The future of Islamic finance looks promising, with 10 of the world's 25 fastest growing markets located in Muslim-majority countries. However, leading Islamic banks have posted lower returns on equity compared to conventional banks, suggesting the need for policy and governance restructuring. The UK has aspirations to become an Islamic financial hub but lacks central bank regulations. There are opportunities for Islamic finance in the UK given its growing Muslim population, yet Islamic retail banking has yet to take off due to insufficient disclosure, risk management, and consumer relations compared to global standards. Policymakers and industry participants must address these issues to strengthen governance and oversight in the UK Islamic finance sector.

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28th
July 2014
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FEATURE
The future of Islamic finance in the
global economy looks bright with
10 of the world’s 25 fastest growing
markets in Muslim majority countries.
According to EY, Islamic banking assets
with commercial banks globally crossed
US$1.7 trillion in 2013 suggesting an
annual growth of 17.6% over the last
four years. Despite this growth, leading
Islamic banks posted 19% lower return
on equity (ROE) compared to their
conventional peers. This would suggest
that there is a dire need of a policy
re-think and governance restructure by
the Islamic finance industry as a whole.
This is most evident in countries having
aspirations to become Islamic financial
centers but lack central bank directives
and regulations, for example the UK.
There are abundant opportunities for
Islamic finance to flourish in the UK —
the Muslim population is growing faster
than any other religious group. Muslims
have started to actively integrate
themselves in British society: in politics,
from parliament to local government,
in the armed forces, policing, the
professions, the arts and sports, and of
course in business. Muslims constitute
one of the youngest demographics in
the UK and the younger generation
is more religion conscious than their
predecessors wanting for example
Shariah compliant house financing
options.
The UK government has been pushing
to be an Islamic financial hub having
set-up a ministerial-led Islamic Finance
Task Force, jointly chaired by Baroness
Warsi and the financial secretary to
the Treasury. The recent issuance of a
GBP200 million (US$341.36 million)
sovereign Sukuk with a GBP2 billion
(US$3.41 billion) oversubscription also
points to this.
In the past, the UK especially London
has seen considerable Islamic capital
market activity with more than US$38
billion being raised through 54 Islamic
Sukuk issues. Major developments and
landmark projects in London such as
The Shard, Chelsea Barracks, Harrods,
Battersea Power Station and the Olympic
Village have in whole or in part used
Islamic financing.
Given all the aspects mentioned, Islamic
retail banking is yet to take off in the
UK given its potential. This is where
the policy re-think and governance
framework restructuring mentioned
above needs to take place globally
especially in the UK.
There are three facets that need
to be redressed — disclosure, risk
management and consumer relations.
Disclosure
One of the key concerns is insufficient
disclosure of Shariah governance in
Islamic financial institutions annual
reports. Issues such as conflict of interest
of Shariah board members within an
Islamic financial institution and with
other Islamic financial institutions among
other issues are largely ignored. As
shown in the table below, inconsistency
between jurisdictions aside, there
appears to be insufficient disclosure of
Islamic financial institutions’ Shariah
governance and other key disclosures in
annual reports.
Islamic financial institutions should set
additional requirements for disclosures
in their annual reports relating to
income purification and disbursement to
charities, due to the inherent sensitivities
associated with these funds. Additional
disclosures can include:
• Value of impermissible income and
late payment fees relating to the
period, including any contingent
amounts.
• Purification amounts that have been
disbursed during the period with
explanations for any non-disbursed
amounts.
• Reporting on the nature of the
charities supported and their social
impact.
• Disclosure of fees paid to Shariah
supervisory board (SSB) members
within the institution’s annual reports
(split by audit and non-audit), similar
to disclosures of fees paid to external
auditors.
• Related party transactions where
Islamic financial institutions have
close connections with any of the
receiving charitable organizations.
• Disclosure by all personnel involved
in the audit (SSB, ISCU members,
Corporate governance in the UK Islamic inance
industry
Despite anchoring itself in the Islamic finance space, the UK has yet to see its Shariah compliant retail banking
sector take off, prompting for a policy re-think and governance framework restructuring. MUJTABA KHALID
analyzes the current structures in place.
continued...
