The Legal and Regulatory Framework

It is necessary to have an adequate legal and regulatory framework for Islamic finance but it must also be understood that there are many things beyond its reach:

The success of and spread of a product or of an institutional-operational model for the financial industry must not be allowed to depend on the rules. It is not the regulator’s or supervisor’s job to determine the economic needs of the market, the products and the services that firms and households need. Selection of the enterprises that offer financial services and products is up to the market. Market participants, for their part, must observe the rules, whose objective in the financial sector is to ensure stability, transparency, investor protection, and hence a level playing field among financial institutions.[1]

The legal framework of conventional finance, unmodified, is not always suitable to cater to Islamic finance, in certain aspect. This does not mean that that a new separate regulatory and legal framework for Islamic finance is needed in all aspects. Where similarity exists, the principles and concepts can be extended to Islamic finance eg in matters like transparency, accountability, conflict of interest etc. This assists Islamic finance, as the regulators do not have to start from scratch.

Singapore focuses on as single legal and regulatory framework for Islamic finance. In Malaysia, although the dual-system regime is adopted, the legal and regulatory framework is not truly dual. The same regulators are still responsible and most of the circulars and guidelines issued are applicable to both the Islamic and conventional financial institutions. This kind of arrangement has its benefits. According to Aldohni:

The partial or the incomplete application of Islamic finance principles under the conventional economic system has enriched the Islamic banking experience. The significant development in the Islamic banking sector could not have been achieved if the Islamic banking were still only a theory. The translation of Islamic banking principles from theoretical to the practical sphere, in the early 1970s, showed the weaknesses and where the theory needed to be developed. Also, it helped to discover new financial products that fit the present situation. All of these benefits could not have been achieved if Islamic banks had waited until they could be applied in a full Islamic economy that only upholds Islamic finance rules.[2]

There are many benefits and advantages of updating and revising the laws and guidelines and having adequate regulatory and legal framework for Islamic finance at international and national level:-

1. Different core: Equity-based, not debt-based

Islamic finance has a different core from the conventional finance. Although maximization of profit is one of the aims of conducting trade and commerce, under Islamic finance, it cannot be done ‘at any cost’. Ethical principles must be observed, particularly the rejection of the usury-based system as Islamic finance held it to be unjust and unfair.

The legal relationship between the parties also differs. At the core of the conventional finance are usually a financier in the form of a creditor, and a borrower in the form of customer. Court cases have firmly established that the nature of the legal relationship between a conventional bank and its customers are usually creditor-debtor relationship. This is because at the core of the transaction is the intention of the customer to get a loan while the intention of the conventional financial institutions is to get the principal together with interest, also known as usury.

However, such arrangement is not feasible for Islamic finance as usury and interest are forbidden. Instead of loan, the transaction must be a sale or purchase transaction, or partnership, or investment or other permissible methods. In general, the main concept is trade is permissible while usury is forbidden.

Failure to have a proper legal framework for Islamic finance will cause unfairness. According to Tai Boon Leong, Executive Director, Monetary Authority of Singapore:

MAS has undertaken several initiatives in recent years to create a conducive environment for Islamic Financial activities in Singapore.  Our policy intent has been to create a level-playing field between Islamic and conventional finance.  In this way, investors and users as well as financial institutions engaged in Islamic Finance will not be disadvantaged in terms of tax or regulation.  Since we first started working with the industry to develop Islamic Finance in 2003, we have increased the number of Shariah-compliant financing arrangements which Singapore-based financial institutions can enter into.  The latest two structures announced in January were the Ijara wa Igtina and Murabaha Interbank placements.  We will continue to work closely with industry players to review other Islamic financing structures so as to broaden the choice of Shariah-compliant instruments.[3]

This requires Islamic financial institutions to have different methods of conducting transaction, although the level of risks that it exposed itself to will varies based on its selected method. Some of the guidelines on conventional finance can be extended to Islamic finance but some need to be modified:

… effective prudential supervision on banks is just as necessary and desirable in Islamic banking as it is in conventional banking. To help reach this goal, a number of standards and best practices established by the Basle Committee on Banking Supervision are useful and provide a valuable reference. These standards, however, are not always applicable to Islamic banking. An appropriate regulatory framework governing Islamic banks need to place a greater emphasis on the management of operational risks and information disclosure issues than is normally the case in conventional banking.’[4]

Legal and regulatory framework for Islamic finance must address the issues caused by the different nature of the financial system.The true aspiration of Islamic finance, to encourage real trade and commerce based on fair allocation of risks like profit-loss-sharing is noble and it would be unfortunate if its development is halted to due technical matter. Various countries, including Singapore and perhaps Australia in the near future, are taking the functional approach. In other words, instead of merely looking at the label attached to the financial product, the regulator will actually look at the true nature of the transaction. Instead of imposing the higher tax allocated for investment or sale and purchase of commodity, Singapore actually impose the standard and lower tax commonly imposed on loan transaction, for Islamic financial products that resemble sale and purchase but are actually merely financing in nature.  The blur in the legal and regulatory aspect will eventually be wider as Islamic financial institutions proceed from their passive role as financier to actual participant with more active role in the trade and commerce eg in the form of partner or investor.

2. Taxation (modus operandi/double taxation)

The conventional financial system differentiates equity-based financing and investments, and credit financing or loan. Since under Islamic finance, usury or interest is prohibited, this cause some obstacles when it operates in a system tailored for the conventional system as the regulatory and legal framework favor credit financing and loan by providing many initiatives:

More specifically, tax law could be quite problematic to Islamic banks, especially since tax law has always treated equity finance and debt finance differently. This means that Islamic banks will not have the same tax treatment as conventional banks, which are based on debt finance. There are two aspects of the taxation problem regarding the financial products of Islamic banks: first, the extra taxes generated by Islamic bank transactions; and second differentiation made between interest and profits …[5]

A new legal framework is needed for Islamic financial product to avoid extra taxation:

… [T]he Murabaha (mark-up) contract is used by Islamic banks to replace personal loans offered by conventional banks. The Murabaha agreement includes two purchasing options, which are taxable transactions. Although both purchased contracts belong to on transaction, it is still due double stamp duty. This means that the cost of this service offered by Islamic banks is far more than that which a customer of a conventional bank would pay for the same service. The same problem can be addressed with regard to Islamic mortgages, where stamp duty land tax will be charged twice: once when the Islamic bank buys the property; and again when the customer completes purchasing all ‘units’ from the banks and obtains the legal title. There could also be stamp duty land tax on the lease to occupy the property.[6]

Under conventional legal framework, interest is given special treatment, can be offset against the payment of tax and in other words, it is tax deductible. Since the interest element is totally eliminated from Islamic finance Islamic banks have no deductions to make in their tax bill. Furthermore, the rewards achieved by equity finance structures to offer similar services to conventional banks, are taxable.

In order to avoid extra taxation and unfair treatment to Islamic financial institutions, established Islamic financial hubs like Malaysia and Iran has long created a level playing field by taking initiatives to ensure fairness.

However, other jurisdictions that are relatively new to Islamic finance are still developing the legal and regulatory framework in relation to taxation. One example is Australia.

On 26 April 2010, the then Australia’s Assistant Treasurer and the Minister for Financial Services, Corporate Law and Superannuation announced that a comprehensive review of Australia's tax laws on Islamic finance will be made.[7] On 18 May 2010, the then Assistant Treasurer announced the terms of reference  for the Board's review and the Discussion paper elaborated that the Board has been asked to[8]:

• ‘Identify impediments in current Australian tax laws (at the Commonwealth, State and Territory level) to the development and provision of Islamic financial products in Australia;
• Examine the tax policy response to the development of Islamic financial products in other jurisdictions (including the United Kingdom, France, South Korea and relevant Asian jurisdictions); and
• Make recommendations (for Commonwealth tax laws) and findings (for State and Territory tax laws) that will ensure, wherever possible, that Islamic financial products have parity of tax treatment with conventional products.’

In conducting the review, it was reported that the Board should consider the following:[9]

• The tax treatment should be based on economic substance of the products rather than form.
• Where an Islamic financial product is economically equivalent to a conventional product, the tax treatment should be the same.

