A presentation I made for a Central Bankers Seminar held at Cambridge in 2011 on Regulating Islamic Financial Products and Markets. The presentation leans towards raising issues relating to the process regulating Shariah compliance in Islamic financial institutions and for Islamic instruments, while trying to provide pragmatic solutions to address some of the core challenges the industry has yet to resolve, with the exception of Malaysia.

1. Sharia Governance for Islamic Finance
Quis custodiet ipsos custodes?
REGULATING ISLAMIC FINANCIAL PRODUCTS AND MARKETS
DR. SAYD FAROOK, GLOBAL HEAD ISLAMIC CAPITAL MARKETS

2. Agenda
• Challenges affecting the growth of Islamic Finance
• Shariah Governance Fundamentals
• Revisiting the Shariah Governance Challenges
• Requirements by standard setters
• Next Steps and logical solutions
• Recommendations
• What Central Banks and Regulators can do
• Q&A

3. Introduction
The Looming Significance & Growth of Islamic Finance
Global Shariah Compliant Assets
Year Assets ($B)
Source: The Banker

4. The Setbacks
• Lack of wider cheaper distribution channels
• Yet-to-be standardized products
• Challenges to core Sharia compliance process

5. SHARIAH GOVERNANCE
FUNDAMENTALS

6. Shari’a Non-Compliance Risk (1/2)
Legal Precedence
Beximco Pharmaceuticals Ltd and others v Shamil Bank of Bahrain E.C. 2004 EWCA Cir 19:
Murabaha financing contract
The contract provided "Subject to the principles of the Glorious Shari'ah, this Agreement shall be governed by and construed in accordance with the
laws of England."
Beximco argued that contract was contrary to Shari‟a law.
Decision: Court ruled in favour of Shamil stating that it is not its responsible to verify compliance with Shari‟a and also Shari‟a not a national legal
system.
Ratio Decidendi: it is for each party to satisfy themselves that the substantive terms of the underlying contract comply with Shari'ah principles.
English court will not judge on Shari‟a compliance or otherwise of the contract, but on the substantive provisions of the contract.
The Investment Dar Company (TID) v Blom Developments Bank SAL (BLOM) 2009 EWHC 3545 Ch:
Investment Wakala contract
TID argued the following:
Constitutional documents did not allow for Shari’a non-compliant transactions
Agreement did not comply with Shari’a
Beyond the corporate powers of TID and therefore void.
Decision: Court found an arguable case for TID, however, principal would have to be returned since court was of the opinion that TID‟s
argument would fail and BLOM could claim for restitution of the full principal, if not the profit payments.
Ratio Decidendi: The Court held that TID‟s counsel had made an arguable case that the Agreement did not comply with shari‟ah and the
Agreement was therefore ultra vires NOT that it would succeed in court.

7. Shari’a Non-Compliance Risk (2/2)
Micro- Mitigation Techniques
Key Considerations for mitigating Shari‟a Non-Compliance Risk:
Request a certificate confirming that the transaction is Shari‟a compliant from the Shari‟a
Committee/Advisor and preferably for material transactions, from the full Shari‟a Supervisory Board
A representation to be inserted into the Shari‟a compliant agreement stating that entry into and
performance by the IFI of that agreement does not conflict with any of its constitutional documents
The waiver by the IFI of any defenses that it might have in connection with the agreement not being
compliant with Shari‟a principles, for instance:
Each Party represents and warrants to the other that on the date of this Agreement and on the date of entering into each
Relevant Wakala Transaction:
it has the legal capacity to enter into this Agreement and the Relevant Wakala Transaction contemplated hereunder;
the execution by it of this Agreement and the Relevant Wakala Transaction has been duly authorized and executed;
it has entered into this Agreement and shall enter into each Relevant ------- Transaction contemplated hereunder after satisfying
itself of their compliance with Shari‟a, it is satisfied that this Agreement does not contravene Shari‟a and it does not have any
objection, nor will it raise any objections, as to matters of Shari‟a compliance in respect of or otherwise in relation to the
provisions of this Agreement;

