Quoted from Business Islamica by M. Umer Chapra. Available at: http://www.islamica-me.com/article.asp?cntnt=100
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.
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.
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.
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.
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.
Umm Al Quwain, Sharjah, United Arab Emirates