(MENAFN Press) The global economic crisis that started during the last quarter of 2008 presented itself as a huge opportunity to the Islamic Finance Industry. As investors lost faith in the conventional system, Islamic Finance presented them with a financial system that was sturdy and immune to the very factors that brought about the Financial Crisis. Although Islamic Finance had it origin in the Arab world, it has been embraced by international communities. In the GCC, all states have embraced Islamic Finance as a sturdy financial system with the exception of Oman.
However, this is not to say that there has been no direct impact on Islamic Financial Institutions. Some Islamic Financial Institutions (IFIs) had significant exposure to real the estate and construction sectors especially in Dubai, where the financial crisis caused the property bubble to pop. The cooperative model that Islamic banks operate in, require their depositors to share in the returns as well as risks of the bank, without receiving any interest.
The growing tendency of Islamic investors to demand for Shariaa compliant products coupled with the massive liquidity of the Gulf caused a phenomenal explosion in demand for Islamic Finance that enabled it to grow at an unprecedented pace. As the number of Islamic financial transactions conducted increased, innovative financial engineering brought a wide range of different Islamic products available to the public allowing the close replication of conventional products. The Islamic Equity funds that provide investors a professionally managed and diversified portfolio, choosing only Shariaa-complaint investments are a good example of such replications. With the creation of the Dow Jones and FTSE Islamic indexes allowing managers to now standardize practices and establish a benchmark to compare their products.
With the exponential growth in the Islamic Finance industry, which is still relatively recent phenomenon based in emerging markets, regulatory issues carries intense implications and importance. The massive capital flows and the liquidity moving through the Islamic markets coupled with the novelty of the industry pose considerable risk to the industry in the absence of effective regulations.
This report attempts to shed light on the regulatory challenges faced by the Islamic Finance Industry.
An evolving financial system
Considering the unique ability of Islamic Finance to replicate conventional products in a Shariaa compliant form coupled with the shooting demand for its products and services, the emergence of Islamic Equity Funds as popular Islamic financial instruments comes as no surprise. Through Islamic Equity funds, Islamic investors were provided with an Islamic equivalent to the conventional equity funds through its professionally managed and diversified portfolio. However, this has not been without considerable roadblocks in terms of their inability to use instruments that most conventional funds use and also in the cost of putting the project together. One of the most important factors that enabled the growth of Islamic Finance was the creation of the Dow Jones and FTSE Islamic indices. These indices enabled the creation of benchmarks against which managers could compare their products and standardize their practices. This was an important step that helped legitimize Islamic Finance in the conventional financial world.
Although the central tenet of Islamic finance is the prohibition of Riba “ a term literally meaning an excess, restricting the description to only a non acceptance of interest would not do justice to the essence of Islamic Finance. The true essence of Islamic Finance is described by its promotion of entrepreneurship, preservation of property rights, transparency and the sanctity of contractual obligations. The demand for the introduction of new products and the promotion of financial engineering started its growth by the late 1990s focusing on the lack of liquidity, a lack of portfolio and risk management tools and the absence of derivative instruments.
The lack of understanding of the dynamic landscape of modern financial markets and the intricacies of rules demanded by the Shariaa proved to be major roadblocks to growth for Islamic Finance. However, it was clear to IFI that the development of capital markets was essential for their survival and further growth. In this interest both conventional and IFI combined efforts to find solutions for liquidity and portfolio management. This resulted in two distinct developments, the introduction of Shariaa compatible equity funds and the launch of Islamic asset-backed securities more commonly known as Sukuk.
Although the popularity of Islamic equity funds grew among investors with sizeable a risk appetite for equity investment, IFI kept demanding securities which, while complying with Shariaa, could behave like conventional fixed income debt securities. Additionally, the need of IFI to extend the maturity structure of their assets beyond the typical short-term maturities led to the creation of Sharia compliant asset-backed securities, Sukuk, which have risk/return characteristics similar to conventional debt securities.
