A CENTRAL BANK’S VIEW OF ISLAMIC BANKING
MICHAEL AINLEY
As a banking supervisor I come at Islamic banking with a perspective which is conditioned by the requirement in the 1987 Banking Act to look after the interests of depositors. This means that we have to be satisfied that our banks – of whatever origin – are prudently run and that their management is fit and proper.
‘Prudently run’ is not defined in the Banking Act but has particular requirements as to capital, liquidity and risk management. Fitness and properness mean that management must be adequate in breadth, depth and experience. And it must be competent to run the business.
We apply these principles to all the 350 or so banks that we supervise. The more complex or unusual a bank’s business, the greater we need to understand the bank’s business rationale, its operating policies (including its approach to risk management) and its strategic direction.
A relevant factor here is the Bank of England’s interest in maintaining the efficiency and integrity of our domestic banking system; there is also the international dimension, where we are co-operating increasingly closely with other central banks and supervisors.
The UK has always welcomed financial innovation. London’s position as an international financial centre has been built on a tradition of openness and on encouragement of strong, well-run financial institutions, from all parts of the world. We welcome competitive innovation in financial market and banking practice which can enhance the services London provides – both for domestic and international users.
This then is the context within which we at the Bank of England approach Islamic banking. We have responsibilities as banking supervisors to ensure that the banking facilities offered in this country – whether Islamic or not – are in accordance with our national legislation. To do that, we need to improve our understanding of what is involved; and we have to work with the Islamic banking community to identify and solve any problems that may exist.
What is Islamic Banking?
In considering the implications of Islamic banking, we face a particular difficulty at the outset. There seems to be no single definition of what constitutes Islamic banking. Th e basic principle is, however, clear, namely that making money out of money is contrary to Islamic law. Rather, wealth should be accumulated from participation in trade and the ownership of real assets.
The Bank of England respects that perception; and we understand the connection with the teachings of the Qur’an on social responsibility and cohesion. Even within a purely secular contest, it is evident how such an approach can help the financing of industry and trade. In the context of the 1980s debt crisis, for example, the Bank of England emphasised, on more than one occasion, the dangers that heavy reliance on debt, rather than risk-sharing, could pose.
Another complication for us is understanding how transactions are approved. Many institutions offering Islamic banking products do so under the guidance of a board of Sharia advisers. According to my contacts in London and the Middle East, different Sharia Boards interpret the acceptability of the Islamic products in their own way. Each Sharia Board, as I understand it, has equal authority. Also, the concept of ‘precedent’ does not generally chart the development of Sharia law. In some jurisdictions, therefore, there is no “definitive” answer as to the status of a particular Islamic banking product.
In some ways, this may be not too different from the introduction of new products in a conventional banking system. These can start as closely-guarded innovations, giving the institution a competitive edge until they acquire a more generalised ‘commodity’ status.
In these cases, too, it sometimes takes time for accounting and other aspects of the transactions to become standardised. But for Islamic banking products, the lack of clear definition can lead to considerable uncertainty about what is, and what is not, the “acceptable” way to do particular business. We, at the Bank, have noticed an important difference in practice between the Middle East, on the one hand, and the Far East on the other.
A third point here: Islamic banking has developed as an alternative to conventional banking for those who wish to adhere to Sharia law. But the possibility of becoming a complete alternative to conventional banking depends on Islamic banks being able to offer their customers all the facilities they need.
In this regard, the ability to offer global banking facilities on an Islamic basis would seem to require a presence or operating ability of some sort in the major western markets, particularly of London and New York. Indeed, London already seems to be developing as a major centre of Islamic banking; the presence of the Institute of Islamic Banking and Insurance here is a testament to that, and one means of fostering the development of interest-free banking. I would also note that it was a London bank that introduced the first Mudaraba in Pakistan. I always find it a little odd, therefore, when I read suggestions that the Bank of England is somehow opposed to Islamic banking.
How Developed is Islamic banking?
There is no doubt that Islamic banking, broadly defined, has grown and is growing. There is now a confirmed Islamic banking presence in at least 25 countries, notably in Africa, the Middle East and the Far East. The number of institutions offering Islamic products is also increasing. One (private) estimate of the present size of the market is $60-80bn. According to Ernst & Young, 15% of private assets in the Gulf states are invested in the Islamic banks. Islamic banking, it might be fair to say, is no longer an experiment.
