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Selasa, 06 April 2010

Trends in Islamic-Finance Regulation

ITA\MAS\Services\Office of Financial Services Industries   Page 1 


By Scott Schmith
 
Executive Summary 

Islamic financial services comply with Islamic
principles on interest, non-Islamic investments,
and speculation. This paper provides a general
overview of this market and its regulatory envi-
ronment. Key findings include:

• Growth in Islamic financial services
presents significant growth opportunities
for U.S. financial service companies and
providers of banking technology.
• At the end of 2006 global Islamic financial
services exceeded $530 billion and are
growing faster than assets in conventional
finance.
• The Islamic finance market extends beyond
its largest markets in the Middle East and
Southeast Asia.
• Islamic banking regulators have prudential
and developmental roles. Depository insur-
ance and interbank funding are two signifi-
cant challenges facing Islamic finance regu-
lators.
• International qualifications and standards
could harmonize the application and devel-
opment of Islamic financial services.
 
Introduction 
Differences from Conventional 
Finance 

Islamic financial services are financial services
that comply with Islamic principles on interest,
the sources and uses of funds, and its restric-
tions on speculation. Traditionally, rather than
charging interest, Islamic financial institutions
will typically share some of their borrowers’
risks and profits. A bank’s profit from these
‘loans’ depends on the overall success of the
loans in generating additional revenue or prof-
its for the borrowers.

Islamic finance also avoids investing in ven-
tures that may have components that are not in
line with the values of Islam (alcohol, gam-
bling, drugs and tobacco) and speculation (e.g.,
reliance on the occurrence of events that may
or may not take place).

Although Islamic financial principles may dif-
fer from those of conventional banks, in prac-
tice Islamic financial products look a lot like
conventional mortgages, leases, and business
loans.

The relatively recent resurgence of Islamic
finance has complicated measuring the size of
this market. However, according to the Interna-
tional Financial Services London (IFSL), the
global market for Islamic financial services, as
measured by Sharia compliant assets, is esti-
mated to have reached $531bn at the end of
2006. This represents over a 10 percent a year
growth rate in the last decade.
1


The Banker’s recent survey of the largest Is-
lamic financial institutions (IFIs) demonstrates
the size and the difficulty of defining this sec-
tor. The 500 largest IFIs have over $500 billion
in total assets. Total Islamic-compliant assets
are likely significantly greater.
2


Still, total assets for IFIs are relatively small
compared with the $74.2 trillion in assets of
conventional banks that make up the Banker’s

1
Islamic commercial banks, investment banks, bond, and
insurance account for 75, 13, 9 and 3 percent of total
assets, respectively.
2
Only 45 percent of the institutions claiming to provide
some type of Sharia-based financial services reported
figures on their Islamic operations.
ITA\MAS\Services\Office of Financial Services Industries   Page 2 

list of the world’s 1000 largest banks.
3
The Is-
lamic finance market, however, is in the early
stages of growth and innovation.
Where are the Islamic Finance Mar­
kets? 

Islamic finance markets are concentrated in the
Middle East and South Asia but spreading ra-
pidly to other developing and developed mar-
kets. The Gulf Cooperation Council (GCC)
states (Saudi Arabia, Kuwait, the United Arab
Emirates, Bahrain, Oman, and Qatar) account
for almost 36 percent of the total market of
$500 billion as measured by the Banker.
4
The
non-GCC Middle East and North Africa (ME-
NA) region (35 percent of the total), is domi-
nated by Iran, with Lebanon and Egypt acting
at significantly lower levels. Asia represents
24 percent of the total and is dominated by Ma-
laysia, Pakistan and Indonesia.
5


Despite its growth, Islamic financial services
are not available for most Muslims. This unmet
demand creates a significant growth opportuni-
ty for banks to expand into predominantly Mus-
lim countries.
6
Saudi Arabia, with $69 billion
in Islamic-compliant assets, and Malaysia, with
$65 billion, have larger overall banking sectors
than Iran. Iran’s Islamic finance market, how-
ever, with $155 billion, is more than twice as

3
Of the 500 institutions listed, only 318 reported assets
and only 221 reported Sharia assets, representing 63.6%
and 44.3% respectively of the overall listing.

