An exclusive interview with the Secretary-General of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), Omar Mustafa Ansari.
Click here for Part 2
LONDON: Over the past few years, key Islamic finance markets, most notably the UAE, are adopting and implementing AAOIFI standards.
As a result, more stakeholders like sukuk issuers and investors are having to understand AAOIFI’s position towards acceptable sukuk structures as well as seeking clarity on the use of certain instruments.
Salaam Gateway spoke to Omar Mustafa Ansari, Secretary General of Bahrain-based AAOIFI on a range of issues.
In the first of a two part interview, Ansari shared his views on sukuk tangibility and whether it will lead to issuers avoiding sukuk. He also clarified AAOIFI's position towards tawurruq in the industry as well as the importance of having an Islamic interbank and repo market.
Salaam Gateway (SG): As part of its drive for industry standardisation, the UAE Central Bank’s High Sharia Authority (HSA) has been enforcing stricter regulations to ensure that all Islamic lenders and sukuk issuances comply with AAOIFI standards. Fitch notes that the implementation of AAOIFI standards in sukuk documentation could impact credit risk profiles and ratings as well as create challenges for issuers and sukuk holders. With rigorous standards for tangibility, are you concerned that this would hinder the sukuk market?
Omar Mustafa Ansari (OMA), Secretary General of AAOIFI:
Islamic finance has gained popularity in the mainstream financial services industry globally and the industry has become significantly important in 14 countries according to the IMF in 2017. Furthermore, the industry’s market share is expected to increase and gain more acceptance globally. However, at the same time, it cannot compromise on the basic principles just to make itself acceptable to the larger audience of the global financial services industry.
There are two types of issues that hold relevance regarding the tangibility requirements. First, the underlying structures that are applied in these transactions are not the preferred structures. As such, several countries where Islamic finance has a presence prohibit any product based on these sukuk structures. This is because the [Shariah] scholars there do not approve these products. When we talk about standardization, we need to set standards that are acceptable on a global basis to a majority of scholars and market participants. Therefore, it is not about allowing less preferred and/or controversial products just because there is a commercial need for that. We agree that there is a commercial need and Islamic finance does cater to that but we may have various other structures that can fulfil that need.
It is not only about the tangibility, but also about the main structure. If we use arguments on the tangibility ratio and keep using the tawarruq-based transaction as the real return generator in such hybrid sukuk, then I believe that we need to question whether we want to continue having Islamic finance like this in the future.
This tangibility issue is not new. It is true there is a new clarification of it now. But it is not a new ratio or a new rule that we have brought in. This has been there in our earlier standards as well, which was applicable to the corporate entities. The sukuk-related rule was not defined clearly, rather the sukuk were considered to be having mainly or rather only the tangible assets or ventures. Basically, the Shariah standards have now defined that and are allowing room for improvement in these structures.
The Islamic finance industry has grown out of its infancy stage. A lot of markets already have 30 to 40 years’ experience, whilst in nearly 14 to 18 jurisdictions the Islamic banking market share has reached more than 15 percent of their banking industry. We understand that even the conventional multilateral institutions like IMF, World Bank and Asian Development Bank recognize that Islamic finance is different. As such, the IMF in particular has recently recognized the core principles for Islamic finance regulation for banking. We continue working with these multilateral institutions in extending guidance where possible including the United Nations Statistics Division (UNSD).
We need to decide if our priority is to have commercial success only or to have a robust, resilient, sustainable, harmonized and globally acceptable Islamic finance system. As an important Islamic finance infrastructure body, AAOIFI will not ignore the commercial aspect, however our role is primarily to set the standards and to keep an eye on the areas where we feel there is a need to improve existing practices. This is to ensure resilience, robustness and soundness of the economic system, Shariah compliance and safeguarding interest of its stakeholders, including structures that are acceptable to the majority of stakeholders considering all the above.
SG: Will it push issuers to issue conventional bonds and Islamic investors not finding proper avenues to deploy their excess liquidity?
OMA: There can be two types of such issuers. Firstly, for those who actually want Islamic finance in a real sense, I believe they will find better structures and there will be no change in their preference. On the contrary, they may find our standards to be better in improving the commercial aspect too in the long run. Conversely, there are those who may not have a clear Islamic finance mindset and use or issue instruments to exploit the Islamic finance market. Perhaps, it can be a hurdle for such stakeholders and they may revert to the conventional industry.
Additionally, a lot of markets do not have these structures at all. Their structures are based on mudarabah and ijarah, diminishing musharakah and others, which actually involve the tangible assets and/or underlying business, and that is the essence of having sukuk. So for them it is not going to make any difference at all. It will make a difference only to those structures that were controversial anyway.
To summarize, we know that it can be challenging, but we believe that our market practitioners, lawyers, rating agencies, investment bankers and product development specialists are already working on developing alternative structures that adhere to Shariah principles better and are close to the essence of Islamic finance. I hope that they will eventually come up with better products to replace these controversial products.
