2.

8 Profile of Shariah compliance

Broadly, the term “Shariah-compliant” is used to describe anything, which is allowed under
the Islamic law. Under Islamic Finance, every financial transaction should be Shariah-
compliant. However, there are five key principles to ensure Shariah compliance as given in
figure 2.14 (Abdullah and Chee, 2010):

Figure 2.14: Key principles of Islamic Finance

Key Principles of
Islamic Finance

Belief in divine No haram Financing is based

guidance investments on real assets

Risk sharing is
No interest
encouraged

Source: Adapted from Abdullah and Chee (2010, p.5)

A similar stance is taken by Iqbal (1997), Loqman (1999), Zaher and Hassan (2001) and Aslam
(2006).
Shariah compliance, while being considered the backbone of Islamic finance is also deemed
to be a source of confidence to the stakeholders that the principles of Shariah are being
followed. On the other hand, non-Shariah compliance, besides damaging confidence, can also
lead to exposure to facing various risks for Islamic Financial Institutions (IFI), such as
reputational risks. However, Shariah compliance is possible by having a formal Shariah
governance system (Hasan, no date).

Non-Shariah compliance results in the loss of reputation for IFIs, which leads to a reduction in
investors and depositors, as the confidence of the investors will be eroded (Ahmed, 2010;
Chapra and Khan, 2000; Rusnah, 2011). A similar stance is taken by Alvi (2005), who also
emphasized on Shariah compliance. He states that “investor confidence can only be boosted
through the conformity of Shariah compliance. Without rigid Shariah compliance regulations,
non conformity would result in declining investor confidence that can cause the failure of one
bank to ultimately lead to a wide ranging crunch on the financial system and possible crisis.”

Rahim (2008, p.1) states “institutions that offer Islamic financial services are expected to
operate by the code of Islamic ethics and must function within the limits of Shariah.” A proper
Shariah compliance mechanism is important for the prosperity of the Islamic Finance industry
(Thani, 2007). Therefore, the area of Shariah compliance must be a focus for all the IFIs
(Vicary, 2005).

To ensure Shariah compliance, a proper “Shariah Governance System” is necessary. It can be

defined as “... the set of institutional and organisational arrangements through which an Islamic
Financial Services Industry (IIFS) ensures that there is effective independent oversight of
Shariah compliance” (Islamic Financial Services Board, 2009, p.2). Shariah compliance is the
factor which makes Islamic Finance unique from conventional banking, so it is important for
Islamic Financial Institution (IFI) to ensure it (Grais and Pellegrini, 2006; Haniffa and Hudaib,
2007; IDB, IFSB and IRTI, 2007; IFSB, IRTI, IDB, 2010; Ahmed.H, 2010; Rusnah, 2011).

Islamic Financial Services Board has focused on ensuring Shariah compliance in IFIs. The
Principle 3.1 of GUIDING PRINCIPLES ON CORPORATE GOVERNANCE FOR
INSTITUTIONS OFFERING ONLY ISLAMIC FINANCIAL SERVICES (EXCLUDING
ISLAMIC INSURANCE (TAKAFUL) INSTITUTIONS AND ISLAMIC MUTUAL FUNDS)
states “IIFS shall have in place an appropriate mechanism for obtaining rulings from Sharī`ah
scholars, applying fatāwā and monitoring Sharī`ah compliance in all aspects of their products,
operations and activities.” (IFSB, 2006, p.11)

The IFSB further emphasizes Shariah Compliance in the GUIDING PRINCIPLES OF RISK
MANAGEMENT FOR INSTITUTIONS (OTHER THAN INSURANCE INSTITUTIONS)
OFFERING ONLY ISLAMIC FINANCIAL SERVICES (2005, p.2), Principle 7.1 states
“Institutions (other than Insurance Institutions) offering only Islamic Financial Services IIFS
shall have in place adequate systems and controls, including Sharī`ah Board/ Advisor, to ensure
compliance with Sharī`ah rules and principles.”

A banking business faces various risks; credit risks, markets risks, liquidity risks and
operational risks. Operational risks faced by IFIs result from a weak internal control and
governance system (Chapra and Khan, 2000; Rusnah, 2011). Reputational risk can also be
added to operational risk, which results because of failure of operational duties (Askari, Iqbal
and Mirakhor, 2009). Compliance risk for IFIs is defined by the Basel Committee on Banking
and Supervision, Compliance and the Compliance Functions in Banks (2005), “...the risk of
legal or regulatory sanctions, financial loss or loss of reputation a bank may suffer as a result
of its failure to comply with all applicable law, regulations, codes of conducts and standards of
good practice (together ‘laws, rules and standards’)...compliance should be part of the culture
of the organization; it is not thus the responsibility of the specialist compliance staff” (As cited
in Rusnah, 2011, p.11).

According to Musa and Daud (2007), Shariah compliance can be achieved by an effective and
proper Shariah review process. The compliance process can be divided into two parts; (i) ex-
ante compliance and (ii) ex-post compliance (Rahim, 2008; Rusnah, 2011).

The ex-ante Shariah compliance part “is basically the Shariah Advisory Council’s (SAC)
supervision, monitoring and control tasks that take place upon and during implementation of
the bank’s dealing. These activities include making sure that the banks and financial institutions
comply with the Shariah rules and guidelines during the designing of the contracts and
agreements, during the process of transactions, during the conclusion and execution of the
contract, and up to the implementation of the terms of contract and liquidation” (Rahim, 2008,
p.3). IFSB (2009, p.8) states “Ex-ante considerations that should take place at the product
design/development stage, before it is offered to the customers”. It includes (i) the issuance if
Shariah resolutions and (ii) compliance checks.

