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Shari’ah Non-compliance Risk Management pdf

Shari’ah Non-compliance Risk Management and Legal Documentations in Islamic Finance

  • Book Title:
 Shariah Non Compliance Risk Management
  • Book Author:
Ahcene Lahsasna
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Sharī`ah non-compliance risk is a unique aspect of Islamic finance that deserves specific focus. Research and studies should be dedicated to this topic in order to further expand its scope and depth, as it is still at its early stage and there is not much written about it. This book tries to lay down the first pillars and foundation in this emerging area of Islamic finance. Sharī`ah non-compliance risk means that the terms, conditions, and other related aspects agreed on in the contract do not effectively comply with the Sharī`ah rules and principles.

 In other words, the terms and conditions in the financial contract do not fulfill the Sharī`ah requirement, hence mak- ing the existing contract concluded invalid, or in need of rectification. It is very important to note that the risk management cycle and process should start from this point, because Sharī`ah non-compliance risk might be chal- lenged at any point of the Islamic banking business activities, which may lead to legal conflicts, disputes, or litigations.

Sharī`ah non-compliance risk may increase the risk portfolio of the Islamic Finance Industry (henceforth IFI), which may result in financial losses and reputational damages. In the context of this scenario, the present book tries to address this issue by dis- cussing a few aspects related to the subject of Sharī`ah non-compliance risk management, which include but are not limited to the examination of legal documentations used in Islamic finance to make sure that they represent the Sharī`ah in its form, substance, and spirit. The Sharī`ah non-compliance risk and the methodology used within its process will identify the gaps between

theory and practice.

PROBLEM STATEMENT                                             

The main concern of this book is Sharī`ah non-compliance risk; it addresses the issues for the following questions:

  • What are the types of Sharī`ah non-compliance risk in Islamic finance?
    • What are the causes of Sharī`ah non-compliance risk in IFI?
    • What are the tools and techniques used to identify the Sharī`ah non- sk in Islamic finance?


  • What is the methodology and process used to address the Sharī`ah non- compliance risk management in Islamic finance?
  • What are the types of issues in the legal documentation used by IFI in offering Islamic facilities?
  • What are the terms and conditions agreed on in the legal documenta- tions that may trigger Sharī`ah non-compliance risk?

OBJECTIVES OF THE RESEARCH                                 

This book aims to achieve the following objectives:

  • Introduce the framework of Sharī`ah non-compliance risk management in Islamic finance.
    • Identify the Sharī`ah non-compliance risk in Islamic finance.
    • Present the tools and techniques used to identify the Sharī`ah non- compliance risk management in Islamic finance.
    • Highlight the methodology used in Sharī`ah non-compliance process.
    • Elaborate on the Sharī`ah rules and principles required in mitigating the

Sharī`ah non-compliance risk.

  • Identify the Sharī`ah non-compliance risk in legal documentation and operation.
    • Eliminate Sharī`ah non-compliance risk pertaining to legal documenta- tions in Islamic banking facilities.
    • Ensure Sharī`ah compliance in legal documentation pertaining to Islamic financial contracts implemented by the Islamic banks.


This research will use the following methodology:

  • Induction methodology through collecting and checking the available legal documents and practices of the Islamic facilities offered by Islamic Financial Institution (IFI) in Malaysia.
    • Analysis and comparative study methodology through the examination of the legal documents of selected financial transactions implemented by the Islamic banks.

THEORETICAL FRAMEWORK                                      

This book tries to identify the area of Sharī`ah non-compliance in Islamic finance, by introducing the Sharī`ah non-compliance risk management

 Introduction 3

framework particularly in legal documents/contracts and practices of Islamic banks in various banking applications.

In order to achieve the objectives mentioned, the study has adopted the following approach.

Platform/Foundation of the Research

This platform is demonstrated in a discussion on the concept of Sharī`ah non-compliance risk, followed by the nature of Sharī`ah non-compliance risk in Islamic banking and finance, along with the Islamic tools and instru- ments to identify incongruence in Sharī`ah non-compliance.

