Principles of Islamic banking and finance/PIBF202/Structure and operations/Role of central bank and shari'ah board

The Role of government, central banks and shari’ah boards

As the structure and operations of Islamic banks are supposed to be different from conventional banks, every country needed new laws and regulatory regimes to allow the establishment of a new system of banking. Furthermore, the nature of formulating new laws would be different if a country tries to transform its entire banking industry under shari’ah laws from those who allow both conventional and Islamic banks to work according to their own principles. For instance, after the Islamic revolution in 1979, the banking system was nationalized. Shortly thereafter, in 1983, the Law of Usury-Free Banking was passed, and on March 21, 1984, interest free banks started to implement Islamic banking based on the 1983 law. . Similarly, in Sudan, the government allowed the establishment of first Islamic bank in the country in 1977, The Fysal Islamic Bank (a private bank owned by Saudis, Sudanese and other nationalities), under the companies Act of 1925. However, the country decided to transform the whole banking system under Islamic structure and consequently passed a law in 1991 to that effect.

However, some countries made new laws specifically for the establishment of Islamic bank such as Malaysia. The enactment of the Islamic Banking Act 1983 enabled the country's first Islamic Bank to be established and thereafter, with the liberalization of the Islamic financial system, more Islamic financial institutions were established. . There could be several reasons for that. Most importantly, at the initial stage, the government may wanted to have a monopoly over Islamic banking to make sure that all the operations were carried out through proper Islamic guidelines. In fact, the Bank Islam Malaysia, the first Islamic bank in Malaysia was established with the full support of the government and the central bank. The country did not allow a second full-fledged Islamic bank until very recently. In a move to stimulate growth in the Islamic banking sector, the government introduced a new full-fledged Islamic commercial bank, Bank Muamalat Malaysia Berhad, to complement Bank Islam's objectives and efforts to promote Islamic banking in Malaysia. However, the government has allowed other conventional commercial banks to open Islamic windows. But having the status of a full-fledged Islamic bank definitely creates a monopolistic advantage.

Most countries lack special shari’ah banking courts to settle disputes, which have to be handled by the justice system under civil laws of the land. "In many instances, the provisions of the UAE law are reflective of Shari’a principles, such as the pre-requisites relating to capacity to contract, the requirement for clarity of contractual terms, the absence of duress and the specific conditions governing sale and purchase transactions. In these instances, such transactions are fully compliant with both Shari’a elements and UAE law from the outset. In other cases, the provisions of the UAE laws are inconsistent with Shari’a principles. For example, the charging of interest is generally permitted under UAE law as long as it is not unduly excessive (this being reflected by the flourishing conventional banking system in the UAE). However, interest is strictly prohibited under Shari’a, no matter how nominal the amount. Similarly, while it is not illegal under UAE law to deal with certain items such as pork products and the entertainment industry, these are prohibited under Shari’a. In such cases, it is best that these restrictions and prohibitions are eliminated from the financing structure and, where applicable, removed from the relevant agreements in order to ensure Shari’a compliance."

While the government may initially enact laws to facilitate the establishment of Islamic banking, later on it is the responsibility of central banks to act as banker of the banks as in case of conventional banking system.

Central banks

Most Muslim countries have allowed the dual banking system with minimum efforts to introduce elaborate laws to govern the operation of Islamic banking. Invariably, the approach was to require each Islamic bank to constitute their own shari’ah board to ensure all of their products, services, procedures and activities comply with Islamic laws. Central banks took larger roles from the outset, in the countries where the governments were more interested and active to establish Islamic banking system (such as Sudan, Bahrain, Iran and Malaysia).

In most countries, the central bank has a separate section that handles issues related to Islamic banks. The central banks of Bahrain and Malaysia (and now UAE & Pakistan among others) have taken keen interest in facilitating Islamic banking operations by devising new rules, regulations and guidelines. The State Bank of Pakistan, for example, has created an Islamic Bank Department with the following mandate:

" ...... Islamic Banking Department has been working to develop a progressive, sound, and stable Shariah compliant banking system. In this regard, the department is responsible to facilitate and catalyze development of Islamic banking industry in the country through (a) enabling legal, regulatory and Shariah compliance framework, (b) promotion of Islamic finance as a distinct and competitive system to serve the financial services needs of the masses, (c) take targeted research initiatives to better explore market dynamics and (d) to collaborate with local and international stakeholders for development of competitive and innovative solutions for the diverse financing needs of the real economy. Additionally, the department is engaged in various special projects which may include sukuk related structuring, devising specific products/schemes. It also disseminates Islamic banking information through Islamic Banking Bulletin (IBB), published on quarterly basis."