SG: We have seen several changes to sukuk structures in the market that followed AAOIFI. How do investors know which structure is AAOIFI-compliant?
OMA: I believe that market participants need to get more acquainted with AAOIFI standards, both at individual and institutional levels. Participants, including sukuk developers, practitioners, rating agencies, lawyers, investment bankers, IFIs and scholars at the product development level need to be well conversant with AAOIFI standards. We at AAOIFI have numerous capacity-building initiatives and they can benefit from these activities.
I would like to emphasize that we have developed a sukuk governance standard that prescribes additional safeguards. These include audit, governance, transparency and disclosure requirements which are contained in the standard as well as a reference to the IFSB capital market standard.
We suggest that requirements should be considered both from a user and investor perspective. In addition, we have issued a governance standard on Shariah compliance and fiduciary ratings for Islamic financial institutions and are working on another governance standard for Shariah compliance and fiduciary ratings for Islamic financial instruments. This standard is expected to provide guidance on the rating services considering not only credit risk assessments provided by conventional rating strategies, but will also include additional elements and considerations.
SG: Let’s discuss AAOIFI standard 59. It has had a great impact on commodity Murabahah which in practice made floating murabaha loans more complex, and as a result contributed to the fragmentation of the industry instead of standardizing the Islamic documentation. How does AAOIFI plan to address this?
OMA: Firstly, AAOIFI Shariah standard no. 30 on monetization (tawarruq) allows tawarruq on a need-only basis and it does not allow the use of tawarruq/commodity murabahah-based transactions to be a common financing and investment product. Rather these are actually the borderline transactions that should be used on a need basis. Wherever other possible modes of Islamic finance and investment are available they should be applied first. The application of commodity murabaha should be used only in need-based (rare) circumstances.
Secondly, commodity murabaha should not be used as a primary product. One of the main criticisms of Islamic finance is that controversial products are used at times. Some of the countries prohibit these products completely. For example Oman and Jordan do not allow tawarruq, and yet the Islamic finance market is growing well in these markets.
Thirdly, rollover in murabahah is prohibited not only by our sale of debt standard (Shariah standard no. 59), but also by our earlier standards. Most scholars are of the view that rollovers are not allowed or are not preferred. So it is not this standard that is bringing up the rollover related issue for the first time–the rollover issue has been there in the past as well. However, this time it has clarified a modus operandi that if there is a minimum one-day gap, then it will not be counted as a rollover. Generally speaking, Islamic finance transactions should be different and hence rollover similar to what is practiced in conventional finance is not allowed.
The complexities arise because of the complex structures of sukuk. This complexity in the structures is because the transaction is Shariah-compliant in the legal form rather than in the substance and by not applying the spirit of what is written in the standards or in the contractual arrangements. The need is to practice genuine Islamic finance transactions, not transactions that replicate conventional financial transactions. These complex structures make Islamic finance transactions very similar to the conventional ones. We need to recognize that Islamic finance and its transactions are different: the need for this industry emanated from the fact that conventional finance does not fulfil the requirements prescribed by Shariah. But if these practices compromise the principles of Shariah, and if less preferred or controversial options are utilised and promoted, then the industry is at a risk of losing its niche identity.
We need to decide as a developing industry that we need to grow as a more robust and sustainable alternative, and for that we need to have products that are acceptable to the majority of stakeholders. We need to be very clear with regard to what our eventual product should look like, their distinction from conventional counterparts and what is the actual selling point.
Islamic finance is primarily a faith and profit driven industry, and hence it has to take into consideration the requirements of Shariah rules and principles. The standards should be set on foundations that are acceptable to the majority. If we standardize based on controversial grounds, it is possible that some of the products we develop and standardize might not be acceptable to a large number of scholars, practitioners or countries. The purpose of standardization can only be served when the products are acceptable to a significant majority.
SG: What is AAOIFI’s position on tawarruq and whether they will intervene to improve transparency on it in ways that could affect the use of LME warrants?
OMA: Tawarruq is a controversial product. We believe that the industry will not be adversely affected if it follows all the principles and rules contained in our standard. This is also against the view of OIC Islamic Fiqh Academy, which has adopted a view that organized tawarruq is impermissible. AAOIFI standard allows tawarruq, and when we study the standard in detail, it says that a tawarruq transaction has to have four independent parties. The structures that we see in the market do not normally have four independent parties. Even some of the other requirements of our standard on commodity murabahah are not being fulfilled. It is also important to note that transactions do not actually take place on the commodity exchange itself. The majority of transactions are being done by brokers and may not be considered genuine transactions.
The level of compliance in the market with regard to tawarruq and commodity murabahah transactions–including those done on the exchange or over-the-counter– have significant issues from a Shariah perspective. We need to understand that our existing standard allows it on a need-basis only. On the contrary, the market uses this as a regular product with little regard to complying with Shariah standards set by AAOIFI. So the first issue is the Shariah compliance, i.e. compliance with the requirements of AAOIFI standard on tawarruq (Shariah standards no. 30).
