-- Oliver Agha, founding Partner of Agha & Co, a
shari'ah-compliant law firm based in the United Arab Emirates
(www.aghaandco.com), 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
-- 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
(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".