In addition, there are some major elements of Sharī`ah non-compliance risk in Islamic banking and finance that have been observed, such as gharar (uncertainty), ghubn (inequality), and others. There are also other factors that can cause Sharī`ah non-compliance risk, such as human error, concept of risk, features of Sharī`ah non-compliance risk, Sharī`ah non-compliance risk events, and the Sharī`ah basis for Sharī`ah compliance.

Fundamental Blocks of the Research

The fundamental blocks represent the major pillars of the research; they form the Sharī`ah fundamental requirements in contracts and the legal framework of the Islamic finance facility. These blocks are as follows:

Sharı¯`ah Building Block/ Sharı¯`ah Rules

 Sharī`ah rules are the first building block in this research; Sharī`ah rules govern the fundamental Islamic prin- ciples and requirements in contracts and legal documentation in the Islamic finance facilities in the bank. The major elements of the contract are sighah of the contract (offer and acceptance), the contracting parties (seller and buyer), and the subject matter of a contract (goods and price). This Sharī`ah building block enables the bank to structure the Islamic finance facility in a Sharī`ah-compliant manner.

Legal Building Block/Legal Framework The legal framework is the second building block, which is based on the incorporation of Sharī`ah requirements into the legal documentations. It includes the functions of the legal docu- mentations, determining the specific prohibitions that should be avoided in the terms and conditions of the legal documentation, and so forth. The purpose of incorporating Sharī`ah requirements in legal documentation is to ensure Sharī`ah compliance and monitor the Sharī`ah non-compliance risk in the Islamic facilities. The critical areas in legal documentation are the terms and conditions (T&C) that affect the rights and liabilities of the  parties in the Islamic financial contract. In addition to that, the T&C gov- ern the Islamic finance facility and represent a point of reference in case of dispute and litigation. The T&C include clauses such as right to recall, cross default, consolidation and set-off, prepayment clause, and others.

The Tools and Techniques Used for Sharı¯`ah Non-Compliance Risk The tools include accounting, financial statements, and cash flow. The techniques include observation, sampling, interviewing, and testing. The tools and tech- niques are both important to identify Sharī`ah non-compliance risk.The Process of Risk Management and Lines of Defence This is related to the process and management of Sharī`ah non-compliance risk, when the lines of defence have been used to screen Sharī`ah non-compliance risk. The lines of defence, in order, are:

  • Product owner
  • Management of the IFI
  • Sharī`ah risk management
  • Sharī`ah management
  • Sharī`ah committee/board
  • Board of directors
  • Sharī`ah Advisory Council at the national level
  • Sharī`ah review
  • Sharī`ah audit
    • The public These lines of defence play a crucial role in preserving the interest of Sharī`ah

in Islamic finance.

4 The Application of the Banking Facility

The Islamic finance application taken into consideration in this book rep- resents various Islamic banking facilities in deposit and financing and other banking products and services.

THE TERMS USED IN THIS BOOK                                 

  • Sharī`ah committee, Sharī`ah supervisory board, and advisory board are used interchangeably. Sharī`ah Advisory Council (SAC) refers to the Sharī`ah Advisory Council of Bank Negara Malaysia.
    • Sharī`ah non-compliance risk and Sharī`ah risk are used interchangeably.
    • Sharī`ah management, Sharī`ah department, and Sharī`ah advisory are used interchangeably.

Fundamental Concept of Sharı¯ `ah and Sharı¯ `ah Non-Compliance Risk


Sharī`ah non-compliance risk in Islamic finance and legal documentations is a very vital topic due to the risk involved, which might lead to serious finan- cial implication rendering the financial contract invalid. This non-Sharī`ah compliance status will trigger the legitimacy of the income generated by the Islamic financial institution. Hence, understanding the Sharī`ah requirements in Islamic banking facilities and legal documentation is crucial. Sharī`ah non-compliance risk consists of three important terms, namely: Sharī`ah, risk, and compliance. A brief definition for each term is given below.

