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.

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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.

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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