CONFERENCE ON ISLAMIC BANKING AND FINANCE
BAHRAIN, 2 MARCH 2003
Howard Davies
Chairman, Financial Services Authority

I am very grateful to the Bahrain Monetary Authority, and particularly to the Governor, for the invitation to speak to you today. And it is a great pleasure to visit Bahrain, in my case for the first time, I am ashamed to say.

But I also speak with some trepidation. Because I have been asked to speak on a subject about which many, if not most of you know a great deal more than I. As I shall try to explain, there are some interesting developments underway in the UK in the area of Islamic finance. But we are a long way away from the leading position of the kingdom of Bahrain.

Bahrain has the largest concentration of Islamic banks and financial institutions in the Middle East – 26 firms according to a survey carried out last summer. The BMA has been a pioneer in the regulation of Islamic banks, and has gained a well-earned reputation for responsiveness and innovation. More recently, we have seen the establishment of the Liquidity Management Centre and the International Islamic Financial market. And, perhaps most importantly in present circumstances, the BMA has been a strong advocate of effective corporate governance in Islamic institutions. Without effective corporate governance it is unlikely that, in the long run, Islamic financial institutions will survive and prosper.

So my own contribution to this important conference comes with a degree of humility. In London, we are just feeling our way in the global Islamic financial market. We are doing so, however, with considerable interest. One important reason for us to think hard about the regulation of Islamic finance is that, in recent years, there has been a significant revival of the historic tradition of Islamic banking. Some countries, notably Iran, Pakistan and the Sudan, have constructed their systems on a purely Islamic basis. In rather more countries, such as Bahrain, Islamic banks have been established alongside conventional banks on the Western model.

There are no firm statistics about the size of Islamic finance globally, but it is clearly of growing importance. Some commentators estimate that the Islamic banking and finance market has grown between 10% and 15% annually over the past decade and that it is currently worth between $200 and $500 billion. As a point of comparison, the sterling assets of the UK banking sector amount to £2.5 trillion (around $4 trillion). So Islamic banking has some way to go. But that is just another way of emphasising the scale of the opportunity.

Partly in recognition of that opportunity, no doubt, a number of regulatory authorities in Muslim countries have now established the Islamic Financial Services Board, with assistance by the Islamic Development Bank and the IMF. The Board was launched in Kuala Lumpur last November. We hope it will play an important role in promoting, disseminating and harmonising best practice in the regulation and supervision of Islamic finance, and will be helpful in guiding authorities, including our own, which so far have limited experience of regulating Islamic financial institutions. One of the express aims of the Board will be to set standards and principles for supervision and regulation, consistent with the Sharia Law and principles, and to liase and co-operate with other standard setters around the world.

In the UK, of course, we do not yet have a large well-developed Islamic financial structure. But there is already a reasonably significant amount of business of various kinds. There are no purely Islamic banks in the UK today, but London is already an important centre for Islamic banking products. Some UK banks have Islamic windows. HSBC is one notable example. They have considerable expertise elsewhere in the world of operating within financial systems in which Islamic banks are their competitors and collaborators. And some banks here use the London Metal Exchange for Murabaha. The customer buys and sells forward a metal on the London Metal Exchange and earns a profit.

But it is fair to say that most Islamic banking in the UK at present is transacted by relatively wealthy individuals or large institutions. Since there is no focused Islamic bank seeking to serve the domestic Muslim community, and some retail sector Islamic products are rather difficult to construct in the UK at present, I would acknowledge that there is a market gap.

That gap could be quite large. There are approximately 1.8 million Muslims permanently resident in the UK. They make up around 340,000 households. These figures were recently confirmed by our latest census. (Though I should add that 200,000 people also said that their religious affiliation was to the Jedi Knights! Star Wars continues to capture the imagination of many of my compatriots). A rough estimate suggests that the UK’s Muslims have, in total, savings of approximately £1 billion. And in addition to the permanently resident population there are of course many Muslims who visit the UK. Last year over half a million Muslims visited from the Middle East and Pakistan, spending nearly £600 million in our economy. So the potential market, whether for savings products, borrowing, or simply transaction-related finance is very large.