3. Globalization

Globalization refers to the increasingly global interaction between people, culture, and also economic activity. The advantages, and also harms, associated with globalization are numerous. From the economic point of view, globalization can be very beneficial when it resulted in more employment, better transfer of skill and knowledge, better financial assistance and cheaper and more affordable price for commodities. On the other side, the collapse of one country, sometimes just one large corporate, in a globalized world will trigger a chain of events that are so catastrophic in nature that it is totally unexpected at the initial stage.

Islamic finance has gone global. According to Dr. Zeti Akhtar Aziz, the Governor of Malaysia Central Bank:

The globalisation of Islamic finance has gained significant momentum in this recent five years. While the early development of Islamic finance was domestic centric, its internationalisation is now manifested by increased cross border flows, greater participation in international Islamic financial markets, the increased presence of financial institutions in new jurisdictions and more recently, the increased number of Islamic financial institutions which have shareholders from multiple jurisdictions. Greater financial integration has essentially been facilitated by the more rapid pace of liberalisation that has been supported by the progress that has been achieved in the development of the international Islamic financial infrastructure. This trend has also been prompted by the need for greater diversification of risks in the management of funds. In the current international financial environment, this trend has become more pronounced prompting investors to consider other asset classes and markets that provide stability. Thus far, the global financial crisis has had limited direct effects on Islamic finance. While Islamic finance by its very nature only engages in transactions that have underlying tangible productive activities, the slower overall growth and the increased uncertainties have affected pricing and activity in certain market segments. However, this in part reflects the shift in activity from the financial markets to the Islamic financial institutions.[10]

Throughout this research, it has been proposed that the rejection of excessive uncertainty and excessive speculative activities, as promoted by Islamic principles will strengthen global trade and commerce.

This is partly due to the nature of globalization itself. In a globalized world, parties will have easier access to each other, although the bargaining powers of the parties will differ. If proper legal and regulatory framework is not in place, there will be those who will take advantages of others, by trying to manipulate the loophole in the system.

For example, as can be seen from the incoming case analysis, that many parties who defaulted in their obligation with Islamic banks in Malaysia will attempt to raise the issue of shariah-compliant. So far, the allegation of non-compliant of shariah seems to be a mere afterthought, or worse, a mere delay tactic that often failed in court. The reason is because Malaysia has a quite clear legal and regulatory framework in the matter, in which the decision of the Shariah Advisory Board of Malaysia (concerning the issue of Shariah-compliant) is acknowledged and in a way, binding. On the other hand, the legal and regulatory framework on this matter, for the global scale, or at international level, is still vague. 

A weak legal and regulatory system will also lead to a lot of wasted opportunity:

… [A] weak banking system is likely to prevent the economy from benefitting from the ongoing process of globalization and the liberalisation of capital markets, particularly in developing and emerging market countries (which are often the ones where Islamic banking principles are followed) where banks are the major (or even the sole) players in domestic financial markets. As in the case of conventional banking, an appropriate regulatory framework for an Islamic financial system should aim, therefore, at reinforcing the operating environment of banks, as well as their internal governance, and market discipline. To help develop such a regulatory framework, standard and best practices established by Basle Committee on banking and Supervision are useful and provide valuablke reference. However, these standards cannot always be applied to Islamic banking in the same way that they are in conventional banking systems.[11]

Suitable legal and regulatory framework is important to ensure that the negative elements of globalization are not extended to Islamic finance. In other words, by having a strong and clear legal and regulatory framework, it will be easier to manage the Islamic financial industry in difficult times.

The effect of globalization and financial crises has been extended to Islamic financial industry before, and failure to have good legal and regulatory framework will be disastrous:

Against the backdrop of this global financial crisis, Islamic finance is inevitably affected and subject to challenging conditions reflected by a steep slowdown in activities such as sukuk issuance and declines in equity value managed by Islamic funds. New sukuk brought to the market in the first three quarters amounted to some US$13 billion, down 40% from the same period last year1. But the pullback in new sukuk issuance and the widening of sukuk yield spreads are generally in line with what has been happening in the conventional market. This broadly suggests that the global sukuk market slowdown has more to do with the general market conditions and a general reluctance to issue US dollar instruments. Observers say that while there are still those who wish to issue sukuk, investors would prefer to stay on the sidelines in the current volatile market environment. It is true that the industry is experiencing a temporary setback, but this also reflects how closely integrated Islamic finance is with the global financial system, which is not at all bad news for the industry because when global markets stabilise and take a turn for the better - as they must in the long run - Islamic finance will ride on that curve and excel.[12]

Under modern finance, trade and commerce, the collapse of the financial system of one country can have profound impact on the global financial community. Indeed, even the collapse of one large corporation can trigger a chain of events, akin a domino effect, to the whole industry. As the fate of the global financial community is more tied to each other than ever, it is fundamental to have a proper regulatory and legal framework so that unnecessary losses can be minimized and immediate actions can be taken when required:

First, financial markets around the globe have become more exposed to systematic failure due to the intertwined nature of their transactions. Systematic risk in this new era has a more extensive impact than ever before, and a banking crisis is not a domestic problem anymore. This is, in particular, because the failure in one financial market could have a contagious effect on the other linked financial markets around the world. Second, securing effective banking supervision has become a very necessary and challenging task at the same time. Therefore, supervisory authorities have begun to issue guidelines that address the risky areas in the banking sector and identify the best methods of supervision in an attempt to set comprehensive supervisory guidelines. However, such attempts were not enough to create the required harmonized banking supervision at the international level.[13]

By ensuring that proper legal and regulatory framework is in place, it will be easier to prevent the ‘domino’ collapse of the financial system.  Furthermore, a standardized framework will be more attractive for the global trade community:

… there is a fundamental need for further standardization and harmonization of both regulatory and Shariah standards across the Middle East and Asia.  The greater use of standardized legal documentation will increase efficiency, certainty, transparency and liquidity.  This would allow for easier cross-border offering of financial products that would reach a wider investor base and thereby bring about greater economies of scale and reduce transaction costs.  Standardisation will also enable better risk management by ensuring that risks are clearly identified and appropriately mitigated between financial institutions and their counterparties.[14]

4. Conducive legal framework

The introduction of Islamic finance into a national market will be hindered if there is no enabling Act in place. The enabling Act can be simple and brief, but it should exist. Enabling Act will remove doubts and uncertainty surrounding the establishment of Islamic financial institution from the regulatory and supervisory aspect. An example of such enabling Act is the Islamic Banking Act 1983 in Malaysia that enables the introduction of fully-fledged Islamic banks in Malaysia and the amendment to Banking and Financial Institutions Act (BAFIA) that enables the introduction of Islamic windows by conventional banks. This is recently replaced by the bulky Islamic Financial Services Act 2013, the most comprehensive legislation on Islamic finance ever.

Malaysia’s experience reveals that consistency and uniformity in decisions is easier to achieve by having clear legal and regulatory framework. For example, the role of the Shariah Advisor Committee is clearly elaborated in Malaysia and this leads to a conducive legal framework for Islamic finance, as dispute concerning the validity of Islamic financial products eg shariah-compliant etc, is easier to be settled.

5. Reducing risk, uncertainty & ambiguity

Another important reason to have adequate legal and regulatory framework for Islamic finance is to remove uncertainty and ambiguity concerning the structure and requirement. For example, some legislation specified the requirement needed from the Shariah Committee Board including the credentials etc. Some other elaborated in detail regarding the Islamic financial products and the issue of corporate governance eg using guidelines. Without adequate regulatory and legal framework, the parties venturing in Islamic finance will be left alone in an unchartered territory, and this should not be the case.

Beyond that, a proper regulatory and legal framework will reduce the level of risk exposed the parties. For example, the global standard principles on banking regulations, as reflected in the Principle 6 of the Core Principles for Effective Banking Supervision dictated that minimum capital requirement must be observed.

Principle 6 stated that ‘the banking supervisors must set prudent and appropriate minimum capital adequacy requirements for all banks. Such requirements should reflect the risks that banks undertake, and must define the components of capital, bearing in mind their ability to absorb losses’.

