“We must adapt Islamic finance to existing international standards”

August 2011

(Part 3 of 3) Conversation with Rifaat Abdel Karim, secretary general of the Islamic Financial Services Board, on – developing and maintaining standards – support from member countries – adapting to new financial scenarios

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Here is the transcript of the video.

1. Adaptability is key to harmonization between Islamic Finance and global standards

Emmanuel Daniel (ED): I’m very pleased to speak with Dr. Rifaat Ahmed Abdel Karim, the first Secretary-General of the Islamic Financial Services Board, a post that he’s held since the IFSB started in 2003. I’m interviewing him at a time when he’s about to step down as Secretary-General of the IFSB. It’s a great pleasure to be able to speak to you today.

Dr. Rifaat Ahmed Abdel Karim (RK): The pleasure is mine. Thank you very much.

ED: 2003, and now it’s 2011. In that time, what would you consider to be your top two or three most important achievements as Secretary-General of the IFSB?

RK: I think, in 2003, not many people or organizations knew about the IFSB. Today, you cannot speak about the Islamic financial services industry without mentioning the IFSB. Number two, I think we provided the platform for many regulatory authorities and international financial institutions, to anchor their interests in IFSB.

We started with only nine members. These were eight central banks and Islamic Development Bank. Today, we have 195 members comprising 53 regulatory and supervisory sovereignties. In fact, by the end of this month, this number of regulatory sovereignties should increase to 55.

Now, this includes the central banks of Japan, China, Singapore, Hong Kong, South Korea, and Luxembourg. This is their entrance to Islamic finance. And I think, had it not been for the IFSB, perhaps these regulatory authorities wouldn’t have been encouraged to come on board with Islamic finance.

ED: You’ve succeeded in bringing a whole range of institutions, both Islamic as well as large countries which have Islamic populations, but which are essentially secular, to the table. Would I be correct to say that your first mandate was to seek some form of harmonization between the disparate Islamic regimes in financial services?

RK: Well, even in our articles of agreement, the first objective states that we should adapt to existing international standards, which means that we should not reinvent the wheel. We have to start, in banking for example, where the Basel Committee has ended, in the capital markets where the IOSCO has ended, and insurance where the International Association of Insurance has started. So we take their standards and adapt it to the specificities of Islamic finance.

So that’s our mandate. Through our development of prudential standards, whether for banking, capital markets, or the insurance sector, we hope that we will enhance the soundness and stability of the financial systems in the jurisdictions where institutions that offer Islamic financial services operate.

ED: In the time that you’ve been Secretary-General and trying to put this harmonization between what is considered secular global standards, or the mainstream standards, and Islamic finance, do you still hold to the view that parallel harmonization, in a way, is still a goal worth pursuing, especially after the global economic crisis where the rest of the world appears to have changed the rules somewhat in terms of the safety and soundness of financial services?

RK: Yes, we do because this emanates from the business model of the institutions to which we are providing these standards to harmonize their regulatory practices. The business model, for example, for Islamic banks comprises many jurisdictions of commercial and investment banking without legal, financial, or administrative separation.

On the mobilization of funds, they are allowed to mobilize funds or investment accounts, which is based on profit-sharing and loss-bearing. This is not the business model of a typical conventional bank, which is based on borrowing and lending.

ED: So why seek harmonization then?

RK: In order for them to have these industries integrated into the global financial system. You cannot just have a system by yourself operating in isolation from the rest of the global financial system. Now, in order to do that, we start with, for example, Basel II and now Basel III. We take Basel II and adapt it to the specificities. Why the specificities? Because if you don’t, then maybe a lot of risk will slip through the supervisory net.

ED: But in reality, is all of Basel II transportable to an Islamic finance model? Doesn’t that put restrictions on the commercial application of Islamic finance in terms of capital and, in fact, even in terms of understanding what risk is and how much capital to allocate to risk? There’s already a fundamental difference.

RK: True, but then let’s take Basel II. Let’s take Pillar I, for example. We speak about credit risk and market risk. If you apply the same concepts of risk to Islamic finance, let’s take the plain vanilla murabaha as a sale on credit for example. Now, the bank has to acquire the asset. By acquiring the asset, it is exposed to market risk. The minute it sells or leases the asset to a customer, then that market risk transforms into credit risk. Now Basel is silent on this transformation of risks, whereas, we speak about it, that’s how we adapt it to the specificities.

