The issue of information asymmetry is a predominant concern in the financial intermediation world. Information asymmetry can result in exploitation, misselling (deceptive practices) of any financial product, and unfair treatment of customers by financial institutions, including banks. There are ultimate financial (e.g., legal and Shari’a non-compliance risk) and non-financial (e.g., reputation risk) consequences. Given the specificities of Islamic finance, it is not merely a fundamental right of the customer to obtain accurate and unbiased information about the products and services they buy from an Islamic bank but is also an ethical obligation of the bank as an Islamic financial institution. This enables the customer to make the best choices based on their welfare and precludes them from being victimized or deceived by the bank.
In this respect, the following key questions emerge which are discussed in this article:
- Whose responsibility is it to ensure consumer protection for customers?
- What is the applicability to Islamic finance of the measures for financial consumer protection in the conventional system?
- What are the key pillars that any supervisory authority can consider as fundamental for setting up an effective consumer
protection regime for Islamic finance in its jurisdiction? and
- Are there any prerequisites for setting up a consumer protection regime?
Foremost, let us understand from a regulatory perspective, how consumer protection works, mainly, in a dual banking system, and what key developments for consumer protection are.
On the prudential side, banking supervisors (usually central banks) while wearing two hats, focus on promoting the safety and soundness of financial institutions including Islamic banks. At the same time, they are also responsible for market conduct focusing on the relationship between banks (including Islamic banks) and their customers; protecting customers, enhancing the integrity of the financial system and promoting competition and efficiency in the interest of customers. Particularly, as Islamic finance is gaining significant market share (as noted below) in many jurisdictions, therefore, it is becoming imperative for central banks to ensure that Islamic banks operating in their jurisdiction provide reasonable assurance to the customers such as:
- The right to safe, secure and efficient service concerning financial products and services;
- Freedom to choose without undue influence or aggressive marketing;
- Complete access to accurate and full disclosure of terms, including in financial promotions (e.g., transparency, no abuse of
- technical language and avoidance of ‘infoxication’ or information overload);
- Freedom to provide feedback, make complaints and seek redress/resolution of disputes under fair treatment (bank level, supervisory level or at the state or federal level);
- The right to have information on the deposit protection limit, calculation and mechanism of sharing profits (fairness and equity) under various Shariʿa-compliant contracts; and
- Promotion of financial literacy and capability to understand and effectively use various financial skills, to make sound financial choices.
However, in a dual banking system with a sizeable Islamic banking component, the banking supervisory authority role is more complicated as the supervisor is required to supervise two sets of banking institutions with different risk characteristics, while ensuring a consistent regime and a level-playing filed. Thus it becomes even more challenging for the banking supervisor to issue detailed guidance for the Islamic banking sector on any particular prudential issue when even the conventional banks have no such guidance in the first place.
In the aftermath of the Global Financial Crisis (GFC), issues of information asymmetry, misselling of financial products and unfair treatment of customers, and the need for consumer protection have attracted attention from governments and international standard setters in the period, particularly as consumers faced more sophisticated, unique, and complex financial products and markets. Financial consumer protection has also gained prominence in the political agendas of governments and international standard-setters such as the Basel Committee on Banking Supervision (BCBS), International Organization of Securities Commissions (IOSCO) and International Association of Insurance Supervisors (IAIS). Moreover, the issue has also been taken up by the Organisation for Economic Co-operation and Development (OECD) and the G20, which has issued the G20 High-level Principles on Financial Consumer Protection. The Islamic Financial Services Board (IFSB) has addressed this issue in several publications as noted below.
More recently, the COVID-19 outbreak has brought a range of potential implications for all types of financial institutions, including Islamic banks. In such times, however, financial digitalisation has been accelerated, and this calls for the increased vigilance and capability of Islamic banks to respond to emerging threats (e.g., cybersecurity risk for banks and their customers). The IFSB in its Exposure Draft 23 recognises this development and stated that with the more prevalent use of technology in providing financial services, there is a need for Islamic banks to strengthen their technology and cyber resilience against operational disruptions to maintain confidence in the financial system.
From financial stability and supervisory perspective, financial consumer protection is needed to ensure that consumers receive adequate and easy-to-understand information and are not subjected to unfair or deceptive practices. For Islamic banks, this will be particularly critical in managing the peculiar risks inherent in a rapid increase in the number of consumers using formal accounts and in the introduction of new products and mechanisms for using these accounts. Therefore, it is imperative to build trust and understanding to encourage responsible and informed use of payments, savings, credit and insurance (Takaful) products. In this context, the existence and enforcement of appropriate consumer protection regulation becomes highly relevant in the jurisdiction to ensure transparency, impartiality and reliability as consumer protection best practices.
