ReutersBy Y-Sing Liau
KUALA LUMPUR, Dec 18 (Reuters) - Malaysia launched the world's first sharia interbank money market and popularised interest-free bonds to establish itself as a leading centre for Islamic finance, but its legal system is struggling to keep up.
Malaysia is not alone. Rival Middle East centres in the $1 trillion sector are also finding that their legal systems are ill equipped to deal with Islamic finance cases as the market grows at a furious pace.
The issue, bankers and lawyers say, is that Islamic economics have a different premise from conventional banking and applying the same legal principles to decide disputes for both markets does not work.
Unlike conventional banking's capitalist conviction that winner takes all, Islam argues for a fair distribution of profit and loss and bans purely speculative activity.
"Strong legal systems give birth to strong banking, strong corporate markets and that will then be able to attract more foreign direct investment (FDI)," Rafe Haneef, managing director of Fajr Capital in Kuala Lumpur, said.
"FDI will come to markets where there is strong corporate governance and therefore a strong legal system is required."
To be sure, few legal disputes have reached Malaysia's high courts. In fact, only 20 cases have come before them in as many years, estimates Megat Hizaini Hassan, a Kuala Lumpur-based lawyer.
The government has not announced any specific steps to deal with the issue, but there are signs it is rising up the political agenda.
"Dispute resolution mechanisms should also be more accommodative to the application of Islamic legal rules and methods in order to avoid embarrassment to Islamic banking cases as a result of incoherent and anomalous legal judgments," Deputy Prime Minister Najib Razak told an industry forum in November, making him the highest ranking government official to sound an alarm over the problem.
Malaysia has carved out a position as the world's largest Islamic bond market, with $66 billion, or 62.6 percent, of global outstanding sukuk issuance as of the end of June.
CONTEXT
Islamic finance is based on the sharia, or Islamic law.
It avoids the interest-based formula of conventional banking and argues that gains must be derived from ethical investing and for profits and losses to be shared between venture partners.
Most Middle East Islamic financial centres use the sharia as one element of their law. They also use other sources of law, such as French law.
But Malaysian law does not draw on sharia. Islamic banking matters are heard in civil law courts staffed by judges who are not formally trained in sharia.
Jal Othman, a Kuala Lumpur-based Islamic banking lawyer, estimates that no more than 10 of Malaysia's 12,000 or so lawyers are experts in Islamic finance. Fewer than 10 judges, or less than a tenth, are skilled in the subject.
"You don't have sufficient precedent which means there may be time bombs ticking," Jal said.
A 2006 mortgage case, the outcome of which was reaffirmed in a recent judgment, highlights the clash between two sets of legal principals confronting Malaysia's court system.
A Malaysian court ruled that if an Islamic home mortgage is terminated prematurely, the lender cannot claim for the unaccrued instalments because they have not fallen due yet.
The loan was given based on a popular Islamic finance structure in Malaysia called bai bithaman ajil in which a bank first purchases a house before selling it to the client at a profit.
Islamic finance experts argue the civil court decision did not reflect the principles of the Islamic finance agreement, which created a contract from the outset where the customer has to repay the bank the entire sum, including the cost of the asset and the profit margin.
"This bai bithaman ajil concept is very heavily used in the housing loan market," said Rasheed Khan, a lawyer. "The sooner this is resolved the better because otherwise it creates a bit of uncertainty."
But reflecting the fractured nature of the Islamic finance market, the bai bithaman ajil structure is not used in the Middle East because it is viewed as too closely resembling interest-based financing.
WHAT SHOULD BE DONE?
Lawyers and academics have suggested Malaysia employ judges skilled in sharia banking law or create special courts to hear Islamic finance cases.
Some Islamic bankers suggest courts should be required to seek the guidance of Malaysian central bank sharia advisers when deciding Islamic finance matters. The central bank has not commented.
"Decisions of the civil court, however powerful they may be, must consider the fact that the underlying basis of the Islamic banking raison d'etre is to observe the sharia," Ahmad Hidayat Buang, an Islamic law expert wrote in a law journal.
Even in the Middle East, where the legal system is much more sensitive to sharia, other issues arise.
In Saudi Arabia, which uses sharia as the only basis for its legal system, Islamic banking disputes are dealt with by a central bank panel, not a sharia court.
This was because of a view that the court may be expert in sharia, but judges are often not expert enough in banking, said Ayman Khaleq, a Dubai-based Islamic finance lawyer.
"Sharia knowledge alone is not the answer. Civil and commercial law knowledge is not the answer. A combination of the two is," he said. (For more Reuters coverage of Islamic finance, click on [ID:nISLAMIC]) (Editing by Neil Fullick)
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