Islamic Banking Regulations in Post Financial Crisis Era

1. Islamic Banking Regulations in Post Financial Crisis Era M. Kabir Hassan University of New Orleans, United States of America

2. Introduction • Islamic Financial Institions (IFIs) are facing immense challenge due to competition from Conventional Financial Institutions (CFIs), excessive presence of complex financial instruments and atypical asset-liability structure. • IFIs are different than the CFIs from the view of: • The mix of contracts on the liability side: Mostly includes – • Shareholders’ equity, • Demand deposit: Guaranteed but no return at all, purpose is Amanah (safekeeping). • Investment deposit: Not guaranteed, no fixed return • Quasi-equity nature of investment deposit (due to PLS system). • A wider variety of assets and financing mixes: • Asset side – • Products can be either PLS based, or based on mark-up pricing, • Equity based PLS of Mudarabah and Musharakah, holding of equity of companies, • Sales based assets through Murabahah, Ijarah, Salam and Istisna. • Financing side – • Murabahah trade financing • Presence of risk sharing and absence of interest

3. Need for Regulation in IFIs • The regulatory regime has been supported because of: • Moral hazard as the root cause of the problem • Proponents of regulation believe that poor regulation brings crisis. • There are more rationales for regulations (Llewellyn, 1999) • Potential external problems: cross-border etc. • Correction of market imperfections and failures • Need for monitoring of the financial institutions • Looking after public confidence on financial system • To ensure a common minimum regulatory requirement for all. • Moral hazard associated with safety net arrangement such as lender of last resort and deposit insurance. • To ensure security and lower cost of transaction as public demands.

4. Need for Regulation of IFIs • Bank failure has severe systemic contagion affect on the economic stability because of various reasons such as: • Banks role in clearing and payment system • ‘Bank runs’ badly affect public confidence • Nature of debt contracts on both sides of the Balance Sheet of IFIs. • Adverse selection and morale hazard associated with safety net arrangements.

5. Need for Regulation in IFIs • The four reasons presented by Chapra and Khan (2000) for the regulation of IFI, in light of the foregoing three views on the rationale for regulation. These four reasons are : • Systemic Considerations; particularly the need to maintain an orderly payments system and ensuring the development of the economy. • The promotion of orderly payments is clearly in the nature of a public good and consistent with this rationale for financial regulation. Regulation is likely to be required to mitigate the risks of disruption in payments. • The promotion of economic development may be beyond the role that should be assigned to financial regulation. This can promote trust in the financial system, encourage more intermediation and diminish the risk of failure, all elements that would encourage activity expansion.

6. The Need for Regulation of IFIs • The design of financial regulation to directly promote development may distort its objectives of ensuring soundness and stability and pose difficult challenges for regulators having to choose between promoting economic development and ensuring the stability of the financial system. • Protecting the interest of demand depositors. In terms of a theoretical IFI model, the case for introducing regulation to protect depositors is less compelling than in conventional finance. • This view underlies the “two-tier mudaraba” model that does not envisage any reserve requirement. The essence of Islamic financial intermediation being symmetrical risk as well as profit and loss sharing, introducing a guarantee on the downside would run counter to the core objective. • Investment depositors should however expect to be informed on the features of the contract they enter into and have a recourse if it is breached. Hence regulation promoting the integrity of fiduciary contracts would be consistent with the theoretical IFI model.

7. The Need for Regulation in IFIs • There is a case for regulation that seeks to protect depositors, public resources and fiduciary contract integrity. The protection of demand depositors is envisaged in the “two-windows” model and can be justified through either of the three perspectives considered. • Ensuring compliance with Shariah. The relationship between civil and religious law varies across national jurisdictions. • In the case where there is an orientation towards a strong separation, it would be difficult to justify assigning to public authorities the role of ensuring that banking activities comply with Shariah. • This would be considered a private religious matter that does not call for public intervention. • The issue of truth in disclosure and in advertisement would however remain and would allow stakeholders to have a recourse.

