Islamic Finance: The Regulatory Challenge

Citation

Weir, D. (2009), "Islamic Finance: The Regulatory Challenge", International Journal of Islamic and Middle Eastern Finance and Management, Vol. 2 No. 1, pp. 80-82. https://doi.org/10.1108/17538390910946285

In this volume, Archer and Abdel Karim have produced a collection of papers that is of first class importance, and will undoubtedly become required reading on the increasingly important topics of Islamic finance and the appropriate frameworks of regulation. It is their misfortune and an irony of recent history that it may not be as much appreciated as it ought to be, because it has of course been overtaken by events in the shape of the unprecedented global crisis of banking and financial markets.

But the changing context also draws added pungency to the explanatory frameworks within which it is clear that this book was originally conceived.

This context was that of Basel II, represented by the document “International convergence of capital measurements and capital markets” issued in June 2004.

The implicit and tacit assumptions of Basel II were that there had emerged a need for an updated version of Basel I in the context as Archer and Abdel Karim put it of the “globalization of financial markets and … the abundance of derivatives and securitization using structured finance” (p. 1).

The editors, cognizant as readers of this journal will be more aware than most, of the continuing and rapid development of Islamic banking and the increasingly urgent need to build bridges between Shari'ah‐compliant and conventional institutions, undertook to review the extent to which Basel II and the philosophies that impelled it “are applicable to the regulation and supervision of Islamic banks” (p. 2).

Thus, this collection contains several chapters that review the extent to which Islamic financial institutions can overcome their apparent intrinsic drawbacks and weaknesses in such factors as risk aversion, investment conservatism, informational opacity and profit and loss sharing rather than rate of interest‐determined return on capital decision making and attain to the levels of sophistication of conventional instruments and institutions.

But a plausible outcome of the present crisis might be to reshape that conceptual framework and in a way turn that set of questions on its head and to consider in its place the implications of the clear possibility that given the reality of the failure of Basel II to create and enforce a regulatory framework for the conventional sectors, whether Shari'ah‐compliant institutions and the philosophies that support them can offer at least a partial or limited alternative road to a more secure future.

With that flexing of emphasis in mind the expert and lay reader, the supervisory authorities and the investment communities alike will all gain much insight from this book.

After a short but very clear overview by the editors in their introduction, van Greuning and Iqbal review research and practitioner expertise on the consequences of operating on principles of profit and loss sharing rather than on interest. They point to some existing issues in respect of duplication of effort, overlapping jurisdiction, contradictory or divisive Fatwa and conflict of advice deriving from lack of universally‐accepted Shari'ah standards associated with several institutions each maintaining Shari'ah boards and Shari'ah advisors in a situation of lack of enough competent Shari'ah experts. Much of this argument is well accepted in the field and has been raised by experienced critics like Mahmoud elGamel for one but it is none the less telling. van Greuning and Iqbal seek regimes in which consistency and transparency are system values.

The themes of consistency and systematic data collection along with those of the need for a comprehensive and transparency are further developed by Sundarajan in a survey of the risk characteristics of Islamic products.

Grais and Kalathunga use a probability analysis of the expected distribution of losses to argue for greater precision in the characterization of types of economic capital that correspond to specific levels of risk tolerance and imply that greater investment in risk management skills are needed to sustain such analyses.

Lee Hin Hock and Haron argue that the special combinations of credit and market risks due to the essential limitations imposed by Shari'ah compliance, as for example under Istisna'a in the case of a defaulting customer who claims justification in cancelling a contract, are characteristic of Islamic financing assets. In an appendix to their chapter they offer a really useful matrix of inherent market and credit risks under the key forms of Islamic finance.

Archer and Haron further develop the analysis of operational risk exposure and again point to the possibility of lack of technical skills in due diligence and financial performance monitoring hindering the continuing growth of the Islamic financial services market.

DeLorenzo and McMillen provide some historical perspective of the development of the legal frameworks that had in the past provided a structural alternative to the ways in which the banking systems emerged to support trade in Europe and show that the recent expansion of Islamic banking and finance rests on firmly established principles of Shari'ah law. So central is their exposition that it could be argued in terms of the organisation of the book that this chapter should be placed earlier.

Hari Bhambra turns attention to the role of the regulator, concluding that greater efficacy can be obtained if regulatory authority extends over the securities markets and the insurance sector.

The next chapters by Freeland, Archer and Abdel Karim, Jackson‐Moore and Fiennes deal with different dimensions of capital adequacy requirements for Islamic finance on capital adequacy and Fiennes in particular identifies specific areas for interest and possible concern again in the intersection of operational and legal risk, in the Islamic activities of conventional institutions and in the potentially ambiguous deposit accounts that may generate opportunities for uncertain claims against the institution.

In Part 3, Abdulqader Thomas reviews the implications of the expansion of sukuk products and argues that these may lead to demands for more active balance sheet management in the quest to provide the market with more attractive tradable products.

Gray and Ismail point to the creation of the Islamic Development Bank and the establishment of the generation of Islamic Banks from the 1970s onwards and briefly return to the ambiguous position of sukuk compared to conventional bonds especially in the case of products that are intended to appeal to both conventional and would‐be Shari'ah compliant investors.

Part 4 deals with issues of corporate governance. Hamid Yunis overviews the field and Archer and Abdel Karim discuss specific governance issues in particular those that relate to the implied agreement of the various stakeholders to consent to statements of fiduciary duties that might consign some of them to the class of “second class equity holders”.

Nakajima and Rider return to Basel Pillar II commenting en passant that the demands on the regulatory systems and on financial institutions of compliance with the various weapons of regulation imposed as part of the “war on terror” and the crusades against organised crime especially relating to drugs have both created a very large but largely uncalculated tax on normal financial functioning but have also combined to create a climate in which “the reality is that financial privacy is – at least in law – a dead issue” (p. 359).

Vicary considers the possibility that the emergence of Basel III can support a “virtuous circle” of transparency.

Finally in Part 5 Nienhaus picks up again on the need for all of these systems of regulation and compliance to be supported by attention to the human resource dimension and in particular to the development of skills and competences as well as the retention in the sector of new cohorts of specialists and professionals.

In conclusion then despite the unwished‐for but not entirely unexpected critical changes in the global financial economy, this collection is indeed nonetheless a milestone publication, scoping the field, reporting developments and issues in the sector and pointing to the need to establish regulatory structures that are both compliant to Shari'ah principles and also sensitive to the competitive requirements of the global markets.