Islamic Finance

The New Regulatory Challenge

Rifaat Ahmed Abdel Karim, Simon Archer

• Publisher: Wiley
• Year: 2013
• ISBN:
  9781118247082
• Edition: 2
• Topic: Business
• Subtopic: Sistemi bancari e finanziari nei paesi islamici
• Index: Business

From the world's foremost authorities on the subject, the number-one guide to Islamic finance revised and updated for a post-crisis world

Because it is entirely equity-based, rather than credit-based, Islamic finance is immune to the speculative bubbles and runaway volatility typical of Western finance. Especially now, in the wake of the global financial crisis, this has made them increasingly attractive to institutional investors, asset managers and hedge funds in search of more stable alternatives to conventional financial products. With interest in Islamic finance swiftly spreading beyond the Muslim world, the need among finance and investment professionals has never been greater for timely and authoritative information about the rules governing Islamic finance. This thoroughly updated and revised second edition of the premier guide to regulatory issues in Islamic finance satisfies that need.

• Addresses the need for banks to develop common Islamic-based international accounting and auditing standards
• Clearly explains the key differences between Shari'ah rulings, standardization of acceptable banking practices, and the development of standardized financial products
• Explores the role of the Shari'ah Boards in establishing common rules regarding the permissibility of financial instruments and markets
• Offers guidance for regulators seeking to adapt their regulatory frameworks to the needs of the fast-growing Islamic finance sector

Part One

The Nature of Risks in Islamic Banking

Chapter 1

Supervision of Islamic Banks: The Regulatory Challenge—Basel II and Basel III

Simon Archer and Rifaat Ahmed Abdel Karim

1. INTRODUCTION

The documents of the Basel Committee for Banking Supervision (BCBS)—International Convergence of Capital Measurement and Capital Standards: A Revised Framework (generally known as Basel II) and the recently introduced new major set of reforms to Basel II, which are aimed at addressing global capital regulatory framework in light of the prevailing global crisis (and are generally known as Basel III)—present a real challenge to banking regulators and supervisors. This challenge is, of course, first and foremost in respect of the application of both documents to conventional banks. Basel II was issued in June 2004 (with some revisions in November 2005) to supersede the original 1988 Capital Accord (Basel I), while Basel III was issued in December 2010, with a revised version in June 2011.

The main innovations introduced in Basel II were, first, a significantly more comprehensive and sophisticated approach to measuring credit risk and, second, a capital requirement for operational risk. With respect to market risk, Basel II did not supersede the 1996 Amendment of Basel I, which had introduced a capital treatment for this category of risk not specifically covered in the original Capital Accord. The two approaches to market risk under Basel II, the Standardised Approach and the Internal Models Approach, are continued under Basel III.1 However, while the scope of regulation has been extended under Basel III to liquidity risk, and the regulatory capital requirements have been increased, and there have been some significant alterations and additions to Basel II regulatory environment, the Three Pillars of Regulation established under Basel II remain and indeed are enhanced under Basel III.

Basel I was a document of modest length that made no great technical demands on the reader. However, the years since 1988 have seen a very significant evolution in banking and finance, including the effects of the globalisation of financial markets and developments such as the abundance of derivatives and securitisations using structured finance. These developments have significant implications for risk and capital adequacy. Hence, Basel II, which (with its appendices) runs to over 250 pages, is a fairly daunting document that makes some nontrivial demands on the reader, both technical and conceptual.

On the other hand, the development of Basel III was mainly prompted by the recent financial crises, which started to take shape in 2007. Basel III emphasises not only the importance of the absolute amount of a bank’s equity position, but most importantly the quality of capital held by these banks, two important issues that were not adequately addressed in Basel II.

The standards issued by the Islamic Financial Services Board (IFSB) have highlighted the fact that neither Basel II nor Basel III was (understandably) written with its application to Islamic banking in mind.2 However, the rapid development of Islamic banking since the early 1990s, and the fact that international financial authorities such as the World Bank, the International Monetary Fund (IMF), and the BCBS understood the consequent desirability of building bridges between Islamic (Shari’ah-compliant) financial institutions and the conventional (Shari’ah–non-compliant) financial sector,3 inevitably raised the issues of how and to what extent Basel II principles and techniques and those of Basel III are applicable to the regulation and supervision of Islamic banks, and of the regulatory and supervisory problems to be overcome in this context.4 These issues constitute the concern of this book.

2. THE STRUCTURE OF BASEL II AND BASEL III: SUPERVISORY IMPLICATIONS

The structure of Basel II is based on three “Pillars.” As mentioned above, these were retained and enhanced under Basel III. Pillar 1 deals with the new approach to credit risk, which replaces that of Basel I, and with operational risk; Pillar 2 addresses the supervisory review process from the standpoint of the responsibility of the supervisor to promote the overall safety of the banking system, and establishes a set of common guidelines for supervisory review, while also stressing the primary responsibility of individual banks and the critical role of dialogue between supervisors and banks; and Pillar 3 lays down a minimum number of public reporting standards on risk and risk management intended to enhance the ability of market participants to be aware of a bank’s risk profile and the adequacy of its capital in relation to this, thus involving the market in the capital adequacy regime. Building on the three pillars of the Basel II framework, Basel III supplemented the risk-based approach by introducing new regulatory requirements (notably concerning liquidity risk and the quantity and risk absorbency of capital) to promote a more resilient banking sector.

