France and Hong Kong encourage Islamic finance

Quoted from New Horizon. (Available at:

The positive signals towards Islamic finance which emanated from the government of France in 2008 (NewHorizon, January–March 2009) have been translated into action in the form of specific changes to the tax code. The purpose of the changes is to ensure that Islamic modes of financing do not attract extra tax penalties in relation to conventional transactions. There would otherwise be a chance that an underlying asset changing hands – a necessary part of an Islamic transaction – would attract levies such as stamp duty. Because there is no requirement for an asset to change hands in a conventional transaction, such a tax would not enter consideration.

The change of the tax code has already encouraged some firms to move into France, including Islamic Finance Advisory and Assurance Services (IFAAS), which decided to relocate in expectation of the change. IFAAS is a UK-based Shari’ah-compliance advisory firm. Invest in France Agency (IFA), a group which encourages foreign direct investment into France, welcomed the move, reflecting the attractiveness of Islamic finance to markets in the West. There are between six and seven million Muslims in France, which is the largest concentration in Western Europe. A survey carried out in 2007 by the French Institute of Public Opinion (IFOP) suggested that half a million Muslims in the country would be interested in Islamic finance.

Senior officials in Hong Kong have echoed the moves taken by the French government. The secretary for the financial services and the treasury bureau of the Hong Kong government, Professor KC Chan, confirmed in a speech at the Asian Sukuk Summit, recently held in the country, that the government is finalising new tax laws. These would make sure that sukuk are treated in the same way as conventional bonds, relating to stamp duty, profits tax and property tax. Confirming Hong Kong’s interest in Islamic finance, Sam Kwok, treasurer at the Hong Kong Monetary Authority (HKMA), also suggested that Hong Kong plans to issue a sovereign sukuk when the market conditions are right.

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    Vatican Position on Islamic Finance


    Daily Vatican newspaper, ‘L’Osservatore Romano, reported that Islamic banking system may help to overcome global crisis.

    Turkish media reported. The Vatican said banks should look at the ethical rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis.

    ‘The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service,’ the Vatican’s official newspaper Osservatore Romano said in an article in its latest issue late yesterday.

    Author Loretta Napoleoni and Abaxbank Spa fixed income strategist,Claudia Segre, say in the article that ‘Western banks could use tools such as the Islamic bonds, known as sukuk, as collateral’. Sukuk may be used to fund the ”car industry or the next Olympic Games in London,’ they said. They also said that profit share, gained from sukuk, may be an alternative to the interest. They underlined that sukuk system could help automotive sector and support investments in infrastructure area. Islamic sukuk system is similar to bonos of capitalist system. But in sukuk, money is invested concrete projects and profit share is distributed to clients instead of interest earned. Pope Benedict XVI in an Oct. 7 speech reflected on crashing financial markets saying that ‘money vanishes, it is nothing’ and concluded that ‘the only solid reality is the word of God.’ The Vatican has been paying attention to the global financial meltdown and ran articles in its official newspaper that criticize the free-market model for having ‘grown too much and badly in the past two decades.’

    The Osservatore’s editor, Giovanni Maria Vian, said that ‘the great religions have always had a common attention to the human dimension of the economy,’ Corriere della Sera reported today.

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    Global Financial Crisis: Can Islamic Finance help?

    Ibnu Khaldun Lecture Series By M. Umer Chapra.

    The whole world is now in the grip of a financial crisis which is far more serious than any experienced since the Great Depression. It has taken more than three trillion dollars of bailout and liquidity injections by a number of industrial countries to abate somewhat the intensity of the crisis. Nevertheless, there are fears that this crisis may have exposed the world economy to a long period of economic slowdown. There is, hence, a call for a new architecture that would help minimize the frequency and severity of such a crisis in the future.

    It is not possible to design a new architecture without first determining the primary cause of the crisis. The generally recognized most important cause of almost all crises has been excessive and imprudent lending by banks. This raises the question of what makes it possible for banks to resort to such an unhealthy practice which does not only destabilize the financial system but is also not in their own long-run interest. There are three factors that make this possible. One of these is the inadequate market discipline in the financial system resulting from the absence of profit and loss sharing (PLS). The second is the mind-boggling expansion in the size of derivatives, particularly credit default swaps (CDSs), and the third is the “too big to fail” concept which tends to give an assurance to big banks that the central bank will definitely come to their rescue and not allow them to fail (Miskhin, 1997, pp.61-62).

