As Islamic Finance steadily progresses from being part of a niche market to joining the mainstream of finance, there will be increasing pressure from both the market and regulatory bodies to ensure that operations are in compliance with Shariah.

The trend towards greater transparency and improved corporate governance, will doubtless see regulators, in the none too distant future, insist that some form of Shariah Compliance Review (SCR) is undertaken on a regular basis in Financial Institutions that offer Shariah compliant products.  Indeed, in the last 9 months, my own organization has completed a number of SCR’s in the Southeast Asian region. At this stage, these reviews have not been driven by the need for regulatory compliance, but rather by a desire from the Bank itself, to ensure that it’s Shariah operations are being conducted in an appropriate manner.  The key business driver has been to determine whether or not the Financial Institution has been exposed to any unnecessary risk, particularly “reputational risk.”

As most readers will already be aware, in Islamic Banking there are requirements to comply with Shariah that go over and above local regulatory standards.  An effective means of gaining assurance that all is well is by conducting a Shariah Compliance Review (SCR). (Please see the attached diagram that outlines the proposed framework for a SCR).

A review of the operational aspects such as product manuals, accounting policies and contract conditions is conducted as part of the exercize. An assessment of the application systems and human resources supporting Islamic Finance operations is also performed. A systems review of the organization structure, roles and responsibilities, together with the capabilities and expertize in Islamic Finance is also undertaken.

Our experience in running a number of SCR’s has demonstrated that there are some challenges that need to be addressed, in order to ensure that the SCR program is successful.

Firstly, proper governance and structure, programs and procedure need to be in place prior to undertaking a SCR.  Otherwise there will be nothing to review against! Secondly, those conducting the review should possess adequate levels of knowledge and skills across the various disciplines.  Thirdly, promote the involvement of the external auditors in order to enhance the independence and transparency of the industry.

Now let’s get down to the details. As a result of conducting an SCR, what sort of findings have we come up with.  These can be classified into six main areas as follows:-

1. Lack of co-ordination between management and the Shariah Advisory Board
   On occasions, we have seen an absence of a dedicated unit or process to co-ordinate activities, meetings and discussions with the Shariah Advisory Board.  There have been examples where, as a result of the absence of a complete process, that the Shariah Advisory Board has not had all Shariah matters referred to them.  This has led to the Board not being able to review all the terms and conditions in all agreements. 
2. Lack of Shariah compliance in agreements, contracts and products
   Many examples have been uncovered where contracts have been executed in accordance with Shariah.  For example, Murabaha without a contract of sale, no evidence of transfer of ownership and stipulation of fixed profit payment to the bank under a Musharakah contract.
3. Lack of standardization in terms and conditions in contracts
   Problems mainly ensued from a lack of centralization, where branches were able to stipulate terms and conditions differently from Head Office.  This lack of centralization could potentially lead to fraud and collusion.  Branch employees were often found to be unfamiliar with Shariah concepts, which in turn led to non-compliance with contractual terms and conditions
4. Lack of skills and capabilities
   Bank employees who have no prior training and exposure to Islamic Finance concepts, were sometimes dealing with customers who were interested in Islamic products. This lack of education and training of staff can potentially lead to a loss of confidence by customers.  They may be the recipients of poor or erroneous information, which would reflect badly on the reputation of the Islamic Bank
5. Co-mingling of funds as a result of Islamic operations being recorded in conventional books
   A rare occurrence, but this misleads the users of accounting information.
6. Misleading terminologies
   Usually as a result of accommodating conventional IT application systems to Islamic finance needs. Examples would be system produced Statements of Account for Islamic Banking customers containing terms such as interest earned and loan amount, instead of profit earned and financing amount

As can been seen by the above, many of the exceptions found could lead to significant “reputational” risk to the bank, if they were to be made public.  This highlights the need for a regular Shariah review in order to ensure compliance, and perhaps heralds the need for regulatory intervention to ensure that Shariah is being complied with.

The problem is arguably more acute in the case of Islamic Window operations, were the sharing of assets and resources may lead to a co-mingling of funds from Shariah compliant operations with riba based operations.