Finding the Right Regulatory Path for Islamic Banking

Saidi, MeysamAuthor Information . Banking & Finance Law Review;

Scarborough Vol. 30, Iss. 1,  (Nov 2014): 89-111

Abstract
TranslateAbstract

Islamic banking is significantly influenced by both Sharia law and market forces. The dichotomy
between ideal Sharia based Islamic banking and real world Islamic banking calls for rethinking
our approach to regulation of Islamic banking in order to enhance anticipatory capacity of
regulatory authorities and legislatures. This Article, therefore, rejects strict adherence to one of
the driver of Islamic banking and neglecting the other. Due to the impact of common regulatory
conditions and market dynamics, Islamic banking, in many aspects, resembles its conventional
counterpart. Nonetheless, the areas of differences are too big to be ignored by regulators due to
their market stability and customer protection implications.

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Headnote

Islamic banking is significantly influenced by both Sharia law and market forces. The dichotomy
between ideal Sharia based Islamic banking and real world Islamic banking calls for rethinking
our approach to regulation of Islamic banking in order to enhance anticipatory capacity of
regulatory authorities and legislatures. This Article, therefore, rejects strict adherence to one of
the driver of Islamic banking and neglecting the other. Due to the impact of common regulatory
conditions and market dynamics, Islamic banking, in many aspects, resembles its conventional
counterpart. Nonetheless, the areas of differences are too big to be ignored by regulators due to
their market stability and customer protection implications.

Tant la chaña que les forces du marché exercent une influence marquée sur les services bancaires
islamiques. Compte tenu de la dichotomie qui existe entre les services bancaires islamiques
idéaux fondés sur la chaña et ceux qui sont effectivement mis en place, il faut repenser
l'approche quant à la réglementation des services bancaires islamiques de façon à améliorer la
capacité anticipative des autorités de réglementation et des pouvoirs législatifs. L'auteur rejette
donc une adhésion stricte à Tun des principes fondamentaux des services bancaires islamiques au
détriment de l'autre. En raison de l'incidence du contexte réglementaire et de la dynamique de
marché, les services bancaires islamiques ressemblent à bien des égards à leur équivalent
conventionnel. Néanmoins, les différences sont trop grandes pour que les autorités de
réglementation les ignorent. Il en va de la stabilité des marchés et de la protection des clients.

1. INTRODUCTION

While the specific externalities and required regulatory measures in relation to Islamic banking
are fairly uncertain, the business is growing across the world. Unofficial data indicates that the
Islamic Finance market is growing with annual rate of 15% and it has reached 1.3 $ trillion size.1
This trend is associated with inherent systematic connection of Islamic financial institutions to
other entities and different sectors of economies. Islamic banking has been subject of market
development policies in major economies, most notably the UK.2 This trend highlights the need
for identification of distinct risk features of Islamic banking and crafting customized regulatory
measures. So far there has not been a significant systemic crisis in this market which can be
attributed to its distinct nature. However, the significant growth and spread of its products
worldwide necessitate an in depth study of its nature for customized congruent regulatory
measures.

In the post financial crisis era some market analysis and reports suggested that the Islamic banks
fairly weathered the crisis.3 As far as heavily blamed conventional financial products such as
subprime mortgage backed securities and speculative credit default swaps were concerned the
immunity claim can be considered true, as Islamic financial institutions were not directly
exposed to such products.4 Nevertheless, similar to the experience of the conventional banking
industry, it can be only a matter of time for Islamic banks to face failures that can be specific to
the nature of their business. Using the experience of conventional banking regulations and
identifying those peculiarities of Islamic banking that need customized regulatory approach can
aid to prevent major failures. Frank Knight has stated that "We perceive the world before we
react to it, and we react not to what we perceive, but always to what we infer."5 The debate over
congruent Islamic banking regulations might not be an exception to Frank Knight's statement but
I will try to base my discussion on concrete evidences. I will first explain both theoretical and
actual features of Islamic banking in order to ascertain to its peculiarities in terms of market
stability and other externalities. Next, I will assess distinct features of Islamic financial
transactions and banking which might require customized regulatory measures. Finally, I will
explore how a more transparent path for the Islamic banking regulations can be drawn.

2. UNDERLYING LEGAL PRINCIPLES OF ISLAMIC BANKING

Islamic banking evolution has been historically fuelled by Islamic law and financial necessities
of Muslim communities. Islamic scholars have discussed and gradually developed these rules
under various religious and non-religious factors. They used several religious sources and tools
to address business needs of Muslims over the centuries.6

Islamic banking was originally founded for Muslim communities who could not use
conventional financial transactions under some Islamic prohibitive rules. Riba is the main
prohibitive rule in the realm of Islamic banking.7 Islamic scholars generally defined the
forbidden Riba as "trading two goods of the same kind in different quantities, where the increase
is not a proper compensation."8 However, not every form of what economists and regulators
describe as "interest" is considered forbidden Riba; especially time value of money.9

Mohammad Fadel explains that most Islamic schools of thoughts including Hanafi, Maliki, and
Shafi' have allowed "deferred trades if one of the two countervalues was gold or silver, or even
copper coins, and the other counter-value was food or any other commodity. Likewise, they all
permitted the deferred trade of food or other fungibles for non-fungibles (e.g., the trade of wheat
for cloth)."10 The permission applies to trades that observe formal limitation on Riba. Pricing
terms of the trade agreements have been left untouched by the Islamic scholars.

