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The Future of Islamic Banking in Europe
Michael Foot Managing Director of the UK Financial Services Authority,speaking at theSecond International Islamic Finance Conference Dubai Sept 22 2003
1. I was honoured to have been asked to address this conference. The request came at a good time for me to renew my acquaintance with the latest developments in Islamic banking, given my responsibilities for banking supervision in the UK. This is because as many of you will know, several firms already authorised in the UK are offering Sharia’a compliant mortgages, there is already one FSA-authorised Islamic investment fund; and, perhaps most interestingly, there is considerable well researched interest in forming a UK-based Islamic bank.
2. We know that there is similar interest (though we think it is generally on a smaller scale) elsewhere in the European Union. When one looks at the statistics, it would not be surprising for there to be interest around the EU. The UK has some 1.8 million resident Muslims as well as at least a further 500,000 who also visit the UK regularly but who are resident elsewhere. But there are an even higher proportion of Muslims resident in France and a broadly similar percentage to the UK in Germany and in a number of smaller members.
3. We know from extensive discussions with relevant groups in the UK that many of these individuals would like to be able to choose from a range of sharia’a compliant financial products. The task is how to do this in ways which meet 3 key objectives:
The products and firms involved must meet the basic EU Directive requirements that are set in place to protect consumers and investors.
Those involved – whether as shareholders or customers - must understand what exactly is being offered. [There will only be long-term damage to the cause if unrealistic expectations are created of what can be achieved.]
Those providing the services must be wholly professional and competent in what they do. There can be no benefit to anyone (and certainly neither to devout Muslims nor to regulators!) from the slightest suggestion that the probity and competence with which sharia’a compliant products are provided are in any way less than those of conventional financial products.
Applying these objectives to sharia’a compliant banking
4. The first point to make is a cautionary one. The powers given to a bank within the EU are so considerable that, inevitably, regulators need to spend a good deal of time and effort with an applicant bank, trying to establish whether indeed it has the capital, the systems and the competence to run the bank successfully. Most importantly, the regulator needs to spend considerably more time with a prospective bank testing out these strengths than it would have to do with a financial organisation that was set on providing a much more limited range of financial services.
5. It follows from this that it is possible (I would say likely) that many sharia’a compliant financial products can and will be provided within the EU by companies that are not banks. This is just as, in the conventional sector, many banks offer residential or commercial mortgages but there are, equally, many mortgage lenders who never have never have been and who have no interest in being a bank.
6. From the FSA’s point of view, it is fortunate that we are a single regulator – by which I mean that we have responsibility for the regulation of the whole range of banking insurance and investment products in the UK. This is “fortunate” in the sense that we will be able to help address Muslim aspirations across the whole range of financial services. In the pre-1998 days when a bank was regulated by one organisation, securities by another, fund management by a third and personal investment by a fourth, it would have been practically impossible for potential applicants to get the whole picture.
7. I need now to return briefly to the question of “why a bank is different”. What critically distinguishes a bank from another financial institution is basically that only a bank takes “deposits” – a deposit being legally defined within the EU as a full unconditional obligation upon the bank to repay the full amount of principal at maturity.
8. Now, as I understand it, there are essentially 3 different types of account in Islamic banks. The first of these – the “Qard Hasan” is what I would understand as an interest-free loan from the customer to the bank. It involves a full direct and unconditional obligation on the bank to repay the full amount of principal on demand. That to my mind – and I stress I am not a lawyer – suggests that there is a good case that such accounts are deposits in the legal sense used in the EU.
9. However, there are two other kinds of account that an Islamic bank may wish to offer, where the position is less clear. I will address only the type which is least like a conventional deposit account (which is what I know as an “unrestricted investment account, UIA”) because the third is essentially only a compound of the UIA and the Qard Hasan.
10. My understanding of the UIA is that these accounts are entitled to profit or loss sharing on a variable basis, after the manager’s (Modarib’s) fee. That is some way away from a conventional deposit as defined earlier. The challenge will be to find ways (such as through an unconditional subordination of shareholder’s rights to those of the owner of the UIA) that would produce the same effect as for a conventional deposit. In other words, we need to find assurance that repayment in full of the UIA account will be made, provided that the bank is not insolvent at the time but in a way that does not offend sharia’a principles.
11. That challenge is already being actively taken up by the lawyers of those who have already expressed active interest in a sharia’a compliant banking licence in the UK. As and when we can find a resolution of this issue, I would hope that such a resolution would also be usable elsewhere in the EU.
