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Islamic finance faces many regulatory barriers, not just tax obstacles

Financial services regulations generally pre-date Islamic finance. Unless the regulatory provisions are adapted, they often preclude Islamic finance transactions. I give three examples.

Posted 19 May 2019

A reader recently pointed out to me that UK building societies are in practice prohibited from offering Shariah compliant home purchase plans. This gave me the idea for my May 2019 column in the magazine "Islamic Finance News."

You can read it below.

Never forget the regulatory barriers to Islamic finance

As a taxation specialist, I have always focused on eliminating those taxation burdens on Islamic finance which do not apply to conventional finance. Left in place, they would risk making Islamic finance prohibitively expensive compared with conventional finance.

However, a reader’s email recently reminded me that regulatory barriers can make Islamic finance impossible unless they are addressed by governments.

Russian prohibition of bank commodity trading

For example, a decade ago when visiting Russia, I learned that Russian banks are not allowed to trade in commodities. Of itself, that is a perfectly sensible piece of banking regulation since commodity trading involves very high risks which could threaten the solvency of a bank.

Unfortunately, that rule also makes it impossible for Russian banks to provide finance to customers using commodity murabaha transactions. Even though commodity murabaha transactions are structured to reduce the bank’s exposure to commodity price risk to a microscopic amount; for Shariah compliance reasons the bank needs to be seen to be trading in the commodity, which falls foul of the Russian prohibition against commodity trading by banks.

As far as I am aware, this problem has not been legislated away in the last decade.

Are sukuk collective investments schemes for UK regulatory purposes?

In the United Kingdom, at one stage sukuk faced a regulatory impediment which risked making them prohibitively difficult to issue. Legally, sukuk are normally structured as undivided fractional ownership interests in an asset, usually real estate or a business. The trustee administering the sukuk divides the rewards from owning the asset (such as rental income or business profits) amongst the sukuk holders.

This looks very much like a collective investment scheme, whereby investors pool their money to collectively invest in an asset. However, the UK has many detailed rules governing collective investment schemes which are intended to protect unsophisticated investors. For example, operators of collective investment schemes require approval from financial regulators.

These detailed rules would have imposed additional burdens on the issue of sukuk which would have made them prohibitively expensive from the perspective of a corporate issuer compared with the issuance of conventional interest-bearing bonds.

Once the UK professionals specialising in Islamic finance pointed out the problem to the government, it was eliminated by legislation. Very briefly, if an instrument meets the detailed definitions set out for “alternative finance investment bonds” (the UK regulatory name for sukuk), then it is automatically excluded from being a collective investment scheme.

The definition of a building society

The regulatory impediment raised by my reader is one of which I was previously unaware. Most home finance in the UK is provided by banks as domestic conventional mortgages. Banks are also able to offer Shariah compliant home purchase finance in the form of “home purchase plans” normally using a diminishing musharaka structure for which there is also specific tax legislation.

Building societies are a form of conventional mutual financial institution which pool members’ money (paying interest on the deposits) and use that to provide domestic conventional mortgages. However, there is a serious impediment to building societies offering a Shariah compliant home purchase plans.

The Building Societies Act 1986 specifies that the purpose, or principal purpose, of a building society must be “making loans which are secured on residential property.” Home purchase plans do not qualify as they are not loans. While building societies are permitted to hold some assets falling outside their principal purpose, in practice building societies could never offer more than an immaterial number of home purchase plans. Consequently, they do not venture into Islamic finance.

Parliament would need to amend the law for the position to change.

 

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