Published June 2, 2009

Islamic banking needs better regulations

Current opaque framework could be masking trouble

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(KUALA LUMPUR) As Western regulators stress test top banks, Islamic finance wants to broaden its regulatory approach and improve disclosure rules amid concerns that unhealthy banks may have slipped under the radar.

'The stress test should not be seen as a stick to be beaten under, but should be an honest assessment of where they are.' - Saad Rahman, Islamic banking executive director at Calyon

Few Islamic financial firms have reported headline-grabbing losses so far, but the industry's relatively modest size and opaque framework could mask more trouble than appearances suggest, bankers and lawyers said.

Rather than stress testing individual banks as in the US, however, Islamic bankers and lawyers said that the sector needs better disclosure rules within stronger regulatory frameworks.

A narrow regulatory approach that examines individual firms rather than the sector, and inadequate disclosure laws could have allowed weak syariah banks to escape the authorities' attention, potentially threatening to spark an Islamic banking crisis.

'Rather than just looking at one bank and examining the risks there, you need to look at a more macro level of the industry,' said Rifaat Ahmed Abdel Karim, who heads Islamic Financial Services Board (IFSB), a top industry body. 'We need to see who's connected with what. It's not only the individual banks, but how they are connected at the macro level because then you can see who's exposed to what.'

Since the global economic and property slump, syariah banks' earnings have dropped by up to 40 per cent on year, and firms such as Kuwait's Investment Dar and Dubai's Tamweel and Amlak Finance are trying to restructure.

UBS has forecast that Dubai house prices could fall up to 70 per cent from a fourth-quarter peak. A Reuters poll predicted that prices will drop over 40 per cent in 2009 and 2010 before recovering in 2011.

The slide in property markets could highlight weakness in the regulation of the Islamic banking industry.

'In certain countries where the regulations are not as tight as in some jurisdictions, we may find one or two institutions that may pass through the sieve for a while,' said Vaseehar Hassan Abdul Razack, chairman of Unicorn International Islamic Bank Malaysia, adding that Bahrain and Malaysia were well regulated. 'Many of the Islamic banks globally, and especially in the GCC (Gulf Cooperation Council countries), are real estate oriented so this could be one risk factor.'

Unlike the US, which recently put 19 top lenders through stress tests to see which can survive a severe downturn, and Europe which is preparing to do the same, there have been few calls for Islamic banks to be tested to see if they need extra capital to weather heavier losses.

While the US stress test results showed that all banks were solvent, regulators ordered them to raise nearly US$75 billion to build a capital cushion.

'One of the biggest weaknesses in Islamic finance is that too many of the banks have gone into real estate and equities, and both of these are underperforming,' said Saad Rahman, Islamic banking executive director at Calyon. 'The stress test should not be seen as a stick to be beaten under, but should be an honest assessment of where they are.'

Islamic banks are governed by national authorities, and if they so choose, by industry bodies. The level and nature of supervision vary across markets, reflecting the industry's infancy and fragmented regulatory framework.

Much depends on the will of regulators to wield the stick, and the Gulf needs a stronger push, said Alex Saleh, partner at law firm DLA Piper Middle East. For example, 'a lot of the (Islamic) investment products that are sold by the investment companies are not regulated in Kuwait', he said.

He cited the example of wakala (agency) investments which could be structured so that an agent need not reimburse the investor the entire sum in the case of a loss.

IFSB has disclosure rules on capital adequacy and credit risks, but like other syariah finance bodies, its regulations are not binding on the sector and compliance is voluntary.

Standard disclosure rules may offer limited protection. - Reuters