Profit-Sharing Investment Accounts (PSIAs);

24. PSIAs currently constitute a significant share of Islamic banks’ funding sources in most countries.⁴ The PSIAs are usually based on a Muḍārabah partnership contract between the bank and the customer, where the Investment Account Holder (IAH) acts as an investor and the Islamic bank acts as the entrepreneur. In some instances, a Wakaāah agency contract is used; and in this arrangement the Islamic bank acts as wakeel (agent) and receives a management fee for managing the customer’s funds.

25. PSIAs can be either restricted or unrestricted. In the case of restricted PSIA, the IAHs impose restrictions as to where, how and for what purpose the funds are to be invested. This arrangement is similar to non-discretionary wealth management accounts offered by private banks. However, unlike mutual funds, account holders’ funds are not vested in a separate legal entity. Instead, they are managed by the Islamic banks and they are reported as “off balance sheet” Funds Under Management (FUM). For Unrestricted PSIAs, the IAHs authorize the bank to invest their funds in a manner that the Islamic bank deems appropriate, without laying down any restrictions. The arrangement has some similarities to the discretionary wealth management accounts offered by private banks, but a major difference is that these are offered to retail clients and not to High Net Worth (HNW) clients; account holders’ funds are also commingled with current accounts and with shareholder funds; and they are reported as “on balance sheet” items.

26. The returns to PSIAs are influenced by a variety of factors. The capital value and returns to PSIAs depend on the banks’ profits, and banks determine the profits on which the payout is based. The proportionate share of profits, between the bank and the holders of PSIAs, is determined ex-ante by mutual consent, but the losses, if any, are borne by the account holders, unless the loss has been caused by mismanagement or negligence on the part of the bank as a manager of the funds, or by a violation of the terms of the contract. ⁵ The returns depend on the profitability of the individual enterprises that are financed, but funding is comingled and payouts smoothed through a “profit equalization reserve” (PER) or Investment Risk Reserve (IRR). Industry or International Financial Reporting Standards (IFRS) specific policies on maintaining appropriate reserves to manage PSIA returns also affect the risk-return mix for PSIAs. Unlike deposits in conventional banks, investment accounts are not liabilities of banks and the bank is not obligated, in the event of loss, to return the original amount.

27. These features of PSIA place consumers at a disadvantage, unless there are well-defined regulations to protect the account holders. In particular, since payouts are largely determined by bank management and there are large asymmetries in accounting information, banks can inflate the expenses, and thereby reduce the profits available for distribution. The PER and IRR raise an intergenerational distribution conflict because profits added to the banks PER do not accrue to existing investors. Because PSIAs are not treated as deposits, in resolution, the claims would be subordinated to creditors. Finally, because the bank stands to benefit from the upside but is protected from losses, this asymmetry creates incentives for a bank to take on excessive risks.

28. The conglomerate structures of Islamic banks also have the potential to create a conflict between the business interests of the group and the fiduciary responsibilities of Islamic banks, and may not incentivize Islamic banks to act in the best interests of IAHs. In particular, Shar’iah principles require Islamic banks to link transactions to real productive economic activities, thus the banks have been permitted to establish subsidiaries of non financial corporations to facilitate investment activities. These SPVs, joint ventures and associate companies benefit from the parent banks in terms of liquidity provisions, operations from shared services, and business referrals. Therefore, from a business perspective, there is an incentive to invest client funds in group companies. However, investments in group companies may not always ensure the best returns for IAHs, who bear the risk of loss. Moreover, the presence of non financial corporations in the group pose challenges for board composition and oversight, which is critical in internalizing a strong risk culture, creating a synergy between risk governance and ensuring a Shar’iah governance framework, and aligning the risk appetite between shareholders and IAHs.

29. IAHs with a strict preference for investment in Shar’iah compliant products could also face Shar’iah non compliance risk, arising from banks breaching client mandate. While a number of countries (Jordan, Malaysia, United Arab Emirates) require banks to separate funds raised by way of Islamic deposits from other funds, there are many others where there are no such requirements, thus the potential for commingling funds is high, particularly for Islamic windows. In addition, some Wakaāah contracts contain provisions that guarantee a specified rate of return or certain profits despite the results of the transaction(s). Such provisions arguably contravene Shari’ah principles as guaranteed returns or profits are not Shari’ah compliant in that they do not enable risk sharing between the wakeel and the muwakkil.⁶ Non compliance with Shar’iah is also possible if there is no governance structure to ensure that products issued by the Islamic banks are Shar’iah compliant.

