setting standards for shariah application in the islamic financial

285

Setting Standards for ShariahApplication in the Islamic Financial Industry

M. Fahim Khan

Executive Summary

The global growth of Islamic banking is taking advantage of the diversity and flexi-bility in the fiqh opinions (often referred to as Shariah) to meet the challenges ofgrowth. While the flexibility in fiqh opinion is presently contributing to global growth,it may soon become a constraining factor in the global growth of the industry if thechallenges arising out of the use of diversity and flexibility in fiqh are not properly rec-ognized and regulated. Though the infrastructure for standardizing the supervisionand monitoring of the global expansion of the Islamic finance industry is rapidlygrowing, institutional arrangement for a regulated use of diversity and flexibility inShariah rules is still a missing link. Such an institutional arrangement is needed notonly to prepare the industry to play a bigger role in the development of global economybut also to ensure the adherence to the very specific element that makes the industry an“Islamic” industry. © 2007 Wiley Periodicals, Inc.

INTRODUCTION

Social changes, taking place rapidly in modern times, have taken the applicationof Islamic law into complexities never known in the past. Diversity and flexibilityin the contemporary application of Islamic law as a response to social change is awelcome development, but it creates new challenges too. The Islamic financeindustry is the most prominent example where the emerging challenges are sig-nificant and are required to be addressed urgently.

M. Fahim Khan is chief of Islamic economics in the Cooperation and Development Division of theIslamic Research and Training Institute at the Islamic Development Bank. Previously, he was deputychief of the Ministry of Planning for the Government of Pakistan, a professor and director in the Inter-national Institute of Islamic Economics at the International Islamic University in Islamabad, and wasseconded to the State Bank of Pakistan as advisor on transformation of the financial system. Dr.Khan holds a BA and MA (statistics) from Punjab University in Pakistan and an MA and PhD in eco-nomics from Boston University in the United States. He has over 15 articles in refereed journals andhas published/edited ten books on Islamic economics, banking, and finance, including Money andBanking in Islam, Fiscal Policy and Resource Allocation in Islam (both jointly edited with ZiauddinAhmed and Munawar Iqbal), and Essays in Islamic Economics (published by the Islamic Foundation,Leicester, United Kingdom). Dr. Khan can be reached via e-mail at [email protected].

Thunderbird International Business Review, Vol. 49(3) 285–307 • May–June 2007

Published online in Wiley InterScience (www.interscience.wiley.com).

© 2007 Wiley Periodicals, Inc. • DOI: 10.1002/tie.20145

The global growth of Islamic banking is taking advantage of thediversity and flexibility in the fiqh opinions (often referred to asShariah) to meet the challenges of growth. While the flexibility infiqh opinion is presently contributing to global growth, it may soonbecome a constraining factor in the global growth of the industry ifthe challenges arising out of the use of diversity and flexibility in fiqhare not properly recognized and taken care of.

When modern application of Islamic law in the finance industry takesadvantage of differences of opinion, it raises some serious concerns.Some of these concerns are:

1. How to keep practice in line with theory and not allow it todrift away from the Islamic spirit and to be Islamic merely in“form”;

2. How to maintain market discipline in the contemporary envi-ronment, particularly to ensure transparency about the Islamicproducts being offered and fairness of the prices beingcharged, so that the customer knows what he is buying and hasan appropriate basis to judge whether the price is right; and

3. How to regulate corporate governance in the industry so thatthe stakeholders’ interests are not subject to moral hazardopportunities implicit in the use of the diversity of fiqh opinions.

Such concerns may not pose a challenge to the growth of the indus-try as long as the industry is confined within the national bound-aries of a Muslim country. But when the industry spreads globallyand develops forward and backward linkages with the global finan-cial network, such concerns can pose a serious challenge to thegrowth of the industry. How unregulated use of diversity and flex-ibility in Shariah rules is contributing to these concerns is brieflydiscussed below.

ISLAMIC FINANCE INDUSTRY: DIVERGING FROM THEORY

Before the concept of Islamic banking came in practice in the mid-1970s, Islamic scholars, generally, believed that Islamic financialintermediation could be institutionalized on the basis of a two-tiermudharabah. The profit that bank will share on its investment withthe businesses will be shared with the depositors (Siddiqi, 1983). Ifthe bank happens to bear losses in its investment, this loss will beborne by the depositors as Rabbul Ma’al (Ahmad, 1993). This the-oretical model was supposed to carry several merits vis-à-vis an

M. Fahim Khan

286 Thunderbird International Business Review • DOI: 10.1002/tie • May–June 2007

The globalgrowth ofIslamic bankingis taking advan-tage of thediversity andflexibility in thefiqh opinions(often referred toas Shariah) tomeet the chal-lenges ofgrowth.

interest-based financial intermediary. It was supposed to make thefinancial system in the country more stable (Al-Bazdawy, n.d., pp.205–206), more efficient and equitable (Ibn al-Arabi, n.d., pp.5425–5426), and more conducive to generating new entrepreneursin the economy, and hence reducing unemployment and alleviatingpoverty (Kahf & Khan, 1992).

Actual practice, however, did not start in this way. In practice,although deposits were collected on the principle of mudharabah,they were mostly invested on the principle of murabahah-basedfinancing, or markup-based financing (Khan, 1986). This mode ofoperation yielded a fixed return to the banks on their investments andenabled them to pay an almost fixed return to depositors. This diver-gence from theory took place and continued despite severe criticismnot only from the Islamic economists who believe in the superiorityof profit-and-loss-sharing principle (in the form of two-tier mud-harabah-based financial intermediation) and viewed the practice onviolating the spirit of Islamic economic and financial principles, but itwas also criticized by several Shariah scholars who considered that thepractice was not fulfilling all Shariah obligations for implementingthe markup-based sale for financing purposes.

The report of the Council of Islamic Ideology of Pakistan (1981) dis-cussed in detail different Islamic principles, in theory, that could beused for operating the institutions of financial intermediation onIslamic lines. The report was jointly prepared by economists, bankers,and Shariah scholars and concluded that profit-and-loss sharingshould be the principle of the Islamic financial intermediation.Markup-based, leasing-based, and other methods of financing wererecommended only in exceptional circumstances (Khan, 1991).

