Global Strategies for Islamic Banking and Finance

American Finance House – LARIBA

 

10th Annual Symposium on Riba-Free Finance & Banking

22 March 2003

Pasadena, California

 

Professor Rifaat Ahmed Abdel Karim

Secretary General

 

Islamic Financial Services Board

http://www.ifsb.org

 

Ladies and Gentlemen

Assalamu alaikum warahmatullah wabarakatu and good afternoon to all of you. I would like to thank the organisers for organising inviting me to speak in this conference which addresses an important and topical issue facing the Islamic banking and finance industryAmerican Finance House (LARIBA) for honouring me and for giving me this opportunity to address this prestigious gathering.

It is heartening to see the Islamic and finance bankingfinancial services industry anticipating and addressing the issues whichissues, which we need to tackle if we are to ensure that this industry is fully integrated into the international financial system.

 

As a person whose career for the last twelve years was involved with the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and now with the Islamic Financial Services Board (IFSB), the two the Secretary General of the Islamic banking industry’s only transnational accounting, auditing and governance standard setting bodybodies of the Islamic financial services industry, I find that the case for global as opposed to national strategies is something which I end up arguing for over and over again. It is my conviction that our the industry can succeed only if we avoid following differing national strategies and work together to follow consistent and harmonised global strategies that attempt to enhance the soundness and stability of the global financial system..

 

I would like to focus on three issues during my presentation.: Tthe importance for the Islamic and finance banfinancial servicesking industry of developing –

 

· a global accounting and financial reporting framework;

· a global prudential and supervisory framework consistent with internationally recognized best practice in the overall global finance industry; and

· a global Shari’ah framework.

 

In my opinion, the importance of these three issues for building market or investor confidence in our this industry and in encouraging more stable, long-term international investment flows cannot by overestimated.

 

I believe that in order to sustain the impressive growth that our this industry has experienced, we must work together to ensure that we are, and are seen to bemoreover are widely recognized as being, transparent and accountable, and to be managing risks by ensuring that we follow appropriate internationally recogniszed standardsbest practices.

 

We can see from the work of trans-national bodies like the International Organization of Securities Commissions (IOSCO) and the Bank for International Settlements (BIS) that the issues of developing global accounting and prudential and supervisory frameworks are being addressed globally, especially in the light of the recent events both here in the USA and in East Asian Economic Crises.

 

The need for developing global accounting, prudential and supervisory, and as well as Shari’a,h frameworks, for the Islamic banking and financefinancial services industry is more acute due owing to the industry’s relatively short history. Since the Islamic banking and finance are is newindustry has recently developed, , many people within the Islamic countries as well as those outside, view our this industry with suspicion since because they either do not understand how our itindustry works or have consciously or unconsciously built upbecome a biased against the industry. This Such suspicion has serious andhas real and serious consequences for our this industry. An obvious consequence is the fact that this leads to Islamic banks financial institutions being assessed viewed as having higher credit risk, and therebyrisk, thereby increasing their cost of capital, which is a serious competitive disadvantage in today’s global marketplace.

 

Let me first address the issue of developing a global accounting and financial reporting framework for the Islamic banking financial services industry. first.

 

The supply of relevant and reliable information regarding all material matters relating to Islamic financial institutions is indispensable for ensuring good corporate governance and for protecting investors. A strong disclosure regime which enforces certain minimum disclosure requirementsregime, which enforces certain minimum disclosure requirements, will also, I believe, lower the cost of capital of Islamic banks by improving the environment for domestic and international investment in the Islamic banking and financefinancial services industry and by increasing the credibility of, and confidence in, Islamic financial institutions.

 

Disclosures have to be made in such a way so that they are reliable, comparable and comprehensive,that they are reliable, comparable and comprehensive and in sufficient detail to enable users to assess the stewardship of the institution and make informed investment decisions.

 

The quality of the information that is provided to the markets is best ensured by the application of a high-quality set of standards whichstandards, which is applied consistently across national boundaries. In my view, implementing an internationally recognised set of financial reporting standards is an indispensibleindispensable means the best way to preservinge and enhancinge the quality and the credibility of the Islamic banking and financefinancial services industry.

