Shawwal 13 1430/October 02 2009

The Friday Bulletin

OPINION

The Regulation of Islamic Financial Institutions: A Case for the
Vetting of Shari'ah Supervisory Board Members

By Amina Bashir

The growth of Islamic banking has been exponential, with more and more fully-fledged Islamic banks being set up by in differ¬ent parts of the world. Many more established conventional banks are also setting up Islamic banking windows in order to tap into the huge market that Islamic banking represents and offer their custom¬ers a wider variety of banking products to suit their faith. Islamic banking is no longer the preserve of Muslim countries and indeed, from Europe to North America to Japan, there has been an increase in the number of Islamic banks being set up and regulatory authorities are working with Islamic bankers and Shari'ah boards to set up a more enabling legislative and regulatory environment for the op¬eration of these banks. Islamic finance is based on the principles of elimination of usury (interest or riba) and ambiguity and uncertainty in transactions (gharar).

Given the importance of ensuring that those Islamic Financial In¬stitutions (IFIs) that deem themselves as 'Shari'ah compliant' are indeed offering Shari'ah compliant financial services, there have been calls from both regulators and religious scholars alike to for¬mulate ways in which such Shari'ah compliance can be measured. Typically, both fully fledged IFIs and conventional banks offering Shari'ah compliant products constitute Shari'ah Supervisory (or Advisory) Boards (SSBs), whose mandate includes ensuring that products offered are Shari'ah compliant and who then also carry out audits to ensure that their rulings or fatawa are implemented by the banks and/or windows. In sharp contrast to the appointment and vetting of boards of directors as provided for in the Central Bank of Kenya's Prudential Guidelines, the membership of such boards in Kenya is not regulated.

How then do depositors and investors alike ensure that the profits generated by these banks are indeed Shari'ah compliant? How does a bank establish that the members of its Shari'ah Supervisory Board are competent enough to analyse the products from an Islamic perspective and to make appropri¬ate rulings in that regard, given that many of the scholars may not be specialised in Islamic finance and/or banking? How do regula¬tors ensure that IFIs that are holding themselves out as providing Shari'ah compliant products are indeed providing their customers with such products and not using the label as a marketing gimmick?

Different regimes in different parts of the world have recognised that the issue of qualification and vetting of members of SSBs is crucial but in the same vein some have reiterated the fact that as regulators, they lack the tools to evaluate such persons from an Islamic knowledge point of view. What can Kenya adopt as a best practice to answer some of the vexing questions posed above?

In Dubai, there are two regulatory regimes – the Dubai Financial Services Authority (DFSA), which regulates firms within the Dubai International Financial Centre (DIFC) and the Central Bank of the UAE which concerns itself with regulation of IFIs which are outside the DIFC.

The DFSA makes it clear that it is not a 'sharia regulator' but a 'sharia systems regulator'. The DFSA requires a firm which con¬ducts Islamic financial business to put in place systems to ensure that such business is conducted in accordance with Shari'ah and this includes 'appointment of a Shari'ah Supervisory Board (SSB) of at least three competent scholars', whose previous experience and qualifications must be assessed to ensure that the proposed schol¬ar is competent to advise on Islamic financial business. The DFSA also directs that firms that conduct Islamic financial business must establish and retain records for 6 years on such assessment, and that such records should clearly indicate; at least: (a) the factors that have been taken into account when making the assessment of competency; (b) the qualifications and experience of the SSB members; (c) the basis upon which the Firm has deemed that the proposed SSB member is suitable; and (d) details of any other SSB of which the proposed SSB member is, or has been, a member.

The UAE's Ministry of Justice and Islamic Affairs plays a super¬visory role – the law provides for the formation of a Higher Shari'ah Authority (HSA) comprising of Shari'ah, legal and banking person¬nel and which is attached to the Ministry and whose role is to under¬take higher supervision over Islamic banks to ensure legitimacy of the transactions according to the provisions of the Islamic shari'ah law, and also to offer opinion on maters which these agencies may come across while conducting their activities. The HSA's opinions are binding on the Islamic banks and its approval on the composi¬tion of SSBs must be sought prior to the incorporation of Islamic banks.

For IFIs that are situate outside the DIFC, the Central Bank of UAE exercises broad jurisdiction over banking and investment business and laws affecting those IFIs reflect the AAOIFI recommendations requiring an IFI to establish an SSB with a minimum of three mem¬bers and to determine the SSB's formation, the discharge of its tasks and its terms of reference.