Notwithstanding this recommendation, the practice of Islamic bank-ing in Pakistan did not adopt the principle of profit-and-loss sharingfor its operations and instead overwhelmingly depended on the useof sale-based modes of financing. Bankers in Pakistan, in fact, chosethat variant of sale-based modes of operation that the majority ofShariah scholars in the country rejected as a valid basis for operatingfinancing activities on Islamic principles. This variant was the buybackarrangement.

Islamic banking in the rest of the world too did not opt for profit-and-loss sharing-based financing and preferred to do most of its busi-ness on the basis of sale-based methods of financing. Recently, a typeof financing called tawarroq has come into practice. Several Islamic

Setting Standards for Shariah Application in Islamic Financial Industry

287Thunderbird International Business Review • DOI: 10.1002/tie • May–June 2007

…the practice ofIslamic bankingin Pakistan did

not adopt theprinciple of

profit-and-losssharing for its

operations andinstead over-

whelminglydepended on the

use of sale-based modes of

financing.

scholars have been critical of this variant as a valid basis for operatingan Islamic banking business (Khan, 1992). The rapidly growing busi-ness of sukuk (often called Islamic bonds) is also raising concerns withrespect to the practice diverging too widely from the theory(Kramers, n.d.).

This divergence resulting from the diversity and flexibility in Shariahopinion is currently being tolerated in many circles of Shariah schol-ars and Islamic economists on account of its role in facilitating thegrowth of the industry at the global level. But there is also a risk thatthis may soon lead to frustration on the part of the end-users of theproducts of the Islamic finance industry, who may finally find it hardto distinguish between the products of the Islamic finance industryand conventional interest-based banking. If the distinction is nottransparent and convincing, this may pose a serious threat to thegrowth of the Islamic finance industry.

DIVERSITY IN SHARIAH OPINION AND MARKET DISCIPLINE

The possibility of Shariah arbitrage on account of a wide diversity inShariah opinion is also a matter for concern, particularly because sucharbitrage may create temptation in the industry to seek profits at thecost of losing the spirit of Islamic finance. The concern, however, isnot merely about the spirit, at least for the regulators and supervisorsof Islamic finance. The concern for them is about market disciplinetoo. It is feared that this may violate market discipline, as the marketmay not be able to punish inefficient players on account of the believ-ers’ willingness to pay a premium for the protection of their faith inthe financial dealings. This concern has already been expressed at theglobal level.

IMPLICATIONS FOR CORPORATE GOVERNANCE

Despite concern from regulators and supervisors, the Islamic bankingindustry can still survive and grow in the market of believers, whichno doubt is a big market and may not pose any limit to the growthof the industry in the foreseeable future. But then it is also obviousthat having the confidence of the market is a crucial factor in the sur-vival and growth of the industry. Good governance in the industry isa key to building and maintaining this confidence. Confidence mustreside not only in the form of the products offered by the industry,but also in the professional competence and ethics employed in pro-

M. Fahim Khan


The possibility ofShariah arbitrageon account of awide diversity inShariah opinionis also a matterfor concern, par-ticularly becausesuch arbitragemay createtemptation in theindustry to seekprofits at thecost of losing thespirit of Islamicfinance.

viding these products to the clients. There is an issue of good gover-nance with respect to the use of the depositors’ money since deposi-tors have to opt for sharing profits/losses with the bank if they intendto earn returns on their deposits.

Islamic banks can offer two types of profit-sharing investmentaccounts: (1) restricted profit-sharing investment accounts and (2)unrestricted profit-sharing investment accounts. Deposits receivedunder the restricted accounts are used in prespecified projects usingprespecified modes. For such accounts, Islamic banks have succeededin developing products that will ensure that the returns to depositorsvary only in a very narrow range with an almost nonexistent possibil-ity of loss. Thus, despite having profit-and-loss-sharing accounts,depositors can have their deposits in Islamic banks with the same riskprofile that clients of conventional banks will get on their savingsaccount. But there is often the issue of market compatibility in thesense that the depositors may not be getting a return equivalent towhat their counterparts may be getting from the conventional banks.

Unrestricted profit-sharing investment accounts, by contrast, are theaccounts where the depositors authorize banks to invest theirdeposits in any investment that the banks consider suitable and thedepositors agree ex-ante to share the profits/losses arising from theseinvestments. Banks use the funds of accountholders in investmentsselected by the banks, and accountholders do not have any say in thischoice. The possibility of moral hazard may arise if depositors’ moneyis used more to suit the bank than the depositors. For their part,depositors are not represented on the board, nor has any Islamic bankso far been able to develop a mechanism of internal control to takecare of the interests of investment accountholders vis-à-vis the inter-ests of shareholders and bank management. A primary concern ofdepositors is that their money is used in a manner that conforms toShariah norms. So far, there is no arrangement to provide a transpar-ent view to depositors that the Shariah is being applied properly inthe use of their funds in order to legitimize the income that they willreceive on their deposits. The Islamic finance industry generally pro-vides only a wholesale Shariah clearance for the operations of thebanks. Details of the process of clearance are not known to the depos-itors. The details of Shariah supervision on different stages of theoperations of Islamic banks are also not known.

Such corporate governance issues cannot be resolved by prudentialregulations. There are aspects that relate to Shariah issues and ethicalissues involved. Even if the Islamic banks try to be transparent by



Islamic bankscan offer two

types of profit-sharing invest-ment accounts:

(1) restrictedprofit-sharing

investmentaccounts and (2)

unrestrictedprofit-sharing

investmentaccounts.

declaring how they are applying Shariah in their operations, this maynot be enough. There is need for some arrangements that will certifythat the Shariah application conforms to the client’s preferredShariah opinion.