Hypothetically, the prohibition of Riba can lead us to an economy in which people in need of
commodities and services can access to interest free facilitating financial arrangements. The
financial facilities are closely tied to commodities and services and so called real economy.
However, Frederic L. Pryor, who explored hypothetical picture of an Islamic economy in 1985
prior to recent development in Islamic banking and finance, explains that "if there is no interest
rate, the aggregate saving would fall."11 He also indicates that risk and profit sharing mechanism
generated under this prohibition would lead to decline in savings due to their risky nature.12 The
actual practice of Islamic banking has departed from the basic theoretical framework toward a
conventional banking pattem during the past few decades. This trend has made it difficult to
draw any conclusion in terms of stability and market dynamics based on a pure theoretical
assumption.

The current forms of Islamic financial transactions do encompass a form of profit margin which
is usually tied to the price of underlying commodities or services. Mahmoud A. El-Gamal used
the term "shari'a arbitrage" to explain the current trend of reconstructing conventional financial
transactions to Islamic ones to seemingly comply with Islamic law despite having all features of
conventional financial products.13
The second major prohibition which has had a significant role in structuring many Islamic
financial transactions is Gharar. Generally speaking, Gharar takes a form of incomplete and
inaccurate information and/or deception, as well as risk and uncertainty associated with objects
of contracts. Since full knowledge is not always possible, some degree of risk and uncertainty is
often inevitable in entering into any contract. Thus, scholars have distinguished major or
excessive Gharar, which nullifies contracts, and minor Gharar, accepted as necessary evil.

3. A SNAPSHOT OF CURRENT ISLAMIC BANKING BUSINESS

Various Islamic rules and current market requirements were orchestrated for shaping viable
Islamic financial transactions. As Friedrich A. Hayek emphasizes, social and economic
institutions are shaped under social and economic surroundings of mind.14 We have not
necessarily chosen them because of their consequential benefits; social and economic
circumstances along with religious factors significantly contribute to shaping institutions.
Therefore, social and economic consequences of such institutions may not be necessarily fully
pre-planned.15 The formation pattem of Islamic banking through history is not excluded from
this presumption. For example, Benjamin Geva explains that, historically and despite pro-
hibitive rules on interest bearing banking, monetary economy of Islamic world required banking
services.16 These services used to be provided by private money exchangers known as Sarrafs
and official money exchangers called Jahbads. Provi- sion of banking services by Jahbads was an
ancillary business activity due to the fact that they were large merchant who had developed an
expertise in monetary matters. Deposit taking was carried out for safekeeping and for
accumulation of depositors' funds for lending purposes.17 These historical examples show us
how markets accommodate Islamic principles in their business in order to meet the needs of
Muslim communities.

The current practice of Islamic banking, under the contemporary market dynamics, resembles the
basic model of conventional banking. Islamic banks receive funds from depositors through
Islamic compliant transactions and allocate these funds to different investment targets using
Islamic compliant transactions. Dahlia El-Hawary, Wafik Grais and Zamir Iqbal have categorized
Islamic financial transactions based on their functions into two main groups of transactional and
interme- diary contracts.18 One set of contracts governs economic relationships between two
parties, which can be called transactional contracts. All contracts with the nature of sale
including Murabaha fall within this category. Under a Murabaha, The Bank agrees to provide a
property for the buyer (Customer) and the buyer undertakes to pay all the costs and expenses
incurred by the seller. Essentially a Murabaha con- sists of two major components: The purchase
price and related costs, and an agreed upon mark-up (profit). The basic features of a Murabaha
contract are the follow- ing: (i) that the buyer should have knowledge of all related costs and the
original price of the commodity, and the profit margin (mark-up) should be defined as a
percentage of the total price plus costs; (ii) that the subject of the sale should be goods or
commodities against money; (iii) that the subject of sale should be in the possession of the seller
and owned by him and he should be capable of delivering it to the buyer; and (iv) that payment is
deferred.19

The other group of contracts function as an intermediary tool for financing purposes and are
referred to as intermediary contracts. A form of partnership is typically the common denominator
of the transactions that fall within this category. Such transactions involve certain terms and
conditions on capital allocation and monitoring and management of the capital. For instance,
under a Mudaraba contract one party provides capital for a business that is to be run by the other
party.

Islamic banks provide Islamic alternatives for deposits in conventional banking as well. Demand
deposits (Basic savings and current accounts) are operated under Wadia or Qard agreements with
depositors bearing no profit. A Wadia agree- ment creates "an agency contract for the purpose of
protecting and safekeeping depositor's assets."20 Whereas, the legal obligation of the Islamic
bank is restricted to negligence and failure in the case of loss under a Wadia agreement, the
Islamic bank guarantees to pay back the deposit money under a Qard agreement. Unlike Wadia,
Qard is virtually an interest free loan under which the entitlement to the funds is transferred to
the bank.21 Deposits made and operated under Mudar aba agreements are Islamic alternatives
for interest-bearing saving accounts in conven- tional banks. However, unlike savings accounts,
Islamic investment accounts do not entail guaranteed interest. Similar to equity type investments
this type of deposit does entail a profit made by the underlying businesses. Mudaraba agreements
are composed of two categories of restricted and unrestricted:

1. Restricted Investment Accounts: The account holders authorize the Islamic bank22 to invest
their funds based on Mudarabah or agency contracts with certain restrictions as to where, how,
and for what purposes these are to be invested.

