The rapid growth of Islamic banking in Arab countries presents important economic opportunities, but it also presents financial stability challenges. Islamic modes of banking can increase financial intermediation, enhance economic growth, and facilitate the “bailing-in” of investors in the resolution of distressed Islamic banks.1 However, the scope of Islamic banking activities extends beyond traditional financial intermediation and, as a result, Islamic banking operations give rise to a unique set of risks that cannot be adequately addressed by prudential regulations designed for conventional banks.2 The unique risks include, among others, displaced commercial risk, rate of return risk, Sharī’ah noncompliance, and equity investment risk.
This chapter reviews the extent to which Arab countries have adapted their banking frameworks for prudential and liquidity management to cater to the unique risk characteristics of Islamic banks. The analysis draws on the 2016 Survey of Prudential Frameworks in Countries with Islamic Banks in their Financial Systems that was undertaken by staff of the IMF, in collaboration with regulatory and supervisory bodies. The conclusions in this report reflect the experiences in 16 of the 22 members of the Arab Monetary Fund, for which questionnaire responses were completed and submitted. In a few cases, Technical Assistance reports provided adequate information to undertake the assessment.
The rest of the chapter is structured in four parts. The first section provides an overview of the scale, growth, and operations of the Islamic banking industry in member countries of the Arab Monetary Fund. The second section discusses the status of the regulatory and supervisory frameworks in those countries, covering the legal framework, the licensing regimes, prudential regulations, Sharī’ah governance, consumer protection, and supervision. The third section reviews liquidity management tools, the financial markets (money and Sukūk3), resolution frameworks, lender of last resort, and Sharī’ah-compliant deposit insurance schemes. The last section summarizes the findings and discusses policy options for the sound development of the Islamic banking industry.
Overview and Recent Developments
Scale and Growth
The Islamic finance industry in Arab countries is dominated by the banking segment. Islamic banking assets account for 80 percent or more of the Islamic finance industry in 21 of the 22 Arab countries. Capital market products—consisting largely of Sukūk and, in some cases, Islamic investment companies and funds—are the other significant segments. The Islamic insurance (Takaful ) and reinsurance (Retakaful ) industries, as well as the Islamic microfinance sector, are still very small.
The Islamic banking industry has grown rapidly in geographical reach, asset value, and market shares. Islamic banks are now present in all but one Arab country and have in most cases gained significant market shares. Using the threshold of 15 percent market share of domestic banking system assets at the end of September 2015, Islamic banking has become systemically important in 11 Arab countries: Bahrain,4 Djibouti, Iraq, Jordan, Kuwait, Mauritania, Qatar, Saudi Arabia, Sudan, the United Arab Emirates, and Yemen. In several other countries, Islamic banking has significant market shares of between 5 and 15 percent, including in Egypt, Oman, and West Bank and Gaza. The stability of Islamic banks is therefore important for overall financial stability (Figure 13.1).
Size of Islamic Banking Sector in Arab Countries
Sources: Islamic Financial Services Board, Financial Stability Report 2016; Ernst and Young 2016; and IMF survey results.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.Size of Islamic Banking Sector in Arab Countries
Sources: Islamic Financial Services Board, Financial Stability Report 2016; Ernst and Young 2016; and IMF survey results.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.Size of Islamic Banking Sector in Arab Countries
Sources: Islamic Financial Services Board, Financial Stability Report 2016; Ernst and Young 2016; and IMF survey results.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.The growth of the Islamic banking industry in Arab countries reflects the interaction of economic, regulatory, political, and other idiosyncratic factors. On the supply side, sustained periods of high oil prices and large savings in oil-exporting Arab countries contributed to a favorable economic backdrop for the growth of Islamic banking. In addition, many countries progressively established an enabling regulatory environment, whereas some governments gave explicit targets for the growth of Islamic banking. On the demand side, favorable demographics played an important role, most notably by large unbanked populations in countries with large Muslim populations (Demirgûç-Kunt, Klapper, and Randall 2013; Imam and Kpodar 2010). In addition to the supply and demand factors, the small starting base for Islamic banks had a statistical effect on the growth rates registered.
