• The Regulatory Environment for the Establishment and Operation of Islamic Bank in Germany
  • October 20, 2011
  • Law Firm: Norton Rose Canada LLP - Montreal Office
  • Introduction

    In October 2009, Jochen Sanio, the President of the German Federal Finance Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht - BaFin), publicly stated that there were no general regulatory obstacles to prevent the establishment and licensing of an Islamic bank in Germany. Mr Sanio also indicated that the regulatory path for Islamic finance in Germany should be positively facilitated.

    Although these statements have been repeated, the fact remains that even now in 2011, no fully licensed Islamic bank exists in Germany.

    This memorandum gives a description of the regulatory environment relevant for the operation of an Islamic bank in Germany. It should be noted, however, that many of the matters described are based on the opinions of the authors; to date BaFin has not issued clear administrative practice guidelines on this subject.

    Banks can be classified as Islamic if they conduct their business exclusively in accordance with the Islamic system of values and norms of the Shariah (and in particular, the rules and principles specified in Muamalat). This means that they use certain techniques in their business transactions which are approved by Shariah law, including, inter alia, the following:

    • Mudaraba (a joint venture-based type of financing, which is also used for structuring Islamic accounts);
    • Musharaka (a partnership-based type of financing, which in the form of a Diminishing Musharaka also allows for the gradual diminution of the share of one partner);
    • Quard Hassan (a form of asset management);
    • Ijara (leasing); and
    • Murabaha (trade credit).  

    Overview of German financial supervisory law

    An entity wishing to conduct banking business or to provide financial services (collectively referred to as Finance Transactions) on a commercial basis in Germany is required in principle to be licensed in accordance with Section 32 sub-section 1 of the German Banking Act (Kreditwesengesetz - KWG). The same applies to companies established in a foreign country which conduct Finance Transactions through a branch office in Germany or through their office in a foreign country on a cross-border basis, unless the relevant company is established in another EEA member state and has obtained a licence from the supervisory authority in that country.

    The licence must be obtained before the commencement of business; entries in the official registers (e.g. commercial registers or registers of co-operative societies) are only permitted after the registration court has been provided with evidence that the licence has been granted. The licence may be granted subject to reservations and/or limited to specific types of banking business. Conducting banking business without a licence constitutes a criminal offence. If Finance Transactions are conducted without having the required licence, BaFin may order the immediate discontinuation of business operations and the immediate settlement of transactions.

    BaFin supervises not only the commencement of Finance Transactions but also the organisation of business operations and the conduct of Finance Transactions. This applies in particular to the trading and offering of financial instruments which are subject to the German Securities Trading Act (Wertpapierhandelsgesetz - WpHG).


    No special rights for Islamic finance

    In Germany, no special supervisory regime has been established for Islamic finance activities. If these activities are subject to regulatory supervision depends on the question whether they qualify as Finance Transactions.

    The German Banking Act specifies the types of businesses that qualify as Finance Transactions and are thus subject to regulatory supervision (aufsichtspflichtige Finanzgeschäfte), including:

    • deposit taking business;
    • lending business;
    • principal broking services;
    • investment brokerage and investment advice,
    • portfolio management; and
    • financial leases.

    Any Islamic finance product must be examined in the actual form in which it is offered in order to identify whether it constitutes a Finance Transaction and is subject to regulatory supervision. While transactions in the form of Mudaraba, Diminishing Musharaka and Quard Hassan will generally be considered to be Finance Transactions, Musharaka, Ijara and Murabaha are not considered as such. It should be noted, however, that the mere offer of one single type of transaction that is subject to supervision is sufficient for the entire business of the offeror to become subject to regulatory supervision.

    The types of Islamic finance transactions offered are also decisive for determining whether a full banking licence is required or whether a partial banking licence or a licence for providing financial services is sufficient. The latter may usually be obtained more easily. If deposit taking and lending business is undertaken - which, for example, is usually the case with Mudaraba and Quard Hassan transactions - a full banking licence will be required in any case.


    Commencement of business
    Under the Banking Act, the granting of a licence to conduct Finance Transactions is subject to a number of requirements, the most significant of which are:

    Sufficient capital
    The amount of capital required varies according to the business conducted. The capital of deposit-taking credit institutions must amount to at least €5 million, while for securities trading banks €730,000 is, in general, sufficient.

