COLUMN-Is Islamic Finance a Failure? An Assessment -Oliver Agha

Fri Jan 27, 2012 1:13pm EST

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-- Oliver Agha, founding Partner of Agha & Co, a shari'ah-compliant law firm based in the United Arab Emirates (, is a board member of the Accounting and Auditing Organisation for Islamic Financial Institutions, and secretary general of the World Islamic Finance Institute, a body created to develop best practice in the industry.

Islamic finance, a faith-based system of ethical finance, is growing while it continues to struggle for its identity; it is torn between the market success of emulating conventional structures and developing genuinely Islamic structures that reflect its spiritual ethos. This article reveals the struggle and highlights the endemic and extraneous pressures that threaten Islamic finance -- and then notes specific remedial actions that must be taken for its redemption.

The Islamic finance industry is reported to be valued at over $1 trillion, with an estimated annual growth rate of 10 percent (Global Islamic Finance Report, 34 (Humayon Dar et al eds., BMB Islamic ed. 2011)). The industry is continuing to grow despite its inherent problems, and some market analysts project it will be valued at anywhere from $3 to $5 trillion by 2016.

Islamic finance should serve as a stabilising force in the global economic order because deposits in Islamic banks (which are not loans but true investment deposits on a mudaraba basis) are reinvested in the real economy for goods/services without any artificial money expansion. In the conventional system, banks increase credit in good times on the fractional reserve banking system principle -- for each dollar deposited (loaned) to a bank, the bank may loan out many more. The "choking" of such credit, in a downturn, can wreak havoc as evidenced by the financial crises, and therefore the equity-based constructs inherent in the Islamic system are likely to serve as a stable pillar of the economic system particularly in these times.

While the spiritual precepts behind Islamic finance espouse risk sharing and partnerships, many products in the market reflect risk profiles of conventional structures. As disputes in such products/structures develop, the judgments (if out of line with Shari'ah precepts in the absence of regulatory and legal frameworks) could threaten the future of the industry. From where we sit, stakeholders need reliability and clarity on laws governing the Islamic finance industry and adjudication of their disputes; in the absence of such clarity the industry will suffer from structural problems risking an exodus.

This article is written, while uncompromisingly, with the intention to have the governmental authorities and stakeholders take serious notice of the issues and address them comprehensively through considered and comprehensive legislation while the industry is still in a nascent stage -- a stitch in time will save nine. It is also a call to all to push for an alignment for the industry with its spiritual core -- not focusing merely on market success. The article ought to be read with this background in mind.

Today, Islamic finance is beset with problems including those relating to credibility, regulatory, enforceability, uniformity (including Shari'ah issues), lack of scholarship/training and being fundamentally out of sync with its spiritual and ethical mandate.

More often than not, people have said to me, "Islamic finance is a sham." They don't see the difference between Islamic banking and conventional banking and cannot differentiate between conventional and Islamic products. Some of this criticism is unfair and due to a lack of understanding of the difference in the actual risk profiles between the two (e.g. in an Islamic ijara project/property finance transaction, the financier assumes the risk of loss of the asset, which is markedly different than a conventional mortgage situation where the mortgagee (bank), as lender rather than owner, does not assume such risk of loss). However, in other products such criticism is warranted. A case in point is the term "Islamic bond" -- this oxymoron, used so commonly by practitioners and the media, suggests Islamic finance can offer a debt instrument that generates an interest-based return -- a complete absurdity. A study of some market sukuk structures, however, reveals the term "Islamic bond" is correctly applied to such "market" structures (for greater detail on sukuk structures and "defaults", please see Oliver Agha et al, Sukuk: Default or No Default?, Credit: The Magazine for Bond Investors, Jan. 2010).

Some of the structures relied upon to solve the "problem" of "uncertainty" in an insurance transaction are a prime example of fundamentally unenforceable structures. To obviate the uncertainty (lack of knowledge of the actual date of occurrence of a risk of loss) in an insurance transaction, structures were devised where the premium payer "gifts" the premium (with no expectation of return) to the credit of the takaful fund and then the takaful fund (while having no obligation to pay) "gifts" back the proceeds (assuming enough of a balance remains in the fund) upon the occurrence of an event of loss. This way the parties are just making the gifts and "not really getting into a contract". But they are and expect it to serve as an enforceable obligation! However, based on Shari'ah precepts, once a gift is made there can be no expectation of a return. Thus, the entire construct is built on a false premise and the contract is invalid (this excludes those contracts where conditional contributions are made to a pooling arrangement). This sort of circumvention (hila), by making two unilateral "gifts", effects the seemingly proscribed transaction through a sham arrangement. Ironically, the "uncertainty" inherent in such transactions is not even of the proscribed type (Oliver Agha, Tabarru in Takaful: Helpful Innovation or Unnecessary Complication? 9 UCLA J. Islamic & Near E.L. 101 (2010)).

