Soft law, self-regulation and cultural sensitivity: The case of regulating Islamic banking in the

UK

Aldohni, Abdul KarimAuthor Information . Journal of Banking Regulation;

Basingstoke Vol. 15, Iss. 2,  (Apr 2014): 164-179.

Abstract
TranslateAbstract

The Islamic banking sector has grown significantly over the last three decades and reached many
international financial markets. As their name suggests Islamic banks are governed by the rules
of Islamic law (Sharia). The Sharia compliance requirement has its implication on the nature of
Islamic banks' operations. The prohibition of interest prevents Islamic banks from using
conventional financial products. Instead, Islamic financial products are based on the principle of
profit-loss sharing. Therefore, the Islamic feature of these banks has brought certain regulatory
challenges. This article is concerned with the UK Islamic retail banking market and it focuses on
the role of soft law and self-regulation in minimising these regulatory challenges.
[PUBLICATION ABSTRACT]

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INTRODUCTION

The complexity of the subject of banking regulation was not only exposed by the 2008 global
financial turmoil but it was also intensified. The crisis highlighted the challenging
multidimensional nature of banking and financial regulations. On the one hand, regulators are
faced with a diverse and innovative financial market, which is inhabited by different breeds of
financial institutions. This adds further complications to the design process of any national legal
and regulatory framework. On the other hand, regulators should consider certain factors that
exceed their national boundaries. For instance, the risks associated with the intertwined business
between financial institutions operating in different jurisdictions and the level of involvement
and exposure to international money markets.

In the wake of the financial crisis, countries around the globe started, collectively and
individually, introducing wide regulatory reforms. Legislators and regulators in the main
financial markets started to reassess the existing legal and regulatory framework of their banking
and financial sector. In the United Kingdom, in addition to introducing a new regulatory
structure, special attention was drawn to the long standing approach of deregulation and the
reliance on self-regulation and 'principle-based' regulation. Serious concerns were raised over the
effectiveness of such approach. Accordingly, there has been a clear shift towards a tighter
regulatory framework for the banking and financial sector in the United Kingdom. 1 A more
hands-on approach can be seen with the introduction of the two new regulators, the Financial
Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). This could mean a
change in the role that self-regulation systems and their soft law components play in the
governance of the banking and financial market.

Self-regulation and soft law still have an important role in the United Kingdom's regulatory
reform for two main reasons. First, some of the well-established rules of soft law will be adopted
as an integrated part of the regulatory framework. For example, the FCA is currently consulting
on its new regime for consumer credit. One of the issues that the FCA is consulting on is the
provisions in voluntary industry codes that should be included in the FCA's new rules and
guidance. 2 It must be noted that the Financial Services Authority (FSA) also previously included
some aspects of soft law in its regulatory regime. For example, the Banking Conduct of Business
Source Code (BCOSC) combines some new high-level rules and the conduct of business rules
and guidance that previously were applied voluntarily to deposit taking by the industry. 3

Second, soft law has been widely used on the international financial scene, which certainly has
its effects on any domestic legal and regulatory reform. For instance, the principles of the Basel
Committee on Banking Supervision have influenced the regulatory frameworks around the globe
despite their voluntary nature. Considering the nature of the banking and financial business, it is
rather difficult to have a legal and regulatory framework in which some soft law rules are not,
one way or another, part of its structure.

One unexamined area has been where Islamic banking stands from these regulatory reforms.
Islamic banking is a relatively new form of banking that has grown significantly over the past 30
years and has been actively present in the UK banking market for nearly 10 years. Despite the
unique nature of their operations Islamic banks in the United Kingdom are governed by the same
legal and regulatory framework that applies to conventional banking.

This article aims to bring focus to the regulatory aspects of Islamic retail banks that are operating
in the UK financial market. It highlights certain regulatory challenges that are imposed by the
Islamic nature of these institutions, and identifies the lack of consistency in the Islamic retail
banking sector as a major regulatory challenge that undermines customers' confidence in the
sector. The adverse impact of this challenge was manifested in a recent setback that the Islamic
retail banking market in the United Kingdom suffered. In October 2012 HSBC decided to close
down its Islamic retail banking operations (HSBC Amanah) in the United Kingdom and this is an
indication of serious problems. Clearly HSBC Amanah could not capture the interests and
confidence of its prospective customers, which was reflected badly in its profitability and led to
the withdrawal decision. 4 Some experts attributed this to the lack of confidence in the integrity
of the products and to legal complexities and overheads.5 Also, there are some further indications
that other major Islamic retail banks are not quite securing their customers' confidence. The
Islamic Bank of Britain has stopped offering any form of Islamic personal finance and only
keeping an Islamic mortgage that has its regulatory framework incorporated in the Combined
View 6 (previously this was a part of the FSA Handbook ).

