The Regulatory Landscape of Islamic Finance in the USA
By: Camille Paldi
There are currently 25 Islamic financial institutions operating in the United States. These institutions are state-chartered entities subject to the same state and federal regulatory guidelines, corporate governance, banking and insurance operations, and tax treatment as conventional financial institutions in the US. The US has not adopted any federal legislation specifically addressing Islamic financing. (Vogel:2016) Although IFI’s may be qualified to do business in different states, the majority of an IFI’s assets are located in the institution’s home state and licensing and other conditions must be satisfied with respect to any state where the IFI seeks to be qualified as a bank or mortgage or loan finance provider. (Vogel: 2016) Illinois and a number of other states have enacted a ‘wild card statute’, which allows IFIs chartered in these states to do anything that is permitted by the OCC to be done by national banks. (Vogel: 2016) The existing US Islamic banks, i.e. Devon Bank and University Bank, are state-chartered, state-licensed banks, which have FDIC insurance for depositors. (Vogel:2016) Three main regulatory issues for Islamic finance include bank ownership of real estate; good programs for anti-money laundering (AML) and Bank Secrecy Act (BSA) compliance; and whether deposits can be approved and insured. (Lynn: 2009) This short article aims to examine the US Regulatory Landscape and the possibilities for Islamic finance business in the USA in the future.
US Bank Offerings Abroad
The Board of Governors of the Federal Reserve allows US financial institutions to offer Shari’ah compliant products in foreign countries where they are mandatory or where they are necessary for the financial institution to be competitive. (Vogel:2016)
Foreign IFI offerings in the United States
Foreign financial institutions may offer in the US Islamic banking structures approved by the OCC or the Office of the Comptroller of the Currency , which includes the ijarah and murabahah structures for home mortgages and retail financing i.e. United Bank of Kuwait (UBK). Foreign institutions are required to comply with all applicable federal and state law, including obtaining all requisite state banking and retail lending licenses for the offering of approved products in those states where they operate. (Vogel: 2016) Muslim investors from the GCC countries have sought to diversify their financial portfolios and to invest their wealth into US assets. I.E. Arcapita Bank and United Bank of Kuwait has structured Shari’ah-compliant transactions in private equity and real estate in the United States to meet client demands. (Ilias: 2010)
Two Office of the Comptroller of the Currency “OCC” Rulings in favor of Islamic Banking in the USA
Only two rulings have been issued by the OCC in 1997, approving an ijarah and murabahah structure for home financing and other retail financial products. (Vogel: 2016) In 1997, the United Bank of Kuwait (UBK) requested interpretive letters from its regulator, the Office of the Comptroller of the Currency (OCC) on ijarah, a financial structure in which the financial intermediary purchases and then leases an asset to a consumer for a fee, and murabahah, where the financial intermediary buys an asset for a customer with the understanding that the customer will buy the asset back for a higher fee, mortgage products. The OCC approved both on the grounds that they were economically equivalent to traditional conventional products. (Ilias: 2010) In terms of ijarah, the OCC determined that ijarah is the functional equivalent of secured lending. In 1999, the NYSBD or New York State Banking Department also approved the ijarah and agreed with the OCC that the product was functionally equivalent to or a logical outgrowth of secured real estate lending. In terms of murabahah, the OCC determined that the bank would be functioning as a riskless principal. (Cavanaugh: 2011)
The OCC was able to look beyond the restrictions on bank ownership of real estate to conclude that the risks that drove the general restrictions were not present because the transactions were equivalent to secured loans or riskless principal transactions. (Rutledge: 2005) These structures have now been approved by the Federal government, the New York State Banking Department, and the banking authorities of several other states. Furthermore, the relevant authorities have removed the double tax jeopardy of these products where tax was incurred by initial purchase and transfer of final payment. The tax authorities in NY and a few other states have dealt with this issue by eliminating double tax burdens on a case-by-case basis where the Shari’ah compliant structure was in substance equivalent to a conventional financing transaction. In 2008, the NYS tax department 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 ijarah arrangement. (Vogel: 2012)
In terms of musharakah (and diminishing musharakah), this type of joint-ownership is not approved for use by banks in the United States and is used only by nonbank mortgage lenders in the United States. The musharakah transaction must be structured to be the functional equivalent of a debt transaction.
In addition, the states of New York and Illinois have enacted legislation intended to encourage Islamic finance transactions, such as the elimination of a double real-estate transfer tax in an ijarah sale-leaseback transaction. In the United States, housing agencies Freddie Mac and Fannie Mae started buying Islamic mortgages in 2001 and 2003 to provide liquidity and they are now the primary investors in Islamic mortgages. (Rutledge: 2005) Companies such as LARIBA, Bank of Whittier, and Guidance Residential are offering home financing through the ijarah and murabahah models.