Such constructs demean the Islamic finance industry and spur the hackneyed adage that "Islamic finance is a sham." In truth, there is substantive basis for the development of Islamic insurance (which should be based on mutual arrangements and a commitment to refund premia on certain events upon non-occurrence of events of loss).

Legal and regulatory frameworks in countries are generally severely deficient (with some exceptions e.g. Malaysia and Pakistan) and do not provide a framework for the fluidity required for efficacious transactions; nor does the system envisage the requisite Islamic procedures/laws/dispute resolution systems -- Islamic finance is not understood and in some instances (and in Islamic jurisdictions) is not even treated on a par with conventional finance.

More needs to be done at the governmental levels, including formulating legal and regulatory frameworks that (i) delineate standards applicable to the products/constructs in the industry (AAOIFI guidelines are helpful though not necessarily dispositive, and in some areas need review and revision to reflect consistency and cogency); (ii) develop substantive laws on property/real estate transactions that detail the rights and obligations of Islamic financier vs. developer vs. customer (clearly mortgage laws have little application in an Islamic ijara financing as the financier/property owner cannot properly be granted a mortgage on property that it owns); (iii) otherwise "level" the playing field between conventional and Islamic banking (e.g. reduce transfer fees in Islamic banking that need to occur twice, where in conventional banking there is just one property transfer); and (iv) simultaneously address the issue of transactions that have Shari'ah Board approval but are in stark contravention of the law of the country (e.g. beneficial ownership is not dispositive while registered ownership is when pursuing a defaulting customer).

Not surprisingly, the relevant authorities have little understanding of how to handle Islamic disputes -- in some instances authorities have sent ijara disputes to rent committees to sort out. This completely misses the picture, as the underlying transaction requires careful consideration as an overall Islamic lease to purchase transaction with a fine understanding of the other elements that such a transaction contain, including complex (and sometimes tenuous) purchase undertakings and in some cases, deeply problematic "forward lease constructs" that are neither forward leases nor necessarily enforceable from a Shari'ah or a legal perspective. Nor is there much consideration of how courts will manage liquidations of Islamic banks -- in particular the treatment allotted to unrestricted investors vs. shareholders.

Our experience in litigating complex Islamic transactions reveals that judges may be at a loss to properly adjudicate complex modern-day Islamic transactions. As a result, there is confusion among Islamic financiers, consumers and other stakeholders about exactly what they can expect in court when things turn sour. This in turn does not augur well for the development of the Islamic finance industry, if left unchecked.

Assuming there is a judicial system that is capable of dealing with Islamic disputes/arbitrations, there are a host of complex enforceability issues at play in Islamic transactions that seem to be lost on issuers and banks and more importantly not highlighted to consumers.

A case in point is a deal where parties elected to subject English law to "Shari'ah" in a contract as per their agreement. In other words, the Islamic instrument was to be enforced in accordance with English law, but always in accordance with applicable Islamic law precepts. However, English courts in such a situation have not applied Shari'ah because it was deemed not to be a governing body of law but a mere embodiment of Islamic religious principles. In the Shamil Bank case, the court noted that the Rome Convention 1980, scheduled to the Contracts (Applicable Law) Act 1990, only contemplated and sanctioned the choice of the law of a country, not a religious principle. Furthermore, the court held that "the reference to Shari'ah law was repugnant to the choice of English law and could not sensibly be given effect to." One can surmise then that when extraneous law is clear and specified, it will still not be applicable if there is a conflict with English Law.

Given such pronouncements, Islamic jurists will invariably revisit English judgments on a "de novo" basis to determine whether there is genuine compliance with Shari'ah principles. Had this critical nuance regarding the impact of conflict of laws (in of itself a highly complex subject) been highlighted to the scholars when such deals were being approved, I am sure such structures would never have been sanctioned in the first place.

The lack of standardisation in Islamic finance creates confusion across the world over the dependability of structures and consistent application of principles. While AAOFI, IFSB and World Islamic Finance Institute are Islamic bodies that work on developing standards, uniformity and developing communications among stakeholders, there is much work to be done on a faster track and with a deeper involvement of the stakeholders from different realms of the industry. There is, unfortunately, a lack of an overall vision and such disparate endeavors lack a cohesive, cogent and comprehensive approach to tackle the key issues facing the industry. Closer coordination must occur between these bodies and a comprehensive approach developed.

