ISLAMIC FINANCE IN THE UNITED STATES- THE REGULATORY FRAMEWORK
ERNEST T PATRIKIS
To pursue Islamic banking in the United States a joint effort between bankers and supervisors is needed. Various issues will have to be looked at. One thing that is clear is that the fact that Islamic banking and finance is based on religious principles is irrelevant to US banking supervisors. Issues of religion are not supervisory matters of concern. If an Islamic banker needs to structure a transaction in a given way, the supervisors will work to try to assist in that process. The fact that this need is grounded on religion does not affect our view of the matter. We will keep our focus on bank supervisory concerns.
In the United States, there exists a complex, if not confusing, financial structure. Over the years, it has grown in a haphazard way. We are just beginning to rationalise our financial system in terms of who can engage in certain activities and who regulates and supervises those firms and/or activities. Broadly speaking, we separate commercial banking from insurance and investment banking. We also separate banking from commerce. Commercial banking and investment banking are supervised or regulated at both the state and federal level. Insurance is regulated primarily at the state level. There are a number of exceptions to these broad separation principles; at some point these exceptions might overcome the general rule.
The reasons for these separations are many. Some go back to the roots of the country in the 18th century, when some banks were associated with business enterprises. Over time, banking became separate from commerce, which became the standard and was eventually codified in the Bank Holding Company Act and the Glass-Steagall Act. In the 1930s, commercial banks were blamed, in part, for bringing on the depression, through links with investment banks and alleged funding of speculative securities transactions. Whether that was an accurate assessment of the facts is far from clear today. Currently, while investment banks and insurance companies can be linked, there are severe restrictions on the affiliation between commercial banks and insurance companies.
One of the key issues of public concern over the years has been the concentration of wealth in banking. That is, if banks were able to invest deposits as equity investments in commercial enterprises, banks would be controlling commercial firms and would not be impartial arbiters of credit. This policy of separating banking and commerce is grounded upon a mixture of safety and soundness concerns and a broader public policy concern about fair and equal access to credit and control over society’s resources by banks. Americans have long had a distrust of the power of banks to allocate credit. Even though the percentage of bank financing transactions has waned as our capital markets have grown, the vestiges of that age-old concern about banks has not gone away, although it is much lessened today.
When conducting Islamic banking or finance in the United States, what must be considered first is the form that enterprise would take – a commercial bank, a branch of a foreign bank, an investment bank, or an ordinary business corporation, such as a finance company.
Generally speaking, a bank supervisor looking at an application will give consideration to several factors; key among these are financial and managerial factors. A supervisor will look to ensure that the bank is well capitalised and has a business plan that shows how that well-capitalised position will be maintained over time. The bank supervisor will also look to ensure that directors and management have the requisite expertise for their respective positions. In addition, if a foreign bank is applying to establish a bank or a branch in the United States, the Board of Governors of the Federal Reserve System would need to determine that the foreign bank was subject to comprehensive consolidated supervision in its home country.
An Islamic financial institution will raise novel questions, in addition to the traditional issues that need to be considered. The general principles of Islamic banking involve adherence to the Islamic prohibition on the charging or receiving of interest, absentee landlordism and speculative activities. Islamic banking stems from Islam’s teaching that money should not be created out of money, but generated by taking risks on productive investments.
Islamic banking arrangements are based on profit-sharing. Account-holders obtain a share of the bank’s profits. This is similar to a shareholder’s dividend. The bank may have something akin to a partnership agreement with the depositor, with a guarantee not of a rate of return but, instead, of a portion of profits. Thus, the bank acts more like a fund manager. If the bank loses money on the transaction, so does the account holder. This would come as a surprise to the typical depositor in the United States. There would be a need to ensure that the “depositor” was well aware of the risks involved with such a transaction.
On the asset side of the balance sheet, the transaction must be structured so as not to involve the payment of interest on a loan. Much creativity is involved in carrying on financial transactions consistent with the teachings of the Qur’an. For example, when some Islamic banks make a home loan, the bank will be repaid the principal amount along with a percentage the bank estimates the house could be rented for. In a business loan, the bank might estimate the potential profit over the course of years and require the borrower to pay back a percentage of that estimate. Islamic banking, as all banking, entails risks. If a bank underestimates the profitability of the borrower, and the borrower fails, the loan will not be repaid. That is nothing new to banking. This will require the bank supervisor to assess how to characterise the risks involved in such a transaction. Should it be regarded as a loan or is it more like an equity investment? If a bank does not have a legal obligation to return its customers’ principal, does it take on a moral obligation to do so?
