Islamic Investor, March 2011
For as long as Islamic finance has been discussed internationally, practitioners have been talking about convergence. No conference is complete without a panel on it; no discussion about global growth in Islamic finance can take place without addressing it. But what does convergence really mean, and how much progress has been made?
The most important distinction to make when talking about convergence is between Shariah opinion, and other standards related to Islamic finance such as regulatory frameworks, tax and accounting treatment. In a nutshell, the first camp will never reach full standardisation, and arguably would be much worse off if it ever did so; the second is where efforts are directed today and where progress is more vital in bringing Islamic finance into the global mainstream.
“We’ve got an opportunity to take Islamic finance to the global stage, and in order to do that we do need to have a great deal more convergence around standards – not just Shariah but tax, legal and accounting,” says Daud Vickery Abdullah, global Islamic finance leader at Deloitte. For Vickery, this means, for example, streamlining Islamic accounting standards in order to dovetail them with International Financial Reporting Standards (IFRS), so that “IFRS understands what Islamic is, and vice versa. There are global standards, everybody understands what they are, and they can accommodate as far as is possible Islamic standards.”
“In order to globalise we need to standardise – but in a rational way,” Vickery says. “Global accounting standards and tax standards: good. More legal definitions and congruence would be good. Greater standardisation on the definition of terminology: what does an ijarah mean, in Malaysia or in Kuwait?”
Several organisations are already involved in trying to make these things happen. Three stand out.
One is the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), a Bahrain-based non-profit body supported by a global institutional membership of 200 members from 45 countries. AAOIFI exists to prepare accounting, auditing, governance, ethics and Shariah standards for the industry, and dates from 1990; its standards have been adopted in Bahrain, the Dubai International Financial Centre, Qatar and several other Middle Eastern and African nations, while some other countries, most notably Malaysia, Indonesia, Pakistan and Saudi Arabia, have issued their own guidelines that closely follow AAOIFI standards. It is a busy organization: its Shari’a Standards 2010 publication contained 41 standards, and its Accounting, Auditing and Governance Standards 2010 report a further 40.
Another is the Islamic Financial Services Board, again a multilateral with widespread participation across the Islamic world, but headquartered in Kuala Lumpur. This is also a standard-setting body, but chiefly concerned with global prudential standards and principles and with a mandate to help promote soundness and stability in the system.
And on the markets side, the key institution for developing standardisation is the Islamic International Financial Market, based in Bahrain and founded collectively by central banks and ministries in Bahrain, Indonesia, Sudan, Labuan (Malaysia), Brunei and the Islamic Development Bank. Its mandate is to standardize Islamic products, documentation and processes.
One could argue IIFM has had the most momentous year of the three. Most practitioners know it for its work around hedging. “What banks need to hedge is currency risk, and fixed to floating [rate risk], because they have mismatches,” says Ijmal Alvi, CEO of IIFM in Bahrain. It achieved a breakthrough in March with the launch of a new master agreement document, called Tahawwut, launched jointly (and crucially so) with the International Swaps and Derivatives Association (ISDA). The document marked the first globally standardized documentation for privately negotiated Islamic hedging products – that is, derivatives such as profit-rate and currency swaps.
There is nothing straightforward about getting something like this to the finish line, and Alvi says it went through 24 drafts as the document passed through industry consultation and Shariah guidance. The endorsement of ISDA, whose conventional master agreement the Tahawwut template closely resembles in structure, was vital in bringing international validation to it. But the work continues, even within this narrow field: IIFM is now working with regulators in jurisdictions around the world to improve the local legal frameworks for hedging products and for close-out netting provisioning, and to develop insolvency laws around the Islamic world accordingly.
