By: Omar Mustafa Ansari - FC
Shariah compliance is the core and essence of Islamic banking. This statement emerges from the fact that Islamic banking has taken grounds from the need of Muslim Ummah to have opportunities to carry on their banking and relevant commercial activities in line with the principles devised by Islamic Shariah.
In the Islamic banking practices, the core responsibility of guiding and supervising the operations of Islamic banks rests with respectable Shariah Scholars duly appointed as the Shariah Advisors and members of Shariah Boards of these institutions. Although, over the last decade, international standard setting bodies and regulators have made numerous efforts to standardize and homogenize the practices of Islamic banking amongst institutions and even across borders, yet, it is the core responsibility of the Shariah Advisors to determine the requirements of Shariah for different transactions and contracts.
The Shariah Boards and the Shariah Advisors are the central point for Shariah compliance, and they are the ones on whose reliance, people rely on Islamic banking and financial institutions. In this article, we will try to summarize the roles and responsibilities of the Shariah Advisors and the members of the Shariah Boards in this respect.
Role of Shariah Scholars on Governance and Risk Management for Islamic Banking
Islamic Financial Services Board (IFSB) standards state that Shariah compliance is central in assuring the integrity and credibility of the Institutions offering Islamic Financial Services (IIFS). They state that Shariah non-compliance risk is the risk that arises from IIFSs’ failure to comply with the Shariah rules and principles determined by the Shariah Board of the IIFS or the relevant body in the jurisdiction in which the IIFS operate.
According to these standards, Shariah compliance is critical to IIFSs’ operations and such compliance requirements must permeate throughout the organization and their products and activities. As a majority of the fund providers uses Shariah-compliant banking services as a matter of principle, their perception regarding IIFSs’ compliance with Shariah rules and principles is of great importance to their sustainability. In this regard, Shariah compliance falls within a higher priority category in relation to other identified risks. They accordingly, require that IIFS shall have in place adequate systems and controls, including Shariah Board / Advisor, to ensure compliance with Shariah rules and principles.
IFSB standards also give Shariah compliance a significant place in the overall governance framework of an IIFS. According to these standards, IIFS shall establish a comprehensive governance policy framework, which will guide them in cultivating a good governance culture. In its governance policy framework, the IIFS should be able to set out the strategic roles and functions of each organ of governance, including the Board of Directors (BOD), its committees, the executive management, the Shariah Supervisory Board (SSB), the internal and external auditors, etc.. It should also address the mechanisms of balancing the accountabilities of each of the organs of governance to various stakeholders.
Appointment of Shariah Advisors
In Pakistan, every Islamic Banking Institution (IBI) is required to appoint a Shariah Advisor (SA). It is required that the appointment of SA together with its terms and conditions should approved by the BOD in case of a local corporate bank, and by the Management / Country Head in case of branches of foreign banks.
The appointment of a SA is for a renewable period of three years. SA should meet the “Fit and Proper Criteria” for SA issued by the State Bank of Pakistan (SBP) and this appointment also requires a pre-approval by the SBP.
Legal Status of Shariah Boards in Pakistan
In Pakistan, SBP has given all the relevant authorities relating to Shariah interpretations, review and supervision to the SA and the formation of a Shariah Board (SB) is not mandatory. However, in certain banks, particularly the full-fledged banks, there are certain SBs and committees comprising at least two members.
An issue arises, as to whether these SBs have any legal authority in Pakistan or these are functioning just as a “marketing symbol”? In case of full-fledged banks, which have included the setting-up of a SB in their Articles of Association, the SB has a legal standing and the bank is obliged to abide by its rulings and decisions. In certain cases, particularly, the Articles define that Shariah means interpretation of their SB. In such cases, these banks are obliged to obtain Shariah rulings from their respective SB in all Shariah matters.
Generally, in Pakistan, the BOD appoints the SB.
According to the standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the SSB is an independent body of specialized jurists, which is entrusted with the duty of directing, reviewing and supervising the activities of an Islamic Financial Institution (IFI). Shareholders in Annual General Meeting (AGM) upon recommendation of BOD appoint it, although they may authorize BOD to fix the remuneration of SSB.
These standards define that SSB shall consist of at least three members. The SSB may seek the services of consultants who have expertise in business, economics, law, accounting or others fields.
It needs to be clarified that AAOIFI’s governance and auditing standards have no legal standing in Pakistan, although these can be applied as benchmark for global best practices.
In this regard, IFSB standards are comparatively liberal. They require that the IIFS shall have in place an appropriate mechanism for obtaining rulings from Shariah scholars, applying Fatawa and monitoring Shariah compliance in all aspects of their products, operations and activities. However, they allow that outside scholars may also provide these guidelines and rulings.