One of the problems with the global standard principles, even Basel Capital Accord is that the guidelines and regulations are made without including the input from the Islamic financial industry. According to Khan and Porzio:

… to date Islamic finance has been at the margin of the consultation process on the rules of Basel 2. This is due not only to the modest weight in financial market that Islamic banks have relative to conventional ones, but also to insufficient ‘political representation’ within the Basel Committee, worsened by the fact that in reality, there is not one model of Islamic bank but many, often very different from the original ‘pure’ version. Rules and supervisory practices differ among the various Islamic countries; the accounting standards used for financial contracts and their associated risks are reported and measured for regulatory purposes very differently; there are five schools of thought, each with its own interpretation of financial transactions and banking products compatible with the Shariah rules (El-Hawary, Grais and Iqbal 2004).[15]

6. More attractive to investors and customers

Any country that have committed regulators that are known to provide the proper and suitable legal framework for Islamic finance will be at an advantage as the country will be more attractive to investors and customers. This is because Islamic finance can sometimes involve complicated as well as unprecedented legal and regulatory issues. Without the proper will power from the regulators and those in charge of the financial affair, the investors and customers will shy away.

For example, in early 2008, Muhammad Taqi Usmani, a well-known Islamic finance scholar, made the shocking announcement that 85 percent of Islamic bonds issued in Middle East were not shariah-compliant.

7. Reducing legal risk and unnecessary litigation

Failure to have adequate legal and regulatory framework will be time and cost consuming, as the parties will sometimes have to resort to court litigation to settle conflicts and issues. This can be avoided by having a proper legal and regulatory framework. For example, in Malaysia, the Kuala Lumpur Regional Arbitration Center has come up with detailed arbitration rules on settling disputes related to Islamic finance that is the first in the world. This will assist in reducing legal risk and unnecessary litigation.

8. Better supervision and monitoring

There are allegations that Islamic finance can be used as a mode of financing illegal activities:

The problems get more complicated in Western countries where there are some Muslim minorities who, for religious reasons, are reluctant to deal with conventional banks. The absence of formal Islamic banks in this case would create opportunities that underground financial bodies purporting to be Islamic can exploit. In fact, those who deal with these underground banks may have no idea about the real nature of their business, their main concern being that they are dealing with ‘allegedly’ Islamic banks. Investing or transferring any money through these organizations, over which the authorities have no supervisory powers, may be a real threat to any government. It is worth noting that controlling underground Islamic banking and investigating their practice is also an Islamic legal requirement: Islamic law stresses the importance of addressing any abuse in the Islamic banking practice, including money laundering.[16]

By having a comprehensive legal and regulatory framework, it will be easier to monitor and supervise the whole industry. However, it is worthy to note that allegation that global Islamic finance (contrary to unregulated underground ‘banking’ system) can be used to finance illegal activities is a simplistic allegation, often not based on facts, but sentiments. This is due to a few reasons. First of all, due to the nature of Islamic finance, Islamic finance is often viewed more skeptically and in a more hostile manner compared to others.

Therefore, Islamic finance is actually subjected to more supervision and monitoring. Secondly, the allegation that Islamic finance will be attractive to bad people like criminal or terrorists is not strong. This is because people like terrorists departed from the mainstream or traditional Islamic view on various matters. For example, the harming of innocent people, even animals and trees are prohibited under Islam. Therefore, for those who have blatant disregard for Islamic principle, it is unlikely that they will all choose to adopt Islamic finance instead. Furthermore, this will make their criminal activities easier to expose.

Concerning supervision and monitoring, there are a few challenges and obstacles. For example, although there are a few international Islamic bodies that are responsible to oversee and ensure the proper performance of the Islamic financial industry, their role is more voluntary in nature and they don’t have any jurisdiction or power.

International Islamic bodies issue many of the guidelines on Islamic finance with no actual binding powers. In a way, this is actually similar to conventional finance. Acceptance is voluntary although common since the regulations provided are very beneficial and assists in maintaining high quality and standardization:

Concerning the problem of adopting the same prudential regulations as western countries, the Islamic Financial Services Board on 15 March 2005 published two draft papers: Guiding Principles for Risk Management and Capital Adequacy. The first document points out 15 principles for implementing risk management procedures in the Islamic banks. The approach adopted considers the risks of the prevailing banking activity and the risks of the different types of contracts offered by Islamic banks. In particular the principles have been grouped with reference to six different risk categories; credit, equity investment, market, liquidity, operating and rate or return… The second document, instead represent a successful attempt at the homologization of Islamic finance to the requirements established by Basel II.[17]

Types of Legal Framework on Islamic Finance

There are many different legal and regulatory regimes governing the framework of Islamic finance. The legal and regulatory regimes can be classified and divided on various methods. For example, they can be classified based on the nature of the Islamic financial products eg Islamic bond or sukuk, Islamic derivatives, musharakah, mudharabah etc. They can also be classified based on the regulatory bodies that issued the guidelines and enact the legislations.  However, for this research, the classification will be made based on countries general practice and approach. This provides for a simpler approach, although the depth of study can still be maintained. The proper legal and regulatory framework to govern Islamic finance has to address numerous important questions. According to Khan and Porzio:

In conclusion, it can be asked: should Islamic banks gradually become equivalent to western commercial banks? Or should they become specialized financial institutions favouring the areas of business where Islamic law is most congenial: mutual fund investments, venture capital, investment funds, services and trade finances? From the theoretical point of view, considering the economic functions typically carried out by banks, is an intermediation process different from the conventional one, typically based on the interest rate, possible and feasible?[18]

The legal and regulatory framework for Islamic finance adopted by the various countries all around the world can be classified into three:

1. Fully Islamic
2. Dual systems
3. Neutral & Partial Inclusion

This brief and simplistic analysis is made with the realization that many countries in the world failed to have any legal and regulatory framework to accommodate Islamic finance. Detailed and comprehensive study on certain aspects of the legal and regulatory framework is already available[19]. Below is the introductory analysis on the three different legal and regulatory regimes:

Fully Islamic

Fully Islamic refers to countries that only accept banking and financing practice that complies with the country’s interpretation of Islamic principles. These countries include The Islamic Republic of Iran and Pakistan.According to Khan and Mirakhor:

A distinction has been made between the concept of Islamic banking implemented as a profit-making enterprise operating in an interest-based system and Islamic banking implemented as an integral part of a complete Islamic system. Each will face different sets of problems. In most of the Muslim world (and in some Western countries) Islamic banks compete with the conventional banks. The problems faced by these banks will be the type experienced by all attempts at transplanting parts of one system into another. Aside from problems of contradictions and conflict in basic values, these institutions will have to meet the challenges emanating from the legal and regulatory framework of the environments in which they wishes to operate, as well as those generated by the requirements of security, viability, and profitability which conventional banking systems have tried to meet.[20]

There are numerous challenges faced by the countries adopting the fully Islamic regime, although history has shown that the challenges can be tacked:

The ban on riba severely restricts a central bank’s grip on the economy and may lead to harmful consequences. A central bank that cannot use interest-based measures to control the commercial banking sector’s lending activities and money creation may easily be tempted to resort to measures that undermine the efficiency of financial markets, in particular direct credit controls. However, it is not entirely without indirect instruments, as variable cash and liquidity ratios can still be applied (Chandavarkar 1996, ch.9). How did countries that fully Islamized their financial system deal with the problem? The Central Bank of Iran (CBI) is authorized to impose ceilings on the banks’ loan and credit volumes, not only in a global sense but for individual economic sectors as well. It may also used required reserve ratios, with different rates for different liabilities and for different fields of activity.[21]

Any country adopting the fully Islamic regime must consider the fact that the global finance and trade, and global monetary system are mostly conventional in nature. However, these should not be a problem if the regulator, commonly in the form of monetary authorities, is flexible enough:

The monetary authorities operating in an Islamic framework continue to have the power to regulate banking and financial operations in the economy, both to allocate resources in conformity with the priorities of the society, and to direct monetary policy toward specific goals. To achieve its policy objectives, the central bank has control over the supply of ‘high-powered’ money (that is, currency plus deposit liabilities of the central bank to commercial banks), the reserve ratios on different types of liabilities, and the maximum amounts of assets that banks can allocate to their profit-sharing activities. A further control is available to the central bank through its purchases of equity shares of banks and other financial intermediaries.[22]