8. The Need for Regulation of IFIs • This would not however be a matter of financial regulation, but one of the broad institutional infrastructure for business. • In jurisdictions where the distinction between civil and religious law is less pronounced, public regulators may be assigned the role of ensuring that banking activity complies with Shariah. • Supporting the integration of IFI in the international financial system. Integration would develop from the participation of IFI in the financing of international trade and international payments. Counterparts of IFI would want to be satisfied of the ability and commitment of IFI to fulfill the contracts they enter into. • In this respect national and international regulation can be founded on the public good need to ensure orderly participation in international payments and the integrity of fiduciary contracts.

9. Areas of Regulatory Concern for IFIs • Banks’ losses on PLS, which might be greater than investment deposit, would affect demand deposit holders. • Banks’ with capital shortage and poor compliance to prudential regulations would suffer from less supply of investment deposit. • Systemic instability is possible in IFIs since investment deposit can also be withdrawn. • There is a competitive disadvantage to the IFIs if they are highly regulated and inadequately capitalized. • Home-host regulatory issues are being debated largely in a market where IFIs are co-existing with CFIs. • The lesser ability of Islamic banks to trade assets makes the potential systemic cost of individual bank failure even stronger than in conventional banks. • Centralized supervision by an official agency boosts up market monitoring and discipline.

10. Areas of Regulatory Concern for IFIs • Consumer confidence, morale hazard and adverse selection problems are equally applicable to Islamic banks. • Islamic bank fully recognizes the risks generated by financial and commercial factors and elements extrinsic to the formation of the business transaction, given the freedom of contracts and prohibition of ‘gharar’ (deception) should be consistent with Shari’ah laws. • Unlike conventional banks, the credit risk and liquidity risk are higher in IFIs since IFIs cannot hold cash equivalents (liquid assets) like conventional banks. • Islamic banks are prohibited by Shari’ah from borrowing at short notice by discounting debt obligation receivables (e.g., through a central bank discount window). • There is also neither a lender of last resort facility offered by central banks, nor are there available deposit insurance schemes to guarantee depositor capital.

11. Areas of Regulatory Concern for IFIs • Islamic banks also face fiduciary risk and displaced commercial risk. • Fiduciary risk: refers to the breach of the Mudarabah contracts, or misconduct or negligence, on the part of the bank as ‘Mudarib’. • Displaced commercial risk: is a type of market risk which arises due to the transfer of the risk associated with deposits withdrawal to equity holder. • IFIs have lack of instruments like short-term financial assets and derivatives and a money market that hampers risk management. • Islamic banks must ensure its faithful compliance with the rules of Shari’ah, which will become difficult without legal definitions, and effective supervision. • If the outstanding Fiqhi issues related to finance are addressed satisfactorily, compliance with the conditions of Shari’ah can be ensured.

12. Areas of Regulatory Concern for IFIs • The issue of transparency also demands regulation of Islamic banks mainly due to increase in cross pillar activity in home-host collaboration. • Ethical standards are another regulatory concern for IFIs since shariah ruling demands ethical banking practice. • However, effective regulation has its own unique characteristics, which includes a tradeoff: • Prescriptive vs. application based • Cost and benefit of regulation • Quality vs. quantity of regulation

13. Islamic Banking in Light of Basel II • Some contend that IFIs should not be subject to only the corporate regulations due to risk sharing between investments depositors and Islamic banks. • However, the argument is invalidated since the failure of a financial institution affects the health and stability of entire financial system and the economy at large. • Islamic bank as a member of the international community should comply with the provisions of the Basel II in so far they are consistent with the laws of sharia’h. • Basel II is different than its predecessor in various in approaches of risk weighting, such as: • Standardized Approach: credit risk is determined by external rating • Internal Rating Based Approach: measures are developed internally • Model-based Approach: measures are based on advanced models

14. Capital Regulation of IFIs • IFSB (2005) largely adopted a complex Basel II capital adequacy standard simplified it into comprehensible and plausible standard based on shariah with minor differences in methodology. • IFSB deviated from the structured and sequential approach of Basel II to capital adequacy and instead starts with standard approach for credit risk management followed by indicator approach for management of operational risk. • The implementation of revised IFSB standard is not without hurdles, while the problems are mostly stemmed from inadequate expertise and poor legal framework. • Alternatively, AAOIFI standard for Capital Adequacy ignored the agency role played by bank, separation of restricted and unrestricted PLS accounts and difference between PLS accounts and deposits with any potential claim.