The word Sukuk reflects participation rights in the underlying assets. The design of the security is derived from the conventional securitization process in which a special purpose vehicle is set-up to acquire assets and to issue financial claims on the asset. Such financial claims represent a proportionate beneficial ownership for a defined period when the risk and the return associated with cash-flows generated by an underlying asset is passed to Sukuk holders (investors).
Although Islamic finance was initially developed for Muslims so as to conduct their savings and investment activities in conformance with the principles of Islam, in the last 5 years Islamic finance has undergone major transformations. The evolution of Islamic Finance is particularly evident from the various aspects of its development.
Although Islamic Finance initially had its focus in Muslim populated regions, its ability to offer security to investors has drawn significant participation by non-Muslims. It is seen as an alternative means of financing for borrowers and as a new asset class for investors. The growth of Islamic finance is not only restricted to the Muslim world on account of the religious and business considerations, but also across the Western world where commercial and business considerations are the factors that drive growth. Today, the total assets of the Islamic financial system have surpassed one trillion US dollars, about fivefold of its magnitude five years ago. Islamic finance is now among the fastest growing financial segments in the world with an estimated annual growth of 20%.
Country/Assets (US billion)
Another aspect of its evolution is the drastic change in the nature of the business of Islamic finance. From being mainly focused on retail and trade financing, Islamic finance has now expanded to the financing of other commercial business activities. The development of the Islamic financial markets and the emergence of more diverse IFI have resulted in the inclusion of private equity, project finance, the origination and issuance of sukuk, and fund, asset and wealth management activities within the scope of Islamic finance business. Moreover the increase in structured products and investment-linked products shows intensified product innovation with more sophisticated Islamic banking and takaful products. These products have become competitive both in terms of product structure and pricing. Also, the attractiveness of Islamic financial markets has increased as an asset class for investments due to its enhanced depth. As a direct result of these developments, an extensive range of Islamic financial products and services are now being offered to consumers and businesses.
The evolution of Islamic finance is also evident in its regulatory and legal framework which has taken into account the distinct features of Islamic financial transactions. This has ensured that the growth and developments of Islamic finance is accompanied by the corresponding development of the supporting legal, regulatory and supervisory framework to ensure its soundness and stability. Marking an important milestone in the development of regulatory standards and best practices for Islamic finance institutions was the establishment of the Islamic Financial Services Board in 2002. Its establishment has also contributed to the harmonisation in the development of Islamic finance across different jurisdictions. At this juncture, two questions are to be answered. Are these systems adequate in enforcing effective regulation? Have these systems been effective enforced and followed?
At the international level, Islamic finance has rapidly gained significance becoming an increasingly important part of the international financial system. Investors from financial centres across the globe have been drawn by the funds raised in Islamic financial markets in different jurisdictions enabling IFI to venture beyond their domestic borders. As market players across continents participate in the expansion of inter-regional investment flows, it has enhanced financial linkages among the major regions. The expansion of the inter-linkages among intermediaries and markets across regions would contribute towards a more efficient allocation of financial resources across borders and thus contribute to enhancing global growth prospects.
Yet another aspect that has seen significant change is the development of human capital in Islamic finance. It has been a vital development that has been crucial in ensuring an adequate supply of talent and expertise for further expansion and development of the Islamic financial services industry. High calibre professionals that have the combined knowledge and understanding of the Shariaa with the necessary skills in finance are now in great demand. Major institutions are now offering highly focussed structured programmes to enable the younger generation to attain higher learning in Islamic finance.
It should be noted that many of these companies used to bag Top Performer awards instituted by agencies in GCC (most of the time, such events were sponsored by these institutions).
By first quarter of 2009, only few companies with strong structure and Shariaa Governance Systems survived the financial turmoil and those devoid of such transparency systems were eliminated from the business map.
Shariaa Governance Systems
In the modern era of business, corporate governance has gained immense functional importance. Today, corporate governance refers to the method by which an organization is directed, administered or controlled in alignment with stakeholders interest. Islamic finance is no exception to this aspect.