Pakistan

Pakistan adopts the fully-Islamic regime. Pakistan, officially the Islamic Republic of Pakistan is a sovereign country with a population of around 177 million.  During 1979-1980, the Islamization of Pakistan banking system was initiated by permitting banks to accept deposit on profit-loss sharing basis. By June 1984, the government of Pakistan announced a gradual plan to transform the entire financial system  to non-interest bearing Islamic financial modes. According to Khan and Mirakhor:

As of July 1, 1984, all financial institutions were allowed to carry out transactions on the basis of either Islamic or interest-based modes, on condition that interest-based accommodation for working capital would not be provided or renewed for more than six months. Since January 1, 1985, all transactions with the Federal and Provincial Governments, public sector corporations, and public or private joint stock companies have been based on Islamic modes and, from April 1, 1985, all financing to all entities and individuals was required to be on an Islamic basis.[23]

There are benefits and disadvantages. For example, comparison can be made with Malaysia. In Malaysia, legal disputes will be argued according to the English common laws.  Islamic finance-contracts will be interpreted according to concepts of the English common laws should there be disputes but this differ from a fully Islamized country like Pakistan. In Pakistan, its Banking Ordinance and Mudarabah 1980 provides provisions for the central bank to determine the maximum and minimum profit margin that Islamic financial institution can use and no reference to English common laws are necessary.

Harmonization between common law principles and Islamic principles are possible, provided that the legal and regulatory framework as provided by the legislation is clear. The common law court will generally respect the wishes of the parties eg to incorporate Islamic principles, provided that the terms or principles are clearly and expressly stipulated in the contract. In any event, it is not the responsibility of the court to ensure such harmonization.

Iran

Similar to Pakistan, Iran also adopts the fully-Islamic regime. Iran, officially the Islamic Republic of Iran is a country with a population of around 75.3 million. The country is the only theocratic Muslim country adopting Shia as the official religion while the highest state authority is the Supreme Leader. The size of Iran is approximately equal to France, Spain, Germany and the United Kingdom combined. Based on GDP, the economy of Iran is the 18^th largest in the world with many of its income come from oil[24], agriculture, large enterprises and trading and services venture.

After the Iran Revolution in 1978, steps were taken to transform the banking system by first nationalizing the system. The banking system in Iran was immediately nationalized after the revolution. The reasons forwarded are the inefficiency of the financial institutions and the need to protect public interest. Prime Minister Bazargan stated that ‘We respect private property but in view of the undesirable and unprofitable conditions in the banks, to protect national rights and wealth and get the wheels of the economy moving, we deemed it necessary to nationalize the banks’ while the head of the Plan and Budget Organization added that ‘many of the owners of private banks did not have good record and did not play their fundamental role in preserving the national wealth and rights’.[25]Wilson elaborates the Islamization process:

The implementation of the Islamization policy had been piecemeal and took six years to be fully introduced. More than 20,000 staff had to be put through courses in Islamic banking. The lengthy process of Islamization was constrained by various economic developments associated with the nationalization of the banking system, political upheavels, the freezing of Iranian assets abroad, acute economic recession, and the Gulf War. It is important to note that at the time of revolution, the banking system in Iran was near collapse. A large number of newly established banks were burdened with high levels of non-performing assets and debts to both Bank Markazi (the Central bank) and foreign creditors. The position of these banks was in particular due to lack of banking and management experience compounded by inadequate regulatory control.[26]

The legal and regulatory framework permit two kinds of partnership: civil and legal. The civil partnership is based on the contribution of cash or non-cash capital by several legal persons to a common pool on a contractual basis to make profit while the second form of partnership is concerned with firms in which the banks provide a part of the capital of a new joint-stock company or buys part of the shares of an existing joint-stock company.[27]

The participation of the bank is only permissible if, after analysis on the technical, economic and financial viability of the firms, the appraisal indicates that minimum expected rates of return could be achieved.[28] Home to more than 70 million people, Iran might become one of the hottest market for Islamic finance due to young population and a need for more infrastructure projects. However, due to bad relationship between Iran and some Western countries, particularly the United States, and due to the serious accusation that Iran is creating nuclear weapon, the development of Islamic finance in Iran is temporarily halted as international traders and investors are a bit reluctant to get involved. The U.N. Security Council has already imposed rounds of sanctions on Iran since late 2006 for refusing to halt sensitive nuclear enrichment activities, while the United States has added sanctions to curb business with the Islamic Republic.

Reuters reports as follows:

Granted, investing in Iran still presents problems. GFH's Kazerooni said legal and political uncertainties were an obstacle after past ownership deals or terms in privatizations were changed after being signed. "Iran doesn't have a good track record, people are a bit wary," he said.

While the Gulf Arab region has attracted many international banks seeking to tap opportunities in the world's top oil-exporting region, many Western banks have halted or reduced Iran-related business as a result of U.N. and U.S. sanctions.[29]

If the diplomatic relationship between Iran and other countries, particularly Western countries and other Muslim countries improved, the development of Islamic finance in Iran will be accelerated.

Dual system

The regime refers to countries that adopt Islamic finance alongside the conventional finance. These countries include Malaysia and Bahrain. The conventional finance as represented by conventional banks and conventional financial institutions are free to practice but the legal and regulatory frameworks are tailored to cater to the interest of Islamic finance as well.

One of the differences between this legal and regulatory regime compared to others is the usual policy to strengthen Islamic finance while maintaining the conventional finance. There are numerous advantages for this regime. Firstly, Islamic finance can be introduced with less risk. One of the benefits is the introduction of Islamic finance can be smoothly and without interrupting the current conventional system. Furthermore, these countries do not have to start from the beginning as the conventional financial institutions can just include Islamic finance in their financial portfolio.

Secondly, the Islamic finance industry can benefit and learn from the long and useful experience of the conventional finance. Usually, in the dual systems regime, the government will made various initiatives to strengthen Islamic finance and the conventional financial institutions will usually be attracted to benefits from these incentives, in addition to diversification.

Thirdly, this kind of regime is suitable for countries where there are significant numbers of non-Muslims or where a large number of foreign non-Muslim investors are needed. These will ensure that the interest and desire of all parties are respected.

Fourthly, this kind of regime will make a country more resilient to financial crisis due to its comprehensive legal and regulatory regime.

Malaysia

Malaysia adopts the dual system. Malaysia is a country with long tradition of Islamic banking, where nearly 50 percent of clients of Islamic financial institutions are non-Muslim.[30]This can be justified simply on the basis that the religion of the participating parties has never been an important issue for consideration in any Islamic financial transaction.[31] The situation in Malaysia is unique. The population of Malaysia is around 28 million, with the percentage of Muslim at around half. Malaysia has a strong tradition with Islam in which the Federal Constitution states that Islam is the religion of the Federation and therefore other religion can be freely practised. Being a multiracial country, the conventional finance flourished to cater the needs of the community. Islamic finance is also popular in Malaysia at the domestic level, among the Muslims and the non-Muslims alike, due to strong support form the government, lack of bias towards Muslims due to long exposure and also due to strong and clear legal and regulatory framework:

In order to have this unique combination of banking systems, the Malaysian government enacted the Islamic Banking Act 1983 and the Banking and Financial Institutions Act 1989, which worked together to regulate the Islamic banking sector. While the Islamic Banking Act 1983 provides the guidelines for licensing and the general regulatory requirements, the Banking and Financial Institutions Act 1989 allocates the supervisory bodies for the conventional and Islamic bank… Islamic banking was initially introduced into Malaysia by the Islamic Banking Act 1982. The scope of Islamic banking business is generally defined in the Act as ‘banking business whose aims and operations does not involve any elements which is not approved by the religion of Islam’. This enables the Islamic bank to provide certain facilities for instance leasing, which is strictly non-banking business under the Banking and Financial Institutions Act 1989.[32]

Bank Islam Malaysia Berhad was incorporated as a limited company under the Companies Act, 1965, on 1^st March 1983. Its memorandum of association states that, ‘All businesses of the company will be transacted in accordance with Islamic principles, rules and practices’. The Bank’s Articles of Association provides that:-

A Religious Supervisory Council, whose members would be made up of Muslim religious scholars in the country, shall be established to advise the company on the operations of its banking business.

