islamic finance (the regulatory challenge) || supervision of islamic banks and basel ii: the...

CHAPTER 1Supervision of Islamic Banks and Basel II:

The Regulatory Challenge

Simon Archer and Rifaat Ahmed Abdel Karim

1. I N T R O D U C T I O N

T he challenge to banking regulators and supervisors representedby the Basel Committee for Banking Supervision (BCBS) docu-

ment International Convergence of Capital Measurement and CapitalStandards: A Revised Framework (generally known as Basel II) is,of course, first and foremost in respect of its application to conven-tional banks. Basel II was issued in June 2004 (with some revisionsin November 2005) to supersede the original 1988 Capital Accord(Basel I). The main innovations introduced in Basel II were, first, asignificantly more comprehensive and sophisticated approach to mea-suring credit risk and, second, a capital requirement for operationalrisk. With respect to market risk, Basel II did not supersede the 1996Amendment of Basel I, which had introduced a capital treatment forthis category of risk, not specifically covered in the original capitalaccord.1

Basel I was a document of modest length that made no greattechnical demands on the reader. However, the years since 1988 haveseen a very significant evolution in banking and finance, including theeffects of the globalization of financial markets and developments suchas the abundance of derivatives and securitizations using structuredfinance. These developments have significant implications for risk andcapital adequacy. Hence, Basel II, which (with its appendices) runs

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Islamic Finance: The Regulatory ChallengeEdited by Simon Archer and Rifaat Ahmed Abdel Karim

Copyright © 2007 John Wiley & Sons (Asia) Pte. Ltd.

2 Islamic Finance: The Regulatory Challenge

to over 250 pages, is a fairly daunting document that makes somenon-trivial demands on the reader, both technical and conceptual.

Basel II was not written with its application to Islamic bankingin mind. However, the rapid development of Islamic banking sincethe early 1990s, and the fact that international financial authoritiessuch as the World Bank, the International Monetary Fund (IMF), andthe BCBS understood the consequent desirability of building bridgesbetween Islamic (Shari’ah-compliant) financial institutions and theconventional (non-Shari’ah-compliant) financial sector,2 inevitablyraised the issues of how and to what extent Basel II principles andtechniques are applicable to the regulation and supervision of Islamicbanks, and of the regulatory and supervisory problems to be overcomein this context.3 These issues constitute the concern of this book.

2. T H E S T R U C T U R E O F B A S E L I I :S U P E R V I S O R Y I M P L I C A T I O N S

The structure of Basel II is based on three ‘‘Pillars.’’ Pillar 1 dealswith the new approach to credit risk which replaces that of Basel Iand with operational risk; Pillar 2 addresses the supervisory reviewprocess from the standpoint of the responsibility of the supervisor topromote the overall safety of the banking system, and establishes aset of common guidelines for supervisory review, while also stressingthe primary responsibility of individual banks and the critical roleof dialogue between supervisors and banks; and Pillar 3 lays downa minimum number of public reporting standards on risk and riskmanagement intended to enhance the ability of market participantsto be aware of a bank’s risk profile and the adequacy of its capitalin relation to this, thus involving the market in the capital adequacyregime.4

Basel II thus presents all banking supervisors with a majorchallenge, both in enforcing Pillar 1 together with the disclosurerequirements of Pillar 3, and in implementing Pillar 2. To be sure,the adoption of Basel II is not intended to be a requirement outsideof the G10 countries who are represented on the BCBS, and thenonly for banks that are internationally active. However, as Basel Ihas been adopted in over 100 countries, the supervisors in these andother countries may be expected to adopt Basel II progressively overthe next few years.

For supervisors in countries where Islamic banks are located, thereis the further challenge of applying Basel II to those institutions. This

Supervision of Islamic Banks and Basel II: The Regulatory Challenge 3

added challenge results from the specificities of the Islamic (Shari’ah-compliant) modes of finance employed by Islamic banks. These raiseissues of capital adequacy, risk management, and corporate gover-nance that differ significantly from those that arise in conventional(non-Shari’ah-compliant) financial institutions. The issues concernthe types of assets to which Islamic financing gives rise, the relatedrisks and the availability of risk mitigants, and the types of non-interest-bearing savings and investment products offered by Islamicbanks for funds mobilization in place of conventional deposit andsavings accounts. The fact that these non-interest-bearing savings andinvestment products have characteristics similar to those of collectiveinvestment schemes, not normally the concern of banking supervisorsor regulators, constitutes a further regulatory challenge.