 

In today’s global economy where institutions operate across national boundaries, the ability to use one set of accounting standards for all purposes has the potential to achieve economies of scale for the Islamic banking and financefinancial services industry and generate considerable cost savings. Not only will Tthis will reduce not only the cost of preparing financial statements but also the cost of auditing, and as well as the costs incurred by financial analysts and rating agencies in assessing Islamic financial institutions. This is particularly important for countries aspiring to become international Islamic financial centres.

 

However, the most important benefits will be in terms of improving the efficiency of the workings of capital markets. The provision to the market of high quality, transparent information on a comparable basis to the market will reduce uncertainties in the information available to the markets to be on a comparable basis to the situation in the conventional financial market. and cConsequently, it should lead to a reduction in the cost of capital of Islamic banks because investors, both shareholders and investment account holders, could not reasonably expect returns higher than those of conventional investments with similar classes of risk. Indeed, nNumerous empirical studies have concluded that the more information you provide on standardised basis, the lower your cost of capital will be. This also makes intuitive sense. More comparable information means less uncertainty and hence the less lower degree of risk that has to be factored in to the price of capital.

 

When I was aAt the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), AAOIFI, we have made a start by developing a core set of accounting, auditing and governance standards for Islamic financial institutions, by working together with relevant parties form from all over the world. We are workingworked in conjunction with central banksregulatory bodies and international standard setting bodies to have these such core standards adopted across the globe as the benchmarks standards for the Islamic banking and financefinancial services industry.

 

I am sure that many peoplepeople, who are not familiar with the work of AAOIFI, may be thinking that my our aspiration to have global strategies and standards is undermined by the the fact that AAOIFI has developed a separate set of standards from those issued by the International Accounting Standards CommitteeBoard, . are contradictoryThis is not the case.

 

Let me address tackle this issue briefly. Islamic banks do not accept or lend funds on an interest-bearing basis. Rather, for mobilizing and allocating funds, Islamic banks use different types of contracts that have specific provisions not usually catered for in similar contracts used by their conventional counterparts. , and therefore Hence, many of the items in their financial statements of these banks are different from those that appear in the financial statements of conventional banks, and vice versa. This has important consequences for accounting standards.

 

For example, the disclosure requirements of International Accounting Standard (IAS) No. 30, which deals with banks, are largely inapplicable to Islamic banks, and hence IAS 30 is not an effective disclosure standard for such institutions. There are also problems with the measurement aspects of certain accounting standards, where the IAS’s do not address issues that arise because of the specificities of the Islamic banking transactions. Consequently, when IAS’s are applied to the financial reporting of Islamic banks, they are only very partially effective in ensuring appropriate standardisation of disclosure and measurement practices..

 

The Islamic banking financial services industry recognised recognized this such problems and established AAOIFI to address these issues. We view AAOIFI’s accounting standards as are complementary to, rather than being in conflict with, IAS’s. We view ourWe viewed the role atof AAOIFI as filling gaps in IAS’s, which do not have specific provisions to standards to deal with the typical transactions of Islamic bankingfinancial services. transactions and hence allow Without AAOIFI filing the gaps, IAS’s would have allowed those preparingers and auditingors of the financial statements of Islamic banks to to have considerable scope for cherry-picking and making ad hoc interpretations of IAS’s,. a process that would result in rendering the financial statements prepared by these institutions less transparent than conventional financial statements, and non-comparable therewith, as well as spawning inconsistencies between the accounting and auditing of different Islamic financial institutions.

 

We are in discussions with the IASC, with the aim of establishing complementarity between AAOIFI and IASC with regards to setting the accounting standards to be followed by Islamic financial institutions. In addition, we areAAOIFI has been actively engaging banking supervisors around the worldin many countries, as well as other relevant international bodies like the International Accounting Standards Board, to convince them of the necessity of adopting the AAOIFI standards as the benchmarks standards for Islamic financial institutions in their jurisdictions, and thereby improving the transparency in and comparability of the financial reporting of Islamic financial institutions.

 

So far, the banking supervisors in a number of countries such as Bahrain, and Sudan and Jordan now require Islamic banks either to comply with AAOIFI’s standards, or, as in the case of Saudi Arabia, are specifying AAOIFI’s standards as guidelines. In Qatar, the central bank has developed standards based on AAOIFI standards, and I understand that Qatar will now converge fully to AAOIFI standards.