Stephen
Timewell and Joe Divanna. “Top 500 Islamic Financial
Institutions - How Fast Is The Islamic Finance Industry
Growing? The Banker (Nov., 2005).
4
In the GCC, Kuwait, with $37.7 billion in Sharia com-
pliant assets (SCAs), is ahead of the UAE with $35.4
billion and Bahrain with $26.3 billion. The UAE has
more SCAs than Bahrain, but Bahrain has 54 institutions
in the Banker’s Top 500 listing compared with 40 in the
UAE. Kuwait has 48 institutions in the listing while the
leading GCC state, Saudi Arabia, has 45; “Top 500 Is-
lamic Financial Institutions - Iran Dominates in the
World of Sharia Compliance” The Banker (Nov. 2007).
5
Ibid.
6
Joe Divanna. “Top 500 Islamic Financial Institutions -
From Emergence to Innovation” The Banker (Nov.
2007).
large as its nearest competitor, but is closed to
U.S. financial institutions.
7


The Islamic finance market is not confined to
developing countries. The United Kingdom,
with $10.4 billion in Sharia-compliant Assets
(SCA) is the 10th
largest country in the Bank-
er’s ranking.
8
The United Kingdom is actively
promoting London as a major center for Islamic
finance.
9
France, with a large Islamic immi-
grant community, is also developing its Islamic
finance sector. The United States has a propor-
tionately smaller Muslim community, but due
to its overall size is also a potentially large
market.
Technology, the Unbanked, and 
Transnational Commerce 

The growth of Sharia-compliant lending ex-
tends beyond the financial sector to influence
the adaptation of new technologies and access
to the financial sector by the unbanked.

Banking technology companies are rapidly de-
veloping products to meet the growing demand
of Sharia compatible products. Banks are
working with software companies to adapt their
products to provide the documentation and au-
dit capability the banks’ Sharia boards require,
or to introduce Sharia-compliant products to
the market.
10
Technology companies can take
advantage of opportunities in this sector if their
products encourage more efficient operations,
attract and engage customers toward a bank’s
brand, and meet the specific needs of Islamic
commercial ventures.
11


Sharia-compliant banking technology could
also contribute to reducing the number of the
unbanked within Muslim countries and com-

7
Timewell and Divanna, “Top 500 Islamic Financial
Institutions - How Fast.”
8
The Banker, “Top 500 Islamic Financial Institutions -
Iran Dominates.”
9
Timewell and Divanna, “Top 500 Islamic Financial
Institutions - How Fast.”
10
Divanna, “Top 500 Islamic Financial Institutions.”
11
Ibid.
ITA\MAS\Services\Office of Financial Services Industries   Page 3 

munities. Mobile phones and intelligent ATMs
could provide access to financial services for
many of the unbanked Muslims.
12

Islamic Finance Hubs 

Financial centers and regulators have respond-
ed unevenly to these trends. Banks have reacted
to the growth in the Islamic finance market by
adding new services and offices. Yet, many
Muslim majority countries have not yet enacted
legislation to authorize Islamic banks. Others,
such as Malaysia, Bahrain, and some Gulf
states have made significant efforts to regulate
Islamic banks separately from conventional
banks. The UK, however, is an example of a
country that has decided to treat Islamic finan-
cial systems in the existing regulatory frame-
work. Many central banks from the Middle
East and Southeast have followed suit.
13