    The false sense of immunity from losses that all these factors together provide, has introduced a fault line in the financial system. Banks do not, therefore, undertake a careful evaluation of the loan applications. This leads to an unhealthy expansion in the overall volume of credit, to excessive leverage, and to an unsustainable rise in asset prices, living beyond means, and speculative investment. Unwinding later on gives rise to a steep decline in asset prices, and to financial frangibility and debt crises, particularly if there is overindulgence in short sales. Jean Claude Trichet, President of the European Central Bank, has rightly pointed out that “a bubble is more likely to develop when investors can leverage their positions by investing borrowed funds” (Trichet, 2005, p.4).

    The Subprime Mortgage Crisis
    The subprime mortgage crisis in the grip of which the US finds itself at present, is a classical example of excessive and imprudent lending. Securitization or the “originate-to-distribute” model of financing has played a crucial role in this. The creation of collateralized debt obligations (CDOs) by mixing prime and subprime debt made it possible for mortgage originators to pass the entire risk of default of even subprime debt to the ultimate purchasers who would have normally been reluctant to bear such a risk. Mortgage originators had, therefore, less incentive to undertake careful underwriting (Mian and Sufi, 2008, p.4; and Keys, et. al., 2008). Consequently loan volume gained greater priority over loan quality and the amount of lending to subprime borrowers and speculators increased steeply. According to Mr. Bernanke, Chairman of the Board of Governors of the Federal Reserve System, “far too much of the lending in recent years was neither responsible nor prudent. … In addition, abusive, unfair, or deceptive lending practices led some borrowers into mortgages that they would not have chosen knowingly” (Bernanke, 2008, p.1). The check that market discipline could have exercised on the serving of self-interest did not come into play. Even the supervisors failed to perform their task effectively by not taking serious notice of the unfair practices at an early stage and nipping them in the bud.

    The result is that a number of banks have either failed or have had to be bailed out or nationalized by the governments in the US, the UK, Europe and a number of other countries. This has created uncertainty in the market and led to a credit crunch, which made it hard for even healthy banks to find financing. There is a lurking fear that this might be only the tip of the iceberg and a lot more may follow if the crisis causes a prolonged recession and leads to defaults on the part of credit card institutions, corporations, and derivatives dealers.

    When there is excessive and imprudent lending and lenders are not confident of repayment, there is an excessive resort to derivatives like credit default swaps (CDSs) to seek protection against default. The buyer of the swap (creditor) pays a premium to the seller (a hedge fund) for the compensation he will receive in case the debtor defaults. If this protection had been confined to the actual creditor, there may not have been any problem. What happened, however, was that hedge funds sold the swaps not to just the actual lending bank but also to a large number of others who were willing to bet on the default of the debtor. These swap holders, in turn, resold the swaps to others. The whole process continued several times. While a genuine insurance contract indemnifies only the actually insured party, in the case of CDSs there were several swap holders who had to be compensated. This accentuated the risk and made it difficult for the hedge funds and banks to honour their commitments. The notional amount of all outstanding derivatives (including CDSs of $54.6 trillion) is currently estimated by the Bank for International Settlements (BIS) to be $600 trillion, more than 10 times the size of the world economy (BIS, September 2008, p.20). No wonder George Soros described derivatives as “hydrogen bombs”, and Warren Buffett called them “financial weapons of mass destruction”.

    One of the most important objectives of Islam is to realize greater justice in human society. According to the Qur’an a society where there is no justice will ultimately head towards decline and destruction (Al-Qur’an, 57:25). Justice requires a set of rules or moral values, which everyone accepts and faithfully complies with. The financial system may be able to promote justice if, in addition to being strong and stable, it satisfies at least two conditions based on moral values. One of these is that the financier should also share in the risk so as not to shift the entire burden of losses to the entrepreneur, and the other is that an equitable share of financial resources mobilized by financial institutions should become available to the poor to help eliminate poverty, expand employment and self-employment opportunities and, thus, help reduce inequalities of income and wealth.

    To fulfill the first condition of justice, Islam requires both the financier and the entrepreneur to equitably share the profit as well as the loss. For this purpose, one of the basic principles of Islamic finance is: “No risk, no gain”. This should help introduce greater discipline into the financial system by motivating financial institutions to assess the risks more carefully and to effectively monitor the use of funds by the borrowers. The double assessment of risks by both the financier and the entrepreneur should help inject greater discipline into the system, and go a long way in reducing excessive lending.

