Address by Head of Markets Policy, Martin Moloney at the IFLC at the UCD School of Law

14 May 2015 Speech


Ladies and gentlemen let me begin by thanking the Conference organisers for inviting me to speak to you this morning. I am conscious of the many prestigious speakers from the academy and practice who will be presenting over the next two days and who, I have no doubt, will provide interesting and insightful perspectives, both Irish and International, on the challenges for Islamic finance and law. 

My aim this morning is to bring to your attention the perspective of a European regulator with some experience with Islamic financial instruments, but also with a slightly different perspective from many of those at this conference.

The first thing to note about European financial services regulation is that because of the wide variety of different financial markets in Europe, it already has a built in flexibility within it, which fits well with allowing us as European regulators to facilitate the issuance of Islamic financial products.

Secondly, in Ireland, as Professor Wilson has already mentioned, we are a common law jurisdiction, which can prove helpful in dealing with Islamic finance. 

Thirdly, it is worth focusing for a moment on the fact that following the outbreak of the financial crisis in 2008, the stabilisation of financial markets in Europe became a priority and financial sector reform a crucial instrument to achieve it. To this end, the European Union has, since the beginning of 2009 directed its attention towards strengthening the supervision of the financial sector in Europe by augmenting and consolidating the single rule book and creating a more level playing field for financial services across Europe.

A number of themes have emerged in Europe in dealing with the lessons of the crisis which may prove relevant in relation to Islamic Finance, namely: 

  • The dangers of ever-increasing complexity and how markets respond to this in stressed conditions.
  • The related issue of the limits of transparency, the limited ability of investors to assess complex products and the tendency of investors to rely on third party quality assessment agents such as credit rating agencies to guide their investment in complex products.
  • The link between reputation and systemic risk such that at times of stress, rational individual investor behaviour can be replaced by a very broad market judgement on a country or a type of financial instrument.
  • The potential impact of regulatory arbitrage.
  • The importance of legal certainty in financial instruments. 

In the course of my remarks, I will try to bring some of these themes to bear in relation to Islamic Finance. 

As regulators, it is not our goal to attract Islamic finance to Ireland. But it is part of our purpose to be ready and able, in an efficient and knowledgeable way, to authorise and supervise financial instruments which require our approval and supervision.

We are conscious of the impetus at Government and policy level to facilitate the location of Islamic finance in Ireland. Ireland now has a comprehensive tax treaty network with Muslim nations. The treatment of Islamic financial instruments both in relation to direct taxation and in relation to VAT has been clarified and there is an exemption where Sukuk (Islamic investment certificates) are issued or transferred; this equates with the current exemption for section 110 securitisation companies. 

In that context and given the continued growth of Islamic Finance internationally, we can expect its further growth in Ireland and the question is whether we as a regulator are well placed to meet the demand, should this sector grow. 

The changes in the tax code have sought to ensure parity of treatment for Shari’ah compliant instruments. Can we say that we can provide parity of regulatory treatment? 

I believe strongly that we can. Let me address the question in the course of reviewing three themes. First, I will briefly consider the development of Islamic finance in Ireland to date; second, I will share some thoughts with you on the scope of supervision as this relates to Islamic Finance and thirdly I will conclude with some more speculative thoughts on some of the wider challenges that may be on the horizon in relation to Islamic Finance as it grows in popularity.

I will concentrate on financial instruments. I am conscious that Islamic finance also offers a wide range of commercial products, which could be of interest in Ireland such as Shari’ah compliant mortgages, deposit accounts and takeful insurance products. But I note Professor Wilson’s comments earlier that the main focus in relation to Ireland should be on asset management-related Islamic Finance and, if I may, I will leave Islamic banking and insurance aside for now. 

Ireland and Islamic Finance 2003-2015

The 27th of March 2015, marked 12 years since Oasis Global Management Company (Ireland) Limited received approval for the launch of two investment companies, Oasis Global Investment Fund (Ireland) plc and Oasis Crescent Global Investment Fund (Ireland) plc in Ireland. The launch of these two investment companies represented Ireland’s first foray as a jurisdiction, into the world of Islamic Finance.

In 2004, Bank of Ireland signed an agreement with the Arab Banking Corporation to launch an Islamic home financing scheme. In 2005, the first Sukuk was listed on the Irish Stock Exchange and my own organisation the Central Bank of Ireland began to examine in earnest the approval process for Shari’ah compliant funds, and by July 2014 had authorised 10 funds and a corresponding 31 sub-funds, including fund launches by iShares, SEI and BNP. All are UCITS except for one unit trust.

When a Shari’ah compliant fund is presented for authorisation, our funds authorisation team will, in addition to looking at whether all regulatory requirements are met, look to see that disclosure is appropriate relative to the investment objective. This includes a considering whether there is clear disclosure of the types of investments that might be prohibited under the terms of the fund, how it will be determined why a particular investment is prohibited, the steps required if an investment becomes non-Shari’ah compliant and the associated risks to the investment policy. We also oversee that the role of the Shari’ah supervisory board has been clearly outlined to investors in the documentation for the fund. 

