Dissertation Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance
The Banking Supervision and the Prudential Regulations in Islamic Finance
By SAMY OUAHIB
STUDENT N: 06242330
ASSESSED BY: NORWOOD WHITTLE
A dissertation submitted in partial fulfilment of the requirements for the degree of MA MANAGEMENT (FINANCIAL ANALYSIS) At the University of Northampton 2009
Word counts: 16,315 words
e vs
and Prudential re ulation in Islamic Finance
ACKNOWLEDGMENT
continuous support. My appreciation goes to my supervisor Norwood Whittle, who patiently assessed my work throughout the process. Your
attention to details contributed immensely to this piece of work. My thanks also go to all my lecturers, who they were helpful at various times. I owe my parents greatly for their encouragement and financial support.
I dedic
e this piece of work to m
family as recognition for their
ABSTRACT
The credit crunch and the turmoil in global financial markets have affected every country in the world. Indeed, the recent financial crisis due the subprime showed us how the banking regulations are essential to guarantee the stability of the financial system. This piece of work focuses on the banking supervision and prudential regulation in the Islamic financia l system. I will deal with the Shariah supervision and the monitoring of Shariah compliance of Islamic banking practices. Also, I will emphasis on choosing an appropriate rating technique approach for the

supervisory authorities. I analysed the CAM
S rating approach
which I think can be efficient after being adapted for the Islamic environment. This research deals also with the attention which should be given to corporate governance in Islamic banking industry. Because in recent years, bad corporate governance proved to be in the heart of many bank failures. For this reason, this study shows how important it is to supervise the corporate governance aspect of Islamic financial institution s. On the other hand, this piece of work deals with the importance of disclosure information and licensing procedures. My findings show how disclosure information and licensing procedure are more important in Islamic banking than in conventional banking. As a conclusion, I made some recommendations, which in my point of view can contribute to improve the banking supervision in Islamic banking.
Table of Contents
Acknowledgment ................................ ................................ ................................ ............. 2 Abstract ................................ ................................ ................................ ............................ 3 Table of Contents .4
CHAPTER ONE: INTRODUCTION ................................ ................................ ........................ 8 1.1 INTRODUCTION ................................ ................................ ................................ ........ 9 1.2 RESEARCH RATIONALE ................................ ................................ ............................ 11 1.3 OBJECTIVES................................ ................................ ................................ ............. 11 1.4 RESEARCH QUESTIONS 1.5 ARRANGEMENT OF THE CHAPTERS CHAPTER TWO: LITERATURE REVIEW 2.1 REVIEW OF THE FUNDAMENTAL FEATURES OF ISLAMIC BANKING 2.2 THE REGULATION OF ISLAMIC FINANCE 2.2.1 Why financial regulation 2.2.2 Regulatory Options 2.2.3 Requisites for effective Regulation 2.3 SEGMENTED APPROACH TO IFI REGULATIONS 2.4 PRUDENTIAL FRAMEWORK FROM ERRICO AND FARRAHBAKSH (1998) A. Legal Foundations B. Management of Operational Risks B.1 Capital B.1.1 Level of the capital adequacy ratio B.1.2 Risk-weighting Methodology B.1.3 Off-balance sheet commitments B.2 Assets ..12 ..12 .13 14 15 ..16 ..20 21 .23 .26 26 26 .27 ..28 29 30 .. 31
B.3 Management B.4 Earnings B.5 Liquidity 2.5 THE REGULATORY CHALLENGES AHEAD CHAPTER THREE: METHODOLOGY 3.1 RESEARCH DESIGN 3.1.1 Approach 3.1.2 Research Philosophy 3.2 RESEARCH CONTEXT 3.3 PROCEDURE 3.4 METHODS FOR DATA COLLECTION 3.5 METHODS FOR DATA ANALYSIS 3.6 RELIABILITY AND VALIDITY 3.7 SUMMARY CHAPTER FOUR: FINDINGS 4.1 SHARIAH SUPERVISION 4.2 THE OFFSITE SUPERVISION 4.3 SUPERVISION TECHNIQUES APPROACH 4.4 LICENSING PROCEDURE 4.5 INFORMATION DISCLOSURE 4.6 CORPORATE GOVERNANCE 4.7 THE RELATION OF THE IFSB WITH OTHER INSTITUTIONS 4.8 FINANCIAL REPORTING IN ISLAMIC BANKS
.32 .32 .33 34 37 .38 .38 40 44 44 46 ..46 ..47 ..47 .48 ..49 ..50 .51 .52 ..53 .54 ..55 .56
CHAPTER FIVE: DISCUSSIONS 5.1 SHARIAH SUPERVISION 5.2 THE OFFSITE SUPERVISION 5.3 SUPERVISION TECHNIQUE APPROACH 5.4 CAMELS IN THE CONTEXT OF ISLAMIC BANKING 5.4.1 CAPITAL 5.4.2 Assets 5.4.3 Management 5.4.4 Earnings 5.4.3 Management 5.4.4 Earnings 5.4.5 Liquidity 5.4.6 Sensitivity to market Risk 5.5 LICENSING PROCEDURE 5.6 INFORMATION DISCLOSURE 5.7 CORPORATE GOVERNANCE 5.8 THE RELATION OF THE IFSB WITH OTHER INSTITUTIONS 5.9 FINANCIAL REPORTING IN ISLAMIC BANKS. CHAPTER SIX: CONCLUSION AND RECOMMENDATIONS 6.1 CONCLUSION .
57 ..58 ..59 59 .61 .61 .63 64 64 64 64 65 .66 . 67 ..68 .71 ..74 75 .76 77 80 .81 82
6.2 RESEARCH CONSTRAINTS AND LIMITATION 6.3 RECOMMENDATIONS 6.4 SUGGESTION FOR FUTURE RESEARCH
6.5 PERSONAL REFLECTIONS REFERENCE LIST BIBLIOGRAPHY APPENDICES
..83 ..84 .88 .. 89
1. INTRODUCTION
1.1 INTRODUCTION 1.2 RESEARCH RATIONALE 1.3 OBJECTIVES 1.4 RESEARCH QUESTIONS 1.5 ARRANGEMENT OF THE CHAPTERS
Chapter one has given a brief overview of the proposed research, themes such as the purpose of the research, main aim and objectives, limitations of the work, arrangement of text and chapters were discussed to make sure the readers of this research will be able to find the answers to the mentioned themes.
1.1 INTRODUCTION
According to some estimates, more that 100 financial institutions in over 45 countries practice some form of Islamic finance, and the industry has been growing at a rate of more than 15% annually for the past five years (Archer, 2003). This dynamism is due to the soaring price of raw materials, in particular, the oil prices creates an excess of liquidity estimated at 1500 billion dollars in the Gulf and Southeast Asia countries. Islamic precepts influence the and activities of banks in several ways, the most important being the prohibition against the payment and receipt of a fixed or predetermined interest rate, 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 (Chapra et al, 2002). Also, because of its rapid development, Islamic finance faces problems of governance, transparency and respect of international standards. With the growing the number of Islamic financial institutions, an imperative need for regulating them was felt given their diverse nature. The rationale behind working towards uniform regulatory codes for Islamic financial inst itutions is the current situation of different guidelines in different countries. The challenges faced by them are growing at a faster pace. Many public policy issues have been raised in the jurisdictions in which they operate and at the
10
international level. These have led international organisations, international standard setters, and national regulatory authorities, policy makers and academia to examine various aspects of Islamic financial intermediation each from their own perspective. The main objective is to build uniform risk and arrive at a standard regulatory framework governing them. The
establishment of accounting and auditing Organisation for Islamic financial institutions (AAOIFI), International Islamic Rating
Agency (IIRA), Islamic Financial Services Board (IFSB) and the liquidity Management Centre was aimed at achieving this
objective. The expansion of Islamic banking industry has created both expectations and apprehensions simultaneously. Risk is inherent in every financial innovation. Islamic finance is no
exception to such risk perceptions. The effect is even more compounded for Islamic finance because of the nature of its products. The main issues of concern are: the divergence between theory and practice; need for Islamic financial
institutions to adapt to their environment to compete with conventional counterparts; combination of each institutions with the
Shariah board and
legal tradition;
interpretations
markets competitive pressure to shape the activity of each Islamic financial institution; need for IFI to comply with the regulations governing conventional financing and to use
accounting standards that may not be fully adapted to the substance of their business activities (Iqbal et al, 2002). I got the idea of doing a dissertation when I was in an internship at the banking supervision department of the central bank of Morocco. While I was assisting to inspector, I noticed that the Islamic banks suffer from a lack in terms of prudential regulation standards. Also, I decided to study a topic regarding Islamic
11
finance in order to expand my knowledge of Islamic finance which can enable me to get a job opportunity within this field.
1.2 REASEARCH RATIONALE

The Islamic finance is becoming an important and growing niche within the global financial economy. Every day Billions of US dollar are traded under the Islamic financial system around the world. By doing my dissertation on the banking supervision in Islamic finance, I am trying to explore an aspect of the Islamic finance which guarantees its soundness and stability. I got the idea of studying the Banking supervision in Islamic finance when I was working as a trainee trader in the Central Bank of Morocco where I noticed that this niche is growing fast and that is getting an increasing interest from clients. Its also an opportunity for me to understand how the Islamic financial product works because its totally different than the way of which the traditional financial product works. As I am quiet interested in starting my career in a financial sector, I thought that a research project on the Islamic finance can improve my knowledge in this type of finance and also enables me to get opportunities to work in banks or corporate which operate within this sector.
1.3 OBJECTIVES
By focusing on the banking supervision and the prudential regulation aspect of the Islamic financial sector, I aim to develop an understanding of how the banking supervision operates and the theories and principles on which the
prudential regulations are based on. I will critically investigate the current situation of the banking supervision in the Islamic finance. Indeed, and my the research will of aim the to evaluate the
effectiveness
reliability
actual
banking
supervision practices, particularly when we know that the IFSB is a recent organisation (created in 2002).
12
On the other hand, I will evaluate the possibility for the Islamic supervisory authorities to use some supervisory
techniques used by the conventional banking supervision. I will end this piece of work with some perso nal recommendations aiming to improve and develop the banking supervision in Islamic finance.
1.4 RESEARCH QUESTIONS

The focal point of my research is as follows:
y
To what extent the banking supervision in Islamic finance is efficient?
Which bank supervision techniques is the more appropriate institutions? for monitoring the Islamic financial
Is
it
really
important
to
include
the
corporate
governance in the banking supervision process?

y
The role of Shariah supervision in the Islamic banking industry
Should
the
supervisory more on the
authorities aspect of
focus
their
inspection
disclosure
information and licensing procedures?
1.5 ARRANGEMENT OF THE CHAPTERS:

The arrangement of text is done so that the reader finds it easy to under the findings on the proposed aim. The dissertation is divided into five chapters which are, Chapter one: Introduction. Chapter Two: Literature Review. Chapter Three: Research Design. Chapter Four: Findings Chapter Five: Discussion Chapter Six: Conclusion and Recommendation .
13
2. LITERATURE REVIEW
2.1 REVIEW OF THE FUNDAMENTAL FEATURES OF ISLAMIC FINANCE 2.2 THE REGULATION OF ISLAMIC FINANCE 2.3 SEGMENTED APPROACH TO IFI REGULATIONS 2.4 PRUDENTIAL FRAMEWORK FROM ERRICO AND FARRAHBAKSH (1998) 2.5 THE REGULATORY CHALLENGES AHEAD
14
This chapter contains the literature associated with the topic of the research. The literature deals with the authors who wrote about the banking supervision in Islamic finance.
2.1 Review of the Fun amental features of Islamic Banking
To understand Islamic Banking is to realize that its banks and their operations are considered to be in an integral part of a complete Islamic economic system, which is based upon the codification of injunctions outlined in Koran and the traditions of Prophet Mohammed, that is the Islamic Shariah (Subbulakshmi, 2004). Key elements of the Islamic economic system include individual rights, property rights, contracts, work and wealth, and the role of the state. While preserving their key tenets, the rules established in the shariah have been elaborated upon and refined over time by Islamic scholars and economists in order to adapt them to the evolving economic environment (khouri, 2005). Islamic banks are characterized by the following features: y Prohibition against the payment an

receipt of a fixed
or predetermined rate of interest. This is replaced by profit and loss sharing (PLS) arrangements where the rate of return on financial assets held in banks is not known and not fixed prior to the undertaking of the tra nsaction (Abdeen, 2002). The actual rate of return can be
determined only ex post, on the basis of actual profits accrued from real sector activities that are made possible through the productive use of financial assets (Abdeen, 2002).
15
Requirement to operate through Islamic modes of financing. These modes affect both the assets and
liabilities sides of a banks balance sheet and can be divided into two groups: the ones that are based on the PLS principle (core modes) and the ones that are not (marginal modes) (Abdeen, 2002). y Investment deposits. Such deposits are not guaranteed in capital value and do not yield any fixed or guaranteed rate of return. In the event banks record losses as a result of bad investment decisions, depositors may lose part or all of their investment deposits (Abdeen, 2002). The only contractual agreement between depositors and banks is the proportion (ratio) according to which profits or losses are to be distributed (Abdeen, 2002). y Demand deposits. Such deposits are guaranteed in capital value, although no returns are paid on them. The reason to justify the capital value guarantee is the assumption that demand deposits have been placed as Amanat (i.e., for safekeeping). Hence, they belong, at any time, to
depositors (Abdeen, 2002).
2.2 The Regulation of Islamic Finance

Greater attention has been paid since the early 1990s to the regulatory and supervisory frameworks governing IFI. Differences between balance sheet structures of Islamic and conventional banks and the features of Islamic financial contracts have been recognised to have important implications for accounting a nd financial accounting. Early study raising the issues of regulation and supervision of IFI include Archer and Karim (1997), Archer, Karim and Al-Deehani (1998), and Errico and Farabakash (1998). These studies note that an appropriate regulatory framework
16
needs to place greater emphasis on accounting standards and information disclosure. 2.2.1 Why Financial Regulation? There are diverse views on the need for regulation in Islamic Finance. They range from positions of almost total opposition to any regulation, to the justification of broad, intrusive regulation. El Sheikkh (2000) argued that: the widely held view by Islamic jurist is that Islamic banks should not be regulated or supervised by any authority. On the other hand, Chapra and Khan (2000) argue the need for regulation. Four reasons presented by Chapra and Khan (2000) for the regulations of IFI are discussed in light of the foregoing three views on the rationale for regulation. a) Systemic considerations , particularly the need to maintain an orderly payments system and ensure the development of the economy (Chapra and Khan, 2000). y The promotion of orderly payments is clearly in the nature of a public good and consistent with this rationale for financial regulation. Whether in the theoretical model of an IFI or in current practice, regulation is likely to be required to mitigate the risks of disruption in payments
(Chapra and Khan, 2000). y The promotion of economic development may be beyond the role that should be assigned to financial regulation. The latter can promote trust in the financial system, encourage more
intermediation and diminish the risk of failure, all elements that would encourage activity expansion. However the design of financial regulation to directly promote development may dis tort its
17
objectives of ensuring soundness and stability and pose challenges for regulators having to choose between promoting economic development and ensuring the stability of the financial system (Chapra and Khan, 2000). b) Protecting the interest of demand depositors. In terms of a theoretical IFI model, the case for introducing regulation to protect depositors is less compelling than in
conventional finance (Chapra and Khan, 2000). This view seems to underlie the two-tier Mudaraba model that does not envisage any reserve requirement. The essence of Islamic financial intermediation being symmetrical risk as well as profit and loss sharing, introducing a guarantee on the downside would run counter to the core objective (Chapra and Khan, 2000). Investment depositors should however expect to be informed on the features of the contract they enter into and have recourse if it is breached. Hence regulation promoting the integrity of fiduciary contracts would be consistent with the theoretical IFI model (Chapra and Khan, 2000). With existing IFI, depositors may not always be fully apprised on the risks they face in principle with their deposits while at the same time IFI try to protect their deposit base by providing sufficient security assurance and returns. In th is case, there is a case for regulation that seeks to protect depositors, integrity. public The resources of and fiduciary contract is
protection
demand
depositors
envisaged in the two windows model and can be justified through any of the three perspectives considered (Chapra and Khan, 2000). c) Ensuring compliance with Shariah. The relationship
between civil and religious law varies across national
18
jurisdictions (Chapra and Khan, 2000). In the case where there is an orientation toward a strong separation, it would be difficult to justify assigning to public authorities the role of ensuring that banking activities comply with Shariah (Chapra and Khan, 2000). This would be
considered a private religious matter that does not call for public intervention. The issue of truth in disclosure and in advertisement would however remain and would allow stakeholders to have recourse. This would not however be a matter of financial regulation, but one of broad
institutional infrastructure for business. In jurisdictions where the distinction between civil and religious law is less pronounced, one can well see a public policy choice for assigning to a public regulator the role of ensuring that banking activity complies with Shariah (Chapra and Khan, 2000). d) Supporting the integration of IFI in the international financial system . Integration would develop from the participation of IFI in the financing of international trade and international payments (Chapra and Khan, 2000). Counterparts of IFI would want to be satisfied of the ability and commitment of IFI to fulfil the contracts they enter into. In this respect national and international regulation can be founded on the public goo d need to ensure orderly participation in international payments and the integrity of fiduciary contracts (Chapra and Khan, 2000). Subbulakshmi (2004) agrees with Chapra and Khan (2000) regarding the reasons behind regulating the IFI. Subbulakshmi (2004) support a heavy and constraining regulation due to the following risk:
19
Withdrawal risks which arise out of competitive pressures

