Chapter 24
Concluding Remarks
1. INTRODUCTION
The regulatory challenge as presented in this book concerns not just the industry regulators and supervisors, and the international body they have set up, the IFSB, but the Islamic banks themselves and the governments and legislative authorities in the countries where they operate. The challenge to industry regulators and supervisors is no doubt the most obvious, in view of the characteristics of Islamic banks as both bankers and asset managers being subject to a requirement for Shari’ah compliance that is fundamental to their relationship with the major part of their clientele—characteristics which mean that they cannot be supervised in the same way as conventional banks. For example, in countries that do not have an integrated financial supervisor, Islamic banks may require supervision by an investment industry or securities market supervisor, as well as by a banking supervisor. The fact that Islamic finance is in a rapidly evolving stage of development, in terms of its products and techniques, adds to this challenge. For the Islamic banks themselves (or, more generally, the Islamic financial services industry sector), the challenge is to be proactive in adopting operational policies and practices that meet international standards of risk management, transparency, and corporate governance, going beyond “box-ticking” minimalist compliance, so as to facilitate the task of the industry supervisors. For both regulators and supervisors as well as for Islamic banks, the challenge is accentuated by the financial and economic crisis that began in 2007 and the subsequent reregulation of capital and liquidity requirements as set out in Basel III. In addition, structural reforms such as those proposed by the Independent Commission on Banking in the United Kingdom and those introduced by the Dodd-Frank Act in the United States may have important implications for Islamic banks with international operations and their supervisors.
The challenge to national governments and legislative authorities has perhaps been less widely recognised and is twofold: (1) to ensure that the industry regulators and supervisors have the necessary powers to perform their functions effectively; and (2) to develop the national legal infrastructure so as to address the problem of legal uncertainty that was highlighted in Chapters 7 and 8. As regards (1), various measures are being adopted in certain Western jurisdictions such as the United Kingdom and the United States, as mentioned above, and are under discussion in the European Union. The banking systems in the Middle Eastern and Asian countries, which host the majority of Islamic banks, have been less affected by the financial and economic crisis, so that the incentive to take such measures is largely absent. In such countries, however, it is the requirement indicated in (2), namely the development of the legal infrastructure, which particularly calls for attention.
2. THE CHALLENGE TO FINANCIAL SECTOR INDUSTRY REGULATORS AND SUPERVISORS
The authors of Basel II were well aware of the supervisory burden involved in the implementation of the framework and placed emphasis, in Pillars 2 and 3, on the supervisory evaluation of risk management and corporate governance, and the roles of transparency and market discipline, in facilitating the supervisory task. Research shows that in the majority of the countries where Islamic banks operate, their transparency leaves much to be desired, and so, in parallel, does the market discipline to which they might be exposed. Typically, these countries have a weak information environment characterized by a paucity of information intermediaries; such an environment neither encourages transparency nor fosters market discipline.
One issue is that of Shari’ah compliance. In Chapter 12, Peter Casey discusses the issues of Shari’ah compliance faced by industry supervisors, which in general are not themselves qualified to judge matters of Shari’ah compliance as such.
Another problem is that of financial reporting standards. The International Financial Reporting Standards (IFRSs) of the IASB are deficient when applied to Islamic banks, because they do not adequately cater for the latter’s Shari’ah-compliant financial instruments and operations. For this reason, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was created in 1991 and has issued 26 Financial Accounting Standards (FASTs). In spite of the high quality of these standards, however, they have been adopted in only a handful of countries. One reason for this is the belief that it is not possible for one set of financial statements to comply with both IFRSs and AAOIFI’s FASTs, the priority being given to those of the IFRS. This belief, which seems to have been based on a misunderstanding,1 is starting to have some justification as the IASB revises its standards and issues new ones (such as IFRS 7). With regard to the disclosure aspect of financial reporting, in December 2007 the IFSB issued a standard Disclosures to Promote Transparency and Market Discipline for Institutions Offering Islamic Financial Services, which is compatible with IAS 32 and IFRS 7.
As mentioned in Chapter 22, there is the possibility of a “virtuous circle” whereby transparency and market discipline may be “bootstrapped” by the supervisor first requiring greater transparency (“sufficient information”), while market participants (with the help of information intermediaries such as credit rating agencies and financial analysts) need to have the ability to process the information correctly. “Bootstrapping” may be expected to occur because once sufficient information becomes available, information intermediaries will start to use it and the information environment will therefore strengthen, so that in response market discipline may be expected to develop, thus encouraging further transparency.
In some jurisdictions, financial sector industry supervisors may lack the powers to apply the “arm twisting” required in order to enforce compliance. Alternatively (or additionally) they may also lack the trained personnel needed for this. Such issues are matters for governments and legislative bodies, as discussed below.
