In recent years, the rapid growth of Islamic banking products, not only in Kenya but globally, has been significant enough that the International Monetary Fund (IMF) commissioned a working paper in 2014 on the need for legal and prudential regulation of the sector. The working paper relied on a survey of a wide spread of areas including the Middle East, Indonesia, the United Kingdom, North Africa and Sub-Saharan Africa. More recently, in January 2017 the IMF published a Multi-Country Report (the Report) in which it recognised that the legal framework in Kenya has not adapted to the specificities of Islamic banking and that there are remaining gaps in the shari’ah governance framework in Kenya. While the Report made reference to the 2014 working paper and noted that a significant number of banks and financial institutions were offering Islamic banking products, with Kenyan banks being the key players in the market, there was a growing need for regulation of the sector to ensure that Islamic banking was being practised within the accepted parameters of shari’ah compliance.
The concept of Islamic banking is rooted in certain elements that are prohibited since they are innately haram (or forbidden) in Islam and for this reason the said elements must be excluded from any contract between contracting parties, as such a contract would be rendered non shari’ah compliant if it incorporates these elements. The said elements include riba (interest), gharar (uncertainty), maysir (gambling) and qimar (speculation). From a financing perspective, a bank offering Islamic banking products to its customers would thus need to ensure that the said elements do not form part of any financing transaction for a contract to be considered shari’ah compliant.
In essence, the unique nature of shari’ah compliance from a financial perspective immediately poses challenges that current regulatory legislation such as the Banking Act (Cap. 488) and the Central Bank of Kenya Act (Cap. 491) (the CBK Act) do not sufficiently deal with. The Kenya Deposit Insurance Corporation Act, 2012 which aims to protect depositors of troubled banks, is equally not well suited to cater for depositors of banks that provide Islamic banking products, as well as conventional banking as deposit premiums from account holders of purely Islamic financial products are not segregated from premiums of regular deposit holders. The premiums from Islamic banking products would need to be aligned to the takaful insurance model which is an Islamic alternative to commercial insurance and also emphasises avoidance of riba, maysir and qimar.
The need for a regulatory framework has become even more pressing, based on the fact that international banks offering Islamic products are keen on breaking into the Kenyan financial market in order to exploit the full potential of Islamic banking, the most recent entry being that of Dubai Islamic Bank, which is one of the largest banks in the United Arab Emirates. It has recently been granted a licence to operate in Kenya.
The Malaysian Model
The regulation of the shari’ah model in the Kenyan context should draw significant inspiration from the Malaysian model of regulation which started with a primer for the Islamic banking business with the enactment of the Islamic Banking Act, 1983 and later made strides toward incorporation of regulation of shari’ah based financial activity by amendments to the Central Bank of Malaysia Act, 1958 in the year 2003 to incorporate provisions for regulation of the Islamic banking industry by amongst other things, establishing a Shari’ah Advisory Council (SAC) as the authority for ascertainment of Islamic laws that would be applicable to shari’ah financial products. On 1st July 2013 the Islamic Financial Services Act (IFSA) was enacted and it repealed the IBA to give way for a consolidated and contract based framework for Islamic finance.
The SAC in Malaysia initially played the role of a referee for court or arbitration proceedings and while the rulings of the SAC were binding on arbitration proceedings, they were only of persuasive value to the courts. The repeal and replacement of the Central Bank of Malaysia Act , 1958 with the Central Bank of Malaysia Act , 2009 changed this position and made it mandatory for courts to take into consideration the rulings of the SAC.
The challenges that a SAC would face in the Kenyan context would be in having the commercial division of the High Court consider rulings by the SAC which would be decided on Islamic finance principles as opposed to other sources of law such as English contract law, and common law as it does now. However, the obstacle is surmountable on the basis that Malaysia, like Kenya, has a system where only matters related to Muslim marriage and divorce matters are adjudicated upon by Kadhis, while all commercial matters are adjudicated upon by secular courts. In so far as an interpretation of Islamic law is not at odds with the English contract law position, the commercial courts in Kenya would be able to apply the principles espoused by a SAC to an adjudication before it.
The need for a SAC is underpinned by fact that shari’ah law has its primary sources being the Quran (the Holy Scripture) and Sunnah (the way of the prophet Mohamed). The model is much like English law which has its primary foundations in statute and subsidiary legislation, the application of which, over time, has developed common law as a secondary source. In Islamic law, the branch of religious knowledge known as fiqh (understanding) informs the theoretical basis and jurisprudence of shari’ah law which in turn is developed by itjihad (interpretation) of the primary sources. The different schools of fiqh inform the interpretation of the principles of Islamic law and the application of these principles through a SAC would be vital in codification and regulation of the sector as it will result in a blue print of the dos and don’ts for the drafting and structuring of Islamic finance contracts by banks. With a SAC in place, law firms would also be in a better position to advise on accepted practice and viability of the structuring of Islamic finance contracts on accepted industry practice within SAC and regulator acceptable guidelines.
The Interpretation Challenge
In Islamic banking, one of the core contracting principles is that a sale is allowed as it is a real transaction and provides for a fair distribution of risk and results in real value while riba is forbidden. The application of the principle can be seen in the most basic home financing agreement, also known as the diminishing musharkah agreement in Kenya. This involves a back to back buying and selling where the customer of the bank will first sell the asset to the bank at a spot price and the bank will immediately sell the asset back to the customer at a higher price, on a deferred payment basis. The model sits squarely within the principles of Islamic banking as the parties are contracting on an ascertainable asset which will result in a profit for the bank on the deferred payment basis and the transaction will result in ascertainable value for the customer thereby knocking out the forbidden elements of riba, gharar and qimar. The bank will usually protect its interest by registering a charge over the property.
A separate form of the diminishing musharakah contract exists known as the bay al’ inah, which is a form of personal financing where the customer has nothing to sell but is in need of obtaining cash in the form of personal financing, In the bay al’ inah contract the bank, as the original owner, will sell the asset to the customer on a deferred payment basis and the customer, being the new owner, will immediately sell the asset back to the bank, at a lower spot payment price in order to obtain personal financing. In this case there is no charge over the asset as it is a mode of personal financing and the same will usually be secured by a pledge or personal guarantee. This form of Islamic finance is from the Shafi fiqh and is validated by some scholars as it conforms with the essential elements of a sale i.e. the subject matter is ascertainable and the transaction involves profit on a deferred payment basis. On the other hand, some schools of thought and some Shafi scholars have disapproved of it on the basis that it involves two sales in one and is a legal device intended to circumvent the prohibition of riba.
The Report recognises that the Central Bank of Kenya has accommodated Islamic banks by exempting them from provisions of the CBK Act that prohibit trading or investment in consideration of their business, but does not provide adequate guidance on the Islamic concepts applicable in Kenya.
The introduction of regulation and the establishment of a SAC will ensure that there is a uniform application of the principles and concepts of Islamic banking and with authoritative determinations from a panel of experts, plus, a sure footed regulatory and governance structure and law firms would also be able to authoritatively advise clients on the best practice on structuring finance agreements, without running the regulatory risk of being adjudged as having breached essential shari’ah compliant elements. This form of regulation would also ensure bank customers that the Islamic finance products that they are subscribing to, fit within established guidelines and they do not run the risk of being subjected to contracts that have been innovatively disguised as shari’ah compliant.
In conclusion, the regulation of the Islamic banking sector would not only prevent it from possible and perceived breaches but would ensure its robust development in the Kenyan market.