Thus, an important dimension of the governance issues arising out ofthe diversity and flexibility in Shariah opinion is whether clients ofthe industry are getting the Shariah value for which they are payinga premium. The industry would not be doing justice to its clients ifit used the diversity in Shariah opinion only to increase their profitwithout being transparent to their clients on the form and method ofapplying shares in their operations. Clients of the Islamic financeindustry follow different schools of fiqh and Shariah opinions. Theindustry is currently not transparent enough on details of Shariahapplication. Shariah scholars who understand and disagree with somedeclared applications chose to remain silent as an expression ofrespect for other Shariah opinions. The industry, thus, is likely to bethriving on the Shariah illiteracy of its clientele. As Shariah literacy inthe clientele of industry increases, and Shariah scholars with differentopinions become vocal, the industry may find its growth severelyconstrained.

It would not be right to say that industry is unaware of these limita-tions. The problem is that it does not have the means to resolve suchissues. Some basic questions for them in this respect are as follows.

1. What type of expertise is required to enable the banks to makecorrect use of the flexibility in the application of Islamic law inthe industry?

2. What types of standards and criteria are needed when applyingShariah to make the application transparent to the satisfactionof their depositors, particularly in matters where the industryis making use of fiqh differences?

A substantial amount of growth in Islamic banking is taking place, atthe global level, out of the desire of conventional banks to provideIslamic banking services to their Muslim clientele and to interfacewith the Islamic finance industry. The above questions are crucial forthem too. Without clear answers about the application of Shariah, theinterface between the conventional and Islamic finance industries willbe made more difficult.

With only a few exceptions, most countries allow Islamic financeunder an act separate from that governing conventional finance. This

M. Fahim Khan


The industrywould not bedoing justice toits clients if itused the diver-sity in Shariahopinion only toincrease theirprofit withoutbeing transpar-ent to theirclients on theform andmethod of apply-ing shares intheir operations.

hesitation on the part of the conventional legal system to governboth the conventional and Islamic finance industries may also proveto be a serious constraining factor in the growth of the Islamicfinance industry, even at the national level. The hesitation, however,is not unjustified. Legal authorities also face the same two questionsmentioned above. Without answers to them, it may not be possiblefor legal authorities to develop a system for evaluating and monitor-ing the performance of Shariah application in the industry. In theabsence of such a system, the legal authorities will be reluctant tosupervise and monitor the conventional and Islamic finance industryunder a single mainstream legal framework used for the conventionalfinancial sector. Until the Islamic finance sector can satisfy regulatorsthat they are amenable to the same standards as applied to the con-ventional financial industry, Islamic finance will remain at the marginsof the financial system.

For the most part, Shariah authority plays only an advisory role in thecurrent practice of Islamic finance. This creates another governanceissue for the Islamic finance industry in terms of to what extent therules prescribed by Shariah scholars are being adhered to. Currently,substantial doubts exist on this particular point. On the other hand,there are instances where Shariah scholars do exercise a veto powerand the industry has to get clearance from the Shariah scholars for alltheir operations. This very process might be seen as putting innova-tion and growth at stake, making it difficult to compete with the con-ventional finance industry.

WHY DIVERSITY IN FIQH RULINGS

At this juncture, it may be instructive to understand why there isdiversity in fiqh rulings. Fiqh is a science. It is an intellectual and tech-nical effort to develop a methodology to understand the Qur’an andthe Sunnah (traditions of the Prophet) and to derive laws from them.

Diversity in fiqh opinions began with the start of interpretative judg-ments, called Ijtehad, on issues where direct guidance was not avail-able from the Qur’an and Sunnah. This Ijtehad, in fact, dates back tothe days of the Prophet. In the absence of divine inspiration on anymatter, he made Ijtehad to enact a law. During the Prophet’s lifetime,however, there was no question of diversity in Ijtehad, as the Prophethimself was making the Ijtehad, and according to the Qur’an itself,“His statements are not whimsical; whatever he says is a divine inspi-ration” (Qur’an 53:3).



Until the Islamicfinance sector

can satisfy regu-lators that they

are amenable tothe same stan-

dards as appliedto the conven-tional financial

industry, Islamicfinance will

remain at themargins of the

financial system.

After the death of the Prophet, when the Islamic State expandedand the Prophet’s companions migrated to different regions andcountries, they faced new customs and traditions and a new envi-ronment and social circumstances. They had to make Ijtehad onseveral matters and in this process they agreed on certain issues anddiffered on others. These differences of opinion were tolerated inthe public good and respect of each other’s understanding of theQur’an and Sunnah. That is how the difference in fiqh opinionstarted. These differences grew over time mainly on account of thefollowing reasons.

First, fiqh, being a science of interpretative judgment, advanced in itsown methodology and techniques. This, on the one hand, providedbetter understanding and interpretation of the Qur’an and Sunnahon newly emerging matters and, on the other hand, generated differ-ences among fiqh scholars on the methodology and outcome of theirinterpretations. The scholars had freedom of choice in choosing log-ical methods for drawing their own conclusions, inferences, andinterpretations, and hence in making rules and laws. This led to dif-ferences in fiqh opinion from scholar to scholar.

Second, the fiqh scholars benefited from advances in related disci-plines such as logic, philosophy, psychology, and even in physical sci-ences, which helped them modify and improve their own methods ofinterpreting the Qur’an and Sunnah. This process generated differ-ences in fiqh interpretations from time to time.

Third, different fiqh scholars faced different circumstances whendrawing conclusions and interpretations in different cultures andnational boundaries. The cultures and customs and specific needs ofthe various societies influenced fiqh interpretations. The fiqh rulingstherefore differed from place to place too.

These differences continued to grow and later on developed intorecognized schools and doctrines of Islamic jurisprudence. Attemptshave been made in Islamic history to reconcile the views of fiqhscholars, standardize their rulings on different issues, and compelpeople to adhere to unified rulings. Such attempts were made asearly as the second century of the Hijrah. One of the Caliphates ofthe second (Hijrah) century appointed Imam Malik (a renownedIslamic jurist of the time) to unify fiqh opinion. The attempt, how-ever, failed, as it was not found feasible to compel people to acceptone opinion or one single school of thought. The diversity, there-fore, continued to prevail.

