Special Comment

January 2004

Contact Phone
London
Andrew Cunningham 44.20.7772.5454

Regulation and supervision: challenges for Islamic

finance in a riba-based global system
This special comment is an edited version of a speech delivered by Andrew Cunningham, a Senior Vice
President in Moody’s London office, at the Programme of Seminars organised by the World Bank on
20-22 September 2003, coinciding with the annual meetings of the World Bank and the IMF.

How to include Islamic financial institutions within the global regulatory system has long been one of the key chal-
lenges for Islamic finance, but the issue has taken on a degree of urgency with the approach of the Basel 2 capital
accord. Although there is much more to global financial regulation than the Basel 2 – recent initiatives on money laun-
dering and enhanced financial disclosure come to mind – Basel 2 occupies the centre stage. “Pillar 1” of the new regu-
lations will set new benchmarks for the management of credit and operational risk, offering incentives – effectively in
the form of lower regulatory capital requirements – for those who are able to demonstrate advanced risk management
practices.
The Basel accord aims to be wide enough and flexible enough to encompass the needs of banks worldwide – so
enabling it to be a truly global standard; yet Islamic bankers fear that their particular financial instruments are not rec-
ognised in the accord. They point to the hybrid nature of many Islamic banking products, which combine several
forms of risk, either simultaneously or sequentially. As a result, they believe, such products cannot be slotted into the
Basel criteria.
The apparent exclusion of Islamic finance from this important new accord has strengthened the hand of those
who would like see Islamic institutions establish a parallel regulatory architecture which explicitly caters for Islamic
financial instruments. They argue – convincingly – that some regulatory organisation has to understand the risk profile
of Islamic banks and set common standards by those banks may then be judged; and if Basel does not, then Islamic fin-
anciers will have to do it themselves.1
But the prospect of Islamic banks being excluded from the Basel framework and adhering instead to another dis-
crete system clearly raises many questions, not only for Islamic banks which hope to continue operating in global mar-
kets, but also for western banks which hope to maintain their current business relationships with Islamic financial
institutions.
The purpose of this paper is to consider the practicalities of integrating Islamic banking into a global regulatory
system. It does so by way of three framing questions:
• Is it desirable to integrate the regulation of Islamic financial institutions into a single global system?
• Is it possible to do so?
• What are the impediments to the creation of a single global system in which Islamic banks will want to be
included?

1. The creation in 2002 of the Islamic Financial Services Board (IFSB) was a significant development in this respect. The Board is based in Kuala Lumpur.
Is it desirable to integrate the regulation of Islamic financial institutions into a single global
system ?

ISLAMIC BANKERS WANT TO PARTICIPATE IN A GLOBAL FINANCIAL MARKET

As a point of departure, it is important to recognise that Islamic bankers do want to operate as part of the global finan-
cial system. If we look at how the vast majority of Islamic financiers operate, it is evident that they see no contradiction
between their role of serving the Islamic community – by facilitating adherence to the Shari’a’s teachings on money
and interest – and involvement in the wider, riba’-based financial community.2 Islamic banks do not seek only Muslim
customers. They do not approach only other Islamic institutions when raising wholesale finance. For example:
• The Bahrain Monetary Agency (BMA) initially marketed its Sukook (Shari’a-compliant government bonds) to
Islamic investors, but now the programme is established it is seeking investors from conventional, riba’-based mar-
kets. When the Government of Qatar issued $700mn of Sukook in September 2003, nearly half of the issue was
bought by conventional investors.
• Islamic financial institutions have extensive interbank funding arrangements (both placing and receiving funds)
with conventional banks. They are also happy to participate in large conventionally-structured syndicated loans or
project financings, through discrete, sharia-compliant tranches.
• Islamic financial institutions which operate outside the Islamic world state that their services are available to every-
one, not just to their local Muslim community.
It seems clear that Islamic bankers have no objection in principle to working within a financial system which is
riba-based, provided that their particular Sharia-related needs are recognised.

FINANCIAL MARKETS ARE BECOMING MORE COMMODITISED AND STANDARDISED

The trend towards greater commoditisation and standardisation of financial markets and products is being driven by
ever-more powerful computing technology and by an improved ability to express and predict financial trends in math-
ematical terms. The increase in the size and scope of financial markets is forcing individual institutions and managers
to rely more on standarised criteria and policies, and allows them less time to deal with outliers. A move towards the
standardisation of credit procedures has been part of this trend, with many banks now using statistical scoring methods
as a key input to credit and counterparty policy.
The implications are clear for any banks which eschew global standards – they run the risk of being cut out of
mainstream financial markets. For example, as part of a credit appraisal process, credit officers typically want to know a
bank’s tier one capital ratio. When nearly every bank in the world is publishing this ratio according to globally-agreed
criteria, those asking for a different capital ratio calculated with different criteria to be taken into account are likely to
receive short shrift.3
It seems clear that from a purely practical point of view, if Islamic banks want to continue to operate as part of the
global financial system, it would be advantageous for them to be able to adhere as far as possible to global reporting
standards.

