internal shariah controls for islamic financial institutions

Mufti Abdul Sattar LaghariShariah Adviser

Habibmetro –[email protected]

Internal Controls for Shariah Compliance in

Islamic Financial Institutions in the light of

AAOIFI Shariah StandardsNIBAF

June 5, 2015

PART 1IntroductionStrategic Importance Of Shariah Compliance

Rulings Of OIC Islamic Fiqh Academy

Globally Acceptable Shariah Standards

AAOIFI Shariah Standards: What Is The Significance?

Shariah Advisors Or Shariah Supervisors & their Roles

INSIDE THE SESSION

PART 2Shariah Compliance – A Theoretical Perspective

Levels of Shariah ComplianceCategories of Shariah complianceBanks’ Internal Shariah ControlsMode Based Shariah Compliance Controls

Q & A

INSIDE THE SESSION

Shariah is the body of Islamic religious law. The term means "way" or "path to the

water source“. It is the legal framework within which the

public and private aspects of life are regulated and controlled based on Fiqh (Islamic principles of jurisprudence).

According to the modern definition, Shariah is the comprehensive body of Islamic laws that regulates the public and private aspects of the lives of the Muslims.

INTRODUCTION Part 1WHAT IS SHARIAH

http://en.wikipedia.org/wiki/Fiqh

http://en.wikipedia.org/wiki/Fiqh

INTRODUCTION

O you who have believed, enter into Islam completely [and perfectly] and do not follow the footsteps of Satan. Indeed, he is to you a clear enemy.

8ه: الل ض@ي< ر< Fع<اص@ ال Fن@ ب ع<مFر@و Fن@ ب :ه@ الل Fد@ ع<ب Oم8ح<م:د @ي ب> أ Fع<ن

: سلم و عليه الله صلى :ه@ الل س8ول8 ر< ق<ال< ق<ال< Fه8م<ا، ع<ن@ه@ " ب Fت8 ج@ئ @م<ا ل <عaا <ب ت ه<و<اه8 8ون< <ك ي :ى ح<ت F8م <ح<د8ك أ 8ؤFم@ن8 ي ". ال<

" " Oاد> ن Fس@ @إ ب Fح8ج:ة@ ال <اب@ @ت ك ف@ي <اه8 Fن و<ي ر< ، sص<ح@يح sح<س<ن sح<د@يث. Oص<ح@يح

The Messenger of Allah (peace and blessings of Allah be upon him) said, “None of you [truly] believes until his desires are subservient to that which I have brought.”

INTRODUCTION

Shariah Compliance means “ Adherence to the guidelines and

rulings of Shariah in all aspects and manners”.An organization or person who claims to be a “Shariah

Compliant” has to follow Shariah in its all Operations and all Activities.

Shariah requires a Comprehensive Adherence as mentioned in above

Ayah and Hadith and not asymbolic one.

INTRODUCTIONDefinition Of Shariah Compliance

Compliance is “ The state of being in accordance with the laws of relevant Federal or Regional Authorities”

In the context of Islamic finance, “ The state of the business operations of an IFI being in accordance with the relevant Shariah Rules and Guidelines issued by:

1. Shariah Ruling Body (AAOFIF) and formalized by a regulatory authorities (SBP)

2. Rulings of Shariah Adviser or Shariah Supervisory Boards.

INTRODUCTIONDefinition Of Shariah Compliance

Adherence to Shariah is WAJIB on every Muslim and Islamic Financial Institution.

Failure leads to disobedience of Allah and His Messenger (Peace be Upon Him).

Failure leads to loss of income i.e. charity.

Failure leads to reputational risk.

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Strategic Importance of Shariah Compliance

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RULINGS OF OIC ISLAMIC FIQH ACADEMY

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(IFSB), which is based in Kuala Lumpur, was officially inaugurated on 3rd November 2002 and started operations on 10th March 2003. It serves as an international standard-setting body of regulatory and supervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry. Since its inception, the IFSB has issued twenty-four Standards, Guiding Principles and Technical Note for the Islamic financial services industry.

AOIFI is an Islamic international autonomous non-for-profit corporate body that prepares accounting, auditing, governance, ethics and Sharia standards for IFIs and the industry.