3. THE CHALLENGE TO THE ISLAMIC FINANCIAL SERVICES INDUSTRY SECTOR
The modern Western banking and insurance industries started their development over 300 years ago, in the mid-seventeenth century, when developments in mathematics and statistics provided powerful tools for financial mathematics and actuarial science, which were paralleled by the emergence of a number of major banks and of the Lloyd’s insurance market in England. These tools were further developed over the following centuries, also influencing the development of economics, especially in the late nineteenth and early twentieth centuries, which saw the beginning of modern financial economics with work such as that of Jevons, Bohm-Bawerk, and Fisher. Such tools, however, were and are largely interest-based as well as having other characteristics that are not Shari’ah compliant.
There was no parallel development of Shari’ah-compliant tools in the Muslim world, then dominated (and in the Middle East and North Africa, controlled) by the Ottoman Empire, which did not accord priority to institutional development. The Ottomans, in their complacent belief that the Muslim world maintained the intellectual and cultural superiority over Western Christendom that it had possessed in the centuries preceding the Renaissance in Western Europe, did not encourage their subjects to participate in the major developments taking place in the latter.2 This complacency extended to financial services; in the Ottoman Empire, commerce relied on forms of financing that did not involve banks as financial intermediaries, such as the use of the mudarabah contract.
Hence, the modern Islamic financial services industry finds itself having to devise, in the space of a few decades, Shari’ah-compliant alternatives to Shari’ah–non-compliant techniques that have evolved over more than three centuries. The challenge to the Islamic financial services industry is to achieve the rapid development of such alternatives while proactively meeting international standards of risk management and corporate governance.
A key role in these vital developments belongs to the experts in fiqh al mua’malat (Shari’ah commercial jurisprudence) on whose opinions the industry and its Muslim customers depend for assurance that the products and services offered are Shari’ah compliant. Such experts are generally referred to as Shari’ah scholars. In Chapter 9 of this volume, Yusuf Talal DeLorenzo and Michael J. T. McMillen comment as follows: “Whatever questions, reservations, or doubts the critics of modern scholarship may have on this subject, the fact that Shari’ah boards [composed of Shari’ah scholars] have been able to achieve consensus on so many key issues suffices to establish the legitimacy of modern Islamic finance, and . . . sets the stage for the establishment of industry standards which may, in turn, provide the impetus for real industry growth.”
Yet, while the epithet “learned” is used to refer to lawyer members in the U.K. parliament (as in the expression “the honorable and learned member”), a practicing lawyer is required to be more than a scholar, and the continuing use of the term “scholar” to designate Shari’ah jurists is indicative of a problem: namely, that they commonly lack the training and experience as commercial lawyers that is expected of experts in secular commercial law, as well as the educational facilities and professional organizations through which the latter achieve professional status and maturity. This hampers the ability of Shari’ah jurists to play the key role that is theirs in Islamic finance. As Volker Nienhaus comments in Chapter 23 of this volume, the challenge to Shari’ah boards as presently constituted can come from financial and law firms who have managed to bundle top-level financial engineering with first-class Shari’ah expertise and intimate knowledge of the relevant markets, backed by a financially powerful partner. By implication, this comment is also applicable to the concept of the Shari’ah “scholar” which still remains prevalent.
4. THE CHALLENGE TO GOVERNMENTS AND LEGISLATIVE AUTHORITIES
DeLorenzo and McMillen comment in Chapter 9 of this volume that achievement of the benefits, both macroeconomic and microeconomic, of securitisation in the field of Islamic finance will depend on, among other things, sukuk issues being able to obtain credit ratings from major international rating agencies, which depends, in turn, upon obtaining acceptable legal opinions on a range of true sale, collateral security, bankruptcy, and other legal issues. But they note that it is clear that such opinions are unobtainable in current circumstances, given the state of development of these legal areas in many jurisdictions within the Islamic economic sphere, and they call for action and legal reform—in particular, the reform of secular law in jurisdictions within the Islamic economic sphere.
These tasks represent a major challenge to the governments and legislative bodies in these countries, all the more in that most of them have code-based rather than common law-based legal systems. Islamic finance is essentially built on a set of (nominate) contracts, and common law jurisdictions with their law of contract seem to be more ready than code-based jurisdictions to adapt to the need to handle the legal issues raised by Islamic finance that involve the interpretation and enforcement of Shari’ah contracts.
One attribute that a legal infrastructure for financial transactions must possess is a reasonable degree of legal certainty. It is, above all, the lack of this attribute which leads to the problem noted above—namely, that of obtaining acceptable legal opinions on a range of issues such as true sale, collateral security, bankruptcy, and other legal issues, which is a requirement if Islamic finance is to develop as a fully-fledged alternative to conventional finance. From this perspective, the tradition of fiqh al mua’malat, with the importance given to the personal opinions of individual Shari’ah scholars, even if consensus between them is also accorded great importance, stands in stark contrast to the concept of “positive law” as an objective social fact that is prevalent in Western jurisprudence.3 In common law-based systems, a key source of legal certainty is the principle of stare decisis, or judicial precedent, whereas in code law-based systems, legal certainty requires legislation—that is, the promulgation of an applicable law or legal code.
