Chapter 12
Supervisory Implications for Islamic Finance: Post-Crisis Environment
1. REGULATION AND SUPERVISION
This chapter discusses the implications for supervision of the risks involved in Islamic finance, with a particular focus on Islamic banking and developments since the financial crisis. It covers takaful to a limited extent only.1 In so doing, it is necessary to keep in mind the distinction which some draw between supervision and regulation. Where this division is drawn, “regulation” means the process of creating a set of laws and rules applicable to the activity in question; “supervision” means ensuring that those laws and rules are complied with, currently and prospectively. It is in essence the distinction between the activities of the legislator and the policeman. This is to some extent a caricature, because good supervisors are rarely driven solely by rules and, conversely, rules are commonly written in broad terms, allowing supervisors considerable latitude. On the other hand, the scope of supervision is always constrained by rules, if only by the broad objectives and responsibilities assigned to the supervisory authority. The boundary issue is further confused by the fact that the supervisor may itself be the rule maker, to a greater or lesser degree. Nevertheless, its scope of action will be at least partly constrained by external legislative provisions, and generally also by process requirements.
2. SUPERVISORS AND SHARI’AH
Section 2 covers aspects of the supervisor’s role in Shari’ah matters, including Shari’ah governance and non-compliance risk.
2.1 The Supervisor’s Role in Shari’ah Matters
A very clear example of the interaction between supervision and regulation is provided by the question of the supervisor’s role in Shari’ah matters. In some jurisdictions (for example, the United States or France), the constitutional separation of the state from religion means that a supervisor is essentially debarred from involvement with Shari’ah issues. Other essentially secular regulators will accept that the claim to be Islamic is an important part of the firm’s representations to its clients or potential clients, and is subject to the same regulatory provisions as other similar claims, for example to be “green.” This in principle provides a basis for supervisory involvement, though in practice such involvement is likely to be limited to the clearest cases of misrepresentation.
At the other end of the spectrum, some jurisdictions (for example, Malaysia or the Sudan), find no conceptual difficulty in establishing a central Shari’ah Council that oversees Shari’ah matters across the whole of the jurisdiction’s Islamic finance industry. Generally, such a model will be supported by Shari’ah Supervisory Boards (SSBs) or Shari’ah advisers in individual firms, together with systems and controls requirements to ensure that Shari’ah decisions are properly implemented across the firm’s business, disclosure, audit requirements, and so on.
An intermediate position is for the regulator to require a firm’s claim to be Islamic to have a sound basis, but not to make judgments on its substance. In such a system, the regulator may impose Shari’ah governance requirements on the firm, covering similar matters to those described in the previous paragraph, but not establish a Shari’ah Council. Implicit in this approach is that the supervisor will apply essentially secular approaches, similar to those it would apply in other control areas, to deliver a religiously based result.
Thus the role of the supervisor in Shari’ah matters will derive from, and influence, the legal context and the formal regulatory regime. Both may also be influenced by market factors. The most important of these is, of course, the lack of consensus on many relevant Shari’ah matters, partly reflecting the relative youth of the modern Islamic finance industry.
Some regulators are understood to have argued that regulation of Shari’ah matters is unnecessary in their jurisdictions because of the strength of market discipline in this respect. More commonly, however, regulators have established some central mechanism of Shari’ah oversight with the specific aim of bringing uniformity to a market.
The merits of this approach depend on the nature of that market. Within a national, largely retail, market there may well be considerable merit in ensuring a uniform approach to what is and is not acceptable. This is, in effect, product regulation, and the brakes it imposes on innovation may be an acceptable price to pay for uniform competition. But that balance will be different in an inter-professional market, such as that for corporate sukuk. It will also be different where the market is highly porous, either in the sense that products can enter freely from outside or in the sense that most products are exported. There is little merit in one country imposing its own standards on products if they will mainly be sold into countries with different national approaches.
