1

Shariah Supervisory Board in Islamic Finance

Maas Riyaz Malik

massriyaz_2005@yahoo.com

International Center for Education in Islamic Finance

This project paper is a partial fulfillment of Module SH1002 of Part I of Certified Islamic Finance Professional (CIFP) INCEIF

2 March, 2010

Abstract The Islamic financial institutions are swiftly spawning their presence around the world. They have responded to the opportunities presented by this rapidly growing new customer segment with a range of Shariah-compliant products. Shariah supervision is an essential component of Islamic finance that ensures the validity of financial products and transactions of these institutions. Shariah supervisory boards in Islamic financial institutions are entrusted with the task of supervision. The paper explores various aspects of Shariah supervisory boards including purpose, duties and responsibilities and applicable laws. The information was collected using a library research where books, journals, articles and online resources were used. The paper further discusses governance issues of the Shariah standard board that could jeopardize its credibility. Finally, paper highlights the need for harmonization of Shariah board opinions across the industry that is vital for further growth.

Contents 1. Title page 2. Abstract 3. .. Contents 4. Introduction 5. An overall view of Shariah Supervisory Board 5.1. What is Shariah supervision? 5.2. The Purpose of SSB 5.3. Roles and functions of SSB 6. Laws relating to SSB in Malaysia 7. Duties and responsibilities of SSB & IFI 7.1. Shariah Supervisory Board 7.2. Islamic Financial Institution 8. Essential Elements of Shariah Supervisory Board 8.1. Composition 8.2. Qualification 8.3. Communication 9. The Corporate Governance and related issues 9.1. Independence 9.2. Confidentiality 9.3. Competence 9.4. Consistency 9.5. Disclosure 9.6. Cost of Maintaining SSB 10. Standardization of SSB Opinions 10.1. Issue of Non-Standardization 10.2. Harmonization of Opinions 11. Models of Shariah Governance from Selected Countries 21-22 22-25 25-27 12-13 13-14 15 16 16-17 17-18 18 18 19 19-20 9-10 11-12 6 6-7 7 8-9 1 2 3 4-5

4 12. Conclusion 13. References 4. Introduction 28 29-30

In an era that economic booms, bursts and calamities occurred, Islamic banking and finance has developed to an unprecedented level. As an alternative for conventional practice of banking and finance it offers a range of products based on the syariah. Interestingly, Islamic finance is viewed by modern banking practitioners as a viable solution to weather the financial crises and promote justice. The rapid development of these institutions in the last few decades has attracted the attention of both Muslims and non-Muslims. Today Islamic finance institutions provide products and services from deposits to sukuk. The potential growth of this sector is enormous. Wharton University published article (2004) outlines that Islamic banking has gone from almost nothing to an industry with assets of hundreds of billions of dollars and half of the consumer market and 10% of the assets under management in countries such as Malaysia. In line with syariah principles Islamic financial institutions are engaged in product development activities to cater the needs of a wide range of parties. It is essential for these institutions to innovate and operate within the ambits of shariah. Hence, need of the supervision is an integral part of any financial institution that deals in the name of Islamic finance. The safeguard to make Islamic financial institutions perform their dealings according to the Islamic laws comes when there is a legitimate control body in the institution (Lahsasna). It is vital for such institutions to form a Shariah Supervisory Board (SSB) consists of fiqh muamalat experts to guide their transactions in accordance with the principles of Shariah. Malaysia and several other countries have passed laws to govern the formation and functions of SSB. Therefore, SSB undoubtedly forms the most important and influential entity in any Islamic financial institution. These functions will be discussed thoroughly in line with established laws in Malaysia. In his article Suleiman outlines that Islamic banking represents a radical departure from conventional banking, and from the viewpoint of corporate governance, it embodies a number of interesting features since equity participation, risk and profit-and-loss sharing arrangements from the basis of Islamic financing. The corporate governance framework in Islamic Finance Institutions (IFIs) mainly comprises of SSB, syariah audits and adequate internal controls. Center to such a framework is SSB, which provides the backbone to IFIs operations. Author

5 Suleiman, also describes that the SSB is vital for two reasons. First, to ensure transactions of Islamic banks are in line with Islamic law. Should the SSB report that any management departure from Shariah law, institution would quickly lose the confidence of the majority of its investors and clients. Second, some Islamic scholars argue that strict adherence to Islamic religious principles will act as a counter to the incentive problems. Therefore, SSB is trusted with the duty to score a balance between those two ends by upholding Shariah principles and minimizing transaction costs. The presence of a Shariah board in Islamic banks was determined as a prerequisite for admission into the International Association of Islamic Banks (Rammal,2006) As in the case of many legitimate control bodies, SSB has also met with various challenges. The professional ethics, coordination and unification of opinions are vital for boards credibility. Author Lahsasna, highlights the shortage of experts in both shariah and finance which need to be produced by Muslim states. In the latter part of this paper it is intended to discuss governance and non-standardization issues. It is expected that paper will be able to highlight number of vital aspects pertaining to SSB.