The level of efficiency of Islamic banks in Malaysia is not lower than conventional banks despite its limitation:

The study finds that there is no statistically significant difference in the level of efficiency between Islamic and conventional banks operating in Malaysia based on data for the priod of 1993-2000. There is also no evidence to suggest that bank efficiency is a function of ownership status (public/private or foreign/local). The study does, however, find that inefficiency is related to bank size and in a non-linear fashion. Increasing size initially provides some scale economies before diseconomies of scale set in once a critical size is reached, thus suggesting a U-shaped average cost function.[33]

The regulatory bodies in Malaysia include the Ministry of Finance, Bank Negara Malaysia, Securities Commission, Malaysia Securities Exchange Bhd and the Labuan Offshore Financial Securities Authority. The MOF is responsible for policies related to fiscal and monetary issues (in addition to managing government-related contracts). Bank Negara Malaysia is the regulatory and supervisory authority over Malaysian financial institutions and insurance companies. It is also responsible for the issuance of currency in Malaysia. The Security Commission has authority over stock exchanges (and stock brokers) although it has to reports to MOF. Labuan LOFSA is created as a unified agency for the registration of offshore companies, and to administer and enforce related legislation.

In Malaysia, the legal and regulatory framework governing Islamic finance is largely shaped by legislations, particularly Islamic Banking Act 1983 and BAFIA, circulars and guidelines issued by the Central Bank of Malaysia, decisions and guidelines by Shariah Advisory Council and court cases. The Islamic Banking Act 1983 consists on 60 sections covering issues ranging from the licensing of Islamic banks, financial requirements and duties of Islamic banks, ownership, control and management of Islamic banks, restrictions on business, regulations on international Islamic banking business, power of supervision and control over Islamic banks and other miscellaneous matters. BAFIA is also an important Act in Malaysia, although it is more for the conventional finance. However, some of the sections touch on Islamic finance. Banking and Financial Institutions Act 1989 is an Act to provide new laws for the licensing and regulation of institutions carrying on banking, finance company, merchant banking, discount house and money-broking businesses, for the regulation of institutions carrying on certain other financial businesses, and for matters incidental thereto or connected therewith.

Besides Islamic Banking Act 1983 and BAFIA, the Central Bank of Malaysia, Bank Negara Malaysia (BNM) also issued a series of guidelines and circulars. These are very important in the legal and regulatory framework of Islamic finance in Malaysia as these guidelines and circulars are comprehensive and very useful.

In addition to BNM, in Malaysia, Malaysia International Islamic Financial Centre (MIFC) also issued guidelines in order to strengthen Islamic finance legal and regulatory framework. The judiciary also plays important role in the development of the legal and regulatory framework of Islamic finance in Malaysia. For example, Zulkifli Hasan classified the evolution of Islamic banking cases in Malaysia into three phases; (1) 1994-2002 phase, where the court was more inclined to rule in favor of the Islamic bank holding that the parties were bound by the express terms of the contract, (2)2003-2007 phase,  where the court indicated its intention to examine more critically the underlying principles behind the Islamic financial products like BBA, and (3) 2008 onward, where the court took more pro-active attitude in examining the Islamic financial products, to the extent of declaring some of the products are not Shariah-compliant.[34]

Neutral

The third legal and regulatory regime is the neutral and partial inclusion. This regime takes the neutral approach and includes some Islamic financial product into their financial portfolio. Examples include United Kingdom, Singapore and Hong Kong. This regime differs from the former regimes due to the aims and objectives. The fully Islamic regime intends to Islamize the whole system. The dual-system regime intends to gradually increase the market of the Islamic finance industry in the country, often with a targeted percentage eg 15%, 20%. On the other hand, the third regime merely intends to provide for a fair and neutral playing field for all parties, without inclination to strengthen or favor Islamic finance, but at the same time without bias eg by revising the legal and regulatory framework to ensure fairness and avoidance of extra taxation etc.

There are a few unique challenges faced by this regime as noted by Archer and Karim:

The salient point is that making the Shariah-compliant investments in the United States and Europe was a broad international and more globalized trend. The transactions involved multiple jurisdictions and participants from a broad range of countries and religious, cultural, and legal systems. Many of the transactional participants, including the financing entities in the United States and Europe, had little or no familiarity with Islam or the Shari’ah. Yet, to give effect to the desires of the Muslims investors, the legal systems in the Western economic sphere had to address the issue of enforcing contracts in accordance with the Shariah, and because the structure of those legal systems, had to do so within the context of enforcement of conventional secular law, substantive and procedural, in those purely secular jurisdictions.[35]

Singapore

Singapore adopted the neutral and partial regime. Singapore is an important global trade and financial center. The inclusion of Islamic finance into secular country like Singapore is understandable as its potential is huge. For example, according to Professor Samuel L. Hayes, of Harvard Business School, “I do not think there is any limit to how big the Islamic banking can get”.[36]

In Singapore, a single regulatory approach is applied:

MAS applies a single regulatory framework to both conventional and Islamic banking because our regulations address prudential issues of liquidity, credit, market, operational and concentration risks. These are relevant to both conventional and Islamic banks.  While Islamic funding and financing structures are different, we consider the economic substance the underlying risk of these structures, and apply the regulatory treatment that is consistent with the risk.  Our regulatory framework therefore provides a level playing field for Islamic and conventional banking.  MAS has for some time now issued regulations to clarify the regulatory treatment of various Islamic finance structures under our rules.[37]

It is noted that some authors have criticized the efficiency of the single approach:

The current practice is to treat Islamic and conventional banks in a similar way when it comes to supervision but this practice is not optimal. Islamic institutions have different contractual agreements and, without understanding the underlying contracts, supervision can overlook areas of potential problems. Although standards for exposure, governance, and supervision have been issued by the IFSB, these standards have yet to be adopted formally by the regulators and national authorities.[38]

The development of Islamic finance in Singapore is largely shaped by the guidelines issued by Singapore MAS as these guidelines aim to provide banks with legal certainty and guidance on the regulation of Islamic banking in Singapore.

To strengthen the legal and regulatory framework of Islamic finance in Singapore, MAS has been cooperating with other important players in the industry. Tai Boon Leong, Executive Director, Monetary Authority of Singapore, ‘Speech’ (IFSB Seminar on Strategies for Development of Islamic Capital Markets, Singapore, 7 June 2011)

3.2      Regulation and standardization

Regulators must eventually acknowledge the presence of an industry handling in excess of US$1 trillion with an annual growth of more than 10 percent and huge, untapped market potential. The regulations on Islamic finance should accommodate its differences, although in areas where there are similarities, similar frameworks can be used. According to El-Hawari et al:

Given the close affinity of prevailing practice of established Islamic finance and conventional banking, the regulatory framework in the transition should be mostly similar to the one applying to the regulatory framework of conventional banks. One overarching issue that needs to be addressed is the standardization of contracts and major financial instruments across the industry to facilitate growth, ease access to liquidity and enhance risk assessment capabilities. Transparency enhancements are also essential for the development of the industry.[39]

The regulation, standardization and harmonization of fiqh opinion can be traced back to the Ottoman Empire with the creation of the Mejelle, which is composed of 1,851 articles based on the Hanafi school of jurisprudence. Islamic financial institutions that find themselves in a situation that has not yet been standardized should adhere to the Shariah view to avoid legal disputes in relation to Shariah-compliance. According to Khan:

A declaration from the Islamic banks with respect to which aspects of fiqh rulings are being utilized in their operations would give a clearer view of the Shariah compatibility of their products to the satisfaction of their clientele. This codification could also be an important element in defining the standards for corporate governance in the Islamic finance industry in the context of Shariah application. As already mentioned, codification is a big and too complex task, and the industry cannot wait for it for too long. Some more feasible arrangements have to be developed quickly.[40]

The absence of standardization is serious in this modern and global era, a problem that is highlighted in the work of Ghoul:

