In This Chapter
Interacting across the aisle as an individual bank
Participating in the global financial industry
Tracing the relationship between Islamic banks and regulatory banks
Islamic banking has become an important sector in the world’s financial industry. More than 300 Islamic banks are operating globally. In the past, Islamic banking was considered a niche market, but as I demonstrate in Chapter 4, it has grown to become the major market in many countries.
As I discuss in Chapter 7, some key differences exist between conventional and Islamic commercial banking (as well as many similarities). Despite these differences, the two systems have to work with each other in nations and regions where they coexist. And because Islamic banks are already operating in more than 50 nations, the systems coexist pretty frequently.
As I explain in the later section “Seeing how Islamic banks fit into national banking systems,” some countries (such as Pakistan, Malaysia, and Bahrain) have a dual financial system, meaning they practice both conventional and Islamic finance. In many more countries (including the United Kingdom and Singapore), Islamic banks operate under the existing conventional bank legal framework, but the regulations that they must follow may differ from the regulations that apply to conventional banks.
In addition, major international conventional banks such as Citibank, Standard Chartered, HSBC, and UBS operate Islamic banking windows. So even though the systems are conceptually different, Islamic commercial banks must cooperate with conventional commercial banks and vice versa. In this chapter, I illustrate what that cooperation looks like both in theory and in practice.
Also, because Islamic banks often (but not always) function within the framework of a conventional central banking system, examining the relationship between Islamic and national central banks is important. I cover that topic in this chapter as well.
Understanding the Nature of Individual Banks’ Cooperation
Islamic banks need to interact efficiently with conventional banks so that, even in markets where both types of banks are functioning with a conventional banking legal framework, the Islamic banks can operate effectively and give their customers what they need.
Cooperation does not mean that Islamic banks must become involved in interest-based transactions, speculation, gambling, or other business practices considered unethical per sharia. (As I explain in Chapters 1 and 7, some offerings of conventional banks violate the principles on which Islamic banks are founded and operate.) Instead, Islamic and conventional banking systems must find common ground, based on their respective legal and regulatory requirements and on mutual understanding, in order to work together for the sake of serving customers. A functional working relationship can help both types of banks.
In this section, I focus on the types of day-to-day cooperation that exist among individual Islamic and conventional banking units. In the later section “Observing Regulations of Central Banks,” I turn my attention to cooperation between Islamic banks and the institutions responsible for planning, supervising, and implementing financial regulations — usually the central banks of countries in which Islamic commercial banks operate.
Connecting across borders
Many customers of Islamic banks do business internationally. Depending on which nations their businesses take them to, they often don’t have access to branches of their own home banks, so they need to interact with conventional banks.
Say you’re a customer with accounts at an Islamic bank in Malaysia, and you want to do business in Ireland (where your Islamic bank doesn’t operate). Your home bank needs to cooperate and interact with a conventional bank in Ireland (because no Islamic banks are operating in Ireland to date) to help you get what you need.
What type of interaction am I talking about? If you’re in Ireland and discover that a great business opportunity awaits as long as you act quickly — perhaps you’ve happened upon a pot of gold for sale that you simply can’t pass up — you may need to get your hands on some cash fast. In that case, your Islamic bank and the conventional bank in Ireland need to arrange a bank transfer so you can pad your wallet. In other cases, you may need the conventional bank to issue a letter of credit, issue traveler’s checks, assist you with bill collection, and so on. Your home Islamic bank and the foreign conventional bank should be able to coordinate all these activities smoothly so you experience no disruption of service. The only stipulation is that your Islamic bank can’t participate in activities that aren’t sharia-compliant.
Issuing letters of credit
International transactions often involve large sums of money; most people can’t just whip out their credit cards or checkbooks and wrap up the transaction. Instead, they need to show the other party that they’re good for the money, so they need to provide a letter of credit.
A letter of credit is a document that provides a financial guarantee; when your bank issues a letter of credit (most often to facilitate international trade activities), it provides a written promise to the exporter (seller) that you (the importer/buyer) have sufficient funds to make the purchase. It also assures you that the exporter will be paid as soon as he submits the shipping documents to his bank.
To continue the earlier example, when you need to secure a letter of credit to buy the pot of gold in Ireland, you may work with a conventional bank — perhaps the exporter’s home bank — that communicates with your home (Islamic) bank. Your home bank provides the assurance to the foreign bank that you’re good for the money, and the foreign bank issues the letter of credit. Your bank then needs to deposit the funds in question into the foreign bank to cover the amount specified in the letter of credit.
