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Regulation and Governance of Islamic Finance
Evolution of the Islamic Banking regulatory framework of Saudi Arabia
i) History of Saudi Arabian Monetary Agency (SAMA)
It has been noted that Arabia did not have the currency system until the mid-twentieth century. In lieu of the existing system they used coins that were full bodied in exchange for the commodity bought. As per the Islamic guidelines banking with interest was reticent however, the very first bank was set up in Jiddah in the year 1926, however not much importance was given to it. In terms of currencies exchange; it was set up at Mecca mainly for the pilgrims. Here, the locals had informal connections to the international currency markets. In the year 1927 the government issued a silver riyal so as to make the monetary issuance standard across this region. With the rise in the oil income for the economy many foreign and domestic banks were cropping up during that time. By the year 1950, there was a sharp rise in such institutions that warranted a regulatory and policy making body to have more formal control over the same. In light of this, in the year 1952 with the assistance of the US technical department, the Saudi Arabian Monetary Agency (SAMA) was created. This bank was created to oversee the central policies but within the confines of the Islamic law. This in turn gave rise to the formation of regulatory frameworks as well as policies by the1980’s. The systems introduced were on the basis of the service charges rather than interest so as to circumvent the Islamic law. From here on the Islamic banking has been developed due to its unique finance systems and also because this is a system with a strong moral and ethical base (Lone & Alshehri, 2015).
Role of SAMA
SAMA, as mentioned above was developed in the year 1952, but has expanded rapidly to date. SAMA is made up of a board of director that consist of a governor and a vice-governor who are appointed by the ‘Royal Decree’ for a term period of four years. The term can also be extended by the Royal Decree in the same manner. A major turning point in the functioning of SAMA and the role it plays was altered by the introduction of the Banking Control Law in the year 1966. This law not only clarified but also strengthened the role of SAMA as a policy making body in the field of banking as per Islamic law. This banking law expanded the services that SAMA can offer including the domains such as banking, securities and investments. The role of SAMA can however be listed out as follows,
- Issuance of the Saudi Riyal (National Currency)
- Acting as the banker to the government
- Supervising other commercial banks in Saudi
- Management of foreign exchange services of the kingdom
- Advising government on issues of public debt
- Economic growth promotion and ensuring the stability of the Saudi financial system
- Setting the monetary policy for price promotion and stability of the exchange rate.
Such roles draw from the functioning of the banks in the Western world and the functioning of the International Monetary Fund (IMF). The other aspects are also drawn from the Western Central banks and the Basel-based banks for international systems (BIS). Therefore it can be stated that SAMA adopts a western central bank approach but implements policies that may be taken up on a global scale following the global crisis of 2008 .
ii) Changes to financial institutions
While it is commonly known that Saudi Arabia is predominantly an oil economy, the present scenario indicates that shift in the same is required. This is because the oil price has declined largely (over 40%) since mid-2014. It is thereby necessitated to explore the impact of the oil economy on the banking system in Saudi Arabia. The situation as it has been is that the economy relied more on the oil rates than on the banking interest rates. This reliance has also had a major impact on the economy as well as financial rates rather than the interests set forth by the bank. However, while a temporary drop in the oil price is not likely to have large long standing impacts on the economy a continuance of this on the other hand can have serious repercussions to only the economy but also the banking sector (Al-Kibsi et al., 2016). This can be seen as the case in which the oil prices are consistently low for longer periods of time, wherein stress on the banking sectors can emerge as a result. This in turn requires for the vigilance of the banks in adjusting the policies in order to be resilient and support the economy. The direct impact on the banks however is in conjunction with the increase in the non-performing loans due to reduced governmental spending. In view of this revision to the policies should be the following.
