Introducing Islamic Banks into Conventional Banking Systems

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islamic 308 banks 99 financial 87 conventional 71 banking 67 institutions 65 shariah 43 countries 37 instruments 35 finance 34 products 33 funds 28 government 26 investment 25 deposit 24 deposits 24 international 23 central 22 systems 22 liquidity 21

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C international monetary fund wp imf working paper monetary and capital markets department introducing islamic banks into conventional banking systems prepared by juan solea authorized for distribution by ghiath shabshigh july abstract this working paper should not be reported as representing the views of the imf
over the last decade islamic banking has experienced global growth rates of percent per annum and has been moving into an increasing number of conventional financial systems at such a rapid pace that islamic financial institutions are present today in over countries

the paper is structured as follows section ii discusses some preliminaries with which the authorities should be familiar before introducing islamic banks section iii explains the different phases in the development of islamic banking section iv discusses the role that the supervisory authority should play in this process section v explains the different elements that are needed to build a supporting islamic financial infrastructure finally section vi concludes

at the same time supervisors need to know the challenges that these new financial products and institutions will impose on the regulated entities as well as the potential implications of the interaction between islamic and conventional banks
besides the well known quran admonishment against riba interest gharar and maisir contractual uncertainty and gambling and haram industries prohibited industries such as those related to pork products pornography or alcoholic beverages there are other principles that must be observed by practitioners and supervisors in order to comply with islamic jurisprudence

an important effort towards achieving international consistency was the creation of two multilateral institutions i the accounting and auditing organization for islamic financial institutions aaoifi which issues internationally recognized shariah standards on accounting auditing and governance issues and ii the islamic financial services board ifsb which issues standards for the effective supervision and regulation of islamic financial institutions

furthermore the pursuit of international consistency would not only ease the task of supervising internationally active institutions but it would also ultimately favor the regulated institutions as islamic transactions would become better understood and thus more attractive for muslim and non muslim investors across the world
awareness campaigns the speed and degree of success with which islamic banking will emerge in conventional systems will largely depend on whether potential depositors and investors are well informed about the opportunities and risks at hand and on whether islamic banking is perceived as a transparent and well regulated activity

this section reviews three broad stages an initial stage where selected islamic products are offered a second stage where full fledged islamic banks are allowed to operate and a third stage where non bank islamic financial institutions develop and expand the range of islamic financial products available

in the last few years the proliferation of islamic instruments has been spectacular and has encompassed a vast range of modalities from sovereign sukuks such as the a million sukuk issuance by the german state of saxony anhalt in to corporate sukuks like the first ever us sukuk issued by the texas based oil group east cameron partners for an amount of us million and to more sophisticated investment vehicles such as societe generale s pioneering shariah compatible hedge fund

in the case of islamic windows the treasury department of the parent bank is typically in charge of managing the liquidity requirements of the bank as a whole which poses the threat of mixing conventional and islamic funds
licensing full fledged islamic banks once a conventional bank has operated an islamic window for some time and has gathered a sizeable customer base for its islamic activities it may decide to establish an islamic subsidiary or even fully convert into a full fledged islamic bank

box the use of tawarruq to make the transition from conventional to islamic balance sheets when a conventional bank decides to fully convert into an islamic institution it must ensure that all the items in its balance sheet are compatible with the shariah
therefore it will have to transform all its loans and deposits into non interest bearing assets and liabilities such as for instance murabaha costplus financing contracts in the case of assets or mudarabah profit and loss sharing deposits for its liabilities

in repayment for the bank s purchase of the commodities the customer will include in the installment payments to the bank an amount commensurate with the forgone interest on the loan
introducing non bank islamic financial institutions and instruments as full fledged islamic banks increase their operations and it is clear that there is a segment of the population interested in these products other financial institutions and products may appear in the market

derivative instruments derivative contracts are another instrument widely used by financial institutions in advanced syste miss these instruments are often used to hedge and reduce the risks associated with certain transactions and as such it could be argued that they perform a vital role in promoting economic activity by allowing the diversification of risk

