Islamic finance: regulation and supervision of Islamic banking

Islamic banking is poised for development in the coming years, this would imply the introduction of a new discipline in the markets. Islamic banks, like conventional banks tend to be able to enjoy a fairly large with respect to depositors and to play an important role in the stability of the payment system.

Hence the need to protect the interests of depositors against any possible abuse of power, of fraud, mismanagement, and excessive risk-taking. Thing that can significantly affect the establishment of trust and cause instability in the financial system and adversely affect, by contagion, the entire economic system.
This implies the need for an adequate regulatory framework to ensure the stability of the payment system, to ensure the proper functioning of capital markets, promote their development and to safeguard the interests of different actors.

In addition, standards of regulation and supervision of Islamic banks should not be too rigid as to cause substantial costs and unnecessarily stifle innovation and creativity. They must therefore be a very precise study to reflect the nature of the various operations and various risks faced by Islamic institutions.

There's so he must ask if the Islamic banks should be subject to the same existing international regulations. Or would it be necessary to develop regulatory standards more appropriate?

As in the conventional system, the effective supervision of Islamic banks would require a preliminary study of the various risks incurred. We will try at first to examine certain aspects of the risks that Islamic banks are exposed and explained how these risks are sometimes different from those of conventional banks.
We will also try to address some aspects of major importance in promoting the creation of effective regulation and supervision of Islamic banking, in particular, internal control, accounting standards, Islamic, and the establishment of an international body monitoring .

Then we will stop the interference of international regulatory standards with the existing Islamic banking while trying to explain the need to apply a more appropriate regulatory treatment to allow effective monitoring.

Section 1: Risk management and internal control of Islamic banks

1 - Risk management

In the banking system, risk management has a place of particular importance. This importance is further accentuated by the interdependence of the various financial institutions. Because the bankruptcy of a bank, even a small size for example, could affect the stability of the entire payment system.
Hence the importance of effective control of risk management in the banking system. Achieving this goal requires the development of the culture of risk management by regulators and control, but also an understanding of the nature of these risks and promote their effective management by internal controls of financial institutions.
The Basel Committee for Banking Supervision, spoke several types of risks associated with banking. We stop on the risk capital, credit risk, market risk and liquidity risk.

1-1 risk capital

A sound banking system is synonymous with an atmosphere of trust between financial institutions, depositors and users of funds. This strength is closely related to the capital of the bank. Because it is the core financial system to protect against the risk of instability.
Among banks, demand deposits constitute the largest mass of all deposits. Because theoretically, they may be reimbursed on request of depositors. Hence the need for banks to strengthen their capital and build up reserves to protect their financial stability in the case of a very large volume of withdrawals unexpectedly.

In general, the level of equity reflects the degree of financial stability of a bank because it is supposed to protect against any unexpected deterioration in its assets. Conventionally the financial stability of the bank can be evaluated by reducing shareholders' equity to total assets. What is its debt ratio. The drawback of this ratio is that it does not take into account the different risk weights. Such as long-term deposits tend to mitigate the potential pressures on equity. But against that risk mitigation is not reflected in the debt ratio.

For this reason, Basel, 1988 Capital introduced the concept of relative risk to assets, distinguishing between single and double allocation of capital. The agreement also sets minimum capital requirements for banks in the G10 countries that operate internationally. These standards were subsequently adopted at the international level to be applied in several other countries including countries of the Islamic Development Bank (IDB). It also provides that other countries are voices to adopt these standards as their implementation has proven itself and has significantly contributed to the reliability and maintenance of financial stability. Therefore the Basel Committee on Banking Supervision has become a decision maker must control standards international banking.

1-2 credit risk

Credit risk is caused by a failure to pay unexpected. Which can cause a significant drop in net cash from the bank and therefore adversely affect the liquidity as well as the quality of bank assets. With the development of prudential management techniques, there are currently in the conventional banking system regulations that require the provision of reserves by banks in order to guard against credit risks and ensure their safety.

Among the factors that determine the level of risk is found, the situation of return, the nature of the legal system, quality guarantees, the extent of use of credit derivatives, the size of the books of banking and commerce.