In 2007 Mufti Usmani shocked the Islamic finance industry by announcing that 85% of non-Ijarah sukuk issues were not Shariah-compliant and had gone too far in imitating conventional debt. The sukuk market took a serious hit and as a result Ijarah-based sukuks came to the forefront. Since then, product developers i.e. bankers and lawyers have had to abide by Shariah standards when structuring sukuks … Y- Sing and Richter (2010) report that in 2008 sales of sukuks declined 50% partly due to an AAOIFI ruling that prohibited borrowers from making an upfront promise to pay back the face value at maturity in sukuk-Mudaraba and sukuk-Musharaka contracts. The authors also report criticisms of sukuks’ fixed-income cash flows.[41]

There are many reasons for standardization. The first is to uphold Shariah and legal certainty. Dr. Mohammed Daud Bakar, a prominent member of the AAOIFI,[42] put it succinctly when he stated that the ‘aim of having a standard is to bring the market into harmonious practice, bring costs down, and to make it clearer for investors’. Proponents of standardization also argue that the introduction of standards into Islamic finance would lead to the firm establishment of financial transaction methods and, consequently, transaction costs would be reduced through the clear integration of Islamic finance principles that, once documented, would assist not only practitioners of Islamic finance, but also the investors.[43] There are many other benefits as well.[44]

While there are numerous international Islamic institutions, the leading ones include AAOIFI, IIRA, IFSB and the Liquidity Management Center (LMC). They are partly responsible for maintaining the high standards of the Islamic financial industry. Despite the existence of these numerous bodies, the legal and regulatory practices related to Islamic finance have not been standardized.

3.3      Legal and Regulatory Framework of Islamic finance in Malaysia as model

The regulatory and supervisory framework continued to support financial stability in Malaysia in the face of continuous risks in the external environment and heightened domestic competition. The framework has also stood up well against the changing character of the domestic financial system which saw the entry of new market participants and the more pronounced regional and international complexion of the financial sector.

In 2011, the Central Bank (“the Bank”) continued to reinforce and advance further the core tenets of regulation and supervision, building on earlier work undertaken to strengthen the legislative framework and improve risk management, governance and business conduct practices. The progress made on the global regulatory reforms also had an important bearing on the Bank’s work. While taking these reforms carefully into account, the Bank has remained focused to ensure relevancy of the reforms and achievement of the intended outcomes. The Bank has continued to leverage its supervisory insights and engagements with the industry to further enhance the integrity and strength of the regulatory and supervisory system in Malaysia.

REGULATORY DEVELOPMENTS AND SUPERVISORY ASSESSMENTS[45]

Regulatory capital and liquidity standards

In line with the announced plans to implement the Basel III reform package in Malaysia in December 2011, the Bank released details on the implementation plan, including the timelines. The plan sets out the Bank’s expectations of banking institutions in transitioning towards the new regime, which also includes the approach to be adopted by banking institutions for the individual components of the reform package. The Basel III reform package seeks to strengthen global capital and liquidity standards for banking institutions by improving the quality and quantity of regulatory capital and ensuring adequate high-quality liquidity buffers. These standards will be implemented in Malaysia in phases, beginning 2013 until 2019, in line with the globally agreed levels and implementation timelines. While the banking system in Malaysia is well-positioned to meet the requirements of the new regime within a shorter timeframe, the adoption of the extended timeframe set by the Basel Committee on Banking Supervision (BCBS) will allow for more gradual adjustments by banking institutions to the new requirements, thus mitigating any adverse impact on credit intermediation, particularly in an environment of slower global growth.

Analysis on the performance trend for banking institutions in Malaysia suggest that the capital requirements can be largely met through prudent earnings retention policies over the period of implementation, thereby avoiding potential market dislocations from synchronous capital-raising actions by the banking institutions.

In addition to the new minimum regulatory capital levels, a primary element of the Basel III reform package is the revised definition of regulatory capital which is intended to ensure higher levels of high-quality and loss-absorbent capital.

Going forward, common equity, comprising paid-up capital and retained earnings will form the predominant component of Tier-1 capital, thus substantially strengthening the loss-absorbing capacity of banking institutions.

Following a detailed assessment of the rules text, the Bank has identified potential areas where implementation could present some challenges for the domestic banking system. These include overcoming the operational complexities of the methodologies specified by the BCBS for the treatment of deferred tax assets as well as the investments in capital instruments of other financial institutions.

The Bank will consult with the industry and market participants on proposals to enhance the loss absorption qualities of capital instruments, particularly on a going concern basis. This would involve requiring all capital instruments to contain provisions for a principal write-down or conversion into common equity when an institution becomes non-viable (``gone concern˝ basis), or when its capital falls below pre-specified triggers (``going concern˝ basis).

A concept paper on the revised regulatory capital definition will be issued for industry feedback in the first half of 2012. Beginning 2016, banking institutions will also be required to hold a capital conservation buffer that can be drawn upon during periods of stress.

Basel III also introduces a leverage ratio which is intended to mitigate the effects of excessive deleveraging in the banking system during distressed periods. While the BCBS has targeted implementation of the ratio from 2018, the Bank will require banking institutions to begin reporting their leverage positions beginning June 2012.

The leverage position reporting would allow the Bank to assess the impact on the behaviour of banking institutions and identify any unintended consequences. This includes the possibility that the non-risk-based nature of the ratio may lead banks to favour higher-risk activities at the expense of low-risk, but economically productive activities such as trade financing.

While banking institutions are expected to meet the requirement, a decision to formally adopt the leverage ratio as a binding measure, as well as the need to fine-tune the measurement of the ratio, will be determined by the Bank closer to the targeted 2018 deadline. The strengthened liquidity standards proposed under Basel III will be implemented through enhancements to the existing Liquidity Framework that has been in place since 2000.

Similar to the leverage ratio, an ``observation period´´ will begin in June 2012 with the requirement that banking institutions report both the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) positions before the measures become binding in 2015 and 2018 respectively. The Bank shares similar concerns expressed by a number of supervisory authorities that the liquidity standards, as currently calibrated, do not adequately address the specific characteristics of funding markets that are unique in some countries. For example, in Malaysia, institutional savings schemes (such as the Employees Provident Fund) capture a significant share of household savings which are in turn deposited by the schemes with banks. Under the standards, such deposits are subjected to severe withdrawal assumptions (or ``run-off´´ rates) which are not reflective of the profile of the underlying liquidity risks.

Data collected from the observation period will be used to consider appropriate adjustments to the run-off rates where needed. An area that will be monitored during the observation period is the potential impact on market liquidity arising from an increase in captive demand by banking institutions for eligible liquid assets and how this in itself may alter the characteristics of such instruments in terms of the availability to meet liquidity needs in times of stress. The requirements under the liquidity standards are also likely to have significant impact on Islamic banks given that investments must comprise only Shariah-compliant instruments. To facilitate compliance with the standards, the Bank will encourage and support the development of solutions by the industry to deepen the sukuk market, while cooperating with other agencies to formulate an appropriate regulatory framework for the issuance of new instruments by banking institutions.

SUPERVISORY CAPACITY AND COOPERATION

In light of the expansion of domestic financial groups across borders as well as the growing presence of foreign financial institutions operating in Malaysia, the Bank initiated and actively supported more structured approaches to cooperation with other supervisory authorities. In particular, the Bank moved to better leverage on the role of supervisory colleges in informing supervisory assessments, coordinating supervisory activities and generally promoting more coherent supervisory frameworks for the cross-border operations of financial institutions.

3.3.1   Islamic Banking Act 1983

Islamic banks in Malaysia are regulated by the Islamic Banking Act 1983. This Act which came into force on 7th April 1983 was enacted to provide for the licensing and regulation of Islamic banking business in Malaysia which is banking business whose aims and operation do not involve any elements which is not approved by the religion of Islam. The Islamic Banking Act 1983 is governed by the Central Bank of Malaysia.

