Islamic Banking and Basel II[1]

Prepared by: Prof. Stefano Miani[2]andDemeh Daradkah[3]

Abstract:

Thirty-three years ago Islamic banking was considered wishful thinking. However, serious research work over the past two-and-a-half decades has shown that Islamic banking is not only feasible and viable, but is an efficient and productive way of financial intermediation. A number of Islamic banks have also been established during this period in heterogeneous social and economic milieus. Many challenges still lie ahead, however, for Islamic banks to be able to comply with international standards and guidelines. A key issue relates to the implementation of Pillar 1 of the Basel II Accord, or capital adequacy requirements. The objectives of this paper are to provide a basic understanding of the fundamental features of Islamic banking with a view of their history, growth and development and to study the implications of applying Pillar 1 to Islamic banks.

Keywords:Islamic Banking, Growth and Development, Regulation and Supervision, Capital Adequacy Requirement, Risk–weighting and Basel II Accord.

Introduction:

Islamic banking started on a modest scale in the early 1970s and has shown tremendous growth over the last 30 years. What started as a small rural banking experiment in the remote villages of Egypt has now reached a level, where many mega-international banks are offering Islamic banking products. The practice of Islamic banking now spreads from East to West, all the way from Indonesia and Malaysia towards Europe and the Americas. The size of the industry that amounted to a few hundred thousands of dollars in 1975 had reached hundreds of billions of dollars by 2008. Like other banks, they are profit-seeking institutions. However, they follow a different model of financial intermediation. The fascinating features of that model have attracted worldwide attention. While it is the preferred way of banking for one-fifth of humanity, it offers a wider choice of financial products to all.

In a global world economy, however, Islamic banks have to face key challenges in order to effectively compete with conventional banks. As of January 2008, commercial banks in OECD countries started implementing the Basel Committee on Banking Supervision’s accord (BCBS) on the Amendment to the Capital Accord to Incorporate Market Risks[4] and on the International Convergence of Capital Measurement and CapitalStandards: A Revised Framework[5], hereby referenced as Basel II Accord, which set standards for capital adequacy and sound banking practices. This implies that eventually, Islamic banks will need to follow up quickly and abide by international standards as well. Capital adequacy has become the keystone for safety that reflects supervisory concerns. The adoption of international standards by Islamic banks will help enhance their credibility and fuel their growth worldwide.

Under the standardised framework, Basel II sets clear guidelines for the calculation of adequate capital. The balance sheet underlying the rules of the Basel Capital Accords, however, belongs to a conventional bank whose structure completely differs from that of an Islamic bank, both in terms of assets and liabilities. No specific requirements addressing the particularity of Islamic banks’ balance sheet structure were introduced under Basel II. As a result of the particular nature of their activities, the risks borne by Islamic banking institutions differ to a greater or lesser extent from those outlined in Basel II. Serious attempts are being made by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) to develop a better capital adequacy framework that addresses the risk profile of Islamic banks. (Turk and Sariedddine 2007)

This paper provides a basic understanding of the fundamental features of Islamic banking with a view of their history, growth and development. After more than quarter of a century of practice, it is time to evaluate this experience. And it also addresses primarily the crucial question of how to apply the international regulatory standards to Islamic banks, the paper reviews the applicability of Pillar 1 set by the Basel Committee for Banking Supervision on Islamic banking. It finds that pillar 1 of the new Basel framework, namely capital adequacy to be relevant to Islamic banks. It argues that adoption of the new system for risk-weighting of assets proposed by the BCBS can help cultivate an effective risk management culture in Islamic banks through internal ratings and proper control systems. The paper argues that it will be easier for these banks to adopt international standards if separate capital standards are set for demand and investment deposits. This will enhance the endorsement of Islamicbanking by international standard setters, thus promoting its worldwide acceptance and enabling it to compete successfully in a globalise environment.

The rest of the paper is organized as follows: the next section offers a brief review of the History and Growth of Islamic banks and Financial Services. The subsequent section provides the latest size of Islamic financial industry while focusing more on Islamic banking, as it’s the main player of the industry. The later Section provides a basic understanding of the fundamental features of Islamic banking with a view to defining a paradigm version of Islamic banking and characteristics of banks operating according to it. Based on this understanding Section Four examines the crucial question of how to apply the international regulatory standards to Islamic banks,focusing on the implications of applying Pillar 1 of Basel II accord to Islamic banks. The paper concluded with a section on policy recommendations.

