Financial Engineering Approach, Policy Development Approach and Hybrid Approach to Regulating Islamic Banking

1. Tariqullah Khan
Regulatory
Approaches to
Islamic Banking
Why each approach is the right
approach?

2. Financial
Engineering
Approach
Policy
Development
Approach
Regulatory Approaches
to Islamic Banking
Bank NegaraSaudi Arabian Monetary Agency
❶ ❷
Hybrid
Approach
Saudi Arabia MalaysiaBahrain
Central Bank
❸

3. Financial Engineering
Approach
The
❸
Principles
Governments to treat
Islamic financial
services as a matter
of financial
engineering and
product development
by service providers

4. ❶
Bank deposits
shall always be
treated as loans
No profit
sharing
investment
deposits
(PSIAs) could
be allowed
Financial Engineering

5. ❷
Shariah supervision is a
matter of clients’
satisfaction & not a
concern of regulators
Banks may
voluntarily
have Shariah
Boards but
Central
Banks do not
need to have
Shariah
Boards
Financial Engineering

6. ❸
No income earning
deposits.
Instead of PSIAs banks
shall offer Islamic mutual
funds
Hence
Islamic
contracts
like Istisna’,
Ijarah and
Murabahah
will be
written only
on the
financing
side of the
balance
sheet
Financial Engineering

7. Pros
&
cons
Financial Engineering Approach

8. Pros: Systemic Safety
Banking instabilities are caused by
the instability of deposits and
pressure on bank capital
❶
By not allowing
PSIAs, Islamic
banking specific
deposit instability is
ruled out

9. Pros: Systemic Safety
❷
Islamic mutual funds as
an alternative to PSIAs
are more transparent and
more risk spreading
As compared to PSIAs mutual
funds will have lesser pressure on
Bank capital

10. ❸
Pros: Systemic Safety
Islamic financial contracts will
only be used on asset side and
not on the funding side
As compared to funding side risks,
asset side risks have lesser severe
implications for banking stability

11. Pros: Wide applicability
Financial Engineering
Approach is widely applicable
worldwide as it
 Doesn’t recognize any special risks of
Islamic banking
 doesn’t treat enforcement of Shariah
supervision as a regulatory requirement;
 Islamic banking can be introduced within the
existing legal, tax and regulatory framework
with some minor adjustments

12. Cons & Pitfalls
The unique funding side, asset side and
systemic risks characteristics of Islamic
banking are not recognized
Shariah compliance is a non-enforceable matter and
hence the genuine benefits of Islamic banking will
not be available;
Overtime the Islamic financial products may
degenerate and converge into the conventional
products;
Banks offering Islamic financial services will be
bound to compete in a field designed and maintained
for conventional banks

13. Cons: Preconditions for application
Neutrality of
Laws
Taxes &
Regulation
 In Saudi Arabia where the
approach is applied there are no
significant taxes to date; other
countries have to ensure tax
neutrality;
 Issues of accounting treatment
of Islamic financial contracts
need resolution;
 Issues of regulatory capital
charges and risk weighting of
contracts need resolution too

14. Policy Development
Approach
The
④
Principles
Governments to
provide policy
support & levelled
playing field to
develop Islamic
financial services in
an orderly and
resilient manner

15. PRINCIPLE ❶
Regulators must recognize all
the funding side, asset side
and systemic characteristics
and risks of Islamic banking
and adapt the relevant
international standards
accordingly
Hence Accounting and
Auditing Organization
for Islamic Financial
Institutions (AAOIFI) is
tasked for adapting
International
Accounting Standards
and Islamic Financial
Services Board (IFSB)
tasked for adapting
standards of Basel
Committee for Banking
Supervision
Policy Development

16. PRINCIPLE❷
Policy Development
Deposits can be based on
interest free loan contract
(current accounts) as well as on
profit and loss sharing contract
(profit sharing investment
accounts (PSIAs)
Allowing PSIAs makes
the business model of
an Islamic bank
different from a
conventional bank. It
introduces important
withdrawal risk due to
fiduciary issues and
due to rate of return
considerations. Risk
sharing by PSIA holders
with shareholders
introduces incentive
issues and banking
stability. IFSB standards
deal with such issues.