Due to its similarity to the conventional system, the existence of a proper framework of corporate governance is a dire necessity. The differing factor, however, is that IFI have the responsibility to ensure the compliance with the Shariaa principles in its products, instruments, operations, practices and management. This factor makes Shariaa governance yet another component that is peculiar exclusively to IFI. According to the IFSB Guiding Principles on Corporate Governance financial institutions must ensure that an appropriate mechanism is created in order to ensure the compliance with all Shariaa principles. Similarly, the IFSB Guiding Principles on Risk Management states that IFI shall have in place adequate systems and controls, including Shariaa Board/advisor to ensure compliance with the Shariaa principles.
In order to ensure effective implementation of these principles, Shariaa governance needs to be followed by government imposed statutory conditions for the establishment of the Shariaa Advisor/Committee (SAC). This is imperative for the development of the Islamic Finance industry which is growing at a phenomenal rate. Through the establishment of the SAC, IFI can obtain services with respect to advice regarding Shariaa matters as well as ensure compliance with the Shariaa tenets and requirements in their operations.
Shariaa compliance forms the backbone of Islamic banking & finance. Through effective Shariaa governance, not only is the legitimacy of the practices of Islamic banking & finance preserved it also boosts the confidence of the shareholders and the public. The absence of an effective Shariaa governance system would have an adverse impact on the confidence of the public and also expose IFI to risks. Most organizations, of late, have established Shariaa Compliance Units (SCU) that will monitor operations and ensure Shariaa compliance in its day to day transactions. Although, this is one step toward ensuring Shariaa compliance, this is not to be mixed up with having a Shariaa Advisor/Committee in place. The SCU is primarily an internal audit function and does not normally have actual Shariaa Scholars to oversee the implementation of the Shariaa principles. The functions of the SAC are in much more detail as compared to that of the SCU and are not to be used interchangeably. However this is not to say that the SCU is completely obsolete. With the implementation of Basel II, the SCU can function as a powerful internal audit function that will ensure Shariaa compliance.
The ultimate purpose of the establishment of the SAC in IFI is to ensure Shariaa compliance to its operations and products. All banks and takaful operators must have provision regarding the establishment of SAC in their Articles of Association and Memorandum of Association. Through the establishment of the SAC, IFI can avail its advisory services in its operation, and to analyze and evaluate Shariaa aspects of new products/schemes submitted by the respective banking institutions or takaful companies.
The primary functions of the SAC, complementing day to day operations, can be described as follows “
1- Product Evaluation
The concept and structure of the product will be evaluated by the SAC along with a periodic review of all existing products.
The Shariaa not only requires the products itself to be Islamic, but also that the documentation be of Islamic nature as well. The SAC will ensure that all documentation is in Shariaa compliance. The SAC will endorse all documents involved and these include the terms and conditions contained in the proposal form, contract, and agreement or other legal documentation used in executing the transactions; and the product manual, marketing advertisements, sales illustrations and brochures used to describe the product.
The structure of the document may vary with each financial institution and also with respect to the products. The SAC will advice in matters of compliance of its documentation with Shariaa principles. They also have the authority to reject any document that may not comply with the Islamic principles or may require the IFIs to make amendments in order to meet Shariaa principles.
3- Business Operations
The business operations of the institution will be monitored by the SAC periodically. In order to ensure that the business operations of the IFI comply with Shariaa principles at all times, the SAC shall continually provide its advisory services. These services will include procedures for transaction, actual business operations, and system applicable to the banking operations. Prior clarification with the SAC is required, in the event that the organization plans on introducing new information system to all its products, so as to ensure that the system complies with the Shariaa principles.
4- Provide Advisory services on request
Parties within the IFI like its auditor, legal counsel, branches, consultant, or a customer may seek advice on Shariaa matters from the SAC. The SAC is required to provide opinion to them so that compliance with Shariaa principles can be assured completely.
