What should Qatar do with Islamic windows?

The Qatar central bank's directive to conventional banks to close their Islamic windows is still the top news story in Islamic finance. Malaysia has come out and said it does not plan to institute a similar move, while commentators see a likelihood that other GCC countries will introduce similar rules.

Reuters reports that the central bank has clarified the reason for the directive being "based on issues related to the supervision and monitoring as well as monetary policy", as well as potential problems in financial reporting. The central bank may create separate capital adequacy rules for Islamic banks.

Not being an expert on financial reporting, I can't comment on that aspect, but other articles report that the directive was based on difficulties with ensuring the segregation of assets between the conventional and Islamic units of banks offering both services. This may even be the key issue behind the ruling with the central bank wanting to create new capital adequacy rules for Islamic banks. There have been complaints before that the capital weighting of Islamic finance products is problematic, although they are generally more conservative (i.e. Islamic banks have to hold more capital for Islamic products than conventional products).

I linked to an article by Sheikh Usmani about Islamic windows (from 2002, ht Islamic Finance Resources) that provides a good commentary on the role of Islamic windows. Sheikh Usmani begins by referencing the critics of Islamic windows of conventional banks:

"It is argued that such windows are established purely for commercial objectives which aim at capturing the Islamic market. The main business of these conventional banks is still based on interest and is intended to remain operative for good, but only a small part of their activities is claimed to be run on Islamic principles. This attitude, according to these critics, is neither sincere nor reliable, and the Muslims should not therefore cooperate with it."

He counters that:

"The criticism is not wholly justified. If a conventional bank opens an Islamic window and it is ensured that all the requisites for a true Islamic window are fulfilled in letter [and] spirit, this step cannot be criticized merely on the ground that the whole bank is not converted. In non-Muslim countries, in particular we find numerous commercial institutions that offer Islamic and non-Islamic products simultaneously. For example, all the hotels and restaurants in non-Muslim countries sell liquor and soft drinks. Nobody can reasonably argue that so long as they deal in liquor, they should not sell soft drinks. On the same analogy, if a conventional bank offers real Islamic products through a separate window, it will not be justified to raise objection against it."

This summarizes the two sides of the debate between allowing conventional banks to offer Islamic financial products through their Islamic windows. The funds are segregated so that there is not impermissible income generated using funds from the Islamic window. However, they are often seeded with funds from the conventional bank. Sheikh Usmani dealt with this issue as well:

"The initial capital employed in the Islamic window must not be a part of interest or any other impermissible income earned by the bank. The ideal method for that purpose would be to raise new capital meant exclusively for the Islamic window. If this is not possible for any reason, 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 still an issue that is raised because money is fungible and there is no distinction between the money generated through a conventional bank's interest-based business and its capital except different line items on the balance sheet.

There is no way to undo the past to separate the bank's capital from the original source of the funds, so the in part the move could be viewed as an admission that the capital for the Islamic window was impermissible from the start and therefore the window was non-Shari'ah-compliant and, thus, should be closed. Even if this was the case (and I am going out on a limb here in terms of the rationale for the move by the central bank[1]), however, the closing of Islamic banking windows isn't the best solution to the problem.

If the issue is the capital backing the Islamic banking operations, then there are three alternatives:

• Shut the units down: this is tack taken in the directive as far as it has been reported, but will likely harm the customers of these bank's Islamic windows.
  
• Force the conventional banks to sell the units to wholly Islamic banks: this outcome would be amenable to consumers because it would cause less disruption and would treat the conventional banks fairly by giving them at least some compensation for losing access to a growing market. However, given the short timeline and regulatory requirement for the sales, they would not necessarily get fairly compensated in the sale.
  
• Allow the conventional banks to apply for Islamic banking licenses, transfer their Islamic units to wholly- or majority-owned subsidiaries.

The final option would be the most just option for the banks, would also minimize disruption for customers and also ensure that there remains the same level of competition in the Islamic banking industry in Qatar. It would also clear up any issues with the capital backing the Islamic units if the central bank forced a recapitalization of the subsidiaries with new funds from investors. This would force the banks to share some of the profitability with the investors, or issue new shares with the funds being directed to the subsidiaries without being "tainted" by being part of the conventional bank.

It would be positive if the uncertainty were cleared up and the final rules were released publicly so that bankers as well as the other industry participants (perhaps worried about similar rules in other countries) could have clarity on the final rules. However, for now, there are only bits and pieces coming out. This will do no good for bankers in the GCC at conventional banks trying to sleep or consumers who are now unclear about the status of their deposits or loans from Islamic windows in Qatar or the rest of the GCC.

[1] There is a non-trivial possibility that the move was based on developing the domestic Islamic banking industry and removing competition from the multinational banking companies that have entered Islamic banking to reach a new market.