3.3.2   Banking and Financial Institutions Act 1989[46]

The objective of the Banking & Financial Institutions Act, 1989 (BAFIA) is "to provide new laws for the licensing and regulation of the institutions carrying on banking, finance company, merchant banking, discount house and money-broking business, for the regulation of institutions carrying on certain other financial businesses, and for the matters incidental thereto or connected therewith".BAFIA was introduced to provide for an integrated supervision of the Malaysian financial system and also to provide the Central Bank with the power to speedily investigate and prosecute, if necessary any illegal activities in an attempt o reduce white-collar crime.

Scope & Ambit Of The Act

BAFIA came into force on 1st October, 1989, Section 128 of BAFIA provides that the Finance Companies Act, 1969 and the Banking Act, 1973 are repealed from the effective date but, notwithstanding the repeal, all regulations, orders, guidelines, circulars, licenses, approvals issued or granted under the 1969 and 1973 Acts and transactions carried out under these Acts continue to be valid and lawful until amended by the provisions of BAFIA

Section 122 of BAFIA provides that where the Minister issues any directive or order under section 24(1) or 93(1) the provisions of the Companies Act, 1965 would continue to apply in addition and not in derogation of such directives and orders, but where there is any conflict between the provisions of the Companies Act and BAFIA regarding any matter under such directive/order, the provisions of BAFIA shall prevail. Section 123 provides the BAFIA shall not affect or derogate from the provisions of the Exchange Control Act, 1953 and in the event of any conflict between the two Acts, the provisions of the Exchange Control Act shall prevail.

Section 124 provides that BAFIA shall not apply to an Islamic Bank.

There are three groups of institutions covered under BAFIA namely :

• licensed institutions namely commercial banks, finance companies, merchant banks, discount houses and money brokers
• scheduled institutions which include credit and charge card companies building societies, factoring and leasing companies, and development finance institutions and
• non-scheduled institutions which include institutions engaged in the provision of finance but other than those named above

Licensing

All licensed institutions are required to hold a valid license granted by the Minister. Every licensed institution is required to affix or paint on the outside of each of its offices in a prominent position and in a legible manner in the national language its name and words clearly indicating the business for which it is licensed such as "licensed finance company".

A licensed finance company is permitted to carry out the business of :

receiving deposits on deposit account, savings account or other similar account ; and

(i)            the lending of money;

(ii)          leasing; or

(iii)         hire-purchase, including that which is subject to the Hire-Purchase Act, 1967; or such other business as the Central Bank may prescribe

Section 32 of BAFIA prohibits any licensed institution to engage, whether on its own account or on a commission basis, in wholesale or retail except in connection with the realization of security given to or held by it for the purpose of carrying out its licensed activities. Section 33 further does not permit a finance company from accepting money on deposit which is repayable on demand or deal in foreign currency.

The Central Bank is authorized to fix minimum or maximum amounts of deposits or specify the minimum and maximum tenor of any of the deposits accepted by licensed institutions. However, such a specification will not affect an existing deposit account or existing agreement with a customer.

Receiving Deposits

Unsolicited Calls

Section 26 of BAFIA provides that no 'unsolicited calls' (i.e. a personal visit or oral communication made without express invitation) may be made, without the written consent of the Central bank to :

• solicit or procure the making of a deposit ; or
• enter into or offer to enter into any agreement with a view to the acceptance of a deposit, from any person in Malaysia or outside Malaysia

In a Press Statement made by the Central Bank on 7th October 1989 it was stated that the intention of this provision is to stem 'illegal deposit-taking activities'. What the central Bank meant is far from clear. Though this section is, technically, breached frequently by marketing officers no reported case on an action by the Central Bank under this section is known to the writer.

Priority of Depositors

As licensed institutions are custodian of public funds, Section 81 of BAFIA provides that in the event where a licensed institution is unable to meet any of its obligations, the properties of the institution shall first be used, in priority over its other liabilities, for the payment of deposits, notwithstanding section 292 of the Companies Act, 1965.

Marketing and Advertising

Section 28 makes it an offense to publish any statement which is misleading, false or deceptive or to conceal any material fact in relation to deposit taking. The offense is committed for recklessness whether made dishonestly or not.

Financial Requirements

Every licensed institution may be required by the Central Bank to maintain

a general reserve;

a statutory reserve;

a liquidity ratio;

a capital adequacy ratio; and

any amount or class of assets/li>

Section 40 of BAFIA requires every licensed institution to appoint an approved auditor who meets with the requirement laid down in the section. This section also lays down the duties of the auditor.

Within three months (or such further period as approved by the Central Bank) after the close of each financial year every licensed institution must submit to the Central Bank its latest audited Balance Sheet, Profit & Loss Accounts and Statement of Sources and Uses of Funds together with the report of the auditors, and directors.

Section 42 provides that within fourteen days of laying of its accounts at its annual general meeting, every licensed institution must publish the account in not less two daily newspapers approved by the Central Bank. It mush further, throughout the year, exhibit in a conspicuous position at every of its office in Malaysia, a copy of its Balance Sheet and such other documents as specified by the Central Bank.

Apart from the above the Central Bank also requires licensed institutions to submit a wide range of returns and reports for the purpose of monitoring their activities.

Ownership, Control & Management

Part VIII of BAFIA limits the amount of shares that a person may hold in a licensed institution and also requiring transaction in shares over a prescribed limit to be approved by the Minister of Finance. Furthermore no person may be appointed as a director of a local licensed institution without the prior written consent of the Central bank. The disqualification of directors is provided in section 56.

3.3.3   Central Bank of Malaysia Act 2009

The Central Bank of Malaysia Act 2009 has come into force on 25 November 2009. With the coming into force of this Act, the Central Bank of Malaysia Act 1958 is repealed and thus, ceases to apply.

Although the Central Bank of Malaysia Act 1958 is repealed, all existing appointments, transactions, arrangements and subsidiary legislation made or any act done under the Central Bank of Malaysia Act 1958 shall be deemed to be made or done under the Central Bank of Malaysia Act 2009.

3.4      Legal Issues in Islamic finance

3.4.1   Jurisdictions of the courts in Malaysia to hear Islamic banking cases

According to the Federal Constitution, for finance, trade and banking matters to fall under the jurisdiction of civil courts.  However, there are some problems associated with this:

(1)  Civil courts that follow the common law clearly do not follow Islamic principles;

(2)  Judges who hear cases in civil courts may not be well-versed with Syariah principles; and

(3)  Judges in Syariah courts understand Fiqh Muamalat (Islamic rules on transactions) better, compared to their counterparts in civil courts.

However, sections 56 to 58 of Central Bank Act clearly state that any dispute on Syariah matters pertaining to Islamic banking, finance and takaful matters should be referred to the Shariah Advisory Council (“SAC”) of Bank Negara Malaysia (“BNM”).  Doing so would ensure compliance with Syariah principles, especially Fiqh Muamalat (which is still developing), unlike other Syariah law matters such as personal law (which is quite developed). Currently, civil courts are in a better position to hear Islamic banking cases because these not only involve Syariah principles, but other laws as well, such as land law.  He commented that disputes regarding Islamic banking transaction that arise are referred to SAC, as the specialist in Islamic banking.

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[1] M. Fahim Khan and Mario Porzio, Islamic Banking and Finance in the European Union: A Challenge (Edward Elgar 2010) 196

[2] Abdul Karim Aldohni, The Legal and Regulatory Aspects of Islamic Banking: A Comparative Look at the United Kingdom and Malaysia (Routledge 2011) 19-20

[3] Tai Boon Leong, Executive Director, Monetary Authority of Singapore, ‘Opening Remarks’ (The Singapore Islamic Finance News Roadshow 2009, 17 March 2009)

[4] Luca Errico and Mitra Farahbaksh, ‘Islamic Banking: Issues in Prudential Regulations and Supervision’, IMF Working Paper, WP/98/30 <http://www.nzibo.com/IB2/IMFprs.pdf> accessed 6 Janury 2012

[5] Abdul Karim Aldohni, The Legal and Regulatory Aspects of Islamic Banking: A Comparative Look at the United Kingdom and Malaysia (Routledge 2011) 109

[6] Abdul Karim Aldohni, The Legal and Regulatory Aspects of Islamic Banking: A Comparative Look at the United Kingdom and Malaysia (Routledge 2011) 109

[7]‘Review of the Taxation Treatment of Islamic Finance: Discussion paper’, The Board of Taxation, Australian Government, October 2010