AAOIFI has gained assuring support for the implementation of its standards, which are now adopted in the Kingdom of Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria.

The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom of Saudi Arabia, and South Africa have issued guidelines that are based on AAOIFI’s standards and pronouncements.


AAOIFI was established in accordance with the Agreement of Association which was signed by Islamic financial institutions on 1 Safar, 1410H corresponding to 26 February, 1990 in Algiers. Then, it was registered on 11 Ramadan 1411 corresponding to 27 March, 1991 in the State of Bahrain.

Total of 88 standards issued: (a) 48 on Shari’a, (b) 26 accounting, (c) 5 auditing standards, (d) 7 governance, (e) 2 codes of ethics.

They now carry global status and acceptability and many financial regulatory authorities have adopted these standard.

AAOIFI Shariah Standards – The Significance

http://aaoifi.com/media/document/CSAA.pdf

SBP has also adopted some standards after thorough discussions on variable forums (SAF, SBP SB, other department of SBP).

Therefore, the Shariah compliance mechanism is done on the basis of these standards.

The explanation of the standard and areas which are not covered in these standards, are covered by Shariah Board / Shariah advisers of the institutions.

AAOIFI Shariah Standards – The Significance

The SB is to consider, decide and supervise all Shariah related matters of the IBI.

The SB is to develop a comprehensive Shariah Compliance Framework with in IBI.

Ensure prior approval for all products and services.

Ensure Shariah conformity for all SPMs, product structures, process flows and marketing tools.

SBMs have to review all internal Shariah audit and Shariah compliance reports for considering appropriate action.

SB’s decisions and rulings are in conformity with AAOIFI Shariah standards and Regulator.

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Role of Shariah Advisers or Shariah Board Members

There are three levels of Shariah compliance:►Top level (Strategic)►Middle level (Tactical)►Lower level (Operational)

Shariah Compliance – Theoretical Perspective

Top level

Tactical level

Operational level

Strategic Level Or Top Level An important level where Shariah compliance becomes very crucial.

In fact Shariah compliance is initiated from this level.

Includes shareholders and top management relations.

Cultural and behavioral issue of management.Shareholders engagement with other Haram businesses – lack of seriousness in Shariah compliance.○ Examples are foreign banks and local banks

with Islamic windows.


Top Level (Strategic):

HR policies and other relationships.■ Marketing Strategies - Techniques■ Shariah governance – Shariah

quality improvement system (Check lists & MISs for Products)

■ Readiness for change.


Middle Level (Tactical):■Customer relationship○Cheating and Lying ○Unattainable Promises■Right and Obligation (customers and subordinates)○Feeling of this responsibility■Ethical motivation of employees


Lower Level (Operational)■ Ethical responsibilities○ Very important here■ Behavior■ Awareness about the Islamic financial

system;○ Product information■ Knowledge of pros and cons of the

system■ Dealing with religious minded people


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Internal Shariah Compliance Scope An Overview

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Includes:►All the financial services and products offered

on asset side (customers to bank relation);■ Corporate, Commercial and Consumer

structured assets – vanilla products;■ Specially structured products – Sukuk,

syndicated transaction etc.;► The general banking operations of Islamic

banks on liability side (Depositors to bank relationship), and

► Interbank relationships with Islamic and non-Islamic financial institutions;

►Relationship with regulators;24

External Shariah Compliance Scope

The relationship with all these fall in ambit of Shariah compliance.

Funds placement with or funds reception from these stockholders must be Shariah compliant.

Islamic modes of financing should be executed according to recommended methods, process-flows and manuals.

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External Shariah Compliance Scope – An Overview

Islamic FinancialIntermediary – Bank

or Insurance Co.