Despite their different regulatory structures, the
UK, Malaysia and Bahrain provide examples of
best practice. In 2006, for example, the UK is-
sued standards on capital adequacy and risk
management and its high courts have signifi-
cantly accommodated the growth in this mar-
ket. These reforms have made Islamic financial
services including mortgages and bonds (su-
kuks) more competitive with their conventional
equivalents.
14
Ultimately, banks and regulators
could look toward international standards to
harmonize and advance their regulatory frame-
works.
Regulating Islamic Banking  
The  Role  of  Banking  Regulators  in 
Islamic Finance 

Regulation supports the development of a vi-
brant financial system by ensuring the stability

12
Ibid.
13
Mufti Barkatulla. “Islamic Report - Sharia Raises Its
Profile - Islamic Sharia Law Is Emerging As An Alterna-
tive Means Of Dispute Resolution For Business And
Commerce In The Secular World” The Banker (Apr.
2008).
14
IFSL, “Islamic Banking 2008.”
of the entire financial system and the proper
conduct of individual institutions. These objec-
tives are similar for both the conventional and
Islamic finance sectors. The Islamic finance
sector, an emerging sector with significant op-
portunities, is also influenced by targeted ef-
forts by regulators to develop this sector do-
mestically and internationally.
15

Prudential Supervision 

Prudential supervision includes countervailing
the potential moral hazard problems inherent to
financial services. The most important type of
moral hazard risk for regulators occurs when
there is an unequal distribution of gains and
losses between individuals and institution.
These risks affect both conventional and Islam-
ic finance institutions. Left unregulated and un-
supervised, both types of banks can pass on
some of their investment or lending risk to de-
positors. Regulators can reduce the occurrence
of moral hazard through regular and compre-
hensive supervision. When moral hazard does
occur, depository insurance programs can les-
sen its impact on depositors and prevent its
spread to other institutions.

Islamic banks comply with Sharia law by struc-
turing their deposits as risk-sharing agreements,
rather than as interest-bearing accounts. In Is-
lamic banking, moral hazard is the result of the
substantial information asymmetries in infor-
mation concerning a bank’s investment risks.
16
Regulators for IFIs, however, have traditionally
been more concerned with fulfilling the Sharia
requirements for risk-sharing between deposi-
tors and investors than reducing moral hazard.
Regulators could reduce depositor risk in these
institutions by requiring disclosure on the na-
ture of depositor risks and providing recourse
in case of breach.
17


15
Juan Solé, “Introducing Islamic Banks into Conven-
tional Banking Systems” IMF Working Paper
WP/07/175 (July 2007).
16
Ibid.
17
Dahlia El-Hawary, Wafik Grais, and Zamir Iqbal.
“Diversity in the Regulation of Islamic Financial Institu-
ITA\MAS\Services\Office of Financial Services Industries   Page 4 

Sharia Compliance 

Sharia compliance requires IFIs to meet lend-
ing and investment standards not required by
conventional banks. It is this convergence of
Islamic principals and finance that attracts
Muslims to IFIs. There are private and public
models to ensure that financial services labeled
‘Islamic’ or ‘Sharia-compliant’ comply with
these principals.
18
In some countries, private
banks maintain their own Sharia advisers to
ensure Sharia compatibility. In others, consul-
tative boards at the supervisory level increase
the predictability and conformity of Sharia-
board decisions.
19
A regulator’s adaptation will
depend on the relationship between civil and
religious law in the country. Countries that
maintain a greater separation between civil and
religious law might find it more difficult to as-
sign a government role to adjudicate what are
essentially religious questions. According to
some scholars, countries with less separation
might more easily enter into or consolidate the
supervisorial role of Sharia compliance. Con-
sumers in both types of countries would still
have recourse when IFIs fail to comply with
promised services.
20