Exposing themselves to credit risks, Islamic banks have a number of features that regulators and control should be well familiar:
The ban on interest does not allow Islamic banks to reschedule loans outstanding through the negotiation of higher earnings credits. Such a situation is likely to encourage borrowers in bad faith to delay their payments voluntarily. Thus increasing the credit risk in Islamic banks. The Foukahas have not yet agreed on an alternative solution.

Another factor characterizing the level of credit risk in Islamic banks is represented by the term credit facilities: The maturities of long-term credit are subject to a higher risk factor. However, Islamic banks in the maturity of the credit facility are mainly granted in the short term which tends to mitigate this risk exposure.

Also, the books of commercial banks in the conventional obligations generally consist of MET with interest, municipal and government bonds. However, in the Islamic financial system, marketable bonds are still very weak. Therefore there is still no book trade itself in Islamic banks.

Furthermore, in conventional banks, credit derivatives are considered to be effective instruments for mitigating credit risk. However this type of instrument is not permitted in Islamic banks for non-compliance with the Shariah. As such they are denied access to this method to mitigate their credit risks.

In addition, as part of a contract Salam, there is a risk against partly related to the supplier that can occur in the case of non-delivery or delay in performance of the operation. Especially since it may depend sometimes even situations that are beyond the control of the supplier, as in the case of natural disasters, drought or crop failure. This shows the importance of credit risk in this type of contract. There is still no consensus among Foukahas on how to protect against such situations.

Also in the contract Istisnae, where the Islamic bank filled the role of owner, manufacturer and supplier. For practical reasons the Islamic bank can not have a specialization in all areas of activity that interfere in this type of contract. Therefore it must make use of subcontractors. This has the effect of exposing not only the Islamic bank to credit risk related to client but also to additional risk that may arise from the failure of a subcontractor to fulfill its obligations in a proper and contractual deadlines.

Finally, the Ijara contract is not practiced by all Islamic banks. For it is not authorized by a number of Fuqaha. Therefore, there is a significant credit risk in the absence of standardized regulatory standards recognized by all Islamic banks.

1-3 Market risk

The term market risk, the risk associated with changes in the economy, taxation, inflation and interest rates. Market risk affects all goods, property and securities. It is also known as systemic risk

Like conventional banks and Islamic banks are also subject to market risk. Even if one might be tempted to think otherwise that Islamic banks do not deal with interest.
Indeed, Islamic banks are also affected by this type of risk, for example, through the sales deferred as part of a contract Salam, due to the delayed payment caused by this type of contract.
This influence can be justified through the use of the principle of Islamic banks LIBOR as a reference in its financial transactions. It follows that they are at risk of change in LIBOR.

Especially since, at an increased rate of LiBOB in the case of Murabaha, for example, Islamic banks are doubly exposed to market risk. For a view of the distribution of profit margins for the benefit of depositors, they must take account of the increase and therefore higher profits distributed to new depositors while deposits were made at a rate lower, previously over the long term.

Moreover, viewed from the bonds, any rate increase must be reflected in the profit margin without the Islamic Bank have the opportunity to reassess the corresponding assets. Because the price is already fixed on the basis of the previous period. Consequently Islamic banks can not escape the risk of rate changes.

Added to this, too, the fact that conventional banks have developed tools that allow them to better manage market risk, including the use of instruments such as option contracts, for example. However the side of the Islamic banks Foukahas have not yet expressed a clear and unanimous on the compliance of such instruments with the Shariah. And it seems that as of today no alternative consistent with the Shari'ah is still proposed to replace the conventional instruments of managing this type of risk.

1-4 The liquidity risk

Liquidity risk arises when the bank meets the cash flow problems, and is unable to raise funds to meet its obligations due or to free up funds to finance its operating activities.
Sound management of liquidity is therefore vitally important for a bank to be able to meet its obligations and continue its operations under normal conditions.

In Islamic finance, there are a number of factors that may cause liquidity risk:
A first element is the importance of the mass of loans on the balance sheet of Islamic banks unless it is able to make liquid through the sale of credits, which we recall is due to the ban the sale of credits by the Shari'ah.

A second point may come from the difficulty of raising funds is due on one hand, a non-existent in Islamic money market and on the other hand the slow development of financial instruments that allow the removal of funds quickly and efficiently.

