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