During this important phase of regulatory reforms in the United Kingdom it is expected that
attention must be paid to the legal and regulatory needs of Islamic banking. However, this article
argues that the regulator cannot deal with these challenges on its own and that participants in the
Islamic retail banking sector should have a collective role in addressing these challenges. The
Islamic law compliance aspect of the business restricts the areas in which the regulator can have
a direct regulatory input. Hence this article argues that because of this, participants should
develop a system of self-regulation in which soft law is a centrepiece. Such a system will
become an essential part of any regulatory framework concerned with the business of Islamic
banks.

This article analyses certain aspects of this proposal in the light of the findings of a limited
number of interviews that have been conducted by the author with some of the main participants
in the Islamic banking sector in the United Kingdom (see Appendix). This article suggests that
the creation of a code of practice for Islamic retail banks is a major step in the right direction. In
addition to improving consistency, this step will help the regulator form a coherent legal and
regulatory framework for Islamic retail banking by incorporating these voluntary rules within its
framework.

In order to advance this argument this article, first, draws on the role that self-regulatory systems
and their soft law components play in the financial sector. Second, it introduces the main
concepts of Islamic banking and finance and it briefly charts the development of the Islamic
retail banking sector in the UK market. Third, in the light of the empirical data it highlights the
main challenges in relation to Islamic retail banking in the United Kingdom, and draws on the
positive role that soft law can play in this context without failing to address the shortcomings of
this proposal.
THE RELATIONSHIP BETWEEN THE FINANCIAL SECTOR, SOFT LAW AND SELF-
REGULATION

The concept of soft law is rather problematic as the meaning and nature of soft law have been
widely debated among academics.7Defining soft law has not proved to be a simple task because
there is not a unanimous agreement among legal scholars regarding the meaning or the nature of
soft law.8

It has been argued that soft law poses a conceptual challenge. On the one hand, the name, soft
law, suggests that it is a type of law with 'a slightly decreased or inferior value'. 9 On the other
hand, one of the main criteria of any law is the binding powers of its rules, which the rules of soft
law lack. Therefore, the use of the term 'law' in this context is imprecise and has created an
oxymoronic term.10

Nevertheless, it must be noted that those who refuse to attribute any legal status to soft law
norms still accept that these - non-legal - norms have regulatory functions. 11 Further, it has been
suggested that soft law cannot be completely relegated to the category of 'political' or 'moral'
rules. Especially because political or moral rules are 'very abstract and general' while soft law
often does not lack the sophistication of a legal regime. 12 Therefore, it has been suggested that
soft law is a force in its own right. This point is based on the non-coercive nature of soft law and
its persuasive power.13 According to network theorists the high level of collaboration and
communication that the introduction of soft law norms requires is what provides soft law with its
presumed force.14

Despite the complexity of the subject there are a number of evident points in relation to soft law.
First, soft law has been primarily associated with international law and more specifically
international financial law. Second, soft law is not confined to only one form as it comes in
several varieties. 15 Third, an intermediary body between the interested parties is normally
required to facilitate the process of soft law creation. Finally, soft law is the centrepiece of any
self-regulatory regime. Examining thoroughly these facts and their inter-linkage helps develop an
informed perception of the applicability of soft law and self-regulation in the context of Islamic
banking regulation.

Soft law and international financial law

In the new era of the global economy it is difficult to envisage the financial sector, in any
national economy, as a domestic entity restricted by its traditional geographic boundaries.
Financial institutions around the globe are interconnected through the international capital
market. This new feature has its great benefits;16 however, at the same time it poses a great
jurisdictional challenge. This is because the impact of any legal and regulatory deficiencies in a
particular country will not be limited to its domestic financial market. Rather, it will spill over to
other connected markets around the globe. Therefore, having a watertight legal and regulatory
framework on the national level would not necessarily mean that the domestic financial market is
ring-fenced.

There are two underlying aspects to this regulatory challenge and they are connected. First, the
dominant presence of a global economic sphere in which all financial markets are linked but not
necessarily in a harmonious way. Second, cross-cultural sensitivity that is inherent to such
environment and adds further difficulty to the regulatory process.

Seeking to overcome the first aspect of this challenge by adopting a self-isolation policy would
prove rather impossible. The presence of this global economic sphere in fact is a part of an
economic evolution. Therefore, a policy that would detach any domestic financial market from
this global economic sphere would seem quite unrealistic. Further, being linked to this sphere
provides many financial advantages such as the easy access to capital, which, arguably, might
outweigh its negative effects. Accordingly, regulators should be willing to adopt policies that
mitigate the risks involved without disconnecting their economies from the new global economic
order. Soft law, on the other hand, can be used in this respect as a means to improve the level of
harmonisation between these financial markets. Soft law helps establish internationally accepted
standards that will be voluntarily adopted by these markets to ensure compliance with what
collectively has been considered as best practice.