Core Responsibilities of SA as per SBP’s Instructions
SBP requires that SA should review operations of the IBIs on a periodic basis for Shariah compliance to ensure that all the products and services offered by the IBI conform to the injunctions of Shariah rules and principles. However, there is a point crucial for understanding, that the role of review encompasses “all the products and services.” There is a dire need for further clarification in this area, as there are many functions, which at present, are considered outside the ambit of SA e.g. Human Resource policies, Marketing policies, Public Relations and so on.
SA is also required to vet all the related policies and agreements regarding the products, and their respective manuals. Once again, there might be some operational areas, which remain outside the ambit of the functions of the SA. SA is, however, responsible for all locations of the IBI.
SA shall on an ongoing basis ensure that all products, services, related policies, and agreements of IBIs comply with Shariah rules and principles. Particularly, before launching any new products and services, SA shall duly vet the related policies and agreements.
SA shall review operations of the IBI on periodic basis in coordination with officials responsible for Shariah compliance to ensure that all the products and services offered by the IBI conform to the injunctions of Shariah.
According to IFSB standards, the mechanism for obtaining rulings from Shariah scholars, applying Fatawa and monitoring Shariah compliance shall cover, both, ex ante and ex post aspects of all financial transactions carried out by the IIFS. It means to ensure Shariah compliance of the contracts and, later, the performance of obligations under the contracts, as well as, the operations of the IIFS, including aspects such as Shariah compliance review, investment policies, disposal of non-Shariah-compliant income, charitable activities, etc.
SA’s Access to Records
SBP empowers SA to have access to all records, documents and information from all sources including professional advisors and IBI employees in discharge of his duties. The management shall be responsible to provide him all information relating to the IBI’s compliance with Shariah.
SA’s Responsibility for Training
SBP makes SA responsible to conduct / arrange Shariah training programs for the IBI’s staff in coordination with the management.
Whenever we talk about Islamic banking and finance, at any forum, people including the SAs express the dire need of training for IBI staff. However, still this is one of the weakest areas in Islamic banking. SA should have access to the training records of each individual and should supervise and arrange the setup of training courses, internally as well as, externally. SA should also ascertain the suitability of the training programs and the budgets available for training, as it is one of the key responsibilities of the SA.
Annual Report of Shariah Advisor
SBP requires that based on review conducted by the SA, he shall issue an annual report, which shall be published in the IBI’s annual report.
In this respect, it would be worthwhile to refer to the IFSB’s standards, which require that IIFS shall undertake a Shariah compliance review at least annually, performed either by a separate Shariah control department or as part of the existing internal and external audit function by persons having the required knowledge and expertise for the purpose. The objective is to ensure that the nature of the IIFS’s financing and equity investment and their operations adhere to the applicable Shariah rules and principles as per the Fatawa, policies and procedures approved by the IIFS’s SB.
Important aspects of the SA’s report include the following:
SA has to report, as to whether he has examined, on test check basis, each class of transaction, the relevant documentation and procedures adopted by IBI. It implies that he shall examine the documentation and procedures (including application of procedures) for each class of transaction i.e. each product and service.
It is also important to note that since it is an annual report, hence, this examination shall not be confined to the new products only, and instead, he should examine all the products in which the bank has entered into during the current year, irrespective of approval of the said product, maybe, a few years back.
SA also has to render his opinion, as to whether the affairs of IBI have been carried out in accordance with rules and principles of Shariah, SBP regulations and guidelines related to Shariah compliance and other rules, as well as, with specific Fatawa and rulings issued by him from time to time. In other words, it means that while he is responsible for determining compliance with his own rulings, he also has to ensure compliance with the SBP regulation for Shariah compliance.
SA is also required to give opinion in respect of profit and loss computation and distribution, as well as, the Haram income and charity.
About the Author
Standards for Shariah Review
While SBP defines the contents of the annual report of SA, which includes the broad scope of review, it is silent about the methodology and detailed scope of such review. In this respect, it is advisable to refer to the relevant AAOIFI’s standard.
According to the said standard, Shariah review is an examination of the extent of an IFI’s compliance, in all its activities, with the Shariah. The objective of the Shariah review is to ensure that the activities carried out by an IFI do not contravene the Shariah.
While the SSB is responsible for forming and expressing an opinion on the extent of an IFI’s compliance with the Shariah, the responsibility for compliance therewith rests with the management of an IFI.
This standard also defines the broad scope and methodology for the Shariah review that includes: planning review procedures; executing review procedures; and preparation and review of working papers; and documenting conclusions and report. It also requires that the SSB shall implement adequate quality control policies and procedures to ensure the conduct of review in accordance with this standard.