A third principle is the lender of last resort that exists in the conventional financial system and which can be accessed only through Islamic banks to the application of interest. What constitutes a real barrier to accessibility but may in the future, pushing the Islamic bank to seek alternative solutions in accordance with the Shari'ah.

A fourth factor could be the dependence of most Islamic banks in current accounts, which by their nature (availability for current accounts) are at risk of withdrawal at any time. And, as in the past this kind of situation is relatively rare, Islamic banks are not sufficiently protected against such a risk. But these difficulties could be overcome in the future through the support of the efforts of Islamic banks, central banks, and Foukahas.

1-5 Operational risk

Operational risk can arise from different origins. It can come from the incompetence of staff, a malfunction in the process or technology. Operational risk can sometimes be quite complex and jeopardize the normal functioning of the organization. Good management implies an involvement of senior management to draw up guidelines that will control it.

To do this managers must establish procedures and standards of review to identify and control operational risks effectively, establish a classification of potential risks associated with each department or each activity of the bank. Rightly, a framework must be established for the operational activities related to investors to be used by the operational team, the management, but also by internal audit teams for reasons of monitoring and control.

Operational risk is complex in nature is varied, it is not always easy to quantify. However, the history of the activity of the bank is full of experiences, plans of action, reporting, management reporting, etc.. which can be a methodical and meticulous exploration and thus be an effective tool for managing risks.

Also, given the variety of sources of operational risk, methods of its management must also be different and appropriate. This requires the establishment of an appropriate process for each risk category with a clear separation of responsibilities of different stakeholders.
Another aspect that should also be made, the objective and reliable than should be the content of audit reports provided.

2 - Internal control of the Islamic financial system

Most researchers agree to identify the failure of internal control systems as the source of the major concerns of instability and financial crises
The importance of internal control in the Islamic financial system is further enhanced by the participatory nature that characterizes this system. Add to that the lack of familiarity of operators with conventional products and the need for compliance with the Shariah financial instruments.
Hence the crucial role that internal control is to play in the Islamic financial institutions to ensure their viability and performance.

As in the case of conventional banks, internal control in the Islamic financial system should have three main objectives:
- The first is to ensure the performance of the institution by an optimal and efficient of all its resources, financial, economic, human, etc..
- The second objective is to manage and provide accurate information in a timely manner to ensure the competitiveness of the organization and to safeguard the interests of its customers and its shareholders.
- The third objective is to ensure the implementation of laws, rules, standards, and ethical principles inherent in the activity.

Such objectives can be achieved only through direct and sustained involvement of Staff of the financial institution. To ensure that control procedures are followed at all levels of the organization and ensure a culture of internal control. The latter must be able to identify and prevent different types of risks related to operations, including risks related to capital, credit risk, liquidity risk, market risk, operational risk and so on.
It must also be able to complete this mission without hitting the smooth running of the organization. And must not only ensure the availability of information at all times but also ensure its reliability and compliance with the requirements of Shariah.

Furthermore, if the control system is all that important, it is necessary to ensure its existence in an effective and sustainable. But one wonders if all Islamic financial institutions are aware of this importance, especially the smaller of them. For this reason it would be the responsibility of supervisors to require the existence of a minimum level of control within these institutions and to encourage them to develop a culture of internal control.

Section 2: The international framework of control and the Islamic financial system

2-1 Specific treatment of the regulation and supervision of Islamic banks

According to earlier findings in this study, Islamic finance will play an increasing role in growing the international financial scene in the coming years. Therefore, the throw-in of a new discipline, expose markets and financial sector operators to new risks whose nature is different compared to the conventional financial system.

It is often assumed that Islamic institutions are not clear separation between business investment and business operations. From this point of view, they should be subject to the same regulations and controls the funds. Such assimilation can pose technical difficulties for the implementation of regulations and effective supervision. Taking for example the Mudaraba contract when Islamic banking comes as part of this instrument (share profits and losses), it can be seen both as a manager of substance such as a bank. Another example is in the Salam (as discussed in chapter two) where the two principles, as well as banking intermediation risk-sharing apply.