30. To protect consumers, regulations on disclosures and governance need strengthening. To enable clients make informed choices among the different banks based on risk preferences, Islamic banks would, ex-ante, need to publish investment strategies, objectives, and risk-reward thresholds in addition to ex-post audited financial statements. There is also a need for board representation to ensure that investment decisions are in their best interest

31. The IFSB and AAOFI have issued a number of standards and guidelines to improve disclosures, transparency and governance, but adoption and enforcement of the standards is highly uneven across countries. Currently, while PSIAs share many features of Collective Investment Schemes (CIS) with respect to fiduciary responsibilities on the part of the bank, in practice, Islamic banks, in many countries, undertake this fiduciary role without being subject to Conduct of Business (COB) rules that ensure adequate disclosures to holders of PSIAs on investment objectives, strategies, risks, computation of profits and valuation of assets.⁷

Ijārah Muntahia Bittamlīk or Lease to Purchase

32. Ijārah is a contract of sale of the right to use an asset for a period of time. Under Ijārah Muntahia Bittamlīk, the legal title of the assets only passes to the lessee at the end of the Ijārah term, through gift, consideration or gradual sale, provided all Ijārah installments are settled.

33. In the absence of tailored oversight, Ijārah Muntahia Bittamlīk contracts could place consumers at a disadvantage in the event of a default on lease payments and with respect to capital gains. Whereas in conventional mortgages property can be sold to pay off the bank, a customer who fails to meet payments mid-way through the term of an Ijārah agreement could lose all past payments. In addition, because lenders retain property ownership (Ijārah and Murabahah loans) or release it only progressively (Mushārakah templates) the consumer cannot take advantage of capital gains to prepay or refinance the mortgage, if his financial position deteriorates.

Sukuk

34. Sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufructs and services or in the ownership of the assets of particular projects or special investment activity [AAOFI 2010]. Although Sukuk instruments rely on common concepts such as equity participation and asset securitization, the production process is akin to project finance, where each deal is structured based on project characteristics. The underlying structure varies, depending on issuer, investors, country-specific and or lead managers. Commonly used structures for Sukuk are Ijārah, Wakaāah, Mushārakah, Murabaha, Istina, Muḍārabahh and Salam or a combination of these structures (hybrid).

35. Sukuk structures may be either asset-backed or asset-based.

• For asset-backed Sukuk, the certificate holders, in principle, have recourse to the underlying assets in the event of default, provided that all the legal arrangements required to become a genuine owner of the assets are put in place. Thus, the risk faced by the investors is at most the risk of capital loss resulting from a decline in the prices of underlying assets (market risk) and/or default of the lessee on rental payments.

• On the other hand, if the Sukuk are asset-based, investors or Sukuk holders have no recourse to the assets. The structuring element embeds a purchase undertaking by the issuer, which then creates a debtor/creditor relationship in the event of a default. The investor, therefore, takes the risk of the “Obligor”—the party providing an undertaking.⁸ Prospective investors, therefore, rely on the creditworthiness of the obligor or sponsor of an asset-based Sukuk rather than on the quality of the assets underlying the Sukuk. In the event of default of the originator, Sukuk are given the status of unsecured debt subordinated to the originator’s other obligations.

36. So far, most outstanding Sukuk are “asset-based”. Sukuk structures have also tended to be complex, in some cases motivated by regulatory arbitrage or tax efficiency considerations. Whatever the motivation, the resulting complex structures render it difficult for investors to discern the risks they are taking on. Appendix 1 presents schematic pictures and description of the cash-flows for various Sukuk structures, including those based on Ijārah, Murabaha, Mushārakah and Muḍārabah.