ISLAMIC FINANCE REMAINS A SMALL ASPECT OF GLOBAL FINANCIAL MARKETS

Islamic financial markets have been expanding greatly, and continue to grow. Yet they remain marginal within the con-
text of the global financial system. Precise and consistent comparisons are difficult to come by, but a sense of propor-
tion can be gleaned from the following figures:
The world’s biggest 1000 banks had core equity of about $1,974bn at the end of 2002. At the same time, banks in
the Gulf had equity of about $40bn – 2% of the top 1000 world banks. The top 1000 world banks had assets of
$43,908billion.4 Assets of Gulf banks were $346billion (0.78% of the Top 1000 assets). 5 The assets of the Malaysian
banking system were a little more than $200billion. Figures on funds under management are more difficult to com-
pare. Global funds under management were around $43 trillion at the end of 2002. Failaka, which monitors Islamic
investment funds, estimated the value of Islamic equity funds at $3.3 billion, in a research note published in March
2002. (Failaka had estimated the value of the funds at $5bn at the height of the stock market boom.)

2. Shari’a is the corpus of Islamic law. Riba’ is sometimes translated as “interest” and sometimes as “usury”, but in practice it refers to the charging of interest. Riba’ is
explicitly condemned in the Quran, the principal source of Shari’a.
3. For the avoidance of doubt, this paper is not arguing that tier one regulatory ratios ought to be a major consideration for credit officers; merely citing it as an example
of a ratio which often is used in this way. In Moody’s bank rating methodology, regulatory capital ratios are not considered a leading indicator.
4. Figures on the top 1000 banks are taken from The Banker magazine, London, July 2003.
5. Figures on Gulf banks are taken from Middle East Economic Survey, Nicosia. 15 September 2003.

2 Moody’s Special Comment

 The point here is that while Islamic finance is a material aspect of the capital markets in the Middle East and some
Asian states, it is rather less material within global markets. Islamic finance has more to gain by ensuring that it is able
to operate within a global regulatory framework, than global markets have to lose by excluding it.

Is it possible to have a single structure ?

ISLAMIC BANKERS HAVE NOT OBJECTED TO OPERATING UNDER SINGLE REGULATORY STRUCTURES
In addressing the second of the three framing questions, the point of departure is again to consider how Islamic bank-
ers themselves act, and what they say. In practice, Islamic banks appear happy to operate as part of a single regulatory
framework, albeit one which recognises the important differences between Islamic and conventional banks. All banks
in Bahrain are regulated and supervised by the BMA. The BMA has a department dedicated to Islamic banks, just as it
has separate departments which focus on insurance and mutual funds. But there appear to be no calls from Islamic fin-
anciers in Bahrain to take the regulation and supervision of Islamic banks out of the purview of the BMA.
In Malaysia, which runs parallel Islamic and conventional banking systems, Islamic banks are inspected by the
same officials who inspect conventional banks. Again, there appear to be no calls from Islamic bankers in Malaysia for
supervision of Islamic banks to be done by a discrete team of inspectors specialised only in Islamic matters.
So there is strong evidence that Islamic bankers do not object to operating under a single regulatory and supervi-
sory regime, provided that the particularities of Islamic finance are recognised.

ACTUAL REGULATORY/SUPERVISORY PROBLEMS WHICH HAVE ARISEN AT ISLAMIC BANKS HAVE NOT
BEEN CONNECTED TO THE ISLAMIC NATURE OF THOSE BANKS
If we look at real examples of Islamic banks which have encountered difficulties, it is hard to argue that those difficul-
ties were due to a lack of understanding by regulators of the nature of Islamic finance. Conversely, it is hard to argue
that those problems would have been avoided if regulators had had a greater appreciation of the particularities of
Islamic finance.
Dubai Islamic Bank (DIB) had to be recapitalised in 1998 following the discovery of unusual transactions in its
accounts. At the time, it appeared that some senior executives of the bank had acted beyond their powers, and as a
result incurred large losses for the bank. This problem had nothing to do with the fact that DIB was an Islamic, rather
than a conventional bank – it lay in a lack of controls at the bank, and the desire of certain executives to exploit that
lack. Conventional banks are equally exposed to this risk, and there are many examples where they have suffered losses
in exactly the same way as DIB.
Many Islamic banks suffered losses arising from their exposure to Bank of Credit and Commerce International
(BCCI), which was closed by regulators in 1990 and subsequently found to be insolvent. Yet many conventional banks
also had material exposure to BCCI. Again, we cannot attribute the losses suffered by Islamic banks to the fact that
they were Islamic. The problem can be classified as one of over-exposure to a single counterparty, and also a lack of
appreciation of the credit quality of BCCI.
Kuwait Finance House (KFH) suffered following the collapse of Kuwait’s Souq al-Manakh in 1982, but so did
every Kuwaiti bank. The weaknesses in KFH’s balance sheet following 1982 were the same in nature as those affecting
all Kuwaiti banks. The fact that KFH was an Islamic bank did not make it any more or less vulnerable to the Manakh
crash and its aftermath.

