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UK bank levy and the nature of Islamic banks' liabilities

I explain why profit sharing investment accounts are liabilities of Islamic banks, after looking at the application of the UK's bank levy.

Summary

Posted 4 April 2019

I receive many interesting questions from readers. The one below led to my March 2019 column in the magazine "Islamic Finance News."

A liability by any other name is still a liability

Because my website makes me easy to contact, I receive interesting questions from time to time.

A reader recently asked me whether the UK’s bank levy provisions would discriminate against Islamic banks. He explained that under the UK’s Finance Act 2011, “The bank levy is charged on certain types of equity and liabilities of certain groups of entities and individual entities.

Underlying his question was possible uncertainty regarding the nature of some of the transactions Islamic banks enter into.

Since the UK’s bank levy only applies where equity and liabilities total more than £20 billion, at present the question is academic, since all UK Islamic banks are much smaller than that size.

While some questions can be difficult, in this case there is a clear answer. When preparing the text of FA 2011, the Parliamentary draughtsman thought about Islamic finance. In the detailed bank levy provisions, FA 2011 schedule 19 paragraph 13(4) contains a definition of lending activities, one of which is “provision of alternative finance arrangements” (which is the UK’s legal terminology for Islamic finance provision.)

More generally, the bank levy legislation in FA 2011 schedule 10 para 14(1) provides that “For the purposes of this Schedule, “assets”, “equity” and “liabilities” have the same meaning as they have for the purposes of international accounting standards.

From time to time, one encounters the argument that when an Islamic bank takes in customers’ money in the form of profit and loss sharing investment accounts, such accounts should not appear on the bank’s balance sheet as liabilities, and the corresponding assets financed using that money should not appear on the bank’s balance sheet as assets.

While local country accounting rules sometimes permit very peculiar treatments, the position under International Financial Reporting Standards is pretty clear.

Where the money received from customers is commingled with other money from the bank, including money from other kinds of customers, such profit and loss sharing investment accounts are in practice (looking at substance over form) liabilities of the Islamic bank and should be presented as such on the bank’s balance sheet. Similarly, the assets financed with the money received from customers should be shown as assets.

The point is further strengthened by the way Islamic banks operate such accounts in practice. The profit and loss sharing customers typically receive a profit share which is comparable to market interest rates, with any excess returns from the financed assets being retained by the bank. Furthermore, banks often operate profit and loss equalisation reserves, to smooth out the returns earned by profit and loss sharing customers.

Banks bend over backwards to avoid customers suffering losses, and sometime supplement the returns to customers from the bank’s own resources. All of these features are indicators of profit and loss sharing investment accounts being liabilities.

It is of course possible for banks to hold customers’ money in entirely different ways. For example, conventional (and Islamic) banks often manage equity investment portfolios, either for individual clients, or on a pooled basis whereby the bank is the trustee of a collective investment scheme. In such circumstances, with total segregation between the bank and the customers’ assets, and 100% of the positive or negative investment returns accruing to the customers, nothing appears on the bank’s balance sheet.

However, the more one compares such different arrangements, the clearer it becomes that normal profit and loss sharing investment accounts are nothing like that, and are instead liabilities of the bank.

 

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