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Early in February, the Qatar Central Bank (QCB) issued a circular saying it has decided to ‘terminate the activities of Islamic fi nance services’ offered by conventional banks. The circular effectively terminates Islamic banking windows’ operations, giving a grace period until year end for banks to comply with the requirements.

The reasoning behind the move, and more importantly the effect of the ban on Islamic windows, has been the subject of a wild speculation in the market. Some bankers have stated that such decisions taken on an ad-hoc basis may hurt Qatar’s top ranking as far as business transparency is concerned.

The impact on the conventional banks with Islamic windows is fairly signifi cant. According to the Peninsula, a Qatar based newspaper, the conventional banks’ Islamic window branches (now amounting to 16) have widened their customer base to some 80,000 individuals and corporate entities.

“The time given to us to wind up our Islamic banking activities is so short that we cannot even imagine how to recover our investments and manage the credit portfolios,” said an industry source to the Peninsula.

It is important to note that this circular relates to all conventional banks with Islamic operations, even if the balance sheet is segregated. However, if a separately capitalized Islamic bank was licensed (even if owned by a conventional bank), presumably it would not fall under the regulatory ban.

Limited access to international capital markets Some commentators have roundly condemned the move rather patronisingly. They state QCB’s decision was poorly determined, without considering the impact on the market, and perhaps aimed to give Islamic banks a free ride. They point to the fact that the major international banks have been single handedly responsible for the major innovations in the Islamic fi nance industry.

One commentator argued that international banks have sole access to global capital markets which are currently inaccessible to Islamic banks who will not be able to support transactions of the same magnitude that are fi nanced in the region.

CounterpointWithout going into details, it is important to point out that the QCB’s directive is not directed only at international banks such as HSBC or Credit Agricole, rather it is directed at all conventional banks with Islamic windows. The circular is not discriminatory towards international banks versus local banks. All conventional banks are affected. Further, the ban does not necessarily (at least this is not explicitly stated) preclude arranging and advisory services that international banks conduct, even where they have no Islamic operations.

Effi ciency is wholly ignoredAnother criticism is that it prevents banks from choosing the most effi cient business model for their needs. The benefi t of Islamic

windows is the ability to offer Islamic services from the conventional bank’s existing branch network without having to establish separate branches for Islamic operations. This was considered more effi cient for some banks as it avoided having to invest in costly overheads such as IT and security systems.

Further, the marketing reach and network of the conventional bank would presumably be much stronger than an Islamic bank. For instance, a bank in the UAE recently moved from an Islamic banking subsidiary model to an Islamic window model offering Islamic services across their existing conventional branch network.

Finally, conventional banks that decide to offer Islamic services initially cannot necessarily afford to invest in the signifi cant set up costs without testing the market for Islamic services. By requiring conventional banks to set up new fully segregated Islamic banks, the barrier to entry is signifi cantly increased thereby limiting the appeal and attractiveness of Islamic fi nance, which could be argued to limit competition and ultimately provide the most effi cient services to the customer.

CounterpointThe fl ipside of this argument is, there is no clear monitoring of the delineation the Islamic window’s that activities from its conventional parent, and this is precisely what the QCB directive is aimed at. If operations, marketing and potentially the balance sheet are mixed, then it is diffi cult to verify what business the Islamic window is generating and how much costs/overheads are allocated to that unit.

Further, a number of complications arise when dealing with customers. Do bank staff promote Islamic products or the conventional equivalent when faced with a customer who is neutral? If you do not have specialized Islamic fi nance staff to entertain prospective customers interested in Islamic fi nance products, then the confl ict of interest heightens within staff.

In addition, if staff are not trained appropriately, they may not be familiar with the salient features of Islamic banking products, such as knowledge about contracts on which a product is built, legal documentation and implications over default and early settlement.

Limiting competitionA number of the conventional banks and Qatar market commentators have stated that such a move could also limit competition. With the monopoly of existing Islamic banks controlling the full market, the quality of services provided would thereby be reduced. They also argue that the existing Islamic banks will have serious diffi culty in managing the service fl ows from the new businesses.