Islamic Deposit Products
In terms of Islamic deposit products in the US, deposit products must be guaranteed by FDIC or the Federal Deposit Insurance Corporation. (Vogel:2016) A Shari’ah compliant profit and loss deposit product is difficult where the deposit must be insured by FDIC as losses cannot be shared by the bank and customer in the US. In 2001, SHAPE Financial Corporation sought FDIC Deposit insurance for an Islamic deposit-like product for which returns would fluctuate with the bank’s profits and losses. The FDIC refused because the deposit could decline in value and the bank would be sharing loss with the customer. (Haltom: 2014) SHAPE was forced to alter the product to be based solely on profit and not loss sharing. The SHAPE profit sharing deposit pays a yield upon the gross operating profit of University Islamic Financial Corporation’s Shari’ah 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. (Cavanaugh, 2011) Therefore, it is hence a profit-sharing instrument, which is allowed in the US. One suggestion has been made to treat this deposit product as an investment security regulated by the SEC rather than a banking product regulated by state and federal banking regulators. (Vogel: 2016)
Restriction on Investments
The range of permissible investments that commercial banks may hold is restricted in the US. In addition, commercial banks must meet numerous disclosure requirements in order to comply with regulatory policy such as the Truth in Lending Act. These requirements typically mandate advance disclosure of APR or Annual Percentage Rate and other terms that do not fit the principles on which Islamic finance is structured. (Rutledge: 2005)
Central Shari’ah Authority in the USA
The US has no central authority responsible for insuring that transactions or products are Shari’ah compliant. IFIs in the US are not required to maintain their own Shari’ah supervisory boards, but may work with the Shari’ah board of another IFI, the Shari’ah Board of America, or other scholars such as AMJA or the American Muslim Jurists Association. There is no regulatory approval required for the appointment by an IFI of Shari’ah Supervisory Board members in the USA. (Vogel)
The ‘establishment clause’ of the First Amendment to the US Constitution presents a serious obstacle to the successful introduction of takaful and retakaful to the US, as this mandates separation of church and state and prohibits the favoring of one religion over another. In addition, the insurance regulatory regime in the US poses a problem for the introduction of takaful, as each state determines its own licensing requirements for insurance companies. In order to obtain a license, an insurance company must demonstrate that it has the experience and management capability to run the company and that it is financially sound. Insurance companies are also required to justify their premium rates. In addition, insurance companies must meet or exceed the solvency requirements set by the state. Furthermore, there may be limits on the types and concentration of investments made with collected premiums via each state’s insurance laws. For example, investment in non-Shariáh compliant investment grade rated bonds may be the only option. Therefore, it may not be possible to have 100% Shariáh compliant takaful in the USA, however, if written into the contract, takaful is still possible. Since the members in a takaful arrangement agree to insure one another and share in risks and profits, there may be some obstacles in establishing the company as a financially sound insurance provider and in justifying tabarru or donation amounts. In case of potential insolvency, the shareholders’ fund must provide an emergency loan to the takaful company to meet existing claim obligations. Capital requirements imposed on US insurance companies may not take into account the separation between policy holder and stakeholder funds in takaful insurance. Another obstacle includes the fact that setting up a state or federal Shariáh Board for the takaful fund may contravene the separation of church and state. However, it may be possible to outsource this function to foreign countries. One option is to draft neutral legislation that would redefine solvency requirements, taking into account that certain insurers may choose to structure the division between shareholder and policyholder funds differently. Another option includes to offer takaful explaining in the contract that non-Shariáh compliant investment grade rated bonds are being used.
The US has seen two major sukuk issuances – the USD165.67 million East Cameron Gas Sukuk, which was the first sukuk al musharakah in America backed by oil and gas assets and the USD 500 million General Electric Sukuk (sukuk al ijarah backed by aircraft leases). Both New York and Illinois have enacted legislation enabling sukuk transactions. Goldman Sachs issued a $2billion sukuk in 2012. There are currently no listings of sukuk on US security exchanges.
There are no special courts, tribunals, arbitral or other bodies, which have jurisdiction to hear Islamic finance disputes. Rather, such disputes are subject to resolution before the applicable US federal and state courts in accordance with applicable rules of jurisdiction and venue and may be subject to arbitral action if required by the terms of a contract between the parties to the dispute. I recommend forming one centralized Islamic finance arbitral tribunal with a standardized dispute resolution contract for Islamic finance, sukuk, sukuk bankruptcy, and takaful. (Vogel)
There are currently no applications for a fully fledged Islamic Bank in the United States. Islamic banking in the US remains largely confined to home finance and further to the two approved models of ijarah and murabahah home financing. There has been no new regulatory developments affecting the retail market since the late 1990’s. Institutions wishing to expand product lines will have to address various challenges, many of which are briefly stated in this article.