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Opalesque Islamic Finance Intelligence

Editor's Note: AAOIFI's Perestroika By Bernardo Vizcaino, CAIA

Thursday, December 16, 2010

With increased calls for the Islamic finance industry to review (and reform) its governance framework, AAOIFI finds itself as a key participant of this process. A perestroika in the making. The increased scrutiny revolves around the role of scholars and structure of Shariah Supervisory Boards. This includes issues pertaining to concentration of board seats in a handful of scholars, an individual holding seats in competing organizations (regardless of concentration), greater accessibility/understanding of the rationale behind rulings, as well as cultivating a wider pool of experienced professionals. While the debate has focused on the potential conflicts of interest, the next step would be to determine what mechanisms can be implemented to strengthen the overall system.

AAOIFI Leads the Way
Such industry feedback has prompted AAOIFI to look into drafting rules to regulate scholar's shareholdings and limit the number of seats they can hold, this in turn has triggered dismissive responses from various scholars. For an industry body that is comprised of scholars the challenge of regulating its own members might require that it leads by example. It can do so in several ways:

1. Transparency (short term) - AAOIFI has issued various standards (currently a total of 86) covering areas such as accounting, auditing, governance as well as ethics, and transparency will be somewhere in there. AAOIFI standards should fit the acronym, they should be Available Anytime Online Ideally Free Immediately. Currently they are only available as paid-for bulky hardcopy publications, and this does not encourage those wanting to learn form them and makes it very difficult for those keen to help disseminate them further. One can even draw a parallel with perestroika (reform) which was introduced together with glasnost (transparency).

The argument is compelling when we consider that similar industry standards are available online such as the Sarbanes Oxley Act of 2002 (see reference link); The International Standards on Auditing (ISA's) issued by the IAASB (see reference link), and closer to home the IFSB Guidelines (see reference link). Perhaps a compromise approach similar to that used by the IFRS Standards (see  reference link) where the core material is available to everyone and the complete standards (together with implementation guidance and the basis for conclusions) require a subscription. If we are to question scholar independence we should equally question why an industry body is selling hardcopy books as a revenue stream. This might sound mundane but this has the potential to trigger over-regulation, since there is an incentive to issue more standards (as this would mean more revenues). This is a clear moral hazard.

2. Rotations (medium term) - Once again, if we are to demand from scholars that they relinquish their tightly held board seats, it is natural that AAOIFI reflects the same. Rotating their headquarters across the Islamic world (say every three years) would help project this industry body globally and even capitalize on the hospitality of the many would-be Islamic finance hubs. Again a compromise here could be to retain their Manama headquarters but break-up responsibilities to other satellite offices (say the Accounting Standards Committee or the Shariah Standards Review Committee), this would further encourage IFIs in the chosen country to consider membership (more on this below).

AAOIFI currently places four year terms on the members of its Shariah board (although these are renewable), but no rotation is stipulated so these seats can be held indefinitely. If we are to suggest the existence of a conflict of interest with entrenched scholars one would expect that AAOIFI take steps to ensure the same does not happen with its own management. AAOIFI has taken clear steps to include more scholars in its board and make it more representative, recent appointments to the AAOIFI Shariah board include Sheikh Aflah bin Ahmed Al Khalili, Sheikh Walid bin Hadi, Dr. Abdulla bin Mohammed Al Mutlag, and Mr. Abdulla bin Hmood Al Ezzi (among others). Instead of rotations one could place a limit on consecutive terms (i.e. no more than 3 consecutive terms held by a board member) or selecting board membres at random who must train a younger scholar by allowing them to 'shadow' them during their four year term.

3. Memberships (long term) - While AAOIFI standards have an impact on current member firms one has to question whether the membership list is representative of the global industry and whether efforts should be directed towards building membership numbers. Following AAOIFI chairman Shaikh Ibrahim bin Khalifa Al Khalifa statement that "the confidence in the AAOIFI stands behind its worldwide application" (see reference link) it would be imperative to ensure global representation. Therefore the growth of AAOIFI membership is of great importance.

