Regulation and supervision over Islamic banks.

Regulation and supervision over Islamic banks

Hassan and Chowdhury (2004) lists the reasons for regulation and supervision for Islamic

banks. These reasons that may be different from regulation necessities for conventional banks

arise from the nature of Islamic banking products. To operate a system, which is designed for

interest bearing instruments, brings many complexities and these are reflected on the

stakeholders of Islamic banks. The regulation and supervision should aim to protect the right of

each stakeholder.

Current account holders are exposed to investment risks. The losses on investments may

deplete the capital and may force Islamic banks to default on their liabilities. The same risk

applies to investment deposits but since they participate to risk directly, their concern is centered

on the capital level of the Islamic bank and on the regulation of Islamic bank in terms of

misconduct and excessive risk. Such regulation is necessary for Shari’ah compliance as well.

The financial system should also be protected against systemic effects of Islamic banks’

withdrawal runs. Since investment funds are financed with PLS accounts, current accounts and

equity, and since PLS accounts and current accounts can be withdrawn at any time, Islamic

banks are susceptible to the risk of withdrawals. Such susceptibility creates a systemic risk and

proper regulation should be enforced.

The Islamic banks coexist with conventional banks within financial systems designed for

interest bearing instruments and conventional banking. This is reflected upon the Islamic banks

as a competitive disadvantage. Islamic banks suffer from application of such rules and

regulations, and require tailor made regulation for their unique products. Suggestions of AAOIFI

and Islamic Financial Services Board (IFSB) should be integrated into local regulations, and

Islamic banks should be regulated accordingly. Any incompatibility will result in risks exposed

to Islamic banks to financial system by Islamic banks. The inexistence of lender of last resort for

Islamic banks is an important aspect and should be integrated into the banking systems.

Centralized supervision should be achieved for Islamic banks for several reasons. The

products and procedures of Islamic banks should be standardized. The internal and external

rating facilities should be standardized. Shari’ah compliance of Islamic banking products should

be standardized.

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