 

 

 

 

Let me now move on to the second issue of developing a global prudential and supervisory framework consistent with internationally recognized best practice in the overall global finance industry.

 

We must ensure that Islamic financial institutions are regulated and supervised to an internationally acceptable standards, in order to:

 

· maintain and enhance the confidence of the the industry’s participants; and

· ensure that these institutions are subject to the same prudential standards, regardless of their country of domicile, and thereby achieving a level playing field for all participants within the Islamic financial services industry; and

· win the respect of governments, regulators, investors and users of funds in non-Muslim countries, so as to enable Islamic banking and finance to be more integrated into the mainstream of global finance.

 

As many of the studies into the East Asian Crisis of 1997 and 1998 have found, although most of the financial institutions that experienced difficulties were complying with their national rules and regulations, many discrepancies were found between national practices and international rules. My proposition assertion is that, as the well well-being of a country’s banking financial services industry has implications for the whole economy and stability of the country, and hencethe experience of the East Asia Crisis shows that the regulation of the Islamic banking financial services industry is too important to be left to individual countries or regulatory authorities to deal withalone.

 

Like As with their situation as regardsthe the case in accounting and auditing situation, at present Islamic financial institutions are currently exposed to differing prudential and supervisory standards. These depend upon ing on the country in which they operate. This, it can be reasonably argued, is mainly dueowing to the lack of proper understanding of the work of Islamic financial institutions and also because of the implementation of different accounting standards. This was evident in the results of the study carried out by a committee – comprising, among others, a number of central banks in co-operation withand AAOIFI – that was formed to develop an appropriate capital adequacy guidelines for Islamic financial institutionsbanks. This committee promulgatedled to the issuance by AAOIFI of the Statement on the Purpose and Calculation of Capital Adequacy Ratio for Islamic Financial InstitutionsBanks, which takes in to account the differences between deposit accounts in conventional banking and investment accounts in Islamic banking. The statement has built up on the capital adequacy principles laid down by the Basle Basel Committee.

 

However, the lessons that we at AAOIFI have learned from the Capital Adequacy study have similaritieare consistent with the implications of ours with our work in preparing accounting standards. Our view wais that, in order to adequately and fairly to regulate Islamic financial institutions, we required a set of prudential and supervisory standards that would take into consideration the specificitiesspecificities y of Islamic banking and finance transactions.

 

To this end, AAOIFI, together organised with the International Monetary Fund and the Islamic Development Bank, organised, a conference on the regulation of Islamic banking last year. One of the major recommendations from that conference, which was endorsed by many central banks, was the establishment of the Financial Services Board within AAOIFI. Although the central banks later decided that the Financial Services Board be established as a separate entity from AAOIFI, we are satisfied that it was AAOIFI which has brought awareness of to the need for such a board to issue prudential and supervisory standards for Islamic financial institutions, so as to ensure a level playing field.

 

An important point which we need to be aware of, and one that became apparent from the work we did in developing the AAOIFI Capital Adequacy Statement, is that the success of the Financial Services Board will to a large extent depend on the adoption of a unified set of accounting standards by the Islamic banking and finance industry.

 

In today’s global economy, when Islamic financial institutions are appearing all over the world, it is simply not acceptable to have Islamic banks financial institutions in different jurisdictions complying with differing prudential and supervisory guidelines. We need to set our sights on having aim to have a level playing field, regardless of which the jurisdictions in which an an Islamic financial institution operates in. When two Islamic banks financial institutions in different countries say that they have a capital adequacy ratio of 2012%, these ratios have to be strictly comparable:, we need to compare apples with apples.

 

It is interesting satisfying to note that it is countries such as Malaysia, Bahrain and Sudan, which have led the drive towards developing specific regulatory guidelines for the Islamic banking industry. However, Iit is difficult for countries, which, which do not have an extensive Islamic banking experience to develop similar guidelines. It is more efficient and cheaper to develop uniform international regulatory guidelines, by leveraging the experience of those who have had the most experience with a greater exposure to the industry and the issues that it has raisedit throws up.

