Features Regulation & Risk

Sharia Compliance And Audit – Key To Success In Islamic Finance Industry

In 2016 the global Islamic financial services industry was reported to have reached beyond US$2.293 trillion at the end of December 2016 . The industry continues to enjoy a period of strong growth, albeit seeing a degree of slowdown compared to previous years. Nonetheless, against this backdrop of growth, a number of key industry stakeholders (including senior Shari’a scholars) have highlighted their concerns regarding the overly engineered nature of contemporary structures, which seem to lose the industry’s essence that believe in equity based form of investment

Shari’a compliance of financial products is assessed and certified by Shari’a scholars either in their individual capacities or more typically by the collective decision making of the Shari’a Supervisory Boards (SSB) within Islamic financial institutions (IFI). Undoubtedly, the demand placed on top tier scholars is uniquely challenging as Islamic finance is a horizontal discipline spread across multiple asset classes, sectors and locations. Hence, the need to reinforce and enhance Shari’a governance frameworks to keep pace with the rapid growth of the industry is paramount in maintaining stakeholder confidence. The fundamental requirement for any Islamic finance product is simply to comply with the Islamic law. Assurance and governance is by no means alien to Islamic practice. The principle itself is deeply rooted in the established concept of Islamic governance also known as the institution of hisbah (ombudsman/ market regulator). Historically, hisbah was initiated by Prophet Muhammad (pbuh) as an institution to govern and supervise commercial transactions in the market. The Prophet appointed a number of officers to supervise and monitor market operations and other trading activities. This article will evaluate the steps that can be taken for effective Shari’a compliance and audit in the IFIs.

Shari’a compliance for IFIs may be divided into three categories:
1. Acceptable Level Failing to ensure compliance with the acceptable level will result in Haram (non-Shari’a complaint) status of the organisation or its activities. The following are elements of acceptable level of Shari’a compliance –
– Not dealing with any business activity that is impermissible according to Islamic teachings e.g. alcoholic beverages, pork etc.
–  Not dealing in Riba (interest)
–  Not Involved in Gharar and Maisir (uncertainty and excessive risk taking)
–  Implementing Islamic laws of contract in normal course of business

Although Islamic banks remain Shari’a compliant if they meet the acceptable level of compliance, there are reservations by scholars regarding the structuring of certain banking products and contracts, such as – commodity Murabahah, Bai’Al Inah, Islamic credit cards, which lie in the grey area and cannot be deemed haram outright.

2. Satisfactory Level This level is a step further from just meeting the bare minimum level of Shari’a assurance. The following entail elements of a satisfactory level of Shari’a compliance
– No doubtful transactions, e.g. commodity Murabahah, Bai’Al Inah
–  Active Shari’a compliance mechanism – periodic Shari’a review, internal Shari’a audits on a regular basis
–  Full Shari’a compliance in agreements and processes
– Comprehensive Shari’a training to the staff members – general Islamic banking trainings, specific productwise trainings, continuous professional development programs, workshops and conferences
– Shari’a compliant marketing and strategy

3. Desirable Level
This level of adherence means best practices that reflect the essence of Islamic teachings and values. This is, however a difficult and long run task. The desirable level of compliance means
– Product innovation; copying and mimicking conventional products is not a proper reflection of the Islamic financial system’
–  Real involvement in trade and business activities; symbolic and artificial involvement creates doubts among consumers
– Less role of Hiba (gift) and rebates
– Islamic values of equitable distribution of wealth in society

– Top Level (Strategic)
– Mid-Level (Tactical)
– Lower Level (Operational)

Strategic – Top Level
This is an important level frowhere Shari’a compliance is initiated. This includes shareholders and top management relationship. Shareholders and top-management
–  Cultural and behaviour issues of management
– Dealing with shareholders – dealing with minority shareholders and their rights
–  Managing shareholder engagement in conjunction with other haram business for example, foreign banks with Islamic windows Organisational
–  Organisational culture – promotion of Islamic values throughout the business
–  Relationship within management – HR policies and other relationships
–  Marketing Strategies
–  Shari’a governance – system to improve and evolve Shari’a compliance and “quality”
– Readiness for change