ED: In your conversations with the Bank for International Settlements, for example, do you feel that you’ve been adding this dimension to the conversation? Are they listening?

RK: Oh, yes. In fact, we’re represented in the Basel Committee for international liaisons. And we’ve even recently been invited to sit on the committee that is drafting and revising the core principles, which shows that we are working together in a close relationship. They value our work. It caters for a growing industry, or sector in the market. You don’t want to be silent on it, right? Rightly so, the Basel Committee is focusing on the conventional side. We are focusing on the Islamic finance side.

2. Islamic Banks can manage exposure to liquidity risk

ED: Now, the global economic crisis, once again, exposed the issue of liquidity risk in commercial banks. How is that being attended to for Islamic finance? And is it realistic to expect that it will be an equivalent crisis in the Islamic finance world once it becomes of a certain size operationally?

RK: There are two aspects to that. One, after the Basel Committee issued its liquidity management standard, we started working on a standard on our liquidity risk to adapt that to Islamic financial services. Number two, the IFSB spearheaded the establishment of the International Liquidity Management Corporation, the ILM, basically to address liquidity management issues in Islamic financial services.

This organization is mandated to issue high quality financial instruments that would help institutions that offer Islamic financial service to manage their liquidity in an efficient and effective manner. It was launched last October. The IFSB facilitated the closing, the development, everything of that organization. 12 central banks and 2 international multilaterals have signed the articles of agreement. That gives it a very good kick up.

ED: So regulation-wise and infrastructure-wise, it seems to be in place. But the actual practice of creating liquidity at a time of crisis – Islamic banks would generally be at a disadvantage to their commercial equivalents because they don’t have the resources of liquid capital markets and liquid instruments.

RK: That was in the past, not after the creation of this organization because if this is high quality – let’s say an AA or AAA-rated sukuk – they can sell them. You can always sell an AAA [product] more easily than your other non-liquid assets.

Number two, we hope that, in the future, those members who have signed articles of agreement will also use these instruments in the monetary policy. They can hold some of it, for example, and then they can either sell it, if there’s a need for that, or buy it from another financial institution to help in facilitating the liquidity management of these institutions.

ED: Let’s move a little bit to the harmonization within the Islamic community. There is the Islamic community in the Middle East, which, in itself, is fragmented somewhat, and then there are initiatives out of Malaysia, out of the U.K., and so on. How successful do you think you’ve been in seeking some form of best practice in the way in which Shariah law is applied?

RK: What would have happened in the absence of the IFSB? Whether it’s in the Middle East, the Far East, Southeast Asia, whatever, each of these countries would have adapted, by themselves, Basel II or Basel III to Islamic finance. Now, their adaptation may differ from one country to another country, hence, borders would be a problem.

By providing standards that these countries can rely on, that would facilitate supervision of these institutions from one country to another and then you provide a level playing field.

ED: But what’s been happening in the scholar community? I think we’ve now created a generation of scholars who are like superstars, and whatever they say sort of stands over and above any of the general standards and general principles.

RK: Not necessarily. I’ll give you an example: For example, the Shariah scholars in a certain institution may approve that that institution may use a certain product. It’s up to the regulatory authorities to allow to what extent that product can be used. If, for example, it would lead to excessive leverage, you can say, “You’re exceeding your leverage ratio.” They’re not above regulatory authorities.

But we need to understand it in that context. They provide advice to the institutions in terms of their products, for example, compatibility with Shariah rules and principles. The use of that product in the context of risk management is up to the regulatory authorities.

ED: What do you fear most in terms of how the Islamic financial landscape will evolve? Even as more money comes into the system, as it becomes larger, and executives are paid more, you get situations where the scholars will be overrated because they see themselves as being important and they might actually undermine the base safety net that you’re trying to put in place.

RK: But we have also seen countries, for example, Malaysia, where by law, you cannot sit on more than one Shariah aboard. This has forced the marketplace to go and train Shariah scholars to sit on their boards. Now, in the long run, they’ll have a pool of trained Shariah scholars.