This leads to the second aspect of the regulatory challenge, brought by the new era of global
economy, which is the issue of cross-cultural sensitivity that has a significant impact on any
harmonisation attempt. Culture as a general concept encompasses a set of social norms,
traditions and customs that shape individuals' behaviour within a nation and help it distinguish
itself from those outside. 17 It is rather important to note that the concept of culture has many
dimensions such as political, legal and social. This article focuses mainly on the concept of legal
culture as the most relevant dimension to the argument that it is perusing (promoting the
regulatory framework for Islamic retail banking in the United Kingdom through the use of soft
law).
Legal culture, as an imperative aspect of culture, describes 'stable patterns of legally orientated
social behaviour and attitudes'.18Accordingly, legal culture is what defines the nature, structure
and operations of a legal system.19

The problem with the current global economic architecture is that it creates a space where
different legal cultures interact and this raises the challenge of conflicting legal cultures. In this
respect, the use of soft law has proved to be quite effective as it does not undermine or discredit
any of these interacting cultures. Instead soft law creates a medium of moderation between these
different legal cultures that helps reduce conflict and reach an acceptable compromise. This
process is usually administered by an intermediary whose role is to utilise the collective intention
of the participants to create non-binding legally effective rulings. 20

The form in which soft law can be manifested is not limited. Soft law has different kinds such as
codes of conduct, guidelines, core principles and Memorandums of Understanding. 21 The process
in which each one of these forms is produced may vary, and this gives soft law the flexibility to
accommodate the needs of the participating parties whether they are nation states or international
organisations.

Unfortunately, the majority of the legal literature attributes the popularity of soft law in the
international financial context to elements such as cost and flexibility, 22 while it fails to recognise
its effective role in dealing with legal cultural sensitivity.

Soft law and self-regulation systems in the financial context

Admittedly all the above, prima facie , indicates that soft law is a primary feature of the
international regulatory system, particularly in the financial context. Nevertheless, the use of soft
law is not exclusive to international affairs as it could equally have a salient regulatory role to
play domestically. Senden captures this fact in her definition of soft law. She defines soft law as:

rules of conduct that are laid in instruments which have not been attributed legally binding force
as such, but nevertheless may have certain - indirect - legal effects, and that are aimed at and
may produce practical effects. 23

This definition does not limit the use of soft law either to nation states or the channels of
international law. Instead, it articulates the three key elements of soft law, which make soft law
useable nationally and internationally alike. First, its rules could target the conducts of States,
institutions or individuals; second, its instruments are not legally binding but have an indirect
legal effect; and finally, it may influence the behaviour of the participating nation states,
institutions or even individuals.

Often when soft law is being domestically used it is introduced through a system of self-
regulation in which it plays a salient role. Both concepts, soft law and self-regulation, bear more
than a passing resemblance and their interaction is rather complementary. It can be suggested
that soft law represents one of the essential means of any self-regulatory system. Self-regulation
is used domestically in relation to particular activities where they could be adversely affected by
a form of market failure and relying on the available instruments of private law has not proved to
be sufficient and cost effective. 24 Further, self-regulation is also relevant in a context where the
issue of cultural sensitivity, in its broad sense, could be a matter for consideration. Although, as
discussed earlier, the issue of cultural sensitivity, particularly its legal aspect, might have been
intensified by the global nature of economic and financial relations, it has always had a
significant domestic dimension. In countries with diverse cultures such as the United Kingdom,
the issue of cultural sensitivity has often been part of the legal debate that influences the legal
and regulatory process. 25

There are certain activities that are inherently exposed to some or even all the above factors and
to which self-regulation has proven essential. A good example is the financial industry where
self-regulation is regarded as one of the salient features of this sector. 26 It has been argued that
self-regulation has the ability to adequately accommodate the innovative nature of the financial
sector,27 and provide solutions where hard law falls short. The use of self-regulation in the
financial industry is usually associated with a number of soft law instruments, such as codes of
conduct and guidance documents. This is quite understandable as soft law contains certain
features that map onto two of the main characteristics of self-regulation, collective and voluntary.
It has been suggested that the term 'self' in self-regulation describes a collective intention rather
than an individual one. 28 This is the same kind of intention that empowers soft law rules; it is the
collective intention of the creators for these rules to 'possess a legal scope'. 29 Further, self-
regulation can be a form of regulation that is voluntarily desired by the industry with no active
involvement from the state.30 Therefore, agreeing on any form of self-regulation requires a self-
regulation agency31 that mediates between the interested parties, which is the same mechanism
that is imperative to the creation of soft law rules.

To sum up, the new global economic order has brought certain legal and regulatory challenges.
In this regard, soft law has proved to be an effective means in dealing with challenging issues
such as the conflict of legal cultures and the need for harmonised legal rules. However, soft law
is not exclusive to the international financial scene. On the domestic level, the financial industry
and the regulators, to a lesser extent, appear to prefer self-regulatory systems that utilise certain
elements of soft law (such as codes of practice or guidance principles) to regulate their practices.

THE THEORY OF ISLAMIC BANKING AND ITS APPLICATION IN THE UNITED

KINGDOM

The ethos of Islam is an integrated part of the business of Islamic banks. As their name suggests
Islam as an ideology governs the way in which these institutions conduct their business. Islamic
banks adhere in their operations to Islamic finance principles, which are derived from Sharia
(Islamic law). This has a significant impact on the type of operations that they are allowed to
carry out, which consequently distinguishes these institutions from their conventional
counterparts.

