sharia governance in islamic banks effectiveness and supervision model

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Sharia governance in Islamic banks: effectiveness and supervision model Hichem Hamza Graduate School of Business, University of Manouba, Tunis, Tunisia Abstract Purpose – The Sharia governance is topic that has generated much interest in the literature of Islamic banking industry. The Sharia supervision plays an essential role in the governance of Islamic banks. The Sharia Board (SB) which is peculiar to Islamic banks is considered as the principal component of the Sharia governance framework. The purpose of this paper is to examines the link between Sharia compliance, the form of Sharia supervision and the effectiveness of Sharia governance. Design/methodology/approach – This paper compares two model of Sharia governance framework, the first is the decentralized model in the Gulf Cooperation Council (GCC) and the second is the centralized model in Malaysia. Findings – The independence of the SB in their mission of supervision and the consistency of Sharia ruling are the principal components of an efficient Sharia governance structure. Centralized Sharia governance system, basically in Malaysia, seems to be beneficial to the industry in term of effectiveness and credibility of the Islamic banks. Research limitations/implications – The research focuses exclusively on the qualitative analysis about the SB and Sharia governance in Islamic countries. Practical implications – The model of centralization is able to strengthen the position and the independence of SB and can better examine the subjects of divergences between the whole of the SB in order to promote, in the long term, the consistency of Fatwas and interpretations between banks and regions. Originality/value – To the best of our knowledge few studies have examined this subject in a comparative discussion between MENA and Southeast Asia region. This paper contributes to the literature on Sharia governance by considering the difference between these two regions in term of supervision model of Sharia rules and principles and its application in Islamic banking. Keywords Sharia Board, Sharia governance, Sharia supervision, Islamic banking regulation, Islam, Banking Paper type Research paper 1. Introduction Islamic banks (IB) have the responsibility to ensure the compliance with the Sharia rules of their products, instruments, operations, practices and management. The compliance with the Sharia principles will be achieved by having a proper Sharia governance framework. In this sense and in the aim of credibility, IB have established their own Sharia Board (SB) usually comprised of a panel of Sharia scholars. The Sharia governance which refers to all the elements about the active role of SB and compliance with Sharia is strongly fundamental for IB. The compliance with the Sharia and the implementation of Sharia governance is encouraged by international institutions of regulation like Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) and Islamic Financial Services Board (IFSB). Today, some observers criticize the genuine morality of Islamic finance and condemn the non-compliance of some Islamic products and operations. In fact, failure The current issue and full text archive of this journal is available at www.emeraldinsight.com/1753-8394.htm International Journal of Islamic and Middle Eastern Finance and Management Vol. 6 No. 3, 2013 pp. 226-237 q Emerald Group Publishing Limited 1753-8394 DOI 10.1108/IMEFM-02-2013-0021 IMEFM 6,3 226

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Page 1: Sharia Governance in Islamic Banks Effectiveness and Supervision Model

Sharia governance in Islamicbanks: effectiveness and

supervision modelHichem Hamza

Graduate School of Business, University of Manouba, Tunis, Tunisia

Abstract

Purpose – The Sharia governance is topic that has generated much interest in the literature ofIslamic banking industry. The Sharia supervision plays an essential role in the governance of Islamicbanks. The Sharia Board (SB) which is peculiar to Islamic banks is considered as the principalcomponent of the Sharia governance framework. The purpose of this paper is to examines the linkbetween Sharia compliance, the form of Sharia supervision and the effectiveness of Sharia governance.

Design/methodology/approach – This paper compares two model of Sharia governanceframework, the first is the decentralized model in the Gulf Cooperation Council (GCC) and thesecond is the centralized model in Malaysia.

Findings – The independence of the SB in their mission of supervision and the consistency of Shariaruling are the principal components of an efficient Sharia governance structure. Centralized Shariagovernance system, basically in Malaysia, seems to be beneficial to the industry in term ofeffectiveness and credibility of the Islamic banks.

Research limitations/implications – The research focuses exclusively on the qualitative analysisabout the SB and Sharia governance in Islamic countries.

Practical implications – The model of centralization is able to strengthen the position and theindependence of SB and can better examine the subjects of divergences between the whole of the SB in orderto promote, in the long term, the consistency of Fatwas and interpretations between banks and regions.

Originality/value – To the best of our knowledge few studies have examined this subject in acomparative discussion between MENA and Southeast Asia region. This paper contributes to theliterature on Sharia governance by considering the difference between these two regions in term ofsupervision model of Sharia rules and principles and its application in Islamic banking.