One major challenge to governments and legislative authorities is thus to find a means whereby an applicable body of “positive law” may be developed in order to provide an effective legal infrastructure for Islamic finance. Another major challenge to such authorities, as noted above, is to equip the supervisory and regulatory bodies concerned with Islamic finance with the authority and the means to perform their functions effectively.
5. CONCLUSIONS
We have summarised in this chapter what we see as the dimensions of the regulatory challenge arising out of the development of Islamic finance and the social and economic need for it to develop further. This need has a certain degree of urgency insofar as it is both unacceptable and potentially dangerous for a large section of humanity to be deprived of fully competitive financial services because of the lack of Shari’ah-compliant alternatives to conventional financial products and structures.
While the industry regulators and supervisors are in the front line facing this challenge, in fact the challenge is much wider, and confronts the firms competing in the industry at the micro level and the governmental and legislative authorities in the host countries at the macro level. It also confronts the profession of experts in Shari’ah commercial jurisprudence, and those educational institutions in which they study, with the need for a greater awareness of the characteristics required by an effective legal infrastructure for Islamic finance. This would apply in jurisdictions where the applicable law is the Shari’ah, as well as those mixed jurisdictions where it is partly Shari’ah-based and those where Shari’ah is not part of the legal system but where financial arrangements based on Shari’ah contracts need the requisite legal support.
The countries that act as hosts to Islamic financial institutions include a number of predominantly Islamic states with emerging markets, as well as other states with highly developed markets such as the United Kingdom. The challenge facing the former countries is to provide an appropriate regulatory environment and legal infrastructure, given the other pressing demands made on limited human resources. The challenge facing the latter countries is to accommodate Islamic finance within a legal and regulatory infrastructure designed for conventional finance.
A typical problem in countries with highly developed markets is the legal definition of a “bank” as a “deposit-taking institution,” deposits having the legal status of debt contracts and being “capital certain,” whereas Islamic banks accept “deposits” as profit-sharing investment accounts that cannot be “capital certain” as the Shari’ah does not permit this; in other words, if the profit-sharing pool in which their funds are invested incurs a loss, the investment account holders must accept their share of the loss. From the narrow perspective of banking law, Islamic banks may better be termed finance houses rather than banks stricto sensu, but they perform the economic function of banks to the Islamic community and may therefore quite reasonably wish to call themselves banks for marketing reasons.4
Another potential problem arises from the fact that the “deposits” accepted by Islamic banks, insofar as they are a form of investment product (that is, a type of collective investment scheme—CIS), may fall to be regulated not by the banking industry supervisor but by the authority responsible for regulating CIS.5
One of the most egregious errors that has been committed by certain ideologists of “free markets” is the failure to acknowledge that markets (including, and indeed especially, financial markets) do not exist in a pure economic space, but are part of a societal structure of which the law and the administration of justice are key components, along with education and business ethics.6 A major advantage of the Shari’ah in this respect is its insistence on the ethical dimension of business. We hope that the coming decade will see important advances in the adaptation of legal systems, in education and training, in regulation and supervision, and in other relevant aspects of institutional development, so that Islamic finance may fulfill its true potential.7
NOTES
1. It appears not to have been generally understood that the rules for presentation and disclosure in FASTs are compatible with those in IFRSs, in that they complement rather than conflict with those in the latter, while the rules for recognition and measurement in FASTs are, or could be applied in a way that is, compatible with those in IFRSs. However, this compatibility may be jeopardized if IFRSs are revised or new IFRSs are issued and no corresponding changes are made to the set of FASTs.
2. As noted by DeLorenzo and McMillen in Chapter 7 of this volume, the Majalat al-Ahkam al-Adaliyah, which was in use throughout the courts of the Ottoman Empire, was originally prepared by Ottoman scholars of the Hanafi school of jurisprudence circa 1285 CE.
3. See, for example, J. Raz, The Authority of the Law (Clarendon Press, Oxford, 1979). Whatever might be thought about the merits of legal positivism in general, the lack of “positive law” in commercial and financial matters is undoubtedly an obstacle to the development of financial markets.
4. In the case of the Islamic Bank of Britain (IBB), established in 2004, an accommodation was reached with the industry supervisor (the Financial Services Authority—FSA) and IBB’s Shari’ah advisors whereby a Muslim who opened a deposit account with the bank could waive his right to “capital certainty” following a loss. (See, for example, condition 6.3(d) in the IBB’s Young Person’s Savings Account Special Conditions.) In such a case, while it is clear that the Muslim depositor who waived his right to be repaid his capital following a loss would be in compliance with the Shari’ah, it is rather less clear that one could say the same in general of the types of deposit account offered by the bank. It remains to be seen to what extent this British example will be followed in other countries.
5. This was not a problem in the case of the IBB in the United Kingdom, since the FSA was a cross-sectoral regulator.
6. While the links between the development of markets and that of democratic institutions in general remain to be demonstrated, those between markets and the rule of law are being increasingly recognized.
7. The IFSB and the Islamic Development Bank (one of its member institutions) have drawn up a Ten-Year Plan for the development of the Islamic financial services industry.