If both banks were conventional commercial banks, the home bank would make an arrangement with the foreign bank for a short-term overdraft with daily interest charges. In other words, the foreign bank would let you have the letter of credit immediately; the home bank would begin a transfer of funds; and the foreign bank would be paid interest for each day until the funds actually arrive.
But because your home bank is an Islamic bank, this interest-based agreement doesn’t fly. Instead, the banks need to use one of the following alternative arrangements:
A one-time no-interest overdraft: The Islamic bank makes arrangements with the conventional foreign bank to grant a short-term loan without any interest charges. The conventional bank agrees to this arrangement for the sake of developing relations with the Islamic bank (the flexibility now may lead to reciprocal no-interest overdrafts in the future) and/or for the sake of serving the supplier/exporter if that person or entity is a customer.
An ongoing no-interest arrangement for both parties: The Islamic bank and the conventional bank agree to establish a reciprocal, ongoing arrangement for interest-free overdraft facilities. The Islamic bank doesn’t charge interest for overdraft in the conventional bank, and vice versa.
In addition to avoiding any interbank interest charges, an Islamic bank also must avoid charging a fee for the letter of credit that in any way relates to the amount of the credit. As the buyer, you’re responsible for paying the bank for the work required to issue the letter of credit. A conventional bank charges a fee that is proportionate to the amount of the letter of credit, but Islamic banks aren’t allowed to do so. (An Islamic bank also can’t be involved in any transaction in which a corresponding conventional bank would charge such a fee.) Islamic banks are allowed to charge fixed fees for letters of credit (and other services) based on the rulings of their sharia boards. (I discuss the role of sharia boards in Chapter 16.)
Another way for an Islamic bank to make sure its customers can secure letters of credit when doing business across borders is to have an ongoing relationship with a bank in every country and every major city. The Islamic bank opens a credit account with the corresponding foreign bank. First preference, of course, is given to a foreign Islamic bank simply because doing so reduces the complexity involved in interbank transactions. But if another Islamic bank isn’t available in the given locale, the relationship is established instead with a conventional bank. The Islamic bank keeps a surplus amount of money in the corresponding conventional bank to cover letters of credit so that no interest charges or fees are involved.
Representing each other (for a commission)
In theory, an Islamic bank and a conventional bank could establish an agreement to represent each other in places where one partner has no branches. (I don’t know of any banks that currently have such an agreement in place.) In this case, one bank would represent the other bank by opening accounts in the second bank’s name, and both banks would agree not to charge each other any interest. Each bank would collect bank drafts and checks on the other bank’s behalf. To make sure the relationship is mutually beneficial (especially if the arrangement is somewhat lopsided, with one bank doing more business on the other’s behalf), the two banks may charge each other a commission for the services performed.
Offering sharia-compliant windows at conventional banks
As I explain in Chapter 4, an overt example of cooperation between conventional and Islamic banks exists when a conventional bank operates an Islamic window as part of its daily business. The Islamic window is an integral part of the bank, and the two sides of the business may share management and/or staff, develop products together, transfer funds, and undertake other cooperative activities — all while the window maintains its identity as a sharia-compliant entity. For example, Lloyds TSB Islamic windows assure that money deposited in Islamic business accounts is used only for sharia-compliant financing.
Scholars continue to debate the sharia compliance of the Islamic window setup, primarily because of the issue of where the funds come from to establish the institution. Many scholars encourage these windows, branches, and subsidiaries to become standalone Islamic banks.
Neither conventional nor Islamic banks stand alone all the time; they often need to share funds to manage their operations. Islamic banks exchange funds with conventional banks according to sharia law, which means that the transactions can’t involve interest (or gambling, speculation, or investment in businesses that engage in practices deemed unethical by Islamic standards). Following are the methods by which Islamic and conventional banks can exchange funds:
Transferring funds from the conventional to the Islamic bank: When an Islamic bank receives funds from a conventional bank — conventional banks rarely receive money from Islamic banks — the transfer is considered an investment account. The return is calculated according to a mudaraba contract (just as it is when the Islamic bank’s regular customers deposit money); see Chapters 9 and 10 for details on Islamic bank operations and offerings.
Cooperating to finance a capital project: Some Islamic banks, with the approval of their sharia boards, cooperate with conventional banks for the joint financing of sharia-compliant capital projects, including those that focus on developing a nation’s infrastructure and industry.