which an IFI faces with existing Islamic or conventional counterparts (Subbulakshmi, 2004).
Solvency risk is the risk that a bank has insufficient

capital to continue operations. AAOIFI defines fiduciary risk as that of becoming legally liable for a breach of the investment contract either for non-compliance with
Shariah rules or for mismanagement of investors funds (Subbulakshmi, 2004).
Innovative risk that is often talked in the recent times

related to governance is operational risk. It is defined as the failure of internal processes as related to people and systems. As example, an internal control problem in Dubai Islamic bank generates a loss of $50 million in 1998 when a bank official did not conform to the banks credit terms. This also resulted in a run on deposits to the extent of $ 138 million, 7% of the banks total deposits in just one day (Subbulakshmi, 2004).
Islamic banks are vulnerable to liquidity risk because of

their limited access to funds to meet their obligat ions. Liquidity risk arises due to mismatch of assets and liabilities of the bank which may lead to either surplus of shortage of cash (Subbulakshmi, 2004).
Another
important
risk
is
credit
risk.
It
is
the
counterparty risk inherent in some modes of Islamic Finance. Absence of well -developed credit risk
assessment systems and associated expertise magnifies the chances of occurrences of such risk (Subbulakshmi, 2004).
20
2.2.2 Regulatory options According to Archer (1998), Regulators have traditionally governed their jurisdictions through direct rules mostly on capital, assets and income allocations. At the same time, regulatory changes often lag financial developments and may consequently either constrain the ability of financial institutions to flexibly manage their portfolios, or provide them with opportunities to take unchecked risks implicitly comforted by the existing safety net (Ayoub, 2002). Baldwin (2002) argues that in adapting to
these developments, the profession is now moving toward letting regulated institutions asses and manage their risks within a framework agreed on with the regulator. In light of the foregoing, two sets of issues face regulators of IFI, once they have clarified the rationale for the introduction of regulation. These issues relate first to the type of regulation needed and second to the method of regulation (Bliss, 2001). In terms of type of regulation, one can consider issues such as capital, transparency or licensing requirements. The method of regulation can rely in various degrees on direct command and control rules, on market discipline (direct and/or indirect) or institution home developed risk assessments (Bliss, 2001). The type and method of regulation chosen will depend on the rationale for regulation adopted and on the type of IFI considered, be it a model Islamic financial intermediary or in line with prevailing practice (Bliss, 2001).
(1) In a theoretical IFI model, minimal regulation is expected with less emphasis on capital requirements, more on transparency and disclosure, probably more on screening management profile and business line in licensing, and equivalent in supervision as
compared to conventional banking. There would be also an
21
expectation of larger reliance on direct market discipline and less on command and control regulation (Ali, 2003).
(2) In an existing IFI, prevailing intermediation practices would seem to point to the need for equivalent emphasis on a capital requirement, supervision and licensing, and a larger one on transparency and disclosure, compared to conventional banks (Ali, 2003). Competitive pressure is inducing IFI in the market to provide sufficient safety and return to depositors in unrestricted investment displacing accounts. They in consequently their face and the risk of to
shareholders
returns
capital
accommodate these depositors (Ali, 2003). As a result they are practically facing a similar intermediation risk to conventional banks and should therefore be subject to similar capital and supervision requirements (Ali, 2003). The pooling of Amana, unrestricted investment deposits and capital in funding their assets raises transparency issues for the distribution of returns or losses. It consequently calls for rigorous transparency and
disclosure requirements (Baldwin, 2002). So, it would also call for significant scrutiny in licensing, notably with respect to managers profiles (Ali, 2003).
2.2.3 Requisites for Effective Regulation
Chami
(2003)
argues
that
effective
regulation
requires
readable, reliable signals of the risks that a financial institution faces resulting from its own behaviour or from events external to it, as well as risks that may affect the financial system through contagion, or infrastructure failure. It also requires an ability to process these readable signals and to introduce the appropriate corrective actions as needed (Chami, 2003). As such it may be more akin to sophisticated art that uses advanced techniques.
22
But even if art presumes independence and creativity, beyond the availability of a good technique, it still requires the necessary tools (Fadeel, 2002). In this respect the role of the broader institutional infrastructure is core of particular importance would be the clarity and enforceability of property rights, the quality of contract law and opportunity to bring prompt remedies to breaches, the efficiency of judicial recourse and other dispute resolution mechanisms (Ali, 2003). The majority of existing IFI operate however in
jurisdictions where there is much left to be desired in these matters, which adversely affects their development (Lewis, 2001). More closely related to finance, the quality and transparency of accounting and auditing play a crucial role. Measurement and comparison of risk exposure should underlie regulation. The efforts at establishing accounting and auditing standards for IFI have made a significant contribution in this respect. However, disclosure of accounting instrument for risk results may not because, be as an adequate a structure ,
assessment
accounting is directed toward value, not risk allocation (El-Gari, 2000). This situation gives additional importance to other
services, such as the collection and dissemination of financially relevant information and credit rating. In addition it would call for renewed efforts at enhancing the relevance of accounting and auditing for risk assessment (Subbulakshmi, 2004). With financial innovation, including through IFI, various instruments and
structures are emerging to meet the demand for specific services. As a result, the functions of financial institutions are evolving continuously. Such increased fluidity of the objects of regulation calls for nimbleness and skills on the part of the regulator with a frequent assessment of the adequacy of their perspective (IFSB, 2007).
23
2.3 Segmented Approach to IFI Regulations
The combination of services o ffered by operating IFI and the prevailing practices they follow compound the difficulties of designing a regulatory framework to govern them (Kazem, 2002). First, the problem of co-mingled funds from different classes of deposit holders needs to be addressed. One approach could be to encourage IFI to structure their operations in clearly defined and separated segments catering to different classes of depositors depending on their respective investment objectives (Kazem, 2002). Iqbal (2002) developed a vision consistent with principles which could see an IFI structured as a group of fairly independent entities, each designed to optimize the functional demands of its clients. This view is elaborated in the following table, which shows three distinct segments.
Assets
Asset-backed Trade financing Minimal Risk Ijara, Istisna, Mudaraba Low-Medium Risk
Liabilities
Segment A Depositors Segment B Depositors
Musharaka Mudaraba Venture Capital Private Equity
Segment C Depositors
24
Segment A is designed to handle funds for depositors who are highly risk averse and require a high level of liquidity and would use the funds for daily transactions or would prefer to keep savings in safe assets where their capital (principal) is preserved (Iqbal, 2002). This segment will invest funds in asset -backed securities with fixed-income characteristics and IFI will intermediate by screening and monitoring such opportunities and making sure that credit and operational risk are contained. The concept is similar to narrow banking and would require a similar approach to its regulation (Iqbal, 2002). Segment B is designed to cater to depositors with the next level of risk appetite who are willing to take some risk in expectation for a higher return, with capital preservation and liquidity less high on their agenda (Iqbal, 2002). IFI would deploy these funds in medium- to long-term instruments, such as Ijara or Istisna, or may prefer to invest on Mudaraba basis directly with the
entrepreneur or through Mudaraba certificates (Iqbal, 2002). If there is a well developed secondary market for Mudaraba based funding, then the form of intermediation taken by IFI will be very similar to mutual funds where IFI will manage and invest depositors money in different Mudaraba funds (Iqbal, 2002). Since the contractual agreement with the depositors would be similar to the fiduciary responsibility of a mutual fund in a conventional system, the same regulatory principles would apply (Iqbal, 2002). Segment C is designed for investors who would be willing to take additional risk and would like to participate in riskier investments, like private equity or venture capital (Iqbal, 2002). IFI could
25
deploy these funds on the basis of Musharaka or Mudaraba instruments. When funds are invested on Musharaka basis, the IFI also gains rights to participate in the governance of the enterprise, which raises another issue for regulators (Iqbal,
2002). The IFI as equity participant becomes an institutional investor that has a vested interest in the governance of the institutions, the recipients of funds. This implies that the financial institution itself becomes a stakeholder in the enterprises that depend on funds it provides (Iqbal, 2002). Since Islamic financial principles advocate a stakeholder approach to corporate
governance,
the IFI would be expected
to conduct active
monitoring of enterprises it invests in. In these circumstances, the IFI would behave in a similar way to financial institutions in a bank based or insider system practiced in Germany or Japan. It would be expected that a representative of IFI participate in supervisory boards of enterprises in which they have considerable investment and a long-term relationship (Iqbal, 2002). The IFIs relationship with Musharaka enterprises would be of long-term nature with active involvement in governance in contrast to a short-term, transactional relationship (Iqbal, 2002). To summarize, an IFI structured to provide financial
intermediation through clearly segmented
windows or even
separate institutions would make the task of regulators easier. Each entity could then be subject to a regulating principle most suited to its nature (Iqbal, 2002)
26
2.4
Prudential
Framework
from
Errico
and
Farrahbaksh (1998)
Errico and Farahbaksh (1998) suggest a supervisory framework based on the standards and best practices established by the Basel committee and an Islamic finance - tailored prudential framework based on the CAMEL system. A. Legal Foundations In order to provide the legal foundations for the supervision of Islamic banks, it is necessary that either the general banking laws or specific laws pertaining to Islamic banks define in detail the nature of these banks and their specific operating relationship with the central bank and other conventional bank if applicable. Such a legal framework should contain provisions relating to licensing, permissible modes of financing, and state clearly powers to address compliance with laws and regulations (Errico and Farrahbaksh, 1998). In particular, such provisions should determine which enterprises may call themselves Islamic banks, collect deposits, and carry out banking practices on the basis of Islamic principles. Moreover, laws should state clearly that the central bank (or separate supervisory authority) has the authority and all necessary powers to supervise Islamic banks and
conventional banks, if applicable (Errico and Farrahbaksh, 1998). B. Management of Operational Risks Management of operational risks in Islamic banks could usefully be addressed through an appropriate CAMEL rating framework (Errico and Farrahbaksh, 1998). CAMEL rating is a measure of the relative soundness of a bank and is calculated o n a 1-5 scale, with one being a strong performance. The acronym stands for capital, assets, management, earning, and liquidity. These are the five
27
critical dimensions of a banks operations. They reflect in a systematic fashion a banks financial condition , compliance with supervisory regulations, and overall operating soundness. The standard CAMEL rating system would need to be appropriately adapted to an Islamic banking environment as discussed below (Errico and Farrahbaksh, 1998). B.1 Capital In a standard CAMEL rating, capital adequacy is evaluated (1 through 5) according to: the volume of risk assets; the volume of marginal and inferior assets; bank growth experience, plans, and prospects; and the strength of management in relation to all the above factors. In addition, consideration may be given to a banks capital ratios relative to its peer group. The bulk of the assets of banks operating according to a paradigm version of Islamic banking is represented by PLS transactions, that is mostly uncollateralized equity financing. These assets are far riskier than the ones represented by non PLS transactions, which are collateralized commercial or retail financing operations. PLS transactions are at the core of Islamic banking, while non -PLS modes are at the margin (Errico and Farrahbaksh, 1998). Hence, the ratio of riskier assets to total assets can be higher in an Islamic bank than it is in a conventional bank. Therefore, a CAMEL rating for capital adequacy in an Islamic environment should place more emphasis on factor (1) than is the case in a standard CAMEL (Errico and Farrahbaksh, 1998). All the other rating factors can usefully be applied in an Islamic framework without major changes from standard practices. Additionally, an
appropriate assessment of the capital adequacy ratio in an Islamic environment should address two issues: the level of this ratio and the risk-weighting methodology for its calculation (Errico and Farrahbaksh, 1998).
28
B.1.1 Level of the capital adequacy ratio According to widely accepted international standards defined by the Basel Committee on banking supervision, banks risk weighted capital adequacy ratio should be at least 8%. However, while the Basel Committees minimum level of eight percent may be an acceptable floor given the operational environment of Banks in OECD countries, it should be somewhat higher in an Islamic environment. This is the case because of specific reasons inherent to the operation of Islamic banking, as well as more general reasons that are de facto part of the high-risk
environment in which most Islamic banks operate. The specific reasons are the following: (1) Mudaraba contracts put depositors funds at risk, but allow a portion of profits to accrue to banks owners (Errico and Farrahbaksh, 1998). This creates a potentially strong incentive for risk taking and for operating financial institutions without suitable capital (Errico and Farrahbaksh, 1998). Hence, to help reduce moral hazard, it would be important for the banker to have substantial amounts of his own capital at risk; (2) as argued above the ratio of riskier assets to total assets is typically higher in Islamic banks than it is in conventional banks; and (3) as noted previously, the lack of control on investment projects in Mudaraba transactions and, more
generally, the absence of collateral and other guarantees in PLS transactions clearly raise the overall riskiness in Islamic banks operations (Errico and Farrahbaksh, 1998). Some of the factors contributing to the high-risk environment of most developing and emerging market countries in which Islamic banks (as well as conventional banks) operate are: (1) a relatively weak legal infrastructure underdeveloped supporting financial bank markets; lending (3) a operations; volatile (2)
economic
environment, contributing to an uncertain financial condition in
29
the enterprises sector; and (4) the less diversified nature of the economy (Errico and Farrahbaksh, 1998). B.1.2 Risk-weighting Methodology Conventional categories of banks assetsassets current side includes to three broad net
facilities
customers,
investments, and mortgage loans that present, inter alia, a credit risk (Errico and Farrahbaksh, 1998). The Basel Committees reference risk weights are 100 percent for current facilities to customers, 100 percent for net investments, and 50 percent for mortgage loans on residential properties. Islamic banks assets side includes all transactions carried out under the permissible Islamic modes of financing. On the basis of the economic functions that these models are expected to fulfil, it is possible to reconcile them with the three conventional broad categories of assets mentioned above, while recognizing that this exercise inevitably involves some approximation. More over, very different Islamic modes, such as mudaraba and non PLS modes that are not secured by a mortgage (e.g., instalment finance) fulfil the same economic functions of current facilities to
customers. Islamic modes of financing also involve different d egrees of riskiness. In particular, PLS modes are far riskier than non -PLS modes. Among the PLS modes, Mudaraba transactions appear to be riskier than Musharaka or direct investment transactions because banks do not hold any tangible assets (i.e., shares representing a portion of equity capital of enterprises banks have invested in) to secure the funds loaned out (Errico and
Farrahbaksh, 1998).
30
Therefore an appropriate risk-weighting structure for an Islamic system should have the Mudaraba contract carryi ng the highest risk weight, followed up by two other main PLS modes, namely Musharaka and direct investment. The lowest risk weight should be assigned to non-PLS modes fully secured by a mortgage (Errico and Farrahbaksh, 1998). All other non-PLS modes should be assigned a risk weight somewhere in between the lowest one in the system and the one assigned to Musharaka and direct investment (Errico and Farrahbaksh, 1998). There appears to be no strong reason why Musharaka and direct investment should not carry the same risk weight assigned by Basel Committee to the comparable assets category of net investment, i.e., 100 percent. If Musharaka and direct investment transactions are assigned a risk-weight of 100 percent, then the appropriate risk weight on Mudaraba transactions should be at least 100 percent to reflect their somewhat higher riskiness (Errico and Farrahbaksh, 1998). Non-PLS transactions fully
secured by mortgage may well carry the same risk weight assigned by the Basel Committee to the comparable assets category of mortgage loans, i.e., 50 percent. By implication, all other non-PLS modes should carry a risk weight somewhere in between 50 percent and 100 percent, to be determined on a case-by-case basis (Errico and Farrahbaksh, 1998). B.1.3 Off-balance Sheet Commitments On the basis of available information, it appears that offbalance sheet activities, such as issuance of letters of credit, endorsements, and guarantees, do not substantially differ from similar activities carried out in co nventional banks (Errico and Farrahbaksh, 1998). Accordingly, the Basel Committee
methodology is applicable in this case. This means that all
31
categories of off-balance sheet commitments must be converted to credit risk equivalents by multiplying the nomina l principal amounts by a credit conversion factor; the resulting amounts are then weighted according to the nature of the counterparts (Errico and Farrahbaksh, 1998). B.2 Assets In standard CAMEL rating, asset quality is rated (1 through 5) according to: (1) the level, distribution, and severity of classified assets; (2) the level and composition of non-accrual and reduced assets; (3) the adequacy of valuation reserves; and (4) the demonstrated ability to administer and collect problem credits (Errico and Farrahbaksh, 1998). With regard to factors (1) and (2), it should be recognised that, in an Islamic environment, assets represented by Mudaraba transactions cannot be classified until the relative contracts expire. Until that moment, there is no recognisable default with the exception of the proved negligence or mismanagement on the part of the agent-entrepreneur. As noted previously, default of PLS contracts mean that the investment project failed to deliver what was expected, that is a lower or no profit, or a loss. Nevertheless, PLS assets that deliver lower or no profit should be considered as reduced rate assets until the expiration of the relative contracts (Errico and Farrahbaksh, 1998). I think that with regard to factor (4), the abilit y of an Islamic bank to administer and collect problem credits should be
evaluated in those cases where PLS contracts default before expiration because of negligence or mismanagement on the part of the entrepreneur as well as in all cases of defaulted non -PLS transactions.
32
B.3 Management In a standard CAMEL rating, management is evaluated (1) through (5) according to: (1) technical competence, leadership, and administrative ability; (2) compliance with banking
regulations and statues; (3) ability to plan and respond to changing circumstances; (4) adequacy of and compliance with internal policies; (5) depth and succession; (6) tendencies toward self-dealing; and (7) demonstrated willingness to serve the legitimate needs of the community (Errico and Farrahbaksh, 1998). B.4 Earnings In a standard CAMEL rating, earnings are rated (1 through 5) according to: (1) the ability to cover losses and provide for adequate capital; (2) earnings trends; (3) peer group
comparisons; and (4) quality and composition of net income (Errico and Farrahbaksh, 1998). Earnings rated 1 are sufficient to make full provision for the absorption of losses and the accretion of capital when due consideration is given to asset quality and bank growth. Banks so rated typically have earnings well above peer group averages. Banks whose earnings are rated 5 are typically experiencing losses (Errico and Farrahbaksh, 1998). The above criteria are generally applicable to Islamic banks. Nevertheless, it should be kept in mind that, in Islamic banking, economic losses would first result in depreciation of the value of the depositors wealth, and then in a decline in the Islamic banks profitability, particularly when that bank has also used its own resources (for example, through a Musharaka arrangement) to
33
finance
the
loss-making
investment
projects
(Errico
and
Farrahbaksh, 1998). B.5 Liquidity In a standard CAMEL rating, liquidity is rated (1 through 5) according to: volatility of deposits; reliance on interest -sensitive funds; technical competence relative structu re of liabilities; availability of assets readily convertible into cash; and access to interbank markets or other sources of cash, including lender -oflast resort (LOLR) facilities at the central bank (Errico and Farrahbaksh, 1998). Contrary to conventional banks, Islamic banks cannot obtain funds through LOLR facilities, including Lombard and discount windows, as well as overdraft or other credit facilities operated by central banks. This is due to the fact that all the above facilities require the payment of an interest rate (Errico and Farrahbaksh, 1998). On the other hand, in an Islamic environment, reserve
requirement (RR) can be viewed as a particular case of liquidity ratios. In principle, a RR ratio on demand deposits of 100 percent would rule out the problem, as is the case in the two windows arrangement (Errico and Farrahbaksh, 1998). This, however, would excessively limit Islamic banks ability to engage in maturity transformation, which is at the core of every banks activity, and add an element of complexity to the transaction and payments functions that demand deposits are meant to perform (Errico and Farrahbaksh, 1998). Therefore, a preferred alternative solution, especially if the ratio of demand deposits to to tal deposits is relatively low, is to mandate specific RR on all deposits held in banks operating according to a two -tier Mudaraba arrangement. However, if applied to total deposits, RR may
34
represent an excessive burden for the banking system given the fact that, in an Islamic framework, RR may not be remunerated. These issues should be considered when calculating an
appropriate level of the RR ratio (Errico and Farrahbaksh, 1998).
2.5 The regulatory challenges ahead