17. PRINCIPLE❸
Policy Development
Shariah non-compliance
could cause systemic
instability and hence
Shariah compliance must
be enforced by regulators
To enforce Shariah
compliance by
financial
institutions
regulatory
authorities need to
have their own
central Shariah
Supervisory
Boards

18. PRINCIPLE❹
Legal, tax, regulatory and
supervisory authorities shall
provide policy support and leveled
playing field to Islamic financial
services recognizing its special
infrastructural needs
Policy Development
Government through
policy support to
provide essential
financial infrastructure
to support Islamic
financial services
 Legal, tax, regulatory
and supervisory
infrastructure
 Transparency
infrastructure
 Safety net
infrastructure
 Systemic liquidity
infrastructure

19. Unique risks of Islamic banks Recognized
I. Fiduciary risk:
Withdrawal risk
due to Shariah
non-compliance
II. Displaced
commercial risk:
Withdrawal risk
due to rate of
return differential
III. Income impurity
risk
I. Transformation
of risks at
different stages
of contracts
II. Bundled nature
of risks
III. Willful default
IV. Contract
specific
structural risks
I. Non-existence of
Islamic banking
specific financial
infrastructure –
LLR, deposit
protection,
systemic liquidity,
access to financial
markets
II. Conflict of
contracts with
different legal
jurisdictions
Funding Side
Unique Risks
Asset Side
Unique Risks Unique Risks
Systemic Side
Policy Development Approach

20. Pros
&
Cons
Policy Development Approach

21. Pros: Offers Genuine Policy Support
Recognizes the benefits of Islamic
banking as a business model for the
society and economy and provides
policy support for its development
and sustainability as such
❶

22. Pros: Recognizing uniqueness of Islamic
banking
Recognizes the unique features and risks of
Islamic banking on the funding side, asset
side and systemic side which is a
precondition to develop a competitive and
sustainable Islamic banking system
❷

23. Pros: Adapting International Best Practice
Standards
Supports the adaptation of international
best practice standards of capital
adequacy, risk management, governance,
financial reporting, transparency, which
is precondition for global credibility of
Islamic banking
❸

24. Pros: Facilitates to build the required
financial infrastructure
Supports the creation of enabling
environment for Islamic banking such as:
legal, regulatory and supervisory
framework, deposit protection, lender of
last resort facility, systemic liquidity and
transparency infrastructure
❹

25. Pros: Supports financial inclusion
Recognizes the need to integrate Zakah,
Awqaf and general philanthropy in the
financial system to provide microfinance
and enhance financial inclusion
❺

26. Cons: Limitations on global
application
The existence of the financial
engineering approach in several
countries shows that there are limitations
in applying the policy development
approach and that is actually so

27. It is actually the policy
development approach but the
central regulatory authority
NOT having its own Shariah
supervisory board
The Hybrid Approach
The approach exists in Qatar & Bahrain

28. Hybrid Approach: Core
principles
Current Account Owners Equity
Equity of Profit
Sharing
Investment
Accounts (PSIAs)
PSIAs allowed but treated as deposits
with full coverage of protection by
shareholder’s equity for calculation of
capital adequacy
PSIAs are not perceived to be a source of systemic stability, hence Central Shariah Board
not needed
All Islamic banks in the jurisdiction
should have a shared Shariah Board.

29. Hybrid Approach: Pros &
Cons
Policy
Development
Approach
Hybrid
Approach
Financial
Engineering
Approach
ConsPros
Pros
&
Cons

30. Because, in regulation
there should not be a
“one size fit for all”
approach
each approach is a right
approach