Regulatory Aspects of Islamic Banking in the United States

1. Regulatory Aspects of Islamic Banking in the United States Greg Cavanagh, Counsel and Assistant Vice President Federal Reserve Bank of New York Fourth UC Berkeley Islamic Finance Forum UC Berkeley School of Law April 9, 2011

2. Important note The views expressed in this presentation do not necessarily reflect the views of the Federal Reserve Bank of New York or any other component of the Federal Reserve System.

3. Outline • Observations of the retail banking market • Financing products • Ijara • Murabaha • Deposit products • Supervisory issues • FRBNY participation at Islamic finance events • Parting observations

4. Observations of the retail banking market • Retail product offerings have been concentrated in home finance • Several community banks offer Islamic banking products, including: • University Bank (Michigan): deposit and financing products • Devon Bank (Illinois): financing products • Bank of Whittier (California): financing products • Nonbanks have also been active in providing financing, including: • Guidance Residential (Virginia) • American Finance House LARIBA (California)

5. Financing products: ijara • 1997 OCC interpretive letter • Approved a residential net lease-to-own home finance product (ijara wa iqtina) • Determined to be functional equivalent of secured lending

6. Financing products: ijara • 1999 NYSBD approval • Approved a net lease product • Agreed with OCC that the product was “functionally equivalent to or a logical outgrowth” of secured real estate lending

7. Financing products: ijara • 2008 NYS Tax Dep’t advisory opinion • Determined that no real estate transfer tax is due when the deed is transferred by a bank to its customer at the end of the lease term in accordance with the terms of the ijara arrangement

8. Financing products: murabaha • 1999 OCC interpretive letter • Approved murabaha-based financing • Commercial inventory or equipment • Real estate • Determined bank would be functioning as “riskless principal”

9. Financing products: murabaha • 2001 NYSBD approval • Approved murabaha-based home financing • Again, agreed with OCC that such financing was “functionally equivalent to conventional financing transactions”

10. Deposit products • Definition of deposit under U.S. law • FDI Act: “the unpaid balance of money or its equivalent received or held by a bank or savings association in the usual course of business and for which it has given or is obligated to give credit…” • Implications for Islamic banking • Deposit accounts that do not bear interest are not problematic from either a bank regulatory or shariah perspective • But what if a customer wants a return on his or her deposit?

11. Deposit products • Ordinarily, a bank in the United States that borrows funds from its customer by taking a deposit pays the customer interest (a rate of return on that borrowing) • FDIC insurance stands behind the bank’s borrowing (up to $250,000), so there is no possibility that the customer will lose money • Outside the United States, Islamic banks often offer profit- and loss-sharing accounts: • Customer places funds with the bank as its mudarib • Bank uses its expertise to invest the funds and earn a return for the customer • Customer may earn a net profit or incur a net loss

12. Deposit products • One example: University Bank’s SHAPETM Profit Sharing Deposit • Pays a yield based upon the gross operating profit of University Islamic Financial Corporation’s shariah-compliant portfolio of assets, including mortgage-alternative assets • The yield may drop to zero, but there is no possibility of loss of principal because the account is FDIC insured

13. Supervisory issues • Concentration risk • Preference for tangible assets • Liquidity risk • Limited supply of short-term, shariah-compliant investments • Limited shariah-compliant government debt instruments • Lack of access to shariah-compliant central bank liquidity • Consumer protection issues

14. FRBNY participation at Islamic finance events • IFSB Summit on Islamic Financial Services and the Global Regulatory Environment (London, May 2004) • IFSB Seminar on Legal Issues in the Islamic Financial Services Industry (Kuwait, March 2005) • Harvard Law School Workshop on the Supervision and Regulation of Islamic Financial Institutions (Cambridge, March 2005) • Arab Bankers Association of North America (ABANA) Conference on Islamic Finance (New York, April 2005) • IFSB Summit on Corporate Governance in the Islamic Financial Services Industry (Doha, May 2005) • Interagency Forum on Islamic Banking in the United States (New York, March 2006) • Harvard University Forum on Islamic Finance (Cambridge, April 2006) • IFSB Summit on Aligning the Architecture of Islamic Finance to Evolving Industry Needs (Beirut, May 2006) • National Bureau of Asian Research Conference on Islamic Finance in Southeast Asia (Washington, October 2007) • US-Bahrain Business Council/Embassy of Bahrain Conference on Islamic Banking and Finance in the Kingdom of Bahrain (Washington, April 2008) • U.S. Department of the Treasury “Islamic Finance 101” Seminar (Washington, November 2008)

15. FRBNY participation at Islamic finance events • Fordham Law School Islamic Law and Finance Symposium (New York, February 2009) • UC Berkeley Islamic Finance Symposium (Berkeley, February 2009) • ABA Section of International Law Program “Through the Eye of the Credit Storm: A Comparative Look at Islamic Finance Products, Risks and Rewards” (Washington, April 2009) • IFSB Seminar on Legal Issues in the Islamic Financial Services Industry (Kuala Lumpur, September 2009)

16. Parting observations • On the retail level, Islamic banking in the United States remains largely confined to home finance • There have been virtually no new regulatory developments affecting the retail market since the late 1990s • Institutions that wish to expand their product lines will have to address various challenges • Federal Reserve staff continue to monitor developments in the field