2.2 Shari’ah and Conventional Governance
The whole area of Shari’ah governance is likely to become more difficult for supervisors as the expansion of Islamic finance creates an increased need for Shari’ah advice. There is a tricky balance to be struck between having scholars of the highest competence, having scholars who can devote enough time to the issues in each firm, and ensuring reasonable consistency of approach, especially between firms competing in the same market.
At the same time, the crisis has raised the level of supervisors’ interest in the governance of the firms—especially banks—that they supervise. A normal position of supervisors is that one and only one body—normally the board of directors of the firm—must be responsible for its overall governance. This of course raises the issue of the position of the SSB. Most supervisors have been able to become comfortable with this on the basis that the SSB is ultimately advisory to the board, and broadly analogous to, say, an Audit and Risk Committee. This is, however, in tension with the insistence of most SSBs that their rulings are mandatory, and must be followed. In practice, these tensions have never come to a head2 in any way that would trouble supervisors, mainly because SSBs generally act in a responsive way: that is, they rule on propositions put to them by the company’s management. That position could change if SSBs took a more activist role, and especially if they moved beyond products and transactions to wider firm issues, for example remuneration.
2.3 Shari’ah–Non-compliance Risk
One major unknown in all this is the scope of Shari’ah–non-compliance risk: the risk arising from the possibility that a product or transaction that should have been compliant will be found noncompliant. One view is that it is broadly akin to legal risk: something that may have a material impact on the financial position of the firm, but would be unlikely to precipitate failure. Another view is that it represents a higher level of risk, in that a major Shari’ah failure might lead investors to desert (especially) a bank in sufficient numbers to cause a run. My own view is that the risk of a run would be very limited in any institution that had some proper basis for its claim to compliance, even if it proved to be wrong. Investors would be more likely to drift away than to run. The possibility of Shari’ah risk does, however, pose a question for those supervisors that for one reason or another forego involvement in Shari’ah matters; they will have difficulty in evaluating the risk, and their only tool for mitigating it will be to set additional capital requirements under Pillar 2 of Basel (or some equivalent).
3. LESSONS OF THE CRISIS AND REGULATORY RESPONSES
Many others have written at great length about the lessons for regulators and supervisors from the global financial crisis. Some of the lessons are still being worked out, and some of the initiatives launched in the early days of the crisis already appear to be losing impetus.
3.1 Macroprudential and Systemic Issues
One such is macroprudential regulation. It is amply demonstrated that behaviour which, in a single institution, can be adequately addressed through normal supervisory tools, may not be so addressed when it occurs across an entire financial system. Rapid credit expansion leading to asset price bubbles is the obvious example. Whereas conceptually it is not the only example, the attempt to find diagnostics for emerging macroprudential problems has narrowed down essentially to this one case, and the search for policy tools, other than those of macroeconomic policy generally, has all but foundered. One key problem has been that the application of some macroprudential tools would be politically difficult in a single country, and would require an unprecedented degree of political consensus to apply throughout a global financial system.
However, there will undoubtedly be a renewed regulatory emphasis on systemic stability, after a period when advanced countries largely believed that systemic threats had been conquered. More broadly, there has been a shift in regulatory philosophy away from one of perfect markets, in which prudential regulation was justified only by relatively limited economic externalities, to one in which it is recognised that markets can be dangerously imperfect for long periods,3 and that firms are not always well managed in the interests of their shareholders. Whilst this has not yet led to a coherent new philosophy of regulation, along with the changes in the political climate it has certainly led to a shift in the dynamic of regulation. One element of this is a more intrusive style of supervision, which will affect Islamic firms as much as conventional ones.