Keywords Sharia Board, Sharia governance, Sharia supervision, Islamic banking regulation, Islam,Banking

Paper type Research paper

1. IntroductionIslamic banks (IB) have the responsibility to ensure the compliance with the Sharia rulesof their products, instruments, operations, practices and management. The compliancewith the Sharia principles will be achieved by having a proper Sharia governanceframework. In this sense and in the aim of credibility, IB have established their ownSharia Board (SB) usually comprised of a panel of Sharia scholars. The Shariagovernance which refers to all the elements about the active role of SB and compliancewith Sharia is strongly fundamental for IB. The compliance with the Sharia and theimplementation of Sharia governance is encouraged by international institutions ofregulation like Accounting and Auditing Organization for Islamic Financial Institution(AAOIFI) and Islamic Financial Services Board (IFSB).

Today, some observers criticize the genuine morality of Islamic finance andcondemn the non-compliance of some Islamic products and operations. In fact, failure

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1753-8394.htm

International Journal of Islamic andMiddle Eastern Finance andManagementVol. 6 No. 3, 2013pp. 226-237q Emerald Group Publishing Limited1753-8394DOI 10.1108/IMEFM-02-2013-0021

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to meet the underlying principles of the Islamic finance would give rise to Shariarisk and damage the credibility and the reputation of the Islamic banking industry.The credibility of IB is linked to the influence of SB in the banking decisions and theconsistency in the Sharia interpretation. Is there a code of ethical responsibility ofthe SB? Does the SB have a real power on the financial operations rules? Does the IBmake a control on the consistency of the various decisions of the SB?

The non-compliance can be attributed to the passive role of the SB in the Shariagovernance scheme. The members of SB, appointed and remunerated by the IB, playonly the role of advisory bodies. They do not have the necessary authority to accomplishthe task and implement decisions and this can be explained by their dependence with themanagement. Also, it should be noted that the diversity of backgrounds and the differentschools of jurisprudence of SB members as well as the regional context andnational regulatory environment in which the members of the SBs function can createinconsistency in the interpretation of Sharia and may thus prevent the harmonization ofproduct and financial operations.

This situation has leaded some countries to develop Sharia governance through thereinforcement of regulation and supervision of IB. In fact, the independence of the SB intheir mission of supervision and the consistency of Sharia ruling can contribute to anefficient Sharia governance structure. The regulation of Sharia governance in IB aimsto preserve the credibility of the industry. The existence of efficient Sharia governanceenhances the stakeholders’ confidence in the IB’s products and activities. In Malaysiaand in the Gulf Cooperation Council (GCC), both are the great centers of the Islamicfinance, the structure and regulation of Sharia governance in IB is not the same. InMalaysia, the SB governance is based on centralized model while in GCC countries wefind a decentralized model.

The main objective of this paper is to examine the effectiveness of Sharia governancein the IB in a context regulation change. Our idea is to make a conceptual relationshipbetween Sharia compliance, the form of Sharia supervision and the Sharia governanceof IB. In this relationship, the essential role is done by the internal and the external SB.The aim is to examine the role of SB in enhancing the Sharia compliance of IB throughthe Sharia supervision and the impact on Sharia governance and credibility.

This paper is divided into two main sections. Section 2 identifies critical issuesabout the risk of Sharia non-compliance and examines the independence of SB and theconsistency of Sharia interpretation as fundament of Sharia governance effectiveness.Section 3 discusses the regulatory framework of the Sharia governance model in someIslamic countries. The last section concludes the discussion.

2. Supervision and Sharia governance effectivenessThe Sharia non-compliance risk arises from failure to comply with the Sharia rules andprinciples determined by the SB of the bank or the relevant body in the jurisdiction inwhich the IB operate (IFSB-1, 2005). Sharia non-compliance risk can hit asset values ofIB with possible loss of investment or reinvestment income. The direct consequence ofnon-compliance can be the fund withdrawals and cancellation of investment contractscausing a decline in profits and performance of IB. The non-compliance with the Shariaaffects public confidence in Islamic finance and exposes the IB to the incredibility risk.

In this sense, IB should have a SB who has to ensure the compliance of products andservices offered to consumers and investors with the rules and principles of the Sharia.

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Is there a code of ethical responsibility of the SB? Does t have a real power on the financial operation rules? Does the IB make a control on the consistency of the various decisions of the SB?
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The SB is composed of experts (Foukahas) in Islamic jurisprudence or FiqhAl-Mouamalat and with sufficient knowledge of contemporary finance. The main roleof the SB is focused on the formulation of fatwas and review process aiming to providea common position in economics, finance and banking.

