Principles of Compliance in Islamic Banking
Bachir El Nakib, Founder, Senior Consultant Compliance Alert (LLC)
Compliance Risks in Islamic Banking?
It is not an easy task, a key starting point in the process of supervising financial institutions is the design of a framework that sets out supervisory expectations around such key areas as risk management, compliance and control, corporate governance and capital policy. Prime Challenge is to seek to understand – what is the Islamic Banking business strategy; what risks arise from that strategy (cutting across such categories as credit risk, market or investment risk, operational risk, and legal risks).
For the good-sake of deliberation, let ask ourselves couple of questions such as:
- how well does management understand, measure, and manage those risks? and
- how sound is the overall governance and control structure of the firm?
- difficulty for Muslim consumers in obtaining shari’a-compliant insurance?
- how Shari’a compliance can be incorporated into hedge funds to produce better returns?
Let's assume that both Hany & Bashir have purchased Islamic structured mortgages.
Both entities require property insurance and private mortgage insurance to be held on the securitized mortgages they purchase. This requirement forces customers of Islamic financial institutions to purchase traditional insurance for these mortgages, as per Shari'a those insurance policies are not compliant with the shari’a.
Looking to Basel II Versus the application of Islamic Banking in today’s World, a Compliance officer has to find answers to:
• Islamic Banking relation with Central banks
• Risks in Islamic banks
• Implications of the prohibition of interest
• Credit risk in Islamic banks
• Operational Risks in Islamic banks
• Other risks: legal, withdrawal, Shari’a confidence, litigation, etc.
• Capital adequacy and risks addressed by Basel II
• The First Pillar – Calculation of Minimum Capital Requirement to offset:
• The Second Pillar – Supervisory Review Process
• The Third Pillar – Market Discipline
• Sensitivity of Islamic banking operations to Basel II proposals
• The effect of restricted deposits, unrestricted deposits and deposits in current accounts on credit and other risks’ exposure in Islamic banks
• Monetary authority supervision: Does it make a difference?
• Market disclosure in Islamic banks: a serious administra-political problem!
• Managing risks in Islamic Banks
• Shari’a-Intrinsic risk mitigation techniques
• Management processes and techniques of specific risks
Islamic finance is a dynamic industry that is widely regarded as a competitive alternative to conventional financing solutions. Islamic finance has developed rapidly over the last 40 years, showcasing their dynamism with a wide array of innovative financial products and services on offer Islamic finance or financial activity which is structured so as to align with the teachings of Islamic law (sharıa).
Borrowers and investors have become more knowledgeable and with the increased competition, they are seeking the best financial deals or returns on investment. This fact suggests Islamic banking and finance can work in a modern context and will continue to attract clients as long as they continue to make profits for shareholders and investment depositors. Finally, this study surveys the attitudes and perceptions among business firms dealing with Islamic banks, towards the compliance of these banks with the key principles underlying Islamic law (sharia).
Islamic finance can be broadly described as a financial service or product principally implemented to comply with the main tenets of Sharia (or Islamic law). For Muslims, Sharia law serves as the principle source of guidance for all areas of their lives (Gohar ,1999) The term "Sharia" can be roughly translated as "Islamic law" In turn, the main sources of Sharia are the Holy Quran, Hadith, Sunna, Ijma, Qiyas and Ijtihad.
More specifically the Holy Quran contains the literal words of Allah as revealed to Prophet Muhammad, whereas the hadith are the recordings of the Prophet Muhammad's actions and words as documented by his contemporaries and later followers via oral tradition (Gohar , 1999).Sunna On the other hand, refers to the habitual practices and behaviors of Muhammad during his lifetime(Gohar , 1999).It has been agreed on that Ijma is the consensus among religion scholars about specific issues not envisaged neither in the Holy Quran nor in Sunna, popularly translated to mean "consensus of jurists.(Hammond , 2007).In addition to what has stated earlier, Qiyas is the use of deduction by analogy to provide an opinion on a case not referred to in the Quran or Sunna in comparison to another case referred to in the Quran and Sunna (Hammond , 2007).Finally, Ijtihad represents a jurists’ independent reasoning related to the applicability of certain Sharia rules in cases not mentioned in either the Quran or the Sunna.(Hammond , 2007).
