Specialized Insolvency Regimes for Islamic Banks: Regulatory Prerogative and Process Design

Abstract

This article proposes the adoption of specialized, administratively managed resolution regimes for Islamic banks. The proposed resolution model addresses current deficits in relevant legal and regulatory environments, advances the Shari’ah policy of effective market regulation, incorporates banking and capital markets provisions fitting of the cross-market nature of Islamic banking, and advances convergence of Islamic and conventional insolvency regimes. Islamic banking has enjoyed significant growth in a short period. Projections for the near-term growth of Islamic banking are optimistic. But, peculiarly, Islamic banks operate in legal and regulatory environments that are incongruous with the Islamic banking model. As a result, Islamic banking products are often marketed and documented in ways that mimic conventional interest-based products. In many jurisdictions, Islamic banks are subject to the same regulations applicable to conventional banks, sometimes with limited carve-outs for Islamic banking. Disputes involving Islamic banks have been resolved by analogy to conventional transactions and the laws governing them, and thus have not yielded meaningful precedent. The status quo has proved passable, but it is not sustainable. As Islamic banks grow in size and number, they will require enabling legal and regulatory environments to facilitate sustainable growth. Such environments must include resolution regimes for Islamic banks. Islamic banks are not yet large or interconnected enough to pose systemic risk, but they are too young to withstand the reputational and regulatory shocks that would flow from the poorly managed failure of one or more Islamic banks. Regulators, standard-setting bodies, and others that have considered insolvency regimes for Islamic banks have framed some of the issues, with a focus on achieving convergence of Shari’ah- and civil law-based insolvency rules. This approach falls short. Shari’ah insolvency rules developed and applied in the context of singe debtors, bilateral relationships, or relatively small groups are not, by themselves, sufficient to inform resolution regimes for Islamic banks. Rather, Shari’ah insolvency rules must be interpreted in accordance with, and further the objectives of, Islamic legal and historical views of market regulation, which require that regulators be empowered to advance lawful market conduct, market discipline, transparency, and consumer protection. Similarly, it is not sufficient to examine conventional insolvency regimes applicable only to banks, because Islamic banking encompasses banking and capital markets activities. The Orderly Liquidation framework recently adopted in the United States is discussed as a model of reference because it incorporates banking and capital markets insolvency rules and substitutes judicially managed bankruptcy with administratively managed resolution to ensure the speedy resolution of failed financial companies. Similarly harmonized resolution frameworks, such as the model proposed herein, are required for Islamic banks.