• Book Title:
 Islamic Finance The Regulatory Challenge
  • Book Author:
Rifaat Ahmed Abdel KarimSimon Archer
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Supervision of Islamic Banks and Basel II: The Regulatory Challenge

The challenge to banking regulators and supervisors represented by the Basel Committee for Banking Supervision (BCBS) document International Convergence of Capital Measurement and Capital Standards: A Revised Framework (generally known as Basel II) is, of course, first and foremost in respect of its application to conventional banks.

Basel II was issued in June 2004 (with some revisions in November 2005) to supersede the original 1988 Capital Accord (Basel I). The main innovations introduced in Basel II were, first, a significantly more comprehensive and sophisticated approach to measuring credit risk and, second, a capital requirement for operational risk. With respect to market risk, Basel II did not supersede the 1996 Amendment of Basel I, which had introduced a capital treatment for this category of risk, not specifically covered in the original capital accord.1

Basel I was a document of modest length that made no great technical demands on the reader. However, the years since 1988 have seen a very significant evolution in banking and finance, including the effects of the globalization of financial markets and developments such as the abundance of derivatives and securitizations using structured finance. These developments have significant implications for risk and capital adequacy. Hence, Basel II, which (with its appendices) runs to over 250 pages, is a fairly daunting document that makes some non-trivial demands on the reader, both technical and conceptual.

Basel II was not written with its application to Islamic banking in mind. However, the rapid development of Islamic banking since the early 1990s, and the fact that international financial authorities such as the World Bank, the International Monetary Fund (IMF), and the BCBS understood the consequent desirability of building bridges between Islamic (Shari’ah-compliant) financial institutions and the conventional (non-Shari’ah-compliant) financial sector,2 inevitably raised the issues of how and to what extent Basel II principles and techniques are applicable to the regulation and supervision of Islamic banks, and of the regulatory and supervisory problems to be overcome in this context.3 These issues constitute the concern of this book.


The structure of Basel II is based on three ‘‘Pillars.’’ Pillar 1 deals with the new approach to credit risk which replaces that of Basel I and with operational risk; Pillar 2 addresses the supervisory review process from the standpoint of the responsibility of the supervisor to promote the overall safety of the banking system, and establishes a set of common guidelines for supervisory review, while also stressing the primary responsibility of individual banks and the critical role of dialogue between supervisors and banks; and Pillar 3 lays down a minimum number of public reporting standards on risk and risk management intended to enhance the ability of market participants to be aware of a bank’s risk profile and the adequacy of its capital in relation to this, thus involving the market in the capital adequacy regime.4

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Basel II thus presents all banking supervisors with a major challenge, both in enforcing Pillar 1 together with the disclosure requirements of Pillar 3, and in implementing Pillar 2. To be sure, the adoption of Basel II is not intended to be a requirement outside of the G10 countries who are represented on the BCBS, and then only for banks that are internationally active. However, as Basel I has been adopted in over 100 countries, the supervisors in these and other countries may be expected to adopt Basel II progressively over the next few years.

For supervisors in countries where Islamic banks are located, there is the further challenge of applying Basel II to those institutions. This added challenge results from the specificities of the Islamic (Shari’ah– compliant) modes of finance employed by Islamic banks. These raise issues of capital adequacy, risk management, and corporate governance that differ significantly from those that arise in conventional (non-Shari’ah-compliant) financial institutions. The issues concern the types of assets to which Islamic financing gives rise, the related risks and the availability of risk mitigants, and the types of non- interest-bearing savings and investment products offered by Islamic banks for funds mobilization in place of conventional deposit and savings accounts. The fact that these non-interest-bearing savings and investment products have characteristics similar to those of collective investment schemes, not normally the concern of banking supervisors or regulators, constitutes a further regulatory challenge.


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

In December 2005 the IFSB issued two prudential standards for Islamic banks that are designed to help supervisors of such banks meet the challenge of implementing Basel II, one on capital adequacy and one setting out guiding principles of risk management (together with

an Exposure Draft of a third standard on corporate governance).5 The

mandate of the IFSB was extended in December 2005 to the domains of insurance and securities market supervisors and regulators.

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The main challenge for the IFSB is to develop a framework that is common and applicable to all jurisdictions. However, unlike the Basel Committee, which can rely on regulatory frameworks and best prac- tices developed by other leading regulators and banks as a background to its global framework, this process could not be readily applied by the IFSB. This is because the IFSB does not have the privilege of bor- rowing ideas from a large number of countries that have developed robust regulatory frameworks specifically for Islamic banks.

Hence, the onus of developing most of the thinking to set internationally accepted common prudential standards for Islamic financial institutions is on the IFSB. This involves identifying the risks in the different types 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 stakeholders who in principle share asset risks with the shareholders, and adapting Shari’ah rules that would be acceptable to the majority of its members.


Since this book deals with a large range of regulatory issues arising from the application of Basel II to Islamic banks, authors who have been chosen are specialists drawn from a variety of relevant backgrounds: international organizations such as the World Bank and the 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, reflecting different aspects of the regulatory challenge, and two concluding chapters, as outlined below.

Part 1: The Nature of Risks in Islamic Banking

This part consists of seven chapters from 2 to 8. In Chapter 2, Hennie van Greuning and Zamir Iqbal examine banking and the risk environment with reference to Islamic banks. They look at how Shari’ah-compliant financial intermediation operates in theory and in practice, and the risks, and corporate governance and transparency issues, to which this gives rise to. The risk characteristics of Islamic products, and the complexities of some of these, such as the phenomenon of displaced commercial risk, are rigorously examined 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 risk management in relation to the level of capital and capital structure and to the nature of Islamic financing assets. The next two chapters focus on specific types of risks in Islamic banks. Credit and market risks inherent in asset-side products are examined by John Lee Hin Hock and Abdullah Haron in Chapter 5. They show how Islamic financing assets possess risk characteristics not found in conventional loans, including combinations of credit and market risks. Consequen- tial or operational risks are analyzed by Simon Archer and Haron Abdullah in Chapter 6.

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 For Islamic banks, as they point out, opera- tional risks include those that may arise from errors in drawing up contracts 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, deals with a complex and daunting set of risks arising from Shari’ah and legal compliance requirements and their interactions, which result inter alia in legal impediments to the development of Islamic securitizations.

The authors also provide a historical outline, from a legal perspective, of the emergence of modern Islamic banking and finance. Finally, Hari Bhambra in Chapter 8 considers the implications of these risks for a financial sector regulator. She concludes that matters are easier if the regulator is a cross-sectional regulator, responsible for securities markets and the insurance sector as well as banking. So far as Shari’ah compliance is concerned, the regulator or supervisor does not need to take positions on issues of Shari’ah, but instead must satisfy itself as to the effectiveness of an Islamic bank’s own systems and procedures for ensuring Shari’ah compliance, both ex ante (in the design of products and the associated contracts) and ex post (in contract execution and product delivery).

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