Banking Supervision and Prudential regulation in Islamic Finance

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³The Banking Supervision and the Prudential Regulations in Islamic Finance´

By SAMY OUAHIB

STUDENT N: 06242330

ASSESSED BY: NORWOOD WHITTLE

A dissertation submitted in partial fulfilment of the requirements for the degree of MA MANAGEMENT (FINANCIAL ANALYSIS) At the University of Northampton 2009
Word counts: 16,315 words

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ACKNOWLEDGMENT

continuous support. My appreciation goes to my supervisor Norwood Whittle, who patiently assessed my work throughout the process. Your

attention to details contributed immensely to this piece of work. My thanks also go to all my lecturers, who they were helpful at various times. I owe my parents greatly for their encouragement and financial support.  

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Banking Supervision and Prudential regulation in Islamic Finance

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ABSTRACT

The credit crunch and the turmoil in global financial markets have affected every country in the world. Indeed, the recent financial crisis due the subprime showed us how the banking regulations are essential to guarantee the stability of the financial system. This piece of work focuses on the banking supervision and prudential regulation in the Islamic financia l system. I will deal with the Shariah supervision and the monitoring of Shariah compliance of Islamic banking practices. Also, I will emphasis on choosing an appropriate rating technique approach for the 

supervisory authorities. I analysed the CAM

S rating approach

which I think can be efficient after being adapted for the Islamic environment. This research deals also with the attention which should be given to corporate governance in Islamic banking industry. Because in recent years, bad corporate governance proved to be in the heart of many bank failures. For this reason, this study shows how important it is to supervise the corporate governance aspect of Islamic financial institution s. On the other hand, this piece of work deals with the importance of disclosure information and licensing procedures. My findings show how disclosure information and licensing procedure are more important in Islamic banking than in conventional banking. As a conclusion, I made some recommendations, which in my point of view can contribute to improve the banking supervision in Islamic banking.

.........3 SEGMENTED APPROACH TO IFI REGULATIONS 2...........1..............4 RESEARCH QUESTIONS 1... 9 1........... ........ ............. ............... 3 Table of Contents .....................2...... Legal Foundations B.. 31 .....................3 OBJECTIVES...........13 14 15 .........16 ............................2 THE REGULATION OF ISLAMIC FINANCE 2..............................4 PRUDENTIAL FRAMEWORK FROM ERRICO AND FARRAHBAKSH (1998) A............2..1 Level of the capital adequacy ratio B........ ........1 INTRODUCTION ...... ............. 11 1.................2 Regulatory Options 2.......3 Requisites for effective Regulation 2.......... ................... .........1 REVIEW OF THE FUNDAMENTAL FEATURES OF ISLAMIC BANKING 2.................12 ...........27 ..28 29 30 . 2 Abstract ......23 ................2 RESEARCH RATIONALE ........ ....... .......1.......26 26 26 ............. ....... ....................Banking Supervision and Prudential regulation in Islamic Finance 4 Table of Contents Acknowledgment ................5 ARRANGEMENT OF THE CHAPTERS CHAPTER TWO: LITERATURE REVIEW 2......1..................2 Risk-weighting Methodology B............2.. 11 1.....4 CHAPTER ONE: INTRODUCTION ........... ...... ...............2 Assets .........12 ............... ............ 8 1......... .....1 Capital B..........1 Why financial regulation 2..............................3 Off-balance sheet commitments B...... ............. Management of Operational Risks B......................20 21 ..

54 ..32 .56 .Banking Supervision and Prudential regulation in Islamic Finance 5 B.5 METHODS FOR DATA ANALYSIS 3.3 SUPERVISION TECHNIQUES APPROACH 4.51 .46 .5 THE REGULATORY CHALLENGES AHEAD CHAPTER THREE: METHODOLOGY 3.1..7 SUMMARY CHAPTER FOUR: FINDINGS 4.32 .4 METHODS FOR DATA COLLECTION 3.52 .3 PROCEDURE 3.1 SHARIAH SUPERVISION 4.4 LICENSING PROCEDURE 4.8 FINANCIAL REPORTING IN ISLAMIC BANKS .55 .5 Liquidity 2..6 RELIABILITY AND VALIDITY 3..48 .2 Research Philosophy 3.47 ..1 RESEARCH DESIGN 3.2 RESEARCH CONTEXT 3.50 .47 .3 Management B..1 Approach 3.7 THE RELATION OF THE IFSB WITH OTHER INSTITUTIONS 4.49 .4 Earnings B.2 THE OFFSITE SUPERVISION 4.33 34 37 .5 INFORMATION DISCLOSURE 4.38 40 44 44 46 .1.6 CORPORATE GOVERNANCE 4.38 ..53 .

81 82 6.68 .4.76 77 80 .2 RESEARCH CONSTRAINTS AND LIMITATION 6.4.5 LICENSING PROCEDURE 5.7 CORPORATE GOVERNANCE 5.61 .1 CAPITAL 5.9 FINANCIAL REPORTING IN ISLAMIC BANKS.4 Earnings 5.3 SUPERVISION TECHNIQUE APPROACH 5.63 64 64 64 64 65 .61 ..4.1 CONCLUSION .8 THE RELATION OF THE IFSB WITH OTHER INSTITUTIONS 5. CHAPTER SIX: CONCLUSION AND RECOMMENDATIONS 6.66 .2 THE OFFSITE SUPERVISION 5..4.3 RECOMMENDATIONS 6..3 Management 5.74 75 .Banking Supervision and Prudential regulation in Islamic Finance 6 CHAPTER FIVE: DISCUSSIONS 5.58 . 57 .6 INFORMATION DISCLOSURE 5.1 SHARIAH SUPERVISION 5.4 CAMELS IN THE CONTEXT OF ISLAMIC BANKING 5.4 SUGGESTION FOR FUTURE RESEARCH .4.6 Sensitivity to market Risk 5.59 59 .4.4.4 Earnings 5. 67 .3 Management 5.4.2 Assets 5..5 Liquidity 5.71 .

5 PERSONAL REFLECTIONS REFERENCE LIST BIBLIOGRAPHY APPENDICES ..Banking Supervision and Prudential regulation in Islamic Finance 7 6..84 . 89 .88 .83 ..

1 INTRODUCTION 1.5 ARRANGEMENT OF THE CHAPTERS .4 RESEARCH QUESTIONS 1.Banking Supervision and Prudential regulation in Islamic Finance 8 1.2 RESEARCH RATIONALE 1. INTRODUCTION 1.3 OBJECTIVES 1.

With the growing the number of Islamic financial institutions. Islamic precepts influence the and activities of banks in several ways. transparency and respect of international standards. an imperative need for regulating them was felt given their diverse nature. main aim and objectives. Many public policy issues have been raised in the jurisdictions in which they operate and at the . limitations of the work. 2002). The rationale behind working towards uniform regulatory codes for Islamic financial inst itutions is the current situation of different guidelines in different countries. more that 100 financial institutions in over 45 countries practice some form of Islamic finance. and the industry has been growing at a rate of more than 15% annually for the past five years (Archer.1 INTRODUCTION According to some estimates. which is replaced by profit and loss -sharing arrangements whereby the rate of return to financial assets held with banks is not known and not fixed prior to the undertaking of each transaction (Chapra et al. The challenges faced by them are growing at a faster pace. the most important being the prohibition against the payment and receipt of a fixed or predetermined interest rate.Banking Supervision and Prudential regulation in Islamic Finance 9 Chapter one has given a brief overview of the proposed research. 1. 2003). Also. Islamic finance faces problems of governance. This dynamism is due to the soaring price of raw materials. arrangement of text and chapters were discussed to make sure the readers of this research will be able to find the answers to the mentioned themes. in particular. because of its rapid development. themes such as the purpose of the research. the oil prices creates an excess of liquidity estimated at 1500 billion dollars in the Gulf and Southeast Asia countries.

The expansion of Islamic banking industry has created both expectations and apprehensions simultaneously.Banking Supervision and Prudential regulation in Islamic Finance 10 international level. combination of each institution¶s with the Shariah board and legal tradition. I got the idea of doing a dissertation when I was in an internship at the banking supervision department of the central bank of Morocco. policy makers and academia to examine various aspects of Islamic financial intermediation each from their own perspective. The establishment of accounting and auditing Organisation for Islamic financial institutions (AAOIFI). 2002). and national regulatory authorities. The effect is even more compounded for Islamic finance because of the nature of its products. I decided to study a topic regarding Islamic . need for IFI to comply with the regulations governing conventional financing and to use accounting standards that may not be fully adapted to the substance of their business activities (Iqbal et al. The main objective is to build uniform risk and arrive at a standard regulatory framework governing them. international standard setters. Also. Risk is inherent in every financial innovation. While I was assisting to inspector. I noticed that the Islamic banks suffer from a lack in terms of prudential regulation standards. Islamic finance is no exception to such risk perceptions. Islamic Financial Services Board (IFSB) and the liquidity Management Centre was aimed at achieving this objective. International Islamic Rating Agency (IIRA). The main issues of concern are: the divergence between theory and practice. need for Islamic financial institutions to adapt to their environment to compete with conventional counterparts. These have led international organisations. interpretations market¶s competitive pressure to shape the activity of each Islamic financial institution.

Indeed. It¶s also an opportunity for me to understand how the Islamic financial product works because it¶s totally different than the way of which the traditional financial product works. 1. and my the research will of aim the to evaluate the effectiveness reliability actual banking supervision practices. I aim to develop an understanding of how the banking supervision operates and the theories and principles on which the prudential regulations are based on. I will critically investigate the current situation of the banking supervision in the Islamic finance.3 OBJECTIVES By focusing on the banking supervision and the prudential regulation aspect of the Islamic financial sector. By doing my dissertation on the banking supervision in Islamic finance. Every day Billions of US dollar are traded under the Islamic financial system around the world. 1. I got the idea of studying the Banking supervision in Islamic finance when I was working as a trainee trader in the Central Bank of Morocco where I noticed that this niche is growing fast and that is getting an increasing interest from clients.Banking Supervision and Prudential regulation in Islamic Finance 11 finance in order to expand my knowledge of Islamic finance which can enable me to get a job opportunity within this field.2 REASEARCH RATIONALE The Islamic finance is becoming an important and growing niche within the global financial economy. . I am trying to explore an aspect of the Islamic finance which guarantees its soundness and stability. As I am quiet interested in starting my career in a financial sector. particularly when we know that the IFSB is a recent organisation (created in 2002). I thought that a research project on the Islamic finance can improve my knowledge in this type of finance and also enables me to get opportunities to work in banks or corporate which operate within this sector.

Chapter Four: Findings Chapter Five: Discussion Chapter Six: Conclusion and Recommendation . Chapter Three: Research Design. Chapter Two: Literature Review. Chapter one: Introduction. .Banking Supervision and Prudential regulation in Islamic Finance 12 On the other hand.5 ARRANGEMENT OF THE CHAPTERS: The arrangement of text is done so that the reader finds it easy to under the findings on the proposed aim. I will evaluate the possibility for the Islamic supervisory authorities to use some supervisory techniques used by the conventional banking supervision.4 RESEARCH QUESTIONS The focal point of my research is as follows: y To what extent the banking supervision in Islamic finance is efficient? y Which bank supervision techniques is the more appropriate institutions? for monitoring the Islamic financial y Is it really important to include the corporate governance in the banking supervision process? y The role of Shariah supervision in the Islamic banking industry y Should the supervisory more on the authorities aspect of focus their inspection disclosure information and licensing procedures? 1. The dissertation is divided into five chapters which are. I will end this piece of work with some perso nal recommendations aiming to improve and develop the banking supervision in Islamic finance. 1.

3 SEGMENTED APPROACH TO IFI REGULATIONS 2.Banking Supervision and Prudential regulation in Islamic Finance 13 2.4 PRUDENTIAL FRAMEWORK FROM ERRICO AND FARRAHBAKSH (1998) 2. LITERATURE REVIEW 2.1 REVIEW OF THE FUNDAMENTAL FEATURES OF ISLAMIC FINANCE 2.2 THE REGULATION OF ISLAMIC FINANCE 2.5 THE REGULATORY CHALLENGES AHEAD .

Key elements of the Islamic economic system include individual rights. property rights. on the basis of actual profits accrued from real sector activities that are made possible through the productive use of financial assets (Abdeen.Banking Supervision and Prudential regulation in Islamic Finance 14 This chapter contains the literature associated with the topic of the research. and the role of the state. The literature deals with the authors who wrote about the banking supervision in Islamic finance. 2002). the rules established in the shariah have been elaborated upon and refined over time by Islamic scholars and economists in order to adapt them to the evolving economic environment (khouri. The actual rate of return can be determined only ex post. 2002). 2. While preserving their key tenets. This is replaced by profit and loss sharing (PLS) arrangements where the rate of return on financial assets held in banks is not known and not fixed prior to the undertaking of the tra nsaction (Abdeen. work and wealth. which is based upon the codification of injunctions outlined in Koran and the traditions of Prophet Mohammed. 2005). 2004).1 Review of the Fun amental features of Islamic Banking To understand Islamic Banking is to realize that its banks and their operations are considered to be in an integral part of a complete Islamic economic system. . contracts. that is the Islamic Shariah (Subbulakshmi. Islamic banks are characterized by the following features: y Prohibition against the payment an  receipt of a fixed or predetermined rate of interest.

In the event banks record losses as a result of bad investment decisions. 2002). Differences between balance sheet structures of Islamic and conventional banks and the features of Islamic financial contracts have been recognised to have important implications for accounting a nd financial accounting. at any time. 2002). The only contractual agreement between depositors and banks is the proportion (ratio) according to which profits or losses are to be distributed (Abdeen. y Investment deposits. Such deposits are guaranteed in capital value. Archer. to depositors (Abdeen. 2002). These modes affect both the assets and liabilities sides of a bank¶s balance sheet and can be divided into two groups: the ones that are based on the PLS principle (core modes) and the ones that are not (marginal modes) (Abdeen. Such deposits are not guaranteed in capital value and do not yield any fixed or guaranteed rate of return.e. they belong. 2002). depositors may lose part or all of their investment deposits (Abdeen. for safekeeping). The reason to justify the capital value guarantee is the assumption that demand deposits have been placed as Amanat (i.. These studies note that an appropriate regulatory framework .Banking Supervision and Prudential regulation in Islamic Finance 15 y Requirement to operate through Islamic modes of financing. y Demand deposits. although no returns are paid on them. Karim and Al-Deehani (1998). 2. Early study raising the issues of regulation and supervision of IFI include Archer and Karim (1997).2 The Regulation of Islamic Finance Greater attention has been paid since the early 1990¶s to the regulatory and supervisory frameworks governing IFI. Hence. and Errico and Farabakash (1998).

The latter can promote trust in the financial system. regulation is likely to be required to mitigate the risks of disruption in payments (Chapra and Khan. On the other hand. El Sheikkh (2000) argued that: ³the widely held view by Islamic jurist is that Islamic banks should not be regulated or supervised by any authority´. They range from positions of almost total opposition to any regulation. intrusive regulation. all elements that would encourage activity expansion. Whether in the theoretical model of an IFI or in current practice.1 Why Financial Regulation? There are diverse views on the need for regulation in Islamic Finance. encourage more intermediation and diminish the risk of failure. 2000). However the design of financial regulation to directly promote development may dis tort its .2. y The promotion of orderly payments is clearly in the nature of a public good and consistent with this rationale for financial regulation. Four reasons presented by Chapra and Khan (2000) for the regulations of IFI are discussed in light of the foregoing three views on the rationale for regulation. Chapra and Khan (2000) argue the need for regulation. to the justification of broad. 2. a) Systemic considerations . 2000).Banking Supervision and Prudential regulation in Islamic Finance 16 needs to place greater emphasis on accounting standards and information disclosure. y The promotion of economic development may be beyond the role that should be assigned to financial regulation. particularly the need to maintain an orderly payments system and ensure the development of the economy (Chapra and Khan.

c) Ensuring compliance with Shariah. In terms of a theoretical IFI model. 2000). This view seems to underlie the ³two-tier Mudaraba´ model that does not envisage any reserve requirement. b) Protecting the interest of demand depositors. the case for introducing regulation to protect depositors is less compelling than in conventional finance (Chapra and Khan. integrity. The relationship between civil and religious law varies across national . 2000). Hence regulation promoting the integrity of fiduciary contracts would be consistent with the theoretical IFI model (Chapra and Khan. public The resources of and fiduciary contract is protection demand depositors envisaged in the ³two windows´ model and can be justified through any of the three perspectives considered (Chapra and Khan.Banking Supervision and Prudential regulation in Islamic Finance 17 objectives of ensuring soundness and stability and pose challenges for regulators having to choose between promoting economic development and ensuring the stability of the financial system (Chapra and Khan. 2000). introducing a guarantee on the downside would run counter to the core objective (Chapra and Khan. 2000). depositors may not always be fully apprised on the risks they face in principle with their deposits while at the same time IFI try to protect their deposit base by providing sufficient security assurance and returns. The essence of Islamic financial intermediation being symmetrical risk as well as profit and loss sharing. In th is case. there is a case for regulation that seeks to protect depositors. Investment depositors should however expect to be informed on the features of the contract they enter into and have recourse if it is breached. 2000). With existing IFI.

