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Some Challenges In Adopting Sharia In The legal And Regulatory Framework

In the process of internationalizing Islamic finance and integrating it into the global system, the industry is still facing some challenges in the adoption of Sharia in the legal and regulatory framework of local jurisdictions as well as globally.

As a regulated industry, Islamic finance is not only regulated by national laws, but also by Shari’a law. ’This has raised public policy issues in the jurisdictions in which it operates and internationally. International organisations, international standard setters, national regulatory authorities, policy makers and academia have examined various aspects of Islamic financial intermediation, each from their own perspective. Islamic finance has to address a number of problems, including credibility, regulatory enforceability and uniformity. An enabling legal and regulatory framework is expected to address these problems from a proper and comprehensive perspective. It is expected that a proper Shari’a governance framework be included in the legal and regulatory framework in order to ensure that all the operations of Islamic financial institutions are Shari’a compliant.

 Legal and Regulatory Framework

In most jurisdictions, the legal and regulatory framework of the Islamic financial industry has been brought into line with international standards and best practices while taking account of its distinct characteristics inspired by the Shari’a. ‘The regulators in those countries have to produce general and specific rules and guidelines for the industry that are in line with the domestic legal and regulatory framework and international standards issued by international standard setting bodies while having a basis in Shari’a principles.

An observation by Nik’Thani & Othman (2008) found that two distinct approaches have been observed in this endeavour:

  1. Setting up a comprehensive separate legal and regulatory framework for Islamic finance parallel to and compatible with the existing laws and regulations for conventional banking and finance; and
  2. Retaining the existing conventional financial framework and taking incremental steps to accommodate the specificities of Islamic finance; this leads to a gradual extension and differentiation of the legal and regulatory system over time, and this process can also factor in experiences of other jurisdictions.

Most jurisdictions have adopted the second approach. They have retained the existing conventional legal and regulatory framework and made necessary adjustments for the integration of Shari’a principles in Islamic financial practices.

1. Some Challenges in Shari’a Adoption

Nevertheless, the adoption of Shari’a in a country’s jurisdiction of the Islamic finance legal and regulatory framework is not that easy. Many aspects need to be considered in order to ensure that Shari’a adoption is comprehensive in all dimensions of a country’s legal and regulatory framework ‘These include acts, standards, courts and alternative dispute settlement systems and, ultimately, a Shari’a governance framework. The following are some of the challenges to that process which require solutions from the regulators and other stakeholders in the industry.

(a) Harmonisation between the Shari’a principle and the existing legal framework

The existing legal definitions of banking and financial services often do not recognise Islamic financial transactions, due to their nature as trade and investment vehicles. Many constraints are to be expected if a country’s general laws are to be applied directly to Islamic financial transactions, resulting in potential conflicts and adverse legal effects.

Considering the fact that Islamic financial institutions are not only operating in purely Shari’a based jurisdictions but also in non-Islamic, largely Western legal systems, the management of tensions between Western and Islamic legal principles constitutes a persistent challenge. A mechanism is needed to ensure that Islamic finance is treated on par with conventional finance and that Shari’a laws and a country’s existing laws are harmonized and converge. The target is to ensure that the commercial law in the country can integrate Islamic commercial law.

(b) Shari’a standards for Islamic financial transactions
Shari’a certainty for the business of Islamic financial institutions is considered one of the important requirements for the Islamic finance legal and regulatory framework. The legal and regulatory framework should acknowledge the wider nature and characteristics of business and transactions of Islamic banking and finance. Islamic banks accept, like conventional banks, deposits for transactional and savings purposes, but unlike conventional finance, Islamic banks do not use loans for financing.

Instead, they use other types of contracts and transactions such as sales, leases, joint ventures and business partnerships. ‘Therefore, solid Shari’a standards on various approved contracts are necessary to guide the industry and to solve the problem of a lack of consensus among fiqh scholars on the contractual rules governing financial transactions. ‘The absence of such standards might raise Islamic banks’ exposure to counter-party risks arising from the unsettled nature of contracts, and may lead to potential litigation problems.