Islamic Funds

Depositors

Takaful

SBP (SLR & CRR + IERS)

Customers

Conventional banks Conventional funds and

Insurance cos

Shariah compliance may be divided into three categories

This division is just for the purpose of continuous practical application:

(1)-Acceptable level:■It is the minimum level that is required to become Shariah Compliant and Acceptable.■Failure results non-Shariah compliant (Haram) status of the organization or activities

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Shariah Compliance Categories

Elements of Acceptable Level:○ Restraining from impermissible business

activities The institution should not involve in any

business or management activity which is not Halal

○ Elimination of RIBA The institution should not go for an option

where interest exists;○ Elimination of Gharar and all types of

gambling; No involvement in Gharar is permissible;○ Implementing the Islamic laws of contract

in normal course of business;

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Acceptable Level (Cont'd);■Although at acceptable level Islamic banks remain in the ambit of Halal and Haram but some reservations in qualitative matters remain there in scholarly circles.○Mimic transactions are example of this level.○Some of transactions are in gray area although we can not call these transactions Haram.○Examples are: Commodity Murabahah, Some credit card structures, Islamic lotteries etc.

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(2)-Satisfactory Level;■ This is a step forward level in

assurance of Shariah compliance.■ The satisfactory level means the

level of adherence to laws and rules that shows their identity as separate system;

■ Failing to assure this level usually results in lack of acceptability and creates differences and debates both valid and invalid;

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Satisfactory Level (Cont'd);■Comprehensive Shariah training;○General Islamic banking training;○Specific trainings – product wise

trainings;○Workshops and conferences;■Shariah compliant marketing strategies and tactics;○Advertisement themes;○Wordings of advertisements;

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■Satisfactory Level (Cont'd);

■Internal and external Shariah compliance;○Revision of processes and system on continuous basis;○Periodic revision of existing agreements and processes to ensure Shariah quality;○The satisfactory level should always be preference of Islamic banks;


►3- Desirable Level:■ The desirable level for Islamic

financial institutions means the level of adherence to guidelines o Islam that reflects Islamic values and features.

■ This is although a difficult and a long run task but it is the main target for which whole system is developed.

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Desirable Level Cont:

Features and Elements of Desirable Level:○Product InnovationCopying and mimicking the conventional products does not reflect contribution of Islam financial system. 33


○ Desirable Level Cont: ○ Real involvement in trade and business

activities.Symbolic and artificial involvement creates doubts about claims of Islamic banks.

○ Less role of Agency, Gift and Rebates.○ Islamic values of equitable

distribution of wealth in society.○ A very Longley waited change that is

dream of ours.34


“Internal Sharia Control Mechanism” assures the compliance of Shariah guidelines and minimizes the risk of deviation in day to day transactions.

Shariah department in coordination with compliance department should ensure that effective Shariah control mechanism is in place.

The Management should be attentive to implementation of the recommended Shariah controls and to proper training of the staff.

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Internal Shariah Control Mechanism

The Shariah control or compliance mechanism consists:► (A)-Operational Control Strategy■ Involvement of SCD in approvals of the

transactions.■ Credit and CAD processing / approval linkage with

SCD approvals;► (B)-Systematic Control Strategy■ Manuals, Process flows, SOPs, Check lists and

forms.■ Quarterly, Monthly or weekly reporting of

transactions.■ Assessment of possible deviations and their

control. 36

Internal Shariah Control Strategy

The SCM may vary with regards to:

►the nature of modes of financing.►the nature of transaction (Consumer or Syndicate)►the nature of business (easy or complex process business)37

Segmentation Of Shariah Control Mechanism (SCM)

The SCM may be divided with regards to modes of financing into FOUR categories:

A. Trade-based mode of financing and their controls.■Four modes fall under this:○Murabahah○Musawamah○Salam○ Istisna'a

Segmentation Of Shariah Control Mechanism (SCM)

B. Rental-based mode of financing and its control:■Ijarah comes under this header.

C. Partnership based modes of financing and their control:■Mudarabah and Musharakah come under this header;

D. Combined modes of financing:■DM falls in this category.

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Segmentation Of Shariah Control Mechanism

Murabahah being a vastly used mode of financing by Islamic banks, a detailed SCM is outlined here for it:

►Murabahah is a kind of sale where the seller (Islamic bank) discloses the cost of the sold goods and the added profit to customer.

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Internal Shariah Control Mechanism – Murabahah

►Points for Shariah Compliance of Murabahah Transaction;■ A list of Murabahah transaction executed by

the Islamic Bank during the period under review.

