The risk of Shari’ah non-compliance is present in all stages of thedevelopment and launch of an Islamic product, including the conceptualizationand structuring of Islamic instruments; legal documentation; contract termsgoverning default and late payment charges; sale and market conduct; executionand implementation; and accounting and disclosure. In order to be able toaddress these risks, an IFI (Islamic Financial Institution) should establish arigorous and comprehensive Shari’ah- governance system. In this article, we discuss anumber of governance models in place around the world based on a survey ofreporting practices of IFIs in the UK, the Middle East and Malaysia. Typically,these comprise of internal and/or external assurance arrangements.
Internal assurance arrangements toachieve/demonstrate Shari’ahCompliance
Internal assurance arrangements are clearly the most prevalentgovernance model currently in place. An IFI’s internal assurance frameworkto ensure Shari’ah compliance will usually consist of a Shari’ah Supervisory Boards (SSB)often supported by the IFI’s internal audit function and, sometimes, by aninternal Shari’ah Review Unit, however, other hybrid arrangements arealso common.
The SSB is responsible for ensuring that an IFI has complied inall its activities with Shari’ah, as well as for directing, supervising andreviewing its activities. The SSBconsists of scholars and industry best practice is for the members of the SSBto be elected by the shareholders of the IFI, in order to establish theirindependence from management who they are required to challenge.
However, we have noted some inconsistencies in the applicationof this model around the world. Firstly, while industry standards around Shari’ah governance have beendeveloped and issued by the likes of AAOIFI and the IFSB, these standards aremandatory in only a few jurisdictions and barely referred to as best practicein other jurisdictions.
As such, some SSBs compriseseveral recognized scholars while others only include one or two. How each ofthese SSBs oversees the activities of their respective IFIs also varies withthe members of some SSBs choosing to directly sample the IFIs transactionsthemselves on a periodic basis. Other SSBs make use of the services of theinternal audit function and issue them with work programs, however a handful ofIFIs also employ their own internal Shari’ah review unit consisting of more junior scholars whoperform compliance testing directly for the SSB. To make matters even moreperplexing, we have noted that the nature and scope of the assurance opinionsissued by the various SSBs also differ. Most SSBs issue Shari’ah compliance opinions on theactivities of the IFI for the year then ended based on the transactionssampling they would have carried out over the period. Most of these opinionsgive positive assurance on the compliance of the IFI. However, some SSBs statethat they have reviewed all transactions and activities of the IFI as opposedto a sample while a minority of SSBs issue negative assurance opinions.
All of this is also compoundedby the fact that there seems to be no industry accepted definition of theexperience and qualifications needed to work as a scholar. This is obviouslyless of an issue when it comes to the big industry names such as Sheikh NizamYaqoubi and Dr Mohamed El Gari to name a few, who are practically householdnames now. However, arguably, this is potentially a barrier to entry for thenext generation of leading scholars.
This leads us on to the nextchallenge, which sees many IFIs being advised by the same scholars. As onesenior Islamic banker stated: “if you want to establish a high quality Islamic finance businesswith zero tolerance for compliance issues then there is a select group ofscholars you have to use”. Some industry commentators respond that this is no differentto the Big 4 accounting firms being auditors to 99% of the FTSE 100, however,the Big 4 are subject to independent oversight by industry regulators aroundthe world. With a few exceptions, there is little independent regulation ofShari’ah scholars currently in place.
External assurance arrangements toachieve/demonstrate Shari’ahCompliance
As noted, some jurisdictions(especially those that follow AAOIFI standards) require some form of externalassurance around the IFIs’ Shari’ah compliance arrangements and this is typically theresponsibility of the IFI’s external auditor.
As such, an external audit of anIFI may entail not only a statutory financial audit, but also an audit of theShari’ah compliance of the entity. Since IFIs are required to adhereto Shari’ah principles in all their business activities andoperations, external auditors in some jurisdictions express an opinion as towhether all transactions and products entered into during the financial yearare in compliance with the Islamic Shari’ah rules and principles, and fulfill the specificdirectives, rulings and guidelines issued by the SSB of the entity.
