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Islamic Banking: Regulations and Risks

Islamic banking is regulated under the principles of Shariah law. These principles prohibit interest-based transactions i.e. the receipt and payment of interest, known as “riba”. According to Goh, the Islamic banks consider money as a medium of exchange in contrast to conventional banks which use money as an asset. Further, Shariah rules do not allow banks to take on ventures with excessive uncertainty, short sales and other ventures which are not considered ethical in Islam such as Alcohol, certain meat products etc. (Goh, 2018)
The underlying fundamental difference is about the factors of production. In the Islamic economic system, there are three factors of production land, labor and entrepreneurship and It does not recognize capital (money) as a factor of production. This basic difference has major implications for the Islamic banks such as they can only use either trading model or profit-loss sharing models for banking. According to Goh, “the balance sheet structure, as well as the risk profile of an Islamic bank, is different from that of a conventional bank. First, the ‘pass-through’ nature of the balance sheet of an Islamic bank. An Islamic bank’s customers’ return is linked to the return on the assets of the bank. This feature removes the typical asset-liability mismatch exposure of a conventional bank. Second, the assets of an Islamic bank contain financing assets where the tangible goods and commodities are purchased and sold to the customers. This practice creates distinct exposures. For example, in conventional car financing, a car is financed by a loan from the bank to the customer. But in the case of an Islamic bank, the asset and the financing are coupled together. Therefore, an Islamic bank is not limited to the exposure as a “banker” but may develop additional exposures resulting from dealing with physical assets. Finally, due to the prohibition of interest, an Islamic bank cannot issue debt to finance the assets. This discourages the creation of leverage in the balance sheet. As a result, an Islamic bank is considered less risky. (Goh, 2018)”
Islamic banking started in the 1970s and since then it is gradually growing. However, the growth picked up the pace in the last decade especially after the industry became standardized because of the efforts of Islamic Financial Services Board (IFSB) “the standard-setting body to promote and enhance stability and soundness of Islamic financial services industry (International Financial Standard Board , 2019)”. The standardization has made industry increasingly attractive for the investors, but it is still concentrated in some countries of the Islamic world. The nine countries have 93% of the total assets of the industry which are close to 2 trillion (MarketLine, 2019). In addition to the Islamic world, the United Kingdom is the biggest market for Islamic financial products. However, Islamic banks are uniquely positioned because they provide a unique opportunity to unbanked clients to become part of the financial system. It provides Islamic banks with a new set of customers and a huge growth opportunity.
This above-mentioned growth in the Islamic banking market has led to a higher market share in the respective markets. The higher market share of these banks has led to unique systemic to the respective markets and other associated risks for the banks which needed new assessment frameworks and control mechanisms. IFSB is setting new standards for Islamic banks to measure and mitigate those risks.
Unique Risks to Islamic Banks:
According to IMF, Islamic Banks will be considered systemically in any Country they have 15% or more market share (Nor Shamsiah Yunus, 2018). To manage those risks, the IMF endorsed the proposal developed by IFSB in coordination with the Basel Committee of Banking Supervision (BCBS) to use the Core Principles for Islamic Finance Regulations. Before understanding these core principles, the unique risks as identified by IFSB and BCBS related to Islamic banks are appended herewith:
Credit Risk: The Islamic banks are exposed to credit risk especially while dealing with Murabahah financing (cost plus profit). In contrast to conventional banks, Islamic bank purchases the underlying goods and then sell on profit to the customer. It exposes Islamic banks to additional risks because of the payment to the supplier and the change of ownership of the underlying asset multiple times. Further, the Islamic principles do not allow banks to charge interest or penalty to the customer in case of default which creates additional problems for the banks. (Nor Shamsiah Yunus, 2018)
Market Risk: in recent years, Islamic banks have introduced multiple new products by using commodities in their transaction structures. These structures expose Islamic banks to movements in market prices. These unfavorable movements can have a negative effect on the balance sheet of the bank. Historically, Islamic banks have hedged such exposures but with the growth of Islamic banks the transaction structures are getting complexed. (Nor Shamsiah Yunus, 2018)