15. Capital Regulation of IFIs … 2 • The striking contrasts between IFSB and AAOIFI standard does not alter the minimum capital reserve requirement at 8%, which will be raised totally from Tier 1 (primary capital). • Investment Account Holders bear the credit and market risk to the limit of the funds they provide while IFIs only bear the operational risk. • Salam contracts expose IFIs to counterparty risk, Murabaha contracts to credit risk through receivables, and Istisna contracts to credit and counterparty risk.

16. Corporate Governance in IFIs • The thread of corporate governance and Islamic banking is to have respect to godly, ethical, human, balanced and moderate system that establishes an Islamic way of life (Lewis, 2005). • IFSB (2006) enumerated four broad principles namely; • A comprehensive governance framework explaining the role and accountability of the stakeholders, • The rights of the investment account holders, • Obtaining, applying and controlling shariah rulings • Disclosing information for better investment decision. • Rating of Islamic banks, standardization, transparency and disclosure can emerge as significant issues to address. • Auditing of accountability and transparency should vouchsafe ethical provision of information. • Establishment of corporate governance culture, central sharia’h council and sharia’h guidelines will be inexorable for effective corporate governance to be achieved

17. Transparency in IFIs • The third pillar of Basel II envisages that supervisors should promote market discipline through disclosure and transparency. • Market discipline eventually refers to dissuade banks from taking arbitrage risk. • Crockett (2001) suggested four principles to effective market discipline and financial stability: • Market participants need to have sufficient information to reach informed judgment; • They need to have the ability to process information correctly • They need to have the right incentives; and • They need to have the right mechanism to exercise discipline.

18. Transparency in IFIs • The Holy Quaran says “… and do not conceal testimony, and whoever conceals it, his heart is surely sinful.” • The lesser the degree of explicit or implicit government guarantee relating to bank liability, the greater the amount of uninsured liabilities in the bank’s balance sheet and the greater the market discipline. • Greater transparency and better accountability can help to reduce frequency and severity of financial crisis by encouraging macroeconomic policy adjustments to begin earlier and occur more smoothly and resolve crises by reducing uncertainty. • Transparency disclosure of accurate financial results by IFIs is even more relevant since Islamic banking is based on PLS and thus financial results are very essential

19. Transparency in IFIs • The Basel II identifies six broad categories of information requirements to effective transparency: • Financial performance, • Financial position (including capital, solvency and liquidity”), • Risk management strategies and practices, • Risk exposure (including credit risk, market risk, liquidity risk and operational, legal and other risks.), • Accounting policies and • Basic business, management and corporate governance information. • Improved transparency is still pivotal though Islamic banks have developed mechanisms such as income smoothing fund, to stabilize the return on individual deposits and stem depositor’s perception of the bank’s performance. • A comprehensive assessment of the risk adjusted assets and related best risk management practice of Islamic banks are urgently required to ensure more transparency since Basel II weights will not match with IFIs.

20. Governance, Disclosure and Transparency in IFIs • The governance structure of IFIs is more complex compared to the CFIs since it involves depositors who have direct financial stake in the bank and have Shariah boards (SB) as an additional regulatory layer. • Gaps exist in the governance structure of the Islamic banks with regard to the role of the Shariah Board (SB) and the role of depositors in assuring performance given their direct financial stake in the bank. • The rating of credit risk through external credit assessment as provided by Basel II will increase transparency by allowing for efficient operation and providing information to the depositors in selection of bank of their choice. • A standardized accounting framework in line with Basel II is needed to facilitate both market discipline, objective comparison among financial institutions and improve transparency since IASs could not capture the true essence of Islamic accounting system.

