Shake-up for Shariah

This year a comprehensive Shariah Governance Framework came into effect that could prove to be the blueprint for the global industry. MUSHTAK PARKER looks at that and the subject overall

Shariah governance is an essential component of Islamic finance. Without it, there can be no closing of an Islamic financial transaction whether a vanilla commodity trade fi nance (Murabaha) or a more complex sukuk (Islamic trust certificates) off ering.

If a deal is promoted as shariah-compliant but without the necessary fatwa (legal opinion) or compliance review, then the shariah legitimacy of that deal is immediately compromised, and both investors and customers, despite thinking that the deal is compliant, would partake at their peril.

Muhammad Bin Ibrahim, deputy governor, Bank Negara Malaysia (BNM), the central bank, at a recent seminar in London on shariah governance in Islamic fi nance, maintained that “in conjunction with a supportive legal framework, it is equally important to have a robust shariah governance framework to preserve the sanctity of shariah in Islamic fi nance. Th is is inevitable given that Islamic finance has its roots in shariah.”

In Malaysia, the integrity and credibility of the shariah governance framework is supported by the role of BNM’s shariah advisory Council (SAC), a centralised referral body for the Islamic fi nance community, which is by law the highest authority in the determination of shariah matters relating to Islamic fi nance. In preserving the sanctity of the shariah, the SAC itself ensures the robustness of its rulings through a rigorous process before arriving at a decision.

Yet, shariah governance in the global Islamic financial industry is at best piecemeal and in most jurisdictions, except Malaysia, either left up to the individual institutions or investors to either buy-in or outsource.

In the past this had serious implications for without quality control it can become a free-for-all, where anyone can claim to be a shariah expert and endorse a real estate or trade fund set up by virtually anyone.

In Saudi Arabia, a few years ago, this is exactly what happened when a spate of unregistered real estate companies were promoting dodgy Islamic real estate investments off ering unrealistically huge returns but endorsed by so-called shariah experts. The result was that these companies, little more than Ponzi schemes, failed, only to be bailed out by the saudi government.

On the other hand, the rush to establish Islamic banks in new markets have sometimes backfired spectacularly because feasibility studies and business plans incredibly overlooked the mundane requirement of shariah governance and regulatory frameworks.

For instance, the Bosna International Bank and the Arab Albanian Islamic Bank were established as Islamic banks in sarajevo and Tirana respectively. Yet, these banks could not conduct even a basic commodity Murabaha transaction nor its more complex variant, Tawarruq, used in cash management and liquidity management, simply because the enabling laws dealing with the rubrics and taxation implications of the transactions were not in place in Bosnia-hercegovina or in albania.

While the situation has improved since a decade or so ago, this problem keeps resurfacing today especially in new markets for Islamic finance such as in the CIS countries in central asia and in some asian, Middle East and African countries.

New agenda

International auditing firm and consultancy, KPMG International in a recent report titled Islamic finance: The new agenda concluded that the doctrinal phase of the Islamic finance industry over the past decade – which was underpinned by the debate of shariah-compliant versus shariah-based products – is eff ectively over, and a new agenda is emerging for Islamic fi nance and that asia, especially Malaysia, will continue to be its engine of growth.

“The Islamic finance industry has spent over a decade debating various issues of principle that the global credit crunch proved to be increasingly irrelevant,” said the report. “replacing them is a new context that has at its centre the continued improvement of governance, better asset and liability management and greater product suitability and transparency. It is important for Islamic fi nance to progress in the right direction as it and conventional fi nance recover from the global crisis.” shariah governance is also a two-way process.

Shariah advisories can interact only on the basis of the information they are given by the bank or the client. Market players such as Stella Cox, managing director of DDCAP Limited, strongly urge a process of continuous engagement between the various stakeholders, including shariah advisories.

In the aftermath of the global financial crisis, Islamic clients sought refuge in cash and core products such as classical Murabaha-based solutions to structured trade finance. “Of course in recent years,” she explained, “we have become all too accustomed to seeing Murabaha criticised for its excessive utilisation, lack of tangible asset backing and even its role in introducing unacceptable amounts of leverage into the Islamic financial system.

“As in the conventional system, Islamic fi nancial contracts can, as recent experience shows, be adapted to support their application to situations outside of their classical or intended purpose and it is important, therefore, that the products and services that include and promote such structures are transparent, open and available to rigorous and regular scrutiny as they traditionally have been.

“To that eff ect it is important that all entities involved are willing to engage with the relevant au- thorities, including shariah advisories and fi nancial regulators, at the earliest stage so that structures can be built upon from a solid foundation to the comfort and satisfaction of all.”

