1. INTRODUCTION
Islamic Banking (‘IB’) has been hailed as one of the financial institutions which promotes good business ethics, fairness, resilience toward crisis 2008. A report released by Islamic Financial Services Board (IFSB) in 2016 shown up to the end 2015 the overall asset of global Islamic banking growth double in digit after the global crisis in 2008.[1] IB will be a promising business because the UK Government has been supportive and in welcoming IB over the last decade. Secondly, the market segment and range of banking products that can be offered by IB. However, it does not mean the establishment and operation in the UK are absence from challenges. The fact that the UK adopts a secular banking system make some adjustment are needed to make the IB is welcomed in the UK. [2]
This writing will provides analysis on the opportunity and challenge in establishing (‘IB’) in the UK. The examination will be conducted through 2 (two) chapters. The first chapter will explore the nature of IB and its inherent differences with Conventional Bank (‘CB’). This part will also show the legal structure of IB’s products with its operational risks. Further, the second part will explore the possibility of sharia law as governing law of the contract. This essay stands with a notion that the IB has big potential to grow because of great supports from UK Government to IB, however, IB also has its own internal problem with regard to Shariah Supervisory Board (SSB).
2. ISLAMIC BANKING: POTENTIAL AND REGULATORY CHALLENGE IN THE UK
The concept of ‘Bank’ in the UK was established by United Dominions Trust Ltmd v Kirkwood.[3] That case set the definition of a bank as an institution that 1) provides ‘current account’, 2) ‘issuing and dealing with cheque-related transaction’, 3)‘has reputation as ‘bank’ and ‘welfare economy’.[4] The ‘current account’ revolves around the concept of ‘reservoir account’[5] of the capital-owner whereas the bank should make repayment to the money collected on the account as well as maintaining the liquidity of the money.[6] Meanwhile, the “cheque-related transaction” may be in many forms such as cash withdrawal, cheque issuance and so forth.[7] Arguably, IB does not face difficulty to meet ‘current account’ and ‘cheque-related activity’ requirements because of the use of Mudaraba contract.[8] The traditional Mudaraba relies on the concept where the capital owner entrusts capital to the entrepreneur to trade and to return to the investor the real investment and the pre-agreed share of profits’. The investor is also expected to accept the loss if the project is failed. In the application of current IB, the Mudaraba is modified to become ‘Two tier mudharaba’ to ensure there is no ‘uncertainty’ transaction which is prohibited under sharia. The first tier mudaraba links depositor with the IB once the depositor place her money in the bank while in the second tier mudaraba, the IB provides a fund to the entrepreneur.[9] Under this mechanism, the profit will be gained separately in each layer of contract based on the concept of Profit and Loss Sharing (PLS). Another sharia contract also can be formed to create ‘current’ account, such as Wakala (Agency Contract). In Wakala, the IB becomes the agent for the depositor to invest the money. The principle difference between Mudaraba and Wakala is, in Wakala the IB is only allowed to invest in particular project chosen by the depositor. Moreover, in Wakala does not employ PLS, rather the IB will gets fee as a result of conveying its duty alongside with any profits generated from[10] Even the Ar-Rayan Bank uses Qard contract (a loan free from any benefit) as their current account scheme. [11] What can be canvassed from this mechanism is, the current account may be made using various Islamic contract. According to ‘muamalat’ principle, every transaction is allowed as long as it is not contrary with Al-Quran and Hadits which primarily prohibit (riba), uncertainty transactions (gambling, gharar, maysir) and illicit (haram) transaction.[12] Meanwhile under statutory, ‘banking’ is regulated by Financial Market and Sevices Act 2000 (‘FSMA’). FSMA does not give description of ‘bank’, but FSMA emphasis the requirement for an institution to manage that to manage ‘deposit account’ should be ‘authorised person’ and ‘regulated activity’.[13] Banking Act 2009 does give many contribution to the definition of ‘bank’ as it referred to FSMA 2000.