Integration would develop from the participation of IFI in the financing of international trade and international payments (Chapra and Khan. 2000). In this respect national and international regulation can be founded on the public goo d need to ensure orderly participation in international payments and the integrity of fiduciary contracts (Chapra and Khan. 2000).Banking Supervision and Prudential regulation in Islamic Finance 18 jurisdictions (Chapra and Khan. Subbulakshmi (2004) agrees with Chapra and Khan (2000) regarding the reasons behind regulating the IFI. it would be difficult to justify assigning to public authorities the role of ensuring that banking activities comply with Shariah (Chapra and Khan. In jurisdictions where the distinction between civil and religious law is less pronounced. In the case where there is an orientation toward a strong separation. This would not however be a matter of financial regulation. 2000). Counterparts of IFI would want to be satisfied of the ability and commitment of IFI to fulfil the contracts they enter into. d) Supporting the integration of IFI in the international financial system . one can well see a public policy choice for assigning to a public regulator the role of ensuring that banking activity complies with Shariah (Chapra and Khan. The issue of truth in disclosure and in advertisement would however remain and would allow stakeholders to have recourse. This would be considered a private religious matter that does not call for public intervention. Subbulakshmi (2004) support a heavy and constraining regulation due to the following risk: . 2000). 2000). but one of broad institutional infrastructure for business.

2004). 2004). 2004).  Innovative risk that is often talked in the recent times related to governance is operational risk. an internal control problem in Dubai Islamic bank generates a loss of $50 million in 1998 when a bank official did not conform to the bank¶s credit terms.  Solvency risk is the risk that a bank has insufficient capital to continue operations. It is the counterparty risk inherent in some modes of Islamic Finance. Absence of well -developed credit risk assessment systems and associated expertise magnifies the chances of occurrences of such risk (Subbulakshmi. 7% of the bank¶s total deposits in just one day (Subbulakshmi.  Another important risk is credit risk. This also resulted in a run on deposits to the extent of $ 138 million.Banking Supervision and Prudential regulation in Islamic Finance 19  Withdrawal risks which arise out of competitive pressures which an IFI faces with existing Islamic or conventional counterparts (Subbulakshmi. . As example. 2004). Liquidity risk arises due to mismatch of assets and liabilities of the bank which may lead to either surplus of shortage of cash (Subbulakshmi.  Islamic banks are vulnerable to liquidity risk because of their limited access to funds to meet their obligat ions. 2004). It is defined as the failure of internal processes as related to people and systems. AAOIFI defines fiduciary risk as that of becoming legally liable for a breach of the investment contract either for non-compliance with Shariah rules or for mismanagement of investors¶ funds (Subbulakshmi.

more on transparency and disclosure. once they have clarified the rationale for the introduction of regulation. In light of the foregoing. the profession is now moving toward letting regulated institutions asses and manage their risks within a framework agreed on with the regulator. 2002). In terms of type of regulation. Regulators have traditionally governed their jurisdictions through direct rules mostly on capital. and equivalent in supervision as compared to conventional banking. These issues relate first to the type of regulation needed and second to the method of regulation (Bliss. 2001). or provide them with opportunities to take unchecked risks implicitly comforted by the existing safety net (Ayoub. minimal regulation is expected with less emphasis on capital requirements. The type and method of regulation chosen will depend on the rationale for regulation adopted and on the type of IFI considered. 2001). 2001). on market discipline (direct and/or indirect) or institution home developed risk assessments (Bliss. Baldwin (2002) argues that in adapting to these developments. probably more on screening management profile and business line in licensing. There would be also an .2. regulatory changes often lag financial developments and may consequently either constrain the ability of financial institutions to flexibly manage their portfolios.Banking Supervision and Prudential regulation in Islamic Finance 20 2. one can consider issues such as capital. assets and income allocations.2 Regulatory options According to Archer (1998). two sets of issues face regulators of IFI. The method of regulation can rely in various degrees on direct ³command and control´ rules. (1) In a theoretical IFI model. At the same time. transparency or licensing requirements. be it a model Islamic financial intermediary or in line with prevailing practice (Bliss.

2003). it would also call for significant scrutiny in licensing.2. prevailing intermediation practices would seem to point to the need for equivalent emphasis on a capital requirement. or infrastructure failure. compared to conventional banks (Ali. The pooling of Amana. 2003). They in consequently their face and the risk of to shareholders returns capital accommodate these depositors (Ali. as well as risks that may affect the financial system through contagion. reliable signals of the risks that a financial institution faces resulting from its own behaviour or from events external to it. 2003). It also requires an ability to process these readable signals and to introduce the appropriate corrective actions as needed (Chami. Competitive pressure is inducing IFI in the market to provide sufficient safety and return to depositors in unrestricted investment ³displacing´ accounts. 2002). 2003). (2) In an existing IFI. notably with respect to managers¶ profiles (Ali. 2003).Banking Supervision and Prudential regulation in Islamic Finance 21 expectation of larger reliance on direct market discipline and less on ³command and control regulation´ (Ali. As such it may be more akin to sophisticated art that uses advanced techniques. . It consequently calls for rigorous transparency and disclosure requirements (Baldwin. 2. 2003). unrestricted investment deposits and capital in funding their assets raises transparency issues for the distribution of returns or losses. supervision and licensing. and a larger one on transparency and disclosure.3 Requisites for Effective Regulation Chami (2003) argues that effective regulation requires readable. So. As a result they are practically facing a similar intermediation risk to conventional banks and should therefore be subject to similar capital and supervision requirements (Ali.

2007). . The majority of existing IFI operate however in jurisdictions where there is much left to be desired in these matters. This situation gives additional importance to other services. it still requires the necessary tools´ (Fadeel. Such increased fluidity of the objects of regulation calls for nimbleness and skills on the part of the regulator with a frequent assessment of the adequacy of their perspective (IFSB. However. In addition it would call for renewed efforts at enhancing the relevance of accounting and auditing for risk assessment (Subbulakshmi. 2002). the quality of contract law and opportunity to bring prompt remedies to breaches. With financial innovation. 2003). the functions of financial institutions are evolving continuously. The efforts at establishing accounting and auditing standards for IFI have made a significant contribution in this respect. 2000). the efficiency of judicial recourse and other dispute resolution mechanisms (Ali. beyond the availability of a good technique. 2001). be as an adequate a structure . including through IFI. Measurement and comparison of risk exposure should underlie regulation. More closely related to finance. not risk allocation (El-Gari. which adversely affects their development (Lewis. various instruments and structures are emerging to meet the demand for specific services. As a result. In this respect the role of the broader institutional infrastructure is core of particular importance would be the clarity and enforceability of property rights. disclosure of accounting instrument for risk results may not because. the quality and transparency of accounting and auditing play a crucial role.Banking Supervision and Prudential regulation in Islamic Finance 22 ³But even if art presumes independence and creativity. 2004). assessment accounting is directed toward value. such as the collection and dissemination of financially relevant information and credit rating.

This view is elaborated in the following table. each designed to optimize the functional demands of its clients. 2002). Assets Asset-backed Trade financing Minimal Risk Ijara. Mudaraba Low-Medium Risk Liabilities Segment A Depositors Segment B Depositors Musharaka Mudaraba Venture Capital Private Equity Segment C Depositors . Iqbal (2002) developed a vision consistent with principles which could see an IFI structured as a group of fairly independent entities. One approach could be to encourage IFI to structure their operations in clearly defined and separated segments catering to different classes of depositors depending on their respective investment objectives (Kazem. Istisna.3 Segmented Approach to IFI Regulations The combination of services o ffered by operating IFI and the prevailing practices they follow compound the difficulties of designing a regulatory framework to govern them (Kazem. First.Banking Supervision and Prudential regulation in Islamic Finance 23 2. the problem of co-mingled funds from different classes of deposit holders needs to be addressed. 2002). which shows three distinct segments.

2002).to long-term instruments. like private equity or venture capital (Iqbal. 2002). The concept is similar to narrow banking and would require a similar approach to its regulation (Iqbal. 2002). such as Ijara or Istisna. If there is a well developed secondary market for Mudaraba based funding. Segment C is designed for investors who would be willing to take additional risk and would like to participate in riskier investments. Segment B is designed to cater to depositors with the next level of risk appetite who are willing to take some risk in expectation for a higher return. then the form of intermediation taken by IFI will be very similar to mutual funds where IFI will manage and invest depositor¶s money in different Mudaraba funds (Iqbal. or may prefer to invest on Mudaraba basis directly with the entrepreneur or through Mudaraba certificates (Iqbal. 2002). This segment will invest funds in asset -backed securities with fixed-income characteristics and IFI will intermediate by screening and monitoring such opportunities and making sure that credit and operational risk are contained.Banking Supervision and Prudential regulation in Islamic Finance 24 Segment A is designed to handle funds for depositors who are highly risk averse and require a high level of liquidity and would use the funds for daily transactions or would prefer to keep savings in safe assets where their capital (principal) is preserved (Iqbal. with capital preservation and liquidity less high on their agenda (Iqbal. 2002). 2002). 2002). Since the contractual agreement with the depositors would be similar to the fiduciary responsibility of a mutual fund in a conventional system. IFI could . IFI would deploy these funds in medium. the same regulatory principles would apply (Iqbal.

the recipients of funds. The IFI¶s relationship with Musharaka enterprises would be of long-term nature with active involvement in governance in contrast to a short-term. To summarize. transactional relationship (Iqbal. Each entity could then be subject to a regulating principle most suited to its nature (Iqbal. When funds are invested on Musharaka basis. which raises another issue for regulators (Iqbal. 2002). 2002). the IFI would be expected to conduct active monitoring of enterprises it invests in. This implies that the financial institution itself becomes a stakeholder in the enterprises that depend on funds it provides (Iqbal. an IFI structured to provide financial intermediation through clearly segmented windows or even separate institutions would make the task of regulators easier. 2002). The IFI as equity participant becomes an institutional investor that has a vested interest in the governance of the institutions. 2002). Since Islamic financial principles advocate a stakeholder approach to corporate governance. the IFI would behave in a similar way to financial institutions in a bank based or insider system practiced in Germany or Japan. 2002) . It would be expected that a representative of IFI participate in supervisory boards of enterprises in which they have considerable investment and a long-term relationship (Iqbal. the IFI also gains rights to participate in the governance of the enterprise. In these circumstances.Banking Supervision and Prudential regulation in Islamic Finance 25 deploy these funds on the basis of Musharaka or Mudaraba instruments.

collect deposits. management. These are the five . In particular. and carry out banking practices on the basis of Islamic principles. Legal Foundations In order to provide the legal foundations for the supervision of Islamic banks. if applicable (Errico and Farrahbaksh.Banking Supervision and Prudential regulation in Islamic Finance 26 2. 1998). Management of Operational Risks Management of operational risks in Islamic banks could usefully be addressed through an appropriate CAMEL rating framework (Errico and Farrahbaksh. with one being a strong performance. Such a legal framework should contain provisions relating to licensing. permissible modes of financing. Moreover. CAMEL rating is a measure of the relative soundness of a bank and is calculated o n a 1-5 scale. B. and liquidity. assets.4 Prudential Framework from Errico and Farrahbaksh (1998) Errico and Farahbaksh (1998) suggest a supervisory framework based on the standards and best practices established by the Basel committee and an Islamic finance . earning. laws should state clearly that the central bank (or separate supervisory authority) has the authority and all necessary powers to supervise Islamic banks and conventional banks. A. 1998). 1998). such provisions should determine which enterprises may call themselves Islamic banks. it is necessary that either the general banking laws or specific laws pertaining to Islamic banks define in detail the nature of these banks and their specific operating relationship with the central bank and other conventional bank if applicable.tailored prudential framework based on the CAMEL system. The acronym stands for capital. and state clearly powers to address compliance with laws and regulations (Errico and Farrahbaksh.

They reflect in a systematic fashion a bank¶s financial condition . compliance with supervisory regulations. Additionally. 1998). and prospects. All the other rating factors can usefully be applied in an Islamic framework without major changes from standard practices. . the volume of marginal and inferior assets. 1998). bank growth experience. Hence. and overall operating soundness. The bulk of the assets of banks operating according to a paradigm version of Islamic banking is represented by PLS transactions.1 Capital In a standard CAMEL rating. an appropriate assessment of the capital adequacy ratio in an Islamic environment should address two issues: the level of this ratio and the risk-weighting methodology for its calculation (Errico and Farrahbaksh. that is mostly uncollateralized equity financing. the ratio of riskier assets to total assets can be higher in an Islamic bank than it is in a conventional bank. 1998). These assets are far riskier than the ones represented by non PLS transactions. while non -PLS modes are at the margin (Errico and Farrahbaksh. which are collateralized commercial or retail financing operations. 1998).Banking Supervision and Prudential regulation in Islamic Finance 27 critical dimensions of a bank¶s operations. capital adequacy is evaluated (1 through 5) according to: the volume of risk assets. B. The standard CAMEL rating system would need to be appropriately adapted to an Islamic banking environment as discussed below (Errico and Farrahbaksh. plans. consideration may be given to a bank¶s capital ratios relative to its peer group. Therefore. and the strength of management in relation to all the above factors. In addition. a CAMEL rating for capital adequacy in an Islamic environment should place more emphasis on factor (1) than is the case in a standard CAMEL (Errico and Farrahbaksh. PLS transactions are at the core of Islamic banking.

the lack of control on investment projects in Mudaraba transactions and. it would be important for the banker to have substantial amounts of his own capital at risk.Banking Supervision and Prudential regulation in Islamic Finance 28 B. This creates a potentially strong incentive for risk taking and for operating financial institutions without suitable capital (Errico and Farrahbaksh.1 Level of the capital adequacy ratio According to widely accepted international standards defined by the Basel Committee on banking supervision. 1998). while the Basel Committee¶s minimum level of eight percent may be an acceptable floor given the operational environment of Banks in OECD countries. However. 1998). but allow a portion of profits to accrue to banks¶ owners (Errico and Farrahbaksh. contributing to an uncertain financial condition in . to help reduce moral hazard. banks¶ risk weighted capital adequacy ratio should be at least 8%. volatile (2) economic environment. Hence. lending (3) a operations. the absence of collateral and other guarantees in PLS transactions clearly raise the overall riskiness in Islamic banks¶ operations (Errico and Farrahbaksh. and (3) as noted previously. it should be somewhat higher in an Islamic environment. more generally. as well as more general reasons that are de facto part of the high-risk environment in which most Islamic banks operate. (2) as argued above the ratio of riskier assets to total assets is typically higher in Islamic banks than it is in conventional banks. 1998).1. Some of the factors contributing to the high-risk environment of most developing and emerging market countries in which Islamic banks (as well as conventional banks) operate are: (1) a relatively weak legal infrastructure underdeveloped supporting financial bank markets. The specific reasons are the following: (1) Mudaraba contracts put depositors¶ funds at risk. This is the case because of specific reasons inherent to the operation of Islamic banking.

