AS a new industry develops, calls for regulation and transparency emerge in tandem. Islamic banking is evolving simultaneously with quite different legal and financial traditions in parts of the Muslim world and bankers say much work is left to be done to clarify the rules under which the industry operates.

Regulation is one complex issue. Banking authorities have to decide how exactly Islamic banks differ from conventional ones and what implications this has for the way they are regulated. This is an issue not only in Muslim countries, but also in parts of the Western world where the industry has a foothold.

Another grey area is product standards and establishing whether products are uniform and comparable. Some bankers say Islamic banks have already evolved a common understanding in many areas. A committee based in Bahrain is working out common accounting standards (see box, page 10). Other bankers believe that the growth of Islamic banking may be held back if potential investors feel unable to compare one institution or product with another.

A unique feature of Islamic banking is the Sharia committee. The industry came into being in the first place because some Muslim investors wanted an alternative to conventional banking, which did not breach specific religious injunctions and also adhered to Islamic ethics in a general sense. Seeing that an Islamic institution actually does this is the task of the Sharia committee, a board of scholars that vets all the bank's business and gives it either a nod or a shake of the head.

Wide differences

However, the Sharia by and large is not a simple legal code. There can be wide and legitimate differences of opinion between various schools of Islamic legal thought on whether a particular activity is acceptable or not. This can make for a lack of comparability between different Islamic banking products and services.

A degree of uniformity has already developed, nevertheless, and the process is likely to continue. 'Somewhere along the line people will start to agree even if it is only three-fifths of the people or four-fifths,' says Adil Ahmad, head of Islamic finance at ANZ International Merchant Bank in London. 'Islamic banking is only about 20 years old. It just hasn't had a long enough history.' If Islamic banking is to continue expanding at a healthy rate, it will have to do more to satisfy the needs of the regulatory authorities. 'Banks have to adapt some basic Islamic requirements to the requirements of the monetary agencies,' says Abdel-Hak Elkafsi of Arab Banking Corporation, a major Middle Eastern conventional bank.

In a recent conference speech, which was reproduced in the spring 1996 edition of the Arab Banker magazine, Bank of England Governor Eddie George spelt out some of the issues that make Western regulators uneasy about Islamic banking. The Bank of England already has a history in this area, having obliged Albaraka International Bank to surrender its banking licence in 1993.

George raises questions about three key areas - the role of Sharia boards, the problem of risk management in the absence of interest rates, and the appropriate levels of capital for Islamic banks.

'Individual boards of Sharia advisers apparently have equal authority, so that in some jurisdictions there is no definitive answer as to the status of an Islamic banking product,' George says. This makes it hard for customers and regulators to compare products and assess the risks of each. In addition, Sharia boards can have an executive role in practice because of their power to approve or reject business, and this makes it harder for a regulator to establish where responsibility rests within the management structure.

The ban on borrowing or lending at interest creates potential problems because interest is the conventional tool for pricing risk and managing liquidity. 'The absence of interest in Islamic banking places a greater burden on risk managers,' George notes. The relatively illiquid nature of Islamic banks' assets may mean they need to hold higher overall levels of liquidity, he says. Another issue, not cited in this speech, is that Islamic banks cannot post a guaranteed return on deposits because of the risk-sharing nature of Islamic investment.

The governor says the jury is still out on the question of whether Islamic banks need lower levels of capital than other banks because risk-sharing with depositors means they do not have to repay liabilities in full, or whether the unfamiliar nature of the business means they should actually have higher levels of capital.

On this last point, some regulators have already made their minds up. The Bahrain Monetary Authority, one of the Gulf's most respected central banks, has indicated that it would like to see Islamic banks in its jurisdiction increase their capital. Faysal Islamic Bank of Bahrain has said the BMA's attitude is one reason why it is raising its equity capital from $70 million to $100 million.

Within the Middle East, governments adopt a variety of attitudes towards Islamic banks. In Iran and Sudan, the whole banking system is officially interest-free. In Oman, the central bank does not issue licences to Islamic banks, while in Saudi Arabia the one domestic Islamic bank does not describe itself as such because it would highlight the fact that other Saudi banks use interest.

Government attitudes

The issue of government attitudes towards Islamic banks has important implications. The ambiguity means that Islamic banks do not have a lender of last resort, even if in practice a government might step in to stop a weak bank collapsing.

'There are probably considerable amounts of funds in the conventional sector, which could move over if it were perceived that Islamic institutions had a lender of last resort and were regulated in the same way as others,' says Stella Cox, head of the Islamic banking division at London-based merchant bank Kleinwort Benson.

Malaysia is often cited as an example of a country where the government has taken a top-down attitude towards the issue of regulating Islamic banking and created a coherent framework. Not that everyone is enamoured of the Malaysian example. 'With the Malaysian style, you get bureaucrats planning the growth of an industry. When they do that, they create obstacles rather than stimulate,' argues Adnan AlBahar, chief executive of The International Investor, the Kuwaiti Islamic investment company.

Al-Bahar expects a consensus to develop over standards as the industry grows in areas where there are no precedents in Islamic law, just as conventional banking has come to agreed standards for derivatives. 'You have to live with Islamic banking being another financial innovation. You innovate, you take risks - that's the nature of life, Islamic or nonIslamic.'