Islamic finance, future challenges

Islamic financial institutions need to consider undertaking internal changes in order to prepare for a much more stringent US and global regulatory environment. Thus they would do well to adopt compliance regimes, establish internal compliance timetables, establish procedures for basic and enhanced due diligence, aggressively manage it and review existing contracts and relationships.

This was the message to the audience of the International Islamic Finance Forum in Geneva from Jonathon Winer, of Alston and Bird (and formerly US Deputy Assistant Secretary of State for International Law Enforcement.)

"Banks should consider appointing a compliance officer responsible for establishing a global compliance regime that is applicable to all units, policies, procedures and training," said Mr Winer. The industry should also consider the checking of all accounts and customers against the UN, US and EU sanctions list, think about shielding other profit and loss sharing arrangements from the risk of these accounts.

"It is also important to enter into appropriate contracts with intermediaries at foreign financial institutions and to aggressively manage FATF [Financial Action Task Force] problems."The fundamental essence of new US financial institutions regulation such as the Patriot Act is about enhancing due diligence and encouraging a much greater level of transparency, explained Mr Winer. And while the regulatory framework of the global financial community may have changed since 11 September, even before this time, the move towards greater transparency and accountability was already well underway.

"The US has gone through a radical change since 9/11 in terms of regime and the EU is going in a similar direction," said Mr Winer noting that the direction is broadly the same as that of the Financial Action Task Force (FATF). This change has led to a heightened concern about procedures and documentation and one which perhaps highlights the difference between Islamic and conventional finance.

"There is a partnership between the Islamic financial institution and the customer which allows for flexibility and results in higher liquidity which is not the case with conventional banks. And in conventional banking it is important to get lots of documents and make sure that they're clear and they tell the full story. Loyalty programs on the Islamic side lead to a different regulatory regime and system."

Increasingly, and with the US Patriot Act, all countries wishing to deal with the US financial markets will have to adopt a heightened sense of the importance of sound regulations. Anonymous accounts for example, will become a thing of the past as the KYC (Know Your Customer) principle becomes the norm although Swiss based numbered accounts, said Mr Winer, will remain acceptable (since the account holder is known to certain members of management).

Regarding Islamic banking, Mr Winer noted that the development of the trust relationship with the client has sometimes been to the detriment of a more rigorous system of procedures and disclosures. "Islamic banking is poorly suited to provide conventional disclosures - this creates a hazardous interface. There is now greater systemic risk and a move to know the sources of customers funds and not just to identify customers."

Moreover, pointed out Mr Winer, increasingly stringent regulations now relate to all financial institutions such as insurance companies and hedge funds and not just banks. And it is not just in the US. "Part of increased regulation in the US is due to 9/11 and Enron has also had its consequences" said Mr Winer but suggested they also relate to the global picture.

"Cross border reporting requirements are also increasing and we have seen assets frozen and sanctions imposed in addition to the UN resolution 1373 which calls for all to fight terrorist funds."

Mr Winer noted that the EU has taken a direct action to impose sanctions on Zimbabwe. Other international initiatives are also underway such as the Non-Cooperative Countries and Territories Initiative of the FATF, OECD tax haven initiatives and multilateral or unilateral sanctions programs.

"Each of these which potentially meant reduced access to financial markets," said Mr Winer, "led to rapid changes in the domestic regulatory regime in targeted countries - laws are changing."

But why should Islamic banks be any different to other banks. "The Islamic regime focuses on compliance with Sharia," said Mr Winer, "and allowed for lot of flexibility which made the relationship of trust essential with less reliance on documentation or internal controls. Recently the IMF issued explicit advice in terms of the future of Islamic regulations calling for more supervision and more regulation applied across the board."

Some areas in particular are likely to be the target of such calls, suggest Mr Winer, such as the Hawala transfer system, gold and metal trading, offshore commercial free zones such as Kish and Quesh in Iran and offshore companies and charitable trusts.

Without increasing regulatory prudence in this areas, said Mr Winer, "the risks created are clear. Foreign intelligence may stimulate foreign law enforcement against the entities operating in that vulnerable sector." Such action could result ultimately in investigations, enforcement action or sanctions against an element of vulnerable sector which can have very negative impact on the reputation of a bank, Islamic or otherwise, innocent or otherwise.

New oversight mechanisms may take time to establish but they are essential for boosting the credibility of the investment sector. Private banking may come under particular scrutiny. "Investors want solid returns protected from political risks as well as commercial risks, they want long-term relationships and frequently use them to preserve discretion and wealth. Audit trails are often broken up for better or for worse. For example, a trust established in Lichenstein may be connected to a company in Isles of Jersey and a bank account in Geneva."

Historically such arrangements may have worked, said Mr Winer, but increasing US regulatory vigilance means they may not in the future. "As of tomorrow and today the US is calling for banks to exercise enhanced due diligence on private banking accounts - they will have to have very high standards and know ownership."

He also suggested that increasing stringency may apply not just to private investors but also to their friends and relatives. It is now illegal, for example, to process funds in the US of a shell bank and foreign banks wishing to operate in the US are required to identify their ownership and the location of their US agents.

"If you are a foreign bank you have to identify owners by the end of October and you have to provide all the documents you held in Zimbabwe to US regulators on request," said Mr Winer.

"Offshore banks also subject to greater scrutiny. Only if a jurisdiction is pre-approved by the US might it get an easier ride. There is a low level of scrutiny for those jurisdictions recognized by the US as being subject to consolidated supervision," said Mr Winer but this is not the case for most countries in the Middle East.

A series of fund managers speaking at the International Islamic Finance Forum in Geneva collectively agreed that post September 11 no changes have been made in marketing their products. Nassif L Aoun, Division Head, Investment Services at National Commercial Bank confirmed that the bank's marketing strategy remains the same.

However, he did say that "we are more sympathetic with customers and more service oriented but long-term story, we always sold our funds based on a long term horizon and on meeting goals in the long term. A year or two of down markets does not change that."

Masood Aijazi, Consultant for Financial Investments at the Saudi Economic and Development Company (SEDCO) reiterated this sentiment. "There have been no major changes. We consider ourselves the educators. We have a tough time in explaining in 1998 that markets went down as well as up but our fund performance really helped us. In the last four months we gained more assets than in the past four years."

In that vein, Mr Aijazi said the time is right for investors to ponder their strategies and that this provides a key role for SEDCO. "We give them tools so they can understand what's happening and we always give them a long term view."

European SRI manager reported similar sentiments. Rene R Kamber, Head of Institutional Clients at Sustainable Asset Management, Switzerland, also played down the negative impacts. "Socially responsible companies in the long run will derive better value to their investments. We are reinforcing the message that now is a good time to look at SRI or Islamic investment."

Similarly, Michel Jacquemai, Partners, Hedge Fund Advisory, Partners Group, Switzerland confirmed that the company has not changed its marketing strategy. "In the 1990s an alternative investment strategy was difficult to market but now market disciplines have realized it's not a one way street especially with low correlated strategies. We will continue to try to add value."