Currently there are over 149 members (according to AAOIFI's website), of which approximately 40 are central banks or service providers, effectively leaving us with roughly 100 IFI's. These numbers should grow further if one considers that there are over 180 Islamic insurance operators (as per the World Islamic Insurance Directory); 139 Islamic rural banks in Indonesia (as per Bank Indonesia); and the banker magazine listing the top 500 Islamic financial institutions (with over 600 registered) - although one could simply focus on the nearly 300 IFI's reporting shariah-compliant assets of almost $900 billion (according to the same list). In the best case scenario AAOIFI membership reflects 30% of the global family of Islamic finance institutions, and it might be more like 15%.

Scholars Lead the Way
For any analysis to be objective it should also consider the perspective of scholars, and Sheikh Nizam himself has highlighted how they should be "treated like other professionals in the field" such as lawyers and accountants (see reference link). With regards to scholar independence, there are two important aspects which must be distinguished from each other: independence in fact (real independence) and independence in appearance (perceived independence). In other words, even if scholars are held to a higher standard in the performance of their duties (independence in fact), the benefits to the institution would be curtailed if the perception by consumers is that the process is deficient (independence in appearance).

We can take various queues from the audit profession on how to mitigate conflicts of interest, whether real or perceived:

1. Audit firm rotation (low probability) - One suggested approach to mitigate conflicts is the periodic rotation of Shariah audit firms (mandatory or self-imposed), in fact the Sarbanes Oxley Act considered such a proposal but this was not included in its final version. This was in great part due to the significant industry lobby (from audit firms) against such a measure. Certain jurisdictions have enforced such a measure such as Italy, where audit firms must change after 9 years (although the implosions of Parmalat and Alitalia are not supportive of its efficacy). The net effect is to: lower/remove incentives for auditors and the firm to work in cahoots (i.e. more likely to maintain arms-length relationships); decrease the possibility of an auditor being intimidated against issuing an unfavourable audit report (for fear of losing the client account); elevating the quality of audit reports (since audit firms will want to avoid any shortcomings being highlighted by the next audit team), etc.

2. Service Limitations (high probability) - The audit profession has segregated the offering of audit and consultancy services (since the Enron debacle), and to an extent this has been implemented in countries such as Malaysia where Bank Negara already stipulates limits on how many IFI's can be serviced by a single scholar in their "Guidelines on the Governance of Shariah Committee for the Islamic Financial Institutions" (see reference link). Hence a scholar can only offer services to one IFI per sector (Islamic baking, takaful, etc) although this does not stipulate which areas, so while a scholar acts on a supervisory role arguably this could be extended to other services (consultancy, asset management, capital raising, lead generation, etc).

3. Principals Rotation (low probability) - While audit firm rotation is not stipulated in Sarbanes Oxley, the rotation of audit principals certainly is. Section 203 of SoX (see reference link) provides for the rotation of audit principals (i.e. individuals) every five years to avoid developing a relationship that could be deemed too close with the client institution. This is harder to enforce in the Islamic finance context since scholars present themselves as individuals rather than legal entities. Nonetheless, there is the alternative of rotating board members (i.e. including a new member every three years) or simply rotating who is appointed as chairman of the board (i.e. rotating among existing board members every two years).

4. Peer Assessment (medium probability) - This is one of the key areas of criticism, as various practitioners argue that a scholar that approves a product cannot objectively audit that same approval process. Therefore the process could be strengthened by segregating the initial approval/certification from the periodic review/audit. This would in turn create a proper maker/checker function where explanations, clarifications and/or fine-tuning can be required of the product in question.

Murphy Leads the Way
While many of these suggestions sound good on paper, one should remember Murphy's law - if something has the potential to go wrong it probably will go wrong. To put it another way, could the industry be closing the door on certain conflicts of interest while opening the window for other kinds of conflicts? In that sense we should be wary of unintended consequences. Any proposed reforms would need to consider potential repercussions and/or side-effects, including:

1. Impact on competition - The main issue here is that limiting the number of board seats might put pressure on the availability and accessibility to expert and seasoned scholars. In this regard AAOIFI has taken positive steps with the introduction of their industry certification CSAA (Certified Shariah Advisor and Auditor). Nonetheless, limiting scholars to one IFI per industry sector might also unduly impact universal Islamic banks (those offering multiple services), just imagine the issues that might arise for these upcoming mega Islamic banks if they must find experienced scholars that are not board members of any competitor (an almost impossible task).