In addition to the authorisation of Shari’ah compliant funds, we also approve Shari’ah compliant instruments which fall under the Prospectus Directive, usually because they are admitted to trading on the Irish Stock Exchange. There are about 35 such instruments with approved prospectuses from us. We approved our first such instrument in 2011. Initially, a lot of these instruments were based on commercial property and more recently there has been an increasing focus on commercial receivables. 

As with funds, we review the prospectus document for appropriate disclosure of risks and in relation to the quality of disclosure of the structure of the financial instrument. Of course, we form no view as to whether an instrument complies with Shari’ah law. 

We have two distinctive policies worth bringing to your attention. Firstly, trustees are a common feature of these structures. We require at least one trustee to be unconnected with the issuer. Secondly we require Sukuk financial instruments to make disclosures to the extent required by Annexes 9 & 13 to the Prospectus Directive. We do this without any judgement as to whether these are debt instruments, but rather because the level and type of disclosure set out in Annex 9 &13 is more appropriate than that set out in Annex 8, i.e. the annex designed for securitisation vehicles. What this amounts to is that we require a clear disclosure of identity of the obligor as well as of the issuer. This approach has not caused any issues, although we understand well that under a Shari’ah approach, this obligor might not be understood as a debtor susceptible, as a matter of otherwise normal investment analysis procedure, to a credit-worthiness assessment.

I should also add that effective co-operation between global financial services regulators is essential for the functioning of the global financial services market. In that regard, since 2008 the Central Bank of Ireland has signed a number of memoranda of understandings with, for example, the Dubai Financial Services Authority, the Emirates Securities and Commodities Authority of UAE, the Central Bank of Bahrain and the Qatar Financial Centre Regulatory Authority.

Ireland – Financial Regulation of Islamic Finance 

Our history, therefore, is one of having sufficient experience with the authorisation and approval of Shari’ah compliant financial instruments to be able to say that we are comfortable with this type of instrument.

But I think it is useful for me now to say something about on-going supervision by the Central Bank and how this relates to approved, Shari’ah compliant financial instruments.

With regard to financial instruments for which a prospectus has been approved under the Prospectus Directive, there is, of course, no on-going supervisory role for the Central Bank. In relation to mutual funds, there is. The question arises as to whether that supervisory role has any significance in relation to the Shari’ah compliance of those funds?

Shari’ah Supervisory Board

Here the key issue is the role of the Shari’ah Supervisory Board. As I understand it, Shari’ah scholars, who comprise the Shari’ah Supervisory Board examine a new product or transaction and, if satisfied it is Shari’ah compliant, issue an approval. The certification of Shari’ah compliance is the result of the independent audit carried out by each Shari’ah Supervisory Board certifying that nothing relating to any of the operations involve any element rendering the financial instrument unacceptable in terms of Shari’ah law.

To effectively perform such a function, a Shari’ah Supervisory Board must be comprised of Shari’ah scholars with specialised knowledge of Islamic law, in addition to knowledge of modern business, finance and economics.

There are a few points to make about the relationship between such boards and supervisors such as ourselves:

  • It would not be appropriate for the Central Bank to take any view on the quality of the different boards and whether they are well placed to make the judgements they make; this is a matter for investors. I do not mean, by this, taking a view on their effectiveness as Shari’ah Scholars, but rather on their grasp of the financial complexities they need to understand to play their role; but even so, it seems to me quite clear that any review of that matter is beyond the competence of a regulator such as ourselves; a suitable analogy might be Article 23(1) of Regulation (EC) No 1060/2009 on credit rating agencies, which provides that regulators will not interfere with the content of the ratings provided by Credit Rating Agencies even though (unlike Shari’ah Boards) they are subject to some regulation; the point is uncontroversial, but, it seems to me, worth saying.
  • Secondly, as a matter of practice, we in the Central Bank do not undertake to check claims made in a prospectus document to be Shari’ah -compliant or to have achieved approval from any given board; there can, I think, be different views as to whether that is a good thing that we do not.
  • Thirdly, should a Shari’ah compliant financial instrument fail to comply on an on-going basis with the undertakings it had given to a Shari’ah Board as to how it would operate, our supervisory practices would not pick that up because we do not as a matter of normal practice inspect funds with the focus of checking compliance with all their Prospectus terms; our supervision is built around themed inspections which would not pick this up; it would be a civil matter between the investors and other parties as to how to deal with such an eventuality.