Malaysia and Pakistan are by far the most advanced regimes in terms of supervision of Islamic financial institutions. In Malaysia, the law provides that an institution wishing to carry out Islamic bank¬ing business must make provision in its constitutive documents for the establishment of a Shari'ah advisory body to be approved by the Central Bank. The Central Bank of Malaysia Act of 1958 establishes a Shari'ah Advisory Council (SAC), whose advise on shari'ah mat¬ters relating to the banking business of an Islamic bank is binding. The Central Bank of Malaysia cites the harmonisation of Shari'ah interpretations as crucial in underpinning a comprehensive and wholesome development of the Islamic banking sector and through the SAC, aims to strengthen the regulatory and supervisory over¬sight of the industry and to also foster and nurture a pool of competent Shari'ah advisers. The SAC is also referred to by courts and arbitrators in disputes relating to Islamic banking and is regarded as the sole authority in Islamic finance by the Central Bank of Malaysia. Its rulings on different Islamic financing products are published as guidelines to all Islamic financial institutions and it also examines and endorses the application of Shari'ah in Islamic financial products as submitted to it by IFIs.

In Pakistan, the Shari'ah Board of the State Bank of Pakistan (which is Pakistan's Central Bank) has approved essentials of Is¬lamic modes of finance and model agreements, which are part of instructions for Shari'ah compliance in Islamic financial institutions operating in Pakistan. Each Islamic banking institution is required to appoint a Shari'ah Advisor who is responsible for giving approvals regarding Shari'ah compliance of all products of such institu¬tions and issuing Shari'ah rulings in regard to their operation. The State Bank's Shari'ah Board advises the State Bank in formulation of regulations on Islamic banking. In case of any difference of opin¬ion between its Shari'ah Board and a Shari'ah Advisor of an Islamic bank, the ruling of State Bank's Shari'ah Board is final.

In the United Kingdom, the situation is very different. The Financial Services Authority (FSA) has taken a different view in regard to the regulation of the Shari'ah aspect of Islamic banks. The FSA regards itself as a regulator of banks and not of shari'ah boards and argu¬ably, it is most likely the lack of expertise in supervising the religious rulings that are issued by Shari'ah boards that causes the FSA, like other regulators in non Muslim countries, to shy away from issuing any guidelines in regard to the qualifications of shari'ah board mem¬bers. Islamic banks that have been licensed in the United Kingdom also have Shari'ah Supervisory Boards, but these boards are not subjected to any fit and proper criteria nor does the FSA require that an Islamic financial institution appoint a Shari'ah board. To sum it up, the FSA, in a paper on Islamic finance in the UK states that 'since the FSA is secular and not a religious regulator, it would not be appropriate, even if possible, for the FSA to judge between different interpretations of Islamic law'.

At a global level, Islamic Finance experts and scholars have recognized the need to have standards to regulate the Islamic financial industry. Two organizations stand out – the Accounting and Audit¬ing Organisation for Islamic Financial Institutions (AAIOFI) and the Islamic Financial Services Board (IFSB). The former is a body of Shari'ah scholars from different parts of the world with particular expertise in Islamic financial matters. AAOIFI prepares accounting, auditing, governance, ethics and Shari'ah standards for Islamic financial institutions and the industry and these Standards have been widely adopted by regulatory authorities. The latter (IFSB) serves as an international standard-setting body of regulatory and supervi¬sory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry and comprises 42 regulatory and supervisory authorities.

Both AAOIFI and IFSB have published standards for the appoint¬ment and composition of Shari'ah Supervisory Boards as well as governance standards for Islamic financial institutions and these standards have served as guidelines for and are the basis for the regulatory provisions that have so far been covered in this article.

Given that the fatawa of SSBs are jurisprudential in nature, differ¬ent scholars have presented different interpretations that lead to different conclusions on whether a transaction is permissible or not. There are numerous instances of differences of opinions be¬tween different SSBs and in emerging Islamic banking markets, this comes into much sharper focus due to the limited experience and/or knowledge in Islamic banking as well as the reluctance to follow pre-established fatawa or guidelines issued by AAOIFI in a wholesale manner. Given also that the issuance of such rulings is taken to be a divine duty with accountability to Allah Almighty, many Shari'ah scholars will only issue rulings that they are comfortable with, even if this means going against established fatawa issued by other scholars.

In attempting to harmonise interpretations of the Fiqh Al Muamalat (Principles and Rules of Islamic Commercial Jurisprudence), some jurisdictions have taken steps to vet the suitability of members of SSBs in terms of their skill sets in regard to both banking and finan¬cial instruments and their use and the Islamic economic jurispru-dence that must underpin these instruments and their use. Whether this will really achieve uniformity amongst rulings in SSBs is argua¬ble but in the long run, vetting the suitability of members of SSBs will only strengthen IFIs by boosting public perception and confidence in their Shari'ah compliance. Kenya can therefore take steps in formu-lating guidelines for the vetting of members of Shari'ah Supervisory Boards and can adopt the standards proposed by AAOIFI and IFSB. After all, Shari'ah Supervisory Boards are really the backbone of the Islamic financial industry.

Amina Bashir is the Head of Legal and Company Secretary at Gulf African Bank