While DDCAP is oft en, and not entirely accurately, principally identified with the facilitation of physical commodity assets for purposes of liquidity management, it prioritises a disciplined approach to all its commitments involving supply of allocated (ie identifiable) and authenticated physical assets incorporating a diverse range of commodity classes.

In fact, DDCAP, in 2010 participated both as a principal and intermediary in a series of structured Murabaha trade financings involving a diverse range of commodity assets for both institutional customers and funds.

But to ensure ongoing and proactive shariah compliance, DDCAP focuses “on our continual adherence to the Murabaha contract stipulations advised to us by our clients’ shariah advisories, which readily transfer to structured Murabaha trade financing opportunities and we encourage regular inspection and audit of our business activities and processes by those advisories, too”.

Contract criticisms

Similarly, despite eff orts to establish clearer parameters, criticism of the Tawarruq contract persists amongst certain scholars and practitioners. Tawarruq has long been a sensitive issue and its merits have been debated at length, especially for us in liquidity management as opposed to say cash management.

DDCAP’s Stella Cox believes that it is absolutely essential that market participants, whether principal or intermediary, have full awareness of, and commit to, the very precise guidelines and standards that are issued by the shariah committees of industry bodies such as AAOIFI and the OIC Fiqh academy, as well as individual bank shariah committees.

These standards are issued in respect not only of products and structures, but where related trade execution is concerned. If asset-backed processes are to be followed strictly in accordance with shariah stipulation there is usually a commercial impact. after all, this is not a conventional financial market practice.

However, warns Stella Cox, in the midst of the pressures faced by financial institutions in recent years, the desire to reduce or remove such cost implications oft en seems to have become a priority.

Endeavours to cut costs can result, intentionally or otherwise, in subtle revisions to approved structures and thereby adherence to the prescribed standards and stipulations for the arrangement. If they are not identified and immediately resolved, situations such as this will ultimately tarnish the integrity of any structure.

“There is no excuse for this as the shariah authorities have made their concerns very clear. Their requirement is that Tawarruq should be utilised selectively in wholesale activity and with the utmost caution at consumer level, where, again, there is particular concern about the introduction of leverage as well as the segregation of contractual responsibilities. We all have a role to play in ensuring that the principles and standards are upheld to the finest detail and respected by all be we sponsors, originators or even market intermediaries,” she added.

Over the past few years indeed there has been a recognition that the shariah governance process needs reforming in manifold ways. At the core of the debate is the question of the establishment of an apex or shariah authority of Last resort (akin to the central bank being the Lender of Last resort for banking) at the central bank or the securities regulator, which sets the rules of the game for shariah governance in that particular jurisdiction.

This is at the heart of the Malaysian practice and it is becoming the model to emulate, with the state Bank of Pakistan, the UAE Central Bank, Bank of Indonesia, Central and Bank of  Brunei all following the Malaysian model of a centralised shariah board.

Other issues

Other issues include the institutionalisation of the process; ways of preventing confl ict of interest by restricting the number of institutions individual shariah advisories can advise; harmonisation as opposed to standardisation of practices, documentation and interpretations, regulation of shariah advisories and the promotion of convergence between various jurisdictions.

Two of the key issues in shariah governance are the number of boards on which shariah scholars can serve, and the question of confl ict of interest. Prominent saudi shariah scholar dr Muhammed elgari is sanguine, emphasising that a human being does have a limited capacity, but in the context of shariah advisory, this can’t be measured by the number of boards scholars sit on. The real test, he maintains, is quality of work and ability to meet the expectations of the other party.

Dr Akram Laldin, executive director of the International research academy for Islamic Finance (ISRA), the shariah research arm of Bank Negara Malaysia, prefers guidelines on how many boards a person can sit on, and agrees that it would be very difficult for a scholar to dedicate adequate time and contribute effectively if he sits on too many boards.

“Th e number of boards a person should serve on should depend on his or her capability and ability. The usual reservation is because not many scholars have enough ability and experience and I believe this can be overcome by placing the combination of senior and beginner scholars on the same board.”

Some people invoke the “conflict of interest” argument to support their desire to restrict the number of boards shariah scholars can sit on. Dr Elgari believes that this is a fair concern and, in several instances, he has emphasised that shariah board members should be conscious of it and try to avoid it.

“I for one have been off ered more than once shares in companies I advise but I always declined because I see the conflict of interest,” he confided. Other scholars similarly see valid arguments on this issue, and suggest the establishment of a framework to manage potential conflict of interest.

The shariah perspective on “confl ict of interest” is clearly defined and some scholars such as Dr Elgari urge scholars to be more transparent by occasionally making statements showing their awareness of the possibility of such conflict and how they could meet its mitigation requirements.