21. Models of Islamic Banking • Two theoretical models have been suggested for the structure of an IFI. • The “two - tier mudaraba” model; both funds mobilization and funds utilization are on the same basis of profit sharing among the investor, the bank and the entrepreneur. • The first tier mudaraba contract is between the investor and the bank. • Investors act as suppliers of funds to be invested by the bank on their behalf as mudarib. • Investors share in the profits earned by the bank's business related to the investors’ investments. • The liabilities and equity side of the bank’s balance sheet shows the deposits accepted on a mudaraba basis. Such profit-sharing investment deposits are not liabilities, but are a form of limited-term, non-voting equity.

22. Models of Islamic Banking • The second tier represents the mudaraba contract between the bank as supplier of funds and the entrepreneurs who are seeking funds and agree to share profits with the bank according to a certain percentage stipulated in the contract. • Banks accept demand deposits that yield no returns and are repayable on demand at par value and are treated as liabilities. • The "two-tier" model does not feature any specific reserve requirements on either investment or demand deposits. It has been argued that, demand deposits are liabilities that do not absorb any loss and therefore reserve requirement should exists for them . • In the "two-tier" model, the assets and liabilities sides of a bank's balance sheet are fully integrated. The need for active asset/liability management is minimized.

23. Models of Islamic Banking • The second model is referred to as the "two-windows" model, which also features demand and investment accounts takes a different view from the "two-tier" model on reserve requirements. • Bank “liabilities” are divided into two windows: • one for demand deposits • the other for investment deposits: that are used to finance risk-bearing investment projects with the depositor's full awareness. • The model requires banks to hold a 100 percent reserve on the demand deposits that are guaranteed by the bank and a zero percent reserve on the investment deposits that are used by the banks to finance risk-bearing investments.

24. A Stylized Balance Sheet of Islamic Bank

25. The Nature of Risk in IFI • IFIs face risks that affect their ability to compete and to meet the interestsof their depositors, shareholders and regulators. • A robust risk management capability, a business friendly institutional environment and an efficient regulatory framework would help Islamic banks reduce their exposure to risks, and enhance their ability to compete with conventional banks. • In the theoretical version, Islamic banks would at face value be less susceptible to instability than their conventional counterparts. This comparative advantage is rooted in the risk sharing feature where banks participate in the risks of their counter - parties, and investment depositors share the risks of the banking business.

26. The Nature of Risk in IFI • In the theoretical model, negative shocks to an Islamic bank’s asset returns is absorbed by shareholders and investment depositors. • While depositors in the conventional system have fixed returns, profit - sharing investment accounts face the risk of loosing all or part of their initial investment. • The risk - sharing advantage is “neutralized” when Islamic banks, operating in mixed systems, pay their investment account holders a competitive “market” return regardless of actual profitability. • Divergence of practice from the theoretical version is reflected in shifts away from profit and loss sharing activities, such as mudaraba & musharaka, to others like ijara &murabaha. This shift is due to risk aversion and vulnerability due to liquidity. • The outcome is a dominance of short – term, low profit and safe trade related transactions in the asset portfolios, limiting the funds for longer - term, more profitable but riskier assets.

27. The Nature of Risk in IFI Risks are grouped into five broad categories. While these categories are also applicable to conventional finance, specific risks within them are more relevant to IFI, the profile of their balance sheets and the nature of contracts they use

28. Objectives of Shariah Compatible Financial System • Objectives of Shariah for Economy: In general there are three objectives: • Promoting Production and Exchange in the Economy • Ensuring Economic and Social justice • Maintaining Harmony and peace in Society • Justice is the distinguishing feature of the Islamic system of life, which covers all aspects of human existence on earth. • The verse (2:279) on the prohibition of interest explicitly mentions this objective by saying “…. [So that] you will not wrong and you will not be wronged”. This objective is built-in in all trade contracts with or without financing. • The rationale of prohibition of interest, as Islamic scholars explain, is also to create peace and harmony in the society.