8. Shari’a Supervisory Board
Institutions offering Islamic products employ services of religious advisors (the
Shari‟a Scholars) who are collectively known as Shari‟a Supervisory Board
(“SSB”). The key roles performed by SSB includes:
Issue Fatwa to certify compliance with Shari’a laws.
Periodic reviews for conformation with Fatwa on an ongoing basis.
Calculation and payment of Zakat.
Disposal of non-Shari’a compliant income (e.g. interest through donation
and charities).
Advise on distribution of cash flows, income and expenses between
shareholders and Sukuk holders.

9. Shari‟a Approval Process
Phase 1 Phase 2 Phase 3
Identify Shari‟a Options Finalise Shari'a Structure Review Legal Documentation
Activities Activities Activities
 Determine our clients‟  Review selected product  Review legal documents
needs and business structure for compliance with
objectives  Liaison with Shari'a Shari'a laws and the
 Identify potential high Client Scholars on the structure structure Fatwa granted
level Shari'a product selects design Client  Liaise with Shari'a
structures methodology  Identify required legal produces Scholars and the clients‟
& builds legal
 Discuss available options detailed
documentation documents legal team during the
with our clients structure  Prepare draft Fatwa documentation drafting
 Work through the  Review of structure by  Legal documentation
commercial and practical Shari'a Board and issue reviewed by Shari'a
considerations with our of Fatwa on structure Board and issue of
clients Fatwa on documentation
Deliverables Deliverables Deliverables
 Preliminary Shari'a  Fatwa on Shari'a  Fatwa on Legal
Report Structure Documentation
 Throughout the process, Dar Al Istithmar adheres to relevant Shari'a industry standards, including the AAOIFI Shari‟a Standards
 All processes are monitored through an internal quality assurance process and frequent consultation with the Chairman of the Shari'a Supervisory Board.

10. Operating Models
Model options Characteristics Shari’a Aspects
Shari’a Compliant Due to rapid development of Islamic Finance, From Shari‟a perspective, these are at the
Islamic Banks new banks are being set-up which are fully lowest risk due to:
Shari‟a Compliant and offer retail as well as • No dealing in conventional / interest based
whole sale banking facilities. products
Since 2004, five fully Islamic banks have been • No risk of mixing of Islamic Funds with
set up in the UK, out of which one is a retail conventional.
bank where as other four are whole sale banks.
• More involvement of Shari‟a Scholars in day to
day activities of the bank.
Conventional bank This model is used by conventional banks which From Shari‟a perspective, Islamic subsidiaries /
with an Islamic want to extend their services into retail and finance vehicles are considered at a lower risk
subsidiary / Finance whole sale Islamic Banking as well as retaining due to:
Vehicle the conventional customer portfolio. • Bespoke IT system and infra-structure for
This model is used by HSBC, Standard Islamic Products.
Chartered, Citi etc. • Segregation of Islamic Funds, cash flows,
assets and liabilities from conventional.
• Involvement of Shari‟a Scholars in day to day
activities of the Islamic Finance Vehicle.
Conventional bank This set-up is primarily used by conventional From Shari‟a perspective, Islamic windows are
with an Islamic investment banks which want to provide its high considered to be high risk primarily due to:
Window net worth individuals and institutional customers • IT Systems and infra-structure of conventional
access to Shari‟a Compliant investments and banks may not be not be flexible enough to cater
Structured products. requirements of Islamic Products.
This model is followed by Deutsche Bank, • Funds generated from Shari‟a Compliant
Barclays Capital etc. sources are not segregated from funds
generated from conventional activities.

