Issues and Challenges of Shari’ah Governance in Islamic Financial Institutions KHALFAN ABDALLAH SALIM. MANAGER, PRODUCT DEVELOPMENT AND SHARI’AH COMPLIANCE-GULF AFRICAN BANK.

Overview.  A brief on Shari’ah Governance System (SGS).  Main Types of Shari’ah Governance System (SGS).  Issues and Challenges on SGS.  Closing remarks.

What is SGS?  Many definitions of SGS prevails.  IFSB-10, 2009, pp2-3) “ the set of institutional and organizational arrangements through which Islamic Financial Institution ensures that there is an effective independent oversight of Shari’ah compliance over the issuance of relevant Shari’ah pronouncement/resolutions, dissemination of information on such Shari’ah resolutions to operative personnel of the Islamic Financial institution, an internal Shari’ah compliance review/audit for verifying that Shari’ah compliance has been satisfied and an annual Shari’ah compliance review/audit for verifying that the internal Shari’ah compliance review/audit has been properly carried out.”  Hasan (2012), “Shari’ah governance is a unique kind of governance in financial architecture as it is concerned with religious aspects of the overall activities of Islamic financial Institutions.”  Al Khamees (2012) have argued that Shari’ah governance system is another term for Shari’ah Supervisory Board (SSB).

What is SSB?.  Shari’ah Supervisory Board which sometimes referred to as Shari’ah board is an epicenter to the Shari’ah governance system.  Shari’ah board as an independent body entrusted with the duty of directing, reviewing, and supervising activities of Islamic Financial Institutions for the purpose of Shari’ah compliance and issuing legal (Shari’ah) ruling pertaining to Islamic banking and finance. (AAOIFI).  The roles of Shari’ah board normally involve three main areas of Shari’ah governance: issuance of fatwa via collective ijtihad, supervision (raqabah) and review (mutabaah) (Hasan, 2012; Dusuki, 2012)

Levels of SSB.  Hasan(2012), The Shari’ah board can be divided into three different levels, namely international, national and individual Islamic Financial Institutional levels.  Dusuki (2012), categorized the roles of the Shari’ah board in terms of the Macro and Micro levels.

Internal Shari’ah Compliance Units.  Apart from SSB, IFSB recommends for IFIs to have Internal Shari’ah compliance units (ISCU ). The key role of ISCU is to ensure compliance with Shari’ah rules and principles as part of IFIs Shari’a governance system (Iqbal; Van Greuning 2008; Grais; Pellegrini 2006; Chapra; Ahmed, 2002).  ISCU provides an assurance that all financial transactions are actually in conformity with the verdicts of the Shari’ah board (Chapra; Ahmed, 2002).  ISCU as well as other aspects of Shari’ah governance are supporting initiatives that enhance SSB performance.

Why SGS? Objectives of SGS.  SGS provides clearance and an assurance to stakeholders that all transactions conform to Shari’ah principles (Van Greuning and Iqbal, 2008).  SGS promote moderation and justice in financial transactions (Wilson, 2009) which ultimately enhance public confidence in IFI.  To assists IFI to address and mitigate Shari’ah non-compliance risk that may incur unimaginable potential of loss and negate IFI credibility (Hasan, 2012; Dusuki, 2012)

SGS Versus Conventional CG.  Shari’ah governance complements the existing corporate governance framework in IFIs.  Hasan, 2010 Shari’ah governance adds additional values to the existing corporate governance framework in IFIs. Source, IFSB (2009). FunctionsTypical Financial InstitutionsExclusive to IFIs GovernanceBoard of DirectorsShari'ah Board ControlInternal/External AuditorInternal/ External Shari'ah Review Unit. Compliance Regulatory and Financial Compliance Officers, unit or departmentsInternal Shari’ah Compliance Unit

Main Types of SGS.  A study by Hasan (2012) on Shari’ah governance system in Malaysia, GCC and the UK concluded by classifying Shari’ah governance system into two types namely:  Regulated and  Self-regulated Shari’ah governance systems.  R-there is an adamant interest from the regulatory authority such as the central bank or financial service authorities to ensure products and operations of IFIs comply with Shari’ah rules and principles. E.g. Malaysia, Bahrain, Kuwait, UAE, Indonesia, Sudan, Pakistan, Nigeria, Uganda, Oman and Qatar among others.  SR- no specific law or any requirement from regulatory authority specifying Shari’ah governance. IFIs establish their own policies and guidelines to deal with Shari’ah issues. E.g. United Kingdom, Saudi Arabia, Kenya, Tanzania, Egypt, Turkey

Issues and Challenges of SGS in IFIs.  The functioning of SSB particularly under self-regulated Shari’ah governance system has been widely criticized from corporate governance and risk management perspectives.  On governance perspective, it is argued that the system raises concerns on SSB independence, confidentiality, competence, consistency, accountability, transparency and disclosure (Grais; Pellegrini, 2006b; Van Greuning; Iqbal, 2008).  From risk management perspective, it is argued that the system poses Shari’ah, reputational and legal risks which can adversely affect the stability and growth of the Islamic finance industry (Ahmed, 2011; Khan, 2012; Al Khamees, 2012).  Challenges are: training and continuing professional development - especially on Shari’ah and Finance, Line of reporting and communications.