. shares representing a portion of equity capital of enterprises banks have invested in) to secure the funds loaned out (Errico and Farrahbaksh. Islamic banks¶ assets side includes all transactions carried out under the permissible Islamic modes of financing. 100 percent for net investments.g. and (4) the less diversified nature of the economy (Errico and Farrahbaksh.e. 1998). a credit risk (Errico and Farrahbaksh.2 Risk-weighting Methodology Conventional categories of banks¶ assetsassets current side includes to three broad net facilities customers. In particular. Islamic modes of financing also involve different d egrees of riskiness. Mudaraba transactions appear to be riskier than Musharaka or direct investment transactions because banks do not hold any tangible assets (i. PLS modes are far riskier than non -PLS modes.Banking Supervision and Prudential regulation in Islamic Finance 29 the enterprises sector. it is possible to reconcile them with the three conventional broad categories of assets mentioned above. such as mudaraba and non PLS modes that are not secured by a mortgage (e. The Basel Committee¶s reference risk weights are 100 percent for current facilities to customers. . More over. inter alia.1. 1998). B. Among the PLS modes. On the basis of the economic functions that these models are expected to fulfil. and mortgage loans that present.. and 50 percent for mortgage loans on residential properties. instalment finance) fulfil the same economic functions of current facilities to customers. while recognizing that this exercise inevitably involves some approximation. 1998). investments. very different Islamic modes.

i.. and guarantees. 1998). 1998). i. namely Musharaka and direct investment.e. it appears that offbalance sheet activities. 50 percent. 1998).1. then the appropriate risk weight on Mudaraba transactions should be at least 100 percent to reflect their somewhat higher riskiness (Errico and Farrahbaksh.3 Off-balance Sheet Commitments On the basis of available information. 1998).Banking Supervision and Prudential regulation in Islamic Finance 30 Therefore an appropriate risk-weighting structure for an Islamic system should have the Mudaraba contract carryi ng the highest risk weight. Non-PLS transactions fully secured by mortgage may well carry the same risk weight assigned by the Basel Committee to the comparable assets category of mortgage loans. B. such as issuance of letters of credit. 1998). all other non-PLS modes should carry a risk weight somewhere in between 50 percent and 100 percent.e. do not substantially differ from similar activities carried out in co nventional banks (Errico and Farrahbaksh. 100 percent. By implication. There appears to be no strong reason why Musharaka and direct investment should not carry the same risk weight assigned by Basel Committee to the comparable assets category of net investment. The lowest risk weight should be assigned to non-PLS modes fully secured by a mortgage (Errico and Farrahbaksh. Accordingly. endorsements. This means that all . If Musharaka and direct investment transactions are assigned a risk-weight of 100 percent. the Basel Committee methodology is applicable in this case. to be determined on a case-by-case basis (Errico and Farrahbaksh. All other non-PLS modes should be assigned a risk weight somewhere in between the lowest one in the system and the one assigned to Musharaka and direct investment (Errico and Farrahbaksh. followed up by two other main PLS modes..

Banking Supervision and Prudential regulation in Islamic Finance 31 categories of off-balance sheet commitments must be converted to credit risk equivalents by multiplying the nomina l principal amounts by a credit conversion factor. Nevertheless. . (2) the level and composition of non-accrual and reduced assets. (3) the adequacy of valuation reserves.2 Assets In standard CAMEL rating. the abilit y of an Islamic bank to administer and collect problem credits should be evaluated in those cases where PLS contracts default before expiration because of negligence or mismanagement on the part of the entrepreneur as well as in all cases of defaulted non -PLS transactions. or a loss. I think that with regard to factor (4). PLS assets that deliver lower or no profit should be considered as reduced rate assets until the expiration of the relative contracts (Errico and Farrahbaksh. With regard to factors (1) and (2). it should be recognised that. there is no recognisable default with the exception of the proved negligence or mismanagement on the part of the agent-entrepreneur. Until that moment. and (4) the demonstrated ability to administer and collect problem credits (Errico and Farrahbaksh. asset quality is rated (1 through 5) according to: (1) the level. assets represented by Mudaraba transactions cannot be classified until the relative contracts expire. 1998). that is a lower or no profit. 1998). As noted previously. 1998). B. distribution. ³default´ of PLS contracts mean that the investment project failed to deliver what was expected. and severity of classified assets. the resulting amounts are then weighted according to the nature of the counterparts (Errico and Farrahbaksh. in an Islamic environment.

Banks so rated typically have earnings well above peer group averages. in Islamic banking. it should be kept in mind that. (2) compliance with banking regulations and statues. 1998). and (7) demonstrated willingness to serve the legitimate needs of the community (Errico and Farrahbaksh. (2) earnings trends. Banks whose earnings are rated 5 are typically experiencing losses (Errico and Farrahbaksh. through a Musharaka arrangement) to . Earnings rated 1 are sufficient to make full provision for the absorption of losses and the accretion of capital when due consideration is given to asset quality and bank growth. (3) ability to plan and respond to changing circumstances. leadership. (3) peer group comparisons. and administrative ability. economic losses would first result in depreciation of the value of the depositors¶ wealth. earnings are rated (1 through 5) according to: (1) the ability to cover losses and provide for adequate capital. management is evaluated (1) through (5) according to: (1) technical competence. 1998). (5) depth and succession. Nevertheless. and then in a decline in the Islamic banks¶ profitability. B. (4) adequacy of and compliance with internal policies.3 Management In a standard CAMEL rating. The above criteria are generally applicable to Islamic banks.Banking Supervision and Prudential regulation in Islamic Finance 32 B. and (4) quality and composition of net income (Errico and Farrahbaksh. 1998).4 Earnings In a standard CAMEL rating. (6) tendencies toward self-dealing. particularly when that bank has also used its own resources (for example.

technical competence relative structu re of liabilities. 1998). In principle. This. Therefore. liquidity is rated (1 through 5) according to: volatility of deposits. Islamic banks cannot obtain funds through LOLR facilities. availability of assets readily convertible into cash. in an Islamic environment. This is due to the fact that all the above facilities require the payment of an interest rate (Errico and Farrahbaksh. RR may . Contrary to conventional banks. especially if the ratio of demand deposits to to tal deposits is relatively low. 1998). a preferred alternative solution. including lender -oflast resort (LOLR) facilities at the central bank (Errico and Farrahbaksh. and add an element of complexity to the transaction and payments functions that demand deposits are meant to perform (Errico and Farrahbaksh. reserve requirement (RR) can be viewed as a particular case of liquidity ratios. if applied to total deposits. B. as is the case in the two windows arrangement (Errico and Farrahbaksh. is to mandate specific RR on all deposits held in banks operating according to a two -tier Mudaraba arrangement. however. 1998). which is at the core of every bank¶s activity.5 Liquidity In a standard CAMEL rating. 1998). including Lombard and discount windows.Banking Supervision and Prudential regulation in Islamic Finance 33 finance the loss-making investment projects (Errico and Farrahbaksh. would excessively limit Islamic banks¶ ability to engage in maturity transformation. and access to interbank markets or other sources of cash. reliance on interest -sensitive funds. On the other hand. a RR ratio on demand deposits of 100 percent would rule out the problem. 1998). However. as well as overdraft or other credit facilities operated by central banks.

2001). 2001). 2000). Given the close affinity of prevailing practice of established Islamic finance and conventional banking. include: a) the presence of balance sheets with limited weight of profit and loss sharing accounts.Banking Supervision and Prudential regulation in Islamic Finance 34 represent an excessive burden for the banking system given the fact that. supervising. like ³displacement risks´. and shaping the vision. c) risks akin to ones faced by conventional banks. and regulating Islamic banks. One overarching issue that needs to be addressed is the standardization of contracts and major financial instruments across the industry to facilitate growth. In managing the transition. regulato rs would want to consider a two pronged strategy: managing the transition. regulators need to promote the stability of existing IFI whose financial intermediation practices reflect the conditions of their environment and their stakeholders¶ demands (Cunningham. These issues should be considered when calculating an appropriate level of the RR ratio (Errico and Farrahbaksh. the regulatory framework in the transition should be mostly similar to the one applying to the regulatory framework of conventional banks (El Sheikkh. These practices and the risks associated with them. 1998). one of the biggest challenges is developing a framework for governing. RR may not be remunerated. and d) market risks based on interest rates benchmarks used by conventional banks (Cunningham. 2. Under the circumstances.5 The regulatory challenges ahead Undoubtedly. Transparency enhancements are also essential for the development of the industry (El Sheikkh. outlined in this paper. Beyond the . in an Islamic framework. ease access to liquidity and enhance risk assessment capabilities. 2000). b) an emphasis on trade and short-term financing.

In particular it is important to be clear on the type of Islamic financial intermediation being considered with a special attention given to the different nature of the theoretical model and current practices. and how it would play it will be essential for its sustainable development. This effort will need to include debates that remain substantive. 1999). It would also bring to bear the market discipline features embedded in the nature of Islamic financial intermediation. and contribute to its stability. 1999). Also. 1999).Banking Supervision and Prudential regulation in Islamic Finance 35 transition. as well as for an industry evolved toward practices more consistent with its premises. An Islamic financial industry incorporating such segmentation would likely require lighter and more focused regulation. Considering the regulation of existing IFI. In particular it sees merit in considering separating the functions of Islamic intermediation in various windows or institutions (Khan. We can highlight elements of a possible vision that would be compatible with the fundamental principles of Islamic finance. Lewis (2001) could got help to the conclusion an that conceptual regulatory benchmarks shape appropriate framework for the transition. and evidencebased. materiality and no exploitation (Khan. prevailing intermediation practices would seem to point to the need for equivalent emphasis on . consultative. 2000). a consensus on a vision of the nature of the industry. A significant intellectual effort geared at providing practical ways of achieving consistency between the demands of the market place and underlying principles will need to be ongoing (El Sheikkh. Such a separation could permit the development of financial intermediation more consistent with the fundamental principles of risk-sharing. enhancing its competitiveness (Khan. the role it would play in the development of the communities it serves. At the same time it could help enhance the transparency of the industry.

2001). compared to conventional banks (Lewis. supervision and licensing. and an equivalent in supervisio n as compared to what applies to conventional banking. .Banking Supervision and Prudential regulation in Islamic Finance 36 capital requirement. There would be also an expectation of larger reliance on direct market discipline and less on ³command and control regulation´ (Lewis. one can expect minimal regulation with less emphasis on capital requirements. 2001). and a larger one on transparency and disclosure. Considering the theoretical IFI model. probably more on screening management profile and business line in licensing. more on transparency and disclosure.

4 METHODS FOR DATA COLLECTION 3.3 PROCEDURE 3.1 RESEARCH DESIGN 3.2 RESEARCH CONTEXT 3.Banking Supervision and Prudential regulation in Islamic Finance 37 3.7 SUMMARY .6 RELIABILITY AND VALIDITY 3.5 METHODS FOR DATA ANALYSIS 3. METHODOLOGY 3.

. The major differences between the two approaches are as following: Deduction emphasis: y y y Scientific principles Moving from theory to data The need to explain causal relationships between variables y y y The collection of quantitative data The application of controls to ensure validity of data The Operationalisation of concepts to ensure clarity of definition y A highly structured approach . 2003).Banking Supervision and Prudential regulation in Islamic Finance 38 This chapter justifies the choice of methods employed during the research project. In the deductive approach the researcher develops a theory and hypothesis and then designs a research strategy to test the hypothesis. 3. The research project involved the use of theory although the theory may or may not be made explicit in the design of the research (Easterby-Smith.. Provides and account of how the research was carried out.1 Research Design 3. There is discussion of how the research methods were chosen. how the research was conducted and how it was gather ed to achieve the desired aim. On the other hand. There are two approaches: and Deductive approach the Inductive which owes which more to owes to Positivism approach Interpretivism.1 Approach Understanding the research approach from an early stage of the research is extremely crucial (Saunders et al. in the inductive approach a theory is developed as the result of data analysis.1. 1995 cited in Saunders et al. 2003).

since this was the first extensive research undertaken by me. As this research tries to find out the reliability of the prudential regulation within the Islamic finance. Also. 2003) For my dissertation. it has been criticised that in the interpretive approach the data collected is specific to the particular topic studied. 1990). However. a deductive approach seemed an unlikely option as it tends to have a rigid methodology. the deductive approach was more appropriate. as such it cannot be generalised. I chose to adopt a deductive approach. At first empirical data was gathered and thereafter conclusions were made and ended up with a developing theory. . 2003) Induction emphasis: y Gaining an understanding of the meanings attach to events y y y A close understanding of the research context The collection of qualitative data A more flexible structure to permit changes of research emphasis as the research progresses y A realisation that the researcher is part of the research process y Less concern with the need to generalise (Saunders et al. and hence reliability is low (Strauss. The strength of this approach is that it helps to study the topic more in depth which results in a better understanding.Banking Supervision and Prudential regulation in Islamic Finance 39 y y Researcher independence of what is being researched The necessity to select samples of sufficient size in order to generalise conclusion (Saunders et al.

2 Research Philosophy According to Saunders et al. In the opinion of Saunders et al (2003.  Finally. the two philosophies have ³different views about the way in which knowledge is developed and judged as being acceptable. Both approaches could be adopted and both would yield valuable data in relation to the topic. who states that.  Firstly. knowledge of research philosophy will enable the researcher to evaluate different methodologies and methods and avoid inappropriate and unnecessary work by avoiding the limitations of particular approaches at an early stage. p.  Secondly. There are two main research philosophies which dominate the literature: positivism and phenomenological (Collis and Hussey. the way we design our research.83). it can help the researcher to refine and clarify the overall research strategy to be used in the study. is et essential al A clear whilst has understanding undertaking identified philosophy a research philosophy research. reasons be Easterby-Smith why the in (1997) of the three may examination relation to research research significant methodology.Banking Supervision and Prudential regulation in Islamic Finance 40 3. 2003).1. (2003) research philosophy depends on the way that we think about the development of knowledge. and even the way in which we write our thesis reflects our of basic beliefs about the world. collect and analyse our data. This opinion is also supported by Hussey and Hussey (1997).´ As such it is difficult to justify which philosophy . It is this thinking that affects the way we do our research. it may help the researcher to be more creative in selection of methods that were previously outside his/her experience.

2003). 1983). researchers should choose the appropriate philosophy depending on the characteristic of their research problem as well as the research question that they are seeking to answer. There is no reality independent of the mind. Phenomenologist believes that social reality is dependent on the mind. 2003) . what is researched cannot be unaffected by the process of the research (Van Maanen. Therefore.Banking Supervision and Prudential regulation in Islamic Finance 41 is better than the other? Therefore. On the other hand phenomenology is concerned with understanding human behaviour from the participant¶s own frame of reference. Features of Positivistic and Phenomenological Paradigms are as following: Positivistic paradigm Phenomenological paradigm to produce qualitative Tends to produce quantitative Tends data Uses large samples Concerned testing Data is highly specific and with hypothesis data Uses small samples Concerned theories Data is rich and subjective with generating precise The location is artificial Reliability is high Validity is low Generalises population from sample The location is natural Reliability is low Validity is high to Generalises from one setting to another (Hussey and Hussey. Positivism is founded on the belief that study of human behaviour should be conducted in the same way as studies conducted in the natural sciences (Collis and Hussey.

their the world. quotatio ns ³reveal the respondents´ levels of emotion. the phenomenological approach has been chosen in this research. and (Saunders et al.Banking Supervision and Prudential regulation in Islamic Finance 42 As the research philosophy depends basically on the research question. . The outcome which was based their opinions helped to test the reliability of theories regarding prudential regulation.e. Due to the above research philosophy. the research logic that used was deduction which is based on a conceptual and theoretical structure developed and then tested by empirical observation. which are the main source of raw data. The research methodology that was used was real ism i. The reason behind this being that the research was based on the opinions of managers who work within the Islamic finance field. thus particular instances are deduced from general inferences. In this specific research. 2003). In the opinion of Patton (1987). the way in which they have organized happening. This was the base of the research philosophy.. an interpretive approach was followed. their thoughts their about basic what are perception experiences. the researcher will collect qualitative and quantitative data and develop a theory as a re sult of data analysis rather than developing a theory first then test it afterwards. It also helped to bring out suggestions which may be given to the regulator authorities to improve the prudential regulation standard in future and also improve the banking supervision within the Islamic finance. The results were interpreted accor ding to the findings based on their opinions and experiences. Open-end questions used in the questionnaires will provide the researcher with quotations.

1985 c ited Hussey and Hussey 1997) argues that all researchers¶ desire high levels of data integrity and results currency. Semi-structured interviews are used to gather data. 2007). these kinds of interviews help the researcher to build on the responses that are given by the respondents (Saunders et al. In such interview types.Banking Supervision and Prudential regulation in Islamic Finance 43 Qualitative data methods were used to assist the research which involved designing this topic within Islamic financ e. for example validity.. managers who deal in a daily basis with the prudential regulation and the banking supervision. 2003 cited in Saunders et al. open-end questions enabled them to reveal their levels of personal opinion regarding their basic perceptions and ideas behind the reasoning. It may also used to explain and explore the themes that have emerged from the questionnaire. Also. In addition to this.. Open-end questionnaires were used which helped to gain a better understanding of the respondent¶s views. (Bonoma. qualitative research using semi -structured interviews may not be used to make generalisations about t he entire subject area across the study since it is based on a small number of cases (Yin. This method of data collection technique or data analysis procedure is used in a situation that generates non-numerical data (Saunders et al. there may be data quality issues which may arise. the researcher has a list of themes and questions to be covered which may vary in each interview depending on the flow of the conversation. undertaking semi-structured interviews of the people who work within the field in various IFI. 2003). Unlike the close-end questionnaires which reduce the options for the respondents. 2003). reliability etc. Since my research . which are normally analysed qualitatively. However.