Even so, a single Islamic bank, or even a few Islamic banks in any one country, do not constitute an Islamic banking system. Bank Negara Malaysia have said in one of their Annual Reports that a banking system, whether Islamic or conventional, requires at least three ingredients to qualify as a system.
These three ingredients are:
First, a large number of players. There must be an adequate number of different institutions participating in the system, to provide depth. This may be the case in a few countries, such as Bahrain and Malaysia, but not, I think, in several others.
The second ingredient is a broad range of instruments. A variety and range of different types of instruments must be available to meet the needs of customers and those of the institutions.
And the third ingredient is an interbank market. There must be an efficient and effective interbank money market to provide a means for institutions to manage their liquidity. This is difficult if there are only one or two Islamic banks in the system. But it is important, if not essential, for supplementing retail deposits or disposing of excess liquidity. The Islamic Development Bank has, I know, done useful work in developing thinking in this area.
I am not sure to what extent Islamic banking meets these three criteria. All that can be said with confidence is that the state of development differs in different countries, depending in part on whether the domestic financial system is, or is not, Islamised.
London is often cited as a leading centre for Islamic finance. Certainly, there are a growing number of institutions in London that are active in Islamic products. Periodically also, banks from Islamic countries discuss with us their plans to introduce Islamic banking in one form or another. So far, at least, these discussions have tended to be preliminary and to focus on fact-finding by both sides.
Based on these discussions, I can see that Islamic banking is well placed to contribute to the financing of industry and trade and to the provision, say, of leasing facilities. In these areas. Islamic banks can provide straightforward competition to conventional banks. But there is, I believe, some way to go before Islamic banks generally are able to offer customers a full range of facilities. As the Vice-President of the Faisal Islamic Bank of Bahrain noted in a Washington Post article, there is scope to develop services in areas like fund management, securitisation and corporate finance.
On the funding side, deposit-taking on interest-free current accounts or, as in Iran, on terms where the capital is certain but the return is not known at the time the deposit is placed, is not a problem. Here also. Islamic banks can compete directly with conventional banks. But moneys taken on a risk-sharing investment arrangement, where the amount to be repaid is uncertain, do not fit comfortably within the definition of deposit-taking, at least as it is defined in UK banking legislation. But there are, of course, many institutions in the UK offering such facilities under our Finance Services rather than our Banking Act.
All banks must be able to meet the short-term demands of customers, and so liquidity management is a significant issue. It is perhaps particularly so for Islamic banks, for whom there are relatively few remunerated outlets for short-term liquid funds. Because of this, their earning portfolio tends towards the long-term and illiquid. This means that such institutions may be required to hold higher levels of overall liquidity, with implications for profitability.
As I have indicated, the existence of an interbank market is essential to assist them in efficient liquidity management. So, too, are deeper markets and a wider range of monetary instruments. The easy availability of such short-term instruments would also increase the ability of Islamic banks to offer a home for short-term savings.
Interaction of Islamic Banking with Conventional Banking
The development of Islamic banking will involve finding ways to co-exist with other banking systems in order to provide a full service to global customers. It is one thing, for example, for a domestic banking system to be founded on Sharia principles, where the local central bank and supervisor can exercise oversight in markets where they have authority and act as lender of last resort; but it is quite another for Islamic banking to operate successfully and on an equal basis in the international economy.
Unless progress is made to establish a complete alternative banking system, co-existing and co-operation are vital. Re-inventing the wheel is surely in no one’s interest. Rather, ways should be sought of using the technical and commercial expertise in conventional banks to develop Islamically acceptable products. There is little justification, it seems to me, for believing that in all cases one has to start from scratch.
This said, there are a number of problems to be solved in dealing with requests that institutions be permitted to offer more general Islamic banking facilities in a conventional economy.
One is how to classify Islamic funds in terms of our own legal framework. One fundamental question is – to what extent, and in what precise forms, are funds placed with an Islamic institution capital-certain, thus falling within the definition of a banking deposit, and to what extent are they participating in a collective investment scheme, thus falling under the Financial Services Act?
