Gulf Times published portions of a note that the Central Bank issued (available as a pdf from the Central Bank):
"Islamic finance is characterised by certain risks of more diversified and complex nature than conventional financing, particularly with regard to the return, liquidity, credit and market risks relating to Mudaraba, Musharaka, Istisnaa and Ijara finance methodologies."The main issue for the Central Bank on the regulatory front is the co-mingling of funds between the conventional and Islamic units within each bank that has both types of businesses. This objection is perfectly understandable. If this were the case, there would (or should) probably be objections from the bank's Shari'ah board.
The issue becomes more complex when a large part of these activities receive their funding from customers’ conventional fixed-income deposits, which are not based on profit distribution as in Islamic deposits. Moreover, these two types of risks are getting reflected in the same financial statement of the bank. As a result, applying oversight instruments and prudential ratios and indexes used for risk management and preserving the two types of depositors’ rights are becoming more complex."
It seems there is a conflict of interest with conventional banks having the two side by side. These affect the stability and growth of Islamic banks."
The article I linked to earlier written by Sheikh Taqi Usmani in 2002 about Islamic windows described the permissible method for conventional banks to fund Islamic windows:
"a portion of the initial capital of the bank is earmarked to be employed in the proposed window. In the absence of a proof to the contrary, the initial capital of the bank may be presumed to be pure.This is consistent with descriptions from conventional financial institutions like HSBC Amanah, which use funds from their conventional bank to seed the Islamic windows (although the HSBC Amanah FAQ linked to is vague on the shifting of assets between conventional and Islamic units).
Accounts of the Islamic window must be separate from the conventional side of the bank. The deposits received by the window must not be mixed up with the deposits taken on conventional side. Similarly, the finances offered by the window must be independent."
The difficulty of the division of funds between conventional and Islamic segments of a mainly conventional bank is that money is fungible, that is, one dollar can not really be distinguished from another and when the financial statements combine both units, as they would be in a consolidated balance sheet and income statement, it requires no more than an accounting entry to designate the funds flowing from conventional to Islamic segments of the bank as coming from the bank's capital rather than its interest income or conventional deposits.
The only way for the bank to really keep the units funds separated with consolidated financial statements is to keep the segments operationally independent from one another. Specifically, a conventional bank opens an Islamic unit as a subsidiary and funds it with $10 million in capital which are put into a segregated account. The Islamic unit starts up and begins opening branches, taking in deposits and extending financing. The income from the assets are used to cover operating expenses and make profit-sharing payments to depositors (with whatever reserve accounts are used to smooth those payments over time, as most Islamic banks do).
However, the difficulty comes from a regulatory perspective because there is a contradiction between the financial statements the bank provides to the regulators (as one company) with a consolidated financial statement showing assets, liabilities and capital, as well as the total risk weighted assets (the denominator in the capital adequacy ratios). However, from an operational perspective, the two segments (Islamic and conventional) must remain separate. That is, there is little way for the regulator to assess whether the Islamic unit is healthy on its own, whether it has adequate capital to support its assets (with their respective risk weightings that are often higher than conventional banks' assets).
At this point, there is a dilemma for the regulators who face potential embarrassment if an Islamic window ran into trouble (for example, by lending lots of its money to dubious real estate projects that subsequently lose value). If this happens, the bank would have two options. First, it could just fold up its Islamic window and force the depositors (apart from the non-profit-returning deposits) to share in the loss. This would be untenable for any bank that wants to reassure its conventional depositors of its solvency. The other solution would be to recapitalize the Islamic unit. However, these funds would not necessarily be Shari'ah-compliant and it would be a public relations disaster for a conventional bank to try and move capital from the conventional side to the Islamic units after the Islamic windows had been operating for a while. And that would embarrass the regulators who were supposed to be overseeing both conventional and Islamic banks.
So, on these grounds the directive makes some sense (if I have not made any serious errors in my analysis). However, this does not make the directive or the method in which it was handed down any better handled in terms of minimizing disruption within the Islamic finance industry. At least there is not a week-long holiday involved like there was when Dubai World declared a standstill agreement back in 2009.
In addition to the handling of the announcement, there is a more substantive argument that the directive is needlessly damaging to banks by forcing them to shut down overnight. The Central Bank's statement says the directive told Islamic windows to "stop opening new Islamic branches, accepting Islamic deposits and dispensing new Islamic finance operations". There are reports (as yet unconfirmed) that the Central Bank is considering merging the Islamic units into one Islamic bank. This could be one solution if the banks contributing their business units were given equity in proportion to the size of their Islamic units, but it's probably not the best solution, in terms of reducing disruption and keeping the possibility open for other conventional banks to open Islamic windows in the future.
The alternative would be to require the conventional banks to spin off the Islamic windows into wholly-owned subsidiaries that are required to hold separate Islamic banking licenses, be regulated along with the Islamic banks in the country and maintain enough capital on their own to satisfy the regulatory requirements. This would provide the regulators with the authority they need to maintain the soundness and stability of the financial system, but would also provide the banks who now have Islamic windows with the opportunity to profit from the growth in Islamic finance, which was the reason they opened these windows in the first place.
I think I'll take this opportunity to end this post, even though there were a couple other points in the Central Bank's press release that I wanted to discuss, but those can be left to a later post.