BNM expects continued progress in evolving a strong Shariah compliance risk culture that is well integrated and self reinforcing within IFIs

By Faizal Jaafar, Mohd Hairi Mohd Tahir & Nurlida Jasmin Ismail

Shariah is the central tenet of Islamic finance. Its principles, which promote fairness and transparency, underpin the conduct of Islamic finance transactions.

Failures in fully observing Shariah principles can thus affect the validity and enforceability of Islamic finance transactions, and increase financial and non-financial risks for Islamic financial institutions (IFIs).

For example, it is prohibited for IFIs to recognise income derived from transactions that have not fully observed Shariah requirements. This could lead to safety and soundness concerns for an IFI.

Incidents of non-compliances on a broader scale can, in turn, undermine confidence in the Islamic financial sector and its stability.

The effective management of Shariah non-compliance risk is therefore paramount, especially with the growing significance of Islamic finance as a key component of the financial system, domestically and globally.

This article highlights the approach by Bank Negara Malaysia (BNM) and the practices of IFIs in inculcating an effective Shariah compliance risk culture.

Shariah Compliance in Malaysia
Section 28 of the Islamic Financial Services Act 2013 (IFSA 2013) requires IFIs to ensure that their aims and operations, business, affairs and activities are aligned to and in compliance with Shariah principles at all times.

In practice, Shariah compliance is supported in Malaysia under a two-tier governance structure that operates at the industry and institutional levels.

This is further reinforced through the regulatory framework, supervision and the control functions of IFIs.

Centralised Shariah Advisory Council: At the industry level, the Shariah Advisory Council (SAC) of BNM is the highest authority in the ascertainment of Islamic law for Islamic financial business conducted by institutions regulated by BNM.

While Islam recognises diversity of fiqh interpretations and approaches to implementation, the existence of a central authority is critical in providing certainty and uniformity in Shariah interpretations.

The role of SAC in providing national level Shariah certainty for Islamic finance has enabled the orderly development of the Islamic financial system, mitigating variations and conflicting Shariah interpretations that may undermine public confidence and create gaps in market practices.

Shariah committees of individual IFIs: At the institutional level, each IFI has a Shariah committee responsible for advising the management and board on matters relating to Shariah in all aspects of the institution’s business, affairs, practices and activities.

While SAC typically deliberates on industry-wide implications of applying a particular Shariah principle, the institutional level Shariah committee focuses on Shariah issues that are specific to the institution.

These include those relating to the development of bespoke products and services, as well as business operations. Currently, there are more than 150 qualified Shariah scholars — local and international — who are appointed as Shariah committee members at 55 IFIs.

Shariah risk management, Shariah review and Shariah audit functions: The role of the Shariah committee is supported by designated control functions within IFIs, namely the Shariah risk management, Shariah review and Shariah audit functions.

These functions are independent of the business lines and responsible to provide an objective assessment and assurance of the effectiveness of an IFI’s compliance with Shariah and management of Shariah non-compliance risks.

The establishment of these control functions and the strengthening of their capacity over time have been instrumental in promoting a strong Shariah compliance risk culture within IFIs.

Regulatory framework: Since 2012, BNM has issued 14 Shariah Standards and Operational Requirements which give effect to rulings by SAC and serve to promote the effective management of risks in Islamic financial business.

This has led to enhanced internal policies and processes of IFIs to effectively manage Shariah non-compliance risks in their business undertakings.

In particular, the regulatory standards have had an important role in reducing legal and operational risks associated with people and system in the operationalisation and innovation of Islamic financial products and services.

The upcoming revision to the Shariah Governance Framework will further strengthen Shariah governance implementation within institutions.

The framework outlines specific expectations for Shariah considerations to be more closely integrated with the business and risk strategies of IFIs.

It further clarifies the roles, responsibilities and accountabilities of the board, Shariah committee and key organs involved in instituting a robust Shariah compliance risk culture.

An increased emphasis is also placed on elevating the professional competence of individuals who helm these roles in respect of their Shariah knowledge and its applications to Islamic finance.

Expectations on the independence and quality of control functions to ensure effective management of Shariah non-compliance risks will also be strengthened under the framework.

Observations on Shariah Compliance
Shariah applications have wide implications for how an institution operates — encompassing its business practices and processes to the behaviours of senior management and employees.

In this section, an overview of Shariah organisational practices observed in IFIs is provided.

• At the apex, the board and senior management set the tone for the organisational culture and desired behavioural norms that promote Shariah compliance.

Increasingly, more IFIs are formally adopting a set of common values and purpose which reflect Shariah principles and underpin the institutions’ business strategy and risk appetite.

• Responsibilities for Shariah compliance and risk management are increasingly devolved to business units and employees, reflecting an increasing emphasis on the first line of defence in mitigating Shariah noncompliance risks.

This has been accompanied by greater empowerment and accountability accorded to business units, with greater involvement in the design of business processes and controls to manage Shariah non-compliance risks.

• Considerations of conduct that impact an IFI’s Shariah compliance have become a more prominent feature of incentive frameworks. Most IFIs adopt penalty and reward systems that relate performance measures to Shariah expectations.

These strategies serve to reinforce a collective focus of the organisation on ensuring Shariah-compliant practices in all aspects of an IFI’s business, and building a strong risk culture among employees.

• Greater emphasis has been directed by IFIs at building strong foundations in Shariah knowledge and applications within the workforce.

Strengthened recruitment practices and higher investment in training and development have been observed. This has been motivated both by an increased focus of IFIs on the sound management of Shariah non-compliance risks, as well as the desire to drive greater innovation in the offering of Shariah-compliant financial solutions.

Increased accountability of Shariah committees has also encouraged the upskilling of scholars that are appointed to the committees, especially in areas relating to business operations and industry practices.

Collectively, these developments have led to better alignment between business operations, processes and practices with Shariah expectations, thereby mitigating incidents of non-compliance.

Conclusion
Moving forward, BNM expects continued progress in evolving a strong Shariah compliance risk culture that is well-integrated and self-reinforcing within IFIs.

This, in turn, will provide the critical foundations for further growth and innovation in the Islamic finance industry, while also contributing to domestic financial stability.

Consistent with Shariah principles, the adoption of value-based intermediation (VBI) will further sharpen the focus of IFIs in ensuring their products, services and practices deliver a positive and sustainable impact on the economy, community and environment.

An increased focus on impactdriven strategies, supported by strong governance, is expected to be embedded within and well-integrated into the risk management practices and product innovation strategies of IFIs.

The development of VBI scorecard and disclosure practices will enable stakeholders to better assess the institutions’ fulfilment of the basic tenets of Shariah.

As such, this ensures that IFIs meet the overarching objectives of Shariah (maqasid Shariah) — which are to preserve and advance the common interest of society at large, by preventing harm and maximising benefits.

This will further strengthen the accountability, transparency and integrity of IFIs.

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The article appeared in the just released BNM Financial Stability and Payment Systems Report 2018.