In this respect, the two most important Islamic rulings that shape the business of Islamic banks
are the prohibition of riba and the prohibition of gharar .

On the one hand, the prohibition of riba was generally and explicitly stated in the
Quran;32 however, the Quran does not explain what qualifies as riba . The explanation of the
meaning of riba can only be found in the Prophetic Sunnah. 33 The Sunnah has specified certain
types of riba concerning some of the main commercial transactions particularly in relation to sale
agreements. Yet the application of this prohibition in relation to the interest paid by conventional
banks is not solely based on a clear ruling in the Sunnah. Rather it is based on the legal analogy
and reasoning that Muslim jurists applied to the rules on riba in the Quran and the Sunnah.
Accordingly, the general understanding of riba , which includes conventional interest, is any
increase to the principal capital that is paid as a compensation for time only.

On the other hand, the translation of the word gharar would roughly include the reference to
gambling, uncertainty and deception. The prohibition of gharar can find its foundation in the
Quranic prohibition of gambling (mayser ) especially because gambling is associated with
excessive risk and uncertainty. In this respect, the Quran states 'they ask you about wine and
gambling; say, in both of them is great sin and some profits for men, but the sin is greater than
the profits'. 34 However, the term gharar was not referred to in the Quran in the commercial
context.

The Prophetic Sunnah refers to gharar in a number of contexts denoting deception, peril,
jeopardy and hazard.35 In the Sunnah the word gharar was also associated with the transaction of
sale where the Prophet explicitly forbade the 'gharar sale'. The abstract definition of
the gharar sale is 'any sale that incorporates a risk that affects one or more of the parties of the
contract and may result in loss of his property'.36

Muslim jurists have associated gharar with selling transactions that include the factor of
uncertainty. Hence, gharar covers both the unknown and the doubtful and 'it obtains where
consequences are concealed'.37 Such uncertainty and ambiguity represent the unacceptable level
of hazard (excessive risk), which is prohibited originally in gambling and applies to all
commercial and financial transactions.

The prohibition of riba and gharar represent the core principles of Islamic finance, which

Islamic banks must observe in their business. They, therefore, cannot charge interest; instead,
their transactions must be based on the principle of profit-loss sharing in a joint venture. Further,
these business ventures should not entail a high level of risk, uncertainty and speculation.

The UK experience with retail Islamic banking

In reality, the operational differences that Islamic finance principles bring have not prevented
these institutions from expanding globally. The United Kingdom is one of the main international
financial markets where Islamic retail banks have been present for a while.

Al Baraka International Bank Ltd was one of the very early Islamic financial institutions to offer
Islamic retail banking services in the City of London. Al Baraka started its operations in the
United Kingdom after taking over Hargrave Securities, in 1982, which was originally licensed as
a deposit taker at the time. However, the boom period of Al Baraka's business started in the late
eighties towards the early nineties. By 1991 Al Baraka extended its network of branches to
include two new branches in London, on Whitechapel Road and Edgeware Road, and a branch in
Birmingham. 38 Despite that, this was a relatively short-lived success as Al Baraka International
Bank Ltd announced its decision to discontinue its business on 31 March 1993 and closed its
branches in the United Kingdom.39 This was after it failed to reach an agreement with the Bank
of England over the ownership structure of its institutions.40

However, this did not stop other high street banks from offering Islamic retail banking services
through what it is known as 'Islamic windows'. Further, in 2004 the banking market in the United
Kingdom witnessed the return of specialised Islamic retail banking. The Islamic Bank of Britain
was authorised in August 2004 by the FSA, the regulator at the time, as the first stand-alone
Sharia compliant retail bank in the United Kingdom. 41
REGULATING ISLAMIC BANKING IN THE UNITED KINGDOM

An overview of the banking regulatory framework in the United Kingdom

On the 1st of April 2013 the United Kingdom went through a regulatory switch over between the
FSA on the one hand and the FCA and the PRA on the other. The following discussion addresses
this regulatory change.

Before April 2013

As 'authorised persons'42 Islamic banks operating in the United Kingdom are no different from
their conventional counterparts in terms of their regulatory treatment. They are subject to the
same legal and regulatory framework that governs the conventional banking market in the United
Kingdom.

The FSA always maintained that its aim was to create a level playing field for all financial
institutions. Therefore, the FSA adopted a 'no obstacles, no special favours' approach in dealing
with Islamic banks.43

Since its creation the FSA relied, in its regulatory framework, on 'principle-based' regulations.
This meant that the FSA was mainly concerned with setting rules, which were expressed at a
high level of generality. In terms of their legal power, these principles were treated as rules and
their breach would, consequently, provoke the FSA's intervention. However, some of these
principles only described the aims that they tried to achieve without prescribing the methods of
attaining the aspired outcome. 44 The participants in the industry were entrusted with the
implementation of these principles.

