Muhammad bin Ibrahim: The polemics of governing law in Islamic
finance - recent developments and the way forward
Keynote address by Mr Muhammad bin Ibrahim, Deputy Governor of the Central Bank of
Malaysia, at the International Shariah Research Academy for Islamic Finance-Institute of
Islamic Banking and Insurance (ISRA-IIBI) 2nd Annual International Thematic Workshop
2010: "The Polemics of Governing Law in Islamic Finance", London, 29 November 2010.
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Let me first thank the organizers for inviting me to speak at this ISRA-IIBI 2nd Annual
International Thematic Workshop 2010. Although I very much regret not being able to be in
London in person, I am thankful for the many advances of modern technology for the
opportunity to briefly address all of you this morning. I am also happy to note that this event
is a continuation of international collaboration between the organizers, the International
Shariah Research Academy for Islamic Finance (ISRA), the Institute of Islamic Banking and
Insurance (IIBI) and Thomson Reuters, following the success of the inaugural workshop held
last year. The theme of this year's workshop, "The Polemics of Governing Law in Islamic
Finance: Recent Developments and the Way Forward", is most apt. With the emergence of
Islamic finance as a new growth area in the global financial landscape, this Workshop
provides an excellent forum to exchange views and information on topical legal issues in
Islamic finance. As Islamic financial activities are increasingly crossing national boundaries, it
is critical for more such dialogues to take place at an international level, in order to gain wider
perspectives that can contribute to the development of a legal framework for Islamic finance
that is internationally facilitative.
Islamic finance today has become a major industry worldwide with over 300 institutions and
an estimated asset size of more than USD1 trillion. Its continuing advances in the
international financial landscape have recently been accompanied by several major efforts
aimed at strengthening its international financial infrastructure. A key structural enhancement
achieved recently was the establishment of the Islamic Financial Services Forum (IFSF) that
serves as a platform for cross-border engagement among regulators to achieve financial
stability in the Islamic financial system. Another important development achieved more
recently was the establishment of the International Islamic Liquidity Management Corporation
(IILM) as a mechanism for more efficient management of liquidity across borders for Islamic
financial institutions. These continuing efforts to strengthen the foundations of Islamic finance
have served to ensure its preparedness in meeting the challenges on the path of
internationalisation. As we open a new chapter of global growth and development with the
unfolding of a new decade, Islamic finance is in a position of strength to play a greater role in
the global financial landscape.
Today, many jurisdictions are interested in Islamic finance and have taken initiatives to
develop the industry. The increasing interest in Islamic finance is a positive development as
a larger number of institutions can contribute to more rapid growth of the industry. An
increasing number of jurisdictions are now taking steps to modify their legislations to cater for
Islamic finance. Ireland earlier this year published its Finance Bill 2010 which introduced
significant amendments that are aimed at facilitating Islamic finance. France has also taken
significant steps to push through changes to their tax and legal codes. Australia, Jordan and
Lebanon are all reportedly working towards reviewing their legislations to be accommodative
to Islamic finance. Given the importance of developing a supportive legal system, these
global moves augur well for sustainable global growth of Islamic finance. In light of this
development, I would like to make some remarks on the evolving legal framework for Islamic
finance. In sharing my thoughts, I will draw heavily on some of the strategies and initiatives
undertaken by Malaysia.
One of the key determinants for successful development of Islamic finance in any jurisdiction
is the existence of a conducive legal framework that supports the operations and growth of
the industry. Given that the legal infrastructure in any jurisdiction has evolved over the
centuries to cater for conventional finance, understandably, governing legislations of a
country have typically required modifications to accommodate Islamic financial transactions
and structures. It is therefore of no surprise that jurisdictions that are able to quickly amend
their legal framework have managed to achieve significant growth in Islamic finance.
The starting point in revising laws is therefore to ensure that the governing laws allow for the
conduct of Islamic finance business. A closely related goal is to consider removing elements
in existing laws, including the non-regulatory laws, which may render the conduct of Islamic
finance business uncompetitive or inefficient. Initial considerations would involve changes to
ensure that Islamic finance is placed on a level playing field with conventional finance. The
purposes and objectives of the governing laws for Islamic finance are known to be largely
similar to conventional finance from the financial regulation standpoint. Notwithstanding this,
an ideal approach is devising a legal framework for Islamic finance that sanctions the
statutory obligations for Shariah compliance in the governing law. This approach however,
may not be feasible as preference for religions concerns can be seen to be contradictory to
the principles of secularism and parity of beliefs rights in certain jurisdictions. We may need
alternative approaches. I will revisit and elaborate on these points in greater detail at a later
part of this speech.
In Malaysia, the new Central Bank of Malaysia Act 2009 explicitly codifies the duality of the
Malaysian financial system which shall consist of the conventional financial system and the
Islamic financial system. In this regard, Malaysia has taken the approach to enact regulatory
laws that are, at least for banking and takaful (Islamic insurance) industry, separate from
conventional finance as the legal foundation for the conduct of Islamic finance business. This
approach has proven to be successful and critical in instilling public confidence in the
Shariah integrity of the industry. Whilst enacting a separate governing law avoids the trap of
confining the scope and operation of Islamic finance within the mould of conventional
finance, this approach has proven in Malaysia to be the most efficient way possible to
regulate Islamic finance.
