Accreditation, rules on Shari'ah scholar conflict of interest begins to gain traction

The move to formalize the requirements for Shari'ah scholars in terms of training (through an accreditation program) and managing potential conflicts of interest is moving forward as the International Shari'ah Research Academy, based in Malaysia, was working with its counterparts in the Middle East on a set of guidelines.  These counterparts include the Islamic Research & Training Institute (part of the Islamic Development Bank group).

The move follows a Malaysian initiative announced back in August to provide an accreditation program for Shari'ah scholars in that country, which was led by Aznan Hasan, the president of the Association of Shari'ah Advisors in Islamic Finance (ASAS), who is also a prominent Shari'ah scholar. 

The regulation and accreditation of Shari'ah scholars is one of the more important areas of standardization in Islamic finance.  If the participation of a Shari'ah scholar on multiple boards is limited, it could result in a more prominent role for junior scholars who sit on boards, but are only slowly gaining name recognition on their own, rather than by virtue of the senior scholars they have trained with. 

Increasing the number of scholars with name recognition has the potential to lower the Shari'ah fees for certifying deals because their fees are likely to be lower than for senior scholars.  However, I think there is a potential for fees on the senior scholars to increase if they are limited to serving on a more limited number of boards, and are likely to see their fees bid up, potentially to the exclusion of smaller Islamic financial institutions. 

However, this might not be a significant problem.  If the senior scholars with the greatest international name recognition shift their focus towards global financial institutions, it will open up more board seats for junior scholars on smaller, more locally-focused Islamic financial institution that will tend to rely more on their Shari'ah board's domestic name recognition, to demonstrate their Shari'ah-compliance to the local market.

Other aspects of the discussions are around Shari'ah board potential conflicts of interest, like owning stock in the institutions on whose boards they sit, and issues around limiting scholars from advising multiple Islamic financial institutions in the same sector or geography who compete against one another.  In Malaysia, for example, Bloomberg describes how Bank Negara regulations do not allow Shari'ah scholars to "sit on more than one board involved in the same business". 

This is likely to be only the first step down a long road of providing more formal oversight of Shari'ah scholars to ensure that the Islamic finance industry has the Shari'ah board capacity that can scale with it.  In addition, more stringent rules on accreditation and managing potential conflicts of interest can avoid problems down the road by mitigating or eliminating these conflicts and potential conflicts of interest. 

Accreditation of Shari'ah scholars is a big step forward

A new organization in Malaysia, the Association of Shari'ah Advisors in Islamic Finance (ASAS), led by Aznan Hasan, the president of the organization and a prominent Shari'ah scholar, is developing an accreditation program including testing financial literacy.  This is an important step for the industry because, while there are rules in some countries about the qualifications for Shari'ah scholars, they are not consistent internationally, and there is not currently a way for scholars to demonstrate their qualifications in finance.

Many and probably most Shari'ah scholars are competent in both Shari'ah and finance, but most of the emphasis is placed on the former and scholars formal training in Shari'ah as well as their training with other more senior scholars (in the case of younger scholars) provides a good way for their qualifications to be established.

There is, however, not nearly as much rigor in formally testing Shari'ah scholars' expertise in finance, which is an equally important qualification for Islamic finance.  Many products are complex and a Shari'ah scholar should not only be qualified to make a Shari'ah ruling on the formal structure of a product, but should also understand how different aspects of a product interacts to avoid the situation where a product may, in its parts be Shari'ah-compliant, but in its entirety become nothing more than a way to circumvent specific prohibitions, which could lead to questions later. 

One example that I have referred to in the past was a product criticized by Sheikh Yusuf DeLorenzo (pdf) that used a total return swap to generate a return from a basket of hedge funds.  There may be other examples, but I refer to this example mostly because DeLorenzo worked through in a public way his concern that the product generated non-compliant income by compliant means.  In his conclusion, Sheikh DeLorenzo writes:

"The classical jurists have stated that whatever leads to involvement in the unlawful will either lead to the unlawful as a certainty or lead to the unlawful as a possibility. This product includes investments, even though they are entered into indirectly, that are clearly unlawful. Moreover, there is no doubt whatsoever that the transactional series leads inevitably, and repeatedly, to what is unlawful." (emphasis added)

With this product, as with any other, there is not necessarily a clear link suggesting the scholars who approved it did so because of unfamiliarity with finance, or because of the potential conflict of interest they face with any transaction where they are being paid by the issuer to make a ruling on Shari'ah-compliance that will be considered by potential investors.  But there does not need to be, there just needs to be a likely perception of either for the industry to be hurt.

The accreditation by an independent body of each scholar's financial knowledge, as well as a body that can sanction scholars if they do not mitigate the potential conflicts of interest or can be ex post be shown to have not taken due care in reviewing the transaction will increase confidence in the integrity of Islamic finance.  This should not be treated lightly since finance (as conventional banks are finding out after scandals involving subprime, LIBOR, sanctions evasion, etc) depends on confidence of its customers and the markets more broadly.  It is also much easier to lose than it is to regain.

An independent body, which will at first be voluntary and only cover Malaysia, should be strengthened and broadened over time to cover the entire industry and to be mandatory.  It will provide a strong signal for the growth and maturation of the Islamic finance industry.

ISRA executive director on Shari'ah board governance

In his regular column, Rushdi Siddiqui interviewed Dr. Mohamad Akram Laldin, the executive director of The International Shari'ah Research Academy for Islamic Finance (ISRA), based in Malaysia, where Dr. Laldin offered a few interesting comments on the oversight of Shari'ah scholars (there's more in the interview, which I recommend reading in full).

