Shamshad Akhtar: Islamic finance: authenticity and innovation - a
regulator's perspective
Keynote address by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at
Harvard Law School, Cambridge, 20 April 2008.
* * *
A. Introduction
It's a privilege to be addressing the floor of Harvard Law School that is now well recognized
for its contribution to Islamic Law. Along with others, I have benefited from the rich debate
among Shariah scholars, academics, researchers and industry specialists on the topic of
"Islamic Finance: its authenticity and innovation." I would like to offer a regulator's
perspective regarding debate on "authenticity and innovation" of Islamic Finance (IF).
Impetus to Islamic Finance (IF) comes from not only its strong appeal and demand both from
Muslims and now from Western world but from recognition and reality that IF is indeed an
alternate and viable financing mechanism. If appropriately nurtured, it has potential to
broaden and deepen financial markets. This is critical for financial markets that suffer from
(a) low level of financial penetration - level of financial exclusion in developing markets is as
high as level of financial inclusion in developed markets; (b) high dependence on bank and
debt based systems; and (c) small and illiquid capital markets. IF's authenticity lies in its
inherent characteristics to enrich and supplement conventional finance by offering options
and solutions to address these gaps in financial system, while effectively and efficiently
allocating capital and allowing opportunities to optimize firm's capital structure.
Triggered by growing knowledge and research undertaken by Shariah scholars and
academics, IF is now being nurtured more by the industry experts and the practitioners as
they recognize the benefit of exploiting synergies between IF and conventional finance.
While IF offers its own ideology, approaches and modalities, legal and contractual structures
and risk management perspectives, conventional finance has steered the global financial
markets for ages backed by the well tested policy, legal and regulatory prescriptions, tools
and structures etc. It is inevitable that this has resulted in juxtaposition and transposition of
the two disciplines to foster innovation and benefit the two fields of finance mutually, while
prompting cross border flows and offering new perspectives on financial stability.
Provided developing interface and synergies between IF and conventional finance is
acceptable to scholars, the debate on authenticity is simplified. In carrying forward this strand
of thought, I propose to:
(i) Make the case that IF is by design authentic as it offers new ethical and equitable
perspectives to world of finance, while allowing flexibility to nurture businesses
based on partnership and profit and loss sharing (PLS) mechanism based on a fair
and just contractual frameworks. Application of these IF-guidelines and principles to
well tested tools of conventional finance itself ought to be treated as innovation.
(ii) Highlight that IF engineering and re-engineering has facilitated proliferation of
Islamic products which include a range of (a) standalone products that have been
tweaked to ensure conformity and convergence of returns with conventional finance,
(b) hybrid Islamic products structured by blending two to three Islamic products that
suit the financing requirements of businesses, and (c) equity based funds, products
and indices, and insurance.
(iii) Finally, it has to be recognized that though pace of financial innovation is occurring
in IF, there is scope for unleashing its potential further which in turn would also
facilitate financial stability. In this context, I propose to offer few selective
perspectives which underscore need for enhancing the legal, regulatory and
supervisory frameworks for IF to allow for greater diversification both on asset and
liabilities side supported by proper governance standards for PLS modalities
including adequate safeguards for investment account holders. Greater appreciation
and understanding of risk frameworks and development of capacities would facilitate
adaption of complex Islamic products and would help in enhancing depth and
breadth of IF.
B. IF features and its interface with conventional finance
Distinguishing features of IF. At one level it is now well established that IF is quite different
from conventional finance simply because former is based on Quranic and Shariah
injunctions and principles. Islam prohibits exploitative transactions such as (riba), or
transactions involving uncertainty (gharar) or speculative behavior (maisir) or trading of
debts. In conjunction, IF advocates "material finality" that underscores backing of financial
transaction with real economic activity/transactions. The combination of these prohibitions
and IF's emphasis on backing transaction with real economic activity are the two key
ideological differences IF has with the conventional finance.
Also, IF encourages financial relationship between financiers and entrepreneurs (borrowers)
where lender and borrowers share investment risks in businesses and assets. Under these
arrangements, returns are not fixed but commensurate with the identifiable rights and
obligations of stakeholders. These transactions are well anchored on an elaborate
contractual framework which drives its application and content from IF. The ideological
underpinnings of Islamic economics and its supportive contractual framework, along with
wide range of financial and business transaction options permissible under IF, allows a rich
array of approaches, options and modalities for IF.
