Challenges of Islamic Banking & Finance For Afghan Banking Association Presented by: Professor Abdul Wassay Haqiqi American University in Afghanistan Legal Advisor to the World Bank & PWC & CEO , Haqiqi Auditing & Consulting Company
Islamic banking & finance has continued to expand and demonstrate its resilience in the current more challenging international financial environment. This advancement has been in terms of the increased range of Islamic financial products and services, the development of the Islamic financial infrastructure and institutions, the greater maturity of the Islamic financial markets and the more comprehensive supporting legal and regulatory framework.
More recently, the international dimension of Islamic finance has gained significance with the move to further liberalize domestic Islamic financial system and the strengthening of the international Islamic financial architecture .
Global demand for an ethical form of banking has led to a near boom in Islamic banking and it is estimated that some 250 financial institutions in more than 45 countries practice some kind of Islamic finance.
The market has been growing at more that 15% per annum and financial assets within the sector are estimated at US$ 500bn with Liquid Funds in the Islamic marketplace looking for quality assets at circa US$ 50bn.
Islamic finance is growing in various parts of the world. It has moved from a mere theoretical concept to a practical reality. A natural consequence of this progress is the opening up of new challenges as well as more avenues for its advancement. Therefore, Islamic finance is confronting some new and some old, but re-formulated, challenges on the intellectual and practical plains.
On the intellectual side, refinements in the philosophical underpinnings of the Islamic finance and the financial system are the core issues. While on the practical side, the diversity of regulatory, supervisory and legal environments faced by Islamic financial institutions; the issues of a proper accounting framework; corporate governance; and making available of a complete spectrum of Islamic financial products have evolved as some of the new challenges..
Islamic finance has grown beyond banking since 1990s and expanded to the realm of capital markets. Now Islamic financial industry comprise of Islamic banks, investment funds, asset management companies, house financing companies, and insurance companies. The industry is growing in double digits since last decade.
Similarly, the number and frequency of practitioners’ conferences have increased which on one hand results in wider dissemination of existing knowledge, networking among professionals from various geographical regions, and on the other hand also contribute to some addition to the body of knowledge. In short, the practice of Islamic finance has outpaced theoretical development
Muslims’ desire to find out the ways and means to fulfill their financial requirements in view of prohibition of interest. Interest based finance had become the dominant system during the colonial period, and continued to be so in many Muslim countries even after their independence.
In this backdrop Muslim intellectuals and economists started to write about Islamic economics and financial system, notably in the Indian Subcontinent and Egypt. The early writings expounded the philosophy and the concepts of interest-free finance along with its effects on the socio-economic welfare of the society.
In the 1960s and early 1970s the developments were mostly on the theoretical plane devoid of any practical experimentation. However, the accumulated theoretical knowledge prepared the ground and developed sufficient collective will for the emergence of first Islamic banks one in private sector (Dubai Islamic Bank) and another as a multilateral organization (Islamic Development Bank) both of which came into being in the early 1970s.
Many more Islamic banks and financial institutions were created in the following years . A combination of practical realities of the business and constraints of the regulatory environment forced the Islamic banks to rely mostly on murabahah and leasing contracts for the financing activities instead of the originally conceived mudarabah contract in the second tier
Major Challenges Faced by Islamic Banking & Finance
The first challenge relates to building the capacity to manage the increasing uncertainties generated by financial innovation, the increasing prominence of the non-regulated sector and the increasing interconnectedness between financial institutions and markets. Such developments have not only resulted in the emergence of new risks to the financial system but have also changed the dynamics of how risks in the financial system are transmitted to the real economy.
In this environment, it is vital to have a legal and regulatory framework that is robust and dynamic enough to enable the central bank to respond to these developments.
Major Challenges Faced by Islamic Banking & Finance…Continues
The second challenge concerns the effective implementation of financial safety nets and the effective coordination of the different components of the safety net to maintain public confidence and to support continuous financial intermediation.