M. Fahim Khan


Attempts havebeen made inIslamic history toreconcile theviews of fiqhscholars, stan-dardize their rul-ings on differentissues, and com-pel people toadhere to unifiedrulings.

CODIFYING THE DIVERSITY IN FIQH

Failing to unify the fiqh opinions, the need was felt to at least codifythe fiqh opinion so as to standardize the differences and avoid anyconfusion that may arise in the application of Shariah in any place atany point in time. The first attempt to codify Islamic jurisprudencewas made in the Ottoman Empire, which resulted in a book entitledMajallatul Ahkam (1293H), which comprised 1,851 articles, adher-ing to the Hanafi school of thought. Consequently, it was decidedthat all countries under Ottoman rule should comply with the provi-sions of the Majalla. However, this decision did not address the issueof diversity of Shariah opinions on different matters in differentschools of thought. Another attempt was made by the Azhar Univer-sity Research Academy to codify Islamic fiqh in accordance withmajor schools of thought. The job, however, was not completed.

More recently, the General Secretariat of the Arab League tried tocodify laws of Arab countries in accordance with Islamic Shariah. TheArab League did compile a codified document relating to financialtransactions (containing 1,316 articles). This job too, however, couldnot be completed to the extent to enable it to be used as standardsfor Shariah opinions on various issues relating to the contemporaryfinance industry.

With the emergence of Islamic financial institutions such as Islamicbanks, Islamic investment companies, Islamic insurance companies,and other Islamic financial institutions, and in the absence of any sin-gle authority to guide and supervise them in Shariah matters, theneed arose for these institutions to have their own Shariah boardsand councils to guide and supervise their activities to conform toShariah and give Shariah clearance on their transactions and con-tracts. The rapid growth of Islamic finance institutions led to agrowth in Shariah bodies advising these institutions. The increase inthese Shariah bodies/Shariah boards further increased the diversityin Shariah rulings on financial matters, and each Shariah board con-centrated on the specific needs of the institution and its clientele.

There exists a strong feeling, in the concerned circles, for the need tounify Shariah rules or to “harmonize” Shariah diversity. Whatever uni-fication or harmonization means, it has yet to take place, and it maynot be possible to accomplish it in the foreseeable future. Codifyingthe diversity in fiqh opinions currently in use in the Islamic financeindustry would probably be an important step in this direction. Dif-ferent strands of fiqh opinion could be given specific code and title



There exists astrong feeling, in

the concernedcircles, for theneed to unify

Shariah rules orto “harmonize”

Shariah diversity.

with full background on the sources and schools of Islamic jurists towhich the various threads primarily belong. A declaration from theIslamic banks with respect to which aspects of fiqh rulings are beingutilized in their operations would give a clearer view of the Shariahcompatibility of their products to the satisfaction of their clientele.

This codification could also be an important element in defining thestandards for corporate governance in the Islamic finance industry inthe context of Shariah application. As already mentioned, codifica-tion is a big and too complex task, and the industry cannot wait forit for too long. Some more feasible arrangements have to be devel-oped quickly.

STANDARDIZATION OF THE APPLICATION OF SHARIAH,RATHER THAN UNIFICATION OR HARMONIZATION, IS THECURRENT NEED

The unification or harmonization or codification alone, even ifachieved, may not solve all of the problems described above. Theimmediate challenge involves more than harmonizing fiqh opin-ions and codifying them. It relates to standardizing the entire pro-cess of how to advise, supervise, and monitor Shariah compatibil-ity of an institution or any of its operations/products, and includeshow a verdict should be arrived at and how a certificate should beformulated when validating the Shariah compatibility of a financialactivity or institution to ensure transparency and good corporategovernance.

Furthermore, the principles of Islamic finance are alien to the exist-ing legal structure applicable to the financial sector in general and tothe banking sector in particular. This is causing Islamic financial insti-tutions either to operate as nonbanking financial institutions or toneed a separate law to operate as a licensed institution in the financialsector, which marginalizes the Islamic financial industry vis-à-vis theconventional finance industry. If the Islamic finance industry is tomove from the margins of the finance industry to the mainstream,standardizing is needed in a fashion that the conventional legal sys-tem governing the finance sector can recognize and benefit from byincorporating the Islamic finance industry under the same roof. Itrequires choosing an appropriate format of standardizing Shariahapplication that the regulators of the financial sector would under-stand and find common ground with when designing the legal sys-tem that will govern the two systems.

M. Fahim Khan


…the principlesof Islamicfinance are aliento the existinglegal structureapplicable to thefinancial sectorin general and tothe banking sec-tor in particular.

Where a unified law does not govern the financial architecture,both conventional and Islamic, there remains a challenge of how todefine the legal responsibility with respect to the application ofShariah in the industry. Some countries require it by law for Islamicfinancial institutions to establish their own Shariah supervisoryboard, while some other countries leave it to the discretion of theinstitution whether or not to have their own Shariah representa-tives. In either case, the specific duties and responsibilities withrespect to Shariah application and its monitoring and supervision ofthe operations of these institutions would be laid down in the lawor in the prudential rules. This absence may be keeping substantialnumbers of potential clients away from the Islamic finance industry,and may also be a factor in the reluctance of conventional law gov-erning the finance industry to be opened up to cover the Islamicfinance industry as well.

PRESENT STATE OF SHARIAH PROCESS

Shariah scholars are themselves the right bodies to work out how bestto monitor and report on the state of Shariah application in that theycan develop specific standards relating to Shariah duties and respon-sibilities. This will be part of specifying the standard process by whichthe Shariah advisors or Shariah board will conduct ex-ante and ex-post Shariah review and by which they will monitor, supervise, andreport on the Shariah application during the entire operation anddetermine where the legal responsibility will lie in case of lapses in theapplication of Shariah and its consequences on the business of anIslamic financial institution.