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44

paradigm is phenomenological the emphasis is on the quality and depth of the data. In the opinion of Hussey and Hussey (1997), ³If a research finding can be repeated, it is reliable.´ The researcher has to take care about this aspect as the interpretivist approach has been under criticism that it is specific to a particular topic studied and as such the reliability will be low as it cannot be generalised.

3.2 Research Context
In the proposed research, the study deals with the reliability of prudential regulation and the banking supervision regarding the Islamic financial institution. To make this study more critical, I a m going to compare the prudential regulation in Islamic finance with the well established prudential regulation in the conventional banking industry. Also, I chose this topic because I have had a firsthand information and experience in working (as trainee) in the Central bank of Morocco which deals the prudential regulation of both sides (Islamic and conventional banking). The core group of respondents were Managers in Islamic financial institutions who deal with the prudential regulation. The results and observations would be based on the opinions of about 30-40 respondents working for various IFI.

3.3 Procedure
In order to not disrupt the daily working schedule of the managers who were selected as respondents, a convenient time was fixed beforehand. As the research was being planned, ethical concerns were kept in mind when seeking to access Islamic financial institution managers. In the context of research, ethics refer to the

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appropriateness of the behaviour of the researcher in relation to the rights of those who become the subject of the research or are affected by it (Hussey and Hussey, 2003). Ethics are defined as moral principles, norms or standards of behaviour that guide moral choices about our behaviour and our relationship with others (Bloomberg et al., 2005 cited in Saunders et al., 2007). It therefore relates to questions about how the research topic is formulated and clarified, how it is designed, how access is gained, data is collected, processed and stored, how the received data is analysed and whether the research findings are written in a moral or responsible way or not. It has to be ensured that the way the research is designed is methodologically strong and morally defensible to all those who are involved. The research was guided by the University of Northampton¶s code of ethics. It provided a guideline with a statement of principles and procedures that were needed to be followed for the conduct of the research. The purpose and outcome of the research and its academic usag e was explained to gain consent. On the other hand, the purpose of the research was not concealed and was completely explained to the respondents. Any special circumstance that might affect the interpretation of the results was to be clearly reported (Gill and Johnson, 1997). No implied pressure was put on the participants and they were asked to give their responses on their own free will. They were explained that they had a right to withdraw as participants and they could decline to take part in a particular aspect of the research.

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3.4 Methods for Data Collection
Open-end questionnaire were distributed to the participant via emails. These questionnaires enable me to get their personal opinion and point of view and also helped to get a firsthand information review of the respondents. Most of the responses were also sent back by email.

3.5 Methods for Data Analysis
Data collected from the questionnaires was analysed carefully. The data was classified according to the aims and objectives outlined. This is a very critical stage in the research as the researcher had to take care of the potential ris ks of

misinterpretation of data. The data was then analysed manually. For this purpose, Qualitative data analysis method was used since the research aims at finding out the personal opinion and experiences of the respondents which is not possible to be quantitatively assessed. This method was used since th e research was commenced from a deductive position and the results that were to be derived were to be adequately grounded in the data (Saunders et al., 2007). Objectivity was maintained which was very vital during the analysis stage to make sure that personal bias was avoided by and the data was not misinterpreted. This was done by analyzing the data on its own merit without drawing any conclusions on the opinions (Zikmund, 2000 cited in

Saunders et al., 2003). To analyse the data, Explanation -building strategy was used which was propounded by Yin in 1989. This strategy is an attempt to build up an explanation while collecting data and analyzing them rather than testing a predicted explanation (Saunders et al., 2007). This type of analysis is primarily concerned with

and so that the participant giv es a response which is fair and true to the topic in question. which may have a negative effect on the reliability of the study. 3. However. 2003). The questionnaires will be transcribed and analysed appropriately for this type of study.Banking Supervision and Prudential regulation in Islamic Finance 47 explanatory case studies where the objective is to provide an explanation of what is happening in the case (Robson. Open -end questionnaires were sent to managers who work within the Islamic finance field. The research strategy has been well-documented and justified in this methodology so that it does not mislead its audience in any way with regards to how the research has been conducted. 3. The reliability. It is imperative that questions are posed in such a way to avoid respondent-bias. . the questionnaires will allow flexibility to explore the topic in detail. Questions that are general to the topic area will be asked at the beginning of the questionnaire to ease the manager into the questionnaire.6 Reliability and validity The main criticism of a semi-structured interview is the lack of standardisation (Saunders et al. validity and limitations of the research have been considered and documented in thi s methodology. 1993). More focused questions will be asked nearer the end of the interview as Healey and Rawlinson (1994) suggest that this allows a greater time for the respondent to build up trust and confidence in the researcher.7 Summary This research is reflective of the phenomenol ogical philosophy and has adopted the deductive research approach. encouraging more reliable responses.

3 BANK SUPERVISION TECHNIQUES APPROACH 4. FINDINGS 4.Banking Supervision and Prudential regulation in Islamic Finance 48 4.1 SHARIAH SUPERVISION 4.7 THE RELATION OF IFSB WITH OTHER INSTITUTIONS 4.5 INFORMATION DISCLOSURE 4.6 CORPORATE GOVERNANCE 4.2 THE OFFSITE SUPERVISION 4.8 FINANCIAL REPORTING IN ISLAMIC BANKING .4 LICENSING PROCEDURES 4.

The total number of respondents was 36 out 41 (despite following them up. The outcomes of the research are based on the issues considered in the literature review.1 Sh riah supervision Regarding  the Shariah supervision. 5 respondents responses). Do s th sh i h sup vision n h n s? 17% d ny Need a hange 83% No need for a hange The answers dealt with issues like standardisation. communication and Independency. Hence.Banking Supervision and Prudential regulation in Islamic Finance 49 This research was carried out by the guidance of questionnaires. with the intention of collecting the information needed for the research. the questionnaires were designed carefully. Questions were sent through email to the middle managers who work in different Islamic banks. The questions were designed keeping important factors in mind such as time required to answer the questionnaire and understanding them.3 ) think that the Shariah supervision should be reviewed while 6 participants think that it doesn¶t need any modification. The rationale behind sending questionnaires was to analyse the strength and the efficiency of the prudential regulation and banking supervision in Islamic finance.   . 30 participants (83. among the participants didn¶t send me their 4.

one respondent answered in order to avoid any conflict of interest. few participants believe that Islamic banks should set up a channel of communication between their top management and the board of the Shariah supervision. the offsite . Also.Banking Supervision and Prudential regulation in Islamic Finance 50 Participants recommended that the Islamic banking industry should have a sort of transnational institution in charge of all the Islamic banks in terms of supervising the Shariah compliance. financial  For more than 50 of the respondents. the Shariah supervision should be completely independent from the top management of Islamic banks. In regards to independency. i i vi i ? i 33% yes 67% No supervision is important because it enables the supervisory authorities to examine regulatory reports. While 12 of the respondents believe that it¶s not an important tool as long as there is an onsite supervision. The offsite supervision Regarding the importance of the offsite supervision carried out by the supervisory authorities. 24 participants think that the offsite supervision is essential. 4.

I asked the participants which supervisory bank rating system is adequate for the Islamic financial institutions. 10 participants chose the ORAP system while 20 respondents chose the CAMELS system. .Banking Supervision and Prudential regulation in Islamic Finance 51 statements and selected ratios. The outcome was as following: 6 participants chose PATROL system. Furthermore. A nd  28% CAMEL 17% 55% The outcome from the questionnaires show. The respondents chose among the following systems: PATROL. 4. some participants believe that the real importance of the offsite supervision is due to the fact that it enables the supervisor to quickly identify negative trends and emerging problems and to resolve the issues before they become so serious that they could negatively affect the bank¶s financial condition. that the CAMELS system could be the appropriate rating system for an Islamic financial institution. Whi h of th follo in b n d qu t fo th : A CA L ? PATROL ORAP tin syst is L.3 Ban supervision techniques approach Concerning the supervisory bank rating systems. ORAP and CAMELS.

34 respondents think that the licensing procedures are essential in terms of prudential regulation and banking supervision.4 L E SING PRO E URE In regards to the licensing procedures.Banking Supervision and Prudential regulation in Islamic Finance 52 4. Is the li ensing procedures an essential tool for the banking supervision? Yes No 6% 94% The answers were mainly dealing with the fact that a licensing procedure will protect the public from fraudulent banks and will protect the banks from an unfair competition. .

Banking Supervision and Prudential regulation in Islamic Finance 53 4. The i portance of information disclosure in the prudential regulation framework Yes No 33% 67% The main answers state that the importance of information disclosure is due to the fact that it will push the bank to disclose information relevant for public and the regulators. Islamic bank will show and prove the transparency of their financial operations. 24 of the participants think that information disclosures are essential for the prudential regulation and banking supervision in the Islamic banking system. . While 12 respondents don¶t believe that information disclosure is that important to be included within the prudential regulation standard.5 INFOR Regarding TION DISCLOSURES the information disclosures. By disclosing information.

While 13 participants think that corporate governance is functioning well in Islamic banks and doesn¶t need any prudential regulation standard. 23 respondents think that the IFSB should issue a prudential regulation in this matter. respondents think that a guideline of good corporate governance should be included in a prudential regulation framework.6 CORPOR TE GO ERNANCE In regard to corporate governance.Banking Supervision and Prudential regulation in Islamic Finance 54 4. . Should the IFSB issue a prudential regulation standard regarding corporate governance? Yes No 36% 64% Because the corporate governance has proven in the past that it can cause the bankruptcy of banks.

Banking Supervision and Prudential regulation in Islamic Finance 55 4. All the respondents (without exceptions) said that the IFSB should cooperate more and more with other organisation. . The relation of the IFSB with other institutions I asked the participants if the IFSB should cooperate more with other international institutions in terms of banking supervision and prudential regulation. Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision? Yes 100% The answers were that the IFSB should be cooperating with for example the International Islamic Rating Agency and the Basle Committee on banking supervision.

32 of the respondents think that standardising supervisory supervision. the accounts to reporting carry out will enable the authorities efficient offsite Can the standardisation of accounting standard improve the banking supervision? Yes No 11% 89% Nearly all the answers were stating that a common accounting report framework will ease the task of the supervisory authorities. FINANCIAL BANKS REPORTING IN ISLAMIC I asked the participants if standardising the financial reporting among the Islamic banks can facilitate the work of the supervisors. .Banking Supervision and Prudential regulation in Islamic Finance 56 4.

6 INFORMATION DISCLOSURE 5.2 THE OFFSITE SUPERVISION 5.8 THE RELATION OF IFSB WITH OTHER INSTITUTIONS 5.7 CORPORATE GOVERNANCE 5.9 FINANCIAL REPORTING IN ISLAMIC BANKING .Banking Supervision and Prudential regulation in Islamic Finance 57 5. DISCUSSIONS 5.3 BANK SUPERVISION TECHNIQUES APPROACH 5.1 SHARIAH SUPERVISION 5.4 CAMELS IN THE CONTEXT OF ISLAMIC BANKING 5.5 LICENSING PROCEDURES 5.

either by its conforming to a recognized Islamic legal norm or by it¶s not violating the same (Sarker. Here the outcome of the email based questionnaire will be examined and judged with the literature review portion of the research. This person will be in charge of keeping the IFI management updated with the decisions and the suggestions of the Shariah supervisory board. The respondents think that the Shariah supervision must be independent from the management. One of the respondents recommends that eventually an IFI could appoint one of its middle managers to act as liaison with the supervisory board. Shariah supervision is the process of ensuring that a financial product or service complies with Islamic legal precepts and principles. 5. The issues which came up from the result of the questionnaire are as following: standardisation. 2002). We all know that the success of any auditing or supervision is a clear communication between the supervisee and the supervisor (Ali. independency. there must be a clear line of communication between the Shariah supervisory board and the management. . 2004).1 Shariah Supervision In essence. Also the independence factor will enable the board of directors and the Shariah supervisory board to work within a spirit of cooperation and accommodation. For this reason.Banking Supervision and Prudential regulation in Islamic Finance 58 This chapter is a continuation from the earlier chapter. Because by being independent the Shariah supervisory board will be able to make decisions binding on management. The other issue related to the Shariah supervision is the factor of communication. awareness and communication.

5. organisation and liquidity. most participants recommend that instead of having an internal Shariah supervisory board for each IFI. deposit. profitability. The participants argue that a board that is sensitive to the business environment is an effective board. . we can have a transnational Shariah supervisory organisation which will be in charge of monitoring the respect of Islamic law by the IFI around the world. The five components of PATROL are as following: capital adequacy. market risks and exchange rate risk (Fadeel. By being aware of what is happening in the market place. Indeed. income on capital. Also. credit quality. 2002). Regarding the issue of standardization. the board will be able to make pertinent decisions. 5. the offsite monitoring systems focuses on the bank¶s current condition. it¶s essential that the Shariah supervisory board remains informed of developments in the industry they supervise. position risk. credit. the offsite supervision is used as an ³early warning device to detect emerging bank financial problems´.Banking Supervision and Prudential regulation in Islamic Finance 59 On the other hand. settlement risk.2 THE OFFSITE SUPERVISION The offsite supervision enables the supervisory authorities to collect and interpret regular reporting returns and other statistical data.g.3 SUPERVISION TECHNIQUES APPROACH The PATROL system has been introduced in 1993 by the bank of Italy as a tool to give a systematic representation of the financial health of banks and to provide a background for an onsite inspection visit (Sarker. e. In PATROL system the capital adequacy is assessed by comparing the own funds of a bank with regulatory prescriptions of capital for credit risk. 2004).

large exposu res and capital adequacy)... market risk. 2003). Rating assigned is validated through comparisons with the actual results of onsite examinations (Errico et al...Banking Supervision and Prudential regulation in Islamic Finance 60 To assess profitability.. 1998). Credit quality is assessed on the basis of aggregate data of adjusted bad debts derived from the central credit register and an individual loan concentration index (Errico et al. earnings (operating income. In PATROL system. and by simulating exogenous shocks over a one year period (Errico et al. 1998). liquidity. the ORAP system (organisation and reinforcement of preventive action) helps to detect potential weaknesses in banking institutions by examining all components of risk associated with the activity and environment of each institution (Chami et al. bad loans and provisions for bad loans).. 1998). 1998). On the other hand. on information obtained from meetings held with the management of banks and onsite examination results (Errico et al. 1998). The interest rate is also taken into account (Errico et al. The organisational component is assessed on the basis of ad hoc information available to the analyst. each component is rated on a scale of 1 (best) to 5 (worst) based on supervisory criteria and guidelines. on and off-balance sheet activity (asset quality. The ORAP includes 14 components which relate to prudential ratios (capital. and the return on equity is related with the average of the banking system. the economic results net of extraordinary items are related to the requirement to cover capital losses stemming from bad debts. non-recurring items and return on assets) and qualitative . Liquidity is assessed after ascertaining maturity mismatch under normal operating conditions.

(3) bank growth experience. 2003). According to the respondents. plans. 2002). there should be some separate provisions to make it conductive and proper to analyse the whole operation of the Islamic banks. CAMELS has been viewed in light of the principles and practices of Islamic banking. mostly uncollateralized equity financing.4 CAMELS in the context of Islamic Banking 5. Each component is rated on a scale of 1 (best) to 5 (worst) (Chami et al. 2003). in principle. In theory. that is.1 Capital In the standard CAMELS framework. the bulk of the assets of Islamic banks should be made up of PLS modes.. and (4) the strength of management in relation to all the above factors (Baldwin. These assets carry far more risk than those made up of non-PLS modes. The IFSB standard states that the minimum capital adequacy requirements for the Islamic financial institutions should not be . (2) the volume of marginal and inferior assets. capital adequacy is assessed according to: (1) the volume of risk assets.4. Hence.. More than the half of the participants believes that the CAMELS are the more adequate rating system for the Islamic financial institution. This statement confirms the view of the authors reported in the literature review. Though all features of CAMELS are not repugnant or contradictory to the Shariah stance. prospects. which are collateralized commercial or retail financing operations.Banking Supervision and Prudential regulation in Islamic Finance 61 criteria (shareholders. the ratio of riskier assets to total assets should typically be higher in an Islamic bank than in a conventional bank (Chami et al. management and internal control). 5.

