Western and Islamic bank compliance a two-way street

Western and Islamic bank compliance a two-way street

With the Islamic financial sector growing rapidly in recent years, Western banks and their Islamic counterparts must make legal and regulatory compliance a top priority.

As transnational trade realizes the benefits of an improving global economy and an unprecedented World Trade Organization deal, banks in Western and Islamic nations are looking to diversify their portfolios by exploring new partnerships with one another. Ensuring compliance between Western global banks and their Islamic counterparts has proven challenging, however, given the differences between Western regulatory principles and those based in Islamic law.

Islamic banks face high costs

Over the past 30 years, the Islamic financial sector has grown from almost nothing to over $1.6 trillion in assets. As these banks begin to work with partners in the West and around the globe, compliance teams face an increasing array of rules and regulations. The Bank of Sharjah, a United Arab Emirates-based Islamic bank with a market value of $1 billion, is spending millions of dollars on new compliance software and doubling the size of its compliance team to meet regulations.

Despite the recent moves by the Bank of Sharjah and other Islamic banks, executives at Western financial institutions still reject working with these banks, fearing their poor compliance systems will result in fines and lawsuits. “The truth of the matter is, on the ground, a lot of these institutions don’t have the basic infrastructures to be able to comply,” said Gordon Acha, head of financial institutions in Africa for Citigroup.

There are several key pieces of this basic infrastructure that have yet to be resolved. According to the Foreign Account Tax Compliance Act (FATCA), banks must disclose assets held by citizens of the United States overseas. Although this rule is specific to the United States, Chairman of the UAE Banks Federation Abulaziz Al-Ghurair estimates it would cost UAE banks “$27 million to get the right systems and infrastructure in place to deal with FATCA.”

Islamic banks may also have trouble complying with Western regulations that are not always universal. For instance, while the United States classifies Hezbollah as a terrorist organization, a status that comes with financial and economic sanctions, until July the European Union did not. With growing unrest and shifting governments in many countries throughout the Middle East and Africa, more differences like this are likely to arise in the future.

Failing to comply with the increasingly complex state of Western financial regulations is more costly than ever. Just last year, HSBC was fined close to $2 billion for “violating sanctions laws by doing business with Iran, Libya, Sudan, Burma, and Cuba.”

Western banks face new challenges

Just as Islamic banks work to comply with Western regulatory policies, Western banks face new challenges as they work to meet the expectations of their Islamic counterparts. Until recently, Islamic banks have invested their money largely in local channels, consisting mostly of real estate. But as these banks grow larger, they are looking to diversify, and Western financial institutions are keen to fill that void.

A key challenge for Western financial institutions has been to create financial instruments for Islamic investment that are compliant with Islamic law, Shariah. For example, American investment bankers are currently working to take rail cars bought by the freight company Continental Rail and package their leases into a security for sale to Islamic banks. If the rail cars transport pork, tobacco or alcohol, however, the deal would be deemed unacceptable, for Shariah prohibits Islamic investment in these three commodities.

Perhaps the most challenging aspect of Islamic law governing financial institutions is its ban on interest-paying loans and bonds. Under Shariah, money can only legally operate as a unit of measure, so Islamic banks cannot profit from conventional bonds, which act as debt instruments with interest payments made on top of a principal monetary investment.

In order to fill the void created by an essential ‘ban on bonds,’ Islamic financial institutions have begun to issue sukuk, which are asset-backed securities. Investors who purchase sukuk are rewarded with a share of the profits derived from the performance of the underlying asset. Since these profits are not technically interest, they do not violate Shariah.

The amount of sukuk sold each year has grown six-fold since 2006, to some $133 billion in 2012. Even with such sharp growth, potential demand for sukuk among Islamic banks in the Middle East and Southeast Asia still exceeds anticipated supply, according to a study by Thomson Reuters. This gap is projected to shrink over the coming years, with everyone from Dow Jones to British Prime Minister David Cameron planning to sell the Islamic notes.

Malaysian issuers currently dominate the sukuk market; they issued $54 billion of sukuk in the first nine months of 2013, followed by Saudi Arabia, with $9 billion, and the UAE, with $5 billion. As more Islamic banks throughout the Middle East, Africa and Southeast Asia seek to diversify and expand their global portfolios, Western banks, companies and governments will likely continue to create instruments that comply with Islamic law.

Whether or not full compliance (and the associated penalties) will be achieved on either end, however, is left to be seen.

Categories: Finance, International

About Author

Rami Ayyub

Rami is an analyst with a US Defense and Space firm, where he works in strategic planning and finance for Civil and Defense programs. He holds Bachelor degrees in Finance and Classical Music from the University of Maryland, College Park.