Abstract
A key feature of Islamic banks is their use of Unrestricted Profit Sharing (and Loss Bearing) Investment Accounts (UPSIA) in place of conventional interest-bearing deposits. In the first place, this raises a supervisory issue: UPSIA are, strictly speaking, investment (that is, capital market) products, rather than banking products. Hence, they call for a regulatory and supervisory approach that differs from that applied to banking deposits by banking regulators and supervisors. In addition, UPSIA give rise to particular problems as regards both the regulation and supervision of capital adequacy, and also corporate governance. Moreover, UPSIA do not meet the requirements of the banking regulations in North American and Western European jurisdictions, and this constitutes a significant barrier to their development in those jurisdictions. In the second place, this characteristic of Islamic banks raises a structural issue: if UPSIA were used to raise funds, not by Islamic banks themselves, but by fund management companies associated with them (for example, as subsidiaries or as fellow subsidiaries of a common parent), then not merely would the barrier just mentioned be removed, but the application to UPSIA of more appropriate regulatory and supervisory approaches would be greatly facilitated. Last but not least, the rights of UPSIA holders in a winding-up of an Islamic bank need to be clarified, as (absent misconduct or negligence) they are not creditors of the bank but have an ownership claim to some of the assets held by it. This article sets out in more detail an approach that would permit these benefits to be achieved. In doing so, we highlight the challenges faced by the Islamic Financial Services Board in developing appropriate regulatory and supervisory regimens for capital adequacy and corporate governance in Islamic banks.
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References
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In conventional banking, the main reason given for separating the investment banking from the rest concerns the retail side. Banks use funds from cheap retail deposits, supposedly low risk, for risky operations in the investment banking side. Deposit protection merely encourages this abuse (the moral hazard problem). However, Islamic banks use UPSIA funds, which in the majority of these banks are the main source of funding, to finance (risky) operations. In many jurisdictions that host Islamic banks, UPSIA are subject to deposit protection.
According to International Financial Reporting Standards (IAS 32), UPSIA are a type of ‘puttable instrument’ that would fall to be classified as a separate category within the liabilities. IAS 32 does not, however, address the corporate governance issues associated with the profit-sharing and loss-bearing status of UPSIA. On the other hand, the Accounting and Auditing Organization for Islamic Financial Institutions treats UPSIA in its Statement of Concepts6 as a separate element of the balance sheet of Islamic banks between liabilities and owners’ equity, suggesting that UPSIA is neither of these.
Accounting and Auditing Organization for Islamic Financial Institutions. (1993) Concepts of Financial Accounting for Islamic Banks and Financial Institutions. Manama, Bahrain: Accounting and Auditing Organization for Islamic Financial Institutions.
See Accounting and Auditing Organization for Islamic Financial Institutions. (1999) Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks. Manama, Bahrain: Accounting and Auditing Organization for Islamic Financial Institutions.
Islamic Financial Services Board. (2010) GN 3 Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders. Financial Services. Kuala Lumpur, Malaysia: Islamic Financial Services Board.
This is to avoid the mudarib contributing to make good a loss suffered by the customer, which would not be compliant with the Shari’ah requirements of the investment contract, whether Mudarabah or Wakalah.
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The bank may also ‘donate’ part of the profits attributable to shareholders in order to enhance returns to UPSIA12.
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Commingling PSIA funds in an asset pool together with those of the shareholders entails commingling them also with funds provided by the bank's creditors (for example, current accounts). However, with the exception of amounts that may be specifically owed by PSIA holders (such as taxes), amounts due to creditors are owed by the bank itself. Hence, such creditors have a first claim against assets financed by the banks’ shareholders’ funds, but no claim against those financed by the PSIA funds.
The bank's shareholders are exposed to the legal risk of whether or not the courts in the jurisdictions in which Islamic banks operate will recognize and implement these rights and obligations. It is also unclear whether or not holders of PSIA (i) are aware of their ranking in the claims of assets that are jointly funded with the shareholders (and current accounts); and (ii) incorporate such a risk in the level of the returns that they expect from the bank.
In Malaysia, in the case of Affin Bank Bhd v. Zulkifli Abdulla in 2006, the court compared the Bay’ Bithaman Ajil (BBA) financing contract with that of a conventional loan. The court dismissed Affin Bank's claim for unearned profits and only granted the profits up to the date of judgement, plus a penalty and daily profit until the full settlement of the judgement sum. However, on 20 October 2010 the Court of Appeal in the case of Bank Islam Malaysia Berhad v. Azhar Osman & Other asserted that BBA contracts are sales contracts.
Archer, S. and Karim, R.A.A. (2006) Corporate governance, market discipline and regulation of Islamic banks. The Company Lawyer 27 (5): 134–145.
In a sense, the takaful would act like a pool of IRRs, with the diversification benefits that this would bring.
Islamic Financial Services Board. (2007) IFSB-5 Guidance on Key Elements of the Supervisory Review Process of Institutions Offering Islamic Financial Services (Excluding Islamic Insurance (Takaful)) Institutions and Islamic Mutual Funds. Kuala Lumpur, Malaysia: Islamic Financial Services Board.
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Archer, S., Karim, R. The structure, regulation and supervision of Islamic banks. J Bank Regul 13, 228–240 (2012). https://doi.org/10.1057/jbr.2012.3
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DOI: https://doi.org/10.1057/jbr.2012.3