    Islamic finance should, in its ideal form, help raise substantially the share of equity and profit-and-loss sharing (PLS) in businesses. Greater reliance on equity financing has supporters even in mainstream economics. Prof. Rogoff of Harvard University states that in an ideal world equity lending and direct investment would play a much bigger role (Rogoff, 1999, p. 40).

    Greater reliance on equity does not necessarily mean that debt financing is ruled out. This is because all the financial needs of individuals, firms, or governments cannot be made amenable to equity and PLS. Debt is, therefore, indispensable, but should not be promoted for nonessential and wasteful consumption and unproductive speculation. For this purpose, the Islamic financial system does not allow the creation of debt through direct lending and borrowing. It rather requires the creation of debt through the sale or lease of real assets by means of its sales- and lease-based modes of financing (murabahah, ijarah, salam, istisna and sukuk). The purpose is to enable an individual or firm to buy now the urgently needed real goods and services in conformity with his/her ability to make the payment later. It has, however, laid down a number of conditions, some of which are:
    1.The asset which is being sold or leased must be real, and not imaginary or notional;
    2.The seller or lessor must own and possess the goods being sold or leased;
    3.The transaction must be a genuine trade transaction with full intention of giving and taking delivery; and
    4.The debt cannot be sold and thus the risk associated with it must be borne by the lender himself.
    The first condition will help eliminate a large number of derivatives transactions which involve nothing more than gambling by third parties who aspire to claim compensation for losses which have been actually suffered only by the principal party and not by them. The second condition will help ensure that the seller (or lessor) also shares a part of the risk to be able to get a share in the return. Once the seller (financier) acquires ownership and possession of the goods for sale or lease, he/she bears the risk. This condition also puts a constraint on short sales, thereby removing the possibility of a steep decline in asset prices during a downtown. The Shari‘ah has, however, made an exception to this rule in the case of salam and istisna where the goods are not already available in the market and need to be produced or manufactured before delivery. Financing extended through the Islamic modes can thus expand only in step with the rise of the real economy and thereby help curb excessive credit expansion.

    The third and the fourth conditions will not only motivate the creditor to be more cautious in evaluating the credit risk but also prevent an unnecessary explosion in the volume and value of transactions. This will prevent the debt from rising far above the size of the real economy and also release a substantial volume of financial resources for the real rector, thereby helping expand employment and self-employment opportunities and the production of need-fulfilling goods and services. The discipline that Islam wishes to introduce in the financial system may not, however, materialize unless the governments reduce their borrowing from the central bank to a level that is in harmony with the goal of price and financial stability.

    One may raise an objection here that all these conditions will perhaps end up shrinking the size of the economy by reducing the number and volume of transactions. This is not likely to happen because a number of the speculative and derivatives transactions are generally known to be zero-sum games and have rarely contributed positively to total real output. Hence a decline in them is also not likely to hurt the real economy. While a restriction on such transactions will cut the commissions earned by the speculators during an artificially generated boom, it will help them avert losses and bankruptcy that become unavoidable during the decline and lead to a financial crisis.

    The injection of a greater discipline into the financial system may tend to deprive the subprime borrowers form access to credit. Therefore, justice demands that some suitable innovation be introduced in the system to ensure that even small borrowers are also able to get adequate credit. Such borrowers are generally considered to be subprime and their inability to get credit will deprive them from realizing their dream of owning their own homes and establishing their own microenterprises.

    There is no doubt that a number of countries have, established special institutions to grant credit to the poor and lower middle class entrepreneurs. Even though these have been extremely useful, there are two major problems that need to be resolved. One of these is the high cost of finance ranging from 30 to 84 percent in the interest-oriented microfinance system (Ahmed, 2007; Fernando, 2006; Sharma, 2002; Mannan, 2007). This causes serious hardship to the borrowers in servicing their debt. No wonder, the Minister of Finance for Bangladesh described microcredit interest rates in that country as extortionate in an address he delivered at a microcredit summit in Dhaka in 2004 (See Fernando, 2006, p.1). It is, therefore, important that, microcredit is provided to the very poor on a humane interest-free basis (qard hasan). This may be possible if the microfinance system is integrated with zakah and awaqf institutions. For those who can afford to bear the cost of microfinance, it would be better to popularize the Islamic modes of profit-and-loss sharing and sales- and lease-based modes of finance not only to avoid interest but also to prevent the misuse of credit for personal consumption.