The Islamic banking industry is highly concentrated in a geographical location and also within the domestic banking systems. Member countries of the Gulf Cooperation Council account for about 90 percent of the total Islamic banking assets of Arab countries and about 40 percent of the global Islamic banking assets. Within the Gulf Cooperation Council, nearly half of the assets of the Islamic banks are in Saudi Arabia, followed by the United Arab Emirates, Kuwait, and Qatar. Bahrain is home to the largest number of Islamic banking institutions, but its share in global Islamic banking assets is small.
The Islamic banks range from small banks that focus on niche markets to domestically and regionally systemically important banks with extensive cross-sector and cross-border operations. At least 13 Islamic banks have cross-border operations, six of which operate in more than five countries, and two operate in 14 and 17 countries, respectively. The operations of some of the Islamic banks span a broad range of sectors, including nonfinancial corporations such as property development companies, but also aviation, hospitals, and schools. Therefore, group and cross-border risks are material to the region; as a result, consolidated and cross-border supervision, as well as cross-border resolution, must be an integral part of the regulatory and supervisory frameworks.
The Corporate and Balance Sheet Structures
The majority of countries allow conventional banks to offer Islamic banking products and services. Commingling of assets is, therefore, a material risk in many of the countries, and segregation of funds should be part of the prudential regulations. In particular, 10 countries (Algeria, Bahrain, Djibouti, Mauritania, Morocco, Oman, Saudi Arabia, Tunisia, United Arab Emirates, West Bank and Gaza) permit full-fledged Islamic banks and conventional banks to offer Islamic finance products and services termed “Islamic windows.”5 Apart from Sudan, which operates an exclusively Sharī’ah-compliant banking system, only four countries (Jordan, Kuwait, Lebanon, Qatar) restrict the provision of Islamic banking products and services by conventional banks through Islamic windows.
Like their conventional counterparts, Islamic banks in the Arab countries are mainly funded by domestic deposits, but their deposits include profit-sharing investment accounts (PSIAs). The share of PSIAs on the balance sheets of Islamic Banks is as high as 50 percent in Bahrain and Jordan. Islamic banks in Saudi Arabia, on the other hand, show greater reliance on nonremunerated deposits. The large share of PSIAs in the liability structure has important regulatory implications for consumer protection, and capital and liquidity requirements.
PSIAs raise the need for greater disclosure on investment strategies and computation of payouts. This requires changes in governance structures to ensure representation of investment account holders’ (IAHs’) interests.
PSIAs raise issues of computation and comparability of capital adequacy ratios (CARs), because Islamic banks, in some countries, use profit equalization reserves (PERs) to smooth out profits to IAHs, and investment risk reserves (IRRs) to protect capital, in an effort to minimize potential for deposit runs in difficult times. Also, not all countries treat PSIAs and these reserves the same way when setting capital adequacy requirements.
Another question concerns the run-off rates for liquidity requirements under Basel III and loss absorption of PSIAs in resolution of Islamic banks in the event of distress.
The assets of the Islamic banks largely consist of debt-like financing, but investment and risk-sharing products have increased to significant levels in some countries. At the end of June 2015, the share of financing instruments in Islamic banking total assets ranged between 40–70 percent in eight countries (Bahrain, Jordan, Kuwait, Oman, Qatar, Saudi Arabia, Sudan, United Arab Emirates). Over 60 percent of this financing are debt-like products based on Murabahah contracts (sales with mark-up) and Ijara (leasing products). Islamic banks in three countries (Djibouti, Sudan, Tunisia), however, have a large share of risk-sharing products based on either Musharakah or Mudarabah (joint partnership) contracts. Investment in Sukūk is significant for Bahrain, Qatar, and Sudan. This asset structure implies that while credit risk is the predominant risk, market and equity risks are significant in some countries. The financing also exhibits significant concentrations in cyclical sensitive real estate, construction, and trade sectors and in households (Figure 13.2), which results in common exposures and may heighten the potential for systemic risks.