- Changes to the macro prudential policy frameworks: it can be stated that placing countercyclical macroprudential policies can mitigate the systemic risks in the financial sector. There do arise certain feedback loops that exist between the asset prices, government spending, non-oil GDP and credit. In this regard, the fiscal policies are the only tools that can safeguard the economy from fluctuations that arise in the oil prices. Therefore setting a countercyclical policy in place not only protects the economy but also secures the financial framework of the nation.
- More microprudential norms: in view of the fact that the economy depends on a single large commodity, there is a need to set in place more microprudential norms. This dependence on oil makes the market more vulnerable due to the lack of diversity in the economy.
- Other aspects of the regulatory requirement can pertain to the capital adequacy ratio, provisioning, leverage ratio, reserve requirement, Loan to value, debt service-to-income, loan-to-deposit- ratio, liquidity further pertaining to the statutory liquidity reserve, LCR and NSFR, counter party exposure and foreign exposure (Abusaaq et al., 2015).
Tightening liquidity tools can increase the resilience to liquidity shocks. However it can be stated that the credit margin may decrease in the process. Amongst other avenues, it is imperative to thus review the regulation frameworks of Islamic banking in Saudi Arabia to make the gradual shift away from the largely oil based economy.
iii) Role of Hisbah
In ancient times, during the initial stages of economic development in Islamic countries where the growth of Islamic banking took place, a supervisory institution called ‘Hisbah’ played a pivotal role in governing the activities of the market. The members of the institution govern and audit business transactions in order to check their compliance with the Shariah laws. In case of offending the Shariah laws, the inspector of Hisbah reports to the central institution which punishes such offenders (Kasim, 2010). The institution possesses Islamic scholars well versed in Shariah principles, accounts and finance in business who are commonly known as ‘Muhtasib’. These scholars are privileged to act independently rather specific to a firm (particular finance institution). The establishment of a separate institution is stated in the holy Quran wherein the implementation of such a system is to ensure the business that occurs in a market (business institutions) should be made in such a way it does not affect the well-being of fellow human beings. An in depth analysis of the term ‘hisbah’ relates the modern day ‘auditing’ (Lahsasna et al., 2014). The hisbah community prevailed long back but today, the conditions have changed wherein internal Shariah experts and auditors work for a specific bank or external auditors perform auditing for compensation. However, such auditing is not a mandatory requirement (Shafii et al., 2010). The lack of a central auditing board to supervise banks is evident in countries like the Europe, US and Asia where malpractices and fraudulent activities are still highly reported (Yaacob, 2012).
In light to the report by Kasim et al. (2009), the need for an auditing body is critical and is stated by many researchers who imply that compliance to Shariah rules can be maintained with such a governing body. In addition, it is also stated that four main concepts pertain to the implementation of a Hisbah institution: the framework, scope, qualification and the independence of the author. However, in the present study the role of hisbah i.e the independence of the auditor plays a major role. Shariah compliance with respect to both macroprudential and microprudential regulations is adversely affected by a number of factors such as lack of a hisbah institution, lack of adequate finance, Islamic and accounting knowledge by banking personnel, shortage of Shariah experts and Shariah auditors. However, Saudi Arabia is considered to be the only muslim nation that holds a separate wing of ‘hisbah’ without the intervention of other regulatory bodies and ministries (Khan, 1999; Kahf, 2000; Elsergany, 2010).
Dogarawa (2011) in his research on the role of hisbah and implementation of the same in Nigeria revealed the importance of such an institution to impart fair play in banking business transactions. It was also inferred that the role of such institutions were predominant in complying with the principles of Shariah and the adaptation of such a system by Shariah-compatible governments was emphasised. The hisbah officers who play a vital role in minimising fraudulence in banking transactions should be priviledged to act independently in accordance with Shariah rules.
