About 85% of Gulf Islamic bonds do not really comply with Islamic law, a body which sets standards across the Middle East has said.
Scholars at the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) said the body could review rules for the industry, which could be worth as much as $50 billion next year.
AAOIFI said it could tighten rules to discourage borrowers signing repurchase agreements that underpin most Islamic bonds, which have drawn investors from Asia to the United States looking for exposure to booming Gulf economies.
Most Gulf Islamic bonds, known as sukuk, have been sold with a repurchase undertaking - a promise that the borrower will pay back their face value at maturity, or in the event of default, mirroring the structure of a conventional bond.
A promise to pay back capital violates the principle of risk- and profit-sharing on which such bonds should be based, said Sheikh Muhammad Taqi Usmani, chairman of the AAOIFI board of scholars.
Islam bans lending on interest as usury and returns derived from underlying physical assets are paid to bondholders instead. These physical assets may be financed through a profit-sharing venture, in which proceeds are distributed to investors.
"You must face the actual consequences of your investment," Usmani said on the sidelines of an Islamic banking conference in Bahrain this week.
"For current sukuk, risk is not shared and reward is not shared according to the actual venture proceeds. About 85% of sukuk are structured this way," he told Reuters.
Scholars on AAOIFI's board of sharia, or Islamic law, will have a discussion on bonds based on repurchase undertakings in January, he said.
Bankers said any decision by AAOIFI to prohibit repurchase agreements explicitly could deal the industry a severe setback.
Without a repurchase agreement at a set price, a sukuk's return would depend upon the performance of the underlying asset, which may deter issuers and investors looking for the steady predictable returns of bonds, bankers said.
"The sukuk would become more of a profit sharing instrument ... from a debt-like instrument to equity, and that's a fundamental change of mindset for investors and issuers," said Harris Irfan, a director at Deutsche Bank in Dubai.
Deutsche is working on ways to tailor sukuk structures to the evolving sharia guidance, he said.
Some 160 institutions from more than 30 countries are members of AAOIFI, which says its standards are mandatory in Bahrain, the Dubai International Financial Centre, Jordan, Qatar, Sudan and Syria, and are used as guidelines elsewhere.
AAOIFI has a board of 20 sharia scholars, who are also members of the sharia boards of most of the world's largest financial institutions.
Usmani is on the sharia advisory boards of HSBC, Dow Jones and Abu Dhabi Islamic Bank, according to HSBC's Web site. Banks consult their sharia boards to check their activities comply with Islamic law.
The Gulf Arab sukuk industry is booming, as more of the region's Muslims demand investments that comply with their beliefs, and more Western and Asian institutions seek exposure to rapidly expanding Gulf economies.
US investment bank Morgan Stanley on Sunday predicted bond sales from the Gulf could double to $50 billion in 2008.
Some sharia boards have overlooked the repurchase clause to allow the industry to develop, but it is now time to review standards, AAOIFI board member Sheikh Mohamed Ali Elgari told Reuters.
Elgari sits on the sharia boards of Citi Islamic Bank and Merrill Lynch, amongst others. Scholars are likely to agree alternative to the repurchase agreement, rather than simply a prohibition "within months", he said.
Such an alternative could encourage more Islamic investors to buy bonds. Abu Dhabi Islamic Bank, the European Islamic Investment Bank and Bahrain's Arcapita Bank are among those that shun sukuk with repurchase agreements, Usmani said.
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