Islamic Finance: “At a Crossroads”

Introduction

Given the substantial developments and growth in the Islamic finance industry over the last 10 years or so, it is clear that the pace of innovation has also had its downsides. Some Shariah scholars and practitioners have criticised the sector’s rapid growth as occasionally being reckless and unnecessarily “pushing the theological boundaries too far”.

Such criticism, whilst primarily theological based, has parallels with criticism faced by the conventional finance industry and both sectors have, of course, suffered because of the global downturn. As a consequence, there has been a continuing move for a “back to basics” approach and specifically in the case of Islamic finance, a conservatism in the interpretation of what is acceptable (halal). It is therefore a good time to take stock of where we are and what issues need to be addressed if the Islamic finance industry is to have a successful future.

Economic Environment

We have all heard about the high profile potential and actual defaults which include the following examples:

It is also fair to say that if various Central Banks had not stepped in to stabilise certain domestic markets, things could have been much worse. In particular, if the Central Bank of the United Arab Emirates had not provided support to the Emirate of Dubai and indirectly to the myriad of underlying and Dubai Government related trading entities, we might be facing a greater number of high profile failures and potentially a massive detrimental effect or indeed a global failure of the Islamic finance industry as a whole. Such an eventuality could have been on a scale which would have been immensely difficult to deal with and from which it would be difficult to recover. Thankfully, we have not reached that “nadir”.

Islamic banks and investors have also suffered through the drop in asset values and commodity prices generally. This has, in particular, manifested itself through the failure of “loan to value” type calculations particularly in the real estate sector.

Theoretical Approach (Reality or Substance)

Critics of the Islamic finance industry have pointed to the fact that whilst the underlying Shariah jurisprudence points to the fact that transactions need to have:

in reality, Islamic banks and financiers have merely replicated (and in some cases, directly copied) investment activity and structures used by more conventional banks and financiers. In particular, an area of criticism much quoted is the growth of investments in derivatives of various sorts badged as being Shariah compliant and using the Salaam (futures arrangement) and Arboun (option) structures.

There has also been a criticism of undue and inappropriate risk adoption and allocation. Whilst the prohibition against Riba (interest) in its various different formats is well known, there are also prohibitions against uncertainty and deception (Gharar) and activity tantamount to gambling (Maysir). This should really prevent investments where the underlying asset is ‘not visible’ and also where there is uncertainty or ambiguity. Essentially, a prohibition against speculative transactions.

In the bond market, for example, Sukuks have increasingly been structured to copy conventional bonds, providing implicit capital guarantees (or underwriting) to investors/bond-holders. On the face of it, this falls foul of the strict rules and concepts on risk/profit sharing inherent in Islamic finance. To that extent, some Shariah Scholars have gone as far to say that most Sukuk already issued are Haraam (not permissible).

Additionally, whilst Islamic banks did not have material exposure, in a direct sense, to the sub-prime mortgage crisis in the USA which directly affected (or caused) the global financial meltdown, the Islamic banking system is inextricably linked to the global banking system and suffered in much the same way.

The Future

Notwithstanding the above background, going forward, if the Islamic banking system can address these systemic and interpretative issues, it can still continue to provide a real partner to conventional financial systems. Islamic retail banks, for instance, have theoretically some advantages over conventional banks in that:

This can sometimes provide the Islamic financial institution with a bedrock of liquidity or profitability that maybe seen as an advantage over conventional banks. The truth is perhaps more complicated. Islamic financial institutions are also, generally and inherently, conservative.

Diversity

The differing interpretations of Shariah compliance in different parts of the world and amongst differing schools of jurisprudence (and even amongst scholars in the same school) has also prevented the industry developing at the rate it was once predicted to do so.

Notwithstanding the excellent work of institutions such as the Islamic Financial Services Board (“ISFB”), the Accounting and Auditing Organisation for Islamic Financial Institutions (“AAOIFI”) and the Islamic Development Bank (“IDB”), there are limited global Shariah standards and where these do exist, there is indeed no wholesale adoption by Shariah national bodies/governments or indeed an implementation of standards in domestic legislation.

The fragmentation of the Islamic finance industry is a continuing hurdle that must be overcome if the industry truly wants to compete with conventional financial systems on a global level.

Standardisation

The issue of standardisation practices (and documentation) has long been a key debate in the Islamic finance industry. A certification (fatwa) should really be specific to a transaction rather than a generic set of differing transactions.