Operational Risk: Operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or external events.” In the Islamic banking environment, the operational risks are much higher than the conventional banks because each product/transaction should get the Shariah board approval. It also increases the reputational risk for the bank because the customer’s faith is part of product offering and in case of any oversight in this regard can hurt the bank’s reputation. In addition to these risks, the transaction structures involve real asset which carries their contractual risks especially buying and selling back transactions which involve multiple changes in ownership. (Nor Shamsiah Yunus, 2018)
Liquidity Risk: Islamic banks have faced liquidity because of the non-availability of wholesale funding in the market and Shariah-compliant products for short term liquidity from the governments except in markets such as Malaysia, Saudi Arabia, etc. Traditionally, the T-bills and government bonds are not Shariah-compliant even in the majority of Muslim countries. Therefore, financial institutions have to rely on a limited amount of Sukuks that are already available. However, the Sukuk market is growing which is increasing the availability of wholesale funding in the market. (Nor Shamsiah Yunus, 2018)
Rate of Return Risk: In contrast to interest rate risks, the Islamic banks are exposed to the rate of return risks. The Islamic Banks are concerned about the holding period returns when their investment matures because it cannot de pre-determined exactly. Further, Islamic banks cannot increase the rate of return on their investments when the overall rate of return increases in the market due to monetary policy measures. Further, Islamic Banks have limited opportunities in the market because these institutions cannot invest businesses that are prohibited in Islam such as Alcohol, Gambling, etc. (Nor Shamsiah Yunus, 2018)
Core Principles for Islamic Finance Regulations:
The core principles for Islamic Finance Regulations were endorsed by the IMF to set the core principles for the regulation and supervision of the Islamic banking industry. The standards were made for the Islamic banks after taking into consideration their special needs and associated risks. These standards will also complement the financial stability of the sector and homogeneous regulatory framework across the globe. These principles will also help governments in supervising, regulating and creating an enabling environment for the Islamic Banking Industry. Further, these appended principles will apply to Islamic banks in addition to Basel Core Principles (BCP):
Treatment of Profit-Sharing Investment Account (PSIA) /Investment Account Holders (IAH): The deposits of Islamic banking are usually structured in the form of Mudarbah where Islamic bank acts as Mudarib or an agent. It means that the bank will act on the customers’ behalf and will invest the funds. Under these accounts, the principles require both parties to disclose or agree upon the profit-sharing ratio upon entering into the agreement and the investor will be solely responsible to absorb the loss. However, the bank needs to act with the utmost caution as it is the fiduciary duty of the bank. Therefore, the regulator is responsible to reinforce market discipline by introducing regulations that require timely and relevant information disclosures. Further, there must be prudential limits on the percentage of funds that can be invested in certain sectors such as real estate, capital markets, and large exposure limits. These will have regulatory implications in terms of appropriate governance (including Shariah governance), capital adequacy requirement, disclosure, and resolution framework (Nor Shamsiah Yunus, 2018). Moreover, the regulators must ensure the competence of Islamic banks to perform their fiduciary responsibilities at all times.
Shariah Governance Framework: Islamic Banks are exposed to Shariah non-compliance risk at all times in all transactions. It starts from the source of funding to the investment of funds. The non-compliance can result in a non-recognition of income, but the bigger risk is reputation risk which can result in a loss in future business, withdrawal of deposits and investment funds. Therefore, Islamic banks must have their Shariah board which will approve each product offering and the large transaction to ensure the compliance of Shariah Principles. In addition to banks, the regulator should also have the mechanism to assess the compliance of Shariah rules and regulations at all times. It should ensure that Islamic banks have the appropriate policies, systems, and procedures to manage the risk. To perform these responsibilities, the regulators must have in-house or external parties at their disposal. (Nor Shamsiah Yunus, 2018)
Rate of Return Risk: Islamic banks are more susceptible to the rate of return risk when the overall return in the market increases, but it is impossible for them to change their investment returns because those are not linked with interest rates. However, the deposit holders expect higher returns which are in-line with the market. In such situations, banks sometimes let go of their share of profit to retain the customers. This decision should be made under the clear policies and procedures approved by the Board of Directors. In addition to such policies and procedures, Islamic Banks must build reserves against such losses. (Nor Shamsiah Yunus, 2018)