In addition, a conventional bank and an Islamic bank can cooperate with each other to finance international trade on the basis of mudaraba, murabaha, musharaka, or ijara contracts. Very briefly, here is what each term means (I offer much more detail in Chapter 10):
• Mudaraba: This contract is based on a partnership agreement. One party is a fund manager, and the other party is an investor. Both share any profits derived from the project.
• Murabaha: In this cost plus contract, a buyer purchases a property or asset from a seller for the item’s cost plus an agreed-upon profit margin, and the payment may be deferred.
• Musharaka: Under this contract, both parties contribute to the capital, which makes it a joint-venture project. The profit and loss are shared between both parties.
• Ijara: This contract is similar to a conventional leasing contract. An asset is leased out, and the ownership rights and all the liabilities remain with the owner.
These types of contracts reduce the risk involved in financing capital projects and offer a fair guaranteed return for the investments. Most often international co-financing supports major projects such as developing infrastructure, purchasing industrial equipment, and putting up buildings.
Conducting foreign exchanges: Banks involved in international business need to convert currencies to complete transactions. For example, suppose that an Islamic bank in London needs money in U.S. dollars in order to complete an international transaction. It may approach a conventional bank that has a surplus of U.S. currency and needs British pounds in exchange. The two banks create a barter agreement to fill their respective currency needs.
Banking on Financial Industry Common Ground
To facilitate cooperation among Islamic and conventional banks, Islamic banks are members of banking associations and institutions; they’re active partners in identifying industry-wide issues and finding solutions. Islamic banks often participate in national-level and international-level events to demonstrate that they’re a key part of the global industry and to ease international transactions. These days, banking journals and other periodicals often devote separate sections to Islamic banking, which raises awareness of special considerations for Islamic banks and the interaction among banks as well.
In the following sections, I outline how conventional and Islamic banks interact in ways that assist the industry as a whole — not just for specific purposes of customer service.
All banks — Islamic and conventional — need to coordinate with each other in transferring information regarding common customers (whether individual clients or corporations) and projects. This information benefits each bank economically. For example, an Islamic bank can provide information to a conventional bank about the financial standing of a specific customer or project, and vice versa. This sharing of information helps both banks make decisions about lending or investment opportunities related to the entity in question.
Developing human resources
Islamic and conventional commercial banks can (and should) cooperate on human resource development as well. Islamic banks are conceptually different from conventional banks (refer to Chapter 7), but Islamic banks mostly use the same financial techniques used by conventional banks in their operations, such as financial modeling, financial statement analysis, and feasibility studies. Industry training on such processes can benefit staff development needs for both conventional and Islamic banks. For example, conventional banks use the techniques of financial statement analysis to check the financial standing of a corporation or individual applying for a loan. Islamic banks can apply the same financial techniques before they approve any products to their customers.
Conventional banking has a rich, centuries-long history during which it has developed best industry practices. Islamic banks, whose modern history stretches back only a few decades (see Chapter 3), can learn from this vast experience as it applies to their scope of operations. For example, all bankers need some expertise on customer satisfaction and online banking. Islamic banks can send their staff members for training on these (and other) topics to conventional banking sessions organized by industry associations and educational institutions.
Of course, the education works both ways: Islamic banks can invite conventional banking professionals to their own staff training programs. This practice goes a long way toward helping conventional banking personnel understand similarities and differences between their own practices and those applied in Islamic banks.
Providing technical assistance
Islamic banks cooperate with conventional banks to get the latest know-how on technical services. Islamic banking is fairly new to information systems, so an Islamic bank may reach out to conventional banks for technical help when developing suitable information systems and ATMs and when integrating its systems with central regulatory authorities.
Observing Regulations of Central Banks
Islamic banks, just like conventional banks, can’t operate in a regulatory vacuum. They must play by the rules that apply in the nation(s) where they operate.
Every country has its own central bank, which is established by that country’s government to regulate the money supply, interest rates, and private and government banks. Each central banking system has its own name, but they all serve similar functions.
The central bank of the United States is the Federal Reserve System (FRS).
In Saudi Arabia, the central bank is called the Saudi Arabian Monetary Agency (SAMA).
In Bermuda, the central bank is called the Bermuda Monetary Authority (BMA).
Central banks in some nations are called (strangely enough) central banks! For instance, you find the Central Bank of Iceland and the Central Bank of Kuwait.
In this section, I briefly expand on the functions of central banks and then describe how Islamic banks interact with them.