Alvi sees that the enabling environment is the key to a market. “With architecture, you create the agreement first, and then you bring the product,” he says. So the next step now is to provide standardising agreements at a product level, around FX forwards and profit-rate swaps, for example, below the overarching Tahawwut framework. As with the master agreement, these documents are going through lengthy consultation both with industry and Shariah advisors; he is reluctant to commit to a timeline beyond “we are trying our best to complete it during 2011, and if we do it earlier it is better for everybody, but we cannot bypass the processes.” When it’s done, he says, “it will provide the whole suite to the industry.” Additionally, banks have to go through their own internal processes with documents, which also takes time.
Alvi and his team continue to work on a host of other standards – in July it launched a paper on I’aadat Al Shira’a, a repo alternative, to help with liquidity management challenges, and it has also been looking at issues around sukuk, although Alvi says they are in too early a stage to be discussed in detail now. But Alvi is also interesting in that he sees that there are limits to beneficial standardisation.
“I often say: we are not supposed to standardise each and every aspect of the industry,” he says. “We are driven by requirements of the industry. It is good to have templates for common kinds of structures, like ijarah. But you cannot put every structure in a standardised form. Each sukuk has certain particular things within it, and within its packaging.”
Another example of, if not convergence, than a common approach to a problem, is the International Islamic Liquidity Management Corporation being built by a collective of Islamic country regulators and central banks, among them Bank Negara Malaysia. “This will issue triple A or double A rated paper, and the shareholders [the countries who back the system] can then nominate any entity within their system to allocate and monetize the assets,” explains Zeti Akhtar Aziz, governor of BNM and one of the drivers behind the new system. “We will have primary dealers identified by shareholders from their financial system, and they will create a market. These instruments will be highly liquid and attractive, and will be issued periodically throughout the year in different reserve currencies.” When interviewed in late October, Zeti said the team had made an offer to a potential CEO and was in the process of “mobilising the team”.
This venture grew out of a financial crisis response in which several groups were tasked to produce a global financial stability report, which generated eight areas within Islamic finance where it was important to put new standards in place. The feeling was that a liquidity framework was so important “we didn’t wait for the report to be finished before we implemented one or two recommendations, and one was the liquidity infrastructure mechanism.” The other was the development of a financial stability board distinct to Islamic finance, “where the regulators discuss possible risks to financial stability in the Islamic financial system.”
Measures like this, by definition, ought to bring a measure of convergence. They demonstrate the industry working together in a way it has never done before; one can argue, in fact, that the financial crisis was the biggest and most important spur towards Islamic financial convergence to date, particularly since Islamic structures fared better than conventional ones in the crisis and now have an opportunity to present more of a case to the financial mainstream.
But that’s all on the prosaic side of regulation, accountancy, tax and law. It’s on the other area, Shariah itself, where things become more complicated.
“Personally, I am not a proponent of Shariah harmonization,” says Raja Teh Maimunah at Bursa Malaysia. “What I would propagate is regulatory harmonization. The world must acknowledge there are two parts to any contract with Islamic banking: one is the legal framework and the other is Shariah compliance. Legal is man’s obligation to another man. Shariah compliance is man’s obligation to God. And a failure to meet your obligations to God does not make your obligation to man invalid.”
It’s a vital distinction, in her view. “In the capital markets, you have a basic framework and then the Shariah compliant elements of it. So with REITs, there can be rules on who the tenants are, how to manage the money – those are things we ought to agree from a regulatory perspective. We can all agree arms and alcohol are not compliant. But in terms of interpretation between contracts, I believe we should allow for differences. It’s OK to have those differences. It provides choice, it gives you options, and it has promoted innovation.”
She cites the recent Islamic RM1 billion debt programme set up by Cagamas, the Malaysian national mortgage company, as an example of this. The deal, lead managed by Saudi Arabia’s Al Rajhi bank, uses a structure called sukuk al-amanah li al-isthithmar, or sukuk ALIm, which incorporates principles of structures such as al-iljarah and al-wakalah in order to make it tradable in more conservative Middle East markets, which are normally off limits to more liberally-structured Malaysian securities. Cagamas itself said the issue was a contribution to harmonization, and it also shows how Shariah differences breed innovation. “They came up with it because their Shariah [advisors] weren’t comfortable with the structures we have in the market,” Maimunah says. “We need diversity.”