    Another problem faced by microfinance is that the resources at the disposal of microfinance institutions are inadequate. This problem may be difficult to solve unless the microfinance sector is scaled up by integrating it with the commercial banks. Commercial banks do not generally lend to small borrowers because of the higher risk and expense involved in such financing. It is, therefore, important to reduce their risk and expense. This may be done partly by a subsidy from zakah and awqaf funds for those borrowers who are eligible for zakah.

    Thus we can see that the Islamic financial system is capable of minimizing the severity and frequency of financial crises by getting rid of the major weaknesses of the conventional system. It introduces greater discipline into the financial system by requiring the financier to share in the risk. It links credit expansion to the growth of the real economy by allowing credit primarily for the purchase of real goods and services which the seller owns and possesses and the buyer wishes to take delivery. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully. In addition, Islamic finance can also reduce the problem of subprime borrowers by providing credit to them at affordable terms. This will save the billions that are spent after the crisis to bail out the rich bankers. These do not, however, help the poor because their home may have already become subject to foreclosure and auctioned at a give-away price.

    The problem is that the Islamic finance is still in its infancy and shares a very small proportion of international finance. In addition, it does not genuinely reflect the ethos of Islamic teachings. The use of equity and PLS is still very small while that of debt-creating modes is preponderant. Moreover, even in the case of debt-creating modes, all the conditions laid down by the Shairi‘ah are not being faithfully observed by the use of legal stratagems (hiyal). This is partially due to a lack of proper understanding of the ultimate objectives of Islamic finance, the non-availability of trained personnel, and the absence of a number of shared or support institutions that are needed to minimize the risks associated with anonymity, moral hazard, principal/agent conflict of interest, and late settlement of financial obligations. The system is, thus, not fully prepared at present to play a significant role in ensuring the health and stability of the international financial system. It is, however, expected that the system will gradually gain momentum with the passage of time and complement the efforts now being made internationally for promoting the health and stability of the global financial system.

    Concluding Remarks
    Since the existing architecture of the conventional financial system has existed for a long time, it may perhaps be too much to expect the international community to undertake a radical structural reform of the kind that the Islamic financial system envisages. However, the adoption of some of the elements of the Islamic system, which are also a part of the western heritage, is indispensable for ensuring the health and stability of the global financial system. These are:
    1.The proportion of equity in total financing needs to be increased and that of debt reduced.
    2.Credit needs to be confined primarily to transactions that are related to the real sector so as to ensure that credit expansion moves more or less in step with the growth of the real economy and does not promote destabilizing speculation and gambling
    3.Leverage needs to be controlled to ensure that credit does not exceed beyond the ability of the borrower to repay.
    4.If the debt instruments, and in particular collateralized debt obligations (CDOs), are to be sold, then there should be full transparency about their quality so that the purchaser knows exactly what he is getting into. It would also be desirable to have the right of recourse for the ultimate purchaser of the CDOs so as to ensure that the lender has incentive to underwrite the debt carefully.
    5.While there may be no harm in the use of credit default swaps to provide protection to the lender against default, it needs to be ensured that the swaps do not become instruments for wagering. Their protective role should be confined to the original lender only and should not cover the other purchasers of swaps who wish to wager on the debtor’s default. For this purpose the derivatives market needs to be properly regulated to remove the element of gambling in it.
    6.All financial institutions, and not just the commercial banks, need to be properly regulated and supervised so that they remain healthy and do not become a source of systemic risk.
    7.Some arrangement needs to be made to make credit available to subprime borrowers at affordable terms to enable them to buy a home and to establish their own microenterprises. This will help save the financial system from crises resulting from widespread defaults by such borrowers.