New framework

In January this year, the most comprehensive and thought-out Shariah Governance Framework (SGF) for Islamic Financial Institutions (IFIs) came into effect in Malaysia, which according to many of the prominent shariah advisories could prove to be the blueprint for the global industry and other countries to follow. IFIs authorised by BNM, and the Securities Commission Malaysia (SC), are required by law to comply with all the requirements of the framework within six months.

The SGF supersedes the Guidelines on the Governance of Shariah Committees of IFIs introduced by BNM in 2004, and aims to enhance “the role of the board, the Shariah Committee and the management in relation to Shariah matters, including enhancing the relevant key organs having the responsibility to execute the shariah compliance and research functions aimed at the attainment of a Shariah- based operating environment”.

Malaysia is the only jurisdiction in which shariah advisories have to be registered with the relevant regulator; must go through a “fit-and-proper” testing regime in terms of educational background and requisite skills sets; and where Shariah advisories are restricted to advise only one institution in a particular industry segment so as to pre-empt conflict of interest and to widen the base of shariah advisories in the market.

The Framework also sets out the expectations of the central bank on an IFI’s shariah governance structures, processes and arrangements to ensure that all its operations and business activities are in accordance with shariah; provides a comprehensive guidance to the board, shariah Committee and management of the IFI in discharging its duties in matters relating to shariah; and outlines the functions relating to shariah review, shariah audit, shariah risk management and shariah research.

Effective implementation of the new shariah governance framework, added deputy Governor Ibrahim, will further promote stakeholders’ confi dence and enhance the integrity of the Islamic financial industry.

While industry bodies such as the Kuala Lumpurbased transnational Islamic Financial services Board (IFSB) have introduced standards on shariah governance in Islamic financial institutions, these have, at best, been limited in scope and are adopted only on the basis of voluntary adoption, which in the Muslim countries is anyway underdeveloped.

More recently, the Bahrain-based accounting and auditing Organisation for Islamic Financial Institutions (AAOIFI) is reportedly in the process of developing a standard that aims to restrict the number of boards shariah scholars could sit on.

An effective adjudication system to give customers, banks, and other stakeholders recourse to law is equally important and relevant, given the increasing number of court cases relating to Islamic financial transactions that have been heard especially in the high Court in London.

“An efficient and authoritative adjudication system,” explained deputy Governor Ibrahim, “helps create certainty and establishes the legitimacy of Islamic fi nancial contracts. Islam places great importance on contracts and on parties to a contract. The ability of parties to enforce a contract is thus critical as it constitutes the core of maintaining public confi dence.

“Therefore, there is a crucial need for a dispute settlement mechanism that is able and competent to dissect in a judicious manner shariah matters in contracts, so that issues of dispute in shariah interpretation can be resolved and enforced accordingly.”

Specialist judge

In Malaysia, for adjudication purposes, a dedicated judge in the commercial division of the high Court in Malaysia has been assigned to preside over litigations relating to Islamic banking and finance. The court’s adjudication role in Islamic finance is reinforced by the support from the saC in its capacity as a consultative body to the Malaysian judiciary system.

Under the law, the Central Bank of Malaysia act 2009 prevails if a question concerning a shariah matter arises in any proceedings relating to Islamic fi nancial business, where the court or the arbitrator shall take into consideration any published rulings of the saC or refer the matter to the SAC for its ruling. The SAC’s rulings are binding on the courts and arbitrators.

This referral system, explained the deputy governor, preserves and enhances the sanctity of shariah rulings and the consistency in the interpretation and application of shariah principles in Islamic financial transactions. To complement the court system, specifi c arbitration rules for Islamic banking and fi nancial services have also been developed, enabling disputes for both domestic and international cases to be dealt with by the Kuala Lumpur regional Centre for Arbitration (KLRCA).

Good documentation of contracts underlying Islamic financial transactions is equally important because it forms an integral part of Islamic               finance as it provides a critical “bridge” between shariah and Islamic finance practices.

The move towards greater standardisation in the legal documentation of Islamic financial transactions is also a major challenge. a more standardised contract creates greater certainty and predictability about the characteristics of the financial contracts. When the parties involved are better able to understand their rights and obligations, stakeholders’ confidence in the market would correspondingly improve.

In essence, according to Bank Negara Malaysia, “standardisation of documentation, products and practices are essential to ensure that the markets are fair, effi cient and transparent. Whilst contract and product standardisation is encouraged to the greatest extent possible, we also need to be mindful not to let it stifle innovation. as a nascent industry, the need for innovation and competition in Islamic finance is so important that its absence might impede its growth”.

One institution making an important contribution to standardised solutions in Islamic finance is the Bahrain-based International Islamic Financial Market (IIFM), which last year launched a reference Paper on I’aadat al shira’a (IS) (the Islamic alternative to repo (repurchase Contracts). The IIFM reference Paper on I’aadat al shira’a provides a basis in terms of fi nding a widely acceptable and market-based solution that will play a major role in liquidity management as well as the creation of a more active Sukuk secondary market.