A study conducted by the International Institute of Islamic Thoughton performance evaluation of Shariah supervisory boards in 1996indicated that 58.4% of a corpus of members of Shariah supervisoryboards are selected by boards of directors. While no recent study hasbeen conducted in this respect, there is no evidence that the situationmight have changed substantially. The fact that Shariah boards aresubordinate to boards of directors may raise questions about conflictsof interest. So far, there is no evidence that this position has in anyway affected the authority of Shariah boards to give the right advice.But as the industry grows and demand for Shariah advice increases,this issue may gain prominence. In order to ensure the appropriateplace and role of Shariah boards of Islamic financial institutions, reg-ulations and standards in the executive hierarchy of these institutionsneed to be laid down.



Shariah scholarsare themselvesthe right bodies

to work out howbest to monitor

and report on thestate of Shariah

application inthat they can

develop specificstandards relat-

ing to Shariahduties and

responsibilities.

This issue can be taken care of at the national level by a governmentauthority, where either the ministry of finance or the central bank orany other appropriate body in the country is assigned to ensureShariah supervision according to defined standards. The Islamicfinancial institutions at the national level can be obliged by the gov-ernment to follow the standards laid down, for example, by a centralShariah board. At the global level, however, the issue is not as sim-ple. It is hard to think of a global body of Shariah that can imposeany standards on individual institutions or on national finance indus-tries. This matter needs careful consideration.

The next section presents a brief overview of the efforts currentlybeing made at the national and global level in the context of stan-dardizing the application of Shariah in the finance industry.

EFFORTS AT NATIONAL LEVEL

The regulators in Muslim countries where Islamic banking has sub-stantial (or full) presence have not been unaware of the need to stan-dardize the application of Shariah in the finance industry, and effortsare being made at the national level to develop structures to providea standardized Shariah framework for the growth of the industry, andthe efforts to improve the nature and scope of such a structure arestill ongoing. The approaches differ from country to country. Threetypes of efforts, however, are prominent.

Sudanese Model The model is specific to Sudan and is not meant to address Shariahissues for the global Islamic finance industry, yet it does have rele-vance for the countries intending to standardize Shariah applicationin the finance industry at the national level and where the entire pop-ulation follows by and large the same string of Shariah opinion as faras Shariah application in financial matters is concerned.

Sudan has subjected its entire financial sector to Islamic principles offinance. Standardization for the application of Shariah, therefore, isas important an issue for them as standardization of operation for theconventional financial sector would be for any country. Sudan hasdesigned a central Shariah system for keeping the entire financial sys-tem on a defined standard of Shariah application. The SupremeShariah Supervisory Authority for Financial Institutions and Banks ofSudan, established by the Ministry of Finance and Economic Plan-ning, under the Banking Act is responsible for designing the system

M. Fahim Khan


It is hard to thinkof a global bodyof Shariah thatcan impose anystandards onindividual institu-tions or onnational financeindustries.

and monitoring its application. The functions of the SupremeShariah Authority are as follows:

1. Work out together with bank officials contract and agreementspecimens for all transactions of banks and financial institutionsthat are engaged in banking activities so as to ensure that theykeep away from all Shariah prohibitions and follow a uniformmethod of application of Shariah in each transaction.

2. Give Shariah opinion on the transactions of banks or financialinstitutions engaged in banking activities that a bank or thegovernor of the Bank of Sudan refers to it.

3. Monitor transactions carried out by the Bank of Sudan, banks,and financial institutions, and give sound Shariah opinion tothe governor of the Bank of Sudan on matters regarding trans-actions of the Bank of Sudan or commercial banks and finan-cial institutions engaged in financial activities.

4. Examine the Shariah problems faced by the Bank of Sudan orother banks and financial institutions in their operations andadvise them how to resolve the problems.

5. Issue Shariah edicts on matters that so require. Review thelaws, by-laws, and publications that govern the activities of theBank of Sudan and other banks and financial institutionsengaged in banking activities to eliminate anything that isincompatible with Islamic Shariah precepts in coordinationwith various bodies.

6. Ensure that the Bank of Sudan and other banks and financialinstitutions engaged in banking activities comply strictly with theShariah when it comes to any banking and financial business.

7. Help technical supervisory bodies of banks to perform theirtasks in accordance with Islamic Shariah precepts.

8. Help the management of the Bank of Sudan to draw up stafftraining programs for banks and financial institutions engagedin banking activities so that they can learn Islamic modes offinancing and Shariah aspects of transactions.

9. Conduct research and studies that can help improve theIslamic approach to economic and financial matters.

10. Submit an annual report to the Minister of Finance and Eco-nomic Planning on the Shariah soundness of the transactionsof the Bank of Sudan and other banks and financial institutionsengaged in banking activities.

The edicts issued by the authority on Shariah matters are binding onfinancial institutions. The Shariah authority also helps the centralbank to run its monetary policy according to Shariah principles.



The edicts issuedby the authority

on Shariah mat-ters are binding

on financial insti-tutions.

The model thus takes care of several issues raised earlier in the con-text of the standardization of the application of Shariah in the financeindustry, but of course at the national level. Global attractiveness ofthe model, however, is limited in view of the fact that it addressesvery specifically to the financial setup of Sudan only, and also in viewof the fact that it does not address how to deal with the issue of diver-sity in fiqh opinions.

Bahraini Model Bahrain is actively involved in developing standards for its Islamicfinance industry but in a way that they can be adopted by interestedinstitutions anywhere in the world. Its focus is on standardizing theoperation of institutions with respect to Shariah application rather thansuggesting transformation of the entire financial system of the country.The model is focusing on developing a Shariah-related structure thatcan be relevant for global application. The Shariah-related infrastructurebeing developed in Bahrain consists of several interrelated components.

One important component is the Accounting and Auditing Organi-zation of Islamic Financial Institutions (AAOIFI), which issuesaccounting and auditing standards for Islamic finance industry. TheAAOIFI has a Shariah council that has the following major functions:

1. Prepare and adopt Shariah standards for modes of investmentfinancing, insurance, and Islamic financial services.

2. Come up with innovative Shariah devices that would enableIslamic financial institutions to keep pace with innovations tak-ing place in the global financial and capital market.

3. The Council considers matters submitted by Islamic financialinstitutions or their Shariah boards for Shariah opinion orarbitration on a particular issue.

