Standard setters
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Emerging Markets

Standard setters

Standardization and uniformity are key to the growth of Islamic finance, capital and money markets

By James Gavin

Regulation has mirrored the geographical development of Islamic finance in its relatively brief modern history. The main regulatory centres have evolved in the two main centres of Islamic financial activity, Bahrain and Malaysia. The key regulatory institutions there reflect the distinct cultures of the two regions they operate in, the Middle East and Asia.

The two prime regulatory institutions are the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), established in 1990, which sets the standard in establishing accounting, auditing and banking practices appropriate to Islamic financial institutions, and Kuala Lumpur’s Islamic Financial Services Board (IFSB), a multilateral body charged with maintaining the stability of Islamic financial services.

A number of smaller agencies assist in the supervision of markets, such as Bahrain’s International Islamic Financial Market (IIFM), founded by the Islamic Development Bank five years ago to develop a primary and secondary market for Islamic financial instruments.

The two main global centres have each evolved regulatory functions that complement the other, rather than compete directly on each other’s turf.  AAOIFI standards for accounting and reporting are similar to international accounting standards, but are tweaked to conform to sharia principles. The IFSB, set up in 2002, aims to build the international financial architecture for Islamic finance, and works in conjunction with other regulatory bodies, to provide guidance on Islamic investment products. The IFSB has established its own Sharia Council, which serves as a central repository of sharia knowledge and advice.

Farmida Bi, partner at law firm DentonWildeSapte in London, says the two bodies have responded to the market’s demand for a firmer regulatory touch. “One of the things they’ve taken on board is the importance the market is placing on conformity.”

But the two bodies face a struggle in evolving common standards for Islamic institutions in an international regulatory framework that has been shaped for conventional, rather than sharia-compliant, products and services. That challenge is made more onerous by the absence of uniformity within Islamic jurisprudence. “The fundamental problem is that there is no supreme body that can give you a definitive analysis or ruling,” Bi tells Emerging Markets.

Different roads

The two centres have pursued different approaches to laying down frameworks for the regulation of Islamic financial sectors. Malaysia, for example, has traditionally held the view that Islamic banks should be subject to a separate regulatory regime from that of conventional banks. Bahrain, on the other hand, has favoured applying the same central bank supervision as for conventional banks, with only slight modifications.

At the national level, regulators in the Middle East and Asia are attempting to provide ground rules for the supervision of Islamic banks and capital markets within their own countries. But the supranational bodies like AAOFI and IFSB are starting to make inroads. Growing numbers of financial players now refer to AAOFI standards, and national authorities in countries as diverse as Saudi Arabia, the UAE and Malaysia are basing their own regulatory system on them.

The IFSB is also trying to forge consensus in key principles on Islamic finance that national authorities can implement in their home countries. These efforts are starting to make headway. “The standards are useful in terms of helping Islamic bankers and lawyers have some reference to the distilled wisdom of Islamic finance,” says Oliver Agha, an Islamic finance specialist at law firm DLA Piper.

On the up

Cross-border regulatory cooperation is on the increase. In April 2007, the Qatar Financial Centre Regulatory Authority and the Dubai Financial Services Authority signed memorandums of understanding (MoUs) with Bank Negara Malaysia (BNM), as part of a plan to establish collaborative relationships with key strategic partners in developing Islamic finance.

These trends may help to overcome the differing interpretations between the Middle East and Asia Pacific. Though the differences tend to be exaggerated, there are significant distinctions. For example, Malaysia’s more liberal interpretation of Islam may jar in conservative Bahrain. “Structures that may find acceptance in Malaysia could find questions raised about their Islamic compliance in the Middle East,” Agha tells Emerging Markets.

The differences also reflect the different challenges facing Islamic institutions in both regions. Under Malaysia’s regulatory model, the national board of sharia scholars sets national guidelines that allow individual scholars on the boards of financial services firms to act as auditors. “They ensure that national auditing guidelines are followed, which means more deals are done. The rate of innovation is also faster,” says Bi.

Though efficient, it might not suit Bahrain. “Malaysia follows a different school, and while the Malaysians are very innovative, they don’t have the levels of liquidity that are available in the Middle East,” says Bi.

Other pretenders

But the emergence of Dubai as an Islamic financial player could change the global equation. The MoU signed between the Qatari and Dubai regulatory bodies and BNM suggests the divisions between the Middle East and Asia Pacific are starting to evaporate.

“There’ve been a number of announcements between Malaysia and Dubai to cooperate and accept the other regulator’s viewpoint on certain issues. There’s more cooperation on the regulatory side, but competition in the financial markets of the Middle East is increasing,” says Michael Gassner, an Islamic finance

consultant.

Malaysia and Bahrain look set to maintain their status as the twin regulatory giants of Islamic finance. Their regulatory agencies are slowly erecting the infrastructure that will underpin market-driven development. Scope for joint initiatives may be limited, but the regulatory nous provided by each should ultimately enable the industry to create the products that will sell across the entire Muslim world – and beyond.

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