Part B- Upcoming regulations by the Bank of England and its impact on Islamic banking
The global financial crisis of 2007-2008 had massive repercussions on the financial system of the world as a whole as it seemingly collapsed. This crisis was seen to be quite a great fiasco since the Great Depression. The eventually crash of the financial markets have led several researchers to delve into the drivers that led to such a severe collapse in the systems(Davis, 2011; Hasan & Dridi, 2011; Merrouche & Nier, 2010). As per Merrouche and Nier (2010), a working paper that was released by the IMF, estimates that three main events may have caused such a crisis. The three causes are, global imbalances with respect to capital flow that was on the rise, lenient monetary policies that also contained several loopholes through which one could operate and in adequacy that was expressed in the regulatory norms for the financial institutions. Davis (2011), while is aligned with the working paper by the IMF, has stated five areas along which the decline in financial states occurred. The author here is of the view that, leverage was a major cause in the aspect that high leverage could only be held in situations where there were increase in the asset prices and also in the investor confidence.
The second contributory factor here was stated as being inadequacies in the regulatory aspects especially pertaining to governance, accountability and remuneration practices of the financial institutions. The third was the creation of liquidity which eventually became uncontrolled which was attributed to the imbalances of accounts on a global scale with the well-endowed countries investing in the deficit ones. The fourth cause was evaluated to be growth that was both disproportionate as well as unregulated and the concept of shadow banking in itself. Further to this several financial instruments were also constructed that increased the dependencies on each segments in the sector. It is interesting to note the rise in economic and financial crimes during those years especially. The final contributor stated by Davis, is the lack of information to the public regarding the risks of the financial system and also the distribution of the same.
In light of this, the impacts that the global financial crisis had on the Islamic banks are also interesting to note here. While the main effects of the crisis extended to the conventional banking system, it can be stated that the impacts on Islamic finance per se were minimal. However, the main impact that comes into play here are the global reforms for all financial organisations. On another note, post the global financial crisis, many Islamic economists were of the view that had the conventional banks adopted the principles of Islamic banking, then the crisis may not have occurred (Chapra, 2008). This can be adequately evidenced in the fact that Islamic banking law lays emphasis to the fact that the equity modes of financing do require much higher protocols of due diligence coupled with rather active forms of monitoring. Additionally, debt cannot be traded as that would lead to riba, making products such as the CDO or MBS null in the Islamic system. Laws such as Gharar also prevent the existence of the CDO. This in turn made the Islamic banks more secure and less vulnerable to false and transferable securities which may be the mainstay reason behind which the Islamic banks were the least impacted and also their compliance with the Shari’ah (Desai, 2008; Brewster, 2008). On the contrary, authors such as (Dar, 2007), and Siddiqi (2006) are of the view that following the Islamic banking framework could have also eventually led to such a crisis. They opine that the aspect of tawarruq causes more harm (mafasid) than benefit (masilah) by circumventing certain prohibitions that have been put forth; therefore, being largely non-compliant to the Shari’ah law. Irrespective of the opposing views however, it has been deemed imperative that financial reforms are in order so as to stabilise the present financial system.
With the above views it is imperative to explore the upcoming regulatory reforms put forth by the Bank of England. As per the Deloitte UK report (Deloitte, 2015), the upcoming reforms are categorised into the ten main areas that require reconsideration. They are,
- Structural reform and resolution in the financial sector
- New institutions in action
- Data and regulatory reporting
- Culture and treatment of customers
- Competition and innovation
- Stress testing and risk management
- Capital Markets Union
- Business model mix
- Solvency II and insurance capital
- The interaction of market structures
For the purpose of this report however, five key areas will be chosen from the same so as to critically evaluate their impacts on Islamic banks.
Structural reform and resolution in the financial sector may be discussed under the particular legislation of ‘ring-fencing’ which has been deemed an important structural change. The next reform pertains to the culture and treatment of customers with the certification regimes. This is so the preventable action may be taken so as to protect the market. In this purview the mortgage market review under the interaction of market structures may also be discussed. Further to this, a reform to the business model mix is considered on the aspects of newer leverage ratios, this is in order to meet the changes of the Basel III. The last regulatory reform considered here is the aspects of financial crimes.
