By Charlotte Kan - Zawya - While regulation has been hardening in conventional finance in the wake of the 2008 credit crisis, Islamic finance still benefits from a much more relaxed regulatory framework, which on the one hand continues to support the industry's growth, but, on the other, creates risk.
The continuing absence of a centralized regulator for Islamic finance and banking is due to several historical, cultural, geographical and economic factors.
First, Islamic finance is comparatively immature compared to conventional finance.
"The modern Islamic finance industry has only been around for 30 or 40 years, whereas conventional finance has been formalized for several hundreds of years to create a regulatory structure. Islamic finance is a young industry - with very ancient roots," notes Jonathan Lawrence, a finance partner who advises on Islamic finance transactions at law firm K&L Gates in London.
"It's too young an industry to impose parameters on itself," Lawrence says.
The maturity of Islamic finance markets varies from country to country, with some markets well-established - like in the Middle East and Malaysia - and others that are more recent, which can prove challenging in terms of standardization of regulation.
Another difficulty is the religious, cultural and geographic mix that Islamic finance encompasses.
"Standardisation of documents and structures would prove difficult, as there are different traditions within Islam with, for example, Shia and Sunni branches. The question is which traditions and which structures emerge," Lawrence says.
Spanning several continents and Muslim traditions makes it difficult to implement a regulatory framework that would fit all. For instance, Shariah compliance in countries like Malaysia or the UAE is considered to be more liberal than in places like Saudi Arabia.
That is why regulation is divided between standard-setting bodies and scholars.
The Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was created in 1991 to issue international standards on accounting, auditing and corporate governance. It has 200 members from 45 countries, including central banks, Islamic financial institutions, and other participants in the Islamic banking and finance industry.
In 2003, another regulatory body was established with the support of the International Monetary Fund by central banks and the Islamic Development Bank: the Malaysia-based Islamic Financial Services Board (IFSB). Its mandate is to "promote and enhance the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors".
However, these bodies only issue standards, and cannot enforce them - there is no mandatory element to it. So how is the risk element controlled?
"The risks are regulated on a country-to-country basis or, in the case of conventional banks' Islamic windows, regulation is already imposed on the institution. It is not a wild-west industry, totally unregulated," Lawrence stresses.
"There's already a huge growth in regulation in all parts of finance, especially conventional finance," he adds.
This status quo on the regulatory context of the industry is convenient for its players.
"Lack of regulation definitely helps the competitive nature of the Islamic finance industry and enables the strongest structures to emerge as most robust in the market. Regulation would be a potential stop on growth," Lawrence argues.
However, many experts worry that the lack of standardization and harmonization in the industry may actually end up harming it in the long term. There are, in particular, concerns about the role of Islamic scholars in the industry.
Financial institutions willing to be involved in Islamic products have a committee of scholars on board to determine what is Shariah-compliant and what is not, through fatwa. Shariah being open to interpretation, Islamic scholars are not always in complete agreement regarding what is compliant with Islamic law. Especially as there are various schools of thought in Islamic jurisprudence (Hanafi, Shafei, Hanbali, Maliki, Ibadi etc).
This fatwa pluralism can create ambiguity in decisions on the veracity of a transaction in terms of its compliance with the Shariah. Furthermore, how the scholars operate, how they are chosen by the institutions they work for and how sympathetic they are to these institutions are open questions.
"The industry has grown despite there being no central regulator and not because there is no central regulator. If Islamic finance is a plant that grows in a garden - then the central regulator is a gardener who cultivates the soil for such a plant to take root; today, Islamic finance grows generally without having such an environment created for it. What is needed is a proper legal and regulatory framework that governs Islamic finance providing clarity for the stakeholders and reliability and resilience for the consumers," says Oliver Agha, founding partner of Agha & Co, a Shariah-compliant law firm based in Dubai.
"With many people having very little knowledge of Islamic finance, the lack of regulation is a hindrance to the industry in the long run. A central regulator would provide cohesive vision and strong overall strategy to tackle the issues confronted by the Islamic finance industry. In the absence of the same, there is a risk of an inconsistent application of principles, which may result in greater confusion and, ultimately, the parties may lose faith in the principles of Islamic finance," says Agha, who is a board member of the AAOIFI, and secretary general of the World Islamic Finance Institute.
Before a central regulatory body is imposed, the industry has to strike a balance between providing effective supervision and facilitating further growth and development.
Many argue that in order to continue to grow properly, Islamic Finance must come back to its spiritual roots and put principle before profit.