Khaled Al Fakih, the new secretary-general of the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), outlined plans for a sweeping review of its guidelines in an interview with Reuters.

Some of AAOIFI's reforms may prove controversial by challenging entrenched interests in the fast-growing business. Islamic financial assets hit $1.3 trillion globally last year, a 150 percent rise in the past five years as the industry expanded beyond core markets in the Middle East and Malaysia, financial lobby group TheCityUK estimates.

"We would like to see insightful debate...that can help us develop standards that can benefit the industry," Fakih said by email from Bahrain, ahead of AAOIFI's annual meeting there on May 7 and 8.

His organization plans to start consultations on reforming the operations of sharia boards, the groups of Islamic scholars which rule on whether financial institutions' activities and products are religiously acceptable, by the middle of this year. A final draft of the reforms is not expected to be ready before the end of next year at the earliest.

AAOIFI will also work on a new framework for disclosing financial data, and will look at revising standards for takaful (Islamic insurance), investment accounts and other products.

Fakih, a Lebanese-born commercial banker who took over at AAOIFI in February, said basic elements of Islamic finance such as murabaha, mudaraba and ijara - structures designed to permit investment while obeying religious bans on paying interest and pure monetary speculation - would be reviewed next year.

CONTROVERSY

For many in the industry, AAOIFI's review cannot come too soon. Although far smaller than conventional banking, which has tens of trillions of dollars of assets, Islamic finance has grown much more quickly in the last few years, so its flaws could start to affect banking systems and economies.

Much of its growth has occurred because it can count on the support of large pools of sharia-compliant funds in the booming Gulf and southeast Asia, which have not pulled back during the global financial crisis as Western funds have.

Last year's Arab Spring uprisings in the Middle East promise a fresh wave of growth; new, Islamist-led governments want to promote the industry after their authoritarian predecessors discouraged it for ideological reasons.

But the growth has exposed weaknesses in Islamic finance. One is the lack of a clear consensus on what products and procedures are permissible; the sharia boards of individual banks and investment firms can issue conflicting rulings.

This can create big controversies. When Goldman Sachs (GS.N) announced last October that it planned a $2 billion sukuk issue, which would make it one of the first top Western banks to raise money in that way, its own sharia advisors approved the plan. But some other scholars criticized it; six months later, the sukuk has not been issued and it is not clear when it might be.

The sharia board system is open to accusations of conflict of interest because scholars are paid handsomely - in some cases, with hourly fees of $1,000 or more - by the very firms whose behavior they are supervising.

The ambiguity in regulation has let some Islamic financial institutions, such as Kuwait's Investment Dar, argue in court that contracts into which they had entered were not valid because they were not sharia-compliant in the first place.

AAOIFI plans to improve the operations of sharia boards by strengthening the certification process for scholars, Fakih said. The organisation currently offers scholars two professional credentials, but they have been criticized as not sufficiently rigorous and too easy to obtain.

In addition, AAOIFI is developing new guidance on the relationship between Islamic financial firms and their sharia boards, "similar to international best practices on terms of reference for financial institutions' board of directors".

One way to reduce conflicts of interest might be to limit the length of scholars' tenure at individual firms, to prevent them from forming excessively close relationships with their employers that might compromise their objectivity. However, Fakih did not mention this idea. Current AAOIFI standards acknowledge "engagement over a prolonged period of time may pose a threat to independence", but do not prescribe specific limits.

AAOIFI will also look at ways of fostering the rise of a new, younger generation of Islamic scholars, through steps such as training courses, Fakih said. This could remove a bottleneck to growth in the industry by loosening the dominance of about two dozen veteran scholars who have practiced for decades and hold multiple board positions.

RESISTANCE

It is not yet clear whether reformers in AAOIFI will be able to push through changes over the potential opposition of many veteran scholars and financiers who profit from the status quo.

Yasser Dalhawi, chief executive of Syariah Review Bureau, an Islamic finance advisory firm in Saudi Arabia, said change would be difficult. But he added that many people in the wider industry would support change as a way of ensuring growth and bringing Islamic finance closer to its religious principles.

A survey of customers' attitudes to sharia boards, conducted a few years ago by a Gulf financial firm, found widespread dissatisfaction which was expressed in some cases with expletives, one prominent scholar told Reuters, declining to be named because of the sensitivity of the issue.

To balance opposition to change within AAOIFI, Fakih seems to want to involve the widest possible range of industry interests in the debate; he called for "rigorous and meaningful discussions...not only among scholars but also with all participants of Islamic finance."

His plans to release a series of draft proposals for public consultation mark a change from AAOIFI's past style, which relied more on decisions made behind closed doors.

ENFORCEMENT

In its review, AAOIFI is also expected to discuss strengthening enforcement of its standards across the globe. They are not backed by any legal sanction, so national financial regulators decide whether to enforce them.

Currently only a small number of countries, including Bahrain and Qatar, have adopted AAOIFI standards wholesale; others use them as references without making them compulsory.

"Unless you have a global rule, it is not really going to work as it creates arbitrage opportunities," said Murat Unal, board member at Funds@Work, a German-based consultancy. He added that in some cases, scholars had avoided strict local regulation by offering their services in countries with looser standards.

At an Islamic finance seminar in Dubai this month, Muddassir Siddiqui, a prominent scholar from Malaysia, pressed his fellow panelists on who could strengthen global enforcement. There was no concrete response except for the vague idea of an international body of some sort.

AAOIFI might conceivably work around this by requiring all scholars, regardless of the country where they are located, to adhere to a code of conduct that would effectively transcend legal or territorial boundaries. But powerful figures inside AAOIFI might oppose anything which limited their room for maneuver so drastically.

In any case, the 21-year-old organisation is likely to have to grapple with such issues as it tries to preserve its status in the industry. So much money is now flowing into Islamic finance that other bodies, such as national regulators, may jump in if AAOIFI does not solve problems.

Some are already doing so. Last year Qatar's central bank banned Islamic windows, which allow conventional banks to offer sharia-compliant products. AAOIFI already had standards which let Islamic windows function if their funds were segregated from the banks' conventional operations. But Qatar decided those standards were not sufficient - a warning sign for AAOIFI as it tries to win industry support for its reforms.

(Additional reporting by Anjuli Davies; Editing by Andrew Torchia)

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