The portfolio will hence discuss the five regulations in two parts. Part A will state the regulation while part B analyses the effects of this regulation on the in-built stabilisers of Islamic banking. The annex that follows both the parts will contain a further background of the legislations.
Structural reforms- Ring fencing
The prudential Regulation Authority (PRA) (England, 2016) has put forth ring fencing as a major structural reform. While this legislation has been contemplated in the past, it has been implemented post the global finance crisis and is expected to be in place by the year 2019. This is especially for those banks whose deposits surpass 25 billion pounds and also to split out the investment banking sector from the retail sector. The implication of the same has been elaborated in Annex1.
The Impact on Islamic banking
It can be stated first off that the impact of ring fencing will not have large impacts on the Islamic banks in the UK straight away. This can be attributed to the fact that such banks in the UK are rather small to medium sized which again means that they will not have core operating deposits of more than 25 billion pounds depicting that they do not fall under the class of ring fenced banks. Even so, the demand for Islamic banks is on the rise, which may subject them to the ring-fence legislation in the future. Further to this, mergers with banks may also take place which can raise the core deposit value which again can put them under ring-fence.
Another aspect needed to be taken into consideration is the fact that as per Shari’ah law the banks can only engage in investment banking activities unto a certain extent only which excludes activities such as market making for derivatives and security lending. The Shari’ah outright prohibits such entities which mean that regulations for such entities have not yet been put forth by the main regulatory authorities such as the Islamic Finance Services Board (IFSB) and the Accounting and Auditing organisation for Islamic Financial Institutions (AAOIFI). This again can be attributed to the capping in the investment banking that Islamic banks hold. Eventually, the main reason that brought such a regulation is to prevent the merging of the retail with the investment sector, with retailers using these deposits for high level investments.
As for the built in stabilisers of the Islamic bank, the legislation does not infringe upon the aspect that it does not require for the bank to deal in interest based transactions. It rather is a structural reform wherein even if conventional banks adopt some aspects of Islamic banking, and are subject to ring fencing they cannot be prone for any risks on the law of the Shari’ah.
An independent commission that was led by Sir John Vickers in the year 2011 constituted the ring-fencing legislative. This was so that when high risk investment is involved retail banking activities will remain largely unaffected and can continue to go on. The high risk investments can include but is not limited to trading, underwriting shares, along with bonds and securities trading (Schwarcz, 2013). As per the Bank of England, the main idea behind introducing such a regulation can be attributed to the global financial crisis. Although implementing ring-fencing was considered prior the crisis, the same gained a large foothold post the crisis which warranted tighter regulations. The implication here thus remains that should a banking crisis arise, the core activities of the functioning can remain unaffected in that the core deposits are secure and cannot be used for ‘risky’ investments. Furthermore, the regulation has been set for implementation in 2019. However it has been requested by the bank of England that the plans for implementing such a change were to have been handed in by January 6, 2015. As result of such a legislative it has been predicted that there will be tremendous changes to the legal as well as the governance structure of the banks in the days to come (Prudential Regulation Authority, 2015, 2014).
Culture and Treatment of customers- The certification Regime
As per the Financial Services Act, 2013 from this very year (2016) onwards banks as well as other financial institutions will be required to follow the certificate regime (Financial Conduct Authority, 2015a). A further elaboration on this regulation has been provided in Annex2.
Impact on Islamic banking
This particular regulation has been deemed to have a negative impact on the Islamic banking institutions. While the certificate regime is quite a positive regulation, which involves the certification of the all the staff in the bank, it demands for a complete revamp of the personnel employed with the need for more experienced that may replace the fresher employees. In specific to Islamic banking, such a replacement of the staff on the whole would mean hiring people who may be well versed in the banking aspects but no much on Islamic law front which poses a grave risk to non-compliance of Shari’ah law. besides this, acquiring new staff and training them to operate under the purview of the Shari’ah law increases the operational cost which if passed on to the customers can making their banking experience more expensive. On another note however it can be stated that like the ring-fencing, this particular regulation too does not have bearing on the main prohibitions of the Islamic law which is interest based and speculative transactions. This therefore makes the workforce more efficient. Additionally, another positive aspect is that with the operational risk at a minimal, the certification regime can prove to be quite useful especially with the involvement of multiple parties for a transaction.