37. Sukuk restructurings and defaults exposed inconsistencies between theoretical principles of Sukuk products and actual structures, as well as gaps in investors’ understanding of the risks. Some of the prominent Sukuk defaults or restructurings include Nakheel and Dana Gas Sukuk of the United Arab Emirates., Golden Belt Sukuk of Saudi Arabia, and The Investment Dar Sukuk of Kuwait. These Sukuk were based on different structures, including Mushārakah, Ijārah and Ijārah manfaa and the majority were issued as asset-based rather than asset-backed. The resolution resulted in unexpected outcomes for investors who believed that they would have recourse to the underlying assets. In other cases (Nakheel and Dana Gas Sukuk) investors ignored the credit risk on expectations of government intervention.

38. The Sukuk default and restructuring cases also highlighted the fact that investors’ rights depend on local laws and on the strength of legal rights in the country where the collateral is likely to be contested. Sukuk are issued in environments with varying legal traditions and divergent views on Shar’iah as a source of law. The outcome, in default cases, depended on decisions taken after a default event and varied with the local laws of the jurisdiction where the underlying assets were domiciled. The cases demonstrated a lack of legal certainty in cross-border insolvencies, lack of transparency, unequal treatment, and a risk of contract unenforceability with respect to Shar’iah compliance issues. The cases also highlight differing understanding of rights between the issuers, investors, traders, lawyers and regulators. For instance:

• When Saudi Arabia’s Golden Belt 1 Sukuk defaulted in November 2009, a royal commission was created to restructure the debts. However, the commission only addressed the amount owed to local investors. Foreign investors, on the other hand, have not been able to gain access to the assets held by the Sukuk sponsor.

• In the case of US-based East Cameron Sukuk, though the issuer filed an adversary proceedings requesting the court to consider the primary Sukuk transaction with the purchase SPV as secured loans and not as true sale of assets, the U.S. court ruled that it was an asset-backed Sukuk and that investors had the right to a certain quantity of gas produced by East Cameron over the life of the Sukuk.

• Very few restructurings of Sukuk securities have been finalized, and most have been ongoing for years. Without a swift resolution precedent and a clear legal framework for debt restructuring, Sukuk holders have to seek resolution and recovery of their investment in case-by-case negotiations, subject to local judicial systems.

39. IIFM review (2013) found that in practice, even in cases of asset-backed Sukuk, legal transfer of ownership, in most cases, where international investors are involved, is either not permissible under applicable local laws or, is a complicated and expensive legal and regulatory process. The restructuring of defaulted Sukuk also faced major obstacles because of minority holders hijacking the restructuring and demanding full repayment.

The Legal and Regulatory Framework

47. The legal and regulatory frameworks for consumer protection in financial services are fragmented and have important gaps and overlaps. Most countries have in place a broad legal framework for consumer protection, but legal provisions relevant to financial services are in many cases diffused in multiple pieces of legislation (Table 1) and the coverage of issues is generally not comprehensive. In addition, very few countries (Oman, Malaysia, Bahrain) provide explicit guidance for Islamic financial products in the regulations governing consumer protection.

Table 1.

Status of Legal Frameworks for Consumer Protection

Source: World Bank CPFL Global Survey Red means not covered in the survey For countries not covered by the survey, information was obtained from an earlier publication by Ardic et al (2011)

Table 1.

Status of Legal Frameworks for Consumer Protection

	General CP law without explicit reference to financial services	CP law with explicit reference to financial services	Separate FCP law	CP regulations within the framework of financial sector legislation	Other FCP law or regulation	Explicit provision for Islamic Finance
Algeria	✔			✔
Azerbajain	✔			✔
Bahrain				✔		✔
Egypt		✔
Indonesia	✔			✔
Iran		✔		✔
Jordan			✔
Kazakhstan		✔	✔	✔	✔
Kuwait	✔	✔		✔
Lebanon	✔			✔	✔
Malaysia						✔
Morocco		✔		✔	✔
Oman	✔			✔		✔
Pakistan	✔			✔
Saudi Arabia	✔	✔	✔	✔	✔
Syria		✔
Sudan	✔
Tajikstan	✔			✔
Tunisia
Turkey		✔		✔	✔
UAE	✔			✔
Yemen

Source: World Bank CPFL Global Survey Red means not covered in the survey For countries not covered by the survey, information was obtained from an earlier publication by Ardic et al (2011)

View Table

Table 1.