3. T H E I S L A M I C F I N A N C I A L S E R V I C E SB O A R D

The Islamic Financial Services Board (IFSB) was launched in 2002 bya consortium of central banks and the Islamic Development Bank (andwith the support of the IMF) with the mandate including the provisionof prudential standards and guidelines for international applicationby banking supervisors in the supervision of Islamic banks.

In December 2005 the IFSB issued two prudential standards forIslamic banks that are designed to help supervisors of such banks meetthe challenge of implementing Basel II, one on capital adequacy andone setting out guiding principles of risk management (together withan Exposure Draft of a third standard on corporate governance).5 Themandate of the IFSB was extended in December 2005 to the domainsof insurance and securities market supervisors and regulators.

The main challenge for the IFSB is to develop a framework that iscommon and applicable to all jurisdictions. However, unlike the BaselCommittee, which can rely on regulatory frameworks and best prac-tices developed by other leading regulators and banks as a backgroundto its global framework, this process could not be readily applied bythe IFSB. This is because the IFSB does not have the privilege of bor-rowing ideas from a large number of countries that have developedrobust regulatory frameworks specifically for Islamic banks. Hence,the onus of developing most of the thinking to set internationallyaccepted common prudential standards for Islamic financial institu-tions is on the IFSB. This involves identifying the risks in the differenttypes of Islamic finance and activities, understanding the substance


as well as the form of the contracts that govern the transactions,dealing with issues that have not been addressed in other inter-national standards, safeguarding the interests of other stakeholderswho in principle share asset risks with the shareholders, and adaptingShari’ah rules that would be acceptable to the majority of its members.

4. C O N T E N T S O F T H I S B O O K

Since this book deals with a large range of regulatory issues arisingfrom the application of Basel II to Islamic banks, authors whohave been chosen are specialists drawn from a variety of relevantbackgrounds: international organizations such as the World Bank andthe BCBS; banking supervisors; the legal and accounting professions;banks and financial institutions; international credit rating agencies;and academia. The book is organized into four main parts, reflectingdifferent aspects of the regulatory challenge, and two concludingchapters, as outlined below.

Part 1: The Nature of Risks in Islamic BankingThis part consists of seven chapters from 2 to 8. In Chapter 2,Hennie van Greuning and Zamir Iqbal examine banking and therisk environment with reference to Islamic banks. They look athow Shari’ah-compliant financial intermediation operates in theoryand in practice, and the risks, and corporate governance and trans-parency issues, to which this gives rise to. The risk characteristicsof Islamic products, and the complexities of some of these, suchas the phenomenon of displaced commercial risk, are rigorouslyexamined in Chapter 3 by Venkataraman Sundararajan. Chapter 4,by Wafik Grais and Anoma Kulathunga, deals with capital struc-ture and risk in Islamic banks. They consider issues of efficient riskmanagement in relation to the level of capital and capital structureand to the nature of Islamic financing assets. The next two chaptersfocus on specific types of risks in Islamic banks. Credit and marketrisks inherent in asset-side products are examined by John Lee HinHock and Abdullah Haron in Chapter 5. They show how Islamicfinancing assets possess risk characteristics not found in conventionalloans, including combinations of credit and market risks. Consequen-tial or operational risks are analyzed by Simon Archer and HaronAbdullah in Chapter 6. For Islamic banks, as they point out, opera-tional risks include those that may arise from errors in drawing upcontracts or in executing transactions that result in non-compliance


with the Shari’ah which may have serious financial consequences.Chapter 7, by Yusuf Talal DeLorenzo and Michael McMillen, dealswith a complex and daunting set of risks arising from Shari’ah andlegal compliance requirements and their interactions, which resultinter alia in legal impediments to the development of Islamic secu-ritizations. The authors also provide a historical outline, from alegal perspective, of the emergence of modern Islamic banking andfinance. Finally, Hari Bhambra in Chapter 8 considers the implica-tions of these risks for a financial sector regulator. She concludesthat matters are easier if the regulator is a cross-sectional regula-tor, responsible for securities markets and the insurance sector aswell as banking. So far as Shari’ah compliance is concerned, theregulator or supervisor does not need to take positions on issues ofShari’ah, but instead must satisfy itself as to the effectiveness of anIslamic bank’s own systems and procedures for ensuring Shari’ahcompliance, both ex ante (in the design of products and the asso-ciated contracts) and ex post (in contract execution and productdelivery).

