1.1 Introduction
It is necessary to first explore the general practice of the Islamic financial services industry (IFSI) before moving into the subject matter of this book. Therefore, this chapter draws attention to matters of particular significance to the progress of the IFSI, which rose to the surface after its great expansion. It highlights some legal and regulatory tensions that exist within the general context of the IFSI. It should also be pointed out that the following discussion of key issues should aid in understanding the main thrust of this book, and serve as an important preamble for any discussion on the IFSI.
1.2 Stability Concern
The willingness of financial regulatory authorities and their professional advisors in both developed and developing markets to ensure soundness and stability within the financial sector has been subject to a sharp increase over the past years. Although there have been many great changes in the financial system arising from the globalisation of financial services and financial innovation, the financial system consists of financial markets and financial institutions at the fundamental level. While financial markets offer opportunities to move funds from the surplus sector (where there are surplus funds) to the deficit sector (where there is a shortage of funds) in the financial system, financial institutions ensure efficient movement of funds within the financial system.1 Financial markets are where the demand for and supply of capital meet—for example, in the debt market, stock market, and foreign exchange market. Without the establishment of financial institutions, such as central banks, banks, insurance companies, and mutual funds, financial markets would not be able to operate efficiently.
There is tendency to use the words ‘sound’ and ‘stable’ to describe the desired state of financial markets and institutions in recent times; it is therefore necessary to define such terms in the context of the financial sector. Lastra notes that the term ‘financial stability’ is still vague, and there is a lack of a common definition as to what constitutes financial stability.2 This is also supported by Čihák, who asserts that there is an absence of an operational definition of financial sector soundness that narrows down possible indictors which could be used to assess the soundness of the financial sector.3 However, Čihák does provide a general definition of financial sector soundness as the ‘smooth functioning of the components of the financial system and resilience to shocks’.4 Another useful definition is provided by Allen and Wood, who define financial stability as ‘a state of affairs in which an episode of financial instability is unlikely to occur, so that fear of financial instability is not a material factor in economic decisions taken by households or businesses’.5 Besides, Allen asserts that ‘financial stability is not merely the absence of crisis, but also the ability to absorb (rather than amplify) shocks’.6
The growing interest in enhancing the soundness of financial markets and institutions can be attributed to several factors. The frequency of financial crises, the destructive impact that these have had, the complexity of new financial instruments, and the large amount of financial transactions are among the factors which have increased awareness of the significance of ensuring financial sector soundness.7 The need for the financial sector to be protected against instability and the importance of preserving its soundness have been well established in the wake of several financial crimes, payment defaults, and insolvency incidents. Developing a sound financial sector is a key requirement for the efficient mobilisation and allocation of resources in any society.8 The efficiency of financial markets and economic growth are proportionally linked, according to historical evidence.9 The significance of financial sector stability manifested itself in the launching of the Financial Sector Assessment Program (FSAP) in 1999 by the International Monetary Fund (IMF) and the World Bank (WB), to provide independent analysis for the financial sectors of different countries.10 After the latest global financial crisis occurred in 2007, a pressing need was recognised for a range of advanced crisis prevention plans to safeguard the financial sector.11 Thus, efforts need to focus on developing measures to improve the financial sector soundness, taking into consideration the lessons that have been learnt from the crisis.12
Financial markets and institutions operate at national, regional, and global levels. At all levels, the prevailing structure and regulations of the financial sector are based on ‘conventional finance’.13 As a result of its existence in major economies and developed countries such as North America and the European Union (EU), conventional finance has shaped the financial sectors of other parts of the world. However, 1963 saw a key development and transformation of the structure and regulation of financial markets and institutions, when a new type of finance emerged that was completely different from conventional finance—this was Islamic finance. The establishment of Mit Ghamr Bank in Egypt in 1963 undoubtedly formed the official starting point of the Islamic financial services industry (IFSI).14 The modern era of conducting financial activities in accordance with Islamic law is better described as the transformational effect of Islamic law on global financial markets.15
The IFSI has made steady progress over the last five decades. Three elements constitute the IFSI—namely Islamic banking, takāful (Islamic insurance), and the Islamic capital market (ICM). As of 2016, the total assets of the IFSI around the world were believed to be around USD 1.89 trillion.16 It is estimated that the total assets of the IFSI grew at a compound annual growth rate of 17.4% for the period 2009–2013.17 While Islamic banking represents the largest segment of the IFSI, with 80% of the total IFSI assets,18 takāful is considered the smallest segment of the IFSI, with 1.1% of the total IFSI assets.19 So far, the IFSI has operated in more than 70 jurisdictions, including Australia, Algeria, Azerbaijan, Bahrain, Bangladesh, Brunei, Egypt, France, Germany, Indonesia, Iran, Jordan, Kuwait, Lebanon, Malaysia, Mauritius, Oman, Pakistan, the Philippines, Qatar, the Kingdom of Saudi Arabia (KSA), South Africa, Sudan, Switzerland, Thailand,...