On the Malaysian national Shari'ah board:

"The existence of the national board is important as it is the check-and-balance mechanism for the syariah advisory services, in the absent of any regulating body. "

The national Shari'ah board does provide oversight in the types of products that can be used by Islamic financial institutions.  This is probably the area where there is most disagreement regarding the move towards standardizing Islamic products versus allowing for innovation in new structures.  They provide checks and balances only in whether products offered fit within their rules for what is and is not Shari'ah-compliant.  They are not responsible for overseeing the conduct of the Shari'ah scholars in how they approve and review products, and to assess continuing compliance in Shari'ah audits.  A few surveys of Islamic financial institutions (including in Malaysia) reveal a gap in the Shari'ah audit process where the auditors may in some cases not be well enough trained in understanding the Shari'ah rules laid down by the Shari'ah board in their fatwa, being instead more focused on auditing the financials. 

On scholars' conflict of interest from sitting on multiple boards:

"regulators, working with the industry and standard-setting bodies, must play a role to ensure the syariah (conflict of interest) risk, actual or perceived, is minimised.

For example a syariah scholar who sits on the syariah board of a particularly entity should not have a vested business interest in the entity in order to preserve the integrity of the scholar and avoid any conflict of interest. 

Furthermore, another possible way to ensure the effective implementation and enforcement of syariah governance is to have a global market-driven entity to establish syariah advisory standards for the scholars. For example, in Malaysia, we have established the Association of Shariah Advisors that will draft the standards and code of conduct for syariah advisers and eventually issue licence for those who want to practice in syariah advisory services. This body will ensure that all its members will uphold integrity in providing their syariah advisory services by abiding to a strict code of conduct and guideline."

The lack of more organizations that set down standards for Shari'ah scholars in their professional conduct is an important gap.  Shari'ah scholars may all act honestly when they are issuing their rulings to Islamic financial institutions, and may already address their conflicts of interest (actual or potential) so that it does not affect their ability to provide a fatwa that reflects only their true belief in the Shari'ah-compliance of a product.  However, if there were a public instance where there were questions (for example, about whether the scholar had a pecuniary interest in an Islamic financial institution), there are no standards by which a situation could be judged.

It is also important for there to be standards decided, made publicly available, as well as a regular review process for Shari'ah scholars, not because there is a widespread problem, but because of the ramifications if a problem occurred.  The Islamic financial institution relies on the process of assessing Shari'ah-compliance of products and institutions to a large degree.  If there were problems, the reputational damage would spread across the industry as consumers lost trust in the ability to rely on the fatawa stating that scholars were reviewing products and institutions for Shari'ah-compliance on an ongoing basis.  Trust is a commodity that is very difficult to repair if it is damaged, and it will be far less costly to put in place ways of spotting problems in advance than it will be to clean up any problems. 

On self-regulation by scholars:

"Scholars, as consultants, are similar to other individuals or bodies that provide services to banks, companies and governments. To date, there is no comprehensive governance framework regulating the syariah advisory services across the globe. 

Therefore, similar to other professions such as lawyers, medical practitioners, etc. It is vitally important to have a self-regulated industry syariah advisory body to preserve the industry's integrity. Although syariah advisory services are different from the dimension that is religious-driven, it should have its own code of conduct as Islam emphasises integrity in all undertakings."

As mentioned above, there should be standards for Shari'ah scholars conduct in dealing with actual or potential conflicts of interest, and in how they interact with the management of the companies who they are overseeing.  Just because it would be beneficial to have a set of standards and a regular review process does not preclude these standards from being designed by the scholars themselves to ensure that their fellow scholars have sufficient knowledge of finance to dig through the massive offering documents and reams of product documentation and understand how the products work.  They are also, being dependent to some degree upon the reputation of the industry as a whole, motivated to enforce any failings in meeting the standards.

Regulating Shari'ah scholars

The Director of Supervision of the Dubai Financial Services Authority David Gray questioned why there was not regulation for Shari'ah scholars in line with regulation of other areas of Islamic finance.  He contrasts the lack of regulation of Shari'ah scholars with lawyers and accountants, who also provide advice to Islamic financial institutions.

I think he has an excellent point.  It is not enough to just work on the faith that Shari'ah scholars will always act as objective parties, because they are human just like the rest of us.  There have been few times when Shari'ah scholars have been directly implicated in a financial scandal, but that doesn't mean it cannot happen, and further that no regulation should be put in place to police potential violations of basic ethical guidelines about conflict of interest and confidentiality.

The guidelines need not lead to a central Shari'ah body like Malaysia has.  They can focus on conflicts of interest caused by serving on many boards simultaneously, as well as providing an enforcement mechanism to discipline scholars, for example, if they disclose confidential information.  These ideas are not meant to suggest there is a current problem, although there has long been concern that Shari'ah scholars may in some cases be faced with a conflict of interest, but why wait until there is a scandal that could damage the image of the industry.  Much better to try and avoid an incident ahead of time.

Shari’ah Supervision: Can The Industry Incorporate More Scholars?

Shari’ah scholars are probably the most important—and often viewed as the most scarce—resource in the Islamic finance industry.  There are fewer than 20 scholars with the widest recognition who are used by the majority of Islamic financial institutions and conventional institutions with Islamic ‘windows’.  The conflicts of interest (actual or perceived) that Shari’ah scholars face with their duties to maintain confidentiality and their receiving of payment directly by the institutions they regulate have come under greater scrutiny over the past several months.

One of the most stringent regulations of Shari’ah boards was recently implemented in the United Arab Emirates for takaful companies, which prevented Shari’ah scholars from being on multiple boards simultaneously and prohibited them from having a financial interest in the company except for their pay for serving as members of the Shari’ah board. 