It is clear that standard practices are developing and more importantly, there is a growing acceptance of the same from practitioners. This can, for example, be seen in the use of the same type of documentation in Sukuk issues where hitherto questions have arisen about the Shariah compliance of certain investment and financing structures. This has created a great deal of uncertainty especially with conventional investors.

It should still be remembered that for most of the largest sovereign, treasury and corporate Sukuks, conventional investors have represented the largest group of buyers and will continue to do so for the foreseeable future. Notwithstanding the real and obvious desire for standardisation, some Shariah Scholars have expressed concerns against standardisation i.e. that standardisation actually caused part of the downturn and led to the reckless adoption of non Shariah compliant structures and therefore speculation without a real and bespoke Shariah diligence on the underlying nature of a deal. Speculation is clearly prohibited under Shariah.

However, notwithstanding such views, it is pretty normal to see the same type of documentation in real estate transactions and financings (Ijara, Murabaha, Tawarruq etc.) and in certain private equity/investment type structures (Murabaha, Musharaka, Mudaraba) and, of course, Sukuks. Our view is that this standardisation process should continue and gather pace with, of course, the ongoing checks and balances being the relevant Shariah Scholar/Committees making sure that the fundamentals follow appropriate Shariah guidance.

Corporate governance and transparency

One of the most pressing and continuing issues facing the industry is the apparent lack of transparency, corporate governance and regulatory oversight of Islamic banks. The global downturn and the consequential increase in the involvement of regulators has shown that Islamic banks are not alien to corruption, mismanagement and bad investment decisions.

It is fair to say that whilst a lot of good work has been done, Islamic financial institutions still tend to be less transparent than regulated conventional entities. Whilst slightly different in emphasis but similar to conventional regulation, these issues are often not fully addressed until the actual financial institution faces the pressure of an external downturn such as a collapse in asset prices or internal shocks such as a governance or systematic failure.

Islamic banks also produce financial statements that are not easy to understand to a conventional trained eye. For instance, some of the methods that Islamic finance institutions use for “smoothing” returns to Investment Account holders is not always understood.

Accordingly, the growth in the Shariah audit industry has to also have alignment with mainstream financial audits.

Development of Regulations

There has been good progress in setting global regulatory standards for Islamic financial institutions by:

Notwithstanding the excellent work and developments referred to above, the regulations have so far been non-binding and compliance is generally voluntary. However, efforts are now being made by regulators such as the Dubai Financial Services Authority, to encompass such regulations in domestic legislation.

Unfortunately, there is still no uniform approach to regulating Islamic banking and finance and there is a mixture between:

Approach to Audit and Systems Regulation

Notwithstanding the comments above, there is no real reason why the same approach to identifying, quantifying and dealing with risks in a conventional banking context cannot be applied to Islamic financial institutions. Islamic financial institutions face many of the same risks that conventional banks face such as payment default and market risk.

There are, of course, some unique risks regarding Shariah compliance and non-compliance i.e. certification (fatwas) but the general methodology used to identify and quantify these risks can be the same as that applied to conventional banks with appropriate modification to reflect the specific issues which arise in Islamic finance. It is then having the appropriate and limited check, balances and reporting systems in place to mitigate those risks.

Development from Conventional Markets

What will hopefully assist the general process of aligning, insofar as possible, the Islamic finance industry with the good governance generally attributable to the conventional markets (global downturn excepted), is the increasing awareness of the importance of Islamic finance sector from conventional jurisdictions.

Notwithstanding the many interesting developments in the Islamic finance industry driven by the growth of the market in the Middle East and South East Asia, the involvement of conventional institutions from conventional economies will also help.

The United Kingdom, for instance, has been at the forefront of developing a system which creates a level playing field for those requiring their investments to be Shariah compliant. Such legislation and regulatory developments that have helped include:

Conclusion

I hope that we have demonstrated that the Islamic finance industry has suffered to an extent in the same way that the conventional finance industry has suffered.

However, the Islamic finance industry does provide an alternative partner to the conventional markets and has a real part to play. In doing this and ultimately being successful, it has to address some of the issues outlined in this paper and luckily and of vital importance, there is a real desire amongst scholars, practitioners and Islamic financiers to engage in that process. However, the excesses over the last few years partly due to a rush to transact/innovate and to an extent to replicate conventional structures, must be moderated by a real desire to stay true to Shariah jurisprudence.

* This Articles was published in Euromoney Islamic Finance Review 15 June 2010