3.2 Capital and Liquidity
International standards have been revised with, in particular, a new version of the Basel Accord. Predictably, this involves more demanding standards for both the quality and the quantity of bank capital. It also involves stress testing and, very significantly, new attempts to impose standards for liquidity. The difficulty of defining good liquidity standards, and the belief that problems could be dealt with through lender-of-last-resort arrangements, had previously deterred regulators from going too deeply into this subject. It remains difficult, but its importance is now recognised. Even (or perhaps especially) if regulatory standards are imperfect, it will be a pressing topic for supervisors. Islamic institutions may have particular problems in this area, because of the limited supply of liquid instruments available to them, and the underdeveloped state of Islamic money markets (a problem that is difficult to solve in a way that is Shari’ah based in substance rather than marginally Shari’ah compliant in form).4 Initiatives are under way to increase the supply of high quality Islamic financial instruments and, in parallel, to define structures within which these can be used as collateral for liquidity provision. Nevertheless, liquidity is likely to remain a supervisory issue for the foreseeable future.
The increased focus on systemic stability has led to attempts to define and apply higher levels of regulation to systemically important financial institutions (SIFIs). This carries difficulties, for example around arbitrage between SIFIs (as defined) and near-SIFIs. No Islamic institutions will at present qualify as SIFIs at the global level, though there will be a few that will qualify within their home jurisdictions. They will be subject to an increased level of scrutiny, and possibly increased capital requirements.
3.3 Recovery and Resolution
Islamic institutions are also likely to be subject to new arrangements for recovery and resolution if they get into difficulties. Much of the debate on resolution arrangements has so far focused on so-called living wills and potential requirements on SIFIs to structure themselves in ways that permit orderly resolution; this may lead to banks making greater use of subsidiaries rather than branches. However, the standard adopted by the Financial Stability Board in November 20115 goes well beyond that. It expects each jurisdiction to create or designate an administrative authority with a broad range of powers and options to resolve a financial institution that is no longer viable. The resolution regime should allow for a sale or transfer of the shares in the firm or all or parts of the firm’s business to a third party, creditor-financed recapitalisation of the entity (so-called “bail-in within resolution”), and the wind-down of all or parts of the firm’s business. The resolution authority should be able to act before a firm is balance-sheet insolvent, and to override the voting rights of shareholders. It should respect the hierarchy of claims that would apply in a liquidation, including protecting those covered by deposit insurance or similar arrangements.
For these arrangements to work, they will need to work across borders, in jurisdictions where global SIFIs (G-SIFIs) have major operations, not merely in their home countries. In any event the arguments for such arrangements apply quite strongly to local as well as global SIFIs. Furthermore, once a jurisdiction adopts such a resolution framework, the local pressures are likely to lead to its use in failures of firms other than SIFIs. Few jurisdictions will be able to justify creating a separate resolution authority, and it is likely that in many cases the responsibility will be given to the supervisory authority.
These developments raise several issues for Islamic institutions (including Islamic windows and subsidiaries of conventional institutions). Thinking about corporate insolvency in the context of Shari’ah law is at a relatively rudimentary level.6 However, one standard Shari’ah principle is that all unsecured creditors rank pari passu, which clearly limits the ability to establish a hierarchy of claims. Furthermore, while some trade-based Islamic contracts (e.g., murabahah) create a debt, others, typically investment-based contracts like mudarabah, do not. An Islamic bank might well be holding funds provided on both bases, for example short-term interbank placements under commodity murabahah and retail profit-sharing investment accounts (PSIA) under mudarabah.
In some jurisdictions, the potential interactions between Shari’ah and civil- or common-law systems may introduce further uncertainty into the resolution process. In any event, establishing a hierarchy of claims will force a view to be taken on whether holders of PSIA should or should not be given the protection normally afforded to depositors. If not, this will need to be clear to them from the beginning. Imagine, for example, that a conventional bank with an Islamic window is put into resolution. If the question has not been addressed in advance, the resolution authority will need to decide, under highly stressed conditions, whether PSIA holders of the window should be given parallel treatment to that given to conventional depositors, how a wholesale funding contributed under wakalah or murabahah should be treated, and so on. There is much thinking to be done in this area.