According to the recently released Cambridge Global Islamic Finance Report 2020-21, within Islamic finance, the Islamic banking segment remains the most dominant with around 75% of Islamic financial assets. According to IFSB, the Islamic banking sector is categorised as systemically important domestically in 13 jurisdictions – Bahrain, Bangladesh, Brunei, Djibouti, Iran, Jordan, Kuwait, Malaysia, Palestine, Qatar, Saudi Arabia, Sudan, and UAE – where the market shares of Islamic banking have reached 15% and above. If we include Pakistan and Oman, both close to 15%, the list becomes 15 jurisdictions. Collectively, these jurisdictions account for nearly 92% of the global Islamic banking assets. These developments highlight the relevance of consumer protection.
While the above developments allow the Islamic banks to further expand their financing avenues, achieve higher growth rates, and improve their profitability, they also raise concerns on the effectiveness of the consumer protection regime in the respective jurisdictions and on ensuring sustainable financial inclusion in the long-run. This article, with the scope confined to the Islamic banking sector, sets out several pragmatic institutional arrangements with a set of recommendations to ensure that the Islamic banking sector develops in accordance with consumer protection standards such as those issued by the IFSB and that individuals and firms have access to full and transparent information on Islamic financial services and products.
Broadly, all measures for financial consumer protection in the conventional system are also applicable in Islamic finance, with minor adjustments due to the Islamic finance providers’ specificities. However, a few additional dimensions the regulators of Islamic finance have to consider – including notably the claim of Shari’a compliance as an essential and distinguishing product feature. The most effective instrument for ensuring Shari’a compliance is a robust Shari’a governance system within the financial institutions.
In light of this, the IFSB has issued guidance on consumer protection in Islamic finance in its IFSB-8 (Conduct of Business), IFSB-10 (Shari’a Governance), and IFSB-22 (Transparency and Market Discipline Disclosures), Technical Note on Financial Inclusion for Islamic Finance (forthcoming) and two working papers on Consumer Protection for Islamic Banking and Takaful. There are other Shari’a-compliant specificities (as presented below) – in the financing business, deposit business and damage containment for Islamic banking consumers, including Islamic specificities in dispute resolution and damage containment in (near) failure cases – which require some consideration while establishing a robust consumer protection regime for Islamic finance providers.
BROADLY, ALL MEASURES FOR FINANCIAL CONSUMER PROTECTION IN THE CONVEN- TIONAL SYSTEM ARE ALSO APPLICABLE IN ISLAMIC FINANCE
10 Key Pillars of an Effective Consumer Protection Regime
The following key pillars can be considered by any supervisory authority as fundamental for setting up an effective consumer protection regime for Islamic finance in its jurisdiction (see Diagram 1).
First and foremost is that the supervisory authority or regulator should review and assess its legislative framework (legal, regulatory and supervisory framework) to ascertain whether it sets out consumer protection objectives and responsibilities regarding the conduct of business regarding Islamic banking products and services and whether it provides a clear definition of the scope of consumer protection mechanisms (consumers vs retail investors). This will identify the legal gaps and formalities to be addressed in establishing an effective consumer protection regime in the country.
Second, it is essential to review and assess the institutional structure (role of an oversight body) to examine whether it provides the supervisory authority with a mandate, authority and resources to make, supervise and enforce (whether directly or indirectly) conduct of business requirements for Islamic banking in an objective, timely and fair manner. This means reviewing the explicit and clearly defined responsibility of oversight bodies for financial consumer protection and assessing whether they have adequate powers, resources and capabilities.
Third, supervisory authorities should make attempts at collecting, analysing and reporting on consumer trends in the country as regards the Islamic banking sector for existing financial activities, including whether all contract and promotional material relating to Islamic banking products is fair, clear and not misleading. It is an essential role of Islamic banks to ensure the Shari’a compliance of such material. Next, review and assessment should be undertaken of both:
- product regulations (e.g., restriction of distribution channels and a ban on particular products such as derivatives which are a potential threat to financial stability); and (b) conduct regulations that address problems of information asymmetries and conflicts of interest, and competition.
Fifth, an essential component of ensuring an effective consumer protection regime in the jurisdiction is assessing the effectiveness of a compliance culture among providers of Islamic banking products and services (e.g., among other things ensuring Shari’a compliance through the implementation of a robust Shari’a governance system such as that proposed in IFSB-10) as required by the supervisory authority, in line with the international standards such as those of the IFSB.
Sixth, reviewing whether Islamic banks offering consumer or retail products are subject to requirements for fair treatment of customers in line with the international standards such as those from the IFSB, including:
- Regard to information needs of consumers and information on mediation and advice bureaus for investors and customers set up by Islamic finance providers;
- Responsible business conduct of Islamic financial services providers and avoidance or management of conflicts of interest;
- Training and competence requirements for those advising consumers;
- Establishment and maintenance of processes for complaint handling and redress (i.e. steps to follow when filing a complaint against an Islamic finance provider’s products or services).
Seventh, reviewing the adequacy of existing disclosure rules benchmarked against the international standards such as those issued by the IFSB (IFSB-8 on Conduct of Business and IFSB-22 on Revised Transparency and Market Discipline Disclosures) on Islamic banking products and risks and reviewing the need for developing common disclosure rules for consumer protection.