Balance Sheet Structure of Islamic Banks
Percent, June 2015
Sources: Central Bank of Bahrain Statistical Bulletin; Islamic Financial Services Board Database; and Qatar Central Bank Statistical Bulletin.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. PSIA = profit sharing investment accounts.Balance Sheet Structure of Islamic Banks
Percent, June 2015
Sources: Central Bank of Bahrain Statistical Bulletin; Islamic Financial Services Board Database; and Qatar Central Bank Statistical Bulletin.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. PSIA = profit sharing investment accounts.Balance Sheet Structure of Islamic Banks
Percent, June 2015
Sources: Central Bank of Bahrain Statistical Bulletin; Islamic Financial Services Board Database; and Qatar Central Bank Statistical Bulletin.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. PSIA = profit sharing investment accounts.Financial Soundness and Outlook
Financial fundamentals of the Islamic banks are generally strong, but credit and liquidity risks are relatively elevated. At the end of September 2015, CARs were above statutory limits in 11 countries.6 However, the ratio of nonperforming financing was high in several countries. The banks remain profitable in aggregate, but less than their conventional peers. Profit margins have also been trending down in some countries. Liquidity conditions have been tightening in the oil-exporting economies, and efficiency indicators, denoted by the high cost-to-income ratios, have weakened in some countries (Figure 13.3).
Financial Soundness and Efficiency Indicators
(Percent)
Sources: Islamic Financial Services Board; and IMF Survey of Islamic Banking.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.Financial Soundness and Efficiency Indicators
(Percent)
Sources: Islamic Financial Services Board; and IMF Survey of Islamic Banking.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.Financial Soundness and Efficiency Indicators
(Percent)
Sources: Islamic Financial Services Board; and IMF Survey of Islamic Banking.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.Risks to the outlook are tilted to the downside. The changing economic dynamics and geopolitical factors have potential to slow the growth of the Islamic banking industry in Arab countries and also affect the financial performance. In several countries, the strong and sustained double digit growth rates registered by the Islamic banking industry underwent a marked decline in 2015. Although it is too early to draw reliable long-term inferences, headwinds from low oil prices have made the macroeconomic environment challenging in jurisdictions in which Islamic finance has a large presence. In some countries (Iraq, Libya, Syria, Yemen), conflicts and other geopolitical developments render the operating environment challenging for banks, including the Islamic banks.
Regulatory and Supervisory Frameworks
Legal and Regulatory Frameworks
Most countries have put in place legislation that recognizes Islamic banking practices, products, and institutions. Banking laws in 13 countries (Bahrain, Djibouti, Iraq, Jordan, Kuwait, Lebanon, Morocco, Oman, Qatar, Sudan, Tunisia, United Arab Emirates, West Bank and Gaza) provide for the establishment of Islamic banks.7 The laws also give central banks powers to regulate and supervise Islamic banks. However, Algeria, Mauritania, and Saudi Arabia have no explicit legal framework for Islamic banking services, even though two of these countries have systemically important Islamic banking systems.
Progress in adapting the licensing requirements to Islamic banking characteristics has been uneven, and the preventative characteristics of the licensing tools are underused. Ten countries (Bahrain, Iraq, Jordan, Kuwait, Lebanon, Morocco, Oman, Sudan, United Arab Emirates, West Bank and Gaza) require banks to obtain an Islamic banking license. However, not all the countries require ex ante evidence of arrangements for an appropriate Sharī’ah corporate governance structure, the right of IAHs to monitor the performance of their investments, the transparency of the financial reporting, internal and external audit functions, and other control measures. In addition, only three countries (Bahrain, Jordan, Oman) require different “fit and proper” requirements for Islamic banks.8 Six jurisdictions (Iraq, Jordan, Kuwait, Oman, Sudan, West Bank and Gaza) have regulations that require Sharī’ah board members to undergo fit and proper tests.
Reforms to adapt regulatory frameworks to the specificities of Islamic banking have also progressed at an equally uneven pace, thus risks unique to Islamic banks may not be adequately addressed. Eight countries (Bahrain, Djibouti, Jordan, Kuwait, Oman, Qatar, United Arab Emirates, West Bank and Gaza) have adapted their regulatory frameworks to include explicit provisions for Islamic banks. In five other countries (Algeria, Iraq, Mauritania, Saudi Arabia, Tunisia), the authorities applied a single integrated regulatory framework without specific provisions for Islamic banking.