Besides, the general confusion created by the heterogeneous interpretations of the fundamental Shariah rules results in differences in financial reporting, auditing and accounting treatments by Islamic banks (World Bank Policy Research Working Paper No. 3227, 2004). Shari’a standards for Islamic financial contracts would streamline the practices and products of Islamic financial institutions. Shari’a standards would serve as a guide for product development as well as for Shari’a reviewers, Shari’a auditors and external auditors when they review and audit the whole operations of Islamic financial institutions.

(c) The Court System and Dispute Settlement Mechanism

Some financial transactions will inevitably end in disputes; thus Islamic finance, like conventional finance, needs a court system and dispute settlement mechanism. Such court systems might vary from one country to another; in some countries, Islamic finance cases are settled in the normal court system, but in others they are settled in Shari’a courts. What ìs important is to ensure that the relevant authorities in a country’s judicial and/or arbitration system have a good understanding of how to handle Islamic finance disputes involving financiers, consumers and other stakeholders. ’The Shari’a standards mentioned above would be a helpful reference to courts and arbitrators in resolving cases and disputes brought to the courts ‘The legal and regulatory framework should take this into account whenever it provides schemes for the settlement of disputes arising from Islamic financial transactions. There is a high potential for anomalies in the interpretation or even contravention of Shari’a principles when civil courts apply western- inspired laws instead of Islamic law simply due to the lack of appreciation or varying competence on the part of legal and judicial personnel. The absence of a comprehensive codification of substantive laws governing Islamic financial institutions can exacerbate this situation.

d) Shari’a Governance Framework

As Shari’a compliance is the paramount objective of Islamic financial practice, the existence of a Sharì’a governance framework is necessary. Shari’a governance essentially refers to structures and processes adopted by Islamic financial institutions to ensure compliance with Shari’a rules and principles. It is a very critical area in Islamic finance and is of no less important than corporate governance is to any institution. However, Sharì’a governance is particular to Islamic finance, as it is the mechanism which determines the ‘Islamicity’ of any particular Islamic business or financial institution as well as of the system as a whole.

Shari’a governance ensures that the industry is at ail times in accord with the Shari’a by ensuring the legitimacy of the products offered and supervising the products applied in the market. Shari’a governance is indispensable for ensuring public confidence in the Islamic finance industry. A proper Shari’a governance framework would ensure strict Shari’a compliance in all the industry’s practices. ’This would give credibility to the industry and instil public confidence. It would also promote operational and financial stability since it would ensure that the value propositions of Islamic finance are implemented in practice.

Effective Shari’a governance requires the setting up of a dear and comprehensive framework within the legal and regulatory system to regulate the Islamic finance industry and guide its development. Fundamental to this process is the definition of all its actors, in particular the Shari’a committee, the board of directors, managers, Shari’a reviewers, Shari’a auditors, etc. ’Their roles and responsibilities for the progress of the whole Islamic finance sector have to be spelled out. Other aspects of Shari’a governance are supporting initiatives to enhance Shari’a advisors’ performance, such as a legitimate mandate, the establishment of a Shari’a secretariat, of Shari’a research capacities and others.


The direction of the Islamic financial industry is very much determined by the certainty of the legal and regulatory framework The framework should take into account the value propositions and principles promoted by Shari’a, which are the backbone of the industry. Countries that have an Islamic finance industry should attempt to develop a solid and comprehensive legal and regulatory framework that would incorporate Shari’a (which is the backbone of the industry) into the legal system. A recent attempt by Malaysia in a new act, the Islamic Financial Services Act (IFSA) 2013, could be emulated by other countries in order to further develop the Islamic finance industry. IFSA aims to provide a comprehensive framework for Islamic finance by introducing a more risk- focused and integrated approach to the regulation and supervision of financial institutions. IFSA aims to safeguard financial stability; provide a comprehensive Shari ah-compliant legal framework in all aspects of regulation and supervision; and ensure effective functioning of the money market, foreign exchange market and payment system

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