But for regulation – that’s different. “The world has gone through a terrible crisis,” she says. “Lots of businesses that survived two world wars did not survive, and we as an industry must come up and make sure we have tightened our practices in risk management, providing liquidity, encouraging cross-border trade. And for that to happen, we need convergence on a regulatory framework.”
Many others agree that diversity of Shariah opinion is a good thing. “I’m firmly of the view that the different schools of thought in Shariah are very good, because they drive discussion and product innovation,” says Vickery. “That should be encouraged and should continue.” But that doesn’t mean there’s nothing to be done. “Where we need to standardise is around the process by which a decision is made. Publish the fatwa, have a database: who was involved? What did they look at? How did they reach their conclusion? A lot of the confusion arises from the fact that you’ve got Shariah scholars sitting on multiple boards, and it appears to the man on the street that they have said yes at Bank A and no at Bank B, but the process of making that decision has not been published.” We could, Vickery says, eventually end up with “a sort of book of common law in place, where people say there was a similar situation and this was the conclusion.”
Zeti argues that, in Malaysia at least, this is already happening. “We have a Shariah advisory board in Bank Negara and when they announce their rulings, it is in great detail, providing the rationale for the ruling,” she says. This, too, might lead to some convergence. “There is discussion on parameters and guidelines, so there will be mutual recognition if they comply with these parameters.”
An important spur for convergence has been that scholars, put simply, talk to each other a lot more. “More international scholars of different backgrounds are on the same panels now, exchanging views and ideas and reaching a kind of common congruence on Shariah,” Vickery says. “They may have differences of opinion, but they’re mainly in a minority.”
Zeti agrees. “Scholars in the Middle East and Asia have been discussing the fundamental differences that exist in different jurisdictions,” she says. “Previously there was no such dialogue so there was no convergence.” Bank Negara allocated around RM200 million of funds to facilitating this dialogue and research. “We believe, with dialogue, we will move to greater convergence.”
It is commonplace to say that most Shariah standards are the same anyway, although it’s interesting how widely this number varies: Vickery talks of scholars saying they agree “90 to 95% of the time”, Zeti says there “has been a convergence on 80% of the issues”, and Maimunah says “from where I stand, the differences are only 5%. 95% of the time, we get along.”
But whatever the true number is, that’s not bad. “The 80/20 rule is a good example,” Vickery says. “If you get 80% agreement you’ve got an international standard, as far as I’m concerned. In the conventional world, if you’re trying to agree on how to account for a derivative transaction, we still haven’t decided how to account and accrue income on it, but 80% of the world has agreed. That is critical mass.”
All these issues are becoming increasingly important as Islamic finance becomes more cross-border. Bankers expect further closeness. “From a commercial standpoint, if you are doing a cross-border deal, then the objective must be to be able to reach out to the maximum pool of investors, and the only way to do that is to go for the standard that will clear the majority,” says Tan Jeh Wuan, managing director of the Islamic Bank of Asia in Singapore. “As we see more and more cross-border deals happening, convergence has to take place.” Asked if this is more likely to be towards more rigorous GCC standards or less onerous ones in Malaysia, he says “somewhere in between, but more leaning towards GCC standards.”
For Vickery, a key challenge is improving international perceptions of Islamic finance. “There is still a view out there that this is terrorist financing and they stone women.” But it’s changing. Before speaking to II, Vickery has been working on a proposal on developing interest in Islamic finance in Azerbaijan, Italy, Brazil, South Africa and India. “It’s because these guys are recognising it’s an international phenomenon, a way of tapping liquidity in the GCC, and it’s good for business. And the more international standardisation and transparency there is, the better it is going to be.”