be that as it may one important caveat to consider regarding the full islamization process is the fact that the gamut of islamic financial instruments is still significantly smaller than in invoked to justify the design of option like securities
with the existing evidence at hand today it is not possible to assert whether a purely islamic financial system would be more or less efficient than a conventional one at intermediating financial flows

third stage some conventional banks fully convert to islamic banks after a certain period of operating islamic windows some conventional banks accumulated a sufficient critical mass of islamic customers to make viable a full conversion of the bank into an islamic institution

the role of the supervisory authorities the role to be played by the regulatory authority in systems with emerging islamic banks is two fold on the one hand there is the traditional prudential supervision aspect but there is also a vital developmental role that is equally important
given that islamic banks can pass a substantial part of the investments losses onto depositors banks could potentially be induced to undertake riskier projects than if they had to guarantee all deposits as in conventional banks

while the failure of a corporation would not have contagion effects the failure of a bank could very well result in the public s loss of confidence in the stability of the banking system as a whole thus triggering a generalized bank run
see the ifsb s guidelines capital adequacy standards for institutions other than insurance institutions offering only islamic financial services and guiding principles of risk management for institutions other than insurance institutions offering only islamic financial services

box the emergence of bahrain as an islamic financial center while it is true that the kingdom of bahrain partly owes its success to a number of external circumstances that gave it a leading advantage the bahraini authorities also undertook prompt and resolute actions to maximize and materialize this advantage
bahrain took advantage of this situation as well as of its favorable geographical location and of its relatively educated population to start developing its own financial services industry

as a result of these efforts bahrain is today the location for the headquarters of important organizations such as the accounting and auditing organization for islamic financial institutions aaoifi the international islamic rating agency iira the international islamic financial market iifm and the islamic liquidity management center ilmc among others

on the other hand if most deposits are mudarabah deposits then not including them under the coverage would limit the impact of the dt in increasing the stability of and the public s confidence in the banking system
a pioneering example is turkey which in july allowed islamic banks to create an islamic deposit takaful see iadi

sundararajan et al and ul haque and mirakhor provide a good although slightly outdated description of some of the basic instruments used in islamic syste miss ayub in turn provides a short panoramic on the use of islamic government securities in a number of countries
for a number of years however islamic banks in conventional systems have operated with no access to tradable short term treasury instruments with which to channel excess funds to other islamic banks

the price of the future sale determines the return of the sukuk while the initial spot payment from the islamic banks to the central bank constitutes the liquidity withdrawal
two types of certificates allow the sudanese government to raise financing at different maturities government investment certificates which are based on a pool of ijara salam and murabaha instruments are used to raise long term financing government musharaka certificates based on equity partnerships have maturities of one year

note however that the potential issuance size of this security will be somewhat capped by the value of the central bank s assets thus effectively limiting the amount of liquidity that can be drained from the market via this instrument

step subsequently the central bank requests the islamic banks to resell the commoditiesa typically at the same price and to the original commodity broker who will cancel the debt acquired in step by the islamic banks
this is indeed a trend that is likely to carry on as oil exporting nations continue to accumulate wealth gcc and south east asian islamic financial markets develop further and companies in western nations keep on competing to attract international investors

finally it should be emphasized again that fortunately a number of multilateral institutions have been recently created in order to provide assistance to governments in the matters discussed above and to issue standards and best practice guidelines for this industry

ul haque nadeem and abbas mirakhor the design of instruments for government finance in an islamic economy imf working paper wp washington international monetary fund
wilson rodney challenges and opportunities for islamic banking and finance in the west the uk experience islamic economic studies vol

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AlHuda Material\islamic banking

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islamic banks banking financial finance investment conventional institutions funds risk financing deposits assets services management international countries equity profit products

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Number of Pages

28

Published Date

2007-07-23 16:35:55

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Introducing Islamic Banks into Conventional Banking Systems

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