Banking Regulation And Supervision Islamic Banks

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A credible and stable banking sector is one of the basic preconditions for a functioning economy. Such stability cannot be guaranteed by market mechanisms alone, so the activities of banks are governed by a large number of restrictive and injunctive regulations, which chiefly take the form of legal rules (banking regulation). Overseeing adherence to these rules and ensuring accountability for any contravention of them is known as banking supervision. However, the term “banking supervision” often embraces banking regulation, too. The supervision of banking activities involves seeing to the sound operation and purposeful development of the banking system and this broadly defined objective means in particular supporting the sound development, market discipline and competitiveness of banks, preventing systemic crises and strengthening public confidence in the banking system.

It is not the aim of banking supervision, however, to prevent the failure of individual banks, to substitute for the police and other law enforcement authorities, or to deal with complaints filed against banks by their clients. The managers of a bank are responsible for its management and financial results. Its own boards and general meeting of shareholders exercise the control function. And its statutory bodies are responsible for ensuring that the internal control mechanisms and risk management in the bank are functioning. The supervisory authority´s job is to carry out subsequent checks focusing on compliance with the regulations. This by itself cannot prevent banks from entering into loss-making transactions. If the supervisory authority uncovers any shortcomings, however, it is obliged to apply its remedial instruments, which can include revoking the bank´s licence or imposing conservatorship.

How Banks are Regulated and Supervised 

How banks are regulated and supervised include the requirements and regulatory powers regarding:
Entry into banking
Powers and activities
External auditing
Internal management/organisation
Liquidity and diversification
Accounting and disclosure
Depositors/savers protection scheme
Disciplining powers


The supervisory objectives, which should not be confused with obligatory regularity requirements, may cover functions like:
(a)  Inspection programme to ascertain whether the financial strength of the bank is being maintained on an ongoing basis.
(b)  Examination all compliance programme requirements such as identifying and controlling risks associated with money laundering and terrorist financing as well as risks and risk management expectations, industry sound practices, and examination procedures.
(c)  Examination of branches and agencies of foreign banks.
(d)  Examination of trading operations and related capital-markets banking activities as well as examination of risk management issues encountered in trading and dealer operations, including market risk, counterparty credit risk, legal risk, financial reporting, accounting, and ethics.
(e)  Evaluating the information technology environments within supervised financial institutions.

Role of Central Banks and Regulators

The objective of any regulatory and supervisory environment for the Islamic banking industry should also be to maintain confidence in the banking system as a whole, in
particular to protect to depositors. Like the conventional financial system, Islamic financial system also requires to be regulated for the following reasons:
1 Increasing the information available to investors
2 Protecting interests of savers
3 Ensuring the soundness of the financial system

In addition, separate banking laws and regulations may need to be enacted to ensuring development of:

  •   Shari´ah-compliant investment instruments;

  •   financial market infrastructure;

  •   providing cost-effective alternative funding;

  •   conformity with best international practices;

  •   central bank’s role as lender of last resort.

Central Banks and Regulators can play a crucial role for the development of a framework for Shari’ah-consistent monetary policy instruments to operate within a level-playing field. Underlying these is the critical role of transparency and common standards to avoid moral hazard problems.

Supervisors face a dual challenge.

On one hand, supervisors are promoting financial diversification and consolidation to achieve market development and innovation. On the other hand, supervisors have to position themselves to recognise the new dimensions and types of risks and encourage appropriate risk mitigation. For Islamic banks the key factors are:

• Stronger inter-dependencies among different segments of Islamic finance are emerging largely because Islamic Financial Institutions (IFIs), in principle, have features and inherent characteristics and more compulsion, than  conventional banking, to conform to universal banking or to evolve inter-linkages among different market segments. 
• Islamic banks’ depositors/borrowers desire to conduct financial transactions that are Shari’ah-compliant. It can be assumed that a person preferring to bank with an Islamic bank will also seek to use other faith-based financial services such as Takaful and Islamic mutual funds. This faith-driven feature in itself forces and provides incentives for Islamic banks to offer, along side bank-based services (i.e. deposit and loans), a wide range of financial services. As a result, Islamic banks end up undertaking non-core banking activities such as fund management, capital market operations, securitisation, leasing, and housing finance. This has enhanced the degree of integration between various segments of Islamic finance. For example: Islamic banks are likely to be strongly integrated with the Islamic capital markets since, on credit portfolio side, Islamic banks do not have the same investment avenues as those available to their conventional counterparts. The outcome is that Islamic banks either end up taking large exposure in the capital markets directly or acquire subsidiaries which primarily engage in such businesses. 
• The differentiating aspect is the nature of contractual arrangements that drive deposits mobilised by conventional banks as compared to Islamic banks. Conventional bank deposits are interest-based contracts with guaranteed interest return whereas Islamic banks raise deposit on a profit and loss sharing basis in either a Mudarabah or Musharakah structure. Mudarabah/Musharakah contracts transform the Islamic banks’ deposits into essentially a fund management product (although currently most regulators recognise these as equivalent to conventional deposit contracts) and this impacts the corresponding asset portfolio. There is a need therefore that Islamic banks acquire assets on a profit-and-loss- sharing (PLS) basis as well and eventually move beyond fixed return products, like Murabaha and Ijarah. This pushes an Islamic bank towards universal banking since in order to manage the portfolio profitability; it needs to invest across sectors in businesses based on Shari’ah principles, like equity and Sukuk in the capital market and trade contracts like Commodity Murabaha, Musharakah, Ijarah and Takaful.

Externally, recognising the specificity of Islamic financial institutions within the broader regulatory approach, would contribute to greater transparency. Regulators need be flexible and to work with Islamic banks in order to become acquainted with the needs of the industry and be able to develop acceptable regulatory frameworks. In jurisdictions where regulations result in constraints on Islamic finance operations, regulatory authorities and market participants should be well-versed in the nature and implication of the rules adopted, and thus helps to promote market discipline without placing an undue burden on the Islamic financial institutions. 

Thus, the regulatory and supervisory authorities in countries where both systems operate side by side must be mindful of setting up a regulatory framework that, while consistent with Islamic precepts, would be pragmatic and flexible enough to meet internationally accepted prudential and supervisory requirements. 

For example, under Shari´ah principles, Islamic banks cannot therefore guarantee the repayment of the full amount of the deposit, with the depositor standing to lose part or whole of their deposits which do not meet the requirements of the regulations in Western countries requiring that deposits have to be returned in full. In Muslim countries such as Malaysia and the Gulf States, separate regulations have been developed to allow banks to share the risk of loss on investments with their clients. In UK, as this would have required a major revision of the banking laws and prudent regulations, another solution had to be found. It took a long time to negotiate a practical solution between the

Financial Services Authority (the FSA) and the Shari´ah scholars. The final solution was to structure the Mudarabah arrangement underlying the savings and deposit/investment accounts in such a manner that the FSA was satisfied that the risk of loss of amount deposited by the depositors was minimal.



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