Welcome Speech to the Seminar on Legal Issues in the Islamic Financial Services Industry

Good morning, ladies and gentlemen. My name is Thomas Baxter, and I am privileged to serve as General Counsel and Executive Vice President of the Federal Reserve Bank of New York. I am especially honored to join Professor Rifaat and His Excellency Sheikh Salem in welcoming you to this Seminar on Legal Issues in the Islamic Financial Services Industry. My New York Fed colleagues and I are delighted to be cosponsoring this event with such distinguished company, the Islamic Financial Services Board and the Central Bank of Kuwait.

For this seminar, we have assembled a distinguished array of lawyers and other experts in the field. At the outset, ladies and gentlemen, I must make a confession to you. While I have 25 years of experience as a central bank legal advisor and official, my knowledge of Islamic finance is more that of a novice than that of an expert. This should not surprise the Islamic scholars in the audience or my friends and colleagues from countries with significant Muslim populations. In fact, my situation is quite typical for a lawyer from a Western market economy and an official from a Western central bank. I begin this morning by essentially marking myself as an exhibit of a condition that ought to change and to speak to you as to why I personally believe we in the West need to change. Please understand that what I speak of are very much my personal beliefs, and I am not here to communicate an official position on behalf of the Federal Reserve.

Nowadays, lawyers and officials in the United States and Europe speak frequently of ethics and integrity, a phenomenon driven largely by our ugly and recent experience with corporate scandal. The word “integrity” literally means adherence to values, and it is the touchstone for my personal belief that we in the West need to understand Islamic finance. We need to understand Islamic finance because such an understanding is necessary to implement one of our core values. The core value is freedom of religion. Consider, for example, Article 18 of the Universal Declaration of Human Rights, which proclaims, in words which I think are beautiful:

Everyone has the right to freedom of thought, conscience and religion; this right includes freedom to change his religion or belief, and freedom, either alone or in community with others and in public or private, to manifest his religion or belief in teaching, practice, worship and observance.¹

Another example is seen in the words of one of my heroes, President Franklin Delano Roosevelt, who spoke about the “Four Freedoms,” one of which is the “freedom of every person to worship God in his own way—everywhere in the world.”² It is the same freedom that is enshrined in the French Declaration of the Rights of Man³ and in the First Amendment to the American Constitution.⁴ You see, we in the West celebrate as a core value the free exercise of religion.

Yet, these are just pretty words describing a laudatory concept unless we also practice what we preach. The Western market economies grew out of cultures that were, and are, largely non-Muslim. There is no conflict between our secular law and the law of the religions that the bulk of our populations practice. But is a secular law based upon interest as the time value of money sufficiently tolerant of the practitioner of Islam? The question answers itself. Accordingly, we must ask whether some of the customary practices in our market economies permit Muslims to follow the precepts of their faith—to abide by the shari‘a. If our secular practices do not accommodate the shari‘a, then perhaps our secular practices are not consistent with one of our core values. To foster integrity, which I define as adherence to such core values, we need to see whether our practices may be changed to accommodate Muslims who seek to freely practice their religion.

Now, part of the difficulty emerges from lack of knowledge, both with respect to the specific religious practices that are hindered by secular law and also by ignorance of the number of people who might be adversely affected. For example, in the United States, we do not even have a reliable estimate of the number of practicing Muslims. Published figures range from approximately 1 million to 7 million, or roughly three tenths of 1 percent to 3.4 percent of the population. The lack of this kind of basic demographic data makes it difficult to assess the size of any potential problem. And even though reliable data is not available, there are indicators that the Muslim population in the United States is not only significant but growing. In 1999, for example, a White House report said that Islam is the “fastest growing faith in the United States.”⁵ But, in a certain respect, the numbers should not matter: if we believe in freedom of religion, and we do, we should seek a secular law that is as accommodative as possible.

The discussion of the Muslim communities in the West leads me to another factor motivating the West (and this is a factor that Sheik Salem mentioned in his opening remarks): our economies are market economies, and growing populations are likely to receive attention from entities seeking to provide services to those populations, including banking services. U.S. financial institutions now offer shari‘a-compliant products, including University Bank in Ann Arbor, Michigan, Devon Bank in Chicago, Illinois, and HSBC Bank USA in my hometown, New York City. Both Freddie Mac and Fannie Mae, two major players in the U.S. mortgage industry, have purchased Islamic-styled mortgages, thereby freeing up capital to permit originators to make additional Islamic home finance investments. In 1998, Dow Jones debuted its Islamic market indices, which track shari‘a-compliant stocks from around the world. Currently, Dow Jones maintains nearly 50 Islamic market indices. This is happening, I suspect, predominantly because these commercial firms see a market to be served; they do not consider themselves to be in business purely for altruistic reasons.

