CHAPTER 11

Legal, Regulatory, Risk, and Operational Framework

Building Investors’ Confidence

Noripah Kamso and Fouzia Amin

Conformity to a condition shall be binding as far as possible.

(Islamic legal maxim)8

People’s usage shall be an operative proof.

(Islamic legal maxim)8

INTRODUCTION

Good governance is necessary for investor confidence. In the conventional space, investment management companies adhere to their home country’s capital market regulations. Investment products need to adhere to the regulations of the country where the products are being established as well as to the company’s respective internal governance processes.

In a Shariah investment framework, investors’ confidence will also rest on Shariah governance. Islamic capital market regulations in many countries may still be undergoing a robust foundation-building process. Therefore, there is a higher reliance on the company’s internal governance processes. In some countries such as Malaysia, Bahrain, the United Arab Emirates, the United Kingdom, and Singapore, these investment processes, policies, and procedures have been standardized to achieve a certain level of international acceptance and build investors’ confidence.

The other potentially thorny issue is the possible variation of Shariah interpretation across different jurisdictions on a single investment product. The perception is that if the Shariah interpretation is not exactly the same in the country where it is issued and the country where it is distributed, the market acceptance of the investment product will face challenges. However, Shariah advisory boards for internationally distributed investment products are now made up of scholars from different jurisdictions. This is to ensure Shariah convergence and acceptability across different markets, even if the wording of the Shariah interpretation is not the same in the two markets. Shariah scholars from different schools of thought and geographical regions are also predisposed to respect and seek harmonization. The challenge is to find the right balance between Shariah interpretation and market acceptance.

At the end of the day, good governance is the key to maintaining the integrity, stability, credibility and growth of Islamic investing. Therefore, this chapter will focus on the investment and Shariah governance from a regulatory standpoint.

THE ISLAMIC FINANCIAL INSTITUTIONS’ REGULATORY FRAMEWORK

We will now observe how regulatory authorities evolve and come together to address issues related to Islamic finance.

Effectiveness of Shariah Advisory Boards

The dominant market practice now is to appoint Shariah advisory boards comprising only scholars of Islamic law. The composition of a Shariah advisory board model could potentially evolve to a mix of these scholars, with Islamic finance professionals such as bankers, lawyers, and accountants. This way, different views can be taken into account, resulting in practical and implementable decisions that bear in mind the Islamic fatwas. In addition to the effectiveness of an Shariah advisory board itself, integrating it into a regulatory framework can further increase its ability to make credible decisions.

In Malaysia, Shariah advisory boards must exist both at the capital markets regulator level and at the individual company level. The Capital Market Services Act, which governs the Securities Commission Malaysia, confers its Shariah advisory board with the authority to establish the Islamic finance regulatory framework and guidelines (for companies) in accordance with Islamic law. The Shariah advisory board is solely dedicated to this singular role, and its members have the necessary expertise to integrate and balance Shariah interpretation with capital markets experience and knowledge. The Shariah advisory board of an individual company must then ensure that it complies with the relevant regulations. Therefore, in the area of Islamic investment management, the Securities Commission Malaysia’s Shariah Advisory Board Malaysia must then approve all Islamic investment products before they are offered to the marketplace, whether in Malaysia or around the world.

Importantly, the inclusion of Shariah advisory board responsibilities within the capital markets regulatory framework enables the admission of cases involving Islamic investment products into civil court, which importantly makes the judicial decision enforceable. This is not the case in some other countries. If this framework is not in place, it is hard, if not impossible, to adjudicate Islamic investment product issues and provide investors with the confidence in the underlying law. Here are two examples:

Islamic Financial Services Board

To match the international standards adhered to in conventional finance in the areas of risk management, capital adequacy requirements, and governance for Islamic collective investment schemes, the Islamic Financial Services Board (IFSB) was established in 2003. Headquartered in Malaysia, the IFSB is an international organization that promotes and enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include banking, capital markets, and insurance sectors.

To increase the international acceptability of Islamic cross-border transactions, the Islamic Finances Services Board Act 2002 provides IFSB with the privileges of an international organization. As of March 2012, the 187 members of the IFSB comprise 53 regulatory and supervisory authorities; 8 international intergovernmental organizations that include as International Monetary Fund, World Bank, Bank for International Settlements, Asian Development Bank, Islamic Development Bank; and 126 market players, professional firms, and industry associations operating in 43 jurisdictions.

Though IFSB has been established with particular needs to accommodate the regulatory needs of Islamic financial system, it complements the existing international regulatory bodies such as the Basel Committee on Banking Supervision and International Organization of the Securities Commissions.1

The IFSB has published 13 standards as of March 2012, a summary of which is provided in Table 11.1.