[14] Interestingly, case laws and statutory do not mentions that a bank should operate with interest-based transaction.[15] However, the establishment of IB in the UK has the ‘non-sharia compliance challenge’ because the FSMA rules that required all money in the ‘current account’ should be repaid.[16] The consequence of this mechanism is, IB must guarantee that the depositor placed its money ‘PLS account’ will get their money back even if the IB suffers loss. This rule contradict with the concept of PLS[17] However, the imposition of ‘guarantee’ mechanism is not a form of discrimination to hamper IB, rather it stems from different perspective of ‘deposit account’ adopted by FSA and IB. The FSA sees money in deposit account as a fund that is borrowed to the bank to conduct business and therefore it needs to be protected to trigger bank allocates the money diligently. Meanwhile, under IB’s perspective, the money in deposit account is seen as fresh business capital. However, this does not mean that the IB in the UK automatically becomes non-sharia. Most scholars argue, this non-sharia risk may be mitigated by offering ‘non-sharia clause’ whereas the depositor is given a freedom whether they want to accept compensation or not if there is a loss from their deposit account. To this matter, the investor should bear in mind that the ‘guarantee scheme’ in saving account is a key to get license from the government especially FSA. Morevoer, with regard to reputation, the case law requires an entity to have systemic effect to society. Aldohni argues IB does not face any difficulty to meet this criteria as according to Islamic Economy principle money should not be converged in one individual/group rather it should be used for creating social welfare whether by voluntarily action or profit-making orientation based on ‘justified enrichment’ (non-interest transaction).[18]
Moreover, the market segment and products of the IB is also growing rapidly. Report released in 2015 shows that IB surpassed Islamic Sukuk and Islamic Insurance Institution (‘Takaful’). IB encompasses 79% of Islamic finance assets while Sukuk and Takaful respectively held 16% and 1%. This fact arguably is driven by the nature of IB’s products that can substitute all products of CB whether ‘merchant CB’ or commercial CB. [19] As a commercial bank, IB provides saving account which is mainly reflected by Investment Products. IB provides opportunity to the depositor in PLS account an opportunity to partnership whether Mudaraba (Silent Partnership) or Musyarakah (Active Partnership). A typical IB will perform this investment functIon by screening the profitable project and monitoring it to gain a profit.[20] However, in practice the fund are mainly applied by means of Commodities and Asset Financing instrument which ranges from mark-up (Murabaha), Advance Purchase (Salam), Leasing (Ijara) and Commissioned Manufacture (Istishna) .The concept relies on trading activity such as Murabaha and Salam is the IB act as a seller of commodity to get ‘capital gain’. Moreover, to avoid the debt-based transaction in financing, IB may employ SUKUK or Islamic Bond.
Arguably, the potential problem that may arise with Investment Products is, how far the IB may get transparency from the entrepreneur and how IB allocates its own capital and the fund gained from the depositor. Please be informed that, apart from the fund from the depositor, IB sometimes uses its own money to have transaction.[21] Therefore when IB, especially the management, may face a conflict of interest whether to shift the profit to the shareholders or depositor mudaraba account. [22] This may be classified as ‘agency problem’ that only can be overcame if the IB has effective boards that have right mindset on this problem.[23] Moreover, since IB has sharia characteristic, the IFSB promotes that every IB should put Sharia Supervisory Board (‘SSB’) which acts as the guardian of the operation of IB. According to Karim, the SSB may be compatible with NEDs except for two things namely: its duty to assess the ‘sharia compliance transaction/products’ and 2) the absolute power given to to SSB for terminate any non-sharia compliance sharia.[24] The question regarding to whom SSB should accountable also becomes the crucial issue because they have big power to terminate operational activity of a products that may affect the stability of IB and react negative respons from consumer. [25]To this matter, arguably the investor must choose the right person and maintain a good relationship with SSB.