Nonethel ess. in practice. This approach will be consistent with the rationale underpinning the first pillar of the proposed New Basel Capital Accord (Basel 2). but also an assessment of the mix of PLS and non-PLS assets. But the participants argued that the minimum capital adequacy in an Islamic environment must be higher than 8% due to the risks involved during the profit-loss sharing transactions.Banking Supervision and Prudential regulation in Islamic Finance 62 lower than 8% of the total capital. the Musharaka and Mudaraba assets account for some 25% of Islamic banks¶ total assets. Therefore . notably mark-up transactions. the managers argue that PLS modes represent a small fraction of Islamic banks¶ total assets. suggested that the supervisory authorities should issue a prudential regulation standard which states that capital must be liquid money and be designated by quantity and also well defined by type and quality. . including through acceptance of internal ratings based systems for banking book credit risk and trading book market risk (Baldwin. it may be reasonable to conclude that the assessment of capital adequacy for Islamic banks should be based not only on a thorough evaluation of the degree of risk of each bank¶s portfolio. it should be noted that the potential losses that capital bears in an Islamic bank are lower in as much as PLS depositors themselves will absorb part of them. notably the proposed changes in the risk -weighting of assets. 2002). According to IFI reports. the majority of which are made up of non-PLS modes. and this factor could well offset the special risk in PLS accounts (Baldwin. One of the participants. who work for an Islamic bank in Morocco. However. 2002).

the ability of Islamic bank to reduce the capital value of investment deposits in case of losses should not be viewed as tantamount to an automatic setting aside of provisions against loan losses. and (4) the demonstrated ability to administer and collect problem credits (Baldwin. 2002). the ability of an Islamic bank to administer and collect problem credits should be evaluated in those cases where PLS contracts do default before . 2002). adequacy of loan-loss reserves remains a key factor in ensuring banking soundness in an Islamic environment. with the exception of proved negligence or mismanagement on the part of the agententrepreneur (Baldwin. Hence.2 ASSETS In the standard CAMELS framework. In fact.4. However. In regard to factor (1). Regarding factor (3). (2) the level and composition of nonaccrual and reduced rate assets.Banking Supervision and Prudential regulation in Islamic Finance 63 5. it would be recommendable to take a proactive and forward looking stance and consider PLS assets that are estimated to yield a lower or no profit as reducedrate assets even before the expiration of the relative contracts. too. it should be borne in mind that in an Islamic environment assets represented by Mudaraba transactions cannot be classified until the underlying contracts expire. with regard to factor (2). and severity of classified assets. adequate loan loss provisioning is needed to provide strong incentives to limit moral hazard. Finally. this situation should not be allowed to dilute sound loan-loss provisioning practices aimed at preserving the solvency and the viability of an Islamic bank as an ongoing concern (Baldwin. (3) the adequacy of valuation reserves. distribution. Indeed. Until that moment. 2002). asset quality is assessed according to: (1) the level. with regard to factor (4). there is no recognisable default.

in this case. and (6) demonstrated willingness to serve the legitimate needs of the community (Baldwin. (2) earnings trends.4. managing commodity inventories at times.Banking Supervision and Prudential regulation in Islamic Finance 64 expiration because of negligence or mismanagement on the part of the entrepreneur. earnings are assessed according to: (1) the ability to cover losses and provide for adequate capital. All these factors are applicable in an Islamic banking environment. (5) tendencies toward self-dealing. as well as in all cases of defaulted non-PLS transactions (Baldwin. leadership. and similar problems. legal uncertainties relating to shariah litigation systems. 5. 2002). 2002).3 Management In the standard CAMELS framework. and (4) quality and composition of net income (Baldwin. Of course. .4. 5. Given the complexity of many Islamic banks¶ operations. (3) ability to plan and respond to changing circumstances. 2002). (3) peer group comparisons. involving the monitoring of investment projects. I think that the provisioning rules must be tightened. management is evaluated according to: (1) technical competence. and administrative ability. (4) adequacy of and compliance with internal policies.4 EARNINGS In the standard CAMELS framework. too. establishing adequate internal systems and controls for managing risks and validation of transactions play a particularly crucial role in the effective management and containment of operational risks. the management¶s specific competence in Islamic banking practices and procedures should be critical in such an evaluation (Baldwin. 2002). (2) compliance with banking regulations and statutes.

which are typically underdeveloped or non-existent in an Islamic environment.5 In the LIQUIDITY standard CAMELS framework. . compa red with conventional banks. might result in reputational damage and loss of depositor base. technical competence relative to structure of liabilities. including lender -oflast resort (LOLR) facilities at the central bank (Baldwin.Banking Supervision and Prudential regulation in Islamic Finance 65 Earnings are considered of hig h quality if they are sufficient to make full provision for the absorption of losses and the accumulation of capital when due consideration is given to asset quality and bank growth. Nonetheless. availability of assets readily convertible into cash. economic losses would first result in a depreciation of the value of the depositors¶ wealth and then affect the bank¶s equity position in the event that it had also used its own resources to finance the loss -making investment project. As discussed. if they materialize. 5. solvency problems (Baldwin. Also. possibly. 2002). in an Islamic bank. 2002). reliance on interest -sensitive funds. 2002). such as Lombard or overdraft facilities operated by central banks or through access to interbank and money markets. At the other extreme are banks that are experiencing losses (Baldwin. such risks to deposits. Banks so assessed typically have earnings well above peer group averages. leading to liquidity and. liquidity is assessed according to: volatility of deposits.4. The above criteria are generally applicable to Islamic banks as well. Islamic banks have fewer opportunities to obtain funds through LOLR facilities. and access to interbank markets or other sources of cash.

2002). sensitivity to market risk is assessed by the degree to which changes in market prices. Also. they typically carry inventory items. notably interest rates. unlike conventional banks.Banking Supervision and Prudential regulation in Islamic Finance 66 5. In principle. and swaps contracts.4. . and equity values adversely affect a financial institution (Baldwin. exchange rates.6 SENSITIVITY TO MARKET RISK In the standard CAMELS framework. interest rate risk affects Islamic banks only indirectly through the mark-up price of deferred sale and lease-based transactions. options. They are also directly exposed perhaps to a greater extent than many conventional banks to equity price risk as the very nature of Islamic banking is equity financing through the PLS modes. forwards. it is natural for the assets of these banks to be exposed to the risk of changes in the LIBOR rate. commodity prices. We have to note that Islamic banks can only rely on fewer riskhedging opportunities than conventional banks because Shariah compliant substitutes for conventional market risk hedging instruments. such as futures. are not yet available to Islamic banks at the current state of development of Islamic finance. Islamic banks are directly exposed to commodity price risk because. according to Chapra (2000) since Islamic banks use LIBOR as benchmark in their financing operations. Islamic banks are exposed to exchange rate risk in the same way as conventional banks are. Owing to the Shariah¶s prohibition against interest-based instruments.

Banking Supervision and Prudential regulation in Islamic Finance 67 5. . set rules for internal controls and external audit functions. we have to note that there are no international agreements on licensing standards. set rules which can prevent the bank from a conflict of interests. engage in securities. define the organisational structure of the bank. new Islamic banks must meet certain requirements to enable them to operate successfully. there are some elements of an appropriate licensing process that are usefully applicable also in an Islamic banking framework. Also.  Capital requirement: set minimum levels and composition of initial capital.  Specify activities: determine to what extent an Islamic bank can take equity positions in non -financial enterprises. licensing. establish of directors standards for owners. To establish an effective entry policy in the banking industry is a key factor to protect the public faith and the banking system from unfair and dangerous competition from undercapitalised.5 LICENSING PROCEDURE Like in conventional banking. underwriting. and requirement for banking license should be published and applied. an appropriate licensing is just as necessary in an Islamic banking framework to enable supervisory authorities to ensure that new banks are sound and stable. regulations. According to the participants. Managers of some Islamic banks suggested that the following elements should be taken into account by the banking supervision authorities:  Set the ground rules: rules for corporate governance. requirements for boards and managers. criteria. Nevertheless. factoring.  Transparency: laws. ill conceived banks or those that are operated by unqualified or less reputable owners and managers.

and adapt them to the specific needs of an Islamic banking environment.Banking Supervision and Prudential regulation in Islamic Finance 68  Business plan: a license application should include a business plan which details the strategy to attain profitability and maintaining it. One of the participants recommended to consider requirements established for investment companies in conventional systems (for example by the financial service authority). 5. until now. Moreover. For this reason. information disclosure can introduce an element of flexibility in the system. Indeed. Also. managers of Islamic banks recommend the Islamic financial service board to issue a licence standard in order to prevent the Islamic banks from unfair competition and to ensure that new banks are sound and stable. The supervisory authorities should focus on a list of appropriate data and information that Islamic banks are to be required to provide. information disclosure is particularly important in an Islamic banking environment. information requirements should be design in a way which enables the supervisory authorities to monitor Islamic banks¶ risk management. there is no prudential regulation standard asking the Islamic bank to apply for a licence application. and provide the supervisory authorities and the public with a better understanding of banks¶ strategies and relevant risks. Information disclosure should be designed to reduce information asymmetries due to the unrestricted Mudaraba contract between an Islamic bank and its depositors and incentives for moral hazard due to the fact that capital value of and returns on investment deposits are not guaranteed. .6 INFORMATION DISCLOSURES According to khan (2003).

particularly those for which there is no established market. internal controls. which may include establishing a limit on aggregate holdings of illiquid assets. including with respect to concentration. Such disclosure may include proposed national or regional legislation involving the financing of the projects. risk factors. business. any economic.Banking Supervision and Prudential regulation in Islamic Finance 69 The information disclosure requirement should include the following areas: types of securities. . the authorities should require the disclosure of professional qualifications and experience of management and senior staff. It should provide an accurate description of the investment objectives and policies. In addition. investment policies. pending civil and religious courts¶ decisions relating to the validity of the projects or the means of financing them. Additionally. Participants added that the information disclosure should be included in a regulatory framework governing Islamic banks. which is an illiquid asset. investment of more than 25% of total assets may define concentration in anyone industry.  Types of securities: this section has to provide the supervisory authorities with an indication of an Islamic bank¶s degree of exposure to any type of securities or other assets. The components of proposed disclosure requirements are as following:  Investment policies: this section should provide the supervisory authorities with information to assess the appropriateness of policies with regard to portfolio diversification. An excessive exposure to illiquid assets should prompt the supervisory authorities to action. or political developments or changes which can affect that industry or group of industries should be briefly discuss ed. and performance data.

including the determination of profit and loss sharing ratios on the projects it finances and the ongoing auditing of these projects to ensure that its share of profits are being fairly calculated. portfolio. and are properly accounted for. thus accruing profits to be shared with its investment depositors. For this reason. These specific activities highlight internal controls as key to ensuring that all phases of the investment process are monitored. As mentioned before. and are properly accounted for. Ill -conceived. the Islamic bank can only indicate the expected rate of return on investment deposits. the supervisory authorities should set standard for internal controls. infrastructure monitoring and handling of risk factors.Banking Supervision and Prudential regulation in Islamic Finance 70  Disclosure of risk factors: This section should provide information on the main risk factors associated with the investment procedures.  Internal controls: An Islamic bank performs internally several complex activities that are not normally performed by conventional banks. These specific activities highlight internal controls as key to ensuring that all phases of the investment process are monitored. . It should and describe the internal for the organisation. Because of the virtually open-ended list of ways to provide funds through the use of combinations of the permissible Islamic modes of financing. each Islamic bank should be allowed some degree of freedom in engineering how best to monitor and handle the risks inherent to its specific activities. comply with Islamic bank¶s investment policies.  Performance data: expected return on investment deposits is key to the depositors¶ choice of a particular credit institution. comply with Islamic bank¶s investment policies. The actual rate depends on the Islamic bank¶s ability to finance successful investment projects.

it becomes a key supervisory issue to reduce the moral hazard inherent in this situation. Hence. This section should provide a brief explanation on how an Islamic institution calculates its historical performance in order to advertise this data. Supervisory authorities should pay more attention to assess staff¶s competence and skills in Islamic banking. including the board of directors.7 Corporate Governance The OECD defines the corporate governance as ³set of relationships between a company¶s management. Hence. its . its board. Moreover.Banking Supervision and Prudential regulation in Islamic Finance 71 unsound institutions might seek to attract depositors by promising unrealistic rates of return.  Management and senior staff: this section should include information on the education and professional background of an Islamic bank¶s management. particularly whether their role should be limited to approving financial products and services or should extend to the approval of individual credit decisions. In order to reduce the moral hazard. Supervisory authorities have to ensure that the advertised yields are based on historical earnings and are not intended to indicate future performance. supervisory authorities should set standard which clarify the role of the shariah boards. Supervisory authorities should satisfy themselves about the ³fit´ and ³proper´ requirements for management and senior staff to ensure that credit and investment decisions are taken by experienced bankers. This should be done in a concise description of the essential features of the data and how it has been computed. thus crowding-out serious and well managed institutions. and senior staff. 5.

the practice of Islamic banks to stabilise the returns on investment deposits is discussed: if banks cushion the returns of the depositors in period of weak performance.Banking Supervision and Prudential regulation in Islamic Finance 72 shareholders and other stakeholders´ (OECD 1999. . This case is taken to illustrate that fairness to all stakeholders as an objective of corporate governance is not only hard to achieve but even hard to define when objectives are multidimensional. Banking supervisors have long recognised the importance o f good governance. supervision can¶t function properly if sound corporate governance is not in place. more specifically. the focus is mainly on those elements that relate to the manner in which the business and affairs of an organisation are governed by its board and managers (Caruana. Corporate governance is an important topic because poor corporate governance lay at the heart of many bank failures over the years. Experience underscores the need to have appropriate levels of accountability as well as sufficient checks and balances. 2006). this may be seen as an example of good corporate governance in favour of the depositors. However. a closer look reveals rather complicated governance issues as well as questions with respect to the Shariah compliance. to their primary stakeholders. There are two factors which push the respondents to ask the IFSB to issue standard regarding corporate governance in Islamic financial institution: y First. 2). banks must act in a way that promotes confidence to the public and the market in general and. In theory. For banking supervisors. although the range of topics that corporate governance may encompass is quite wide.

Banking Supervision and Prudential regulation in Islamic Finance 73 y Second. The IFSB should issue a corporate governanc e standard by for example adopting the corporate governance standard of Basel 2 to the Islamic banking environment. They are the stakeholders whose interest should be protected or supported foremost by the institutional setup which determines corporate governance in Islamic banks. The advantage of recommended codices is that it allows some experimentation. IFSB can also use some recommended codices. but is not obliged to do so. But we could imagine that guidelines of AAOIFI or IFSB may take the form of recommended codices nationally before they become internationally recognised standards. . Investment depositors are seen in a special situation in Islamic banks compared to depositors in conventional banks (interest-based banks). These standards as such as they are not legally binding. the proposal of a depositors¶ representative in corporate bodies is discussed. By issuing a ³corporate governance code for Islamic financial institution´ each Islamic institution will have to take the code and its best practice examples and recommendations as a guideline. This case is taken to illustrate that a participation in corporate bodies must not be an effective instrument to ensure fairness and that external control institutions may be more effective. and the content can be revised easier than that of codified laws or regulations. but when national authorities approve them. the compliance with the standards can be enforced by regulators. On the other hand. It seems that the instrument of recommended codices has not been used in Islamic banking.

The IIRA measures the effectiveness of corporate governance on the basis of the following characteristics: transparency and adequate disclosure. demonstrated trustworthiness. on their own. by building a strong relationship with the Basle committee. While the Basle committee on banking supervision since its creation in 1974. Confidence in the corporate governance processes at the bank will enhance the supervisor¶s overall confidence that the bank is being operated prudently. issued 25 principles which represent the core of banking supervision in conventional banking industry. . By cooperating.8 The relation of the IFSB with other institutions In terms of prudential regulation published. and the effectiveness of the top management team and process. In an Islamic banking environment. the prudent operation and financial soundness of a supervised bank. Banking supervisors must rely on the competence. the IFSB can cooperate with supporting institutions like the Islamic International Rating Agency (IIRA). skills and prudence of th e board and management.Banking Supervision and Prudential regulation in Islamic Finance 74 In order to improve the banking supervision in the area of corporate governance. the IFSB will be able to develop more prudential regulation standard which will cover all the potential risks facing the Islamic banking industry. The guidance inspections and oversight activities of supervisors cannot guarantee. the IFSB and the IIRA could reduce the information asymmetry between bank managers. and by this they contribute to a more effective supervision. history. 5. Hence. good corporate governance and supervisory actions complem ent one another. the IFSB only developed 5 prudential regulation standards so far. shareholders and PLS depositors.