Table 11.1 IFSB Standards

In the area of Islamic investment, the 2008 Published Standard by the IFSB on “Guiding Principles on Governance for Islamic Collective Investment Schemes” specifies guiding principles that cover the areas of governance policy framework, accurate timely disclosure of information in an investor-friendly manner, effective monitoring systems and mechanisms for Shariah compliance, the movement of the Islamic collective investment scheme’s funds or assets, and transparency of fees.

The Accounting and Auditing Organization of Islamic Financial Institutions

For the Shariah community to standardize its accounting, auditing, governance, ethics, and Shariah standards for Islamic financial institutions, the Accounting & Auditing Organization of Islamic Financial Institutions (AAOIFI) was registered in 1991. AAOIFI is an independent international organization supported by 200 institutional members from 45 countries, including central banks and financial institutions.2 AAOIFI standards are more comprehensive and entail 85 standards as of 2010, covering all five areas of accounting, auditing, governance, ethics, and Shariah individually.

AAOIFI has gained considerable recognition as regards setting standards, and these standards are now adopted by the Kingdom of Bahrain, the Dubai International Financial Centre, Jordon, Lebanon, Qatar, Sudan, and Syria. Other national authorities have also shown the initial recognition to AAOIFI standards by issuing guidelines conforming to AAOIFI standards. These countries include Australia, Malaysia, Indonesia, Pakistan, and the Kingdom of Saudi Arabia.

COUNTRY EXAMPLES

The Malaysian Framework

As part of the overall strategy to identify new sources of growth 30 years ago, Malaysia focused its efforts to build a niche to build a recognizable presence on the global financial landscape. As a country with a Muslim majority, Malaysia has long aspired to be a modern Islamic developed nation. In 2006, Malaysia embarked on a conscious strategic intent to internationalize its Islamic finance leadership to transform the country as a global financial hub for Islamic finance. It established a platform called Malaysian International Islamic Financial Centre (MIFC). The five pillars of focus for MIFC are Sukuk origination, Islamic fund and wealth management, international Islamic banking, international Takaful, and human capital development. The universally accepted legal and regulatory frameworks offered to international players are supported by a strong political will and market players.3 It is clearly articulated in the Economic Transformation Programme (ETP) to transform Malaysia into a developed nation by 2020. Islamic finance is one of the national key economic areas (NKEA).4 The framework involves statutory authorities such as the Central Bank of Malaysia and Securities Commission, with the Ministry of Finance playing a pivotal role in ensuring the right regulatory and supervisory framework exists for the IBF (Islamic Banking and Finance) to flourish. The exchange authorities like Bursa Malaysia provided a platform to ensure liquidity of the Islamic financial instruments, a requirement in modern securities trading and liquidity risk management. The Shariah advisory board is at the heart of the Islamic regulatory framework. Malaysia identifies the imperative role of Shariah advisory and has realized the participation of finance-savvy Shariah advisers at the regulatory level. Shariah Council must endorse any Islamic financial instrument that is approved by Securities Commission. This structural plan ensures the validity and enforceability of the Islamic financial products and services. This makes Malaysia an interesting case study compared to other Gulf Cooperation Council (GCC) countries, where the Muslim populations control the majority of the wealth.

The precursor to the Malaysian model of Islamic Banking and Finance (IBF) was the enactment of the first Islamic Banking Act in 1983. Ever since then, Malaysia has evolved into a leading hub for IBF through various developmental phases. With diverse ethnic demographics, Malaysia adopted a dual-banking system in which the Islamic system grew side by side with its existing conventional counterpart. This may lead to an important remark regarding the existence and enforceability of Shariah-based system vis-à-vis conventional system. Unlike Pakistan and Iran, the jurisdictions that tried to convert their respective financial systems to completely comply with the Shariah principles, Malaysia introduced the Shariah-based system to coexist with the conventional and has managed to become a leading international financial player in IBF.

Malaysia today has a comprehensive Islamic financial system that coexists within its financial system. It has a diversity of players and a wide range of products supported by legal, Shariah, and regulatory framework. This resulted in Malaysia being one of the favored jurisdictions for Islamic fund domiciles, totaling to date 170 funds as at end-June 2012, and its AUM is the second largest after Saudi Arabia.

The Malaysian model presents international investors with a platform that adheres to global standards and best practices. This comprehensive framework provides the governance that will enable market players and investors to have confidence, for it ensures admissibility in court and enforceability of all cases involving Islamic finance and investing.

Legal and Regulatory

To ensure the diverse players and wide range of products are supported by enforceable legal Shariah and regulatory framework, Malaysia has instituted the Islamic Banking Act, the Takaful Act, the Government Funding Act, and the Capital Market Services Act.

