Setting Standards for Shariah Application in the Islamic Financial Industry

Transcription

1 Setting Standards for Shariah Application in the Islamic Financial Industry M. Fahim Khan Executive Summary The global growth of Islamic banking is taking advantage of the diversity and flexibility in the fiqh opinions (often referred to as Shariah) to meet the challenges of growth. While the flexibility in fiqh opinion is presently contributing to global growth, it may soon become a constraining factor in the global growth of the industry if the challenges arising out of the use of diversity and flexibility in fiqh are not properly recognized and regulated. Though the infrastructure for standardizing the supervision and monitoring of the global expansion of the Islamic finance industry is rapidly growing, institutional arrangement for a regulated use of diversity and flexibility in Shariah rules is still a missing link. Such an institutional arrangement is needed not only to prepare the industry to play a bigger role in the development of global economy but also to ensure the adherence to the very specific element that makes the industry an Islamic industry Wiley Periodicals, Inc. INTRODUCTION Social changes, taking place rapidly in modern times, have taken the application of Islamic law into complexities never known in the past. Diversity and flexibility in the contemporary application of Islamic law as a response to social change is a welcome development, but it creates new challenges too. The Islamic finance industry is the most prominent example where the emerging challenges are significant and are required to be addressed urgently. M. Fahim Khan is chief of Islamic economics in the Cooperation and Development Division of the Islamic Research and Training Institute at the Islamic Development Bank. Previously, he was deputy chief of the Ministry of Planning for the Government of Pakistan, a professor and director in the International Institute of Islamic Economics at the International Islamic University in Islamabad, and was seconded to the State Bank of Pakistan as advisor on transformation of the financial system. Dr. Khan holds a BA and MA (statistics) from Punjab University in Pakistan and an MA and PhD in economics from Boston University in the United States. He has over 15 articles in refereed journals and has published/edited ten books on Islamic economics, banking, and finance, including Money and Banking in Islam, Fiscal Policy and Resource Allocation in Islam (both jointly edited with Ziauddin Ahmed and Munawar Iqbal), and Essays in Islamic Economics (published by the Islamic Foundation, Leicester, United Kingdom). Dr. Khan can be reached via at mfahimkhan@hotmail.com. Thunderbird International Business Review, Vol. 49(3) May June 2007 Published online in Wiley InterScience ( Wiley Periodicals, Inc. DOI: /tie

2 M. Fahim Khan The global growth of Islamic banking is taking advantage of the diversity and flexibility in the fiqh opinions (often referred to as Shariah) to meet the challenges of growth. The global growth of Islamic banking is taking advantage of the diversity and flexibility in the fiqh opinions (often referred to as Shariah) to meet the challenges of growth. While the flexibility in fiqh opinion is presently contributing to global growth, it may soon become a constraining factor in the global growth of the industry if the challenges arising out of the use of diversity and flexibility in fiqh are not properly recognized and taken care of. When modern application of Islamic law in the finance industry takes advantage of differences of opinion, it raises some serious concerns. Some of these concerns are: 1. How to keep practice in line with theory and not allow it to drift away from the Islamic spirit and to be Islamic merely in form ; 2. How to maintain market discipline in the contemporary environment, particularly to ensure transparency about the Islamic products being offered and fairness of the prices being charged, so that the customer knows what he is buying and has an appropriate basis to judge whether the price is right; and 3. How to regulate corporate governance in the industry so that the stakeholders interests are not subject to moral hazard opportunities implicit in the use of the diversity of fiqh opinions. Such concerns may not pose a challenge to the growth of the industry as long as the industry is confined within the national boundaries of a Muslim country. But when the industry spreads globally and develops forward and backward linkages with the global financial network, such concerns can pose a serious challenge to the growth of the industry. How unregulated use of diversity and flexibility in Shariah rules is contributing to these concerns is briefly discussed below. ISLAMIC FINANCE INDUSTRY: DIVERGING FROM THEORY Before the concept of Islamic banking came in practice in the mid- 1970s, Islamic scholars, generally, believed that Islamic financial intermediation could be institutionalized on the basis of a two-tier mudharabah. The profit that bank will share on its investment with the businesses will be shared with the depositors (Siddiqi, 1983). If the bank happens to bear losses in its investment, this loss will be borne by the depositors as Rabbul Ma al (Ahmad, 1993). This theoretical model was supposed to carry several merits vis-à-vis an 286

