FINANCIAL MODERNIZATION IN 21ST CENTURYAND CHALLENGE FOR ISLAMIC BANKING. Fahim Khan

1. Dynamism in the Banking Industry

Banking industry is changing fast. The following factors are believed to be responsible for the changing dynamicsof the industry:

1.Changing client needs for financing and investment

2.Cost reducing strategies and technologies

3.Emerging new potential markets with different demographic and social characteristics

4.Technology based financial services products

5.Regulatory reforms to align with financial modernization

Each one of these factors is contributing dynamism in the industry and hence introducing new competitive environ-ment and making the environment more and more challenging for the Islamic Banking movement. It is not possiblehere to discuss implications of all these factors for Islamic Banking. I am narrowing down the discussion to focuson the last factor only i.e. Regulatory Reforms for Financial Modernization (currently in process in USA and othercountries may also follow) that will trigger new dynamics for the industry and will present a new competitiveenvironment to Islamic Banking.

2. Glass-Steagall Act (1933) Repealed

Regulators are actively considering reforms to support the financial modernization and to align with the changingdynamics in the industry. One such reform recently introduced in USA is in the direction of relaxing some of therestrictions on banking activities and granting them flexibility in designing their products and services. This has beendone by repealing a 65-year old act called Glass-Steagall Act. The Act (1933) prohibited banks from engaging insecurities market activities including the sale of mutual funds. (This prohibition, however, did not apply when theAmerican Banks operated in other countries).There were several reasons for introducing this act. One important reason was that frequent failures of banksduring Thirties were attributed to the bank's involvement in risky activities which included the investment in secu-rities and mutual funds.

One failure or bad investment on asset side (particularly when the assets are highly concentrated) would make theassets substantially lower than the liabilities and hence creating apprehensions of bankruptcy. This increased therisk of run on the bank and the run did occur in several cases and resulted in banks' failures during 1930s.A Small Digression: Such situation is less likely to arise under the concept of Islamic banking. Assets andliabilities are supposed to be balanced always under the concept of Islamic banking. If there is shock onasset side, it will be immediately reflected on the liability side (because deposits share the profits/losses ofthe banks). Also theoretically Islamic banks assets or investments may not be concentrated as much as theyare in conventional system and hence a single shock on asset side may not be as damaging as it would bein conventional banking system where advances/loans are high concentrated.Coming back to the point. It was considered in USA that prohibiting banks from dealing in securities, mutual fundsetc. would contribute to reducing the problem of moral hazard and adverse selection and hence reducing theprobability of bank failures. Hence the Act known as Glass-Steagall Act was introduced.

3. The New Rule

The commercial banks found it unfair to disallow them to compete with investment banks and brokerage firms.Their lobby finally succeeded in getting the law repealed. The new rule approved by federal regulators on Novem-ber 20, 1999 allows commercial banks to establish subsidiaries to market new products and services includingsecurities and insurance as long as subsidiaries' capital and operations are separate from the banks?Is this a Good News for Islamic Banks?Is this development good news for Islamic Banking? Some are arguing that it is good news because it removes thewall separating investment banking from commercial banking. Investment banking is an integral part of Islamicbanking and hence a major hurdle has been removed from the way of Islamic banking to enter USA.But will they now be really allowed to enter? That good news has yet to come.Investment banking will be allowed only as a subsidiary to a commercial bank on case to case basis. This surelyallows banks like Chase Manhattan or Citibank, to establish an Islamic bank as a subsidiary, if they so wish.Islamic banking has already been slipping to the control of conventional banks and the new rule will make the waymore slippery for Islamic banking. If other countries where Islamic banks have their presence also adopt such rulesthen Islamic banks will face a very tough competition from conventional banks. According to this rule, the conven-tional banks can establish Islamic banks subsidiaries, while Islamic banks will not be able to do conventionalbanking. The conventional banks thus will attract Islamic banking clientele and thus grabbing the substantial part ofthe market share of Islamic banks. Conventional bank may get bigger on account of Islamic clientele while Islamicbank may shrink. There is all the risk that Islamic banking may get diluted within the conventional banking unlessIslamic banks do something to establish their distinction as "Islamic Banks".

Financial Reforms that Islamic Banks should seek from Regulators

Islamic banks in the last two decades have benefited from continued global economic expansion and low inflation.These good times may not last forever. Financial reforms like those mentioned above will make the competition forIslamic banks too tough. They need to make a lobby to persuade the regulators not to make competitive environ-ment less conducive for them. Of course Islamic banks are too small to make any meaningful lobby. Yet there areat least two basic reforms that conventional banks are already pursuing and Islamic banks will not be at disadvan-tage or face unfair competition with the conventional banks if they join conventional banks lobby for these reforms.Demand for commercial banks loans is globally declining for various reasons. The conventional banks are lookingforward to reforms that can allow them to expand the span and mode of their activities and some of their demandsif accepted may open new horizons for the Islamic banking too.

There are two main areas in which the financial reforms sought by conventional banks can benefit Islamic banksas well:

a. Allowing banks to engage in any genuine financial activity

b. Allow them to choose the organization structure that best suits to their needs.

