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Kuala Lumpur. As Western regulators stress test top banks, Islamic finance wants to broaden its regulatory approach and improve disclosure rules amid concerns that unhealthy banks may have slipped under the radar.

Few Islamic financial companies have reported headline-grabbing losses so far, but the industry’s relatively modest size and opaque framework could mask more trouble than appearances suggest, bankers and lawyers say.

Rather than stress testing individual banks as in the United States, however, Islamic bankers and lawyers say the sector needs better disclosure within stronger regulatory frameworks.

A narrow regulatory approach that examines individual companies rather than the sector and inadequate disclosure laws could have allowed weak Shariah banks to escape the authorities’ attention, potentially threatening to spark an Islamic banking crisis.

“Rather than just looking at one bank and examining the risks there, you need to look at a more macro level of the industry,” said Rifaat Ahmed Abdel Karim, who heads the Islamic Financial Services Board, a top industry body.

“We need to see who’s connected with what,” he said. “It’s not only the individual banks, but how they are connected at the macro level because then you can see who’s exposed to what.”

Since the global economic and property slump, Shariah banks’ earnings have dropped by up to 40 percent on year and companies like Investment Dar of Kuwait and Tamweel and Amlak Finance of Dubai are trying to restructure.

UBS has forecast Dubai house prices could fall up to 70 percent from a fourth-quarter peak. Predictions are that prices will drop more than 40 percent in 2009 and 2010 before recovering in 2011.

The slide in property markets could highlight weakness in the regulation of the Islamic banking industry.

“In certain countries where the regulations are not as tight as in some jurisdictions, we may find one or two institutions that may pass through the sieve for a while,” said Vaseehar Hassan Abdul Razack of Unicorn International Islamic Bank Malaysia, adding that Bahrain and Malaysia were well regulated.

“Many of the Islamic banks globally, and especially in the [Gulf Cooperation Council], are real estate-oriented, so this could be one risk factor,” he said.

Unlike the United States, which recently put 19 top lenders through “stress tests” to see which could survive a severe downturn, and Europe which is preparing to do the same, there have been few calls for Islamic banks to be tested to see if they need extra capital to weather heavier losses.

While the US stress test results showed all banks were solvent, regulators ordered them to raise nearly $75 billion to build a capital cushion.

“One of the biggest weaknesses in Islamic finance is that too many of the banks have gone into real estate and equities and both of these are underperforming,” said Saad Rahman, Islamic banking executive director at Calyon.

“The stress test should not be seen as a stick to be beaten under, but should be an honest assessment of where they are.”

Islamic banks are governed by national authorities, and, if they so choose, by industry bodies. The level and nature of supervision vary across markets, reflecting both the industry’s infancy and its fragmented regulatory structure.

Much depends on the will of regulators to wield the stick, and the Gulf needs a stronger push, said Alex Saleh, a partner at law firm DLA Piper Middle East.

For example, “a lot of the Islamic investment products that are sold by the investment companies are not regulated in Kuwait,” he said.

He cited the example of wakala , or agency, investments which could be structured so that an agent need not reimburse the investor the entire sum in the case of a loss.

The Islamic Financial Services Board has disclosure rules on capital adequacy and credit risks, but like other Shariah finance bodies, its regulations are not binding on the sector and compliance is voluntary.

Standard disclosure rules may offer limited protection.

“Quite often you have a lot of mezzanine products so the banks have a lot of latitude on whether to report those things under one or the other category,” said Raj Madha, an analyst for EFG-Hermes, referring to instruments with debt and equity features.

“It allows for opacity, which certainly some banks are able to take advantage of, and at least in principle, it creates the opportunity for not disclosing some losses,” Madha said. “Obviously those listed entities, particularly in the UAE, with good public disclosure policies operate to a much higher standard than that.”

Reuters