The Legal and Regulatory Aspects of Islamic Banking

A Comparative Look at the United Kingdom and Malaysia

Abdul Karim Aldohni

• Publisher: Routledge
• Year: 2012
• Print ISBN: 9780415555159
• eBook ISBN: 9781136703157
• Edition: 1
• Topic: Economics
• Subtopic: International Economics
• Index: Economics

During the last ten years the Islamic banking sector has grown rapidly, at an international level, as well as in individual jurisdictions including the UK. Islamic finance differs quite substantially from conventional banking, using very different mechanisms, and operating according to a different theory as it is based on Islamic law. Yet at the same time it is always subject to the law of the particular financial market in which it operates. This book takes a much-needed and comprehensive look at the legal and regulatory aspects which affect Islamic finance law, and examines the current UK and international banking regulatory frameworks which impact on this sector.

The book examines the historical genesis of Islamic banking, looking at how it has developed in Muslim countries before going on to consider the development of Islamic banking in the UK and the legal position of Islamic banks within English law. The book explores company, contract, and some elements of tax law and traces the impact it has had on the development of Islamic banking in the UK, before going on to argue that the current legal and regulatory framework which affects the Islamic banking sector has on certain occasions had an unintended adverse impact on Islamic banking in the UK. The book also provides an overview of the Malaysian experience in relation to some of the main legal and regulatory challenges in the context of Islamic banking and finance.

1   Introduction

1.1 An overview

Today’s banking market has developed many new features – and diversity, in terms of the participants, products, and services, is one of the key characteristics of this new banking era. In this respect, traditional banking institutions are not, anymore, the only participants in the market – various competitors have joined the market as well. Some of these players are not banks, but they offer the same services and perform similar functions. Others represent a unique form of banking that uses completely different financial tools from those used by mainstream banking to serve the same goals. The latter institutions are known as Islamic banks or interest-free banks.

Islamic banking can be described as one of the fastest growing financial sectors. The growth of Islamic banking has extended beyond Muslim countries to reach a number of Western countries, which has led to the internationalisation of Islamic banking. For instance, many high-street banks in the UK either started offering some Islamic financial products, such as Lloyds, or devised an entity within their group to offer a full range of Islamic banking products, such as HSBC Amanah – part of HSBC Group.

Moreover, some Western countries, such as the UK, are hosting fully fledged Islamic banks. Islamic Bank of Britain started operating in the UK market in 2004 and was the first fully fledged retail Islamic bank. Further, the European Islamic Investment Bank, which is based in London, raised £110m before it started operating in April 2006.¹

This development has been associated with significant attention at the academic level. The rapid growth and unique nature of this sector has made Islamic banking and finance an ideal topic for academic research. The majority of this research was financially or economically orientated. On the other hand, until recently, there has been little research done into the legal and regulatory aspects of Islamic banking. This angle of the topic has been insufficiently covered, despite its great importance.

1.1.1 Why is the legal aspect important and challenging?

In the context of banking, the legal aspect, in its broad sense, encompasses the relevant legislative and regulatory frameworks. In relation to Islamic banking there is another layer that must be added, which is Islamic law (‘sharia’). Among the other unique characteristics brought by Islamic law, the prohibition of interest can be described as the most distinctive feature. Islamic banking transactions are based on the principles of profit-and-loss sharing (PLS) rather than interest. Therefore, the application of Islamic law results in the creation of different financial products from those used by conventional banks.

At the same time, Islamic banks cannot operate outside of the applicable laws in any financial market. These rules are not just restricted to banking regulations, but they also include various laws that are of relevance to the business, such as company law, contract law and others. Such levels of legal complexity represent the most difficult challenge, especially since the development of this sector relies heavily on having a solid legal foundation that supports Islamic banks’ functions.

1.1.2 What this book aims to do

This book does not claim to cover all of the issues that are related to the legal and regulatory aspects of Islamic banking, but rather it focuses on some elements of these aspects, primarily in the UK with a reference to Malaysia.

The book charts the implementation of Islamic banking in the UK and the legal impediments that have arisen in this context. Seeking to present a comprehensive examination of certain elements of the subject, the book explores the genesis of Islamic finance and the elements that have led to the introduction of this new sector in the banking market of the UK. Further, it examines the structure and methodology of the Islamic legal system in the light of the English legal system, since an understanding of both legal systems will underpin the legal analysis at which this book aims.

