Sharia Governance and Islamic Banking and Finance


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A presentation I made for a Central Bankers Seminar held at Cambridge in 2011 on Regulating Islamic Financial Products and Markets. The presentation leans towards raising issues relating to the process regulating Shariah compliance in Islamic financial institutions and for Islamic instruments, while trying to provide pragmatic solutions to address some of the core challenges the industry has yet to resolve, with the exception of Malaysia.

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  • Ladies and gentlemen, the growth of Islamic finance at more than 15% per annum is undisputed. Yet, the startling fact remains that as compared to the percentage of the Muslim population standing at around 25%, Islamic finance is not even 4% of the global financial system, which means even if IF is adopted by 25% of the population, there is still a long long way to go. In countries where Islamic finance has been provided the right enabling infrastructure to flourish, it has achieved up to 55% of penetration.
  • Despite this looming growth, the industry faces a number of challenges, not least of all: lack of wider cheaper distribution channels; standardised and ‘conventionally efficient’ products and threats to the core Sharia compliance process.
  • Framework Notes:A checklist of criteria and processes to followIssuance of the fatwaExplaining the arguments and sources used to an independent board for validation (AAOIFI for instance)Review process in the future to determine whether or not the fatwa is still validUpdating or revoke the fatwa if necessary
  • Sharia Governance and Islamic Banking and Finance

    2. 2. Agenda• Challenges affecting the growth of Islamic Finance• Shariah Governance Fundamentals• Revisiting the Shariah Governance Challenges• Requirements by standard setters• Next Steps and logical solutions• Recommendations• What Central Banks and Regulators can do• Q&A
    3. 3. Introduction The Looming Significance & Growth of Islamic FinanceGlobal Shariah Compliant AssetsYear Assets ($B)Source: The Banker
    4. 4. The Setbacks• Lack of wider cheaper distribution channels• Yet-to-be standardized products• Challenges to core Sharia compliance process
    6. 6. Shari’a Non-Compliance Risk (1/2) Legal PrecedenceBeximco Pharmaceuticals Ltd and others v Shamil Bank of Bahrain E.C. 2004 EWCA Cir 19:Murabaha financing contractThe contract provided "Subject to the principles of the Glorious Shariah, this Agreement shall be governed by and construed in accordance with thelaws of England."Beximco argued that contract was contrary to Shari‟a law.Decision: Court ruled in favour of Shamil stating that it is not its responsible to verify compliance with Shari‟a and also Shari‟a not a national legalsystem.Ratio Decidendi: it is for each party to satisfy themselves that the substantive terms of the underlying contract comply with Shariah principles.English court will not judge on Shari‟a compliance or otherwise of the contract, but on the substantive provisions of the contract.The Investment Dar Company (TID) v Blom Developments Bank SAL (BLOM) 2009 EWHC 3545 Ch:Investment Wakala contractTID argued the following:Constitutional documents did not allow for Shari’a non-compliant transactionsAgreement did not comply with Shari’aBeyond the corporate powers of TID and therefore void.Decision: Court found an arguable case for TID, however, principal would have to be returned since court was of the opinion that TID‟sargument would fail and BLOM could claim for restitution of the full principal, if not the profit payments.Ratio Decidendi: The Court held that TID‟s counsel had made an arguable case that the Agreement did not comply with shari‟ah and theAgreement was therefore ultra vires NOT that it would succeed in court.
