Issue No: 11 January 1993
Alternative Tools of Supervision by Central Banks for Islamic Banks
In the latest of a New Horizon series looking at different ways in which Islamic banks might both improve the scope and quality of their operations, and strengthen their relationships with their Central Banks, Economic Consultant Ahmed H Radwan looks at alternative supervisory tools which might be used by monetary authorities in the control and monitoring of Islamic banks.
- Profit Sharing Techniques for Regulation
- Ceiling on Outside Resources
- Investment Programmes
- Other Regulations to Safeguard Investors' Interests
- Profit Equalisation Fund
When we speak of alternative tools of supervision, it is crucial to depart from the current steam of thinking which treats both conventional and Islamic banks with almost the same remedies instead of giving due regard to the special characteristics of Islamic banks. The truth of the matter is, we really don't have to stretch old formulas to cover new problems.
First of all when we talk about Islamic banks we should know if we are talking about any one particular unit in any one specific country. An Islamic bank should not necessarily be a composite bank which does almost everything, and is engaged in all fields of activity. In other words each Islamic bank is a unit and not a system of its own.
It could be a commercial, industrial, developmental or investment unit. But in each case it will be liable to the relative sets of supervision and control which are applied to it by a Central Bank or by a monetary authority. Nevertheless, what I want to talk about here is a commercial bank unit accepting demand and term accounts, and which is using its funds in Islamic modes of finance for the short or medium-term.
The second important regulation from the Central Bank's view is how to determine the Islamic modes of finance. Each Central Bank should have its own understanding of Islamic modes of finance and see to it that this understanding is properly communicated to Islamic banks and to other units of the financial market.
There is no better example than Circular No. 13 of the State Bank of Pakistan. Possible modes of finance are detailed under three captions which are: Financing by Lending, Trade Related Modes of Finance, and Investment Type Modes of Finance. Each transaction experienced in their banking system whether located in trade and commerce, industry, agriculture and fisheries, housing, or personal advances, is related to a range of possible modes of financing.
As the rate of interest is used by Central Banks and monetary authorities to regulate the volume and quality of credit, profit and loss techniques realise to the controlling agencies almost the same objectives.
As an alternative to the "bank rate" for regulating credit expansion, the Central Bank can use the profit sharing ratio. This rate could be the one resulting from a specific investment fund or could be the average rate of all operating funds. The actual payment of profits to the Central Bank can take place on the usual payment dates to customers quarterly, semi-annually or annually. However, the bank could pay its Central Bank interim profits on specified dates to be settled later according to the realised profits.
As to the use of the interest rate to help directing credit to priority sectors or vice versa, the Central Bank could enforce a change in profit rates on trade-related modes of finance and profit sharing in investment-related modes. In addition, the Bank could regulate the other conditions of sales in Mudarabah, (business contract) deferred sales and hire purchase by changing the commitment payments or the period of finance.
In cases where the Central Bank needs to change rates of interest on deposits for monetary objectives especially when fulfilling a stabilization programme, it can also change the customer's portions of profit in the case of Islamic banks. This is perhaps a delicate point in Islamic central banking as profit rates are contractual and fateful.
But if we appreciate a change on the investment side, a proportionate change should occur on the liabilities side. The much more controversial point in regulatory tools is to enforce a profit rate schedule on investment accounts arranged according to maturity, i.e. the longer the period, the higher the rate.
This attempt has been experienced by at least one Central Bank. The technique in theory is to compute the volume of a certain group of deposits for the profit distribution process at their par (face) value. Then you make other groups of deposits subject to different "weights" where some are below par and others are above par. To cut a long story short, if saving accounts (the zero point) earn 8.9 per cent in Pakistan (on an annual basis) notice deposits for 7-29 days will earn 5.5 per cent while three months term deposit will earn 9.8 per cent, five years term deposit 15.6 per cent and equity 21.2 per cent. The idea is to encourage customers to deposit their funds in longer maturities in the same way as conventional banks.
While the problem is appreciated on the basis of funding stability, it raises many reservations when related to Shari’ah principles. If an Islamic bank is left with ample time to work for a profit rate schedule according to maturity, it could endeavour to establish separate funds, each financed by a different maturity source. These sources are directed towards different groups of investments that vary in risk and duration. In so doing, it may end up in the long run with a profit rates schedule relative to duration of different investment accounts.
The duration of the investment account also could affect the profit rates if the longer maturity are given some concession by the Central Banks' regulations. Deposits in Egyptian pounds held for more than two years in Egypt are exempted from a cash ratio of 20 per cent. It would only be fair that holders of such accounts should be privileged by a proportionate higher rate of profit. Their complete funds are competing with 80 per cent of other funds.
If the history of conventional banks is traced back to the indigenous money lenders who accepted money for safekeeping and made loans at high rates of interest, the theory of Islamic banks rests on the experience of the highly knowledgeable, and much respected businessmen who were approached by their relatives, neighbours and friends offering them their idle funds for investment on a Mudarabah basis. This formula requires a successful record, high credibility and sound reputation on the part of the concerned businessman.
This background is brought here to emphasise the necessity of back-records and the availability of amply-owned resources on the part of Islamic banks. Capital should be adequate to recruit experienced staff and to initiate enough business. In the course of development, care should be given to maintain a gradual growth and restrain an outburst of activity.