In addition to the UAE regulation, the Islamic Financial Services Board (IFSB) released a new standard (IFSB-10) covering the “Guiding Principles On Shariah Governance Systems For Institutions Offering Islamic Financial Services”.  The IFSB standard is not as rigid as the UAE regulation and it does not set a maximum number of boards that a scholar can sit on, so long as he is able to devote enough attention to each board of which he is a member. 

The central bank of Malaysia, Bank Negara, has adopted standards in line with the IFSB standard for Islamic financial institutions in that country.  Clearly, the question of Shari’ah scholar independence and potential conflicts of interest are being addressed.  However, with more stringent regulations, it will be a challenge if the top 20 scholars are included on nearly every board.  The latest report from Funds@Work and Zawya (pdf) found that the Top 20 scholars held 624 positions while the remaining 300 held only 520 positions (the report only looked at scholars who are on a Shari’ah board).

With a cluster of the top 20 scholars holding such a disproportionately large share of Shari’ah board memberships, it raises the question about how the industry will be able to sustain its growth as the number of institutions multiplies across the world.  However, the ability of such a small number of scholars to represent such a large number of institutions suggests that, if their time is managed well and the less represented scholars are incorporated into Shari’ah boards, the industry is not facing as much of a shortage of scholars as is commonly stated. 

However, the fact remains that despite significant attention being paid to the ‘scarcity’ of top scholars, there has not been much movement towards incorporating less experienced scholars into the boards at Islamic financial institutions.  What can be done to change this?  Are there ways that the traditional role of older Shari’ah scholars as teachers and mentors for younger scholars can be used as a way to spread the responsibilities for Shari’ah review and supervision more effectively across the industry?

I think there is a solution that can maintain the requirement of having experienced Shari’ah scholars on each board, while also broadening the pool of scholars who sit on multiple boards.  However, this will require a change in attitude by many Islamic financial institutions which may face resistance from some (particular international financial institutions), who rely on prominent scholars as a way to demonstrate their Shari'ah-compliance to potential clients. 

One of the areas where the Zawya Shariah Scholars database[1] can contribute is by showing the linkages between different scholars (who has worked with whom in the past) as well as the relative areas where each scholar has the most experience.  However, the availability of that information may be necessary, but is not sufficient.  There needs to be a change in the way that Shari’ah boards are put together, which may require more stringent regulation by standards setting bodies and national regulators.  It is not evident that Islamic financial institutions will voluntarily move away from hiring the most recognized scholars.

However, that being said, a regulation that specifies the maximum number of boards on which any one scholar can serve, is not the best way to regulate Shari’ah boards.  There is no hard and fast number of positions where a Shari’ah scholar becomes too busy to effectively serve each institution and each scholar will have his own limit.  The peripheral issues raised by the UAE, BNM and IFSB regulations relating to perceived conflicts of interest can be more widely applied without too much difficulty. 

There are two different tracks that I could see being an effective way of leveraging the relationships that already exist between Shari’ah-scholars are 1) Shari’ah advisory firms; and, 2) retaining the institution-by-institution system with some form of limitation that limits the most well recognized scholars from serving together on boards.  I think the limitations of regulation make the latter idea not practicable. It would more likely represent a status quo approach reliant on the voluntary decision by institutions to find a way to reduce their own reliance on the most in-demand scholars.  The former, by contrast, would create a way to manage conflicts of interest as well as use the existing relationships between scholars.

As I have mentioned before, the Shari’ah advisory firm model reshapes the Shari’ah advisory function into something that more closely resembles law firms and accounting firms.  Instead of hiring individual Shari’ah scholars, the institution would hire an advisory firm, who would be responsible for assigning the individual scholars to different firms based on their experience in that firm’s type of business, as well as the time constraints facing their scholars. 

There remain unsolved questions associated with this method.  For example, how would the potential for large firms with higher budgets to hire the top scholars while the smaller, local firms be forced to have less experienced scholars assigned to their boards be mitigated?  Would there be overlap allowed between Shari’ah advisory firms (for example, would one scholar be allowed to work at more than one Shari’ah advisory firm?).  How would the firms avoid becoming entrenched in one way of thinking.  For example would Shari’ah advisory firm A be known for being more lax on interpretations, while firm B would be known as having scholars who provide more conservative interpretations? 

Despite these unresolved questions, the Shari’ah advisory firm model is more realistic in my opinion, because it avoids the question of how to determine the maximum number of board positions each Shari’ah scholar is allowed.  It also makes a step forward in ‘professionalizing’ the Shari’ah review business that can over time limit the cost to Islamic financial institutions by spreading administrative and workflow management costs across a larger number of scholars.  This should ease the strain on the existing scholars who hold the most positions, reduce costs for the industry and also help to bring less prominent Shari’ah scholars onto more boards where they can learn from the top scholars and ensure the industry has the resources it needs to continue growing and pass Shari’ah supervisory duties from one generation of scholars to another.

[1] The Zawya Shariah Scholars database provides information on over 300 scholars with information about their affiliations, statistics on the other scholars with whom they have worked and the sukuk for which they have provided fatawa.  Thanks to Zawya for providing me with a tour of the features of the database.

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.

