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Old Monday, November 19, 2007
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Default Islamic Finance: Emerging Challenges of Supervision

. Background

Diversification and structural transformation in financial sector has beenaccompanied by increasing integration among different segments of the financial sector.The traditional boundaries between banks and non-bank financial institutions are erodingand we are witnessing the growth of universal banking and/or mergers among differentsegments of sectors.
This trend has its benefits but has associated risks as well. Supervisors face a dualchallenge. On one hand, supervisors are promoting financial diversification andconsolidation to achieve market development and innovation. On the other hand,supervisors have to position themselves to recognize the new dimensions and types of risksand encourage appropriate risk mitigation. These considerations have triggered world widedebate on how to effectively supervise different segments of financial sector inconglomerate and universal structure.

So far these debates had been concentrated around conventional banking but now itis widely gripping the world of Islamic Finance (IF). Stronger inter-dependencies amongdifferent segments of IF are emerging largely because Islamic Financial Institutions (IFIs), inprinciple, have features and inherent characteristics and more compulsion, thanconventional banking, to conform to universal banking or to evolve inter-linkages amongdifferent market segments.

II. Factors Driving Cross-sector Linkages and Interdependencies

First and foremost, IFIs’ depositors/borrowers desire to conduct financialtransactions that are Shariah compliant. It can be assumed that a person preferring to bankwith an Islamic bank will also seek to use other faith-based financial services such asTakaful and Islamic mutual funds. This faith-driven feature in itself forces and incentivizesIFIs to offer, along side bank-based services (i.e. deposit and loans), a wide range offinancial services. As a result, Islamic banks end up undertaking non-core banking activitiessuch as fund management, capital market operations, securitization, leasing, and housingfinance. This has enhanced the degree of integration between various segments of IF. Forexample: Islamic banks are likely to be strongly integrated with the Shariah capital marketssince on credit portfolio side, Islamic banks do not have the same investment avenues asthose available to their conventional counterparts. The outcome is that Islamic banks eitherend up taking large exposure in the capital markets directly or acquire subsidiaries whichprimarily engage in such businesses.

Second differentiating aspect is the nature of contractual arrangements that drivedeposits mobilized by conventional banks as compared to Islamic banks.

Conventional bankdeposits are interest based contracts with guaranteed interest return whereas Islamic banksraise deposit on a profit and loss sharing basis in either a Mudaraba or Musharaka structure.Mudaraba/Musharaka contracts transform the Islamic banks’ deposits into essentially a fundmanagement product (although currently most regulators recognize these as equivalent toconventional deposit contracts) and this impacts the corresponding asset portfolio. There isa need therefore that Islamic banks acquire assets on a PLS basis as well and eventuallymove beyond fixed return products, like Murabaha and Ijara. This pushes an Islamic banktowards universal banking since in order to manage the portfolio profitability; it needs toinvest across sectors in businesses based on Shariah principles, like equity and Sukuks inthe capital market and trade contracts like commodity Murabaha, Musharaka, Ijara andTakaful.

Thirdly, further development of Islamic banking itself depends on concurrentdevelopment of Islamic capital market. For instance, development of Islamic debt market iskey to the provision of adequate liquidity support while providing additional investmentavenues. Likewise, Takaful development is critical to provide insurance coverage to Islamicbanking products, like auto and consumer financing, while strengthening secondary capitaland Islamic bond markets by being a major buyer of Islamic instruments. It is the confluenceof these factors that have induced regulators to encourage and IFs to promote rapid anddeeper financial inter-linkages and integration.

III. Supervisory Challenges posed by Cross-sector Developments
It is some of these above considerations that have augmented strategic alliancesand linkages of various types among IFIs, both within country and cross borders. As such,IFIs are evolving either as part of a global financial concern or as a domestic bank acquiringor establishing subsidiaries and/or the two arms, i.e. Islamic and conventional banks coexist.Moreover, as the conventional parts of financial institutions move towards cross-sectorintegration, their Islamic counterparts (either as specialized window or as independententities) will also follow eventually.

While it has by now been well established that there are significant benefits ofenhanced integration and inter-linkages or conglomeration in IF, such as the economies ofscale, operational synergies and effective use of scarce human resource, there are definitelycertain risks. In this area, I would like to offer few basic observations.Firstly, it is inevitable that enhanced exposure of Islamic banks into capital marketsexposes them to the volatility in associated businesses. Likewise, conglomeration, whetherthrough universal banking or through parent subsidiary model,2 exposes them to a variety of issues such as contagion risk, regulatory arbitrage, high group exposures, conflict of interestetc. These risks apply equally to both Islamic and conventional modes of finance. However,Islamic banks have thus far not erected firewalls, like conventional banks, to separatelegally, financially and managerially their investment and commercial banking activities.Obviously these risks pose a challenge to the supervisors and necessitate that appropriatechanges be made in the supervisory regime.

Secondly, Shariah compliance issues necessitate taking a more aligned view acrossIF businesses as user of Islamic products may be oblivious of ideological differences as wellas varying perceptions and interpretation of the Shariah advisors or boards and/or byregulators. Since institutions being supervised by one regulatory authority may be offeringproducts of institutions being supervised by a different regulatory body, this could introducecomplications and the challenge of ensuring uniform Shariah compliance across financialinstitutions and products.

Thirdly, traditionally different segments have been regulated by their specializedsupervisory authorities. These authorities have adopted risk management principles andsupervisory stances which are strictly in line with the risk profile of supervised sectors inisolation. With sector integration, supervisors have to coordinate closely in policy formulationand regulation as well as on-site supervision. They have to coordinate creation of necessaryfirewalls, remove moral hazards and govern the degree of cross segment exposure. Thismay even call for institutional restructuring through merging various supervisory bodies intoa single entity or for closer coordination between supervisors through creation of a thirdcoordinating body.