The guiding principles regarding Islamic finance represent the theological norms upon which the Islamic finance industry rests and the structural parameters of shariah compliant financial activity, distinguishes Islamic financial activity from conventional financial activity, these main Islamic principles include the following:
- The prohibition of Riba means that any predetermined payment over and above the actual amount of principal is prohibited (usually interpreted as usury or interest). Riba has been interpreted by many classical scholars as unjustified gain resulting from an unfair exchange of counter-values between contractual parties. Numerous Islamic scholars have justified this prohibition on the basis that in Islam, money itself is not considered to have any intrinsic value; currency should only have value as a medium of exchange rather than as a commodity for exchange. Instead, participants in the financial activity are encouraged to earn legitimate profit through risk sharing and effective involvement in an economically beneficial activity.
- The prohibition of uncertainty (Gharar) and gambling (maysir), find support in the roots of Islamic law Preventing speculation, exploitation and unfair gain. These roots have been interpreted as forbidding games of chance and all kinds of gambling which allow someone to get something too easily. More over and linked to the notion of speculation as illegitimate in Islamic finance, the prohibition of gharar acts to prevent activity in which there is an excessive level of uncertainty, ignorance or confusion, encompassing the transparency, full disclosure of information, and good governance, though legitimate rational business risk is permitted and indeed encouraged in Islam.
- Islamic economic principles also place strict limits on the type of activity, transaction, or company that can be invested in. There are important areas which are explicitly prohibited including the making or selling of alcohol, pornography, and pork products. Earning money through the involvement in these prohibited industries is forbidden (haram), and Muslims must refrain from any connection with such activities whether directly or indirectly support practices or products that are forbidden (or discouraged) by Islam.
- An emphasis on risk-sharing, the provider of financial funds and the entrepreneur share business risk in return for a pre-determined share of profits and losses. The lender must share in the profits or losses arising out of the enterprise for which money was lent. - The desirability of materiality, a financial transaction needs to have “material finality”, that is a direct or indirect link to a real economic transaction, value-based innovation.
- Consideration of justice, a financial transaction should not lead to the exploitation, (unfairness) of any party to the transaction.
These principles followed and retrieved among the several agencies that pass guidelines and regulate Islamic financial systems internationally such as: The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in Bahrain, Islamic Financial Services Board (IFSB) in Malaysia, Islamic International Rating Agency (IIRA), International Islamic Financial Market (IIFM) in Bahrain, and International Islamic Fiqh Academy in Saudi Arabia. These agencies are considered as a structure of various regulatory bodies based in different countries, with different membership prepares ethics and Sharia standards and requirements for evaluating products and services provided from Islamic financial institutions.
The considerable growth of Islamic Finance in the emerging markets as legitimate alternative to conventional products has triggered the interest of most of conventional financial institutions to adopt a dual-banking system and undertake Islamic financial activities to meet the demands of its clients seeking Sharia compliant products/services.
A typical Islamic-window approach is a form of operating structure in a conventional bank which offers Islamic banking products and services through its conventional branches by dedicated team equipped with sufficient knowledge of Sharia aspects.
The framework of operational activities should be in-line with the rules and principles of Sharia as stated by the Sharia Supervisory Board. Such approach requires full segregation of accounts and operations, funds collected from depositors must be invested in Sharia-compliant transactions, liquidity management policy of funds should comply with Sharia law and staff employed under the Islamic-window should adhere to Islamic code of ethical conduct and should refrain from performing any roles towards conventional banking operations.
Taking into consideration that strict adherence to SSB guidelines and the standards of other regulatory bodies such as Accounting and Auditing Organization for Islamic Financial Institutions "AAOIFI" and Islamic Financial Services Board "IFSB" have a significant impact on how clients approach banking, the inadequate segregation of operations/accounts of conventional and Islamic activities, absence of Standard Operating Procedures from Sharia perspective and lack of Sharia trained staff to execute Islamic transactions create the following challenges:
- Lack of clients confidence that their funds may be co-mingled with funds in the conventional interest based transaction books
- Efforts made for the innovation of investment products that meets desire of Muslims' clients towards diversification of investments are always below expectations compared to wide-range of conventional products.