Undoubtedly, one of the biggest challenges is developing a framework for governing, supervising, and regulating Islamic banks. Under the circumstances, regulato rs would want to consider a two pronged strategy: managing the transition, and shaping the vision. In managing the transition, regulators need to promote the stability of existing IFI whose financial intermediation
practices reflect the conditions of their environment and their stakeholders demands (Cunningham, 2001). These practices and the risks associated with them, outlined in this paper, include: a) the presence of balance sheets with limited weight of profit and loss sharing accounts, b) an emphasis on trade and short-term financing, c) risks akin to ones faced by conventional banks, like displacement risks, and d) market risks based on interest rates benchmarks used by conventional banks (Cunningham, 2001). Given the close affinity of prevailing
practice of established Islamic finance and conventional banking, the regulatory framework in the transition should be mostly similar to the one applying to the regulatory framework of conventional banks (El Sheikkh, 2000). One overarching issue that needs to be addressed is the standardization of contracts and major financial instruments across the industry to facilitate
growth, ease access to liquidity and enhance risk assessment capabilities. Transparency enhancements are also essential for the development of the industry (El Sheikkh, 2000). Beyond the
35
transition, a consensus on a vision of the nature of the industry, the role it would play in the development of the communities it serves, and how it would play it will be essential for its
sustainable development. A significant intellectual effort geared at providing practical ways of achieving consistency between the demands of the market place and underlying principles will need to be ongoing (El Sheikkh, 2000). This effort will need to include debates that remain substantive, consultative, and evidencebased. In particular it is important to be clear on the type of Islamic financial intermediation being considered with a special attention given to the different nature of the theoretical model and current practices. We can highlight elements of a possible vision that would be compatible with the fundamental principles of Islamic finance. In particular it sees merit in considering separating the functions of Islamic intermediation in various windows or institutions (Khan, 1999). Such a separation could permit the development of financial intermediation more consistent with the fundamental principles of risk-sharing, materiality and no exploitation (Khan, 1999). At the same time it could help enhance the transparency of the industry. It would also bring to bear the market discipline features embedded in the nature of Islamic financial
intermediation, and contribute to its stability. An Islamic financial industry incorporating such segmentation would likely require lighter and more focused regulation, enhancing its
competitiveness (Khan, 1999). Also, Lewis (2001) could got help to the conclusion an that conceptual regulatory
benchmarks
shape
appropriate
framework for the transition, as well as for an industry evolved toward practices more consistent with its premises. Considering the regulation of existing IFI, prevailing intermediation practices would seem to point to the need for equivalent emphasis on
36
capital requirement, supervision and licensing, and a larger one on transparency and disclosure, compared to conventional banks (Lewis, 2001). Considering the theoretical IFI model, one can expect minimal regulation with less emphasis on capital
requirements, more on transparency and disclosure, probably more on screening management profile and business line in licensing, and an equivalent in supervisio n as compared to what applies to conventional banking. There would be also an
expectation of larger reliance on direct market discipline and less on command and control regulation (Lewis, 2001).
37
3. METHODOLOGY
3.1 RESEARCH DESIGN 3.2 RESEARCH CONTEXT 3.3 PROCEDURE 3.4 METHODS FOR DATA COLLECTION 3.5 METHODS FOR DATA ANALYSIS 3.6 RELIABILITY AND VALIDITY 3.7 SUMMARY
38
This chapter justifies the choice of methods employed during the research project. Provides and account of how the research was carried out. There is discussion of how the research methods were chosen, how the research was conducted and how it was gather ed to achieve the desired aim.
3.1 Research Design

3.1.1 Approach Understanding the research approach from an early stage of the research is extremely crucial (Saunders et al., 2003). The
research project involved the use of theory although the theory may or may not be made explicit in the design of the research (Easterby-Smith, 1995 cited in Saunders et al., 2003). There are two approaches: and Deductive approach the Inductive which owes which more to owes to
Positivism
approach
Interpretivism. In the deductive approach the researcher develops a theory and hypothesis and then designs a research strategy to test the hypothesis. On the other hand, in the inductive approach a theory is developed as the result of data analysis. The major
differences between the two approaches are as following: Deduction emphasis: y y y Scientific principles Moving from theory to data The need to explain causal relationships between
variables y y y The collection of quantitative data The application of controls to ensure validity of data The Operationalisation of concepts to ensure clarity of definition y A highly structured approach
39
y y
Researcher independence of what is being researched The necessity to select samples of sufficient size in order to generalise conclusion (Saunders et al, 2003)
Induction emphasis: y Gaining an understanding of the meanings attach to events y y y A close understanding of the research context The collection of qualitative data A more flexible structure to permit changes of research emphasis as the research progresses y A realisation that the researcher is part of the research process y Less concern with the need to generalise (Saunders et al, 2003) For my dissertation, I chose to adopt a deductive approach. As this research tries to find out the reliability of the prudential regulation within the Islamic finance, the deductive approach was more appropriate. Also, since this was the first extensive research undertaken by me, a deductive approach seemed an unlikely option as it tends to have a rigid methodology. At first empirical data was gathered and thereafter conclusions were made and ended up with a developing theory. The strength of this approach is that it helps to study the topic more in depth which results in a better understanding. However, it has been criticised that in the interpretive approach the data collected is specific to the particular topic studied, as such it cannot be generalised, and hence reliability is low (Strauss, 1990).
40
3.1.2 Research Philosophy According to Saunders et al. (2003) research philosophy
depends on the way that we think about the development of knowledge. It is this thinking that affects the way we do our research. This opinion is also supported by Hussey and Hussey (1997), who states that, the way we design our research, collect and analyse our data, and even the way in which we write our thesis reflects our of basic beliefs about the world. is et essential al A clear whilst has
understanding undertaking identified philosophy a
research
philosophy
research. reasons be
Easterby-Smith why the in
(1997) of the
three may
examination relation to
research research
significant
methodology.
Firstly, it can help the researcher to refine and clarify the

overall research strategy to be used in the study.
Secondly, knowledge of research philosophy will enable

the researcher to evaluate different methodologies and methods and avoid inappropriate and unnecessary work by avoiding the limitations of particular approaches at an early stage.
Finally, it may help the researcher to be more creative in

selection of methods that were previously outside his/her experience. There are two main research philosophies which dominate the literature: positivism and phenomenological (Collis and Hussey, 2003). Both approaches could be adopted and both would yield valuable data in relation to the topic. In the opinion of Saunders et al (2003, p.83), the two philosophies have different views about the way in which knowledge is developed and judged as being acceptable. As such it is difficult to justify which philosophy
41
is better than the other? Therefore, researchers should choose the appropriate philosophy depending on the characteristic of their research problem as well as the research question that they are seeking to answer. Positivism is founded on the belief that study of human behaviour should be conducted in the same way as studies conducted in the natural sciences (Collis and Hussey, 2003). On the other hand phenomenology is concerned with understanding human behaviour from the participants own frame of reference. Phenomenologist believes that social reality is dependent on the mind. There is no reality independent of the mind; Therefore, what is researched cannot be unaffected by the process of the research (Van Maanen, 1983). Features of Positivistic and Phenomenological Paradigms are as following: Positivistic paradigm Phenomenological paradigm to produce qualitative
Tends to produce quantitative Tends data Uses large samples Concerned testing Data is highly specific and with hypothesis data
Uses small samples Concerned theories Data is rich and subjective with generating
precise The location is artificial Reliability is high Validity is low Generalises population from sample The location is natural Reliability is low Validity is high to Generalises from one setting to another (Hussey and Hussey, 2003)
42
As the research philosophy depends basically on the research question, the phenomenological approach has been chosen in this research. In this specific research, the researcher will collect qualitative and quantitative data and develop a theory as a re sult of data analysis rather than developing a theory first then test it afterwards. Open-end questions used in the questionnaires will provide the researcher with quotations, which are the main source of raw data. In the opinion of Patton (1987), quotatio ns reveal the respondents levels of emotion, the way in which they have organized happening, their the world, their thoughts their about basic what are perception
experiences,
and
(Saunders et al., 2003). The research methodology that was used was real ism i.e. an interpretive approach was followed. This was the base of the research philosophy. The reason behind this being that the research was based on the opinions of managers who work within the Islamic finance field. The results were interpreted accor ding to the findings based on their opinions and experiences. The outcome which was based their opinions helped to test the reliability of theories regarding prudential regulation. It also helped to bring out suggestions which may be given to the regulator authorities to improve the prudential regulation
standard in future and also improve the banking supervision within the Islamic finance. Due to the above research philosophy, the research logic that used was deduction which is based on a conceptual and theoretical structure developed and then tested by empirical observation; thus particular instances are deduced from general inferences.
43
Qualitative data methods were used to assist the research which involved designing this topic within Islamic financ e,
undertaking semi-structured interviews of the people who work within the field in various IFI, managers who deal in a daily basis with the prudential regulation and the banking supervision. Semi-structured interviews are used to gather data, which are normally analysed qualitatively. In such interview types, the researcher has a list of themes and questions to be covered which may vary in each interview depending on the flow of the conversation. It may also used to explain and explore the themes that have emerged from the questionnaire. Also, these kinds of interviews help the researcher to build on the responses that are given by the respondents (Saunders et al., 2003). This method of data collection technique or data analysis procedure is used in a situation that generates non-numerical data (Saunders et al. 2003). Open-end questionnaires were used which helped to gain a better understanding of the respondents views. Unlike the close-end questionnaires which reduce the options for the respondents, open-end questions enabled them to reveal their levels of personal opinion regarding their basic perceptions and ideas behind the reasoning. However, qualitative research using semi -structured interviews may not be used to make generalisations about t he entire subject area across the study since it is based on a small number of cases (Yin, 2003 cited in Saunders et al., 2007). In addition to this, there may be data quality issues which may arise, for example validity, reliability etc. (Bonoma, 1985 c ited Hussey and Hussey 1997) argues that all researchers desire high levels of data integrity and results currency. Since my research
44
paradigm is phenomenological the emphasis is on the quality and depth of the data. In the opinion of Hussey and Hussey (1997), If a research finding can be repeated, it is reliable. The researcher has to take care about this aspect as the interpretivist approach has been under criticism that it is specific to a particular topic studied and as such the reliability will be low as it cannot be generalised.
3.2 Research Context

