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Wednesday, 10 September 2008

A critical review of Central Bank’s guidelines for institutions in Islamic banking services finance

The race to develop an Islamic financing industry through new products, such as shari’ah-compliant hedging instruments, has become the latest focus in the financial sector. «Shari’ah» laws, current practices and proper supervision are highlighted.

The U.S subprime crisis and global credit crunch have spurred greater interest in shari’ah-compliant financing. It clearly appears that the philosophy of Islamic finance, which involves dealing with real assets, reducing uncertainty, avoiding interests as well as implementing other Islamic prohibitions against investing in sectors such as alcohol, pornography and gambling, have made Islamic Finance a more stable and also viable alternative for non Muslims.

To put it simply, the shari’ah Compliance Framework is at the base of the critical success factor (CSF) of any Islamic Financial Institution (IFI) and its businesses. The framework is the very essence of an IFI which gives confidence to market participants that products, contracts used and the day-to-day operations of the IFI are all shari’ah-compliant.

Generally, the provisions of the framework should include (although not limited to) the advisory board, compliance officers, and periodic reviews. Most IFIs have a three board member shari’ah committee panel. Full time resources are not a necessity but accountability is a must. The board must be transparent and open to scrutiny of market participants. Other CSFs include a liquid Islamic money market, an efficient transaction platform to ensure shari’ah compliance due to involvement of multiple parties, a low transaction cost which is at least at par with conventional products, and a reliable supply of products.

Inevitably, a shari’ah supervisory board or shari’ah advisors are crucial. The supervisory board would entrust the responsibilities of ensuring shari’ah compliance in the advisers.

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) stipulates, in its at paragraph 2 of the The Governance Standard for Islamic Financial Institutions No.1, shari’ah Supervisory Board: Appointment, Composition and Report, that : “A shari’ah supervisory board is an independent body of specialised jurist 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.”

Therefore, the requirement to have expertise in Islamic Commercial Law is a necessary pre-requirement for the proper discharge of the duty of ensuring shari’ah compliance. This is simply because most, if not all, of the issues involved in banking and finance are commercial and financial in nature.

It has been reported that in the early stages of Islamic banking and finance, many of the shari’ah advisers were not qualified in Islamic commercial law. They were individuals who enjoyed a good reputation in the society because of their general knowledge of Islam and their significant role in the society. They were in fact scholars which their society accepted and recognized as reputable entities even though they were not academically trained in Islamic commercial law and related disciplines.

The imposition of this academic requirement is missing in some national legislations pertaining to shari’ah advisers. Malaysia is such an example. In some other countries, (e.g. Sudan), although there is mention of academic qualifications, no reference is made to fiqh al-mu’amalat (Islamic commercial laws). Instead reference is made to “scholars of shari’ah”.

In the case of Mauritius, the Central Bank’s guidelines for Institutions Conducting Islamic Banking Services Finance have set a complete list of criteria for a shari’ah advisor. He/she should be a person with knowledge of fiqh al-mu’amalat, and have the highest integrity, honesty, ethical reliability, and proven experience or knowledge in the delivery of shari’ah rulings and issuing scholarly opinions on matters of Islamic law.

Most Mauritian Muslim jurists who have been fully trained locally in shari’ah laws are not conversant with the local legislation and modern financial theory and practices. On the other hand, overseas universities, especially in the Middle East, include fiqh al-mu’amalat as a common course for graduates of shari’ah. In some other shari’ah programmes, the conventional law as well as finance and accounting treatments are included. The knowledge and mastery of all these facets of finance will determine the quality of shari’ah supervision, not to mention product development and enhancement.

Ideally, a shari’ah adviser must be able to understand not only shari’ah but also issues pertaining to law and economics in today’s world. This would indeed conform to paragraph 15 of the guidelines.