Approaches to capital adequacy requirements have continued to vary, undermining comparability of solvency risks. The differences relate to the capital requirements for PSIA with regard to loss-absorption (alpha factor), which represents the ratio of actual risk transfer to shareholders of Islamic banks, the eligibility of PER and IRR and risk weights for assets, such as for profit-sharing financing like Musharakah and Mudarabah. There is also regulatory uncertainty regarding instruments that qualify for additional Tier 1 (AT1) and Tier 2 (T2) capital instruments. More specifically:
Seven countries (Bahrain, Iraq, Jordan, Kuwait, Oman, Qatar, Sudan) apply the Islamic Financial Services Board (IFSB) formula in the calculation of the CAR.9
Three countries (Bahrain, Jordan, Oman) apply an alpha of 30 percent, Kuwait and Sudan apply 50 percent, and Qatar applies 100 percent.
In five countries (Bahrain, Djibouti, Iraq, Qatar, Sudan), PER is permitted in the calculation of the CAR, and Bahrain and Qatar also allow IRR in CAR computation.
Contractually, PSIAs should be loss-absorbing, but because many countries treat the accounts as deposits, the loss-absorption capacity of PSIAs is either limited or nonexistent. In several countries (Bahrain, Jordan, Oman, Sudan, United Arab Emirates, West Bank and Gaza), Islamic banks are required to maintain capital against assets funded by PSIAs, implying that the PSIAs are not loss-absorbing. Similarly, Djibouti, Tunisia, and the United Arab Emirates treat restricted investment accounts (RIA) as on-balance-sheet items, in which case the bank may undertake joint investment and the account holders may be covered by the deposit insurance schemes. For the United Arab Emirates, banks are also required to maintain capital against the RIA.
Regulations in many countries do not require segregation of Islamic deposits from conventional funds, thus commingling is a material risk. Only five countries (Bahrain, Morocco, Oman, Tunisia, United Arab Emirates) require conventional banks to maintain Islamic deposits separately from the banks’ other funds.
Jordan, Kuwait, Lebanon, the United Arab Emirates, and West Bank and Gaza allow Islamic banks to invest in fixed properties such as land and buildings, while restricting or prohibiting conventional banks from such investments. The provision for Islamic banks to invest in properties has resulted in some Islamic banks investing in a broad range of nonfinancial corporations whose risk profiles can be difficult to assess and, therefore, make the corporate structures complex and challenging to supervise.10
Three countries (Jordan, Lebanon, West Bank and Gaza) allow Islamic banks to undertake trading activities in movable assets (vehicles, equipment, trading goods), and for these countries, the inventory risk can be substantial.
Supervisory Frameworks
Islamic banks are subject to supervisory oversight in all the Arab countries, but only a few have tailored their examination manuals to identify the risks unique to them. Several countries (Jordan, Oman, Saudi Arabia, Tunisia, United Arab Emirates, West Bank and Gaza) use onsite and offsite examination manuals that apply to all banks with no distinction between Islamic and conventional banks.
Consolidated and cross-border supervision for Islamic banks remains a challenge. Six countries (Bahrain, Iraq, Kuwait, Oman, Saudi Arabia, West Bank and Gaza) are required to supervise their Islamic banks on a consolidated basis, and Bahrain and Kuwait report having cross-border supervisory arrangements for the Islamic banks. The United Arab Emirates and Qatar, which do not undertake consolidated or cross-border supervision, are home to Islamic banks with cross-sector subsidiaries and cross-border operations. Cross-border supervision is also undertaken against the backdrop of different practices in countries with respect to prudential measures, accounting, and, in some cases, Sharī’ah interpretation.
Countries continue to apply different accounting standards, which affects consistency and comparability of Islamic banking financial statements. Five countries (Bahrain, Djibouti, Jordan, Qatar, West Bank and Gaza) have made it mandatory for Islamic banks to adopt Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and IFSB standards. In Kuwait and the United Arab Emirates, Islamic banks are required to adopt International Financial Reporting Standards like their conventional counterparts, and IFSB and AAOIFI standards are neither mandatory nor an option, even though IFSB standards are considered in the formulation of regulations.
Corporate Governance Frameworks
Corporate governance frameworks have increasingly been adapted to address the specificities of Islamic banking, but practices vary and Sharī’ah noncompliance remains a material risk. Centralized or national Sharī’ah boards (NSBs) that help standardize industry practices and improve consumer perceptions are required and have been established in seven countries (Bahrain, Djibouti, Iraq, Morocco, Sudan, United Arab Emirates, West Bank and Gaza).11 Five countries (Algeria, Iraq, Mauritania, Morocco, Saudi Arabia) do not require Islamic banks to establish a Sharī’ah board at the bank level.