CONCEPT OF SHARl¯`AH                                         

The Arabic word Sharī`ah refers in its literal meaning to the road to the watering place, the straight path to be followed,1 whereas the technical mean- ing refers to designating a rule of law, or a system of law, or the whole of the message of particular prophet.2 However, in the Islamic context Sharī`ah refers to the laws and commandments and way of life prescribed by Allah to mankind.3 Another definition of Sharī`ah is: “The sum total of Islamic teach- ing and system, which was revealed to prophet Muhammad (s.a.w) recorded in the Quran as well as deducible from the Prophet’s divinely guided lifestyle called the sunnah.”4

 In other words, “Sharī`ah refers to commands, prohibi- tions, guidance, and principles that God has addressed to mankind pertain- ing to their conduct in this world and salvation in the next.”5 It has also been defined as: “The body of those institutions that Allah has ordained in full or in essence to guide the individual in his relationship with God, his fellow Muslim, his fellow men and the rest of the universe.”6 Abdul Karim Zaidan defines Sharī`ah by saying: “as the path of religion and the various aspects of laws (al-ahkam) which Allah provides for his servants, i.e. human.”

In the context of the various definitions, Sharī`ah basically is the knowledge of the laws relating to men’s acts and behavior, and the commands of Islam in par- ticular matters and application. Sharī`ah is the code of life that consists of ideology, faith, behavior, and obligation in the practical daily matters; since it is a divine law, it is a legislation based on the totality of Allah’s commands revealed to Prophet Muhammad.

Fiqh is another term that has been used with a legal connotation within the concept and scope of Sharī`ah. Fiqh means understanding al-fahm, or the absolute understanding Mutlaq al fahm.7 In its technical sense, fiqh means “knowledge of the legal rules, pertaining to conduct that have been derived from their specific evidences.”8

From the foregoing deliberation we conclude some points as follows:

  • The word Sharī`ah has a very wide meaning as compared to fiqh.
  • Sharī`ah consists of law, rules, regulations, commands, obligations, guid- ance, principles, ideology, faith, and behavior that govern the human being in every aspect of life.
  • Sharī`ah includes all aspects of human life in this world.
  • Sharī`ah is meant for two different worlds, happiness in this life and in the hereafter.
  • Sharī`ah is the whole divine law and values as given by Allah, whereas fiqh is the law extracted by Muslim jurists from the sources of Islamic law.
  • Fiqh contains human involvement such as the involvement of jurists who perform a sort of ijtihad and interpretation.
  • The term Islamic law refers to fiqh, which can also be used to describe



Definition of Compliance

Compliance means to comply with all relevant laws, rules, regulations, and regulatory guidelines. Compliance refers to proper supervision and a com- petent system of internal controls within an organization to mitigate the risk and to preserve the Bank’s reputation as well as safeguarding of its assets and compliance with all relevant regulatory requirements.

 Fundamental Concept of Shar¯ı`ah and Shar¯ı`ah Non-Compliance Risk 7

Definition of Compliance Risk

Compliance risk can be defined as “The risk of legal or regulatory sanction, material financial loss, or loss to reputation a bank may suffer as a result of its failure to comply with laws, regulations, rules, related self-regulatory orga- nization standards, and codes of conduct applicable to its banking activities.”

Consequences of Non-Compliance

Failure to comply with all applicable laws, rules, regulations, and regulatory guidelines will constitute a breach. It may result not only in the imposition of disciplinary, civil, or criminal sanctions against the Islamic financial insti- tution, but also in damaging one of Islamic financial institution’s (IFI’s) most important assets, its reputation. In addition, it may also result in the banking license being suspended/withheld by the regulator.

Objective of Compliance Operation Manual

Every Islamic financial institution has a compliance operation manual. This compliance operation manual describes the guiding principles for managing compliance at the business/support sectors within the IFI. The business/sup- port sectors are responsible for ensuring that the activities of the department and its staff are conducted in accordance with all applicable laws, rules, regulations, Sharī`ah rules and principles, and regulatory guidelines and the highest ethical standards.

