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Despite its substantial growth in recent years,Islamic banking is facing challenges when itcomes to deeper global market penetration.The solution, say these authors, is moreconsistency and harmonization.

Living inperfectharmony

Islamic banking

16 | Deloitte | A Middle East Point of View | Fall 2015

The growth of Islamic banking has outstripped that ofconventional banking in recent years with total Islamicbanking assets crossing the US$1.5 trillion mark in 2013.The widely held expectation that this superior growthrecord will continue is understandable given thatapproximately one-sixth of the world’s population isMuslim–most of which is based in the Middle East andAsia. Taking note of the demand, a number of westerncountries have recently started allowing Islamic banks tooperate in their respective jurisdictions. The UK becamethe first leading western country to issue a governmentSukuk (Islamic bond.) The first full-fledged Islamic bankin Germany was launched earlier this year; whileJapanese regulators are considering issuing regulationsthat will allow Japanese banks to provide Islamic financeproducts in Japan.

Yet, despite the increased interest, Islamic bankingpenetration in non-Muslim countries has been slow asIslamic banks find it difficult to expand into differentjurisdictions and face regulatory and Shari’acomplications in terms of approvals. Islamic banks arealso finding it challenging to cope with the evolvingglobal banking environment and making appropriaterules and regulations to cope with these changes whilestill remaining competitive with their conventionalcounterparts. Additionally, the industry lacks consistencyin product structures and investment practices thatadversely affects its credibility, reputation, perceptionand regulation capabilities.

The challengeIslamic banks are essentially governed by their Shari’aboards–the religious scholars that deem a productShari’a-compliant, or not. But the challenge is that thereis no central authority promulgating Shari’a law, and theunderstanding of what is hence permissible and what is not varies among Islamic scholars and jurisdictions.The rapid growth of Islamic banking over the years has resulted in the introduction of complex bankingproducts and structures, which now require Shari’aharmonization at a global level. At present, thatharmonization is lacking. For example, the Islamiccontract of Tawwaruq or Commodity Murabaha is onlyallowed by certain scholars. Similarly Bai-al-dain, or saleof debt, although disallowed by the majority of Muslimscholars, is allowed by some scholars in Malaysia.Recently a prominent Shari’a scholar concluded thatapproximately 85 percent of Sukuks in the market fallshort of basic Shari’a principles.

While conventional banks have harmonized andapproved regulatory standards that banks around theworld follow, making it easier for them to expand andconduct operations in different countries, there are noapproved standards per se for Islamic banks; they followthe conventional banking regulations.

But because Islamic banking differs from conventionalbanking, it is difficult for Islamic banks to completelyfollow these global conventional standards. Forinstance, the capital structure in Islamic banks isdifferent from that of conventional banks. Because ofthe prohibition of interest, Islamic banks mobilize andutilize funds using Shari’a-compliant instruments orcontracts that are not used by conventional banks andhence their capital structure primarily consists of Tier 1capital only, while only a handful of Islamic banks haveTier 2 capital. Another differentiation between the twobanking models is the bank’s ownership of the asset: inIslamic banking contracts like Murabaha, Islamic bankshave to own the asset for a period of time, a practicethat is not required in conventional banking practices.

The challenge is that there is no centralauthority promulgating Shari’a law, andthe understanding of what is hencepermissible and what is not varies amongIslamic scholars and jurisdictions

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Industry responseThe industry realizes this challenge and certain countriesand governments have fostered the development of theIslamic banking sector. Countries like Malaysia, Bahrain,and Oman have developed separate legal and regulatoryframeworks for Islamic banks to follow, while Qatar hasaimed to separate Islamic banking from conventionalbanking by banning Islamic windows withinconventional branches in the country. Other countries,like the United Arab Emirates (UAE) and Turkey, havebeen focusing on promoting the Islamic bankingindustry and are becoming centers of excellence. Yetdespite these improvements, these countries have beenworking in isolation rather than collectively to addressthese issues. As a result, the industry still lacks a clearstrategy and direction to help achieve its potential.

Nevertheless, the industry has taken certain steps; theIslamic Development Bank (IDB) recently echoed theneed for a Global Shari’a advisory board that offersgreater uniformity to the Islamic finance industry. Also,the Association of Shari’a Advisors in Islamic Finance(ASAS) was officially registered in 2011 with theobjective of establishing a global entity to ensureprofessionalism among Shari’a advisors and experts in Islamic Finance. The aim of the Association is to“develop Malaysia as a reference center for Islamicfinancial transactions” and the country is working on the development of human capital in Islamic financeand is establishing the necessary Shari’a, legal,regulatory and supervisory frameworks. The success of such associations will rest heavily on individualgovernments and local regulators to enforce thestandards within their jurisdictions.

ConclusionIt is imperative for the Islamic banking industry to focuson the development of products that foster marketintegration and attract investors and entrepreneurs tothe risk-return characteristics of the product rather thanconcentrating only on its Shari’a compliance. Islamicbanks need to invest in the research and thedevelopment of new products that are acceptable by a“Global Shari’a Board.” At the moment, there is a

dilemma as Shari’a opinion is diversified, leading tosituations where one school of thought may approve aproduct or service as being Shari’a-compliant only for itto be rejected by another school of thought. A big steptowards achieving harmony would be to set up a centralboard at a global level with representation from alldifferent schools of thought.

For harmonizing standards and structures, the industrydoes encourage ijtihad in the global community through international conferences and convocations.Organizations such as the Islamic Financial ServicesBoard (IFSB) and the Accounting and AuditingOrganisations for Islamic Financial Institutions (AAOIFI)have been formed to recommend principles and industry best practices at global levels. However, theseorganizations unfortunately have no binding powers to implement their standards on the industry and theymerely develop recommendations. If Islamic banking is to achieve its potential, it needs to be supported by governments and regulators. Most importantly, all aspects of Shari’a compliance need to be properlydefined; ultimately the harmonization of Shari’acompliance is a critically important component toensuring the stability, which is intrinsic to the Islamicfinance model.

by Bhavin Shah, Director, Forensic, Deloitte CorporateFinance Limited and Saad Qureshi, Manager, Forensic,Deloitte Corporate Finance Limited (regulated by theDubai Financial Services Authority)

The harmonization of Shari’a complianceis a critically important component toensuring the stability, which is intrinsic to the Islamic finance model

Islamic banking