In the proposed research, the study deals with the reliability of prudential regulation and the banking supervision regarding the Islamic financial institution. To make this study more critical, I a m going to compare the prudential regulation in Islamic finance with the well established prudential regulation in the conventional banking industry. Also, I chose this topic because I have had a firsthand information and experience in working (as trainee) in the Central bank of Morocco which deals the prudential regulation of both sides (Islamic and conventional banking). The core group of respondents were Managers in Islamic financial institutions who deal with the prudential regulation. The results and observations would be based on the opinions of about 30-40 respondents working for various IFI.
3.3 Procedure
In order to not disrupt the daily working schedule of the managers who were selected as respondents, a convenient time was fixed beforehand. As the research was being planned, ethical concerns were kept in mind when seeking to access Islamic financial institution managers. In the context of research, ethics refer to the
45
appropriateness of the behaviour of the researcher in relation to the rights of those who become the subject of the research or are affected by it (Hussey and Hussey, 2003). Ethics are defined as moral principles, norms or standards of behaviour that guide moral choices about our behaviour and our relationship with others (Bloomberg et al., 2005 cited in Saunders et al., 2007). It therefore relates to questions about how the research topic is formulated and clarified, how it is designed, how access is gained, data is collected, processed and stored, how the received data is analysed and whether the research findings are written in a moral or responsible way or not. It has to be ensured that the way the research is designed is methodologically strong and morally defensible to all those who are involved. The research was guided by the University of Northamptons code of ethics. It provided a guideline with a statement of principles and procedures that were needed to be followed for the conduct of the research. The purpose and outcome of the research and its academic usag e was explained to gain consent. On the other hand, the purpose of the research was not concealed and was completely explained to the respondents. Any special circumstance that might affect the interpretation of the results was to be clearly reported (Gill and Johnson, 1997). No implied pressure was put on the participants and they were asked to give their responses on their own free will. They were explained that they had a right to withdraw as participants and they could decline to take part in a particular aspect of the research.
46
3.4 Methods for Data Collection

Open-end questionnaire were distributed to the participant via emails. These questionnaires enable me to get their personal opinion and point of view and also helped to get a firsthand information review of the respondents. Most of the responses were also sent back by email.
3.5 Methods for Data Analysis

Data collected from the questionnaires was analysed carefully. The data was classified according to the aims and objectives outlined. This is a very critical stage in the research as the researcher had to take care of the potential ris ks of
misinterpretation of data. The data was then analysed manually. For this purpose, Qualitative data analysis method was used since the research aims at finding out the personal opinion and experiences of the respondents which is not possible to be quantitatively assessed. This method was used since th e research was commenced from a deductive position and the results that were to be derived were to be adequately grounded in the data (Saunders et al., 2007). Objectivity was maintained which was very vital during the analysis stage to make sure that personal bias was avoided by and the data was not misinterpreted. This was done by analyzing the data on its own merit without drawing any conclusions on the opinions (Zikmund, 2000 cited in
Saunders et al., 2003). To analyse the data, Explanation -building strategy was used which was propounded by Yin in 1989. This strategy is an attempt to build up an explanation while collecting data and analyzing them rather than testing a predicted explanation (Saunders et al., 2007). This type of analysis is primarily concerned with
47
explanatory case studies where the objective is to provide an explanation of what is happening in the case (Robson, 1993).
3.6 Reliability and validity

The main criticism of a semi-structured interview is the lack of standardisation (Saunders et al, 2003), which may have a negative effect on the reliability of the study. However, the questionnaires will allow flexibility to explore the topic in detail. The research strategy has been well-documented and justified in this methodology so that it does not mislead its audience in any way with regards to how the research has been conducted. It is imperative that questions are posed in such a way to avoid respondent-bias, and so that the participant giv es a response which is fair and true to the topic in question. Questions that are general to the topic area will be asked at the beginning of the questionnaire to ease the manager into the questionnaire. More focused questions will be asked nearer the end of the interview as Healey and Rawlinson (1994) suggest that this allows a greater time for the respondent to build up trust and confidence in the researcher, encouraging more reliable responses.
3.7 Summary
This research is reflective of the phenomenol ogical philosophy and has adopted the deductive research approach. Open -end questionnaires were sent to managers who work within the Islamic finance field. The reliability, validity and limitations of the research have been considered and documented in thi s methodology. The questionnaires will be transcribed and analysed appropriately for this type of study.
48
4. FINDINGS
4.1 SHARIAH SUPERVISION 4.2 THE OFFSITE SUPERVISION 4.3 BANK SUPERVISION TECHNIQUES APPROACH 4.4 LICENSING PROCEDURES 4.5 INFORMATION DISCLOSURE 4.6 CORPORATE GOVERNANCE 4.7 THE RELATION OF IFSB WITH OTHER INSTITUTIONS 4.8 FINANCIAL REPORTING IN ISLAMIC BANKING
49
This research was carried out by the guidance of questionnaires, with the intention of collecting the information needed for the research. Hence, the questionnaires were designed carefully. The questions were designed keeping important factors in mind such as time required to answer the questionnaire and understanding them. Questions were sent through email to the middle managers who work in different Islamic banks. The rationale behind sending questionnaires was to analyse the strength and the efficiency of the prudential regulation and banking supervision in Islamic finance. The outcomes of the research are based on the issues considered in the literature review. The total number of
respondents was 36 out 41 (despite following them up, 5 respondents responses). among the participants didnt send me their
4.1 Sh riah supervision

Regarding

the
Shariah
supervision,
30
participants
(83.3
) think that the Shariah supervision should be
reviewed while 6 participants think that it doesnt need any modification.
Do s th sh i h sup vision n h n s?
17%
d ny
Need a hange 83% No need for a hange
The
answers
dealt
with
issues
like
standardisation,
communication and Independency.
50
Participants recommended that the Islamic banking industry should have a sort of transnational institution in charge of all the Islamic banks in terms of supervising the Shariah compliance. Also, few participants believe that Islamic banks should set up a channel of communication between their top management and the board of the Shariah supervision. In regards to independency, one respondent answered in order to avoid any conflict of interest, the Shariah supervision should be completely
independent from the top management of Islamic banks.
4.
The offsite supervision
Regarding the importance of the offsite supervision carried out by the supervisory authorities, 24 participants think that the offsite supervision is essential. While 12 of the respondents believe that its not an important tool as long as there is an onsite supervision.
vi i
?
33%
yes
67%
No
supervision is important because it enables the supervisory authorities to examine regulatory reports, financial
For more than 50
of the respondents, the offsite
51
statements
and
selected
ratios.
Furthermore,
some
participants believe that the real importance of the offsite supervision is due to the fact that it enables the supervisor to quickly identify negative trends and emerging problems and to resolve the issues before they become so serious that they could negatively affect the banks financial condition.
4.3 Ban
supervision techniques approach
Concerning the supervisory bank rating systems, I asked the participants which supervisory bank rating system is adequate for the Islamic financial institutions. The
respondents chose among the following systems: PATROL, ORAP and CAMELS. The outcome was as following: 6 participants chose PATROL system, 10 participants chose the ORAP system while 20 respondents chose the CAMELS system.
Whi h of th follo in b n d qu t fo th : A CA L ?
PATROL ORAP
tin syst is L, A nd

28%
CAMEL
17%
55%
The outcome from the questionnaires show, that the CAMELS system could be the appropriate rating system for an Islamic financial institution.
52
4.4 L
E SING PRO E URE
In regards to the licensing procedures, 34 respondents think that the licensing procedures are essential in terms of prudential regulation and banking supervision.
Is the li ensing procedures an essential tool for the banking supervision?

Yes No
6%
94%
The answers were mainly dealing with the fact that a licensing procedure will protect the public from fraudulent banks and will protect the banks from an unfair competition.
53
4.5 INFOR
Regarding
TION DISCLOSURES
the information disclosures, 24 of the
participants think that information disclosures are essential for the prudential regulation and banking supervision in the Islamic banking system. While 12 respondents dont believe that information disclosure is that important to be included within the prudential regulation standard.
The i portance of information disclosure in the prudential regulation framework

Yes No
33%
67%
The main answers state that the importance of information disclosure is due to the fact that it will push the bank to disclose information relevant for public and the regulators. By disclosing information, Islamic bank will show and prove the transparency of their financial operations.
54
4.6 CORPOR TE GO ERNANCE

In regard to corporate governance, 23 respondents think that the IFSB should issue a prudential regulation in this matter. While 13 participants think that corporate
governance is functioning well in Islamic banks and doesnt need any prudential regulation standard.
Should the IFSB issue a prudential regulation standard regarding corporate governance?
Yes No
36%
64%
Because the corporate governance has proven in the past that it can cause the bankruptcy of banks, respondents think that a guideline of good corporate governance should be included in a prudential regulation framework.
55
4.
The
relation
of
the
IFSB
with
other
institutions
I asked the participants if the IFSB should cooperate more with other international institutions in terms of banking supervision and prudential regulation. All the respondents (without exceptions) said that the IFSB should cooperate more and more with other organisation.
Do you believe that the IFSB should cooperate more with other organisations in terms of banking supervision?
Yes
100%
The answers were that the IFSB should be cooperating with for example the International Islamic Rating Agency and the Basle Committee on banking supervision.
56
4.
FINANCIAL BANKS
REPORTING
IN
ISLAMIC
I asked the participants if standardising the financial reporting among the Islamic banks can facilitate the work of the supervisors. 32 of the respondents think that standardising supervisory supervision. the accounts to reporting carry out will enable the
authorities
efficient
offsite
Can the standardisation of accounting standard improve the banking supervision?

Yes No
11%
89%
Nearly all the answers were stating that a common accounting report framework will ease the task of the supervisory authorities.
57
5. DISCUSSIONS
5.1 SHARIAH SUPERVISION 5.2 THE OFFSITE SUPERVISION 5.3 BANK SUPERVISION TECHNIQUES APPROACH 5.4 CAMELS IN THE CONTEXT OF ISLAMIC BANKING 5.5 LICENSING PROCEDURES 5.6 INFORMATION DISCLOSURE 5.7 CORPORATE GOVERNANCE 5.8 THE RELATION OF IFSB WITH OTHER INSTITUTIONS 5.9 FINANCIAL REPORTING IN ISLAMIC BANKING
58
This chapter is a continuation from the earlier chapter. Here the outcome of the email based questionnaire will be examined and judged with the literature review portion of the research.
5.1 Shariah Supervision

In essence, Shariah supervision is the process of ensuring that a financial product or service complies with Islamic legal precepts and principles, either by its conforming to a recognized Islamic legal norm or by its not violating the same (Sarker, 2004). The issues which came up from the result of the questionnaire are as following: standardisation, independency, awareness and communication. The respondents think that the Shariah supervision must be independent from the management. Because by being
independent the Shariah supervisory board will be able to make decisions binding on management. Also the independence factor will enable the board of directors and the Shariah supervisory board to work within a spirit of cooperation and accommodation. The other issue related to the Shariah supervision is the factor of communication. We all know that the success of any auditing or supervision is a clear communication between the supervisee and the supervisor (Ali, 2002). For this reason, there must be a clear line of communication between the Shariah supervisory board and the management. One of the respondents recommends that eventually an IFI could appoint one of its middle managers to act as liaison with the supervisory board. This person will be in charge of keeping the IFI management updated with the decisions and the suggestions of the Shariah supervisory board.
59
On the other hand, its essential that the Shariah supervisory board remains informed of developments in the industry they supervise. By being aware of what is happening in the market place, the board will be able to make pertinent decisions. The participants argue that a board that is sensitive to the business environment is an effective board. Regarding the issue of standardization, most participants
recommend that instead of having an internal Shariah supervisory board for each IFI, we can have a transnational Shariah
supervisory organisation which will be in charge of monitoring the respect of Islamic law by the IFI around the world.
5.2 THE OFFSITE SUPERVISION

The offsite supervision enables the supervisory authorities to collect and interpret regular reporting returns and other statistical data. Also, the offsite monitoring systems focuses on the banks current condition, e.g. deposit, credit, income on capital. Indeed, the offsite supervision is used as an early warning device to detect emerging bank financial problems.
5.3 SUPERVISION TECHNIQUES APPROACH

The PATROL system has been introduced in 1993 by the bank of Italy as a tool to give a systematic representation of the financial health of banks and to provide a background for an onsite inspection visit (Sarker, 2004). The five components of PATROL are as following: capital adequacy, profitability, credit quality, organisation and liquidity. In PATROL system the capital adequacy is assessed by comparing the own funds of a bank with regulatory prescriptions of capital for credit risk, position risk, settlement risk, market risks and exchange rate risk (Fadeel, 2002).
60
To assess profitability, the economic results net of extraordinary items are related to the requirement to cover capital losses stemming from bad debts, and the return on equity is related with the average of the banking system. The interest rate is also taken into account (Errico et al., 1998). Credit quality is assessed on the basis of aggregate data of adjusted bad debts derived from the central credit register and an individual loan concentration index (Errico et al., 1998). The organisational component is assessed on the basis of ad hoc information available to the analyst, on information obtained from meetings held with the management of banks and onsite
examination results (Errico et al., 1998). Liquidity is assessed after ascertaining maturity mismatch under normal operating conditions, and by simulating exogenous shocks over a one year period (Errico et al., 1998). In PATROL system, each component is rated on a scale of 1 (best) to 5 (worst) based on supervisory criteria and guidelines. Rating assigned is validated through comparisons with the actual results of onsite examinations (Errico et al., 1998). On the other hand, the ORAP system (organisation and
reinforcement of preventive action) helps to detect potential weaknesses in banking institutions by examining all components of risk associated with the activity and environment of each institution (Chami et al., 2003). The ORAP includes 14 components which relate to prudential ratios (capital, liquidity, large exposu res and capital adequacy); on and off-balance sheet activity (asset quality, bad loans and provisions for bad loans), market risk, earnings (operating income, non-recurring items and return on assets) and qualitative
61
criteria (shareholders, management and internal control). Each component is rated on a scale of 1 (best) to 5 (worst) (Chami et al., 2003). More than the half of the participants believes that the CAMELS are the more adequate rating system for the Islamic financial institution. This statement confirms the view of the authors reported in the literature review. According to the respondents, CAMELS has been viewed in light of the principles and practices of Islamic banking. Though all features of CAMELS are not
repugnant or contradictory to the Shariah stance, there should be some separate provisions to make it conductive and proper to analyse the whole operation of the Islamic banks.
5.4 CAMELS in the context of Islamic Banking 5.4.1 Capital

