BAHRAIN

Bahrain Monetary Agency Issues New Islamic Banking Regulations

The Bahrain Monetary Agency (BMA), the country’s central bank, announced on 12 January that it had issued new regulations for Islamic banks, under the title ‘Prudential Information & Regulatory Framework For Islamic Banks’ (PIRI). The regulations (which can be accessed on bma.gov.bh) follow guidelines from the Bahrain based Accounting & Auditing Organization for Islamic & Financial Institutions (AAOIFI) and the Basle Committee on Banking Supervision and were formed in conjunction with accounting firm Ernst & Young following consultations with many of the country’s banks, said a BMA source. The regulations, which took around two years to put together, formalize changes that have been evolving in Bahrain’s banking industry over the last 10 years, he noted. Given that Bahrain has typically promoted itself as the center of Islamic finance, with the BMA particularly active in encouraging the development of Islamic commercial paper alternatives for major projects (MEES, 11 June 2001) it is therefore not surprising that Bahrain is the first country to publish such regulations.

Professor Rifaat 'Abd al-karim, Secretary-General of AAOIFI, told MEES that the new regulations are a positive step for Bahrain’s banking industry. The regulations will give the Bahrain banks a competitive edge in the Islamic banking industry, he noted, pointing out that they comply with international standards and are comprehensive, taking into account both the investment and commercial banking aspects of Islamic banking. He expects other countries to adopt similar regulations if they were to “enhance their competitive advantage of attracting Islamic banks.” While the regulations provide a new framework for some already existing practices, the key difference, notes Professor 'Abd al-Karim, is that Bahrain’s Islamic banks now have to comply with AAOIFI’s standards on capital adequacy and follow AAOIFI’s Shari'a standards as well as AAOIFI’s governance standards. The change will enhance transparency and narrow the disparities between the previously different rulings emanating from each banks in house Shari'a committee. Professor 'Abd al-Karim expects AAOIFI’s standards to be adopted outside Bahrain, noting that such standards are needed for cross-border transactions.

The BMA regulations are considered a step ahead of the Islamic Financial Services Board (IFSB), the body that will be established to issue prudential and supervisory standards for the Islamic banking and finance industry. Representatives of central banks (Bahrain, Malaysia, Sudan, Jordan, Indonesia, Kuwait, Iran and Saudi Arabia) and the IMF, IDB and AAOIFI met earlier in January at the IMF offices in Paris to agree on a draft agreement for the establishment of the IFSB which will be located in Malaysia.

The BMA notes that with Bahrain at the heart of the growing Islamic banking industry, it has a “responsibility to ensure that the Islamic banks are regulated and supervised so as to maintain and enhance the confidence of the participants in the financial services industry and investors towards Islamic banks.” The objective of the regulations (which cover six main areas, including capital adequacy, asset quality, management of investment accounts, earnings quality, liquidity and corporate governance) is not simply to provide a regulatory framework, but to also access information (from the returns that banks have to fill out) that can be used to monitor banks’ operations and identify any sign of deterioration in their performance, the BMA noted. The returns for each section must be submitted to the agency by the 20^th day after the end of each quarter and all Islamic banks operating in Bahrain must comply with the regulations. Prior to the regulations, banks were unofficially asked to use Basle guidelines, although they do not cover the off-balance profit-sharing agreements which are used in Islamic banking instead of interest, which is prohibited by Islamic law, noted the BMA source.

The BMA has set capital adequacy at a figure of 12%, which is derived from the capital adequacy formula stipulated by Basle and AAOIFI. To cater for fiduciary risk and displaced commercial risk, the BMA has accepted AAOIFI recommendations and requires 50% of the risk-weighted assets of the profit-sharing investment accounts to be included in the denominator of the capital adequacy ratio. The essential elements for computing the capital adequacy ratio for Islamic banks are tier capital, credit risk, market risk and risk weighted total assets less 50% of profit-sharing investment accounts. BMA notes that as the numerator of the capital adequacy ratio, tier capital is the cornerstone of a bank’s strength and should represent a permanent and unrestricted commitment of funds, be freely available to absorb losses and thereby enable a bank to keep operating whilst any problems are resolved and not impose any unavoidable charge on the earnings.