Status of Legal Frameworks for Consumer Protection

	General CP law without explicit reference to financial services	CP law with explicit reference to financial services	Separate FCP law	CP regulations within the framework of financial sector legislation	Other FCP law or regulation	Explicit provision for Islamic Finance
Algeria	✔			✔
Azerbajain	✔			✔
Bahrain				✔		✔
Egypt		✔
Indonesia	✔			✔
Iran		✔		✔
Jordan			✔
Kazakhstan		✔	✔	✔	✔
Kuwait	✔	✔		✔
Lebanon	✔			✔	✔
Malaysia						✔
Morocco		✔		✔	✔
Oman	✔			✔		✔
Pakistan	✔			✔
Saudi Arabia	✔	✔	✔	✔	✔
Syria		✔
Sudan	✔
Tajikstan	✔			✔
Tunisia
Turkey		✔		✔	✔
UAE	✔			✔
Yemen

Source: World Bank CPFL Global Survey Red means not covered in the survey For countries not covered by the survey, information was obtained from an earlier publication by Ardic et al (2011)

48. There are no international guidelines with respect to specific disclosures and country practices vary significantly. Some countries (Malaysia, Pakistan, Bangladesh) have issued guidelines on calculation of profits by Islamic banks but for many others the rules are silent.

49. The regulatory treatment of PSIAs in supervisory frameworks remains unclear and does not offer adequate protection for the IAHs. Only a few countries (such as Saudi Arabia) require Islamic banks’ investment activities to be licensed by the Capital Market Authority (CMA). Some countries (Yemen) do not have capital markets and therefore no securities regulation, thus, Islamic banks in these countries would be undertaking investment activities in a regulatory vacuum. In the absence of clear Conduct of Business rules governing the investment—such as disclosure requirements, segregation of funds, certification of investors, custody rules—the potential for comingling investor assets is high and, in bankruptcy, IAHs could suffer losses unrelated to their investments.

50. Many countries that have issued Sukuk have weak Insolvency frameworks (Figure 6). Enforcing contracts still takes several years in most of these countries. Also, as indicated by the index of insolvency, the legal framework applicable to liquidation and reorganization proceedings also remains weak, with most of the countries ranking below 7 on a scale of zero to 16. The underdeveloped domestic bankruptcy laws, cross-country differences in local laws, and limited legal precedents create uncertainty over the enforceability of investor rights, particularly in default events.

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Strength of Legal Rights

Citation: IMF Working Papers 2015, 107; 10.5089/9781513515106.001.A001

Source: World Bank Doing Business Survey, 2015

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51. Bankruptcy remoteness and enforceability of investors’ rights are indispensable prerequisites for any innovation in Sukuk securitization, but at present a robust legal framework for securitization is also lacking in many countries. The absence of a conducive legal and regulatory infrastructure (for example, true asset sale or separation of title from beneficial ownership; trust laws; taxation, insolvency, and bankruptcy laws) is a major challenge for Sukuk securitization, and it explains the prevalence of “asset-based” Sukuk over “asset-backed” Sukuk.

Enforcement Mechanisms

52. The regulations are, in many cases, not systematically implemented and enforced. A recent survey by the World Bank [2014] shows that financial institutions in some countries are required to report statistics on the number of complaints, operate a hot-line for complaints or monitor the market’s advertising. These programs, however, relate to financial services in general and not specifically to Islamic financial products. Statistics on consumer complaints that could help in formulating effective policies were generally not available; and this raises questions about the extent of monitoring and enforcement.

53. Disclosure practices are improving but progress is uneven. Market pressures, International Financial Reporting Standards (IFRS), Basel II and the IFSB’s 2007 guidance on disclosures for Islamic financial institutions have contributed to enhanced disclosure requirements. Islamic financial institutions, like conventional banks, now disclose a wide range of information, including management policies, risk exposures and risk management practices. However, there are notable variations in the disclosures that are specific to Islamic finance, such as investment objectives, strategies, payout formulas related to IAHs and Shar’iah compliance. Many respondents to the IMF survey indicated that not all countries are required to publish statements about Shar’iah compliance and for many countries, Islamic and conventional banks are subject to the same disclosure requirements. The IFSB/IOSCO/Malaysia [2013] review on disclosure requirements by capital market regulators in various jurisdictions found that the contents of Sukuk prospectuses varied significantly, and there is no international standards in respect of specific disclosures.