■ A representative sample of the transactions executed during the period and their documentation.

■ Review the process flow and agreement prepared by the bank and approved by the Sharia Advisor.

■ Ensure that all the agreements executed with customer are in compliance with the process flow and agreement approved by the Sharia advisor.

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Methodology and Approach of Shariah compliance assurance in Murabahah:►Following are major steps of correct

execution of Murabahah transaction:■Pre Disbursement:○Business analysis: Halal or Haram status.

■Business Structure Of The Parties:○Ownership structure – both companies are not owned by one party who ultimately becomes buyer and seller in one time.

■Processing Difficulties (Transaction Is Not Possible In Terms Of Practicality):○Perishable items and fast moving items have different modalities for correct Murabahah;

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■Real Trade Possibility:○Possibility of possession of goods○Possibility of delivery of goods○Possibility of on time offer and acceptance○Possibility of physical inspection○Mode of payment○Possibility of specification and quantification of goods

■Check list & Process flow should be designed and filled properly and signed■Specific Shariah approval in case of any exception■Physical inspection where required

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Internal Shariah control mechanism – Murabahah

Documentation■Proper process flow of documents■Standardized formats to avoid confusions■Approved agreements by Shariah and legal■Signing of Promise for purchase is essential here○In case it is not signed, the customer may not be bound to buy the goods he ordered.○Similarly bank can not ask him for any compensation of loss.

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►Following documents are required for MurabahahA. General documents (one time documentation) and their execution;○Master Murabahah agreement along with facility limit, tenure and terms and conditions;


B. Transaction Based Document Execution:■Purchase requisition■Offer and acceptance■Any other detail for transaction such as:○Payment mode○Payment tenure (monthly or quarterly etc.)○The terms of the agreement are not changed except with the specific approval of the Sharia Advisor

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SCM For Murabahah Should Also Ensure That:►The proper documentation has been

executed.►The charity account is in place to

manage charity received from a customer in case of delayed payments / defaults.

►The Murabahah transaction is not used as buy back facility.

►The correct invoices have been received for the goods.

►The invoices are original and not back dated or conflict with date of Murabahah declaration.

►The offer & acceptance are correctly executed with details of goods purchased by agent.

►The sale is concluded correctly and the ownership as well as risk is transferred to the customer.

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Ijarah is a lease of a non consumable asset.

The difference b/w conventional lease and Ijarah is segregate arrangement of asset transfer at the end of lease term.

Shariah Control Mechanism Of Ijarah:Some processes are same as in Murabahah like document vetting by Shariah adviser, standardized documentation etc.

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Internal Shariah Control Mechanism – Ijarah

SCM Of Ijarah Should Ensure :►The proper documentation of the

transaction.► A charity account in place to manage

charity.►The asset is specified and known.►The Ijarah period is known.►A proper mechanism is agreed in case of

variable rental and fixed rentals..►The Ijarah is concluded correctly and the

usage right is transferred to the customer.►The responsibility of asset risk is clearly

known to both bank and customer.49


►The nature of rentals is clearly known i.e. advance or arrears.

►The rental shall start after the delivery of the assets and not from the contract date or disbursement.►Any evidence for assurance of asset delivery to the customer is in place e.g. delivery order or.►The asset is transferred (by mean of sale or gift) through a separate contract at end of the lease term.

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DM is a hybrid product that comprises of Shirkah (joint ownership), Ijarah (Rental agreement) and Bai' (Sale).

Rules of all these mode need be ensured in this product.

Shariah Control Mechanism Of DM:

Some processes are same as in Murabahah and Ijarah like document vetting by Shariah adviser, standardized documentation etc.

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Internal Shariah Control Mechanism – DM

SCM Of DM Should Ensure That:► The steps of implementation should be

defined in advance i.e. Shirkah first, then Ijarah and then sale.

► This arrangement should not be used for cash financing.

► In a sale and DM back transaction, the sale of units will start after completion of one year to avoid buyback arrangement.

►Mechanism for early maturity and balloon payments should be clearly specified.