As Islamic banks have joined the market alongside their conventional counterparts, they are subject to the same domestic legal rules and regulations. In this respect, the business of banking in the UK is subject to a regulatory framework and various general pieces of legislation, such as company law, tax and contract law, and others. The book argues that the current legal and regulatory framework affects, to a certain extent, the Islamic banking sector on many levels and that this often impacts negatively on the development of Islamic banking in the UK. In order to achieve this, the book first evaluates the compatibility of the general applied laws with and their impact on, Islamic banking business. It then examines the current, national and international, banking regulatory framework in the UK in order to illustrate its impact on the Islamic characteristics of this sector.

Drawing on empirical work conducted in Kuala Lumpur, Malaysia, the book presents an inclusive overview of the development of Islamic banking in Malaysia. It then highlights how the Malaysian financial authorities have dealt with certain legal concerns that are raised in this book, in particular some of the main regulatory issues.

1.2 Structure of the book

Chapter 2 lays the foundations of the topic by illustrating the historical and ideological background of Islamic banking and finance. The aim of this chapter is to give an overview of the basic components of the subject. Therefore, the chapter is divided into two parts, the first of which expands on the origins and historical roots of Islamic banking, and how the idea was initiated in Muslim countries. Further, it addresses the main factors that have transferred Islamic banking from theory to practice. It also explores the elements that have led to the emergence of Islamic banking and finance in the UK financial market. The second part of this chapter elaborates not only on the religious justification of Islamic banking, but also its economic and ethical justifications.

Chapter 3 represents, alongside Chapter 2, another layer in the foundation of this topic as it examines the legal sphere in which these institutions are operating. On the one hand, all of the principles of Islamic banking and finance are derived from the Islamic legal system. On the other hand, the focus of this book is the UK; therefore understanding the English legal system is a necessity, because it is the system under which these institutions are operating. Accordingly, the main theme of this chapter is a comprehensive legal analysis of the English legal system alongside the Islamic legal system.

Chapter 4 moves the discussion to a different level, as it presents the actual analysis of the legal position of Islamic banks in the UK. The chapter deals with some primary legal issues, such as the definition of ‘bank’ under UK law. The chapter draws on common law (case law) and the relevant statutes – including EU Directive 2006/48/EC – in order to establish whether an Islamic financial institution falls within the legal definition of ‘bank’. Also, the chapter examines the nature of the Islamic banking business in the light of the classical classification of commercial and investment banking.

Chapter 5 presents a thorough legal analysis of the practice of Islamic banks in the UK. First, it examines the establishment of Islamic banks in the light of company law. More specifically, it addresses the special structure of Islamic banks and the presence of the Sharia Supervisory Board alongside the directors’ board. Second, since all Islamic finance products are based on various types of contract, the chapter explores the doctrines of Islamic contract theory and their applicability under English contract law. Then, it expounds upon the main financial products used by Islamic banks. It also examines how the English courts have dealt with the disputes that have arisen from Islamic finance contracts.

Finally, after presenting a detailed analysis of the structural and operational aspects of Islamic banks, the chapter highlights the key legal challenges faced by Islamic banks in this context.

Chapter 6 deals with the other set of rules with which banks are exclusively obliged to comply – the banking regulatory framework. This chapter covers a wide range of banking regulatory matters, starting first with examining the justifications for banking regulation. Second, it identifies the regulatory structure of the banking sector in the UK, and the relationship between the legislative and financial authorities that oversee the financial sector in general. Third, it elucidates the objectives that the regulator seeks to achieve and examines the key prudential methods used by the regulator in this context. Further, it pays special attention to the safety net schemes, lender of last resort and deposit insurance, designed to protect the banking sector. Finally, it extends the analysis to the international banking standards that have become embedded in most banking systems around the globe, the UK being no exception. Thus the chapter gives a brief introduction of the Basel Core Principles and Basel II, which are adopted by the UK banking regulatory system.