The IFSB in this regard has made recommendations to the effect of the requirements of the members on the Shari’ah board. It recommends firstly that all members be trained and assessed for their knowledge on Islamic laws for banking as well as their understanding of the same. Interestingly, the regulations authority, Bank of Negara, Malaysia recommends for the Shari’ah framework on governance, but however has not yet laid the foundations for a certificate regime as put forth by the FCA.
As aforementioned, the new proposal is slated to have been implemented in the present year 2016. As stated in the joint report as commissioned by both the PRA as well as FCA, the certificate regime will ensure that not a single employee of the organisation will perform a ‘significant harm function’ unless otherwise certified by the firm to do so (HM Treasury, 2015) . In view of this a ‘significant harm function’ may be described as the actions of an employee of carrying out the regulatory functions of the bank as that which can cause great harm to the bank as well as its customers. It has been stated in this context that as per the PRA this will apply to the risk takers while from the viewpoint of the FCA will apply to any and all personnel that interact with the customers directly. It can thus be stated that the certificate of regime may help to reduce the operational risks (Shearman and Sterling, 2015; Allen & overy, 2014).
Mortgage market review
The mortgage market review (MMR) was introduced in April of 2014 after nearly five years of deliberation by the FCA. The regulation came into play for the lenders to assess whether the borrowers can pay the loan back irrespective of changes to the interest rates. The explanation for the same has been provided in Annex 3.
Impact on Islamic Banking
The mainstay idea behind the MMR is to protect the consumers. It is to ensure that the consumer is aware of all the aspects involved when availing a mortgage. It is also so that the lenders may take the necessary steps so to make sure that the borrowers are able to pay back the loan even in cases of altered interest rates.
With respect to the impact of MMR on Islamic banking is dependent on the type mortgage that can be availed in this institution. Home financing in this regard is rather different from the ones that are offered in the conventional banks. As per the law od Shari’ah Islamic banks do not directly lend loans to the buyers as that would mean charging above the principal amount, incurring an interest which is prohibited. Rather, the bank buy the houses for the buyers and lease it out and sell shares over the period of the lease or sells it to the buyer in a mark-up scheme. The first method is known as Ijarah while the second is known as Murabahah (Karim et al., 2012).
As per the Murabahah, there can be no changes that can be made once the sale has been fixed between the bank the consumer. In view of this for this type of housing finance, fluctuations in the interest rates will not have an impact. For the Ijarah type of financing on the other hand, the leasing period is used to sell the shares to the client. It is interesting to note here that in the UK Islamic banks still use the local LIBOR to set their rental/lease rates. In this case, it implies that the banks would have to do a ‘stress test’ on the interest rates to determine if the consumer can in fact afford the payments on continuance as if the interest on the rent go up the payment rate would also rise.
The MMR is a regulation that was out forth by the FSA in the year 2009 to be implemented in the year 2014 by the FCA. The key feature of this regulation is that the responsibility of assessing the borrowers and their ability to pay back loans are the solely on the lenders including the verification of their incomes. In this case, the banks would conduct an ‘interest rate stress test’ to so as to determine the viability of the borrower’s ability in loan pay backs in the case of changes in the interest rates (Financial Conduct Authority, 2016).
