Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
Middle EastMay 1 2005

Islamic banking arrives in the UK

The authorisation of the first fully Shariah-compliant bank in the West has created considerable interest. Michael Ainley looks at the FSA’s approach and what lies ahead.
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon

Islamic banking has grown rapidly across the world in the past 25 years, with major centres established in the Gulf and the Far East. London, too, has become an important centre for wholesale Islamic products, such as LME mudaraba trading and sukuks, which are traded by a range of international banks. These products are relatively uncomplicated from a regulatory standpoint – many, such as ijara leases, are not regulated by the Financial Services Authority (FSA). But there has been no outlet on the retail side, until now, for Islamic savings products in the West. Yet the potential market is quite large. There are about 1.8 million Muslims living in the UK, accounting for 3% of the population, as well as a further half a million Muslim visitors annually.

Since the early 1990s, the Bank of England and then the FSA have held a fairly active watching brief on Islamic banking. Eddie George, the former governor, recognised early on that Islamic banking was a major development which Western regulators should understand and work alongside.

Working together

Contacts with influential Muslim organisations were continued by Howard Davies, former chairman, at the FSA. In 2000, a Bank of England Working Party, with representatives from the City and the FSA, looked at the barriers to Islamic mortgages in the UK. By far the most important was the issue of double stamp duty on Shariah compliant mortgages; the government removed the anomaly in 2003. International links have also been developed, with the Accounting Standards Organisation (AAOIFI) and the Islamic Financial Services Board (IFSB) where the FSA now participates on various working groups and committees.

But these ties are a long way from authorising an Islamic bank. Under the Financial Services and Markets Act 2000 (FSMA), there is no discrimination for or against a particular sector, such as Islamic banking. All applicants have to meet five, basic criteria, or Threshold Conditions.

Among the most important are adequate financial resources (capital and liquidity); sound management; and reliable systems and controls. Such criteria are common to all major countries. In the UK, however, the FSA has the advantage of being a single regulator and is therefore able to ‘look across’ financial sectors at the different types of Islamic products being proposed.

Hurdles to jump

In the case of Islamic Bank of Britain (IBB), the bank prepared the ground thoroughly and took appropriate advice – essential for any applicant. It provided a credible business plan and was able to demonstrate that the Threshold Conditions could be met. But the risks in Islamic operations are different and there were, inevitably, obstacles, some practical and some legal.

The major legal issue was that of Islamic deposits. The legal definition of a deposit in the UK is a sum of money that has to be repaid in full. The FSA’s interpretation (and that in other major countries) is that this requires capital certainty. But the IBB wanted to offer (as well as a simple non-interest bearing account) a profit and loss sharing account, a mudaraba contract in which the customer has to accept the risk of loss to his/her original capital.

The question for the FSA was whether this was a deposit or an investment or something else entirely. The distinction matters as the FSA’s regulation of deposit-takers is designed to ensure that the customer gets full repayment, provided the bank remains solvent. If capital certainty is not assured, other regulations on treating customers assume greater importance. For their part, IBB were keen to classify the product as a deposit so as to compete with conventional products.

After extensive discussion, it was agreed that IBB would offer full repayment of the investment, thus ensuring compliance with the legal definition of a deposit. At the same time, the bank will calculate the amount repayable to comply with its risk-sharing formula; and the customer does not have to accept repayment in full if his/her religious conscience dictates. This was acceptable to all the lawyers and Shariah scholars involved; but there is no guarantee that it would work with other applications. FSA will have to look at the merits of each case.

A second issue, unique to Islamic banks, is that of Shariah compliance and the role of the Shariah Supervisory Board. The FSA is a financial not a religious regulator; and it is not able to get involved in questions of whether something is Shariah compliant or not. But it did – and does – need to know, from a financial and operational perspective, exactly what the role of the Shariah Board was to be. It needed, in particular, to know how it affects the running of the bank; and if the board were to have an executive or directorial role, the FSA would need to approve the individuals. This was relatively easy to establish with IBB but practices can vary considerably; and Shariah compliance is an operational risk which has to be managed. Again, future cases will have to be taken on their merits.

Clear thinking

Two other issues – not confined to IBB – are also worth mentioning. Both concern transparency. First, because Islamic banking is still new and ‘different’ in the West, any Islamic bank will have to be very clear to their customers about the risks and nature of the products they are offering. As with other banks, the FSA will watch carefully to see that all promotional material is clear, fair and not misleading. IBB recognise this very well.

Second, there are still unresolved questions over corporate governance in the Islamic banking model. These relate mainly to potential conflicts of interest between different classes of investor and the position of investment account holders, in particular. The issue here is whether and how investment account holders can be sure they are being treated fairly and that insiders (to the bank) are not taking advantage of their privileged information at an opportune time. These are not problems for IBB, at least not yet, but the FSA will continue to look to the boards of individual Islamic banks to come up with the right, transparent policies in these areas.

Constructive approach

In all, it took 18 months to work through these and other tricky questions. According to Michael Hanlon, CEO of IBB: “An incredibly constructive approach was taken by the regulator.” The FSA took full account of one of its Principles of Good Regulation – namely to promote diversity and innovation. But it is important to note, too, that its essential prudential requirements have been met; and depositors have the same protection as in other banks. The flexibility which the FSA found was very much within a common regulatory framework.

Since it opened for business, IBB’s capital has been doubled through a successful IPO; and it now has four branches. Looking ahead, people are asking whether this is the start of a trend, of more Islamic banks and insurance companies being authorised in the UK. The FSA have had recent soundings from two or three firms from different parts of the world, but it is too soon to know the upshot. Major UK banks are entering the market – for example, Lloyds TSB has recently announced a Shariah compliant deposit account. The FSA also regulates or is likely to regulate all Islamic mortgages, following newly implemented legislation.

But the FSA has no sweeping ambitions in this sector and will look at new applicants case by case. It will continue to help in the development of common Islamic standards through AAOIFI and the IFSB. This work is of particular important now as Islamic banks head towards the implementation of Basel II. Indeed, common standards could be the most useful way of promoting greater understanding of Islamic products (and balance sheets) in the West, thereby helping in the further growth of Islamic banking. In the UK, there is considerable potential for growth in Islamic financial markets – but it is up to the market and the consumer how this demand will be met. The FSA will watch closely.

Michael Ainley is head of the wholesale banks department at the FSA. E-mail: michael.ainley@fsa.gov.uk

Was this article helpful?

Thank you for your feedback!

Read more about:  Middle East , Western Europe , UK