Islamic banks today exist in all parts of the world and are looked upon as a viable alternative system. While it was initially developed to fulfill the needs of Muslims, Islamic banking has now gained universal acceptance. Lilacs banking has been in existence since the sass, and it has shown tremendous growth over the last 30 years. The practice of Islamic banking now spreads all over the world from the East to the West, all the way from Malaysia, Bahrain to Europe and the US.
As of 2004, the size of the banking industry assets has reached hundreds of billions of dollars from rely hundreds of thousands of dollars In the sass. Since early 1 sass, studies that were focused on the efficiency of financial Institutions have become an Important part of banking literature (Berger and Humphrey, 1997). Islamic banks are governed by Shari’s principles which make their functioning different from conventional banks. First, Shari’s forbids trading in speculative activities (gharry dealing with derivatives and investing in non-permissible (harm) sectors and products such as tobacco, alcohol and pork.
Shari’s also prohibits Islamic banks from paying or receiving interests (rib) to/from their financial and commercial orientations. The prohibition of interest makes the investment approach adopted by Islamic banks unique since they operate on profit/loss sharing arrangements. This principle requires banks to share with their customers the profits and losses resulting from co-funded projects. Product development must follow the guidelines and adhere to shard’s prior to Its introduction. Islamic banking product need to be endorsed by the Internal shard’s supervisory board.
The variations In product, which have the same contract, may be due to the different Interpretations by the cardiologist’s. Islamic banking has adapted the sharing of profit and loss through numerous ways. The first approach was through partnership (Muskrat), or the sharing of investments by the bank without being part of the management teams. Then there was Muhammad approach, which was based on the mark-up for a resale or leasing contract, called ajar, which in Western banks works on interest (Behalf and Luzon, 2004).
Operating a bank In this manner would Increases the stability of the banking system because It encourages banks to diversify their Investments to minimize risk and Increase profits. This practice In turn tends to attract more Investors and thereby helps banks operate more efficiently. The Share banking systems conduct through four different business laws. The first Is the principle of the lender and borrower The third is assessing no interest, and the fourth is the lender-borrower alliance.
Regulation is necessary to ensure economic stability and better banking performance, but it should not cross the limit. That is, the regulation should be cautious and balanced one and it should not exert any undesirable influence of grave consequences on the economy and banking arena. (Hosannas and Chowder, 2004). In terms of accounting standards, Islamic banks follow the regulations of their domicile. Application of International Accounting Standards (AS) is possible if SIS is accepted throughout their countries.
In addition to ‘AS, standards prepared by PAYOFF should be implemented to the accounting framework. Accounting standards prepared specially for Islamic banks will provide better accounting practices that are in line with Islamic financial products. They will also ensure reliability of financial statements and comparability. 1. 1 Problem Statement Impact of standardized banking regulation around the world has an effect to the efficiency and performance of Islamic banks. To what extent financial and policy indicators that impacts the overall performance of Islamic banks. Imperative performance indicators of Islamic Banks and commercial banks operating in the same market in countries where Islamic Banks operate side by side with conventional banks. 1. 2 Research Question How could conventional regulation in banking sector effect the effectiveness of Islamic Banking. Does efficiency and risks are correlated in Islamic banking system. Does stricter regulation could hamper Islamic banking efficiency. 1. 3 Research Objective 1) To examine association between risk and efficiency with regulation and supervisory approaches in the Islamic banking system. ) Examine whether bank regulation, supervision and monitoring enhance or impede technical efficiency of Islamic banks across the globe. 3) The existence off powerful supervisory body could also lead to inefficiency. 1. 4 Theoretical Framework Basel II Capital Accord and its successor, Basel Ill, make no distinction between conventional banks endoplasmic financial institutions, because the Basel committee embers largely comprise central bank governor and prudential supervisor from non-Muslim countries. (N. Lam) 1. Hypothesis HOI: There is no correlation between implications of Basel II. HUH: There is no correlation between amendments of existing law. HUH: There is no correlation between lacks of harmonize interface between the Shari principles and existing legal framework. HUH: There is no correlation between civil court applying western-inspired laws instead of Shari. Chapter 2 Literature Review A key feature of Islamic banks is their use of Unrestricted Profit Sharing (and Loss Bearing) Investment Accounts (PUPAS) in place of conventional interest-bearing deposits.
In the first place, this raises a supervisory issue: PUPAS are, strictly speaking, investment (that is, capital market) products, rather than banking products. Hence, they call for a regulatory and supervisory approach that differs from that applied to to particular problems as regards both the regulation and supervision of capital adequacy, and also corporate governance . Moreover, PUPAS do not meet the requirements of the banking regulations in North American and Western European Jurisdictions, and this constitutes a significant airier to their development in those Jurisdictions.
In the second place, this characteristic of Islamic banks raises a structural issue: if PUPAS were used to raise funds, not by Islamic banks themselves, but by fund management companies associated with them (for example, as subsidiaries or as fellow subsidiaries of a common parent), then not merely would the barrier Just mentioned be removed, but the application to PUPAS of more appropriate regulatory and supervisory approaches would be greatly facilitated.