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Documents involved in D M transaction :1. Offer Letter2. Musharakah Agreement■ Description of Asset, Percentage of share

3. Monthly Payment Agreement or Ijarah Agreement.

Rental Payment Schedule4. Undertaking to Purchase Musharakah Units ■ Unit purchase price

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The relationship with fund providers is called Liability side

operation of Islamic banks.Funds received by banks are of two types:►Non Remunerative■They are based on Qard whereby the principle amount is guaranteed with no return or extra facilities.

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Liability Management Deposits, Acceptance And Placements

►Remunerative►They are of two types:■ General saving and time deposits■ Interbank deposits (Acceptance)►Remunerative deposits are normally

managed under:► (1) Modarabah + Musharakah► (2) Musharakah ► (3) Wakalah tul Istismar (see

summary in coming slide)


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Modarabah + Musharakah Model

Depositors Bank

Pool of fund

Depositors' contributio

n (Deposits)

Financing & investments

Profits or Loss

Distribution of profit or loss among multiple depositors (Arbaabul Amwaal) through weightage

system

A B C D E F G H

I J K L M N O P

Portfolio of assets

Share of Rabbul Maal

Share of Mudarib

Distibuteable Profit (Gross Profit)

Mudarib's contribution in as balancing

amount

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Summary Of Deposit Management Modes

Islamic Financial Institution

Mods of Deposits (fund providing) to Islamic bank

Mudarabah:1. Mudarabah is similar to Musharakah and differes with it in some features;2. Funds are provided by deposit holders and bank uses its expertise;3. The funds available for investment are totally provided by Rabbul Maal;

Musharakah:1. Bank rceives deposits and mixes it own fund with this deposit and keep it in a pool which is used to finance assets;2. This mode is not in use nowadays because of some practical issue in management of deposits;3. Bank and depositors share in profit as per the agreed PSR (Profit Sharing Ration);4. The loss is shared pro rata in case of real loss;5. Special facilities may be offered to these deposit holders.

Mudarabah + Mushrakah:1. This the vastly used model as it has operational flexibilities;2. Fund are provided by Rabbul Mall(s) but Mudarib may add his cpital to funds in case of need;3. Islamic banks use this model to manage their deposit;

Amanah:1. It was an early mode which was used but due to Shari'ah issues it is not in use anymore;2. Amanat can not be used by Ameen and he is not responsible in case of real loss (that is not caused by his negligance;

Qarz:1. Qarz is used for reception of deposit in current accounts;2. Deposits in current accounts are non-remunerative and the return of principal amount is guaranteed;3. No special facilities are allowed to these deposit holders;

Wakalatul Istithmaar:1. This model is in use in Islamic banks inPakistan. However Islamic funds use this model;2. The fund provider (Muwakkil) authrises his agent (Wakeel) fund user to invest fund;3. The agent receives a fee as remuneration + an incentive;

SCM of Deposits should ensure that:►No fixed return is committed with high value depositors.►No extra privilege is given to current account holders.►The actual status of the deposit is clearly mentioned in the account opening document and in the correspondence with the customer.►The profit earned during the period has been distributed according approved distribution formula.

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►Profit distribution sheets of every tenure is approved

by Sharia Advisor.►The profit is allocated using the concept

of daily product and weightages system.► The relationship b/w bank & depositors

and among pool members are clearly explained and documented. See next slide for understanding:

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Relationship B/W Pool Members

Islamic Bank

Mudarabah + Musharakah

1. All the pool members are partners among each other.2. This partnership is a Shirkatul A'qd (business partnership) and not a Shirkatul Milk (joint ownership).3. The partners' contribution to pool in different both in terms of money and duration of investment.4. The weightage system manages the Musharakah among partners.

Mudarabah pool (pool of Depositors

Treasury acceptance also follow rules of general deposits.

Another mode of financing is also used for these acceptance.

The mode “Wakalatul Istithmaar” fall under the rules of fee based agency.

The risk and reward mechanism should be clearly defined.

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Q & A

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internal shariah controls for islamic financial institutions

Documents

shariah advisors

shariah supervisors

shariah compliant

rulings of shariah adviser

relevant shariah rules

shariah supervisory

shariah compliance controls

islamic financial institution