Appropriate legislation and regulations that ensure credibility and integrity of the safety nets are an essential part of maintaining financial stability.
Regulatory problems arise not only because of the need for domestic regulators – operating within diverse national regulatory norms and cultures – to cooperate and coordinate in the domestic environment but also across jurisdictions
Major Challenges Faced by Islamic Banking & Finance…Continues
The third challenge relates to the increasingly and highly complex financial and economic integration associated with globalization . This has resulted in a significant expansion in cross-border financial activities and introduced new sources of risks to domestic financial systems. The recent crisis raised many issues for which clear solutions, or even consensus, have yet to emerge, suitable approaches to cross-border resolutions, and the significant challenge of coordinating policies across different legal and institutional frameworks.
Operational and legal issues in cross-border resolution arise where the regulatory frameworks of different countries do not provide for a common solution in areas such as the unwinding of financial transactions and the enforceability of secured parties' rights to collateral in the foreign jurisdiction.
Major Challenges Faced by Islamic Banking & Finance…Continues
The fourth challenge in Islamic Banking & finance is accounting & auditing standards . The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has made an important regulatory beginning. It seeks to support the faith of Islam by developing accounting standards for Islamic investment vehicles and by conducting related training and publicity.
It also expects to strengthen the effectiveness of Sharia committees by facilitating evaluation of emerging financing instruments and by aiding in the implementation of Islamic ethics. The agency merits close monitoring by Western bankers and their accountants, given the rapidly growing asset base of Islamic financial institutions.
Major Challenges Faced by Islamic Banking & Finance…Continues
The fifth challenge is strict principles of Islamic finance:
Prohibition of interest (riba): The prohibition of riba , literally translated as ‘increase’, ‘excess’ or ‘usury’ . R iba restrictions are best understood as a type of price setting regime designed to reinforce a public guarantee of a minimum distribution of basic goods.
Prohibition of speculative risk (Gharar): it encompasses some forms of incomplete information and/or deception, as well as risk and uncertainty intrinsic to the objects of contract’. However, since contracts are never complete and therefore always contain some measure of risk and uncertainty, it is only excessive gharar , affecting the principal component of a contract, which is prohibited.
Major Challenges Faced by Islamic Banking & Finance…Continues
Duty of almsgiving (Zakat): Islam requires that every Muslim, having resources over and above a basic minimum threshold level, pays a proportionate contribution or zakat , levied as a tax (obligation) on his or her net worth or agricultural produce. It is calculated at an annual 2.5 percent of the total value of capital and profits minus any un-recovered debts and depreciation, while varying between 5 and 10 percent in agriculture.
Prohibition of sinful activities (Haram): Activities that are in violation with Sharia are considered sinful (H aram ) and can therefore not be financed. These activities include those related to alcoholic, pork or non-ritual slaughtered products, gambling, pornography and weapons. It is argued that Sharia prohibits all forms of economic activity which are deemed morally or socially harmful.
Islamic finance has become a competitive form of financial intermediation that has been able to meet the differentiated requirements of our economies. In an environment of rapid change, a key factor that will influence the future prospects of the Islamic financial services industry will be the investments to build the foundations on which further progress can be achieved.
Investing in the future, in in the development of talent and expertise will be the differentiating factor that will contribute to the effectiveness, resilience and competitiveness of the industry. This undertaking needs to be the joint responsibility of both the private and public sectors..
There is also the need for extensive education of the consumer and business community. This would increase the outreach resulting in increased demand for new and innovative products and approaches .
Against these developments, it is timely to move away from "plain vanilla" innovation and to embrace a new wave of innovation that will evolve Islamic financial instruments into distinct products that will maximize the potential and wisdom of the Shariah and that meets the greater sophistication of consumers and the more complex requirements of today's businesses .
As a discipline, Islamic banking and finance has evolved both theoretically and empirically. It has emerged as a lively, provocative and dynamic branch of economics that it may be interpreted as the dawn of the only alternative to the current orthodoxy in banking and finance .
