The Need for Standardized Regulation of Islamic Finance

Vikram Modi

Writing the Rules
The Need for Standardized Regulation of Islamic Finance

by Vikram Modi
From A Tilted Balance, Vol. 29 (1) - Spring 2007
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Vikram Modi is a Staff Writer for the Harvard International Review.
Islamic finance has been one of the fastest-growing areas of the global financial services industry over the last decade. This growth, estimated at 15 percent annually over the last three years, has been primarily driven by vast inflows of petrodollars, the search by Western banks for high-margin businesses, and widespread innovation in Islamic financial engineering. However, Islamic financial institutions have not achieved the same degree of success in creating regulatory environments conducive to greater innovation and development of Islamic capital markets. Standardized regulation is critical to the future growth of Islamic finance.
The State of Islamic Finance
Interest is at the foundation of conventional financial systems. Payments on interest compensate creditors for both the time value of money and default risk. However, interest is prohibited under Shari’ah, or Islamic law: the Qu’ran states, “And that which you give in gift, in order that it may increase from other people’s property, has no increase with Allah.” It also declares, “We have prepared for those among men who reject faith a grievous punishment.”
For a devout Muslim, all fixed income instruments from mortgages to interest rate swaps are clearly haram, or forbidden. Additionally, Shari’ah bans excessive gharar, or risk. This condition is more ambiguous than the prohibition of riba. For example, an exporter could use currency options to hedge foreign exchange risk, while a speculator could use the same options to make bets on exchange rates. In the former situation, options are used to decrease risk, while in the latter, options are used to increase risk. Even in this simple example, Shari’ah scholars could (and do) have differing opinions. Clearly, the absence of standardized regulation can lead to significant confusion among investors.
Despite the bans on riba and gharar, Islamic banks have developed Shari’ah-compliant financial products from loans and insurance to equity funds and exotic derivatives. These financial products often take the form of profit-sharing agreements between a “debtor” and a “creditor.” For example, in mudarabah, sometimes called participation financing, an entrepreneur asks a bank to provide capital; profits are shared between the entrepreneur and the bank according to an agreed ratio. Profit sharing continues until the “loan” has been repaid.
On the other hand, in murabahah, a bank can purchase a good for a customer and sell that good to the customer at an above-market price that is equivalent to the market price plus the amount the bank would have earned from interest. The customer then pays the bank in installments, just as if he or she had taken a conventional loan. However, the bank cannot charge the customer extra money for late payments, so instead the bank has custody of the good until full payment has been received.
Each financial product must be approved by Shari’ah advisory committees or consultants. Because it is nearly impossible for any product to be approved by every Shari’ah scholar in Islamic finance, banks traditionally focus on some target group or appeal to as many people as possible. Some Islamic scholars have remained opposed to Islamic finance, maintaining that the industry’s techniques are simply legal fudges. They draw comparisons to contractum trinius, a method European bankers used during the Middle Ages to circumvent the prohibition of usury. A banker would invest the amount of money required by a borrower and then purchase insurance for the investment from the borrower. Finally, the lender would sell the borrower the right to any profit made on some percentage of the investment. The three contracts used in contractum trinius, investment, insurance, and sale of profit, were individually permitted; put together, they behaved like an interest-bearing loan.
Islamic finance is one of the most rapidly growing areas of international finance today. Islamic banks currently manage between US$200 and $300 billion, an amount that has been increasing between 12 and 15 percent each year. With over a billion adherents worldwide, Islam is the world’s fastest growing major religion, potentially making Islamic finance an even more lucrative market. Mukesh P. Shah, CEO of Cube Graphics LLC, notes two major reasons for the increasing popularity of Islamic finance: “The growth of Islamic finance is linked to the surge in petrodollars and the related opportunity for financial institutions to create Islamic financial products.”
Western banks have already taken notice. In the United Kingdom, for example, both HSBC and Lloyds TSB began to offer Islamic mortgages in 2005. Muslims make up 3 percent of the British population, but in some cities, such as Leicester, they make up as much as 20 percent. However, according to Shah, Islamic finance still remains a niche market. Part of the reason for this lies in the lack of standard regulation, particularly across borders.
The Need for Regulation: Current Approaches
Despite the overall bright picture of Islamic finance today, significant questions remain. The most pressing issue is the need for standardized regulation and greater integration between the fragmented areas of Islamic banking. One of the main concerns is that regulators often know less than the Islamic banks do about the Islamic financial products they are supposed to supervise, as the Chicago Federal Reserve noted in a report in 2005. William Rutledge, executive vice president of the Federal Reserve Bank of New York, told the Arab Bankers Association of North America that regulators were participating in more Islamic finance seminars in order to learn about the risks associated with Islamic financial products. There has indeed already been an explosion in Islamic finance education. The Harvard Islamic Finance Information Project (HIFIP), for example, hosted a seminar for the Treasury Department in Washington, DC in April 2002.
The other issue is the lack of coordination between regulators. While the creation of the Islamic Financial Services Board (IFSB) in November 2002 is a step in the right direction, it is just one step. Promisingly, the IFSB was underwritten by the Islamic Development Bank and the International Monetary Fund. The participation of established transnational financial institutions clearly demonstrates both recognition of and support for the creation of regulatory bodies.
Recognizing Unique Concerns
The United Kingdom’s Financial Services Authority (FSA) has taken the lead in opening up dialogue with Islamic banks. Not only has the FSA participated in several seminars on Islamic finance, but the agency has also sought to integrate Islamic financial institutions into its regulatory framework. Islamic banks are still held to the same standards as conventional ones. However, recognizing the unique nature of Islamic financial transactions, the FSA has tailored its regulations to meet the new market. Specifically, the profit and risk-sharing nature of financial transactions means that creditors often take on risks traditionally associated with equity rather than debt. Similarly, depositors’ accounts take on some characteristics associated with equity stakes. Indeed, this has led some to reconsider whether Islamic banks are actually banks in the first place. Therefore, the FSA has said that capital requirements for Islamic banks may be lower.