3.4 The Scope of Regulation
Another major focus following the crisis has been on ensuring that all financial institutions that might have an impact on systemic stability are appropriately regulated. After a period of considerable uncertainty, the focus has centred on those non-bank institutions where credit creation may take place (“shadow banking”). In general, these have been much less a feature of Islamic than of conventional banking, but supervisors will clearly be taking a wider view of group structures and related entities than they have done in the past.
3.5 The International Standards Architecture
Among the most important post-crisis developments have been the changes in the international standards architecture led by the Financial Stability Board (FSB) as the agent of the (expanded) G20. The FSB now clearly leads, and to some extent directs, other standard-setters such as the Basel Committee. It has also become the main driving force for standards implementation, though working closely with other bodies such as the International Monetary Fund (IMF) and the World Bank. This has important implications for the Islamic finance standard-setters, which go beyond the scope of this chapter. The international pressure for standards implementation is, however, important. It will, no doubt gradually, lead to greater, though still imperfect, convergence in both the standards applied and supervisory practices. The focus will, of course, be on the standards endorsed by the FSB, which will in turn be those of the main conventional standard-setters. Even those regulators who implement special standards for Islamic finance are likely to base them largely on their conventional counterparts.
4. THE ISSUES FOR SUPERVISORS
Section 3 discussed some important developments occurring at an international level. Section 4 discusses the implications of these developments for supervisors working in Islamic finance.
4.1 Common Ground between Islamic and Conventional Finance
The first point to note in any discussion of this kind is that many of the priorities and issues for supervisors in Islamic finance will be the same as in conventional finance. For example, any supervisor will evaluate the ownership of a financial institution, with a particular focus on integrity, but also on matters such as whether the financial needs of a parent company might place strains on a subsidiary. A supervisor will also evaluate the fitness and propriety of the board and senior management, and governance matters such as the existence of proper compliance and risk management arrangements. The scope of this scrutiny may be extended if the supervisor has a role in Shari’ah governance. For example, the evaluation of fitness and propriety may be extended to members of an SSB. But this will not detract from the common core applicable to both conventional and Islamic business.
Broadly similar comments could be made in other areas, for example the management of conflicts of interest especially around securities dealing. In particular, a core activity of any banking supervisor is the evaluation of credit controls, and of provisioning for credit defaults. Such work is just as important in Islamic banking. Indeed, in certain areas it may be more important, since the bias towards forgiveness of debtors may make it harder, for example, to repossess a house that is the subject of a mortgage.
In capital markets supervision, there may be even less distinction at the supervisory level between conventional and Islamic finance. An obvious example would be an Islamic fund, using a third-party Islamic screen to select its investments. Whilst the supervisor might well have an active role in considering the screening method and the disclosures to be made to potential investors, once the fund is in operation the Shari’ah issues are likely to be minimal, and the main supervisory concerns will be matters such as safeguarding of the fund assets, asset valuation, and general governance. There will be very little difference from the approach taken towards a conventional long-only fund.
4.2 Strategy and Governance
In the post-crisis environment, supervisors can be expected to take a more active interest in business strategy, including both markets and funding. The latter will be subject to more sceptical scrutiny than has been the case in the past. The potential for wholesale market runs on banks came as something of a shock to regulators during the crisis, and led to the Basel Committee’s attempt to develop a Long-term Stable Funding Ratio as part of its new liquidity package. There is considerable scepticism as to whether the Committee has got this right, and full implementation has been delayed in favour of an extended monitoring period. The absence of a firm standard may, however, simply increase the intensity of supervisory interest. The scepticism about wholesale market funding is likely to force Islamic banks to rely more on organic growth from their retail investors, in contrast to the immediately pre-crisis period when new Islamic banks were launched in the expectation that much of their funding would be wholesale. This will tend to benefit the more established players, including established conventional banks with Islamic windows.