There is also an increased awareness and understanding amongst the international financial community on the distinct nature of Islamic banking and financial operations& sophisticated Islamic financial products that are being structured based on multiple Shariah concepts.
A key challenge for Islamic financial institutions is to attract a knowledge-based workforce with the skills required to enhance the potential for innovation, productivity and performance. The Islamic financial services industry needs to continually promote human capital development and expertise to create a larger pool of experts and high caliber professionals.
This involves attracting and retaining the existing talent, and building a robust pipeline of skilled individuals for the future. In addition, specialists in Islamic finance would need to combine knowledge and understanding of the Shariah with the necessary skills in finance with career development having a key role in the sector.
Training is a joint responsibility between the industry and Government to establish training institute on Islamic finance.. These would include training workshops and courses in new and emerging product lines which require specialized skills and expertise.
Education of graduates and other personnel entering the Islamic financial market is also important. Undergraduate opportunities to study Islamic finance or Shariah, either as a specialty or a major component of a business degree, should be readily available to provide program which keep pace with changes in financial innovation and technology requiring rigorous, extended programs such as the post-graduate programs in Islamic banking principles.
At the same time, relevant organizations can support such programs by creating funds to sponsor promising students to pursue formal education and by providing increasing programs and initiatives. These Should develop a sufficient number of competent Shariah scholars who are equipped with sound knowledge and expertise in both Islamic jurisprudence and Islamic commercial laws to deal with innovative and cutting-edge products.
The legal aspects in Islamic finance represents an important "bridge" between the governing Shariah principles and the practice of Islamic finance. The application of Shariah principles in the light of the governing laws and regulations in each Islamic financial transaction are interpreted through legal advice, in legal documentation of the financial transactions, and dealing with disputes.
In documenting financial transactions based on specific Shariah principles that underlie a financial product, the legal documentation reflects the tenets of Shariah and that it is in full compliance with the laws and regulations governing the financial transactions. Varying interpretations of Shariah in particular between countries adds to the complexity when cross-border transactions are involved.
The Islamic banking system without the law is futile and meaningless. The legal system is supposed to regulate and license the Islamic banking business, besides imposing control and supervision on the affairs of the Islamic banks. The legal framework is also important for defining the characteristics of contracts and their enforcement.
Thus, it helps in development and introduction of new financial products. With the rapid development of the Islamic banking and finance in different places, the law must also be able to keep up with the speed of that development. Thus the study of development of legal regime becomes an important area .
In providing legal services, the industry has an important role of bridging the Shariah parameter with the legal parameters of the Islamic financial contracts. This is in particular important in preparing the legal documentation of Islamic financial transactions so as to avoid ambiguity, inconsistency and to avoid the risk that the legal document be considered void by a court of law on the grounds of contravention with Shariah.
From a domestic perspective, more jurisdictions are considering a central Shariah Council (Shariah Board) as the ultimate decision making body on Shariah matters. Across jurisdictions, there has been greater engagement thus bringing about increased convergence.
The study of development of legal regime becomes an important area.A difficulty with the legal framework for Shari[ah laws in Afghanistan is related more only to the Civil Law of Afghanistan.. Consequently, Shari[ah compatibility in enforcement of financial contracts and dispute resolution becomes uncertain—a legal risk.
Islamic financial transactions have their own unique risk characteristics that need to be managed. Risk areas that are unique to Islamic finance transactions include the legal risk of losses due in the event of lawsuits and non-compliance with relevant laws, the risks associated with non-compliance of Shariah principles and the fiduciary risk arising from failure to perform contractual obligations based on the underlying Shariah principles.
The introduction of new, more innovative and complex products and financial transactions enables the dis-aggregation and repackaging of risks in ways that has not been explored. Shariah advisors ( Sharia Board) would require the collective expertise including legal practitioners, to identify and understand the permissibility of a given structure. Islamic financial institutions in turn would need to address the attendant implications.