Against that background, it is perhaps surprising that, in spite of many initial expressions of interest, and much energy expended by knowledgeable enthusiasts, so far no dedicated Islamic banks have been established in London. That certainly does not reflect any lack of dialogue between the FSA and the Islamic community. Those links go well back into the time when banking supervision was the province of the Bank of England, and the current Governor has throughout his time of office taken a particular interest in Islamic financial issues. I have met a number of representatives from the Islamic community, to set out the FSA’s approach to banking regulation and supervision and debate the issues with them.

The FSA is now well established as a single regulator for the whole of the UK’s financial system, so it is a good moment to take stock of the way we now operate, of the objectives given to us by Parliament, and the way in which those objectives, and the regulations which flow from them, can be transposed to handle the particular needs and demands of Islamic financial institutions.

You will be pleased to know that I do not plan to take you through all 500 clauses of the Financial Services and Markets Act, passed in the year 2000, and which provides the legal basis for our work. Indeed, I will restrict myself to a few words only about the clause which sets out the objectives of financial regulation. Under the statute we are given four main tasks.

First, we are required to work to maintain confidence in the UK’s financial markets. That has been something of a challenge in recent months, as we have been blown by unfavourable winds from across the Atlantic, which have dented confidence in financial reporting and in accounting and auditing standards. We have not experienced problems on anything like the same scale in London, but our markets have nonetheless been volatile and weak.

Our second principal objective is to promote public understanding of the financial system. That is a new role for a regulator. It has taken us into areas of consumer education which previous regulators have not touched. We have developed materials for use in schools to educate children in the principles of finance. That applies from primary schools, right up to the 16 –18 age group. We hope that, over time, all that work will have the effect of enhancing financial literacy, which is distressingly low in the UK. And I imagine we are not alone in that.

Our third objective is to protect consumers of financial services, but bearing in mind their own responsibilities. In other words we are not meant to protect people from any mistaken saving or investment decision they may make. The "buyer beware" principle certainly still applies. Under that heading we try to ensure that financial institutions in our care are reasonably sound in financial terms, that they offer fair contracts which can be reasonably well understood by consumers, and that there is an ombudsman scheme, and a compensation scheme, to underpin the market when things go seriously wrong, as they sometimes do in even the best ordered markets.

Our fourth objective is to work to reduce financial crime. That objective has gained particular prominence in the last twelve months as international concerns about money laundering, in particular, have come to the top of the political agenda. It is our responsibility to try to ensure that financial institutions have systems in place which protect them against abuse by those who wish to launder the proceeds of drug dealing or other organised crime, or who wish to finance terrorism.

I mention these four objectives, because they underpin everything we do, and we must ensure that however we regulate financial businesses we are contributing to those aims set for us by the Government and Parliament.

When we translate that to the arrangements for supervising banks, we require new applicants to meet five - what we call - threshold conditions for authorisation as an institution entitled to take deposits in the UK. Some of those conditions, such as the legal status of a bank, its location etc, are entirely straightforward. No bank should have difficulty meeting them. The two key conditions are that a bank must have adequate resources and must have reasonable systems and controls to manage the type of business it wishes to undertake in a reasonably sound and prudent way. That will include systems to guard against money laundering.

How do these principles apply, or how would they in principle apply to an Islamic bank? I should emphasise that we have not yet received a formal Islamic bank application, though we are aware of some interest in making such an application, and as I have said we have held preliminary discussions already about how our conditions might be met. Some of you may be aware of an interesting initiative known as the Islamic House of Britain, which is being sponsored by a Bahrain-based investment house and backed by a number of Middle Eastern shareholders. It hopes to offer Sharia compliant products such as mortgages and current accounts, and is currently advertising for a Chief Executive.