3 Setting Standards for Shariah Application in Islamic Financial Industry interest-based financial intermediary. It was supposed to make the financial system in the country more stable (Al-Bazdawy, n.d., pp ), more efficient and equitable (Ibn al-arabi, n.d., pp ), and more conducive to generating new entrepreneurs in the economy, and hence reducing unemployment and alleviating poverty (Kahf & Khan, 1992). Actual practice, however, did not start in this way. In practice, although deposits were collected on the principle of mudharabah, they were mostly invested on the principle of murabahah-based financing, or markup-based financing (Khan, 1986). This mode of operation yielded a fixed return to the banks on their investments and enabled them to pay an almost fixed return to depositors. This divergence from theory took place and continued despite severe criticism not only from the Islamic economists who believe in the superiority of profit-and-loss-sharing principle (in the form of two-tier mudharabah-based financial intermediation) and viewed the practice on violating the spirit of Islamic economic and financial principles, but it was also criticized by several Shariah scholars who considered that the practice was not fulfilling all Shariah obligations for implementing the markup-based sale for financing purposes. the practice of Islamic banking in Pakistan did not adopt the principle of profit-and-loss sharing for its operations and instead overwhelmingly depended on the use of salebased modes of financing. The report of the Council of Islamic Ideology of Pakistan (1981) discussed in detail different Islamic principles, in theory, that could be used for operating the institutions of financial intermediation on Islamic lines. The report was jointly prepared by economists, bankers, and Shariah scholars and concluded that profit-and-loss sharing should be the principle of the Islamic financial intermediation. Markup-based, leasing-based, and other methods of financing were recommended only in exceptional circumstances (Khan, 1991). Notwithstanding this recommendation, the practice of Islamic banking in Pakistan did not adopt the principle of profit-and-loss sharing for its operations and instead overwhelmingly depended on the use of sale-based modes of financing. Bankers in Pakistan, in fact, chose that variant of sale-based modes of operation that the majority of Shariah scholars in the country rejected as a valid basis for operating financing activities on Islamic principles. This variant was the buyback arrangement. Islamic banking in the rest of the world too did not opt for profitand-loss sharing-based financing and preferred to do most of its business on the basis of sale-based methods of financing. Recently, a type of financing called tawarroq has come into practice. Several Islamic 287

4 M. Fahim Khan The possibility of Shariah arbitrage on account of a wide diversity in Shariah opinion is also a matter for concern, particularly because such arbitrage may create temptation in the industry to seek profits at the cost of losing the spirit of Islamic finance. scholars have been critical of this variant as a valid basis for operating an Islamic banking business (Khan, 1992). The rapidly growing business of sukuk (often called Islamic bonds) is also raising concerns with respect to the practice diverging too widely from the theory (Kramers, n.d.). This divergence resulting from the diversity and flexibility in Shariah opinion is currently being tolerated in many circles of Shariah scholars and Islamic economists on account of its role in facilitating the growth of the industry at the global level. But there is also a risk that this may soon lead to frustration on the part of the end-users of the products of the Islamic finance industry, who may finally find it hard to distinguish between the products of the Islamic finance industry and conventional interest-based banking. If the distinction is not transparent and convincing, this may pose a serious threat to the growth of the Islamic finance industry. DIVERSITY IN SHARIAH OPINION AND MARKET DISCIPLINE The possibility of Shariah arbitrage on account of a wide diversity in Shariah opinion is also a matter for concern, particularly because such arbitrage may create temptation in the industry to seek profits at the cost of losing the spirit of Islamic finance. The concern, however, is not merely about the spirit, at least for the regulators and supervisors of Islamic finance. The concern for them is about market discipline too. It is feared that this may violate market discipline, as the market may not be able to punish inefficient players on account of the believers willingness to pay a premium for the protection of their faith in the financial dealings. This concern has already been expressed at the global level. IMPLICATIONS FOR CORPORATE GOVERNANCE Despite concern from regulators and supervisors, the Islamic banking industry can still survive and grow in the market of believers, which no doubt is a big market and may not pose any limit to the growth of the industry in the foreseeable future. But then it is also obvious that having the confidence of the market is a crucial factor in the survival and growth of the industry. Good governance in the industry is a key to building and maintaining this confidence. Confidence must reside not only in the form of the products offered by the industry, but also in the professional competence and ethics employed in pro- 288