Islamic banks, of pooling all types of deposits for investment and then distributing the generated profits to deposit holders is Shari[ah incompatible and violates the principle of equity and justice enshrined in the rules of mudarabah —the contractual basis on which investment deposits are collected.
In order to avoid inappropriate asset transfer between current and future investment depositors as well as between various categories of depositors and the bank; he proposes use of segregated mudarabah investment pools with separate accounting and profit distribution for each such pool. This is an innovative idea that requires further careful and detailed analysis.
While the segregated treatment will increase transparency and justice it will, however, also increase accounting and investment costs. The positive effects of separate treatment of different deposit categories on bank stability are clear, but the effect of segregation across time of the past and current depositors will require further study before its general acceptance. Supply and scope of investment opportunities and size of the individual banks all would have to be considered in determining the viability of such a proposal.
Banking regulations in the conventional system are predominantly for avoiding systemic risk. However, depositor/investor protection, enhancement of efficiency, and other social objectives are not totally ignored. Shariah considerations give rise to issues of a different sort in which equity and justice acquire central role in establishment of stability, depositor/investor protection, efficiency, and other social objectives
Islamic banks are poised for rapid future growth with the pool of investors has accelerated. There are sufficient Muslim investors and borrowers in both Islamic and non-Islamic countries to warrant the attention of traditional banks who seek to serve such clients and capture a potentially profitable slice of a still relatively untapped market.
Islamic finance is making the news on a daily basis. Major players are countries in the Gulf, including United Arab Emirates, Bahrain and Kuwait. For this to take place successfully, investment opportunities and products must increasingly be structured in a way that stands up to scrutiny from the Shariah Boards. This opens up a huge new challenge for those involved with structuring and marketing such products.
3. Globalization of Islamic Banking. Continues
The more challenging part is to effectively address cross-border issues facing national financial systems. Regardless of whether we are in a state of crisis, these challenges will continue to be relevant given that conditions will continue to be dynamic and the trend towards a more globalize world will not reverse.
Mutual recognition of the interpretation of Shariah principles across countries will contribute to the sustained growth of Islamic finance.
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) which was set up in in 1991has made an important regulatory beginning. It seeks to support the faith of Islam by developing accounting standards for Islamic investment vehicles and by conducting related training and publicity. It also expects to strengthen the effectiveness of Sharia committees by facilitating evaluation of emerging financing instruments and by aiding in the implementation of Islamic ethics.
The AAOIFI’s work is of special importance to international public accounting firms which may be confronted by (a) new rules relating to both accounting and auditing, and (b) the actions of Sharia committees in regard to the observance of Islamic ethics.
It seems that Islamic practice diverges widely from such creations as the “conceptual framework” of International Financial Reporting Standards (IFRSs) and of the U.S. Financial Accounting Standards Board (FASB). The FASB has sought to provide “decision usefulness” primarily to investors and creditors , with little attention to other “stakeholders .
However, decision usefulness from the point of view of a Muslim will require enrichment through the addition of Islamic ethical imperatives; thus Sharia committees will be confronted with a great challenge to make rules that are in accord with Islamic ethics.
Until recently, Islamic banking problems included a lack of standardized accounting and auditing rules. Historically, uncertainty in accounting principles involved revenue realization, disclosures of accounting information, accounting bases, valuation, revenue and expense matching, etc.
More than two decade ago, Professor Abdul W. Haqiqi coauthored recommendations for (a) establishment of Islamic bank accounting standards, (b) a focus on auditing, possibly before tackling accounting, (c) conformity of new rules to Islamic and Arab social and religious objectives, and (d) a coordinated and unified approach to the interpretation of pertinent Islamic law. Source: Haqiqi, A.W., and F. Pomeranz. 1987. Accounting needs of Islamic banking. Advances in International Accounting, ed. Kenneth Most, 153-167. Greenwich, CT: JAI Press. www.financeinislam.com.