GCC sukuk markets may grow in Q4, Shari'ah scholars and standards, women in Islamic finance

One of the many themes I have tried to articulate on this blog is the areas where Islamic finance can differentiate itself from conventional finance.  An article in Maktoob Business points to one area that may be difficult  for Islamic finance, but should not be impossible given the low bar set by conventional finance.  This is the role of women in Islamic finance.  Currently, there are few women in top roles in Islamic finance although there are several exceptions in Malaysia (with the head of one Islamic bank, the central bank and one Shari'ah scholar being women).  As I mentioned, there is a relatively low bar set by conventional finance: the industry is one of the more male-dominated industries across the world.  As the article mentions, Islamic finance has not yet seen as much participation by women in top roles, but there is no inherent reason why this cannot be the case.  Should Islamic finance be successful n becoming more balanced in terms of gender participation, it would set an example for conventional finance, but also counter popular misconceptions about women and Islam more generally.

The move by Dubai Islamic Bank to up its stake in Tamweel to 57.33% has led to rumors that Emaar, the largest shareholder of Amlak Finance, will sell its stake in the other Islamic mortgage company in Dubai, which was expected to be merged with Tamweel.

Qatar Islamic Bank has reportedly priced its five-year, $750 million sukuk at 262.5 basis points over midswaps.  There has been little corporate sukuk issuance in the GCC outside of regular Bahraini Central Bank short-term issues and Saudi corporate issues.  The resolution of the Dubai World debt agreement for $25 billion of debt has led to a revived pipeline that at $5.5 billion which now surpasses the pipeline in Asia of $2.1 billion.  Particularly since the Dubai debt crisis, Asian issuers have been much more active in the primary market for sukuk as investors have viewed the GCC as being significantly more risky, even though most of the problems were contained to Dubai (and to a few Kuwaiti investment banks).  However, the Dubai World situation is not resolved entirely and remains dynamic, which could quickly increase the risk aversion of investors towards the GCC.

The issue of ensuring proper governance with respect to Shari'ah scholars has become a widely discussed issue since ISRA proposed a global certification, which Reuters describes as having 'overwhelmed' the industry.  The ISRA proposal and the issue of coordination of Shari'ah standards in general has received a cool reception from Megat Hiziani Hassan, a lawyer at Malaysian firm Zaid Ibrahim.  In an opinion article in Maktoob Business, Dr. Rusni Hassan, a Shari'ah advisor to HSBC Amanah Malaysia, reminds the Islamic finance industry that Shari'ah scholars are best suited as 'guides', not 'police'.  I agree in general--Shari'ah scholars should have a 'teaching' role to ensure that practitioners understand the rules around Shari'ah-compliance and the reasons for them.  However, there is a role for Shari'ah scholars as 'police' as well that will prevent or at least mitigate the Shari'ah risk associated with future reversals in approval of controversial products' Shari'ah-compliance.  In many ways, Shari'ah scholars are 'regulators' of the Islamic finance industry and without their setting firm boundaries, financial engineering can be taken too far in creating products that meet the letter but not the spirit of the rules governing the industry.

ISRA Shari'ah scholar certification

The plan by ISRA to set up a global certification for Shari'ah scholars is proceeding and the body expects to pick a board of regulators to develop the qualifications by year-end. The goal of the certification is to ensure that all Shari'ah scholars have requisite training and competence not only in Shari'ah, but also finance. I believe the primary beneficiaries of the qualification will be the less well known scholars who may find more demand for their services with the certification providing some confirmation that they are qualified. However, there will remain significant momentum among particularly the global financial institutions to recruit the highest profile scholars to their Shari'ah boards as a way of enhancing their reputation as being Shari'ah-compliant.

Other News

• Moody's Investor Services and Mashreq Capital DIFC believe that the Nakheel trade creditor sukuk will spur secondary market activity in sukuk because many trade creditors will sell them.
  
• Dana gas and Aldar's convertible sukuk performed well in the first two months of the third quarter, with their yield falling from 13.6% to 10.77% (for Dana Gas). The GCC sukuk market has been slow since the financial crisis and the AAOIFI resolution on sukuk.
  
• Padiberas Nasional Bhd issued sukuk as part of a RM750 million ($240 million) sukuk program. While issuance has rebounded in Malaysia, it has remained sluggish in the GCC following the Dubai debt crisis last fall.
  
• The National Bank of Ethiopia is close to approving a directive to allow Islamic banks and Islamic windows at conventional banks. Stanbic Bank in Tanzania, which launched Islamic financial products earlier this year, submitted an application to the country's central bank to widen its product offering.
  
• An article on an Islamic finance conference in Switzerland provides a good summary of the challenges facing Islamic finance if it wants to become more attractive and attract non-Muslim clients.
  
• An article from Trade Arabia discusses one small part of the Islamic financial industry that is Islamic exchange traded funds (ETFs)>
  
• Sudan delayed its planned $300 million sukuk issuance again citing the financial crisis.
  

Indonesia sukuk, rules on forward currency transactions, ISRA to set up Shari'ah scholar org

Indonesia sold sukuk through a private placement for 336 billion rupiah ($37.45 million). There was an indication that the government would move away from the auction method towards private placements after several auctions where the yields demanded by investors were higher than the Ministry of Finance was willing to expect. The higher yields versus conventional bonds were attributed to lower liquidity in secondary markets for sukuk compared to conventional bonds in Indonesia, something that is common in other countries as well. The current issue is non-tradable sukuk with a yield of 7.3% maturing in 2014.

The Shari'ah Advisory Council of Bank Negara Malaysia, the country's central bank, ruled that no payment can be made in exchange for a forward currency transaction used for hedging (based on a binding promise, wa'ad). The basis for the ruling was that the upfront fee would turn the transaction into a bilateral wa'ad, which is viewed as a contract, which is not permissible. The unilateral (binding) promise is viewed as acceptable because it is a promise made without compensation. The issue of bilateral wa'ad also emerged as a stumbling block in the IIFM report on sukuk repo transactions.