This is not to say that there were not any detailed rules within the FSA regulatory framework.
The FSA was empowered by the Financial Services Market Act 2000 (FSMA) with legislative
functions that were, to a certain extent, exercised in the FSA Handbook . FSMA s2 (4a-d)
prescribes these legislative functions as following: making rules, making codes, giving general
guidance, determining the general policy and principles.

Despite the FSA's power to make secondary legislation, not all the material in the handbook was
the product of these legislative functions.45 The handbook also adopted standards of good
practice that were first introduced by the industry in voluntary codes.
There has been always a convincing argument in favour of the important role of self-regulation
especially when it is compared to externally imposed regulations. 46 Self-regulation is often
introduced as a response to the practical needs of the industry. It provides the required level of
guidance without being intrusive or overburdening and, most importantly, is generally introduced
in line with the participants' timetable. Nevertheless, the effectiveness and the enforceability of
self-regulation have been questioned as it mostly lacks the required underlying legal support. 46

As mentioned earlier, in the wake of the 2008 crisis the FSA started to move from its hands-off
regulatory approach. Therefore, in view of the above and particularly in relation to retail
banking, the FSA, in November 2009, introduced a statutory regime for retail deposit taking
replacing the self-regulatory framework (which was made of the Banking Code and the Business
Banking Code). 47 The BCOSC - alongside the Payment Services Regulations 2009 that came in
force on 1 November 2009 - was thought to create the new Banking and Payment Services
Regime.48

The BCOSC combines some new high-level rules and the already existing conduct of business
rules and guidance that were previously applied voluntarily by the industry to deposit taking. 49 In
other words, almost all aspects of the two Codes were implemented by the BCOSC and what has
been left out of the BCOSC, such as lending, is now subject to a form of self-regulation 'the
Lending Code', which is enforced by a new 'Lending Standards Board'. 50

As can be seen these industry voluntary rules cannot be described as soft laws any longer as they
became part of the regulatory framework ,which was policed and enforced by the regulator.

As to what applies to Islamic retail banking, the FSA, as stated earlier, did not provide a special
framework for Islamic banking except on some very rare occasions. The only aspect of the
business that was addressed particularly by the FSA was Islamic home finance.

The FSA Handbook included some general rules and guidance in relation to Islamic mortgages
under what is known as Home Purchase Plans (HPPs). Apart from that the handbook did not
contain any similar rules or guidance in relation to the other unique products that Islamic banks
use in their day-to-day business.

After April 2013

As mentioned above, as a part of a major regulatory reform in the United Kingdom the FSA has
been replaced by two new regulators: the PRA, a subsidiary of the Bank of England, and the
FCA, and the FSA Handbook has been divided between these two authorities according to their
roles. The FCA is set out to take a more interventionist approach than that of the FSA in
conducting its regulatory role.51 All the business conduct regulation sections in the FSA
Handbook have become a part of the FCA Handbook , for instance the BCOSC.

In relation to Islamic retail banks, it is not expected that the FCA will have a different approach
from that of the FSA's 'no obstacles no special favours'. The provisions of the HPP (Islamic
mortgage) are now part of the Combined View that 'combines the FCA Handbookand PRA
Handbook in a single view and it is not a Handbook in its own right'. 52 Also, the FCA includes in
its handbook specific provisions on responsible financing of HPPs.53

Islamic banking, soft-law and self-regulation: Prospective and challenges

Although the FSA stance, which probably will not change with the FCA taking over, was that the
current regulatory framework is capable of catering for Islamic banking business, there are
certain facts that could challenge this standpoint.

Islamic banking products are based on Islamic finance principles that have been briefly
explained earlier in this article. The main feature of these principles is that they are general, thus,
their application in the context of banking and finance is open to interpretation within a
particular methodological framework known as usul al fiqh (Islamic jurisprudence). Therefore,
within the same market the same product could be structured differently and described by each
institution as the most Sharia compliant product available in the market. This eventually impacts
adversely on the level of certainty and consumer confidence in the Islamic banking sector in
general.

The Islamic characteristic of these institutions represents an inherent risk to their business. The
legitimacy of Islamic banks depends on their observance of Islamic law and any questionable
adaptation of its rules would undermine their position in the market. Accordingly, the issue of
standardisation of practices has been the focus of different international initiatives led by some of
the main international standards setting organisations for Islamic financial institutions, such as,
the Islamic Financial Services Board (IFSB) and the Auditing and Accounting Organisation for
Islamic Financial Institutions (AAOIFI). These institutions have been successful in using soft
law, in its international sense, effectively. The IFSB for example has introduced many sets of
standards that have been implemented by its central banks members such as Bank Negara
Malaysia. On the other hand, domestically, the use of self-regulation and the tools of soft law in
the context of Islamic banking regulation have been very limited. There is hardly any example
where the Islamic financial industry in a particular jurisdiction has developed a self-regulatory
system that harmonises its practice, especially where the regulator is not capable of interfering in
this regard. Considering the history of Islamic banking and finance in the United Kingdom, there
might be a good opportunity for the industry to start developing such a framework. It is an
argument worth exploring taking into account its role in promoting certainty and improving
consumer confidence.