2. Unrestricted Investment Accounts: The account holders authorize the Islamic bank to invest
their funds based on Mudarabah or Wakalah, which is a simple agency authorization,
agreements, without laying any restrictions. The Islamic bank can commingle these funds with
their own funds and invest them in a pooled portfolio.23
Banks keep the funds intended for Islamic-compatible investments separated with those of non-
Islamic investments. The rationale behind this principle is rather one of prudence, in the sense of
taking all the necessary precautions to ensure that Islamic funds do not become mixed with other
funds that may be involved with Riba, Gharar, or haram (prohibited) activities. In this sense then,
when a conventional bank opens an Islamic window, to a large degree, it is in fact establishing a
separate entity from the rest of the bank.24

As it is illustrated in the figure, financings provided by Islamic banks are mostly made through
commodity trade contracts such as Murabaha. Serhan Cevik and Joshua Charap show in their
paper25 that "most Islamic banks rely on debt-like instruments such as Murabaha which are
typically commodity or services trade contracts with deferred payment obligations entailing a
profit margin as part of the price of the property traded under such agreements. Moreover,
Islamic banks tend to link the mark-up to a conventional interest rate, typically the London
Interbank Offered Rate (LIBOR) or a domestic equivalent." As it was explained, these debt like
agreements take the form of sale or lease agreements and the profit margin becomes a part of the
rent or sale price. This practice of Islamic banking resembles conventional debt instruments with
a predetermined price which might not necessarily reflect profitability of underlying businesses
and real economic activity as it is assumed in theories of Islamic finance and banking.

Further to debt like transactions, Profit and loss sharing modes of financings also form a part of
Islamic bank's asset portfolio. These transactions seem to expose banks to the risks of underlying
businesses. In my experience Islamic banks mainly use these types of transactions for financing
projects or businesses. The theoretical picture of these transactions might suggest that "Islamic
banks have no legal means to control the agent-entrepreneur who manages the business financed
through Mudaraba contracts"26 However, I have observed that Islamic banks have managed to
benefit from the green light that has been given to them by Islamic law to insert supervisory and
even veto rights in relation to the underlying business, especially in Musharaka agreements
which are equity type partnerships. These types of rights essentially resemble the monitoring
rights of banks in project loan agreements in project financing format. For example under a
Musharakah agreement which is widely used for financing construction and manufacturing
projects, some key decisions are taken with the bank's approval and even in the case of default in
fulfilling some key terms of the agreement, the bank has the right to take over management of
the project. However, it cannot be yet concluded that these contractual arrangements fully isolate
the bank from the risks involved in the underlying businesses. Furthermore, proper exercise of
such management and supervisory rights require sufficient knowledge on each specific business
financed by the bank.
In dealing with credit risk, Islamic banks are left with not much contractual mitigation tools. It
should be noted that in profit and loss sharing financing modes, the credit risk is less relevant to
the counterparty and more correlated with the performance of the underlying business financed
by the bank. The financing provided by the bank might not be fully repaid due to various
incidents. Whatever arrangements made by the Bank in minimizing its exposure to the credit
risk, it is not allowed to obtain a guarantee for full repayment of a Musharaka or Mudaraba
financing.27

Due to various reasons discussed above, Islamic banks tend to use transactions that resemble
conventional loans in terms of the financial obligations of their customers. Under these
transactions, such as Murabaha, Ijara28 and Istisna,29 the bank is legally guaranteed to be paid
the principal amount of financing and a profit margin embedded in the price of the commodity or
the rent of the property. This profit margin constitutes a portion of the agreed price and does not
fall within prohibition of Riba, as they are sale or lease transactions allowed to bear a profit
margin. Therefore, unlike equity type transactions, the bank as a seller of commodity or owner of
the leased property is guaranteed to receive the principal and profit margin.

The formation and adaptation of different Islamic financial products and institutions over the
history and under various circumstances suggest that we are not dealing with one static form of
Islamic banking.

Market structure and non-religious factors have not been of any less impact on the practice of
Islamic banking than religious rules. Due to globalization and interconnectedness of markets, the
market dynamics and non-religious factors are even of greater significance in understanding the
current trends in Islamic banking. A comprehension of these dynamics helps us to generally
grasp the actual feature of Islamic banking in today's economy. Consequently, we can avoid
being misled by hypothetical picture of Islamic banking in our attempt to reach an appropriate
regulatory strategy for this market. Thus, In order to analyse distinct features and regulatory
needs of current Islamic banking, I will first discuss non-religious factors which have been
involved in forming the current Islamic financial industry. I will, then, attempt to draw the
current general trend of Islamic banking.

4. THE ROLE OF NON-RELIGIOUS FACTORS

As I explained above, Similar to its conventional counterpart Islamic banking is significantly

influenced by several market dynamics and factors including competition, risks, demand, costs,
governing laws and regulations. Therefore, we need to take into consideration current
circumstances under which Islamic banking is formed and operated.

(a) Competition

Some forms of Islamic banking and finance have now been adapted in the countries which have
a Muslim population such as the UK, the US, Canada30 and Australia.31 However, according to
the study conducted by the UK Islamic Finance Secretariat, part of the City UK lobby group, it is
estimated that only 12 percent of Muslims use Islamic financial products.32 Such conditions
mean that Islamic financial institutions have to compete with well established large conventional
banks in both Islamic and conventional economies in order to keep and attract their current
customers. Mahmoud A. El-Gamal explains that, "competition will naturally drive implicit
interest rates on Islamic financing closer to that benchmark rate. However, bankers do their
customers a disservice by limiting the process of Islamic financing to explicit benchmarking of
interest rates to LIBOR or any other market rate, and implicitly to rates that competitors would
charge."33 Terms and conditions of investment deposit accounts of Islamic banks often indicate
the popularity of this practice.

Competition will also influence type and size of Islamic financial transactions. For example, as
Mahmoud A. El-Gamal explains the distinctive feature of Salam contract as a type of sale with
two major features of pre-payment and deferred delivery is that it provides a flexible tool for
both financers and customers in a competitive market. A manufacturer of commodity can raise
funds through this transaction and financier can also provide financing in a form of pre-payment
for a commodity that will be delivered in the future.34 Since price in Salam is generally lower
than the spot sale; the price difference is considered a valid profit for the purchaser. Therefore,
Salam provides a flexible tool for agricultural finance, export finance, liquidity and short-term
financing in a competitive market.