Industry Development 

Regulators’ influence can extend beyond ensur-
ing financial stability by fostering an environ-
ment receptive to Sharia-compliant products.
Regulators foster development without provid-
ing regulatory advantage for IFIs by anticipat-
ing regulatory challenges and assuring public
support. A regulatory environment that main-
tains a level playing field yet acknowledges
distinctions between conventional and Islamic
finance will encourage the creation and demand
for Sharia-compliant products.
21
For example,

tions.” The Quarterly Review of Economics and Finance
46, (2007): 778-800.
18
Solé, “Introducing Islamic Banks.”
19
Ibid.
20
El-Hawary, Grais, and Iqbal, “Diversity in the Regula-
tion.”
21
Solé, “Introducing Islamic Banks.”
the UK’s policy of “no obstacles, no special
favors” has encouraged the introduction of
Sharia-compliant mortgages. These mortgages
must meet the same degree of supervision as
conventional mortgages, yet still meet the prin-
ciples of Islamic finance.
22


International transactions are also an important
component of Islamic financial services. Coun-
terparts that deal with international financial
institutions require confidence in their interna-
tional transactions. Regulatory participation in
this market can ensure this confidence and sup-
port.
23


Licensing Islamic banks and services, however,
increases the supervisory burden, especially for
conventional banking regulators that are unfa-
miliar with Islamic finance. Regulators can
ease the supervisorial transition to Islamic
finance by temporarily restricting the number
of Islamic licenses it grants.
24,25

Banking Structure 

The regulatory environment influences the va-
riety of structural forms of institutions that of-
fer Islamic financial services. These restrictions
range from allowing conventional banks to
open an Islamic window within an existing
subsidiary or branch, to only permitting Sharia-
compliant products. According to the Banker,
72 percent of the largest 500 IFI operate within
fully Islamic financial systems. Twenty-eight
percent operate with Islamic windows.
26

Islamic Finance Window 

An Islamic finance window is a window within
a conventional bank where customers can

22
Ibid.
23
El-Hawary, Grais, and Iqbal, “Diversity in the Regula-
tion.”
24
This is not without precedent. In developing the Ku-
waiti market, the Central Bank of Kuwait limited the
number of Islamic banks to three.
25
Solé, “Introducing Islamic Banks.”
26
Timewell and Divanna, “Top 500 Islamic Financial
Institutions - How Fast.”
ITA\MAS\Services\Office of Financial Services Industries   Page 5 

access Islamic-finance products. Islamic win-
dows are more prevalent in Southeast Asia and
the developed countries than in the Middle
East, where Islamic subsidiaries are more
common.

In many cases this may be a more
cost efficient way for an existing bank to enter
the Islamic market. Often these initial products
include deposits and Islamic trade-finance
products for small and medium enterprises
(SMEs).
27

Islamic Subsidiaries 

Conventional banks with considerable custom-
er bases might decide to establish an Islamic
subsidiary. This could allow a bank to offer a
wider range of Sharia-compliant banking prod-
ucts.
28

Full Islamization  

A fully Islamic banking system only permits
Sharia-compliant financial services. Govern-
ments in countries with large Muslim popula-
tions, such as Iran and Sudan may find it expe-
dient to abolish interest-based financial servic-
es.
29
In other Muslim countries Sharia-
compliant institutions have existed in a variety
of forms. In Malaysia and Bahrain this mix has
created a highly competitive banking sector
that offers a larger variety of more complex and
cost-efficient products.
30

Implementing Islamic Banking 
Maintaining the Integrity of Sharia Ac­
counts 

Banks offering Sharia compliant products need
to separate the conventional and Islamic ac-
counts to avoid mixing conventional and Sha-
ria compliant funds. This will often require that
banks maintain separate capital funds, capital

27
Solé, “Introducing Islamic Banks.”
28
Ibid.
29
Ibid.
30
Ibid.
funds, and reporting systems.
31
Islamic subsidi-
aries and banks operating in fully Islamic coun-
tries are not affected.
Dispute Resolution  

Islamic banks, like conventional banks, rely on
dispute resolution systems. For Islamic banks
these usually begin with Sharia boards. Sharia
boards consist of Sharia scholars familiar with
the intersection of Muslim social and legal
practices. Board members play an important
role in validating a bank’s Islamic financial
services for the Muslim community.