2.1 Certification and review roles of SBAs described by DeLorenzo (2007), the SB assists in all steps of the products or serviceprocess and lifecycle. First, the SB assists in the pre-certification step in which product isunder development and structuring. Then, the SB will issue a fatwa to certify thefinished product or service before its introduction in the market. After that, the SB shouldfollow the evolution of product by identifying and mitigating all possible risk primarilythe Sharia compliance risk. For the successful management of Sharia compliance riskand during all steps, SB must work closely with management throughout the process ofproduct development and its lifecycle.

According to the AAOIFI Governance Standard for IB[1] (GSIB Nos 1 and 2), ShariaCommittee is an independent body entrusted with the duty of directing, reviewing andsupervising the activities of the Islamic financial institution in order to ensure that theyare in compliance with Islamic Sharia rules and principles. The AAOIFI (1999, 2008)Standard requires at least three individuals in the board. In contemporary practice,most of the IB appoint between three and six members. According to the principles ofthe IFSB (2005, 2006)[2], an appropriate mechanism must be created to ensure thecompliance with the Sharia principles, this adequate system includes SB.

The SB is assisted by Sharia review to monitor and oversee the compliance of allactions and commitments of IB with SB ruling. Following the recommendation GSIB No. 3of the AAOIFI, most of IB have established an internal Sharia review structure, generallyin the form of review units. With a methodological approach in conducting the review, theinternal Sharia review assesses compliance of all transactions with the fatwas issued bythe Sharia Committee in term of proper implementation by the managers. Even after usinga new product, the audit of the operations of financial institutions is very important toensure that actual practice conforms to the requirements of Sharia (Iqbal et al., 1998). In theend of the annual period, a report is issued to certify that all financial transactions complywith the Sharia principles. This constitutes insurance for customers on the compatibilityof products and practices of IB with the Sharia. Although the Sharia review is in charge ofthe review of all transactions, the Sharia Committee remains the ultimate arbiter inmatters of Sharia compliance (Grais and Pellegrini, 2006).

The separation between the SB and the Sharia review or audit is an essentialrequirement for efficient supervision model. Failure in this separation implies that thefatwa issued may be modified by the Sharia Committee when there is slippage on the partof executive managers. With this separation we can avoid certain complicity betweenmanagers and Sharia Committee. The executive managers have an ethical responsibilityto implement correctly the recommendation of SB. Also, the board of directors has a moralresponsibility to request a perfect compliance of the IB behavior with the Sharia. Thedetermination of the board of directors is essential for the implementation of efficientSharia governance (Figure 1).

Sharia supervision operates at the macro level as well as the micro level(Nathan Garas and Pierce, 2010). It is clear that SB, through the supervision of thebanking activities, is the most important governance structure to ensure compliance

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with Sharia. The soundness and the reliability of the Sharia governance will dependbasically on the independence of SB and the consistency of pronouncements or Shariaruling between the various SBs in a state or a region.

2.2 Independence of the SBGiven their vital place and nature of their tasks, members of SB are directly involved ingovernance with board of directors and managers. The impact of ethics on the financialperformance can be the cause of divergence between SB, executive management andboard of directors. In this sense, IFSB (2009) stresses particularly the independence ofSB from the management of IB and how the potential interest conflicts should bemanaged. As the members of SB are appointed and remunerated by the IB, for aservice of assessment and review provided, is potentially problematic and could createa conflict of interest. In this situation they cannot be completely impartial andindependent.

The SB members are under double pressure, first, the pressure of the IB forcommercial reasons and second, they seek to preserve their reputation in order thatvalidated products must be without fault. For example, Sharia scholars must prohibitthe IB to realize certain profitable transactions or impose a reallocation of illicit income tocharity which leads to a lower performance. Under these circumstances, the IB managersmay be tempted to use their leverage to influence SB members (Grais and Pellegrini,2006). The religious factor, which gives much reason for Islamic finance compared to theconventional system, will lose of its interest compared to the interference of the IBmanagers who use SB in their own way. Indeed, in the aim to preserve their status, theSBs give their agreement to products that are moving away from Sharia principles. TheIB run a risk of reputation, when they are perceived as not complying with the rules ofSharia, this could involve a movement of distrust of certain stakeholders andwithdrawal of deposits by the clients.