“Since 2005, there has been a lot of improvement in Islamic banking services as a result of QCB’s liberalized policy of permitting commercial banks to offer Shariah compliant banking services,” said one source to the Peninsula. But given the monopoly returning, the services can only be expected to deteriorate

Qatar’s Ban on Islamic Banking Windows: Good or Bad for the Islamic Finance Industry?

By Sayd Farook

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Qatar’s Ban on Islamic Banking Windows: Good or Bad for the Islamic Finance Industry? (continued)

But with the monopoly returning, services can only be expected to deteriorate rather than improve. The QNB Islami branch has no less than 45,000 customers generating profi ts of around QAR900 million (US$247 million) last year. Having to forego such a signifi cant part of their business would certainly not be appealing to these conventional banks who have invested signifi cant effort to build their Islamic franchises.

CounterpointThe impact on the conventional banks will be signifi cant and substantially unfair. To counter this loss in opportunity, the conventional banks can seek to negotiate with the QCB if it is possible for them to set up independent Islamic banks that have completely segregated operations and accounting from the conventional parents, with separate licensing requirements.

This would, ideally speaking, ease the concern of the QCB, while allowing the conventional banks to retain their Islamic fi nance market penetration. However, the extent to which the QCB will accept such a solution and allow for new licences for new Islamic banks is yet unknown.

Benefi ts of the decisionThat said, while the short-term impact of the decision may be damaging to the country’s conventional banks, the QCB’s move may be seen as foresight in a region where regulation usually follows bad practice.

Weak Shariah governanceIt has long been a concern of some Shariah advisors and commentators that Islamic banking windows are the cause of a number of serious Shariah compliance failures. They point to the many ‘innovative’ new products that have actually been detrimental to the reputation of Islamic fi nance and have sustained the criticism that Islamic fi nance is a wrap around solution for conventional fi nance.

For instance, the Murabahah based deposit is sometimes accepted by the Islamic banking windows without any ensuing Murabahah transaction taking place once the Islamic bank client deposits the money. At the end of the period, the Islamic bank client receives his deposit plus a return, allegedly earned from a deferred payment Murabahah transaction.

There have been countless anecdotal reports of these sorts of practices occurring in conventional banks. However, it has been very diffi cult to verify or refute as there is no requirement for an independent Shariah auditor for these conventional banks.

Similarly, the dual promise to circumvent the forward contract was developed by a prominent Islamic banking window of a global bank.

In contrast, the pure Islamic banks have been able to largely avoid dubious practices due to their conservative nature, and some would argue, constant Shariah supervision, oversight, and risk management that prevent dubious practices seeping through the cracks of the Shariah compliance controls. By requesting all banks to establish separately capitalized Islamic banks or subsidiaries, Shariah governance is better monitored and therefore establishes a stronger environment for transparency. Each institution can have their own independent internal Shariah reviewer and auditors in place and thereby vet and maintain control of all practices within the institution.

Some have argued that such an extreme measure to ban all operations is not necessarily the only option to ensure proper Shariah governance. Sheikh Taqi Usmani argues that as long as there is appropriate Shariah governance in the form of a permanent Shariah unit in addition to the Shariah supervisory board and a complete separation of accounts, staff, offi ce and funds, then it would not be mandatory that a separate Islamic bank has to be formed.

Perhaps the reason the QCB initiated this directive was because they, as a central bank, were having diffi culties monitoring the Islamic banking business of the conventional banks as there may not have been clear delineation of the conventional and Islamic arm.

One could argue that they could specify ex-ante regulations that require Islamic banking windows and units to have their own Shariah audit units, independent operations and separate balance sheets as subsidiaries if they wanted to achieve the aim of appropriate monitoring.

LeakageBesides the argument that Islamic banking windows are hard to monitor, banning windows ensures that Islamic funds do not leak out into the conventional system, thereby strengthening the base of authentic Islamic fi nance. Islamic banking windows can take Islamic funds and then recycle it within the conventional banking system.

