Canada: U.K. Paper On Regulation And Challenges Of Islamic Finance Has Relevance For Canada

Canada: U.K. Paper On Regulation And Challenges Of Islamic Finance Has Relevance For Canada

Late last year, the Financial Services Authority (FSA), the independent organization that regulates most financial services markets, exchanges and firms in the U.K., published a paper regarding Islamic finance, which considered the recent growth in this sector of the financial services industry and identified some of the challenges and opportunities specific to Islamic finance. The issues identified are consistent with those outlined in Stikeman Elliott’s April 2007 Financial Services Update in respect of Canada, and highlight the challenges to which Canadian regulators and financial institutions will need to respond in addressing this growing area of financial products and services.

Background

Islamic finance consists of financial products and services structured to comply with Islamic law (Shari’ah), which covers all aspects of Muslim life. The Islamic economic model emphasizes fairness and shared risk and return, while forbidding transactions involving alcohol, pork-related products, armaments, gambling and other activities viewed as socially detrimental. Shari’ah law also prohibits transactions involving the paying or receiving of interest. As such, modern Islamic banking has initiated the development of products and services that replace interest income with cash flow tied to an underlying tangible asset, such as real estate. In the consumer area, while the nomenclature and certain underlying mechanics of financial products may vary from those with which consumers are familiar, the actual products offered, such as mortgages, insurance and investments, are similar to conventional products.What was once a niche area of financial services has recently seen spectacular institutional and, to a lesser extent, consumer, growth in the Middle East, Malaysia and the U.K. The market for Islamic finance has increased by 20% to 30% per year since 2001, and is currently the fastest growing segment of the financial services industry, worldwide. Many new Islamic financial institutions have recently been established, as have many Islamic “windows” within conventional institutions. The United Kingdom, meanwhile, has specifically sought to increase its ability to attract Islamic financial services businesses by reviewing and updating financial regulation in order to encourage growth in the sector.

Much like in the U.K., Canada’s Muslim population has recently enjoyed strong growth, and the potential market for Islamic financial services continues to expand. The number of Muslim Canadians has grown from an estimated 253,300 in 1991 to over 800,000 in 2006. By 2017, Canada’s Muslim population is expected to comprise between 3.7% and 4.9% of the country’s population. While some limited Shari’ah-compliant products are available in Canada, no major financial institution yet offers Islamic financial products or services. The relative youth and high level of education of this segment of the population, however, suggest that the demand for Islamic financial products and services in Canada will only increase in the coming years, providing a tremendous opportunity for financial firms prepared to serve this growing market. Investments in Canada by sovereign investment funds and other investors from Islamic nations also appear to be poised to accelerate in the short and medium term. Outside of Canada, certain of such investments have been structured to be Shari’ah compliant, and that also may become more typical.

Challenges And Opportunities

The FSA’s recently released paper demonstrates the initiative with which other jurisdictions are pursuing this area and the FSA’s review of the industry should provide a basis upon which Canadian financial institutions can accelerate accessing the Islamic financial market. The challenges identified by the FSA include:

  • Shari’ah ‘arbitrage’ – Currently, there is a diversity of opinion regarding whether certain products or practices comply with Shari’ah law. While regulators will not be in a position to assess the compliance of products with Islamic principles, regulators will need to ensure that transparency of the Shari’ah compliance process is appropriately communicated to the financial consumer. Further, the FSA believes that common Shari’ah standards would be beneficial, and it is currently supporting the development of such standards by various organizations, which would make it easier for bankers and investors to assess, and access, the market;

  • Shari’ah compliance throughout the product life cycle – While a product may be deemed Shari’ah compliant prior to its launch, firms must also be cognizant of the need to maintain compliance after launch by monitoring their products and services. Compliance must be considered an ongoing obligation, as a breach of Shari’ah rules could undermine investor confidence in the products and threaten the firm’s solvency;

  • Issues for Shari’ah scholars – As there is currently a shortage of Shari’ah scholars to certify that products conform to Islamic law, it is currently not uncommon for scholars to hold consulting positions within more than one financial firm. This raises concerns regarding the ability of scholars to apply a high level of oversight to the various products and services at different firms, as well as concerns of potential conflicts where scholars are both approving products and auditing existing products and processes within the same firm or at different firms;

  • Human resources – Like the shortage of Shari’ah scholars with relevant financial experience, there is also a shortage of experienced professionals in the Islamic finance field. Education and professional training programs will be required to address this ongoing need;

  • Contract and documentation risk – While the structures of such transactions are designed to comply with Islamic law, the agreements are governed by local law or, often, English or New York law. The U.K. courts have refused to apply Shari’ah law in disputes, and the debate regarding the interpretation of Shari’ah principles to certain financial products would add further uncertainty. Thus, particular consideration must be given to the drafting of contracts to minimize the potential for disputes, and to identify the governing law;

  • Risk of contagion – As the Islamic finance industry is relatively young and limited in breadth, its various business models remain untested on the scale enjoyed by more established financial products and services. The FSA recognized that a failure in this nascent industry could affect the future development of Islamic finance.

The FSA’s focus is indicative of the level of activity occurring in the area of Islamic finance. The Office of the Superintendent of Financial Institutions (Canada) (OSFI), meanwhile, together with other federal Canadian government departments and agencies, has recognized these recent developments and has also begun to assess the place of Islamic financial products within the Canadian system. The issues identified above are equally relevant to Canada and the Canadian financial services marketplace, and provide Canadian financial firms with a set of constructive points and risk management options to consider as they move into the Islamic finance sector. To this end, Canadian firms are moving forward, and there are currently a number of applications at various stages before OSFI and the Ministry of Finance for the licensing of new Canadian Islamic banks. While challenges are to be expected, the opportunity presented by Islamic finance in Canada is also becoming more readily apparent.

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