- Non-disclosure of earnings from interest-based activities and its subsequent treatment in the financial statements.
- Increase in the outstanding amount of the financed product/service against postponement of installment or rescheduling of outstanding debts.
- Cross-selling of alternative conventional products in-case of shortfall in the sale of the Islamic products.
- Utilization of conventional accounts which are subject to pre-determined interest charges as a recovery accounts of installment of Islamic finance products.
- Auto-payment option on conventional credit cards for recovery of Takaful Premium and Zakat payment.
- Acceptance of conventional insurance policies in Murabaha and Ijarah instead of Takaful policies.
From Muslim client's perspective, failure to comply with Sharia principles is a deliberate violation of the Divine law as revealed in the Quranic injunctions and Sunnah. Thus, clients may feel guilty and sinful due to non-compliance to obligations towards the creator (Allah SWT) and subsequently ends-up the relationship with the bank.
The most important Islamic investment techniques practiced by the Bank are as follows:
- The Bank provides structuring, arranging, and placement services, as well as advisory services, for companies seeking financing through Sukuk issuance, and sees great opportunities and potential for Islamic finance and Islamic financial markets in this area, whereby new issues are distributed to investors in the primary market, and existing securities are traded in the secondary market.
- The capital market is the market where companies can raise long-term financing. Nowadays, Sukuk are being looked at as an Islamic equivalent of bonds, hence Sukuk are securities that comply with the Islamic law and its investment principles and provide access for both Islamic investors and companies seeking Shari'a-compliant financing to the capital market.
- Sukuk basically relies on the concept of asset monetization, and can be issued on existing as well as specific assets that may become available at a future date; the concept of Sukuk can in some cases also be viewed as Islamic securitization which is very similar to conventional asset-backed securitization whereby a corporate entity moves its assets to an ostensibly bankruptcy-remote vehicle that acquires the assets with the proceeds of issuance of securities.
- This transaction is executed when a customer approaches the Bank for assistance in purchasing a particular commodity. In such circumstances, the Bank buys the goods from a third party (supplier) at a price agreed between the Bank and the supplier without interference from the customer.
- The Bank will then offer the goods to the customer at a price including profit. The customer then has the option to accept the goods or reject it within a fixed period of time. If the customer accepts the goods the Bank will sell the goods to the customer and he/she will then pay the sale price in instalments to the Bank over an agreed period of time. A Musawama sale transaction is usually confined to goods purchased from the local market.
- The Bank provides this service to its clients who need to acquire goods from abroad through letters of credit.
- The customer approaches the Bank for assistance in importing certain goods and provides the Bank with the specifications of the goods in terms of description, quantity, price etc.
- The Bank then imports the goods on its own account in order to sell to the client at a price which covers the cost and an agreed profit margin. The customer pays the price to the Bank instalments over an agreed period of time.
- This is a form of contractual relationship whereby the client agrees with the Bank to execute a certain project bearing all the costs of raw materials and salaries. The Bank then delivers the accomplished project price and commissions one or more construction companies to execute the project.
- Mudaraba is a mode of financing whereby the Bank would provide the funds for a certain business project or transaction and the customer would provide the professional expertise and know-how to run the business or execute the transaction. Thus, a joint venture is formed between the Bank and the client and any profits are shared in a predetermined ratio.
- Through this mode the Bank has executed and continues to execute various projects on a regular basis.
- Musharaka Investment is considered to be the main factor that differentiates an Islamic bank from a conventional commercial bank. According to this technique the Bank provides a share of the finance required by a customer for a business project or for the purchase of specific merchandise and becomes a partner in the business or the transaction. The resultant profits or losses are shared by the Bank and the customer at a Shari'a-compliant ratio agreed upon in advance.
- The Bank has financed many businesses and projects in Qatar through Musharaka.
- Under this method the Bank purchases an asset like a building, machinery or equipment and leases it to others. Before an Ijarah is undertaken, a feasibility study is conducted to ascertain its profitability and compliance with Shari'a.