Equity Investment Risk: The funds invested by Islamic banks may be used to purchase shares in a publicly traded company or privately held equity or invested in a specific project, portfolio or through a pooled investment vehicle. In the case of a specific project, IBs may invest at various stages of the project. Besides, the delays and variation in cashflow patterns and possible difficulties in executing a successful exit strategy may pose a challenge. The capital invested by the provider of finance does not constitute a fixed return but is explicitly exposed to capital impairment risk in the event of losses. The supervisory authority should ensure that the Islamic Banks have appropriate and consistent valuation methodologies, define and establish the exit strategies in respect of their equity investment activities and have sufficient capital when engaging in equity investment activities, and that rules or guidelines are in place for measuring, managing, and reporting the risk exposures when dealing with nonperforming equity investments and providing provisions. (Nor Shamsiah Yunus, 2018)
Islamic “Windows” Operations: An Islamic window operation is part of a conventional financial institution that provides both fund management (investment accounts) and financing and investment that are Shar?`ah compliant. Islamic windows raise supervisory issues beyond those posed by full-fledged IB, because of the potential for commingling of funds and regulatory arbitrage. In addition, supervisory practices for regulating Islamic windows related to capital requirements vary considerably across jurisdictions. The supervisory issues raised by such operations are substantially the same as those faced by full-fledged Islamic banks but include issues on the legitimacy of the generated profits and risk management in respect of the Shariah-compliant assets and liabilities. Therefore, Banks need to have internal systems, procedures, and controls to provide reasonable assurance that the transactions and dealings of the windows comply with Shar?`ah rules and principles, Islamic and non-Islamic business are properly segregated and the institution provides adequate disclosures for its window operations. (Nor Shamsiah Yunus, 2018)
Conclusion
The Islamic banking industry has seen unprecedented growth in the last two decades in terms of assets and market size. These banks are positioned to provide financial services to the unbanked population, but the risk is that the population is not financially savvy. This increases the responsibility of the regulator to protect the interests of depositors and the health of the overall financial system. Further, these banks have to comply with Shariah laws which makes it harder for them to integrate into the conventional economic system; hence, it needs government support for the enabling legal and regulatory environment to thrive. Further, the Islamic banks are less risky in the long run because the transactions are based on real asset and it cannot create leverage without underlying real assets, but these banks are more susceptible to short term price movements of the market. Therefore, the IMF has endorsed the recommendations proposed by IFSB, in coordination BCBS, to provide a regulatory framework that assesses the risks associated with the industry. This is a huge step forward for the industry because it makes it easier for countries to adopt Islamic banking and from a regulatory perspective, it will be easier to create a regulatory framework and supervise the industry. The introduction of separate principles for Islamic banking supervision in addition to basic principles will provide a sound framework for supervisors and new opportunities for Islamic banks.
Works Cited
Goh, S. K. (2018, August 31). Reporting practices of Islamic financial institutions in the BIS locational banking statistics. Retrieved from BIS.org: https://www.bis.org/ifc/publ/ifcb49_41.pdf
International Financial Standard Board . (2019). Retrieved from ifsb.org.
MarketLine. (2019). Marketline – Islamic finance . Marketline .
Nor Shamsiah Yunus, N. J. (2018). ISLAMIC FINANCE REGULATIONS AND ASSESSMENT METHODOLOGY. IMF.
https://www.thebanker.com/Reports/The-Banker-s-Top-Islamic-Financial-Institutions-2019
https://www.moodysanalytics.com/regulatory-news/may-24-18-imf-board-decides-to-formally-recognize-cpifr-for-banking-sector
https://www.economist.com/finance-and-economics/2014/09/13/big-interest-no-interest

Industry report on the United Kingdom banking and finance industry

1. Industry overview
In 2018, the financial services sector in the UK contributed £132 billion to the UK economy, that is 6.9% of total economic output, with 49% of output generated in London. (financial services, 2019) Furthermore, the UK finance and banking industry hosts 1.1 million financial services jobs; 3.1% of all jobs. UK exports of financial services were worth £60 billion in 2017, while imports were worth £15 billion, therefore we can observe that the Finance and banking industry has a surplus of £44 billion.
Measures of the financial and banking sector usually include activities of a wide range, these include retail banks, building societies, investment banks and hedge funds. However, for the focus of this report I will take a narrower view, focusing on the leading banks, this is so points can be correctly analysed in detail rather than on a wide spectrum.