The International Shari'ah Research Academy for Islamic Finance (ISRA) may set up an international body for Shari'ah scholars with the hope of creating a (self-)regulatory organization for Shari'ah scholars. Currently, there is no international body that regulates Shari'ah scholars, although the procedures for Shari'ah-compliance are standardized through AAOIFI and the IFSB. I think it is a good effort, but I agree with Muneer Khan, head of Islamic finance at the law firm Simmons & Simmons, who is quoted saying that "It's very difficult to set up an international body which actually has the power to effect these changes [...] It all depends on voluntary cooperation. A lot of work would have to take place behind the scenes to get regulators to sign up".

The editor of Arabian Business, Damian Reilly, wrote an opinion piece in the paper about Moody's recent downgrading of Bahrain's rating from A2 to A3. He says that, despite Moody's claim that the ratings downgrade was based on its budget deficits and dependence on higher oil prices of $80 to balance its budget, it was based on Moody's view that the outlook for Islamic banking in 2011 was diminished. The Moody's analysis also cited the size of Bahrain's banking sector--much of which is Islamic banks--that has assets of three times the country's GDP. Mr. Reilly counters that the large size of Islamic banking as a share of the country's banking sector--and that industry's better performance in the financial crisis--suggests that Moody's is becoming more cautious on Islamic banking. In my opinion, his point avoids the real detriment that a global recession can have on an Islamic banking system. Even if the Islamic banking system performs better than conventional banks, the government would find it hard to support the banking industry if things became worse. The budget deficit is currently 7.3% of GDP (expressed another way, 2.4% of total banking assets) and even a small requirement for cash from the government by the banking industry would have a disproportionally large share of the country's GDP and also a large increase in the budget deficit, which could make the country's creditors uneasy.

JP Morgan estimates that the tradable sukuk paid to Nakheel's creditors for 60 percent of what they were owed (with the remaining 40 percent paid in cash) are worth about 60% of their value if they made all principal and periodic payments. The estimates of their fair value is based on Nakheel being able to pay "almost all" coupon payments but JP Morgan doubts Nakheel's ability to repay the principal in 2015. The five-year sukuk have a coupon of 10% per year. The terms of Nakheel's payment to trade creditors was higher than their offer to debt holders of Dubai World, who extended maturities of debt with a 1% yield. The holders of Nakheel's 2009 and 2010 sukuk received redemption in full with funds from the Dubai Financial Stability Fund and the 2011 sukuk are expected to be repaid in full from the same source.

Other News

• The Islamic Development Bank's $3.5 billion sukuk program securities will be listed in Kuala Lumpur and London. So far $1.1 billion has been issued and another $1 billion will be issued by year end in 5-, 7-, and 10-year sukuk. This is separate from the RM1 billion sukuk that was listed on Bursa Malaysia yesterday.
  
• The bill to put sukuk on equal footing with conventional bonds in the tax code in South Korea has been held up by the (unfounded) concern that it could lead to money laundering and financing of terrorist groups. This is unfortunately not an isolated case where unfounded fears hamper the growth of Islamic finance.
  
• The East Asian region lead the Dow Jones Islamic Indices in August according to a report from Dow Jones.
  
• Affin Bank has applied for the first Islamic bank license in China, according to an article in Business Times. The Ningxia Hui Autonomous Region was working in 2009 to develop a pilot Islamic financial services institution in northwest China.
  
• Indonesian bank BNI Syariah wants to partner with foreign investors to expand its Islamic banking business.
  
• Another article discusses the dichotomy between the GCC and Malaysia in the state of their Islamic finance sectors, primarily new sukuk issuance.
  
• The CEO of the Qatar Exchange, Andre Went, says it is drafting new rules to cover trading in bonds and sukuk. Trading was expected to begin in September, but Mr. Went did not say when trading would begin.
  

GCC sukuk markets slow to recover, new AAOIFI rules on Shari'ah scholars may be coming

The headline is promising: "GCC bond and sukuk market bounce-back in Q2". The article--which reflects data from National Commercial Bank in Saudi Arabia--continues to show data that supports continued weakness in sukuk markets in the GCC (particularly compared to Asia). After a rosy headline of a bounce-back, the press release describes that "the primary sukuk market also picked up, lead by sovereign issuances, and reached a total value of $3.4bn, a significant rise over the same period last year." (emphasis added) This type of comparison--regardless of the data being reported--is relatively easy to make at the current time because one year ago, the global economy was just exiting a severe financial crisis. Reading further, "Sovereign sukuk issuance totaled $1.5bn during the quarter, whereas activity proved much more lackluster in the corporate sukuk space with the notable exception of a landmark issue by Saudi Electric Company". (emphasis added). The press release quantifies this weakness. There were eight sukuk issues from the GCC region in the second quarter of 2010, seven of which ($1.5 billion worth) were issued by sovereigns (Qatar and Bahrain), which leaves only the Saudi Electric Company sukuk from the corporate space (making up the $1.9 billion remainder). The details of the press release confirm that the market for sukuk--at least in the GCC--is still open primarily to governments. The corporate sector has not returned in the wake of the credit crisis, which saw defaults by Saad and Algosaibi, The Investment Dar, International Investment Group and the near-default of Nakheel increase uncertainty about sukuk. I would expect the third quarter sukuk issuance to be similarly slim, but it will be interesting to see what deals currently in the pipeline are brought to market after Ramadan.