Next, supervisory authorities should review and assess Shari’a-compliant specificities in:
- Shari’a compliance as a defining product feature;
- The financing business such as product features (from recommended to mandatory), specific product restrictions, general suitability of products for retail clients, ban on specific products and restriction of distribution channels, and conduct regulation;
- The deposit business such as better explanation and disclosure of smoothing practices including the formation and utilisation of profit equalisation reserve (PER) and investment risk reserves (IRR), disclosure in analogy to collective investment schemes, quasi risk-free and quasi fixed-income term deposits on a wakala basis, murabaha- based term deposits which offer a fixed return, and strict separation of risk-free Islamic deposits and risk-taking investment accounts; and
- Fair treatment in disputes and damage containment for Islamic banking customers, including Islamic specificities in dispute resolution and damage containment in (near) failure cases. The dispute resolution and damage containment procedures should be in accordance with Shari’a rules and principles.
Ninth, supervisory authorities should review the protection of consumer data and privacy and protect of customers’ assets against fraud and misuse (customers’ deposits, savings and similar financial assets to be protected, in particular, against fraud, misappropriation and other misuses).
Finally, supervisory authorities should review financial literacy, awareness and education initiatives and programmes, and review the need for developing training standards for the industry, and the role of financial consumer advice institutions in the country.
Additional Considerations – Address- ing Key Prerequisites
For the implementation of the above ten pillars, several prerequisites are essential for the successful establishment of a consumer protection regime for Islamic finance in dual banking systems:
- Within the financial safety nets (i.e., lender-of-last-resort and deposit protection), a key element of the framework for systemic protection is a Shari’a-compliant deposit insurance scheme designed to apply to unrestricted profit-sharing investment accounts (PSIA), which can contribute to public confidence in the system and thus limit contagion from Islamic banks in distress. The business model of Islamic banks calls for certain adjustments in how such a scheme should be structured for fund providers, mainly PSIA. This requires careful consideration of Shari’a-based issues by supervisory authorities.
- In the context of proposed regulations on consumer protection, the enhancement of the supervisory review and evaluation process (SREP) is significant, and requires the supervisory authorities to enhance their existing, and implement new, related prudential and supervisory frameworks such as those proposed in IFSB-3 (Corporate Governance), IFSB-8 (Conduct of Business), IFSB-22 (Disclosures to Promote Transparency and Market Discipline), and IFSB-10 (Shari’a Governance Systems).
- The supervisory authorities should have intra-agency and inter-agency collaboration in place to strengthen the supervisory capacity for dealing with consumer protection issues. The intra-agency aspect covers coordination between various departments at the central bank (e.g., Banking Supervision and Banking Policy & Regulation). And within the Supervision Department, there is a need to have coordination between Off-site surveillance and On-site examination with respect to compliance with consumer protection regulations. For inter-agency, there should be collaboration between the central bank, the capital market regulator and the insurance regulator and various other agencies such as Deposit Protection, Financial Ombudsman, and banking associations. Appropriate consideration should also be given to the training and awareness of the court judges and lawyers regarding Islamic finance specificities.
- It is essential to develop and enhance supervisory capacity in terms of the number and quality of staff, along with appropriate hands-on training on consumer protection issues.
Financial consumer protection should be, an integral part of the legal, regulatory and supervisory framework. As a growing segment of the Islamic financial services industry, the position of Islamic banking underlines the importance of having in place a very robust consumer protection regime for Islamic finance in dual banking systems. Within a jurisdiction, a well-functioning and implemented consumer protection regime can present a competitive advantage to Islamic banks within that jurisdiction.
It would be extremely challenging, not to say impossible, for the supervisory authorities to implement a consumer protection regime for Islamic finance in the absence of corresponding measures for financial consumer protection in the conventional system. This implies that a satisfactory dual regime needs to be developed. While many measures for consumer protection in conventional finance are equally applicable in Islamic finance, with minor adjustments due to the specificities of the Islamic finance providers, there are few additional dimensions that Islamic finance regulator have to consider as highlighted in the note.
The central banks, being lead regulators, should seek to assert and uphold the rights of consumers and foster consumer protection in their respective jurisdictions. They may do this by identifying and addressing threats to consumers’ financial well-being in the financial services sector, to promote a transparent and fair market in Islamic financial products and services for retail consumers. This will contribute to the stability, integrity and effectiveness of the financial system as a whole.
Finally, the ten pillars and some prerequisites highlighted in this article can provide an important step in moving forward for the supervisory authorities that wish to introduce a financial consumer protection regime in their respective countries. The establishment of regulation for consumer protection would be the outcome of implementing these 10 recommendations, which the supervisory authorities should carry for banks in their respective jurisdictions. The resulting set of regulations should be made available on the supervisors’ website, with adequate communication to both the industry players and those concerned with informing and advising consumers.
Dr Chattha is the Islamic Finance Adviser to the Expertise France and French Development Agency. He is also the former Assistant Secretary-General of the IFSB. Being a former regulator, he advises the IMF on Islamic banking supervision. He can be reached at: jamshaid.anwar@ gmail.com. The views expressed in this article are those of the author.