I think what is needed is that we cater for the supply because, rightly so, whom you now call the minority are sitting on so many. They have exerted a lot of effort to learn the business and they have excelled in that, and hence, they are in demand. But we don’t see a lot of supply coming in. Countries should also, perhaps, take steps to help in providing that supply.

I agree you cannot depend on a few for an industry, but in the long run, whereby we will have institutions that provide the training for this – I mean, in Bahrain, they have the BIBF, in Malaysia, they have the NCF, in other countries, they have their own institutions. The more we give attention to that, in order for Shariah scholars to be conversant in banking, economics, accounting, and finance, and of course, in addition to their own knowledge in Islamic jurisprudence, the more we provide a supply of these scholars, the more it will make this industry more stable and facilitate its growth.

ED: At the end of the day, the quality of an Islamic finance asset, or Islamic asset, is dependent on enforceability. We came very close to testing that with the Dubai crisis, really. Today, there are cases in the U.K. courts in terms of the enforceability of our contracts. Very often, the problem arises, not so much in the interpretation of the law, but the opportunistic desire to take advantage of unclear aspects of Islamic law. What should the non-Islamic world expect to see happening to make recourse a more definitive principle in Islamic finance?

RK: Two things: The IFSB as early in 2004 started organizing seminars on legal risks. I think that’s what you’re referring to. We have exerted a lot of effort in trying to create awareness of the legal risk in Islamic finance. We have also published a book, called Global Legal Issues in Islamic Finance, where, for the first time, we addressed securitization laws, insolvency laws, trust laws, and how these should be adapted to Islamic finance.

Recently, at the last IMF/World Bank and UN meetings in Washington, alongside those meetings, we organized with the World Bank a roundtable on insolvencies, and the papers that were presented there were so good, we’re presenting them in a book that will be released this March.

So we have, I think, created a lot of awareness about the issues relating to legal risks, whether it’s insolvency, trust law, security, on and on. The case you have referred to doesn’t go outside the sphere of these laws.

ED: It’s interesting to hear you speak that way because in commercial law, or rather in commercial infrastructure to deal with commercial trade in the mainstream, there is the principles-based approach and there is the legal, or the rules-based approach which the Americans tend to take. In your writings and in your speeches, you tend to talk more about ethics. Ethics, in a way, appears to be not as persuasive as the principles-based or the rules-based approach. Do you think that the work of the IFSB in sort of promoting a non-binding ethical culture is, perhaps, a weaker approach than if you had been more enforceability driven?

RK: By our articles of agreement, we are only mandated to recommend. We don’t have any legal enforcement powers.

ED: But in a way, you are the founding member of the IFSB. You could have influenced it to go further.

RK: But then you are impeding on the sovereignty of jurisdictions. None of the international standard sitting bodies have legally binding in enforcements, Basel Committee, The International Economic Standards Board, you name it. But instead of this, what do we do? We try to produce high quality standards that will convince regulatory authorities to implement them in order to enhance the safety and stability of their own financial system.

3. Education important for success in implementing Islamic Banking standards

ED: Are you happy with the way in which your respective members have incorporated the principles that you’ve espoused?

RK: Before incorporating those, we had a duty, and we started doing it; the duty of facilitating the implementation of these standards. How? By education. We conduct a lot of training now, just like the Financial Stability Institute of the Basel Committee and others.

We have conducted a number of training courses in several jurisdictions and even in different languages in order to educate both the regulatory authorities and the marketplace of the IFSB standards to implement them. I think we have now seen, recently, that one of the countries in the Gulf said that they’re going to implement the IFSB standards.

ED: And that would have been one, but a number of your members should be, but are not.

RK: Another market forces that. The more you’re in your jurisdiction, the more you start having a high percentage of Islamic finance in the financial service, the more you will be looking for the IFSB, hopefully, for that because if, for example, 34 or 35 percent of your financial services are Islamic, then, hopefully, the IFSB will be of relevance there to help.

ED: In terms of what you just said, it’s interesting that a number of Middle Eastern countries in that transition phase. Not all of them have necessarily very clearly adopted the principles that you put in place. If you look at what Qatar is doing right now, trying to force-feed its otherwise commercial institutions to become Islamic overnight without the infrastructure being put in place, is that a good thing or is that going ahead of the process that you probably envisaged?

