The Dutch central bank and regulator AFM have published a joint analysis of UK Islamic finance.
The reason for the study is the strong rise of Islamic financial products and services in the UK. Within a few years a broad range of financial products and services has been introduced for the professional and private market.
The UK has adapted legislation to create a level playing field with conventional financial products and services and from a consumer protection perspective.
Anticipating possible developments in the Netherlands, the Dutch central bank and the AFM have carried out a joint study.
The offer of Islamic financial products and services has surged worldwide. In the UK the niche market for Islamic financial products and services is considered important for the position of London as a global financial centre.
In other European countries a centre of activities is yet to form and the range of products is largely limited to the professional market and wealthy individuals.
In the Netherlands the market is also in development. The first retail investment products have been launched and various financial institutions have shown interest in the retail market.
The Dutch report aims to improve knowledge of the Islamic finance sector and investigates whether the existing regulatory framework is fit for purpose.
With respect to improved knowledge, the study concludes that suppliers, consultants and consumers have only limited knowledge of Islamic finance at the moment.
The report warns that this poses a potentially heightened risk of miss-selling of financial products and services, which in turn may lead to reputational damage and legal action.
Islamic financial products meet the same economic needs as conventional ones, but generally have a different format.
There are many different Islamic types of contract for these products, which are moreover often of a complex legal nature. This brings with it specific risks, which require all parties to have ample understanding of the matters at hand.
With respect to the adequacy of the regulatory framework the study concludes that the most frequently used types of contract – for Islamic mortgages – are outside the regulator’s peripheral vision.
This is caused by the limited scope of the definition of credit in the Dutch law on financial market regulation. The criteria for a duty of care, however, are open to a much wider definition in this legislation.
As a result, the report concludes that they can probably also be applied to Islamic financial products and services. A similar problem arises in respect of other regulatory aspects. Not every Islamic financing contract qualifies as a loan.
The report notes that there is at present little transparency in respect of the compulsory alms (“zakat”) and halal elements of Islamic finance products such as Takaful (Islamic insurance), muamalat (Islamic banking transactions) and Sukuk (Islamic securities).
The regulatory emphasis is on the co-mingling of funds, the checks and balances in the verification of financial products by Sharia (“Shari’ah”) scholars and compliance with Sharia law in general.
There are also marked differences with conventional banks when it comes to the specific risk profile of Islamic banks. The credit, operational, liquidity and financial risk profile differ. In addition, displaced commercial risk is a typical element in Islamic banking.
By contrast, Islamic banks do not carry interest liabilities, which limits the risk in comparison with conventional banks.
As a result, not every institution qualifies as a ‘ bank’ under the terms of the law and, therefore, does not qualify for a banking license.
When an institution does fall under the legal definition of a ‘bank’, however, the report concludes that the existing regulatory framework of Basel II offers sufficient flexibility to address issues in respect of corporate governance and liquidity.
Definitions may need to be reconsidered
To what extent legislation may need to be adapted in future depends in part on the range of products and associated types of contract that may appear on the market, according to the report.
In particular, the report notes that definitions of common terminology such as “interest” may need to be reconsidered.
The study suggests that financial service providers may need to be better educated on Islamic finance products and services in order to achieve the objective of a true level playing field with conventional financial products and services in respect of legal consumer protection.
The analysis is currently only available in Dutch, although an English translation will be made available by the Dutch central bank in due course.