An Islamic bank may provide investment funds to a project and receive a share of profits in return. An Islamic bank can act as an intermediary or middleman in trade transactions by importing a product and then selling it at a mark-up. An Islamic bank can enter into a lease or a lease-purchase transaction. An Islamic bank can also enter into an advance payment transaction, such as purchasing goods before they are produced and then selling the goods at a profit. Another form of transaction is the deferred payment sale, where an asset is purchased from and resold to the same person, the difference in the two prices involving a predetermined profit. There is also money-market instruments or inter-bank instruments where the rate will be based on the profitability of the borrowing bank.
How will all of this fit with the banking system in the United States? The first issue encountered is whether these transactions are “banking” within the definitions of our statutes. In the United States, banks are one of the few types of corporate entities that have separate charters and limited powers. There is the often-told story of how Alexander Hamilton founded the Bank of New York, receiving a charter from the New York legislature. Aaron Burr wanted also to establish a bank but could not get a charter. Burr ultimately sought a charter for a water company and sneaked in a reference to banking. That bank is now the Chase Manhattan Bank. Aaron Burr later killed Alexander Hamilton in a duel in New Jersey. At the Chase Bank you can find two reminders of this, the duelling pistols and a piece of the wooden water pipe of the original Manhattan Company. History aside, the relevance here is that banks are limited to banking as defined in the relevant federal or state law. For example, the powers permitted a New York State-chartered bank are defined in the New York Banking Law and for a national bank in the National Bank Act.
In addition, in order to establish a branch, a foreign bank must be engaged in banking activities usually in connection with the business of banking in the country in which it is located. (12 U.S.C. Section 3101(7).) The Board of Governors of the Federal Reserve System has defined this to mean that foreign banks must: (1) be foreign chartered, (2) engage in the business of banking, (3) be recognised by the bank supervisory or monetary authority of its home country, (4) receive deposits to a substantial extent in the regular course of its business, and (5) have the power to accept demand deposits. Therefore, in order to establish a branch in the United States, the foreign bank must meet that definition. If it does not do so, it would not be able to establish a banking branch. But that would not be the end of the inquiry. It may well be that the Islamic bank is akin to an investment company and come under the jurisdiction of the Securities and Exchange Commission as an investment company.
If the desire is to charter a domestic bank, then what will need to be done is to explore the proposed activities of the proposed Islamic bank to ensure that they are consistent with the relevant banking law. Activities such as repurchase agreements and financial lease transactions may well be appropriate activities. Taking equity investments might be impermissible depending on the bank’s ownership structure and whether there is a need for Federal deposit insurance.
On the liability side, it is not clear to me that an account where the return is measured in a way that could result in a loss of the paid-in principal amount is not a deposit. I have come across references to some accounts offered in New York State where the return of the full amount of principal was not deemed to be a necessary feature of a deposit.
Another issue to be considered is how our usual supervisory tools would be applied to an Islamic bank. Bank supervisors’ first concern is with safety and soundness and systemic risk. Systemic risk concerns the impact of the financial failure of an organisation on other financial organisations and on financial markets and ultimately on the real economy. Safety and soundness concern whether the institution is being operated with appropriate controls and limits and is otherwise in compliance with relevant laws and regulations. A good deal of the process is supervisory, that is, qualitative, not regulatory; that is prescriptive. What is meant by that is that it involves an assessment by bank examiners of the financial strength and managerial controls of the bank. This is done in a “hands-on” way by examiners looking at the bank’s systems, books, and records on site and assessing the quality of its management. In addition, we rely on reports of the bank, which are issued quarterly and made public to allow the public – investors, depositors and counterparties – to assess the creditworthiness and risk profile of the bank. Another issue to be considered is the bank’s liquidity management. The examiners will need to assure themselves that the bank has sufficient liquid assets to repay claims on the bank.
Of course, another issue will be whether the examiners’ traditional tools of assessing capital adequacy can be applied to a bank engaged in Islamic banking.
There may also be questions of accounting. Another area that needs to be explored is the extent to which a particular arrangement resembles a mutual fund where the investors’ money is pooled into investments that meet Islamic requirements. It seems that this fits within our traditional notion of a mutual fund. Many mutual funds target certain types of investments. This does not appear to be a complex issue.
Where does all of this lead us? I would like to come full circle. Much needs to be learned by us about Islamic banking. The primary message is that as bank supervisors we have an open mind on how to approach any issues Islamic bankers may raise. Islamic bankers have been quite ingenious in developing financial transactions that suit their needs: bank supervisors, too, can be ingenious and are willing to work with those who wish to engage in Islamic banking in the United States. It is hoped that any issues raised can be resolved to the mutual satisfaction of the bankers and supervisors.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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