The Sharī’ah boards differ in their mandate, scope, governance, and accountability, making harmonization of rulings a challenge. In particular, of the seven countries that require centralized or NSBs, in Bahrain and Djibouti the Sharī’ah boards only have advisory powers. The NSB in Iraq has powers to evaluate Sharī’ah compliance in addition to advisory powers. In the other four countries (Morocco, Sudan, United Arab Emirates, West Bank and Gaza), the NSBs have rule-making and enforcement powers in relation to Islamic banks. By contrast, most of the Sharī’ah boards at the commercial banks have decision-making powers to rule on the compliance of products and contracts with Sharī’ah, with the exception of those in Bahrain and Lebanon. These disparities open room for arbitrage and introduce uncertainty among consumers regarding the Sharī’ah compliance of some products.
Sharī’ah noncompliance remains a material risk because not all countries require Islamic banks to have internal controls for enforcing Sharī’ah compliance. Only five countries (Bahrain, Jordan, Oman, Sudan, United Arab Emirates) require Islamic banks to have specific internal control units for Sharī’ah compliance, in addition to the (regular) internal audit unit. The role of external auditors in ensuring Sharī’ah compliance is also not well-integrated in the risk management and supervisory process. Seven countries (Djibouti, Iraq, Jordan, Kuwait, Oman, Sudan, Tunisia) require external auditors of an Islamic bank to review the adequacy and the effectiveness of the internal controls systems for Sharī’ah compliance.12 Seven other countries (Algeria, Lebanon, Mauritania, Morocco, Saudi Arabia, United Arab Emirates, West Bank and Gaza) do not specify any role. Thus far, only Bahrain has conducted an external Sharī’ah audit, and Kuwait more recently issued new governance rules that include requirements for Sharī’ah audits.
Consumer Protection
Consumer protection frameworks are part of the regulatory frameworks in many countries, but some gaps remain. In countries that have enacted laws to protect consumers, there has been a greater focus on addressing information asymmetries related to Sharī’ah compliance. Less attention has been given to disclosures on the investments of IAHs, on ensuring that their interests are represented on the board, or on providing frameworks for speedy and cost-effective resolution processes. Consumer education is also proceeding at an uneven pace.
Disclosure requirements have focused more on Sharī’ah compliance and there has been less progress in ensuring representation of IAHs’ interests. Twelve of the 16 respondents require Islamic banks to disclose the state of Sharī’ah compliance but only five countries (Bahrain, Jordan, Kuwait, Oman, Sudan) require greater disclosures from Islamic banks regarding the operations of the investment accounts, with some adopting IFSB and AAOIFI standards. All but three countries (Iraq, Mauritania, Saudi Arabia) require Islamic banks by law or regulation to inform their RIA and URIA customers of their profit-smoothing practices, but only three countries (Bahrain, Sudan, West Bank and Gaza) require Islamic banks to appoint independent board directors representing (explicitly or implicitly) the interests of IAHs.
Less progress has also been made in other aspects of consumer protection, such as ensuring speedy and cost-effective dispute resolution mechanism. Only Saudi Arabia and Sudan have Sharī’ah courts with jurisdiction over Islamic banks. In addition, only Bahrain, Sudan, and Tunisia have arbitral forums or alternative dispute resolution forums that customers may go to for the resolution of Islamic banking disputes.
Liquidity Management, Resolution, and Safety Nets
Liquidity Management
Liquidity management by Islamic banks remains a challenge. Whereas notable progress has been made in developing Sharī’ah-compliant instruments to manage liquidity at the bank level, limited progress has been made for systemic liquidity management by central banks and the development of Islamic interbank markets. Issuance of Sukūk, though increasing, is still limited to a few countries and secondary markets are yet to develop. Many countries do not have sufficient Sharī’ah-compliant, high-quality liquid assets to meet the Basel III liquidity requirements, forcing Islamic banks to maintain a high level of cash.
Interbank markets are more developed between Islamic banks and conventional banks than among Islamic banks, possibly reflecting the limited number of players. Interbank markets between Islamic banks and conventional banks are reported to exist in six countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates). Meanwhile, only four countries (Bahrain, Saudi Arabia, Sudan, United Arab Emirates) have developed a domestic currency interbank Mudarabah market among Islamic banks.