In the standard CAMELS framework, capital adequacy is assessed according to: (1) the volume of risk assets; (2) the volume of marginal and inferior assets; (3) bank growth experience, plans, prospects; and (4) the strength of management in relation to all the above factors (Baldwin, 2002). In theory, the bulk of the assets of Islamic banks should be made up of PLS modes, that is, mostly uncollateralized equity financing. These assets carry far more risk than those made up of non-PLS modes, which are collateralized commercial or retail financing operations. Hence, in principle, the ratio of riskier assets to total assets should typically be higher in an Islamic bank than in a conventional bank (Chami et al., 2003). The IFSB standard states that the minimum capital adequacy requirements for the Islamic financial institutions should not be
62
lower than 8% of the total capital. But the participants argued that the minimum capital adequacy in an Islamic environment must be higher than 8% due to the risks involved during the profit-loss sharing transactions. Nonethel ess, it should be noted that the potential losses that capital bears in an Islamic bank are lower in as much as PLS depositors themselves will absorb part of them, and this factor could well offset the special risk in PLS accounts (Baldwin, 2002). However, in practice, the managers argue that PLS modes represent a small fraction of Islamic banks total assets. According to IFI reports, the Musharaka and Mudaraba assets account for some 25% of Islamic banks total assets, the majority of which are made up of non-PLS modes, notably mark-up transactions. Therefore , it may be reasonable to conclude that the assessment of capital adequacy for Islamic banks should be based not only on a thorough evaluation of the degree of risk of each banks portfolio, but also an assessment of the mix of PLS and non-PLS assets. This approach will be consistent with the rationale underpinning the first pillar of the proposed New Basel Capital Accord (Basel 2), notably the proposed changes in the risk -weighting of assets, including through acceptance of internal ratings based systems for banking book credit risk and trading book market risk (Baldwin, 2002). One of the participants, who work for an Islamic bank in Morocco, suggested that the supervisory authorities should issue a prudential regulation standard which states that capital must be liquid money and be designated by quantity and also well defined by type and quality.
63
5.4.2 ASSETS
In the standard CAMELS framework, asset quality is assessed according to: (1) the level, distribution, and severity of classified assets; (2) the level and composition of nonaccrual and reduced rate assets; (3) the adequacy of valuation reserves, and (4) the demonstrated ability to administer and collect problem credits (Baldwin, 2002). In regard to factor (1), it should be borne in mind that in an Islamic environment assets represented by Mudaraba transactions cannot be classified until the underlying contracts expire. Until that moment, there is no recognisable default, with the exception of proved negligence or mismanagement on the part of the agententrepreneur (Baldwin, 2002). However, with regard to factor (2), it would be recommendable to take a proactive and forward looking stance and consider PLS assets that are estimated to yield a lower or no profit as reducedrate assets even before the expiration of the relative contracts. Regarding factor (3), the ability of Islamic bank to reduce the capital value of investment deposits in case of losses should not be viewed as tantamount to an automatic setting aside of provisions against loan losses. Indeed, this situation should not be allowed to dilute sound loan-loss provisioning practices aimed at preserving the solvency and the viability of an Islamic bank as an ongoing concern (Baldwin, 2002). In fact, adequate loan loss provisioning is needed to provide strong incentives to limit moral hazard. Hence, adequacy of loan-loss reserves remains a key factor in ensuring banking soundness in an Islamic environment, too. Finally, with regard to factor (4), the ability of an Islamic bank to administer and collect problem credits should be
evaluated in those cases where PLS contracts do default before
64
expiration because of negligence or mismanagement on the part of the entrepreneur, as well as in all cases of defaulted non-PLS transactions (Baldwin, 2002). I think that the provisioning rules must be tightened.
5.4.3
Management
In the standard CAMELS framework, management is evaluated according to: (1) technical competence, leadership, and
administrative ability; (2) compliance with banking regulations and statutes; (3) ability to plan and respond to changing circumstances; (4) adequacy of and compliance with internal policies; (5) tendencies toward self-dealing; and (6)
demonstrated willingness to serve the legitimate needs of the community (Baldwin, 2002). All these factors are applicable in an Islamic banking environment, too. Of course, in this case, the managements specific competence in Islamic banking practices and procedures should be critical in such an evaluation (Baldwin, 2002). Given the complexity of many Islamic banks operations, involving the monitoring of investment projects, managing
commodity inventories at times, legal uncertainties relating to shariah litigation systems, and similar problems, establishing adequate internal systems and controls for managing risks and validation of transactions play a particularly crucial role in the effective management and containment of operational risks.
5.4.4
EARNINGS
In the standard CAMELS framework, earnings are assessed according to: (1) the ability to cover losses and provide for adequate capital; (2) earnings trends; (3) peer group
comparisons; and (4) quality and composition of net income (Baldwin, 2002).
65
Earnings are considered of hig h quality if they are sufficient to make full provision for the absorption of losses and the
accumulation of capital when due consideration is given to asset quality and bank growth. Banks so assessed typically have earnings well above peer group averages. At the other extreme are banks that are experiencing losses (Baldwin, 2002). The above criteria are generally applicable to Islamic banks as well. Nonetheless, in an Islamic bank, economic losses would first result in a depreciation of the value of the depositors wealth and then affect the banks equity position in the event that it had also used its own resources to finance the loss -making investment project. Also, such risks to deposits, if they materialize, might result in reputational damage and loss of depositor base, leading to liquidity and, possibly, solvency problems (Baldwin, 2002).
5.4.5
In the
LIQUIDITY
standard CAMELS framework, liquidity is assessed
according to: volatility of deposits; reliance on interest -sensitive funds; technical competence relative to structure of liabilities; availability of assets readily convertible into cash; and access to interbank markets or other sources of cash, including lender -oflast resort (LOLR) facilities at the central bank (Baldwin, 2002). As discussed, compa red with conventional banks, Islamic banks have fewer opportunities to obtain funds through LOLR facilities, such as Lombard or overdraft facilities operated by central banks or through access to interbank and money markets, which are typically underdeveloped or non-existent in an Islamic
environment.
66
5.4.6
SENSITIVITY TO MARKET RISK
In the standard CAMELS framework, sensitivity to market risk is assessed by the degree to which changes in market prices, notably interest rates, exchange rates, commodity prices, and equity values adversely affect a financial institution (Baldwin, 2002). Owing to the Shariahs prohibition against interest-based
instruments, interest rate risk affects Islamic banks only indirectly through the mark-up price of deferred sale and lease-based transactions. Also, according to Chapra (2000) since Islamic banks use LIBOR as benchmark in their financing operations, it is natural for the assets of these banks to be exposed to the risk of changes in the LIBOR rate. Islamic banks are directly exposed to commodity price risk because, unlike conventional banks, they typically carry inventory items. They are also directly exposed perhaps to a greater extent than many conventional banks to equity price risk as the very nature of Islamic banking is equity financing through the PLS modes. In principle, Islamic banks are exposed to exchange rate risk in the same way as conventional banks are. We have to note that Islamic banks can only rely on fewer riskhedging opportunities than conventional banks because Shariah compliant substitutes for conventional market risk hedging
instruments, such as futures, forwards, options, and swaps contracts, are not yet available to Islamic banks at the current state of development of Islamic finance.
67
5.5 LICENSING PROCEDURE

Like in conventional banking, an appropriate licensing is just as necessary in an Islamic banking framework to enable supervisory authorities to ensure that new banks are sound and stable. To establish an effective entry policy in the banking industry is a key factor to protect the public faith and the banking system from unfair and dangerous competition from undercapitalised, ill conceived banks or those that are operated by unqualified or less reputable owners and managers. According to the participants,
new Islamic banks must meet certain requirements to enable them to operate successfully. Also, we have to note that there are no international agreements on licensing standards. Nevertheless, there are some elements of an appropriate licensing process that are usefully applicable also in an Islamic banking framework. Managers of some Islamic banks suggested that the following elements should be taken into account by the banking supervision authorities:
Set the ground rules: rules for corporate governance;

establish of directors standards for owners; requirements for boards and managers; define the organisational
structure of the bank; set rules for internal controls and external audit functions; set rules which can prevent the bank from a conflict of interests.
Transparency: laws, regulations, criteria, and requirement

for banking license should be published and applied.
Capital requirement: set minimum levels and composition of

initial capital.
Specify activities: determine to what extent an Islamic bank

can take equity positions in non -financial enterprises, engage in securities, underwriting, licensing, factoring.
68
Business plan: a license application should include a

business plan which details the strategy to attain
profitability and maintaining it. Indeed, until now, there is no prudential regulation standard asking the Islamic bank to apply for a licence application. For this reason, managers of Islamic banks recommend the Islamic financial service board to issue a licence standard in order to prevent the Islamic banks from unfair competition and to ensure that new banks are sound and stable.
5.6 INFORMATION DISCLOSURES

According to khan (2003), information disclosure is particularly important in an Islamic banking environment. Information
disclosure should be designed to reduce information asymmetries due to the unrestricted Mudaraba contract between an Islamic bank and its depositors and incentives for moral hazard due to the fact that capital value of and returns on investment deposits are not guaranteed. Also, information disclosure can introduce an element of flexibility in the system, and provide the supervisory authorities and the public with a better understanding of banks strategies and relevant risks. Moreover, information requirements should be design in a way which enables the supervisory authorities to monitor Islamic banks risk management. The
supervisory authorities should focus on a list of appropriate data and information that Islamic banks are to be required to provide. One of the participants recommended to consider requirements established for investment companies in conventional systems (for example by the financial service authority), and adapt them to the specific needs of an Islamic banking environment.
69
The
information
disclosure
requirement should
include
the
following areas: types of securities; investment policies; risk factors; internal controls; and performance data. Additionally, the authorities should require the disclosure of professional
qualifications and experience of management and senior staff. Participants added that the information disclosure should be included in a regulatory framework governing Islamic banks. The components of proposed disclosure requirements are as following:
Investment
policies:
this
section
should
provide
the
supervisory authorities with information to assess the appropriateness of policies with regard to portfolio
diversification. It should provide an accurate description of the investment objectives and policies, including with respect to concentration, investment of more than 25% of total assets may define concentration in anyone industry. In addition, any economic, business, or political developments or changes which can affect that industry or group of industries should be briefly discuss ed. Such disclosure may include proposed national or regional legislation involving the financing of the projects; pending civil and religious courts decisions relating to the validity of the projects or the means of financing them.
Types
of
securities:
this
section
has
to
provide
the
supervisory authorities with an indication of an Islamic banks degree of exposure to any type of securities or other assets, particularly those for which there is no established market, which is an illiquid asset. An excessive exposure to illiquid assets should prompt the supervisory authorities to action, which may include establishing a limit on aggregate holdings of illiquid assets.
70
Disclosure of risk factors:
This section should provide
information on the main risk factors associated with the investment procedures, portfolio. It should and describe the internal for the
organisation,
infrastructure
monitoring and handling of risk factors. Because of the virtually open-ended list of ways to provide funds through the use of combinations of the permissible Islamic modes of financing, each Islamic bank should be allowed some degree of freedom in engineering how best to monitor and handle the risks inherent to its specific activities.
Internal controls: An Islamic bank performs
internally
several complex activities that are not normally performed by conventional banks, including the determination of profit and loss sharing ratios on the projects it finances and the ongoing auditing of these projects to ensure that its share of profits are being fairly calculated. These specific activities highlight internal controls as key to ensuring that all phases of the investment process are monitored, comply with Islamic banks investment policies, and are properly
accounted for. These specific activities highlight internal controls as key to ensuring that all phases of the
investment process are monitored, comply with Islamic banks investment policies, and are properly accounted for. For this reason, the supervisory authorities should set standard for internal controls.
Performance data: expected return on investment deposits

is key to the depositors choice of a particular credit institution. As mentioned before, the Islamic bank can only indicate the expected rate of return on investment deposits. The actual rate depends on the Islamic banks ability to finance successful investment projects, thus accruing profits to be shared with its investment depositors. Ill -conceived,
71
unsound institutions might seek to attract depositors by promising unrealistic rates of return, thus crowding-out serious and well managed institutions. Hence, it becomes a key supervisory issue to reduce the moral hazard inherent in this situation. In order to reduce the moral hazard. This section should provide a brief explanation on how an Islamic institution calculates its historical performance in order to advertise this data. This should be done in a concise description of the essential features of the data and how it has been computed. Moreover, Supervisory
authorities have to ensure that the advertised yields are based on historical earnings and are not intended to indicate future performance.
Management and senior staff: this section should include

information on the education and professional background of an Islamic banks management, including the board of directors, and senior staff. Supervisory authorities should pay more attention to assess staffs competence and skills in Islamic banking. Hence, supervisory authorities should set standard which clarify the role of the shariah boards, particularly whether their role should be limited to
approving financial products and services or should extend to the approval of individual credit decisions. Supervisory authorities should satisfy themselves about the fit and proper requirements for management and senior staff to ensure that credit and investment decisions are taken by experienced bankers.
5.7 Corporate Governance

The OECD defines the corporate governance as set of
relationships between a companys management, its board, its
72
shareholders and other stakeholders (OECD 1999, 2). Corporate governance is an important topic because poor corporate
governance lay at the heart of many bank failures over the years. In theory, banks must act in a way that promotes confidence to the public and the market in general and, more specifically, to their primary stakeholders. Banking supervisors have long recognised the importance o f good governance; supervision cant function properly if sound corporate governance is not in place. Experience underscores the need to have appropriate levels of accountability as well as sufficient checks and balances. For banking supervisors, although the range of topics that corporate governance may encompass is quite wide, the focus is mainly on those elements that relate to the manner in which the business and affairs of an organisation are governed by its board and managers (Caruana, 2006). There are two factors which push the respondents to ask the IFSB to issue standard regarding corporate governance in Islamic financial institution: y First, the practice of Islamic banks to stabilise the returns on investment deposits is discussed: if banks cushion the returns of the depositors in period of weak performance, this may be seen as an example of good corporate governance in favour of the depositors. However, a closer look reveals rather complicated governance issues as well as questions with respect to the Shariah compliance. This case is taken to illustrate that fairness to all stakeholders as an objective of corporate governance is not only hard to achieve but even hard to define when objectives are multidimensional.
73
Second, the proposal of a depositors representative in corporate bodies is discussed. Investment
depositors are seen in a special situation in Islamic banks compared to depositors in conventional banks (interest-based banks). They are the stakeholders whose interest should be protected or supported foremost by the institutional setup which determines corporate governance in Islamic banks. This case is taken to illustrate that a participation in corporate bodies must not be an effective instrument to ensure fairness and that external control institutions may be more effective. The IFSB should issue a corporate governanc e standard by for example adopting the corporate governance standard of Basel 2 to the Islamic banking environment. These standards as such as they are not legally binding, but when national authorities approve them, the compliance with the standards can be enforced by regulators. On the other hand, IFSB can also use some recommended codices. By issuing a corporate governance code for Islamic
financial institution each Islamic institution will have to take the code and its best practice examples and recommendations as a guideline, but is not obliged to do so. It seems that the instrument of recommended codices has not been used in Islamic banking. But we could imagine that guidelines of AAOIFI or IFSB may take the form of recommended codices nationally before they become internationally recognised standards. The advantage of recommended codices is that it allows some experimentation, and the content can be revised easier than that of codified laws or regulations.
74
In order to improve the banking supervision in the area of corporate governance, the IFSB can cooperate with supporting institutions like the Islamic International Rating Agency (IIRA). The IIRA measures the effectiveness of corporate governance on the basis of the following characteristics: transparency and adequate disclosure, history, demonstrated trustworthiness, and the effectiveness of the top management team and process. By cooperating, the IFSB and the IIRA could reduce the information asymmetry between bank managers, shareholders and PLS depositors, and by this they contribute to a more effective supervision. In an Islamic banking environment, good corporate governance and supervisory actions complem ent one another. The guidance inspections and oversight activities of supervisors cannot
guarantee, on their own, the prudent operation and financial soundness of a supervised bank. Banking supervisors must rely on the competence, skills and prudence of th e board and management. Confidence in the corporate governance processes at the bank will enhance the supervisors overall confidence that the bank is being operated prudently.
5.8 The
relation
of
the
IFSB
with
other
institutions
In terms of prudential regulation published, the IFSB only developed 5 prudential regulation standards so far. While the Basle committee on banking supervision since its creation in 1974, issued 25 principles which represent the core of banking supervision in conventional banking industry. Hence, by building a strong relationship with the Basle committee, the IFSB will be able to develop more prudential regulation standard which will cover all the potential risks facing the Islamic banking industry.
75
On the other hand, IFSB can also cooperate with the IIRA (Islamic International rating agency). IIRA provides rating
services to the banking sector in predominantly Islamic countries. The IFSB can use these ratings to evaluate the soundness of banks and to improve its standards. Hence, IIRA could also act as an external auditor on the behalf of IFSB, and provide reports of on-site supervision to IFSB.
5.9
FINANCIAL REPORTING IN ISLAMIC BANKS
By adopting the international accounting standard, Islamic banks can facilitate the task of supervision carried out by the
supervisory authorities. Moreover, the Islamic banks report their accounts according to the accounting regulation of the country where they are established, it makes it difficult for the IFSB to supervise and compare the financial health of the Islamic financial institutions. Also, reporting their accounts according to international standard will enable the supervisory authority to highlight easily and quickly any suspicious figures which can lead the bank to a failure. Hence, the supervisory authority will be able to compare the Islamic banks in terms of financial health and then issue recommendations to banks with bad financial performances.
76
6. CONCLUSION AND RECOMMENDATIONS
6.1 CONCLUSION 6.2 RESEARCH CONSTRAINTS AND LIMITATION 6.3 RECOMMENDATIONS 6.4 SUGGESTIONS FOR FUTURE RESEARCH 6.5 PERSONAL REFLECTIONS
77
This chapter concludes the research. It interprets the conclusion on the basis of the research carried at the same time recognize the likely limitations of the research carried. A suggestion to a research in future is put forward, were this research shall be supportive. This chapter concludes by some personal suggestions and views are expressed shortly.
6.1 CONCLUSION
Prudential regulation and banking supervision represent an important aspect of any type of financial system. Hence, the recent financial crisis so famously known as Credit Crunch was mainly due to a lack in regulation and supervision towards mortgage loans with high risk. I chose to do my dissertation on banking supervision in Islamic finance because during my internship at the central bank of Morocco, I noticed that the Islamic banks were supervised and monitored the same way the conventional banks were supervised. My research focused on the banking supervision in Islamic finance and the issues facing this supervision such as: corporate
governance,
Shariah
supervision,
supervision
techniques,
licensing procedure and disclosure information. In regards to Shariah supervision, analysing the questionnaires, I conclude that the main problems are: standardisation,
independency and communication.
The outcome from the
questionnaires was that the Islamic banking should have a sort of international Shariah council which will be in charge of ensuring that the financial product advertised by Islamic banks complies with the Shariah law. Also, the decision made by this co uncil should be free of any kind of involvement from the Islamic banks top management. Because any management involvement would reduce via conflict of interest the fairness of the council decisions.
78
The other issue in regards to Shariah supervision was the factor of communication. Indeed, I think that the Islamic financial institutions should appoint an executive who will be in charge of keeping the top management updated with the recommendations and the decisions of the council. Moreover, this intermediary should keep the Shariah council board updated with the evolution and development of the Islamic banking industry. The second main issue highlighted by this research was the aspect of corporate governance. Corporate governance topic is well known particularly for being the origin of the collapse of many big multinational companies such as Enron and the Maxwell Empire. In regards to this matter, I think that the supervisory authorities should emphasis on the corporate governance in Islamic banks. It is true that the S hariah law gives some recommendations regarding corporate governance but I dont believe that these guidelines are enough. The IFSB should issue standard which defines the characteristics of effective corporate governance. Hence, the supervisory authorities should ensure that the IFSB standards regarding corporate governance are fully implemented by the Islamic financial institutions. Concerning the supervision techniques, I think that CAMELS is the appropriate techniques for Islamic banking. As I mentioned before, CAMELS covers the following areas: capital, assets, management, earnings, liquidity and sensitivity to market. The
CAMELS technique has proven its ef ficiency within the banking supervision in western banking. Moreover, CAMELS will enable the supervisory authorities of Islamic banks to evaluate the financial situation of a particular bank and detect any problem which can eventually lead the bank to a failure.
79
Licensing procedure is also a main issue for the Islamic banking, that its why this process should be included in the prudential regulation framework. Licensing procedure protect established banks from an unfair competition and the public from fraudulent banks which operate against any kind of moral ethics. In my opinion, The IFSB should develop standard which set the basic conditions to open an Islamic banks. These conditions will have to encourage any new Islamic bank to provide the regulators wi th the following information: Business plan, initial capital, type of activities, name and functions of shareholders. Finally this research highlighted the issue of disclosure
information. As I mentioned in the literature review, in Islamic banking the investment deposits and the rate of return on demand deposits are not guaranteed at all. So, because of this counterpart risk, Islamic financial institutions should disclose more information to the public investors and the supervisory authorities. I do believe that the IFSB should recommend to the Islamic banks via prudential regulation framework, to provide or disclose the following information: investment policies, type of securities, risk factors, internal control reports, performance data, management and senior staff. This kind of information if disclosed by the Islamic banks will first inform the public about where their funds are invested. Secondly, the supervisory authorities will be able monitor the degree of risk taken by the Islamic banks in their financial operations. I have to note, that the aspect of banking supervision in Islamic banking is only in its development stage which can explain the existence of such issues. But nevertheless, the regulators should find solutions to fix these problems in order to avoid any crisis to the banking system in Islamic finance Prevention is better than cure.
80
I hope that this piece of work has brought a positive contribution towards finding a solution to the Issues facing the banking supervision in the Islamic environment.
6.2 RESEARCH CONSTRAINTS AND LIMITATION

