Profit-sharing investment accounts in Islamic banks: Regulatory problems and possible solutions

Original Article Profit-sharing investment accounts in Islamic banks: Regulatory problems and possible solutions Simon Archer is Visiting Professor at the ICMA Centre, Henley Business School, University of Reading (UK). Previously he was Professor of Financial Management at the University of Surrey (UK), having been Midland Bank Professor of Financial Sector Accounting at the University of Wales (Bangor). After studying Philosophy, Politics and Economics at Oxford University, he qualified as a chartered accountant with Arthur Andersen (London) and then moved to Price Waterhouse (Paris), where he became a partner in Management Consultancy Services. Professor Archer has written and contributed to a number of publications and academic articles on international accounting, as well as corporate governance and related issues in Islamic financial institutions. He has also been involved in Islamic finance-related consultancy projects. Rifaat Ahmed Abdel Karim has been the Secretary General of the Islamic Financial Services Board since 2002. Before this, he was the Secretary General of the Accounting and Auditing Organisation for Islamic Financial Institutions, a post he held for over 8 years. He was a member of the Standards Advisory Council of the International Accounting Standards Board, and is currently a member of the Consultative Advisory Group of the International Auditing and Assurance Standards Board. Professor Rifaat was Visiting Professor at the University of Surrey (UK) and Honorary Professor at Monash University (Australia). He is currently Visiting Professor at the ICMA Centre, Henley Business School, University of Reading (UK). Correspondence: Simon Archer, ICMA Centre, Henley Business School, University of Reading, Whiteknights, Reading, RG6 6BA, UK ABSTRACT As interest-bearing deposits are not permitted by the rules and principles of the Islamic Shari’ah, Islamic banks typically raise deposits in the form of profit-sharing investment accounts. These accounts differ from conventional deposits not merely by virtue of the profit-sharing nature of the returns they offer, but also because the contact between the depositors and the bank is not a debt contract, and the deposits are in consequence not ‘capital certain’ (that is, the depositors are required to accept negative returns or losses). This latter characteristic leads to serious regulatory problems in jurisdictions where bank deposits are required by legal definition to be ‘capital certain’. More generally, the presence of such ‘puttable instruments’ in the capital structure of Islamic banks leads to complications in assessing their capital adequacy. In addition, the fact that the profit-sharing investment account holders are a type of equity investor without the governance rights of either creditors or shareholders raises a major problem of supervision. This article explains these problems in further detail, and proposes a solution in the form of a structural distinction between the Islamic bank in the narrow sense on the one hand, and the entity that manages the profit-sharing investment accounts on the other hand. Journal of Banking Regulation (2009) 10, 300–306. doi:10.1057/jbr.2009.9 Keywords: Islamic finance; profit-sharing investment accounts; regulation; supervision; capital adequacy; corporate governance r 2009 Palgrave Macmillan 1745-6452 Journal of Banking Regulation www.palgrave-journals.com/jbr/ Vol. 10, 4, 300–306 PSIAs in Islamic banks INTRODUCTION The aim of this article is to examine the regulatory and supervisory problems arising from the use of profit-sharing investment accounts (PSIAs) by Islamic banks, and to suggest a solution to the main regulatory problem, which will also greatly reduce other problems, including those of supervision. The section ‘The nature of PSIAs’ of this article provides an analysis of the nature of PSIAs, their contractual basis and its implications for profit and loss as regards the bank and its customers holding PSIAs. The main regulatory problem and the related problems of supervision to which these give rise are then examined in the ‘The main regulatory problem and other related problems’ section. A possible solution to the main regulatory problem, which may also mitigate the supervisory problems, is described in the ‘A possible solution’ section, and the final section sets out some concluding remarks. THE NATURE OF PSIAs The contractual basis of PSIAs and their implications for profit and loss sharing One of the key differences between Islamic and conventional banks is that the former do not offer interest-bearing deposit accounts, as payment or receipt of interest are forbidden by the Shari’ah. Instead, Islamic banks offer profit-sharing and loss-bearing investment accounts, usually based on a Mudarabah partnership contract between the bank and the customer; alternatively, a Wakalah agency contract may be used as the basis. A Mudarabah partnership is a ‘partnership between work and capital’, in which one partner, the mudarib, provides the work in the venture, while the other partner, the rabb al mal, provides the capital as a ‘sleeping partner’. The partners share profits according to an agreed ratio, but subject to the exception noted below the rabb al mal bears any losses r 2009 Palgrave Macmillan 1745-6452 (the mudarib having no capital in the partnership to absorb losses). The share of profits received by the mudarib (the mudarib share) is that partner’s remuneration for managing the funds invested by the rabb al mal. It is also possible for the partner that is the mudarib to invest in the venture as a capitalproviding partner or Musharik (in which case the venture is a Musharakah partnership), and that partner will receive the profits and bear any losses proportionately to its share of the total capital in the venture, as well as being entitled to the agreed mudarib share of the profits on the rabb al mal’s share of the capital. Such an arrangement is known as a bilateral Mudarabah or Mudarabah-Musharakah. Note that (again subject to the exception noted below) the mudarib does not share in any losses on the rabb al mal’s share of the capital. Not merely would this be inconsistent with the contractual logic of a Mudarabah-Musharakah, but it is expressly forbidden by the Shari’ah for the mudarib as such to bear losses attributable to the rabb al mal. The mudarib may, however, waive part or all of its mudarib share in order to improve the return to the rabb al mal. As musharik, it may also donate part or all of the profit on its share of the total capital in the venture to the other partner. It cannot ‘donate’ to cover a loss of the other partner, for in case of such a loss it too would be faced with a loss on its own share of the venture. If the bank accepts PSIAs on the basis of a Wakalah contract, according to which it acts as wakeel or agent, it receives a management fee for managing the customer’s funds. Again (subject to the exception note (...truncated)