54. The dispute resolution framework in Islamic finance continues to evolve and encompass both litigation and Alternative Dispute Resolution (ADR) mechanisms. The complexity of the Islamic financial instruments, which needs the attention of Shar’iah experts in dealing with disputes and the inadequacy of the present contract laws to deal with Islamic transactions, is contributing to the use of ADRs. A number of countries (for example, Malaysia, Qatar, United Arab Emirates) have established local arbitration centers to resolve disputes in Islamic finance. The kinds of ADR commonly used are negotiation, conciliation, mediation and arbitration. For retail clients, many countries have established an Ombudsman office. A survey of the arbitration centers by Jonathan Lawrence (2012) showed that there have been very few cases involving Islamic finance. Overall, while sound grievance and redress mechanisms exist for bank customers, their effectiveness is undermined by inadequate awareness of the process and by the complexity of the procedures. Information on whether the Ombudsman offices have expertise in Shar’iah laws was not available.

Deposit Insurance Schemes

55. Deposit insurance is relatively new to Islamic finance. Despite the large number of countries adopting Islamic finance, only selected countries (Bahrain, Jordan, Kuwait, Malaysia, Turkey, Singapore, Sudan, the United Kingdom) have introduced Islamic deposit insurance schemes (IDIS). Among these countries, there are notable variations in the approaches. Bahrain introduced an ex post IDIS in 1993 and, to date, remains the only country to have implemented such a system. Sudan developed a full-fledged ex ante IDIS in 1996. Malaysia has a dual deposit insurance system that includes parallel but separate insurance schemes for Islamic banks and for conventional banks. In other countries (Indonesia, Jordan, Kuwait, Singapore, the United Kingdom), Islamic deposits are protected under the country’s deposit insurance system.

Financial Literacy and Capability

56. Programs to improve financial literacy in Islamic finance are still in the developmental stages. In several countries, there is a growing trend of offering degree programs and professional qualifications in Islamic finance among major institutions of higher learning and training organizations in a number of countries. The Islamic Development Bank (IsDB) has been collaborating with central banks on jointly organized programs for regulators and policy makers. Financial supervisors in some economies (Malaysia, Saudi Arabia) are actively involved in financial education activities. In Bahrain, a special fund (the Waqf Fund) was established to support Islamic finance training, education and research.¹⁰ Many other countries, however, are yet to provide education programs for financial literacy, especially in Islamic finance. Shar’iah scholars also remain scarce.

Strengthening the regulatory and supervisory framework

59. A sound and stable banking system protects consumers from losses, thus it is important that regulatory and supervisory frameworks seek to address the risks facing an industry more comprehensively. Islamic banks undertake investment banking in addition to standard banking intermediation functions; their corporate structures are made complex by the prevalence of subsidiaries of non financial corporates in the groups; and their transactions are required to be Shari’ah compliant. Therefore, regulatory and supervisory frameworks need additional provisions to address these risks that are specific to Islamic finance.

60. International standard setting bodies for Islamic financial institutions have developed standards to address these unique risks, but progress in adopting these standards has been uneven across the countries and the standards have also not been consistently applied. Regulators do not always have the capacity (or willingness) to ensure Shari’ah compliance, which undermines consistency of approaches within and across borders.

61. A broad range of reforms are, therefore, needed. Islamic banks require a hybrid of banking and capital markets regulations to cover the cross sector operations in banking and investment business; and to enforce conduct of business rules, including those related to segregation of funds for restricted investment account holders, best execution principle and breach of client mandate. Tailored regulations are also needed to minimize group risks arising from the complex conglomerate structure of Islamic banks and which fall out of the scope of consolidation for consolidated supervision. There is also a need to address the risk that the financing of Islamic banks do not have any secondary market, which serves as a key to manage withdrawal risk in open ended mutual funds. Shari’ah governance structures also need strengthening and harmonized.