Iqbal et al. (1998) propose, for the long-term interest of IB, the establishment of anindependent SB to oversee the implementation of the principles of Sharia. These authorsemphasize that if the Islamic banking system is not perceived as Islamic, existing IBwill soon lose much of their market. Bin Ibrahim (2009) stresses the importance for theboard of directors to understand clearly the role of Sharia governance and acknowledgethe independence of SB. If there is an influence from board of directors or managersthis will compromise the governance process and taint the Sharia decision. In fact, theintegrity of the SB is possible only with whole independence in the execution of theirmissions. This independence reinforces the credibility of the IB with the public,

Figure 1.Sharia governance

and supervision

Sharia Governance inIslamic banks

Macro supervision in the country level:Central bank and regulation of Sharia

ruling consistency

Micro supervision in the IB level:Independence of the Sharia committee and

Sharia review

Sharia Compliance

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Reliability of the Shariah Governance will depend basically on the independence of SB and the consistency of pronouncements or Shariah ruling between the various SB's in a state or region,
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the investors and the companies. This independence is one of the key factors of goodgovernance. The appointment and the remuneration should be done by another bodylike central bank or government to ensure the independence of the SB.

Another element which is related to the SB independence is the confidentiality ofinformation. In fact, the SB members who sit on the SB of more than one financialinstitution should preserve the confidentiality of each IB in term of information anddocumentation about contracts, operations and activities. With the possession of thistype of information, the SB members may find themselves in a strong position withmanagers and board of directors and this will perhaps create another type of conflict ofinterest. So if confidentiality is compromised an IB should have procedures in place totake appropriate disciplinary action to protect its interests.

2.3 The consistency of Sharia rulingSharia which governs all financial decisions is subject to a variety of interpretations andcontexts in which it applies. In economic and financial transactions, Sharia is subject tointerpretations from different schools of thought (Madhaheb) which generate a diversityof views on the same issues. The variations or divergence between SB’s members in theiropinions on the permissibility of the implementation of certain Islamic financial productsmay be attributed to a diversity of backgrounds, to schools of jurisprudence, as well as tothe regional context and national regulatory environment in which the members of theSBs function (Gintzburger, 2010). Questions were raised about the differing judgmentsissued for similar practices causing confusion for all IB customers. For the same product,such differences were found between banks or geographic areas more or less liberal.Sharia scholars of a country may permit a financial transaction which may differsubstantially from the point of view of Sharia scholars of other country.

The heterogeneity on similar matters may thus prevent the harmonization of productand financial procedures. This diversity of opinion among the Sharia scholars that composethe religious councils could be one of the greatest challenges to be raised by Islamic finance.The lack of centralization and religious supervision can lead to a lack of standardization ofSharia ruling and uniformity in Islamic financial and banking products within the samejurisdictions and among various regions. The aim of centralized regulation is to ensure theharmonization of Sharia ruling and to reinforce the credibility of SB.

Ingar (2008) stresses the fact that each bank has its own SB amplifies the lack ofconsistency despite the fact that often the same SB members sit in several IB. Suchsituation creates a lack of efficiency and coherence throughout the Islamic financialindustry. Ingar (2008) also states that environmental factors increase the disparitiesbetween the SBs like the strong competitive environment in which IB tend to havemonopolistic behavior. Then the circles of intellectuals and religious organizationshave a significant influence on the SB. There is also the degree of practice and religiouseducation of the population which appears to be another influencing factor. It seemsthat more a community is educated religiously; it is more demanding about the productcompliance to the Sharia.

If this heterogeneity is properly harmonized across different IB and regions, it canbecome a great strength for the Islamic financial services industry and will resolve theconflicting Sharia opinions and interpretations. Khan and Feddad (2004) suggestthe gradual international codification and standardization of fatwas. This duty may bedelegated to an existing international organization, whose mission already involves the

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promotion of harmonization and convergence of Sharia interpretations (Grais andPellegrini, 2006). The IFSB Standard Guideline on Sharia Governance (2009) encouragethe improving of consistency in terms of the professionalism of members of the SB,which could be crucial in enhancing their credibility and confirming their integritythrough a set of best practices. Also, the purpose of the AAOIFI’s SB is to achieveharmonization and convergence in the concepts and application among the Shariasupervisory boards of IB to avoid contradiction or inconsistency between the fatwasand applications by these institutions, thereby providing a pro-active role for theSharia supervisory boards of IB and central banks.

3. Models of Sharia governanceThe SB plays crucial role in monitoring and ensuring best practices of Shariagovernance which is unique to IB. In practice, the Sharia governance framework ismore centralized in Malaysia, Sudan and Pakistan than in the GCC countries.

3.1 The decentralized modelIn this approach the IB have their own SBs which are independent of the Central Bank.In the GCC countries and other states, each IB has its own SB, which decides on theconformity of products offered. It is the cases of Kuwait, Saudi Arabia, Bahrain, Qatar,the UAE, Jordan, Yemen, Gambia and Indonesia. In the GCC, there are no effectivenational SB at the level of central banks. There are individual SBs at the level of the IB.The permissibility of contracts and Sharia compliant financial products is decided atthe level of these institutions by their own Sharia Committee. We note the influence ofstandards and opinions of the AAOIFI board on most IB SBs in the GCC states.