Moreover. Also. 5. it makes it difficult for the IFSB to supervise and compare the financial health of the Islamic financial institutions. and provide reports of on-site supervision to IFSB. IIRA provides rating services to the banking sector in predominantly Islamic countries. the supervisory authority will be able to compare the Islamic banks in terms of financial health and then issue recommendations to banks with bad financial performances.9 FINANCIAL REPORTING IN ISLAMIC BANKS By adopting the international accounting standard. IIRA could also act as an external auditor on the behalf of IFSB. Islamic banks can facilitate the task of supervision carried out by the supervisory authorities. reporting their accounts according to international standard will enable the supervisory authority to highlight easily and quickly any suspicious figures which can lead the bank to a failure. the Islamic banks report their accounts according to the accounting regulation of the country where they are established. IFSB can also cooperate with the IIRA (Islamic International rating agency).Banking Supervision and Prudential regulation in Islamic Finance 75 On the other hand. Hence. . The IFSB can use these ratings to evaluate the soundness of banks and to improve its standards. Hence.

2 RESEARCH CONSTRAINTS AND LIMITATION 6.1 CONCLUSION 6.4 SUGGESTIONS FOR FUTURE RESEARCH 6. CONCLUSION AND RECOMMENDATIONS 6.Banking Supervision and Prudential regulation in Islamic Finance 76 6.3 RECOMMENDATIONS 6.5 PERSONAL REFLECTIONS .

the recent financial crisis so famously known as ³Credit Crunch´ was mainly due to a lack in regulation and supervision towards mortgage loans with high risk. My research focused on the banking supervision in Islamic finance and the issues facing this supervision such as: corporate governance. In regards to Shariah supervision. Shariah supervision. I chose to do my dissertation on banking supervision in Islamic finance because during my internship at the central bank of Morocco.1 CONCLUSION Prudential regulation and banking supervision represent an important aspect of any type of financial system. Because any management involvement would reduce via conflict of interest the fairness of the council decisions. Also. This chapter concludes by some personal suggestions and views are expressed shortly. analysing the questionnaires. 6. Hence. the decision made by this co uncil should be free of any kind of involvement from the Islamic bank¶s top management. were this research shall be supportive. I noticed that the Islamic banks were supervised and monitored the same way the conventional banks were supervised. A suggestion to a research in future is put forward. supervision techniques. licensing procedure and disclosure information. The outcome from the questionnaires was that the Islamic banking should have a sort of international Shariah council which will be in charge of ensuring that the financial product advertised by Islamic banks complies with the Shariah law. independency and communication. It interprets the conclusion on the basis of the research carried at the same time recognize the likely limitations of the research carried. I conclude that the main problems are: standardisation. .Banking Supervision and Prudential regulation in Islamic Finance 77 This chapter concludes the research.

. liquidity and sensitivity to market. Corporate governance topic is well known particularly for being the origin of the collapse of many big multinational companies such as Enron and the Maxwell Empire. earnings. this intermediary should keep the Shariah council board updated with the evolution and development of the Islamic banking industry. Hence. CAMELS will enable the supervisory authorities of Islamic banks to evaluate the financial situation of a particular bank and detect any problem which can eventually lead the bank to a failure. I think that the supervisory authorities should emphasis on the corporate governance in Islamic banks. As I mentioned before. The second main issue highlighted by this research was the aspect of corporate governance. Moreover. Indeed. Moreover. CAMELS covers the following areas: capital. management. The CAMELS technique has proven its ef ficiency within the banking supervision in western banking. the supervisory authorities should ensure that the IFSB standards regarding corporate governance are fully implemented by the Islamic financial institutions. I think that the Islamic financial institutions should appoint an executive who will be in charge of keeping the top management updated with the recommendations and the decisions of the council. It is true that the S hariah law gives some recommendations regarding corporate governance but I don¶t believe that these guidelines are enough. The IFSB should issue standard which defines the characteristics of effective corporate governance. assets. I think that CAMELS is the appropriate techniques for Islamic banking. In regards to this matter. Concerning the supervision techniques.Banking Supervision and Prudential regulation in Islamic Finance 78 The other issue in regards to Shariah supervision was the factor of communication.

that the aspect of banking supervision in Islamic banking is only in its development stage which can explain the existence of such issues. I have to note. name and functions of shareholders. I do believe that the IFSB should recommend to the Islamic banks via prudential regulation framework. The IFSB should develop standard which set the basic conditions to open an Islamic banks. So. the supervisory authorities will be able monitor the degree of risk taken by the Islamic banks in their financial operations. because of this counterpart risk. in Islamic banking the investment deposits and the rate of return on demand deposits are not guaranteed at all. risk factors. But nevertheless. These conditions will have to encourage any new Islamic bank to provide the regulators wi th the following information: Business plan.Banking Supervision and Prudential regulation in Islamic Finance 79 Licensing procedure is also a main issue for the Islamic banking. Islamic financial institutions should disclose more information to the public investors and the supervisory authorities. that it¶s why this process should be included in the prudential regulation framework. type of activities. type of securities. to provide or disclose the following information: investment policies. initial capital. performance data. internal control reports. As I mentioned in the literature review. This kind of information if disclosed by the Islamic banks will first inform the public about where their funds are invested. the regulators should find solutions to fix these problems in order to avoid any crisis to the banking system in Islamic finance ³Prevention is better than cure´. . Finally this research highlighted the issue of disclosure information. management and senior staff. Secondly. In my opinion. Licensing procedure protect established banks from an unfair competition and the public from fraudulent banks which operate against any kind of moral ethics.

There for the chief limitation in this project was time and availability of resources. Moreover. which can be helpful for studying the issue in a better level. Indeed. which is comparatively not a big target population. I have to note that most of the questionnaires have been sent to managers of Islamic banks which are established in my home country: Morocco. 6. To an extent this can have an influence on the accuracy of the data attained during the questionnaire. In terms of the availability of the resources. where the target population was narrowed to 45 respondents. this research was carried with the assistance of questionnaire send through email. the use of interviews personally might have given facts. I found out that some written article or books are hardly accessible. I had to translate my questionnaire in French. This situation forced me to spend more time and effort on looking for secondary data. Here the constraints related towards the research are as follows. But . I received the answers in French and I had to translate them to English in order to analyse them.Banking Supervision and Prudential regulation in Islamic Finance 80 I hope that this piece of work has brought a positive contribution towards finding a solution to the Issues facing the banking supervision in the Islamic environment. The research project at master¶s (postgra duate) stage consists of various limits such as time and resources availability. In the available time and material related to the research accessible to the researcher. which brings a barrier towards the research scope.2 RESEARCH CONSTRAINTS AND LIMITATION All research has its own constraints. Also. Due to the fact that Morocco is a French speaking country.

So. This will allow the supervisory authorities to carry out efficient offsite and onsite supervision of the banks. The research was carried out with a relatively small sample size which is a major limitation. Islamic banks are at the initial stage of growth and their sizes are small to medium. However. There are several reasons for Islamic banks to comply with the Basel 2 regulations.Banking Supervision and Prudential regulation in Islamic Finance 81 due to the facts that the respondents live and work abroad. supervising and guiding the Islamic banking system. it was difficult and costly to do interviews.  Islamic banks should follow some recommendations of Basel committee of banking supervision. The standards developed by AAOIFI and IFSB should be added to the Basel 2. 6.3 Recommendations  Regulatory and supervisory authorities should improve and develop adequate legal framework for controlling.  The AAOIFI should promote the establishment of international accounting standards by the Islamic banks. the sample size is believed to be realistic and representative. The regulatory framework prescribed by Basel committee of banking supervision will then bring standardisation for the Islamic banks. IFSB and AAOIFI with the cooperation of regulatory authorities in Muslim countries. should create a Shariah supervision council which will be in charge of monitoring the Shariah compliance of Islamic . Basel 2 requires Islamic banks to meet legal and regulatory standards as specified in Basel 2. Basel 2 compliance becomes a cover stone. in order for them to gain international recognition.  As I mentioned.

4 SUGGESTION FOR FUTURE RESEARCH Importance of banking supervision is spreading globally. y Conduct and manage different training courses. particularly with the resent financial crisis.  IFSB should promote the use of an adapted CAMELS approach which looks to me as the appropriate rating system for Islamic banks.  IFSB has to promote and develop standard regarding the corporate governance. 6.Banking Supervision and Prudential regulation in Islamic Finance 82 financial product. . this research can be supportive for a future research based on the implementation of the IFSB standards in one or a few countries. this research can be the basis for a future study based on one particular standard such as on the IFSB capital adequacy standard and Basel 2 in one particular country or one financial institution. The functions of this S hariah supervisory council will be as following: y Ensure that the activities of Islamic banks comply with Shariah principles. For example. y Conduct Shariah audit and inspection of specific branches/offices of the Islamic banks and financial institutions. I think my research can be used as support for future studies. Future studies need to be carried out with large samples size and should be based on interviews. Moreover. y Develop legal religious recommendations on banking and financial matters. This research emphasise on the banking supervis ion and prudential regulation in the Islamic banking system. seminars on Shariah and financial matters.

this happened with the consultation and guidance of my tutor from the University of Northampton. The major drawback of the research was the available time in hand. it was a genuine hard task to narrow down the aim of this research. The guidance received from my supervisor was helpful in deciding my research topic. demanding. Initially the research had a broader idea. It was hard process to examine the data obtained from the email based questionnaire and ample effort was focused towards the questionnaire in order to obtain the utmost probable facts concerning the research question.5 PERSONAL REFLECTIONS This research enabled me to expand my knowledge of banking supervision. The research has its own pros and unanticipated cons. I thought that doing a research on Islamic finance will give me more chances to get a job by showing to the potential employer my interest for the subject. . particularly in Islamic banking. because I want to start a career in Islamic finance.Banking Supervision and Prudential regulation in Islamic Finance 83 6. Ultimately the period dedicated to this research turned out to be a remarkable progress since this research was supervised by a highly professional lecturer from the university. Indeed. This helped me in doing this research taking into consideration the time period and other resources. At this juncture it can be concluded that the research was exciting. The research is well planned and as precise and accurate as achievable with a lot of effort. interesting and chiefly an experience which has enhanced my knowledge since it has been completed by improving the researcher¶s ability in managing a research project.

(State Bank of Pakistan: Karachi. ³Agency Theory. Ahmed (2003). Paper presented at the Fifth Harvard University Forum on Islamic Finance.A. Pakistan) y Baldwin. The Accounting & Auditing Organization for Islamic Financial Institutions. y Ayoub. Abdel Karim & S. ³The Emerging Islamic Financial Architecture: The Way Ahead´. World Bank. March 1999. Islamic Banking and Finance: Theory and Practice.. Karim (1997).Deehani (1998). S. Journal of Management and Governance. K. 176 - 197). Mimeo. Research in Accounting Regulation. ³Financial Contracting. In R. Al . 2. pp. ³Emerging Standards for Islamic Financial Institutions: the Case of the Accounting & Auditing Organization for Islamic Financial Institutions´. y Ali. Vol. Corporate Governance and the Accounting Regulation of Islamic Banks´. pp. Governance Structures and the Accounting Regulation of Islamic Banks: An Analysis in Terms of Agency Theory and Transaction Cost Economics´. (2002). Abdel Karim & T. R. & T. Ahmad (2002). (2002) ³Risk Management in Islamic Banks´. April 6 ± 7.Banking Supervision and Prudential regulation in Islamic Finance 84 REFERENCE LIST y AAOIFI (1999). Islamic Finance: Innovation & Growth (pp. Special International Edition. M. Supplement 1. Euromoney Books and AAOIFI. S. published by . 2002 y Archer. y Archer. 149 ± 170. y Archer. Archer (Eds). Statement on the Purpose and calculation of the Capital Adequacy Ratio for Islamic Banks. & R. S. 97 ± 114.

Ahmed (2002). March. "Development of Islamic Financial Institutions and Challenges Ahead.Banking Supervision and Prudential regulation in Islamic Finance 85 y Basel Committee on Banking Supervision (BCBS) (2003). UK). y Errico. Khan (2000). (2001). y Chapra U. ³Regulation and Supervision of Islamic Banks´. y El Sheikkh. The Journal of International Banking Regulation. y Cunningham. ³Consultative Document-Overview of the New Basel Capital Accord´. y Chapra. 6. L. Bank for International Settlements. April (2003). UK. IMF/98/30. (London. "Legal Aspects of Islamic Finance". IMF working paper.) Islamic . Occasional Paper no. (Washington: International Monetary Fund. Islamic Research and Training Institute: Islamic Development Bank. ³Corporate Governance in Islamic Financial Institutions´.´ in Simon Archer and Rifaat Abdel Karim (eds. London. & M. Mahmoud (2002). A. y Fadeel.) Islamic Finance: Growth and Innovation. Euromoney Books. in Simon Archer and Rifaat Abdel Karim (eds. Fath El Rahman (2000). & H. ³Islamic Banking: Issues in Prudential Regulation and Supervision´. Zamir and Abbas Mirakhor (2002). pp 43 . Fall (2000). September (1998). y Iqbal. Occasional Paper no. 3. U. Islamic Research and Training Institute: Islamic Development Bank.49. Bank for International Settlements. & T. 1998). ³Enhancing Supervisory Bank Transparency: that Public Disclosure Safety and and Information Promote Soundness in Banking System´. ³Culture of Accounting: What are the Real Constraints for Islamic Finance in Riba-Based Global Economy?´ Moody's Investor Services. y Basel Committee On Banking Supervision (BCBS) (1998). Farrahbaksh (1998). ³The Regulation of Islamic Banks by Central Banks´.

y Khan. http://www. y Lewis. Y. y Khan. 1. T. 2. ³Islamic Interest . published by Euromoney Books and AAOIFI. 163 ± 175). 1. 33. Khan and Abbas Mirakhor. IMF Staff Papers. and Latifa M. Islamic Research and Training Institute: Islamic Development Bank. . In R. ³Islam and the Economic System´. UK) y Maroun. 36 (2). M. M. Mirakhor (1992). Vol. ³Liquidity Management and Trade Financing´. the International Journal of Accounting. London. (Texas. 1987).asp?ID=27 y Khan.. No. Mohsin S.27 y Khan. 1 . (1986). y Khan. Mohsin S. 2. (Edward Elgar: Cheltenham. 5. Algaoud (2001). December 1994 y Khan.com/article/Paging2. Mervyn K. ³Islamic Risk Management: Towards Financial Risk Management in Islamic Finance´. Ahmed (2001).Free Banking: A Theoretical Analysis´. Islamic Finance: Innovation & Growth (pp. pp. & A. y Karim. Review of Islamic Economics. & H. Occasional Paper no.ieicenter. Vol. pp. (1987) "Islamic Interest-Free Banking: A Theoretical Analysis´. pp. USA: The Institute of Islamic Studies. (2001). Fahim (1994). Rifaat Ahmed Abdel (2001). ³International Accounting Harmonization. Islamic Economic Studies.) Theoretical Studies in Islamic Banking and Finance. 169-193. UK. (2002). (ed. Abdel Karim & S. No.¶ in Mohsin S. Euro money Books. Archer (Eds). 2001. ³Risk Management: An Analysis of Issues in Islamic Financial Industry´. Vol. Islamic Banking. ³Comparative Economics of Some Islamic Financing Techniques´. T.Banking Supervision and Prudential regulation in Islamic Finance 86 Finance: Growth and Innovation. 1 . pp. Vol. Banking Regulation and Islamic Banks´. 15-36.29.

. ³Islamic Banking in Bangladesh: Achievements and Challenges´. Hayes 3 (1998). Dar. I. Islamic Banking: Answers to some Frequently Asked Questions. Errico (2002). 2005.) Islamic Banking and Finance. Edward Elgar. F. Journal of Islamic Economics and Finance. Occasional paper No. M. USA: Kluwer Law). y Sadr. Vol. IMF/02/192. E and S. Loughborough University.Banking Supervision and Prudential regulation in Islamic Finance 87 y Mulajawan. ³Islamic Financial Institutions and products in the Global Financial System: Key Issues in Risk Management and Challenges Ahead ´. y Al-Jarhi.B. & L. y Vogel. A.J.4. y Sarker. IDB. IMF working paper.L. J (2005) Basel 2 and corporate governance issues. Edinburgh University Press. Kualalunpur: IFSB. (2005). (Boston. July-December. 1. Islamic Research and Training Institute. Economics Research Paper. y Sundararajan. Islamic Finance in the Global Economy . No. UK. 2002). erp 02 ± 13. MA. . November. H." in Munawar Iqbal and David T. and Hall. (2002): ³A Capital Adequacy Framework for Islamic Banks: The Need to Reconcile Depositors¶s Risk Aversion With Managers¶ Risk Taking´. Llewellyn (eds. D. (2000). y Warde.A. (Washington: International Monetary Fund. Kazem and Zamir Iqbal (2002) "Choice between Debt and Equity Contracts and Asymmetrical Information: Some Empirical Evidence. y Caruana.1. V. In: 2nd Islamic Financial Services Board (IFSB) Summit 2005: The Rise and Effectiveness of Corporate Governance in the Islamic financial services industry. Islamic law and Finance. Doha. Mabid Ali and Munawar Iqbal (2001). A.

