In mid-December of 2009, the high court in London issued a summary judgment in a little-known legal battle between Kuwaiti shareholding firm The Investment Dar (TID) and Blom Bank, a conventional bank out of Lebanon. What started as a simple lawsuit over TID's refusal to pay Blom US$10 million in principal invested in an Islamic finance transaction, plus 5% in a guaranteed return, quickly became an attack on the structuring of the Islamic finance deal that sent ripples of concern throughout the fast-growing Islamic finance industry.

In a move that stunned the almost US$1 trillion Islamic finance industry, TID argued that the deal — which was approved by its own Islamic legal board — ultimately did not comply with Islamic law because the additional fixed return constituted interest and was therefore void. The charging of riba, or interest, is not allowed under Islamic law and TID's charter prohibits it from entering into non-Islamic transactions. A judge upheld that while TID should repay the principal sum, it had an arguable defense regarding the extra profit should Blom Bank choose to press for payment of the promised return.

The judgment forced Islamic bankers and attorneys specializing in Islamic finance to quell fears among potential investors over the long-term risks associated with entering into a deal compliant with Islamic law by pointing out the unusual structuring of the transaction, which seemed to offer a risk-free fixed return on an investment. But for the growing number of Islamic scholars who sit and advise on Islamic law, or Shariah, to ensure compliance in financial transactions, the ruling was a personal blow to their credibility and highlighted how the lack of standardization in Islamic finance could potentially cripple an industry poised to hit US$2.8 trillion by 2015, according to the Kuala-Lumpur-based Islamic Financial Service Board.

"There is a lot of talk about standardization and many different bodies, such as Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) that set guidelines on how Islamic deals should be structured, but how do you force Shariah scholars to abide by those guidelines when they're sitting in their individual boards? There needs to be consensus among Shariah scholars first before standardization can even be an issue," says a Gulf-based Shariah consultant at a major Islamic bank.

No Real Standardization

Shariah boards review the details of business transactions and structures and issue a fatwa — or ruling — on whether the deals are compliant. Scholars make sure there is proper risk sharing in a deal, that there is no interest being paid out and that the deal is not engaging in any practices that violate the tenets of Islam, such as speculation. In the case of sukuk, the Islamic equivalent of a bond, Shariah boards make sure there is a transfer of assets in the deal, as Shariah does not recognize a borrower-lender relationship involving debt. Shariah boards also help advise companies on how to structure product, like derivatives, in a way that they hedge risk but do not engage in speculation. But individual boards can vary in their interpretation of Shariah, as there is no real standardization in Islamic finance.

To that end, prominent Egyptian Islamic scholar Hussein Hamid Hassan, chairman of the Shariah Coordination Committee of the Islamic Financial Institutions in the United Arab Emirates, said the Gulf Cooperation Council (GCC) suggested that a single Shariah council could be established by 2013 to aid in standardizing the industry, according to an interview with Bloomberg in May. Hassan, who is credited with helping to develop the Islamic finance industry through its infancy in the 1970s, noted that the industry needs stability to grow, citing how banks in the UAE struggle to do business with each other due to variations in Shariah interpretation of deal structuring from board to board.

From a business standpoint, a centralized GCC-based Shariah council would benefit the industry by reducing differences in Shariah interpretation, which would lead to a reduction in overall transaction costs of structuring a deal, and increase the flow of business by attracting new entrants to the market and fueling competition, says Harris Irfan, head of Islamic products at Dubai-based Barclays Capital. "If a sincere effort is made to create a pan-GCC Shariah council, then this is excellent news for the industry," Irfan states. "One of the principal benefits is the reduction in time taken to bring a product to market. Right now, the bespoke nature of each transaction … is causing the timeline to drag out to such an extent that the transaction can become commercially unviable."

Difficult to Achieve Consensus

While the Islamic finance industry managed to weather the global financial crisis far better than its conventional peers — a fact that has actually raised the popularity and interest in Islamic finance over the last two years — a widespread credit slowdown and inherent caution among corporations has already slowed down Islamic bond issuance and delayed the introduction of some products to market. Extended dealings to reach an accord with varied Shariah boards only add to the slowdown, bankers say.

