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Promotion of Islamic Finance in current scenarios

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Muhammad Arif : Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), Former Head of FSCD SBP, Former Head of Research ArifHabib Investments and Member IFSB Task Force for development of Islamic Money Market, Former Member of Access to Justice Fund Supreme Court of Pakistan

Islamic finance has the potential for further contributions in at least three dimensions.

First, it promises to foster greater financial inclusion, especially of large underserved Muslim populations.

Second, its emphasis on asset-backed financing and risk-sharing feature means that it could provide support for small and medium–sized enterprises (SME), as well as investment in public infrastructure.

Finally, its risk-sharing features and prohibition of speculation suggest that Islamic finance may, in principle, pose less systemic risk than conventional finance. For this potential to be realized, however, and to allow this industry to develop in a safe and sound manner, a number of challenges will need to be addressed. Islamic banking Specific standards have been developed by specialized standard-setting bodies, but regulatory and supervisory frameworks in many jurisdictions do not yet cater to the unique risks of the industry. Partly as a consequence, the practice of Islamic banking (IB) has, in some jurisdictions, resulted in complex financial products and corporate structures.

Moreover, crossborder operations have expanded without regulatory harmonization. These developments indicate a need for increased regulatory clarity and harmonization, closer cooperation between Islamic and conventional financial standard-setters, and further enhancement of tools for effective supervision. An important regulatory challenge is to ensure that profit-sharing investment accounts (PSIA) at Islamic banks are treated in a manner that is consistent with financial stability.

 Many regulators treat these as deposits, which undermines their loss and liquidity absorbency feature. When regulators do allow for some loss-absorbency, they do not always pay sufficient attention to the implications for corporate governance and consumer protection. Regulation and supervision should ensure that PSIAs are not treated as pure deposits, while also ensuring better disclosure and enforcement of the investors’ rights, including those related to payouts and reserves.

Regulators do not always have the capacity (or willingness) to ensure Shari’ah compliance, which undermines consistency of approaches within and across borders. Greater harmonization should be sought across and within countries, including through better implementation of existing standards for Shari’ah governance and possibly by establishing central boards at the national level.

Although Islamic banks appear well-capitalized, there will be challenges with the implementation of the Basel III Accord. For example, further clarification will be needed from national regulators regarding the instruments that are eligible for treatment as additional Tier 1 and Tier 2 capital. Also, the scarcity of Shari’ah-compliant high-quality liquid assets (HQLA) makes it difficult for Islamic banks to satisfy the Basel III liquidity coverage ratio (LCR) requirement.

Therefore, it is important that national authorities use the leeway given by Basel standards to grant highly rated and tradable Sukuk HQLA status, and take steps to deepen local Sukuk and money markets. Safety nets and resolution frameworks remain underdeveloped. Very few countries with IB have a full-fledged Islamic deposit insurance scheme with premiums invested in Shari’ah-compliant ISLAMIC assets.

Moreover, only a small number of countries have developed a Shari’ah-compliant lender-oflast-resort facility. Developing such facilities, together with Shari’ah-consistent resolution frameworks, will be essential as Islamic banks grow in systemic importance.

 Notwithstanding its potential, IB appears to have had a limited impact so far on access to finance. To help unlock this potential, it will be important to reduce the tax and regulatory impediments to Islamic bank financing, as well as to enhance the financial infrastructure.

Sukuk are seen as well-suited for infrastructure financing because of their risk-sharing property could also help fill financing gaps. The supply of Sukuk, however, falls short of demand and, except in a few jurisdictions; issuance takes place without a comprehensive strategy to develop the domestic market.

National authorities should, therefore, focus on developing the necessary infrastructure, including promoting true securitization and enhanced clarity over investors’ rights, and on stepping up regular sovereign issuance to provide a benchmark for the private sector. Increased sovereign issuance should be underpinned by sound public financial management.

Monetary policy formulation and implementation are challenging in the presence of Islamic finance because of the scarcity of Shari’ah-compliant monetary policy instruments and a lack of understanding of the monetary transmission mechanism. In addition to weakening the transmission channel for monetary policy, the scarcity of instruments also forces Islamic banks to hold higher unremunerated reserves, affecting their ability to compete with conventional banks.

Therefore, it is important to further deepen Sukuk markets and develop Shari’ah-compliant monetary policy instruments. Macro prudential policies will need to play a more important role because systemic risks can result from the mix of deposits and investments on the liability side, as well as the greater concentration of assets in cyclically sensitive sectors. Thus, efforts are required to develop crosssectoral supervision, explore the use of macro prudential tools to contain concentration risks, close data gaps, and develop the capacity to assess systemic risks. Islamic finance raises a number of taxation issues. These include tax incentives for debt over equity, the tax treatment of sales and additional layers of transactions in some instruments. Moreover, differences in the treatment of Islamic and conventional finance, if unchecked, can create cross-border spillovers and encourage international tax arbitrage. Tax systems should base treatment on economic substance and move away from distortionary transaction taxes toward more neutral profit-based taxes. International standards for accounting and auditing of Islamic finance should be further developed, and regional and global tax cooperation strengthened.

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