Islamic Banking - Issues in Prudential Regulations and SupervisionWP/98/30-EAWP/98/30 .Islamic Banking: Issues in Prudential Regulations and Supervision. Luca Errico and Mitra Farahbaksh Islamic precepts influence the structure and activities of banks in several ways, the most important being the prohibition against the payment and receipt of a fixed or predetermined rate of interest, which is replaced by profit- and loss-sharing arrangements whereby the rate of return to financial assets held with banks is not known and not fixed prior to the undertaking of each transaction. Islamic banks thus differ from conventional banks, but the issue of what prudential standards should apply to Islamic banks has received little attention. This paper argues that effective prudential supervision on banks is just as necessary and desirable in Islamic banking as it is in conventional banking. To help reach this goal, a number of standards and best practices established by the Basle Committee on Banking Supervision are useful and provide a valuable reference. These standards, however, are not always applicable to Islamic banking. An appropriate regulatory framework governing Islamic banks needs to place greater emphasis on the management of operational risks and information disclosure issues than is normally the case in conventional banking. To help develop such a regulatory framework, a CAMEL rating system adapted to an Islamic environment is discussed, along with issues such as legal foundations, information disclosure requirements, and licensing procedures. Islamic banking in actual practice diverges markedly from its paradigm version and is carried out in a variety of ways that lie somewhere in between the benchmark case and conventional banking. The degree of divergence from the benchmark differs from country to country. The focus of banking supervision should shift accordingly, and each argument discussed in the benchmark case needs to be reevaluated and given the appropriate emphasis in light of the circumstances and specific Islamic banking practices prevailing in a country. Islamic banking is expanding outside the traditional borders of Muslim economies into western countries where conventional banking is followed, notably the United Kingdom. This situation is unprecedented. Specific areas in the operation of Islamic banks are likely to be viewed by supervisory authorities in conventional systems as well as potential counterparties as difficult to understand. To mitigate these concerns, effective prudential supervision of Islamic banks in their home countries should be viewed as a key factor in the process of establishing a fuller international integration of Islamic banking. |