A number of analysts recommend that the regulation and supervision of Islamic banks must have a particular focus on the operational risk management than in conventional banks. They base this argument on the specific nature of operational risk profile in the Islamic banking system, either through alternative financing PBP or other modes. Investment risk is the risk the most important means of financing for PBP.
Further exposure of Islamic banks in risk is accentuated by the nature of the liability of the agent-entrepreneur in the contract PBP, which can not be questioned that if it was determined that is negligence or mismanagement on his part.
If, for example as part of a Mudaraba financing, the project has recorded losses, the bank will be unable to recover its funds because it must accept any contract losses. The agent-entrepreneur in this case, will lose the time and effort he spent on the project. In addition, there is no specific legal rules, allowing the Islamic bank to control the work of the agent-entrepreneur in the Mudaraba contract, hence the complexity of proving negligence or mismanagement of the project .

Thus, it is necessary to safeguard the interests of different stakeholders, given the nature of different risks but also to protect markets and to ensure a stable global financial system.
Such a goal can be achieved through the establishment of appropriate regulations and effective supervision, able to regulate the various components of the financial system in a comprehensive and integrated dimension.

2-2 Applicability of international regulatory standards in Islamic banking

The above analysis leads us to ask how the control model recommended by the Basel Committee on Banking Supervision, it is applicable to Islamic banks. Otherwise, the question would be, what are the regulatory standards that would suit her and what the potential difficulties with such regulations?

According to the Basel Committee, Banking Supervision is based on a number of basic principles related to the management and effective prudential banking institutions to ensure the stability of the financial system.
These principles relate to capital adequacy, internal control procedures, external audits required to ensure the identification, management of different types of risks and the techniques used to manage credit effectively.
In addition, the Basel Committee stresses the importance of identifying all foreseeable risks by implementing measures to anticipate, manage and control them effectively. But this goal can only be accessed if the controllers are equipped with the necessary legal authority that would allow them to conduct corrective action in the appropriate times.

This leads us to wonder about the relevance of Islamic financial institutions to submit to the standards of regulation and control, established by the Basel Committee.
At first glance one is tempted to say no to this question by arguing that the nature of the risks of Islamic banks is different from conventional banks. For, as we saw earlier, depositors of an Islamic bank to the risk involved and therefore the bank in this case, should be considered as an investment fund or as a normal society. However, the fragility of such an argument can be demonstrated through a number of notable differences between an Islamic bank and a normal corporation.
A first difference is that a systemic point of view, the failure of a normal society particularly affects its own shareholders, while the bankruptcy of a bank affects the stability of the entire financial system and connective tissue the economy.
A second difference lies in the fact that the power of banks increases gradually as the mass of deposits increases. Faced with such a configuration, appropriate regulation is needed to restore balance and safeguard the interests of the depositor against any possible abuse of power. In the same vein, appropriate regulation will protect the banks from excessive exposure to risk and to ensure the reserve necessary to protect the interests of its customers.
A third element concerns the accession of Islamic banks in the interbank system that could be accessed only through compliance of Islamic banks to international regulatory standards.
And finally, the need for regulation on the international standard to ensure compliance with the requirements of Islamic banks in the Shari'ah. This will result in the harmonization and the fluidity of international operations.

Note also that the Islamic financial system is still in its infancy. To qualify for a better integration into the international financial system, it is required to prepare an acceptable and flexible legal framework under international regulations. It is also required to make better use of modern technology already adopted by the conventional system. It must also ensure that compliance with the Shariah is not an obstacle for the development of innovative products to meet diverse and dynamic requirements.
Such a challenge can be met only through the combined efforts of a hand, scholars of religion, to ensure compliance with the Shariah and on the other hand the involvement of experts in engineering Financial and economic experts.

In parallel with these efforts of reflection and implementation of regulations in order endogenous Islamic financial system, an effort of reconciliation should be considered the side of the international bodies of regulation and supervision in order to integrate the various components of regulation in an international dimension.

This brings us back to the dynamic spirit of the role displayed by the banking supervision across international in this regard: "The Banking Supervision is a dynamic function that must adapt to market changes. Therefore, supervisors should be prepared to review their policies and supervisory practices in the light of new trends or developments, they must have a sufficiently flexible legislative framework. "

Section 3: Accounting standards and oversight body of Islamic banks

3-1 The Islamic accounting standards

The financial statements presented by the institutions, balance sheets, operating accounts, statements of financial summaries, and other states are required to give picture of financial health. The reliability of these states is of paramount importance to the shareholders of these institutions, customers, for partners but also for regulators and control. Hence the need for a standardization of accounting standards to facilitate the use of these states and allow the market to work seamlessly and efficiently. In this respect, the standards set by the International Accounting Standards Board (IASB) are applied by the vast majority of financial institutions worldwide.