The national SB of the Central Bank of Bahrain serve and asses only the Shariacompliance of its own products. The members of national SB are not restricted to serveany financial institution, also no limitation to serve more than one institution. The IBshall establish a Sharia Supervisory Committee to ensure and review the Shariacompliance products in line with the AAOIFI’s Governance Standards. All the ShariaSupervisory Committee have to submit to the shareholders an annual report and reviewabout the operations and the activities of the IB. The AAOIFI aims to harmonizeconcepts and applications among Sharia Supervisory Committee of various IB. Itsobjective is to prevent inconsistencies between Sharia Supervisory Committee ofdifferent banks and assist with developing new products (Figure 2).

In the case of Kuwait, the Central Bank Law 32/1968 provides that every IB shall haveits own Sharia Supervisory Board. IB’s SB are influenced by both AAOIFI and theIslamic Fiqh Academy Sharia standards. In the case of conflict of opinions concerning

Figure 2.Sharia governance in GCC

Islamic FiqhAcademy (OIC)

AAOIFI GovernanceStandards

ShariaCommittee

ShariaGovernance inIslamic Banks

ReviewCommittee

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a Sharia ruling, disagreement or disputes among SB members this should be referred tothe board of directors of the IB. They can then transfer the matter to the fatwa board ofthe Ministry of Awqaf and Islamic Affairs, which will serve as the final authority andwhich can be considered as a national SB (Wilson, 2009). The fatwa board is notauthorized to issue fatwa for products of the IB and the Sharia compliance review is doneby the internal audit committee of each IB as there is no national approval by the centralfinancial authorities on products issued by IB (Gintzburger, 2010). There is no restrictionfor the members of the fatwa board or the SB to serve in any IB. Also, there is nolimitation to serve as a member of Sharia Supervisory Board of more than one IB. SBs arerequired to submit an annual report to the general assembly that the banks operationscomply with Sharia principles and this report should be included in the annual financialstatements.

In the UAE, the first Islamic banking law in the GCC was implemented in 1985. TheArticle 6 of the UAE Islamic banking law states that each IB, financial institution andinvestment company should establish its own Sharia Supervisory Authority to ensurethat its transactions and practices conform to Islamic law. The same law indicates theestablishment of “Higher Sharia Authority” to supervise IB, financial institutions andinvestment companies (Art. 5, Federal Law No. 6 of 1985). This body will be the finalauthority in Sharia matters in Islamic banking and finance. No restrictions are imposedto the Sharia scholars of different SBs.

In Qatar, there is no Central Bank’s SB, but disputes and issues can be referred tothe Supreme Sharia Council of the Ministry of Awqaf. This council has no influence onthe permissibility of Islamic financial products. Like in Kuwait, every IB shall have itsown Sharia Supervisory Board and the Sharia compliance review is done by theinternal audit committee of IB. There is no restriction to Sharia scholars to be amember of SB in more than one IB.

In Saudi Arabia there is no national SB. There are Sharia supervisory boards at thelevel of IB which are only influenced by the Sharia standards of the Islamic FiqhAcademy. From the perspective of jurisprudence, the Islamic Fiqh Academy is involvedin establishing legal norms and the treatment of subject’s differences (Table I).

In the GCC countries, some uniformity is ensured by the fact that most Sharia scholarssit on several SB. This type of approach allows products innovation contributingsignificantly to the dynamism of the industry (Wilson, 2009). Nevertheless, the risk is thelack of regulation where the regulators do not have their own SBs and therefore the issue

Bahrain Kuwait UAE Qatar KSA

Fatwa issued by IB U U U U U

Existence of reviewcommittee

U U U U U

Presence of scholars inother IB

U U U U U

Nomination of Shariascholars by IB

U U U U U

Authority of Shariaconflict

The nationalSB in CentralBank

Ministry ofAwqaf andIslamic Affairs

HigherShariaAuthority

TheMinistryof Awqaf

Islamic FiqhAcademy

Table I.Sharia governanceregulation in the GCC

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of dispute resolution becomes more problematic, this will gives rise to inconsistenciesin the fatwas across SB, or even over time in the same SB.

3.2 The centralized modelThe centralized approach is based on central SB, attached to the Central Bank, whichrules on the conformity of products and activities of all the IB. Each IB shall have itsown SB, but it must comply with the rules set by the central SB. The existence of a SBin the Central Bank will reduce the differences of interpretation, provided that theCentral Bank does not try to impose his own opinions but to crystallize the viewsthrough open debate (Chapra and Khan, 2000).