Independence  IFSB-10 and AAOIFI (2010e) requires independence of SSB members.  However, it is argued that in jurisdictions where there are no regulatory Shari’ah governance requirements, SSB independence from IFI shareholders/BOD/management may be compromised.  Five factors which can possibly compromise SSB independence, namely the appointment approach, high remuneration and providing credit facilities to SSB members, ownership of Shares in the IFI and working in an executive position  Moral beliefs and religious values which Shari’ah board members are expected to have, may provide required shield from any interference to Shari’ah board judgments.  Appointments, removal and resignation should be under the BOD on behalf of Shareholders.

Confidentiality.  The issue of confidentiality arises from this practice of Shari’ah scholars who are often sitting on the SSBs of several IFI.  Ninty four (94) scholars sat on the boards of 467 IFIs 40 per cent of Shari’ah board positions in the world are held by the top 10 scholars.  It grants a small group of people a considerable amount of power over the direction of the industry.  This has led some Shari’ah scholars to compete on the basis of leniency, not on the quality of the supervision.  What is confidential? Internal policies, decisions of the board/management, info on new product development, internal reports, views of various parties among others.  Limit number of IFI in the same industry.

Competence.  Shari’ah board members are required to combine a diverse set of competencies such as familiar with Islamic law and to have financial expertise, commercial laws, banking and accounting practices. Besides, SSB members must fulfil the ethical- with upright moral characters which include uprightness in religion, honesty, truthfulness and good manners.  Hasan (2012), a survey on Islamic Banking practices shows 8.6 percent are well versed in Shari’ah and commercial law and only 11.4 per cent have expertise in Shari’ah, Law and economics and other studies indicates that there are issues about the different criteria and competence of the Shari’ah board members.  There should be a set of fit and proper criteria for appointments.  Engage other professionals for consultations, formal process of assessing performance of SSB members, succession planning programs and continuous knowledge enhancements via training, research publication or seminars among others.

Consistency (Professionalism)  Many SSBs may issue conflicting fatwa (religious opinions) to IFIs which can creates inconsistency, uncertainty, confusion and instability in Shari’ah compliance.  For example, financing contract or arrangement may be endorsed by one Shari’a supervisory board and not endorsed by another equally prominent Shari’a authority. Recently in Jordan, a highly prominent Shari’ah figure criticized the punishment imposed on a defaulting debtor in Murabaha, which goes to charity, and expressed his belief that this is nevertheless a type of Riba even though it goes to charity (Jamal, 2008).  SSB are expected to develop a structured process in arriving Shari’ah decisions which must be documented and maintained at all times.

Accountability  SSBs are not liable for any damage or professional negligence arising from their remissness and would lose nothing from circumventing Islamic finance restrictions.  Lack of accountability can emanates from the failure of SSB to fulfill its duties, for example declaring the financial institution as Shari’ah- compliant without carrying out a sufficient review, deliberately not reporting violations of Shari’ah in a product or service, not holding SSB meetings, or frequent absence from meetings.  IFSB-10 shows the need of SSB to be held accountable for their actions within IFI. Rules and By-laws on disciplinary and/or other administrative actions against the Shari`ah board must be in place so that SSB members understand the level of accountability when breaching code of best conduct such as leaking or revealing confidential or market sensitive information to inappropriate parties to limit the damage of such leakage

Transparency and Disclosure.  Generally, key areas that requires disclosures and transparency are SSB composition, Shari’ah scholars’ professional background, affiliation with other SSBs, SSB members’ financial rewards like BOD, the SSB annual report to shareholders, the publication of fatwa¯ or decisions, SSB duties, SSB decision power (binding or advisory), supervision processes and selection procedures.  A survey by Hasan (2011) indicated only 52 per cent of IFIs made open disclosures on the Shari’ah board composition to the public, less than 54 percent of IFIs did not have a written policy on the preparation and dissemination of Shari’ah information, more than 68 per cent don’t publish Shari’ah pronouncements.  On serious note, not all IFIs (80%) grant authority to SSB to have access to all documents, information and records for the purpose of Shari’ah compliance.

Legal and Reputation Risk.  Legal risk in IFIs arises from the diversity of Fatwa issued by various SSBs within the same country.  Reputation risk can be associated with inconsistency of judgments in regards to products permissibility or impermissibility between IFI Shari’ah board in a country or across countries.  In order to mitigate this risk, in some legal documentation there is ‘waiver of Shari’ah defense’ which waives the borrower right to bring any defense based on the non-compliance of the transaction with Shari’ah principles‘waiver of Shari’ah defense’

Closing Remarks.  It is critical for IFI and the regulators to look onto these issues and respond to them in a manner that will ensure stability and confidence in the Islamic Finance Industry. THANK YOU.