Bloomberg is reporting that the Secretary General of AAOIFI, Mohamad Nedal Alchaar, said that the body is considering placing rules on Shari'ah scholars to minimize potential conflicts of interest. The rules may limit the number of boards on which a scholar may sit and may also limit the scholar's ability to have investments in those institutions as well. It will be interesting to see whether there is push back, both from scholars, but especially from Islamic financial institutions. My expectation is that the financial institutions--particularly the mid-size ones--will complain (in some cases validly) that the limitation on Shari'ah scholar's participation on multiple boards will harm them because there is a shortage of well known scholars and the multi-national financial institutions will be able to draw the most recognizable scholars. This is probably a valid concern (depending on how low the bar is set as far as the maximum number of boards each scholar can sit on). In the longer-term, it will be beneficial by helping younger scholars become more well recognized, but there will be a cost in the interim where the mid-sized institutions that have thus far been able to have well regarded Shari'ah boards may get priced out of their services by multinational banks. But until there is a firm proposal on the table from AAOIFI, this is just speculation.

Other News

• Falling yields on sukuk issued by Malaysia and Indonesia may be the result of their rising currencies against the US dollar which has attracted foreign investors, reports Bloomberg.
  
• Cagamas issued RM230 million ($72.8 million) in three-year, variable rate commodity murabaha sukuk.
  
• There is a good article in Arab News about a conference held at the George Washington Law School. The conference featured Frank Vogel, Yusuf DeLorenzo, Umar Moghul, Aamir Rehman and Ibrahim Warde.
  
• Deutsche Bank's Saudi-joint-venture Deutsche Gulf Finance launched its Islamic mortgage product that offers home financing for up to 30 years, according to a press release.
  
• A Malaysian expressway company is planning to issue new sukuk to redeem their outstanding sukuk because the tolls will be insufficient to cover the first repayments later this year.
  
• Indonesia sold 2.855 trillion rupiah($319 million) in 4-year sukuk to the government's Islamic Haj Fund. The planned global sukuk sale was cancelled because the deficit is smaller than expected and the government had trouble attracting investors at yields it would accept. The illiquidity of the sukuk were cited as the reason for higher yields.
  
• Qatar Islamic Bank (which owns Asian Finance Bank in Malaysia) is reportedly searching for a partner to expand into Indonesia. There have been quite a few Malaysian Islamic banks that recently announced interest in or completed acquisitions to enter the Indonesian market.
  

TID, Islamic CDs, the halal market and sustainability

The Investment Dar
The Investment Dar case became more complex with the Shari'ah board of TID requesting that the bank stop contesting the claim by Blom Bank based on the wakala contract's non-compliance with Shari'ah. In addition, the Shari'ah board asked that a similar defense not be used in the future without first consulting the Shari'ah board to determine the legitimacy of its contracts. An article in Arabian Business comments that "While the sharia board's statement puts a wrench in Investment Dar's ability to move forward with a case against Blom regarding the deal, legal experts say the reputational damage to the industry has already been done".

I disagree with the contention that TID's case has damaged the Islamic financial industry. In contrast, the UK courts held a skeptical view of TID's defense and now the institution's Shari'ah board has come out in support of the wakala product's Shari'ah-compliance. This accomplishes two things for the industry. First, the court's skeptical ruling on TID's defense provides another secular court precedent that a party to an Islamic contract cannot, ex post, argue that the contract is not Shari'ah-compliant to get out of their obligations. I have argued before that the court's ruling provides Shari'ah scholars and boards with more freedom to change their mind on Shari'ah-compliance without worrying about upsetting existing contracts.

Second, I believe it is positive is that TID's Shari'ah board came out against the institution and upheld their initial ruling. There is always a potential conflict of interest between a Shari'ah board and the institutions for whom they work. However, this provides one example of a Shari'ah board publicly demonstrating that their duty to ensure Shari'ah-compliance and preserve the integrity of their ruling is placed above their employment with one institution. The only clear loser in this development is TID, who are stuck between an adverse court ruling in a secular court and their own Shari'ah board's ruling that contradicts their claims in that court.

UAE central bank to offer Islamic CDs to Islamic banks
The UAE central bank is planning to offer Islamic CDs as short-term money market instruments for Islamic financial institutions. The lack of short-term money markets outside of Malaysia (and to a limited extent in Bahrain) hampers the Islamic banking industry because it leads banks to hold excess reserves in cash, which lowers Islamic banks' returns compared to conventional banks because they cannot generally generate returns from this cash. The Islamic CDs received preliminary approval last week from the Shariah Coordination Committee with what Hussain Hamed Hassan, the committee's chairman, described as "minor changes". It may receive final approved next week according to Mr. Hassan. Islamic CDs are offered in the US by one institution, the University Islamic Financial Corp and are used by some of the Islamic mutual funds in the US as a way to generate a return on their cash balances.

The halal market and social responsibility
The Managing Director of Al Islami said that Islamic branding is a "myth" at a halal market conference in Brunei. The point being made was that the halal brand--the certification--was important but without a quality product, it is not likely to succeed. The point was expanded by Shahed Amanullah, the founder of Halal Media, as a way to expand the market to non-Muslims as well either from incorporating organic and socially responsible halal certifications in food and through social responsibility in the broader marketplace so that "non-Muslims can see Muslims promoting halal values which includes social responsibility, stewardship of the earth and economic justice". I think that this is an often understated point. Although Islamic products, particularly in the financial world, were created to cater to Muslims' needs, they do not need to remain constrained to just Muslims. However, to reach out to non-Muslims, incorporating other shared ethical values and leverage the success of sustainable finance to expand the potential market for Islamic financial products.

Other News

• Hussain Hamad Hassan said it was "not a far-fetched reality" for a Gulf-wide Shari'ah board to be in place by 2013.
  
• Gulf Finance House continues to restructure its debts. In May, Mohammed Khnifer, Aatef Baig and Frank Winkler released an article called "The Rise and Fall of Gulf Finance House", which analyzes the pre-crisis years and how they might have led to GFH's current problems.
  
