KUALA LUMPUR, (Reuters) – Islamic financial markets heaved a sigh of relief after dodging the securitisation crisis which hit traditional banks, but the fallout may spark a global regulatory overhaul that could stifle the $1 trillion industry.
As Western governments and regulators look to tighten supervision of banks in the wake of the worst financial crisis in decades, reforms could be launched which may also discourage the use of Islamic finance instruments and check the sector’s growth.
Stricter policing of conventional securitisation markets, in particular, could trigger changes for the Islamic banking sector, which relies heavily on asset sales for funding structures.
“They may implement a number of sweeping rules or regulations that are actually negative for Islamic banking without thinking of it,” said Abdulkader Thomas, chief executive of Kuwait-based sharia advisory firm Shape Financial.
“We’re expecting things that will radically affect the asset-backed markets and the use of special purpose vehicles.”
The U.S. government recently announced a revamp of its financial regulatory system, including proposals for tougher laws for issuers of asset-backed securities.
Securitisation originators, sponsors or brokers will need to keep at least 5 percent of the performance risk and loan originators would be barred from transferring that risk. Issuers also face new reporting rules, including compensation information on brokers, originators and sponsors.
Islamic industry bodies could weigh similar rules.
Traditionally, the Islamic Financial Services Board, a key standard-setting body, has adopted conventional banking’s regulatory standards but modified them to suit the Islamic finance industry’s needs. It is expected to apply a similar model if tougher capital rules are imposed on conventional banks which are originators of securitised assets.
Such rules could force financial institutions originating Islamic bonds to hold capital against the assets being securitised, restricting their flexibility. The firms do not need to do so now.
Analysts say the unrestrained sale of debt, especially through multiple securitisations, sowed the seeds for the recent financial meltdown. Sharia bankers argue the chaos that followed strengthens the case for Islam’s restrictions on debt transfers.
Islam allows a creditor to sell debt to a debtor at par, but scholars disagree on whether debt can be sold to a third party due to the uncertainties that can arise from such transactions.
Conventional regulators are also expected to make it harder for banks to use the originate-to-distribute model which has been blamed for the recent U.S. subprime mortgage crisis.
Islamic banking also relies heavily on rental and sale and purchase transactions as financing instruments instead of using interest-based loans.
For example, under the ijara, or Islamic leasing, bond structure, a special purpose vehicle buys assets such as real estate from an issuing entity or other sellers. This is then leased back to the issuing entity for a period equal to the maturity of the bond, with periodic rental payments.
“If it’s a high growth area in particular, regulators will bring in specific regulation to make sure mistakes made in the conventional financial area are not repeated in Islamic finance,” said Khalid Yousaf, executive vice president with Yusr Islamic Investment Bank in Dubai.
Islam’s restrictions on the sale of debt to third parties is already one of the biggest points of contention among religious scholars who oversee the sharia banking industry.
The Hanafi school of thought does not allow debt to be sold to third parties, but some schools sanction it under certain conditions, including that the price must be paid on the spot and that the sale must not lead to interest.
Middle Eastern jurists frown on the sale of debt to third parties, but some bankers say the curbs hold back the industry by limiting the development of a liquid, secondary Islamic bond market and a deeper, more sophisticated sharia banking system.
However, some market watchers do not expect Islamic financial markets to be badly hit by any regulatory changes.
“What the regulators in the West are trying to do is to regulate a market that got out of control, which are the credit markets, but the credit markets don’t really exist in Islamic finance in the same way because we can’t use financial assets,” said Simon Eedle, global Islamic banking managing director of Calyon.