The AAOIFI’s guidelines give the management of a financial institutionthe responsibility to ensure that its institution is operating in accordancewith Islamic Shariah precepts and principles. As far as the Shariah boardor Shariah authority of the institution is concerned, the AAOIFI stan-dards require that its responsibility be confined to expressing an inde-pendent opinion based on its observation of the financial institution’soperations and to preparing a report on the matter. For some, this isessential in order not to mix up the Shariah authority with the executiveauthority and not to introduce ambiguity in matters relating to corporategovernance. In some quarters, however, it is thought to be undesirableto give executive authority the responsibility to ensure Shariah compati-bility of their operations, as it requires specialized Shariah knowledge.

M. Fahim Khan


Bahrain isactively involvedin developingstandards for itsIslamic financeindustry but in away that theycan be adoptedby interestedinstitutions any-where in theworld.

The Shariah Council of the AAOIFI has so far issued Shariah stan-dards relating to the following major financial operations:

1. Currency trading,2. Discount cards and credit cards,3. Delinquent default,4. Debt clearing,5. Guarantees,6. Murabahah to the orderer of purchase,7. Leasing and purchasing back lease,8. Salam (forward sale) and parallel salam,9. Istisna and parallel istisna,10. Documentary credits,11. Transformation of a conventional bank into an Islamic finan-

cial institution,12. Debt transfer (hawala),13. Mudarabah, and14. Musharakah.

The standardizations being developed by the AAOIFI, includingthose related to Shariah application, are binding on the Islamic finan-cial industry in Bahrain. These standardizing elements, however, arealso being utilized by other countries in the region, with some mak-ing them binding on their Islamic finance industry too and somemaking them only recommendations.

The AAOIFI, including its Shariah council, has done substantial work inthe way of standardizing financial reporting, including the reporting onShariah compliance. These standards are being applied not only in theIslamic finance industry, but are also being adopted by Islamic financeinstitutions in other countries and gaining wider application, and henceplaying an important role in promoting standards at the global level.

With respect to the standardization of application of Shariah, theAAOIFI Shariah council is limited to developing standards mainly toShariah issues relating to financial reporting. There are several issuesrelated to the Shariah application in the developing of Islamic finan-cial products and services, preparing of documentation underlyingthese financial products and services, supervising and monitoringthe conduct of products, and supervising and reporting on theirShariah performance.

Standards have yet to be developed on these aspects of the applica-tion of Shariah in financial institutions. All these aspects are not cov-



The standardiza-tions being

developed by theAAOIFI, includingthose related to

Shariah applica-tion, are binding

on the Islamicfinancial industry

in Bahrain.

ered in the AAOIFI standards. Also, the Shariah council of theAAOIFI does not address the issue of diversity of Shariah opinions.This too limits the scope of these standards to be adopted widely atthe global level, particularly in the context of Shariah application.

Malaysian Model The legal basis for the setting up of Islamic banks in Malaysia is theIslamic Banking Act 1983 (IBA). The Act provides the Central Bankof Malaysia (BNM) the authority to regulate and supervise theIslamic banks, similar to the authority it has in case of conventionalfinancial institutions. The IBA requires that the Articles of Associa-tion of the Islamic bank incorporate provisions for the establishmentof a Shariah advisory body to advise the Islamic banks on the opera-tion of the Islamic banking business. BNM has an elaborate mecha-nism of supervision and regulation for the Islamic banks to ensurethat their operations remain in line with the overall objective of thebanking system in the country.

Parallel to this, conventional banks, which are governed by the Bank-ing and Financial Institutions Act (BAFIA), have also been allowed,through a 1996 amendment to the Act, to carry out the Islamicbanking business in addition to the existing licensed business (of con-ventional banking). These conventional banks are required to complywith any written directives, issued from time to time by the BAFIA,relating to Islamic banking business. The directives are issued by theBNM in consultation with its Central Shariah Advisory Council. Anyconventional bank, licensed under the BAFIA, carrying out Islamicbanking business in addition to its conventional licensed businessmay from time to time seek advice from the Central Shariah AdvisoryCouncil of the BNM in its Islamic business operations in order toensure that it does not involve any element that is not Shariah-com-patible. The provisions relating to the Islamic banking business in theBAFIA do not apply to Islamic banks because they are governed bythe separate IBA, which requires Islamic banks to have their ownShariah advisory body to advise them on their business operations.

The Malaysian model allows diversity in the application of Shariah byallowing Islamic banks to have their own Shariah advisory bodies thatare not subject to regulation from the Central Shariah AdvisoryCouncil of the central bank of the country. In this respect it providesa good example of Shariah-related infrastructure for the financeindustry for countries where there is diversity in the fiqh opinionsrelating to financial operations. On one hand, the model standardizesthe Shariah application in the mainstream (conventional) financial

M. Fahim Khan


BNM has anelaborate mech-anism of super-vision and regu-lation for theIslamic banks toensure that theiroperationsremain in linewith the overallobjective of thebanking systemin the country.

industry without giving them flexibility to benefit from Shariahdiversity. On the other hand, it leaves room for the Islamic financeindustry to benefit from fiqh diversity but standardizes their opera-tions with respect to the monetary objectives of the economy.

EFFORTS AT GLOBAL LEVEL

The Islamic Development Bank (IDB), based in Jeddah, Saudi Ara-bia, has been a catalyst in promoting supporting infrastructure for theIslamic finance industry at the global level. Central banks of Malaysia,Bahrain, and several other countries where Islamic banking exists alsoplayed an active role in infrastructure building individually and col-lectively. A brief overview of these efforts with particular reference toShariah application is given below.

The IDB played an important role in establishing the Accounting andAuditing Organization for Islamic Financial Institutions (AAOIFI),which, as described earlier in detail, is working on standardizing someaspects of Shariah application as well. These standards are gainingglobal recognition even at the level of such international organiza-tions as the World Bank and International Monetary Fund, as well asat the level of some international rating agencies.

