With Islamic banking gaining momentum throughout the Middle East, questions about its regulatory framework are increasingly asked. Executive interviewed Dr. Ahmad Jachi, First Vice-Governor of the Central Bank of Lebanon and Chairman of the Islamic Banking Committee, about the issue.
E What is the view of the Central Bank on regulating Islamic banking in Lebanon?
The duty of the Central Bank is to safeguard the currency, economic stability and basic structure of the banking system as well as the development of the monetary and financial market. Therefore, the bank’s approach to the regulation process resides in creating a level playing field for a sound and stable Islamic financial system, one that is viable and well integrated in our financial system.
E What is the legislative framework for Islamic banks in Lebanon?
The promulgation of Law 575 in 2004 allowed the Central Bank’s Central Council to license Islamic Banks in Lebanon. The Central Bank started by establishing a special Islamic banking committee, chaired by its First Vice-Governor. This committee is in charge of defining the regulatory framework for Islamic banks. It outlined the banking, financial and other activities that were to be provided by Islamic institutions and set the ground rules for the protection of depositors and customers as well as the preservation of an adequate level of liquidity and capital. The commission examined the standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and reviewed the Islamic banking legislation and practices in several countries in order to gain from their experiences before setting proper practices in Lebanon. Commission members were in majority part of the Central Bank staff.
E What is the regulatory framework for Islamic banks in Lebanon?
In Lebanon, only fully fledged banks are allowed to operate in the field of Islamic finance, if they have a minimum capital of $20 million and a share value of $100. Islamic banks provide all banking, commercial and investment services and operations, including the establishment or participation in new or ongoing ventures. Deposits have a minimum term of six months and are protected by the deposit guarantee law. Investments and placements in Lebanon must account for at least for 50% of the bank’s total assets. The Central Bank has also stressed the establishment of a Corporate Governance Committee, whose primary responsibility is to safeguard stakeholders’ interests. Islamic banks will also be monitored by an independent sharia auditor and will have to publicly disclose their sharia board annual report. In addition, Islamic banks will have to feature monetary and special reserve requirements on deposits and investments.
E What is the role of the Sharia Supervisory Board (SSB) and what is the background of its members?
The Sharia Supervisory Board is usually comprised of scholars versed the interpretation of Islamic law and its application within Islamic financial institutions. The role of the SSB is to ensure and certify that all contracts and agreements related to the institution’s financial transactions are sharia-compliant. In Lebanon, each Islamic bank will have its own Sharia Supervisory Board, which usually consist of three scholars specialized in sharia who have deep knowledge of financial and banking operations. This consultative body reports to the respective board of directors and the general assembly.
E Do Arab central banks do oversight on sharia-compliant products?
There is no unified practice among the Arab central banks vis-à-vis the centralization of SSBs. Countries like Bahrain and Sudan have established centralized SSBs, which in turn supervise the SSBs of Islamic banks. Other countries, like Lebanon and the UAE, do not have a central SSB. Moreover, there is no standardization regarding the supervisory authority’s model. Some countries have created a separate supervisory authority drawn on the FSA model overseeing Islamic banks’ operations, such as in Lebanon, Bahrain and Sudan, while in others, like Saudi Arabia, the supervisory authority is still part of the central bank.
E How are Islamic products usually benchmarked? Is this done from a perspective of absolute returns or risk-adjusted returns?
Islamic financial instruments co-exist with conventional financial instruments in an open market structure governed by demand and supply. Although sharia-compliant finance is centered on return on investment rather than on interest rate, the competitive forces in an open market would eventually mediate between both systems to create a level playing field and hence comparable ‘rates of return’. Islamic banks are faced with the same classes of risk and risk exposure as their conventional counterpart. Credit risk, market risk, operational risk and legal risk are inherent to any financial operation regardless of its nature, whether conventional or Islamic. However, IFIs are faced with some additional types of risk such as reputation risk and sharia-compliance risk. Displacement risk — as a result of lower yields given by the Islamic banks as compared to the conventional ones — is also important for IFI stakeholders.
E How are the different Islamic funds structured to comply with sharia principles?