All research has its own constraints, which brings a barrier towards the research scope. Here the constraints related towards the research are as follows. The research project at masters (postgra duate) stage consists of various limits such as time and resources availability. There for the chief limitation in this project was time and availability of resources. In terms of the availability of the resources, I found out that some written article or books are hardly accessible. This situation forced me to spend more time and effort on looking for secondary data. In the available time and material related to the research accessible to the researcher, this research was carried with the assistance of questionnaire send through email, where the target population was narrowed to 45 respondents, which is
comparatively not a big target population. To an extent this can have an influence on the accuracy of the data attained during the questionnaire. Also, I have to note that most of the
questionnaires have been sent to managers of Islamic banks which are established in my home country: Morocco. Due to the fact that Morocco is a French speaking country, I had to translate my questionnaire in French. Moreover, I received the answers in French and I had to translate them to English in order to analyse them. Indeed, the use of interviews personally might have given facts, which can be helpful for studying the issue in a better level. But
81
due to the facts that the respondents live and work abroad, it was difficult and costly to do interviews. The research was carried out with a relatively small sample size which is a major limitation. However, the sample size is believed to be realistic and
representative.
6.3 Recommendations
Regulatory and supervisory authorities should improve
and develop adequate legal framework for controlling, supervising and guiding the Islamic banking system.
Islamic banks should follow some recommendations of

Basel committee of banking supervision. Basel 2
requires Islamic banks to meet legal and regulatory standards as specified in Basel 2. There are several reasons for Islamic banks to comply with the Basel 2 regulations. Islamic banks are at the initial stage of growth and their sizes are small to medium. So, in order for them to gain international recognition, Basel 2 compliance becomes a cover stone. The standards developed by AAOIFI and IFSB should be added to the Basel 2. The regulatory framework prescribed by Basel committee of banking supervision will then bring
standardisation for the Islamic banks.
The
AAOIFI
should
promote
the
establishment
of
international accounting standards by the Islamic banks. This will allow the supervisory authorities to carry out efficient offsite and onsite supervision of the banks.
As I mentioned, IFSB and AAOIFI with the cooperation

of regulatory authorities in Muslim countries, should create a Shariah supervision council which will be in charge of monitoring the Shariah compliance of Islamic
82
financial
product.
The
functions
of
this
S hariah
supervisory council will be as following: y Ensure that the activities of Islamic banks comply with Shariah principles. y Develop legal religious recommendations on banking and financial matters. y Conduct Shariah audit and inspection of
specific branches/offices of the Islamic banks and financial institutions. y Conduct and manage different training
courses, seminars on Shariah and financial matters.
IFSB should promote the use of an adapted CAMELS

approach which looks to me as the appropriate rating system for Islamic banks.
IFSB has to promote and develop standard regarding the

corporate governance.
6.4 SUGGESTION FOR FUTURE RESEARCH

Importance of banking supervision is spreading globally, particularly with the resent financial crisis. This research
emphasise on the banking supervis ion and prudential regulation in the Islamic banking system. Future studies need to be carried out with large samples size and should be based on interviews. I think my research can be used as support for future studies. For example, this research can be supportive for a future research based on the implementation of the IFSB standards in one or a few countries. Moreover, this research can be the basis for a future study based on one particular standard such as on the IFSB capital adequacy standard and Basel 2 in one particular country or one financial institution.
83
6.5 PERSONAL REFLECTIONS

This research enabled me to expand my knowledge of banking supervision, particularly in Islamic banking. Indeed, because I want to start a career in Islamic finance, I thought that doing a research on Islamic finance will give me more chances to get a job by showing to the potential employer my interest for the subject. The research is well planned and as precise and accurate as achievable with a lot of effort. The research has its own pros and unanticipated cons. Initially the research had a broader idea; it was a genuine hard task to narrow down the aim of this research, this happened with the consultation and guidance of my tutor from the University of Northampton. Ultimately the period dedicated to this research turned out to be a remarkable progress since this research was supervised by a highly professional lecturer from the university. The guidance received from my supervisor was helpful in deciding my research topic. This helped me in doing this research taking into
consideration the time period and other resources. The major drawback of the research was the available time in hand. It was hard process to examine the data obtained from the email based questionnaire and ample effort was focused towards the questionnaire in order to obtain the utmost probable facts concerning the research question. At this juncture it can be concluded that the research was exciting, demanding, interesting and chiefly an experience which has enhanced my knowledge since it has been completed by improving the researchers ability in managing a research project.
84
REFERENCE LIST
y AAOIFI (1999). Statement on the Purpose and calculation of the Capital Adequacy Ratio for Islamic Banks. March 1999. The Accounting & Auditing Organization for Islamic Financial Institutions. y Ali, Ahmad (2002). The Emerging Islamic Financial
Architecture: The Way Ahead. Paper presented at the Fifth Harvard University Forum on Islamic Finance, April 6 7, 2002 y Archer, S. & T. Ahmed (2003). Emerging Standards for Islamic Financial Institutions: the Case of the Accounting & Auditing Organization for Islamic Financial Institutions. Mimeo, World Bank. y Archer, S., R. Abdel Karim & T. Al - Deehani (1998). Financial Contracting, Governance Structures and the
Accounting Regulation of Islamic Banks: An Analysis in Terms of Agency Theory and Transaction Cost Economics. Journal of Management and Governance. Vol. 2, pp. 149 170. y Archer, S. & R.A. Karim (1997). Agency Theory, Corporate Governance and the Accounting Regulation of Islamic Banks. Research in Accounting Regulation, Supplement 1, Special International Edition, pp. 97 114. y Ayoub, M. (2002), Islamic Banking and Finance: Theory and Practice, (State Bank of Pakistan: Karachi, Pakistan) y Baldwin, K. (2002) Risk Management in Islamic Banks. In R. Abdel Karim & S. Archer (Eds), Islamic Finance:
Innovation & Growth (pp. Euromoney Books and AAOIFI.
176 -
197), published by
85
Basel Committee on Banking Supervision (BCBS) (2003), Consultative Document-Overview of the New Basel Capital Accord. April (2003), Bank for International Settlements.
Basel Committee On Banking Supervision (BCBS) (1998), Enhancing Supervisory Bank Transparency: that Public Disclosure Safety and and
Information
Promote
Soundness in Banking System. September (1998), Bank for International Settlements. y Chapra, U. & H. Ahmed (2002). Corporate Governance in Islamic Financial Institutions. Occasional Paper no. 6. Islamic Research and Training Institute: Islamic Development Bank. y Chapra U. & T. Khan (2000). Regulation and Supervision of Islamic Banks. Occasional Paper no. 3. Islamic Research and Training Institute: Islamic Development Bank. y Cunningham, A. (2001). Culture of Accounting: What are the Real Constraints for Islamic Finance in Riba-Based Global Economy? Moody's Investor Services, (London, UK). y El Sheikkh, Fath El Rahman (2000), The Regulation of Islamic Banks by Central Banks. The Journal of International Banking Regulation, Fall (2000), pp 43 - 49. y Errico, L. & M. Farrahbaksh (1998). Islamic Banking: Issues in Prudential Regulation and Supervision. IMF working paper, IMF/98/30. (Washington: International Monetary Fund, March, 1998). y Fadeel, Mahmoud (2002), "Legal Aspects of Islamic Finance", in Simon Archer and Rifaat Abdel Karim (eds.) Islamic Finance: Growth and Innovation, Euromoney Books, London, UK. y Iqbal, Zamir and Abbas Mirakhor (2002), "Development of Islamic Financial Institutions and Challenges Ahead, in Simon Archer and Rifaat Abdel Karim (eds.) Islamic
86
Finance: Growth and Innovation, Euro money Books, London, UK. y Karim, Rifaat Ahmed Abdel (2001), International Accounting Harmonization, Banking Regulation and Islamic Banks, the International Journal of Accounting, Vol. 36 (2), 2001, pp. 169-193. y Khan, M. Fahim (1994). Comparative Economics of Some Islamic Financing Techniques, Islamic Economic Studies. Vol. 2, No. 1, December 1994 y Khan, M. (1987) "Islamic Interest-Free Banking: A Theoretical Analysis, in Mohsin S. Khan and Abbas Mirakhor, (ed.) Theoretical Studies in Islamic Banking and Finance, (Texas, USA: The Institute of Islamic Studies, 1987), pp. 15-36. y Khan, Mohsin S. & A. Mirakhor (1992), Islam and the Economic System, Review of Islamic Economics. Vol. 2, No. 1, pp. 1 - 29. y Khan, Mohsin S., (1986), Islamic Interest - Free Banking: A Theoretical Analysis, IMF Staff Papers, Vol. 33, pp. 1 - 27 y Khan, T. (2001). Islamic Risk Management: Towards Financial Risk Management in Islamic Finance. http://www.ieicenter.com/article/Paging2.asp?ID=27 y Khan, T. & H. Ahmed (2001). Risk Management: An Analysis of Issues in Islamic Financial Industry. Occasional Paper no. 5. Islamic Research and Training Institute: Islamic Development Bank. y Lewis, Mervyn K. and Latifa M. Algaoud (2001), Islamic Banking, (Edward Elgar: Cheltenham, UK) y Maroun, Y. (2002). Liquidity Management and Trade Financing. In R. Abdel Karim & S. Archer (Eds), Islamic Finance: Innovation & Growth (pp. 163 175), published by Euromoney Books and AAOIFI.
87
Mulajawan, D., Dar, H.A. and Hall, M.J.B. (2002): A Capital Adequacy Framework for Islamic Banks: The Need to Reconcile Depositorss Risk Aversion With Managers Risk Taking. Economics Research Paper, erp 02 13. Loughborough University.
Sadr, Kazem and Zamir Iqbal (2002) "Choice between Debt and Equity Contracts and Asymmetrical Information: Some Empirical Evidence," in Munawar Iqbal and David T.
Llewellyn (eds.) Islamic Banking and Finance, Edward Elgar, UK. y Al-Jarhi, Mabid Ali and Munawar Iqbal (2001). Islamic Banking: Answers to some Frequently Asked Questions. Occasional paper No.4, Islamic Research and Training Institute, IDB. y Sarker, A. A. (2005). Islamic Banking in Bangladesh: Achievements and Challenges. Journal of Islamic
Economics and Finance. Vol. 1, No.1, July-December. y Caruana, J (2005) Basel 2 and corporate governance issues. In: 2nd Islamic Financial Services Board (IFSB) Summit 2005: The Rise and Effectiveness of Corporate Governance in the Islamic financial services industry, Doha, 2005. Kualalunpur: IFSB. y Sundararajan, V. & L. Errico (2002). Islamic Financial Institutions and products in the Global Financial System: Key Issues in Risk Management and Challenges Ahead . IMF working paper, IMF/02/192. (Washington: International Monetary Fund, November, 2002). y Vogel, F. E and S.L. Hayes 3 (1998). Islamic law and Finance, (Boston, MA, USA: Kluwer Law). y Warde, I. (2000). Islamic Finance in the Global Economy . Edinburgh University Press.
88
Saunders, Student.4
th
M.
(2007).
Research
Methods
for
Business
ed. Harlow : Financial Times Prentice Hall, 2007
BIBLIOGRAPHY y El-Gari, M (2000). Are Risks higher in Islamic banks

than in their conventional counterparts?. Paper presented in a conference on Islamic Financial Industry in Alexandria, Egypt. Prepared by the Arab Academy for Sciences, Technology and Maritime Transport, Islamic Jordanian Bank and International Investment Kuwaiti Co.
y Mirakhor, A. (1989). General Characteristics of An

Islamic Economic System, in B. Al-Hasani and A. Mirakhor (Eds), Essays on Iqtissad: The Islamic Approach to Economic Problems (pp45-80), published by Nur Corp., MD, USA.
89
APPENDICES
90
SAMPLES OF THE ANSWERS TO THE QUESTIONNAIRE SENT TO THE PARTICIPANTS.