IV. Sector Inter-linkages of Pakistan’s Islamic Finance System
In Pakistan, besides offering trade loans, like Murabaha, Islamic banks are offeringequity and quasi equity products, such as Musharaka and diminishing Musharaka, andinvestment banking activities such as loan syndication, structured finance, etc. The six fullfledged Islamic banks with a network of 108 branches and another 58 stand alone Islamicbranches of 13 conventional banks have registered phenomenal growth and as of April2007, the Islamic banking sector constituted 3.3% of total banking assets.3 In view of theequity based nature of Islamic banking and lack of Shariah compliant financial instruments,central bank has allowed Islamic banks a relatively higher exposure (35% direct and 10%future of their equity) in capital markets compared to conventional banks (20% direct and10% future). In addition, the State Bank of Pakistan (SBP) has relaxed statutory reserverequirement (SLR) for Islamic banks at 8% versus industry norm of 18%.Furthermore, Islamic banks are allowed to nurture parent-subsidiary/affiliate modelwhereby Islamic banks are by and large setting up asset management companies,brokerage firms and, now, Takaful businesses. Thus far the supervision of IFIs is bifurcated,with Islamic banks being regulated by SBP and non-bank IFIs, namely, Modarabas, Islamicmutual funds, Takaful companies and securities operations under the regulatory oversight ofSecurities and Exchange Commission of Pakistan (SECP).

Sector specific supervisory approach is also characterized by varying regulatoryrequirements vis- -vis operational matters, governance framework and Shariah complianceacross the range of IFIs. The differences extend to minimum capital requirements ranging from Rs6 billion for Islamic banks (by the year 2009), Rs500 million for family Takafuloperators (by the year 2011), Rs300 million for general Takaful operators (by the year 2011)and Rs30 million for Islamic fund managers to Rs2.5 million for Modaraba managementcompanies. The low capital base of financial institutions, engaged in the business of Takafulor fund management, poses a significant risk to the solvency of financial conglomerates thatcharacterize the Islamic financial markets. In terms of financial reporting, Takaful companiesare not required to circulate quarterly accounts among shareholders whereas all otherIslamic financial institutions are required to do so in terms of the legal and regulatoryframework.

The segregated supervisory approach has resulted in carving of legal frameworkspecific to each sector for both conventional banks and IFIs4 but eventually there is a needfor addressing the idiosyncratic nature of IF industry, products and market players.Moreover, with regard to IF, both the regulators are following different approaches towardsShariah compliance in the institutions regulated by them. SBP requires Islamic banks toappoint Shariah advisors according to a prescribed fit and proper criteria and a ShariahBoard has been constituted at the level of SBP to deal with issues relating to Shariahinterpretation and compliance among Islamic banks. SECP’s approach varies acrossdifferent segments of IF. A Religious Board, constituted by the government, is responsiblefor approving the prospectus of each Modaraba containing the types of business to beconducted, management, etc. While the Religious Board has a significant role, there is norequirement for Modarabas or their management companies to appoint Shariah advisers atindividual fund level. Islamic mutual funds and Takaful operators, on the other hand, arerequired to appoint Shariah Council/Boards but no explicit fit and proper criteria has beenlaid down by SECP in this regard. SECP is also authorized to appoint a Central ShariahBoard under the Takaful Rules, 2005, which has not been established as yet.The greatest challenge resulting from different Shariah compliance practicesfollowed by Islamic banks, Modarabas, Takaful companies, etc. is the reputational risk facedby IFIs and misperceptions in the minds of public about Shariah compliance. This issue,therefore, needs to be addressed through coordination amongst the supervisors.Another issue arises from overlapping supervisory jurisdiction. The BankingCompany Ordinance allows banks to act as Modaraba management companies forfloatation of Modarabas. In terms of Modaraba Companies Ordinance, Modarabas can beformed to conduct any type of business, which is permitted under Shariah, be it trading,manufacturing, airline, financing, leasing, services, etc. and these are regulated by SECP.Due to overlapping regulatory jurisdictions, banks are floating modarabas through separatesubsidiaries,5 resulting in higher administrative, set up and regulatory costs. For sometime(from 1991-1997), these Modarabas were under the regulatory control of SBP, but thepowers relating to licensing, winding up, etc. were retained by SECP; consequently theregulatory authority has been reverted to SECP. Again, this highlights the need for crosssector regulation of IFIs.

Eventually there is a need to develop mechanisms for oversight of financial sector inan integrated manner. Besides coordination and cooperation among regulators, there is a need for consolidated supervision framework for financial institutions, guidelines forconsolidated public financial statements and application of regulatory prudential limits ongroup wide basis and coordination to examine the intra group linkages with industrial andcommercial entities. While conventional and Islamic financial industry would have to adoptsimilar approaches to integrated supervision, it has to be recognized that the latter is arelatively nascent industry and hence the targets should be modified to match the groundrealities.

V. Conclusion
IFSB’s ten year roadmap has highlighted the cross sector nature of IFIs and theresultant need for supervision to evolve accordingly. It is in recognition of these factors thatIFSB has sought to broaden its membership to securities and insurance supervisoryauthorities as Full Members of IFSB. IFSB’s efforts for developing Islamic regulations as wellas accounting, auditing and governance standards will facilitate adoption of unifiedprinciples for the development, operation and regulation of Islamic financial services.
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