In order to be sharia-compliant, investments need to go through a set of conditions or filters. The main filters are related to the company’s business activity, whether or not it is in accordance with sharia requirements, the interest component of company revenues, whether the company borrows and lends frequently on interest basis and the leverage of debt to equity and whether the sale and purchase of shares is backed by debt.
The role of any fund’s Sharia Supervisory Board is to screen and accept asset classes underlying the investment vehicle, which is usually done twice a year. For instance, the SSB of the Dow Jones Islamic Fund has developed a two-step process whereby companies are subject to both an industry and a financial screening. The industry screening rejects companies dealing with non-sharia-compliant products and services such as alcohol, pork, defense, pornography, entertainment, insurance and conventional banking.
The financial screening excludes companies with unacceptable levels of debt or interest income and is subdivided in three applied filters. Companies excluded are those with a total debt divided by trailing 12-month average market capital greater than 33%. Investment is also prohibited in companies whose sum of cash and interest-bearing activities divided by trailing 12-month average market capital is greater than 33% or whose account receivables divided by total assets are greater than 33% .
E Doesn’t the prohibition of speculative behavior in Islamic finance contradict the basic principles of financial investment?
It is true that gharar, which is translated to ‘speculation’, is prohibited. However, the true meaning of gharar is any element of uncertainty in any business or contract. This is quite different from financial speculation as we know it. Therefore, I do not see any salient contradiction between financial speculation and sharia.
E What about prohibition of riba? Aren’t Islamic financial products usually more expensive than conventional ones?
In some cases, structuring new Islamic financial products entails relying on the expertise of lawyers or sharia scholars. This may account for the incremental fee faced by investors or depositors who pay the price of an added level of expertise.
E How is due diligence implemented on the different Islamic instruments?
Islamic financial instruments are in general asset-based or asset-backed. The intermediary role of an IFI is to ensure the financial prudence necessary to preserve its depositor’s investment. Due diligence for IFI is mainly done on utilizations and sources of funds. It takes into consideration the quality of the client and project at stake, its inherent risks and default probability, as well as, the liquidity and quality of the underlying asset. The IFI should inform its stakeholders of the placement target of their funds, the expected rate of return and tenure along with any change in the investment portfolio. Profit calculation, allocation and distribution schemes should be clearly disclosed, besides the SSB qualification of the investment scheme.
E Are there any special ratings for Islamic financial products and how accurate are they?
Some of the Islamic financial institutions as well as Islamic products such as sukuk are currently rated by Moody’s, S&P and Fitch. The different types of liabilities are being addressed by the different rating types. For instance, Moody’s bank ratings comprise the Bank Financial Strength Rating (BFSR), the baseline credit assessment, the local and foreign currency deposit ratings. Fitch and Moody’s do not believe, however, that a separate rating methodology or rating scale is needed as they deem their rating criteria and methodologies flexible enough to cover the specificities of sharia-compliant issuers and issues. It is worth noting that their analysis does not extend to whether or not a transaction, security or issuer is in compliance with the sharia. The Islamic International Rating Agency (IIRA) is the single institution that offers in addition to credit rating, sharia quality rating and corporate governance rating.
E Do you think that the Islamic financial market is at risk of facing a crisis comparable to the subprime one?
Investment share of the Islamic financial institutions in the structured products is very negligible; therefore their exposure to the current subprime crisis is very limited.
E What type of growth are you forecasting for Islamic products in the next year?
Fueled by the oil boom, the Islamic finance industry witnessed in the past decade a strong growth rate varying between 15 to 20%. While investors request liquidity, capital protection and profit on their investment, some investors are also seeking sharia compliance as well. The industry is currently driven by a high demand, exceeding the supply, and there are no signs that this trend will slow down as witnessed in the sukuk market boasting a compound annual growth rate of 121% from 2001 to 2007. Additionally, some 150 Islamic funds and funds of funds are available in the GCC and global market with a total capitalization of $10 billion as of 2005. All indicators seem to point to a faster expansion of the sector as through financial engineering, new contracts can be designed in compliance with gharar and riba prohibitions. Moreover, many Western banks and fund managers are entering this new field, relying on their financial acumen and the sharp know-how of strategic asset allocation.