Another legal key that must be bear in mind with investor is the Capital Adequacy Ratio (CAR) and corporate governance during the operation of IB. Errico and Frahbaksht the ‘equality’ concept that is promoted by the PLS prohibits IB to ask ‘collateral’ asset to the entrepreneur. This condition creates ‘overall riskiness in Islamic Banks’ operation compare to conventional banks. Therefore, IB is expected to maintain higher Capital Adequacy Ratio (‘CAR’) compared to CB. However, Fiennes argues the nature of PLS which relies on ‘partnership’ instead of ‘lender and borrower’ relationship should not make IB categorized as a bank which needs higher minimum capital. The exposure of the bank’s own capital is limited to the effects of forced asset disposals on the assets financed while under sharia it does not have an obligation to pay the money as a result of the failure of business. Therefore, logically IB does not need as much as capital in relation to balance sheet asset as conventional banks.[26] This criticism is makes sense if looking back to the principle of islamic transaction. However this is difficult to implement especially when IB operates within the UK Banking regime and international banking environment which employ secular approach. Hayes and Vogel argue IB does not immune from ‘runs’ in the sense of large volumes of ‘panic’ withdrawals of from deposit fund. Put another way, IB still faces liability risks that may arise from its external circumstances. Therefore, CAR will be also beneficial for IB to stabilise itself when it is exposed with systemic risks.[27] While on the other hand, fulfil principles standard also become problematic for the IB because it may be contradictory with sharia. The current CAR requirement is regulated under Basel III principles which requires 3 (three) tier of capital namely: Tier 1 capital which consists of loss-absorbing instrument such as common shares and retained earning; Tier 2 ‘leverage ratio’, and Tier 3 which requires IB to have Liquididy Coverage Ratio (LCR) to ensure the banking institutions hold sufficient high-quality liquid assets. Arguably, the IB will face difficulty to meet the Tier 3 because IB is prohibited to operate the debt-based products. However, CAR will be beneficial for IB to invoke Lender of Last Resort to the Bank of Britain if systemic risk happen [28] However, the Bank of England seems proactive to find the solution for non-shariah compliance feature in Basel III through consultation sessions with IB executives, experts and government. It is suggested to fulfil the CAR although it is contrary with sharia and indirectly make the IB to invest in debt-based products while waiting the best solution from the consultation.
3. English Law Treatment to Islamic Financial Law
Under English Law, the law governing contracts is governed by the Contract (Applicable) Law Act 1990. This law enacted the Rome Convention on the Law Applicable to Contractual Obligations 1980. Under this Applicable law 1990, interpretation of the law governing a contract should refer to substantive law of relevant country.[29] The rationality under this principle is, a law cannot exist ‘in vacuum’ without being enforceable in the courts of any jurisdictions. Sharia law derives from Al-Quran and sunna which contains a substantial provisions which can be qualified as ‘legal, but does not constitute code or comprehensive body of norms.[30] The variation of approach to interpret the Quran and Sunna to which may differ in various jurisdiction arguably makes difficulty in determining the content of commercial sharia.[31] Therefore, in Shamil Bank of Bahrain EC v Beximco Pharmaceutical Ltd decide the murabaha financing contracts which states the governing law ‘subject to the principles of the ‘Glorious sharia’ not applicable. Morison J said that: ‘there is a clearly great controvercy as to the strictness with which principles of Sharia law will be interpreted of applied. While Potter RJ when rejected the appeal of from the claiman also pointed out that the diversity of ‘school of taught’ arising the problem of ‘certainty’. The court is not stands alone with this uncertainty, a report shows many practitioners also feel uncomfortable with this ‘litte uniformity amid a wide range of product structur and differing standards of Sharia Compliance. [32] However, this does not mean the sharia law is cannot use as governing law, the development of case law which adopt ‘indirect’ approach to sharia law shows the sharia law is still possible as governing law within two qualifications, namely: 1) sharia law is incorporated in an agreement; 2) sharia law which is a part of specific national law.