Rima Turk Ariss has analysed competitive conditions between Islamic banking and conventional
banking. She has used sample data from 16 countries within the period of 2000 and 2006 which
is marked with rapid growth of Islamic banking.35 Although more recent similar market data is
still needed, some of her findings can still significantly help us in crafting more congruent
regulatory policies for Islamic banking. Using data from 58 Islamic and 192 conventional banks
in 13 countries, she has found that "over the sample period, the average loans to assets ratio of
Islamic banks stands at 52.78% versus 43.96% for conventional banks and the equity to asset
ratios for the two banking segments are 14.01 and 12.42% respectively."36 She adds that this
means Islamic banks are better capitalized than their conventional counterparts. She also leaves
the question of whether Islamic banks are more exposed to credit risk due to the nature of their
assets. I will provide further analysis on what would be the implication of such a difference for
capitalization and credit risk.

The average return on assets and return on equity of Islamic banks are 2.04 and 14.19%
respectively, whereas these figures for conventional banks are 1.85 and 14.04%, respectively.
However, her regression37 analysis shows that there is not sufficient evidence that Islamic banks
are generally more profitable than conventional banks.38

(b) Risks

Any financial system is a web of channels of funds "from the agents with surpluses to the agents
with deficits"39 which are associated with risks for all players in the scene. As Allen and Gale
have explained, "One of the most important functions of the financial system is to share risk and
it is often argued that financial markets are well suited to achieve this aim."40

An attempt in drawing hypothetical picture of Islamic banking under the prohibitive rules that
were discussed earlier, suggests use of a risk sharing model of banking under which the risks of
underlying businesses are shared among the capital provider and the entrepreneur. However, in
Islamic banking, legal and financial engineering of financial products are significantly influenced
by the risks affecting the parties involved.41 As it is suggested in the figure, profit and loss
sharing assets represent less than thirty percent of total banks' assets in Saudi Arabia and Bahrain
and less than twenty percent of total banks' assets in other countries.

Hedging risks in Islamic banking is more challenging than conventional banking, as common
risk containment tools available for Islamic banks are not necessarily permitted in Islamic
banking. Credit risk of a certain asset of a conventional bank, for example, can be hedged by a
credit default swap provided by another entity; whereas due to its uncertainty conventional credit
default swap is not permissible under the Gharar rule.

Considering unique legal structure of Islamic financial transactions, their legal enforceability
might be as certain as conventional transactions and with the same legal consequences as
intended by the parties. Conventional legal system and conflict of laws rules might pose
significant legal uncertainty over legal implications of Islamic financial transactions.

(c) Demand
Islamic finance was usually debuted in new markets in the form of few Islamic financial
products for providing commodity and real estate credits due to consumer demands. In the UK,
for example, the market first started by Islamic mortgage facilities in 1990 and early 2000.42 In
the US, the Islamic mortgage products were offered in mid 90th and a report issued by the US
congress suggests that "In the United States, Shariah-compliant [financial products] largely exists
in personal home mortgages."43 However Islamic financial transactions are not limited to
mortgage products in the US. "Other forms of Shariah-compliant services are offered as well.
Shariah-compliant mutual funds are offered by intermediaries such as the Amana Mutual Funds
Trust, Azzad Funds, and the Dow Jones Islamic Fund."44 A study conducted by Toronto
Financial Centre Alliance in 2010 in Canada suggests, "Over the past several years, a number of
Canadian based financial entities have emerged have focused on a growing demand for Islamic
law compliant residential mortgages. In addition, there appears to be growing interest from the
international community, both Islamic financial institutions and individuals (including Canadians
living abroad), in investing in Canada in entities or structures that are compliant with the
principles of Islamic commercial law."45

In countries with major Muslim population Islamic banking was launched in its full mode. Banks
started to collect deposits from depositors and provide financings for their customers. As the
figure shows, the type of transactions used by Islamic banks for financings follow a similar
pattem in such jurisdictions which is shaped by customer demands. Islamic securities market also
forms a significant part of Islamic financial industry.

(d) Costs

Some complex legal and financial structures used in Islamic banking result in an inevitable
increase in transaction costs for Islamic financial institutions. Using more risky equity type
transactions with a profit and loss sharing framework would mean more costs for entrepreneurs
who raise funds through Islamic banks. Costly equity type transactions, therefore, are typically
unattractive for both banks and their customers.

Unlike small transactions and entities, Transaction costs in large scale financings are not usually
unbearable for corporate customers. Commodity and service trade contracts, such as Murabaha,
are more straightforward in terms of structuring and less costly for both banks and customers, in
comparison to profit and loss sharing transactions that take the form of a partnership. Profit and
loss sharing agreements with minimum guarantee or no guaranteed repayment has to encompass
various monitoring and management terms and conditions to secure the parties' interests and
cover their risk exposures. Whereas, such trade agreements banks act as an intermediary between
the supplier and customer to supply commodities and services, adding a profit margin to the
price of the commodity with prospective buyer. Mahmoud El Gamal discusses "to cater to small
borrowers at the retail level, Islamic banks in [Golf Cooperation Council GCC countries needed
to reduce those transaction costs. Thus, they resorted to the transaction known as Tawarruq46
(literally: monetization)" although it still entails more transactional costs compared to
conventional loans. Under a Tawarruq the customer purchases a commodity from the bank on a
deferred payment basis and sells it in order to raise money.47

Similar to conventional banking, the asset composition of Islamic financial institutions is

influenced by cost of equity48 versus cost of debt implications. Debtlike agreements in forms of
commodity and service trade agreements are heavily used in Islamic banking. Murabaha, for
instance, renders access to liquidity with a pre-determined profit margin over the price of the
commodity which can be potentially lower than the return on a risky equity type transaction
shared in the downside and the upside.