Perhaps the first important thing to say in terms of our attitude to these developments is that as a general principle we welcome diversity and innovative developments in the world of finance. London has prospered over the centuries by providing a congenial home for international financial institutions, and innovation has been its life blood. So we have a clear economic interest, as a nation, in trying to ensure that the conditions for a flourishing Islamic financial market are in place in London. The business opportunity is large and potentially very attractive. We recognise that there are no banks catering specifically to the large and growing UK Muslim population, and I can tell you that in principle we have absolutely no objection to the idea of an Islamic bank.

But, that said, we are obliged by our legislation to treat applications from Islamic institutions no differently from any other. Of course there has to be a level playing field for competition between banks and it would not be appropriate, or even legally possible for us, to lower our standards for one particular type of institution. Indeed I would strongly argue that since, if it was to be successful, an Islamic bank would need a reputation for capital soundness and proven management, it would in any but the very shortest term be entirely counterproductive to authorise a bank on a different basis from that which we apply to conventional institutions. I also know that this is the widely-held view of those who have dipped a toe in the water in the UK: their greatest fear is that the launch of an Islamic bank with a strategy that is badly thought through or with inadequate management will set back the credibility and development of the sector.

But we recognise that, to fit the bill, our requirements will need to be shaped to suit the particular demands of an Islamic bank. Islamic banks differ from conventional banks in four main ways. They offer a rather different range of types of Islamic finance, from Murabaha through Ijarah and Salam to Istisna. I know that there are other – to me – exotic products like sukuks. I am not going to stand here today and tell you that I am expert in these different types of transaction. But, ‘I know a man who is’. We have a small team in the FSA who have made a study of Islamic banking, and its regulation.

We recognise that the risk sharing characteristics of these Islamic contracts are rather different from those in place in a conventional bank. For example, there is typically a mix of contracts on the liability side. In particular, unrestricted Islamic investment account holders share in the risks of the bank, since their deposits have some of the characteristics of equity stakes. It is entirely reasonable to take some of these defined features into account when looking at the capital structure of the bank. If customers genuinely share risks, and understand that they are doing so, that may reduce the amount of capital required.

We also think it is important for Islamic banks themselves to be clear about the type of products they wish to offer. If we were to authorise an Islamic bank we would look carefully at its business plan, just as we do with any other institution. We want to know that it has understood the nature of its market, the profit opportunities open to it in that market, the nature and intensity of the competition, and the types of products it wishes to offer. For example, will the bank offer capital-certain deposit products or not? In some, but not all, Islamic deposits the client’s capital is generally at risk if the bank loses money, even if it doesn’t fail. If that is so, then it is important for potential customers to understand that they do not benefit from the deposit protection arrangements in quite the same way as depositors in Western style institutions.

Relevant to this point is the question of whether Islamic banks are truly banks, or are essentially more like fund managers, even though they may offer traditional banking services such as money transmission. I know that this question is one which is often discussed in the Islamic financial community. But I have to say that, now that we are a single regulator, we think it is of rather secondary importance. At least, that is, from a regulatory perspective. Since we have one regulator we have one basic set of conditions for authorisation, which needs to be met by any firm transacting financial business, albeit the details will differ in the case of a fund manager, on the one hand, or a bank on the other. That is, perhaps, a distinctive London approach to regulation. In many other countries the approach taken to the regulation of banks and fund managers respectively are much more distinct.

But these differences in the nature of Islamic banks are, I believe, less important than the similarities between Islamic and other banks. What we are really looking for when we authorise a bank is an organisation which abides by sound principles of corporate governance, which has adequate capital for the risks it plans to take on, and which has a capacity for managing those risks which we believe to be robust. In the case of an Islamic institution, we would include in that advice and assessment of legal and documentation risks, though I think it would not be appropriate, or even possible, for us to check compliance with Sharia law, which is perhaps an additional risk factor which needs to be taken in to consideration. That in our view, is a matter for the institution itself.