5 Setting Standards for Shariah Application in Islamic Financial Industry viding these products to the clients. There is an issue of good governance with respect to the use of the depositors money since depositors have to opt for sharing profits/losses with the bank if they intend to earn returns on their deposits. Islamic banks can offer two types of profit-sharing investment accounts: (1) restricted profit-sharing investment accounts and (2) unrestricted profit-sharing investment accounts. Deposits received under the restricted accounts are used in prespecified projects using prespecified modes. For such accounts, Islamic banks have succeeded in developing products that will ensure that the returns to depositors vary only in a very narrow range with an almost nonexistent possibility of loss. Thus, despite having profit-and-loss-sharing accounts, depositors can have their deposits in Islamic banks with the same risk profile that clients of conventional banks will get on their savings account. But there is often the issue of market compatibility in the sense that the depositors may not be getting a return equivalent to what their counterparts may be getting from the conventional banks. Unrestricted profit-sharing investment accounts, by contrast, are the accounts where the depositors authorize banks to invest their deposits in any investment that the banks consider suitable and the depositors agree ex-ante to share the profits/losses arising from these investments. Banks use the funds of accountholders in investments selected by the banks, and accountholders do not have any say in this choice. The possibility of moral hazard may arise if depositors money is used more to suit the bank than the depositors. For their part, depositors are not represented on the board, nor has any Islamic bank so far been able to develop a mechanism of internal control to take care of the interests of investment accountholders vis-à-vis the interests of shareholders and bank management. A primary concern of depositors is that their money is used in a manner that conforms to Shariah norms. So far, there is no arrangement to provide a transparent view to depositors that the Shariah is being applied properly in the use of their funds in order to legitimize the income that they will receive on their deposits. The Islamic finance industry generally provides only a wholesale Shariah clearance for the operations of the banks. Details of the process of clearance are not known to the depositors. The details of Shariah supervision on different stages of the operations of Islamic banks are also not known. Islamic banks can offer two types of profitsharing investment accounts: (1) restricted profit-sharing investment accounts and (2) unrestricted profit-sharing investment accounts. Such corporate governance issues cannot be resolved by prudential regulations. There are aspects that relate to Shariah issues and ethical issues involved. Even if the Islamic banks try to be transparent by 289

6 M. Fahim Khan The industry would not be doing justice to its clients if it used the diversity in Shariah opinion only to increase their profit without being transparent to their clients on the form and method of applying shares in their operations. declaring how they are applying Shariah in their operations, this may not be enough. There is need for some arrangements that will certify that the Shariah application conforms to the client s preferred Shariah opinion. Thus, an important dimension of the governance issues arising out of the diversity and flexibility in Shariah opinion is whether clients of the industry are getting the Shariah value for which they are paying a premium. The industry would not be doing justice to its clients if it used the diversity in Shariah opinion only to increase their profit without being transparent to their clients on the form and method of applying shares in their operations. Clients of the Islamic finance industry follow different schools of fiqh and Shariah opinions. The industry is currently not transparent enough on details of Shariah application. Shariah scholars who understand and disagree with some declared applications chose to remain silent as an expression of respect for other Shariah opinions. The industry, thus, is likely to be thriving on the Shariah illiteracy of its clientele. As Shariah literacy in the clientele of industry increases, and Shariah scholars with different opinions become vocal, the industry may find its growth severely constrained. It would not be right to say that industry is unaware of these limitations. The problem is that it does not have the means to resolve such issues. Some basic questions for them in this respect are as follows. 1. What type of expertise is required to enable the banks to make correct use of the flexibility in the application of Islamic law in the industry? 2. What types of standards and criteria are needed when applying Shariah to make the application transparent to the satisfaction of their depositors, particularly in matters where the industry is making use of fiqh differences? A substantial amount of growth in Islamic banking is taking place, at the global level, out of the desire of conventional banks to provide Islamic banking services to their Muslim clientele and to interface with the Islamic finance industry. The above questions are crucial for them too. Without clear answers about the application of Shariah, the interface between the conventional and Islamic finance industries will be made more difficult. With only a few exceptions, most countries allow Islamic finance under an act separate from that governing conventional finance. This 290

7 Setting Standards for Shariah Application in Islamic Financial Industry hesitation on the part of the conventional legal system to govern both the conventional and Islamic finance industries may also prove to be a serious constraining factor in the growth of the Islamic finance industry, even at the national level. The hesitation, however, is not unjustified. Legal authorities also face the same two questions mentioned above. Without answers to them, it may not be possible for legal authorities to develop a system for evaluating and monitoring the performance of Shariah application in the industry. In the absence of such a system, the legal authorities will be reluctant to supervise and monitor the conventional and Islamic finance industry under a single mainstream legal framework used for the conventional financial sector. Until the Islamic finance sector can satisfy regulators that they are amenable to the same standards as applied to the conventional financial industry, Islamic finance will remain at the margins of the financial system. For the most part, Shariah authority plays only an advisory role in the current practice of Islamic finance. This creates another governance issue for the Islamic finance industry in terms of to what extent the rules prescribed by Shariah scholars are being adhered to. Currently, substantial doubts exist on this particular point. On the other hand, there are instances where Shariah scholars do exercise a veto power and the industry has to get clearance from the Shariah scholars for all their operations. This very process might be seen as putting innovation and growth at stake, making it difficult to compete with the conventional finance industry. Until the Islamic finance sector can satisfy regulators that they are amenable to the same standards as applied to the conventional financial industry, Islamic finance will remain at the margins of the financial system. WHY DIVERSITY IN FIQH RULINGS At this juncture, it may be instructive to understand why there is diversity in fiqh rulings. Fiqh is a science. It is an intellectual and technical effort to develop a methodology to understand the Qur an and the Sunnah (traditions of the Prophet) and to derive laws from them. Diversity in fiqh opinions began with the start of interpretative judgments, called Ijtehad, on issues where direct guidance was not available from the Qur an and Sunnah. This Ijtehad, in fact, dates back to the days of the Prophet. In the absence of divine inspiration on any matter, he made Ijtehad to enact a law. During the Prophet s lifetime, however, there was no question of diversity in Ijtehad, as the Prophet himself was making the Ijtehad, and according to the Qur an itself, His statements are not whimsical; whatever he says is a divine inspiration (Qur an 53:3). 291