(e) Governing Laws and Regulations

Similar to any innovative transaction, Accommodation of financial transactions into any market
can be faced with legal and regulatory barriers and difficulties. Such transactions can benefit
from pre-established laws on Islamic contracts in Islamic States in relation to mutual interests of
the parties involved. However, regulatory requirements remain similar in both Islamic and non-
Islamic states due to the common need for stability and customer protection. Regulatory regimes
of markets may not be fully prepared for immediate embrace of all aspects of Islamic banking.
This complication may limit options for entities seeking Islamic financial transactions. Policy
makers still need to take action and adjust the rules and regulations in order to accommodate
Islamic finance in their markets.

Taxation rules have been identified as the first major hurdle in almost every country including
the UK, the US, Canada and Australia.49 In the UK, for instance, The Finance Acts 2005 and
2006 introduced new rules sought to put Islamic financial products on the same tax level as their
conventional counterparts. The main obstacle against development of Islamic mortgage products
was identified to be double stamp duty both once they purchase the property and when the
property is transferred to the customer. For instance, Under an Ijara agreement which is a lease-
to-own, the bank buys the property the customer wants then leases it out to the customer. At the
end of the term the bank transfers ownership of the property to the customer. Two purchase
agreements are involved and accordingly double stamp duty used to be applied. The Finance Act
2007 defined a clear tax framework for Sukuk.50 These attempts and measures eventually
enabled FSA to consider the authorisation of wholly Islamic firms.51 Under the Finance Act
2007, Ijara-based contracts were brought within the regulatory framework referred to as Home
Purchase Plans (HPPs). This measure aimed to provide the same level of protection for
customers of HPPs as the conventional mortgage products. In the US, The Office of the
Comptroller of the Currency (OCC) released two directives concerning Islamic compliant
mortgage products. In 1997, the OCC issued a guideline on Ijara and in 1999, the OCC
recognized Murabaha.52

Lack of a comprehensive regulatory measure for recognition and accommodation of Islamic

banking within a market can lead to confusion and uncertainty of the market players. For
instance, in Austraila, where Islamic banking has yet to realize its full market potential, under
Corporations Act 2001, profit and loss sharing financial transactions including Musharakah,
partnership, can fall within definition of "managed investment funds". Moreover, Sharia
supervisory boards which monitor compliance of financial products of Islamic financial
institutions with Is lamic rules may not be accommodated within current regulation especially
with respect to meeting prudential qualifications relating to directors.53

The experience of most countries with a developed conventional financial market, therefore,
indicate that Islamic banking could not be practiced in its full mode unless a comprehensive
legislative plan is furnished in terms of recognition and accommodation of Islamic financial
products and institutions.

5. POPULARITY OF COMMODITY AND SERVICE TRADE FINANCING AGREEMENTS

A combination of religious rules, market structure and legal atmosphere has led to desirability of
some forms of financial products over others. The following figure suggests that transactions
with a sale or lease nature especially Murabaha are more attractive to Islamic banks than those
with partnership nature including Musharakah.54

Popularity of Murabaha is due to several factors including: (i) Murabaha is a short term
investment mechanism, and, compared with profit and loss sharing, is convenient; (ii) mark-up in
Murabaha can be fixed in a manner which ensures that Islamic banks can earn the same level of
revenue as similar interest rate based banking; (iii) Murabaha avoids the uncertainty attached to
earnings of businesses under a system of profit and loss sharing;56 and (iv) it does not allow the
Islamic bank to interfere with the management of the business since the bank is not a partner
with the client. Their relationship instead, under Murabaha, is that of a debt nature as the
customer is obliged to pay the principal amount of financing and the profit margin over the price
of the assets and in instalments.

6. ISLAMIC BANKING AND REGULATION

The critical issue that will be discussed here is what regulatory measures should be taken
considering the theoretical and actual dimensions of Islamic banking as described above.

Prior to emergence of the current picture of Islamic banking industry, Islamic compliant
transactions were widely used by Muslims. Historically, Similar to common law of contracts,
Islamic contract law was developed in a traditional market with minimum administrative
intervention.57 Similar to any business activity, the business of Sarrafs and Jahbads was
governed by Islamic contract and property laws. Their businesses were of a private nature
defined by bilateral benefits and understanding with limited number of customers.

Client protection and risk externality require safety and soundness of Islamic banks, a matter of
regulatory concern. Prudential regulation aims to address imperfect consumer information and
agency problems58 associated with Islamic banking. Systemic regulation, on the other hand,
addresses financial stability and systemic failure of Islamic financial institutions. As it will be
explained below, these regulations might need to address their objectives in an Islamic banking
context in a different way than the conventional counterpart.

The peculiarities of Islamic banking suggest the need for some different regulatory measures.
The precise nature of such regulatory measures might not look the same in various jurisdictions
due to differences in several branches of Islamic laws and continental market structure and legal
environment. This section deals with appropriate regulatory measures for the most common
forms of Islamic banking in various jurisdictions as pictured above.

(a) Protection of Depositors

Many depositors of Islamic banks, especially investment account holders, have equity type rights
without typical voting or monitoring rights for equity holders. These types of deposits raise some
important customer protection and information asymmetry concerns. A higher degree of agency
problem can occur in with respect to such types of deposits in comparison to conventional
deposits and debt like deposits operated under Qard arrangement.

Islamic banks have been also criticized for shrouding the value of deposits while they do state
value of their assets. This means that losses on the asset side are incurred by either depositors or
equity holders.59 Moreover, it "raises the issue of the separation of asset categories to match
them to liabilities either through firewalling or segmentation."60 According to a popular
argument, any gain should be associated with a risk of loss while gain without risk is not just.61
Risk sharing as the distinct feature of many Islamic financial transactions can significantly
generate new types and amount of risks.