29. Objectives Shariah-Compatible Financial System Facilitating Financial Accommodation • The primary objective of any financial system is to allow and facilitate the surplus funds owners to meet the needs of those who are short of funds. • Regarding that part of the financial system that facilitates financial accommodation for credit worthy and investment worthy finance deficit units, Shari'a aims at taking care of information cost and moral hazard problems, the two major concerns of the contemporary financial world. • While the convention financial system minimizes the need for information by guaranteeing the principal and a fixed return on it secured by collaterals, Shari'a ensures maximum information to make the markets competitive which in turn serves the purpose of minimizing the information cost for the financial deal in the transaction.

30. Specific Objectives of the Islamic Financial System Developing Capacity to Pool and Diversify Risk • Shari'a makes finance surplus units in the economy to share the risks of production and exchange, if they intend to earn return on the use of their finance. • Promoting financial institutions that can reduce risk by diversification and other means, therefore, becomes a corollary of the objectives of Shari'a for the financial system in the economy. • But it is clear from Fiqh sources that these institutions will have to deal with real economic activities as a part of their financing activities. • The Islamic financial system is supposed to have financial institutions to achieve the objective of Shari'a to promote financial accommodation for the less privileged and deprived members of the society.

31. Specific Objectives of the Islamic Financial System • Such financial institutions, however, will be outside the market system and will be based on the principle of “lending to God”, not demanding any returns from the users of funds. • Risk is a cost and it is religious obligation to reduce cost because of the Quranic injunction (Chapter 7: Verse 31). Distributing Risk in production and exchange from those who cannot afford to bear it to those who can afford. • A good example of this objective can be seen in the modalities of the forward trading called Salam contract. • In Salam trading, the trader not only takes part of price risk but also finances production of commodities whose prices are highly volatile so that production decisions of the producers of such commodities are not distorted by the high uncertainty of the prices of their commodities in the market.

32. Specific Objectives of the Islamic Financial System Enhancing Availability of Risk bearing capital for mobilizing potential entrepreneurs • The presence of a strong interest based financial system supported by well regulated and protected banking institutions will promote more non-risk bearing capital than promoting the risk bearing capital generated by market based financing. • Giving more weight to the market based financing (to generate risk bearing capital) than banking based financial system (generating non-risk bearing capital) may involve trade offs that would require policy decision. • A Muslim economy that wants to keep the two system to coexist to leave it to the choice of people, a policy choice would need to be made how much to strengthen the market based financing and what institutions need to be developed to promote such institutions.

33. Specific Objectives of the Islamic Financial System Helping the less privileged members of the society • Objective of risk bearing capital is of three folds: • promoting production and exchange, • promoting socio economic justice, and • promoting peace and harmony in the society. • This will be a joint result of following three components of Islamic financial system. • Eliminating the interest based lending and borrowing (God destroys interest and gives increase for charity—Chapter 2: Verse 276) • Islamic principles and methods of financing only risk bearing capital • Motivating affluent members of the society to finance economic activities of less privileged members of society as financing of God (requiring no paying back of the principal or return on it)

34. Specific Objectives of the Islamic Financial System Helping the less privileged members of the society • Making risk-bearing capital available to less privileged members of the society is probably the best way to ensure economic justice without comprising on efficiency. • How to do it is a matter of policy and a matter of institution building to make the Islamic methods of financing to generate more risk bearing capital. • The supply of risk bearing capital through Islamic methods of financing will prefer diversified portfolio and this will enhance the chances of small businesses and traders to get access to risk bearing capital.