Last but not least, the rights of PUPAS holders in a winding-up of an Islamic bank deed to be clarified, as (absent misconduct or negligence) they are not creditors of the bank but have an ownership claim to some of the assets held by it. This article sets out in more detail an approach that would permit these benefits to be achieved. With conventional interest-bearing deposits,a bank has full discretion in applying the funds in its asset portfolio. A similar level of discretion is achieved by Islamic banks through the use of Unrestricted ASIA, as the contract gives the bank an unrestricted investment mandate.
Clamminess may also offer Restricted ASIA (Reaps),which are a Oromo of collective investment scheme in which the banks mandate is restricted in some way or other, normally by the pre-specification of the asset allocation. However, as a result of these restrictions, RAPIST are perceived by Islamic banks to be an ineffective substitute for conventional deposits accounts. The Committee of Basel II defines operational risks as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. It is the risk of faulty system, people or procedures regardless of whether the fault is intentional, such as fraud or theft or unintentional such as internet or electricity failure and regardless of whether the loss is caused by outsiders such as changes in regulatory policies or insiders such as inadequate or incompetent internal safely procedures. Operational risk includes legal risk, but excludes strategic and reputation risks. The Basel II Proposed Accord suggests either of three methods to measure the minimum capital requirement for operational risk exposure and leaves the choice between them to the supervisory authority.
These three methods are: the Basic Indicator Approach, the Standardized Approach and the Advanced Measurement Approach. They are considered as three levels of development and advancement and the Committee suggests moving from one to the other as banks become “more sophisticated” in their tools of measuring operational risk. It also recommends that the more a bank is internationally active the more sophisticated it is supposed to be in measuring operational risks. Basel II also requires Islamic banks to meet legal and regulatory standards as specified in Basel II.
Some opine that Islamic banks should not be subject to all ejaculatory measures specified by Basel II, but they should be subject to regulations similar to corporations due to the participation of the investments depositors in the risk of Islamic banks” (Hosannas and Chowder, 2004). There are several reasons for Islamic banks to comply with the Basel II regulations. Islamic banks are at the early stage of growth and their sizes are normally small to medium. In order for them to gain international recognition, Basel II compliance becomes a cornerstone.
Also, as long as PAYOFF and IFS suggestions can be added to he Basel II, the regulatory framework will bring standardization for Islamic banks. The new Basel regulatory framework aims to establish greater market discipline which is necessary for the stability of international financial system. It is also required for the purposes of leveling the field. Chap and Khan (2000) suggest that the Islamic financial system realize this by participation of the risks by the banks and the depositors, directly or indirectly. Such a sharing of risks should help motivate demand greater transparency in the affairs of the bank they choose. ” (Chap and Khan, 2000). Promoting market discipline through greater transparency and disclosure is suggested as the third pillar of Basel II. Six categories are identified for financial disclosure and transparency: financial performance, financial position, risk management strategies and practices, risk exposure, accounting policies and basic business, management and corporate government information (Hosannas and Chowder, 2004).
The interrelation of different financial institutions also brings challenges. Regulation of commercial banks, investment banks, insurance companies and mutual funds ere traditionally done separately. “To protect the soundness of each sector and its positive role in enhancing the soundness of the financial system, inter-sector activities are prohibited. ” (Chap and Khan, 2000). However there is a tendency to merge regulatory frameworks to include wider range of financial institutions such as Financial Services Authority of England.
Basel II regulatory framework suggests supervision in line with such developments. Inclusion of Islamic banking will further enhance the Basel II applications and will bring international recognition to Islamic banks. The nature of different Islamic products is that they are similar to those of conventional banks, mutual funds, leasing companies, venture capital companies and risk participation companies. Such unique financial structure is very much in line with the international trend and Basel II. 2. . 2 Financial stability and related challenges Regulatory challenges in many Jurisdictions in which Islamic banks operate, central banks are their main regulators and supervisors. The policies and tools of regulation that are used by almost all these central banks (with the exception of very few) are eased on the business models of conventional commercial banks, particularly interest-based lending and borrowing. These central banks’ approach to supervision is also based on the protection of depositors.
Central banks are also mindful, especially after the recent crises, that banks should have adequate capital in order to meet their obligations, which include, inter alai, repaying depositors 100 per cent of their funds. Given that they mainly focus on financial stability with a particular concern for preventing systemic risk, central banks in many Jurisdictions have tended to regulate Islamic banks by reference to their yester of regulation, based on the business model of conventional commercial banks.
Hence, in the absence of regulation that takes their specificities into consideration, Islamic banks have had to fit into the conventional system of regulation that was used by central banks. Accordingly, as with depositors, Islamic banks may not be allowed by their central banks to pass losses on to holders of PUPAS, as doing so might trigger large numbers of withdrawals by holders of these However, this would put the Islamic banks shareholders at a disadvantage, because hey would have to bear the risk of losses on assets funded by PUPAS, which is not consistent with the shareholders’ contractual relationship with the bank.