In some countries, many of the rules applicable to conventional commercial banks, however, continue to be applicable to Islamic banks (Nigeria being one example).

The central banks are traditionally entrusted to manage supply of money to ensure proper liquidity in the economy, control interest rate and inflation and facilitate full employment (in collaboration with other organs of the government). Their position of lender of last resort is essential for the smooth functioning of the banking system. Islamic banking necessitate further responsibilities for a central bank especially in countries where the share of Islamic banking is significant. According to Sekoni Abiola Muttalib (2016) " Traditionally, central bank as the apex bank of a country plays key role decision making and implementation of monetary policy in an economy. It formulates and ensures enforcement of government monetary policies as well as regulates, supervises and controls various activities of the commercial banks and monitors monetary development so as to ensure stability of the financial system. Also, it acts as Banker to the government and the commercial banks. But emergence of Islamic banking system in international financial arena poses great challenges to the role of central bank in both interest based traditional and interest-free Islamic financial systems" . He examined the functions of central bank by theoretically exploring and explaining how a central bank can adapt, adopt and modify the existing available tools in an interest based financial system in dealing with its regulatory, control and stabilization functions in an interest free Islamic banking framework operating in a dual banking system. He concluded that the tools of monetary policies available to the central banks could be easily modified for Islamic banks.

In explaining the role of central bank in an Islamic state economy, Iraj Toutounchian (2002) came up with six different crucial functions to be performed at different levels of rigorousness: .

1. Active participation in the process of preparing economic development plan.
2. Informing individual Islamic banks about the priorities of investment projects as outlined in the country's economic development plan at different regions and various sectors.
3. Calculating and submitting to Islamic banks the profit shares of banks relative to those of capital for different projects at various regions and sectors.
4. Calculating and submitting to Islamic banks the value of risk involved in different projects, different regions, and various sectors of the country.
5. Constant inspection and supervision to make sure that projects have properly been financed relative to the priorities and the value of risks.

Toutounchian noted that to do all above functions effectively an Islamic central bank is supposed to be well equipped with highly qualified personnel in portfolio and risk management and project appraisal. This is also a must for each individual Islamic bank. Furthermore, he admitted that monitoring cost in Islamic banking compared to the conventional banking is relatively high. However, potential benefits as to its effects on reducing unemployment and keeping prices constant over-shadow the cost. Most important, distribution of income and wealth is expected to be more equitable than otherwise.

The shari’ah boards

The central bank should also have the responsibility to assure the compliance of shari'ah rules for Islamic banking. Some central banks have constituted a shari'ah committee or shari'ah board under their jurisdiction such as Sudan, Pakistan and Iran. they provide guidelines on shari'ah compliance and also approve Islamic bank products, services and procedures. Individual Islamic bank can still have their own shari'ah board for internal audit and reputation of the bank.

Models of shari'ah advisory services

Shari’ah advisors are generally people who are entrusted to ensure the compliance aspects of particular products and instruments used in the Islamic Finance industry. The structure of shari'ah councils or boards are different in various countries. Laldin (2017) divides them into 5 different categories:

• Central Shariah Advisory Council and different Shariah Advisory Boards at Banks level, Malaysia, Pakistan, Sudan)

• Shariah Advisory Boards at Bank Level only (GCC)

• Outsourcing of Shariah Advisory Services (Europe)

• Central Shariah Board for the whole Group (Dallah al-Barakah)

• Individuals undertaking the Shariah Advisory role

The Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) describes the role of shari'ah supervisory body as follows:

Shari’ah advisors are specialized jurists particularly in Fiqh Muamalah and Islamic Finance entrusted with the duty of directing, reviewing and supervising the activities related to Islamic finance in order to ensure that they are in compliance with Shari’ah rules and principles. The views of the Shari’ah advisor shall be binding in the specific area of supervision.

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