Early in February, the Qatar Central Bank (QCB) issued a circular declaring it ‘has been decided to terminate the activities of Islamic finance services’ offered by conventional banks. Banks with Islamic windows have until end of 2011 to comply with the requirement. (See background below).
The reasoning behind the decision has been the subject of wild speculation in the market. Some bankers have stated that such decisions, taken on a seemingly ad-hoc basis, may hurt Qatar’s top spot in the ‘Transparency in Doing Business’ ranking.
According to the Peninsula newspaper , the conventional banks’ Islamic window branches (now amounting to 16) have widened their customer base to some 80,000 individuals and corporate entities.
“The time given to us to wind up our Islamic banking activities is so short that we can’t even imagine how to recover our investment and manage the credit portfolio,” said an industry source to the Peninsula.
It is noteworthy that the circular relates to all conventional banks with Islamic operations, even if the balance sheet is segregated. However, if a separately capitalised Islamic bank were licensed (even if owned by a conventional bank), presumably, it would not fall under the regulatory ban imposed here.
Criticism 1. Access to international capital markets limited
Some commentators have condemned the move, stating that the QCB did not account for the potential impact on the market, and perhaps intended to give the Islamic banks a free ride. The critics also state that the major international banks have been unilaterally responsible for the major innovations in the Islamic finance industry. One commentator argued that international banks are the sole access to global capital markets for Islamic banks, and that Islamic banks will not be able to support transactions of the magnitude that are currently financed in the region.
The QCB directive is directed at all conventional banks with Islamic windows, not just multinational ones. The directive is not prejudiced towards international banks; rather, all conventional banks are affected by it. Further, the ban of Islamic operations does not necessarily preclude arranging and advisory services that international banks conduct.
Criticism 2. Efficiency is wholly ignored
Another criticism of the decision is that it prevents banks from choosing the most efficient operational business model. Islamic windows allowed conventional banks to offer Islamic services directly from their existing network; bypassing the cost and overhead associated with setup of separate Islamic operations. Further, the marketing reach and network of the conventional bank is much stronger than an Islamic bank. Finally, conventional banks could gauge demand via Islamic windows, before heavily investing in setup costs of a separate entity By requiring conventional banks to set up new fully segregated Islamic banks, the barrier to entry is significantly increased, thereby limiting the entry of new players into field of Islamic finance; arguably stifling competition, and ultimately hurting the customer.
There is no clear monitoring of activities of the Islamic window in relation to its conventional parent. If operations, marketing and potentially the balance sheet are mixed, then it is difficult to verify the revenue and cost attributed to the Islamic window. Further, a number of complications arise when dealing with customers. Does the bank staff promote Islamic products or the conventional equivalent to a neutral customer? A conflict of interest may arise if conventional staff members are unable to cater to and service customers interested in Islamic finance. In the absence of specialized training, staff may not be aware of the salient features of the Islamic banking products, especially as it pertains to contracts, legal documentation and implications of default and early settlement.
Criticism 3. Limiting competition
‘Since 2005, there has been a lot of improvement in Islamic banking services as a result of the QCB’s liberalised policy of permitting commercial banks to offer Sharia compliant banking services’ said one source to Peninsula, a Qatar newspaper. A number of critics have stated that QCB’s most recent move could also limit competition, creating a banking monopoly for Islamic banks. They also argue that the existing Islamic banks will have serious difficulty in managing the service flows from the new businesses. Both points indicate that services can only be expected to deteriorate rather than improve.
The QNB Islamic branch currently services 45,000 customers generating profits of around QR 900m last year. Having to forego such a significant chunk of business will trouble banks that have heavily invested in building up their Islamic franchises.
To counter this loss in opportunity, the conventional banks can seek to negotiate with the QCB, possibly setting up independent Islamic banks with completely segregated operations and accounting from the conventional parents. This would, simultaneously, ease the concern of the QCB, while allowing conventional banks to retain their Islamic finance market share.
Benefits of the decision
While the short term impact of the decision may be difficult for the country’s conventional banks; the QCB move may be heralded as foresight, in a region where regulation usually follows bad practice.