The IDB has also played an active role in the establishment of theIslamic Financial Services Board (IFSB) as a global body to developregulating and supervisory standards. The members of the Board arecentral bank governors of the countries where Islamic banking exists.The core function of the IFSB is to develop best practice standards.Standardization of several aspects of Shariah application will fallunder the jurisdiction of this Board when developing best practicestandards for such elements as risk management, capital adequacy,corporate governance, disclosures, and the like in the Islamic financeindustry. Since the IFSB is seeking to introduce, for the Islamicfinance industry, international standards consistent with Shariah prin-ciples, they will be seeking internationally acceptable Shariah princi-ples as well.

The IDB has helped in establishing an Islamic Financial Market (IFM)where the standardized concept of sukuk (trust certificates as Islamicfinancial securities) was introduced. The IFM is operating since April2002. Since then, the IFM has endorsed five significant sukuk issuesthat not only provide a standard format for issuing sukuk, but alsointroduce international standards for the application of Shariah in



Since the IFSB isseeking to intro-

duce, for theIslamic finance

industry, interna-tional standardsconsistent withShariah princi-

ples, they will beseeking interna-tionally accept-

able Shariahprinciples as

well.

developing Shariah-compatible instruments for trading in secondarymarkets. As a part of its growth strategy, the IFM faces the challengeof seeking harmonization of fiqh opinions in developing standards thatwould be globally acceptable for the issuance of sukuk.

An International Islamic Rating Agency (IIRA) has been establishedin Bahrain with multinational financial institutions, rating agencies,Islamic banks, and insurance companies as its major shareholders.The IIRA is starting with a vision “to become the reference for thecredit rating in accordance with Shariah principles” and its mission is“introducing standards for greater disclosure and appropriate gover-nance in Islamic banking and helping clients understand and managevarious risks in compliance with Shariah principles.” The functions ofthe IIRA include assessment of compliance with principles of Shariahand assurance of transparency with respect to application of Shariah.Developing standards of Shariah application in the finance industry,therefore, will be the business of this agency too.

Another recent development at the global level is the establishment ofthe International Islamic Centre for Reconciliation and CommercialArbitration for Islamic Finance Industry, which was launched in April2005 with 50 percent of the capital contributed by the Islamic Devel-opment Bank. The center, the headquarters of which will be situated inDubai, will settle financial and commercial disputes between financialor commercial institutions that have chosen to comply with Shariah.One of its roles will be to develop some common understanding ofstandards in the application of Shariah. Reconciling disputes in the con-text of Shariah application requires a scientific understanding of thediversity in Shariah opinion and defining some globally acceptablestandards for benefiting from Shariah diversity in the application ofShariah in the industry. This may be one of the major functions thatthis center may take on once it is fully in operation.

THE MISSING LINK IN THE INFRASTRUCTURE

The rapidly growing infrastructure for standardizing the supervisionand monitoring of the global expansion of the Islamic finance indus-try is indicative of the fact that the industry is maturing to play a big-ger role in the development of the global economy. This infrastruc-tural development is, however, still missing an important link, and thatrelates to the very specific element that makes the industry an“Islamic” industry. The industry needs infrastructural setup to defineand lay down a standardized framework for the application of Shariah

M. Fahim Khan


As a part of itsgrowth strategy,the IFM facesthe challenge ofseeking harmo-nization of fiqhopinions indeveloping stan-dards that wouldbe globallyacceptable forthe issuance ofsukuk.

in the operation of the industry. Unless this link is properly establishedin the growing regulatory and supervising infrastructural develop-ments, the industry will feel constrained in fully exploiting its poten-tial role as an effective partner in the global development. This link ismissing in all the infrastructural developments described earlier.

Various infrastructural developments described in the previous sectionhave one common element. They all need to deal with diversity in fiqhopinions and they all need to have standards defined for benefiting fromthe Shariah diversity in the application of Shariah in the finance indus-try. Since the size of the business and market is still small, it may be desir-able for each of these institutions to have its own standards in thisrespect. But as the market is growing rapidly, it will soon be feasible tohave an independent institution taking care of this common factor.

The Shariah-standardizing link in the institutional framework for thestandardization of the industry is needed more at the global level thanat the national level. At the national level, it may be relatively easier inmost countries for the regulatory authorities to make sure that theapplication of Shariah in the finance sector is properly standardized andregulated within the legal framework of the country and that the clientsof the Islamic finance industry in the country clearly know which fiqhopinion or school of thought is being followed in the industry, who arethe Shariah experts evaluating the Shariah compatibility of the financeindustry, and where legal responsibilities lie for fulfilling the Shariahrequirements. At the global level, however, the situation is different.Since different countries are following different approaches and differ-ent models as well as different Shariah schools in the Islamic financialsector, there is a need for coordination at the global level to standard-ize this diversity in approaches and models toward providing theShariah framework to the finance industry. This coordination can takeplace in different scenarios. Some suggestions are given below.

Probably, somewhat along the lines of International Organization forStandardization (ISO), an International Organization for Standard-ization for Shariah Application in the Finance Industry (IOSSAFI) isneeded to explain standardized variations in the application ofShariah in the finance industry along with standardized informationon Islamic jurisprudence underlying its Shariah application and codethem appropriately.

Taking the example given earlier, we may find in the global financialmarkets sukuk issued with the Shariah condition of more than 50 per-cent of ijarah-based transactions underlying them, along with sukuk



The Shariah-standardizing

link in the insti-tutional frame-

work for thestandardization

of the industry isneeded more atthe global level

than at thenational level.

not observing this condition. There is a need for an institution oftrust and credibility to explain such diversity in a standardized frame-work. What the industry needs is the presence of an international ref-erence for “quality management” in the application of Shariah, a ref-erence that would reflect good Shariah management practices in aninstitution that is delivering Shariah-compatible products and ser-vices. Such a reference would mean that:

1. the products and services of the institution are compatible withcertain defined Shariah principles derived from a definedschool of Islamic jurisprudence, and

2. “good practice” has been filtered through a certain specifiedset of standardized requirements in the application of theShariah principles.