2. Quality of audit activities - Another source of contention is that any restrictions (especially firm rotation and scholar limitation) would be unduly disruptive to the Islamic finance institution. Such information leakage might occur when replacing individuals that understand and know how to navigate the inner workings of an IFI. Nonetheless, this can also be addressed by standardising the reporting documentation and to an extent commoditizing the compliance process (at least as it pertains to plain vanilla products). In fact the increased adoption of AAOIFI standards across the globe would be a positive development in this regard and mitigate the erosion of quality of the Shariah compliance function.

3. Costs of audit services - If we add more moving parts to the process and require more individuals involved this could translate into greater costs for the IFI. This would be counterproductive, especially for small entities, start-ups and boutique IFIs. Furthermore, if service limitations and peer assessments are put in place this could raise the number of issues highlighted in an audit/review (although this does not necessarily translate into raising the quality of the audit/review itself). Overall, costs will be a function of having an increase supply of providers (i.e. qualified and experienced scholars), which will in turn encourage a healthy price competition for their services. Publishing pricing guidelines for scholar services could also help clarify what are the costs involved, since the quotes involved can vary significantly (in some cases the range of quotes can vary by as much as US$40k to even US$80k).

4. Market Reaction to changes - Far more difficult to predict is how the industry will react to any reforms. To an extent a certain cross-border arbitrage has been observed in Malaysia (where scholars have service limitations to only one entity per industry sector) since some scholars have started offering their services in other countries. This would have very little impact in Southeast Asia (most of the industry is split between Malaysia and Indonesia, with very little overlap) although this would not be the case in the GCC (where IFIs are much more intertwined as they compete in multiple markets, with many having operations within the regional hub of Bahrain).

Another by-product of service limitations is the propensity for product exclusivity. If a Shariah advisory firm can only offer its services to one IFI per market, then the incentive is for them to promote products that are more complex (i.e. which garner greater fees and revenues) and to an extent more risky (since they will be far from plain-vanilla and untested). Similarly these can become one-off products since their sophistication would be protected by intellectual property rights (making them even more expensive for the pioneering IFI) and this could curtail product innovation (harder for competitors to gain access to the same offering).

There is also a separate trend towards moving from individual scholars (as consultants) towards the emergence of advisory firms (as partnership-based). As long as these are not one-man entities they can increase the supply of experienced scholars and address the issue of competency, since younger scholars will be able to reply on a team of seasoned colleagues. Once again accreditation programs such as those from AAOIFI can play a big part and we might even see advisory firms being formed without any high profile scholars (instead a team of individuals who are equally well-qualified).

Service limitations should also be considered with regards to requirements to have a board with a minimum of three scholars (as some jurisdictions require). Here an IFI might retain the services of one experienced scholar and use other less-well known scholars. This might not be an issue on the surface but this can increase key man risk as the SSB will have a tendency to rely too much on the opinion of that one scholar. Nevertheless, it is also equally likely that the board members will represent various geographical reasons (as they would be sourced from non-competing markets), which will in turn increase the cross-border appeal of Islamic banking products and services. This however does nothing to support single-country or single-product providers.

We Lead the Way
Are we asking for AAOIFI to reinvent the wheel or should we just ask them to fix the flat tire? It is quite possible that existing AAOIFI standards can accomplish the intended benefits without any major changes, the key requirement is to broaden their implementation. Once again (argumentum ad nauseam) the growth of AAOIFI membership is crucial. AAOIFI can stand alone in these efforts or it can get our full encouragement to find the right balance between regulation and promotion.

Effectively any reforms risk falling into lengthy discussions and circular debates, whereas perestroika and glasnost came alongside uskoreniye (acceleration) which reminds us that these reforms need to be incorporated in a timely manner. Timely so that the Islamic finance industry is ready to expand alongside the recovering global markets.

The above lines should therefore be taken as constructive criticism and support for the advancement of the industry. While there is a great need to promote the industry, this should be done with an objective assessment of the market reality. With so many issues at hand and so many moving parts it is imperative that AAOIFI receives our support in carrying out these reforms, but it also needs to receive our honest feedback. Perestroika, glasnost and uskoreniye, they are all needed in equal measure.

Your feedback and comments are very important to us, please feel free to contact the author via email.

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