Contract and documentation risk

It is worth my saying a bit more on this issue of the enforceability of terms and conditions in contracts for Islamic transactions. As with all contracts, the enforceability of terms and conditions depends largely on the governing law. There seems to me to be an element of trust involved in Shari’ah-compliant instruments and a reliance on promises which may fall short of the status of legally binding contractual commitments and that may create certain specific risks.

These understandings as to how a Shari’ah compliant instrument will be managed could create legitimate expectations which could prove to be frustrated. I am not aware of any such cases in this jurisdiction. But the possibility should not be discounted.

It is relevant to recall that the UK courts have determined in the case of Shamil Bank of Bahrain v. Beximco Pharmaceuticals Ltd et al1, that as the Convention on the Law Applicable to Contractual Obligations 1980 (the Rome Convention) requires that the governing law of an agreement must belong to a country and as a consequence Shari’ah issues are not justiciable, that the Courts - in the UK at least - will avoid commenting or ruling on the compliance of the agreement with Shari’ah law.

This decision, where essentially the UK courts distinguished between Shari’ah and the contractual governing law of an Islamic finance agreement, has led to a situation whereby contracts have to be written very carefully to minimise potential disputes and state the governing law, in an attempt to incorporate with certainty, terms and conditions that are essential from a Shari’ah perspective. Since that is not always going to be possible, could it be that there is a role for arbitration to help in resolving disputes? I have a personal suspicion that arbitration may be a useful mechanism in this area, particularly since the 2010 Arbitration Act here in Ireland strengthened our conformity to the UNCRITAL model law, but others may have a different view. 

False marketing

On the related question of sanctions and remedies available where a financial product has been falsely marketed as Shari’ah-compliant, there are also a number of interesting points to be made.

As I understand the matter, an investor who finds himself invested in a product which proves not to be Shari’ah-compliant, although advertised as such, may find himself feeling obliged to surrender profits to charity.

If the relevant product is a securities offering, that is made through a public offering where a prospectus is issued that contains untruths or misrepresentations as to Shari’ah compliance of the securities offered, on the face of it, the person liable for the prospectus may be liable in damages to the person who has acquired the securities who has suffered a loss as a result of any untrue or misleading statement in the particulars.

However, there would surely be difficulties in proving loss where profits have been voluntarily surrendered. For that reason, it may be particularly important in relation to Islamic finance products, as they are still new and the structures are complex, that advertising and presentation is clear and transparent. I am not myself aware that this is an issue that Islamic Scholars see as within their remit. But if it is not and since it lies outside our area of potential competence, it is difficult to see who deals with it.

Challenges for the future of Islamic Finance in Ireland

Before concluding this morning, I want to leave you by setting out some observations that might be relevant to discussions on the future of Islamic Finance in an Irish and a European context. Islamic Finance seems likely to grow; growth inevitably throws a spotlight on some issues that might not have seemed important at an earlier stage of development.

First, Ireland has no central authority responsible for ensuring that transactions or products are Shari’ah compliant. Is this where we should be? That is a wider policy question than just regulation and I don’t propose to deal with it as a regulator. We as regulators can do our work with or without such an authority. However, if it existed, I have no doubt that we would be happy to engage with it to understand its role and perhaps that is a point worth making here.

Secondly, is there such a thing as Shari’ah arbitrage and should a regulator be concerned with it? At the moment, this may seem a very theoretical question. There is a diversity of opinion in the Islamic world as to whether particular practices or products are Shari’ah compliant; this means that some products and services may be approved as being Shari’ah compliant by some Shari’ah scholars but not others.

As Shari’ah compliant products increase in volume and range, as I have no doubt they will, is there a danger that promoters of these products will shop around as between different authorities in a way which would cause an increase in reputational risk for Islamic Finance in general and who is or should be concerned about that? At the moment this may not be a significant problem. But are we sure that it could not become one in the future?

Thirdly, another concern was illustrated in the case of The Investment Dar Company KSCC v Blom Developments Bank Sal 2which indicated that the validity and effectiveness of Islamic contracts may be called into question on the ground that one or more parties lack the capacity to enter the transaction, where those parties are required to act in accordance with Shari’ah and where there is lack of precision in the drafting of the relevant provisions. As a regulator, we do have an interest in the capacity of parties to contract. This may be a legal risk issue. But lack of capacity can arise on any transaction, Islamic or otherwise, where the counterparty is incorporated in a jurisdiction where companies have limited capacity and contracts outside that capacity are consequently void under the law of the place of its incorporation. This may add a layer of complexity that could impede the development of Islamic Finance in Ireland, even in the context of the removal of the doctrine of ‘ultra vires’ in Ireland by the 2015 Companies Act.

Finally, at a time when we are all considering the forthcoming implications of Capital Markets Union in Europe, the principles of socially responsible investing as exemplified in the recent European Social Entrepreneurship Funds Regulation has never been in sharper focus. This provides, in my view, an environment in which financial regulators in Europe can view Islamic Finance positively.