5- Endorse Shariaa Compliance Manuals
The Shariaa compliance manual, maintained by the financial institution, will specify the manner in which a submission or request for advice be made to the SAC, the conduct of the SAC's meeting and the manner of compliance with any Shariaa decision.
The Regulatory Problem
With Islamic Finance growing at an accelerated pace, its hubs being located in different parts of the globe, the massive liquidity it contains and its ever growing demand, the need for regulation in the system is of utmost importance. Regulation helps support the development of a vibrant financial system by ensuring the stability of the entire financial system. However, with respect to Islamic Finance, there have been very less discussions of the practical policy issues pertaining to the role that the regulators should play. In order to avoid being viewed as acting against Islamic interests and in conflict with the Shariaa principles, most central banks and finance ministries regard issues in this regard as areas where caution and diplomacy are needed.
Shariaa compliance requires IFIs to meet lending and investment standards not required by conventional banks. It is this convergence of Islamic principles and logical financing that attracts Muslims to IFIs. There are private and public models to ensure that financial services labeled Islamic or Shariaa-compliant comply with these principles. In some countries, private institutions maintain their own Shariaa advisers to ensure Shariaa compatibility. In others, consultative boards at the supervisory level increase the predictability and conformity of Shariaa board decisions. A regulators adaptation will depend on the relationship between civil and religious law in the country. Countries that maintain a greater separation between civil and religious law might find it more difficult to assign a government role to adjudicate what are essentially religious questions. According to some scholars, countries with less separation might more easily enter into or consolidate the supervisory role of Shariaa compliance. Consumers in both types of countries would still have recourse when IFI fail to comply with promised services.
This reinforces the need for regulators who have in depth knowledge of the Shariaa laws. Experts steeped in the Muslim scriptures are critical to Islamic finance, which requires a religious stamp of approval before a bond, mortgage contract or other financial product can be marketed as moral according to the standards of the Holy Quran. But qualifying for this work takes much more time and effort than other jobs in finance require. What we need is an Islamic Scholar with financial acumen.
The most alarming problem faced by Islamic Finance today is that industry is rapidly growing at a pace that is running ahead of the emergence of new Shariaa Scholars with expertise in Islamic finance. As many financial institutions in the world explore alternatives to conventional finance and with majority turning towards Islamic finance the services of competent Shariaa Scholars in order to adequately guide financial institutions in pursuing legitimate Shariaa compliant products and services is in huge demand.
The truth is that the industry is unable to churn out adequate number of scholars primarily due to the large gestation period required to produce a qualified Islamic scholar. Candidates must first study Islamic law or Shariaa for many years, and then master finance. It has been seen in the past decade or so that only a handful of Scholars with the relevant expertise are available to financial institutions to approve their products and services. Although the numbers of competent Scholars have increased in the last two or three years, there is still inadequate involvement of Scholars in Islamic finance transactions, products and services offered by financial institutions to their customers. What ADVANTAGE understands is that, it may take more than a decade to train more scholars, but even the most optimistic ones do not expect a new generation of scholars for at least five years.
Naturally, Shariaa scholars are going around the world to provide their services since new scholars are not being trained fast enough to take their place. Another factor is that there is a strong linguistic problem involved. Most Shariaa scholars insist on working only in Arabic, the language of Islam. However the global market needs scholars fluent both in Arabic and in languages such as English or French. There is also a lack of consensus on what qualifications and experience are needed for the role. What is important is that the shortage could lead to conflicts of interest and inadequate supervision. With the demand for Islamic Finance expanding from the Middle East as more of the world's 1.3 million Muslims seek investments that comply with their faith, it is alarming that there are hardly 100 scholars in the world qualified to sit on Shariaa boards.
There is wide criticism on the fact that certain Shariaa Scholars sit on too many Shariaa boards and take on too much responsibility and are not able to give much attention to financial institutions as they are so thinly spread. And even though, available Islamic Scholars are working hard to cope with the growing demand, the lack of Scholars creates a severe hindrance to the development of business activities of the financial institutions. Currently Scholars are being put under unrealistic pressures to respond to Shariaa queries and hence the problem with the accessibility to the Shariaa Scholars is immense and needs to be addressed sooner rather than later.
