Challenges faced by Islamic Banks

As Islamic finance extends its reach to serve the global community and becomes integral part of global financial system, it will be increasingly tested by risks and developments in the international financial system. In this context, it is necessary to take a look at the challenges faced by present day Islamic banks. These challenges can broadly be classified as (A) Systemic issues and (B) Operational Issues.

(A)  Systemic Issues: Some of the main systemic issues are as follows

1. Lack of Standardization and familiarity with the Islamic Banking System

The most important challenge faced by the Islamic banking is lack of standardization of Islamic banking  practices. It is generally felt by Islamic bankers that  many people in the Muslim and non-Muslim world do not understand what Islamic banking actually is.

The basic principle is clear, that it is contrary to Islamic law to make money out of money and that wealth should accumulate from trade and ownership of real assets.

However, there does not appear to be a widely accepted definition of what is or not an Islamic-banking product.

A major issue here is that it is the Shariah Councils or Boards at individual Islamic banks that actually define what is and what is not Islamic banking, and what is and what is not the acceptable way to do business, which in turn can complicate assessment of risk for both the bank and its customer.

More generally, the uncertainty over what is, or is not, an Islamic product has so far prevented standardization.

This is difficult for regulators as they like to know exactly what it is they are authorizing.

2. The Regulatory environment

The central banks generally exercises authority over Islamic banks under laws and regulations that are engineered to supervise conventional banks. There are some inherent conflicts on issues such as deposits of customers of Islamic banks in comparison with deposits of customers of conventional banks. When a conventional bank incurs losses, the amount of money deposited by customer and the amount of interest payable on such deposits is generally not impacted while depositors of loss making Islamic banks may not get any returns on their deposits as Islamic bank deposits are in the nature of investment accounts which are eligible to share profits and losses incurred on investments made from the proceeds of such deposits. Further, If there are disputes to be handled, civil courts are not sufficiently acquainted with the rationale of the operations of Islamic Banking in many countries.

3. Shortage of Supportive and Link Institutions

Any system, however well integrated it may be, cannot thrive exclusively on its built-in elements. It has to depend on a number of link institutions and so is the case with Islamic banking.

The interbank placements on Murabaha basis requires at least two interbank brokers who also deal in commodities (Metals like Platinum) and documentation requirements are also more complicated. These result in lack of interbank Islamic money brokers and consequent disadvantage to Islamic banks.

For identifying suitable projects, Islamic banking can profitably draw the services of economists, lawyers, insurance companies, management consultants, auditors and so on. They also need research and training forums in order to prompting entrepreneurship amongst their clients. Such support services properly oriented towards Islamic banking are yet to be developed in many countries.

4. Islamic Products for modern day requirements of customers

Many Islamic banks do not have the diversity of products essential to satisfy the growing need of their clients. The importance of using proper advanced technology in upgrading the acceptability of a product and diversifying its application cannot be over emphasized. Given the potentiality of advanced technology, Islamic banks must have to come to terms with rapid changes in technology, and redesign the management and decision-making structures and, above, all introduce modern technology in its operations.

5. Need for Professional Bankers

The need for professional bankers or managers for Islamic banks cannot be over emphasized. Some banks are currently run by by managers who have not had much exposure to Islamic banking activities, nor are conversant with conventional banking methods. Consequently, many Islamic banks are not able to face challenges and stiff competition. There is a need to institute professionalism in banking practice to enhance management capacity by competent bankers committed to their profession. Because, the professionals working in Islamic banking system have to face bigger challenge, as they must have a better understanding of industry, technology and the management of the business venture they entrust to their clients. They also have to understand the moral and religious implications of their investments with the business ventures. There is also a need for banking professionals to be properly trained in Islamic banking and finance. Most bank’s professionals have been trained in conventional economics. They lack the requisite vision and conviction about the efficiency of the Islamic banking.