    Qualified and reliable managers
    The institution must have at least two professionally qualified and reliable managers. The managers must have a clean criminal record and must have sufficient management experience. Although it is generally desirable that the management experience has been gained in Germany, in case of Islamic finance transactions it is conceivable that BaFin will take into account the fact that German practice in this area has so far been non-existent.

    In addition, all important business decisions must be taken by the managers. In this context, the Shariah Board is significant: while under German law it is permissible in the context of Islamic finance transactions that the Shariah Board undertakes an advisory role, the relevant business decisions must still be taken by the managers.

    Reliability of shareholders
    In addition to the managers, the owners and the representatives or general partners of a company who exercise substantial influence on the institution (which is generally presumed in case of an interest of at least 10 per cent) must also be reliable. This means that the foreign shareholders of an Islamic bank operating in Germany will have to provide evidence as to their reliability to BaFin in appropriate form.

    The licence application, accompanied by a number of specified documents, must be submitted to BaFin. Of particular importance are the following: a business plan, containing details of the planned business and a substantiated indication of its future development (projected balance sheets and projected profit and loss accounts) for the first three full business years following the commencement of business operations, a presentation of the organisational structure of the institution and a presentation of the planned internal control procedures.


    Organisation of business operations
    Under the KWG, the organisation of a bank’s business operations must comply with certain requirements, including in particular:

    Own funds and liquidity
    Banks must have adequate own funds in order to meet their obligations to their creditors and, in particular, safeguard the assets entrusted to them. Moreover, banks must always invest their assets so as to maintain sufficient liquidity to meet their payment obligations at all times.

    With respect to risk weighting and liquidity assessment, the peculiarities of Islamic finance products have to be taken into account. In this respect, there is still a deficit of experience and a need for further development of regulatory practice.

    Risk management
    Banks must have a proper business organisation which ensures compliance with the applicable statutory rules and operational requirements. A proper business organisation must, in particular, include an appropriate and effective risk management function, on the basis of which an institution shall monitor its risk-bearing ability on an ongoing basis.

    In the case of Islamic banks, some aspects which are of lesser importance than in conventional financing transactions will become important, such as purchase agreements in Murabaha transactions.

    Membership of a deposit guarantee scheme
    German banks are obliged to protect their deposits (and liabilities arising from securities transactions) by joining a compensation scheme (Section 2 of the Act on the Protection of Deposits and Investor Compensation. (Einlagensicherungs- und Anlegerentschädigungsgesetz - EAEG)). This obligation may conflict with the obligation to bear losses under a Mudaraba. One way to avoid this conflict could be a model already applied in the United Kingdom under which banks are required to offer to their customers the protection provided by a deposit guarantee scheme while giving them the option of bearing the risk of loss themselves.

    Prevention of money laundering, terrorist financing and fraud
    The Money Laundering Prevention Act (Geldwäschebekämpfungsgesetz - GwG) which implements the Money Laundering Directive 91/308/EEC of 10 June 1991, as amended, imposes extensive identification and reporting duties on banks, financial institutions, insurance companies and German branches of foreign credit institutions or financial services institutions. BaFin supervises those institutions’ compliance with the duties arising under the GwG.


    Rules of conduct to be complied with in business operations; securities regulatory law

    When conducting their business, banks must observe comprehensive duties and requirements, such as the rules of conduct and transparency that apply in connection with the distribution of financial instruments (Sections 31 et seq. of the WpHG). In particular customers must be fully informed of all risks associated with the products. These duties apply to Islamic banks, for example, when distributing Sukuk. Due to the fact that such products are still largely unknown in the German market, information standards still remain to be developed.


    Tax
    Some Islamic financing techniques, such as Ijara or Murabaha, involve a transfer of title to property or comparable rights. In Germany, a sale and transfer of title is usually subject to tax - i.e. in general, value-added tax, or, in the case of real property, real property acquisition tax. Taxation may lead to a substantial increase in the cost of Islamic finance transactions, which may make them unattractive when compared with conventional financing. However, there are ways to reduce the tax burden. One example is the Sukuk Ijara of the German state of Saxony-Anhalt issued in 2003, where the underlying real property was not transferred but implemented through a head lease-sublease structure.