The UK financial services industry is operated by very few large firms, these companies are as follows:
Barclays
HSBC
Lloyds banking group
RBS
Bank of England
Standard chartered
2. Market structure: As a result it is clear that the UK finance and banking industry, is clearly oligopolistic. In order for a firm to be oligopolistic it must have a few large firms, they are usually differentiated and heavily advertised products, varying barriers to entry and, choice over prices, inevitably with interdependence leading to price stability.
Micheal J Mazzeo States that “Each individual firms product choice affects its own profitability, and the extent of product differentiation influences the intensity of competition for all market participants” Mazzeo, M. (2002). In analysis we can recognise that similarly the UK banking and finance industry can be viewed as competitive, due to the above point of the wide range of financial activities in the industry, including investment banking to hedge funds. Furthermore, supporting the point that the industry is in fact oligopolistic. In contrast it can be examined that an oligopolistic market creates a downward sloping demand curve, with relatively inelastic pricing.
At this point it is clear that the market leader in the industry is HSBC, with the highest market capitalisation of 149.7 billion dollars, therefore we can identify HSBC as the price maker of the industry, and the remaining firms price takers, resulting in market wide price interdependence, ultimately leading to price stability. It can be observed that the UK banking a finance industry supports the theory of collusive oligopolies. Collusion can be defined as “Oligopolists agree, formally or informally, to limit competition between themselves” this can be observed through price fixing, quotas, and the limitations of advertising. However, on the other hand, it can also be recognised that the UK banking and finance industry also holds symptoms of tacit collusion, specifically the leader – follower model.
3. Collusion:
Tacit collusion can be defined as “a situation where firms have an unspoken agreement to engage in joint strategy” Typically within tacit collusion the price is set by the largest firm, in this case HSBC. Additionally, tacit collusion can also host barometric price leadership, in which the price is set by the most ‘reliable’ firm; the one with the best barometer of the market conditions. There are several factors contributing to collusion in a market, for example, very few firms, all known to each other, they are open about costs and production methods, they have similar production methods and transaction costs. Conclusively each of these points can be used to describe the UK banking and finance industry, therefore supporting the point that the industry follows the leader-follower system of tacit collusion.
Another example of collusion between the largest banks happened on the 16th May 2019, 5 of the largest banks in the United Kingdom were fined more than €1bn (£875m) by the European Union for rigging the multitrillion-dollar foreign exchange market. The European commission stated that the banks, which include Barclays and RBS, formed two cartels to manipulate the spot foreign exchange market for 11 currencies, including the US dollar, the euro and the pound. Makortoff, K. (2019)
As a result, we can recognise the severity of collusion within the UK banking and financial industry, not only is there evidence of tacit collusion but also the formation of cartels.
4. Concentration analysis:
An industries concentration relates to the competitiveness of the industry; concentration is measured as a percentage from 0% – 100%. Seller concentration is one of the most widely used indicators of market structure and examined by the number and size distribution of buyers and sellers. The importance of size distribution as an industry with no identically sized firms has different competitive conditions compared to an industry with one dominant firm and 9 smaller followers, hence why sellers concentration often is perceived as an indication of competition intensity.
Concentration is determined by dividing the market share of the leading firms by the entire market size, then multiplying the result by 100% to form a percentage. In this case, as we are using a narrower outlook, therefore the market will consist of the 6 biggest firms.
Therefore we can observe that the 6 leading firms by market capitalisation are: 1st – HSBC – 149.7 billion dollars 2nd – Lloyds banking group – 52.8 billion dollars 3rd – Barclays – 37.8 billion dollars 4th – RBS – 35.1 billion dollars 5th – Standard chartered – 28.6 billion dollars 6th Virgin Money – 2.6 billion dollars
Market size of the leading firms: 306.6 billion dollars
Next we need to add the market share of the four largest firms together: 149.7 52.8 37.8 35.1 = 275.4 billion dollars
Then we divide our market share of the leading four firms by the total market size: 275.4/306.6 = 0.898 X 100 (to give us a percentage) = 89.82%
As a result of this analysis we can recognise the fact that the UK banking and finance sector is in fact a very oligopolistic market. This is due to the fact that these sums translate into how much of the market is run and owned by the top four firms, and for an oligopoly to exist very few firms must hold the majority of the market power. In contrast it can be argued that due to the leading four firms dividing 89.82% of the total market, there is a severe decrease of competitiveness within the market, this can be examined using the large numbers of barriers to entry that exist within oligopolies.