Strengthening Consumer Protection Frameworks

62. Many countries have been reforming their consumer protection frameworks for financial services, but important gaps remain. The areas for further reform identified in this review include: (i) streamlining the legal and regulatory framework for consumer protection in financial services; (ii) providing regulatory clarity for IAHs; (iii) enhancing disclosure requirements; (iv) monitoring compliance; and (v) establishing cost-effective dispute resolution frameworks.

63. The current diffused nature of legal provisions relevant to consumer protection for financial services poses a number of challenges. First, different laws may contain conflicting provisions, making compliance difficult. Second, the laws may assign supervisory and regulatory powers to a number of different agencies which creates difficulties for effectively implementing legislation. An effective coordination mechanism among regulators and key stakeholders is, therefore, needed to help define strategic priorities and clarify roles and responsibilities.

64. The treatment of IAHs in resolution should be clarified in law. Currently, many regulators treat these as deposits, but their ranking in bankruptcy situations remains unclear and it is often not codified in law. Under a conventional deposit insurance scheme all depositors are ranked equally, but this is not necessarily the case under an Islamic deposit insurance scheme, where a distinction could be made, first, between actual deposits (Wadiah) and Qard on the one hand and PSIA on the other hand, and second, between restricted and unrestricted PSIA.

65. Disclosure practices can be enhanced by implementing IFSB and AAOIFI standards and guidelines on disclosures and governance. Because unrestricted investment accounts allow the bank to commingle its own funds with IAHs funds, adequate transparency is absolutely essential to enable the IAH to assess the performance of the management. Islamic banks should, therefore, disclose the policies, strategies, and profit allocation basis of investment accounts; differences between restricted and unrestricted IAH; and the role of various reserves and other policies used to manage the rates of returns and the risks associated with PSIA. Banks should also make available accurate, relevant, and timely financial statements on the investments, including their performance and valuation; clarify their governance structure for ensuring Shar’iah compliance, the circumstances where losses are to be borne by IAHs, and the investors’ contractual rights with regard to early withdrawal or redemption. For Ijārah Muntahia Bittamlīk, consumer rights in default should be clarified ex ante.

66. Consistent with IFSB recommendations, the management of restricted IAHs funds should be governed by International Organization of Securities Commission (IOSCO) principles governing Collective Investment Schemes (CIS). Such investment business should be subject to capital markets regulations related to client mandates, commingling of client assets, segregation of client funds, disclosures on investments and requirements for training and certification of fund managers. For countries without capital markets and therefore no securities regulation, the regulator should be given legal powers to develop a prudential framework for Islamic banks that incorporates conduct of business rules and to oversee these rules. Supervision should ensure that customer agreements are followed.

67. Monitoring compliance with financial consumer protection regulations is essential to effective implementation of the legislation, and can help inform public policy. Therefore, regulators should build capacity to enforce and monitor the consumer protection mandate. Country level impact assessments of the regulation on the users of Islamic financial services, as well as on the cost to financial institutions, are important in determining the most effective approaches to ensure fairness and transparency. Data on consumer complaints should be compiled and used to inform consumer protection policies.

68. Cost effective dispute resolution mechanisms are needed, including ADR mechanisms while retaining the customer’s right to go to court. This is particularly important for retail clients where amounts in dispute for each consumer are usually not large enough to warrant the expense and time of litigation. Also, litigation is not geared towards resolving Islamic finance disputes, unless the judges are schooled in Shar’iah principles. Therefore, arbitration procedures that involve a financial ombudsman who has the requisite knowledge both of Shar’iah and relevant commercial transactions, are particularly useful. There is also a need to increase consumer awareness of redress mechanisms.

Promoting Financial Literacy

69. Islamic finance education and training opportunities are more readily available now than in the past, but there is significant scope for improvement at all levels. A major challenge continues to be the human resource development of practitioners, Sharī`ah scholars, lawyers, accountants, regulators, judges, politicians and other stakeholders. A related issue is limited awareness about Islamic finance among the general public, including among the educated and influential elite. Addressing the shortage of Sharī`ah scholars should therefore be a policy priority as well as expediting financial literacy programs.