General Objectives of Compliance Operation Manual

The compliance operation manual in the Islamic financial institution tries to achieve the following objectives:

  1. Improve the quality and effectiveness of the compliance function.
    1. Provide uniform practice guide on compliance, which would serve as a basis for guidance and measurement of performance of the compliance function by the compliance officer.
    1. Facilitate the understanding and correct implementation of compliance function and procedures.
    1. Ensure that compliance officers meet the minimum job expectation level imposed by the Bank.
    1. Minimize the non-compliance to laws, rules, regulations, Sharī`ah rules and principles, and regulatory guidelines that may result not only in the imposition of penalties, rendering the contract null and void, and staff disciplinary action, but also damage the IFI’s reputation.

Specific compliance responsibilities that compliance operation manual intends to convey is that compliance should be looked upon as an entire system of the following:

  1. Compliance with laws, rules, regulations, Sharī`ah rules and principles, regulatory guidelines, and standards.
  2. The prompt reporting of any compliance incidents (including Sharī`ah


  • Taking appropriate action if compliance incidents occur.

Process of the Compliance Operation Manual (COM)

The compliance operation manual normally applies to compliance officer and all staff of the IFI.

Scope of Coverage The scope of compliance operation manual is one of the general compliance standards and requirements that govern the over- all working and business within the IFI. It should neither be interpreted as an all-encompassing manual that has exhaustively and conclusively listed out all the laws, rules, and regulations that the IFI is subjected to, nor as a substitute to the regulations.

Areas of Compliance The areas of compliance for business/support sector shall cover all regulatory (including Sharī`ah rules and principles) and statutory requirements.

Frequency of Review Normally the compliance operation manual of the IFI needs to be reviewed on an annual basis and as and when the follow- ing circumstances occur:

  • Change of work process/procedures/structures
    • Computerization of work process
      • Circulars issued by group compliance
      • Regulatory requirements
      • Others

Compliance Responsibilities

  1. Compliance Officer The responsibilities of a compliance officer are as follows:
  1. To facilitate the business/support sector in complying with all applica- ble laws, rules, Sharī`ah rules and principles, regulations, and regulatory guidelines related to the business/support sector including monitoring the

 Fundamental Concept of Shar¯ı`ah and Shar¯ı`ah Non-Compliance Risk 9

changes in regulations affecting the respective business/support sector, and providing value-added feedback to relevant departments in the IFI.

  • To become the liaison officer and advice business/support sector on any compliance matters that they may face in the course of their work.
  • To ensure the establishment and proper/effective implementation of compliance program, which, amongst others, shall include submission of compliance reports, independent testing/checking, compliance educa- tion/training, and so on.
  • To proactively identify, measure, assess, and document the compliance risk related to the business/support sector. This shall include completing risk control self-assessment of the compliance functions and key risk indicators (KRI).
  • To conduct independent testing/checking/review in order to gauge the level of compliance with regulatory requirements (including Sharī`ah rules and principles) at business/support sector as well as to mitigate/ minimize the compliance/ Sharī`ah non-compliance risk.
  • To promptly inform the relevant head of the compliance of any compli- ance incidents/breaches/potential breaches upon discovery of the inci- dents. Thereafter, to monitor, manage, review, and follow up on any non-compliance issues reported and detected until resolved.
  • To participate in providing feedback, comments, recommendations and sign-off for any product/project/outsourcing/policy review sign-off.
  • To facilitate business/support sector in complying with FATF 40 Recommendations pertaining to anti-money laundering and counter financing of terrorism as well as Bank Negara Malaysia (BNM) UPW/ GP1 and UPW/GP1(1) and other related regulatory requirements.
  • To promote a culture of compliance awareness at business/support sec- tor by providing/arranging training/briefings, via regular/constant com- munications to all employees in the business/support sector.
  • To ensure proper record keeping on all the compliance activities/pro- gram conducted for future reference.

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