ISLAMIC BANKS : TROUBLE BENEATH CALM WATERS?

Extracted from Reuters

As Western regulators stress test top banks, Islamic finance wants to broaden its regulatory approach and improve disclosure rules amid concerns that unhealthy banks may have slipped under the radar.

Few Islamic financial firms have reported headline-grabbing losses so far, but the industry's relatively modest size and opaque framework could mask more trouble than appearances suggest, bankers and lawyers say.

Rather than stress testing individual banks as in the United States, however, Islamic bankers and lawyers say the sector needs better disclosure rules within stronger regulatory frameworks.

A narrow regulatory approach that examines individual firms rather than the sector and inadequate disclosure laws could have allowed weak shariah banks to escape the authorities' attention, potentially threatening to spark an Islamic banking crisis.

Since the global economic and property slump, shariah banks' earnings have dropped by up to 40 percent on year and firms such as Kuwait's Investment Dar and Dubai's Tamweel TAML.DU and Amlak Finance AMLK.DU are trying to restructure. UBS has forecast Dubai house prices could fall up to 70 percent from a fourth-quarter peak. A Reuters poll predicted prices will drop over 40 percent in 2009 and 2010 before recovering in 2011.

The slide in property markets could highlight weakness in the regulation of the Islamic banking industry. Many of the Islamic banks globally, and especially in the GCC (Gulf Cooperation Council countries), are real-estate oriented so this could be one risk factor.

Unlike the United States, which recently put 19 top lenders through "stress tests" to see which can survive a severe downturn, and Europe which is preparing to do the same, there have been few calls for Islamic banks to be tested to see if they need extra capital to weather heavier losses.

While the U.S. stress test results showed all banks were solvent, regulators ordered them to raise nearly $75 billion to build a capital cushion.

"One of the biggest weaknesses in Islamic finance is that too many of the banks have gone into real estate and equities and both of these are underperforming," said Saad Rahman, Islamic banking executive director at Calyon. "The stress test should not be seen as a stick to be beaten under, but should be an honest assessment of where they are,”

Islamic banks are governed by national authorities, and if they so choose, by industry bodies. The level and nature of supervision vary across markets, reflecting the industry's infancy and fragmented regulatory framework.

IFSB has disclosure rules on capital adequacy and credit risks, but like other shariah finance bodies, its regulations are not binding on the sector and compliance is voluntary. Standard disclosure rules may offer limited protection.