IF and conventional finance interface. At another level, to properly nurture IF it is
inevitable that IF relies on conceptual framework of conventional finance and its tools. The
interface and linkages between Islamic and conventional finance will help promote
development of IF, though this process needs to be delicately managed. While IF converges
and conforms to basic principles of finance, to ensure its acceptability and originality this
should be achieved without compromising its ideological and spiritual distinction and
uniqueness which is critical to public confidence in the system. Concurrently, there is need to
recognize that the comparative advantage of IF is rooted in the risk sharing features of IF
modalities.
C. Financial re-engineering and innovation
Generally, IF industry has witnessed explosion and proliferation of Islamic products offering
close to full-menu of conventional finance industry options and instruments. Today, industry
offers standalone or hybrid Islamic products, offers capital markets options for fund
management, insurance products via takaful, and meets requirements for sovereign,
corporate and retail sector. To ensure competitiveness and customer acceptability,
replication and aligning of returns on Islamic products with conventional products has
generated concerns regarding dilution and excessive concentration of banks on one or two
products. Practically, the Islamic industry currently is bank-based. Product diversification,
albeit slow, is emerging but returns are engineered to ensure conformity and convergence
with conventional industry. Re-engineering and engineering in IF can be grouped as follows:
(i) Islamic synthetic products. Adopting reverse engineering, a number of Islamic
products have been designed as conventional product equivalents.1 Three core
structures are most popular: (i) Murabahah synthetic (debt based) products that are
backed by sale-repurchase agreements or back to back agreement of a borrower
Al-ijarah
held asset or lender's purchase, (ii) leasing (asset backed) provide
financing; and (iii) equity based profit sharing contracts Musharakah or Mudarabah
or crop sharing (Muazarah).
(ii) Re-engineering of Islamic synthetic products. Drawing from the core products
identified above, re-engineering has been possible in some cases such as the
reverse Murabahah, diminishing Musharakah to provide housing finance, Sukuk and
its variants along with Musharakah Term Finance Certificates (MTFCs) which is a
form of Sukuk. MTFCs have greater appeal since these are issued against the
strength of issuer's balance sheet rather than specific assets of the corporate and
are close to PLS framework.
(iii) Hybrid Islamic products. Supported by advancements in Islamic securitization,
there has been acceptance of Islamic Investment Certificates, i.e. Sukuk bonds that
are Shariah compliant and tradable asset backed securities. Industry has floated
different types of Sukuk with AAOIFI recognizing about 14 different types of Sukuks.
Most Sukuks are sponsored by sovereigns, both in domestic and international
markets, backed by approved Government assets. Although Ijara (asset based)
Sukuk2 are the most popular, other hybrid-Sukuk's backed by synthetic loans,
salelease backs or head-lease/sublease ijarah and profit sharing structure are now
emerging to be quite popular. Underlying pool of assets for some Sukuk comprise of
Istisna' and Murabahah receivables as well as Ijarah.3 Another example is the
convertible Sukuk - whether pure Ijara or hybrid it can have an embedded option
allowing them to be converted into another asset form depending on specified
conditions.
(iv) Islamic mortgages. These are fast gaining ground and are being structured as: (a)
the Ijarah (lease) contract along the lines of conventional mortgage; (ii) equity
partnership (diminishing Musharakah), where the mortgagee (lender) and mortgagor
(borrower) jointly share ownership, which over a period of time is transferred to the
mortgagor, who buys shares in interest of ownership by contributing each month
toward buying out the mortgagee's share in the property and return to the lender is
generated out of the fair rental value of the property; (iii) Murabahah (sales
transaction), is practiced in the United Kingdom, where the property transfer tax
(stamp duty) discriminates against the Ijarah - or Musharakahh-based mortgage;
and (iv) cooperative societies, where members buy equity (Musharakahh)
membership and help each other to purchase property from the pool of the society's
funds.
In parallel to these developments, IF has progressed on capital market development. Few
significant development on this front are:
(i) Islamic benchmark has evolved to provide an alternate to LIBOR by introducing
Islamic sovereign paper. Some initiatives include (a) Sudan Government Investment
Certificates based on pool of Ijara, Salam, and Murabahah instruments to raise long
term financing, one year maturity Government Musharakah Certificates based on
equity partnerships; (b) Bay al-dayn (debt trading) Government Investment Issues
(GII) by Malaysia; and (c) Baharian al-salam Sukuks whereby Government agrees
to sell forward to Islamic banks a commodity (typically aluminium) against spot
payment. Islamic banks in turn designate the Government their agent to sell the
commodity to a third party on delivery and the price of sale determines the price of
the Sukuk.
(ii) Islamic investment indices. Equity benchmark indices are designed to track the
performance of leading publicly trading companies who are involved in activities
consistent with Islamic Shariah law. Examples of this are Dow Jones and FTSE
Islamic indices which focus on limited range of companies excluding companies
which are involved in products/businesses not permissible under Islam.