Ijlal Alvi, Chief Executive officer of IIFM, commenting on the importance of the paper said, “The lack of liquidity management tools, particularly a repo-like product, is a challenge that has been faced by the Islamic finance industry for some time. IIFM initiated the process with the assistance of the working team consisting of leading practitioners from the industry to find a solution or identify the key factors that may eventually lead to the development of a product which Islamic financial institutions can use for their short-term liquidity management requirements.”

The IIFM has thus far issued three Standardisation Initiatives. In 2009, it issued the Master Agreements for Treasury Placement (MATP), which has been completed; in March 2010, it announced the IIFM/ISDA Tahawwut (Hedging) Master Agreement; and now the Reference Paper on I’aadat Al Shira’a (IS) (the Islamic Alternative to Repo), which explores the possibilities of Shariah-compliant repurchase and collateralisation prospects.

Value of diversity

Shariah scholars extol the value of diversity of Shariah opinion in Islamic finance, which according to officials such as BNM Deputy Governor Ibrahim also is “the seed to harness innovation in Islamic finance”. The best way to move forward in this respect is through the concept of mutual recognition of the interpretations and decision of Shariah principles reached by a recognised Shariah body across countries.

Differences in Shariah interpretations can be overplayed because there is an overwhelming consensus of the core principles of Fiqh Al-Muamalat (Islamic Law relating to Financial Transactions). “While the issue of standardisation of documentation and practices are still pertinent to the growth of the industry, differences in Shariah interpretations in different regions are becoming less significant, although some of these variances still pose issues relating to liquidity management in terms of acceptable instruments,” the KPMG report emphasised.

The new agenda for Islamic finance, according to KPMG, is underpinned by the fact that the process of standardisation has been helped by the emergence of a general consensus within the industry about the nature and principles of the products being offered; Shariah advisory is dominated by a limited cadre of leading scholars, with only an elite small number possessing the detailed theological knowledge as well as an understanding of modern financial instruments; the existence of this small elite is leading to a broad commonality of Shariah interpretations across different markets; and that there are no major regulatory barriers to the implementation of Islamic banking in existing markets. Diversity in Shariah interpretation remains a strength and not a weakness as some bankers claim. Islam has no Vatican and as such no single authority on the Shariah. Many officials and market players emphasise that diversity is the seed to harness innovation in Islamic finance.

“Diversity in opinions and practices generate wider options for consumers and practitioners,” explained Deputy Governor Ibrahim. “I believe that this is very fundamental. It is also for this reason that Malaysia subscribes to the concept of mutual recognition of the interpretations and decision of Shariah principles reached by a recognised Shariah body across countries. We believe in the need for diversity as it is an impetus for sustainable global growth of Islamic finance.”

While diversity would create a conducive environment for Islamic finance to prosper, varying interpretations of Shariah especially within a single jurisdiction can add to the complexity of the operating framework of IFIs. The progressive harmonisation of Shariah interpretations, in this respect, can be an important driver towards greater acceptance and avoid possible confusion by the public.

Malaysia addressed the issue through a centralised SA C, which through collective wealth of experience and expertise of its members, its independence and its rigorous process of rule-making, has ensured the credibility of Shariah ruling on Islamic finance transactions. But, at another level, facilitating the internationalisation of Islamic finance would involve a delicate balancing act in nurturing innovation and pushing for greater Shariah convergence, harmonisation and acceptance.

One way of doing this could be to standardise contracts for mature and widely acceptable cross-border concepts and structures into common documentation, products and services in a unified manner.

Once again, Bank Negara Malaysia is playing a pioneering role in this respect with its initiative in enhancing the transparency on jurisprudential reasoning in Islamic finance through the publication of Shariah resolutions by the SAC, and, perhaps more importantly, in issuing a series of “Shariah Parameters” for several major Shariah contracts aimed at promoting consistent application of such contracts.

In fact, BNM published the draft of its latest Shariah consultation on Islamic financial products, the Concept Paper of Shariah Parameter Reference 5: Istisna’ Contract (SPR5) in late December 2010. This is the latest consultation paper to be published since BNM started developing its Shariah Parameter initiative in 2009 to provide a standard guidance on operations and application of the main Shariah contracts in Islamic finance and to promote harmonisation of Islamic finance market practice in Malaysia.

The contracts identified under this initiative are Murabahah, Ijarah, Mudarabah, Musharakah, Istisna’ and Wadiah. Thus far, the central bank has issued Shariah Parameters on all the above contracts, save the Wadiah (current account) contract.