The commodities market, on the other hand, is using products where they should not be used. Our standard clearly says that it (tawarruq) should not be used with conventional financial institutions, yet hundreds of transactions take place globally between Islamic and conventional financial institutions. This is a clear non-compliance to our standard.
Moreover, our standard says that it (tawarruq) should not be used as a deposit-taking product. A lot of IFIs take deposits based on tawarruq which is contrary to what the standard says, i.e. it should not be used as a common financing and investment product if other common products are available to serve the purpose. Therefore, our stance is that it should be acceptable only if it is used on a need basis in line with our standard, and only if it complies with all the requirements of our standard.
Despite this, we need to accept that the regulatory and supervisory control (and implementation of standards) in this area is very weak. We have reviewed some of the transaction structures in different parts of the world and note that a lot of improvement opportunities exist even for the borderline transactions.
There is a need to improve these systems and their related controls. To this effect, our governance and ethics board has decided to develop a standard on the governance and controls that should be applicable to tawarruq and commodity murabahah transactions. We are currently forming a working group and shortly you will see some progress. This governance standard will be in addition to our Shariah standard. It is intended to develop controls that should be applied on such transactions to ensure compliance with Shariah principles and rules and will provide guidance on systems as well as system-based controls, in addition to controls on manual transactions applied in the market.
SG: The Islamic interbank and repo market continues to remain a work in progress. Other industry bodies like the International Islamic Finance Market (IIFM) and International Islamic Liquidity Management (IILM) are seeking to address these areas by providing standards and instruments. What is the relative importance of building an Islamic interbank market versus an Islamic repo market? Which is harder?
OMA: Having an Islamic interbank market as well as Islamic repo market is very important to manage liquidity in the Islamic finance market. It is required to develop a robust and resilient system, including liquidity management and placement systems.
They have their own needs as well as pros and cons, as one of them may be suitable to one market player and the other one to other market players. We believe that the process of managing cash balances safely and efficiently raises some issues in the Islamic money market transactions based on mudarabah and wakalah and how these are entered and executed. Similarly, some of the transactions that take place in the Islamic repo market, which is actually developing at this time, also have issues.
For example, according to the principal-agency relationship if we do a transaction on wakalah basis, the asset should be in the books of the principal and not in the books of the agent i.e. the respective IFI. This is mentioned in our Financial Accounting Standard (FAS) 31. It can be a big issue that wakalah transactions are considered presently in the market as a placement and as a liability of the agent, rather than real principal-agent relationship-based transactions. This is just one example.
Similarly, there are examples of execution in mudarabah-based transactions where practically fixed return is provided, and at times when the assets need to be identified and segregated, it is not done. These are practical issues in the implementation of these transactions.
On the repo side there are also some issues. Conventionally, the repo is considered as a collateralized borrowing and lending. However, from an Islamic perspective, the first leg of the transaction has to be an outright sale and the second leg has to be a promise which will convert into a sale on the due date. Essentially, an outright sale means that the selling party must recognize the securities on its books, and it can only do so once the assets or the commodity or securities are purchased back on a future date and the corresponding accounting treatments need to be done by the purchaser. This means that the accounting and revenue recognition will not be similar as per market practices. The conventional repo accrues interest on a daily basis. However, from a Shariah perspective, if one undertakes a genuine transaction of repo, it means that it needs to be done in the above manner. We have our Shariah standard and we have developed FAS on wa’ad, khiyar and tahawwut as well.
We believe it is not only the issue of developing the transaction structure and executing it, but it is also about how to record and report it. From a Shariah perspective, there is an outright sale of securities, but if it is not recognized in the books from an accounting perspective, it means that either there is a fault in the execution of the transaction or that the reporting of the transaction is misrepresented. This will be different from the conventional perspective, because under IFRS, people may say that the real objective and real essence of the transaction is not the sale. But from a Shariah perspective, when the real essence is not the sale, then this transaction is not permissible. Therefore, we cannot keep both things side by side.
AAOIFI accounting and Shariah standards are normally aligned with each other, but when one tries to execute them in a conventional market and apply conventional contracts, it may not be acceptable. This is because the first leg of the transaction has to be an outright sale whereby all risks and rewards incidental to ownership of those securities are transferred to the counterparty. The future purchase, where the assets are returned to the original seller, is merely a promise at this stage. AAOIFI accounting standards have provided solutions, but in practical application parties de-recognize the asset they want to sell under repo at this stage. Unfortunately, this comes from a conventional mindset. These are just a few examples of issues and challenges. It is not that one of them is more challenging than the other, but both of them have their own pros and cons.
Islamic interbank and Islamic repo markets need to be active, and enough transactions need to be there in them to make Islamic banking more robust. All transactions, including recording, reporting and executing should be strictly in line with the Shariah rules and principles.
Click here for Part 2 of the Q&A
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