THE financial services industry is a highly-regulated industry due to the mobilisation of investors, depositors and policyholders, that is, public funds. Significant public trust demands proper supervision and monitoring of financial services and, hence, the promulgation of statutes, statutory provisions, guidelines and circulars with direct supervision from financial authorities.

Soundness and stability of the financial system are the universal concern of all financial authorities, as specified by World Bank Financial Soundness Indicators (FSIs).

With regards to regulation of Islamic financial institutions and services, various jurisdictions present different forms of regulatory framework. Variations of such framework are attributed to a country’s specific approach to the adoption of Islamic financial institutions, in particular, and embracing of the Islamic financial system, in general.

A social choice to regulate significantly depends on the types of government financial systems and their perspectives on financial liberation, as well as either having a banking (such as Germany) or capital market (such as the United States) orientation. In this respect, the regulators’ view on country, institution and market readiness towards desired transparency and market discipline will effectively influence the nature and degree of regulation.

Predominant Muslim governments that replace conventional financial institutions with Islamic ones in their respective jurisdictions present a “total” approach with the immediate dissolution of conventional institutions in the 1980s, as evident in Pakistan and Iran.

This approach recognises a single legislation and novel Modaraba companies are set up in addition to new “Islamic” financial institutions to mobilise Islamic funds.

This approach posed significant regulatory and policy changes to both regulatory and financial institutions due to the lack of a priori understanding of regulation and compliance with the Islamic financial institution and system, as well as resources. This lacuna has led to a significant reliance on existing conventional regulatory framework and hypothetical remedies based on early Muslim civilisation investment and trade credit experience.

Other Muslim-majority governments, on the other hand, considered a “dual-banking” approach, where both conventional and Islamic financial institutions coexist.

This approach presents a different regulatory landscape to supervise and monitor both conventional and Islamic financial institutions.

Though conventional legislation continues to be implemented for conventional institutions, several adaptations are implemented to cater to the dual-banking approach.

In countries like Malaysia, which pioneered dual legislation in 1983, separate legislation for Islamic financial institutions was introduced.

Specific guidelines for Islamic financial products, services and activities are prescribed to guide Islamic banking practices. In many respects, this approach is a “government-led policy approach”, where the financial authority proactively promotes comprehensive legal and governance frameworks for both conventional and Islamic financial institutions.

In the United Arab Emirates and Gulf economies, however, a single legislation is adopted with specific guidelines introduced to regulate Islamic financial services.

An important and significant observation is that conventional legislation is relevant and applicable to both conventional and Islamic financial institutions, and is subject to specific provisions and guidelines prescribed for financial institutions offering Islamic financial services.

In the case of later market entrants into dual banking from Muslim-minority countries, single legislation, that is conventional legislation, is applied to both conventional institutions and institutions offering Islamic financial services. In cases of financial structuring and resolving disputes, expert syariah opinions are sought to formalise the structure and resolve the conflict with specific legislative instruments.

From multi-jurisdiction approaches and legislative provisions, compliance with regulation or regulatory requirements applies to both conventional and Islamic financial institutions with additional provisions, where relevance has been prescribed for Islamic financial institutions. This is evidenced in Malaysia, where the Islamic Financial Services Act 2013 has additional provisions as compared with the Financial Services Act 2013.

Technically, it is dual legislation with additional provisions for Islamic financial institutions compared with conventional institutions.

Finance, as an interdisciplinary field that assumes multidisciplinary forms, arrangements and approaches, is essentially fluid in the financial services industry.

Financial assets and obligations are represented in various products or instruments in the banking and financial markets. Regulatory supervision and control take cognisance of market practices and the required supervision.

In most provisions and initiatives, the licensing of institutions and the proper approval of products and services are the main regulatory mechanisms. In addition, close supervision of the conduct of banking and finance activities by the supervisory authorities is implemented.

Financial institutions are categorised as banking (deposit-taking) and non-banking institutions in the financial system, and financial products and services are distinguished as core banking deposits and loans, or financial securities.

Both, according to international financial reporting standards, are financial instruments.

With the syariah prescription for trade to avoid usury, various attempts to transform institutions and reform products are proposed in various jurisdictions.

Among the factors that induce such reforms are financial inclusion and sustainable growth of a distinct segment of Islamic financial products and services.

Regulatory and policy initiatives in terms of financial inclusion were evident in 1993 in Malaysia, when “Islamic windows” were allowed for conventional banks to engage in Islamic financial products and services. An encouraging accelerated growth of Islamic banking products and services that mirror as an alternative to conventional products and services are observed.

Similarly, the introduction of Islamic bonds had a similar effect on the capital market. With sizeable sustainable Islamic banking activities, conventional banks were then directed to convert the windows to subsidiaries of conventional banks.

Though greater autonomy was granted to subsidiary banks, shared services continued with the parent conventional financial institution.