Compliance Risks in Islamic Banking
Risk entails both vulnerability of asset values and opportunities of income growth. Successful firms take advantage of these opportunities (Damodaran, 2005). An important element of management of risk is to understand the risk–return trade-off of different assets and investors. Investors can expect a higher rate of return only by increasing their exposure to risks. As the objective of financial institutions is to create value for the shareholders by acquiring assets in multiples of shareholder-owned funds, managing the resulting risks faced by the equity becomes an important function of these institutions. As Islamic banking is relatively new, the risks inherent in the instruments used are not well comprehended. Islamic banks can be expected to face two types of risks: risks that are similar to those faced by traditional financial intermediaries and risks that are unique owing to their compliance with the shari’a. Furthermore, Islamic banks are constrained in using some of the risk mitigation instruments that their conventional counterparts use as these are not allowed under Islamic commercial law.
The unique risks that arise owing to compliance with the shari’a and the special nature of risk mitigation enforced on Islamic financial institutions by the shari’a mandate is organized as follows.
First we examine the nature of risks in Islamic banks. After defining and identifying different risks, we report on the status of risk management processes in Islamic banks. Then specific issues related to risk measurement and mitigation in Islamic banks are discussed. The last section draws some conclusions.
Risks in Islamic banks
The asset and liability sides of Islamic banks have unique risk characteristics.
The Islamic banking model has evolved to one-tier mudaraba with multiple investment tools. On the liability side of Islamic banks, saving and investment deposits take the form of profit-sharing investment accounts. Investment accounts can be further classified as restricted and unrestricted, the former having restrictions on withdrawals before maturity date.
Demand deposits or checking/current accounts in Islamic banks take the nature of qard hasan (interest-free loans) that are returned fully on demand. On the asset side, banks use murabaha (cost-plus or mark-up sale), instalment sale (medium/long-term murabaha), bai-muajjal (price-deferred sale), istisnaa/salam (object deferred sale or pre-paid sale) and ijara (leasing) and profit-sharing modes of financing (musharaka and mudaraba).
These instruments on the asset side, using the profit-sharing principle to reward depositors, are a unique feature of Islamic banks. Such instruments change the nature of risks that Islamic banks face. Some of the key risks faced by Islamic banks are discussed below.
Credit risk is the loss of income arising as a result of the counterparty’s delay in payment on time or in full as contractually agreed. Such an eventuality can underlie all Islamic 144 modes of finance. For example, credit risk in murabaha contracts arises in the form of the counterparty defaulting in paying the debts in full and in time. The non-performance can be due to external systematic sources or to internal financial causes, or be a result of moral hazard (wilful default). Wilful default needs to be identified clearly as Islam does not allow debt restructuring based on compensations except in the case of wilful default. In the case of profit-sharing modes of financing (like mudaraba and musharaka) the credit risk will be non-payment of the share of the bank by the entrepreneur when it is due. This problem may arise for banks in these cases because of the asymmetric information problem where they do not have sufficient information on the actual profit of the firm.
Market risks can be systematic, arising from macro sources, or unsystematic, being asset or instrument-specific. For example, currency and equity price risks would fall under the systematic category and movement in prices of commodity or asset the bank is dealing with will fall under specific market risk. We discuss a key systematic and one unsystematic risk relevant to Islamic banks below.
Islamic financial institutions use a benchmark rate to price different financial instruments. For example, in a murabaha contract the mark-up is determined by adding the risk premium to the benchmark rate (usually the LIBOR). The nature of a murabaha is such that the mark-up is fixed for the duration of the contract. Consequently, if the benchmark rate changes, the mark-up rates on these fixed income contracts cannot be adjusted. As a result Islamic banks face risks arising from movements in market interest rate. Markup risk can also appear in profit-sharing modes of financing like mudaraba and musharaka as the profit-sharing ratio depends on, among other things, a benchmark rate like LIBOR.
Commodity/asset price risk
The murabaha price risk and commodity/asset price risk must be clearly distinguished. As pointed out, the basis of the mark-up price risk is changes in LIBOR. Furthermore, it arises as a result of the financing, not the trading process. In contrast to mark-up risk, commodity price risk arises as a result of the bank holding commodities or durable assets as in salam, ijara and mudaraba/musharaka. Note that both the mark-up risk and commodity/asset price risk can exist in a single contract. For example, under leasing, the equipment itself is exposed to commodity price risk and the fixed or overdue rentals are exposed to mark-up risks.