The Sukūk market is still very limited. In only four countries (Bahrain, Oman, Qatar, Sudan) does the government issue domestic Sukūk, and among these, only Bahrain and Sudan issue Sukūk regularly. The limited development of the Sukūk market reflects a variety of constraints, with several countries (Djibouti, Saudi Arabia, United Arab Emirates) citing lack of interest or need, Kuwait facing legal impediments, and Jordan and Iraq citing uncertainties on how best to issue the Sukūk. In the absence of Sharī’ah-compliant securities and remunerated reserves, Islamic banks are forced to hold a large share of their assets in cash and unremunerated reserves to comply with liquidity requirements at the expense of profitability.
The adaptation of central bank operations, on the other hand, is uneven and mostly incomplete. In only five countries (Bahrain, Kuwait, Saudi Arabia, Sudan, United Arab Emirates) do central banks or monetary authorities conduct regular liquidity provision and absorption operations for Islamic banks. Very few countries have Sharī’ah-compliant lender of last resort facilities or emergency liquidity assistance (ELA) for solvent banks facing sustained liquidity pressures. A few countries (Saudi Arabia, Kuwait, Sudan, United Arab Emirates) issue central bank securities.13 Another small group (Bahrain, Oman, Saudi Arabia, Sudan) issue government securities or Sukūk to manage liquidity in Islamic banks. Only three countries (Kuwait, Saudi Arabia, United Arab Emirates) have developed overnight standing credit facilities for Islamic banks, and only one, Saudi Arabia, offers an overnight standing deposit facility. None have developed foreign exchange swap facilities for Islamic banks. Still to be developed are Sharī’ah-compliant lenders of last resort that have clear governance procedures, work allocations, collateral criteria, oversight, eligibility rules, and operational procedures.
Resolution Framework and Sharī’ah-compliant Deposit Insurance Scheme
The legal and policy frameworks for bank resolution are being strengthened in a number of Arab countries, but generally they are not yet well-developed. Two countries (Kuwait, United Arab Emirates) do not provide explicit powers for taking official control of a failing bank. The distress-resolution process for Islamic banks does not differ from that of conventional banks, except in Jordan and Qatar. There are no arrangements in place to resolve Islamic banks with cross-border operations. With respect to liquidation, only Djibouti, Jordan, and Qatar have liquidation laws for banks that contain features that are exclusive to Islamic banks. In five countries (Algeria, Bahrain, Kuwait, Oman, United Arab Emirates), liquidation of banks is governed by the corporate bankruptcy laws. Sharī’ah boards do not play a role in any of the countries’ resolution process.
Sharī’ah-compliant deposit insurance schemes (SDIS) have been slow to develop. Only Bahrain and Sudan have SDIS in place, and Jordan is in the process of establishing one.14 Sudan’s SDIS covers current accounts (Qar) and investment accounts (Mudarabah), whereas that of Bahrain and the planned SDIS for Jordan cover Islamic deposits and unrestricted investment accounts. In all three countries, the SDIS is modeled on the Takaful (Islamic insurance) principle. In four countries (Algeria, Lebanon, Saudi Arabia, West Bank and Gaza) Islamic banks are covered by the same deposit insurance framework as conventional banks, and the deposit insurance premiums collected are managed in a single indivisible pool. In Djibouti, Jordan, and Oman, the deposit insurance system is only for conventional banks and does not cover Islamic banks. Three countries (Kuwait, Tunisia, United Arab Emirates) do not have an explicit deposit insurance framework.15
Conclusion and Policy Recommendations
Arab countries have made significant advances in strengthening the prudential and liquidity management frameworks for Islamic banks, but progress has been uneven. With few exceptions, countries have enacted legal frameworks that provide greater clarity and certainty on permissible activities and on the supervisory oversight of Islamic banks. However, progress has been uneven in adapting licensing requirements, prudential regulations, and consumer protection, and in developing comprehensive data for surveillance of the industry and liquidity management instruments. Less progress has been made in adapting resolution frameworks and in developing SDIS. At the country level, only a few countries have systematically reformed the regulatory and supervisory frameworks in line with industry standards, including through detailed rulebooks for Islamic banks, or have adapted supervision tools and strengthened corporate governance frameworks. The agenda, therefore, remains broad.