The size of the UK Islamic retail banking sector is relatively small yet there are still many
disagreements among its participants regarding the structure and compliance of their products.
Take for example the offering of Islamic mortgages in the United Kingdom. Before the
introduction of HPPs regulation by the FSA, Islamic mortgage agreements varied in their
structure. Some institutions used mark-up contracts for home finance, which mean that the
Islamic bank would buy the property and resell it to the client who would pay the original price
and an added margin of profit to the bank. Other institutions used the vehicle of a lease
( ijara) that leads to ownership where the client would be given the option to buy the property by
the end of the lease agreement. This is normally done in a separate contract or a side letter.

Also, diminishing partnership and lease were used by some institutions to finance Islamic home
purchase transactions. This type of home finance was explained by HM Treasury:

the bank buys the property with the customer, who must contribute at least 10% to the purchase
price. The bank as provider has the legal title and holds the property on trust for himself and the
customer in the proportions contributed to the purchase price. The customer then purchases
additional 'units' from the bank every month, gradually increasing the customer's beneficial
share in the property. The customer also enters into a lease agreement and pays a monthly rental
on the share of the property beneficially owned by the bank (provider). The rent is typically
reassessed every six months. Legal title is transferred to the customer after all payments have
been made.  54

The FSA adopted this last form of Islamic home finance, described previously in the FSA
Handbook and now in the Combined View as HPP, as its regulated and recognised Islamic
mortgage. There is no doubt that the introduction of HPP regulation was a major step in the
regulatory development of Islamic retail banking in the United Kingdom. It reassures consumers
that their protection will not be jeopardised by the complicated structure of this mortgage. This is
because the regulation shows that the regulator understands and recognises the agreements that
are used in this form of home finance.
Nevertheless, Islamic financial institutions still differ in applying their HPPs, which clearly does
not benefit the quest for consistency in the Islamic retail banking market. For example, there is
no uniform way according to which the diminishing partnership agreement is executed. The
diminishing partnership contract ( Diminishing Musharakah ) is of great importance to the
Islamic mortgage agreement from a Sharia compliance perspective. It allows the bank to share
the risk with the client, which justifies the margin of profit that the bank is making through the
Islamic mortgage agreement.

A senior manager C1 in one of the leading Islamic banking retailers (C) in the United Kingdom
expressed the importance of this component of the Islamic mortgage agreement:

... type of Diminishing Musharakah contract, is that the bank and the customer are registered
title owners from day one ... what we have done, from day one we set up a trust, so ... the
property is registered in joint names. As the customer makes a monthly payment, within the
trustee document there is a physical transfer of ownership. So, if a customer took us to a court of
Law and said five years down the line how much of this asset do I own it would be clearly
distinguishable that the customer's share has increased and the bank's share has diminished.

He added that currently in the market some of the used HPPs do not apply a real diminishing
partnership (Diminishing Musharakah ):

if you look at ... [A]'s product when it was running and [B] ... . Well, [A]'s diminishing
musharakah looks like the Ijara with a side letter similarly [B]'s is an Ijara with a side letter and
we are the only ones with a separate trust.

Accordingly, although the regulator has provided the required framework for this product there is
still a level of inconsistency regarding its application in the same market. An important aspect of
this product - setting up a separate trust - is missing from some of the used HPPs in the UK
market.

This disparity, which is not only limited to HPPs but can also be seen in other aspects of the
business, leads to what could be described as Sharia compliance arrogance. This can be seen
when each institution describes its product as the only Sharia compliant product in the market
and discredits the other competitors' products. With the absence of any commonly agreed set of
standards that can be referred to, these exchanged allegations of Sharia non-compliance would
linger unsettled in the market. The long-term effect of this issue is quite worrying as it
undermines consumer confidence in the Islamic characteristic of this sector. This can have
significant adverse impact on these banks' performance and their profitability as evidenced in the
HSBC Amanah withdrawal from the UK retail banking market.

Further, it can be argued that the problem of Sharia compliance arrogance intensifies a particular
type of risk that Islamic financial institutions are exposed to on the distribution side of their
business. Senior manager C1 explained this risk:

... one of the inherent risks I believe exists within the distribution side of the business is now
what we say and how we say may be construed as just purely factual information. Five/ten years
down the line somebody could say well a particular scholar has completely contradicted what
your board said ten years ago. I have been mis-sold a product based on a value-belief system
and as such wish to seek compensation and that is something that we need to be careful about.
This is one of the issues that needs to be clarified and there needs to be an intellectual debate
around the subject as to whether or not Islamic Finance should be regarded as an advised or a
non-advised sale.

It can be argued that there is a fine line between preaching Islam and providing factual
information about the product and this line is what differentiates 'advised sale' from 'non-advised
sale' in the context of Islamic banking. Clearly the claim of offering the only Sharia complaint
products will not help reduce the institution's exposure to the risk of mis-selling compensations
where the sale could be easily construed as 'advised sale'. Therefore, as C1 rightly suggested, we
need to have defined in terms of how far you can go about talking about the compliance of your
product in the framework of Sharia .