In Mauritius, the main issue could be the appointment of the shari’ah advisor at the Bank level. The AAOIFI standard on the appointment of the members of the shari’ah advisory board stresses the point that the authority to appoint them must be vested in the annual general meeting (AGM) of all shareholders of the institution. The reason for this is to ensure that the members of the shari’ah board upon their appointment would be free from any undue influence by the management board because the latter does not have the authority to appoint or to dismiss them. However, it is acceptable for the management board to propose the names of prospective members of the shari’ah board to the AGM for deliberation and endorsement.

The AAOIFI standard might not be applicable to the appointment of shari’ah advisers at the level of central banks in some countries. For example, in Malaysia, the power to appoint the shari’ah advisers at the State level is vested in the government. Another example is the UAE; all appointments of members of shari’ah advisory councils at banks in UAE must be subject to the approval and endorsement of the UAE’s shari’ah advisory board at the central bank.

This provision, though its wordings are in conflict with the provision in the AAOIFI’s standard, is not necessarily problematic because the aim of the AAOIFI is to prevent any undue influence of the management board over the shari’ah advisers which may exist if the former were to be given the appointing authority.

There is a consensus among Muslim economists that the Central bank of any country should supervise the Islamic financial institutions. This supervision should not be confined to a formal audit of transactions but should encompass a material appraisal of the quality of management decisions especially with respect to more risky profit & loss sharing instruments. One of the aims of this supervision is to protect the clients who put their money into investment accounts against avoidable losses.


«Ideally, a shari’ah adviser must be
able to understand not only shari’ah but also issues
pertaining to law and economics in today’s world.»


Another issue would be the centralised shari’ah supervisory board for all commercial banks as suggested by the guidelines. This approach has not been fully tested yet. To further examine this in detail, an examination of the process through which the shari’ah supervisory board arrives at any decision is required. It appears that the most common method is through having periodical meetings between the shari’ah supervisory board and the management of the bank.

There could be many reasons why this method is preferred, not only by the shari’ah advisers, but also by the management. It may be that in this way, the bank would only present the cases that they think require deliberation. In other words, the bank can shortlist the issues for discussion. However, this can be very problematic if the bank management fails to disclose areas of practices that they think are not shari’ah complaint in their banking operations. The other possible reason is that the shari’ah advisers are not full time shari’ah advisers to the bank.

Although having a permanent office of shari’ah advisory board at the bank is less common amongst the IFIs, it is believed that the presence of a full time internal shari’ah compliance officer would be more appropriate and very significant in regard to the realization of the objectives of shari’ah supervision. This is similar to the internal audit committee in a corporation.


«One of the aims of this supervision
is to protect the clients who put their money
into investment accounts against avoidable losses.»


The AAOIFI standard has pointed out that shari’ah supervision is intended to investigate to what extent the financial institution has adhered to shari’ah rules and principles in all its activities. The investigation and vetting would include examination of the bank’s memorandum and articles of association, its contracts, agreements, policies, products and transactions, its financial reports and various others reports, particularly the report of the internal auditor and the reports of any investigation undertaken by the central bank.

Thus, the internal shari’ah compliance officer would review the internal procedures prior to the launch of new Islamic products and services and report to the shari’ah advisory board. It is for this reason that IFIs would need an internal shari’ah compliance officer.

The cost involved in running the centralised shari’ah advisory board would be a determining factor for all the banks to solve. If all the IFS in Mauritius are to offer standard shari’ah compliance products, then having a common shari’ah advisory board would be more cost-effective, taking into consideration that the centralised advisory board will have to be impartial in its dealing with the banks.

Having said that, while members of the shari’ah advisory board should be amongst Muslim scholars, the internal shari’ah compliance officer must be an Islamic Finance Expert and could be from any religions other than Islam.

Muniruddeen LALLMAHAMOOD
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Alfalah Consulting - KL: www.alfalahconsulting.com 
Islamic finance consultant: www.ahmad-sanusi-husain.com 
Islamic Investment Malaysia: www.islamic-invest-malaysia.com

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