(iii) Islamic equity funds include Shariah-compliant equity and hedge funds,
commodity, leasing and trade related funds. Barring equity funds, other funds are
low risk. In the case of leasing, the fund is a securitized pool of lease contracts
dealing with collateralized assets generating a steady stream of cash flow. Similarly,
commodity funds have a short-term exposure in markets that are efficient and have
developed forward markets, thus reducing the level of risk. In contrast, equity funds
are similar to conventional mutual funds and are exposed to a higher degree of
risks. Such funds are designed to ensure that equity stocks included in the fund are
not only well diversified but also fully compliant with the Shariah's guidelines.
(iv) Development of derivatives and its equivalents. There is a debate on whether IF
allows setting price at a future date with some scholars arguing it is not permissible
and others with flexible interpretation that forward trades are permissible in Islam, if
structured to provide specific quantity, time, weight and date. Devising solutions
which are acceptable to all players are further complicated by difficulties in
structuring contractual obligations, methods of eliminating risk inherent in the
derivatives contract i.e. counterparty and operational risks, and lack of benchmark
data. Despite these impediments, few Islamic OTC financial derivatives on the lines
of the conventional ones have been structured. For example: Standard Chartered
and Bank Muamalat Malaysia structured Islamic Cross Currency Swap (US$ 10
million) and Citigroup floated a 5-year US$ 230 million Currency Profit Rate Swap,
while work is underway to float Forward Rate Agreement (equivalent of conventional
FRA), Profit Rate Swap (equivalent of interest rate swap) etc.
D. Way forward for Islamic financial innovation
Industry's effort to engineer and re-engineer financial innovation has been impressive, but
authenticity demands that industry continues its efforts to innovate. To facilitate this, there is
need for IF industry and regulators to now consider a change in mind set accompanied by
enhancement of the legal, regulatory and supervisory infrastructure backed by proper
governance framework to allow banks to transact in equity based transactions.
Traditionally, banks main business has been debt financing and regulators have been
conservative in allowing bank's to indulge in equity products or nonbanking businesses.
However, consolidation and conglomeration has pushed the financial industry to universal
banking and other structures to retail better different products. Among others, this has
resulted in scale and efficiency of financial institutions and required regulator's to change
their regulatory frameworks and supervisory approaches. Given this, in this section I offer
some selective perspectives which should allow IF to move and compete in tandem with
conventional finance.
Consistent with IF provisions, one concrete way forward is to focus efforts to develop
right framework and applications for PLS-Shariah compliance products. Currently,
equity investment share in IF ranges from 0% to 24% of the Islamic bank's books. PLS
modalities, such as mudaraba and musharaka, being driven by equity partnership
arrangements offer interesting options for innovation but weaknesses in policy, regulatory
and legal have impeded growth of such options. Some of the constraints to its effective
application4 include (i) equity holders and entrepreneur's aversion to risk given the
uncertainties with return on businesses in PLS arrangements; (ii) absence in most countries
of proper property rights which could protect PLS contracts in case of litigation; and (iii) PLS
does not lend itself for short term financing and equity transactions underlying it are taxed
more than interest income.
Nevertheless, promoting PLS modality would help move financial system from being bank
centric to market based and thereby facilitate system-wide financial and risk diversification.
Workable solutions to reducing principal-agent problems and built in supportive screening
and monitoring of projects upfront would go a long way to promote efficiency in capital
allocation as it links returns with actual project. Promoting more equity based products would
also tackle the mis-match of assets and liabilities which has aggravated since IF has relied
excessively on short-term, low-profit and fixed-income assets. Moreover, risk-sharing edge of
IF products can be neutralized when Islamic banks pay investment account holders
benchmark return regardless of the performance and profitability of business venture.
To fully comprehend complexities and dimensions of proper risk and reward sharing
mechanism there is need to enhance understanding of management and mitigation of the
specific and multiple risks associated with certain types of Islamic products. This requires a
mindset change of both Islamic banking industry and regulators whose primary focus has
been debt-based financial intermediation. At the same time, it requires development of
financial legal and regulatory infrastructure which will help manage principal
agententrepreneur relationships, while catering for investment account holders concerns.
While augmenting regulatory framework to facilitate IF-innovation, there is need for
development of the IF supervisory framework. Currently, the process of thinking of IF
supervision varies. By and large, Islamic banks are supervised using the same methodology
and approaches adopted for conventional bank. Suitable modifications are needed to delve
into oversight of Shariah compliance, a task daunted by the lack of Shariah expertise in
regulators and differences in fiqh. A review of Shariah compliance will help facilitate
innovation and enhance transparency and disclosure in Islamic banks.