    7. 7. Shari’a Non-Compliance Risk (2/2)Micro- Mitigation TechniquesKey Considerations for mitigating Shari‟a Non-Compliance Risk:Request a certificate confirming that the transaction is Shari‟a compliant from the Shari‟aCommittee/Advisor and preferably for material transactions, from the full Shari‟a Supervisory BoardA representation to be inserted into the Shari‟a compliant agreement stating that entry into andperformance by the IFI of that agreement does not conflict with any of its constitutional documentsThe waiver by the IFI of any defenses that it might have in connection with the agreement not beingcompliant with Shari‟a principles, for instance:Each Party represents and warrants to the other that on the date of this Agreement and on the date of entering into eachRelevant Wakala Transaction:it has the legal capacity to enter into this Agreement and the Relevant Wakala Transaction contemplated hereunder;the execution by it of this Agreement and the Relevant Wakala Transaction has been duly authorized and executed;it has entered into this Agreement and shall enter into each Relevant ------- Transaction contemplated hereunder after satisfyingitself of their compliance with Shari‟a, it is satisfied that this Agreement does not contravene Shari‟a and it does not have anyobjection, nor will it raise any objections, as to matters of Shari‟a compliance in respect of or otherwise in relation to theprovisions of this Agreement;
    8. 8. Shari’a Supervisory BoardInstitutions offering Islamic products employ services of religious advisors (theShari‟a Scholars) who are collectively known as Shari‟a Supervisory Board(“SSB”). The key roles performed by SSB includes:Issue Fatwa to certify compliance with Shari’a laws.Periodic reviews for conformation with Fatwa on an ongoing basis.Calculation and payment of Zakat.Disposal of non-Shari’a compliant income (e.g. interest through donationand charities).Advise on distribution of cash flows, income and expenses betweenshareholders and Sukuk holders.
    9. 9. Shari‟a Approval Process Phase 1 Phase 2 Phase 3 Identify Shari‟a Options Finalise Sharia Structure Review Legal DocumentationActivities Activities Activities Determine our clients‟  Review selected product  Review legal documents needs and business structure for compliance with objectives  Liaison with Sharia Sharia laws and the Identify potential high Client Scholars on the structure structure Fatwa granted level Sharia product selects design Client  Liaise with Sharia structures methodology  Identify required legal produces Scholars and the clients‟ & builds legal Discuss available options detailed documentation documents legal team during the with our clients structure  Prepare draft Fatwa documentation drafting Work through the  Review of structure by  Legal documentation commercial and practical Sharia Board and issue reviewed by Sharia considerations with our of Fatwa on structure Board and issue of clients Fatwa on documentationDeliverables Deliverables Deliverables Preliminary Sharia  Fatwa on Sharia  Fatwa on Legal Report Structure Documentation Throughout the process, Dar Al Istithmar adheres to relevant Sharia industry standards, including the AAOIFI Shari‟a Standards All processes are monitored through an internal quality assurance process and frequent consultation with the Chairman of the Sharia Supervisory Board.
    10. 10. Operating Models Model options Characteristics Shari’a Aspects Shari’a Compliant Due to rapid development of Islamic Finance, From Shari‟a perspective, these are at the Islamic Banks new banks are being set-up which are fully lowest risk due to: Shari‟a Compliant and offer retail as well as • No dealing in conventional / interest based whole sale banking facilities. products Since 2004, five fully Islamic banks have been • No risk of mixing of Islamic Funds with set up in the UK, out of which one is a retail conventional. bank where as other four are whole sale banks. • More involvement of Shari‟a Scholars in day to day activities of the bank.Conventional bank This model is used by conventional banks which From Shari‟a perspective, Islamic subsidiaries /with an Islamic want to extend their services into retail and finance vehicles are considered at a lower risksubsidiary / Finance whole sale Islamic Banking as well as retaining due to:Vehicle the conventional customer portfolio. • Bespoke IT system and infra-structure for This model is used by HSBC, Standard Islamic Products. Chartered, Citi etc. • Segregation of Islamic Funds, cash flows, assets and liabilities from conventional. • Involvement of Shari‟a Scholars in day to day activities of the Islamic Finance Vehicle. Conventional bank This set-up is primarily used by conventional From Shari‟a perspective, Islamic windows are with an Islamic investment banks which want to provide its high considered to be high risk primarily due to: Window net worth individuals and institutional customers • IT Systems and infra-structure of conventional access to Shari‟a Compliant investments and banks may not be not be flexible enough to cater Structured products. requirements of Islamic Products. This model is followed by Deutsche Bank, • Funds generated from Shari‟a Compliant Barclays Capital etc. sources are not segregated from funds generated from conventional activities.