There is no doubt that the above issues, among many others, should concern the Islamic retail
banking industry as they can be major hindrances to the development of the sector in the United
Kingdom. The key issue that must be addressed in this respect is finding the best way to respond
to these challenges. This requires identifying, first, the source of the problems and, second, the
most efficient solution.

Regarding the first step, the common element between the concerns raised above is that they all
stem from the lack of standardisation in the UK Islamic retail banking sector. Hence, there is a
pressing need for a more harmonised approach not only to the products' structure side of the
retail business but also to the distribution side as well. This leads to the second issue, finding the
most practical and effective solution. The nature of Islamic banking and the significant role of
Sharia in this respect make the direct regulatory intervention rather difficult. For instance, the
regulator has introduced the HPP regulation acknowledging the two main agreements, lease and
diminishing partnership, which the plan entails. However, it is rather difficult to expect the
regulator to describe the most Sharia compliant form in which the diminishing partnership
agreement should be executed. Understandably, the FSA kept its regulatory input, regarding
Islamic banking, to the minimum owing to its concerns about its status as 'a secular and not a
religious regulator' 55 , and it is highly unlikely that this will change after the FCA replaced the
FSA.

It can be suggested, therefore, that a self-regulatory system that include aspects of soft law is the
best available option for Islamic financial institutions to address their differences and promote
consumer confidence in the market. As discussed earlier, one of the main features of soft law is
its ability to deal with different aspects of the concept of cultural sensitivity. The use of soft law
may help Islamic financial institutions create a self-regulatory system that promotes the
harmonisation of the industry's practices regarding not only products' structure but also products'
distribution.

There are a number of facts in the United Kingdom that can be used in favour of this argument.
First, the size of the Islamic retail banking market is relatively small, which would allow any
initiative in this respect to be very inclusive. Second, the UK banking market already has a
recognised self-regulatory agency, the British Bankers Association (BBA), which can assist in
finalising this aspired form of self-regulation whether it is a code of practice or a guidance
document. The BBA has expressed their support of the idea. A1, a director at the BBA,
stated ... One thing we would support is some kind of retail code and ideally one that came from
the industry that was badged as the BBA. In principle we would have no objections . A1
explained that the BBA can help finalise clear and concise and easily implementable set of
standards. The BBA finds the idea in principle appealing from a commercial point view, A1
added ... it would be a useful selling point for them as well to say that they are adhering to
certain standards.

On the other hand, although participants in the UK Islamic retail banking sector accept that there
is a need to harmonise their practices, some are concerned with the cost of achieving this aim.
B1, a senior manager in institution B, which is one of the main conventional banks offering some
Islamic retail banking products, expressed this concern. B1 stated that ... we would, from my own
perspective, be happy to help on a reactive basis. We don't have that much resources at the
moment that we can turn towards proactive initiatives. One of the main factors that have
influenced B1's opinion was the fact that his institution offers a very limited number of simple
Islamic financial products. Therefore, institution B has a relatively small stake in the UK Islamic
retail banking market compared to other Islamic banking retailers. For example, C1, a senior
manager in institution C, which has a much bigger stake in the market, presented a more
comprehensive view that goes beyond the current position of his institution in the market. C1
stated:

To be honest, if we are going to build a viable and sustainable industry we have got to put our
differences aside and work together as participants because at this moment in time there are
enough critics out there who are looking to undermine the value, the benefit, the integrity and
the actual real defined need of this in the UK.

There is no doubt that costs might deter some participants from taking this initiative.
Nevertheless, the benefits that they would gain from introducing a form of soft law would
outweigh the initial costs. It can be argued that participants in the UK market should be
concerned with the long-term benefits that they will gain from having the only standardised
Islamic retail banking sector in Europe. A more consistent and coherent market would result with
higher demand from both customers and investors.

Finally, introducing a form of self-regulatory regime that includes elements of soft law for the
Islamic retail banking industry in the United Kingdom - whether a code, guidance or standards -
paves the way for the regulator to adopt these rules within its legal framework. The FSA did this
previously, in November 2009 the new statutory regime for retail banking business has
implemented certain aspects of the two Banking Codes, which were beforehand introduced and
voluntarily applied by the industry.

It can be argued that in the financial regulatory context a system of self-regulation provides the
necessary narrative for hard law. Robert Cover explains in his seminal article 'Nomos and
Narratives' the relation between law and narrative. 56 He states that 'No set of legal institutions or
prescriptions exists apart from the narratives that locate and give it meaning'. 57 It has been
suggested that the term 'narrative' has been used in Cover's article to 'indicate the stories that
provide legal rules with context and meaning'.58 In the context of Islamic banking, it is rather
difficult for the regulator to explore the stories upon which the legal rulings can be found
considering the Islamic characteristic of the sector and the secular nature of the regulator. While
on the other hand, the industry has the ability and the required knowledge to carry out this task.
Hence, the industry can contextualise these stories in a form of self-regulation, which constitutes
the essential narratives upon which the regulator can prescribe the law.

