ALTERNATIVE TOOLS OF REGULATION
AHMED H RADWAN
When we speak of alternative tools of supervision, it is crucial to depart from the current stream of thinking which treats both conventional and Islamic banks with almost the same remedies instead of giving due regard to the special characteristics of Islamic banks. The truth of the matter is, we really do not have to stretch old formulas to cover new problems.
First of all, when we talk about Islamic banks we should know if we are talking about any one particular unit in any one specific country. An Islamic bank should not necessarily be a composite bank, which does almost everything, and is engaged in all fields of activity. In other words, each Islamic bank is a unit and not a system of its own.
It could be a commercial, industrial development or investment unit. But in each case, it will be liable to the relative sets of supervision and controls that are applied to it by a central bank or by a monetary authority. Nevertheless, this article is about a commercial bank unit accepting demand and term accounts, and which is using its funds in Islamic modes of finance for the short-or medium-term.
The second important regulation from the central bank’s view is how to determine the Islamic modes of finance. Each central bank should have its own understanding of Islamic modes of finance and see to it that this understanding is properly communicated to Islamic banks and to other units of the financial market.
There is no better example than Circular No. 13 of the State Bank of Pakistan. Possible modes of finance are detailed under three captions, which are: Financing by Lending, Trade Related Modes of Finance, and Investment-Type Modes of Finance. Each transaction experienced in their banking system, whether located in trade and commerce, industry, agriculture and fisheries, housing, or personal advances, is related to a range of possible modes of financing.
Profit-Sharing Techniques for Regulation
As the rate of interest is used by central banks and monetary authorities to regulate the volume and quality of credit, profit-and-loss techniques realise for the controlling agencies almost the same objectives.
As an alternative to the “bank rate” for regulating credit expansion, the central bank can use the profit-sharing ratio. This rate could be the one resulting from a specific investment fund or could be the average rate of all operating funds. The actual payment of profits to the central bank can take place on the usual payment dates of customers, quarterly, semi-annually or annually. However, the bank could pay its central bank interim profits on specified dates to be settled later according to the realised profits.
As to the use of the interest rate to help in directing credit to priority sectors or vice versa, the central bank could enforce a change in profit rates on trade-related modes of Finance and profit-sharing in investmentrelated modes. In addition, the Bank could regulate the other conditions of sales in Mudaraba (business contract), deferred sales and hire-purchase by changing the commitment payment or the period of finance.
In cases where the central bank needs to change rates of interest on deposits for monetary objectives, especially when fulfilling a stabilisation programme, it can also change the customer’s portions of profit in the case of Islamic banks. This is perhaps a delicate point in Islamic central banking as profit rates are contractual and fateful. But if we appreciate a change on the investment side, a proportionate change should occur on the liabilities side.
The much more controversial point in regulatory tools is to enforce a profit rate schedule on investment accounts arranged according to maturity, i.e., the longer the period, the higher the rate.
This has been attempted by at least one central bank. The technique in theory is to compute the volume of a certain group of deposits for the profit distribution process at their par (face) value, then make other groups of deposits subject to different “weights”, where some are below par and others are above par.
For example, if saving accounts (the zero point) earn 8.9 per cent in Pakistan (on an annual basis), notice deposits for 7-29 days will earn 5.5 per cent, while three-months term deposits will earn 9.8 per cent, five-years term deposit 15.6 per cent and equity 21.2 per cent. The idea is to encourage customers to deposit their funds in longer maturities in the same way as conventional banks do.
While the problem is appreciated on the basis of funding stability, it raises many reservations when related to Sharia principles. If an Islamic bank were given ample time to work for a profit rate schedule according to maturity, it could endeavour to establish separate funds, each financed by a different maturity source.
These sources would be directed towards different groups of investments that varied in risk and duration. In so doing, the bank may end up in the long run with a profit rate schedule relative to the duration of different investment accounts.
The duration of the investment account could also affect the profit rates if the longer maturities were given some concession by the central banks’ regulations. Deposits in Egyptian pounds held for more than two years in Egypt are exempted from a cash ratio of 20 per cent. It would only be fair that holders of such accounts should be privileged by a proportionately higher rate of profit. Their complete funds are competing with 80 per cent of other funds.
Ceiling on Outside Resources
If the history of conventional banks is traced back to the indigenous money-lenders who accepted money for safekeeping and made loans at high rates of interest, the theory of Islamic banks rests on the experience of the highly knowledgeable, and much respected businessmen who were approached by their relatives, neighbours and friends offering them their idle funds for investment on a Mudaraba basis.
This formula requires a successful record, high credibility and sound reputation on the part of the concerned businessman. This background is brought in here to emphasise the necessity of back-records and the availability of amply-owned resources on the part of Islamic banks. Capital should be adequate to recruit experienced staff and to initiate enough business. In the course of development, care should be given to maintain a gradual growth and restrain any outburst of activity.
Central banks can regulate the initial steps by stipulating an adequate capital account and can help in attaining a gradual growth by limiting the inflow of outside investment funds. As an example, the Islamic banks should not seek outside fresh funds for more than its capital account in any one financial year. The increases are cumulative and subject to the changes in capital accounts but should not exceed ten times the capital at any one time.