Strengthening Corporate Governance Structures

70. Governance arrangements need strengthening to ensure the protection of IAHs and Shar’iah compliance. In line with IFSB guidelines, the establishment of a Governance Committee with the responsibility to oversee governance issues relating to IAHs, can help to enhance the transparency of returns and risks, and ensure that investment decisions are in the best interest of IAHs. Consumers who want to invest in Shar’iah compliant products would need protection to ensure that their requirements are complied with.

71. An important decision that would need to be made is whether to establish a centralized Shar’iah board that covers Islamic banks or keep Shar’iah governance decentralized at the bank level. Supervisors need to have full understanding of the pros and cons of each model and any Shar’iah governance system, at the national or institutional level, should have the necessary features of “competence, independence, confidentiality and consistency”. Overall, a centralized Shar’iah board offers the advantage of harmonizing Shar’iah rulings across the Islamic sector, reducing the cost of Shar’iah compliance for Islamic banks, enhancing consumer confidence and easing constraints arising from the lack of sufficient numbers of Shar’iah scholars.

Strengthening the Protection of Sukuk Investors

72. Sukuk structures can be very complex and this can make it difficult for investors to discern risks. In addition, the legal and regulatory frameworks are not harmonized across countries, thus investors are exposed to legal risks, particularly in cross border defaults. Therefore, protection of Sukuk investors requires action on four broad fronts. These in the main include strengthening domestic bankruptcy regimes, harmonizing the international legal and regulatory environment; standardizing contracts and strengthening securitization laws.

73. There is a need to strengthen domestic bankruptcy regimes and harmonize the international legal and regulatory environment for Sukuk. The experience with Sukuk defaults exposed the vulnerability of investors’ to cross-country differences in legal frameworks, demonstrated how ex-post outcomes were contingent on local laws, and also exposed disparities between ex ante provisions and ex-post outcomes. The rights of investors were also better protected in countries with stronger insolvency regimes.

74. The rising volume of cross-border Islamic financial transactions underscores the urgent need to harmonize regulatory frameworks and so reduce the legal risk in Sukuk default. Sukuk issued from jurisdictions with underdeveloped legal and regulatory infrastructures have resulted in investor rights not being upheld. Although asset-backed Sukuk are expected to behave differently in the event of stress or the originator’s default, even true asset securitization may be challenged given the limited experience with the instrument and the variation in legal opinion across jurisdictions. Collaboration at the international level is, therefore, needed to address cross-country differences in the insolvency regimes.

75. Standardization of contracts would also enhance consumer protection. The growing number of structures used to construct Shari’ah-complaint Sukuk has brought its own complexities and differences in understanding between the issuers, investors, traders, lawyers, and regulators. To protect consumers or investors, there is a need for clearer understanding with documentation, guidelines, best business practices, and transparency, while strengthening and streamlining the Shari’ah approval processes. The IIFM efforts to create greater transparency, market unification and Shari’ah harmonization are an important step. Current work by the IIFMs in the area of Islamic Capital & Money Market (ICMM) standardization will play an important role.

76. Finally, securitization laws need strengthening to facilitate issuance of asset-backed Sukuk. Apart from consumers and investors’ preference, and their unwillingness to accept the risk of underlying assets and limitations in available assets, the inadequacies in securitization laws are among the reasons that most countries issue asset-based Sukuk in which the investors do not have recourse to the underlying assets. For some countries, it will be necessary to enact new laws; others will need to ensure that the existing laws cater to the specifics of Islamic capital market products.

Deposit Insurance Schemes

77. Countries that offer Islamic financial services should seek to ensure that the Deposit Insurance Schemes are Shari’ah compliant and should clarify the treatment of PSIA. The IFSB has not adopted a standard or guideline on Shari’ah-compliant deposit insurance. At present, jurisdictions are divided on the definition and treatment of PSIA; some countries provide protection to both unrestricted and restricted PSIA holders, some only provide protection to unrestricted PSIA, and some do not provide any protection to PSIAs. But apart from PSIAs, there are other types of accounts, such as Wadiah, which are a type of current account. The latter should, therefore, be guaranteed and unlike conventional accounts for which coverage is usually up to a specified amount only, these accounts would require full coverage. To minimize the risks of Shari’ah non compliance, there is need to strengthen governance structures and ensure that investments are consistent with Shari’ah rules.