Similar trends are observed with takaful (mutuality) subsidiary companies of conventional financial institutions, whether bank or insurance companies. In a similar vein, sukuk is well-defined Islamic securities as compared with Islamic bonds and is distinguished from conventional bonds.

Transformation of the Islamic financial institution and its products will attract varied responses to regulation and compliance. In core banking, the “deposit-lending behaviour” is transformed into “investment-account financing behaviour”. Similarly, the “premium for risk transfer” in insurance is transformed into “contribution to risk pool” in takaful.

In economic substance, such transformation requires significant adjustments in business models and regulatory provisions to facilitate institutional growth and sustainability; financial product diversity and customer protection; and financial system soundness and stability.

Current practices with peculiar “teething problems” arising from a paradigm shift from “usury-based services” to “trade-based services”, as well as the required mindsets and skill sets, would continue to be highlighted in formalising the proper and timely compliance with requirements to be implemented. These would require significant human capital transformation to ensure timely and effective compliance.

Syariah, as the source of guidance for mankind, applies to all facets of human life as enunciated in its goals (Maqasid Al Syariah). Hence, it applies to all social activities, including economic, political and legal aspects.

Though the initial ideas on the establishment of usury-free economic institutions came from Islamic economics, significant developments in the adoption or adaptation of financial products and services in the Islamic financial system have been propelled by syariah legal prescriptions.

From a micro perspective, conventional financial products and services transforming from conventional to Islamic significantly rely on juristic rulings based on the interpretations of sources of syariah as Islamic law, as well as the applications of Islamic legal maxims.

The promulgation of syariah standards, as well as its resolutions produced by established syariah institutions, comprising eminent scholars, are particularly evident.

Given the progressive and substantive development of syariah promulgations, the need to observe the resolutions and rulings becomes a compliant requirement.

Effectively, the social dynamics of compliance can be identified as organic and inorganic in nature.

Investor-led Islamic financial institutions present an “organic self-governance” dynamics of syariah compliance. Islamic-preference investors effectively establish Islamic financial institutions with due regard to Maqasid al Syariah.

Hence, the philosophy, as well as the vision and mission of the institution, do not only present a commercial or social character, but religious in its own right to propagate Islam.

With an innate belief as described in the philosophy and worldview of the institution, it is a “built-in purposive mission” to establish syariah as the guiding light without the specification for regulation and external governance. This feature could be recognised in the first mover institution built on such a belief system. Islamic finance and banking business, from a holistic perspective, is the goal way forward as it is a sustainable value proposition.

However, with increased competition for survival within an uneven financial landscape (playing field), the initial vision could be blurred or coloured with information asymmetry and, hence, may lack the required discipline required for a sophisticated institution in a complex environment. Hence, excellent self-governance may be impaired without a proper institutional governance to support a sustainable self-governance initiative.

Conventional institutions, on the other hand, engage in the Islamic finance and banking business with anticipation to explore new market segments with innovative products to generate the growing segment revenue.

An “inorganic external governance” phenomenon can be observed when conventional banks are licensed to set up Islamic windows, Islamic subsidiaries or Islamic funds within the conventional financial holding company.

Primarily, the motivation of the parent conventional bank to continue its existing conventional financial activities without the need to comply with syariah requirements persists.

Its economic interest represented by and confined to syariah compliance only relates to the window operations, the subsidiary or the fund, which it procures the licence to operate from the regulator.

Unlike organic self-governing institutions, where self-governance is the precursor to institutional
syariah governance, inorganic external governance institutions confound syariah governance as an external governance requirement to be met.

The implications to the company as a whole are a “cost benefit consideration” that, as long as the economic benefit exceeds the compliance cost, Islamic finance or banking business perpetuates.

Hence, within a similar regulatory regime in a particular jurisdiction, it poses challenges for organic
self-governing institutions, also referred to as full-fledged banks, to operate concurrently with inorganic external governing institutions, also referred to as Islamic bank windows, funds or subsidiaries.

The nature of compliance varies between and within the single and dual systems, with single or dual legislation. In other words, full-fledged Islamic bank compliance requirements are not comparable with the Islamic bank subsidiary of a conventional bank within a dual system of similar or different legislation.

A more diverse compliance behaviour is expected in the dual system with dual legislation.

Despite the product and institutional reforms to properly and effectively portray the syariah governance system of framework and policies, divergent responses are expected from organic self-governance and inorganic external governance structures.

Harmonisation towards a common value system for both structures is necessary. This implies a need to inculcate common shared values and beliefs to establish a syariah-compliance culture.

The culture with a common code of conduct will guide Islamic finance best practices based on common shared values that can facilitate to embrace Maqasid Al Syariah.

Dr Syed Musa Alhabshi is an associate professor at International Islamic University Malaysia’s Institute of Islamic Banking Finance (IIiBF) and a member of the International Council of Islamic Finance Educators (ICIFE). He also serves on various boards and in syariah advisory capacities in the Islamic financial services industry

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