Basel II and Basel III thus present all banking supervisors with a major challenge, both in enforcing Pillar 1 together with the disclosure requirements of Pillar 3, and in implementing Pillar 2. The adoption of Basel II was not intended to be a requirement outside of the G10 countries represented on the BCBS, and then only for banks that are internationally active. However, as Basel I had been adopted in more than 100 countries, the supervisors in these and other countries may be expected to adopt both Basel II and Basel III progressively over the next few years. The G10 was broadened to include additional members and renamed G20. Following the financial crisis that began in 2007, the G20 gave more powers to the Financial Stability Board (formerly the Financial Stability Forum), which, inter alia, include oversight over the implementation of Basel III. The membership of the Financial Stability Board includes, among other standard-setting bodies, the BCBS.

For supervisors in countries where Islamic banks are located, there is the further challenge of applying Basel II and Basel III to those institutions. This added challenge results from the specificities of the Islamic (Shari’ah-compliant) modes of finance employed by Islamic banks. These raise issues of capital adequacy, risk management, market discipline, and corporate governance that differ significantly from those that arise in conventional (Shari’ah–non-compliant) financial institutions. The issues concern the types of assets to which Islamic financing gives rise, the related risks and the availability of risk mitigants, and the types of non-interest-bearing savings and investment products offered by Islamic banks for funds mobilisation in place of conventional deposit and savings accounts. The fact that these non-interest-bearing savings and investment products have characteristics similar to those of collective investment schemes, not normally the concern of banking supervisors or regulators, constitutes a further regulatory challenge.

3. THE ISLAMIC FINANCIAL SERVICES BOARD

The Islamic Financial Services Board (IFSB) was launched in 2002 by a consortium of central banks and the Islamic Development Bank (and with the support of the IMF) with the mandate to provide prudential standards and guidelines for international application by banking supervisors overseeing Islamic banks.

In December 2005, the IFSB issued two prudential standards for Islamic banks that are designed to help supervisors of such banks meet the challenge of implementing Basel II, one on capital adequacy and one setting out guiding principles of risk management. A third standard on corporate governance was issued in 2007.5 The mandate of the IFSB was extended in December 2005 to the domains of insurance and securities market supervisors and regulators.

The main challenge for the IFSB is to develop a framework that is common and applicable to all jurisdictions. However, unlike the Basel Committee, which can rely on regulatory frameworks and best practices developed by other leading regulators and banks as a background to its global framework, this process could not be readily applied by the IFSB. This is because the IFSB does not have the privilege of borrowing ideas from a large number of countries that have developed robust regulatory frameworks specifically for Islamic banks. Hence, the onus is on the IFSB to develop most of the thinking to set internationally accepted common prudential standards for Islamic financial institutions. This involves identifying the risks in the different types of Islamic finance and activities, understanding the substance as well as the form of the contracts that govern the transactions, dealing with issues that have not been addressed in other international standards, safeguarding the interests of other stakeholders who in principle share asset risks with the shareholders, and adapting Shari’ah rules that would be acceptable to the majority of its members.

In addition, whereas after the financial crises the Financial Stability Board has been given more powers to enhance the implementation of Basel III, the IFSB, according to its Articles of Agreement, can only recommend its standards to be adopted.

4. CONTENTS OF THIS BOOK

Since this book deals with a large range of regulatory issues arising from the application of Basel II and Basel III to Islamic banks, authors who have been chosen are specialists drawn from a variety of relevant backgrounds: banking and capital markets supervisors; the legal and accounting professions; banks and financial institutions; and academia. The book is organised into four main parts, reflecting different aspects of the regulatory challenge, and a concluding chapter, as outlined below.

Part One: The Nature of Risks in Islamic Banking

Part One consists of 12 chapters, this overview of the book being the first. In Chapter 2, Brandon Davies examines banking and the risk environment. He looks at the regulatory developments that have recently taken place following the financial crisis that started in 2007. The risk characteristics of Islamic products, and the complexities of some of these, such as the phenomenon of displaced commercial risk, are rigorously examined in Chapter 3 by Venkataraman Sundararajan. Chapter 4, by Sami Al-Suwailem, highlights the benefits that can in principle be derived from Islamic finance in light of the recent financial crisis, especially in enhancing global financial stability. The chapter points out how Islamic finance provides a framework for balancing the relationship between risk and returns, which, as Sami reminds us, requires careful and proper implementation to be practically relevant.

Chapter 5, written by the two editors of this book, Simon Archer and Rifaat Ahmed Abdel Karim, examines issues of capital structure and risk in Islamic banks and takaful insurance firms. Simon and Rifaat point out that the capital structures of both Islamic banks and takaful undertakings present complexities not found in the case of conventional financial institutions. With respect to the former, Archer and Karim show how capital structure and risk are linked, from a regulatory perspective, via risk weightings and capital requirements set out by the IFSB based on the Basel II and III Accords and the Standardised Approach to risk weighting. They highlight specific risks in contracts used by Islamic banks and the implications in these contracts for the capital requirements, and in some cases the capital structure, of these banks. With regard to takafu...