RISK MANAGEMENT INISLAMIC FINANCE

Mahyuddin Khalid

Shariah Non-Compliance Risk

Co

nte

nt What Is Shariah Non-compliance

Risk?

Measures To Manage Shariah Non-

Compliance Risk

Shariah Non-Compliances Risk

Profile for Certain Shariah Contract

Examples Of Shariah Non-

compliance Events

Learning Outcome

• To clarify Shariah non-compliance risk

in Islamic finance

• To expose the rules and principle of

shariah that required in Islamic finance

• To show the examples of Shariah non-

compliance events in islamic finance

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Introduction

There are various opinions and interpretations in the discussion of Shariah non-compliance risk (SNCR).

The element of subjectivity is unavoidable, some Shariah advisers may consider a particular activity as being shariah non-compliant, while others might take a different view.

So, we refer to shariah standards that were accepted as international standards by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

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What Is Shariah Non-Compliance Risk?

The Islamic Financial Service Board (IFSB) defines the SNCR as the risk arising from Islamic banks’ failure to comply with the Shariah rules and principles determined by the Shariah board or the relevant body in the jurisdiction in which the Islamic finance operates.

The failure to comply with such principles will result in the transaction being cancelled, and hence the income cannot be recognised.

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Shariah compliance is a consistent process which should be maintained at all times, and such compliance requirements must permeate throughout the Islamic finance’s organisation, products and activities.

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SNC Risk Measurement

SNC Risk can be divided into three (3) types Severe

SNC events lead to invalidation of contracts and non recognition of income

Medium Defective contract that hinders enforceability

Tolerable Events that do not lead to consequences mentioned under high &

medium type of risk

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Shariah Non-Compliance Risk in Islamic Banks

Islamic banks are exposed to risk relating to Shariah non-compliance risks and also to reputational risk.

These risk exposes Islamic banks to fund providers’ withdrawals, loss of income or voiding contracts leading to a diminished reputation or the limitation of business opportunities.

Islamic banks shall at all times comply with the Shariah rules and principles as determined by the shariah board with respect to products, activities and contract documentation.

Islamic banks shall undertake a Shariah compliance review.

Islamic banks shall keep track of income not recognized arising out of Shariah non-compliance.

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The Condition of Pillars in Contract

The contracting parties (Buyer & Seller) possess legal capacity (ahliyyah) Must have legal authority (wilayah) to execute the contract For example has sound mind, an adult, rational and able to be held

accountable

The subject matter (ma’qud ‘alaih) should be in the form of a valuable asset according to the Shari ʻah

free from uncertainty (gharar), known by both parties, recognised by the Shari ʻah, and in existence during the contract’s session.

Offer and acceptance must be clear and understandable, consistent and continuous.

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In addition, the contract should be free from prohibitive elements such as, riba duress (ikrah)

mistake (ghalaṭ) inequality (ghubn) deception (taghrir) illegal goods or illegal assets.

Failure to satisfy the essential elements of a contract and the necessary requirements renders the contract invalid

Hence the risk of Shari ʻah non-compliance will arise.

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Measures To Manage Shariah Non-Compliance Risk

Aqad based

Maqasid shariah

Financial reporting

Legal documentation clearly stating elements of riba-free or shariah compliant

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Measures To Manage Shariah Non-Compliance Risk

Aqad based Fulfil aqad for each transaction; agents of contract (‘aqidani)

objectives of contract, subject matter (ma’qud ‘alaih) and offer and acceptance (sighah).

Maqasid shariah a transaction must produce more benefits than harm to the

society. For instance, BBA has become not acceptable due to several

intolerable issues which considered harmful; In abandoned housing project, the bank is the seller. However, the buyer

does not have any recourse to the bank, thus need to continue instalments When customer first sells the house to the bank, it does not own the

property because he only pays a portion. This actually has violated the aqad.

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Measures To Manage Shariah Non-Compliance Risk

Financial reporting IFI activities should be reflected in their financial reporting

The aqad performed should be properly recorded in financial documents

E.g. in Murabahah transaction, the relevant inventories should be reflected in financial reporting before sales to third parties

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Measures To Manage Shariah Non-Compliance Risk

Legal documentation clearly stating elements of riba-free or shariah compliant Islamic banking cases have been published in various law reports, also

been quoted and reported e.g. BBA financing 1st phase: 1994-2002-- jurisdictions favour Islamic banks

e.g. the case of BBA facility of BIMB vs. Adnan Omar, the court ruled on the basis that contracting parties are bound to terms & condition of contracts, overlooked on the issue of non-shariah elements in BBA.

2nd phase: 2003-2007 – jurisdictions examine underlying principles of offered facility

e.g. earlier jurisdiction is criticised for applying classic common law approach whereas Islamic banking is different. Critical examination of contracts is presented from both legal and shariah aspects.