Experts note that a centralized Shariah council in the GCC would likely mirror that of Malaysia's national Shariah council. Malaysia has the largest global market for Islamic bonds and, not surprisingly, has the most accommodating regulatory system for Islamic finance. The financial rulings issued by the country's central Shariah council are used throughout the country's Islamic financial institutions. Malaysia has a distinct advantage over the GCC as the nation's government has made a major push to help the industry grow. Malaysia's central bank, Bank Negara, has tightened Shariah rules for Islamic banks by requiring them to set up Shariah review, audit and risk management functions to reinforce compliance. The GCC is divided into various nations, with individual laws and standards for Islamic finance, making it difficult to achieve consensus in Shariah interpretation among a council of scholars that would appease all the regulatory systems in the region.

"The Malaysia model is backed by the enforcement arm of local laws and its central bank," says Sheikh Muddassir Siddiqui, a Shariah scholar and partner at Dubai-based law firm Denton Wilde Sapte. "At this stage most GCC governments have provided legislations related to the corporate governance of Islamic financial institutions. However, they have refrained from prescribing rules for developing Shariah compliant contracts." Siddiqui notes that GCC governments currently require each provider of Islamic finance services have their own Shariah board that will review the compliance of the transaction in relation to the laws and policies of the country in which the deal is taking place. To create a centralized pan-GCC council to oversee such matters would mean the different nations within the region would have to re-jigger individual regulatory systems, monetary policies and religious interpretations into one set standard, requiring all markets to scrap their current system and start from scratch to assure uniformity.

Uniformity in regulation would also mean that the governments would ultimately have to determine and agree on the most convenient interpretation of Islamic finance, in order to allow for a cross-GCC Shariah council to have a set standard to work with. Malaysian regulators have often been criticized in the GCC for being too liberal in their interpretation of Shariah and allowing Islamic finance products to mimic their conventional counterparts. Within the GCC, Saudi Arabia's interpretation of Shariah is far more conservative than that of neighboring Bahrain or the UAE, making it difficult to reach consensus on deals between the different nations. Siddiqui warned that trying to create regional councils to set Shariah standards might fragment the industry further by alienating those with differing opinions. "If the purpose is to exchange views on specific and unique challenges facing GCC Islamic financial institutions then it is a good idea," he notes. "But if the idea is to form a local GCC council to issue Shariah Standards, then I would recommend strengthening AAOIFI's role as a standard setting body for Islamic finance."

Maintaining Industry Oversight

The AAOIFI has 41 accounting and governance guidelines for Islamic financial institutions. Individual regulators in Bahrain, Qatar, Syria and Sudan made the standards mandatory for Islamic financial institutions but they are merely considered advisable in countries such as Malaysia, Saudi Arabia and the United Arab Emirates."It is not our policy to enforce our standards on any government," Mohamad Nedal Alchaar, secretary general of AAOIFI, said during an Islamic finance conference in Dubai. "But we are finding that governments are adopting our guidelines by default and that is a positive thing." Alchaar added that in order for the industry to grow and thrive, it will have to harmonize its practices, including reaching more consensus in Shariah interpretation.

But the industry may already be moving towards more consensus, states Majid Dawood, chief executive of Islamic consulting firm Yasaar Ltd. Dawood says that given the fact that a number of current Shariah boards throughout the GCC have the same few scholars in attendance already strengthens uniformity in the region. According to consulting firm Funds At Work, of the 132 Shariah scholars active in the GCC, the same top ten scholars make up almost half of Shariah board positions. While that helps with more uniformity of interpretation, it does not make it easy for scholars to maintain oversight of the industry, notes Yasser Dahlawi, CEO of Shariah Review Bureau, a consultancy licensed by the Central Bank of Bahrain.

"If you have a single scholar on the board of 60 organizations, how can he supervise efficiency?" Dahlawi asks. "What we need is for scholars to perform more of a supervisory role of the industry to make sure that Islamic products and structures are executed properly." To that end, Dawood says it would be unlikely that a centralized Shariah council would do away with the role of individual Shariah boards at financial institutions but rather serve to set more guidelines and provide oversight as well as possibly conflict arbitration.

A centralized body to provide oversight could have minimized risk by further examining the controversial deal between Investment Dar and Blom Bank, which resulted in such a black eye for the industry, experts say. But it was unlikely that even the strongest central body would be able to prevent such an occurrence from happening. Even with a pan-GCC Shariah council, Islamic financial institutions would ultimately still determine how to use those standards, Dawood points out. "There are rules, but at the end of the day, an umpire still decides. A council would likely serve an advisory role for individual Shariah boards and perhaps create more convergence in interpretation, which is the direction we're headed in anyway."