THE ACTIVITIES OF ISLAMIC FINANCIAL INSTITUTIONS DIFFER FROM THOSE OF CONVENTIONAL BANKS
– BUT BY HOW MUCH ?
Islamic financiers argue that the instruments which they use are fundamentally different from those employed in con-
ventional finance, and that they therefore require a separate regulatory and supervisory structure.
Certainly, services offered by Islamic financial institutions are very different from those used by conventional
banks. A crucial difference lies in the frequent requirement for Islamic banks to take legal title to underlying assets at
some point during the financing process -- a risk to which conventional banks only face in specific circumstances. (For
example, when an Islamic bank provides finance to an importer, it will generally own the goods being imported at
some stage during the transaction. A conventional bank would not.) Islamic banks are also constrained in their ability
to charge for late payments, or even, in some circumstances, to pursue debtors.6
6. It is not being argued here that Islamic financing is inherently more risky than conventional financing: there are times when it may be more risky and there are times
when it may be less so. The point being made is that Islamic banks are subject to some different risks.

Moody’s Special Comment 3

 Yet it is hard to see how such products and services provide an insuperable challenge to regulators. In recent times,
regulators (and banks) came to grips with a range of new and important risks. Asset/liability management was not a
major issue for banks before the collapse of the Bretton Woods agreement in 1973, but now is central to their risk cul-
ture; Value at Risk as a method of assessing market risk was adopted by large international banks in the early 1990s.
The systematic management of operational risk has an even shorter history. Yet in each of these cases, regulators have
been able to incorporate these new risks into regulation and into their supervisory agendas.

What are the impediments to a single regulatory structure ?

Why then has the question of global regulation proved so controversial ?
There is clearly a widespread feeling among Islamic financiers that western regulators do not recognise the partic-
ularities of Islamic finance, and that therefore Islamic finance will be disadvantaged under a global regime constructed
around western financial institutions. It is easy to understand how Islamic financiers have arrived at this view: an elec-
tronic search of the 216 page Consultative Document on the New Basel Capital Accord (dated April 2003) finds no
references to Islamic finance. In fact, a search finds only two uses of the word “Islamic”: both in reference to the
“Islamic Development Bank”, a multilateral development bank.
The consultative document does make reference to the need to give national regulators some leeway in imple-
menting the accord, and, in deference to emerging market banks, it also provides simplified versions of the Standard-
ised Approach for credit risk and the Basic Indicator Approach for operational risk. But Islamic finance, as a genre, is
not recognised.
It must also be recognised that some Islamic bankers are less than enthusiastic about having their business sub-
jected to prudential rules set by global regulators. Indeed, many argue strongly that a separate corpus of regulation
designed specifically for Islamic banks is the optimal route to take, rather than second best. Whatever one’s perspective
on these issues, it is obvious that Islamic finance is about much more than finance: it is also in part a statement of
Islamic identity. Many believe that this identity can find a clearer voice as part of a distinct regulatory structure.
Clearly, the impediments to a single regulatory structure arise both from global regulators and from Islamic bank-
ers themselves.
However the dilemma is resolved, Moody’s will continue to analyse Islamic financial institutions on the basis of
their fundamental credit strengths, rather than on the basis of regulatory ratios – this is our practice for banks through-
out the world. We recognise that Islamic financial institutions sell products and use financial instruments which have
different characteristics to those used by conventional banks. We also recognise that the corporate governance struc-
ture of Islamic banks is different, due to the existence of Shari’a boards.7 The ethical underpinning of Islamic financial
institutions may also lead them to place less emphasis on profit maximisation than conventional banks. Analysts need
to be sensitive to these areas where Islamic institutions may, as a class, differ from conventional banks, but they also
need to look case-by-case at how particular Islamic institutions have responded to these differences. In our view, man-
agement’s strategy, and its response to the opportunities and challenges of Islamic finance are likely to be stronger driv-
ers of creditworthiness than the regulatory structure under which they operate.

7. Shari’a boards comprise religious scholars and their task is to ensure that all the institution’s business conforms to the shari’a.

4 Moody’s Special Comment

Related Research
Analyses:
Al-Rajhi Banking and Investment Corporation, December 2003 (# 80799)
Kuwait Finance House, February 2003 (# 77359)

Special Comments:
Analysing the Creditworthiness of Islamic Financial Institutions, November 1999 (# 50620)
Culture of Accounting: What are the real constraints for Islamic Finance in a Riba-based global economy? January
2001 (# 63369)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this
report and that more recent reports may be available. All research may not be available to all clients.

Moody’s Special Comment 5

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Author Senior Production Associate

Andrew Cunningham David Ainsworth

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8 Moody’s Special Comment