3rd phase: 2008 onwards – Issue: Defendants were asked to pay full amount of selling price in case of default.

The court ordered the plaintiffs to seek price closest to the market price and o return original facility they had extended

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Shariah Non-Compliances Risk Profile for Certain Shariah Contract

Basically vary from one contract to another, because each contract has a specific feature, nature and requirement.

TAWARRUQ

MUDHARABAH

ISTISNA’

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Shariah Non-Compliances Risk in Tawarruq

Al-Ghazali identified potential incidents of Shariah non-compliance in the tawarruqtransaction as follows:

The tawarruq arrangement is used to grant financing facilities to individual or non-individual entities whose activities explicitly involve Shariah non-compliant elements, such as riba-based transactions, liquor production, gambling and brothels.

While using the bank’s name, the bank’s staff are engaged in Shariʻah noncompliant activities with clients.

The commodity and/or collateral used for the tawarruq arrangement is Shariʻah non-compliant.

The contract is executed before the bank possesses the commodity. The series of sale transactions does not follow the sequential process appropriately. The terms and conditions are not properly and clearly stated, which may lead to

misinterpretation during the contract process. The appointment of an agent is arranged prior to the commodity possession, which may

lead to fictitious issues. The disbursement of facility is done before the contract is executed. The compensation (taʻwiḍ) for late payment does not reflect actual losses. The execution of debt rollover in restructuring and rescheduling.

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Shariah Non-Compliances Risk in Istisna’

The parties entered are ineligible to execute the contract. The asset is not properly specified in the agreement.

The istiṣnāʻ asset to be constructed and/or its purpose is not Shari ʻah compliant.

The istiṣnāʻ asset is already available or completed at the time of execution of the istiṣnāʻ contract.

The parties have failed to determine or agree on the price at the time of execution of the istiṣnāʻ contract.

The manufacturer unilaterally increases the price of the istiṣnāʻasset as a result of a request for extension of the payment period.

The manufacturer fails to adhere to the conditions stipulated by the buyer.

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The time of delivery is not specified and agreed at the time of execution of the istiṣnāʻ contract.

The punitive condition imposed by the buyer on the manufacturer due to late delivery is not based on the estimated loss incurred.

The manufacturer stipulates a condition to waive his liability for an incomplete istiṣnāʻ asset or a defective asset.

The buyer sells to another party the istiṣnāʻ asset before he takes possession of the asset to another party.

The seller (bank) grants a financing facility under an istiṣnāʻcontract for the completed asset.

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Shariah Non-Compliances Risk in Mudharabah

The muḍārib does not adhere to the terms and conditions stipulated by the capital provider (rabb al-māl).

The muḍārib does not act in the interest of the capital provider. The capital provider stipulates a condition to guarantee the capital

and/or profit.

The capital value is not determined and agreed at the time of execution of the contract.

The profit-sharing ratio is not agreed and determined at the time of execution of the contract.

The profit is linked to the amount of muḍārabah capital.

The muḍārabah contract stipulates that any loss in the project will be borne by the capital provider, or by some capital providers in the case of multiple capital providers.

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Examples Of Shariah Non-compliance Events

Shariah Contract Involved

Description of Event

Tawarruq • The asset is sold to the customer before the bank purchases the asset from the broker/platform.

• The facility is disbursed before the contract is executed.

• There is no wakālah arrangement involved in the commodity murābaḥahtransaction.

• The price is mistakenly disclosed to the customer. • The legal document involves a provision that restricts the customer, as the

purchaser, from taking delivery of the commodity. • The financing facility is used for Shariah non-compliant purposes.• There is no evidence of commodity trading.

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Shariah Contract Involved

Description of Event

Istisna • In some legal documentation, it is found that the bank as the seller has required the customer to accept the constructed project/property under

istiṣnāʻ contract on an “as is, where is” basis

Mudarabah • The documents contain a clause indicating the capital guarantee to the capital provider.

• The profit is distributed based on an indicative rate, not on the actual performance of the venture or the actual profit realised.

• Client activities are proven to be Shariah non-compliant.

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Some Impact of Shari’ah Non-Compliance Risk

Slowdown of global Sukuk issuance.

By the end of 2008, global Sukuk issuance had declined by more than 50% compared to 2007.

Chairman of the AAOIFI Shari’ah board- criticized a common form of sukuk that apparently violates the Sharia-compliant principles surrounding risk and profit-sharing. He estimated that up to 85% of Gulf Sukuk structures were not Shari’ah-compliant.

AAOIFI made a recommendation to Islamic finance market participants to refrain from issuing Sukuk structures that have a purchase undertaking or guarantee from the Sukuk issuer to repurchase at a future date at a specific price.

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Mahyuddin Khalid

End of Chapter

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