Nonetheless, in regards to protection of depositors, similar institutional forms used in

conventional financial markets have already provided us with a great regulatory experience
which can be used in the context of Islamic banking. As I discussed above, some depositors of
Islamic resemble status of equity holders of a company without having enough monitoring rights
and protection. Accordingly more protective regulatory measures shall be taken in relation to
such depositors.

Even in the context of conventional deposits, some scholars have advocated the idea of
expansion of fiduciary duties of the directors toward depositors as a legal tool for maximizing
managers' responsibility toward them.62 Fiduciary duties generally include duty of care and duty
of loyalty of an agent imposed by legal system when they are not addressed by contractual
terms.63 Fiduciary duties require agent to act under exclusive benefit of its principal.64 Macey
and O'Hara argued that fiduciary duties "will be especially valuable devices in the banking
context because of the inherent difficulties in monitoring banks."65 In their view, Technological
and financial sophistication together with opacity of bank balance sheet have extended
difficulties in regulatory intervention for safety and soundness of banking system.66

Some forms of Islamic investment accounts under Mudaraba arrangements leave the customer
with an equity type investment without officially recognized entitlement to sufficient monitoring
rights. Therefore, Extension of fiduciary duties to directors of Islamic banks seem to be plausible
only especially in these cases. Under Mudaraba agreements Islamic banks actually manage
Investment deposit account holders' funds as their agent. The fiduciary duties are also applied in
relationship between banks and saving accountholders once they are managed under Wadia
agreement under which the bank acts as a safeguard agent. However, once saving accounts are
managed under Qard agreements which are debt-like transactions, the relationship between bank
and depositors of such account is not of agency nature and application of fiduciary relationship is
justifiable only on the basis of regulatory concerns as it was discussed.

Some argued that equity type rights of depositors of Islamic banks "underscores an interesting
similarity between the operation of Islamic Banks and investment companies".* * * * 6'
However, unlike shareholders of investment companies, depositors of Islamic banks are not
legally entitled to any voting rights whatsoever. Shareholders of investment companies are
entitled to receive regular information on development of the company's business.68

Recognition of fiduciary duties of Islamic banks toward depositors is necessary but it is not
sufficient for consumer protection. "Fiduciary duties redress the inequality of information or
power between parties to a contract. Nice try, but it is hopeless as a description-for the most
conspicuous differences in size, power, and sophistication."69 Moreover, "Fiduciary duties are
not special duties; they have no moral footing; they are the same sort of obligations, derived and
enforced in the same way, as other contractual undertakings."70

Consequently, the interest of depositors of Islamic banks should be protected with an ex-ante
regulatory approach. Deposit insurance schemes are implemented in almost all jurisdictions with
an Islamic banking sector.71 However, the amount of deposits covered by such insurances is
limited and do not eliminate the need for regulatory intervention for protection of depositors.
Similar to investment companies' regulations, the regulations on Islamic banks should ensure that
depositors can have access to information on the bank's business and developments.
Furthermore, depositors consist of a large number of individual and entities who may not have
the knowledge required for assessing complex and information of the bank on one hand and on
the other they are practically unable to influence the decisions made within the bank. It seems
that in an Islamic banking system, the regulatory agencies are better poised to monitor Islamic
bank activates in terms of protection of depositors. Therefore, a profoundly robust monitoring
scheme should be designed with respect to Islamic banking.

(b) Financial Stability Perspective

Islamic banks as other financial institutions might pose certain threats to the stability of the
markets. So far we can assume that problems within an Islamic bank can spread to other entities
and potentially destabilize the entire financial system. However, we still need to know what
aspects of Islamic banks are different from conventional banks in terms of stability. In order to
understand how regulations should address stability concerns of Islamic banks, I will try to offer
a picture of distinct stability aspects of Islamic banks.

Islamic banks provide financing through profit and loss sharing transactions including Mudaraba
and Musharaka, although these types of assets do not represent a great portion of most Islamic
banks' balance sheets. Hence, in process of customization of regulations for Islamic banks we
still need to take these profit and loss sharing transactions into account. They have equity
investment implications and expose the performance of various underlying businesses. Whereas,
traditional conventional banks developed fixed income non-tradable assets while trying to hedge
credit default risk through different tools.72

Similar to their conventional counterparts, Islamic banks can be also exposed to credit default
risk in commodity and service trade transactions. Dahila El-Hawary, Wafik Grais & Zamir Iqbal
argued that "in a deferred delivery, bay' salam, as well as in production orders, Istisna, contracts,
the bank is exposed to the risk of failure to supply on time or at all or failure to supply the quality
of goods as contractually specified."73 In a typical Murabaha, the bank buys the goods from the
seller and then sells the goods to the buyer who otherwise could buy the goods himself and
borrow the purchase price from the bank.

Islamic banks can employ transactional tools in order to avoid some risks associated with these
types of transactions. For example in a Murabaha agreement, Banks only purchase goods when it
has already a signed agreement with a buyer (client). The title of the buyer over the purchased
product can be stipulated to occur at the same time as the agreement of the bank with the main
seller comes into force. The client can be even appointed as the agent of the bank in finding the
supplier and making the sale agreement on behalf of the bank with the supplier. Therefore, all
claims against the bank in terms of quality and defects of goods are waived in the agreement
with the client as he is responsible for the goods acting as the agent of the bank.74 The purchased
commodity is kept as the collateral until the whole amount of credit including principal price of
commodity, profit margin and fees are fully paid by the client.