Liquidity risk arises from either difficulties in obtaining cash at reasonable cost from borrowings (funding liquidity risk) or sale of assets (asset liquidity risk). The liquidity risk arising from both sources is critical for Islamic banks. For a number of reasons, Islamic banks are prone to facing serious liquidity risks. First, there is a fiqh restriction on the securitization of the existing assets of Islamic banks, which are predominantly debt in nature. Second, because of slow development of financial instruments, Islamic banks are also unable to raise funds quickly from the markets. This problem becomes more serious because there is no inter-Islamic bank money market. Third, the lender of last resort (LLR) provides emergency liquidity facility to banks whenever needed. The existing LLR facilities are based on interest, therefore Islamic banks cannot benefit from these.
Risk management in Islamic banking
Operational risk is the ‘risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and technology or from external events’ (BCBS, 2001, p. 2). Given the newness of Islamic banks, operational risk in terms of personal risk can be acute in these institutions. Operation risk in this respect particularly arises as the banks may not have enough qualified professionals (capacity and capability) to conduct the Islamic financial operations. Given the different nature of business, the computer software available in the market for conventional banks may not be appropriate for Islamic banks. This gives rise to system risks of developing and using informational technologies in Islamic banks.
Legal risks for Islamic banks are also significant and arise for various reasons.
First, as most countries have adopted either the common law or civil law framework, their legal systems do not have specific laws/statutes that support the unique features of Islamic financial products. For example, whereas Islamic banks’ main activity is in trading (murabaha) and investing in equities (musharaka and mudaraba), current banking law and regulations in most jurisdictions forbid commercial banks undertaking such activities.
Second, non-standardization of contracts makes the whole process of negotiating different aspects of a transaction more difficult and costly. Financial institutions are not protected against risks that they cannot anticipate or that may not be enforceable. Use of standardized contracts can also make transactions easier to administer and monitor after the contract is signed. Finally, lack of Islamic courts that can enforce Islamic contracts increases the legal risks of using these contracts.
A variable rate of return on saving/investment deposits introduces uncertainty regarding the real value of deposits. Asset preservation in terms of minimizing the risk of loss due to a lower rate of return may be an important factor in depositors’ withdrawal decisions. From the bank’s perspective, this introduces a ‘withdrawal risk’ that is linked to the lower rate of return relative to other financial institutions.
Fiduciary risk can be caused by breach of contract by the Islamic bank. For example, the bank may not be able to comply fully with the shari’a requirements of various contracts. Inability to comply fully with Islamic shari’a either knowingly or unknowingly leads to a lack of confidence among the depositors and hence causes withdrawal of deposits. Similarly, a lower rate of return than the market can also introduce fiduciary risk, when depositors/investors interpret a low rate of return as breaching an investment contract or mismanagement of funds by the bank (AAOIFI, 1999).
Displaced commercial risk
This is the transfer of the risk associated with deposits to equity holders. This arises when, under commercial pressure, banks forgo a part of their profit to pay the depositors to prevent withdrawals due to a lower return (AAOIFI, 1999). Displaced commercial risk implies that the bank may operate in full compliance with the shari’a requirements, yet 146 Handbook of Islamic banking may not be able to pay competitive rates of return as compared to its peer group Islamic banks and other competitors. Depositors will again have the incentive to seek withdrawal. To prevent withdrawal, the owners of the bank will need to apportion part of their own share in profits to the investment depositors.
It is uncommon for the various risks to be bundled together. However, in the case of most Islamic modes of finance, more than one risk coexists. For example, in salam, once the bank has made an advance payment, it has started to take the counterparty risk concerning delivery of the right commodity on time, the market risk of the commodity, the liquidity risk of its conversion into cash, the operational risk of its storing and movement and so on. The same is the case with istisnaa, financial murabaha, ijara and musharaka/mudaraba.
Bachir A. El Nakib, CAMS, ACFE, CFAP
Founder, Senior Consultant, Compliance Alert (LLC)