Islamic accounting standards are based primarily on the International Accounting Standards (IAS). The organization of accounting and auditing for Islamic Financial Institutions (OCAIFI) played a significant role to adapt the international accounting standards and make them applicable to Islamic financial institutions.

It should be noted that the objectives of accounting standards do not always converge with the concerns of regulators and control. While accounting standards are concerned to declare the balance sheets the assets according to their real value, regulators and control will be more concerned with a statement that would better measure the risk and volatility of assets.
Therefore we are faced with two contradictory approaches. To overcome this difficulty, the accounting standards-setters, regulators, banks and stakeholders need to cooperate closely for the development of accounting standards to improve the best risk management in banking institutions.
In the same vein the OCAIFI should join these efforts to the development of accounting standards for Islamic financial institutions to strengthen risk management in these institutions.

3-2 Establishment of a monitoring and supervision

It should be noted that the wishes of an establishment of an Islamic financial system regulation, have already been expressed in 1991 by the governors of central banks and monetary authorities of member countries of the Organization of Islamic Conference (OIC).

Since the 90s, the efforts of regulation and control have increased at several levels. The Islamic Development Bank (IDB) has played a significant role in developing policies and procedures to standardize accordance with the Shariah, which could be adopted internationally. Other international institutions working on the harmonization of regulatory standards between countries. Including the organization of accountants and auditors of Islamic financial institutions (AAOIFI), the Islamic rating agency rating (ANII), the Islamic Financial Services Board (CSFI), the center of Islamic liquidity management, (CGLI) and the International Islamic Financial Market (MFIII).
The accounting standards issued by AAOIFI, which have not yet acquired binding, are only applied by a number of countries. These institutions aim to foster the development of a financial services sector prudent and transparent and provide advice and assistance to Islamic financial institutions in regulation and control. As the development of standards for capital adequacy, risk management, standards of governance institutions, etc.. Once established and accepted international standards facilitate the verification of the strength, stability and integrity of Islamic financial institutions around the world.

Once the guidelines for the establishment of audit and supervision of Islamic banks are established, it will be a specialized agency to be responsible for their implementation and monitoring. In this context, a recommendation was made at a meeting to establish a council of Islamic services, the IDB, the IMF, the World Bank, the Bahrain Monetary Agency (BMA) and the organization accounting and auditing for Islamic Financial Institutions (OCAIFI).

At this meeting it was decided to establish an interim committee with the central banks of a number of member countries of the IDB, IMF, IDB and OCAIFI. The purpose of this committee is to work towards developing a concrete and detailed proposal for the establishment of an Islamic Financial Services Board (CSFI), with the aim of creating an autonomous regulatory and control for Islamic Banks.
At the same meeting, the IDB has been mandated by the representatives of central banks of countries represented to play a central role in the establishment and operation of this institution.

To do so, a number of conditions are necessary to enable the CSFI to fulfill its mission.
In the first place it is strongly recommended that the board is with a great expertise of regulatory standards and controls established by the Basel Committee on Banking Supervision (BCBS), International Organization of Securities Commissions (OICT) and the International Association of Insurance Supervisors (IAIS). Then it must be perfect knowledge of the Islamic financial system to its characteristics, strengths, weaknesses and various issues related to current and future practice. It must also be able to coordinate with banks, securities organizations, investment funds, insurance and all other non-bank financial institutions. For the sole support of financial institutions bank can not allow it to fulfill its mission of regulation and control effectively. And finally an equally important, is to acquire the authority to respect and implement its recommendations. Which requires the involvement and support unconditioned monetary authorities.

