Sharia Governance and Islamic Banking and Finance
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Sharia Governance for Islamic FinanceQuis custodiet ipsos custodes?
REGULATING ISLAMIC FINANCIAL PRODUCTS AND MARKETS
DR. SAYD FAROOK, GLOBAL HEAD ISLAMIC CAPITAL MARKETS
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
IntroductionThe Looming Significance & Growth of Islamic Finance
Global Shariah Compliant AssetsYear Assets ($B)
2005 386.032006 500.482007 639.082008 822.142009 953.022010 1095.97Source: The Banker
The Setbacks
• Lack of wider cheaper distribution channels
• Yet-to-be standardized products
• Challenges to core Sharia compliance process
SHARIAH GOVERNANCE FUNDAMENTALS
Shari’a Non-Compliance Risk (1/2)Legal Precedence
Beximco Pharmaceuticals Ltd and others v Shamil Bank of Bahrain E.C. 2004 EWCA Cir 19 :
Murabaha financing contract
The contract provided "Subject to the principles of the Glorious Shari'ah, this Agreement shall be governed by and construed in accordance with the laws 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 legal system.
Ratio Decidendi: it is for each party to satisfy themselves that the substantive terms of the underlying contract comply with Shari'ah 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 contract
TID argued the following :Constitutional documents did not allow for Shari’a non-compliant transactions
Agreement did not comply with Shari’a Beyond 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’s argument 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 the Agreement was therefore ultra vires NOT that it would succeed in court.
Shari’a Non-Compliance Risk (2/2)Micro- Mitigation Techniques
Key Considerations for mitigating Shari’a Non-Compliance Risk:
Request a certificate confirming that the transaction is Shari’a compliant from the Shari’a Committee/Advisor and preferably for material transactions, from the full Shari’a Supervisory Board
A representation to be inserted into the Shari’a compliant agreement stating that entry into and performance by the IFI of that agreement does not conflict with any of its constitutional documents
The waiver by the IFI of any defenses that it might have in connection with the agreement not being compliant 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 each Relevant 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 satisfying itself of their compliance with Shari’a, it is satisfied that this Agreement does not contravene Shari’a and it does not have any objection, nor will it raise any objections, as to matters of Shari’a compliance in respect of or otherwise in relation to the
provisions of this Agreement ;
Shari’a Supervisory Board
Institutions offering Islamic products employ services of religious advisors (the Shari’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 donation and charities).
Advise on distribution of cash flows, income and expenses between shareholders and Sukuk holders.
Shari’a Approval Process
Phase 1Identify Shari’a Options
Phase 1Identify Shari’a Options
Activities Determine our clients’
needs and business objectives
Identify potential high level Shari'a product structures
Discuss available options with our clients
Work through the commercial and practical considerations with our clients
Activities Determine our clients’
needs and business objectives
Identify potential high level Shari'a product structures
Discuss available options with our clients
Work through the commercial and practical considerations with our clients
Deliverables Preliminary Shari'a
Report
Deliverables Preliminary Shari'a
Report
Phase 2Finalise Shari'a Structure
Phase 2Finalise Shari'a Structure
Activities Review selected product
structure Liaison with Shari'a
Scholars on the structure design
Identify required legal documentation
Prepare draft Fatwa Review of structure by
Shari'a Board and issue of Fatwa on structure
Activities Review selected product
structure Liaison with Shari'a
Scholars on the structure design
Identify required legal documentation
Prepare draft Fatwa Review of structure by
Shari'a Board and issue of Fatwa on structure
Deliverables Fatwa on Shari'a
Structure
Deliverables Fatwa on Shari'a
Structure
Phase 3Review Legal Documentation
Phase 3Review Legal Documentation
Activities Review legal documents
for compliance with Shari'a laws and the structure Fatwa granted
Liaise with Shari'a Scholars and the clients’ legal team during the documentation drafting
Legal documentation reviewed by Shari'a Board and issue of Fatwa on documentation
Activities Review legal documents
for compliance with Shari'a laws and the structure Fatwa granted
Liaise with Shari'a Scholars and the clients’ legal team during the documentation drafting
Legal documentation reviewed by Shari'a Board and issue of Fatwa on documentation
Deliverables Fatwa on Legal
Documentation
Deliverables Fatwa on Legal
Documentation
Throughout the process, Dar Al Istithmar adheres to relevant Shari'a 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 Shari'a Supervisory Board.
Client selects
methodology & builds detailed structure
Client produces
legal documents
Operating ModelsModel options Characteristics Shari’a Aspects
Shari’a Compliant Islamic Banks
Due to rapid development of Islamic Finance, new banks are being set-up which are fully Shari’a Compliant and offer retail as well as whole sale banking facilities.
Since 2004, five fully Islamic banks have been set up in the UK, out of which one is a retail bank where as other four are whole sale banks.
From Shari’a perspective, these are at the lowest risk due to:
• No dealing in conventional / interest based products
• No risk of mixing of Islamic Funds with conventional.
• More involvement of Shari’a Scholars in day to day activities of the bank.
Conventional bank with an Islamic subsidiary / Finance Vehicle
This model is used by conventional banks which want to extend their services into retail and whole sale Islamic Banking as well as retaining the conventional customer portfolio.
