Qatar Central Bank (QCB) sent out a circular on 1 February 2011 asking conventional banks to stop taking deposits through their Islamic branches and close them down by the end of the year. The decision came as a surprise to many in the industry and stands to reshape the country’s banking sector.

The central bank decision on conventional banks’ Islamic units is going to be an opportunity for us

Ahmad Meshari, Qatar Islamic Bank

The circular was the third in a series of central bank notices introducing more regulation to limit the activities of conventional banks selling Islamic banking products. First, QCB said banks should set up separate branches for Islamic products, rather than selling them through the premises of their conventional banks in ‘Islamic windows’.

That forced banks to invest in new buildings and real estate to build branches purely for customers looking for sharia-compliant banking services.

Prior notices of new banking regulations

Later, in August 2010, the central bank put limits on how much lending conventional banks could do through their Islamic arms. It also told conventional banks that applications for new Islamic branches would not be accepted. Most banks still saw good opportunities for growing their Islamic business as the limits were based on sharia assets not being able to exceed 15 per cent of total assets. As long as the bank’s total assets were growing, the Islamic arm would still be able to grow, albeit at a slower pace.

Senior bankers in Qatar say the August 2010 circular came as no surprise and the central bank had let some figures within the banking industry know the ruling was coming. That meant 2011 budget forecasts were able to be based on putting it into effect.

The February 2011 circular was different, however. No one was expecting it, even within Qatar’s largest bank, the government-owned Qatar National Bank (QNB). As such, its impact will be much more dramatic. “The loss of the Islamic banking franchise is credit negative for Qatari conventional banks, which derive 10-15  per cent of their yearly earnings from sharia-compliant banking,” ratings agency Moody’s Investors Service said in a statement.

Among the local banks, QNB will be the hardest hit by the new legislation. It has a 39 per cent share of the overall banking sector and a 20 per cent share of the Islamic banking market.

“We knew that the central bank was going to limit Islamic lending,” says a banking executive in Doha. “We had got used to that idea, but then they ordered us to close down our Islamic branches altogether. That took us completely by surprise and seems to have been done without any consultation with the industry, or even too much thought about how we would implement it.”

Lacking details

Despite the ruling being more than a month old, further clarity has yet to emerge on how banks should go about implementing the changes. A frantic lobbying effort has started, with bankers, their lawyers and advisers desperate to get the central bank to change its mind. But there is no sign of that happening.

The segregation of the Islamic business … will provide room for growth for the Islamic banks

Elena Panayiotou, Moody’s Investors Service

That negotiations are still ongoing with the central bank is emphasised by just how few people are willing to discuss the new directive. “The central bank has been desperately trying to justify its actions,” says a Doha-based source. “It had no idea of the level of scrutiny it would come under as a result of this and has been sending out several new documents explaining why it is best to create a completely separate set of Islamic banks and conventional banks.”

On 10 February, the central bank issued a press release – its first public statement on the issue – which listed several reasons for preventing conventional banks from taking Islamic deposits. Among these were the complexities of regulating banks with both Islamic and conventional assets and deposits, and the difficulty of producing financial reports for banks that have to satisfy different accounting standards.

The pending introduction of Basel 3 regulations, along with rules by the Islamic Financial Services Board, would further complicate the problem, the statement added. The central bank said “it is difficult for conventional banks that have Islamic branches to combine these two types of instruction in one financial position”.

Islamic finance experts say that in the long term, Qatar’s Islamic banking sector will emerge stronger because of the new regulations.

“Islamic finance in Qatar will ultimately improve as a result of the segregation of Islamic and conventional banks,” says Amjad Hussein, partner at local law firm Eversheds. “The central bank has made this decision after considering issues of risk and lessons learnt from the financial crisis. [It] wants to produce a strong platform for Islamic banking in Qatar.”

Islamic finance is based on the principle of profit and loss sharing, so both parties put capital at risk. It restricts investable assets and does not include interest. That creates difficulties for banks selling both Islamic and conventional products as sharia scholars are concerned that the money essentially goes into the same place. The mingling of deposits negates any sharia-compliance in the way capital is deposited or withdrawn.

In the short term, however, no one is sure how banks will be expected to comply with the new regulations. Sources close to the central bank say it is considering creating an Islamic ‘superbank’, in which all the conventional banks would put their assets, while they wind down their operations. Other options include forcing banks to spin off their local Islamic arms or sell them to purely Islamic lenders. The central bank could issue Islamic banking licences to conventional banks, which would force them to operate their Islamic arms as an independent subsidiary, but there is currently no sign that it will do this.

Asset sales in Qatar

Local Islamic banks are expecting to benefit from the change. The assumption is the central bank’s ruling was in some way a sop to them, as conventional banks, such as QNB, had built up significant market share. Shares in local Islamic banks rose in the wake of the central bank’s circular. Qatar Islamic Bank (QIB), the largest purely sharia bank in the country, has said it would consider buying the Islamic assets of conventional banks.

“The central bank decision on conventional banks’ Islamic units is going to be an opportunity for us,” Ahmad Meshari, QIB’s chief executive said at the MEED 2011 Qatar Projects conference held in mid-February.

A banking adviser in Doha says the heads of Islamic banks in Doha are “very pleased” with the central bank’s decision.

“While we do not expect major changes in the Qatari banking landscape, the segregation of the Islamic business from the conventional banks will provide room for growth for the Islamic banks, which operate in a highly competitive market,” says Elena Panayiotou, Qatar banking analyst at Moody’s.

Bankers in Doha also say the decision was to some extent influenced by the desire to strengthen Islamic banks in preparation for the financing requirements for developing the infrastructure for the 2022 World Cup.

Over the next few months, the situation threatens to become more chaotic. Conventional banks will not let go of their Islamic businesses without a fight. Customers, meanwhile, may find out just how much conventional banks had been subsiding their Islamic arms to make them more attractive.

There is also the broader danger that the unexpected move by the central bank will put off some investors, leaving them worried about further last minute changes in the rules. Despite the lobbying by both local and international banks operating Islamic arms in Qatar, the message the central bank is sending is that the new regulations are here to stay. At best, it seems the conventional banks may be granted an extension to the period during which they have to wind down their Islamic operations.

Long-term benefit for Islamic finance sector

Ultimately, the Islamic finance sector in Qatar should emerge stronger because of the central bank’s actions. Now, a smaller number of banks are able to focus on the sector and invest for its long-term development, creating truly Islamic products, rather than just products that do the same as conventional banks, but in a sharia-compliant manner.

Whether the ruling really does end up strengthening Islamic finance will take a long time to discover. Either way, the conventional banks will not be sharing the risk of developing Qatar’s Islamic finance market anymore.