Central Banks can regulate the initial steps by stipulating an adequate capital account and can help by attaining a gradual growth by limiting the inflow of outside investment funds. As an example, the Islamic bank should not seek outside fresh funds for more than its capital account in any one financial year. The increases are cumulative and subject to the changes in capital account but should not exceed ten times the capital at any one time. If investments are made at the risk of Arbaab-al-Maal (managers of funds), they should have enough information, back-records and time to judge and decide whether to participate.
To make the investment opportunities attractive to most financiers in the market, the Islamic bank should make different combinations that would encourage growth, stability, profitability and liquidity. The interested party might be able to grasp the salient features and the expected outcome of the programme but he is in no way fit to undertake a thorough evaluation.
As the investor is not materially covered by any guarantee on revenue or principal (except in cases of fraud or negligence) the Central Bank is expected to interfere to safeguard public interest. This could be achieved by' directing banks not to implement any investment programme or to make it known to the general public unless it is evaluated and sanctioned by it.
The programmes in question should be those that are offered to a prescribed minimum of investors or exceed a certain amount. If the Central Bank has any reservation about doing that job directly, it could be assigned to independent auditors for appraisal and follow-up.
Whilst equity holders' interests in Islamic banks are safeguarded by management, auditors and law, the rights of investors are governed only by the Mudarabah contract which is drafted and implemented by the bank. They provide funds and shoulder risks but are not around by any means when decisions are taken or when returns are computed and distributed.
To bring more balance and more justice into this bank/investors relationship, some corrective regulations should be taken by the concerned Central Bank. The following proposals are illustrated for guidance:
- Deposit holders (investors) should be represented in the meetings of Directors and the General Assemblies by well-chosen experts who may participate in deliberations as observers. The reason for not suggesting a voting right to them is to keep them away from management commitments, a precondition that is clearly and rightly formulated by Shari’ah principles. The selection of observers, their remunerations and how to cover their administrative expenses, together with their means of communications with fellow investors could be organised by a decree. The activities of the observers could be very effective if they are given the right to address the controlling agency occasionally.
- Alternatively, deposit holders could appoint independent auditors from a list agreed upon by the controlling agency. Those auditors are directed to examine some points of interest to investors and report to them and to the controlling agency. Their audit may cover the evaluation and the follow-up of the investment programmes, the checking of revenue and expense account and the distribution of net profits between equity holders and deposit holders. In order to avoid conflict and duplication of work, the company's auditors could be entrusted with the additional responsibilities if they are reporting to the controlling agency in fulfilment of a legal requirement.
- The Central Bank examiners may also cover the above points of interest and await for an explanation or for an application of the prompt corrective measures.
Central Banks are responsible for promoting an efficient and competitive banking environment through branch restrictions and ceilings on deposit yields and other bank prices. Islamic banks are part of the banking system and observe tariffs on banking services.
However, profit rates in most cases are left to each bank's policy. The liberal attitude of Central Banks in this regard could be attributed to three reasons.
- Islamic banks are still experiencing their first stage of development and should not be impeded by untimely kinds of regulations.
- Islamic banks in general do not present severe competition to other banks.
- Rates of distributed profits have not been exceptionally high so as to disturb the balance in the financial market.
With hope for the expansion of a network between the Islamic banks and the improvement in profit rates, competition pressures may deem the issue of regulatory tools necessary. Competition may arise not only among Islamic banks and conventional banks but also among Islamic banks themselves. To restore order and to help alleviate the swift movements of funds from one institution to the other, the Central Bank may urge Islamic banks to establish a "Profit Equalisation Fund".
The objective of such a Fund is to mitigate the ups and downs of distributable profits. This regulation may not necessarily disturb the profit-sharing principle as most depositors stay with their bank over a long period of time.
The technicalities of this organ is left to the local conditions in each country. In general terms, one should first determine what a normal rate of return is. If the rate is put at 10 per cent of investment accounts, the bank should credit the Fund with, say, one percentage point if the realised rate is more, and debit the Fund with whatever is needed and available to enable the bank to distribute 10 per cent of investments. The Fund should always be replenished if its balance is below a certain figure, say 20 per cent outstanding deposits.
In this twilight period. Central Bankers as other bankers, depend upon realities and seek the truth. Islamic banks are now a reality with different phases. One has to describe and to define properly what is in hand then try to work out the logistics and put the system in motion.
This paper has tried to give some answers to the alternative tools of regulation. It has suggested that profit-sharing techniques make a good substitute for bank rate and interest policies. Can profit rates follow in theory the existing maturity schedule of term deposits? The answer is negative unless we establish investment funds that match every maturity we have. Capital adequacy is more important to Islamic banks and the leverage rate should be more conservative and well spaced out. In safeguarding public interest, the Central Bank might find it proper to evaluate and to follow up the new investment programmes of banks either directly or through independent auditors.
Should investors wait at leisure for their periodic checks or should they busy themselves with the usual investor/ manager relationship? The answer is clearly the latter. If the bank realises a good profit record, should it distribute it to the last coin or keep some aside for bad years? In this case, the Profit Equalisation Fund seems to be the best answer.