Questionnaire 1
1) Does the Shariah supervision need any changes? Yes 2) If yes, why? Identification of the probable rating areas for
understanding and authentication of implementation status of Shariah rules, regulations and standards in the day to day operations of the Islamic banks should be the prime area of concern of the regulators and supervisors of the Islamic banks. What I would suggest is to develop a Shariah Matrix or
inspection areas through which one can understand what shariah instructions are an Islamic bank is
following and what
the
areas of violations
committed by this bank. 3) In your opinion, what are the consequences of this crisis on the Islamic Banks? No consequences at all. Because the Islamic banks has not been affected by the recent crisis. 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Risks faced by an Islamic financial institution can be broadly classified into 5 categories and one of them is the systemic risks. In my opinion, Islamic financial institution should have a prudential regulation
standard in regard to the systemic risks.
91
5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? NO 6) Do you consider the offsite supervision as an important process? Offsite supervision carried out by central banks or independent supervisory authorities is an important step within the supervision process. Basically, the offsite supervision is used as a wake up call. By examining authorities financial will be reports, able to the supervisory any kind of
detect
irregularities, which will push the supervisor to ask for onsite supervision. On the other hand, the offsite supervision is less costly than the onsite supervision. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? As you know one of the causes of this recent crisis is the absence of a strong regulation. In my opinion, the regulatory authorities should concentrate their effort in strengthening the banking regulation by forcing the banks to follow the recommendations made for example by the Basle committee or by the central banks of the G8 countries. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? I would choose CAMELS. But some modifications should be made to the actual CAMELS in order to use in an Islamic environment.
92
9) Is the licensing procedure an essential tool for the banking supervision? Yes. In fact licensing procedure is essential for any type of industry: manufacturing, banking and others. Licensing procedure and is the guarantee protection of a fair our
competition
customer
within
Islamic banking industry. 10) The mode of remuneration of Banks CEO and traders has
been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? Its true that in conventional banking, top
management still get huge bonuses even if the financial institution is losing money. I think that this topic will involve many debates in the future. In Islamic banking, the system of remuneration or the reward system is based on the financial performance of the bank. 11) Do you consider information disclosure as a vital aspect of
the prudential regulation Framework? Information disclosure is the guarantee of a
transparency for the financial operation. It also gives more information to the supervisory authorities to facilitate the conduct of supervision mission. 12) Given the evolution of the banking crisis, are you optimistic
or sceptical about the future of Islamic finance and its role within the international finance. I am optimistic because the Islamic finance industry knows a growth at a really rapid pace.
93
13)
Do you believe that the IFSB should cooperate more with
other organisations in terms of banking supervision? The cooperation is a winning-winning strategy. So I think that the Islamic Financial Service Board should cooperate with regulators in Muslim countries to strengthen the prudential regulation framework. 14) Should the IFSB issue a prudential regulation standard
regarding corporate governance? Corporate governance should be the primary target of any financial regulator around the world. One of the reasons is that the corporate governance has been in the origin of many financial scandals. In my opinion, the IFSB should issue or develop an for
appropriate
prudential
regulation
framework
corporate governance. 15) Can the standardisation of accounting standard improve the
banking supervision? The standardisation of accounting reports has many positive sides and one of them is to increase the ability of a supervisory to efficiently supervise a financial institution.
94
Questionnaire 2
1) Does the Shariah supervision need any changes? Yes 2) If yes, why? Shariah supervision should be completely
independent from the management. A close relation between the Shariah board and the management can lead to a conflict of interest which can damage the reputation of Islamic banks. 3) In your opinion, what are the consequences of this crisis on the Islamic Banks? There are no consequences whatsoever because the Islamic banks dont operate in the western financial market. 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Yes, prudential regulation is an undisputable part of any financial system. Prudential regulation framework guarantees the stability of the financial system. Even if the Islamic finance is not affected by the risk related to interest rate, risks such as: counterpart risk, credit risk, liquidity risk can still affect Islamic banks. 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? NO. Its due to the fact that our customers know that we didnt invest in high risk financial product.
95
6) Do you consider the offsite supervision as an important process? No as long as there is an onsite supervision. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? I think that we cant leave a financial market without a financial regulator. As we know, there is
speculation on the financial market which to some extent led the world to this financial crisis. For this reason, any strategy aiming to regulate and organise the financial market will be more than welcome. Nevertheless, we also have to make sure that the financial regulation wont interfere in the financial operation because we live in liberal market. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? The American CAMELS will suit the Islamic banks. CAMELS system has been in use by the American regulator for more than a decade and had proven its efficiency. But we have to note that some features of the actual CAMELS cant be applied in an Islamic environment. So, CAMELS still has to be adapted and modified in order to be used for supervising Islamic banks.
96
9) Is the licensing procedure an essential tool for the banking supervision? In my opinion licensing procedure represent an extra protection for the banking system. Licensing
procedure set rules which have to be met in order to enter the banking industry and ensure a fair
competition between banks within the industry. On the other hand, licensing procedure will protect the customers and particularly their deposit for being managed by unqualified people. 10) The mode of remuneration of Banks CEO and traders
has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? As in any bank, the system of remuneration is mainly based on the performance of the bank within a specific period. 11) Do you consider information disclosure as a vital
aspect of the prudential regulation Framework? I dont think that the information disclosure is essential in the Islamic banking because all our financial operations enjoy a high level of
transparency. 12) Given the evolution of the banking crisis, are you
optimistic or sceptical about the future of Islamic finance and its role within the international finance. Since it appearances, the Islamic finance has been experimenting a high growth. So we are optimistic about the future and we hope that it will reach the level of western finance. 13) Do you believe that the IFSB should cooperate more
with other organisations in terms of banking supervision?
97
IFSB can only benefit from an external cooperation with other organisation. The IFSB can have potential partner such as: AAOIFI, IIRA or even the Basle Committee of banking supervision. 14) Should the IFSB issue a prudential regulation
standard regarding corporate governance? No before our company act already set guidelines for efficient and fair corporate governance. 15) Can the standardisation of accounting standard
improve the banking supervision? YES
98
Questionnaire 3
1) Does the Shariah supervision need any changes? Yes 2) If yes, why? Shariah supervision should be independent from the management of Islamic banks which means that the department of Shariah supervision should not
included within the structure of the Islamic banks. 3) In your opinion, what are the consequences of this crisis on the Islamic Banks? The Islamic banks have not been affected by the subprime crisis 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Yes 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? NO 6) Do you consider the offsite supervision as an important process? Offsite supervision represents an undisputable part of the supervision process which also includes the onsite supervision. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? We cant leave the financial market without regulator because its the authority in charge ensuring that the
99
core rules of finance are respected by the players. Personally, I am strong supporter of a strategy that will lead to a regulated financial market. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? CAMELS 9) Is the licensing procedure an essential tool for the banking supervision? The Islamic finance (especially the banking industry) suffers from the absence of licensing procedure which makes to For it difficult the for the supervisory of the new
authorities entrants.
control this
legality the
reason,
regulator
should
concentrate on developing a licensing procedure framework. 10) The mode of remuneration of Banks CEO and traders
has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? The system of rewards is based on the financial performance of the bank. 11) Do you consider information disclosure as a vital
aspect of the prudential regulation Framework? Information disclosure must be included in the prudential regulation framework. Indeed, the
existence of a high level of counterpart risk in Islamic financial operations makes the information disclosure undisputable in order to carry out
effective banking supervision.
100
12)
Given the evolution of the banking crisis, are you
optimistic or sceptical about the future of Islamic finance and its role within the international finance. I am optimistic for the future of the Islamic Finance. 13) Do you believe that the IFSB should cooperate more
with other organisations in terms of banking supervision? Cooperation can only be beneficial. 14) Should the IFSB issue a prudential regulation
standard regarding corporate governance? Corporate governance has been the nightmare of many big companies because it was the origin of their failures. Knowing that bad corporate
governance has been the cause of many financial scandals, the IFSB should develop a prudential
regulation standard regarding corporate governance. 15) Can the standardisation of accounting standard
improve the banking supervision? Yes
101
Questionnaire 4
1) Does the Shariah supervision need any changes? Yes 2) If yes, why? Shariah supervision should be independent from the management of Islamic banks which means that the department of shariah supervision should not
included within the structure of the Islamic banks. 3) In your opinion, what are the consequences of this crisis on the Islamic Banks? The Islamic banks have not been affected by the subprime crisis 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Yes 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? NO 6) Do you consider the offsite supervision as an important process? Offsite supervision represents an undisputable part of the supervision process which also includes the onsite supervision. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? We cant leave the financial market without regulator because its the authority in charge ensuring that the
102
core rules of finance are respected by the players. Personally, I am strong supporter of a strategy that will lead to a regulated financial market. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? CAMELS 9) Is the licensing procedure an essential tool for the banking supervision? The Islamic finance (especially the banking industry) suffers from the absence of licensing procedure which makes to For it difficult the for the supervisory of the new
authorities entrants.
control this
legality the
reason,
regulator
should
concentrate on developing a licensing procedure framework. 10) The mode of remuneration of Banks CEO and traders
has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? The system of rewards is based on the financial performance of the bank. 11) Do you consider information disclosure as a vital
aspect of the prudential regulation Framework? Information disclosure must be included in the prudential regulation framework. Indeed, the
existence of a high level of counterpart risk in Islamic financial operations makes the information disclosure undisputable in order to carry out
effective banking supervision.
103
12)
Given the evolution of the banking crisis, are you
optimistic or sceptical about the future of Islamic finance and its role within the international finance. I am optimistic for the future of the Islamic Finance. 13) Do you believe that the IFSB should cooperate more
with other organisations in terms of banking supervision? Cooperation can only be beneficial. 14) Should the IFSB issue a prudential regulation
standard regarding corporate governance? Corporate governance has been the nightmare of many big companies because it was the origin of their failures. Knowing that bad corporate
governance has been the cause of many financial scandals, the IFSB should develop a prudential
regulation standard regarding corporate governance. 15) Can the standardisation of accounting standard
104
Questionnaire 5
1) Does the Shariah supervision need any changes? No 2) If yes, why? 3) In your opinion, what are the consequences of this crisis on the Islamic Banks? No consequences because its only the western
finance which has been affected by the subprime crisis. 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Yes 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? NO 6) Do you consider the offsite supervision as an important process? Offsite supervision is important because its the step before the onsite supervision. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? Its true that if we had more regulation this crisis could be avoided. For this reason, the strategy of regulation is the strategy which will bring the
stability to the financial markets.
105
8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? I think the CAMELS will be the appropriate rating system. 9) Is the licensing procedure an essential tool for the banking supervision? Licensing procedure is the insurance for a fair
competition in the Islamic banking industry. I think that regulator should and must include this factor in their supervisory process. 10) The mode of remuneration of Banks CEO and traders
has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? I am not allowed to disclose our policy in regard to remuneration. 11) Do you consider information disclosure as a vital
aspect of the prudential regulation Framework? Yes. Information disclosure represents the black dot in Islamic banking because there is absence of regulation banking in this matter. has with Basle committee for
supervision
developed the
many
recommendations
dealing
information
disclosure framework. And I think that the IFSB should use these recommendations as a referential to develop prudential regulation framework in
regards to information disclosure. 12) Given the evolution of the banking crisis, are you
optimistic or sceptical about the future of Islamic finance and its role within the international finance. I am optimistic for its future.
106
13)
Do you believe that the IFSB should cooperate more
with other organisations in terms of banking supervision? I think that the IFSB should cooperate more with the Basle committee on banking supervision. 14) Should the IFSB issue a prudential regulation
standard regarding corporate governance? Yes and in fact I urge the IFSB to do so. 15) Can the standardisation of accounting standard
107
Questionnaire 6
16) NO
Does the Shariah supervision need any changes?
2) If yes, which kind of changes? 3) In your opinion, what are the consequences of this crisis on the Islamic Banks? The Islamic banks are not affected at all because our financial operations are interest free. 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? I think any type of financial system should be regulated by a prudential regulation framework. We all know that the banking system should be monitored in order to ensure its stability and its soundness. For this reason, the IFSB (Islamic financial service board) promotes and enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors. 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? No
108
6) Do you consider the offsite supervision as an important process? As I mentioned before, the banking supervision is an important aspect of any financial system. The offsite supervision enables the regulator to
supervise the bank through the investigation of periodic report. Indeed, the offsite supervision helps the regulator to draw a picture of the financial situation of a particular bank. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? The trend in the recent years was to encourage a less regulated financial market. But the subprime crisis showed that a less regulated market encouraged the bank to lend risky loans without backing them with enough provisions. We learned from this crisis that the banking supervision should be tighten in order to avoid any other crisis. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? I think PATROL will be appropriate. PATROL is an Italian system which enables the regulator to have a representation of the financial situation of a particular bank. PATROL stands for: capital
adequacy, profitability, credit quality, organisation and liquidity.
109
9) Is the licensing procedure an essential tool for the banking supervision? Not really. As long as there is an efficient and permanent supervision of Islamic banks, I dont think that the regulator should emphasis on the licensing procedure. 10) The mode of remuneration of Banks CEO and traders
has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? Sorry its confidential matter 11) Do you consider information disclosure as a vital
aspect of the prudential regulation Framework? No, because as you know our operations are based on A Profit-Loss Sharing mode. So we share the profits and the losses of the operation with the client which force us to inform our customers about risk surrounding the contract. 12) Given the evolution of the banking crisis, are you
optimistic or sceptical about the future of Islamic finance and its role within the international finance. Because the Islamic finance didnt get affected from the current crisis, so it shows that Islamic banking is quiet stable and we can only be optimistic. 13) Do you believe that the IFSB should cooperate more
with other organisations in terms of banking supervision? Absolutely I think that the IFSB should learn more from the Basle committee of banking supervision on how effectively apply the prudential regulation standard developed.
110
14)
Should the IFSB issue a prudential regulation
standard regarding corporate governance? No. Corporate governance is well defined in our company act. Therefore I dont we need a standard in this matter. 15) Can the standardisation of accounting standard
improve the banking supervision? Personally I dont think so
111
Questionnaire 7
1) Does the Shariah supervision need any changes? Yes 2) If yes, why? I think we should have an independent organisation in charge of supervising the Shariah compliance of financial products. In Islamic finance we already have the IFSB which develops prudential regulation standards and the AAIOFI which is in charge of the accounting and auditing matters. So, in my opinion we should follow the same idea and create Shariah service board which will approve or disapprove the Shariah compliance of Islamic financial products. 3) In your opinion, what are the consequences of this crisis on the Islamic Banks? None because our financial system is a free interest based system. 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? YES. Systemic risks are present in both conventional and Islamic financial system. When there is financial operation between two parties there is always a potential systemic risk. For this reason, I do believe that the IFSB (Islamic Financial Service Board)
should develop standard in regards to this matter. 5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? NO
112
6) Do you consider the offsite supervision as an important process? Not really. I think that the onsite supervision provide the supervisor with enough information about the supervised bank. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? Its always good to have an authority to police or regulate the financial market. There are so many funds invested in the financial markets around world that we cant leave it without an appropriate
regulation. In answer to your question, I support this strategy because it reduces speculation (bad ones) and increase the public confidence toward the
transparency of the financial markets. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? ORAP rating system can be adapted for the Islamic environment. 9) Is the licensing procedure an essential tool for the banking supervision? Licensing procedure isnt only essential for the
banking supervision, but also for the entire banking industry. Licensing procedure protects the customers from illegal banks and it also ensures that there is a fair competition within the banking industry.
Regarding the banking supervision matter, licensing procedure enable the regulator to check if the
potential bank meet all the requirement of the banking industry.
113
10)
The mode of remuneration of Banks CEO and traders
has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? The system of remuneration is mainly based on the financial performance of the Islamic financial
institution. 11) Do you consider information disclosure as a vital
aspect of the prudential regulation Framework? Information reduces disclosure is paramount because to it
information
asymmetries
due
the
unrestricted Mudaraba contract between an Islamic bank and its depositors. Personally, I think that information disclosure standard in an Islamic
environment should encourage the Islamic banks to provide the following data: type of securities,
investment policies. 12) Given the evolution of the banking crisis, are you
optimistic or sceptical about the future of Islamic finance and its role within the international finance. Islamic finance cant compete with the conventional one because the Islamic finance or the Islamic financial products are for Muslim clients. So, we cant offer our financial product to all type of customers. However, the Islamic finance is growing at rapid and sustain pace which will only increase our confidence for its future.
114
13)
with other organisations in terms of banking supervision? As we know, London and I mean the City represent the Global hub of Islamic finance in the world. What I would recommend, is that the IFSB can cooperate with the FSA (Financial service authority) to develop prudential regulation standard for Islamic banks. 14) Should the IFSB issue a prudential regulation
standard regarding corporate governance? Corporate governance is too important to be left without a prudential regulation standard. My bank has even urged the IFSB to develop standard which will represent the guidelines for effective and fair corporate governance. 15) Can the standardisation of accounting standard
improve the banking supervision? I have to note that the standardisation of account reports is in process. The standardisation of account reporting will facilitate the work of the supervisor and will increase the transparency of the accounts.
115
Questionnaire 8
1) Does the Shariah supervision need any changes? YES 2) If yes, which kind of changes ? I think that the Shariah board should keep in touch with the top management. We know that the success of any undertaking is communication. There must be clearly delineated lines of communication between management and Shariah supervision. Moreover, I would recommend appointing one person to be in charge of coordinating and documenting regular meetings, arranging for the requirements of shariah supervision, suggestions, following and up on decisions and and
processing
channelling
communications to and from supervision.
3) In your opinion, what are the consequences of this crisis on the Islamic Banks? None 4) Do you think that prudential regulations specific to Islamic finance can protect the Islamic financial institutions from a systemic crisis? Absolutely because I dont think any financial system could survive without an appropriate prudential regulation framework. For this reason, in 2002 a group of Arab central banks decided to create the IFSB which is the equivalent of the Basle committee.
116
5) Are there any customers of the Islamic Banks who were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? As far as I know none of our customers none of our customers claimed or withdraw their deposits. 6) Do you consider the offsite supervision as an important process? If there is onsite supervision, so there is no need for offsite supervision. 7) It seems that in general, the trend is towards more regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? I think that the American understood that free market doesnt mean necessarily free regulation. Regulation exists to protect both public investors and financial institutions by ensuring the financial stability of the financial institutions. 8) Which of the following bank rating system is adequate for the Islamic financial institution: PATROL, ORAP or CAMELS? CAMELS can be adapted to the Islamic environment. 9) Is the licensing procedure an essential tool for the banking supervision? Licensing procedure helps To establish an effective entry policy in the banking industry is a key factor to protect the public faith and the banking system from unfair and dangerous competition from
undercapitalised, ill-conceived banks or those that are operated by unqualified or less reputable owners and managers.
117
10)
has been criticized recently as a factor explaini ng the crisis. Can you tell us how the remuneration system functions within the Islamic banks? The remuneration of the system bank. is In based our on the
performance
bank
(BMCE
MOROCCO) the remuneration system is based on the financial performance of our employees during the financial year. 11) Do you consider information disclosure as a vital
aspect of the prudential regulation Framework? No, I think the supervisory authorities should focus more on issues like credit risk, liquidity risk and capital adequacy. 12) Given the evolution of the banking crisis, are you
optimistic or sceptical about the future of Islamic finance and its role within the international finance. I have to say that Islamic finance is quiet recent and didnt experiment any kind of crisis. Islamic finance cannot compete with conventional finance, because we provide our financial product only to Muslim customers. For this reason, we can say than in international finance, Islamic finance represents an alternative for Muslim customers whom dont to invest in western finance. With the sustainable
growth of Islamic finance, I am optimistic for its future.
118
13)
with other organisations in terms of banking supervision? The IFSB should cooperate with Arab central banks and private rating agencies with intention of developing a wide prudential regulation framework for the Islamic banking industry. 14) Should the IFSB issue a prudential regulation
standard regarding corporate governance? No its not necessary 15) Can the standardisation of accounting standard
improve the banking supervision? Yes because having a common account reporting will help the supervisory authorities to efficiently analyse the financial reports and compare them a predetermined referential.
119
Questionnaire 9
17) Yes 18)
If yes, why? One of the central issues towards developing a
dynamic Islamic financial industry is the Shariah. The Shariah should always be viewed as an enabler to innovation and creativity, rather a constraint. Efforts therefore need to be enhanced to fully appreciate and maximise the true potential and wisdom of the Shariah. The collaboration among the Shariah
scholars, practitioners, researchers and regulators to undertake in depth studies and research to create new products will provide the fundamental
foundation towards the development of dynamic Islamic financial system. 19) In your opinion, what are the consequences of this
crisis on the Islamic Banks? None 20) Do you think that prudential regulations specific to
Islamic finance can protect the Islamic financial institutions from a systemic crisis? Absolutely, the prudential regulation represents one of the bases of any financial system. The expansion of Islamic banking industry has created both expectations and apprehensions simultaneously. Risk is inherent in every financial innovation.
120
21)
Are there any customers of the Islamic Banks who
were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? No. All our clients know that we were not affected by the subprime crisis because our mortgage loan policy isnt based on interest rate. 22) Do you consider the offsite supervision as an
important process? No as long as there is an onsite supervision. 23) It seems that in general, the trend is towards more
regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? This strategy is necessary because many scholars argued that regulation provides a public good that the market cannot supply on its own. The foremost objective is to alleviate risks taken by stakeholders (e.g. depositors) who are otherwise unable to
undertake the necessary due diligence to assess these risks. The second objective will be to reduce the risks of by disruption the of the normal in business terms of
performed
financial
system
payments on the provision of liquidity. 24) Which of the following bank rating system is adequate
for the Islamic financial institution: PATROL, ORAP or CAMELS? I would choose CAMELS.
121
25)
Is the licensing procedure an essential tool for the
banking supervision? Licensing procedure is essential particularly in a rapidly licensing changing procedure environment. framework will An adequate the
protect
consumers from fraudulent banks. Also, the regulator can use the licensing procedure to monitor the competition within the Islamic banking industry. 26) The mode of remuneration of Banks CEO and traders
has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? The mode of remuneration is based on the
performance of the bank. 27) Do you consider information disclosure as a vital
aspect of the prudential regulation Framework? No, not really. I think that because the Islamic banking industry is recent, we should be developing standard in order to prevent systemic risks. 28) Given the evolution of the banking crisis, are you
optimistic or sceptical about the future of Islamic finance and its role within the international finance. In my opinion there are still few challenges facing our banking industry and which we have to
overcome. But with the real growth within the industry, we can only be optimistic for the future. 29) Do you believe that the IFSB should cooperate more
with other organisations in terms of banking supervision? Yes. IFSB and IIRA should work together in order to: y y Develop prudential regulation standard Conduct onsite supervision
122
30)
Should the IFSB issue a prudential regulation
standard regarding corporate governance? Yes, and I think it should be one of the priority of the IFSB. It is recognised reinforces It that sound good corporate and
governance supervision.
regulation
contributes
towards
maintaining
market confidence, and strengthening transparency and accountability. Its emphasis is to be value oriented and promote fairness and justice with
respect to all stakeholders of the banking institution. 31) Can the standardisation of accounting standard
improve the banking supervision? Yes. The establishment organisation (AAOIFI) of for has the accounting and
auditing institutions
Islamic made a
financial significant
contribution in formulating and issuing accounting and auditing standards for Islamic financial
institution.
123
Questionnaire 10
32) No 33) 34)
If yes, why? In your opinion, what are the consequences of this
crisis on the Islamic Banks? The subprime crisis only affects financial institutions operating in the financial system based on interest. 35) Do you think that prudential regulations specific to
Islamic finance can protect the Islamic financial institutions from a systemic crisis? YES 36) Are there any customers of the Islamic Banks who
were afraid for their savings or their financing as happened to other conventional banks in the U.S. and Europe? NO 37) Do you consider the offsite supervision as an
important process? No as long as there is an onsite supervision. 38) It seems that in general, the trend is towards more
regulation of financial markets to avoid the mistakes that led to the current crisis. What do you think of this strategy? I totally approve it. We should remember that the causes of this crisis were: high risk financial product not backed by an appropriate provision, and the absence of regulation. I will say that regulation and particularly supervision would guarantee a stable and sound financial system.
124
39)
Which of the following bank rating system is adequate
for the Islamic financial institution: PATROL, ORAP or CAMELS? In my opinion, ORAP will be adequate for the Islamic financial institution. ORAP will enable the supervisory authorities to highlight potential weaknesses in banking institutions by examining all components of risk associated to a financial operation. 40) Is the licensing procedure an essential tool for the
banking supervision? Yes because its the best way to prevent the Islamic banks from an unfair competition. I think that licensing procedure in Islamic banking should require the following information: y Ground rules: define the organisational
structure of the bank; set rules for internal controls and external audit functions; set rules which can prevent the bank from a conflict of interests. y Transparency: requirement for banking license should be published and applied. y Capital requirement: set minimum levels and composition of initial capital. y Define the activities: define to what extent an Islamic bank can take equity positions in non financial companies. y Business plan: any license application should include a business plan.
125
41)
has been criticized recently as a factor explaining the crisis. Can you tell us how the remuneration system functions within the Islamic banks? I am not allowed to disclose this kind of information. Sorry. 42) Do you consider information disclosure as a vital
aspect of the prudential regulation Framework? No 43) Given the evolution of the banking crisis, are you
optimistic or sceptical about the future of Islamic finance and its role within the international finance. Yes I am quite optimistic for its future. 44) Do you believe that the IFSB should cooperate more
with other organisations in terms of banking supervision? Yes particularly with the AAOIFI (Accounting and auditing organisation in order to for Islamic the financial prudential
institutions)
develop
regulation framework. 45) Should the IFSB issue a prudential regulation
standard regarding corporate governance? No, I think our internal company act define clearly our mission statement, voluntary corporate bodies and personalities. 46) Can the standardisation of accounting standard
126
Table : Islamic modes of financing Type PLS Modes Mudaraba Description Profit and Loss sharing modes Trustee finance contract the bank provides the entire capital needed for financing a project, while entrepreneur offers his labour and expertise. The profits (or losses) from the project are shared between the bank and the
entrepreneur at a certain fixed ratio. Financial losses are borne exclusively by the bank and the entrepreneur at a certain fixed ratio (Syedain, 2004). Financial losses are borne exclusively is by the bank. The his liability of the
entrepreneur
limited
only to
time and
efforts.
However, if the negligence or mismanagement of the entrepreneur can be proven he may be held responsible for the financial losses incurred (Syedain, 2004). It is usually employed in investment projects with short gestation periods and in trade and commerce. It affects both assets and liabilities sides of banks balance sheet. On the liabilities side, the contract between the bank and the depositors is known as unrestricted Mudaraba
because depositors agree that their funds be used by the bank, at its discretion, to finance an open-ended list of profitable investment and expect to share with the bank the overall profits accruing to the banks business. On the assets side, the contract between the bank and the agent entrepreneur is known as restricted Mudaraba because the bank agrees to finance a specific project carried out by a specific agent-entrepreneur and to share the relative profits according to a certain percentage (Uzair, 1999).
127
Musharaka
Equity participation contract The bank is not the sole provider of funds to finance a project. Two or more partners contribute to the joint capital of an investment (Al -shahi, 2000). Profits (and losses) are shared strictly in relation to the respective capital contributions. It is usually employed to finance long-term investment projects (Al-Shahi, 2000).
Muzarah
Traditional counterpart of the Mudaraba contract in farming (Al-Shahi, 2000). The harvest is shared between the bank and the
entrepreneur. The bank may provide funds or land. Musaqat Traditional counterpart of the Musharaka contract in orchard keeping (Zaidi, 2001). The harvest is shared among the partners based on their respective contributions. Direct Investment The same concept as in conventional banking. The bank cannot invest in the production of goods and services which contradict the value pattern of Islam, such gambling (AlShahi, 2000). Non-PLS Modes Non profit and loss sharing modes
128
Qard Hasanah
al Beneficence loans These are zero-return loans that the Quran exhorts Muslims to make to those who need them. Banks are allowed to charge the borrowers a service fee to cover the administrative expenses of handling the loan, provided that the fee is not related to the amount or maturity of the loan (Zarqa, 2006).
Bai Muajjal
Deferred payment sales The seller can sell a product on the basis of a deferred payment in instalments or in a lump sum payment. The price of the product is agreed upon between the buyer and the seller at the time of the sale and cannot include any charge for deferring payments (Zarqa, 2006).
BaiSalam or BaiSalaf
Purchase with deferred delivery The buyer pays the seller the full negotiated price of a product that the seller promises to deliver at a future date. This mode only applies to products whose quality and quantity can be fully specified at the time the contract is made (Zarqa, 2006). Usually, it applies to agricultural or manufactured products.
Ijara Ijara Iqtina
or wa
Leasing A party leases a particular product for a specific sum and a specific period of time. In the case of a lease-purchase, each payment includes a portion that goes toward the final purchase and transfer of ownership of the product (Subbulakshmi, 2004).
129
Murabaha
Mark-up The seller informs the buyer of his cost of acquiring or producing a specified product; then profit margin (or markup) is negotiated between the buyer and the seller. The total cost is usually paid in instalments (Subbulakshmi, 2004).
Joalah
Service Charge A party undertakes to pay another party a specified amount of money as a fee for rendering a specified service in accordance to the terms of the contract stipulated between the two parties. This mode usually applies to transactions such as consultations and professional services, fund placements, and trust services (Subbulakshmi, 2004).