Fully capitalized banks or subsidiaries of conventional banks with distinct balance sheets however can only accept money that they will invest in their own assets (through Wakalah and Mudarabah). Whereas, windows can accept money and then reinvest that money into conventional markets since the fi rst transaction with the customer who is depositing is merely a sale (Murabahah) and therefore, the other leg can be anything as long as the funds promised as the sale price are paid.

As a result, the ensuing argument from Islamic fi nance purists goes that by allowing such window operations, a lot of Islamic banking assets are being funnelled into the conventional system rather than being placed back into the Islamic fi nance ecosystem.

This can also be evidenced in the management of reserves in Islamic window operations. The conventional treasury department usually handles money market operations. Daily surpluses are usually passed on to the conventional treasury for overnight transactions for earning some marginal income.

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“With the monopoly of existing Islamic banks controlling the full market, the quality of services provided would thereby be reduced”

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Qatar’s Ban on Islamic Banking Windows: Good or Bad for the Islamic Finance Industry? (continued)

Sometimes, treasuries may not have enough surpluses from Islamic reserves to cover its positions. In these instances, it would use the proceeds from sale of conventional papers to cover the Islamic deposit obligations at maturity.

If a separate subsidiary with a separate independent treasury is established, the Islamic bank would not have to commingle funds with the conventional treasury. Further, all the funds accepted would have to be directed at Islamic funds.

ConclusionThe decision by the QCB to limit the Islamic banking operations of conventional banks came as a huge blow to the conventional banks in Qatar. Commentators considered it an imprudent move to limit competition in the high growth Islamic banking market of Qatar while limiting access to global markets.

Despite the short-term impact on the affected banks, it is the author’s view that it is for the overall benefi t of the Islamic fi nance industry, particularly in Qatar. The ban would alleviate the serious governance/control failures that plague Islamic operations in conventional banks while it would also prevent the leakage/mixing of Islamic funds with conventional funds, a practice which has drawn the ire of scholars and external cynics alike.

Now it is up to the QCB to decide on which course of action the conventional banks should take. It would be advisable, subject to policy restrictions, that the QCB allow the conventional banks to apply for new Islamic banking licences for their Islamic windows. Where this is not possible, conventional banks should at least be able to merge their Islamic assets and create two to three fully segregated Islamic banks.

Regardless, the decision by the QCB will be observed closely by regulators elsewhere in the region to ascertain the impact on the growth and transparency of the Islamic fi nance industry in their jurisdictions. If it does and given the support from Shariah scholars, it is likely that some of these jurisdictions will consider such a move. Malaysia has required the same of its conventional banks and it was considered a pioneer when it did. Given the potential move towards such requirements, conventional banks should therefore consider whether their operating models are optimal going forward.

The views expressed in this article are his own and do not represent in any way the views of his employer.

Dr Sayd FarookGlobal head of Islamic capital marketsThomson ReutersEmail: sayd.farook@yahoo.com.auDr Sayd Farook leads up Thomson Reuters Islamic fi nance transactions initiative as global head of Islamic capital markets.

The February Circular makes reference to Circular 74/2010, which we understand was issued in late August 2010 (the August Circular). Among other things, the August Circular states that conventional banks operating in Qatar were not permitted to open any additional branches for Islamic banking or to allocate more than 10% of their issued capital to Islamic banking operations. Banks were given until the end of 2011 to comply.

The August Circular has been interpreted as a move by the QCB to encourage the growth of dedicated Islamic banking institutions.

The February Circular Among other things, the February Circular supersedes the August Circular. In particular, the February Circular requires conventional banks with immediate effect:

• not to accept new Islamic deposits• to reimburse Islamic term depositors at their agreed

maturity date, and• not to enter into any new Islamic fi nance transactions during

the Grace Period, although they should continue to collect payments from their customers in accordance with their existing arrangements.

Following the end of the Grace Period, conventional banks with Islamic operations will be required to consolidate their Islamic portfolios until all payments are collected in accordance with their agreed terms and conditions. In the meantime, conventional banks are permitted to transfer all or part of their Islamic portfolios to existing Islamic banks in Qatar.

(Source: Simmons and Simmons)

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