Shari'ah scholars have largely done well in handling the inexorable demands placed on them and heavy pressure to yield to structures that are cleverly crafted to appear compliant but lack substantive compliance. However, they need to make some clear strides in certain areas. Their opinions need to be published and clearly set forth with their legal reasoning. Individual diktats that lack basis in Islamic law must be questioned -- the doctrine of necessity, which was used sparingly and mostly in life and death situations (e.g. permissibility to eat pork to survive if starving), is not appropriate to sanction instruments that serve economic convenience and would never independently be acceptable under Shari'ah. The fee arrangements under which the scholars operate need to be transparent to avoid any suggestion of undue compensation or perception of conflict of interest. There needs to be consistency in methodology and approach and acknowledgement of precedent; the hackneyed phrase that "Shari'ah does not acknowledge precedent" is overly simplistic. Islamic Law simply gives the judge greater discretion in determining whether to apply a previous judgment, based on a broad consideration of whether there are any different factors present in the current case. When an Islamic judge (Qadi) applies analogical reasoning (Qiyas) and reviews an earlier case, the earlier ruling is applied if the underlying cause ('illa) of the old case is present in the one before the court. A judge is not bound to blindly apply precedent, but it would be very unusual for a judge to disregard precedent capriciously and without any ameliorating circumstances.

There is a dearth of human capital in the Islamic finance industry. At the core, there are few western-style Islamic institutions that attract and educate the best and brightest in the Islamic world. Generally, many lawyers practicing as Islamic finance lawyers have little knowledge of Islamic law and have just worked on a subset of transactions without an independent study of the core sources of Islam or Islamic law. Imagine a securities lawyer practicing securities law in the U.S. without having read the securities acts, or a tax lawyer who has never studied the tax code!

Conventional bankers largely seem enthused about the market opportunity which exists, but in most cases without a due appreciation for the spiritual principles that underlie Islamic finance. When you go through the challenges confronting the Islamic finance market, it is a wonder that it has survived at all; in fact, it continues to grow despite the endemic and extraneous pressures. Islamic finance has survived and grown despite the mistakes/inadequacies of stakeholders/practitioners.

The solutions are relatively simple to enumerate -- but harder to implement:

-- The Islamic world needs visionaries that take on the mantle of ethical finance and seek to develop it along the lines originally intended i.e. a spiritual system of finance that builds partnership and risk-sharing constructs rather than exploitative or adversarial contracts which leave no room for accommodation in a downturn. There is a crying need for prominent magnates to show that money can be made (and success achieved) in this world while preserving spiritual principles.

-- Governments need to establish Islamic finance task forces in their countries to critically assess the state of Islamic finance; such groups need to comprehensively review regulatory and legal structures, promulgate laws that fill in gaps, and create proper dispute-resolution centers.

-- Governments need to devote significant amounts of funds to developing fine institutions that offer Harvard-, Yale- or Oxford-style educations and train sophisticated and integrated Islamic jurists as well as financiers, lawyers and accountants.

-- Conventional dispute resolution centers need to be recalibrated to handle Islamic disputes -- with a rework of the applicable rules/procedures.

-- Corporations, Islamic banks and insurers need to reflect best practices as suggested by AAOIFI, by having at least three scholars on their boards as well as a financial advisor and a lawyer who is well versed in Shari'ah. Otherwise, opinions/fatwas may reflect problematic gaps.

-- As importantly, individual consumers need to examine what they are offered and ask questions if anything seems to be in basic conflict with Shari'ah principles. Islamic finance is not rocket science; it is a simple discipline made unnecessarily complicated, sometimes to achieve impermissible ends. Consumers should make their opinions known and write to Islamic banks and institutions in an effort to help develop the industry, and failing that to the quasi-regulatory bodies mentioned above.

Perhaps the greatest philosopher in Islamic history, Ghazali, noted when asked about his quest to discern truth from error:

(M)y daring in mounting from the lowland of servile conformism to the highland of independent investigation...what I found loathsome among the methods of the devotees of ta'lim, who restrict the truth to uncritical acceptance of the Imam's pronouncements...what I seek is knowledge of the true meaning of things...sure and certain knowledge is that in which the thing known is made so manifest that no doubt clings to it, nor is it accompanied by the possibility of error and deception, nor can the mind even suppose a possibility. (Abu Hamid Muhammad al-Ghazali, Al-Ghazali's Path to Sufism 17-20 (R.J. McCarthy trans., Fons Vitae 2000)).

So, is Islamic finance a failure? No; it is never fair to blame a discipline for the failures and shortcomings of its adherents. However, for it to continue to grow in a correct way, it must come back to its spiritual underpinnings best reflected by the motto: "Principle before Profit".


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