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    Authenticity in Islamic Finance

    Quoted from Business Islamica by M. Umer Chapra. Available at:

    I can vividly recall the high degree of skepticism that existed about interest-free banking during my college days in the early 1950s. Anyone who talked of Islamic banking was considered to be crazy. Within such a skeptical environment, the establishment of the first full-fledged Islamic bank, Dubai Islamic Bank, and the multinational Islamic Development Bank (IDB) in 1975 were great milestones. Since then, the Islamic financial system has gained substantial momentum. It has attained respectability and favourable media coverage. Its merit has been recognized by a number of central banks and supervisory authorities even in industrial countries. International financial institutions such as the IMF and the World Bank and prestigious centres of learning such as Harvard Law School and Durham University have also given their blessings to the concept. The skepticism that prevailed earlier has gradually faded over the years. It is expected that the call for a new architecture that is now being made at practically every financial forum around the world since the start of the prevailing financial crisis will provide a further boost to Islamic finance.

    While there is a great deal of satisfaction in what has been accomplished, there is also a realization that the Islamic financial system, as it is being practiced, does not appear to a number of its critics to be a genuine or authentic reflection of Islamic finance. The way the Islamic financial system has progressed so far is only partly, but not fully, in harmony with the Islamic vision_ it has not been able to come out of the straitjacket of conventional finance. While there is nothing basically wrong in trying to minimize risk as much as possible, the fundamental Islamic principle of “no risk, no rain” must prevail. The prevailing position, however, is that the use of equity and PLS modes has been scant, while that of the debt-creating sales- and lease-based modes has been predominant. Even in the case of debt-creating modes, all Islamic banks and branches or windows of conventional banks do not necessarily fulfill the conditions laid down by the Shariah. They try to adopt different legal stratagems to transfer the entire risk to the purchasers or the lessees. Consequently, there is a great deal of criticism of the reality of Islamic finance. This has led to an apprehension that if the Islamic financial system does not make significant progress in terms of authenticity, it will lose credibility in the eyes of the Muslim masses and the rapid progress that it has been making may not be sustainable.

    Why the Lack of Authenticity?
    Why has the Islamic financial system been unable to make significant headway in attaining greater authenticity when the raison d’être of the system is not to be a mirror image of the conventional system, but rather to be a genuine reflection of Islamic teachings? There are a number of reasons for this. However, the most important of these is that the institutions that are necessary to minimize the risks associated with anonymity, moral hazard, principal/agent conflict of interest, and late settlement of financial obligations have not yet been created. These institutions would enable the banks to obtain reliable information about their clients and ensure that the funds lent to their clients are employed efficiently according to agreement and that the profit declared by them reflects the true picture of the business. These institutions would also help banks receive repayments on schedule and get justice promptly in case of disputes or willful procrastination of payment by clients. They would also enable banks to gain liquidity when needed due to unforeseen circumstances. The establishment of such institutions would go a long way in providing a favourable environment.

    A great deal of progress has undoubtedly been made in the establishment of some necessary infrastructure institutions such as the Islamic Financial Services Board (IFSB), Islamic Research and Training Institute (IRTI), Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), International Islamic Financial Market (IIFM), International Islamic Rating Agency (IIRA) and the Liquidity Management Centre (LMC). The IDB has played a crucial role in the establishment of these institutions, which have rendered valuable service in strengthening the system. However, more institutions are needed and their establishment would go a long way in providing a favourable environment for increasing authenticity. Some of these institutions are briefly discussed below.

    Centralized Shariah Board
    One of the indispensable needs of Islamic finance for realizing greater authenticity is to get verdicts that are in harmony with not just the form, but also the spirit, of the Shariah. This demands that the members of the Shariah board should be scholars who have a clear understanding of the objectives of the Shariah (maqasid al-Shari’ah) and the role of the financial intuitions in realizing these. They should not only be people of exemplary integrity and well-versed in the Shariah, but should also be insulated from moral hazard. This hazard arises because every bank hires its own Shariah board members and pays their remuneration. In addition to being costly, particularly for small banks, this practice leads to conflicting opinions which create inconsistency and uncertainty. It also carries the potential of creating a conflict of interest, possibly tempting board members to give verdicts that are more profitable for the banks but not in keeping with the spirit of the Shariah. To overcome this problem, it is necessary to adopt some effective measures. One of these is to make full transparency mandatory with respect to the verdicts given by Shariah boards. The verdicts should be published along with the Shariah rationale behind them. The risk of getting a bad reputation should help induce the Shariah boards as well as the banks to be on their guard.