Regulators in many countries are also establish-
ing institutions to deal with Sharia-finance dis-
putes. Malaysia’s high court, for example, as-
signs Islamic finance matters to special courts
to legitimize outcomes and make them more
predictable and efficient. In addition, Malay-
sia’s central bank reviews the assimilation of
Sharia principles with common law.
32


Dispute resolution becomes more complicated
upon crossing international borders. Should
common or civil law, Sharia, or some combina-
tion of the two govern international contracts?
In many cases large multinational companies
have chosen common or civil law to resolve
their Islamic finance contracts.
33
In other cas-
es, the development of international standards
offers a solution.
International Accounting and Man­
agement Standards 
 
Standards provide essential guidelines and a
frame of reference for performance. Often, they
become mandatory after adoption into a coun-
try’s legal system.
34


In 1990 the Accounting and Auditing Organi-
zation for Islamic Financial Institutions

31
Ibid.
32
Barkatulla, “Islamic Report – Sharia.”
33
Barkatulla, “Islamic Report – Sharia.”
34
Ibid.
ITA\MAS\Services\Office of Financial Services Industries   Page 6 

(AAOIFI) was created. Its main goals included
the design and dissemination of accounting and
auditing standards for Islamic institutions.
35

These standards are based on the best practices
of Sharia supervisory panels and boards.
36
The
AAOIFI plays a critical rule in harmonizing the
frequently different standards applied at the
national and local levels. Universal acceptance
of new products is important to convince many
Muslim and non-Muslims to participate in the
Sharia-compliant market.
In 2002, central banks from several Islamic
countries created the Islamic Financial Services
Board (IFSB) in Kuala Lumpur. The IFSB is
the AAOIFI equivalent for the development of
capital adequacy, risk management, corporate
governance, transparency, disclosure, and su-
pervision standards.
37
 

The inclusion of many financial regulatory in-
stitutions within the AAOIFI and the IFSB
promote transparency, soundness, and stability
standards for IFIS. These standards, however,
have yet to fill the transparency gap between
Sharia and conventional banks. There are still
gaps in the reporting of Sharia activities on
balance and income statements.
38

Deposit Takaful  

In conventional finance systems, deposit insur-
ance assures public confidence amidst the po-
tential for significant moral hazard problems.
Depository insurance (takaful) could also play
a significant role for Islamic-finance systems.
The creation of a sound deposit takaful (DT)
system could encourage public participation
and confidence that in many countries is fre-
quently in short supply. The International As-
sociation of Deposit Insurers (IADI) includes
the following important principles for deposito-
ry insurance: the coverage of the deposit taka-

35
Solé, “Introducing Islamic Banks.”
36
Barkatulla, “Islamic Report – Sharia.”
37
El-Hawary, Grais, and Iqbal, “Diversity in the Regula-
tion.”
38
Divanna, “Top 500 Islamic Financial Institutions.”
ful, the limit and scope of DT account cover-
age, the funding of DT coverage, the invest-
ment of DT funds, and the resolution process
for failed banks.
39


Sharia law, however, does not typically ac-
knowledge takaful as commonly practiced in
the West. Most Islamic banks are not presently
covered by a DT plan. Many of these banks,
however, are eligible for coverage within their
general deposit insurance programs. In contrast,
Turkey created a Sharia-compatible DT in
2003 and Malaysia is planning on introducing a
plan in 2008.
40

Islamic Interbank Money Market 

Temporary maturity mismatches between
shorter term liabilities and longer term assets
often require banks to seek short-term loans
from other banks. These loans are called inter-
bank loans and are part of the interbank money
market. They play an important role in reduc-
ing liquidity risks and bank failures. Like other
loans, however, they involve interest, which is
not permitted in Islamic finance. Until recently,
Islamic banks in conventional systems met
their liquidity requirements with higher cash
reserves. Sharia compliant interbank options
are now available, however.
41

Regulating  Islamic  Banking  in 
the United States 

Although difficult to measure, the Muslim pop-
ulation in the United States is probably between
1.8 and 4.5 million people.
42
This section ex-
plores the important regulatory barriers that
affect the creation of an Islamic banking market
in the United States.


