Islamic Banking - Issues in Prudential Regulations and Supervision


WP/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.