<http://www.taxboard.gov.au/content/content.aspx?doc=reviews_and_consultations/islamic_finance_products/default.htm&pageid=007> accessed 6 January 2012

[8] ‘Review of the Taxation Treatment of Islamic Finance: Discussion paper’, The Board of Taxation, Australian Government, October 2010

<http://www.taxboard.gov.au/content/content.aspx?doc=reviews_and_consultations/islamic_finance_products/default.htm&pageid=007> accessed 6 January 2012

[9] ‘Review of the Taxation Treatment of Islamic Finance: Discussion paper’, The Board of Taxation, Australian Government, October 2010

<http://www.taxboard.gov.au/content/content.aspx?doc=reviews_and_consultations/islamic_finance_products/default.htm&pageid=007> accessed 6 January 2012

[10] Zeti Akhtar Aziz, ‘Governor’s Keynote Address: Islamic Finance: A Global Frowth Opportunity Amidst a Challenging Environment’ (State Street Islamic Finance Congress 2008, Boston USA, 6 October 2008)

[11] Angelo M Venardos, Islamic banking & Finance in Southeast Asia: Its Development and Future (World Scientific 2007) 106

[12] ‘Eddie Yue, Deputy Chief Executive of the Hong Kong Monetary Authority, ‘Keynote Address’ the (Hong Kong Islamic Finance Forum 25 November 2008)

[13] Abdul Karim Aldohni, The Legal and Regulatory Aspects of Islamic Banking: A Comparative Look at the United Kingdom and Malaysia (Routledge 2011) 109

[14] Lim Hng Kiang, Minister for Trade and Industry and Deputy Chairman, Monetary Authority of Singapore, ‘Opening Remark’ (2nd World Islamic Banking Conference: Asia Summit 2011, Pan Pacific Hotel Singapore, 8 June 2011)

[15] M. Fahim Khan and Mario Porzio, Islamic Banking and Finance in the European Union: A Challenge (Edward Elgar 2010) 113

[16] Fath E. Rahman Abdalla El Sheikh, ‘The Underground Banking System and their Impact on Control of Money Laundering: With Special Reference to Islamic Bank’ (2002) 6, 1 Journal of Money Laundering Control 42

[17] M. Fahim Khan and Mario Porzio, Islamic Banking and Finance in the European Union: A Challenge (Edward Elgar 2010) 106

[18] M. Fahim Khan and Mario Porzio, Islamic Banking and Finance in the European Union: A Challenge (Edward Elgar 2010) 108

[19]See Abdul Karim Aldohni, The Legal and Regulatory Aspects of Islamic Banking: A Comparative Look at the United Kingdom and Malaysia (Routledge 2011); Hossein Askari, Zamir Iqbal and Abbas Mirakhor, New Issues in Islamic Finance & Economics: Progress  & Challenges (Wiley Finance 2009); Mohamad Illiayas Seyed Ibrahim, ‘The Regulatory Framework and Legal Aspects of Islamic Banking and Finance in Malaysia’ in Mohd Daud Bakar and Engku Rabiah Adawiah Engku Ali (eds), Essential Readings in Islamic Finance (CERT Publications Sdn Bhd 2008); Simon Archer and Rifaat Ahmed Abdel Karim, Islamic Finance: The Regulatory Challenge (Wiley 2007)

[20] Mohsin S. Khan and Abbas Mirakhor, Theoretical Studies in Islamic Banking and Finance (Islamic Publications International 2005)

[21] Hans Visser, Islamic Finance: Principles and Practice (Edward Elgar 2009)

[22] Mohsin S. Khan and Abbas Mirakhor, Theoretical Studies in Islamic Banking and Finance (Islamic Publication International 2005) 7

[23] Mohsin S. Khan and Abbas Mirakhor, Theoretical Studies in Islamic Banking and Finance (Islamic Publication International 2005) 9-10

[24] Iran ranks third in world oil reserves and it ranks second it world natural gas reserve.

[25] Hosssein Aryan, ‘Iran: The impact of Islamization on the financial system’ in Rodney Wilson, Islamic Financial Market (Routledge 1990) 155

[26] Hosssein Aryan, ‘Iran: The impact of Islamization on the financial system’ in Rodney Wilson, Islamic Financial Market (Routledge 1990) 157

[27] Hosssein Aryan, ‘Iran: The impact of Islamization on the financial system’ in Rodney Wilson, Islamic Financial Market (Routledge) 159

[28] Hosssein Aryan, ‘Iran: The impact of Islamization on the financial system’ in Rodney Wilson, Islamic Financial Market (Routledge) 159

[29] Ulf Laessing, ‘Islamic banks see Iran opportunities’ Reuters US Edition (Manama, 16 April 2009)

<http://www.reuters.com/article/2009/04/16/us-islamicbanking-summit-iran-idUSTRE53F3T620090416> accessed 30 December 2011

[30] Malaysia International Financial Centre, ‘Islamic Finance: Lower Risk But at What Cost’ (9 November 2009)

<www.mifc.com/index.php?ch=menu_med_ifcnews&pg=menu_med_ifcnews_int&ac=429>  accessed 20 January 2011

[31] Abdul Karim Aldohni, The Legal and Regulatory Aspects of Islamic Banking: A comparative look at the United Kingdom and Malaysia (Routledge 2011) 6

[32] Abdul Munir Yaacob and Hamiza Ibrahim, Islamic Financial Services and Products (Institute of Islamic Understanding Malaysia 2002) 113

[33] Mariani Abdul Majid, Nor Ghani Mohammed Nor and Fatin Faezah Said, ‘Efficiency of Islamic Banks in Malaysia’ in Munawar Iqbal and Ausaf Ahmad (eds), Islamic Finance and Economic Development (Palgrave Macmillan 2005)

[34] Zulkifli Hasan, ‘Shariah and Legal Issues in Al-Bay’ Bithaman Ajil Facility in the case of Arab-Malaysian Finance Bhd v Taman Ihsan Jaya Sdn Bhd & Or’ [2008] 5 MLJ

[35] Simon Archer and Rifaat Ahmed Abdel Karim, Islamic Finance: The Regulatory Challenge  (Wiley 2007) 156-157

[36] Nicholas Bray, ‘Islamic Banking Grows to Meet Religious Laws: While Sector is in Infancy, Some Western Giants are Expanding in Field’, The Wall Street Journal, 11 March 1996, A9

[37] Heng Swee Keat, Managing Director, Monetary Authority of Singapore, ‘Welcome Address’ (The 6th Islamic Financial Services Board Summit, Singapore, 7 May 2009)

[38] Zamir Iqbal and Abbas Mirakhor, An Introduction to Islamic Finance: Theory and Practice (2^nd edn, Wiley 2011) 321-322

[39] Dahlia El-Hawary, Wafik Grais and Zamir Iqbal, ‘Regulating Islamic Financial Institutions: The Nature of the Regulated’ (World Bank Policy Research Working Paper No. 3227, 25 February 2004) 39.

[40]M. Fahim Khan, ‘Setting Standards for Shariah Application in the Islamic Financial Industry’ (2007) Thunderbird International Business Review, Vol. 49(3) (May–June) 293-294.

[41]Wafica Ali Ghoul, ‘The Dilemma Facing Islamic Finance and Lessons Learned from the Global Financial Crisis’ (2011) Journal of Islamic Economics, Banking and Finance, Vol. 7 No. 1 (January-March) 60.

[42] The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is responsible for the development of international Islamic banking and finance standards while Fiqh Academy is involved in the issuances of major fatwas on Islamic banking and financial products.

[43]Rahail Ali and Mustafa Kamal, ‘Standardizing Islamic Financing: Possibility or Pipe Dream?’, Business Law International, 19 (2009) 20.

[44] For example, Islamophobia and strong hatred towards the Muslim community are occasionally extended to Islamic finance. As a result, the scholars of Islamic finance must coordinate with each other in this time of great challenge to mount a more focused international coordination and standardization effort. Proper regulation, supervision and standardization are necessary to ensure the efficiency of the Islamic financial industry.

[45] For details, see BNM website.

[46] See BNM’s website