Another important area where work is underway but needs to be accelerated is to
develop proper understanding of prudential regulations and Shariah inspection and
Guidance on prudential regulatory framework should
supervision of Islamic banks.
incorporate appropriate amendment and refinements to the Basle or other best practices with
the objective of providing effective treatment of risks associated with the Islamic products
and balance sheets. An important contribution is the introduction of profit equalization
reserve fund which is created for the PLS modalities to provide a cushion for the associated
risks of businesses, while safeguarding the investment account holders interests. Islamic
banks have to incorporate interests of depositors who are considered creditors and first
claimants on the banks' assets and the interest of investment account holders has to be
aligned with the Islamic banks' owners. Accompanying this is the Shariah corporate
governance framework which protects the interest of the investor and customer by
underscoring need for compliance and ethics as well as maintaining high degree of
transparency and disclosures.
Before delving into the mechanics of Shariah supervisory framework, it is pertinent to
highlight the key challenges faced by Islamic banks with respect to Shariah governance.
These challenges are inter-linked and mutually reinforcing and range from:
•
Reputational risk arising from lack of or uncertainty on Shariah compliance;
•
Demarcation and responsibility and accountability between Board, Management and
Shariah Advisor;
•
Investment policies - compliance with Shariah prohibitions;
•
Investors' protection;
•
Disclosure and transparency of Shariah rulings;
•
Harmonization of Shariah rulings and offerings; and
•
Vigilance and Oversight of the supervisor to cater for above factors.
Currently, in absence of well conceptualized framework, Shariah compliance standards and
their oversight varies across jurisdictions:
• In Iran, Council of Ministers and Regulations under the Usury Free Banking Act,
1983 serve as the Shariah Board and set guidelines for the IF industry;
• In Malaysia, under Central Bank Act, 1958, Shariah Advisory Council has sole
responsibility for IF and court of arbitrator refers disputed cases to this council for
their position/advice;
•
In Indonesia, the National Shariah Board is responsible for Shariah rulings on
Islamic products, with IFIs required to establish a Shariah Division in the institutions
and NSB approves the Shariah Supervisory Board to oversee the division;
•
In Pakistan, three tier model of Shariah framework is put in place. This includes
Shariah Advisory Board that provides advise and guidance on prudential
regulations, guidelines, modes of financing, and model agreements for Islamic
industry, but the central bank issues instructions though in case of differences in
perspectives on Shariah matters the advisory boards notified by central bank is final;
Shariah Advisor, meeting central bank fit and proper criteria, approve products and
give guidance on legal and tax matters etc.; and a mechanism for Shariah Audit
System which inspects the Shariah compliance of all bank operations. Shariah
Advisory Board has Shariah scholars but also industry representatives.
• Bahrain, Sudan and Syria have adopted Shariah standards issued by the
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and
some others use them as guidelines.
Both the prudential regulation and Shariah inspection and supervision are integral elements
of the check and balances to ensure products and transactions meet the test of authenticity
and compliance with Shariah. While these systems may not be in place right away but
development and implementation of this regulatory and supervisory infrastructure requires
build up of capacities both at institution and regulators level and will pave way for building
confidence in Islamic system.
E. Conclusion
In conclusion, from a regulator's perspective development of IF in tandem with conventional
finance will help broaden and deepen financial markets which will help not only meet diverse
requirements but will also infuse financial stability. The evolution and path pursued by IF
industry has triggered debates regarding the authenticity and innovation. What is critical to
recognize is that IF by design has to be authentic and brings in additionality both in terms of
superior corporate governance framework as good ethical practices are embedded in IF, and
risk sharing structures which along with product diversity that the system offers lend itself to
innovation.
Product proliferation and approaches to security markets, development of Islamic exchange
and fund management will help nurture financial diversification from bank based to market
centric system. Proper application of PLS system will help provide greater opportunities for
innovation provided it is backed by the right corporate governance architecture.
On their part regulators have provided the industry free play. Cooperation among regulators
has helped to develop core and supportive IF infrastructure which better weaves in the
unique features and nuisance of the IF. Development of Islamic prudential regulatory and
supervisory framework, which subscribes to Basel standards for conventional banking, will
pave the way for development of IF, while tweaking the regulations to accommodate special
risk characteristics of the IF. Institutional framework and evolving approaches for supervision
systems will help build confidence among investor and customers. It is my belief that proper
practical application of IF has the potential of taking global finance to new frontiers and
heights.