In general, some risks seem to have the potential to make Islamic banking more risky than
conventional banking. Dahlia El-Havary, Wafik Grais and Zamir Iqbal explain that Islamic
financial institutions "face five broad risk categories: transaction, business, treasury, governance
and systemic risks"75 but as they have emphasized in their work displacement risk, quality of
management, harmonization of institutional environment, liquidity management and
counterparty risk are specifically important in the case of Islamic banks.

Competition of Islamic banks with their conventional counterparts may sometimes lead them to
maximize the profits allocated to investment accountholders more than what is stipulated in their
agreements with the accountholders. Islamic banks are exposed to displacement risk when they
try to keep their business attractive to investment accountholders by sacrificing interest of their
shareholders. "As a result, during bad times the bank may forgo up to all its shareholders' profits,
adversely affecting its own capital."76 Accordingly, the Islamic bank would need to maintain its
reserve capital at higher level than what would be needed under a pure profit and loss sharing
regime.77
Empirical evidence suggests that although the rate of return on investment deposits of Islamic
bank follows the rate of conventional banks' deposits, it has not been always higher than
conventional banks' deposits. Within the period between January 1997 and January 2010 the
rates of conventional bank deposits and rate of return of Investment deposit accounts had 91
percent correlation in Malaysia and 92 percent in Turkey.78

Some conflicts of opinions among Islamic scholars and regulatory complexities in various
jurisdictions in which Islamic banks operate have led to "limits in the harmonization of
institutional environment."70 For example, while some Islamic scholars believe that Murabaha
and Istisna are binding for the buyer, some others believe that the buyer can terminate the
transaction.

Given prohibition on conventional borrowing modes for injecting liquidity into an Islamic bank,
liquidity management of Islamic banks is more complex than it is in conventional banks. This
problem is even greater for Islamic banks operating in conventional financial systems and
jurisdictions where access to liquidity of central banks and interbank money market has not been
yet defined for Islamic banks.80

Martin Cihak and Heiko Hesse have conducted a study on stability of Islamic banks which was
published in 2008.81 In their analysis they separated "the financial stability impact of the Islamic
nature of a bank from the impact of other bank-level characteristics, and from macroeconomic
and other system-level impacts."82 They found "that (i) small Islamic banks tend to be
financially stronger than small commercial banks; (ii) large commercial banks tend to be
financially stronger than large Islamic banks; and (iii) small Islamic banks tend to be financially
stronger than large Islamic banks."83 In their definition, a total asset of one billion is the
borderline between small and large banks.84 The results indicate that small scale Islamic
banking is more stable than large scale Islamic banking. As they have indicated it is probably
related to difficulty in credit risk management for large Islamic banks which are involved in
various types of transactions and profit and loss sharing financings for different businesses.

Contrary to the theoretical picture of Islamic banking, the empirical analysis indicates that
Islamic banks can fail. Such failure can also generate a domino effect in the market especially in
the case of large Islamic banks. Islamic banks in practice do have fixed liabilities when they act
as buyer of products and services in case of Murabaha and Istisna. They are still exposed to risks
such as commodity price risk, counterparty risk and liquidity risk. Any of these risks might result
in failure of the bank in fulfilling its obligation toward its creditors.85
(c) Regulatory Measures

An accurate regulatory plan with respect to Islamic banking would be a comprehensive one.
Capital regulation is one aspect of the broader congruent regulatory and supervisory regime.
Capital requirements have been set to function as a cushion against losses which might occur for
any of the reasons discussed earlier. At international level, under Basel III banks are required to
hold 4.5% of common equity and 6% of Tier I capital of risk-weighted assets (RWA). A
mandatory capital buffer of 2.5% is also required to be held by banks. Furthermore, national
regulators are given discretion to require banks to hold an extra 2.5% capital buffer in times of
credit growth.86 Further to capital adequacy ratios Basel III has provided supervisory principles
to assist banks maintain adequate capital under Pillar 2. It has also addressed public information
disclosure.

Since Islamic banks use different set of contracts than their conventional counterparts some
initiatives have been taken to address stability of Islamic banks. Such measures have mainly
followed the footprints of conventional banking regulations. They are usually aimed to facilitate
application of capital adequacy standards to Islamic banks. The Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI) issued the "Statement on the Purpose
and Calculation of the Capital Adequacy Ratio for Islamic Banks in 1999. This document was
the first international initiative that addressed Islamic banking risks. Its methodology resembles
Basel standards, with the major differences in respect to liabilities of Islamic banks.87 In 2002
Islamic Financial Services Board (IFSB) was founded by a group of governors, central banks and
monetary authorities of several Islamic countries, supported by the Islamic Development Bank,
the AAOIFI and the International Monetary Fund. IFSB aims to develop and harmonize practices
in the regulation and supervision of the Islamic financial services industry by setting
international standards.88

In setting capital adequacy ratio for Islamic banks, the asset composition of Islamic banks should
be taken into account. It should be still noted that profit and loss sharing assets do not represent a
major portion of Islamic banks worldwide but they do exist in balance sheet and agenda of
Islamic banks. Therefore, their unique risk portfolio has to be considered in capital adequacy
ratio of Islamic banks.

As the data analysis indicated Islamic banks similar to their conventional counterparts, are
exposed to various risks which mostly resemble risks involved in conventional banking. Large
Islamic banks are exposed to even more complex risks due to various complicated contracts that
they are involved in. However, the nature and degree of risk for Islamic banks has some
differences from conventional banks. As I argued, the operation of Islamic banks and the limits
in the harmonization of Islamic banks have different dimensions from conventional banks due to
use of special Islamic contracts.

