The Comparative Costs and Benefits of Models of Islamic Finance Regulation

Islamic finance is under increased scrutiny. Just last week, the Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFI) announced plans to more aggressively develop centralized standards to regulate the boards responsible for assessing sharīʿa-compliance among banks and financial institutions doing business in GCC countries. UAE editor Paul Lee provides some context. From a series of interviews he conducted last year with Islamic finance practitioners in the Dubai International Financial Centre (DIFC), he gleaned a number of insights and opinions in the industry useful for assessing the costs and efficacy of different models of  Islamic finance. Because Islamic law prohibits charging interest, sharīʿa-compliant banks must look to financial instruments that do not rely on interest. The industry has developed to offer three choices that coordinate among those instruments: a systems-based model, a centralized model, and a model of competitive equality. Each model relies on Sharīʿa Supervisory Boards (SSBs), but to varying degrees and with varying results. While the systems-based and centralized models save transactions costs by creating standards for best practices among financial agents, the systems-based model may allow agents to “shop” for sharīʿa advisors most amenable to their requests ( as would the competitive model), and the cost of standardization for the centralized model may result in overregulation that creates disincentives for investors. The Islamic finance jury is still out. The AAOIFI’s recent move may make available more empirical evidence to more decisively assess the efficacy of the centralized model, but more is required to assess the other theories.

There are three models of Sharīʿah compliance: (1) the systems-based model, (2) the centralized model, and (3) the model of competitive equality.[1] These models have different costs and benefits for regulators, issuers, and investors. In particular, they vary across the following dimensions: (1) transaction and monitoring costs, (2) innovation and customization, (3) need for qualified scholars, and (4) effectiveness in ensuring Sharīʿah compliance. In analyzing these costs and benefits, this post draws upon interviews with Islamic finance practitioners in the Dubai International Financial Centre (“DIFC”).

Generally speaking, transaction costs include paying financial, legal, and Sharīʿah advisors to structure and draft documents for a transaction, whereas monitoring costs pertain to ongoing oversight of activities by a Sharīʿah Supervisory Board (“SSB”) or other compliance personnel where necessary. These costs are likely to be the smallest for Islamic finance participants in a centralized model because of the greater degree of standardization achievable. For example, because the relevant Sharīʿah Advisory Council (“SAC”) makes binding determinations on questions of Sharīʿah compliance in Malaysia, there is a uniform understanding across the market of how Islamic finance activities must be conducted, driving down costs.[2] These cost reductions result from, inter alia, the ease of finding precedential documents, the ease of negotiation, and the ease of finding or training Sharīʿah compliance personnel. Participants also face less risk that an activity will be deemed non-compliant, sometimes termed Sharīʿah risk.[3]

Standardization in a centralized model may explain the large size of the Malaysian domestic market, in particular its ability to handle small- and mid-cap issuances that would be cost-prohibitive in a jurisdiction like the DIFC.[4] Although standardization via the use of precedential transactions was mentioned as a potential cost-saver even in the systems-based model, there was general consensus that the systems-based model in the DIFC was more expensive for potential issuers due to larger costs in hiring SSBs and advisors.[5] Similarly, to the extent that a model of competitive equality would require, in practice, various entity-level SSBs and advisors to structure a transaction, it is likely to have higher costs as well.

Conversely, a centralized determination of Sharīʿah compliance reduces opportunities and incentives for individual parties to innovate in structuring transactions and makes it more difficult for parties to customize the transaction to the needs of a specific issuer or investor. In a systems-based model, parties are able to make their own determinations of Sharīʿah compliance, allowing for a greater possibility of innovation and customization in each transaction.[6] The attraction of the DIFC for international issuers and investors, despite the fact that transaction costs may be higher, may be due in part to this greater ability to innovate and customize. Again, to the extent that a model of competitive equality would rely on SSBs and advisors, it is likely to possess the same potential for innovation and customization.