Thus, the proposed institution (IOSSAFI, or whatever we may call it)may focus not only on products and services of the institutions, butit may also focus on developing generic standards for the good prac-tice of an Islamic financial institution in managing its processes oractivities that lead to developing and marketing Shariah-compatibleproducts and services.

In the context of diversity of fiqh opinions, this IOSSAFI-like insti-tution will not only help an Islamic financial institution select whichspecific Shariah opinion could be used, but it will also specify whatrequirements are to be met in the application of the particular fiqhopinion. The IOSSAFI-like institution would not declare any fiqhopinion right or wrong. Rather, it will codify different fiqh opinionsbeing used in the industry for a specific operation or a part of it andprovide detailed fiqh background and underpinnings of these codedfiqh opinions.

Furthermore, such an institution would not act as a regulatory bodyin the sense of imposing its standards on any institution or any coun-try. The standards developed by such an institution may, however,help the individual institutions to regulate themselves, while at thesame time providing regulators at the national level or global levelwith defined standards against which to supervise, monitor, and eval-uate Shariah content for those institutions that claim to offer Shariah-compatible financial products and services.

The work of such an institution also will be distinct from the work ofthe International Islamic Rating Agency being established with U.S.$2 million paid-up capital (and U.S. $9 million authorized capital) in

M. Fahim Khan


What the indus-try needs is thepresence of aninternational ref-erence for “qual-ity manage-ment” in theapplication ofShariah…

Bahrain for which one of the functions is to provide an independentassessment of compliance (of a financial institution or its product)with Shariah principles. While the IIRA will be rating the institutionor product on the level of Shariah compliance, the institution pro-posed above has two distinct concerns. One is the quality of man-agement in the compliance of Shariah, and the other is the disclosureof the Shariah principles in the process of compliance. The IIRA, infact, would also need such an institution to carry out its assessmentof the level of Shariah compliance.

There is also the need for an institution to give a standardized char-ter to the Shariah expertise that the financial institutions use or canpotentially use. There are several models of institutions taking care ofcertification or awarding a charter with respect to practicing variousexpertise required in the finance industry. These institutions areestablished to maintain high standards of practice and professionalconduct of expertise in specific fields. The Institute of CharteredAccountants, for example, has a primary responsibility to set andenforce a standard of performance and conduct of its members whoare experts in accounting. Similarly, there is an Association of Invest-ment Management and Research (AIMR), an international nonprofitorganization of investment practitioners and educators, that offersChartered Financial Analysts (CFAs) designed with a mission to leadthe investment profession globally by setting the highest standards ofeducation, integrity, and professional excellence.

An Association for Research and Management of Shariah Applicationin the Finance Industry (ARMSAFI, or whatever we may call it) isneeded to be established with a mission to develop a team of Shariahexperts globally for setting the highest standards of professionalexcellence in the application of Shariah in the finance industry, as wellas to be a leader to conduct and promote education and research forShariah application in finance to help the industry compete in thecontemporary globalizing and liberalizing environment. This will bea self-regulatory body.

Such an association can serve the Islamic finance industry in severalways besides generating a supply of professionally competent andcommitted Shariah expertise.

1. It can play an instrumental role in the corporate governance ofIslamic financial institutions.

2. It can be a body that can effectively monitor the professionalintegrity of its members serving the industry.



There are sev-eral models of

institutions tak-ing care of certi-

fication orawarding a char-

ter with respectto practicing var-

ious expertiserequired in the

finance industry.

3. It can monitor legislative and regulatory activities affecting theglobal finance industry and help its members in the industrywith Shariah-compatible methods to solve problems that suchregulatory activities may create for application of Shariah inthe industry.

4. It can develop a code of ethics to set forth standards of con-duct expected from its members in giving Shariah advice andin dealing with conflict of interest that may arise from theirofficial relationship with the executive authorities.

5. It can organize conferences and workshops to create awarenessabout Shariah-based activities in the finance industry and pro-vide a forum for discussions on issues relating to application ofShariah in the industry.

6. It will provide public testimony and reports to regulatoryauthorities and other concerned bodies.

It might be asked why Shariah compatibility should be judged byShariah scholars duly qualified for that purpose. The question canbe answered by analogy to the medical consultation. For any med-ical problem or question, every person would like to consult thoseduly qualified, if not the best, in the profession of medicine. Anal-ogously, any financial institution facing a Shariah problem in itsoperations would look for duly qualified Shariah scholars, if notthe best, to suggest the solution. This is a good analogy, becauseit directly tells us what we need to do to institutionalize a stan-dardized service in this respect. I believe it may be the right timeto start simply with an International Association of Shariah Schol-ars for the Finance Industry and later on develop it into a full-fledged ARMSCFI.

REFERENCES

Ahmad, A. (1993). Contemporary practices of Islamic financing techniques. Research PaperNo. 20. IRTI. Jeddah: Islamic Development Bank. Al-Bazdawy, A. A. (n.d.). Kashfal-Isra, 3, 205–206.Council of Islamic Ideology. (1981). The elimination of interest from the economy of Pakistan,Islamabad.Ibn al-Arabi, M. A. (n.d.). Ahkam al-Qur’an, 2, 5425–426.International Institute of Islamic Economic Thought. (1996). Evaluation of shari’ah supervi-sory bodies. Cairo, Egypt: Author.Kahf, M., & Khan, T. (1992). Principles of Islamic financing: A survey. IRTI. Jeddah: IslamicDevelopment Bank. Khan, M. F. (1991). Comparative economics of some Islamic financing techniques. ResearchPaper No. 12. IRTI. Jeddah: Islamic Development Bank.Khan, M. F. (1992). Human resource mobilization through profit-loss sharing based financialsystem. Research Paper No. 17. IRTI. Jeddah: Islamic Development Bank.

M. Fahim Khan


Khan, M. S. (1986). Islamic interest free banking. IMF Staff Papers. Kramers, J. (n.d.). Droit de l’Islam et Droit Islamique. Analecta Orientalia: Posthumous writ-ings and selected minor works of J.H. Kramers, 2, Leidan Bill.Siddiqi, M. N. (1983). Banking without interest. Leicester, UK: Islamic Foundation.



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