The Investment Dar Company KSCC v Blom showed the approach used by the Court to assess the validity of ‘Wakala contract’. Difference with Beximco case which took sharia law as a medieval religious philosophy, the judge in Bloom determine the nature of the Wakala contract by carefully the look to the evidence experts and the text of the contract itself. The approach used by this court showed that the Court may deal with sharia contract as a ‘a stand-alone financial product that is structured according to Islamic finance’ [33] principles. The possible risk from this approach is, the court may have their own definition on such transaction rather than an ideal form of transaction under sharia law. In Halpern v Halpern,[34] although the case does not deal with Sharia, by the Court to assess rather Jewish law, this decision arguably may depicts another different approach used ‘foreign law’. Al-Midani v Al Midani which categorised the sharia law which a part of Saudi Law as a ‘branch of applicable law to a contract. The judge in Halper uses this assessment and rules that sharia law may be used as governing contract with three qualification: 1) the choice must be expresss; 2) if it is to be implied the implication must be demonstrated with reasonable certainty by the terms of the contract or the circumstances of the case; and (3) the choice can relate to the whole contract or part of a contract. Arguably, if the investor uses sharia law as governing law and wants the English Court to adjudicate it, the investor should mention specific sharia law which is adopted by particular country such as Saudi Arabia with its Basic Rule of Governance. By following this approach the court treat the Sharia law the same treatment with ‘conflict of law’ treatment and may consider Sharia law as a part of freedom of contract to the party. However, the investor should bear in mind that, by referring to another law it means the validity of contract may be used the approach of the chosen country and therefore the investor needs to understand the forming of contract on that different jurisdiction. All in all, considering various ‘indirect’ approach by English Court, it seems using Sharia Law as governing law is still risky. However, it does not mean that there is no chance at all. The case shows the trend that English court puts effort to make Sharia Law can be adjudicated using ‘indirect approach’. Arguably, in this case the investor must put attention on how they define the ‘Sharia Law’ under the contract. The mitigation can be done by carefully drafting the transaction contract and the choice of law. Another mitigation step can be done by bringing the conflict to arbitration law instead of the Court. Under section 46 (1) (b) of the Arbitration Act 1996, the arbitrator may consider Sharia principls and other national rules, as long that is the choice of law by the parties in the agreement
4. CONCLUSION
The potential to open Islamic Banking in the UK is widely open because of the given by the hospitality provided by UK Banking law and the potential of growing market segment. IB will not face difficulty to establish in the UK as it does not meet significant difficulty to meet criteria ‘banking institution’ set by the common law and civil law in the UK. However, the potential of non-shariah compliance does exist because the FSA requires every bank institution to given guarantee to the holder of current account. This approach does met with the PLS principle which is adopted in first tier mudaraba, but may be tackled by providing term and condition to the consumer of IB, giving them freedom whether to accept or not such compensation if a failure happen. Furthermore, the investor also should take into account their CAR to comply with FSA requirement and the most important thing to defend themselves if systemic risk. Furthermore, the IB will face more complicated ‘agency problem’ because the management will find ‘conflict of interest’ to whom they will allocate funding and profit gained from it. Moreover, the investor also must bear in mind to choose a proper and skilful man to fill the Sharia Supervisory Board (SSB) to ensure the products of IB may sharia compliance to statutory. Finally, the using of sharia law as governing law is not possible according, however the Court seems not refusing the sharia law as a whole, some Court uses ‘indirect’ approach to adjudicate sharia law as governing law of the contract. The sharia law may be considered by the court if it is a part of specific jurisdiction which employs particular sharia codification; and if it ‘incorporated into’ the contract.
[1] Islamic Financial Services Board,’Islamic Financial Services Industry Stability Report 2016’ [2016] Islamic Financial Services Board <file:///C:/Users/B4051993/Islamic%20Finance%20Essay/Islamic%20Stability%20Report.pdf> accessed 10 January 2016
[2] Bank of England, ‘Shari’ah Compliant Liquidity Facility: Establishing a Fund Based Deposit Facility’ (April 2017) Bank of England Consultation Paper 1; DDCAP Group, ‘The UK: Leading Western Centre For Islamic Finance’ (November 2015) DDCAP Group < https://www.thecityuk.com/research/the-uk-leading-western-centre-for-islamic-finance/> accessed 03 May 2017
[3] United Dominions Trust Ltd v Kirkwood [1966] 1 Lloyd’s Rep 418
[4] Abdul Karim Al-Dohni, ‘The Legal and Regulatory Aspect of Islamic Banking’ (2011) 59
[5] E. P. Ellinger, Eva Lomnika and Richard Hooley, Ellinger ’s Modern Banking Law (4th edn, Oxford University Press, 2006), p 212
[6] Anu Arora, Practical Banking and Building Society Law (Blackstone, 1997)
[7] Al-Dohni, ‘The Legal and Regulatory Aspect of Islamic Banking’ (2011)
[8] Hennie van Greuning and Zamir Iqbal, ‘Banking and the Risk Environment’ in Simon Archer and Rifaat Ahmed Abdel Karim (eds) Islamic Finance: The Regulatory Challange (John Wiley & Sons Asia 2007) 17
[9] Frank E Vogel and Samuel E Hayes, ‘Islamic Law and Finance Religion, Risk and Return’ (Brill 2006) 131
[10] Wakala Treasury Deposit Account: Special Conditions, clause 4.1–4.2; 60-Day Notice Account: Special Conditions, clause 5.1–5.2; Fixed-Term Deposit Account Special Conditions, clause 5.1–5.2.