8 M. Fahim Khan Attempts have been made in Islamic history to reconcile the views of fiqh scholars, standardize their rulings on different issues, and compel people to adhere to unified rulings. After the death of the Prophet, when the Islamic State expanded and the Prophet s companions migrated to different regions and countries, they faced new customs and traditions and a new environment and social circumstances. They had to make Ijtehad on several matters and in this process they agreed on certain issues and differed on others. These differences of opinion were tolerated in the public good and respect of each other s understanding of the Qur an and Sunnah. That is how the difference in fiqh opinion started. These differences grew over time mainly on account of the following reasons. First, fiqh, being a science of interpretative judgment, advanced in its own methodology and techniques. This, on the one hand, provided better understanding and interpretation of the Qur an and Sunnah on newly emerging matters and, on the other hand, generated differences among fiqh scholars on the methodology and outcome of their interpretations. The scholars had freedom of choice in choosing logical methods for drawing their own conclusions, inferences, and interpretations, and hence in making rules and laws. This led to differences in fiqh opinion from scholar to scholar. Second, the fiqh scholars benefited from advances in related disciplines such as logic, philosophy, psychology, and even in physical sciences, which helped them modify and improve their own methods of interpreting the Qur an and Sunnah. This process generated differences in fiqh interpretations from time to time. Third, different fiqh scholars faced different circumstances when drawing conclusions and interpretations in different cultures and national boundaries. The cultures and customs and specific needs of the various societies influenced fiqh interpretations. The fiqh rulings therefore differed from place to place too. These differences continued to grow and later on developed into recognized schools and doctrines of Islamic jurisprudence. Attempts have been made in Islamic history to reconcile the views of fiqh scholars, standardize their rulings on different issues, and compel people to adhere to unified rulings. Such attempts were made as early as the second century of the Hijrah. One of the Caliphates of the second (Hijrah) century appointed Imam Malik (a renowned Islamic jurist of the time) to unify fiqh opinion. The attempt, however, failed, as it was not found feasible to compel people to accept one opinion or one single school of thought. The diversity, therefore, continued to prevail. 292

9 Setting Standards for Shariah Application in Islamic Financial Industry CODIFYING THE DIVERSITY IN FIQH Failing to unify the fiqh opinions, the need was felt to at least codify the fiqh opinion so as to standardize the differences and avoid any confusion that may arise in the application of Shariah in any place at any point in time. The first attempt to codify Islamic jurisprudence was made in the Ottoman Empire, which resulted in a book entitled Majallatul Ahkam (1293H), which comprised 1,851 articles, adhering to the Hanafi school of thought. Consequently, it was decided that all countries under Ottoman rule should comply with the provisions of the Majalla. However, this decision did not address the issue of diversity of Shariah opinions on different matters in different schools of thought. Another attempt was made by the Azhar University Research Academy to codify Islamic fiqh in accordance with major schools of thought. The job, however, was not completed. There exists a strong feeling, in the concerned circles, for the need to unify Shariah rules or to harmonize Shariah diversity. More recently, the General Secretariat of the Arab League tried to codify laws of Arab countries in accordance with Islamic Shariah. The Arab League did compile a codified document relating to financial transactions (containing 1,316 articles). This job too, however, could not be completed to the extent to enable it to be used as standards for Shariah opinions on various issues relating to the contemporary finance industry. With the emergence of Islamic financial institutions such as Islamic banks, Islamic investment companies, Islamic insurance companies, and other Islamic financial institutions, and in the absence of any single authority to guide and supervise them in Shariah matters, the need arose for these institutions to have their own Shariah boards and councils to guide and supervise their activities to conform to Shariah and give Shariah clearance on their transactions and contracts. The rapid growth of Islamic finance institutions led to a growth in Shariah bodies advising these institutions. The increase in these Shariah bodies/shariah boards further increased the diversity in Shariah rulings on financial matters, and each Shariah board concentrated on the specific needs of the institution and its clientele. There exists a strong feeling, in the concerned circles, for the need to unify Shariah rules or to harmonize Shariah diversity. Whatever unification or harmonization means, it has yet to take place, and it may not be possible to accomplish it in the foreseeable future. Codifying the diversity in fiqh opinions currently in use in the Islamic finance industry would probably be an important step in this direction. Different strands of fiqh opinion could be given specific code and title 293