Related to strategy is the issue of governance. (Remuneration is also related, but has few if any features peculiar to Islamic finance.) Despite the difficulties of doing so, supervisors will need to consider whether their institutions are well governed, with a particular eye to how risks are assumed and managed. This will involve careful consideration of the part that an SSB plays in governance, and whether it adds to or subtracts from good governance. The prudential issues are, for the present, considered more important than the conflicts of interest between institutions and their customers, so elements of governance that bear dominantly on the latter, like the IFSB’s proposal for a Governance Committee,7 may be considered less important for the present. Nevertheless, the unique set of conflicts of interest created by Islamic finance structures remains one of the distinctive supervisory issues.
4.3 Capital and Liquidity
In addition to the stability of firms’ long-term funding, there will also be a greater supervisory focus on shorter-term liquidity. As already noted, this will be a challenge for some Islamic banks, because of the limited supply of secure liquid instruments available to them. Various pieces of work are under way, both nationally and internationally, to increase the supply of highly rated sukuk, and also to develop tools for short-term liquidity support. However, the restricted choices available to them mean that Islamic banks may have to accept lower rates of return on their liquid assets than comparable conventional banks. Also, the need for instruments carrying minimal risk to capital or return means that government initiatives are likely to focus on sukuk economically as close as possible to conventional bonds; the pursuit of innovative sukuk offering new combinations of risks and returns will be left to the private sector.
As new capital regimes are introduced, regulators and supervisors will inevitably need to consider again the relationship between PSIA and deposits. The issues here are well known. The Shari’ah basis of a PSIA is that both return and principal are at risk, but in practice banks may not disclose these risks clearly to customers, and commonly create mechanisms to mitigate them. In addition, unrestricted PSIA typically involve maturity transformation, so if investors begin to withdraw money in search of better returns elsewhere, there will be liquidity reasons as well as commercial reasons to support the rate of return. So far as capital adequacy is concerned, the resulting concept of “displaced commercial risk” may be expressed through a parameter—α in the IFSB’s capital adequacy standard—that modifies the normal calculation of risk-weighted capital. In a climate of regulatory conservatism, regulators may be more likely to treat unrestricted PSIA as pure deposits both for capital adequacy purposes (effectively setting α = 1), and also for depositor protection purposes. The latter might be influenced by a view that, if an Islamic bank fails, the political pressures to compensate retail PSIA holders may not be materially different from the pressures to compensate depositors in a conventional bank. They will also have in mind that depositor protection is considered to have a preventive function, reducing the likelihood of a (retail) run on the bank.
In implementing the Basel Accords, supervisors in the countries where Islamic finance is strong are likely to concentrate mainly on standardised approaches, reflecting the limited capacity of domestic banks to use more model-dependent approaches and increased supervisory scepticism about internal models. In any event, relatively few Islamic banks have the track record and the long data series needed to gain supervisory approval for model-based approaches.
Of much greater relevance is likely to be the handling of operational risk, whether through set Pillar 1 capital charges or through Pillar 2 risk review and the setting of individual capital requirements. A particular issue here will be the handling of Shari’ah–non-compliance risk: in this context, the risks that the effects of contracts will be different from those expected because of Shari’ah deficiencies, and that perceived Shari’ah deficiencies will cause Muslim customers to shun the institution. Of these two components, one is closely akin to legal risk, the other to reputational risk. In principle there is nothing conceptually new here. The issue for supervisors will be, however, to gauge the scale of the risks, in a situation where there is very limited experience available. In particular, there is little jurisprudence on Shari’ah challenges to financial sector contracts and, where there is, it is not always easy to extrapolate into a different national legal environment. In these circumstances, supervisors may take widely different views of the potential scale of Shari’ah–non-compliance risk, and possibly apply widely different capital charges for it. It will be some time before any objective basis is available to assess this risk outside a few jurisdictions with well-developed Islamic finance industries.