Dissertation Islamic Finance

Enviado por

Dados do documento

Descrição original:

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

Dissertation Islamic Finance

Enviado por

Direitos autorais:

Formatos disponíveis

Banking Supervision and Prudential regulation in Islamic Finance

The Banking Supervision and the Prudential Regulations in Islamic Finance

ASSESSED BY: NORWOOD WHITTLE

and Prudential re ulation in Islamic Finance

e this piece of work to m

family as recognition for their

Banking Supervision and Prudential regulation in Islamic Finance

supervisory authorities. I analysed the CAM

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

6.5 PERSONAL REFLECTIONS REFERENCE LIST BIBLIOGRAPHY APPENDICES

..83 ..84 .88 .. 89

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

Shariah board and

Banking Supervision and Prudential regulation in Islamic Finance

1.2 REASEARCH RATIONALE

Banking Supervision and Prudential regulation in Islamic Finance

1.4 RESEARCH QUESTIONS

To what extent the banking supervision in Islamic finance is efficient?

governance in the banking supervision process?

The role of Shariah supervision in the Islamic banking industry

supervisory more on the

information and licensing procedures?

1.5 ARRANGEMENT OF THE CHAPTERS:

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

2.1 Review of the Fun amental features of Islamic Banking

Banking Supervision and Prudential regulation in Islamic Finance

depositors (Abdeen, 2002).

2.2 The Regulation of Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

between civil and religious law varies across national

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

 Withdrawal risks which arise out of competitive pressures

 Solvency risk is the risk that a bank has insufficient

Shariah rules or for mismanagement of investors funds (Subbulakshmi, 2004).

 Innovative risk that is often talked in the recent times

 Islamic banks are vulnerable to liquidity risk because of

Banking Supervision and Prudential regulation in Islamic Finance

compared to conventional banking. There would be also an

Banking Supervision and Prudential regulation in Islamic Finance

2.2.3 Requisites for Effective Regulation

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

2.3 Segmented Approach to IFI Regulations

Musharaka Mudaraba Venture Capital Private Equity

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

the IFI would be expected

intermediation through clearly segmented

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

environment, contributing to an uncertain financial condition in

Banking Supervision and Prudential regulation in Islamic Finance

Banking Supervision and Prudential regulation in Islamic Finance

methodology is applicable in this case. This means that all

Withdrawal risks which arise out of competitive pressures

Solvency risk is the risk that a bank has insufficient

Innovative risk that is often talked in the recent times

Islamic banks are vulnerable to liquidity risk because of

Firstly, it can help the researcher to refine and clarify the

Secondly, knowledge of research philosophy will enable

Finally, it may help the researcher to be more creative in