A centralized Sharia governance model is practiced in Malaysia, Pakistan andSudan. In Malaysia, the central financial authorities are the Central Bank, Bank NegaraMalaysia, and the Securities Commission. Two Sharia governance structure has beenestablished, comprising a Sharia Advisory Council (SAC) at the Central Bank ofMalaysia for both financial authorities and a Sharia Committee in each IB. The Shariastandards followed are those of the SAC of Bank Negara Malaysia and of the SecuritiesCommission. These standards are influenced externally by both the Sharia standardsof the AAOIFI, the Islamic Fiqh Academy (Mujma’al fiqh il islamy) of the OIC inJeddah, the IFSB standards and internally by the opinions of Malaysian SB memberswith certain opinions particular to Malaysia (Gintzburger, 2010). The review and auditof Sharia compliance is done by the IB to support Sharia Committee.

In Malaysia, the Islamic Banking Act 1983 and Takaful Act 1984 require theestablishment of an independent Sharia Committee within each IB with a minimum ofthree and a maximum of seven Muslim religious scholars[3]. The first ShariaCommittee was set up in 1983 by Bank Islam Malaysia Berhad (BIMB) which startedits operations as Malaysia’s first IB on 1 July 1983.

According to the Financial Stability and Payment Systems Report (2010), the SAC wasestablished in 1 May 1997 as the highest authority and sole reference on all Sharia matterspertaining to banking and takaful. The SAC is responsible for all Sharia compliancymatters and also for validating all Islamic banking and takaful products to ensure theircompliance with Sharia. The Sharia Committee will refer to the SAC for its resolutions on aSharia issue. The SAC serves as the final arbiter in the interpretation of Sharia principleson Islamic banking and takaful matters and practices. The aim is to ensure uniformity andharmonization of Sharia interpretations and strengthening the regulatory framework andpromoting good governance within the Islamic financial sector.

Apart from the central SAC, Sharia Committee at the IB level remains the mostimportant governance mechanism to ensure compliance with Sharia. The IB need toreceive approval from the financial authorities to appoint any Sharia scholars as SBmembers. Both the SAC in the Central Bank and the Sharia Committee have set thestandard for any Sharia matters and governance for the operations of the IB. Theauthorities have a monitoring system to check Sharia compliance and governance inorder to protect the interest of the Sharia framework, the shareholders and stakeholdersof the IB as well as their customers (Gintzburger, 2010) (Figure 3).

In December 2004, Bank Negara Malaysia issued the Guidelines on the Governanceof Sharia Committee for the IB outlining the role, scope of duties and responsibilities ofa Sharia Committee and its members and the relationship and working arrangementbetween the Sharia Committee at individual institutions and the SAC at the

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national level. Only the SB of Bank Negara and the Securities Commission can issuefatwa, the role of the Sharia Committee of IB is to ensure that this fatwa is implementedwith respect to the contracts offered. Members of the SBs of Bank Negara and theSecurities Commission cannot serve on the boards of Islamic financial institutions andvice versa. For reasons of confidentiality, Sharia Committee members can only serve asa member of Sharia Committee in one financial institution in the same industry (Islamicbanking and takaful are considered as different industries).

Similar to Malaysia, Pakistan also has established a SB at Central bank, which is thesole authority in matters pertaining to Islamic finance with the power to issue fatwa. Ithas also required the establishment of a Sharia advisor for each IB. In 2008, the StateBank of Pakistan issued a detailed instructions and guidelines for Sharia compliance inIslamic banking institutions[4]. According to these instructions, SB or advisors shouldbe appointed by the board of directors in the case of a domestic bank, or by themanagement in the case of foreign IB having branches in Pakistan. Any member of SBat the State Bank of Pakistan is allowed to serve as Sharia advisor for only onefinancial institution. In the case of conflict of opinions, disagreement or disputes amongSharia advisors members, it should be referred to the State Bank of Pakistan’s SBwhich is the final authority and their decisions are compulsory (Table II).

In Sudan, the government has developed continuously the Islamic finance since theestablishment of the first Sharia-compliant bank, the Faisal Islamic Bank in 1978. In1984, the banking and financial industry changed its practices to conform with Sharia.Similar to Malaysia, the government established in 1992 a SB at Central bank called the

Malaysia Pakistan Sudan

Fatwa issue done by Central Bank U U U

Review committee U U U

Presence of scholars in other IB No U U

Appointment of Sharia scholars by IB U U Ua

Authority of Sharia conflict Central Bank Central Bank Central Bank

Note: aAfter approval of Central Bank

Table II.Sharia governanceregulation in theMalaysia, Pakistanand Sudan

Figure 3.Sharia governancestandards

BNMGuidelines

IFSBStandards

AAOIFIGovernanceStandards

ShariaGouvernance

ShariaCommittee

AuditCommittee

Sharia Advisory Council(SAC)

Islamic

Banks

Islamic

Banks

Source: Bin Hasan (2007)

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High Sharia Supervisory Board (HSSB) to ensure compatibility of financial practiceswith Islamic principles (Article (7) of 1992 Act). The body is a centralized nationalSharia advisory council and is the sole authority in matters pertaining to Islamicfinance with the power to issue fatwa. In fact, the Sharia compliance is supervised attwo levels: the HSSB and the IB’s Sharia Supervisory Boards.