Recently, Malaysia has undertaken the initiative to establish a Law Harmonisation Committee
with the main objectives to review existing Malaysian laws which are applicable to Islamic
financial transactions and to propose necessary amendments to give legal recognition to
Islamic financial transactions under the law. The mandate of the Committee extends beyond
those that are regulatory in nature to include all laws relevant to execute the whole chain of
Islamic finance practices. The desired outcome of the Committee's work is the creation of
laws that are facilitative, contemporary, and easily enforceable. Another objective is to
provide facilitative legal framework for the Islamic finance industry and develop Malaysian
laws as the law of choice for international Islamic financial transactions. This initiative is
consistent with our continuous effort to foster an efficient, innovative and competitive Islamic
financial system, given the more globalised and liberal operating environment within which
Islamic finance will operate.
The consideration for evolving the legal framework in Islamic finance would not be complete
without extending due regard to the robustness of Shariah governance framework. This is
inevitable given that Islamic finance has its roots in Shariah. The overarching requirement for
an Islamic financial institution is to ensure that its objectives and operations are in
accordance with Shariah. In Malaysia, our experience suggests that mandating this
requirement in the laws governing Islamic finance is fundamental not only in the context of
defining the business scope of an Islamic financial institution, but also in preserving the
sanctity of Shariah in Islamic finance.
This legal mandate is also crucial for the Bank to take supervisory and regulatory remedy
against an Islamic financial institution, which may include revocation of licence, in cases,
where a violation by the institution poses reputational risk that might cause an erosion of
confidence and could threaten the systemic stability of the Islamic financial system. The
integrity and credibility of Shariah governance framework in Malaysia is also fundamentally
supported by the role of the Bank's Shariah Advisory Council (SAC), a centralized referral
body for Islamic finance community, which is statutorily positioned as the highest authority in
the determination of Shariah matters relating to Islamic finance. In preserving the sanctity of
the Shariah, the SAC itself ensures the robustness of its rulings through a rigorous process
before arriving at a decision.
Another essential element in developing an effective legal infrastructure is the role of an
adjudication system. A supportive adjudication system in the context of Islamic finance is one
which can authoritatively enforce the principles of Shariah in dispute settlements involving
Islamic financial transactions. An efficient and authoritative adjudication system helps create
certainty and establishes the legitimacy of Islamic financial contracts. Islam places great
importance on contracts and on parties to a contract. The ability of parties to enforce a
contract is thus critical as it constitutes the core of maintaining the confidence of the public at
large. Therefore, there is a crucial need for a dispute settlement mechanism that is able and
competent to dissect in a judicious manner Shariah matters in contracts, so that issues of
dispute in Shariah interpretation could be resolved and enforced accordingly. Whilst it is
neither practical nor desirable to change the entire court system, a potential solution is to
create a special Islamic bench that deals with financial transactions undertaken in
accordance with the Shariah. This could be a viable option particularly for Muslim majority
countries, as is the case in Malaysia. The use of market discipline is another option to ensure
the sanctity of Shariah via mandating sufficient check and balance in adherence to Shariah
matters including a minimum disclosure requirement, certification by the Shariah committee
or an external audit done on the Shariah compliance aspects of an institution's operations.
In Malaysia, we have taken the approach in ensuring that the sanctity of contracts is always
paramount and enforceable in our court of law. For adjudication purposes, a dedicated judge
in the commercial division of the High Court in Malaysia has been assigned to preside over
litigations relating to Islamic banking and finance. The court's adjudication role in Islamic
finance is reinforced by the support from the SAC in its capacity as a consultative body to the
Malaysian judiciary system. Under the law, the Central Bank of Malaysia Act 2009 prevails, if
a question concerning a Shariah matter arises in any proceedings relating to Islamic financial
business, where the court or the arbitrator shall take into consideration any published rulings
of the SAC or refer the matter to the SAC for its ruling. The SAC's rulings are binding on the
courts and arbitrators. This referral system preserves and enhances the sanctity of Shariah
rulings and the consistency in the interpretation and application of Shariah principles in
Islamic financial transactions. To complement the court system, specific arbitration rules for
Islamic banking and financial services have also been developed, enabling disputes for both
domestic and international cases to be dealt with by the Kuala Lumpur Regional Centre for
Arbitration (KLRCA).