To accommodate and to serve the Muslim community, we in the West need to understand the basic religious principles that must be satisfied. Because our secular commercial and regulatory laws developed in an environment where those principles were unknown, or at least not well known, we need understanding, analysis, and an action plan. While the challenges are real, they are not insurmountable. First, American banking law, though conceived in an interest-based economy, is neutral on its face with respect to religion. This is not enough, to be sure, but it is a good start. Second, as my remarks tomorrow will elaborate, U.S. regulators have shown that they are more interested in substance than in form. Religious law, perhaps more than secular law as it has evolved in common law jurisdictions like the United Kingdom and the United States, tends to focus on form as well as substance. There is probably sufficient common ground to harmonize the needs of both.

So far, I have been focused on the need for learning so that we in the West can be true to one of our core values and can “market” services to a new and growing population. Of course, there are other things that the West may learn from Islamic finance. By requiring Muslims to take part only in activities or ventures that are considered halal, the shari‘a represents an early form of socially responsible investing. Investments in certain industries or products are forbidden, including investments in alcohol or pork-related products, riba-based financial services, and the entertainment industry (including companies engaged in gaming or pornography). Shari‘a scholars often advise against investments in tobacco manufacturers and defense or weapons contractors as well. Once these unacceptable business activities have been excluded, Islamic funds and indices apply a set of financial filters to exclude companies that are highly leveraged or have a high proportion of accounts receivable on their balance sheets. Although based on Islamic principles, these filters also serve a broader purpose of excluding unhealthy companies that may be susceptible to future problems. Undoubtedly, we will hear more about these guiding principles in the first session of the seminar. Some of the conditions that create problems of law and policy in the West may be considered in light of these principles of Islamic finance.

After numerous scandals in the United States and Europe, business has turned its attention once more to issues of corporate governance and disclosure. Here, too, Islamic finance can offer practical lessons. In the wake of the Enron collapse, some of our financial institutions have created special senior management committees to consider whether certain complex structured financial products are “appropriate.” The “appropriateness” review is broader than whether the transaction is in compliance with the governing secular law, and includes topics like reputational risk and whether the transaction is consistent with the ethical tone at the top of the organization. While not directly analogous, the shari‘a supervisory boards of Islamic financial institutions have long been engaged in similar conduct. They review the appropriateness of proposed investments from the perspective of Islamic law. When necessary, the scholars on such boards issue fatawa, formal legal opinions, concerning issues of Islamic law. Typically, they also oversee compliance with the institutions’ responsibilities under the shari‘a. This may include audits to ensure that investors’ funds are being handled appropriately. Such corporate governance issues are the subject of our second session today, and we in Western market economies might learn some things that might avoid future Enrons.

The seminar’s third session will cover legal risks involved in Islamic financial contracts and the regulatory issues raised by the practice of Islamic finance. As I will be discussing regulation of Islamic financial services in the United States tomorrow, I will not spend any time on that now. I will say, though, that I am looking forward to hearing what issues other jurisdictions have encountered and how they have dealt with those issues.

Our last session is a practical one. It involves three different case studies presented by three different practitioners. Case studies are always useful insofar as they represent a synthesis of all the issues that we otherwise examine on an isolated basis. That is, successful practitioners must not only understand the principles of the shari‘a, but they must be able to comport their transactions to those principles. They must analyze and act with respect to the issues of disclosure and corporate governance to which I have already alluded. They must address the legal risks inherent in whatever transactions they have undertaken. Last, but by no means least, they must deal with the regulators, some of whom may be from a central bank like the Federal Reserve or the Central Bank of Kuwait.

The goals of secular law (like American banking law) and religious law (like the shari‘a) are different, but they can be complementary. In focusing on “appropriateness,” whether to comply with a regulatory directive or a religious principle, a corporate body will be less likely to engage in a transaction that may be legally right but reputationally wrong. Morality and ethics have a place in business, and trust, which is a key ingredient in any market economy, is the child of both.

To conclude, let me summarize why a Western lawyer and central bank official like me should pay attention to Islamic finance. The first reason is to be true to my own set of values and beliefs. Because the free exercise of religion is one of those values and beliefs, this Western lawyer needs to understand Islamic finance principles or I cannot hope to break down the barriers that may exist in our secular law and may well fetter Muslims who seek to freely practice their faith. The second reason is even simpler: given that we in the West operate within market economies and that Muslims are a growing population within those economies, we need to understand the needs to be served. The third reason is that Islamic finance principles may be imported by us in the West because they may well lead to an improvement in our own institutions, especially in the areas of ethics and appropriateness, where we have been challenged lately.

Ladies and gentlemen, thank you again for the opportunity to share these personal remarks with you. As the novice among all the experts, I have much to learn, and I look forward to the sessions ahead. Thank you.