Before I finish, I wonder if I might say a word about one particular issue which has been of some concern in the Islamic community in the UK, the question of Islamic mortgages and how they might be treated. A working party led by the Governor of the Bank of England, and of which one of my staff is a member, has been looking specially in recent months at the barriers to Islamic mortgages. The main problem we see is that they unwittingly attract stamp duty twice: once when a lender buys a property and a second time when it is transferred to the mortgagor. I am aware that we are not the only country where this has presented a problem but – with stamp duty ranging up to 5 % the problem may be especially acute in the UK. It is a matter for the Treasury and the Inland Revenue and not the FSA to resolve. The signs are that the Government are giving serious consideration to a change which would make it easier to offer Islamic mortgages. We should learn more on that shortly. It is worth pointing out though that one UK institution does already offer Sharia-compliant mortgages. It is Ahli United Bank (formerly the United Bank of Kuwait) and it has recently teamed up with the West Bromwich Building Society – which operates in an area with a large Muslim community.

There is another potential difficulty with mortgages, though one which I believe to be of somewhat less importance than the stamp duty point.

As far as we can see, the current Basel Capital Accord which governs the principle and practice of banking supervision around the globe today, does not appear to give member countries discretion for anything other than 100% capital treatment for Ijarah mortgages. This means a bank would have to carry twice as much capital in respect of an Ijarah mortgage as it would for a conventional mortgage, where the weighting is 50%.

While that it is not necessarily a complete block on the development of the market, it certainly has the effect of making Islamic mortgages a little more expensive than conventional ones. This is something we are looking at very carefully at present, in conjunction with the Bank and the Treasury. It is a particularly difficult issue because the Basel rules are incorporated into European Union law, which therefore restricts our room for manoeuvre. We are trying to look in a sympathetic way at the possibility of a different treatment under the existing rules, and we have asked Islamic financial institutions for more information which might conceivably allow us to propose a case for different treatment. Some work on that issue is under way at present and I understand Ernst and Young should be producing the case very shortly. We are also looking with interest at developments in the US, where HSBC Amanah launched Islamic mortgages last year, and Fannie Mae are currently interested in a partnership with an Islamic finance house in Southern California.

Even if it were to prove impossible to take a different approach to capital weighting now, there is help on the horizon. The Basel committee have now published a new version of its capital accord, for consultation. And that would allow a more flexible treatment of Islamic mortgages if it goes through on current plans, which would probably remove this competitive disadvantage. I have to say, however, that we do not expect the new Accord, known as Basel 2, to be finally approved for use until around 2006, which undoubtedly is a problem for institutions wishing to get into this market at present.

There are in short, a lot of exciting developments under way, on which we keep a close eye. So let me end where I began. We see no objection of principle to the establishment of an Islamic bank in the UK. Indeed, we would welcome a soundly financed and prudently managed Islamic financial institution in our country, which would be good for Muslim consumers, good for innovation and diversity in our markets, and good for London as an international financial centre. But we have to treat applications from Islamic institutions in the way we do those from other, conventional firms, to ensure that they can compete effectively, and in the long term, on a level playing field with conventional finance providers.

I do not see that as any barrier to the development of the market, and I think it very likely that, before too long, we will be able to authorise an Islamic bank in London. If so, that would be a welcome addition to the London financial community. It would also allow us to share more fully in the discussion between regulators in other markets with Islamic institutions about common issues, which would help all of us, I think.

The challenge is to ensure that Islamic banks are well, but sympathetically regulated. I do not think that challenge is beyond us, particularly if we can continue to develop a partnership between Islamic and western countries.

These are nervous and worrying times in the Middle East, for reasons which we all understand. They are nervous times in London, too, where uncertainty about a possible war is casting a pall over financial markets, which are already in a nervous condition as doubts about the robustness of the economic recovery have grown. But all these anxieties should not deflect us from looking ahead, to a time – which we shall surely see – when the clouds have lifted, and we can move forward with greater confidence. And, in these difficult times, it is more important than ever for us to work, in whatever part of the economy we operate, on building bridges between the Islamic world and the West.

In my view the somewhat dry and dusty subject of banking regulation can play a small, but not insignificant part in building that understanding. And I hope I have contributed in a modest way to that objective by coming to join you today.

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