Mohammad Daud Bakar, a Malaysian sharia scholar

Cross-border standardisation and rigorous product development processes will help to diversify the sharia-compliant financial markets. Writer Philip Alexander

The November 2009 debut sukuk (Islamic notes) issue by US utility giant General Electric, one of the world's largest companies and most recognised capital market brands, emphasised the extent to which Islamic finance is going global. But the market share of sharia-compliant wholesale products remains small.

Cross-border sukuk issuance in 2009 was equivalent to just under 10% of total emerging market bond issuance, according to Commerzbank data, and a far smaller proportion of the total bond market. Islamic financing packages for merger and acquisition (M&A) activity are relatively rare, while sharia-compliant investment funds total just $35bn, according to financial advisory firm Ernst & Young.

This should come as no surprise, given that the modern Islamic finance market is still in its first decade. Nonetheless, the challenges of reducing time-to-market and all-in product development costs, together with broadening a fragmented investor base, should not be understated. In particular, to increase the speed and efficiency of Islamic financial markets, it is vital to make the process of sharia compliance itself a smooth part of the issuance cycle.

This also raises the much-discussed question of standardising or harmonising sharia compliance across markets and jurisdictions. Mohammad Daud Bakar, a Malaysian sharia scholar who has served on numerous sharia supervisory boards, including those of his country's central bank and of BNP Paribas Islamic finance unit Najmah, emphasises that no scholar can invalidate the fatwa (ruling) of another scholar. Once a product is declared sharia-compliant by a supervisory board, it remains so.

But different investors will follow the views of different scholars and invest accordingly. This leaves international issuers with a dilemma in terms of how to maintain a large enough sharia-compliant investor pool.

Industry standards

The Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and Malaysia-based Islamic Financial Services Board are both seeking to establish international standards, but their relationship with other authorities is not formalised. Bahrain has made AAOIFI standards compulsory; other jurisdictions only advocate them as best practice.

"In addition to working with Islamic financial institutions themselves, AAOIFI also seeks to work with national regulators to achieve full adoption of the standards," says Mohammed Nedal Alchaar, secretary-general of AAOIFI. He feels it is vital for the integrity of the industry to broaden the adoption of AAOIFI standards so banks can demonstrate clearly to their clients that they meet their sharia obligations.

Dawood Ahmedji, European head of Islamic finance at Deloitte, says it will take "some time" for a truly standardised industry to emerge, but adds: "Is there a driver from the industry itself to standardise? Clearly there is, to mitigate the risks of being out on a limb and facing criticism after the event."

Deloitte now offers clients a sharia equivalent of a regular capital markets roadshow, presenting to key sharia scholars who are important for the investor base. "We see the industry increasingly having a self-disciplining effect - although their own sharia board may have signed off on something, it is in the interest of an issuer to check if it is in line with the market and other scholars' views," says Mr Ahmedji.

For this reason, Afaq Khan, CEO of Standard Chartered Saadiq, suggests the harmonisation question should not be exaggerated. Market forces already encourage structurers to devise products with the widest possible investor audience.

"There is a need to standardise in a broader sense, to reduce time to market. But individually, because these transactions are distributed to other Islamic banks, their sharia boards also look at the documentation and approve it. Every transaction has gone through maybe 30 sharia boards by the time it reaches the market," says Mr Khan.

Richard Thomas, CEO at UK Islamic investment bank Gatehouse, says establishing greater uniformity in the treatment of Islamic finance under national laws - especially tax laws - is often more of a challenge than standardising the scholars' fatwas themselves.

"In some countries, the basic commodity murabaha instrument Islamic financial institutions have largely standardised is treated as a sale and purchase for tax purposes, incurring capital gains tax in a way a regular financing would not. That means there is no level playing field between Islamic and conventional finance," says Mr Thomas.

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Muhammed Shikder, head of sharia advisory, Gatehouse

Well-integrated scholars

Deciding when and how to involve scholars in the product design process is essential. There is a consensus that, as scholars attain deeper understanding of more complex financial instruments, it is possible and desirable to bring them in at an early stage.

"If it is a new product in the market, the bank should engage the scholars from the first day. This is very much encouraged because it can not only save the time and cost of having to go back and prepare the product again, but can also make the sharia compliance more refined," says Mr Bakar.

Natalie Schoon, head of product development for Bank of London and the Middle East, says that her bank's staff tend to examine first if a transaction is financially possible, then to consider in house what the sharia challenges will be. "After that, we send or present a brief write-up to the sharia board with our suggested approach and some alternatives. There is a discussion around those and a decision about the way to go, although that may of course change over time. It's a very co-operative process," she says.

Consulting early does raise the question of whether to return to the sharia board if the transaction is subsequently altered to suit the needs of the client. According to Mannan Mansoor, head of the central sharia group at HSBC Amanah: "The litmus test for whether a product needs to be referred back to the sharia committee during its development is whether a change relates to structural aspects of the product or not."

Monitoring duties

Even after a product is launched, the sharia board has to monitor the use of its fatwa in the marketplace. This has become a particularly significant topic since the Organisation of the Islamic Conference (OIC) Fiqh Council, one of the highest authorities on Islamic jurisprudence, warned in early 2009 about the reverse tawarruq structure.

This is a deferred payment purchase and sale (usually of commodities), which many Islamic banks have been using to create short-term money market instruments. The OIC Fiqh meeting suggested that, in many cases, it had become too close to conventional borrowing with interest.

"The feedback was not so much around the principles as around implementation. The sharia board had signed off on something but the bank had not delivered quite what was approved. The criticism was about how reverse tawarruq was being applied in practice, so the Fiqh Council and AAOIFI reminded sharia boards that they had ongoing post-sign-off monitoring responsibilities," says Mr Ahmedji.

In the current economic environment, the leverage ratio of a company to which sharia-compliant investors are exposed could exceed the limits set by most scholars - usually 30% to 35%. This could affect equity investors or those providing sharia-compliant financing in an M&A transaction.

"With the majority of the sharia boards, if there is a good reason why this [breach] has occurred, and you have reason to believe the deal will come back into compliance... they will typically request higher monitoring of the client, but will let the transaction stand for a while. If you look at underlying Islamic principles, it would be very bad to say 'I want my money back' just because the client has fallen on hard times," says Ms Schoon.

Deeper Sharia principles

Increasingly, Islamic financial institutions are looking beyond the purely structural aspects of a transaction to fit deals and investment funds into the general concept of using finance to promote virtuous commercial activity and practices.

Gatehouse Bank teamed up with conventional fund manager Sustainable Asset Management to structure a sharia-compliant fund investing in companies and projects related to supplying clean water. Muhammed Shikder, head of sharia advisory at Gatehouse and a member of its sharia supervisory board, explains that this will have a deep appeal to investors seeking a product in tune with their religious principles.

"The Prophet Muhammad encouraged able people to construct a well so that the poor who do not have regular access to water can benefit from it," says Mr Shikder.

In its new set of standards published at the start of 2010, AAOIFI laid out in detail the ways in which Islamic finance should embrace the general concept of corporate social responsibility (CSR). Mr Alchaar says the new standard provides guidance on recommended conduct, including areas such as the social and environmental impact of Islamic project finance transactions.

AAOIFI's Mr Alchaar says: "CSR is already developed in Islamic finance, and with the issuance of the standard, it is hoped Islamic financial institutions will be able to enhance their CSR activities even more - and improve the way this is carried out and reported."

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