The Islamic banking and finance as a discipline has evolved both theoretically and empirically. It has emerged as a lively, provocative and dynamic branch of economics. It may be interpreted as the dawn of the only alternative to the current orthodoxy in banking and finance .
The five key features – interest free; trade related and a perceived “genuine” need for the funds ; in its purest form, it is performance and therefore equity related; it is meant to avoid exploitation – no usury; ethically directed .
Central banks in the advanced financial systems have resorted to unorthodox measures to prevent a systemic collapse of the global financial system.
Most of Muslim countries are LDCs and using the religious and social ideology of Islam is very useful to establish institutions and to bring moral and ethical change for development in these countries. However, the provision and use of financial services and products that conform to Islamic religious principles pose special challenges for the identification, measurement, monitoring, and control of underlying risks.
Effective risk management in Islamic financial institutions has assumed particular importance as they endeavor to cope with the challenges of globalization. This requires the development of not only a more suitable regulatory framework & standards, but also new financial instruments and institutional arrangements to provide an enabling operational environment for Islamic finance.
The IMF study by Martin Cihak& Heiko Hesse in January, 2008 found that (i) small Islamic banks tend to be financially stronger than small commercial banks; (ii) large commercial banks tend to be financially stronger than large Islamic banks; and (iii) small Islamic banks tend to be financially stronger than large Islamic banks, which may reflect challenges of credit risk management in large Islamic banks. They also find that the market share of Islamic banks does not have a significant impact on the financial strength of other banks.
Islamic finance is an old concept but a very young discipline , but lacks the required extent and level of models needed for expansion and implementation of the legal framework provided by Islam. As a result, unawareness and confusion exist as to the form of the Islamic financial instruments.
Adequate allocation of resources for infrastructure development : Islamic financial institutions are continually being confronted with new challenges that need to be addressed. Their institutional capacities and capabilities need to be continuously strengthened. This includes attention to continually review their strategic orientation and key priorities and the necessary adjustments that need to be made to position the institutions to effectively respond to the new developments and challenges that have emerged.
In order to meet the increasing demands of a modern and sophisticated market, financial institutions must continually invest in the supporting infrastructure that promotes research and development for enhancing the capacity for innovation. Attention also needs to be given to the applied approach to Islamic finance and its modern practice.
2. Issuance of Shariah Parameters: To promote consistent application of Islamic financial contracts in Afghanistan, the Central Bank must issue "Shariah Parameters" aimed at promulgating a standard point of reference on Shariah for Islamic finance practitioners. The Shariah Parameters should outline the main Shariah requirements in the contracts and provides examples, methods and models for practical application of such contracts .
3. Readiness for Globalization: International standards for cross-border Islamic securitizations shall be established to help overcome legal uncertainties.
4 . Developing Accounting & Auditing Standards: The international standards will increase comparability and understandability of financial statements, save time and money, ease interpretation and improve the credibility of the financial reporting process and profession.
5. Expediting Legislation On Islamic Banking & Finance: While adapting a Shariah Board, the Da Afghanistan Bank should get extra help from the State to pass the related laws to specify Shariah parameters taking into consideration of potential expansion of Islamic banks to mobilize the flow of millions of dollars not being circulated in the conventional banks.
6. More emphasis on achieving financial stability: The proposed Islamic Banking Law by the Central Bank of Afghanistan should emphasize risks that disrupts the financial intermediation process, or which affects public confidence. In addition it should provide comprehensive provisions for heightened surveillance, pre-emptive actions and expanded resolution powers to facilitate the swift and orderly resolution of financial crises. The Bank may also take appropriate intervention actions to avert risks that stem from unregulated entities.
7. Enhanced governance and accountability framework: The governance and accountability framework in the proposed law in Afghanistan on Islamic Banking to be emphasized. The upcoming law may consider to establish three specific committees within the Sharih Board, namely Governance Committee, Audit Committee and Risk Committee that are chaired by a non-executive director, to ensure the independence of the oversight on the functioning of the Central Bank, as practiced in Malaysia.
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