 

To this end, AAOIFI, together with the International Monetary Fund and the Islamic Development Bank, organised a conference on the regulation of Islamic banking in 2000. One of the major recommendations from that conference, which was endorsed by many central banks, was the establishment of the IFSB. At present, the Full Members of the IFSB Council comprise Bahrain, Indonesia, Iran, Kuwait, Malaysia, Pakistan, Qatar, Saudi Arabia, Sudan, and the Islamic Development Bank. Malaysia is the host country of the IFSB.

 

I am honoured to be appointed the first Secretary-General of the IFSB, which serves as an international standard-setting body of central banks and monetary agencies, and which is entrusted to ensure the stability of the global Islamic financial services industry by developing prudential standards and promoting international best practices in the regulation and supervision of this industry. In advancing this mission, the IFSB will promote the development of prudent and transparent financial services through introducing new, or adapting existing, international standards consistent with Islamic rules and principles; and will recommend these for adoption.

 

In addition, the IFSB will focus on the development of risk management instruments and the cultivation of sound risk management practices. It will facilitate the implementation of robust risk control mechanisms in Islamic financial institutions through research, training and technical assistance. Its focus will encompass the adoption of present international best practices on risk management standards, as well as the development of new risk management techniques in conformity with Islamic rules and principles.

 

In this respect, the IFSB combines aspects of the mission of the Basel Committee on prudential matters and aspects of that of the UK Financial Services Authority in relation to good practice for other financial services, namely insurance, capital markets and investor protection.

 

 

Let me now move on to the issue of developing a global Shari’a framework.

 

At present, in most countries, with the possible exception of Malaysia, Islamic financial institutions have attempted to self-regulate the process of complying with Shari’ahShari’a precepts by appointing their own Shari’a Boards consisting of part-time membersmembers to oversee the Shrai’a compliance function. Not surprisingly, the terms of reference of Shari’a Boards vary widely from institution to institution. Each Shari’a Board has complete discretion as to how it performperforms its work and expresses its opinion. This has resulted in a lack of standardisation of for Islamic banking and finance transactions, a situation which again makes the financial statements of Islamic financial institutions non-comparable.

 

I note from the program guide for this conference that there is a session devoted to dealing with harmonizing Shari’a issuesrulings, so I will not go into specific details during this session. However, what I would like to highlight is that MmMost of the accounting, prudential and supervisory issues that arise in the Islamic banking financial services industry results from Shari’a rulings, and hence its is imperative that we work towards developing a global Shari’a framework. If we do not make progress towards harmonising Shari’a rulings, our work relating to harmonising accounting, prudential and supervisory standards will be undermined.

 

 

 

 

At AAOIFI, we have taken an initiative to established a Shari’a Board in response to an initiationive ofby Islamic financial institutions. The Shari’ah Board withhas members from different Islamic countries, to develop and promulgate Shari’a standards with the aim of harmonising Shari’a rulings between Islamic financial institutions and across national boundaries though the Board’s own developments and promulgation of Shari’a standards.

 

It is our hope that theThe Shari’a Board’s irse Shari’ah pronouncements willare intended to to be used as a benchmark for the Shari’ah rulings of Shari’ah supervisory Bboards in Islamic Ffinancial Iinstitutions worldwide. This, we believe, will approach should support the development of the Islamic Bbanking and Ffinance industry and enhance both its transparency and its credibility.

 

However, there are those who believe that the AAOIFI Shari’a Board should have adequate representation of the various schools of Islamic jurisprudence, broaden the composition of its members to include representatives from relevant sectors of the industry to provide specialist knowledge (e.g. in banking, finance and accounting), and that its Shari’a scholars should have the required expertise in the various specialized areas of the Islamic financial services industry

. I believe that these are genuine concerns and that they should be addressed in the ongoing development of that important Board. In this regard, the IFSB could contribute, especially since it will be issuing codes of good practice, and Shari’a precepts are central to the business ethics of Islamic financial services.

 

 

Conclusion

 

Let me conclude by saying that,In my view in today’s world, any country that takes a purely national approach to regulation, especially in those aspects relating to Islamic banking and finance, is, is likely to be viewed with suspicion by the market,, and the Islamic financial institutions based in that country may pay a price in terms of having a higher cost of capitalbe disadvantaged. The challenge facing us the Islamic financial services industry is to ensure that we take an international approach to regulation since, whether we like it or not, we live in a world where national frontiers have become less relevant – especially in finance.

source : Lariba.com

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