The serious shortage of scholars has now caused scholars to function in multiple institutions without restriction. Among the Top 20 scholars who are actively serving multiple financial institutions, there are scholars who service over 46 different institutions across the GCC and internationally. Expecting them to process every query without delay and holding them responsible for delaying transactions is hardly justifiable. Not only are such consultations hard to believe, it also leaves the possibility of inadequate evaluation of facts before sanctioning transactions.
Moreover, there are also cases of a small group of Shariaa Scholars taking advantage of their small numbers and forming a monopoly state forming a hindrance to the younger generation. Monopolizing on their small numbers, these Shariaa Scholars also receive inflated packages. The rewards sometimes range from USD 100,000 to USD 250,000.
Many countries are actually putting in place number of initiatives to bring through a new generation of scholars. Given that the market is so skeptical of experts from outside the elite group of scholars, it is perhaps inevitable that it is they who are helping drive education programs. It is also noted that most of the senior scholars are bringing through protgs who will in time gain sufficient market experience to work independently.
However, in the end, it is up to the banks and financial institutions to begin employing new scholars independently. Without trust being placed in the new experts, companies will be at the mercy of the handful of scholars currently dominating the field. With the industry desperate to move forward, economic self interest should force their hand.
Considering the sophistication and innovation recent products offer combined with the complexity of the related documents, Shariaa Scholars need to be engaged full time in order to oversee their effective execution and implementation as well as monitor the day to day activities of financial institutions dealing with such products. Scholars providing these services should be members of a Shariaa Supervisory Board and certain executive powers should be vested in them to enable them to execute some simple and repeat transactions without having the need to convene a full Shariaa Supervisory Board meeting. However, considering the inability of the system to produce adequate Shariaa Scholars, these functions are far from reality.
Another advantage of appointing a full time Shariaa Scholar is that training programs for junior graduates can be customized to the requirement of financial institutions to enable them to satisfy the demands of their businesses. Unless further graduate training programs are put in place, there will be a constant shortage of supply in meeting the increasing demands of financial institutions for Shariaa Scholars.
As a primary initiative evaluations need to be conducted on the extent to which financial institutions have contributed towards bringing in new Shariaa Scholars. Is adequate support is being provided to new graduates of Shariaa involve them in the Islamic finance industry? Are they supporting any trainee programs for newly Shariaa graduates to gain experience? Over the last 30 years or so, very few initiatives have been taken by even some of the established IFI to create opportunities for bringing fresh Shariaa Scholars on boards and this is true even for the GCC states.
Due to the non availability, there is also a huge risk that the Islamic Finance industry may engage unqualified or mediocre Scholars who are not ready to handle Shariaa matters. If left unchecked this could lead to financial institutions carrying out transactions without correctly observing Shariaa principles. Approaches that will ensure the development of the Shariaa Scholar base need to be taken to ensure that this risk is mitigated.
Education and training is another area that will be reinforced by the appointment of a full time Scholar. This will enable employees to be trained in the application of Shariaa principles in all areas of the working environment. In addition to being relevant to legal and compliance matters, this will also greatly assist in areas of both internal and external audit process. Additionally, there is also the requirement of following the instructions from the Shariaa Scholar in day to day activities of the financial institutions such as the adherence to Shariaa principles of truth, transparency, honesty and fairness and entertaining guests and clients in a manner that complies with the principles of Shariaa.
Finally there are also considerable criticisms that question the interest of IFI as they offer Shariaa compliant products. Allegations that IFIs offer Shariaa compliant products for commercial benefit only and there is no desire to follow the true spirit of Shariaa principles are common misunderstandings they encounter. However, earning a profit in a Shariaa compliant manner is hardly discouraged. In fact, from a Shariaa perspective this is very much encouraged.