My understanding is that Islamic funds may fall into either of these categories (or indeed others). But supervisors and investors in the West certainly need to understand better the developing principles and practices in this area.
Whatever form they take, I think it is likely that the concepts will be familiar to supervisors and regulators in the UK; and that we can find satisfactory answers to these questions, perhaps through the organisational structure. To give an example: Barclays bank takes deposits; collective investments are provided through a separate body; and Barclays Unicorn provides unit trusts.
A second issue is risk. I would simply note that the absence of the interest rate mechanism can place a greater burden on risk managers within Islamic banks; and this links back to the need for Islamic institutions to hold higher levels of overall liquidity, with implications for profitability.
I do not believe that these two problems are insuperable, either for the banks concerned or for their supervisors. For any institution, we as supervisors will require assurance that risks to which depositors’ funds are exposed are properly assessed and controlled; and that a bank has adequate resources in terms of management, liquidity, systems and capital.
In this sense, and from a supervisory perspective, Islamic products do not raise fundamentally different issues from any other banking product, be it swaps, options, syndications or whatever. But they do cause the supervisors to probe thoroughly for explanations that they fully understand.
We are bound to do this as a matter of statutory duty, and it is right that we should – just as we are properly obliged to probe all the less familiar banking products. That a growing number of institutions are active in Islamic products in London shows that solutions can be found in this area.
Some central bankers in predominantly Islamic countries have argued that the central bank should itself be equipped to judge which kinds of contract are acceptable in Islamic law and which are not. There is certainly a supervisory case for this. For example, a perception that a bank was engaging in Islamically unacceptable businesses could put that banks’ liquidity under strain. Malaysia is an example of a country where there is a common Sharia Board advising the central bank and commercial banks alike.
In this country, however, as in many Western countries, we would expect all banks, as a matter of course, to take legal advice to ensure all contracts conform fully with local law. But we leave it to the banks themselves, and their Sharia advisers, to judge what is acceptable in terms of Islamic law, because the systemic and liquidity risks are proportionately much less here.
More Particular Issues of Supervision
I think there would be little argument with the proposition that Islamic banks should be supervised just as any bank is supervised. Indeed, this proposition was agreed by the Central Bank Governors of Islamic States as long ago as their 1981 meeting in Khartoum.
Islamic banks, like any other bank, take funds from the public and so there needs to be some authority watching over the interests of those members of the public – particularly those who are more vulnerable. There is also the issue of confidence in the banking system, which is equally important to the fortunes of Islamic banks as it is for banks in conventional systems.
Whether there are persuasive arguments for Islamic banks being supervised under special rules, perhaps to different standards in view of their different approach to banking, is perhaps more debatable. In the UK the reality is that the Bank of England must implement the law as it currently stands; and the success of institutions in developing Islamic products in London suggests that it is no fundamental impediment.
It is certainly the case that any supervision should be directed at the whole of a bank, and that this supervision should encompass all activities undertaken by the organisation which might affect either its financial position or the banking system in which it operates. Supervision of the whole bank seems to me to extend also to a banking group; however, it is structured and however many countries it operates in. This certainty is a key element in the Bank’s current supervisory approach.
The globalisation of financial services means that financial regulators are dependent more and more on their counterparts abroad. These days, financial disturbances can originate in almost any significant market in almost any country This can lead to quite unpredictable knock-on effects, transmitted through payments and settlement arrangements, anywhere in the world.
Partly as a result, banking supervisors in different countries increasingly work together; and the members of the Group of Ten, who meet together in Basle under the auspices of the Basle Committee, have issued a number of joint papers on their approach to the supervision of banks. These have tended to set a benchmark for supervisory best practice in other parts of the world.
To work out how the supervision of Islamic banks fits into this established approach, one of the fundamental concerns of banking supervisors is to understand how Islamic banks are presently supervised and the methods and procedures used by local supervisors in assessing these operations. We would also wish to understand the basis on which the supervision of these banks is founded.
In the UK, as in many countries, the fundamental objective in supervising banks is to protect the interests of depositors. This is a single, clear objective. There is perhaps an equally clear objective in the case of the wholly Islamic banks, where the supervisor’s task would be to protect both “depositors” and “investors” from poor controls and management.