4.4 Group Supervision
Several elements of the crisis have increased the emphasis on group supervision. This of course includes group consolidation, that is, the application of capital adequacy standards at the level of the group rather than only to individual entities, but it is not limited to that. It also includes consideration of risks at the group level, plans for resolution of the group, and arrangements for supervisory collaboration and exchange of information, usually through what is called a supervisory college. There are of course many issues around group supervision, and this chapter discusses only those that bear particularly on Islamic finance.
The effects of group consolidation are to apply a single set of capital standards at the level of the group. These will be in the hands of the lead supervisor, where the institution is headquartered. Islamic windows or subsidiaries will therefore need to maintain, or be able to convert, their accounting records into the standards accepted by the lead supervisor, which are most likely to be based on International Financial Reporting Standards (IFRS) or U.S. Generally Accepted Accounting Principles (GAAP). More importantly, lead supervisors will take their own view of the capital to be held in respect of Islamic transactions and structures, for example PSIA. To the extent that these are significant in group terms, therefore, their treatment by lead supervisors will be at least as important as their treatment by the solo supervisor of the individual entity in question. The default position of conventional supervisors will presumably be to treat them as deposits, which will place some pressure on Islamic finance supervisors to justify a different approach.
The existence of supervisory colleges, and participation in them by Islamic finance supervisors, will also have impacts. It has the potential to bring the discussion of Islamic finance into the mainstream of everyday supervisory work, but will also expose regulatory and supervisory practices to international scrutiny and debate. For example, previously purely conventional supervisors may need to understand, and Islamic finance supervisors to explain, the role of an SSB in governance.
4.5 The Impact of the New Standards Architecture
More generally, the new supervisory architecture has created a new level of international pressure for standards implementation, especially implementation of the Core Principles of the Basel Committee, the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS). In addition to the well-established reviews by the IMF and the World Bank, the FSB is managing its own programme of peer reviews, and pressing the standard-setters to monitor standards implementation among their members.8 These reviews cover supervisory practice as well as the formal regulatory provisions. Like participation in colleges, they will create a greater degree of international convergence, and force discussion of how far Islamic finance should be treated differently from conventional finance. As yet, the standards of the specifically Islamic standard-setters are not included in such reviews, and the onus will therefore be largely on supervisors themselves to articulate their approach.
4.6 The Challenge for the Future
For the future, the challenge for supervisors will be to keep up with innovation in Islamic finance. Whilst in conventional finance the challenge is likely to come from new and exotic products, in Islamic finance it may well come from products that are superficially similar to products well-known in the conventional world, but with differences in their risk characteristics that may not be fully appreciated and whose effects may be unknown.
NOTES
1. I have written at greater length on supervisory issues in Islamic insurance in Takaful Islamic Insurance: Concepts and Regulatory Issues (Hoboken, NJ: John Wiley & Sons, 2009).
2. Though it would be interesting to know what the Shari’ah committee of The Investment Dar thought of that firm’s decision to resist payment on a contract they had approved, on the grounds that the contract was not Shari’ah compliant.
3. A macroeconomic version of Keynes’s comment that “Markets can remain irrational a lot longer than you and I can remain solvent.”
4. An example of Shari’ah compliance in form (but arguably not in substance) is the use of commodity murabahah for interbank transactions, in which the underlying commodity is immediately resold to produce cash while the murabahah mark-up remunerates the party providing the liquidity
5. Key Attributes of Effective Resolution Regimes for Financial Institutions, Financial Stability Board, November 2011: www.financialstabilityboard.org/publications/r_111104cc.pdf
6. A helpful collection of papers is “Effective Insolvency Regimes: Institutional, Regulatory and Legal Issues Relating to Islamic Finance, Islamic Financial Services Board and The World Bank,” March 2011, ISBN 978-967-5687-02-0.
7. IFSB. Guiding Principles on Governance for Institutions Offering only Islamic Financial Services. December 2006.
8. See, for example, A Coordination Framework for Monitoring the Implementation of Agreed G20/FSB Financial Reforms, Financial Stability Board, October 2011: www.financialstabilityboard.org/publications/r_111017.pdf