LONDON, 20 February 2006 — With the rapid growth of Islamic finance, the quality of financial reporting, disclosure and transparency in the sector has also come under greater scrutiny. There have been calls for greater standardization, for instance, of auditing and accounting standards, and of reporting and presentation of financial statements.
In a recent report titled “Enhancing Financial Reporting and Transparency; Keys to the Future of Islamic Finance”, international credit rating agency, Standard & Poor’s (S&P’s) warns that “standardization of financial reporting is a key challenge for the rapidly-growing Islamic finance industry, in order to avoid fragmentation and ultimately ghettoization at a time when Shariah-compliant investment vehicles, as an asset class are coming of age.”
The rating agency warns that financial disclosure practices among Islamic financial institutions (IFIs) still fall short of international best practice. This is partly because IFIs are largely active in emerging markets, “which generally have low financial disclosure, ... and where disclosure obligations are minimal, and compare unfavorably with more disintermediated, mature markets.”
While this also true of conventional banks in these markets, the problem for IFIs are even greater because the economic mechanisms “hidden behind their published accounts may be less familiar and more complex than those of their conventional counterparts, which would benefit from greater explanation, clarity, and detail.” Islamic financial institutions, says the report, tend not to speak the same financial language. They have not adopted a single financial reporting framework. IFRS is the main reporting framework adopted but has vague global recognition. Domestic regulation in IFI countries remains a constraint, thus differing national accounting standards create heterogeneity (as opposed to uniformity) in financial reporting.
Saudi Arabia follows the IFRS accounting standards. These can differ from country to country. Al-Rajhi Bank for instance, deducts distributions to profit-sharing investment accounts from operating revenues to calculate net operating income, whereas others, such as Dubai Islamic Bank and Kuwait Finance House, compute an operating income before distribution to these depositors, which once deducted leads to net profits.
S&P makes several recommendations. These include a dual standards approach — IFRS and AAOIFI; or AAOIFI FAS as the norm but IFRS where the former is not applicable or available. IFIs should make their financial reports available in the public domain.
Islamic finance is a faith-based ethical system of financial management. It is an alternative system of financial management with its own unique structures. There are some similarities with conventional finance, but also key differences. While the two systems can cooperate and inter-act (there is already growing cooperation in this respect), it would be both naive and dangerous to suggest that for Islamic finance to become “mainstream” all you need to do is Islamize conventional structures and practices in banking, finance, accounting standards and intermediation such as ratings.
On the contrary, Islamic banking practice in the UK has shown that you can achieve the requisite authorization without compromising both the UK Banking Act and the principles of Fiqh Al-Muamalat (Islamic law relating to financial transactions). In the UK, for instances, Islamic mortgages are now on the same stamp duty footing as conventional counterparts, although the issue of risk weighting is still in the process of being resolved.
S&P is mistaken to suggest that Islamic banking and finance jargon “does not easily lend itself to standards that take the perspective of the economic nature of any banking transaction rather than its contractual aspect as is the case in Islamic finance.” Perhaps standards should combine both the economic nature and contractual aspects of transactions.
Western credit rating agencies have also flatly refused to develop a rating methodology and criteria for Islamic financial institutions, based on the argument that current methodology and criteria (for conventional banks) would suffice. Yet in Malaysia, both Rating Agency of Malaysia (RAM) and Malaysian Rating Corporation (MARC) have devised a Shariah-compliant methodology and criteria.
Islamic finance has not evolved simply to fit in with Western conventional concepts of finance and intermediation on the exclusive basis of Western criteria and methodology. If that is the belief then it smacks of both chauvinism and opportunism. What is needed is to take the best of both practices but without comprising the very ethos of the faith-based Islamic system of financial management.