In countries where Islamic banks are operating without a legal foundation, the necessary laws and regulations should be enacted. Policymakers should focus on putting in place an enabling environment that levels the playing field with the conventional banking industry and allows market forces to play their role.
Licensing guidelines and the approval process for Islamic banks and Islamic windows needs strengthening. Whereas several elements of an appropriate licensing process are common to Islamic and conventional banking, additional specific requirements related to the licensing of Islamic banks and authorization of Islamic windows are needed. In particular:
Islamic banks should be required to obtain Islamic licenses. Approval of the Islamic license should be conditional upon proof of arrangements for an effective Sharī’ah governance framework and strong control functions that address risks inherent in Islamic banking activities.
Conventional banks planning to conduct Islamic banking (through windows or dedicated branches) should be subject to prior approval by the regulatory authority. They should be required to have the internal systems, procedures, and controls to ensure that transactions and activities of windows are in compliance with Sharī’ah rules, that Islamic and conventional business are properly segregated ex ante and ex post, and that adequate disclosures are made on windows operations.
Fit and proper criteria for management and major shareholders should include knowledge of Islamic finance, and Sharī’ah scholars should also be subject to similar fit and proper requirements.
Greater adoption of IFSB standards on capital adequacy is needed to ensure loss absorbency of PSIA, as well as consistency in assessing solvency risks. Regulators should adopt IFSB guidelines on capital adequacy ratios, notably the introduction of the alpha factor to allow for some loss-absorbency by PSIAs. On the capital side, regulators should adopt the IFSB standards, including for eligible AT1 and T2, which are in line with the Basel III requirements to enhance banking system resilience. Sharī’ah governance frameworks could be further strengthened, including through the establishment of NSBs and an enhanced audit function. NSBs would provide further clarity and consistency on Sharī’ah issues, support the supervision function, including fit and proper examination of bank-level Sharī’ah advisors, and facilitate the development of Sharī’ah-compliant central bank monetary operations and sovereign. In addition, strengthening the independence of Sharī’ah boards at the bank level and enhancing Sharī’ah audit functions, including by external auditors, should remain priorities for countries. Further attention should be devoted to education and training in Islamic financing to ease constraints on the availability of qualified scholars.
Rules governing investments in properties and movable assets warrant reconsideration to limit permissible activities to those critical to the functioning of Islamic banks. In countries where Islamic banks are permitted to invest in properties and undertake trading activities, the prevalence of nonfinancial corporations in the groups can create complex corporate structures, which present substantial challenges for consolidated supervision as well as for consumer protection. Therefore, regulators are encouraged to reconsider these rules, grandfathering the existing structures while giving them enough time and incentives to wind down their nonfinancial subsidiaries.
Supervisory capacity should continue to be upgraded to ensure adequate skills and expertise in assessing emerging risks in the industry. Supervisory authorities should, in particular, continue to equip themselves with risk analytical tools, including adapted onsite and offsite examination tools. They should also seek to cover the risks comprehensively, including the misselling of Islamic banking products and services, ensuring consumer protection, promoting governance, and maintaining internal controls. In that regard, implementing the IFSB Core Principles for effective supervision of Islamic banks would be a step in the right direction. Supervisors will need to adapt rating methodologies, such as the CAMELS system, to Islamic banking and implement the IFSB standard on stress testing.
Comprehensive data on Islamic banking balance sheets and soundness is needed to facilitate risk analysis and monitoring. Consolidated balance sheets for Islamic banks and more granular data on the instruments used for funding and financing are critical for identifying emerging risks and their materiality as well as the potential impact on macroeconomic policy formulation.
Consumer protection frameworks that cater to the specifics of Islamic banking products should be an integral part of regulatory frameworks in countries with Islamic banking sectors. Sharī’ah principles, which govern Islamic finance, provide a strong foundation for consumer protection, but the features alone cannot guarantee adequate protection for consumers. Consumer protection frameworks should be anchored in laws, disclosures, financial education, and cost-effective enforcement mechanisms. In addition to disclosure of Sharī’ah compliance, more is needed to improve consumer education, enhance disclosures to IAHs on their investments, including as it relates to payouts and use of PER and IRR, and to ensure representation in the governance structure.