Weak Shari’a Governance
Shari’a advisors have long been concerned that Islamic banking windows are the cause of a number of serious Shari’a compliance failures . Many ‘innovative’ products have actually hurt the reputation of Islamic finance; earning the criticism that Islamic finance is just a work-around of conventional finance products.
For instance, the Murabaha based deposit is sometimes accepted by the Islamic banking windows, without any ensuing Murabaha transaction taking place upon deposit. At the end of the period, the Islamic bank client receives his deposit plus a return; allegedly earned from a deferred payment Murabaha transaction. There have been countless anecdotal reports of these practices occurring in conventional banks. However, it has been very difficult to verify or refute these reports, as there is no mandated independent Shari’a audit for these conventional banks.
By requesting all banks to establish separately capitalized Islamic banks or subsidiaries, Sharia’ governance is better monitored and establishes a stronger environment for transparency. Each institution can have its own independent Internal Shari’a reviewer/auditor in place and thereby maintain Shari’a compliance within the institution.
Some have argued that such an extreme measure to ban all operations is not necessarily the only option to ensure proper Shari’a governance. Sh. Taqi Usmani argues that as long as there a permanent Shari’a unit in addition to the Shari’a supervisory board and a complete separation of accounts, staff, office and funds, then it would not be mandatory that a separate Islamic bank has to be formed.
Banning windows also ensures that Islamic funds do not leak out into the conventional banking system, strengthening the base of authentic Islamic finance. Islamic banking windows can take Islamic funds and then recycle it within the conventional banking system. Islamic banks, however, can only accept money that they will invest in their own assets (through Wakala and Mudaraba). On the other hand, Islamic windows, are not bound by the same restrictions, and can reinvest into conventional markets. Since the first transaction (customer deposit) is merely a sale (Muabaha), the second leg can be anything, as long as the sale is completed.
Islamic finance purists say that by allowing such window operations, Islamic banking assets are being funnelled into the conventional system rather than being placed back into the Islamic finance ecosystem.
This can also be evidenced in the management of reserves in Islamic window operations. The conventional treasury department usually handles money-market operations. Daily surpluses are usually passed on to the conventional treasury for overnight transactions for earning some marginal income. Sometimes, treasuries may not have enough surplus from Islamic reserves to cover its positions. In these instances, it would use the proceeds from sale of conventional papers to cover the Islamic deposit obligations at maturity.
If a separate subsidiary with a separate independent treasury is established, the Islamic bank would not have to commingle funds with the conventional treasury. Further, all the funds accepted would have to be directed at Islamic funds.
The decision by the QCB to limit the Islamic banking operations of conventional banks came as a huge blow to the conventional banks in Qatar. Commentators considered it an imprudent move to limit competition in the high growth Islamic banking market of Qatar while limiting access to global markets.
Despite the short term impact on the affected banks, it is the author’s view that it is for the overall benefit of the Islamic finance industry. The ban would alleviate the serious governance/control failures that plague Islamic operations in conventional banks while also preventing the leakage/mixing of Islamic funds with conventional funds. It would be advisable, subject to policy restrictions, that the QCB allow the conventional banks to apply for new Islamic banking licences for their Islamic windows. Where this is not possible, conventional banks should at least be able to merge their Islamic assets and create two to three fully segregated Islamic banks.
Regardless, the decision by the QCB will be observed closely by regulators elsewhere in the region to ascertain the impact on the growth and transparency of the Islamic finance industry in their jurisdictions. If it does and given the support from Shari’a scholars, it is likely that some of these jurisdictions will consider such a move. Malaysia has required the same of its conventional banks and it was considered a pioneer when it did. Given the potential move towards such requirements, conventional banks should therefore consider whether their operating models are optimal going forward.
About the Author:
Dr. Sayd Farook is the Global Head of Islamic Capital Markets at Thomson Reuters, USA. As Global Head of Islamic Capital Markets, Dr Farook is the principal architect of Thomson Reuters’ vision of a global interconnected and diversified Islamic finance and capital markets without borders.
He holds a Ph.D. in Islamic Finance, Business and Law degrees from the University of Technology Sydney and is a Certified Islamic Professional Accountant (CIPA) from AAOIFI.
Disclaimer: This article represents Authors views in his personal capacity and does not in any way represent the views of Thomson Reuters.