Using the structure-conduct-performance paradigm we can recognise that only efficient firms will survive in a market with high concentration, this is because large firms exploit economies of scale to gain market power within oligopolies, eventually leading to interdependence of firms on each other within the market. Therefore, firms that produce inefficiently in the market may have to withdraw as competition intensifies. This is especially true for the UK banking and finance industry, there is such vast interdependence of the leading four firms in the market that the smaller less efficient firms cannot keep up.
5. Barriers to entry
Tacit collusion within oligopolies defer smaller firms from entering the market, within the UK banking and finance industry tacit collusion defers smaller firms from entering the market because the price is set by the biggest firm, HSBC, using dominant price leadership, this acts as a strong barrier to entry due to the fact that the price is set to a point in which only the biggest firms can afford.
Further barriers to entry in financial markets can occur due to licensure laws, capital requirements, access to financing, regulatory compliance and security concerns. For example, the introduction of E-banking, which produces increasing fees that start-ups will struggle to afford. Furthermore, the banking industry has a complicated relationship with barriers of entry and competition, this is due to two factors the perceptions of banks as a driving force behind economic stability or instability and a theory among policy makers that excessive competition in the banking industry is harmful to the overall efficiency of the market, tactically avoiding price wars and aggressive advertising campaigns. Investopedia (2019)
Numerous neoclassical and free-market economists have argued that increased competition in the banking and finance industry in the United Kingdom would lead to lower costs and improved efficiencies. These arguments assert that the incentives of free competition can create an atmosphere among firms that would improve quality, customer responsiveness and product innovation. The theoretical models of Besanko and Thakor (1992) further suggest that financial products and capital structures are heterogeneous and a relaxing of entry barriers would lead to declining loan costs and increasing interest rates on current accounts. This, ultimately, would lead to higher growth rates in the greater economy.
Within the UK banking and finance industry it is generally expensive to establish a new bank or financial services company due to high fixed costs and large sunk costs in the production of financial services. As a result, this causes it to be difficult for start-ups to compete with the leading firms that have scale efficiencies and act as an oligopoly. Regulatory barriers exist between commercial banks and investment banks. As a result the costs of compliance and threat of litigation are sufficient to deter new products or firms from entering the market.
As a result of outdated regulatory barriers and examples of collusion within the UK banking and finance industry the Financial Conduct Authority (FCA) have introduced new regulations to combat the barriers of entry to the market as a result of a collusive oligopoly being present, for example, the FCA publication ‘An evaluation of reducing barriers to entry into the UK banking sector’ FCA (2013) which reads, “The rate of entry into the UK banking sector is higher than before the 2013 review. While not all entry can be solely attributed to the changes in the authorisations process, firm interviews have indicated that the interventions have encouraged entry into the UK banking sector.” These regulations included The FCA’s approach to authorising new banks or banks that are expanding their activities, aiming to:
Balance our objective to promote competition in the interests of consumers
Apply appropriate barriers to entry to deliver consumer protection.
Ensure that the approach does not cause disproportionate barriers to entry or expansion, and by doing so, have an adverse effect on competition.
Therefore, as a result benefiting the UK banking and finance industry, increasing competition within the market for the ongoing future. In contrast this will not limit the leading banks in the UK and decrease their market power, but instead, forge non collusive ties, for example Even without collusion, when oligopolies conduct business, they still have to take into considerations the reaction of their competitors, This leads us to the kinked demand theory. The kinked demand theory assumes that if an oligopolist increases prices then their competitors will not since if they keep their prices lower, they will gain more customers than the acting firm, whereas if the oligopolist in this case HSBC cuts its prices then the rivals will follow to maintain market shares and prevent losing customers to the acting firm. The outcome is continued price stability within the market.
6. Summary
In summary we can observe the determinants to the UK banking and finance industry, the industry is clearly oligopolistic with high levels of competition due to the wideness of services that are offered. The market holds a concentration ratio of 89.82%, resulting in significant barriers to entry for smaller/start-up firms. In addition, as a result of the oligopolistic market we can observe various degrees of barriers to entry and how barriers of entry can be resolved through government intervention or crisis.
References:
Mazzeo, M. (2002) ‘Product choice and oligopoly market’, The RAND journal of economics, vol 33 (pg 221-224), Available at: https://www.jstor.org/stable/3087431?read-now=1

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