General conclusion and points for consideration:

In recent years, several research works have shown the feasibility and viability of the Islamic financial system. This was also demonstrated through the successful operations of Islamic institutions in several countries. However, these performances rather satisfactory should not make us lose sight of the problems the Islamic financial system is facing. To support its growth it is expected to meet a number of challenges, some of these challenges are related to the environment in which Islamic banks operate and others comes from the internal environment of the Islamic financial system:

Although the basic principles of Islamic finance can promote ethics in banking practice, this does not mean that the Islamic financial system is safe from abuse which the conventional system is exposed. It is therefore necessary to establish appropriate arrangements for governance, regulatory and risk management.

The shortage of Shari'ah experts with a master of both the economic and financial aspects of operations can also be an obstacle to the development of Islamic financial system. For example, failing to validate compliance with the Shariah, Islamic banks may be deprived of effective instruments and yet compatible with the Shariah.
The central bank can provide great support for training to Islamic banks. Since usually it is involved in training programs for the benefit of conventional banks, it could in the same way to help the Islamic banks in the same vein.

The central bank may also help Islamic banks to solve the problem of lender of last resort. This can be done through the establishment of a common, as are the statutory reserves, which the Islamic banks and mutual help that can be used when needed liquidity in accordance with a number of conditions to comply with the Chari has.

Also, the boards of compliance with the Sharia can be very expensive to Islamic banks, especially the small ones, hence the need to solve problems is through the establishment of a joint council for a group of banks or the creation of an autonomous council under the authority of the central bank. This will benefit not only reduce costs but also to ensure standardization of opinions related to Fiqh, something that might help the process of certification of Islamic financial instruments. As such the OIC and the committee Rabitah Al Fiqh are important to reconcile the different opinions of Fiqh by holding meetings for discussion among the fuqaha to discuss various matters of Ijtihad. The Council of Islamic Banks (CBI), established by the IDB is also considerable work in this direction.
These efforts have enabled substantial progress, though much work remains to troubleshoot issues that still exist Fiqh.

Another factor is the lack of an Islamic financial market. Efforts must be multiplied in order to promote the development of Islamic banks. An agreement was signed by the IDB, the Administration of Offshore Financial Services Labnan (LOFSA) of Malaysia, and the monetary authorities of Bahrain (OMB) to establish a secondary market for Islamic financial instruments. Also, the creation of a cash management committee (GLC) to expand the international Islamic capital market and to launch the international Islamic capital market (MMII).

If Islamic banks have succeeded in mobilizing large amounts of deposits, this can not be explained solely by improved performance and better service. But by the religious motivations of depositors. For want of an alternative more advantageous and consistent with the Shari'ah, many of them accept low income or even zero income. Islamic banks also have orgasms until very close to the monopoly market of Islamic finance. Now the situation has changed. Islamic banks face competition from increasingly growing conventional banks, including multinational Western banks.

If the entry into operation of these Western banks in the Islamic finance market is further evidence of the viability and development potential of the Islamic financial system, it also announced a competition very fierce. One might wonder whether this situation will make the Islamic financial system? The answer to this question will be based on strategies that will be adopted by Islamic banks meet this challenge. In principle, competition is considered a lever for growth in any industry. It allows the optimization of production costs, improving quality, and requires the least efficient firms to adapt to the market or to disappear.
We cite in this connection the statement of the Director of British origin, the Monetary Board of the State of the Emirates, which has been one of the founders of the central bank in the country. He had said after a long debate on Islamic finance that "if you succeed, we will convert to your way not to lose our customers ...."
While Kids are back in the game of Western banks in the Islamic finance market is very recent, they have the advantage of size and experience of banking practice. This puts Islamic banks face very strong competition. Therefore the viability of Islamic institutions depend on their ability to meet the challenge of efficiency and performance.

Finally, among the major challenges facing the Islamic system is also found the introduction of regulation and effective supervision in a position to allow for better risk management, ensuring the interests of depositors, promote market stability and provide a significant contribution to the entire international financial system.

The supervisory authorities, organs of international controls, and financial institutions are faced with the dilemma of understanding the needs of this sector and to find a balance between, on one hand, the introduction of effective control and, On the other hand, encourage innovation and development of Islamic financial institutions.
This double challenge can be solved by strengthening cooperative efforts of the institutions concerned and the creation of an enabling environment. In other words, the establishment of necessary mechanisms and equitable development of the sector according to the law of the market. For a healthy and efficient financial system can offer considerable opportunities for development and economic growth through the financing of economic infrastructure and job creation.

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