10 M. Fahim Khan the principles of Islamic finance are alien to the existing legal structure applicable to the financial sector in general and to the banking sector in particular. with full background on the sources and schools of Islamic jurists to which the various threads primarily belong. A declaration from the Islamic banks with respect to which aspects of fiqh rulings are being utilized in their operations would give a clearer view of the Shariah compatibility of their products to the satisfaction of their clientele. This codification could also be an important element in defining the standards for corporate governance in the Islamic finance industry in the context of Shariah application. As already mentioned, codification is a big and too complex task, and the industry cannot wait for it for too long. Some more feasible arrangements have to be developed quickly. STANDARDIZATION OF THE APPLICATION OF SHARIAH, RATHER THAN UNIFICATION OR HARMONIZATION, IS THE CURRENT NEED The unification or harmonization or codification alone, even if achieved, may not solve all of the problems described above. The immediate challenge involves more than harmonizing fiqh opinions and codifying them. It relates to standardizing the entire process of how to advise, supervise, and monitor Shariah compatibility of an institution or any of its operations/products, and includes how a verdict should be arrived at and how a certificate should be formulated when validating the Shariah compatibility of a financial activity or institution to ensure transparency and good corporate governance. Furthermore, the principles of Islamic finance are alien to the existing legal structure applicable to the financial sector in general and to the banking sector in particular. This is causing Islamic financial institutions either to operate as nonbanking financial institutions or to need a separate law to operate as a licensed institution in the financial sector, which marginalizes the Islamic financial industry vis-à-vis the conventional finance industry. If the Islamic finance industry is to move from the margins of the finance industry to the mainstream, standardizing is needed in a fashion that the conventional legal system governing the finance sector can recognize and benefit from by incorporating the Islamic finance industry under the same roof. It requires choosing an appropriate format of standardizing Shariah application that the regulators of the financial sector would understand and find common ground with when designing the legal system that will govern the two systems. 294

11 Setting Standards for Shariah Application in Islamic Financial Industry Where a unified law does not govern the financial architecture, both conventional and Islamic, there remains a challenge of how to define the legal responsibility with respect to the application of Shariah in the industry. Some countries require it by law for Islamic financial institutions to establish their own Shariah supervisory board, while some other countries leave it to the discretion of the institution whether or not to have their own Shariah representatives. In either case, the specific duties and responsibilities with respect to Shariah application and its monitoring and supervision of the operations of these institutions would be laid down in the law or in the prudential rules. This absence may be keeping substantial numbers of potential clients away from the Islamic finance industry, and may also be a factor in the reluctance of conventional law governing the finance industry to be opened up to cover the Islamic finance industry as well. PRESENT STATE OF SHARIAH PROCESS Shariah scholars are themselves the right bodies to work out how best to monitor and report on the state of Shariah application in that they can develop specific standards relating to Shariah duties and responsibilities. This will be part of specifying the standard process by which the Shariah advisors or Shariah board will conduct ex-ante and expost Shariah review and by which they will monitor, supervise, and report on the Shariah application during the entire operation and determine where the legal responsibility will lie in case of lapses in the application of Shariah and its consequences on the business of an Islamic financial institution. A study conducted by the International Institute of Islamic Thought on performance evaluation of Shariah supervisory boards in 1996 indicated that 58.4% of a corpus of members of Shariah supervisory boards are selected by boards of directors. While no recent study has been conducted in this respect, there is no evidence that the situation might have changed substantially. The fact that Shariah boards are subordinate to boards of directors may raise questions about conflicts of interest. So far, there is no evidence that this position has in any way affected the authority of Shariah boards to give the right advice. But as the industry grows and demand for Shariah advice increases, this issue may gain prominence. In order to ensure the appropriate place and role of Shariah boards of Islamic financial institutions, regulations and standards in the executive hierarchy of these institutions need to be laid down. Shariah scholars are themselves the right bodies to work out how best to monitor and report on the state of Shariah application in that they can develop specific standards relating to Shariah duties and responsibilities. 295

12 M. Fahim Khan It is hard to think of a global body of Shariah that can impose any standards on individual institutions or on national finance industries. This issue can be taken care of at the national level by a government authority, where either the ministry of finance or the central bank or any other appropriate body in the country is assigned to ensure Shariah supervision according to defined standards. The Islamic financial institutions at the national level can be obliged by the government to follow the standards laid down, for example, by a central Shariah board. At the global level, however, the issue is not as simple. It is hard to think of a global body of Shariah that can impose any standards on individual institutions or on national finance industries. This matter needs careful consideration. The next section presents a brief overview of the efforts currently being made at the national and global level in the context of standardizing the application of Shariah in the finance industry. EFFORTS AT NATIONAL LEVEL The regulators in Muslim countries where Islamic banking has substantial (or full) presence have not been unaware of the need to standardize the application of Shariah in the finance industry, and efforts are being made at the national level to develop structures to provide a standardized Shariah framework for the growth of the industry, and the efforts to improve the nature and scope of such a structure are still ongoing. The approaches differ from country to country. Three types of efforts, however, are prominent. Sudanese Model The model is specific to Sudan and is not meant to address Shariah issues for the global Islamic finance industry, yet it does have relevance for the countries intending to standardize Shariah application in the finance industry at the national level and where the entire population follows by and large the same string of Shariah opinion as far as Shariah application in financial matters is concerned. Sudan has subjected its entire financial sector to Islamic principles of finance. Standardization for the application of Shariah, therefore, is as important an issue for them as standardization of operation for the conventional financial sector would be for any country. Sudan has designed a central Shariah system for keeping the entire financial system on a defined standard of Shariah application. The Supreme Shariah Supervisory Authority for Financial Institutions and Banks of Sudan, established by the Ministry of Finance and Economic Planning, under the Banking Act is responsible for designing the system 296