IFSB Standards broadly describe that for internal Shariah compliance reviews, the SSB or Shariah scholars of IIFS shall work together with either a separate Shariah control department or the designated internal auditors / Shariah reviewers. This would enable the SSB or Shariah scholars to advise the Shariah control department or designated internal auditor / Shariah reviewers on the scope of audit / reviews required. As the Shariah control department or designated internal auditors / Shariah reviewers shall be responsible for producing the internal Shariah compliance reports, they shall acquire the relevant and appropriate training to enhance their Shariah compliance review skills.
SA’s Responsibility for Profit and Loss Distribution
SBP requires that IBIs shall have a policy statement in place, vetted by the SA and approved by the BOD.
SBP further requires that in the annual report, SA shall report as to whether or not in his opinion, the allocation of funds, weightages, profit sharing ratios, profits and charging of losses (if any) relating to PLS accounts conform to the bases vetted by him in accordance with Shariah rules and principles.
In addition, SBP also requires that based on aforementioned policy, the distribution of profit and loss by IBIs shall be subject to verification / audit jointly by SA and the external auditor.
SA’s Responsibility for Charity Fund
SA has the authority to declare the income considered non-compliant with Shariah that should be credited to the charity fund. These instances may arise out of his normal Shariah compliance supervisory requirements or because of internal or external Shariah audit. Except for the amounts of purification from capital market operations in line with a set of rules, SA is the only authority to decide which income has to be taken to charity.
SBP also empowers the SA to vet the policy in respect of the utilization of the amount in charity fund for charitable and social welfare purposes. This is a key area of weakness in Islamic banking because, in a number of IBIs, these policies are not clear and the funds remain idle for long periods.
SA is also required to include his opinion in his annual report as to whether any earnings realized from sources or by means prohibited by Shariah rules and principles have been credited to charity account. This is a very controversial matter and needs to be dealt with due care and prudence.
SA also has the authority, at his sole discretion, to approve deposit of such funds in a Shariah compliant remunerative account.
Limitations of SA’s Authority for Interpretation of Shariah
According to SBP, SA has full authority for decisions and rulings subject to anything contained in the Instructions and Guidelines for Shariah Compliance in IBIs and the instructions, guidelines and directives issued by SBP Shariah Board from time to time.
SA’s Powers to Adopt AAOIFI’s Shariah Standards
SBP authorizes the SA to adopt / use as a guideline, the AAOIFI’s Shariah Standards for the Islamic financing modes for which the SBP has not prescribed the essentials.
SBP’s Conflict Resolution Mechanism
SBP has also provided a dispute resolution mechanism. According to the said mechanism, in case any difference of opinion between SA of the IBI and SBP’s inspection staff or other SBP department regarding Islamic banking practices, SBP may refer the case to SBP Shariah Board and the decision of SBP Shariah Board, notified by SBP, shall be final.
IBIs may refer issues relating to Shariah compliance to SBP for consideration of SBP Shariah Board. In case management of any IBI has a difference of opinion on any ruling of their SA based on Shariah principles, the management shall refer the case to the audit committee or BOD for decision. In case the matter remains unresolved, the same shall be referred to SBP Shariah Board for final decision. The management shall produce the ruling and arguments of SA along with their views based on Shariah. The decision of the SBP Shariah Board, notified by SBP, shall be final.
SA of any IBI, with the concurrence of management, may also refer issues relating to Shariah compliance to SBP for consideration of SBP Shariah Board along with his arguments based on Shariah. The SBP Shariah Board shall provide guidance in such cases at its earliest convenience.
Resignation and Termination of SA
Termination of SA or his removal before the expiry of his term shall be with the approval of authority, which has approved his appointment i.e. BOD in case of local IBIs and the management in case of branches of foreign banks.
IBIs shall be required to notify SBP of any resignation or termination of the SA within 14 days of the date of resignation or termination. IBI shall also state the reasons of such termination and alternate arrangements for interim period.
It is worthwhile to note that according to AAOIFI standards, the dismissal of member of the SSB shall require a recommendation by the BOD and approval of the shareholders in a general meeting.
Responsibility for Shariah Compliance Mechanism
SBP’s guidelines require establishment of a strong and sound Shariah compliance mechanism, within each IBI as a part of its control structure. SA has to play a central and pivotal role in this function.
These guidelines suggest close coordination of compliance officials with SA of the IBI, which may further help in streamlining the process with necessary inputs by the SA. In addition, irregularities, if any, related to Shariah compliance shall be properly recorded and rectified with the approval of SA.
To some extent, we may conclude that SA is responsible to have an oversight on the overall Shariah compliance mechanism.
Limited Responsibility in Respect of Internal Shariah Audit
While Shariah compliance may be termed as amongst the responsibilities of the SA, internal Shariah audit does not form a part of his responsibilities. Unfortunately, in our culture, compliance and internal audit, which are different phenomenon; are being used and applied interchangeably. It is pertinent to note that in order to ensure the independence of SA, as well as, to avoid the self review threat, it is better to avoid involvement of SA in the internal Shariah audit process.