Banking Supervision and Prudential regulation in Islamic Finance 88 y Saunders. Prepared by the Arab Academy for Sciences. published by Nur Corp. USA. 2007 BIBLIOGRAPHY y El-Gari. MD. (1989). Technology and Maritime Transport.. ³General Characteristics of An Islamic Economic System´. Al-Hasani and A. y Mirakhor. Paper presented in a conference on Islamic Financial Industry in Alexandria. (2007). . Mirakhor (Eds). Harlow : Financial Times Prentice Hall.4 th M. Islamic Jordanian Bank and International Investment Kuwaiti Co. Student. Egypt. Essays on Iqtissad: The Islamic Approach to Economic Problems (pp45-80). ³Are Risks higher in Islamic banks than in their conventional counterparts?´. Research Methods for Business ed. A. in B. M (2000).

Banking Supervision and Prudential regulation in Islamic Finance 89 APPENDICES .

regulations and standards in the day to day operations of the Islamic banks should be the prime area of concern of the regulators and supervisors of the Islamic banks. Questionnaire 1 1) Does the Shariah supervision need any changes? Yes 2) If yes. Islamic financial institution should have a prudential regulation standard in regard to the systemic risks. 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Risks faced by an Islamic financial institution can be broadly classified into 5 categories and one of them is the systemic risks. what are the consequences of this crisis on the Islamic Banks? No consequences at all. 3) In your opinion.Banking Supervision and Prudential regulation in Islamic Finance 90 SAMPLES OF THE ANSWERS TO THE QUESTIONNAIRE SENT TO THE PARTICIPANTS. why? Identification of the probable rating areas for understanding and authentication of implementation status of Shariah rules. Because the Islamic banks has not been affected by the recent crisis. In my opinion. What I would suggest is to develop a ³Shariah Matrix´ or inspection areas through which one can understand what shariah instructions are an Islamic bank is following and what the areas of violations committed by this bank. .

Banking Supervision and Prudential regulation in Islamic Finance 91 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U. the offsite supervision is used as a ³wake up call´. On the other hand. which will push the supervisor to ask for onsite supervision. But some modifications should be made to the actual CAMELS in order to use in an Islamic environment. By examining authorities financial will be reports. What do you think of this strategy? As you know one of the causes of this recent crisis is the absence of a strong regulation. . able to the supervisory any kind of detect irregularities. the regulatory authorities should concentrate their effort in strengthening the banking regulation by forcing the banks to follow the recommendations made for example by the Basle committee or by the central banks of the G8 countries. and Europe? NO 6) Do you consider the offsite supervision as an important process? Offsite supervision carried out by central banks or independent supervisory authorities is an important step within the supervision process. 7) It seems that in general. the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. ORAP or CAMELS? I would choose CAMELS. the offsite supervision is less costly than the onsite supervision. In my opinion.S. Basically. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL.

are you optimistic or sceptical about the future of Islamic finance and its role within the international finance. Licensing procedure and is the guarantee protection of a fair our competition customer within Islamic banking industry. I think that this topic will involve many debates in the future.Banking Supervision and Prudential regulation in Islamic Finance 92 9) Is the licensing procedure an essential tool for the banking supervision? Yes. Can you tell us how the remuneration system functions within the Islamic banks? It¶s true that in conventional banking. In Islamic banking. I am optimistic because the Islamic finance industry knows a growth at a really rapid pace. the system of remuneration or the reward system is based on the financial performance of the bank. 11) Do you consider information disclosure as a vital aspect of the prudential regulation Framework? Information disclosure is the guarantee of a transparency for the financial operation. In fact licensing procedure is essential for any type of industry: manufacturing. top management still get huge bonuses even if the financial institution is losing money. 12) Given the evolution of the banking crisis. banking and others. . 10) The mode of remuneration of Banks CEO and traders has been criticized recently as a factor explaining the crisis. It also gives more information to the supervisory authorities to facilitate the conduct of supervision mission.

In my opinion. . One of the reasons is that the corporate governance has been in the origin of many financial scandals. So I think that the Islamic Financial Service Board should cooperate with regulators in Muslim countries to strengthen the prudential regulation framework. the IFSB should issue or develop an for appropriate prudential regulation framework corporate governance.Banking Supervision and Prudential regulation in Islamic Finance 93 13) Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision? The cooperation is a winning-winning strategy. 15) Can the standardisation of accounting standard improve the banking supervision? The standardisation of accounting reports has many positive sides and one of them is to increase the ability of a supervisory to efficiently supervise a financial institution. 14) Should the IFSB issue a prudential regulation standard regarding corporate governance? Corporate governance should be the primary target of any financial regulator around the world.

A close relation between the Shariah board and the management can lead to a conflict of interest which can damage the reputation of Islamic banks. prudential regulation is an undisputable part of any financial system.Banking Supervision and Prudential regulation in Islamic Finance 94 Questionnaire 2 1) Does the Shariah supervision need any changes? Yes 2) If yes. It¶s due to the fact that our customers know that we didn¶t invest in high risk financial product. liquidity risk can still affect Islamic banks.S. what are the consequences of this crisis on the Islamic Banks? There are no consequences whatsoever because the Islamic banks don¶t operate in the western financial market. 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U. Even if the Islamic finance is not affected by the risk related to interest rate. why? Shariah supervision should be completely independent from the management. . and Europe? NO. risks such as: counterpart risk. 3) In your opinion. credit risk. Prudential regulation framework guarantees the stability of the financial system. 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Yes.

As we know. What do you think of this strategy? I think that we can¶t leave a financial market without a financial regulator. ORAP or CAMELS? The American CAMELS will suit the Islamic banks. there is speculation on the financial market which to some extent led the world to this financial crisis.Banking Supervision and Prudential regulation in Islamic Finance 95 6) Do you consider the offsite supervision as an important process? No as long as there is an onsite supervision. Nevertheless. . CAMELS system has been in use by the American regulator for more than a decade and had proven its efficiency. any strategy aiming to regulate and organise the financial market will be more than welcome. But we have to note that some features of the actual CAMELS can¶t be applied in an Islamic environment. we also have to make sure that the financial regulation won¶t interfere in the financial operation because we live in liberal market. CAMELS still has to be adapted and modified in order to be used for supervising Islamic banks. For this reason. the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. 7) It seems that in general. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL. So.

Can you tell us how the remuneration system functions within the Islamic banks? As in any bank. the system of remuneration is mainly based on the performance of the bank within a specific period. On the other hand.Banking Supervision and Prudential regulation in Islamic Finance 96 9) Is the licensing procedure an essential tool for the banking supervision? In my opinion licensing procedure represent an extra protection for the banking system. licensing procedure will protect the customers and particularly their deposit for being managed by unqualified people. So we are optimistic about the future and we hope that it will reach the level of western finance. are you optimistic or sceptical about the future of Islamic finance and its role within the international finance. the Islamic finance has been experimenting a high growth. Licensing procedure set rules which have to be met in order to enter the banking industry and ensure a fair competition between banks within the industry. Since it appearances. 10) The mode of remuneration of Banks CEO and traders has been criticized recently as a factor explaining the crisis. 12) Given the evolution of the banking crisis. 11) Do you consider information disclosure as a vital aspect of the prudential regulation Framework? I don¶t think that the information disclosure is essential in the Islamic banking because all our financial operations enjoy a high level of transparency. 13) Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision? .

IIRA or even the Basle Committee of banking supervision. 14) Should the IFSB issue a prudential regulation standard regarding corporate governance? No before our company act already set guidelines for efficient and fair corporate governance. 15) Can the standardisation of accounting standard improve the banking supervision? YES .Banking Supervision and Prudential regulation in Islamic Finance 97 IFSB can only benefit from an external cooperation with other organisation. The IFSB can have potential partner such as: AAOIFI.

7) It seems that in general. the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. and Europe? NO 6) Do you consider the offsite supervision as an important process? Offsite supervision represents an undisputable part of the supervision process which also includes the onsite supervision. why? Shariah supervision should be independent from the management of Islamic banks which means that the department of Shariah supervision should not included within the structure of the Islamic banks.Banking Supervision and Prudential regulation in Islamic Finance 98 Questionnaire 3 1) Does the Shariah supervision need any changes? Yes 2) If yes. What do you think of this strategy? We can¶t leave the financial market without regulator because it¶s the authority in charge ensuring that the . 3) In your opinion. what are the consequences of this crisis on the Islamic Banks? The Islamic banks have not been affected by the subprime crisis 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Yes 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S.

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99

core rules of finance are respected by the players. Personally, I am strong supporter of a strategy that will lead to a regulated financial market. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? CAMELS 9) Is the licensing procedure an essential tool for the banking supervision? The Islamic finance (especially the banking industry) suffers from the absence of licensing procedure which makes to For it difficult the for the supervisory of the new

authorities entrants.

control this

legality the

reason,

regulator

should

concentrate on developing a licensing procedure framework. 10) The mode of remuneration of Banks CEO and traders

has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? The system of rewards is based on the financial performance of the bank. 11) Do you consider information disclosure as a vital

aspect of the prudential regulation Framework? Information disclosure must be included in the prudential regulation framework. Indeed, the

existence of a high level of counterpart risk in Islamic financial operations makes the information disclosure undisputable in order to carry out

effective banking supervision.

Banking Supervision and Prudential regulation in Islamic Finance

100

12)

Given the evolution of the banking crisis, are you

optimistic or sceptical about the future of Islamic finance and its role within the international finance. I am optimistic for the future of the Islamic Finance. 13) Do you believe that the IFSB should cooperate more

with other organisations in terms of banking supervision? Cooperation can only be beneficial. 14) Should the IFSB issue a prudential regulation

standard regarding corporate governance? Corporate governance has been the nightmare of many big companies because it was the origin of their failures. Knowing that bad corporate

governance has been the cause of many financial scandals, the IFSB should develop a prudential

regulation standard regarding corporate governance. 15) Can the standardisation of accounting standard

improve the banking supervision? Yes

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Questionnaire 4

1) Does the Shariah supervision need any changes? Yes 2) If yes, why? Shariah supervision should be independent from the management of Islamic banks which means that the department of shariah supervision should not

included within the structure of the Islamic banks. 3) In your opinion, what are the consequences of this crisis on the Islamic Banks? The Islamic banks have not been affected by the subprime crisis 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Yes 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? NO 6) Do you consider the offsite supervision as an important process? Offsite supervision represents an undisputable part of the supervision process which also includes the onsite supervision. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? We can¶t leave the financial market without regulator because it¶s the authority in charge ensuring that the

regulator should concentrate on developing a licensing procedure framework. . Personally. I am strong supporter of a strategy that will lead to a regulated financial market. the existence of a high level of counterpart risk in Islamic financial operations makes the information disclosure undisputable in order to carry out effective banking supervision. control this legality the reason. 10) The mode of remuneration of Banks CEO and traders has been criticized recently as a factor explaining the crisis.Banking Supervision and Prudential regulation in Islamic Finance 102 core rules of finance are respected by the players. Indeed. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL. ORAP or CAMELS? CAMELS 9) Is the licensing procedure an essential tool for the banking supervision? The Islamic finance (especially the banking industry) suffers from the absence of licensing procedure which makes to For it difficult the for the supervisory of the new authorities entrants. 11) Do you consider information disclosure as a vital aspect of the prudential regulation Framework? Information disclosure must be included in the prudential regulation framework. Can you tell us how the remuneration system functions within the Islamic banks? The system of rewards is based on the financial performance of the bank.

are you optimistic or sceptical about the future of Islamic finance and its role within the international finance.Banking Supervision and Prudential regulation in Islamic Finance 103 12) Given the evolution of the banking crisis. 14) Should the IFSB issue a prudential regulation standard regarding corporate governance? Corporate governance has been the nightmare of many big companies because it was the origin of their failures. 15) Can the standardisation of accounting standard improve the banking supervision? Yes . the IFSB should develop a prudential regulation standard regarding corporate governance. 13) Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision? Cooperation can only be beneficial. Knowing that bad corporate governance has been the cause of many financial scandals. I am optimistic for the future of the Islamic Finance.

the strategy of regulation is the strategy which will bring the stability to the financial markets. and Europe? NO 6) Do you consider the offsite supervision as an important process? Offsite supervision is important because it¶s the step before the onsite supervision. What do you think of this strategy? It¶s true that if we had more regulation this crisis could be avoided. the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis.S. 7) It seems that in general.Banking Supervision and Prudential regulation in Islamic Finance 104 Questionnaire 5 1) Does the Shariah supervision need any changes? No 2) If yes. why? 3) In your opinion. . 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Yes 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U. For this reason. what are the consequences of this crisis on the Islamic Banks? No consequences because it¶s only the western finance which has been affected by the subprime crisis.

And I think that the IFSB should use these recommendations as a referential to develop prudential regulation framework in regards to information disclosure. 11) Do you consider information disclosure as a vital aspect of the prudential regulation Framework? Yes. 12) Given the evolution of the banking crisis. Can you tell us how the remuneration system functions within the Islamic banks? I am not allowed to disclose our policy in regard to remuneration. I am optimistic for its future.Banking Supervision and Prudential regulation in Islamic Finance 105 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL. . 9) Is the licensing procedure an essential tool for the banking supervision? Licensing procedure is the insurance for a fair competition in the Islamic banking industry. 10) The mode of remuneration of Banks CEO and traders has been criticized recently as a factor explaining the crisis. are you optimistic or sceptical about the future of Islamic finance and its role within the international finance. has with Basle committee for supervision developed the many recommendations dealing information disclosure framework. Information disclosure represents the black dot in Islamic banking because there is absence of regulation banking in this matter. I think that regulator should and must include this factor in their supervisory process. ORAP or CAMELS? I think the CAMELS will be the appropriate rating system.

Banking Supervision and Prudential regulation in Islamic Finance 106 13) Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision? I think that the IFSB should cooperate more with the Basle committee on banking supervision. 14) Should the IFSB issue a prudential regulation standard regarding corporate governance? Yes and in fact I urge the IFSB to do so. 15) Can the standardisation of accounting standard improve the banking supervision? Yes .

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Questionnaire 6

16) NO

Does the Shariah supervision need any changes?

2) If yes, which kind of changes? 3) In your opinion, what are the consequences of this crisis on the Islamic Banks? The Islamic banks are not affected at all because our financial operations are interest free. 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? I think any type of financial system should be regulated by a prudential regulation framework. We all know that the banking system should be monitored in order to ensure its stability and its soundness. For this reason, the IFSB (Islamic financial service board) promotes and enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors. 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? No

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6) Do you consider the offsite supervision as an important process? As I mentioned before, the banking supervision is an important aspect of any financial system. The offsite supervision enables the regulator to

supervise the bank through the investigation of periodic report. Indeed, the offsite supervision helps the regulator to draw a picture of the financial situation of a particular bank. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? The trend in the recent years was to encourage a less regulated financial market. But the subprime crisis showed that a less regulated market encouraged the bank to lend risky loans without backing them with enough provisions. We learned from this crisis that the banking supervision should be tighten in order to avoid any other crisis. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? I think PATROL will be appropriate. PATROL is an Italian system which enables the regulator to have a representation of the financial situation of a particular bank. PATROL stands for: capital

adequacy, profitability, credit quality, organisation and liquidity.

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9) Is the licensing procedure an essential tool for the banking supervision? Not really. As long as there is an efficient and permanent supervision of Islamic banks, I don¶t think that the regulator should emphasis on the licensing procedure. 10) The mode of remuneration of Banks CEO and traders

has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? Sorry it¶s confidential matter 11) Do you consider information disclosure as a vital

aspect of the prudential regulation Framework? No, because as you know our operations are based on A Profit-Loss Sharing mode. So we share the profits and the losses of the operation with the client which force us to inform our customers about risk surrounding the contract. 12) Given the evolution of the banking crisis, are you

optimistic or sceptical about the future of Islamic finance and its role within the international finance. Because the Islamic finance didn¶t get affected from the current crisis, so it shows that Islamic banking is quiet stable and we can only be optimistic. 13) Do you believe that the IFSB should cooperate more

with other organisations in terms of banking supervision? Absolutely I think that the IFSB should learn more from the Basle committee of banking supervision on how effectively apply the prudential regulation standard developed.