    11. 11. Contrast of Shariah Governance with ExistingGovernance StructureFUNCTIONS TYPICAL FINANCIAL ADDITIONS IN IFIS INSTITUTIONGovernance Board of Directors Shari‟ah BoardControl Internal Auditor Internal Shariah Review Unit External Auditor External Shariah ReviewCompliance Regulatory and Internal Shariah Financial Compliance Compliance Unit
    12. 12. Voluntary Standards on Shariah GovernanceAAOIFI Governance Standards 1. Shariah Supervisory Board: Appointment Composition and 2. Shariah Review 3. Internal Shariah Review Report • At least 3 members (no directors or shareholders) • SSB forms opinion, but Shariah compliance rests with • Internal division or part of internal audit • Requirements for report suggest Sharia board must play a management • Examination and evaluation of the adequacy and effectiveness deep role in review of bank‟s operations. • Examination includes of the IFI‟s system of internal Shari‟a control and the quality of • Recommendation to publish fatwas, rulings and guidelines contracts, agreements, policies, products, transactions, memo performance in carrying out assigned responsibilities. randum and articles of association, financial statements, reports (especially internal audit and central bank inspection), circulars, etc. • complete and unhindered access to all records, transactions, and information from all sources including professional advisers and the IFI employees.The SSB review procedures shall normally include:• obtaining an understanding of the management‟s awareness, commitment and compliance control procedures for adherence to the Shari‟a;• reviewing of contracts, agreements, etc.;• ascertaining whether transactions entered into during the year were for products authorised by the SSB;• reviewing other information and reports such as circulars, minutes, operating and financial reports, policies and procedures, etc.;• consultation/co-ordination with advisors such as external auditors; and• discussing findings with an IFI‟s management.
    13. 13. Voluntary Standards on Shariah GovernanceIFSB Standards 10 • The Sharī`ah governance structure adopted by the IIFS should be commensurate and proportionate with the size, complexity and nature of its business I. General • Each IIFS must ensure that the Sharī`ah board has: Approach • clear terms of reference regarding its mandate and responsibility; • well-defined operating procedures and lines of reporting; and • good understanding of, and familiarity with, professional ethics and conduct. • The IIFS shall ensure that any person mandated with overseeing the Sharī`ah Governance System fulfils acceptable fit and proper criteria. II. • The IIFS shall facilitate continuous professional development of persons serving Competence on its Sharī`ah board, as well as its ISCU and ISRU, if any. • There should be a formal assessment of the effectiveness of the Sharī`ah board as a whole and of the contribution by each member to the effectiveness of the Sharī`ah board. • Play a strong and independent oversight role, objective judgement on Shariah. III. NO INDIVIDUAL or GROUP should be allowed to dominate decision making Independence • Compliete adequate and timely information prior to all meets and on an ongoing basis IV. Confidentiality • Internal information kept confidential • IFI should understand legal and regulatory framework for issuance of Shariah V. Consistency pronouncements in jurisdiction of operation. • Should promote convergence of Shariah governance standards
    14. 14. Voluntary Standards on Shariah GovernanceIFSB Standards 10• INTERESTING POINTS:• Independence requires (among other usual BOD requirements), where multiple memberships, sufficient time and attention given to affairs of each IFIs.• Fit and Proper requires „Good Character‟, „Competence and Capability‟ and „expertise‟ for Shariah Advisory firms outsourcing this work
    15. 15. Revisiting the Challenges Challenges Multi-board Conflict of Increased Costs Shariah Diligence Interest Representations Multiple Shariah Insufficient Conflicts of Hired by IFI Advisory Coverage Interest Concentration Standard of Structuring Paid in BPs Risk Due Diligence Cost Documentation Implications Supply Constraints Governance and Due Process Constraints Previous proposals Current Process: Certifying future Supranational Sharia Participation and learn generations Body by doing
    16. 16. Costs of Sharia Due DiligenceExample:• Cost of sukuk issuance is usually in six figures; and it includes Shariah advisory, structuring, and legal documentations.• Sukuk costs can be up to 60% higher than conventional bonds.-------------------------------------------------------The same concept applies to every otherIslamic product.