According to SBP’s guidelines for internal Shariah audit, which are primarily in line with AAOIFI’s standard on internal Shariah review, the internal Shariah auditors shall have direct and regular communications with management and SA. Any disputes / difference of opinion between management and Internal Shariah auditors on matters relating to Shariah interpretation shall be referred to the SA for decision. Similarly, the final report of the internal Shariah audit shall be placed before the SA for advising the appropriate corrective action.
Accordingly, one may conclude that the internal Shariah audit function is outside the ambit of the functions of the SA, except for giving the rulings on differences of opinions and the corrective measures.
Difference between Advisory and Supervision
According to a definition taken from www.dictionary.com, an advisor is “One that advises, such as a person or firm that offers official or professional advice to clients.” On the contrary, a supervisor is “a person who supervises workers or the work done by others; superintendent” or “one who is in charge of a particular department or unit.”
SBP regulations, in Pakistan, use the term “Shariah Advisor” while AAOIFI standards use the term “Shariah Supervisory Board.” IFSB standards are comparatively open and do not standardize the term. However, while providing best practices these standards state that Shariah compliance is central in assuring the integrity and credibility of IIFS, and is one of the ultimate responsibilities of the BOD. As a result, the BOD needs to establish a swift and efficient mechanism, as and when required, to obtain rulings from Shariah scholars and monitor Shariah compliance. The Shariah scholars may be external or internal, depending on the requirements of the IIFS’s business model.
In view of the above, a question arises as to whether the responsibilities of these scholars are of advisory in nature, or that of the supervision. In our humble view, since review, monitoring and oversight are amongst their functions, hence, their responsibility is not of advisory, but of supervision in nature. This is correct in light of all, i.e. SBP, AAOIFI and IFSB standards, irrespective of the nomenclature and terms used.
SA’s Responsibilities to the Auditors and Advisors
SBP also requires that if the legal counsel, auditor or consultant of an IBI seeks advice on the Shariah matters from the SA, he shall provide such advice to them. However, it does not provide detailed mechanism in this respect.
Whom SA should Report?
SA reports functionally to the BOD, in case of IBIs incorporated in Pakistan. In case of branches of foreign banks, SA reports to the Country Head.
Nevertheless, as per AAOIFI standards, SSB is an independent body and is accountable to the shareholders only. This apparently provides better support and increased level of “independence” to these scholars.
Auditors’ Testing for Shariah Compliance
According to AAOIFI’s relevant auditing standard, when testing for Shariah compliance, the auditor shall obtain sufficient appropriate audit evidence in this respect. For this purpose, the rulings and guidance issued by SSB form the basis on which the auditor considers whether the IFI has complied with Islamic Shariah rules and principles.
The auditor shall issue his report only after he has taken note of the SSB’s draft report on the IFI’s compliance with Islamic Shariah rules and principles. If the SSB’s draft report indicates that compliance with Islamic Shariah rules and principles is lacking, and the auditor decides, based on the SSB’s draft report, to modify his draft report, he shall provide an adequate explanation of the nature of and reasons for the modification.
Even in Pakistan, in case of full-fledged Islamic banks, normally the auditors require first obtain the SA’s / Shariah Auditors’ report to ascertain compliance of Shariah because it is required by the objects of the banks.
Independence of SSB / SA
The importance of SSB emanates from its role in enhancing the public confidence in IFIs, as well as, achieving the fundamental objective of an IFI. Accordingly, AAOIFI has given due weightage to the independence of SSBs and has issued a comprehensive standard on the same.
The said standard defines independence as an attitude of mind, which does not allow the viewpoints and conclusion of its possessor to become reliant on or subordinate to the influences and pressures of conflicting interests. It is achieved through organizational status and objectivity.
These standards specifically require that the SSB should not include directors or significant shareholders of IFI.
The objective of this article is to summarize and identify the roles and responsibilities of Shariah Advisors and Shariah Boards according to the Pakistan law, as well as, according to the international best practices. It is expected, that the same shall be beneficial for both, the Shariah scholars and the management of the IFIs enabling them to improve the overall Shariah compliance mechanism and to comply with the legal requirements and the global best practices.
Omar is a fellow member of the Institute of Chartered Accountants of Pakistan. Presently, he is working as Partner – Islamic Financial Services Group at Ford Rhodes Sidat Hyder & Co. which is a member firm of Ernst & Young Global Limited. Omar has considerable experience in providing services to Islamic finance industry particularly including audits, Shariah audits, training, manual development, risk management, product structuring and advisory. Omar has time to time contributed articles on various topics, particularly on Islamic finance. He is author of a book on Islamic finance, namely “Managing Finances – A Shariah Compliant Way