Wednesday, November 03, 2010

The role of Shari'ah advisory firms

A Reuters article deals with an interesting topic: the role of Shari'ah advisory firms as a way to 'outsource' the Shari'ah supervision and approval for Islamic financial institutions. I think this is an interesting topic and the article included one thing that I disagreed with: criticism of Shari'ah advisory firms for diluting the Shari'ah approval process. I would argue that, in contrast to the criticism, an outside Shari'ah advisory board would strengthen, not weaken, the Shari'ah approval process by making the scholars more independent of the companies for which they work, just like lawyers and accountants are.

There is a clear discrepancy between the role of lawyers and accountants on the one hand, and Shari'ah scholars on the other: there are many of the former, while relatively few of the latter. This is important because of the overlap between Shari'ah scholars on financial institutions' boards and those on the boards of the standards setting bodies like AAOIFI and the IFSB. This is important and will become more so if those bodies expand their work into determining broader standards about what is and what is not Shari'ah-compliant, as they appear to be doing. The overlap between the individuals devising the standards and those working for the financial institutions in approving new products poses a potential conflict of interest that will be difficult to overcome if the scholars are hired directly by the financial institutions.

With a Shari'ah advisory firm, the scholars work for the advisory firm, which handles the workflow and is hired by the financial institution. It can then assign Shari'ah scholars based on the needs of the client institution. This provides efficiency relative to each institution hiring a Shari'ah board by handling the contractual relationship with the client, but should also make it easier to handle any issue that might arise where the client needs to consult the Shari'ah scholars. It will be able to have the documentation behind each individual fatwa ready if one of the scholars who provided the original fatwa is not available.

However, there are benefits beyond just the issue of efficiency in reducing the costs of Shari'ah supervision. Having one organization that coordinates the client's need for Shari'ah review and supervision, it can provide a way to integrate younger scholars and provide them with experience working with more senior scholars at the firm. This can provide a way to reduce the bottleneck associated with too few top name scholars to accommodate the industry's growth, which was becoming acute before the financial crisis slowed the growth in Islamic finance.

However, with regards to the criticism that outsourcing Shari'ah review and supervision functions to a Shari'ah advisory firm, I think the trend of Shari'ah advisory firms can limit this. Rather than selecting a set of Shari'ah scholars that are the most likely to approve a product, the firms will hire the Shari'ah advisory firm with the most competent group of scholars and those firms will determine which scholars are most appropriate for each financial institution or product. The 'scholar shopping' that was credited with leading to controversial products being approved will be mitigated if the firms are more limited in their ability to directly hire--and pay--the scholars who review their products.

The Shari'ah advisory model is not without its potential flaws. For example, an advisory firm may essentially do the same scholar selection based on the likelihood of a given product being approved in order to maintain or gain market share. However, when there are many advisory firms to choose from, there will be a reputational risk for advisory firms that are associated with more controversial products (or even ones which were viewed as permissible at one time and then later viewed as impermissible). The same reputational risk is present with individual scholars, but it is more difficult to track whether a given scholar was on boards that approved controversial products (although services like Zawya's Shariah Scholar database, which it launched in partnership with Funds@Work are designed to help). With an advisory firm coordinating the Shari'ah review, it is much easier to track whether one advisory firm is known as relatively 'easier' to receive approval or for which there is a track record of approving more controversial products. The reputation and track record these firms accumulate will in turn affect their ability to recruit and retain scholars. An advisory firm with a high turnover rate of Shari'ah scholars will be a red flag for future clients about the quality of advise it can provide. Finally, it will be easier to implement some of the proposed certification and regulations over actual or perceived conflicts of interest with advisory firms rather than individual scholars.

The advisory firm model still presents many of the same issues that the direct hiring of Shari'ah boards by institutions, but it also presents several advantages from a monitoring, regulation and efficiency standpoint compared to the status quo of banks hiring their own boards. The criticism may be warrented in some cases, but the advisory firm setup can contribute to the development of the Islamic finance industry.

1 comment:

Nexus said...

The cost is acting like a barrier in the future of Shariah Adviosry and the growth of the industry