Bank Shariah regulation Comprehensive Shariah
advisor’s report
Related party
transactions
Statement of
Purification of Income
Shariah Board
Remuneration
Zakat
Meezan Bank —
Pakistan
Islamic Banking Department
guidelines — SBP
Yes Yes Yes Yes
Bank Islam —
Malaysia
BNM guidelines No No Yes Yes
Bank Melli —
Iran
Central Bank of Iran banking
regulations
No No No Yes
Al Rajhi Bank —
Saudi Arabia
Central bank regulations (not
stringent)
No No No Yes
Islamic Bank of
Britain — UK
No central regulation No No No No

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FEATURE
etc.) of any interests such as
shareholdings, a relative/related
party working in a senior role in the
institution, commercial relationships
as a customer or supplier (either
with the individual or with a related/
linked company of which the SSB or
any relative may be a director), etc.
Risk management
The challenge going forward is for
Islamic banks to establish a cultural
mindset and operating framework that
embed balance sheet risk — something
beyond the regulatory requirements set
out under Basel III.
The distinct contractual relationship of
an Islamic financial institution’s balance
sheet are illustrated in the following
diagram:
Return on assets Investment returns
Assets Liabilities
Inventory
Real estates/
Automobiles
Current/Demand
deposits
Wadiah /Qard
Asset-backed
transactions
Murabahah/Ijarah/
Istisnah/ Salam
Unrestricted
investment accounts
Mudarabah
Restricted
investment accounts
Mudarabah
Profit Sharing
Transactions
Mudarabah/
Musharakah
Reserves
Fee-based services
Ujr
Equity
As regulations become more stringent
and the market becomes saturated,
banks need to enforce an inclusive
risk management ensuring effective
teamwork. Diagram 1 gives a brief
illustration of what might be needed for
Islamic banks to be more effective.
An important risk faced by Islamic
financial institutions is non-compliance
risk, which in-turn can lead to
reputational risk. As more complex deals
are being executed and more complicated
products being developed, if any
institution, inside or outside the Islamic
financial institution, deserves scrutiny, it
is the Shariah scholars. Therefore, apart
from a Shariah audit to check compliance
with the Shariah governance frameworks
provided by the Shariah board, I
propose a Fatwa audit. This would be
an independent audit carried out to
determine what Ijtihad was used by the
Shariah scholar or board in deeming a
deal, product or transaction as Shariah
compliant. This can be a revolutionary
step in tackling the creeping cynicism
about Islamic finance among Muslims.
Being suitably qualified requires both
a minimum level of knowledge and
skill as an entry criterion, and also the
need to have ongoing training. Shariah
scholars working as advisors to an
institution need also to consider the
risks of litigation over the advice they
provide as increasing litigation activity
related to Islamic finance is being seen in
courts. Initiatives in the Islamic finance
industry specifically addressing the issue
of competence include “fit and proper”
criteria set by industry regulators and
the Islamic Finance Council UK’s Scholar
Professional Development Program
developed exclusively for Shariah
scholars and those associated with the
Shariah assurance process.
Consumer relations
One aspect that is lagging especially in
Islamic banks based in the UK is effective
consumer relations policy. Aspects such
as anticipating a change in consumer
needs and how they will defer in the
next five years, how to respond to such
changes and how to target new consumer
groups.
Commercial transactions include
an element of trust. Research shows
that the quality of customer-facing
employees and the ease of doing day-
to-day business are the most important
elements in building or reinforcing trust.
Islamic financial institutions should
create service excellence on top of
operational excellence.
This requires proactive relationship
management: maintaining a dialogue
with customers, creating awareness
about Islamic finance among consumer
groups through conferences and
education programs, acting in their best
interests and coming up with solutions
for personal financial situations.
Islamic banks in the UK should also bear
in mind that, as mentioned above, most
of the Muslim demographic is young
and their consumer base would mostly
consist of Gen-Y individuals. These
individuals tend to be higher educated
and critical; they often have above
average incomes and are extensive users
of technology. Therefore effective use of
technology in terms of products which
are not only easy to understand but also
reduce effort and the use of social media
for marketing campaigns should be
employed effectively.
Mujtaba Khalid is a senior associate at the
UKIFC. He can be contacted at mkhalid@
ukifc.com.
Continued
Strategy