[11] Al Rayan Bank, ‘Current Account’ <https://www.alrayanbank.co.uk/current-account/> accessed 26 May 2017
[12] Iqbal Munawar and Molyneux Philip, Thirty Years of Islamic Banking (Palgrave Mcmillan, 2005) 6
[13] FSMA 2000, Part III, s 31 and Part II, s 22., see Karim
[14] Aldohni (n 4)
[15] Aldohni (n 4)
[16] Banking Act 1987m s 5(1) (a); Graham S. McBain (ed), Butterworths Banking Law Handbook (BVetterworths, 1989), p.18
[17] Aisyah Abdul-Rahman and Shifa Mohd Nor, ‘Challenges of Profit-and-Loss Sharing Financing in Malaysian’ (2016) 40 Malaysian Journal of Society and Space 39
[18] Aldohni (n 4)
[19] Thorsten Beck, Asli Demirguc-Kunt and the others, ‘Policy Research Working Paper 5446 Islamic vs Conventional Banking Business Model, Efficiency and Stability’ (2010) World Bank < http://documents.worldbank.org/curated/en/482731468333056240/Islamic-vs-conventional-banking-business-model-efficiency-and-stability> accessed 13 January 2017; see also Aldohni (n
[20] Vogel and Hayes (n 9) 134
[21] Aldohni (n 4)
[22] Vogel and Hayes (n 9) 134
[23] Islamic Financial Service Board, ‘ Guiding Principles on Corporate Governance for Institutions Offering Only Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds) (December 2006) IFSB < http://www.ifsb.org/standard/ifsb3.pdf> accessed 07 May 2017 see para 10
Nadler D, ‘Building Better Boards’ (2004) 82 (5) Harvard Business Review 105; see also Cadbury Report, ‘Report of the Committee on the Financial Aspects of Corporate Governance: The Code of Best Practices’ [1992] < https://www.governance.co.uk/resources/item/255-the-cadbury-report> accessed on 18 April 2017
[24] Aldohni (n 4)
[25] Aldohni (n 4)
[26] Toby Fiennes, ‘Supervisory Implications of Islamic Banking: A Supervisor’s Perspective’ in Simon Archer adn Rifaat Ahmed Abdel Karim (eds) Islamic Finance: The Regulatory Challange (John Wiley & Sons 2007)
[27] Adeoluwa Onagoruwa ‘Contingent Convertible Capital: a Perfect Tool for More Resilient Banks’ in Aldohni, AK (ed) Law and Finance after the Financial Crisis: The Untold Stories of the UK Financial Market. (Routledge, 2017)
[29] Contract (Applicable) Law Act 1990, s
[30] Reed Rupert , ‘ The Application of Islamic Finance Principles under English and DIFC Law’ [2014] Butterworths Journals of International Banking and Financial Law 573
[31] Foster Nicholas H.D, ‘Islamic Finance Law as Emergent Legal System’ (2007) 21 (2) Arab Law Quarterly 170
[32] The Islamic Financial Services Board, Guiding Principles Work on Islamic Standardization’, Downjones Newswires (10 May 2006)
[33] Aldohni (n 4 )
[34] Halpern and others v Halpern and another – [2007] EWCA Civ 291
