Transformation processes

2.1.1 Transformation processes

A variety of approaches have been adopted in different jurisdictions to authorize Islamic financial services. Among these are two somewhat distinct approaches:

i) a policy framework approach that requires legal reforms and distinct licensing initiatives; and

ii) a market-driven financial engineering approach that encourages the development of Shari’ah-compliant products and services within the existing legal and licensing regimes.

In the GCC region and in South Asia, which are home to more than 50% of the total Islamic banking industry, as well as in other countries, based on a policy framework approach, the most dominant and dynamic strategy has been to allow a dual banking system, whereby Islamic banking co-exists alongside conventional banking. In this framework, Islamic banking services are offered through three types of governance structures:

i) full-fledged Islamic banks, either newly licensed or converted from conventional banks: Major progress is being achieved in a number of jurisdictions in transforming conventional institutions into Shari’ah- compliant institutions;

ii) Islamic banking windows of conventional banks;

iii) Islamic banking subsidiaries of conventional banks either newly established or converted from existing Islamic windows. For Islamic banking windows and subsidiaries, the overriding regulatory concern has been the prevention of any mixing of Shari’ah-compliant and non- compliant income that could create confidence issues, leading to fund withdrawals. Hence, such windows and subsidiaries have to comply with firewall requirements, including separate capital for the two types of banking services in some countries.

On the other hand, Iran and Sudan, where the public sector has a large share in the banking system, have adopted the strategy of complete conversion of their banking systems into totally Shari’ah-compliant ones, leaving no place for conventional banking. Pakistan was initially in this group of countries but later adopted the dual banking strategy. However, in the near future, conventional banking will also be permitted in the semi-autonomous Southern Sudan.

With respect to the financial engineering approach, an increasing number of conventional financial institutions worldwide are confident that in the medium term, if allowed by regulators, most banks will be able to offer Shari’ah-compliant services alongside their conventional banking activities. The regulatory response has been positive. In an increasing number of jurisdictions, the regulatory authorities have approved contracts such as murabahah and ijarah, which banks in their jurisdictions may use to offer financing to their clients. However, such an offering of asset-side products falls short of the definition for a “full Islamic window” operation, which also mobilizes funds in a Shari’ah-compliant manner.

There are therefore two different forms of the financial engineering approach. One form of the approach does not allow full Islamic window operations as described above. Instead, it encourages Shari’ah-compliant investment opportunities to be offered in the form of mutual funds. The other form of this

approach permits full Islamic window operations as well as full-fledged IIFS, provided they are able to comply with existing banking regulations, although tax rules may be amended to avoid the double taxation of Shari’ah-compliant financing transactions based on murabahah or ijarah contracts. However, in either case, Shari’ah compliance is considered to be a matter of market discipline rather than a regulatory issue. At most, supervisory authorities will be concerned with the issue of whether the institution or Islamic window has in place an appropriate internal Shari’ah compliance system. In contrast, in the policy approach, Shari’ah compliance is usually considered to be a regulatory issue.