It should be noted that making gains in its name is something Shariaa will never allow when their activities may not conform to the principles of Shariaa. Such kinds of criticism faced by IFI can be overcome by engaging a full time Shariaa Scholar to oversee their day to day activities based on strict, honest and unbiased decisions in accordance with Islamic Shariaa principles. This will not only enhance the quality of the services of the institution but also heighten the confidence of both employees and customers.
Incorporating Basel II into Islamic Finance
Basel II, the second of the Basel Accords making recommendations on banking laws and regulations issued by the Basel Committee, has gained relevance and has become a mandatory requirement in todays banking world. However, some of the finer aspects of its application to Islamic Banks may need further explanation. Simply put, the intention of Basel II is to enable regulators to ensure that banks proactively maintain sufficient reserves to protect both themselves as well as their clients against risks in their loans, their operations or, the market itself. Essentially, this means that for every set of defined categories of risk, the bank needs to set aside capital. As the risk factor goes up, the more capital the bank will need to provide a cushion against untoward events. While Basel I addressed only credit risk, Basel II looks at credit, market and operational risks. Basel II also provides for an assessment of a banks capital adequacy, which is more risk sensitive.
With respect to Islamic Banks, the implementation of this new capital adequacy framework will enhance their credibility and sustain their growth globally. In Kuwait, the CBK has taken the first step and given the directive for the implementation of the amended capital adequacy framework. The major factors that have been amended include the minimum capital requirements, supervisory review of capital adequacy and market discipline. CBK Governor, Sheikh Salem A. Al-Sabah pointed out that In light of risk measurement methods, capital requirements will be defined amid more sensitivity to bank exposure, aiming to give Islamic banks incentive to improve risk management.
Although the implementation of Basel II in Islamic banks is similar to that of conventional there are a few differences that need to be noted.
1- Capital treatment is dependent on the type of Shariaa contracts underlying the transaction;
2- Profit sharing investment accounts are recognized as risk mitigants;
3- Physical collateral is recognized as a risk mitigant for credit risk;
4- Availability of supervisory slotting criteria method and more granular risk weights for the specialized lending type of Islamic financing transactions; and
5- The capital requirement for inventory risk arising from risks associated with the holding of physical assets has been introduced.
Although the similarity between the risk profiles of IFI and conventional institutions are prominent, there are some unique and distinct risks pertaining to IFI. For example “ The structure of a home financing facility in Islamic finance is that of a Diminishing Musharakah. This results in the Islamic financial institution having co-ownership in the house purchased in which the house is just collateral to the financial institution.
The Islamic Finance industry has come a long way since its inception and the recent global financial crisis has enabled a growth explosion within the industry. The increasing awareness and appreciation of the inherent strengths of Islamic finance and its tremendous potential for advancement have ignited interests amongst the global financial community to venture into this new sphere of finance. Taking advantage of the increasing role of Islamic finance in bringing together different parts of the world with surplus funds in search of investment opportunities will increase these mutually reinforcing prospects.
However, there is the enormous task of reinforcing Islamic Finance to handle the immense demand it is attracting. The risks of leaving the gaps unchecked are too great to be overlooked and may bring about the downfall of the Islamic Finance sector. The most imminent danger for Islamic Finance sector is because of the perception that banks and scholars are failing to provide adequate solutions. Allegations of corruption among Shariaa Scholars and lust that most institutions like banks have for profits are weakening the credibility of Islamic Finance Industry. Moreover, the dwindling number of Shariaa scholars make it impossible to handle the demand Islamic finance has in the market which can in turn cause educated and informed customers and clients to question its credibility.
Immediate action need to be taken in terms of effective governance systems as well as bringing in the younger generation of Shariaa scholars. Islamic Finance is unique which makes the usage of conventional standards obsolete. IFI require standards that are fine tuned to its requirements. For example an Islamic LIBOR is something that has been long overdue. Such a standard can help Islamic banks and institutions standardize the rates at which they lend funds between each other.
We call upon the leaders of the Islamic Finance industry to take control of the situation and use the innovative power, which the industry is abundant with, to reinforce the sector and lead toward exponential growth.