9 November 2009
The UK is globally recognised as the leading Western country for Islamic finance. However from time to time proponents of Islamic finance ask me why the UK does not allow Islamic banks to offer “true” profit and loss sharing investment accounts. This piece is a long answer to that short question.
The UK government has set out its strategic approach in the December 2008 document “The development of Islamic finance in the UK: the Government’s perspective” which can be downloaded from HM Treasury’s website. Paragraph 1.14 on page 12 states that “the UK Authorities’ support for Islamic finance is characterised by an approach of equal treatment for conventional and Islamic finance.” Despite devoting the whole of page 18 to regulation, the document adds little more to that. Accordingly, when writing this I set out to “reverse engineer” the regulatory principles that the UK has been following by looking at what it has done. The following key points emerged
I have previously noted that, strictly speaking, the UK does not have any special tax law for Islamic finance. Instead, it defines certain types of transactions or instruments such as “alternative finance investment bonds” (AFIBs) and specifies a tax treatment for them. The definition of an AFIB is such that most sukuk having the economic characteristics of debt should qualify as AFIBs. However, the tax definition is self contained and does not depend in any way on the Shariah status of the instrument.
The same approach of religious neutrality is followed when regulating companies offering Shariah compliant financial services. In the UK, Islamic banks are licensed as banks, and takaful operators are licensed as insurance companies. There is no special regulatory regime for Islamic banks or for takaful companies. This contrasts, for example, with Malaysia where takaful operators are licensed under the Takaful Act 1984 while other legislation governs Malaysian insurance companies.
Two consequences appear to flow from this approach.
The decisions taken regarding regulation imply a government view that all customers depositing money with UK licensed banks should be entitled to be repaid in full unless the bank becomes insolvent. This can be deduced from the fact that Islamic banks are not allowed to offer profit and loss sharing investment accounts. The nearest approximation they can offer is an account where the customer’s money is invested into a pool from which investment returns are paid. However, if losses arise in the pool, the bank is obligated (unless it is insolvent) to provide funds from its own resources to ensure that customers are repaid in full. Customers are given the right to elect, at that time, to take less than full repayment, and are also advised that if they elect to receive full repayment they will not be acting in accordance with Shariah.
This approach maintains equality of customer protection between Islamic banks and conventional banks, while allowing customers of Islamic banks to comply with Shariah principles if they so wish. In particular, it avoids the misselling risk that would otherwise arise if customers, when opening an account were allowed to irrevocably expose themselves to the risk of not being repaid in full. The misselling risk arises from the fact that in reality many customers would fail to appreciate the full economic impact to them of receiving less than full repayment, or may fail to properly evaluate how likely that risk might be to materialise.
That is why under the UK’s approach, the customer is only called upon to decide whether to accept less than full repayment when the circumstances have actually arisen, and is not asked to make a prospective election when the account is opened.
Islamic banks sometimes complain to me that Shariah compliant mortgages require a larger amount of capital to support them compared with conventional mortgages. However, where that arises, the reason will be a difference in the risks faced by the bank.
The customer documentation of one Shariah compliant house mortgage plan contains a table of key differences from a conventional mortgage, from which I have copied the following extract:
Shariah Compliant Finance
Interest based mortgage
Both the bank and the customer have different responsibilities towards maintaining the property
All maintenance responsibilities rest with the customer
The bank as a partner in the property will be subject to the risks associated with ownership of the property
The bank as lender will not have exposure to any ownership risks
If the leaflet is accurately describing the differences in risks, then in the case of the Shariah compliant mortgage the bank faces additional risks which a conventional lender does not face. If that is the case, a higher capital charge would appear to be warranted for its Islamic mortgages compared with conventional mortgages.
As explained above, Islamic banks are licensed as banks and takaful operators (Islamic “insurers”) are licensed as insurance companies. Nevertheless sometimes existing legislation cannot adequately cope with Islamic financial instruments.
A specific example is sukuk. For some time there has been doubt regarding whether sukuk might fall within the legal definition of a collective investment scheme. If they did, then the regulatory responsibilities of sukuk issuers would be significantly more onerous than the corresponding responsibilities of issuers of conventional debt.
To resolve this, secondary legislation is being introduced to define (for regulatory purposes) an investment called an alternative finance investment bond (AFIB). At the risk of causing confusion, the regulatory definition of an AFIB is similar to, but not identical with, the tax legislation definition of an AFIB. If an investment qualifies as an AFIB for regulatory purposes, then it will be classified for regulatory purposes as equivalent to debt and excluded from the definition of a collective investment scheme.
This is explained in a Treasury consultation document "Consultation on the legislative framework for the regulation of alternative finance investment bonds (sukuk)" issued in December 2008. It is also worth reading the Treasury's "Summary of responses."
Consistent with the religion neutral approach outlined above, the regulatory definition of an AFIB does not depend in any way on whether it is, or is not, Shariah compliant.
The UK’s approach to the regulation of Islamic finance works, in the sense that Islamic financial institutions are able to operate within it. It does have the drawback that certain products offered overseas cannot be offered in the UK, such as profit and loss sharing investment accounts. However this limitation is a small price to pay compared with the advantages of having a uniform regulatory regime that applies across the whole of the financial services sector, both conventional and Shariah compliant.