Corporate governance is well defined in our company act. 15) Can the standardisation of accounting standard improve the banking supervision? Personally I don¶t think so .Banking Supervision and Prudential regulation in Islamic Finance 110 14) Should the IFSB issue a prudential regulation standard regarding corporate governance? No. Therefore I don¶t we need a standard in this matter.

In Islamic finance we already have the IFSB which develops prudential regulation standards and the AAIOFI which is in charge of the accounting and auditing matters. why? I think we should have an independent organisation in charge of supervising the Shariah compliance of financial products. 3) In your opinion. When there is financial operation between two parties there is always a potential systemic risk. 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? YES. Systemic risks are present in both conventional and Islamic financial system. and Europe? NO .S. in my opinion we should follow the same idea and create Shariah service board which will approve or disapprove the Shariah compliance of Islamic financial products.Banking Supervision and Prudential regulation in Islamic Finance 111 Questionnaire 7 1) Does the Shariah supervision need any changes? Yes 2) If yes. So. I do believe that the IFSB (Islamic Financial Service Board) should develop standard in regards to this matter. what are the consequences of this crisis on the Islamic Banks? None because our financial system is a free interest based system. For this reason. 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.

Banking Supervision and Prudential regulation in Islamic Finance 112 6) Do you consider the offsite supervision as an important process? Not really. What do you think of this strategy? It¶s always good to have an authority to police or regulate the financial market. 7) It seems that in general. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL. the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. . There are so many funds invested in the financial markets around world that we can¶t leave it without an appropriate regulation. Regarding the banking supervision matter. Licensing procedure protects the customers from illegal banks and it also ensures that there is a fair competition within the banking industry. licensing procedure enable the regulator to check if the potential bank meet all the requirement of the banking industry. In answer to your question. but also for the entire banking industry. 9) Is the licensing procedure an essential tool for the banking supervision? Licensing procedure isn¶t only essential for the banking supervision. ORAP or CAMELS? ORAP rating system can be adapted for the Islamic environment. I think that the onsite supervision provide the supervisor with enough information about the supervised bank. I support this strategy because it reduces speculation (bad ones) and increase the public confidence toward the transparency of the financial markets.

are you optimistic or sceptical about the future of Islamic finance and its role within the international finance.Banking Supervision and Prudential regulation in Islamic Finance 113 10) The mode of remuneration of Banks CEO and traders has been criticized recently as a factor explaining the crisis. . Can you tell us how the remuneration system functions within the Islamic banks? The system of remuneration is mainly based on the financial performance of the Islamic financial institution. Islamic finance can¶t compete with the conventional one because the Islamic finance or the Islamic financial products are for Muslim clients. However. we can¶t offer our financial product to all type of customers. I think that information disclosure standard in an Islamic environment should encourage the Islamic banks to provide the following data: type of securities. 11) Do you consider information disclosure as a vital aspect of the prudential regulation Framework? Information reduces disclosure is paramount because to it information asymmetries due the unrestricted Mudaraba contract between an Islamic bank and its depositors. the Islamic finance is growing at rapid and sustain pace which will only increase our confidence for its future. investment policies. 12) Given the evolution of the banking crisis. Personally. So.

My bank has even urged the IFSB to develop standard which will represent the guidelines for effective and fair corporate governance. . 15) Can the standardisation of accounting standard improve the banking supervision? I have to note that the standardisation of account reports is in process.Banking Supervision and Prudential regulation in Islamic Finance 114 13) Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision? As we know. 14) Should the IFSB issue a prudential regulation standard regarding corporate governance? Corporate governance is too important to be left without a prudential regulation standard. London and I mean the City represent the Global hub of Islamic finance in the world. What I would recommend. is that the IFSB can cooperate with the FSA (Financial service authority) to develop prudential regulation standard for Islamic banks. The standardisation of account reporting will facilitate the work of the supervisor and will increase the transparency of the accounts.

There must be clearly delineated lines of communication between management and Shariah supervision. I would recommend appointing one person to be in charge of coordinating and documenting regular meetings. We know that the success of any undertaking is communication. Moreover. . For this reason. following and up on decisions and and processing channelling communications to and from supervision. 3) In your opinion. which kind of changes ? I think that the Shariah board should keep in touch with the top management. suggestions.Banking Supervision and Prudential regulation in Islamic Finance 115 Questionnaire 8 1) Does the Shariah supervision need any changes? YES 2) If yes. arranging for the requirements of shariah supervision. in 2002 a group of Arab central banks decided to create the IFSB which is the equivalent of the Basle committee. what are the consequences of this crisis on the Islamic Banks? None 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Absolutely because I don¶t think any financial system could survive without an appropriate prudential regulation framework.

so there is no need for offsite supervision. .Banking Supervision and Prudential regulation in Islamic Finance 116 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U. What do you think of this strategy? I think that the American understood that free market doesn¶t mean necessarily free regulation. 7) It seems that in general. Regulation exists to protect both public investors and financial institutions by ensuring the financial stability of the financial institutions. the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. ORAP or CAMELS? CAMELS can be adapted to the Islamic environment. 9) Is the licensing procedure an essential tool for the banking supervision? Licensing procedure helps To establish an effective entry policy in the banking industry is a key factor to protect the public faith and the banking system from unfair and dangerous competition from undercapitalised. ill-conceived banks or those that are operated by unqualified or less reputable owners and managers.S. and Europe? As far as I know none of our customers none of our customers claimed or withdraw their deposits. 6) Do you consider the offsite supervision as an important process? If there is onsite supervision. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL.

11) Do you consider information disclosure as a vital aspect of the prudential regulation Framework? No. are you optimistic or sceptical about the future of Islamic finance and its role within the international finance. is In based our on the performance bank (BMCE MOROCCO) the remuneration system is based on the financial performance of our employees during the financial year.Banking Supervision and Prudential regulation in Islamic Finance 117 10) The mode of remuneration of Banks CEO and traders has been criticized recently as a factor explaini ng the crisis. I have to say that Islamic finance is quiet recent and didn¶t experiment any kind of crisis. Can you tell us how the remuneration system functions within the Islamic banks? The remuneration of the system bank. . With the sustainable growth of Islamic finance. liquidity risk and capital adequacy. Islamic finance cannot compete with conventional finance. we can say than in international finance. For this reason. I am optimistic for its future. I think the supervisory authorities should focus more on issues like credit risk. 12) Given the evolution of the banking crisis. Islamic finance represents an alternative for Muslim customers whom don¶t to invest in western finance. because we provide our financial product only to Muslim customers.

14) Should the IFSB issue a prudential regulation standard regarding corporate governance? No it¶s not necessary 15) Can the standardisation of accounting standard improve the banking supervision? Yes because having a common account reporting will help the supervisory authorities to efficiently analyse the financial reports and compare them a predetermined referential. .Banking Supervision and Prudential regulation in Islamic Finance 118 13) Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision? The IFSB should cooperate with Arab central banks and private rating agencies with intention of developing a wide prudential regulation framework for the Islamic banking industry.

Efforts therefore need to be enhanced to fully appreciate and maximise the true potential and wisdom of the Shariah. researchers and regulators to undertake in depth studies and research to create new products will provide the fundamental foundation towards the development of dynamic Islamic financial system. what are the consequences of this crisis on the Islamic Banks? None 20) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Absolutely. The expansion of Islamic banking industry has created both expectations and apprehensions simultaneously. . rather a constraint. the prudential regulation represents one of the bases of any financial system. 19) In your opinion. The Shariah should always be viewed as an enabler to innovation and creativity. practitioners. The collaboration among the Shariah scholars. why? One of the central issues towards developing a dynamic Islamic financial industry is the Shariah.Banking Supervision and Prudential regulation in Islamic Finance 119 Questionnaire 9 17) Yes 18) Does the Shariah supervision need any changes? If yes. Risk is inherent in every financial innovation.

23) It seems that in general. and Europe? No. 24) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL.g. All our clients know that we were not affected by the subprime crisis because our mortgage loan policy isn¶t based on interest rate.Banking Supervision and Prudential regulation in Islamic Finance 120 21) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U. . The second objective will be to reduce the risks of by disruption the of the normal in business terms of performed financial system payments on the provision of liquidity. depositors) who are otherwise unable to undertake the necessary due diligence to assess these risks. ORAP or CAMELS? I would choose CAMELS. the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. The foremost objective is to alleviate risks taken by stakeholders (e.S. What do you think of this strategy? This strategy is necessary because many scholars argued that regulation provides a public good that the market cannot supply on its own. 22) Do you consider the offsite supervision as an important process? No as long as there is an onsite supervision.

26) The mode of remuneration of Banks CEO and traders has been criticized recently as a factor explaining the crisis. we can only be optimistic for the future. 28) Given the evolution of the banking crisis. 27) Do you consider information disclosure as a vital aspect of the prudential regulation Framework? No. I think that because the Islamic banking industry is recent. 29) Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision? Yes.Banking Supervision and Prudential regulation in Islamic Finance 121 25) Is the licensing procedure an essential tool for the banking supervision? Licensing procedure is essential particularly in a rapidly licensing changing procedure environment. framework will An adequate the protect consumers from fraudulent banks. are you optimistic or sceptical about the future of Islamic finance and its role within the international finance. not really. In my opinion there are still few challenges facing our banking industry and which we have to overcome. But with the real growth within the industry. we should be developing standard in order to prevent systemic risks. the regulator can use the licensing procedure to monitor the competition within the Islamic banking industry. Can you tell us how the remuneration system functions within the Islamic banks? The mode of remuneration is based on the performance of the bank. Also. IFSB and IIRA should work together in order to: y y Develop prudential regulation standard Conduct onsite supervision .

31) Can the standardisation of accounting standard improve the banking supervision? Yes. . Its emphasis is to be value oriented and promote fairness and justice with respect to all stakeholders of the banking institution. and strengthening transparency and accountability. regulation contributes towards maintaining market confidence. and I think it should be one of the priority of the IFSB. The establishment organisation (AAOIFI) of for has the accounting and auditing institutions Islamic made a financial significant contribution in formulating and issuing accounting and auditing standards for Islamic financial institution.Banking Supervision and Prudential regulation in Islamic Finance 122 30) Should the IFSB issue a prudential regulation standard regarding corporate governance? Yes. It is recognised reinforces It that sound good corporate and governance supervision.

. What do you think of this strategy? I totally approve it. 38) It seems that in general. the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. why? In your opinion. We should remember that the causes of this crisis were: high risk financial product not backed by an appropriate provision. and Europe? NO 37) Do you consider the offsite supervision as an important process? No as long as there is an onsite supervision. 35) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? YES 36) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U. and the absence of regulation. I will say that regulation and particularly supervision would guarantee a stable and sound financial system. what are the consequences of this crisis on the Islamic Banks? The subprime crisis only affects financial institutions operating in the financial system based on interest.S.Banking Supervision and Prudential regulation in Islamic Finance 123 Questionnaire 10 32) No 33) 34) Does the Shariah supervision need any changes? If yes.

set rules for internal controls and external audit functions. 40) Is the licensing procedure an essential tool for the banking supervision? Yes because it¶s the best way to prevent the Islamic banks from an unfair competition. y Business plan: any license application should include a business plan. set rules which can prevent the bank from a conflict of interests. ORAP will enable the supervisory authorities to highlight potential weaknesses in banking institutions by examining all components of risk associated to a financial operation. y Transparency: requirement for banking license should be published and applied.Banking Supervision and Prudential regulation in Islamic Finance 124 39) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL. ORAP will be adequate for the Islamic financial institution. y Define the activities: define to what extent an Islamic bank can take equity positions in non financial companies. . ORAP or CAMELS? In my opinion. y Capital requirement: set minimum levels and composition of initial capital. I think that licensing procedure in Islamic banking should require the following information: y Ground rules: define the organisational structure of the bank.

42) Do you consider information disclosure as a vital aspect of the prudential regulation Framework? No 43) Given the evolution of the banking crisis. Yes I am quite optimistic for its future. Sorry. I think our internal company act define clearly our mission statement. Can you tell us how the remuneration system functions within the Islamic banks? I am not allowed to disclose this kind of information. 46) Can the standardisation of accounting standard improve the banking supervision? Yes .Banking Supervision and Prudential regulation in Islamic Finance 125 41) The mode of remuneration of Banks CEO and traders has been criticized recently as a factor explaining the crisis. 45) Should the IFSB issue a prudential regulation standard regarding corporate governance? No. 44) Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision? Yes particularly with the AAOIFI (Accounting and auditing organisation in order to for Islamic the financial prudential institutions) develop regulation framework. voluntary corporate bodies and personalities. are you optimistic or sceptical about the future of Islamic finance and its role within the international finance.

if the negligence or mismanagement of the entrepreneur can be proven he may be held responsible for the financial losses incurred (Syedain.Banking Supervision and Prudential regulation in Islamic Finance 126 Table : Islamic modes of financing Type PLS Modes Mudaraba Description Profit and Loss sharing modes Trustee finance contract the bank provides the entire capital needed for financing a project. The his liability of the entrepreneur limited only to time and efforts. 2004). It affects both assets and liabilities sides of banks¶ balance sheet. On the assets side. Financial losses are borne exclusively is by the bank. Financial losses are borne exclusively by the bank and the entrepreneur at a certain fixed ratio (Syedain. while entrepreneur offers his labour and expertise. 1999). It is usually employed in investment projects with short gestation periods and in trade and commerce. 2004). . On the liabilities side. The profits (or losses) from the project are shared between the bank and the entrepreneur at a certain fixed ratio. to finance an open-ended list of profitable investment and expect to share with the bank the overall profits accruing to the banks¶ business. at its discretion. the contract between the bank and the depositors is known as unrestricted Mudaraba because depositors agree that their funds be used by the bank. However. the contract between the bank and the agent entrepreneur is known as restricted Mudaraba because the bank agrees to finance a specific project carried out by a specific agent-entrepreneur and to share the relative profits according to a certain percentage (Uzair.

The bank cannot invest in the production of goods and services which contradict the value pattern of Islam. 2000). such gambling (AlShahi. 2000). Muzar¶ah Traditional counterpart of the Mudaraba contract in farming (Al-Shahi. The bank may provide funds or land. The harvest is shared between the bank and the entrepreneur. 2000). 2000). The harvest is shared among the partners based on their respective contributions. Direct Investment The same concept as in conventional banking. Two or more partners contribute to the joint capital of an investment (Al -shahi. Musaqat Traditional counterpart of the Musharaka contract in orchard keeping (Zaidi.Banking Supervision and Prudential regulation in Islamic Finance 127 Musharaka Equity participation contract The bank is not the sole provider of funds to finance a project. 2001). It is usually employed to finance long-term investment projects (Al-Shahi. Profits (and losses) are shared strictly in relation to the respective capital contributions. Non-PLS Modes Non profit and loss sharing modes .

Banks are allowed to charge the borrowers a service fee to cover the administrative expenses of handling the loan. In the case of a lease-purchase. Usually. The price of the product is agreed upon between the buyer and the seller at the time of the sale and cannot include any charge for deferring payments (Zarqa. it applies to agricultural or manufactured products. Bai¶Salam or Bai¶Salaf Purchase with deferred delivery The buyer pays the seller the full negotiated price of a product that the seller promises to deliver at a future date. provided that the fee is not related to the amount or maturity of the loan (Zarqa.Banking Supervision and Prudential regulation in Islamic Finance 128 Qard Hasanah al Beneficence loans These are zero-return loans that the Quran exhorts Muslims to make to ³those who need them´. 2006). 2006). Bai¶ Mua¶jjal Deferred payment sales The seller can sell a product on the basis of a deferred payment in instalments or in a lump sum payment. 2004). each payment includes a portion that goes toward the final purchase and transfer of ownership of the product (Subbulakshmi. . Ijara Ijara Iqtina or wa Leasing A party leases a particular product for a specific sum and a specific period of time. 2006). This mode only applies to products whose quality and quantity can be fully specified at the time the contract is made (Zarqa.

This mode usually applies to transactions such as consultations and professional services. The total cost is usually paid in instalments (Subbulakshmi. 2004). . then profit margin (or markup) is negotiated between the buyer and the seller. Jo¶alah Service Charge A party undertakes to pay another party a specified amount of money as a fee for rendering a specified service in accordance to the terms of the contract stipulated between the two parties. fund placements. and trust services (Subbulakshmi. 2004).Banking Supervision and Prudential regulation in Islamic Finance 129 Murabaha Mark-up The seller informs the buyer of his cost of acquiring or producing a specified product.

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