Islamic finance and insolvency: Growing need for a safety net
February 27 2018 10:55 PM
Delegates talk at the Malaysia International Islamic Financial Centre (MIFC) booth at the Global Islamic Finance Forum in Kuala Lumpur on September 3, 2014. Malaysia’s Islamic Financial Services Board (IFSB) is developing a detailed guidance on financial safety nets in case of insolvencies and bankruptcies to help harmonise Islamic principles with existing legal systems.

By Arno Maierbrugger/Gulf Times Correspondent /Bangkok

Bankruptcy, insolvency and restructuring in Islamic finance can be tricky issues in terms of Shariah compliance, particularly due to the risk-sharing nature of Islamic debt and in terms of legal proceedings.
The status quo is that insolvency or bankruptcy in Islamic finance is not clearly covered by a comprehensive regulatory or legal framework in any Muslim country as of today. The Islamic principle of insolvency or inability to repay debt, iflas, stipulates that debt cannot be written off unless there is specific “forgiveness” by a creditor. Under this principle, there is no voluntary or unilateral provision for insolvency or bankruptcy – the terms are interchangeable in Islamic finance –, but it requires a resolution by an official authority, normally a Shariah board or an Islamic court.
Two factors are making a closer view into this very topic necessary. One is the speed and scale at which Islamic finance products and services as well as Islamic financial institutions are expanding into new jurisdictions across the world; the other one is the changing nature of the global economy where new businesses are increasingly disrupting old-school operations and lead to mergers, acquisitions or wind-downs of entire corporations with subsequent liquidation or restructuring, and the Muslim world is not insulated from this in any way. 
This brings with it a consequential risk of the rise of defaults, insolvencies and bankruptcies which requires preventive regulations for Islamic finance debt transactions in order to protect the interests the rising number of creditors, investors and other stakeholders.
The Islamic finance industry, although seen as being generally more robust than its conventional counterpart, is not immune against macroeconomic events and financial shocks that can lead to liquidity problems and defaults. Since Islamic finance discusses debt default often in the context of sukuk, the insolvency and bankruptcy problem can best be illustrated best by the mechanisms of a sukuk default. In principle, sukuk are not debts from an issuer, but joint proportional interests in underlying assets. This arrangement is ideally meant to insulate the sukuk from default and provide a profit-and-loss sharing structure in which all involved parties are interested in the success of the venture.
However, sukuk can fail for reasons such as sloppy legal arrangements, for example when the underlying assets are not really tangible but just guaranteed by contract (asset-based vs. asset-backed), for poor credit risk, for poor liquidity, for over-reliance on short-term debt, for scholarly reasons (like in Dana Gas’ sukuk case in the UAE), in case assets get frozen or simply when fraud occurs.
Questions arising in the case of insolvency can be complex, such as the extent to which one class of creditors may claim preference or priority over others, what options are viable for restructuring, whether corporations can refer to limited liability, if applicable, or have to tap stakeholders to repay the debt.
While in conventional finance such problems are all subject to legal definitions and proceedings – a good example is Chapter 11 of the US bankruptcy code –, in Islamic finance this is not the case. But while the profit-loss-sharing structure of most Shariah-compliant transactions may give a feeling of greater stability of an Islamic debt investment, sukuk defaults and the number of other Islamic debt cases come before courts. This disputes the idea that Islamic finance debt arrangements are safe from default as per their nature.
Given the fact that Islamic finance asset are now valued at more than $2tn globally, which is about 15% of the world’s total bank assets, they have become systemically important in a number of countries. Thus, it is of utmost macroeconomic interest that regulators have to seriously consider an Islamic bankruptcy regime at all levels of the industry. It would, in general, provide better and less complicated options for restructuring and default resolutions in Islamic finance jurisdictions and in the process attract more institutional investors looking for alternatives to conventional financing since most of them are legally bound to put their money only in investments which have clearly-cut legal foundations with regards to debt risks.
In a latest initiative, Malaysia’s Islamic Financial Services Board (IFSB), one of the most influential regulatory bodies in the Islamic finance world with 185 members, including regulators, central banks and commercial banks all over the Islamic world, is developing a detailed guidance on financial safety nets in case of insolvencies and bankruptcies to help harmonise Islamic principles with existing legal systems. 
In its 2018 agenda, the IFSB discusses the implementation of such safety nets for Shariah-compliant transactions, deposit insurance, dispute resolution, restructuring options and guidance for bankruptcy proceedings. The aim is to provide universal and comprehensive guidelines regarding the implementation of a Shariah-compliant legal framework for insolvencies and bankruptcies for IFSB members, which also include Qatar’s central bank, the country’s financial market supervisory authority, its financial market regulator and its largest banks.

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