1. Histories and Growth of Islamic Banks and Financial Services:

Although many factors appear to have led to the emergence of Islamic banks, the most important of them could be the following:

(i)Neo-Revivalist condemnation of interest as riba, Islamic banking theory was being developed under the influences of neo-revivalist thinking until Islamic banks began to be established on a large scale in the 1970s.

(ii)The oil-wealth of conservative Gulf States, the accelerated growth of Islamic banks at national and international levels occurred after the oil price rises of 1973 and 1974. Almost all Islamic banks established in the 1970s in the Middle East were partly, and in some cases totally, funded by oil-linked wealth. The most active countries in contribution the necessary capital for Islamic banks, at private or public sector levels, were Saudi Arabia, Kuwait and the United Arab Emirates (UAE). The four hundred percent increase in the oil price after the Arab oil embargo of 1973 was the important determinate in the revenue increase for these countries. This increase in revenue created large foreign reserves, the increase was beyond their absorptive capacity, which led to a problem of the recycling of “petro-dollars”.

(iii)The adoption of the traditional interpretation of riba by several Muslim states at policy-making level, the political decisions relating to its promotion are manifest on three fronts: 1-the prohibition of interest in the laws of some Muslim countries; 2-the decision to establish an international Islamic bank; 3-the participation of Muslim governments in the emerging Islamic banking movement. (Saeed 1996)

1.1 Modern History of Islamic Banking and Financial services:

For the sake of minimizing the historical details, further discussion on the history of Islamic economic and finance is limited to the developments since the nineteenth century. One can divide the developments and efforts made toward implementing a Shariah-compliant economic, financial and banking system into three phases; pre-1950, 1950-1990 and from 1990 to the present.

1.1.1 Phase I: Pre-1950

Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at low ebb in the late nineteenth century, where several Muslim countries were under colonies rule of different rules through the nineteenth century and through a good part of the twentieth century.

The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import export requirements of the foreign businesses. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. The local trading community avoided the “foreign” banks both for nationalistic as well as religious reasons. However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then many confined their involvement to transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank were strictly avoided in order to keep away from dealing in interest, which is prohibited by religion.

With the passage of time, however, and other socio-economic forces demanding more involvement in national economic and financial activities, avoiding the interaction with the banks became impossible. Local banks were established on the same lines as the interest-based foreign banks for want of another system and they began to expand within the country bringing the banking system to more local people. As countries became independent the need to engage in banking activities became unavoidable and urgent. Governments, businesses and individuals began to transact business with the banks, with or without liking it. (Abdul Gafoor 1995).

A formal critique and opposition to the element of “interest” started in Egypt in the late nineteenth century when Barclays Bank was established in Cairo to raise funds for the construction of the Suez Canal. The establishment of such an interest-based bank in a Muslim country evoked opposition from its inception. Further, a formal opposition to the institution of “interest “can be found as early as 1903 when the payment of interest on post office saving funds was declared contrary to Islamic values and therefore illegal by Shariah scholars in Egypt. In India, a minority community of Muslims in southern India took the first step toward their desire to purse an Islamic mode of economic activities by establishing interest-free loans as early as in the 1890s. Another such institution called Interest Free Credit Society was also established in Hyderabad in India in 1923.

During the first half of the twenties century, there were several attempts to highlight the differences between the emerging conventional economic system and the areas it conflicted with Islamic values. The need for an alternative economic system conforming to the principles of Islam soon came to the fore and econometrics began to lie out alternatives to the conventional banking system by exploring Shariah –compliant contracts, especially equity partnerships. The earliest references to the reorganisation of banking of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948). By the end of 1950s, Islamic scholars and econometrics started to offer theoretical models of financial intermediation as a substitute to interest –based banking.

1.1.2 Phase II: 1960s-1980s

By the start of the 1960s, there was enough demand for Shariah-compliant banking and it resulted in establishment of the Mit Ghamr Local savings Bank in (1963-1967) by the noted social activist Ahmad-Al-Najjar, the bank proved to be a huge success with accounts and deposits swelling within a short period of its existence. However this experiment led to the creation of the Nasser Social Bank in Egypt 1971 as an example of the first state sponsorship in the establishment of an interest-free institution.

In the meanwhile there were a parallel efforts in Malaysia in 1963, where the Malaysian government set up the “Pilgrim’s Saving Corporation” to help prospective pilgrims to save and profit, which was latter incorporated into the Pilgrims’ Management and Fund Board in 1969.

Islamic banks began to be established on a large scale in the 1970s, largely due to the huge increase in the revenue of several oil-rich Muslim countries, especially in the Middle East as a result of the oil price rise during that decade and the growing influence of neo-revivalism.