Focusing on primary functions of central banks
Central banks perform functions that are fundamental to any national economy. Here are some of the most important responsibilities:
Regulating and supervising the nation’s banking industry: In many countries, the central bank is responsible for implementing laws for the banking industry. The central bank serves as the banking industry’s supervisor.
Establishing monetary policy: A central bank decides and implements monetary policy to achieve the nation’s greater economic goals, such as stabilizing the financial markets, prices, foreign exchange markets, and interest rates.
Determining the short-term interest rate: The central bank is involved in determining and controlling the short-term interest rate of the country, which has a direct effect on the stock, bond, and mortgage markets.
Managing the money supply: The central bank decides and controls how much money is supplied to the nation’s economy.
Acting as the lender of last resort: The central bank helps the nation’s commercial banks by lending money when they need cash, including when they are about to collapse because of liquidity problems.
Seeing how Islamic banks fit into national banking systems
In only two nations — Iran and Sudan — the central banks are Islamic, meaning that the rules and regulations of the central bank comply with sharia law. In those two nations, operating an Islamic bank is fairly easy because the regulatory authority jibes with the principles on which each individual Islamic bank is established. (I cover the four main principles of sharia in Chapter 1.)
In all other nations, Islamic banks and central banks must find common ground and be willing to educate each other in order to accommodate both Islamic banking practices and the need for nationwide regulations. In this section, I broadly explain the relationship between Islamic banks and central banks, describe how they currently cooperate with each other, and offer suggestions for how the relationship may be improved in the future.
Supervising banking activities
The central bank or an authorized delegate supervises all banking transactions in a given nation to safeguard customer deposits and achieve the bank’s greater monetary policies. In Chapter 16, I explain that the direct supervision of an Islamic bank comes from a sharia board: a group of scholars who ensure that the bank is complying with Islamic principles and approve (or don’t approve) new products.
How does an individual Islamic bank manage its operations with two distinct supervisory entities watching its every move? The short answer is that an Islamic bank must please both entities in order to operate. The slightly longer answer is that in most countries, the central banks now have the authority to allow banks to operate in sharia-compliant ways.
The central bank is the only authority that can grant a license for any bank — conventional or Islamic — to operate within the borders of that country. So if the central bank disapproves of the way an Islamic bank is operating, that bank won’t have a license for long. However, most nations these days have specific laws that grant permission to establish and practice a banking business based on sharia. (Obviously, Iran and Sudan don’t require such laws because the central banks themselves are sharia-compliant.)
Some countries, such as Malaysia and Bahrain, practice dual or parallel financial systems, which means separate legal requirements are in place to establish conventional and Islamic financial institutions. In other words, two separate regulatory systems (sets of laws) exist: one for conventional financial institutions and one for Islamic institutions. The nation’s entire financial system (not just its banking system) may be covered by the two separate sets of laws.
In a few countries, such as the United Kingdom, Singapore, and Sri Lanka, Islamic banking is allowed by special provision in the regular (conventional) law. The provisions allow Islamic banks to exist as special financial organizations. Such laws may influence only the banking system in the country; its capital markets may be unaffected, for example.
Managing stockholders’ equity and mandatory reports
The central bank sets a minimum amount of stockholder capital that is required to operate a commercial bank, whether conventional or Islamic. It does so to ensure that the bank is financially stable. (If owners’ equity drops too low, the bank may rely too much on deposits as its source of funds, which isn’t ideal.) In Malaysia, for example, a full-fledged Islamic bank needs to have a minimum of $100 million in paid-up capital (stockholders’ equity). All banks are also required to submit reports to the central bank about their operations and financial positions.
No universally accepted or standardized reporting requirements exist among central banks. Instead, the requirements vary from country to country. Just to offer a taste of what’s necessary, following are some of the mandatory reports required by the Central Bank of Bahrain:
Financial statement reporting: Both local and foreign incorporated banks need to submit financial statements to the central bank; these statements must be prepared according to the International Accounting Standards Boards (IASB) and International Financial Reporting Standards (IFRS).
Prudential information reporting (PIR): Under this reporting system, banks need to prepare two different reports:
• Capital adequacy reports need to include information about the bank’s capital requirements based on its credit, market, and operational risk.
• Large exposure reports need to include the exposure information faced by the banks due to off balance sheet transactions (those that don’t appear on a company’s balance sheet) and counter party obligations (any financial obligation the bank may owe to an individual, corporation, or other legal entity).
