Understanding Islamic financing

In April 2002, inspired by a terrific briefing on Islamic finance at Citibank’s facility in Bahrain, I hosted the “Islamic Finance 101 Conference” in Washington, DC, which was the first conference on Islamic finance for US government officials and financial regulators to raise awareness of the global Islamic finance industry.

In September 2003, Randy Quarles, Assistant Secretary of the Treasury of International Affairs, spoke about our involvement in Islamic finance at the first International Islamic Finance Conference in Washington, DC.

Also in 2003, Secretary Snow and I attended the second International Islamic Finance Conference in Dubai. We had a remarkable opportunity to sit down with Islamic bankers to discuss the real issues they face.

And the US Treasury Department has launched an Islamic Finance Scholar-in-Residence program to generate more awareness and catalyze deeper policy discussions on Islamic finance domestically and internationally. We will be hiring as our first Scholar-in-Residence a noted Islamic finance expert. We intend for this scholar to work with us and others in Washington, DC on public policy issues related to the role and importance of Islamic finance.

This new position will provide an opportunity to engage with key policymakers from the US regulatory bodies and members of Congress, on comparing and contrasting Islamic finance and conventional banking, and promoting international standards. The first person to occupy this new position will be Dr. Mahmoud El-Gamal of Rice University in Houston.

There are some very interesting new areas for further research in Islamic finance. As this industry evolves, a range of new Shari’a-compliant products is emerging. Some examples are the government and corporate bonds - so-called sukuks - which have seen an increase in issuances over the last few years, and the development of repo facilities, which allow for open market operations in Islamic finance banks and help in the development of a global Islamic money market.

The Islamic Development Bank (IsDB) is also financing infrastructure-development projects using new mechanisms that rely on the depth and innovation in the sukuk market. Islamic finance securitization has also been growing both in the US and abroad. Freddie Mac has been offering mortgage backed-securities as a financing option to the Muslim community in the US.

As we all know, however, the process of replication or mimicking conventional banking instruments certainly does not mean that the replicated Islamic products are identical to their conventional counterparts. Deposit taking at fixed terms is a highly different business than taking equity participations, leasing, or profit sharing. And it is simpler and relatively more straightforward.

Because of the transformation costs, complex Islamic financial products appear to be inherently less transparent and less efficient than conventional ones. This may have the undesirable effect of making Islamic finance a less attractive practice in the longer run. Dr. El-Gamal’s calls for a fundamental paradigm shift in the development of Islamic finance to reduce complexity and increase competitiveness are thought-provoking and worthwhile to consider.

The replication and transformation of conventional financial products into their corresponding Islamic finance analogues have important implications for the regulation and supervision of Islamic financial institutions.

First, the various lending structures generate different risk and balance sheet exposures for Islamic banks that need to be carefully monitored and managed. For example, while only a few Islamic financial products generate different liquidity profiles from conventional products, the lack of uniformity of standards for “Islamic banking” practices across Islamic countries makes it difficult to apply the same prudential regulatory standards (e.g., capital adequacy requirements) across the board. This calls for more harmonization of Islamic banking practices, which in turn calls for harmonization of Shari’a standards at the national and international levels.

Second, the treatment of profits/losses will have consequences for the balance sheet structure and will require particular adjustments to meet minimal prudential requirements. For example, in mudaraba transactions, the bank bears full financial responsibility for any losses but shares relative profits with the client. Any losses stemming from uncollateralized equity financing may require higher loan loss provisioning and additional capital.

Mudaraba transactions are essentially investment partnerships in which all the capital is provided by the financial institution while the business is managed by the entrepreneur/client. Profits are shared in pre-agreed ratios, and losses are borne by the bank (which is passed on to the depositors).

Third, disclosure requirements may need to be comprehensive and more frequent to inform investors of the investment techniques, so they can make decisions based on their risk preference. Maintaining clear transparency and ensuring adequate disclosure of financing mechanisms are important steps towards building the necessary foundation for Islamic finance. And with respect to firms in which financial institutions take stakes, greater transparency, along with strengthened corporate governance, are necessary.

As part of the international effort to design a regulatory framework for Islamic finance, regulators need to factor in the differences in these forms of finance and have at least minimal standards or benchmarks to gauge compliance and assess risks. There needs to be some level of consistency in regulatory treatment across the board, subject to the particular country’s legal and regulatory regime.

Malaysia and the GCC countries have been making notable progress on deve-loping Islamic banking laws. Recognition and enforcement of these laws by the relevant national regulators would set the stage for making true progress on establishing internationally-accepted regulatory standards. Equally important is ensuring strong anti-money laundering oversight for these transactions targeted mainly at preserving the integrity of and bolstering investor confidence in Islamic finance.

Looking ahead, there is much that remains to be accomplished. We welcome the work of the Islamic Financial Services Board (IFSB) in Malaysia and the Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFI) in Bahrain that is looking at formulating standards for Islamic financial institutions, for example in corporate governance, accounting, and capital adequacy.

We look to see how policymakers mainstream their approach to Islamic finance in countries where this industry has grown significantly. The IMF as part of its overall financial surveillance work - particularly in the context of its Financial Sector Assessment Programs (FSAPs) and its Reports on Standards and Codes (ROSCs) -- should explore what, if any, systemic implications Islamic finance can have on the overall financial systems in the relevant countries, and it should also consider how its surveillance instruments can be better aligned with monitoring Islamic finance.

The World Bank through its financial sector work can enhance the effort to develop international regulatory frameworks and explore how Islamic finance can have a positive development impact in communities. International standard-setting bodies, such as IOSCO and BIS, have a role to play, first in understanding the basic implications of Islamic finance, and secondly to take into account implications of Islamic finance on the implementation of existing standards.

I hope that the international institutions - like the IMF, WB, and the IsDB - work closely with national authorities to factor in a country’s monetary policy framework and the capacity of the country’s regulators, who will eventually have to implement the standards developed by those bodies. These are but a few examples on the regulatory front.

In conclusion, developments in Islamic finance are of great interest to us at the US Treasury, and we look forward to the lively discussions on new product development and differentiation and on recent legal and regulatory issues that have emerged as the Islamic finance industry grows. As with conventional financing, Islamic financing will benefit from transparency, good governance, and an internationally-accepted regulatory framework that will govern this important form of financing. OGFJ

The author

John B. Taylor is the Raymond Professor of Economics at Stanford University and the McCoy Senior Fellow at the Hoover Institution.

Editor's Note:

Dr. Taylor formerly served as Under Secretary of Treasury for International Affairs from 2001 to 2005. In this capacity, he had operational responsibility for developing and implementing US international financial policy. He left the position in August 2005 and now teaches economics at Stanford University. This article is excerpted from his keynote address at the Forum on Islamic Finance, held at Harvard University on May 8, 2004.