The HSSB supervises the Sharia Supervisory Boards of IB – Governance as well asproducts – and the conformity of the Central Bank activities to the principles of theSharia. The Bank of Sudan Act passed in 2002 (law regulating the banking activity)specifically stipulates that the Bank will abide by Islamic Sharia principles in theperformance of its duties and objects, and in the exercise of its functions and supervisionof the banking systems. The council includes 11 people, the majority of whom are Shariascholars also we find economists, specialists in finance, jurists and bankers (includingthe Central Bank Governor) among its members. All members are appointed by thepresident of the country upon recommendation of the bank Sudan’s governor andthe minister of finance. The members are allowed to sit in HSSB and in the SBs of IB.The HSSB provide fatwa on all Sharia-related matters. It studies and suggests solutionsfor the problems that face the banking sector with regards to the application of Shariaprinciples. The HSSB has the final decision in cases where there are different opinions onan issue specific to banking and insurance. The HSSB intermediates for disputesbetween various IB, IB and Bank of Sudan, and IB and its customers. A bank can alsoturn to the HSSB as the ultimate authority if it does not agree with a decision of itsinternal SB (Bekin, 2009). The board is also empowered to inspect banks and insurancecompanies to ensure proper implementation of Sharia principles and submit to theMinister of Finance annual reports on the consistency of banking and insurancetransactions with Sharia principles.

In addition to the HSSB for the application and the supervision of Sharia governance,every IB is required to establish its Sharia Supervisory Board composed of threemembers. The nominations of the Sharia Supervisory Board membership are done bythe management after approval by the general assembly, they have to be ratified andapproved by HSSB. The Sharia Supervisory Boards provide fatwa on matters referred toit by the IB. It examines and revisits all IB’s transactions and certifies conformity of theIB’s performance with Sharia.

4. ConclusionSharia compliance allows the IB to consolidate their differentiation factor compared toconventional financial institutions and support their reputation and credibility. Thereinforcement of the SB role in the IB is necessary and allows strengthening of the Shariadecision-making process. This role should be emphasized on control and review toensure compliance with Sharia rules. In this sense, regarding their tasks, theappointment and the remuneration of the SB members should be done by another bodylike central bank or government to ensure the independence of the SB which is crucial forcredibility. Also, the divergence of interpretations or inconsistency between the SBs ofIB can affect the credibility of the industry. It is requesting a standardization of Shariaruling and uniformity in Islamic financial and banking products within the sameregulation and among various regions.

The Sharia governance frameworks reflect a difference in the approach ofgovernance and regional variations in the application of Islamic finance contracts.

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In the GCC countries, the decentralized approach is often applied where each IB has itsSB which is independent from the Central Bank authority. With this approach it isdifficult to achieve consensus in Sharia interpretation and to manage properly theexisting interest’s conflicts. In Malaysia basically, the centralized approach knowsadvances in term of fatwa and review and seems to give harmonization to the industry.The Central Bank of Malaysia, Bank Negara, has tightened Sharia rules for IB byrequiring them to set up Sharia review, audit and risk management functions toreinforce compliance. In Africa, only Sudan has a Sharia governance framework whichis based on centralized approach like in Malaysia. The existence of decentralized andcentralized approaches in the same time can increase significantly the regionaldifferences in the application of Islamic finance contracts. This situation is harmful tothe credibility of Islamic industry and need more coordination between main players.

The model of centralization is able to strengthen the position and the independenceof SB and can better examine the subjects of divergences between the whole of the SBin order to promote, in the long term, the consistency of fatwas and interpretationsbetween banks and regions. The existence of a model of centralization becomesobvious and starts taking place in several countries. In this model, the question now isabout the cooperation between the internal SB (micro-supervision) and the central SB(macro-supervision). In this sense the creation of council of all SB of all the IB in acountry can harmonize Sharia governance practices in collaboration with the CentralBank.

Notes

1. The AAOIFI had provided standards on Sharia Supervisory Board, Sharia Review andInternal Sharia review under its Governance Standard (GSIB, 1999 and 2008).

