ISLAMIC FINANCE: ISLAMIC BANKING BY THE BOOK
By Anita Hawser
The growing popularity of Islamic financing and an
intensified focus on risk management in the global banking
industry are prompting greater awareness of the need for a
unified-and appropriate-regulatory regime.
When the Basel Committee on Banking Supervision first drafted
the Basel Capital Accord in 1988, it was focused on creating a
framework for measuring credit risk and setting minimum capital
standards to safeguard banks against a loss or default. The
committee's overarching ambition was to encourage national banking
regulators globally to converge toward "common approaches and
standards." With later revisions of the accord, the Basel Committee
may have anticipated the risk issues faced by large global banks.
But one thing it did not foresee was the increasing globalization
of Islamic finance, which in 1988 was largely confined to a handful
of Middle Eastern countries. Although the Islamic finance industry
still represents only a small percentage of total banking assets,
it is growing at more than 15% per year, and Islamic banks have set
up shop in such major financial centers as London, Malaysia and
Singapore.
Ramakrishnan: Typically, Islamic banks are
well-capitalized
Despite the emergence of Islamic finance onto the global stage,
the Basel II Capital Accord and its successor, Basel III, make no
distinction between conventional banks and Islamic financial
institutions. This is perhaps unsurprising, given that historically
the Basel committee's members largely comprised central bank
governors and prudential supervisors from non-Muslim countries. In
a speech he gave in 2008 in Jordan, the former chairman of the UK's
Financial Services Authority, Howard Davies, pointed to the need
for greater collaboration between the Basel committee and Islamic
standard-setting bodies such as the Islamic Financial Services
Board (
IFSB
), based in Kuala Lumpur. "It is hard to imagine, given the scale
of Islamic finance today, that another capital accord can be
developed without taking account of the particular needs of Islamic
banks, as the Basel II accord was," Davies stated.
Suresh Sankaran, risk consultant and country head EMEA, Kamakura
Corporation, maintains that the standardized approach under Basel
II is punitive for Islamic banks. He cites the example of
collateralized debt such as mortgages. Under Basel II, collateral
such as a house can be used to offset the exposure. However, with
reference to an Islamic loan, or a murabaha transaction, which is
based on a partnership approach with the risk shared, Sankaran says
the collateral cannot be applied against the exposure.
Despite the shortcomings of the Basel standards when applied to
Islamic banks, the IFSB has worked hard to develop standards or
guidelines that address risk issues specific to Islamic financing,
as well as adapting elements from the Basel standards to make them
more relevant to Islamic banks. In December the IFSB published a
risk management and capital adequacy guidance note for commodity
murabaha transactions. This guidance complements previous work by
the IFSB in those areas.
The IFSB's Capital Adequacy Standard, issued in 2005, as well as
the Basel Committee's Basel II framework form the basis of the
Capital Adequacy Framework for Islamic banks (Cafib), issued in
2007. According to Malaysia's central bank, Bank Negara Malaysia
(BNM), the Cafib addresses credit, market, operational and
liquidity risks inherent to Islamic banks, as well as risks
peculiar to Islamic banking transactions, such as shariah
non-compliance risk, rate-of-return risk, displaced commercial
risk, and inventory and equity investment risks. Yet, as
Subramanian Ramakrishnan, group vice president and general manager
of software provider Oracle's financial services analytical
applications business, points out, "The question remains as to
whether individual regulators grant exemptions to Islamic financial
institutions within their jurisdiction to follow the IFSB
standards, or treat them on a par with other institutions following
the Basel II standard."
BNM says Islamic institutions in Malaysia have adopted the Basel II
standards, with most adhering to the standardized approach to risk
measurement. But there is some debate over how the new set of
international capital adequacy standards in the Basel III proposals
would be adapted to fit the market dynamics of those countries
where Islamic finance is prevalent. Basel III is largely a response
to the systemic failures that occurred in the conventional banking
system, says Amjad Hussain, Islamic finance partner at law firm
Eversheds, and as such it is trying to resolve a problem that
Islamic financing should never find itself in. "Under true shariah
financing, banks have to carefully vet borrowers before embarking
on a business relationship," he explains. "Neither Basel III nor
its predecessor fully grasps the fact that Islamic banks do things
differently when it comes to dealing with their customers."
Sankaran: Basel II is punitive for Islamic banks
In December the IFSB's secretary general, Rifaat Ahmed Abdel
Karim, reportedly stated that it would seek approval to amend
capital adequacy standards as per the Basel III requirements to
encourage a level playing field between Islamic financial
institutions and conventional banks. Even so, Hussain maintains,
the prudential requirements of Basel III could unnecessarily
restrict the growth of Islamic finance. Others take a more sanguine
view, pointing out that some aspects of Basel III already play to
the strengths of Islamic banks in certain countries, such as
Malaysia. BNM says the Basel III capital proposals emphasize the
role of common equity-ordinary shares and reserves-as the strongest
form of capital, a practice the bank says is in line with those of
Malaysian Islamic banks. The central bank estimated in June 2010
that more than 80% of Malaysian Islamic banks' total capital was in
the form of common equity.
The majority of Islamic banks in Malaysia already maintain
capital levels well above the current regulatory minimum, BNM says,
and the liquidity coverage ratio (LCR) under Basel III is
conceptually similar to the liquidity framework adopted by
Malaysian Islamic banks. However, it says the LCR will require
Islamic banks to hold more liquid assets for wholesale funding than
under the existing liquidity framework. "Typically, Islamic banks
are deemed to be well capitalized compared to their conventional
banking counterparts," says Ramakrishnan of Oracle. He says Islamic
banks should look into the specific areas of liquidity risk
management and stress testing espoused by the Basel III directive
and incorporate these into their own risk management and capital
adequacy standards.
Generally, though, Islamic banks still have some way to go if they
are to achieve the same level of sophistication in risk management
as their conventional counterparts, Sankaran believes. Added to
this, he says, is the complexity inherent in the partnership or
profit-and-loss-sharing approach that underpins Islamic finance.
"What is the probability of default of a partnership? We do not
know," he says. "If there is a default, what is the loss? These
numbers are difficult to compute. Under profit and loss sharing,
who carries the risk? Depositors would argue they do not carry the
risk because it is a partnership."
Greater transparency is needed in Islamic finance, says Sankaran,
as it is difficult to obtain reliable data regarding Islamic banks,
particularly in regions such as the Middle East. One good thing,
however, has emerged from the recent financial crisis. "Islamic
banks can no longer argue that risk management is not as relevant
for them," says Sankaran. And while international standards like
Basel may not have been designed with Islamic institutions in mind,
he says it is up to organizations like the IFSB to make them more
relevant. "Perhaps a Basel 3.5 or an Islamic Banking Act 1, which
is directly relevant to Islamic institutions, is needed," he
ventures. Hussain maintains that a one-size-fits-all approach does
not work and that it may be more worthwhile to create mandatory
requirements for all banks, and other requirements that are
specifically tailored for different industry subsets, such as
Islamic financial institutions.