Legal and regulatory framework for Islamic banking needs tightening: IMF

Gaps in prudential and accounting standards could pose systemic risks

Gulf News

Dubai: The current framework governing Islamic Banking (IB) contains many gaps that need to be closed through the development of a more comprehensive enabling environment that ensures financial stability and sound development, according to the Executive Board of the International Monetary Fund (IMF).

In a recently adopted staff paper “Ensuring Financial Stability in Countries with Islamic Banking”, the IMF calls for further strengthening of the legal and regulatory environment and institutional framework in countries that have Islamic banking.

“Islamic banking continues to grow rapidly, in size and complexity, posing a challenge to supervisory authorities and central banks. While accounting for a small share of global financial assets, Islamic banking has established a presence in more than 60 countries and has become systemically important in 14 jurisdictions,” the IMF study said.

Islamic Finance principles underpin Islamic banking and involve operations, balance sheet structures, and risks that differ from their conventional banking counterparts.

The legal environment within which Islamic banks operate can be complex and challenging and may have implications for financial stability. Islamic banks operate in diverse legal environments, some of which are more evolved than others in providing strong legal underpinnings for Islamic banks.

“Legal clarity and certainty for Islamic banking are important to promote confidence in the industry, as well as to mitigate the potential risk of regulatory arbitrage and strengthen supervision,” the IMF Staff Paper said.

International governance standards apply to Islamic banks but need to be customised to take into account their distinct governance features. These relate to decision-making structures, Sharia compliance, and the rights of investment account holders.

The IMF Director Board said that significant progress has been achieved in developing prudential standards for Islamic banking, although broader implementation and more consistent application are needed. Prudential standards for conventional banks generally apply to Islamic banks but gaps exist reflecting the specific features of IB and their associated risks.

Prudential standards have been developed to complement international standards, including, inter alia, on capital adequacy, “Core Principles of Islamic Finance Regulation for Banking,” and the supervisory process. The adoption of these standards has progressed albeit at different speeds across jurisdictions.

International guidance is needed to address the limited progress that has been achieved in developing resolution and financial safety net frameworks for Islamic banking. The international principles for deposit insurance, lender-of-last-resort, and effective bank resolution regimes, are broadly relevant.

Country practices in this regard, have diverged on several important fronts, including, the insurability of investment accounts, the priority of claims, the role of deposit insurance in resolution, and the adequacy of Islamic banking instruments and collateral.

 

Liquidity issues

The IMF observed that progress has been slow in developing Islamic banks’ liquidity management and money markets. A dearth of high quality liquid assets (HQLA), including, most importantly, government sukuk, have undermined IBs’ capacity to manage liquidity, interact with central banks, and develop money markets. This situation has given rise to IB practices that may achieve some liquidity management objectives but are inefficient and present risks. The lack of progress in this area has also impeded efforts to strengthen financial safety nets specific to IBs.

The emergence of hybrid financial products in IB that replicate aspects of conventional finance in an IB context has raise financial stability concerns. This trend is spurred by opportunities for profit in a rapidly growing IB sector, coupled with slow progress in developing adequate infrastructure for traditional IB. However, the growth of hybrid products raises a number of concerns, including the emergence of new complex risks, the applicability of existing prudential regimes, governance and consumer protection issues, and reputational risk.

The IMF has been providing technical advice, as needed, to member countries on IB issues for the past 20 years and has been cooperating with relevant standards setters and international organisations on efforts to develop supplementary standards for IB in areas that are not covered by existing international standards. In recent years, the number and complexity of IB issues arising during IMF country surveillance and the demand for policy advice and capacity development in this area have increased, requiring a more formal IMF involvement.

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