If investments are made at the risk of Arbaab-al-Maal (managers of funds), they should have enough information, back-records and time to judge and decide whether to participate.
Investment Programmes
To make the investment opportunities attractive to most financiers in the market, the Islamic bank should make different combinations to encourage growth, stability, profitability and liquidity The interested party might be able to grasp the salient features and the expected outcome of the programme, but he is in no way fit to undertake a thorough evaluation.
As the investor is not materially covered by any guarantee on revenue or principal (except in cases of fraud or negligence), the central bank is expected to interfere to safeguard public interest. This could be achieved by directing banks not to implement any investment programme or to make it known to the general public unless it has been evaluated and sanctioned by the central bank.
The programmes in question should be those that are offered to a prescribed minimum of investors or exceed a certain amount. If the central bank has any reservation about doing this job directly, it could be assigned to independent auditors for appraisal and follow-up.
Other Regulations to Safeguard Investors’ Interests
Whilst equity-holders’ interest in Islamic banks is safeguarded by management, auditors and law, the rights of investors are governed only by the Mudaraba contract, which is drafted and implemented by the bank. They provide funds and shoulder risks but are not consulted by any means when decisions are taken or when returns are computed and distributed.
To bring more balance and more justice into this bank/investor’s relationship, some corrective regulations should be taken by the concerned central bank. The following proposals are illustrated for guidance:
1. Deposit-holders (investors) should be represented in the meetings of Directors and the General Assemblies by well-chosen experts who may participate in deliberations as observers. The reason for not suggesting a voting right for them is to keep them away from management commitments, a precondition that is clearly and rightly formulated by Sharia principles.
The selection of observers, their remunerations and how to cover their administrative expenses, together with their means of communications with fellow- investors, could be organised by a decree. The activities of the observers could be very effective if they were given the right to address the controlling agency occasionally.
2. Alternatively, deposit-holders could appoint independent auditors from a list agreed upon by the controlling agency. These auditors would be directed to examine some points of interest to investors and report to them and to the controlling agency. Their audit might cover the evaluation and the follow-up of the investment programmes, the checking of revenue and expense accounts and the distribution of net profits between equity-holders and deposit-holders.
In order to avoid conflict and duplication of work, the company’s auditors could be entrusted with the additional responsibilities if they were reporting to the controlling agency in fulfilment of a legal requirement.
3. The central bank examiners may also cover the above points of interest and await an explanation or an application of prompt corrective measures.
Profit Equalisation Fund
Central banks are responsible for promoting an efficient and competitive banking environment through branch restrictions and ceilings on deposit yields and other bank prices. Islamic banks are part of the banking system and observe tariffs on banking sei-vices. However, profit rates in most cases are left to each bank’s policy. The liberal attitude of central banks in this regard may be attributed to three reasons.
1. Islamic banks are still experiencing their first stage of development and should not be impeded by untimely regulations.
2. Islamic banks in general do not present severe competition to other banks.
3. Rates of distributed profits have not been so exceptionally high as to disturb the balance in the financial market.
With hope for the expansion of a network between Islamic banks and an improvement in profit rates, competition pressures may deem the issue of regulatory tools necessary. Competition may arise not only between Islamic banks and conventional banks, but also among Islamic banks themselves. To restore order and to help alleviate the swift movements of funds from one institution to the other, the central bank may urge Islamic banks to establish a “Profit Equalisation Fund”.
The objective of such a Fund would be to mitigate the ups and downs of distributable profits. This regulation may not necessarily disturb the profit-sharing principle as most depositors stay with their bank over a long period of time.
The technicalities of this organ would be left to the local conditions in each country. In general terms, one should first determine what a normal rate of return is. If the rate is put at 10 per cent of investment accounts, the bank should credit the Fund with one percentage point if the realised rate is more, and, if less, to debit the Fund with whatever is needed and available, to enable the bank to distribute 10 per cent of investments. The Fund should always be replenished if its balance is below a certain figure, say 20 per cent of outstanding deposits.
Conclusion
In this twilight period, central bankers, as other bankers, depend upon realities and seek the truth. Islamic banks are now a reality with different phases. One has to describe and to define properly what is in hand and then try to work out the logistics and put the system in motion.
This article has tried to give some answers regarding alternative tools of regulation. It has suggested that profit-sharing techniques make a good substitute for bank-rate and interest policies. Can profit rates follow in theory the existing maturity schedule of term deposits? The answer is negative unless we establish investment funds that match every maturity we have.
Capital adequacy is more important to Islamic banks and the leverage rate should be more conservative and well spaced out. In safeguarding public interest, the central bank might find it proper to evaluate and to follow up the new investment programmes of banks either directly or through independent auditors.
Should investors wait at leisure for their periodic cheques or should they busy themselves with the usual investor/manager relationship? The answer is clearly the latter If the bank realizes a good profit record, should it distribute it to the last coin or keep some aside for bad years? In this case, the Profit Equalization Fund seems to be the best answer.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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