12. This point apart, authorisation of an Islamic bank in the UK would (from the regulator’s view) raise many of the same issues as would a conventional bank. And, while these hurdles are not negligible they are of known size and all, I think, can be jumped.
13. For example, such a bank – like a traditional bank - will need adequate capital. The only specifically “Islamic” question I can see here is whether the nature of the conditions required to be sharia’a compliant introduce what we would otherwise call new “legal” or “operational risks”. In areas such as mortgage lending I think that will come down to need for reassurance that the way in which security is taken is as sound as with a conventional mortgage.
14. An Islamic bank will also, as I’ve already noted, need to have shareholders of standing and management of proven effectiveness. Personally, even if the regulator did not exist or did not require these conditions to be met, I think they would in any case be necessary for the commercial success of the operation. There may well be many Muslims in the UK and other EU member states who want sharia’a compliant products. But the fact is that the providers and (to some extent the products) will be new. The reassurance of well-known backers and senior management is likely to be an important aspect of turning potential business into reality in these new ventures and of building up the scale of business that will be needed.
15. There will also need to be adequate arrangements to ensure the liquidity of any new Islamic bank. But I am hopeful that experience already gained in the Middle East (especially experience with commodity murabaha and the growing market for sukuk bonds) will make this an easier hurdle to overcome than it would have been even a few years ago. It does, however, make even more important than would otherwise be the case the need for an Islamic bank to be of undoubted high standing, to limit to a minimum the risk of a liquidity run from depositors taking fright at some piece of bad news.
16. There will also need to be the usual guards against misuse of a bank for purposes of financial crime or terrorism. But I see no reason why the conditions that will need to be met for sharia’a compliance need make any more difficult than for a conventional bank the key task of “knowing your customer” which is at the heart of most good safeguards for banks against financial crime.
17. Finally, to round off the criteria I set out earlier, there needs to be instruction for the potential customer in the nature of the products he is buying. In the UK, the FSA has a role to play in improving customer understanding of financial issues and in trying to ensure customers get adequate disclosure during the course of the transaction.
18. We will no doubt continue to play that role in respect of sharia’a compliant products too (and in some case our rules will leave us no choice). However, I think it is also true to say that we shall be looking for help from experts wherever we can find them. And I should also add – though it is probably unnecessary for me to say this – we shall have neither the ability nor the desire to monitor a bank’s actual sharia’a compliance. That has to be something for the sharia’a board and for the institution itself.
Putting in the hard work on the detail
19. It is one thing to talk in generalities, another to produce detailed plans that will work. We in the UK have been very much aware of that and in respect of one product for which there is thought to be considerable demand (an Islamic mortgage) we have followed a path of detailed examination at the highest level. (This has involved a Working Party chaired by the last Governor of the Bank of England and it may be that this is a model for what we need to do in respect of other possible products too.)
20. The sad fact is that modern economic life is complicated. And even in the case of a relatively simple product such as a mortgage, the reality is that a number of Government departments are potentially interested and changes are needed to tax and social security arrangements (to name just two areas) before a sharia’a mortgage can successfully be launched.
21. I am pleased to say that the main hurdle in the UK– which is that a sharia’a compliant mortgage may require the payment of stamp duty twice instead of the usual once –will be eliminated with effect from November.
22. We regulators are doing our part, not least in examining ways in which ijarah mortgages might qualify within the current Basel Capital Accord for a capital weighting similar to a conventional mortgage. [On the face of it, an ijarah mortgage will otherwise require a bank to keep twice the capital that a conventional mortgage will require. Such a requirement, because of course banks have to earn profit on the capital tied up in their balance sheet, currently makes an Islamic mortgage modestly more expensive than a traditional one. There may be no way out of this, at least until the new Basel Accord comes into effect at the end of 2006, but if there is we are committed to finding it.
23. And we are partuicularly encouraged by the launch of the Islamic Financial Services Board, which we hope will help to harmonise standards and product definition in this area. It is pleasing to note that work is already starting on some of the knottier problems it has to address - such as capital adequacy and corporate governance for Islamic banks. The FSA is playing its part here with participation in both groups.
24. Similarly –and I hope my presence here today is some proof of this – we are committed to whatever detailed work it takes to find ways of allowing the authorisation and subsequent successful operation of Islamic banks and of Islamic products provided through other (non-bank) channels. This is one reason why we are supporting the work of the groups contributing to the Islamic Financial Services Board. The ways we find must be consistent with our own and the wider EU statutory requirements. But I am confident that this can be done.