The second part of the process should focus on compliance with the operations and
managements of products; however, most of the IFIs consider the first part to be enough for
the Shariah compliance process (Rusnah, 2011). According to Rahim (2008, p.3), ex-post
Shariah compliance is not undertaken widely by IFIs. He defines it as “...thorough and
comprehensive Shariah audit to review and check the transactions that took place after the
execution of the contracts. The ex-post Shariah compliance is basically to perform the random
samples of completed transactions to ensure that these transactions conform to Shariah rules
and guidelines. An internal audit or external audit may be required to perform this where the
result of the audit needs to be reported to the management.”

IFSB (2009, p.9) states that ex-post considerations should take place once the product has been
offered to the customers. Moreover “For good risk management and progressive verification
of product viability, an IIFS (Institutions offering Islamic Financial Services) would want to
ensure that it’s Shari`ah Governance System covers the relevant ex-post processes – namely,
internal Shari`ah review and Shari`ah governance reporting. Without such follow-up, the IIFS
would not be able to monitor the consistency of its Shari`ah compliance and effectively manage
any Shari`ah compliance risk that may arise over time.”

IFSB (2009, p.11) emphasizes on Shariah compliance by stating “both ex ante and ex post
aspects of all financial transactions carried out by the IIFS – that is, to ensure Sharī`ah
compliance of the contracts and, later, the performance of obligations under the contracts”.

Grais and Pellegrini (2006) categorize the process of Shariah compliance into (i) internal and
(ii) external arrangements, where the internal arrangements to ensure Shariah compliance are
undertaken by internal bodies of the IFIs, such as the Shariah Supervisory Board (SSB) and
internal audit teams and control departments, and the external arrangements are maintained by
the centralized Shariah Supervisory Board (SSB) or other external regulatory authorities, rating
agencies and Islamic indices, such as the Dow Jones Islamic Indexes and the FTSE Global
Islamic Index. Countries like, Kuwait, Malaysia and Pakistan have taken major steps to have
external arrangements to ensure Shariah compliance. According to Alvi (2005), “Islamic
Rating Agency provides investors with reliable risk and Shariah quality assessment of Islamic
Financial Instruments.”

According to Rusnah (2011, p.34 and 36) “Shariah governance is taken seriously by the
management of the bank, and proper mechanisms are in place to ensure the bank’s operation
are conducted in line with the Shariah requirements... The willingness and serious commitment
from the top management are very critical in ensuring that an effective Shariah compliance
review process takes place in a particular Islamic bank.”

The next section discusses the role of Shariah Supervisor boards in IFIs.
2.10 Role of Shariah Supervisory board and Shariah advisor in ensuring Shariah
compliance in an IFI
According to Qattan (2005), the Shariah governance process is a unique feature of Islamic
banking, which is achieved by different forms by the IFIs and is widely embodied within a
Shariah Control Committee (SCC). The most common term for SCC is Shariah Supervisory
Board (SSB).

Rammal (2006, p. 204) discusses about SSBs as followed:

To ensure that the products offered to the clients fulfil the criteria of being halal
(acceptable under Islamic law), Islamic financial institutions seek the advice of
Muslim scholars. These scholars are known as Shari’ah advisers, and are
usually part of Shari’ah supervisory boards (SSBs).

There is limited literature available on the functions and responsibilities of Shariah Advisor
and Shariah Supervisory Board (SSB). Choudhury and Hoque (2006) state that an IFI is
directed either by the SSB or by a Shariah Advisor. The Accounting and Auditing Organization
for Islamic Financial Institutions (AAOIFI) terms it as Shariah Supervisory Board (SSB) and
defines it as (as cited in Bakar, 2002, p.76):

A Shari’ah supervisory board is an independent body of specialised jurists in

fiqh al-mu’amalat (Islamic commercial jurisprudence). However, the Shari’ah
supervisory board may include a member other than those specialised in fiqh al-
mu’amalat but who should be an expert in the field of Islamic financial
 institutions and with knowledge of fiqh al-mu’amalat. The Shari’ah supervisory
board is entrusted with the duty of directing, reviewing and supervising the
activities of the Islamic financial institutions to ensure that they are in
compliance with Islamic Shari’ah rules and principles. The Fatwas and rulings
of the Board shall be binding on the Islamic financial institution.

It is compulsory for an IFI to have a Shariah board to be a member of International Association

of Islamic Banks (IAIB), which outlines the main features of a Shariah board as (As cited in
El-Nagar, 1980, p.20):
It is formed of a number of members chosen from among Jurists and men of
Islamic jurisprudence and of comparative law who have conviction and firm
belief in the idea of Islamic Banks. To ensure freedom of initiating their opinion
the following are taken into account: (a) they must not be working as personnel
in the bank. That means: They are not subject to the authority of the board of
directors. (b) They are appointed by the general assembly, as it is the case of the
auditors of accounts, (c) The general assembly fixes their remuneration. (d) The
Legitimate Control Body has the same means and jurisdictions as the auditors
of accounts.

The main functions of a SSB are Banaga, Ray and Tomkins (1994):
i. Preparation of contracts for the IFIs
ii. Determination of rate of Zakat and division to the deserving institutions
iii. Review of the operations of IFI to assure that they are according to Shariah
iv. To conduct meetings with the management
v. To analyze the dealings and nature of transactions of the IFIs to confirm that they
are in accordance with Shariah
vi. Issuance of Fatwa if needed for any particular issue