35. Specific Objectives of the Islamic Financial System Minimizing Information cost and Moral Hazard through Ethical Responsibilities for finance receiver and finance provider • Moral hazard can be handled well by ethics, morals and sense of social responsibility than by the rules and regulations. • Quran teaches ethics and moral way of live along with the way to be accountable (Chapter 2: Verse 188, Chapter 7: Verse 31, Chapter 11: Verse 85, Chapter 4:Verse 29) • The ethics govern the entire human life in all its aspects. The ethics as integral part of Shari'a rules aim at minimizing information cost and moral hazard.

36. Specific Objectives of the Islamic Financial System Reducing non productive speculative tendencies in the society • Gambling is one easy way, which refrains capital from playing a role in enhancing the production and exchange. • A financial system based on banking institutions that provides an easy access to loans in cash has been found generating speculative activities. • Islamic system of financing, taking away the incentive of earning interest, makes it unattractive to advance cash loans (except when lending to God) and hence discourages the speculative behavior.

37. Specific Objectives of the Islamic Financial System • The futures market that is based on the conventional concept of forward trading where price is not to be made in advance has made futures market as a vehicle for pure gambling. • However, financing through forward trading, by making it mandatory to pay the full price in advance, is an example of how to prohibit gambling as opposed to futures market, which is in practice in Islamic system. • The Islamic principles of finance do provide a range of instruments, which can serve as policy instruments. • Different methods of financing are capable of providing policy instruments, such as mark up rate on financing trade, profit sharing ratio in Mudarabah / Musharakah based financing, leasing rate (in leasing based financing), forward prices (for forward sales of key commodities).

38. Institutional Perspectives of Islamic Financial Regulation Reducing Moral Hazard and Information Cost • A substantial part of the Fiqh literature on commercial dealings relate to providing information and avoiding moral hazard in formulating and implementing contractual obligations and responsibilities. • Ethics relating to business particularly aim at reducing moral hazard. • Shari'a rules coupled with ethics and set of beliefs are expected to reduce cost of information and moral hazard. Reducing Moral Hazard and Information Cost • It will require not only substantial provisions in the legal structure governing markets, business, corporate activities etc but will also require specific reforms in the market operations also.

39. Institutions Institution of Hisbah • Institution of Hisbah for good governance and to control moral hazard is available as an example from the early Islamic history. • What is mostly missing in Muslim countries is: the arrangements for registration and documentation of businesses and maintenance and monitoring of their accounts is one such arrangement that is required on its own merit but is more than needed for promoting the financial system. • There are five major schools of thought relating to Fiqh, which though agree on basic Shari'a rules, yet there are differences in the details. • There is however need for an institution to monitor practices, particularly in the context of application of Shari'a in the market activities and dealings, which was named as Hisbah in the early history of Islam.

40. Institutions • “Let there arise from you a group calling to all that is good, enjoining what is right and forbidding what is wrong. It is these who are successful."(Chapter 3:Verse104) • That is how Hisbah has been recognized in Quran. • There are other reforms needed to allow market to support the introduction of Islamic financial system in the economy. Some of these reforms are mentioned below: • Documentation of the businesses, showing their business history • Ensuring and monitoring accounting to keep record of fair market value • Transparency in Application of Shari'a rules • Establishing Trade Houses including clearance of parallel forward sales to facilitate financing • Promoting REIT type institutions • Promoting Venture capital and Mutual Funds • Documentation of Human Capital

41. Institutions Institution of QardHasan (Loans to God) • Islamic financial system is popularly identified as providing social justice, one element of which relates to making financing available to less privileged members of the society as easily as it is made available to the affluent members of the society. • In the early history of Islam, the institution of BaitulMaal (Government Treasury) was responsible for providing QardHasan and financing the less privileged members of the society who could not get the help from the voluntary private sector. • Building up institutions that carry the trust of the public can mobilize enough resources in the form of donations and QardHasan to meet the needs of the needy.