A PROPOSED ACTION PLAN

On the basis of the above, it is important to provide the narrative that informs any future
regulatory intervention in the Islamic retail banking market in the United Kingdom. The starting
point of this process could be the creation of a code of practice that is designed to reduce the
main inconsistencies that the market could be riddled with at the moment. A code of practice can
provide a set of rules that deals specifically with some of the main sources of the problem. Such
a code should consist of three main parts.

Part one should deal with products' structure. Participants should agree on the form in which
HPPs should be executed. Primarily they should establish the standards that ensure that the
diminishing partnership agreement is fulfilling its main purpose in terms of sharing the risk.
Further, they should identify the key forms of mark-up agreements that can be used to facilitate
personal finance that the UK Islamic retail banking market lacks at the moment.

Part two should be designed to deal with the problem of Sharia compliance arrogance. In other
words, it should mainly deal with the products' distribution aspect of the business. This requires a
clear agreement among the participants on the limits that must be implemented in relation to
their advice on the Sharia compliance of their products. The participants should provide the
criteria according to which they introduce their Sharia compliance information.

Also, the rules should disallow participants from discrediting the sharia compliance of the
products of their competitors as a part of their marketing strategy.

Part three has rather special importance as it should deal with the way in which this code should
be revised and updated. Although a small market has its advantages regarding the creation of soft
law (for example, by being inclusive and easier to reach an agreement) it has also some
downsides. One of the main problems is that in a small market a limited number of participants
will create the rules and design them in a way that serves their interests and, which could prevent
others from joining the market. Therefore, it is essential that participants agree on the
mechanisms that should be used to ensure that the agreed rules can be revisited and updated
regularly. This can be achieved through publishing an annual consultation on the voluntary code
that allows not only existing participants but also perspective ones to have their say. This annual
consultation and its outcome should be made public by an intermediary body such as the BBA.

The presence of such a code in the market provides the most needed regulatory foundation that
the regulator can adopt as a part of its regulatory framework. This step is important as it allows
policing and enforcing of the code by the regulator.
The regulator in the United Kingdom previously adopted voluntary industry codes, for instance
in relation to retail deposit taking, and consulting on doing the same in relation to its new
consumer credit regime. This approach can be extended to Islamic retail banking if such a
voluntary industry code, such as the one here proposed, is available.

CONCLUSION

The growth of Islamic retail banking in the United Kingdom is rather dependent on the
improvement of the underlying legal and regulatory framework. This is not wholly exclusive to
Islamic banking as the same can be said in relation to the development of any segment of the
banking sector in general. However, in the context of Islamic banking there is a pressing need for
further regulatory advancement. Discrepancies in participants' practices (products' structure and
distribution) and the lack of standardisation in the UK Islamic retail banking sector are
undermining consumer confidence. This consequently is not only affecting the sector's potential
growth but also threatening its existence. Moreover, the regulator's direct involvement is
primarily hindered by the fact that many of these regulatory challenges are rooted in the Islamic
characteristic of the business. This, to a certain extent, means that the regulator's role in this
respect is rather limited, which leaves the participants with the task of developing the suitable
regulatory framework.

Self-regulation and soft law have been widely used in the banking context internationally and in
the United Kingdom. Although there might be a shift in the regulatory approach towards a more
'rule-based' system, the standards set by the industry are still representing the foundation of the
imposed regulatory rules. For example, the BCOSC, which became part of the FSA Handbook ,
is largely made up of the self-regulatory rules (Banking Code and the Business Banking Code)
previously applied by the industry on a voluntary basis.59

In the context of retail Islamic banking, it can be suggested that it is the participants' task to
address the regulatory challenges stemmed from the application of Islamic law. Their collective
action can be materialised in the form of a self-regulatory regime that relies on certain elements
of soft law to provide the required standards to harmonise their practices.

The importance of such a step is that it paves the way for introducing more enforceable rules in
the future. The agreement among the participants on certain set of rules or standards provides the
required narrative for a more informed regulatory intervention. The regulator would be guided by
the industry's collective views on certain aspects of the business, which will certainly still protect
its position as a 'secular regulator'.
Although this initial step might seem costly to a number of participants in the UK market it has
many benefits that outweigh its costs. For example, it would provide the UK Islamic banking
market, especially the Islamic retail section, with features that none of the other competing
markets in the EU has. A coherent and consistent Islamic retail banking market is needed to
promote consumers' confidence. There is no doubt that consumer confidence especially in the
context of Islamic banking is a major element of success and prosperity, while the lack of it can
only diminish the chances of this sector in the United Kingdom.

Correspondence : Abdul Karim Aldohni, Newcastle Law School, UK E-mail:

a.k.aldohni@newcastle.ac.uk

Acknowledgements

I am grateful to Dr Alison Dunn for her useful comments on this article.

References

References and Notes

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59. This part of the code could also deal with the corporate governance challenge that Sharia
Supervisory Board poses in relation to the structure of the Islamic financial institution.