RK: Qatar did not force all the banks to go Islamic. What was said to the central bank is that conventional institutions are not allowed to have Islamic windows. So either you have a full Islamic bank or you have a conventional one. They’re not allowing these windows to operate. Perhaps they have risk management issues; how are you coming to all these funds, corporate issues, and whatnot. That’s what the central bank of Qatar did.

And in their statement, they also said that, for Islamic banks, they’ll be implementing the IFSB standards because they believe that – if, for example, you have an Islamic window, how would you calculate capital adequacy? If you start accepting different investment accounts, that then leads to a different capital adequacy. Also, we adapted the Basel Committee one. If you take our standardized formula, we deduct it from the denominator, the assets funded by the investment accounts and whatnot.

What they said is that you cannot have two different ones in order to have two different capital adequacies. So that’s their position. In that respect, these are market forces again, regulatory forces, which could lead, today, to the implementation of the IFSB, which we always welcome.

ED: Are you happy with the work you’ve done at the IFSB? Do you think the IFSB will survive your personality, given the fact that you are a very erudite, very cosmopolitan man who’s been able to achieve an amazing thing in the Islamic finance world, which is to bring the whole world together to sit on the table at the regulatory front? In a way, it’s still at a stage where it requires something of your personality to continue driving it.

RK: I think the work of the IFSB now speaks for itself. In eight years, we’ve increased our membership, we have issued fourteen standards, we have gained a lot of recognition and respect, whether it’s from the IMF, the World Bank, the BIS, the Asian Development Bank. These are all our members, and I think it adds to our credibility at the IFSB.

I’m happy that the IFSB can now stand on itself, but also the support of its members is very important. I think we have been providing the members with quality work that made them happy to continue supporting us.

ED: How would you differentiate what the IFSB has been achieving and the Accounting and Auditing Organization?

RK: The Accounting and Auditing Organization for Islamic financial institutions issues accounting and auditing standards and, recently, Shariah standards. The IFSB does prudential ones. Their work tends to complement that of the International Accounting Standards Board and the International Auditing and Assurance Standards Board.

ED: Who is closer to the business; is it the accounting standards or the prudential standards?

RK: Wouldn’t that be two different aspects of it? Because in a business, you need accounting and auditing standards, but you also need the regulatory aspects. I don’t think they are mutually exclusive.

ED: And at what point do you think the IFSB model becomes an enforceable model, like the BIS almost?

RK: Well, the Basel Committee now, as you know, they’re a member of the Financial Stability Board, and the Financial Stability Board is a driving force now trying to push all the international standard-setting bodies to issue standards and to have them implemented in order to enhance financial stability.

In our case, as I said earlier, it’s the high quality of the standards that, hopefully, others will recognize, given the increase in the proportion of these industries in their own jurisdictions.

ED: We’re having this conversation at a time when there’s great change taking place in the Middle East today. How do you read those changes, what do you think will be the next two or three steps that will define the Middle East, and how will they affect financial services?

RK: At the IFSB, we tend to be apolitical because we deal with central banks and securities and insurance regulators. Whatever political impact it has on financial services, we tend to adapt.

ED: But at the same time, there’s going to be a very profound political impact because a number of these societies would probably want to become even more Islamic than they are right now. It might see the proliferation of greater Islamic institutions in a number of Middle Eastern countries.

RK: The only impact I see is that that will lead to, for example, more demand for Islamic products, and you have to provide the institutions to do that because you don’t want them to be financially secluded. Financial inclusion is an important aspect. You need them to be within the formal system rather than outside the system.

So if that is the case, then it may lead to more institutions which may need to be licensed in order to cater for that demand to provide financial inclusion. That will then create demand for the work of the IFSB because, as I said earlier, the more Islamic finance, the more you’ll be looking at the IFSB for harmonization of potential aspects.

ED: How do you expect your successor to continue on and build on what you did?

RK: Well, during the last eight years, we have provided many of the foundations for the IFSB. The next stage will be to maintain and develop the IFSB to cater for, perhaps, the new changes that are taking place. It needs to keep that momentum. So that would be my expectation.

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