While Chapter 6 sets the scene for the banking regulatory framework in the UK, Chapter 7 examines the impact of the current regulatory framework on Islamic banks. It first explores whether Islamic banks share similar rationales for regulation despite having a different nature. The discussion draws on the relationship between Islamic banks and the main financial authorities involved in the banking business, in particular the Financial Service Authority (FSA) and the Bank of England. Throughout the discussion, the chapter evaluates whether the FSA has managed to achieve its general objectives in relation to Islamic banks. It expands on the issues of consumer protection, public awareness, and crime prevention. Additionally, it examines some of the challenging regulatory requirements imposed by the FSA in the context of Islamic banking. In terms of prudential banking regulation, the chapter examines the applicability of the safety-net schemes – the deposit insurance scheme and lender of last resort – in the context of Islamic banking. Finally, the chapter explores the compatibility of Islamic banks’ practice with the Basel Core Principles and Basel II.

Chapters 3–7 are very UK-focused, but Chapter 8 details a Malaysian case study, which sheds light on the Malaysian experience in the Islamic banking sector. Malaysia was chosen as a case study for various reasons; first, because its legal system shares certain elements with the UK legal system; second, and more importantly, Malaysia has much greater experience in the sector of Islamic banking, and has, over the years, managed to develop an advanced regulatory framework. The chapter examines the Malaysian approach in dealing with some of the regulatory challenges. It presents an overview of the Malaysian economy and the contribution of the banking sector to the economy in general. The chapter also provides a detailed analysis of the Malaysian legal system and explores the influence of English law. It also highlights the potential differences between the experience of Malaysia and the UK with regard to Islamic banking. Finally, the discussion highlights a few leading legal and regulatory issues regarding Islamic banking in Malaysia.

Chapter 9 pulls together the themes discussed in the previous chapters, presenting the findings and contextualising their impacts. Finally, it suggests a comprehensive approach that can be used to overcome some of the legal and regulatory challenges in the context of Islamic banking.

1.3 A note on terminology and methods

It is important to clarify some of the terms that might seem, at first, relatively wide or vague. The terms ‘Islamic banking’ and ‘Islamic finance’ have been used inter-changeably, and on some occasions they have been used together, especially where the discussion is quite general.

The terms ‘East’ and ‘West’ have been used: the term ‘East’ is mainly used to describe Muslim countries, especially in the Middle East and Malaysia; the term ‘West’ is meant to refer to non-Muslim countries in the West such as the UK, other European countries and the USA. The terms ‘UK law’ and ‘UK banking system’ do not include Scotland because Scottish law is not part of this research. Further, in this book, the term ‘common law system’ is used synonymously with ‘English legal system’. Finally, the term ‘banking regulation’ is meant to include regulations, rules, and, more importantly, supervision.

The book does not focus on the important work of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in the regulatory sphere of Islamic banking and finance. Instead the book considers some of the work of the Islamic Financial Services Board (IFSB) in this respect. This is simply because of the great influence that the IFSB has had on the regulatory framework in Malaysia – which is the case study in this book.

1    Jane Croft, ‘Euro Islamic Bank Coming to Aim’, Financial Times, 10 March 2006.

2 The historical and ideological background of Islamic banks

2.1 Introduction

Islamic banks have developed rapidly during the last thirty years. Using the expression ‘Islamic bank’ does not mean that this type of banking is strictly religious in a way that forbids dealing with non-Muslims. On the contrary, Islamic banks have both Muslim and non-Muslim customers, whether in Islamic or Western countries. There are certain examples that prove this point: Malaysia is a country with a long tradition of Islamic banking, where nearly 50 per cent of clients of Islamic financial institutions are non-Muslim.¹ This can be justified simply on the basis that the religion of the participating parties has never been an issue for consideration in any Islamic financial transaction.² Further, even in a country where Islamic banking is still at its embryonic level, such as the UK, Islamic Bank of Britain has managed in a short period of time to attract a number of non-Muslim customers who ‘like the ethical standpoint’ of the bank, according to Steve Amos, Head of Marketing.³

Why is it called an ‘Islamic ba...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Dedication
• Contents
• Acknowledgements
• Table of cases
• Table of legislation
• Table of statutory instruments
• Table of European legislation
• 1. Introduction
• 2. The historical and ideological background of Islamic banks
• 3. Legal analysis of the English legal system in comparison to the Islamic legal system
• 4. The legal description and classification of Islamic banks under the English law
• 5. Islamic banks in practice: the operational aspects of Islamic banking
• 6. The banking regulatory and supervisory system in the United Kingdom: an overview
• 7. The application of Islamic banking under the conventional banking regulation of the United Kingdom: fit or conflict?
• 8. Islamic banking in Malaysia: the Malaysian case study – a legal analysis
• 9. Concluding remarks
• Bibiliography
• Index