On the other hand, the need to find qualified scholars to sit on SSBs may present an additional challenge for a systems-based model or a model of competitive equality. In these models, scholars must be capable of issuing their own opinions rather than simply complying with the fatāwā of a national authority or referring controversial issues to the national authority. Such scholars must be experts not only in Islamic law but also have some knowledge of finance, must usually be fluent in Arabic as well as English, and must possess the reputational capital to have their fatāwā be respected by other scholars.[7]The scarcity of qualified scholars has lead to a limited number of scholars sitting across enormous numbers of SSBs.[8] This creates not only the potential for conflicts of interests where one scholar sits across, and is paid for, two or more sides of a transaction,[9] but also the risk that scholars will be unable to exercise adequate due diligence by virtue of being stretched too thin.[10]

Finally, in terms of effectiveness in ensuring Sharīʿah compliance, the lack of regulation specifically addressing Sharīʿah issues may result in lower levels of compliance for jurisdictions with a model of competitive equality. Although this discussion is made difficult by the fact that there is no single consensus as to which activities comply with Sharīʿah, lower levels of compliance can manifest via looser interpretations of what kinds of transactions are actually Sharīʿah-compliant, and in some cases an outright misrepresentation of a transaction that a large majority of jurists would consider to be non-compliant as being compliant. In jurisdictions without explicit rules addressing these issues, scholars would face no penalties for certifying non-compliant transactions.

In that regard, the systems-based model may also be weaker in ensuring Sharīʿah compliance than a centralized model. Most significantly, commentators have suggested that scholars who depend financially on being hired by clients seeking an opinion of Sharīʿah-compliance have a conflict of interest, given that they are unlikely to be hired if they are too strict on their interpretation of what is Sharīʿah-compliant.[11] This problem is further exacerbated by the potential for fatwā-shopping, where a client contemplating a transaction shops around for a scholar willing to approve the transaction.[12]

Although these concerns are very real for a systems-based model (and a model of competitive equality, to the extent it relies on SSBs as a practical matter), there are a few mitigating factors not often discussed in the literature. First, scholars face countervailing incentives due to the need to maintain their reputational capital. The fatwā of a scholar who is known to issue opportunistic opinions is likely to face higher scrutiny from other scholars, reducing demand for that scholar’s services. Furthermore, in a transaction between sophisticated parties, not only the SSB of the issuer, but also the SSBs of the underwriters and investors will need to be satisfied that a contemplated transaction is Sharīʿah compliant. The presence of multiple SSBs should have the effect of constraining opportunistic fatāwā in the issuance of Islamic securities. Relatedly, practitioners described the ultimate structure of an Islamic finance transaction as a negotiated outcome between the scholars and the other parties,[13] meaning that there was some give and take in order to reach a mutually agreeable form rather than pure opportunistic behavior by issuers. For instance, a scholar could have the issuer restructure parts of the transaction in order to be satisfied that the transaction would in fact be Sharīʿah-compliant.

Second, to the extent that the Islamic capital markets of different jurisdictions are engaged in a competition to attract issuers and investors, they may have incentives to relax their interpretation of Sharīʿah principles. For instance, organized tawarruq, a very controversial transactional structure in Islamic finance,[14] is permissible and widely used in Malaysia.[15] Thus, competition between centralized model jurisdictions may resemble competition between individual scholars, reducing or eliminating any differences in which activities are considered compliant with Sharīʿah.

Therefore, although the centralized model appears more effective in terms of ensuring Sharīʿah compliance, one might expect that the difference is not large in practice. Consequently, a systems-based model might be seen as sacrificing cost-effectiveness and efficient use of scholars for greater innovation and customization. A similar distinction might apply to a model of competitive equality when compared to a centralized model, except that on the whole the model of competitive equality is likely to be the least effective in ensuring compliance with Sharīʿah.

[1] This set of commentaries explores three different models of Islamic finance regulation: (1) systems-based model, (2) centralized model, and (3) a model of competitive equality. These are derived in part from an International Organization of Securities Commissions (“IOSCO”) report on Islamic securities. IOSCO, Analysis of the Application of IOSCO’s Objectives and Principles of Securities Regulation for Islamic Securities Prodcuts at 17 (Sep. 2008) available at

[2] This view was expressed by various practitioners in interviews. Interview Notes (on file with author).