Flexibility in the Span of Activities for the Banks

The banking institutions are seeking a flexibility to allow them to take up activities relating to investment bankingand insurance along with their commercial banking activities. Islamic banks should join their voice with them andshould seek flexibility not only to allow investment banking and insurance but also to allow following also as a partof activities.

i) Trade (including export/import) banking

ii) Lease banking

iii) Infrastructure banking

Regulators can be persuaded to grant this flexibility, as a part of Twenty First-Century vision for financial reform.They may envisage this flexibility, not for the sake of Islamic banking but for the sake of enhancing competitiveenvironment in the financial market. The competition of course will help reducing the cost of providing financialservices to the users and to give all forms of alternative banking (such as Islamic Banking, Ethical Banking, SocialBanking etc) fair chance to compete in the financial market.The regulators of course, will have to develop innovative safeguards to ensure that banking activities continue tooperate smooth and depositors or small business interests are not unduly put at stake by the reforms.

Flexibility in the Organization Structure of the Banks

The banking institutions are seeking flexibility in choosing the corporate organization structure that best suits theirspan of activities. There are three broad models of organization structure that the banking institutions can adopt toconduct non-banking financing activities as well (such as investment banking, insurance, trade banking etc.):Bank Holding Company Model: Under this model a parent organization holds separate organization for differentactivities e.g. holding an organization for investment banking, an organization for commercial banking, an organiza-tion to conduct trade banking etc.Bona Fide Subsidiary Model: Under this model a bank can establish bona fide subsidiary (rather than separateorganization) that has its own capital and has all its operations physically separated and distinct from the operationsof the bank. The subsidiary must maintain separate accounting and other corporate records. The subsidiary willhave its own Board of Directors meeting (the majority not to be from the Directors of the Bank).Universal Banking Model: Under this model all different activities are carried within the same entity/organization.Thus a bank would be doing commercial banking, investment banking, insurance etc. all under the same roof.Universal banking, though exists in Germany, the Netherlands, and Switzerland and though have been successfulfor some time, is not being currently considered as a model to best fit dynamic financial market place in countries.

Like USA and Japan. This model may suit some conventional banks to continue their commercial banking activitieswith insurance banking and insurance. The model, however, may not best suit the Islamic banking because of thewide difference in the nature of activities that Islamic banks would like to include, namely; investment banking,commodity trade based banking, leasing based banking, Istisna-based banking insurance and the normal commer-cial banking. The regulators may also find it difficult to regulate them if Islamic banks adopt such an organizationstructure.Regulators may find difficulties in regulating the Bona Fide Subsidiary model as well, whether in the context ofconventional banking or Islamic banking. The conflict of interest among the subsidiaries will be the main source ofproblem for the regulatory bodies to design rules for regulation. Subsidiary models, however, may be suitable forIslamic banks, if they intend to establish one or two subsidiaries. For example it may not pose much difficulty forregulators, if an Islamic bank has a subsidiary for insurance and/or for investment portfolio. But if they want tohave more subsidiaries to cater to wide range of their activities then regulators may not find it a convenientstructure from their point of view.A holding company model will be more relevant for Islamic banks and can help them establishing the distinction oftheir financing operations compared to those of conventional banks and can also get them the support of regulators.Islamic banks are currently criticized on the ground that their operations are almost similar, if not exactly similar, tothose of interest based banks. And this can become a major hurdle in the growth of Islamic banks in the 21stcentury. The Islamic banks cannot escape this criticism because their present organization structure does not allowthem to directly carry out trading, leasing or construction activities and hence they end up doing only financialoperations. Operating under a Bank Holding Company Model, holding separate organizations for commodity tradebased operations, leasing based operation, infrastructure operation, insurance etc. will help them wash away mostof the above criticism and will make it convenient for regulators also to supervise and monitor their activities.

Conclusion:

Repeal of Glass-Steagall Act (1933) in USA that separated commercial banking from investment banking, cur-rently, may not be more than a bad news for Islamic banking. The new rule, implicitly allows the conventional banksin USA to take up some Islamic banking activities as well and hence leaving little justification for the establishmentof separate "Islamic banks" in USA. The big banking corporations are now in a position not to leave any room foran Islamic banks to compete with them in USA. They already had this privilege abroad (and they utilized it) asGlass-Steagall Act did not apply on US banks abroad.A strategy for Islamic banks for 21st century would be to join hands with conventional banks to pursue with theregulators such financial modernization that will equally benefit the conventional banks and Islamic banks to en-hance their business.

The Islamic banks may press for the following at national as well as global level:

i. Flexibility for a banking institution to conduct any genuine financial activity in any genuine way. This isneeded for Islamic banks to conduct their operations activities according to Shari'ah. This is also needed byconventional banks to enhance their span of activities because there is a declining trend in the demand for thebanks' commercial loans.

ii. Flexibility for a banking institution to choose an organization structure that suits it best. This flexibility isneeded by Islamic banks as well as conventional banks. For Islamic banks it will be productive to adopt a BankHolding Company Model and will help them maintain Islamic distinction in their operations and help them competeout conventional banks to do Islamic banking activities. The adoption of Holding Company Model by Islamic bankswill make it convenient for regulators also to supervise and monitor their operations.