Business model mix: Newer leverage ratio
The government of England proposed that the Financial Policy Committee (FPC) from Bank of England be granted the direction over setting the leverage ratio requirement at a minimum that is required for the functioning of all banks. However, the same will only be applicable for Global Systemically Important Banks (G-SIB’s) and other banks in the UK that are domestic. This is inclusive of building societies and other PRA regulated firms. The regulation is to come into effect from 2018 onwards. In view of this, it has been decided by the FPC to set the minimum required ratio at 3% of the exposures (Bank of England, 2015). The same has been further elaborated in Annex 4.
Impact on Islamic Banking
It has been stated that banks will be required to have a leverage ratio of 3% that is mainly made up of tier 1 capital. It has also been observed that the ratio levels as set by the Basel committee which coincidentally is also 3% will not have a significant impact on the functioning of the Islamic banks. This can be mainly attributed to the fact that ratio as proposed by the FCP requires that more than half (75%) of the core value has to come from tier capital. From this viewpoint the Islamic banks will not appreciate much change as much of their capital is tier 1. This is mainly because tier 2 capitals consist of interest and debt instruments which are prohibited under Islamic Law. Therefore the chances of having tier 2 capital are very slight. Contrastingly, both tier 1 and tier 2 constitute to core capital in the case of conventional banks making them more susceptible to such a regulation than the Islamic banks (Bitar et al., 2014).
Any company for the sake of smoother financial operations relies on the conjunctions of capital equity as well as the debt. A leverage ratio in this aspect measures the amount of capital incurred by the firm as debt, or in other words to evaluate whether a firm meets its financial obligations or not (Brei & Gambacorta, 2014).
The formula in this regard may be that leverage ratio equals the capital divided by exposures that is greater than or equal to 3%. As mentioned above, the FPC directs that the minimum leverage ratio to be at 3% for global systemically important banks, building societies and PRA regulated banks for implementation by 2018.
While financial crimes are not new in the financial world there have been two very important reforms made on the same by the FCA. These are the Serious Crime Act 2015 and the Crime and Courts Act of 2013. The Serious Crime Act pertains specifically to money laundering while the Crime and Courts act was established to investigate money laundering and terrorist funding (ICAEW, 2016; Financial Conduct Authority, 2015b). These were put forth by the FCA.
Impact on Islamic banks
It has been noted that all banks irrespective of whether they are conventional or Islamic take special precautions to ensure that their personnel do no commit any financial crime. These acts can be even such as bribery and corruption. Additionally the banks also take other precautions to ensure that they are not subject to money laundering or terrorist funding. In this regard such regulations put the Islamic bank in a state where they would need to exercise enhanced caution over their practice of both funding as well as accepting funds from Muslim charities. Evidence has projected that many Muslim charities have been shut down in the past few years for financial crimes that pertain specifically to terrorist funding.
In this scenario it can be stated that in the face of financial crimes Islamic banks are more susceptible than the conventional banks mainly due to the fact that Islamic banks will prefer to work with other Islamic institutions so as to ascertain their compliance to the Shari’ah. The downside here however mainly stands in the fact that due to the above mentioned many Islamic banks will be forced to refuse funding from such organisation for fear of long term implications on the same. This in turn translates to a business risk for these Islamic banks as it will result in the loss of not only deposits but also client-ship with these institutions. The eventuality hence is that the capital maybe reduced along with the decrease in profits. Therefore, Islamic Banks in order to keep with this regulation must exercise more caution on the selecting such institutions for funding by referring to other regulatory boards such as charity commissions.
As evidenced above it can be stated that pertaining to the regulatory changes that have come about as a result of the global financial crisis must be treated as those that do bear impacts on the Islamic banking structure. With respect to the five regulations as stated above, two have a definitive negative impact on Islamic banking. These are financial crimes and mortgage market review. New certificate regimes also project a negative impact but is balanced out by other positives while ring fencing and leverage ratio seems to have no or minimal impact. The main recommendation therefore pertains to Islamic banks in the UK embracing the new regulations as put forth while also keeping in compliance with the Shari’ah.
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