42. Institutions • There are two other institutions, which are part of the loan to God institutions but are identified independently in the history as well as Fiqh books. These are the Institution of Zakah and Ushr (Rights of have-nots in the Property of Haves) and the Institution of Awqaf. • The purpose of these institutions in the context of financial system is to reduce or eliminate the need to borrow to meet some urgent, or unexpected or critical needs faced by people of small means. • These institutions though not market institutions would support the market activities, as it will help motivate small and micro enterprise to think of innovative business opportunities and use them to improve their economic conditions. • Awqaf type institutions are the best institutions to take care of financing needs of microenterprises, which conventional micro banks and microfinance institutions failed to take care of.

43. Scope of Regulation at Present Time • Less reliance should be placed on detailed and prescriptive rules; • More emphasis given to prudential regulation and official supervision; • A greater focus on incentive structures; • An enhanced and strengthened role for market discipline and monitoring; and • A more central role for corporate governance arrangements within banks

44. A Regulatory Roadmap for Islamic Finance • The combination of services offered by operating IFI and the prevailing practices they follow compound the difficulties of designing a regulatory framework. • The problem of co-mingled funds from different classes of deposit holders needs to be addressed. IFI could be encouraged to structure operations in clearly defined and separated segments catering to different classes of depositors depending on respective investment objectives. • For example, one class of depositors may be looking for custodial services only while the others may need to place funds for performing day to day transactions and therefore would not exhibit any risk appetite. • Therefore, a vision consistent with principles, could see an IFI structured as a group of fairly independent entities, each designed to optimize functional demands of its clients.

45. A Regulatory Roadmap for IF

46. A Regulatory Roadmap for Islamic Finance • Segment A is designed to handle funds for depositors who are; • highly risk averse • require high level of liquidity • would use the funds for daily transactions • would prefer to keep savings in safe assets where their capital is preserved. • This segment will invest funds in asset-backed securities with fixed-income characteristics and IFI will intermediate by screening and monitoring of such opportunities and making sure that credit and operational risk is contained. • The concept is similar to narrow banking and would require a similar approach to its regulation.

47. A Regulatory Roadmap for Islamic Finance • Segment B is designed to cater depositors who are willing to take some risk in expectation for a higher return with capital preservation and liquidity less high on their agenda. • IFI would deploy these funds in medium- to long-term instruments such as ijara or istisna or may prefer to invest on mudaraba basis directly with the entrepreneur or through mudaraba certificates. • If there is a well developed secondary market for mudaraba based funding, then the form of intermediation taken by IFI will be very similar to mutual funds where IFI will manage funds by investing depositor’s funds in different mudaraba funds. • Since the contractual agreement with the depositors would be similar to fiduciary responsibility of a mutual fund in a conventional system, the same regulatory principles would apply.

48. A Regulatory Roadmap for Islamic Finance • Segment C is designed for investors who would be willing to take additional risk and would like to participate in riskier investments like private equity or venture capital. • IFI could deploy these funds on the basis of musharaka or mudaraba instruments. When funds are invested on musharaka basis, the IFI also gains rights to participate in the governance of the enterprise which raises another issue for regulators. • The IFI itself becomes a stakeholder in the enterprises that depend on funds it provides. • Since Islamic financial principles advocate a stakeholder approach to corporate governance, the IFI would be expected to conduct active monitoring of enterprises it invests in. • In these circumstances, the IFI would behave in a similar way to financial institutions in a bank-based or insider system like is practiced in Germany or Japan.

49. A Regulatory Roadmap for Islamic Finance • It would be expected that a representative of IFI participate in supervisory boards of enterprises in which financial institution have considerable investment and long-term relationship. • The IFI’s relationship with musharaka - enterprises would be of long-term nature with active involvement in governance in contrast to a short-term, transactional relationship. • To summarize, an IFI structured to provide financial intermediation through clearly segmented windows or even separate institutions would make the task of regulators easier. Each entity could then be subjected to a regulating principle most suited to its nature.

50. Conclusons • Given the emerging nature of the industry, there is a need for flexibility and alertness on the part of regulators due to; • need to adapt to the needs of the markets it serves, • the competitive pressure from conventional finance, • the variations of views on the role it should play, • the divergence between its practice, • the theoretical model on which it is based.