Sunday, April 08, 2012

Islamic finance should support greater diligence of offshore companies

It would be a welcome development if Islamic finance were to take the lead on a contemporary financial issue, rather than just wait for new developments to sprout up and then find ways to benefit.  The Economist this week described the profitable business of registering companies in offshore locations (and some surprising onshore locations as well), based on a World Bank study released in late 2011 [pdf] that focused on the potential for these companies to facilitate money laundering because they are not required to undertake the level of diligence required by banks and other financial institutions.

Most of the structures that use the companies and other corporate entities detailed in the report have legitimate economic uses (for example the SPVs used in sukuk transactions), but many of them can also be used in money laundering by corrupt government officials, for example.  At issue in the report is the flimsy diligence required by the service companies who help set up the companies and get them bank accounts.  There is little that can be done by the Islamic banking industry in this regard, at least directly, since they are already subject to much more stringent anti-money laundering (AML) laws.

However, as a growing segment of the financial industry, and one which is frequently subject to the false accusation that it facilitates money laundering and financing of terrorism, it could benefit the industry if it were to advocate for strengthening the requirements by these service companies to perform additional due diligence on the companies they set up, including the SPVs that are used to facilitate sukuk issuance.

There would be some cost if the additional requirements were placed on the service companies (who would undoubtedly pass the cost on to their clients), but it would likely be minimal for the end users since the costs associated with the SPVs are de minimis compared to the transaction sizes involved in most sukuk.

The benefits, however, would be much greater.  It would show that the Islamic financial industry is not only committed to applying the current AML laws, but that it is interested in encouraging greater disclosure in financial transactions and curbing avenues for money stolen through corruption and money destined to fund illegal activity to move around undetected.  Islamic financial institutions expend considerable efforts to make commercial activity work in a way that is fair to both parties through disclosure, risk sharing and by limiting transactions where one party gains at the other's expense.

Encouraging the world to take relatively modest steps against money laundering, especially when a lot of the money involved is proceeds from corruption, would be a good way to offer evidence that Islamic finance is not just about replicating the conventional financial industry's products, but wants to take the lead in creating a more just world.

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