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."
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.