    17. 17. Conflict of Interests• Scholars are appointed by thefinancial entities themselves.• Some scholars are paid in term ofBP per fund managed.------------------------------------------------Central Shariah Committee as asolution??
    18. 18. Multiple Board Representation The Top 20 Scholars based on positions in Islamic Financ InstitutionsInteresting Facts:• Top 50 scholars occupy 834positions (over 73% of positions)• Multiple conflicts of interests• Cost implications ofconcentration.Time + Effort + Rep. = 6 Figures• The advantages of MBP
    19. 19. Shariah Diligence• Are all documents andstructures properlycovered by the Shariahscholar?• What are the standardsused for appropriate duediligence?
    20. 20. Shariah Non-Compliance And Due Process• No framework to issue contraryopinions.• Issuers of fatwa & Fatwa Shopping.• Fatwas deal with the micro-juristic;not the macro-implications.
    21. 21. Previous Proposals• Current qualificationsParticipation and learn-by-doing, rather thaneducation, research and gainingexperience.• Transferring knowledge to the next generation.Two solutions:1) A supranational Sharia association2) Certifying newer generations of would-be scholars
    22. 22. One SolutionThe Certified Shariah Advisory & Audit(CSAA) Program• What is this program?• The disadvantages:1) Does not qualify to form new opinions2) Exam-based, rather than research-based3) No qualification process for the unqualified
    23. 23. What about a doctorate system?Key Elements:1) Very high research standards2) Great knowledge of certain field(s)3) Supervision by mentor(s)4) Universal in a competitive world
    24. 24. What is the next step? Way Forward: Increase New Set of Governance and Quality Supply Standards Due Process Recognition Pre-requisites of Shariah to Fatwa scholars issuance
    25. 25. Recognising Shariah Scholars Hypothetical Set of Criteria• Peer recognition - Letters of recommendation• Education - Doctoral degree - Diploma and reference letters - X years under the “wing” of a scholar• Experience - X years of Shariah auditing and advisory - X years of Islamic Shariah law counseling• Continued qualification process
    26. 26. Pre-requisites before issuing a fatwaDue Process• Reporting procedures for issued fatwas• Checklist before issuing a fatwa• In return, the support of AAOIFI
    27. 27. Recommendations Rundown (Examples)• Scholars hired and supervised by a central Shariah committee (CSC); appointing them to specific IFIs and paying them to prevent conflicts of interest and Fatwa shopping.• One certified Shariah scholar per IFI; certified and qualified by the CSC.• Junior certified Scholars at IFIs; senior certified Scholars at CSC.• Qualification structures: - Doctoral degree + X years of experience to qualify as a Senior Scholar - Doctoral degree to qualify as a Junior Scholar - Masters in Shariah Advisory and Auditing as a minimum for proper due diligence• Standardized framework for Fatwa issuance and approval Checklist Issuance Validation Review Update
    28. 28. ConclusionWhat Central Banks and Regulators Can Do Leave as much as possible to the Shariah scholars; only prompt and encourage them to come together in each jurisdiction. Regulate the process; not the law One step at a time; local, then global Set standards for Shariah qualifications and Fatwa process Provide guidelines and assistance for self regulation Promote cooperation and collaboration through greater dissemination Create a national Shariah supervisory board Learn from other countries‟ experiences
    29. 29. Quis custodiet ipsos custodes?Who will guard the guards themselves? - Juvenal
    30. 30. Sayd Farook PhDGlobal Head Islamic Capital