Part 2: Capital Adequacy

This part contains four chapters. Chapter 9, by Charles Freelandand Steven Friedman, examines the need for bank capital in order toabsorb banking risks, providing the rationales and historical back-ground of the Basel I and II frameworks. There follows a chapterby the editors, Simon Archer and Rifaat Ahmed Abdel Karim, whichhighlights an important set of issues concerning the measurement ofrisk for capital adequacy purposes that results from the use by Islamicbanks of profit-sharing and loss-bearing investment accounts in lieuof conventional bank deposit and savings products. In Chapter 11,Elisabeth Jackson-Moore deals with the measurement of operationalrisk for capital adequacy purposes. Among other things, she pro-vides a suggested mapping of banking activities into business linesfor operational risk measurement as required for the StandardisedApproach under Pillar 1 of Basel II. Finally, the supervisory impli-cations of the above are addressed by Toby Fiennes in Chapter 12.He states that it is quite possible for an Islamic bank to be bothShari’ah-compliant and Basel II-compliant, and refers to the work ofthe IFSB in facilitating this. But he identifies some problems: a higherlevel of operational and legal risk; Islamic ‘‘windows’’ in conventionalbanks; and the ambiguous situation of profit-sharing and loss-bearing


‘‘deposit’’ accounts: what is the nature of the claims on the bank thatthe holders of such accounts are entitled to make, and what are therisk implications of these claims? He concludes by emphasizing theneed for transparency.

Part 3: Securitization and Capital Markets

There are three chapters in this part. Chapter 13, by AbdulkaderThomas, deals with the developing phenomenon of Islamic securitiza-tions, or sukuk, emphasizing the distinction between the issuance oftradable securities that do not result in the derecognition of assets fromthe balance sheet and true asset securitizations resulting in derecog-nition (the latter being rare for reasons discussed in Chapter 7). Theauthor concludes that the rapid development of the Islamic financespace, with the emergence of new opportunities and methods to serveclients better, must ultimately lead to business activities that requiremore active balance sheet management (including securitizations thatresult in asset derecognition) than has been hitherto performed byIslamic banks. In Chapter 14, Stella Cox considers the opportunitiesand challenges in the Islamic capital and money markets, and partic-ularly the need to create a Shari’ah-compliant asset base and financialinfrastructure for the creation of liquid Shari’ah-compliant assets. Theregulation of Islamic capital markets is discussed by Robert Gray inChapter 15. He points out that the legal and regulatory environmentsin the most advanced capital markets (such as those of the UnitedStates and Europe) are not unfriendly to Islamic finance and to theissuance of Islamic securities. U.K. law has served as the basis forsukuk issues in a number of Islamic countries, while many of themost successful international sukuk transactions have been made incompliance with the guidelines in U.S. Regulation S for the offeringof securities outside the United States. However, Gray calls for theintroduction of non-mandatory guidelines to regulate non-Islamicinstitutions offering Islamic capital market products.

Part 4: Corporate Governance

This part contains four chapters. The first, Chapter 16 by HamidYunis, considers issues of corporate governance as they apply tobanks. Chapter 17, by the editors, examines specific corporate gover-nance issues in Islamic banks, notably those raised by the requirementfor compliance with the Shari’ah, and those resulting from the use


by Islamic banks of profit-sharing and loss-bearing savings andinvestment products in place of conventional deposit and savingsaccounts. In Chapter 18, Chizu Nakajima and Barry Rider exam-ine corporate governance and supervision from a Basel Pillar 2perspective, with particular reference to problems of the legal envi-ronment and of regulatory over-reaction to certain types of threat. InChapter 19, David Vicary considers the transparency and market dis-cipline implications for Islamic banks of Basel Pillar 3, indicating thepotential key role of the regulator in promoting or ‘‘bootstrapping’’ avirtuous circle of transparency.

Part 5: Conclusion

In the first of two concluding chapters, Chapter 20, Volker Nien-haus examines the human resource management implications of theconceptual and technical challenges facing the Islamic banking sec-tor, including the need to recruit, train, motivate, and retain highlycompetent personnel in an environment rendered highly competitiveby rapid growth and the presence of the major international banks.Finally, Chapter 21 by the editors presents some overall conclusions.

ENDNOTES1 For further details and a historical background, see Freeland and Friedman (2006),

Chapter 9 in this volume.2 In part, this was due to a series of conferences organized by one of the editors of

this volume, then Secretary-General of the Accounting and Auditing Organizationfor Islamic Financial Institutions (AAOIFI), notably the Conference on Regulationof Islamic Banking held in February 2000.

3 The essential differences between conventional and Islamic financial intermediationare explained in Chapter 2 of this volume.

4 Freeland and Friedman, loc. cit.5 Exposure Drafts of IFSB standards on the supervisory review process (Pillar 2) and

transparency and market discipline (Pillar 3) are due to be issued in the second halfof 2006. The Exposure Draft on Corporate governance is due to be issued as astandard in early 2007.

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