Islamic Finance in a New Key, or Is Regulation the Answer?

By Meagan Froemming

Many identify the absence of clear regulatory standards as the most significant challenge to the Islamic finance industry’s continued growth.[1] Yet, is the development of a uniform regime even possible given the many variations in approach within Islamic finance practice?[2] And does comprehensive regulation actually portend global growth for Islamic finance? To answer those questions, one must come to terms with the significant fragmentation that pervades the Islamic finance industry today.

There is no single body imbued with sufficient authority to make rulings as to It is easy to imagine, therefore, a scenario in which a product deemed sharīʿa-compliant in Malaysia might find itself rejected on non-compliance grounds in a GCC country.

Without uniform standards, many innovative Islamic finance tools suffer from a lack of cross-border scalability and are handicapped by increased transaction costs.[4] The costs of this industry disaggregation militate in favor of the development of a uniform regulatory regime. However, this disaggregation itself also poses the most significant and costly obstacle to the development of comprehensive standards.

Nicholas H.D. Foster, in his article, Islamic Finance Law as an Emergent Legal System, breaks down the process of standardization into two categories of action for building regulatory uniformity: the organic and the institutional. Organic forces pushing toward increased certainty “[arise] as a result of the ‘natural’ pressures in the market and the professions, particularly the legal profession, which service it.”[5] Reliance on standardization by organic means? fails to meaningfully address a key feature of modern Islamic finance practice, however. In this industry, product structures are often deemed proprietary and are not publicly available. As such, an ad hoc standardization process is unlikely to take root in an inter-institutional, international way.

There may be space, however, for developing a model Islamic financing agreements to serve as a contractual baseline upon which an organic mode of regulatory convergence can take place. Through whom such models might legitimately develop is itself a complicated question touching on issues of national sovereignty and religious authority, and thereby rendering global reliance on any such model agreements unlikely.

In Foster’s theory, the “institutional” mode of regulatory action is triggered by the organic: institutionalism builds on and codifies industry practice in light of its organic development.[6] One example is the AAOIFI, the International Islamic Financial Market, has risen to prominence through its efforts at producing accessible and relevant global regulation. This institution competes for relevance with others, however, with none achieving total industry primacy or enjoying enforcement capability. More importantly, there is no clear precedential relationship between these transnational organizations and country-specific regulatory systems.

Despite the challenges highlighted above, all hope is not lost when one takes a long view. Repeated use of a particular approach (for example, the Dubai Though legislative enforcement capacity would still be lacking, consumer influence could have a powerful conforming effect on industry practice and behavior.[7] Industry ‘shaming’ dynamics – particularly strong in the Islamic finance context – may thus work to produce sufficient enforcement-like effect under this approach.[8]

Regulation provides a framework within which market participants can systematically lower transaction costs.[9] Such a framework increases consistency, may attract new participants, and could engender greater capital investment.[10]

It is worth considering challenges to this hypothesis, however. First, there is arguably a closed circuit of investors willing to participate in the Islamic finance marketplace, regardless whether a regulatory regime exists. Second, there is a risk that “[designing] financial regulation to directly promote development may distort its objective of ensuring soundness and stability” in the market.[11] If the impetus for regulatory development is industry growth, then the regulations may suffer from a ‘bad seed’ problem and come to be seen as illegitimate.

There are no easy answers with regard to Islamic finance regulation. It appears the challenges and associated costs of imposing a global regulatory regime, even if produced through organic practice, may outweigh the benefits of regulation. Ultimately, when considering support for regulatory standardization, it is for the practitioner herself to balance the aspirational goal of a widely diffuse Islamic finance practice with a realistic assessment the industry’s global potential.


[1] See, e.g., Chian Wu, Islamic Banking: Signs of Sustainable Growth, 16 Minn. J. Int’l L. 233 (2007); Ibrahim Warde, The Relevance of Contemporary Islamic Finance, 2 Berk. J. Middle E. & Islamic L. 159 (2009).

[2] Shaheen Pasha & Liau Y-Sing, ANALYSIS-Lack of standardization hobbles Islamic finance, Reuters (May 10, 2010). (“Some Islamic finance players say standardization is an unrealistic goal given the fragmented nature of Islamic finance…”).

[3] Id. (“Standardization bodies do exist but the adherence to their standards varies from country to country.”)

[4] Archana Narayanan & Al-Zaquan Amer Hamzah, Goldman Sachs plans debut sukuk issue as Islamic finance goes mainstream, Reuters. (September 14, 2014) (noting that an early attempt to issue a ṣukūk (Islamic bond) in the UK in 2011 failed because “some in the industry accused it of failing to follow Islamic principles…”).

[5] Nicholas H.D. Foster, Islamic Finance Law as an Emergent Legal System in Arab Law Quarterly 21, 2: 2007, 178.

[6] Id.

[7] Mahmoud A. El-Gamal, Islamic Finance: Law, Economics, and Practice 183 (2006 (“…as competitive pressures mount, jurists are likely to [offer] innovations that lead to convergence of Islamic financial practice with its conventional counterpart. This, in turn, will cause disenchantment among potential new customers and existing customers of Islamic finance, as product differentiation between an Islamic product and its conventional counterpart appears increasingly more contrived.”).

[8] Ibid. (“…loss of credibility may be [exposed] by…highly qualified jurists who have not played any significant part in the industry’s development to date. Institutions that retain the services of such highly credible jurists may claim that other Islamic finance institutions have in fact gone too far in their innovation.”).

[9] See, e.g., Joshua Fairfield, The Cost of Consent: Optimal Standardization in the Law of Contract, 58 Emory L.J. 1401, 1432 (2009) (“…consumers, who search for deals, prefer standardized deals because standardization reduces consumer costs”).

[10] Malaysia International Islamic Finance Centre, 2014 – A Landmark Year for Global Islamic Finance Industry, 5(2014) (noting that “regulatory advancement and adaptation have been instrumental in supporting the growth of Islamic finance”).

[11] Dahlia El-Hawary, Wafik Grais, et al., Regulating Islamic Financial Institutions: The Nature of the Regulated, World Bank Policy Research Working Paper 3227, March 2004, quoting Chapra and Khan 31 (2000).

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