    Another necessary measure is to establish a centralized Shariah board in the nature of a supreme court with members who are well-respected for their knowledge and integrity and who are also independent of banks. This would enable market participants to challenge any product which they feel is not in conformity with the spirit of the Shariah. It would also help standardize products as much as possible. It is imperative to have standardization at the level of not only individual countries, but also all Muslim countries. Some differences of opinion are bound to remain. This may, however, be healthy for the financial system because it would promote innovation and also provide different alterna¬tives for doing business instead of imposing a rigid conformity. However, when there is a difference of opinion, then the rationale should be clearly stated. Again, transparency should be made mandatory so that banks’ clients and depositors know which alternative the bank has adopted. This would also help raise market discipline by enabling bank customers to make a choice based on objective information.

    Shariah Clearance and Audit

    Among the most crucial challenges for an Islamic bank is to create confidence in its depositors as well as the other operators in the market about the harmony of its operations with the Shariah. For this purpose, two important steps need to be taken. The first step is to get clearance from a Shariah board about the Shariah compatibility of its products, not only in form, but also in spirit. The second step is to provide assurance that all its transactions conform with the verdicts of the Shariah board. The first step is like going to a legal expert to ascertain whether a specific mode of a bank’s operations conform with the country’s laws and, if not, what changes need to be introduced. The second is what auditors and banking supervisors do: ensuring that none of the bank’s transactions violate any laws.

    Shariah boards are like legal experts. They can only perform the first task. It is difficult for them to perform the second task, which demands a review of all, or at least a random sample of, the different transactions that have taken place in different branches of the bank. This demands a visit to the bank’s premises to examine its operations in the same way as auditors and supervisors do. It is generally assumed that Shariah boards perform this task. However, members of Shariah boards do not have the time or the staff to perform such a task effectively. The question that therefore arises is how to ensure the implementation of Shariah board decisions by the bank management. If this is not ensured, the existence of the Shariah board loses its meaning.

    There are three alternatives which may be considered for this purpose:
    * One of these is for the supervisory authority in the country concerned to undertake the Shariah audit of banks in the course of its normal supervisory visits. This may not be considered desirable by Islamic banks in countries where the government and the supervisory authority are not favourably inclined towards Islamic banking. However, it has the advantage that, if the supervisory authority performs the Shariah audit, it will also try to standardize the fiqhi decisions.

    * The second, more preferable alternative is to establish independent Shariah audit firms in the private sector. These firms would have to hire and train sufficient staff to examine the transactions of banks with a view to determining whether they are in conformity with the Shariah. This alternative has the disadvantage that it would involve a proliferation of insti¬tutions. Inspectors from three different institutions would knock at the doors of banks at different times. The first of these would be from the supervisory authority to determine the conformity of the bank’s operations with the country’s laws and the principles of safe and sound banking. The second would be the Shariah auditors, who would go to the bank to determine the conformity of its operations with the Shariah. The third would be the chartered auditors who would go to the bank to ensure that financial statements have been prepared in conformity with the generally accepted account¬ing standards. Inspection by all these three institutions might not be convenient for banks because it would keep a number of their staff engaged in assisting these inspectors at different times, and thus add to their costs.

    * A third, and even more preferable, alternative is for the existing chartered audit firms to acquire the necessary expertise in the Shariah to enable them to undertake Shariah audits. This would help avoid the proliferation of institutions that Islamic banks have to deal with. The banks would probably prefer this alternative because it would be more conve¬nient for them to have the Shariah audit at the same time as the accounts audit.

    Credit Rating Agencies, Chambers of Commerce, and Trade Associations
    Credit rating agencies, which rate banks themselves as well as their counterparties, exist in industrial countries, but they do not at present exist in all Muslim countries. The experience of the United States in the case of structured subprime loans clearly indicates the shortcomings of credit rating agencies. Even though concern for safeguarding their own reputations may serve as a check on rating agencies, a more effective regulatory framework needs to be developed to serve as a check on the moral hazard.

    Legal Reform
    Even though Islamic financial institutions have been established in nearly all Muslim countries, the basic legal framework under which they operate has not evolved in the light of the Shariah. Cosmetic changes have been made in the existing conventional legal framework. It is necessary to prepare a comprehensive legal framework to bring the financial system into harmony with the Shariah. Preparing such a framework may not be an easy task because it requires expertise in maqasid al-Shari’ah, conditions that must be satisfied to make the modes Shariah-compatible, and the complexities of the international financial system. While this kind of expertise is rare, it is developing.