BMA notes that certain risks are associated with profit and loss sharing, which is the basis by which Islamic banks mobilize funds, and to cater for them, it has adopted AAOIFI regulations and requires the inclusion of 50% of the risk weighted assets of the profit-sharing investment accounts in the denominator of the capital adequacy ratio. The agency has adopted the risk weightings recommended by Basle, and has separately addressed the issue of risk weightings for some of the commonly used Islamic contracts, including Murabaha (resale contract for short term credit), Mudaraba (equity sharing between bank and client), Musharaka (profit-sharing partnership between bank and client), Ijarah (leasing contract)/Ijarah Muntahia Bittamleek (leasing ending up with the transfer of ownership) assets, Istisna (manufacturing contract) and parallel Istisna contracts, and Salam (forward sale where bank advances money and client delivers goods later on) and parallel Salam. However, if banks are involved in contracts not covered, they need to contract the BMA to agree on an appropriate risk weighting category. Where banks have investments in associated companies or subsidiaries, they must compute capital adequacy on a consolidated basis. Establishing a subsidiary or associate needs prior approval of the BMA.

A bank doing negligible business in foreign currencies and one which does not take foreign exchange positions for its own account, may, at the discretion of the agency, be exempted from calculating the capital adequacy for these positions. For this to apply, the bank’s holdings or positions taken in foreign currencies, including gold (defined as the greater of the sum of the gross asset positions and the sum of the gross liability position in all foreign positions and gold) must not exceed 100% of its eligible capital and the bank’s net overall open position must not exceed 2% of its eligible capital.

BMA notes that it is important for Islamic banks to maintain sound quality assets and the agency must be notified where exposure to a counterparty will be equal to or exceed 10% of the eligible capital base. Where the exposure will exceed 15%, prior approval of the agency to accept the exposure is required.

For management of investment accounts, banks need to ensure that there are adequate policies in place that safeguard the interests of not only the shareholders of the bank but also those of profit sharing investment account holders. The BMA says that financial accounting standard No.11 issued by AAOIFI covers the provisions and reserves measurement and disclosure for Islamic banks and notes that in accordance with this, bank returns require full disclosure of profit equalization and investment risk reserve. Banks must agree with the BMA on their public policy statements which refer to safeguarding the interest of profit sharing investment account holders. They are not permitted to transfer funds between restricted investment accounts and corporate books (carrying self-financed assets and those financed by unrestricted investment accounts) without the BMA’s prior approval.

In order to determine earnings quality, the BMA requires disclosure of earnings based on amounts received with a breakdown of the aging of the amounts receivable, with additional breakdowns of earnings from the bank’s 10 largest customers, related parties and geographical segments. This information is to assist the BMA in assessing the soundness of the bank through monitoring the trend of its earnings quality.

BMA notes that monitoring and controlling liquidity is one of the most critical responsibilities of a bank’s management, pointing out that it is of even greater importance in Islamic banks due to the interpretation of some Fuquha (Shari'a scholars) that Mudaraba contracts (equity sharing between bank and client) are non-binding in terms of maturity, implying that investment account holders can withdraw their funds at any time. The BMA stipulates that banks must monitor their equity mismatch position for both corporate books (carrying self-financed assets and those financed by unrestricted investment accounts) and restricted investment account holders. It has laid down criteria for reporting inflows and outflows from 0-6 months on a cash basis and from 6 months to 5 years on maturity basis. The agency has set mismatch limits for the unrestricted investment accounts of 15% for the 0-8 day time band and 25% for the 8 days to 1 month band. However, on a consolidated basis for both corporate books (carrying self-financed assets and those financed by unrestricted account holders) and restricted investment accounts, the BMA has set a ceiling of 15% for the 0-8 days time band and 25% for the 8-days-1 month time band.

On corporate governance the BMA said that in addition to compliance with all AAOIFI issued accounting standards and pronouncements issued by AAOIFI’s Shari'a board, banks are also required to submit a statement of strategy and objectives for a minimum period of 3 years, outline their organizational structure, and note responsibilities of key management personnel. New recruitment of key management will require prior approval of the BMA and needs to be reported immediately. The bank must also have an independent Shari'a supervision committee complying with the AAOIFI’s governance standard for Islamic institutions and an audit committee which must be comprised solely of non-executive directors.