11. Contrast of Shariah Governance with Existing
Governance Structure
FUNCTIONS TYPICAL FINANCIAL ADDITIONS IN IFIS
INSTITUTION
Governance Board of Directors Shari‟ah Board
Control Internal Auditor Internal Shariah
Review Unit
External Auditor External Shariah
Review
Compliance Regulatory and Internal Shariah
Financial Compliance Compliance Unit

12. Voluntary Standards on Shariah Governance
AAOIFI Governance Standards
1. Shariah Supervisory Board: Appointment Composition and
2. Shariah Review 3. Internal Shariah Review
Report
• At least 3 members (no directors or shareholders) • SSB forms opinion, but Shariah compliance rests with • Internal division or part of internal audit
• Requirements for report suggest Sharia board must play a management • Examination and evaluation of the adequacy and effectiveness
deep role in review of bank‟s operations. • Examination includes of the IFI‟s system of internal Shari‟a control and the quality of
• Recommendation to publish fatwas, rulings and guidelines contracts, agreements, policies, products, transactions, memo performance in carrying out assigned responsibilities.
randum and articles of association, financial
statements, reports (especially internal audit and central bank
inspection), circulars, etc.
• complete and unhindered access to all
records, transactions, and information from all sources
including professional advisers and the IFI employees.
The SSB review procedures shall normally include:
• obtaining an understanding of the management‟s awareness, commitment and compliance control
procedures for adherence to the Shari‟a;
• reviewing of contracts, agreements, etc.;
• ascertaining whether transactions entered into during the year were for products authorised by the SSB;
• reviewing other information and reports such as circulars, minutes, operating and financial reports,
policies and procedures, etc.;
• consultation/co-ordination with advisors such as external auditors; and
• discussing findings with an IFI‟s management.

13. Voluntary Standards on Shariah Governance
IFSB Standards 10
• The Sharī`ah governance structure adopted by the IIFS should be
commensurate and proportionate with the size, complexity and nature of its
business
I. General • Each IIFS must ensure that the Sharī`ah board has:
Approach
• clear terms of reference regarding its mandate and responsibility;
• well-defined operating procedures and lines of reporting; and
• good understanding of, and familiarity with, professional ethics and conduct.
• The IIFS shall ensure that any person mandated with overseeing the Sharī`ah
Governance System fulfils acceptable fit and proper criteria.
II. • The IIFS shall facilitate continuous professional development of persons serving
Competence on its Sharī`ah board, as well as its ISCU and ISRU, if any.
• There should be a formal assessment of the effectiveness of the Sharī`ah board
as a whole and of the contribution by each member to the effectiveness of the
Sharī`ah board.
• Play a strong and independent oversight role, objective judgement on Shariah.
III. NO INDIVIDUAL or GROUP should be allowed to dominate decision making
Independence • Compliete adequate and timely information prior to all meets and on an ongoing
basis
IV.
Confidentiality • Internal information kept confidential
• IFI should understand legal and regulatory framework for issuance of Shariah
V. Consistency pronouncements in jurisdiction of operation.
• Should promote convergence of Shariah governance standards

14. Voluntary Standards on Shariah Governance
IFSB Standards 10
• INTERESTING POINTS:
• Independence requires (among other usual BOD
requirements), where multiple memberships, sufficient time and
attention given to affairs of each IFIs.
• Fit and Proper requires „Good Character‟, „Competence and
Capability‟ and „expertise‟ for Shariah Advisory firms outsourcing this
work

15. Revisiting the Challenges
Challenges
Multi-board Conflict of
Increased Costs Shariah Diligence Interest
Representations
Multiple
Shariah Insufficient
Conflicts of Hired by IFI
Advisory Coverage
Interest
Concentration Standard of
Structuring Paid in BPs
Risk Due Diligence
Cost
Documentation
Implications
Supply Constraints Governance and Due Process Constraints
Previous proposals
Current Process: Certifying future Supranational Sharia
Participation and learn generations Body
by doing

16. Costs of Sharia Due Diligence
Example:
• Cost of sukuk issuance is usually in six
figures; and it includes Shariah
advisory, structuring, and legal
documentations.
• Sukuk costs can be up to 60% higher
than conventional bonds.
-------------------------------------------------------
The same concept applies to every other
Islamic product.

