As discussed in last week’s article, in addition to the ready ground for a robust governance model in the shape of unwavering transactional principles, an Islamic bank is required to comply with multiple layers of Shariah and corporate governance. Relatively speaking, the conventional banks do not have to put up with such stringent governance dominion. The following is a summary of governance measures an Islamic bank has to conform to.
Islamic banking license
The central bank of the jurisdiction where the bank is domiciled issues the permission to commence the Islamic banking operation once it is fully satisfied that all formalities have been completed by the shareholders of the Islamic bank. The license has various conditions attached to it which must be meticulously followed by the bank, or else the bank risks having its license revoked.
Moreover, the Islamic banks are subjected to the same monetary tools that are applied to conventional banks such as capital adequacy, risk management, reserve requirement and observing the reporting regime besides various other measures introduced by the central bank from time to time based on the country’s prevalent economic conditions.
Central bank examiners
A country’s apex bank is responsible for keeping the financial environment of its jurisdiction healthy and free from pitfalls and anomalies. To this end, the central banks send examiners to the financial institutions which have been licensed to operate in the country, including the Islamic banks. The main inspection areas of the central bank examiners are scrutiny of the bank’s policies and procedures, analysis of board and senior management oversight, effectiveness of internal controls and the level of Shariah compliance and monitoring and reporting to the central bank.
Memorandum and articles of association
To a great extent, an Islamic bank is self-governed through its memorandum and articles of association which are considered the backbone of the bank’s internal regulatory regime. The memorandum and articles of association have a separate article on the subject of Shariah compliance which prevents the Islamic bank from entering into any transaction or matter which may not be Shariah compliant since such an act may be tantamount to violating its own constitutional document.
Board of directors
The senior management of an Islamic bank reports to the bank’s board of directors. A board’s mandate is to develop strategy and provide direction to the bank’s management besides establishing policies for corporate management, making decisions on major issues and tracking the bank’s overall performance vis-à-vis the approved performance targets and expenses budget. The board of directors is also responsible for managing any crisis situation by providing the necessary guidance to the senior management of the bank.
The internal auditors directly report to the board of directors and not to the management of the bank, giving them the operational freedom to work in safeguarding the bank’s interests. They ensure the health of the Islamic bank’s financing portfolio besides ascertaining the precision of risk mitigation measures for various functions, recommending the necessary improvement, corroborating the extent of the bank’s physical assets and ensuring they are protected and probing internal fraud or any staff misconduct in violation of established norms and policies.
Simply put, the external auditors’ objective is to determine whether the Islamic bank’s accounting records are accurate and complete, whether these are prepared in accordance with the required provisions of the prevalent accounting regulations (such as IFRS, GAAP or AAOIFI) and whether the financial statements present fairly the Islamic bank’s financial position and the results of its financial operations for the relevant financial year.
The existence of the Shariah board in an Islamic bank is the core difference with its conventional counterpart. The role of the Shariah board is not advisory but supervisory in nature. It is the responsibility of the Shariah board to oversee the functioning of the Islamic bank without any bias toward shareholders or depositors. This approach is different from a conventional bank’s management whose efforts are always fixated at increasing the shareholders’ value. All products and services offered by an Islamic bank must be approved by the Shariah board before launch. The Shariah board is also responsible for examining and approving the periodic profit between the bank as the Mudarib and the depositors as the Rab Al Maal.
Internal Shariah auditors
Similar to the internal auditors directly reporting to the Islamic bank’s board of directors, the Shariah auditors report directly to the Shariah board. The core responsibility of the Shariah auditors is to make sure that all affairs of an Islamic bank are run in compliance with Shariah principles and in accordance with the guidance and approval provided by the bank’s Shariah board from time to time. As such, the perspective of internal Shariah auditors is different than that of internal auditors.
Central bank’s Shariah board
In some countries, the governments have initiated the process of establishing the higher Shariah boards at the central bank level. This new phenomenon is fast catching up due to a strong urge in the industry to consolidate, standardize and harmonize products and practices, issue resolutions and provide guidance and enhance the culture of best practices.
External Shariah auditors
The central bank’s Shariah board requires licensed Islamic banks and financial institutions to provide a report from the external Shariah audit firms similar to the annual report submitted by the external financial auditors. It is to confirm that an independent party has examined and verified the Shariah health of the Islamic bank.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.