Tactical – Mid Level
–  Organizational culture – promotion of Islamic values among subordinates
–  Relationship within management – mid-level management and subordinates
–  Marketing techniques |
– Forcing sales team to meet targets in any form possible is not recommended
– Customer Relationship
– No cheating and lying
–  No unattainable promises
–  Creating awareness of rights and obligations – among both customers and subordinates
– Ethical/Islamic motivation of employees

Operational – Lower Level
–  Awareness of ethical responsibilities – very important at this stage
– Marketing and relationship
–  Behaviour
– Awareness of Islamic system; e.g.: bank sales team should have in-depth knowledge of the products they are selling
–  Knowledge of the advantages and shortcomings of Islamic based e.g. banking
–  Dealings with public – religious minded people, ethically motivated people. Non-believers
–  Respect of ethical values of Islam – e.g. Recommend specific dress code for women, prayer breaks etc.

Similar to the conventional financial system, the Islamic financial system also requires internal operational controls to:
i) Ensure sound error free information is available to investors
ii) To protect the interests of the customers (depositors etc.)
iii) Ensuring the workings of the organization comply with Shari’a

Effective prudential supervision of Islamic financial institutes (IFIs) would require an internal controls system based on:
i) Standardised contracts
ii) Uniform and appropriate accounting system
iii) Frequent financial reporting

1. Regulatory Controls This is to ensure that the IFIs comply with the regulation put in place by the central bank for the operations of Shari’a compliant financial institutes. In jurisdictions where the central bank does not have any such laws, the IFIs shall follow a self-regulatory model making relevant information available
to all stakeholders and related parties. The regulations on assessing IFIs mainly base on the assessment of capital adequacy, asset quality, management of Investment
Accounts, earning quality, profit and loss of Islamic banks and liquidity management: Capital Adequacy Islamic banks, like conventional banks are required to
maintain an adequate level of capital.

The Basel Committee has set this level at 12% (Basel III is not applicable until 2019). AAOIFI has approved and recommended a Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic banks. The statement focuses on two main issues:
(a) Funds of Investment Accounts of Islamic banks are not liabilities, but act as financing assets managed by the bank as Mudarib.
(b) Whereas legally the bank’s own capital is not exposed to the risk of the assets under management (except in cases of misconduct and negligence), banks are at times under pressure to absorb some of that risk in order to give competitive returns (displaced commercial risk). There is also the risk of misconduct or negligence and its implications for risk to the bank’s own capital (fiduciary risk)

Asset Quality Like conventional banks, Islamic banks are to maintain good quality assets. They are also expected to have policies and procedures in place to ensure that any impairment of assets is identified timely and provisions are maintained to reflect such impairment. For example, The Bahrain Monetary Agency (BMA) requires banks to notify cases where exposure to counter-party risk would be equal to or exceed 10% of the eligible capital base. Where the exposure exceeds 15%, prior approval
of the BMA is required to accept the exposure.

Management of Accounts
It is the responsibility of Islamic banks to safeguard the interest of shareholders along with P&L sharing account holders and Investment Account Holders. AAOIFI’s Financial Accounting Standard No. 11 covers the provisions and reserves recognition, measurement and disclosure for Islamic banks. Earnings Quality Maintaining a
consistent level of quality earnings is essential for the long-term health of to any financial institution. Economic losses in IFIs would be reflected in the depreciation in the value of the Investment Account Holders Fund as well as in the bank’s margin.

To counter the income and owing mismatch, there should be a proper monitoring policy laid down and a reporting criteria should be set to assess inflows and outflows of the investments and deposits of different maturities.

 Operational Control
Internal operational systems should be in place that not only ensure what conventional errors and frauds are reduced, but also guarantees that all aspects of the operations adhere to the Shari’a teachings

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