13 Setting Standards for Shariah Application in Islamic Financial Industry and monitoring its application. The functions of the Supreme Shariah Authority are as follows: 1. Work out together with bank officials contract and agreement specimens for all transactions of banks and financial institutions that are engaged in banking activities so as to ensure that they keep away from all Shariah prohibitions and follow a uniform method of application of Shariah in each transaction. 2. Give Shariah opinion on the transactions of banks or financial institutions engaged in banking activities that a bank or the governor of the Bank of Sudan refers to it. 3. Monitor transactions carried out by the Bank of Sudan, banks, and financial institutions, and give sound Shariah opinion to the governor of the Bank of Sudan on matters regarding transactions of the Bank of Sudan or commercial banks and financial institutions engaged in financial activities. 4. Examine the Shariah problems faced by the Bank of Sudan or other banks and financial institutions in their operations and advise them how to resolve the problems. 5. Issue Shariah edicts on matters that so require. Review the laws, by-laws, and publications that govern the activities of the Bank of Sudan and other banks and financial institutions engaged in banking activities to eliminate anything that is incompatible with Islamic Shariah precepts in coordination with various bodies. 6. Ensure that the Bank of Sudan and other banks and financial institutions engaged in banking activities comply strictly with the Shariah when it comes to any banking and financial business. 7. Help technical supervisory bodies of banks to perform their tasks in accordance with Islamic Shariah precepts. 8. Help the management of the Bank of Sudan to draw up staff training programs for banks and financial institutions engaged in banking activities so that they can learn Islamic modes of financing and Shariah aspects of transactions. 9. Conduct research and studies that can help improve the Islamic approach to economic and financial matters. 10. Submit an annual report to the Minister of Finance and Economic Planning on the Shariah soundness of the transactions of the Bank of Sudan and other banks and financial institutions engaged in banking activities. The edicts issued by the authority on Shariah matters are binding on financial institutions. The edicts issued by the authority on Shariah matters are binding on financial institutions. The Shariah authority also helps the central bank to run its monetary policy according to Shariah principles. 297

14 M. Fahim Khan Bahrain is actively involved in developing standards for its Islamic finance industry but in a way that they can be adopted by interested institutions anywhere in the world. The model thus takes care of several issues raised earlier in the context of the standardization of the application of Shariah in the finance industry, but of course at the national level. Global attractiveness of the model, however, is limited in view of the fact that it addresses very specifically to the financial setup of Sudan only, and also in view of the fact that it does not address how to deal with the issue of diversity in fiqh opinions. Bahraini Model Bahrain is actively involved in developing standards for its Islamic finance industry but in a way that they can be adopted by interested institutions anywhere in the world. Its focus is on standardizing the operation of institutions with respect to Shariah application rather than suggesting transformation of the entire financial system of the country. The model is focusing on developing a Shariah-related structure that can be relevant for global application. The Shariah-related infrastructure being developed in Bahrain consists of several interrelated components. One important component is the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI), which issues accounting and auditing standards for Islamic finance industry. The AAOIFI has a Shariah council that has the following major functions: 1. Prepare and adopt Shariah standards for modes of investment financing, insurance, and Islamic financial services. 2. Come up with innovative Shariah devices that would enable Islamic financial institutions to keep pace with innovations taking place in the global financial and capital market. 3. The Council considers matters submitted by Islamic financial institutions or their Shariah boards for Shariah opinion or arbitration on a particular issue. The AAOIFI s guidelines give the management of a financial institution the responsibility to ensure that its institution is operating in accordance with Islamic Shariah precepts and principles. As far as the Shariah board or Shariah authority of the institution is concerned, the AAOIFI standards require that its responsibility be confined to expressing an independent opinion based on its observation of the financial institution s operations and to preparing a report on the matter. For some, this is essential in order not to mix up the Shariah authority with the executive authority and not to introduce ambiguity in matters relating to corporate governance. In some quarters, however, it is thought to be undesirable to give executive authority the responsibility to ensure Shariah compatibility of their operations, as it requires specialized Shariah knowledge. 298