    External Audit
    The growing complexity of the banking business, as well as the crises that the international financial system has witnessed, have raised the function of external audit to a position of critical importance in all financial systems. It is even more demanding and challenging in the Islamic financial system. It would be necessary for the external auditor to ensure not only that the bank’s financial statements are prepared in all material respects in conformity with the professionally accepted financial reporting stan¬dards, but also that the profit or loss declared by the bank truly reflects the bank’s condi¬tion and that its profit has been derived without violating the teachings of the Shariah.

    Conventionally, it is not considered to be the task of auditors to perform a Shariah audit. At present, they are not even equipped to do so. However, if this task were assigned to external auditors, then they would have to create the necessary expertise. This would demand that auditors also be trained in the finan¬cial aspects of the Shariah, as well as in auditing and law. If such training proved too cumbersome, it would also be possible for the auditing firm to hire Shariah scholars and provide them with some necessary background in auditing to be able to perform Shariah audits.

    The experience of the auditing firm Arthur Andersen has clearly revealed that an auditor should be independent and objective and there should not be anything that indicates the auditor’s vested inter¬est in protecting the bank’s management. It is only such an impartial audit that can create trust in the auditor’s report and promote confidence in the bank. Even though it is the job of the internal controls system to prevent, or detect and correct, material mis¬statements arising from fraud and error, the internal auditors may succumb to the management’s dictates for fear of losing their jobs in countries where there is a high rate of unemployment. The external auditor cannot be exonerated from the responsibility of ensuring that this has been done conscientiously.

    Shariah Courts or Banking Tribunals
    Another indispensable requirement of the Islamic financial system is the availability of some judicial facility that would help banks recover their loans promptly from clients who unjustifiably procrastinate repayment, and also help bank clients get prompt justice at low cost when the bank is itself acting unjustly. The existence of Shariah courts or banking tribunals would be very helpful in getting prompt verdicts on disputes of banks with their clients and vice versa. Normal civil court verdicts usually take several years in most Muslim countries.

    The Shariah courts or banking tribunals would have a greater deterrent effect if the names of banks or their clients that the courts have found to be guilty were also pub¬lished in the media. The fear of getting bad publicity would help minimize contractual violations. Furthermore, the names of parties who violate habitually could also be sent to chambers of commerce and trade associations for blacklisting in order to create the same effect that social ostracism had in the Classical period, when the Islamic financial system operated effectively.

    Audit Organization
    It may also be desirable to have an audit organization jointly owned by banks to evaluate the profit-and-loss accounts of clients that the banks feel have tried to cheat them in a PLS arrangement. Clents’ fear of being exposed to a thor¬ough check of accounts by such an organization would complement market forces in helping minimize shortchanging of banks by users of PLS funds. The creation of such an audit organization would save individual financial institu¬tions the need to hire a large staff of auditors. It would thus create a substantial economy in expenses for all financial institutions. It would also give assurance to direct investors that businesses would have accounts properly examined by a qualified, impartial institution.

    The whole concept of “audit” may have to undergo a transformation in the case of primary modes of Islamic finance. Conventional auditing is not designed to uncover management fraud. If the auditor performs a diligent audit and evaluates the financial statements according to generally accepted accounting principles, the professional obligations of the auditor have been fulfilled. The auditor has no responsibility to detect management malpractices or to determine the “real” profit. He does not have the responsibility to check and to question. Accounting firms generally tend to accommodate their clients, particularly the big clients who hire them. In contrast, an auditor would fail in discharging his responsibility in a PLS system if he did not try to detect and disclose dishonest and questionable acts of the management and to determine the real amount of profit so as to ensure a “fair” return to sharehold¬ers and mudarabah depositors.

    Depositors’ Associations
    It is of crucial importance to establish mechanisms that would enable depositors to protect their own interest in a PLS financial system. Even demand depositors need such protection because the deposit insurance system does not generally insure demand deposits beyond a certain limit. One of the mechanisms that could enable depositors to protect their interest would be to have a voice at shareholders’ meetings. The ease with which shareholders and depositors can participate in meetings and use their votes to influence important bank decisions or to remove directors and senior management from office can play an important role in improving corporate governance in banks. However, this may be difficult for depositors to do in practice. Voting rights are generally not exercised by shareholders and this would be more so in the case of depositors, because their number is much larger than that of shareholders. Moreover, it can be expensive for shareholders and depositors to exercise if they can do so only by attending the meetings.