• Cagamas Bhd, the Malaysian national housing company, may issue up to RM1 billion ($303 million) in sukuk that are designed to be acceptable in Malaysia and the GCC.
  
• The Shari'ah-compliant non-bank financial company being established in the Indian state of Kerala has received significant interest from GCC- and Indian-based institutions (Doha Bank and Reliance Capital, respectively), although the government has said it will not sell more than 20% of the NBFC to any single investor.
  
• The Islamic Bank of Thailand became a major shareholder of a Thai leasing company, Nava Leasing Plc, in which it will own 49%.
  
• A Malaysia law firm has released a booklet in Australia to explain commonly misunderstood aspects of Islamic finance among Muslims as well as non-Muslims. The headline writers, of course, took the most sensationalistic topic titling the article: "Islamic finance not jihad".
  

Takaful shortfalls, Islamic money markets, Shari'ah scholars

Takaful
Reuters has a fascinating article about takaful and specifically what happens if the policy holders' pool is in deficit. The article highlights a discrepancy between the regulatory view and the Shari'ah view. The regulatory view says that the shareholders of the takaful provider should be responsible for shortfalls (through a letter of guarantee for any shortfall) and the policyholders should benefit from the gain on any investments financed by the shareholders' funds. However, the Shari'ah view, as articulated in the article, says that policy holders should contribute to finance any shortfall and if there is a letter of guarantee but no cash drawn, the shareholders should receive the benefit. This is an issue that I had not spent much time thinking about, although I have acknowledged that the lack of sukuk and other fixed income products have made a shortfall more likely because the funds contributed by policy holders are invested in riskier assets than the premiums paid into conventional insurers (which are typically invested in bonds). There are no specific examples mentioned, which increases the risk to takaful companies and policy holders without significant experience where shortfalls are actually experienced and managed. However, based on the general trend for Islamic financial products to mirror conventional products, I think it is extremely unlikely that policy holders would be forced to make additional contributions to cover a shortfall.

Islamic finance needs money market to grow
Bloomberg has an article with several interesting comments from Mohamad Nedal Alchaar, secretary-general of AAOIFI. In addition to his comments about the need for more Shari'ah-compliant money market products to facilitate better liquidity management, he warned about "overexposure" to a single industry by Islamic financial institutions. His call is welcome given the fallout from the global financial crisis and property boom and bust in parts of the GCC, and it adds to the recognition that Islamic finance was hurt by the global financial crisis but this damage was accentuated by a concentration of investments in a few industries. He also warned that if there is not more done to create a more transparent forum for Shari'ah scholars to reach consensus from an industry body on products where there are no existing fatawa, the industry would remain dependent on a "fatwa-by-fatwa basis". While it is not surprising to hear the head of a standard setting body call for Shari'ah standards to involve an industry body, his point could strike a healthy balance between individual institutions being able to develop new products if their Shari'ah boards approve and the need for greater consensus among scholars through a central forum without requiring what could become rigid standardized fatawa.

Shari'ah scholars
Another article on the development of a younger group of Shari'ah scholars includes a profile of Taha Abdul-Basser, a scholar and the Muslim chaplain at Harvard University. Congratulations to him for being recognized and profiled as one of the prominent younger Shari'ah scholars who will be responsible for continuing the growth in Islamic finance that the senior scholars helped create during the past 35 years.

Other News

• Qatar issued its first local-currency bond of the year yielding 6.5% and sukuk of the year with a $2.75 billion issue split evenly between a conventional bond subscribed by five conventional banks and sukuk, which was purchased by four Islamic banks.
  
• A firm with links in the Middle East is planning to launch an Islamic REIT in Singapore. There is currently one Islamic REIT in Singapore and plans for another later this year.
  
• Four mostly state-owned companies in Abu Dhabi are cooperating to launch a takaful company in the Emirate.
  
• Tabreed, the National Cooling Company in Dubai which missed a payment on its sukuk, may sell conventional or Islamic debt as a part of its recapitalization program.
  
• A Malaysian firm is planning an Islamic gold ETF in the country. There is currently only one Islamic gold ETF, the Dubai Gold Securities. In addition, companies like Bullion Management Group in Canada offer a gold bullion fund that is Shari'ah-compliant.
  
• The CIS has potential for Islamic finance, but there is little legislation in place that enables Islamic finance, according to a summary of a conference in Moscow written by Mushtak Parker in Arab News.
  
• Indonesian sukuk issuance is expected to rise 10-20% compared to last year according to the CEO of HSBC Amanah, Mukhtar Hussain. He said that the Asian economies have had a limited impact from the European debt crisis. Sukuk issuance was $23.3 billion in 2009, which was lower than the peak of $34.3 billion issued in 2007 according to Standard & Poor's.
  
• The Central Bank of Bahrain short-term sukuk al-salam issue was oversubscribed by over 400 percent. The sukuk matures in 91 days and has an expected return of 0.85%.
  
• Khaleej Times has an article on Islamic finance business education.
  

Tuesday news bullets

• Rushdi Siddiqui opines on the possibility for a World Cup or Olympics sukuk in the future as a few countries in the GCC are considering bids to host the competitions.
  
• DBS Group is shrinking its Singapore-based Islamic unit which Reuters attributes to a struggling effort by Singapore to attract Islamic finance.
  
• A report from Ernst & Young about Islamic funds found that the segment of the industry stagnated. There were four articles with slightly different takes on the report including the press release from E&Y. The other articles were from Emirates Business 24/7, Reuters and Gulf Times.
  