Such comprehensive legal infrastructure for Islamic finance is unique to Malaysia and
essentially reflects the support and dedication by the legal fraternity in keeping abreast with
the development of Islamic finance. Adding to the strength of the institutional and legal
framework in Malaysia is our continuing emphasis on human capital development. Various
measures have been implemented to ensure that our market players, including the judges
and lawyers, are well-trained in Islamic finance. Moving forward, with the existence of a
dedicated court for Islamic finance, competent human capital and consistent legal
precedents, Malaysia is well-placed to serve as a platform for adjudication and dispute
settlement. The KLRCA in particular can be leveraged upon as an alternative dispute
settlement mechanism for arbitrating international disputes relating to Islamic finance.
Another important legal aspect in the conduct of Islamic finance is in ensuring good
documentation of contracts underlying Islamic financial transactions. Legal documentation
forms an integral part of Islamic finance sector as it provides a critical "bridge" between
Shariah and Islamic finance practices. There are two major considerations in ensuring good
legal documentation of Islamic financial transactions. Firstly, there is a need to ensure that
the documentation conforms to Shariah in such a way that it enables the operationalisation of
Shariah principles into legally enforceable Islamic finance contracts. This is crucial to avoid
legal and reputational risks arising from the failure to faithfully reflect the principles of Shariah
which could undermine public confidence in the industry. It also underscores the importance
of legal advisors, Shariah advisors, and other key organs such as the compliance and
internal audit functions, as well as the board in performing their obligations towards ensuring
Shariah compliance. The importance of these various components is reflected in the newly
revised guidelines on Shariah governance framework that was issued recently.
The second consideration relates to the importance of moving towards greater standardization
in the legal documentation of Islamic financial transactions. A more standardized contract
creates greater certainty and predictability about the characteristics of the financial contracts.
When the parties involved are better able to understand their rights and obligations,
stakeholders' confidence in the market would correspondingly improve. In essence,
standardization of documentation, products and practices are essential to ensure that the
markets are fair, efficient and transparent. Whilst contract and product standardization is
encouraged to the greatest extent possible, we also need to be mindful not to let it stifle
innovation. As a nascent industry, the need for innovation and competition in Islamic finance
is so important that its absence might impede its growth. One important area is the need to
appreciate and subscribe to the value of diversity in Shariah. I believe that diversity in
Shariah interpretation is the seed to harness innovation in Islamic finance. Diversity in
opinions and practices generate wider options for consumers and practitioners. I believe that
this is very fundamental. It is also for this reason that Malaysia subscribes to the concept of
mutual recognition of the interpretations and decision of Shariah principles reached by a
recognized Shariah body across countries. We believe in the need for diversity as it is an
impetus for sustainable global growth of Islamic finance.
While diversity would create a conducive environment for Islamic finance to prosper, varying
interpretations of Shariah within a country can add to the complexity of the operating
framework of Islamic financial institutions. The progressive harmonisation of Shariah
interpretations, in this particular respect, can be viewed as an important driver towards
greater acceptance and avoid possible confusion by the public. Malaysia had addressed the
issue through a centralised SAC, which through collective wealth of experience and expertise
of its members, its independence and its rigorous process of rule-making, has ensured the
credibility of Shariah ruling on Islamic finance transactions. But at another level, facilitating
the internationalisation of Islamic finance would involve a delicate balancing act in nurturing
innovation and pushing for greater Shariah convergence, harmonization and acceptance.
One option is to standardize contracts for mature and widely acceptable concepts and
structures as it leads to consistency and efficiency and in some instances promote
interjurisdiction transactions. Given that majority of Shariah interpretations are actually very
similar, more attention needs to be given to translate these rulings that are commonly
practised into documentation, products and services in a unified manner. However, this could
only happen if there is common understanding on the issues or fatwas involved. To
contribute towards this process, Bank Negara Malaysia has taken the initiative to enhance
the transparency on juristic reasoning in Islamic finance through the publication of Shariah
resolutions by the SAC. We have also been issuing a series of "Shariah Parameters" for
several major Shariah contracts which are aimed at promoting consistent application of these
contracts in Islamic finance. By leading these various efforts, we hope it can pave the way
towards greater understanding and contributes towards international convergence on
Shariah matters across jurisdictions.
Before I end my remarks, I would like to take this opportunity to highlight the importance of
continuing a close and effective partnership in Islamic finance between Malaysia and the UK.
Collaboration between financial centres in Islamic finance is an important part of the process
that would contribute towards expanding global development of the industry. With London's
keen ambition to establish itself as the center in Islamic finance in Europe, there is certainly
much room for cooperation between Kuala Lumpur and London. The importance of our
relationship has been cemented not long ago with the signing of the Memorandum of
Understanding between Bank Negara Malaysia and the UK Trade and Investment. Our
strong collaborative endeavors are already visible in the area of education and capacity
building, evidenced by the growing number of strategic alliances between several Malaysian
and the UK education and training institutions in recent years. Several UK financial
institutions have also successfully established presence through joint-venture with local
partners in our takaful market. I am most hopeful that there will be more collaborative
endeavors going forward to exploit the strength and synergies between the two centers,
particularly in areas that will lead to enhancing the efficiency of Islamic finance and greater
cross-border transactions.
On that note, I wish all of you a successful Workshop. Thank you.