Whether or not the shareholders of an Islamic bank would take legal action in such a situation against the banks management and regulators to block the reimbursement of losses to the holders of PUPAS funds, and, if so, whether De facto capital certainty would with- stand such a legal challenge, has yet to be seen. Such an approach to supervision has been encouraged by the behavior of holders of PUPAS that was offered to above, namely that they tend to behave like depositors although their contractual relationship with the bank is based on an investor rather than a depositor relationship.
There are only a few Jurisdictions in which the regulatory or supervisory authority does not require Islamic banks to absorb losses on PUPAS holders’ funds. However, market pressures may have a somewhat similar effect. 2. 2. Market pressure Market pressures the vast majority of Islamic banks operate in a mixed (conventional plus Islamic) banking environment. The resultant market pressures appear to force Islamic banks to distribute to PUPAS a return that matches, as far as possible, the rate of interest paid on interest bearing deposits.
This practice also results in PUPAS being treated much like conventional deposits, in spite of the fundamental contractual differences (whether under Madras or Hacksaw contracts). Competition (whether from conventional banks or among Islamic banks) appears to have forced the latter to develop the practice of creating PER and IR, as described above. While the use of PER and IR raises issues of corporate governance (transparency and moral hazard) t the micro-level with implications at the macro-level, at the latter level their formation by Islamic banks has helped to mitigate systemic risk.
Indeed, if IR is of adequate size, it can reduce the need for the public authorities to provide a guarantee of the capital of PUPAS at times of financial crises, similar to those provided to depositors of conventional banks (either through existing depositor protection schemes, or by means of ‘bail-outs’ over and above such schemes as in the recent financial crisis). Chapter 3 Research Methodology This paper aims to examine whether bank regulation, supervision and monitoring enhance or impede technical efficiency and risk-taking behavior of Islamic banks across the globe.
Furthermore, the Islamic Finance industry has been affected by many issues, and while many relate to the lack of proper supervision others are simply due to the lack of compliance and regulatory measures. When reading such a paper it is easy to dismiss the importance of Islamic Fainthearted it be because of our own ignorance, lack of understanding of the system, prejudices or to a certain extent familiarity with conventional banking. However, the Islamic financial markets re among the fastest growing financial products in the world.
This will see further growth in years to come as more and more countries are embarking Islamic banking and discovering the benefits of using Islamic Finance over conventional financing schemes. As highlighted by Raman and Perry (201 1), “while many of the conventional banks suffered major loses in the aftermath of the sub-prime mortgage crisis, most banks following the Islamic system were largely profitable”. However, some dark clouds exist over the horizon for it to be universally accepted as a mainstream bank as it is mostly considered to be an alternative.
Bank regulation and supervision can take the form of detailed and prescriptivism’s rules under which all banks operate in the given territory. For example, activity restriction rules may specify which banking activities banks can undertake to reduce their rockiness and prevent them from going bankrupt. If such rules do not truly reflect the risks involved, they could unintentionally induce banks to be involved in unprofitable and risky ventures.
Therefore, it is imperative to observe how banks’ operate in the given regulatory and supervisory structure and hat is the resultant impact on the technical efficiency and risk taking behavior of banks. 3. 2 Data Sources The methodology employed by this paper is that of frontier data envelopment analysis (DEAD) model. The DEAD model of data analysis with regard to bank efficiency has generally been favored by most academics (Berger et al. , 1993; Berger and Humphrey, 1997; Case and Molybdenum, 2003).
Despite criticism from some academics (Similar and Wilson, 2007; Removal et al. , 2010), it is generally accepted by most academics that the DEAD model is a sound technique for efficiency estimation. McDonald (2009) examined the second stage DEAD efficiency analyses and found that there are good arguments for treating DEAD efficiency scores as descriptive measures in a second stage analyses. He summed up that the DEAD method was simply the better one as it was relatively simple to use and a broad range of people could understand its usage and the idea behind it.
The dataset used in this study is composed of 70 Islamic banks from 11 countries (Egypt, Bahrain, Bangladesh, Indonesia, Kuwait, Malaysia, Pakistan, Qatar, Saudi database or done by manually referring to the annual reports of these banks for year 006-2010. The reasoning for a five-year data test is because it would yield a better dataset due to accuracy, and, also, where the Islamic banking system was newly established it would have had sufficient time to mature.
The other reasoning is that it would also be able to monitor the overall performance during the recent financial crisis (Table l). Figure 2 shows the banking regulation and supervisory scores on a country basis. Most countries score very high on supervisory index indicating the great extent of official supervisory powers reserved by authorities. In respect of the capital acquirement index, Kuwait and Pakistan score the highest on this index with a maximum of 8 points each suggesting strict capital regulations in their countries.
In respect of private monitoring, most countries score very high on this index indicating considerable private monitoring of the Islamic banks in those countries. In terms of activity restrictions of Islamic banks, Indonesia is the only country to score a maximum score of 4, while Qatar scores the least. The regulation and supervisory scores for each country highlight significant differences among the nations practicing Islamic finance.