39
Solé, “Introducing Islamic Banks.”
40
Ibid.
41
Ibid.
42
Michael Taylor. “Islamic Banking – the Feasibility of
Establishing an Islamic Bank in the United States.”
American Business Law Journal (winter, 2003).
ITA\MAS\Services\Office of Financial Services Industries   Page 7 

The United States has a dual banking system. A
bank in the United States is statutorily defined
by both state and federal regulators.
43
The de-
posit gathering aspect of banking further dis-
tinguishes banks from other financial institu-
tions.
44


The dual state-federal chartering system defines
the banking activities of commercial banks,
savings associations, and credit unions.
45
In
practice, these distinctions have somewhat dis-
sipated with the blending of customers, finan-
cial services, and federal preemption.
46


How  do  Commercial Banks,  Savings 
Banks and Credit Unions Differ?
 
Commercial Banks: Commercial banks –
chartered under federal and state law – are
permitted to offer a wide range of banking ser-
vices including demand, savings and time de-
posits, investments, and loans.
47
Statutes, judi-
cial findings, and regulatory rulings shape new
financial service activity. Commercial banks
with an interest in providing Islamic financial
services need to seek a determination as to the
acceptance of these practices. Currently, com-
mercial banks are prohibited from entering into
partnerships or joint ventures and the owner-
ship of real estate and common stock.
48
These
limitations complicate the ability of commer-
cial banks to engage in many types of Islamic
financial services supported by asset buy-backs
and risk sharing.

Savings Banks: The Office of Thrift Supervi-

43
Only the federal (Office of the Comptroller of the Cur-
rency) and state banking regulators can authorize these
charters.
44
Patricia McCoy, Banking Law Manual Second Edi-
tion: Federal Regulation of Financial Holding Compa-
nies, Banks and Thrifts Banking Law Manual. (U.S.:
Mathew Bender, 2000).
45
Ibid.
46
Ibid.
47
Michael Malloy, Banking Law and Regulation (Bos-
ton: Little, Brown, 2001).
48
Milton Schroeder, The Law and Regulation of Finan-
cial Institutions (Boston, MA: Warren Gorham and La-
mont, 1995).
sion charters these banks and has traditionally
limited them to noncommercial deposit and
lending. These activities have broadened
somewhat but housing finance remains a key
component of savings banks’ activities. Sav-
ings banks may be organized as either mutual
or stock entities and are required to serve a
“community purpose.”
49
To meet the communi-
ty purpose requirement, savings associations
are allowed to invest in real estate by establish-
ing a service corporation subsidiary. These sub-
sidiaries can invest in real estate for prompt
development or subdivision, to hold for rental
or resale, for maintenance and management,
and for real estate brokerage, among other ac-
tivities.
50


Credit Unions: Credit unions’ activities are
also directed toward their communities that
have traditionally been limited to specific em-
ployers, associations, or neighborhoods. Re-
cently these limitations have been relaxed, but
credit unions still rely on the pooled savings of
their members to support their lending activi-
ties. Credit unions are regulated and chartered
by the National Credit Union Administration.
51

Conclusion 

The Islamic finance sector offers significant
opportunities for U.S. bank and bank technolo-
gy companies. To remain competitive, U.S.
banks must adapt their products and strategies
to accompany important regulatory and market
trends. This paper has highlighted some of
these trends for the growing Islamic finance
sector and their importance for U.S. financial
institutions.



49
Malloy, Banking Law and Regulation.
50
Taylor. “Islamic Banking – the Feasibility.”
51
Ibid.

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