17. Conflict of Interests
• Scholars are appointed by the
financial entities themselves.
• Some scholars are paid in term of
BP per fund managed.
------------------------------------------------
Central Shariah Committee as a
solution??

18. Multiple Board Representation
The Top 20 Scholars based on positions in Islamic Financ
Institutions
Interesting Facts:
• Top 50 scholars occupy 834
positions (over 73% of positions)
• Multiple conflicts of interests
• Cost implications of
concentration.
Time + Effort + Rep. = 6 Figures
• The advantages of MBP

19. Shariah Diligence
• Are all documents and
structures properly
covered by the Shariah
scholar?
• What are the standards
used for appropriate due
diligence?

20. Shariah Non-Compliance And Due Process
• No framework to issue contrary
opinions.
• Issuers of fatwa & Fatwa Shopping.
• Fatwas deal with the micro-juristic;
not the macro-implications.

21. Previous Proposals
• Current qualifications
Participation and learn-by-
doing, rather than
education, research and gaining
experience.
• Transferring knowledge to the
next generation.
Two solutions:
1) A supranational Sharia
association
2) Certifying newer generations
of would-be scholars

22. One Solution
The Certified Shariah Advisory & Audit
(CSAA) Program
• What is this program?
• The disadvantages:
1) Does not qualify to form new opinions
2) Exam-based, rather than research-based
3) No qualification process for the
unqualified

23. What about a doctorate system?
Key Elements:
1) Very high research standards
2) Great knowledge of certain field(s)
3) Supervision by mentor(s)
4) Universal in a competitive world

24. What is the next step?
Way Forward:
Increase New Set of Governance and
Quality Supply Standards Due Process
Recognition Pre-requisites
of Shariah to Fatwa
scholars issuance

25. Recognising Shariah Scholars
Hypothetical Set of Criteria
• Peer recognition
- Letters of recommendation
• Education
- Doctoral degree
- Diploma and reference letters
- X years under the “wing” of a scholar
• Experience
- X years of Shariah auditing and advisory
- X years of Islamic Shariah law counseling
• Continued qualification process

26. Pre-requisites before issuing a fatwa
Due Process
• Reporting procedures for issued fatwas
• Checklist before issuing a fatwa
• In return, the support of AAOIFI

27. Recommendations Rundown (Examples)
• Scholars hired and supervised by a central Shariah committee (CSC);
appointing them to specific IFIs and paying them to prevent conflicts of
interest and Fatwa shopping.
• One certified Shariah scholar per IFI; certified and qualified by the CSC.
• Junior certified Scholars at IFIs; senior certified Scholars at CSC.
• Qualification structures:
- Doctoral degree + X years of experience to qualify as a Senior Scholar
- Doctoral degree to qualify as a Junior Scholar
- Masters in Shariah Advisory and Auditing as a minimum for proper due
diligence
• Standardized framework for Fatwa issuance and approval
Checklist Issuance Validation Review Update

28. Conclusion
What Central Banks and Regulators Can Do
 Leave as much as possible to the Shariah scholars; only prompt
and encourage them to come together in each jurisdiction.
 Regulate the process; not the law
 One step at a time; local, then global
 Set standards for Shariah qualifications and Fatwa process
 Provide guidelines and assistance for self regulation
 Promote cooperation and collaboration through greater
dissemination
 Create a national Shariah supervisory board
 Learn from other countries‟ experiences

29. Quis custodiet ipsos custodes?
Who will guard the guards themselves?
- Juvenal

30. Sayd Farook PhD
Global Head Islamic Capital Markets
sayd.farook@thomsonreuters.com
islamic.finance@thomsonreuters.com