In 1970, Muslim heads of state held a meeting in morocco to create what later became the organisation of Islamic Conference (OIC), where it was decided that Muslim governments should consult together with a view to promoting close co-operation and mutual assistance in the economic, scientific, cultural and spiritual fields.

Two more conferences where held in Jeddah March 1970 and the second one in Karachi December 1970. Following these two conferences an important meeting in Cairo 1972 were held to arrive at an alternative Islamic method of dealing with financial matters and to find ways of facilitating the investment of the surplus capital of the oil-rich Muslim countries in a way which would be of benefit to the Muslim community. At that meeting an important document called the Egyptian study[6] were discussed. And it is also further discussed in the third conference in Jeddah 1972.

In 1975, The Islamic Development Bank was established as an international financial institution in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of Muslim Countries held in Jeddah in 1973, with the object of promoting economic development and social progress as well as offering development finance of member countries (The present membership of the Bank consists of fifty-six counties) and Muslim communities individually as well as jointly in accordance with the principles of Shariah .

Followed with the establishment of the Dubai Islamic bank by some traders in 1975as one of the earliest private initiatives in the UAE. Academic and research activities were launched with the first international conference on Islamic economics held in Makkah, Saudi Arabia 1976.In Jeddah, Saudi Arabia 1978, the first specialized research institution, namely the Centre for Research in Islamic Economics was established at the King Abdul Aziz University.(Saeed 1996)

The major developments of the 1980s include continuation of series research work at the conceptual and theoretical level. As a result the Islamic Research and Trading Institute was established in 1981by the Islamic Development Bank. Where the Islamic republics of Iran, Pakistan and Sudan announced their intentions to transform their overall financial systems to make them compliant with the shariah. Other countries such as Malaysia and Bahrain started Islamic banking within the framework of the existing systems.

In the early stages of 1980s the increased demand attracted the western banks in different ways: first, the lack of quality investment opportunity in Islamic banks created business opportunities for the conventional banks to act as intermediaries to deploy Islamic banks’ funds according to the guidelines given by the Islamic banks. Secondly, western banks started to offer Islamic products thought Islamic windows[7] in an attempt to attract the clients directly, without having an Islamic bank as intermediary. Finally, non-western conventional banks also started to offer Islamic windows because of the growing demand for shariah-compliant product and the fear of losing depositors.

1.1.3 Phase III: 1980s-present

By the early 1990s, the market had gained enough momentum to attract the attention of public policy makers and of institutions interested in introducing innovative products. The following are some of the noteworthy developments:

  • Recognizing the need to present adequate, reliable and relevant information to users of the financial statements of such organizations had lead to seek the most appropriate financial accounting standards. The interest in developing financial accounting standards for Islamic banks started in 1987. In this respect, several studies have been prepared. These studies have been compiled in five volumes and deposited in the Library of the Islamic Research and Training Institute of the Islamic Development Bank. The outcome of these studies has been the formation of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), which was registered as a not-for-profit organization in the State of Bahrain in 1991. Since its inception the Organization has continued the efforts to develop accounting standards.
  • Islamic equity funds were established.
  • Islamic Financial Services Board (IFSB) was established in 2003 to serve as an international standard-setting body of regulatory and supervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry, which was defined broadly to include banking, capital market and insurance. In advancing this mission, the IFSB promoted the development of a prudent and transparent Islamic financial services industry through introducing new, or adapting existing international standards consistent with Shariah principles and recommend them for adoption.
  • Further progress was made in developing capital markets such as Islamic assets-backed certificates, Sukuks (Islamic bonds), which were introduced in the market
  • During the equities market boom of the 1990s, several equity funds based on Shariah-compatible stocks emerged. Dow Jones and Financial Times launched Islamic indices to track the performance of Islamic equity funds.
  • Several international infrastructure institutions were established to create and support the Islamic financial system such as the International Islamic Financial Market (IIFM), the General of Islamic Banks and Financial Institutions (CIBAFI) that was established in 2008 and the Arbitration and Reconciliation Centre for Islamic Financial Institutions (ARCIFI). As well as other commercial support institutions such as the International Islamic Rating Agency (IIRA), which was established in 2005, and the Liquidity Management Center (LMC).

The systemic importance of Islamic banks and financial institutions has been recognized in several jurisdictions. The Governments of United Kingdom and Singapore extended tax neutrality to Islamic financial services. (Iqbal and Mirakhor 2007).