[3] See Nikan Firoozye, Tawarruq: Shariah Risk or Banking Conundrum? Opalesque (Jul. 3, 2009) available at

[4] Interview Notes (on file with the author). These issuances are for smaller amounts of funds, meaning that transaction costs of hiring bankers, lawyers, and scholars would comprise a larger part of the amount being raised¾thereby making them uneconomical.

[5] Id.

[6] Practitioners consistently mentioned innovation as a benefit of the DIFC approach. Id.

[7] For discussion of the challenges in meeting the need for qualified scholars, see Sayd Farook & Mohammad Omar Farooq, Sharīʿah Governance, Expertise and Profession: Educational Challenges in Islamic Finance, 5 Int’l J. Islamic Fin. 137 (2013).

[8] See David Bassens et al., Setting Shari’a Standards: On the Role, Power and Spatialities of Interlocking Sharia Boards in Islamic Financial Services, 42 Geoforum 94, 99 (2011) (showing that 97 scholars created 583 interlocking relationships between boards); Funds@Work, The Small World of Islamic Finance at 8 (Oct. 5, 2010) available at (noting that the top 10 scholars hold 450 of 1141 board positions, and the top 100 account for 953). The AAOFI, an international standard setting body, is considering proposals for guidelines limiting the number of boards scholars may sit on. Dana El Baltaji & Haris Anwar, Scholar on More Than 50 Boards Opposes Limits: Islamic Finance, BloombergBusiness (Nov. 23, 2010) available at

[9] See, e.g., Matthias Casper, Sharia Boards and Sharia Compliance in the Context of European Corporate Governance at 11 (Center for Religion and Modernity, Universität Münster, Jan. 2012) available at The issue of conflicts of interest is discussed in detail later in this subsection.

[10] Farook & Farooq, supra note 7 at 143.

[11] See, e.g., Farook & Farooq, supra note 7 at 140-41. Some commentators, most notably El-Gamal, have further argued that this leads to a broader phenomenon of Sharīʿah arbitrage, where “bankers, lawyers and jurists commonly start with an existing conventional product . . . replacing its various conventional components that are deemed un-Islamic with others that can be presented to the public and defended as Islamic . . . In many cases, the contemporary practice marketed under some premodern Arabic name bears only very superficial similarity to the premodern financial practice discussed in classical jurisprudence.” The additional costs imposed in fees for bankers, lawyers, and jurists in Sharīʿah arbitrage reduces efficiency (reducing total social welfare). Mahmoud A. El-Gamal, Islamic Finance: Law, Economics, and Practice at 11-12 (2006).

[12] Farook & Farooq, supra note 7 at 152.

[13] Interview Notes (on file with the author).

[14] In a tawarruq transaction, the bank purchases a commodity other than gold or silver, sells it to the borrower at a deferred price marked-up to reflect conventional interest, and the borrower sells the commodity in the market to obtain the desired liquidity. In organized tawarruq the bank handles this final step of sale to a third-party as an agent for the borrower¾a form traditionally deemed impermissible. See, e.g., El-Gamal, supra note 11 at 69-70. See also Rafe Haneef, Is the Ban on “Organised Tawarruq” the Tip of the Iceberg? (Int’l Sharīʿah Research Acad., Research Paper No. 2, 2009) available at the ban on organised tawarruq by the International Islamic Fiqh Academy of the Organisation of the Islamic Conference). The Fiqh Academy is one of two international fatwā issuing bodies for Islamic finance, the other being the Sharīʿah board of the AAOIFI. See, e.g., Rodney Wilson, Legal, Regulatory and Governance Issues in Islamic Finance at 228 (2012)..

[15] See Firoozye, supra note 3. See also Bank Negara Malaysia, Shariah Resolutions in Islamic Finance, 2nd ed. at 96 (2010).