• There are fresh concerns that Islamic finance has too few well-known Shari'ah scholars.
  
• The Global Head of Islamic Markets at Bursa Malaysia recently said at a conference that Islamic finance needs to develop a more diverse set of investment products to cater to investors with different investment needs.
  
• Kenya's central bank may allow Islamic financial products in the country two years after the first Islamic bank in the country was licensed.
  
• The Cagamas sukuk being developed with Al Rajhi Bank will be for $3.02 billion and will be structured to be acceptable in the Middle East as well as in Malaysia.
  
• Indonesia's latest auction of sukuk had no winning bidders as the finance ministry rejected the 1.2 trillion rupiah ($130 million) in bids.
  
• Bahrain's Islamic finance industry is recovering in spite of the worries around the Greek debt crisis, although it could affect sukuk issuance through the first three quarters of 2010, according to Nida Raza of Unicorn Invesment Bank. Another article describes the Islamic banking market in the UAE including their use of e-banking.
  
• It appears that the structured product market in Islamic finance is returning with another, offered by Dubai Islamic Bank, that returns 88% of capital after two months but pays profits on the full amount invested based on the performance of the Middle Eastern markets.
  
• The Association of Islamic Banking Institutions Malaysia believes that the country has exceeded the 20% target for the market share of Islamic finance this year. The new banking licenses for foreign banks are expected to be announced although the two new Islamic banking licenses may be delayed.
  
• The GCC represents 70.4% of the global takaful market.
  
• An article in Arab News expresses hope that the growth in the number of conferences on Islamic finance in the Commonwealth of Independent States (CIS) reveals a potential growth area for the industry.
  
• Islamic finance in the UK will not be negatively affected by the change in government according to a delegation from the Muslim Council of Britain to the World Islamic Economic Forum in Malaysia. The Bank of London & the Middle East is planning an absolute return fund that "it is in no way a hedge fund". The BLME launched a money market fund last year that has returned 0.30% compared to an expectation of 1.00% which it expects to reeturn once yields 'normalize'.
  
• The Malaysian retail 1Malaysia sukuk has received a 'lukewarm' response.
  

Rushdi Siddiqui interviews four scholars, sukuk update

First, thank you to those who have responded with feedback about a possible email newsletter of blog postings (and maybe other commentary). I would appreciate any other feedback, either as a comment to this post or in an email to blake@sharingrisk.org.

I think that Rushdi Siddiqui's latest article, an interview with four prominent Shari'ah scholars, Dr. Hussain Hamid Hassan, Dr. Mohammad Daud Bakar, Yousuf Talal DeLorenzo and Dr. Mohammad Akram Laldin is one of the most important articles for everyone interested in Islamic finance to read. It contains insights into how Shari'ah scholars see their role, the role of Shari'ah governance and the integration of younger less well-known scholars into the Shari'ah advisory role. It contains the most candid reflections of Shari'ah scholars that I have seen published about their own role both as advisors to Islamic financial institutions and as teachers and mentors of the Shari'ah scholars who will someday fill their shoes.

There is a good chunk of news about sukuk from the last couple days. The forward looking news starts with a $1.9 billion sukuk issued by Saudi Electric Company, which was issued at 95 basis points over SIBOR. As I wrote about in July 2009, the last sukuk from SEC was at a significant premium (160 bps over SIBOR) compared to it's (pre-crisis) sukuk issuance which was priced at 45 bps over SIBOR. The current sukuk is still at a premium to its 2007 sukuk, but by a far smaller margin. The shrinking yield premium for highly-rated issuers could lead to other non-high-grade corporate issuers to re-enter the sukuk market. The last estimate I have seen of the sukuk pipeline (sukuk planned but not issued) from Standard & Poor's was $50 billion, which likely includes lower rated corporates waiting for yield spreads for new issuance to decline.

Issues of sovereign sukuk, both domestically and internationally, remains active with Malaysia issuing a three-year, $311 million (MYR 3 billion) Sukuk 1Malaysia 2010 for domestic investors. In the wake of the Greek debt crisis, Indonesia is trimming but not cancelling the sukuk issuance expected in June or July of this year, but reiterated guidance that it would be a "benchmark" size, which typically means at least $500 million. The previous announcement was that the sukuk would be for $750 million. The Dubai Multi Commodities Centre just redeemed its $200 million, five-year sukuk issued in May 2005 with a final $20 million repayment. The certificateholders of Nakheel's $980 million Nakheel Development 2 sukuk have been told informally that the sukuk will be repaid on time. The funds necessary to repay the sukuk are reported to have been provided by the Dubai Financial Support Fund. This could spark some controversy among other Dubai World subsidiaries' creditors groups who have not yet finalized a debt restructuring which could see the other debt maturities extended and a 1% interest rate paid to creditors.

An article tackling the oft-debated issue of standardization in Islamic finance provides a very interesting view on the issue and what the current issues raised by tawarruq and the TID v. Blom Bank case. Reuters adds a factbox about the regulation of Islamic finance globally.

PricewaterhouseCoopers raises the issue, likely to confront Asian issuers of sukuk, about whether the illiquidity (and possible fluctuations) in their currencies will hamper the development of their Islamic finance appeal outside of the region. The issue has been confronted to some degree with Indonesia's dollar-denominated global sukuk issue last year and talk about a 10-year Malaysian dollar-denominated sukuk. There should remain a focus on developing domestic markets for Islamic finance, particularly within Indonesia where Islamic finance remains less developed. However, the internationalization of Islamic finance within Southeast Asia (and potentially South Korea, Japan and China) will strengthen the industry as a whole by providing additional geographical diversification for investors in dollar (and euro and pound and yen) denominated sukuk.