15 Setting Standards for Shariah Application in Islamic Financial Industry The Shariah Council of the AAOIFI has so far issued Shariah standards relating to the following major financial operations: 1. Currency trading, 2. Discount cards and credit cards, 3. Delinquent default, 4. Debt clearing, 5. Guarantees, 6. Murabahah to the orderer of purchase, 7. Leasing and purchasing back lease, 8. Salam (forward sale) and parallel salam, 9. Istisna and parallel istisna, 10. Documentary credits, 11. Transformation of a conventional bank into an Islamic financial institution, 12. Debt transfer (hawala), 13. Mudarabah, and 14. Musharakah. The standardizations being developed by the AAOIFI, including those related to Shariah application, are binding on the Islamic financial industry in Bahrain. The standardizations being developed by the AAOIFI, including those related to Shariah application, are binding on the Islamic financial industry in Bahrain. These standardizing elements, however, are also being utilized by other countries in the region, with some making them binding on their Islamic finance industry too and some making them only recommendations. The AAOIFI, including its Shariah council, has done substantial work in the way of standardizing financial reporting, including the reporting on Shariah compliance. These standards are being applied not only in the Islamic finance industry, but are also being adopted by Islamic finance institutions in other countries and gaining wider application, and hence playing an important role in promoting standards at the global level. With respect to the standardization of application of Shariah, the AAOIFI Shariah council is limited to developing standards mainly to Shariah issues relating to financial reporting. There are several issues related to the Shariah application in the developing of Islamic financial products and services, preparing of documentation underlying these financial products and services, supervising and monitoring the conduct of products, and supervising and reporting on their Shariah performance. Standards have yet to be developed on these aspects of the application of Shariah in financial institutions. All these aspects are not cov- 299

16 M. Fahim Khan ered in the AAOIFI standards. Also, the Shariah council of the AAOIFI does not address the issue of diversity of Shariah opinions. This too limits the scope of these standards to be adopted widely at the global level, particularly in the context of Shariah application. BNM has an elaborate mechanism of supervision and regulation for the Islamic banks to ensure that their operations remain in line with the overall objective of the banking system in the country. Malaysian Model The legal basis for the setting up of Islamic banks in Malaysia is the Islamic Banking Act 1983 (IBA). The Act provides the Central Bank of Malaysia (BNM) the authority to regulate and supervise the Islamic banks, similar to the authority it has in case of conventional financial institutions. The IBA requires that the Articles of Association of the Islamic bank incorporate provisions for the establishment of a Shariah advisory body to advise the Islamic banks on the operation of the Islamic banking business. BNM has an elaborate mechanism of supervision and regulation for the Islamic banks to ensure that their operations remain in line with the overall objective of the banking system in the country. Parallel to this, conventional banks, which are governed by the Banking and Financial Institutions Act (BAFIA), have also been allowed, through a 1996 amendment to the Act, to carry out the Islamic banking business in addition to the existing licensed business (of conventional banking). These conventional banks are required to comply with any written directives, issued from time to time by the BAFIA, relating to Islamic banking business. The directives are issued by the BNM in consultation with its Central Shariah Advisory Council. Any conventional bank, licensed under the BAFIA, carrying out Islamic banking business in addition to its conventional licensed business may from time to time seek advice from the Central Shariah Advisory Council of the BNM in its Islamic business operations in order to ensure that it does not involve any element that is not Shariah-compatible. The provisions relating to the Islamic banking business in the BAFIA do not apply to Islamic banks because they are governed by the separate IBA, which requires Islamic banks to have their own Shariah advisory body to advise them on their business operations. The Malaysian model allows diversity in the application of Shariah by allowing Islamic banks to have their own Shariah advisory bodies that are not subject to regulation from the Central Shariah Advisory Council of the central bank of the country. In this respect it provides a good example of Shariah-related infrastructure for the finance industry for countries where there is diversity in the fiqh opinions relating to financial operations. On one hand, the model standardizes the Shariah application in the mainstream (conventional) financial 300

17 Setting Standards for Shariah Application in Islamic Financial Industry industry without giving them flexibility to benefit from Shariah diversity. On the other hand, it leaves room for the Islamic finance industry to benefit from fiqh diversity but standardizes their operations with respect to the monetary objectives of the economy. EFFORTS AT GLOBAL LEVEL The Islamic Development Bank (IDB), based in Jeddah, Saudi Arabia, has been a catalyst in promoting supporting infrastructure for the Islamic finance industry at the global level. Central banks of Malaysia, Bahrain, and several other countries where Islamic banking exists also played an active role in infrastructure building individually and collectively. A brief overview of these efforts with particular reference to Shariah application is given below. The IDB played an important role in establishing the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), which, as described earlier in detail, is working on standardizing some aspects of Shariah application as well. These standards are gaining global recognition even at the level of such international organizations as the World Bank and International Monetary Fund, as well as at the level of some international rating agencies. Since the IFSB is seeking to introduce, for the Islamic finance industry, international standards consistent with Shariah principles, they will be seeking internationally acceptable Shariah principles as well. The IDB has also played an active role in the establishment of the Islamic Financial Services Board (IFSB) as a global body to develop regulating and supervisory standards. The members of the Board are central bank governors of the countries where Islamic banking exists. The core function of the IFSB is to develop best practice standards. Standardization of several aspects of Shariah application will fall under the jurisdiction of this Board when developing best practice standards for such elements as risk management, capital adequacy, corporate governance, disclosures, and the like in the Islamic finance industry. Since the IFSB is seeking to introduce, for the Islamic finance industry, international standards consistent with Shariah principles, they will be seeking internationally acceptable Shariah principles as well. The IDB has helped in establishing an Islamic Financial Market (IFM) where the standardized concept of sukuk (trust certificates as Islamic financial securities) was introduced. The IFM is operating since April Since then, the IFM has endorsed five significant sukuk issues that not only provide a standard format for issuing sukuk, but also introduce international standards for the application of Shariah in 301