Shariah Advisory Council

There exist two Shariah advisory councils at the national level. One is at the central bank and the other is at the Securities Commission. The Shariah Advisory Council at the central bank makes decisions under the local standards of the Central Banking Act. The Shariah Advisory Council in the Securities Commission makes decisions based on the Capital Market Services Act.

Dispute Resolution

In the interest of protecting investors’ interests and the Islamic finance community as a whole, Malaysia has a judicial system that offers a dedicated high court to resolve Islamic finance cases. It also established the KL Regional Centre for Arbitration. The Financial Mediation Bureau was established to further inculcate a speedy resolution to challenges confronted in an infant industry.

On top of this, as Malaysia progresses to establish its international recognition as a global hub, it has also domiciled international centers for the use of international players.

International Centre for Education in Islamic Finance (INCEIF) was established in 2006 as a subsidiary of Bank Negara, the Central Bank of Malaysia. INCEIF represents a global university that specializes in providing various qualifications in Islamic finance ranging from certification to doctorate programs. Equipped with the highly recognized academic staff across the globe, INCEIF has attracted and equipped the bright students from all continents to participate actively and contribute to the Islamic financial industry.

International Shariah Research Academy for Islamic Finance (ISRA) was established in 2008 to serve as the repository of knowledge through intensive research and scholarly discourse in the corpus of Shariah with a focus on the Islamic jurisprudence on transactions, a discipline that covers all the areas related to Islamic finance. ISRA provides a platform of exchange among scholars, academicians, regulators, and practitioners to arrive at appropriate fatwas pertaining to issues in Islamic finance through multiple perspectives.

The Islamic Financial Services Board (IFSB) is an international standard-setting organization that promotes and enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include banking, capital markets, and insurance sectors. The IFSB also conducts research and coordinates initiatives on industry-related issues, as well as organizes roundtables, seminars, and conferences for regulators and industry stakeholders.

The International Islamic Liquidity Management Corporation (IILM) is an international institution established by central banks, monetary authorities, and multilateral organizations to create and issue short-term Shariah-compliant financial instruments to facilitate effective cross-border Islamic liquidity management. By creating more liquid Islamic financial markets for institutions offering Islamic financial services (IIFS), IILM aims to enhance cross-border investment flows, international linkages, and financial stability.

Established on October 25, 2010, IILM has 14 founding members consisting of the central banks or monetary authorities of Indonesia, Iran, Kuwait, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey, the United Arab Emirates, and two multilateral institutions, the Islamic Development Bank and the Islamic Corporation for the Development of the Private Sector.

Membership of IILM is open to central banks, monetary authorities, financial regulatory authorities or government ministries or agencies that have regulatory oversight of finance or trade and commerce, and multilateral organizations. IILM is hosted by Malaysia and headquartered in Kuala Lumpur. As an international institution, IILM enjoys a range of privileges and immunities conferred by the IILM Act 2011 of Malaysia.

Bahrain Model5

Bahrain is the smallest country in the GCC and the first country where oil was discovered. To provide a viable alternative source of GDP growth in addition to the oil and gas industry, Bahrain diversified into financial services. Bahrain has served as a major offshore banking hub for the GCC, given its various benefits. These include the strategic geographic location of the country, a tax-free regime, a well-defined legal and administrative framework, and a well-established infrastructure of physical and telecommunications. The relatively free economy provides convertible currency, liberal trade relations, and foreign exchange.6

Bahrain has played important role in advancing the regulatory framework for the Islamic financial industry. The then Bahrain Currency Board, the predecessor of the Bahrain Monetary Agency, has played a pivotal role in promoting the country as an Islamic financial center. The Central Bank of Bahrain was the first regulatory authority that allowed the Islamic window concept. The Islamic window concept allows conventional banks to cater to the Islamic financial services market through their existing infrastructure. Bahrain also pioneered the development and implementation of regulations specifically for the Islamic banking industry. This framework should give investors confidence that the governance of Shariah investment offerings in Bahrain is sound.

On the international front, Bahrain has also contributed significantly to the growth and development of Islamic finance through the organizations it hosts. Among them is the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) discussed earlier in the chapter. The other organizations that facilitate Islamic finance internationally from Bahrain include the following:

• Liquidity Management Centre (LMC) was established in response to the growing surplus liquidity with in the Islamic banks and financial institutions. LMC facilitated the flow of this excess liquidity into Shariah compliant short- and medium-term financial instruments. The main instruments used include short-term secured investment Sukuk, Islamic investment fund issuance, and bilateral funding structures. LMC has played an important role in the creation of an active Islamic inter-bank market, which enables Islamic financial institutions to manage their short-term liquidity mismatch, an important aspect toward the maturity of Islamic banking industry.
• International Islamic Financial Market (IIFM) is the result of joint effort of various regulatory authorities toward the standardization of Islamic capital and money market frameworks. The various authorities involved entail the Central Bank of Bahrain, Bank Indonesia, Central Bank of Sudan, Labuan Financial Services Authority of Malaysia, Autoriti Monetari Brunei Darussalam, and the Islamic Development Bank based in Saudi Arabia. The main purpose of IIFM is to achieve the global standardization in three areas: Islamic financial products, documentation, and relevant processes. The IIFM, though based in Bahrain, carries a vision of providing a global platform for Islamic capital and money markets, a great leap toward Shariah harmonization and, hence, wider acceptance across jurisdictions.
• Islamic International Rating Agency (IIRA) was established to provide global acknowledgment for the Islamic financial industry as regards their conformation to prudential standards and greater transparency. The rating methodology involves corporate and Shariah governance (including transparency and disclosure), compliance with Shariah principles, and asset manager quality.7 This comprehensive methodology takes into account the distinctive features of Islamic financial institutions that would serve to develop and deepen the Islamic capital markets. To preserve its objectivity and fairness, IIRA is overseen by a board of directors and a completely independent rating committee.

Bahrain has maintained its primary focus on the quality of its regulatory system. Bahrain was one of the first countries in the region to impose the Basel capital ratios and to maintain capital asset ratios above the mandatory levels across the banking sector. This prudence has also been reflected in the Islamic banking sector. Bahrain’s proactive stance in establishing international organizations with the long-term goal of standardizing of relevant processes is to ensure Islamic finance offerings are widely accepted internationally.

CONCLUSION

Having discussed investor protection and confidence that is supported by the validity and enforceability of regulations, Islamic investing is a prudent alternative, as it emphasizes transparency, justice, and fair treatment. As Islamic investment products mature, treatment and governance of them will center on global best practices. The governance of Shariah investment solutions focuses on two areas: investment and Shariah compliance.

Islamic investing seeks to reduce investment risk in a very similar manner to conventional investment governance, where there is a clear benchmark in terms of global best practices. More advanced risk management and investment performance tools are being used to provide better information to progressively build investor confidence.

It is in the area of Shariah governance where the industry is still coming together toward international convergence and acceptability. The authorities are ensuring that all Islamic financial transactions are well addressed in prudential regulations. More developments will be observed in the future with greater investor knowledge and awareness in the realms of Islamic finance.

Most jurisdictions focus on both aspects of governance. However, investors should only consider Islamic investment products that are governed by a Shariah capital markets framework to protect their interests. Having a Shariah advisory board at the capital markets regulator level and at the individual company level will ensure that cases are admissible in court. This is the Malaysian model, and it should be emulated.

The differences in regulatory frameworks across jurisdictions do not draw any fundamental variations since the basic foundation of all frameworks is derived from Shariah. For example, there have not been any fundamental differences between Malaysia and Bahrain, as they both have common primary objectives that clearly focus on safeguarding the investors’ wealth by establishing internationally acceptable regulatory frameworks for Islamic financial transactions.

The successful development of a robust and credible investment and Shariah-compliant governance environment is best achieved on a collaborative effort, taking heed of international investors’ concerns. A robust governance framework will be of immeasurable value to provide comfort to investors when financial crises occur.

NOTES

1. Islamic Financial Services Board, www.ifsb.org

2. Accounting and Auditing Organisation for Islamic Financial Institutions, “Overview,” AAOIFI: www.aaoifi.com/aaoifi/TheOrganization/Overview/tabid/62/language/en-US/Default.aspx

3. Bank Negara Malaysia, “Overview,” Shaping Islamic Finance Together (January 24, 2001): www.mifc.com/index.php?ch=seg_tal_pro&pg=seg_tal_pro_ovr.

4. “KLIFD in Economic Transformation Programme,” 1Malaysia Development Berhad: www.1mdb.com.my/klifd1/klifd-economic-transformation-programme.

5. Humayon Dar and Mufti Talha Ahmad Azami, Global Islamic Finance Report. (An Edbiz Consulting Publication, 2011).

6. I. Warde, Islamic Finance in the Global Economy (Edinburgh: Edinburgh University Press, 2000), 128.

7. Islamic International Rating Agency, www.iirating.com

8. The above legal maxims state the importance of legislation and the legal aspects of doing anything, including business and trade, along with their financial transactions. They show the appreciation of the various regulatory and governing bodies for the Islamic financial system, as long as there is a realization of the objectives of Shariah.

General Reading

Islamic Financial Services Board. “Islamic Finance: Surveys on Global Legal Issues and Challenges.” IFSB, 2008.

“New Rating System Captures Essence of Islamic Finance,” The Review, Central Bank of Bahrain.