Liquidity management frameworks need further strengthening, including the provision of ELA. Further developing Islamic interbank money markets and central bank monetary operations is critical for enhancing Islamic banks’ liquidity management capacities. In particular, central banks should develop Sharī’ah-compliant open market operations (outright transactions or repo), standing facilities, and ELA that have clear governance procedures, work allocations, collateral criteria, oversight, eligibility rules, and operational procedures for providing ELA. Deepening Sukūk markets, including by regular sovereign issuance of tradable Sukūk with different maturities, could help provide a benchmark pricing curve and increase the provision of income-generating, high-quality, liquid assets.
Islamic banks are not immune to the risk of failure, thus legal frameworks for their resolution are important for preserving overall financial system stability. Some countries (Bahrain, Djibouti, Sudan, West Bank and Gaza) have experienced bankruptcies of some Islamic banks, requiring responses by national authorities. It is therefore important to ensure that countries with Islamic banks have in place legal and regulatory frameworks, including bank resolution and deposit insurance regimes, that facilitate their orderly resolution. Legal clarity on the treatment of investment accounts in resolution is needed, and SDIS should be further developed, and its role better clarified, in the resolution process. The ability to resolve large and complex Islamic financial institutions with cross-border operations should also be ascertained.
References
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Lukonga, Inutu. 2015. “Islamic Finance, Consumer Protection, and Financial Stability,” IMF Working Paper 15/107, International Monetary Fund, Washington, DC.
Lukonga, Inutu. 2015. “Seven Questions on Islamic Finance.” IMF Research Bulletin 16 (2): 6–9.
Inutu Lukonga is a senior economist and financial sector expert on banking, securities, and pensions regulations in the Middle East and Central Asia Department of the IMF. The author acknowledges the input of Abdullah Haron and the guidance of Zeine Zeidane.
See IMF 2015 and Barajas, Ben Naceur, and Massara 2015 for a more detailed discussion of the benefits that Islamic banking offers.
These include raising funding using profit-sharing investment accounts (PSIAs) and, on the asset side, acting as a partner in property ownership or trade in tangible assets.
Sukūk is the Islamic equivalent of bonds.
Bahrain’s Islamic banking is systemically important in the retail sector.
In four countries (Djibouti, Tunisia, Morocco, West Bank and Gaza), however, conventional banks have not yet established Islamic banking operations, although they are permitted to do so.
Figure 13.3 charts are based on CARs reported in the survey and other indicators as reported to the IFSB (http://www.ifsb.org/). For Bahrain, the figures reflect domestic retail banks.
Indications are that Iraq, Syria, and Yemen also have a legal framework in place that recognizes Islamic banking, but questionnaire responses have not been received yet.
Fit and proper requirements for the three countries include a requirement for management and shareholders to have knowledge of Islamic banking or training in Islamic banking principles and accounting.
The IFSB formula ensures that PSIAs are somehow loss absorbing and therefore do not require Islamic banks to hold capital against full or part of credit and market risk-weighted assets funded by PSIAs (see IFSB 15, Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services).
The nonfinancial corporations mostly include property management and real estate companies, but some Islamic banks are invested in aviation, hospitals, and schools.
Oman is in the process of finalizing the establishment of a Sharī’ah board. In the case of Kuwait, while the central bank law does not provide for a national Sharī’ah board, in case of any conflicts in the opinion by Islamic banks, they can refer the issue to the Fatwa council in the Ministry of Awqaf and Islamic Affairs, which is the final authority on all fiqh (Islamic Jurisprudence) issues in the Islamic financial industry.
In the case of Oman, external auditors, in addition to certifying that controls and systems have been maintained, are required to ensure that in the case of the Islamic window there is no commingling of funds with the conventional parent.
The maturity structure of these securities varies, with Saudi Arabia and the United Arab Emirates offering a broad range of maturities from short to long term, and Kuwait offering three and six months. The contracts underlying the central bank securities also vary, with Kuwait basing the instruments on Tawarruq, Saudi Arabia using Murabahah, Sudan using Ijara, and the United Arab Emirates using commodity Murabahah.
In Bahrain, Islamic banks are covered by the same deposit insurance regulatory framework as conventional banks, but the deposit insurance premiums collected from Islamic banks are managed separately, on a Sharī’ah-compliant basis.
Tunisia is in the process of developing a deposit insurance scheme.