Moreover, liquidity risk in Islamic banking is still an important issue that has to be addressed by
central banks of the countries in which Islamic banks operate. There are only few countries that
have a major Islamic banking industry which have developed theirs interbank market. Therefore,
a harmonized set of transactions should be designed for a worldwide Islamic interbank credit
market so that Islamic banks in conventional banking systems could have access to liquidity of
Islamic banks in other countries. This will create a worldwide liquidity web among Islamic banks
facilitating liquidity flow within this fragmented banking system.

7. CONCLUSION

Due to the impact of common regulatory conditions and market dynamics, Islamic banking, in
many aspects, resembles its conventional counterpart. Nonetheless, in the process of crafting and
implementing appropriate regulations, the areas of differences are too big to be ignored due to
their market stability and customer protection implications.

Depositors of Islamic banks, particularly investment account holders, need to benefit from more
protective regulations than what is in place for depositors of conventional banks. Investment
account holders are legally exposed to the losses of the bank operations and yet they do not
benefit from any special monitoring or decision making rights. An Islamic banking regulatory
regime should ensure that fiduciary duties are imposed on the Islamic banks which act on behalf
of such depositors. The regulatory agencies should also take a stronger monitoring role in such
areas. In establishing and implementing such regulations the experience of investment companies
could be used especially in terms of information disclosure and investors' protection. Islamic
banks tend to be less involved in profit and loss sharing modes of financings and they use more
Islamic sale and lease agreements which resemble popular conventional financing modes in
terms of risks and profits. However, profit and loss sharing assets still form a notable part of total
Islamic banks' assets and involve risk management complications especially for large Islamic
banks. More emphasis, therefore, should be put on operational risks by regulations with respect
to profit and loss sharing assets.

Except those Islamic banks that operate in the countries with a full or prevailing Islamic banking
system, stand-alone Islamic banks in other countries have limited access to liquidity and
interbank loan markets due to restrictive Islamic rules on interest bearing loans. Accordingly,
Islamic banks need to establish a harmonized and synergized international interbank market in
order to maximize their access to liquidity.

Footnote

1 "Focus Islamic Finance", Online: The Economist

<http://www.economist.com/blogs/graphicdetail/2012/04/focus-2>, see also Kuwait Finance
House [KFH], "Global Emerging Markets and Islamic Finance 2013", Online: KFH
<http://www.kfhresearch.com/product/global-emerging-markets-and-islamic-finance-2013>.

2 The British Prime Minister David Cameron just recently announced that: "I WANT London to
stand alongside Dubai as one of the great capitals of Islamic finance anywhere in the world." See
Online: Economist <http://www.economist.eom/blogs/schumpeter/2013/l l/islamic-finance>. "In
recent years, Islamic finance has grown rapidly across the world, conservatively estimated at 10-
15% a year.l Given the UK's position as one of the leading international financial centres, it is no
surprise that part of this growth has taken place in London which is now seen as an emerging
global 'hub' for Islamic finance. At the same time, the government has wanted to give the UK's
relatively large Muslim community (around 3% of the population) access to financial services
consistent with their religious beliefs" Michael Ainley et al, "Islamic finance in the UK:
Regulation and the challenges''' (2007), Financial services authority (FSA). See also, online:
<www.hm treasury.gov.uk ./newsroom_and_speeches/speeches/econsecspeeches/speech_est_290
307.cfm>.

3 Rodney Wilson, "The development of Islamic finance in the GCC Report" (May 2009), at 19,
online: London School of Economics (LSE)
<http://www2.lse.ac.uk/newsAndMedia/news/archives/2009/05/IslamicBanking.aspx>, see also
Lucy Williamson, "Islamic Banks Better in Crisis" (March 2, 2009), Online: BBC NEWS
<http://news.bbc.co.Uk/2/hi/asia-pacific/7918129.stm>, "Experts Say Islamic Finance Sector
More Resilient to Crisis" (Mar. 25, 2009), INTELLASIA.NET, Online:
<http://www.intellasia.net/news/articles/finance/111260684.shtml>.

4 Due to Islamic prohibitive rules on interest bearing debt and also ban on transaction with major
uncertainty, Islamic banks were not, at least directly, involved in such transactions. See "Islamic
Banking in GCC - Reslience in the Financial Crisis", online:
<http://www.english.globalarabnetwork.com/201002244935/Finance/islamic-bankingin-gcc-
resilience-in-the-financial-crisis.html>.
Footnote

5 Frank Knight, Risk Uncertainty and Profit, at 88 (New York: Sentry Press, 1921).

6 For a general review of history of Islamic law see: Wael B. Hallaq, The origins and evolution
of Islamic law, (Cambridge University Press, 2005). And also N.J, Coulson, History of Islamic
law, (Edinborough university press 1964) and see also Mahmoud A. El- Gamal, Islamic finance,
law, economics and practice, (Cambridge university press, 2006).

7 This term has the same meaning as the Hebrew name for forbidden usury: Ribit or Ribis; see:
Reisman, Y, The Laws of Rib bis, (New York: Mesorah Publications, 1995) and Stem, J. líRibit:
A Halachic Anthology" (Fall 1982), Journal of Halacha and Contemporary Society.

8 Al-Jaziri, Al-Fiqh, l"ala Al-Madhahib Al-Arba'a" (Cairo, Dar Ihya Al-Turath Al'Arabi, 1986). It
has to be noted that forbidden Riba is not as the same as interest that has been recognized by
Biblical scholars as difference between legitimate interest, which is proper compensation for
time, etc., and usury, which is excessive interest charged for the sheer act of credit extension;
Kerridge, E, Usury, Interest and the Reformation, (Ashgate: Hants, U.K., 2002).

9 For a comprehensive study on socio-economic context and dimensions of Riba and where it
stands in the distributive justice context see Muhammad Fadel, Riba, Efficency and Prudential
Regulation: Preliminary Thoughts (April 2008), Wis. Int'l L. J, 655.