18 M. Fahim Khan As a part of its growth strategy, the IFM faces the challenge of seeking harmonization of fiqh opinions in developing standards that would be globally acceptable for the issuance of sukuk. developing Shariah-compatible instruments for trading in secondary markets. As a part of its growth strategy, the IFM faces the challenge of seeking harmonization of fiqh opinions in developing standards that would be globally acceptable for the issuance of sukuk. An International Islamic Rating Agency (IIRA) has been established in Bahrain with multinational financial institutions, rating agencies, Islamic banks, and insurance companies as its major shareholders. The IIRA is starting with a vision to become the reference for the credit rating in accordance with Shariah principles and its mission is introducing standards for greater disclosure and appropriate governance in Islamic banking and helping clients understand and manage various risks in compliance with Shariah principles. The functions of the IIRA include assessment of compliance with principles of Shariah and assurance of transparency with respect to application of Shariah. Developing standards of Shariah application in the finance industry, therefore, will be the business of this agency too. Another recent development at the global level is the establishment of the International Islamic Centre for Reconciliation and Commercial Arbitration for Islamic Finance Industry, which was launched in April 2005 with 50 percent of the capital contributed by the Islamic Development Bank. The center, the headquarters of which will be situated in Dubai, will settle financial and commercial disputes between financial or commercial institutions that have chosen to comply with Shariah. One of its roles will be to develop some common understanding of standards in the application of Shariah. Reconciling disputes in the context of Shariah application requires a scientific understanding of the diversity in Shariah opinion and defining some globally acceptable standards for benefiting from Shariah diversity in the application of Shariah in the industry. This may be one of the major functions that this center may take on once it is fully in operation. THE MISSING LINK IN THE INFRASTRUCTURE The rapidly growing infrastructure for standardizing the supervision and monitoring of the global expansion of the Islamic finance industry is indicative of the fact that the industry is maturing to play a bigger role in the development of the global economy. This infrastructural development is, however, still missing an important link, and that relates to the very specific element that makes the industry an Islamic industry. The industry needs infrastructural setup to define and lay down a standardized framework for the application of Shariah 302

19 Setting Standards for Shariah Application in Islamic Financial Industry in the operation of the industry. Unless this link is properly established in the growing regulatory and supervising infrastructural developments, the industry will feel constrained in fully exploiting its potential role as an effective partner in the global development. This link is missing in all the infrastructural developments described earlier. Various infrastructural developments described in the previous section have one common element. They all need to deal with diversity in fiqh opinions and they all need to have standards defined for benefiting from the Shariah diversity in the application of Shariah in the finance industry. Since the size of the business and market is still small, it may be desirable for each of these institutions to have its own standards in this respect. But as the market is growing rapidly, it will soon be feasible to have an independent institution taking care of this common factor. The Shariah-standardizing link in the institutional framework for the standardization of the industry is needed more at the global level than at the national level. At the national level, it may be relatively easier in most countries for the regulatory authorities to make sure that the application of Shariah in the finance sector is properly standardized and regulated within the legal framework of the country and that the clients of the Islamic finance industry in the country clearly know which fiqh opinion or school of thought is being followed in the industry, who are the Shariah experts evaluating the Shariah compatibility of the finance industry, and where legal responsibilities lie for fulfilling the Shariah requirements. At the global level, however, the situation is different. Since different countries are following different approaches and different models as well as different Shariah schools in the Islamic financial sector, there is a need for coordination at the global level to standardize this diversity in approaches and models toward providing the Shariah framework to the finance industry. This coordination can take place in different scenarios. Some suggestions are given below. The Shariahstandardizing link in the institutional framework for the standardization of the industry is needed more at the global level than at the national level. Probably, somewhat along the lines of International Organization for Standardization (ISO), an International Organization for Standardization for Shariah Application in the Finance Industry (IOSSAFI) is needed to explain standardized variations in the application of Shariah in the finance industry along with standardized information on Islamic jurisprudence underlying its Shariah application and code them appropriately. Taking the example given earlier, we may find in the global financial markets sukuk issued with the Shariah condition of more than 50 percent of ijarah-based transactions underlying them, along with sukuk 303