Clearly defined accounting rules in the allocation of profit between shareholders and investors, and between different categories of investors, have a crucial role to play here. However, it seems to me that the task of supervision can get particularly complicated when there are different sets of risk-sharing funds involved. So, we need to understand – clearly – the local system of supervision and then try to see how it measures up to the practices laid down by the Basle Committee.
A further issue in supervising banks operating in different jurisdictions is the question of consolidated supervision. As part of the Basle minimum standards for the supervision of international banks, all banking operations must be capably supervised on a consolidated basis. For Islamic as well as other banks, this involves questions of structure, which can often lead to difficulty in identifying the precise group to be consolidated – especially where ownership is established through common individuals rather than companies.
Islamic banks may also operate differently under different regimes, which can complicate the consolidated picture. For example, a number of ‘Islamic’ banks in London operate on a conventional basis here – such as Iranian and Pakistani banks – although their Head Offices are part of an Islamic banking system.
A related issue which is often raised is the level of capital which Islamic banks should be required to maintain. The Basle Committee envisages all banks being subject to the same minimum capital requirements.
Given the nature of Islamic banks’ funding, however, especially when on a risk-sharing basis, the need to carry a level of capital equivalent to that required by banks which are obliged to repay their funding in full (whatever their financial position), sometimes leads to suggestions that this is unnecessarily restrictive.
On the other hand, regulators of Islamic banks in some Islamic countries take the view that because Islamic banks are dealing in many new and unfamiliar forms of finance, and because many of their assets are rather long-term and illiquid, they are different from most conventional banks. As a result, they perhaps need a greater safety margin.
This view was expressed by Abdul Malik al-Hamar, a former governor of the UAE Central Bank, when he said: “Because of the differences in their nature and operations, Islamic banks, especially at the start, require more strict supervision than is usually conducted vis-a-vis traditional banking.” This issue is, I know, the subject of continuing debate.
Another issue with Islamic banks concerns the nature of their management. Supervisors are generally required to be satisfied that the management of banking institutions is “fit and proper”, or some other term essentially meaning the same thing. In particular, we would expect decisions in respect of banking products, particularly credit decisions, to be taken by experienced bankers.
In Islamic banks, the precise role played by Sharia boards in approving particular credits is sometimes unclear to us. Knowing whether the Sharia Board’s role is only to approve products as opposed to individual credits may provide some clarification – experience suggests that some Boards have ruled on individual credits.
But it does complicate our task if there are more non-bankers involved in making banking-type decisions in an Islamic bank than there are in a conventional bank. Understanding precisely who makes decisions is therefore important to the supervisor, in order that we can be satisfied that the risk associated with the assets put on the books have been properly assessed.
A related question is the need to understand better the accounting and auditing principles and practices of Islamic banks. There is a lack of clarity and consistency at present, which makes it almost impossible to compare financial statements of different Islamic banks. It is encouraging that the major accountancy firms and some of the major players in Islamic banking are now collaborating to produce new common standards.
Some of the concerns here include how to treat investment accounts, whether on-or-off balance sheet; and this, of course, could have a significant impact on capital adequacy calculations in some cases. As important, are the principles governing disclosure on the audit side where local practices continue to differ. For supervisors these two areas are critical.
Conclusions
As a central bank and as banking supervisors we have no difficulty, in principle, with Islamic banking. As banking supervisors, we also have responsibilities to act in the interest of depositors and we apply our supervisory principles to all banks in an even-handed way. There is still some way to go to ensure that we understand all the intricacies of Islamic banking and the way it operates, in particular the implications of Sharia Boards taking different views about similar transactions.
Islamic banking is developing steadily but is still not yet at a point where customers can choose from a fully comprehensive range of Islamic products. There are, undoubtedly, ways in which Islamic banks can co-exist with conventional banks; and there are areas where co-operation would avoid re-inventing wheels.
There are, however, still issues to be dealt with concerning the extent to which Islamic products conform with local law; and there are also a number of supervisory issues which, in a jurisdiction such as the UK, need to be addressed. But I do not believe that these issues are insuperable.
In short, we need to improve our understanding of what Islamic banking is to identify and solve the problems that arise.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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