(B) Operational Issues: Some of the main operational issues are as under

6. Absence of Islamic Money Market and its impact on profitability of Islamic banks

Many Islamic banks lack liquidity instruments such as treasury bills and other marketable securities, which could be utilized either to cover liquidity shortages or to manage excess liquidity.

In the absence of an active Islamic money market, the Islamic banks cannot invest their surplus fund i.e., temporary excess liquidity to earn any income rather than keeping it idle.

As most of the Government Treasury Bills and other approved securities are interest bearing, the Islamic banks cannot invest their liquid surplus in those securities.

On the contrary, the conventional banks do not suffer from this sort of limitations. As such, the profitability of the Islamic banks is adversely affected.

7. Relationship with International Banks

Another important issue facing Islamic banks is maintaining banking relationships with conventional international banks and conducting international operations. This is, of course, an issue closely related to the creation of financial instruments, which would be simultaneously consistent with Islamic principles and acceptable to conventional banks (for example: the issue of payment of penalty for delayed payments)

8. Difficulties in obtaining gurantees, securities and collaterals

Islamically, it is either difficult or not lawful  to obtain security from the partner against dishonesty or negligence, both of which are very difficult if not impossible to prove.   This puts Islamic banks in an disadvantageous position when compared to conventional banks.

9. Difficulties in booking forwards and other hedging contracts

As many Shariah Boards do not permit forward contracts and many types of hedging, Islamic banks and their clients are often deprived of cost effective methods of hedging exposures. It is also sometimes prohibited to deal in the forward money market even if the purpose is hedging.

10. Export Bill Purchase/Foreign Bill Purchase :

This is another problem of Islamic Bank where the exporters immediately after export of the goods approach to the bank for fund before maturity of the bills to meet their daily needs. But Islamic banks cannot discount / purchase  these bills as done by conventional bank as many Shariah Boards do not permit the same. The Islamic banks cannot take anything by providing fund to the exporter except collection fee for collection of the Bill, which does not adequately compensate cost of funds and collection charges.

Conclusion:

The efforts on being made to overcome these issues and the efforts by AAOIFI and IFSB to overcome many constraints and setting up standards are commendable. Due to increasing innovation and efforts of these apex institutions, Islamic banking is firmly on its way to assume its premier place in global finance.

Prop. Trading may be monitored like Money Laundering!!!

Future may see proprietary trading by banks being treated almost like money laundering by the regulators. FT reported on 6th January that US regulators want to use techniques pioneered in the fight against money-laundering to crack down on “proprietary trading” by banks as part of new financial reforms.

The question of how to define trading done with banks’ own funds is one of the thorniest for the US authorities in the post-crisis regulatory overhaul as it is difficult to differentiate such activities from market-making on behalf of clients.

The “Volcker rule”, proposed by the former Federal Reserve chairman Paul Volcker and included in last year’s Dodd-Frank law, aims to reduce banks’ risk-taking by forbidding them from placing short-term trading bets.

After months of internal discussions and talks with banks, which have mounted a vigorous lobbying campaign, regulators are leaning towards a “multi-tiered test” like those used to detect illegal money transfers.

The first tier would involve automated “tripwires” that alert banks’ compliance departments. Depending on the market and the trade, “tripwires” could be the length of time a trader holds a position, its size, riskiness, or other measurable criteria (In detecting money laundering, banks look at “filters” such as size and provenance of a transfer).

The second tier may see internal compliance and risk management departments quiz the trader on the nature of the position.

Finally, regulators will also be able to see the “tripwires” and monitor both traders and compliance departments. There may be suitable reporting requirements to the regulators.

Banks are likely to welcome this approach, after arguing that a strict definition of proprietary trading based on one-size-fits-all metrics would have cut off liquidity to large swaths of global capital markets.

Experts say that  a multi-tiered test would make sense if coupled with surprise visits to trading desks by regulators. They are of the view that spot checks by regulators should be part of the package. Regulators should make sure traders know they are not waiting to act until after the cow is out of the barn.