    It would be helpful for depositors to appoint a representative on the board of directors. This would be easier if the formation of depositors’ associations is encouraged. Such associations could also enlighten depositors on the condition of the bank in addition to representing at the board and shareholders’ meetings. However, until such time as such associations start functioning effectively, external auditors may be assigned the task of acting as guardians of depositors’ interest in the same way as they are expected to guard shareholders’ interest.

    Qualified Pool of Talent
    To enable the Islamic system to fulfill the requirements of the Shariah as well as those of the Basel Committee on Banking Supervision (BCBS) and the Islamic Financial Services Board (IFSB) and also ensure greater authenticity, it will be necessary to train the management, staff and clients of banks, as well as the general public, in the principles of Islamic finance. However, this will not be enough. It will also be necessary to create a large pool of experts and highly qualified profes¬sionals with in-depth knowledge of not only the Shariah and its objectives, but also Islamic and conventional finance and financial engineering. This would be possible if first-rate institutions were created for this purpose with the collaboration of financial institutions, central banks, universities and the governments. Directors and senior management of Islamic banks, as well as Shariah advisers, should also be required to take such courses. If the central banks, as well as universities, could participate, as is done in the case of conventional banking, the task of Islamic banks would become rela¬tively easier.

    Islamic Financial Market
    The absence of a secondary market for Islamic financial instruments makes it extremely difficult for Islamic banks to manage their liquidity. Consequently, they end up main¬taining a relatively higher ratio of liquidity than that which is generally maintained by conventional banks. This affects their profitability and competitiveness. The establish¬ment of the IFSB, International Islamic Financial Market (IIFM) and the Liquidity Management Centre (LMC) are steps in the right direction and will help provide the insti¬tutional infrastructure needed for an Islamic financial market.

    The IFSB helps promote uniform regulatory and supervisory practices and pru¬dential standards for Islamic financial institutions in the same way as is done by the BCBS. The IIFM enhances cooperation in the finance field among Muslim coun¬tries and financial institutions by promoting product development and harmonizing trading practices. This will serve as a catalyst for the development and promotion of a larger supply of Shariah-compatible financial instruments. The LMC serves as an operating arm of the IIFM in the effort to facilitate the creation of an interbank money market that will enable Islamic financial institutions to manage their assets and liabilities effectively. This will create short-term Shariah-compatible investment opportunities by providing liquid, tradable, asset-backed treasury instruments (sukuks) in which these institutions can invest their surplus liquidity. It will also facilitate the sourcing and secu¬ritization of assets and trade actively in sukuks by offering buy/sell quotations.

    These three institutions together will help establish an Islamic financial market by removing the obstacles experienced by Islamic banks due to lack of standardization of terms and instruments and the unavailability of quality Shariah-compatible assets for trading in secondary markets. This should help the Islamic financial system to expand at a faster rate in the future and create a larger niche for itself in the financial markets of Muslim countries.

    Lender of Last Resort
    Islamic banks also need a facility akin to the lender of last resort which is available to conventional banks to overcome unforeseen liquidity crises. Such a facility is available to Islamic banks at present on the basis of interest and is therefore unacceptable. It may be worth considering creating a common pool at the central banks to provide mutual accommodation to banks in case of need. All banks may be required to contribute a certain mutually agreed percentage of their deposits to this common pool, just as they do in the case of statutory reserve requirements. They would then have the right to borrow interest-free from this pool with the condition that the net use of this facility is zero (that is, drawings do not exceed contributions) over a given period of time. In a crisis, the central banks may allow a bank to exceed the limit, with appropriate penalties, warnings and a suitable corrective programme. This would be a more organized means of replacing the framework for mutual cooperation that prevailed among the sarrafs during the Classical period.

    Reform of the Stock Market
    Reform of the stock market is also needed in light of Islamic teachings to ensure that share prices reflect underlying business conditions and do not fluctuate erratically as a result of speculative forces. The discipline that the Shariah helps introduce through the prohibition of short sales or the sale of what one does not own and possess should greatly help in realizing this goal. In addition, rules and procedures need to be streamlined and enforced to protect investors and ensure stability and sanity in the stock market. This would help raise the confidence of savers and investors in the system and enable them to buy or sell shares in response to their circum¬stances or their perceptions of future market developments. Such a reform would consti¬tute one of the most important pillars for supporting the edifice of an interest-free and equity-based economy.

    Best Regard

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