National and Global Islamic Financial Architecture:
Problems and Possible Solutions for the OIC Member Countries
46
face and how these are mitigated in case the issuer becomes insolvent. Certain specific issues
arise in Islamic financial transactions due to compliance with Shariah. For example, while in an
asset-backed sukuk investors have a claim on the assets underlying the issuance, an asset-
based sukuk meanwhile has the investors having a claim on the issuer with no recourse to the
assets. Similarly, the rights of profit-sharing investment account holders need to be clearly
defined in case a bank declares bankruptcy.
3.2. Regulation and Supervision Framework
In a well-functioning financial system, the supervisors and regulators act on behalf of the
society at large and protect the interests of the different stakeholders and ensure stability in
the financial system as a whole (Pistor and Xu 2003). A proactive enabling regulatory and
supervision framework will ensure the application of rules and laws, protection of property
rights, the stability of the financial sector, consumer protection, and the fairness and efficiency
of markets (see Llewellyn 2006 and GOT 2008). The complexity and dynamism of modern
financial products and markets make regulation itself complex and multi-dimensional (Black
2012). If not approached correctly, inappropriate regulations can create risks and
vulnerabilities that can potentially lead to harmful and costly economic downturns.
Regulatory perimeters determine the boundaries of the regulated and unregulated activities
and institutions. Determining the regulatory perimeters will depend on various factors. Among
others, the degree of systemic risks and customer sophistication will determine the level of
regulatory intervention. The tools and goals of regulation include micro-prudential regulation
to promote the safety of individual financial institutions, macro-prudential regulation and
supervision for the stability of the financial sector, conduct of business regulation to establish
rules for appropriate business behavior and practices, product regulation to limit specific
harmful products, consumer protection regulation to protect consumers, and indirect
regulation to limit exposures of institutions to certain activities and to enhance the fairness
and efficiency of markets (BOE 2012; GOT 2008; Llewellyn 2006). Other regulatory functions
relate to providing safety net arrangements (deposit insurance and lender of last resort) and
ensuring the integrity of the payments system and markets. The regulators must also have
measures in place to handle emergency situations such as handling insolvent institutions and
resolving crises.
There are various models of regulatory frameworks for the financial sector. While in some
countries separate bodies regulate the banking, insurance and the securities markets, in others
these sectors are regulated by a single body. The GFC showed that, if legal and regulatory
regimes fail to adjust to the changing situations, they become ineffective in mitigating the new
risks that can lead to costly systemic problems. Furthermore, there can also be a separation of
the prudential regulation and supervision from a conduct of business and consumer protection
regulation under the ‘twin peaks’ approach (Crockett 2009: 19).
Various international bodies have come up with the various principles and standards of
regulations and supervision of different segments of the financial sector. The Basel Committee
for Banking Supervision (BCBS) is responsible for developing international regulatory
standards for the banking sector. It came up with the Basel III standards to strengthen the
regulatory regimes for the banking sector after the GFC. The new standards bolster Basel II by
enhancing the quality and quantity of capital and introducing risk coverage of the
systematically important financial institutions. It also enhances the supervisory review process