Statistics reporting: This quarterly report should break down the bank’s balance sheet by country, class of customers, currency, and classification of loans.
Suspicious transaction reporting (STR): Such reports are prepared on an ad-hoc basis if the bank becomes aware of any money laundering or terrorist financing activities occurring within the institution.
Functioning as lender of last resort
The central bank provides short-term funds to individual banks when they need money. In most nations, these short-term loans are provided on an interest basis; the central bank charges interest so it profits from the loans. But Islamic banks can’t use this method to fulfill their short-term liquidity needs.
In some countries, central banking systems offer alternatives to solve this problem. For example, in Malaysia, the Government Investment Act 1983 empowered the government to create Government Investment Issues (GII), which were sharia-based government securities. Investing in these securities allowed Islamic banks to meet their short-term liquidity requirements. (The issue of these securities was considered the initial step in developing Islamic bonds, or sukuk — a topic I cover in Chapter 13. However, the GII later lost their status because they were deemed to be non-sharia-compliant.)
In order to help the burgeoning Islamic banking industry manage its risks, all central banks should allow for special agreements that enable Islamic banks to borrow short-term funds on a profit and loss sharing (PLS) basis rather than an interest basis. I predict that these agreements will be forthcoming as the Islamic banking industry continues to thrive and grow.
Maintaining legal reserve requirements
A legal reserve requirement is a deposit — established by statute — that every bank, thrift institution, and credit union is required to keep in the central bank. The legal reserve requirement varies from country to country. In South Africa, for example, the requirement is 2.5 percent of the bank’s total deposits. In Russia, that amount is 4 percent; in Malawi, it’s 15 percent; and in Suriname, it’s a whopping 25 percent.
Islamic banks must maintain a reserve in the central bank just as conventional banks do. However, the requirement seems unfair to Islamic banks because the central bank pays interest to conventional banks for these reserves. That is, the conventional banks are rewarded for their (mandatory) participation, but Islamic banks can’t accept the interest payments from the central banks. Therefore, banking practitioners in many nations are advocating that the reserve requirement be lowered for Islamic banks.
Distributing profit and loss
Conventional banks pay their customers interest for their deposits or investments, and the minimum interest level is set by the central bank. (In recent years, the minimums have dropped extremely low in some countries, including the United States. That’s why your bank can get away with offering you peanuts for keeping money in your savings account.) Obviously, a regulatory problem exists here for Islamic banks, which don’t charge or pay interest. Islamic banks work on a profit and loss sharing basis.
What’s the solution? Some central banks have a mechanism in place to establish the profit and loss ratio between the bank and the depositor, just as they set the minimum interest rate limit for conventional banks. For example, in Pakistan, the central bank (the State Bank of Pakistan) determines how profit should be distributed between the bank and the depositor; it states that profit should be shared based on the business activity on a weighted basis (according to the maturity of the deposits). I expect more central banks to follow this type of model in the future.
Banks run big risks when their customers default on loans (as has happened for the past several years in the United States). Too many loan defaults undermine a bank’s ability to repay its depositors’ money and can lead to the bank’s closing. To avoid such circumstances, some countries have established an insurance to protect the depositors partially or fully from bank defaults. In the United States, this protection comes from the Federal Deposit Insurance Corporation (FDIC).
All deposit insurance schemes are initiated and regulated by the central banks. Participation in deposit insurance is mandatory in some countries. For example, Malaysia introduced the Islamic Deposit Insurance System in late 2005 for Islamic banks. It required both Islamic and conventional banks to become members of the insurance company to ensure the safety of the banks’ deposits. This requirement is acceptable to Islamic finance institutions because it protects the public interest and the financial stability of the Islamic finance industry itself.
Advising on financial matters
Central banks conduct informal meetings with commercial banks to discuss central bank policies or advise them on how to reach their goals. The benefits of such outreach to Islamic banks will increase if the central banks make a concerted effort to become educated about Islamic bank operations.
Following are just two of the areas where the central banks can potentially advise Islamic banks:
Choosing the best modes of financing each project: The central bank can advise the Islamic bank on how to select a business sector for its investments and identify the best method of contract (such as mudaraba, murabaha, or ijara) suitable for each project.
Setting customer service fees: Islamic banks charge their customers tariffs, which are essentially service charges. If an Islamic bank isn’t in a position to decide the tariff, the central bank should be able to advise the bank on fees that are appropriate within that country.