For large multinational organizations such as international banks, governance is paramount. Without governance policies and procedures in place, there will be disasters from the most unlikely sources. International banks have over the years learned many painful lessons where the governance or oversight was not robust enough and disasters happened. As such, most if not all international banks have a policy and procedure in place with respect to the use of their core banking system right down to hiring cleaners for their offices. An international bank’s approach to Shariah governance is no different. DERMOT O’REILLY discusses about Islamic windows in terms of (i) what the risks are (ii) how they are mitigated, and (iii) who is responsible.
Risks
There are four main risks associated with carrying out Islamic finance activities:
1. Shariah risk — transactions not done in accordance with Shariah principles
2. Reputation risk — Shariah noncompliance incidents will negatively affect an Islamic window’s reputation in the market
3. Regulatory risk — if the jurisdiction where the Islamic window operates has specific regulatory obligations with respect to Islamic finance like onshore UAE, and
4. Fiduciary risk — where the Islamic window acts as an agent in Islamic transactions such as commodity Murabahah.
Mitigation of Shariah risk
International banks will appoint eminent Shariah scholars either on a bilateral basis or as part of an outsourced Shariah supervisory board (SSB) to assist with mitigating Shariah risk. Insofar as there is no national SSB that determines what is or is not Shariah compliant on a jurisdictional basis, a bank’s SSB will be the highest authority for the interpretation of Shariah.
The bank will have a policy to that effect. The bank will also, through its governance procedures, oblige all members of staff who interact with the SSB to deal with it in an honest and transparent basis. If the SSB is unhappy with the quality of information provided, it can escalate the matter to the management through the Shariah compliance/governance unit (SCU).
If the SSB remains unhappy, the SSB members may resign, publicly, and state the reasons for their resignation. This may destroy the bank’s reputation in the market and of course every international bank does not want this to happen.
To ensure that the business is not like ‘the fox guarding the hen house’, most international banks will create an SCU. It will sit under the risk/compliance or audit support function. It will liaise with the SSB on behalf of the bank. It is not some stand-alone appendix housed in a branch that does not report to anybody apart from the local management and is not taken seriously by other branches.
If the business justifies it, there could be several such units around the globe, or one center of excellence that all branches refer Islamic business to for approval by the SSB. It should report, within one or two layers of separation, to the global head of risk/compliance or audit in order to be effective.
The role of the SCU should be to act as all of the following: Shariah secretariat, Shariah review, Shariah advisory, Shariah audit (internal) and liaison for the external Shariah audit (performed by third-party experts such as IFAAS or Amanie Advisors).
However, the SCU will sit under risk/compliance or audit, and since business guys like talking to other business guys, so many international banks will create a team of Islamic experts to assist the business to develop its Islamic franchise and provide some hand-holding when dealing with the SCU or the SSB itself. This team will have its own governance structure which should complement the SCU’s. They will be two sides of a sphere.
Responsibility
As the SCU will sit under risk/compliance or audit, it is the global head of risk or global head of audit who will be ultimately responsible for any Shariah compliance breach. However, the local regulator will not want someone in the head office, they may pursue the local branch CEO, particularly in jurisdictions where there are regulations concerning Islamic finance.
The bank’s policies will be clear on responsibility — it is everyone’s business (who is involved in Islamic finance) to ensure that all transactions are carried out in a Shariah compliant manner. The policies are well thought out and put there for a reason, they are followed and as such the international banks should survive for another few years yet.
Dermot O’Reilly was in the Shariah compliance/governance unit of an international investment bank before joining ARX Financial Engineering (regulated by the Dubai Financial Services Authority) to set up its Ethical Finance desk. He can be contacted at [email protected].