This model is used by HSBC, Standard Chartered, Citi etc.
From Shari’a perspective, Islamic subsidiaries / finance vehicles are considered at a lower risk due to:
• Bespoke IT system and infra-structure for Islamic Products.
• 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 with an Islamic Window
This set-up is primarily used by conventional investment banks which want to provide its high net worth individuals and institutional customers access to Shari’a Compliant investments and Structured products.
This model is followed by Deutsche Bank, Barclays Capital etc.
From Shari’a perspective, Islamic windows are considered to be high risk primarily due to:
• IT Systems and infra-structure of conventional banks may not be not be flexible enough to cater requirements of Islamic Products.
• Funds generated from Shari’a Compliant sources are not segregated from funds generated from conventional activities.
Contrast of Shariah Governance with Existing Governance Structure
FUNCTIONS TYPICAL FINANCIAL INSTITUTION
ADDITIONS IN IFIS
Governance Board of Directors Shari’ah Board
Control Internal Auditor
External Auditor
Internal Shariah Review UnitExternal Shariah Review
Compliance Regulatory and Financial Compliance
Internal Shariah Compliance Unit
Voluntary Standards on Shariah GovernanceAAOIFI Governance Standards
1. Shariah Supervisory Board: Appointment Composition and
Report
•At least 3 members (no directors or shareholders)
•Requirements for report suggest Sharia board must play a deep role in review of bank’s operations.
•Recommendation to publish fatwas, rulings and guidelines
2. Shariah Review
•SSB forms opinion, but Shariah compliance rests with management
•Examination includes contracts, agreements, policies, products, transactions, memorandum 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.
3. Internal Shariah Review
•Internal division or part of internal audit
•Examination and evaluation of the adequacy and effectiveness of the IFI’s system of internal Shari’a control and the quality of performance in carrying out assigned responsibilities.
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.
Voluntary Standards on Shariah Governance IFSB 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
•Each IIFS must ensure that the Sharī`ah board has: •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.
I. General Approach
•The IIFS shall ensure that any person mandated with overseeing the Sharī`ah Governance System fulfils acceptable fit and proper criteria.
•The IIFS shall facilitate continuous professional development of persons serving 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.
II. Competence
•Play a strong and independent oversight role, objective judgement on Shariah. NO INDIVIDUAL or GROUP should be allowed to dominate decision making
•Compliete adequate and timely information prior to all meets and on an ongoing basis
III. Independence
•Internal information kept confidential
IV. Confidentiality
•IFI should understand legal and regulatory framework for issuance of Shariah pronouncements in jurisdiction of operation.
•Should promote convergence of Shariah governance standards
V. Consistency
Voluntary Standards on Shariah Governance IFSB 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
Revisiting the ChallengesChallenges
Increased Costs
Shariah Advisory
Structuring
Documentation
Multi-board Representations
Multiple Conflicts of
Interest
Concentration Risk
Cost Implications
Shariah Diligence
Insufficient Coverage
Standard of Due Diligence
Conflict of Interest
Hired by IFI
Paid in BPs
Current Process: Participation and learn
by doing
Previous proposals
Certifying future generations
Supranational Sharia Body
Supply Constraints Governance and Due Process Constraints
Costs of Sharia Due Diligence
Example:
• 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 other Islamic product.
Conflict of Interests
• Scholars are appointed by the financial entities themselves.
• Some scholars are paid in term of BP per fund managed.
------------------------------------------------
Central Shariah Committee as a solution??
Multiple Board Representation
Interesting Facts:
• Top 50 scholars occupy 834 positions (over 73% of positions)
• Multiple conflicts of interests
• Cost implications of concentration.
Time + Effort + Rep. = 6 Figures
• The advantages of MBP
The Top 20 Scholars based on positions in Islamic FinancInstitutions
Shariah Diligence
• Are all documents and structures properly covered by the Shariah scholar?
• What are the standards used for appropriate due diligence?
Shariah Non-Compliance And Due Process
• No framework to issue contrary opinions.
• Issuers of fatwa & Fatwa Shopping.
• Fatwas deal with the micro-juristic; not the macro-implications.
Previous Proposals
• Current qualifications
Participation and learn-by-doing, rather than education, research and gaining experience.
• Transferring knowledge to the next generation.
Two solutions:1) A supranational Sharia
association2) Certifying newer generations
of would-be scholars
One Solution
The 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
What about a doctorate system?
Key Elements:
1) Very high research standards
2) Great knowledge of certain field(s)
3) Supervision by mentor(s)
4) Universal in a competitive world
What is the next step?Way Forward:
New Set of Standards
Recognition of Shariah scholars
Pre-requisites to Fatwa issuance
Increase Quality Supply
Governance and Due Process
Recognising Shariah ScholarsHypothetical 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
Pre-requisites before issuing a fatwaDue Process
• Reporting procedures for issued fatwas
• Checklist before issuing a fatwa
• In return, the support of AAOIFI
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
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
Quis custodiet ipsos custodes?
Who will guard the guards themselves? - Juvenal
Sayd Farook PhD
Global Head Islamic Capital Markets
. .sayd farook@thomsonreuters com
. .islamic finance@thomsonreuters com