 2005

Finance Acts 2003Source: Official country websites and central bank annual reports

Laws and Legislations