In addition, some jurisdictions,such as Malaysia, Pakistan, Oman and Nigeria, have set up a Centralized Shari’ah Board (CSB). The advantage ofa CSB is that it brings consistency to financial products and services offeredby IFIs. The disadvantage of a centralized structure is that it can inhibit theSSB’s ability to provide solutions and innovations that are relevantto that particular IFI. Further to this, an IFI operating across differentjurisdictions may find it difficult to adhere to guidelines set by differentCSBs. Nevertheless, it seems that a CSB can complement the SSB function byproviding clarification at a regional level over Islamic investment andaccounting issues. At the other end of the spectrum is the UK, which istypically accepted as the leading hub for Islamic finance in the Western worldgiven the number of institutions (including stand-alone) offering Islamicfinancial products there together with the recent UK Government Sukuk issuance.
However, the regulators over theyears have taken a strictly secular approach to Shari’ah governance, preferring to letthe industry itself arrive at what the right framework might look like. Whilethis approach is understandable, it is also a little risky given that Shari’ah compliance is a fundamentalaspect of operational risk in an Islamic financial institution. The result isthat Shari’ah governance models range fairly widely acrossIslamic financial institutions in the UK.
It always needs to be rememberedthat while the wider conventional financial markets have been in place forhundreds of years, modern Islamic finance only really emerged on to the scenein the 1970s. As such, it has had a whole suite of issues to address as itdeveloped over the past forty years from product development to convincingskeptical customers of the validity of its offering and Shari’ah governance has been only oneof many challenges.
However, there is recentevidence to suggest that more and more stakeholders within the industry arerecognizing the need for more regulation and standardization around forms ofShari’ah governance frameworks within the Islamic world.
In May 2016, the UAE Cabinetapproved the launch of a new Shari’ah Authority, a national regulator to set standardsfor Islamic finance products, oversee the Islamic financial sector, approvefinancial products and set rules and principles for banking transactions inaccordance with Islamic jurisprudence. Members of the new board will beselected by the UAE Central Bank and subject to its oversight. The UAE Shari’ah Authority will be modeled onthe Malaysian version and will effectively act as a higher level of approvalfor products approved by individual Islamic finance SSBs which will continue toexist.
The Central Bank of Bahrain(CBB), in the meantime, has proposed new governance rules that would requireIslamic banks in the Kingdom to conduct annual external Shari’ah audits of their operationswhich will be a significant shift away from the existing internal assurancearrangements. It is understood that this move is partially to placate concernsof some market participants and customers that the activities of some Islamicfinance houses are sailing too close to the wind of conventional finance.
There does not seem to be asingle accepted model of achieving and demonstrating ‘Shari’ah compliance’ to the market and the stakeholders of the IFI. Thecurrent structures and processes established within IFIs for monitoring andevaluating Shari’ah compliance consist of internal and, in some cases,external features. One of the defining lessons of the recent financial crisishas been around the need for better and more transparent corporate governance.We believe this should also apply to developing more consistent and rigorousShari’ah governance models across the Islamic finance industry aroundthe world and we welcome some of the recent moves to greater standardizationaround Shari’ah governance frameworks within the region, which willfurther fortify governance frameworks overall.
Samer Hijazi is a Partner and the Head of IslamicFinance for Grant Thornton in the United Arab Emirates.He has extensiveexperience leading complex audit engagements for global investment banks, FTSE100 banks, sovereign wealth funds, investment managers and international banks.He has directed the audit of a number of financial services teams of clientsthat have multi-location operations, in Europe, Asia, Africa and the MiddleEast. He was instrumental in the formation of the UK Islamic finance practice anddeveloped new products and solutions to deliver to all UK Islamic financialinstitutions, FTSE 100 banks and global investment banks, which saw himbecoming de facto UK Head of Islamic Finance in 2009 and Global Head in 2013for a Big Four. As Global Head of Islamic Finance, Samer played a key role inthe industry lobbying of the British government which resulted in the launch ofthe UK Government Sukuk which was oversubscribed 10 times. As a result of hisintegral role in the UK and Global Islamic Finance, he was awarded ‘Global Islamic Finance Adviserof the Year –International 2014’ by Professional Sector Network.