2. Principle 3.1 of the IFSB Guiding Principles on Corporate Governance (IFSB-3, 2006).Principle 7.1 of the IFSB Guiding Principles on Risk Management (IFSB-1, 2005).

3. Pursuant to Section 3 (5) (b) of the Islamic Banking Act 1983 (IBA 1983) for Islamic banks,Section 124 (7) of the Banking and Financial Institution Act 1989 (BAFIA 1989) for IslamicBanking Scheme Banks, Section 8 (3) (a) Takaful Act 1984 (TA 1984) for Takaful operatorsand Section 16B of the Central Bank of Malaysia (Amendment) Act 2003 (CBA 2003) forCentral Bank of Malaysia.

4. State Bank of Pakistan, Instructions for Sharia Compliance in Islamic Banking Institutions,Karachi, Annexure 1 of IBD Circular Nos. 1 and 2 of 2008.

References

AAOIFI (1999, 2008), Governance Standard for Islamic Financial Institutions, AAOIFI, Manama.

Bekin, R. (2009), “Sudan: forgotten center of Islamic finance”, NewHorizon Magazine, April-June,pp. 22-26.

Bin Hasan, A. (2007), “Optimal Sharia governance in Islamic finance”, paper presented at theFinancial Regulators Forum in Islamic Finance – Global Islamic Finance Forum (GIFF),Kuala Lumpur, Malaysia, March.

Bin Ibrahim, M. (2009), “Managing Sharia risk through Sharia governance”, Keynote addressedat the joint Conference Between International Sharia Research Academy for IslamicFinance (ISRA) Together with Institute of Islamic Banking and Insurance London (IIBI)and Thomson Reuters, Kuala Lumpur, Malaysia, August.

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Chapra, M.U. and Khan, T. (2000), “Regulation and supervision of Islamic banks”, OccasionalDocument No. 3, Islamic Research and Training Institute-Islamic Development Bank, Jeddah.

DeLorenzo, Y. (2007), “Sharia compliance risk”, Chicago Journal of International Law, Vol. 7 No. 2,pp. 1-12.

Financial Stability and Payment Systems Report (2010), Press Statements, Bank NegaraMalaysia, Kuala Lumpur.

Gintzburger, A.S. (2010), “An analysis of global trends and regional pockets in the application ofIslamic finance contracts in Malaysia and the Gulf Cooperation Council”, paper presentedin International Conference on Islamic Banking & Finance, Cross Border Practices& Litigations, Kuala Lumpur, Malaysia, June.

Grais, W. and Pellegrini, M. (2006), “Corporate governance and Shari’ah compliance in institutionsoffering Islamic financial services”, World Bank Policy Research Working Paper.

IFSB-1 (2005), Guiding Principles of Risk Management for Institutions (other than InsuranceInstitutions) Offering only Islamic Financial Services, IFSB-1, Kuala Lumpur.

IFSB-10 (2009), Guiding Principles on Shariah Governance Systems for Institutions OfferingIslamic Financial Services, IFSB-10, Kuala Lumpur.

IFSB-3 (2006), Guiding Principles on Corporate Governance for Institutions Offering only IslamicFinancial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic MutualFunds), IFSB-3, Kuala Lumpur.

Ingar, L. (2008), “Le developpement de la finance islamique sur fond de crise financieremondiale”, Keynote addressed at the Second French Forum on Islamic Finance, Paris,France, November.

Iqbal, M., Ahmad, A. and Khan, T. (1998), “Challenges in Islamic banking”, OccasionalDocument No. 2, Islamic Research and Training Institute-Islamic Development Bank,Jeddah.

Khan, M.F. and Feddad, L. (2004), “The growth of Islamic financial industry: need for settingstandards for Sharia application”, paper presented at the 6th Harvard University Forum inIslamic Finance, Cambridge, MA, USA, May.

Nathan Garas, S. and Pierce, C. (2010), “Shari’a supervision of Islamic financial institutions”,Journal of Financial Regulation and Compliance, Vol. 18 No. 4.

Wilson, R. (2009), “Shari’a governance for Islamic financial institutions”, paper presented at theMeeting Re-Imagining the Shari’a: Theory, Practice and Muslim Pluralism at Play, Venice,Italy, September.

Further reading

Chapra, M.U. (2008), “The global financial crisis: can Islamic finance help minimize the crisis inthe future?”, paper presented at the Forum on the Global Financial Crisis Held at theIslamic Development Bank, Jeddah, Saudi Arabia, October.

IFSB (2010), Islamic Finance and Global Financial Stability (Report), IFSB, Kuala Lumpur.

Corresponding authorHichem Hamza can be contacted at: [email protected]

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