5. An overall view of Shariah Supervisory Board Shariah supervision is the single most important element that distinguishes between a conventional and an IFI. It is the only way of certifying that its services, products, and operations are actually Shariah-compliant. In the emerging Islamic financial sector, therefore, Shariah supervision is not a matter to be taken lightly. The corporate governance is the theme of SSB.

5.1 What is Shariah supervision? While it may be convenient to explain Shariah supervision as a religious audit but its scope is far more comprehensive. In essence, Shariah supervision is the process of ensuring that a financial product or service complies with Islamic legal precepts and principles, either by its conforming (to one degree or another) to a recognized Islamic legal norm or by its not violating the same (DeLorenzo). Ideally, Shariah supervision will be a part of an Islamic product or service from the time of its development, to its launch, and throughout the period it is offered. At the stage of research and development, or of drafting contracts or offering memorandums, Shariah supervision, in one form or another, should be an active participant. According to DeLorenzo by including Shariah supervision and advice at the earliest stages, management may save costly legal fees that may be required at a later stage if elements of the proposed business contracts need to be modified to comply with Shariah principles and precepts. Moreover, once a product is launched, Shariah supervision may take the form of ongoing monitoring through periodic audits. Such audits may be undertaken by means of site visits, document reviews, or consultation with management at regular intervals.

5.2 The Purpose of SSB The most obvious and immediate purpose of Shariah supervision is to certify for practicing Muslim consumers and clients that the financial product or service being offered to them is acceptable from an Islamic legal perspective and is therefore lawful to them (DeLorenzo). Such certification according to author DeLorenzo, is generally documented in a formal fatwa (Shariah position paper), may be thought of as a form of due diligence.

7 The primary beneficiary of Shariah supervision will be Muslim consumers or investors who may not have necessary skills or knowledge to evaluate the Islamic banking products in the light of Shariah teachings. It also supplies form of guarantee and advocacy that money being invested in the IFIs is duly used in compliance with Shariah rulings and haram elements are eliminated. From the view point of corporate governance, IFIs embody a number of interesting features since equity participation, risk and profit loss sharing arrangements from the basis of Islamic finance. SSB functions as an extra layer of governance in IFIs in order to bring transactions under strict conformity with the Islamic law and expectations of Muslim community.

5.3 Roles and functions of SSB As a legitimate control body SSB consists of a number of members chosen among well qualified men of Islamic jurisprudence and comparative law. The education and qualification of these members will be dealt in a later section of this paper. The credibility of the Islamic banking activities is highly dependent on the credibility of the Shariah advisers. Author Rahman notes that the credibility of Shariah advisers may also depend on the perceptions and confidence of the bank managers in their role. In order to ensure the modern application of banking system is in line with Shariah requirements, it is strongly stressed that the objectives of the establishment of Islamic Bank are to achieve Falaah (Rahman, 2006). The objectives of Islamic banks may therefore differ greatly from the conventional bank's objectives. Therefore, in order to ensure compliance to the Syariah, IFIs use the service of well-verse Shariah scholars.

6. Laws relating to SSB in Malaysia The laws governing the functions and operations and other matters of SSB have been detailed in several Acts and guidelines provided by regulators. The Takaful Act (Malaysia) 1984 is one of the acts of parliament aimed at controlling insurance practices in Malaysia. A financial institution licensed under the Banking and Financial Institutions Act 1989 (BAFIA) required to comply under relevant laws. Bank Negara Malaysia has provided a set of guidelines clearly aimed at the SSB. It will be important to discuss the application of these guidelines issued by the Islamic Banking and Takaful Department of central bank of Malaysia.

8 Bank Negara Malaysia (BNM) has prepared the Guidelines on the Governance of Shariah Committee for the Islamic Financial Institutions that regulates the governance of Shariah Committee of an Islamic financial institution. In the Part B of guidelines, under establishment of Shariah Board it outlines the following requirements: Every Islamic financial institution is required to establish a Shariah Committee. In the case of a BAFIA IBS bank, it may establish one Shariah Committee for the banking group. However, if a takaful operator is part of that group, the tactful operator must establish its own separate Shariah Committee, due to the legal requirement under the TA. (Guidelines on the Governance of Shariah Committee for the Islamic Financial Institutions, p.3) The guidelines clearly uphold the establishments of the SSB in align with relevant laws governing the respective institution. For instance a single committee is not allowed to act on behalf of both takful and Islamic bank that part of one group. Regarding the appointment and reappointment, Part C of the guidelines provides following. The Board of Directors of an Islamic financial institution upon recommendation of its Nomination Committee shall appoint the members of the Shariah Committee. The appointment and reappointment of a Shariah Committee member shall obtain prior written approval of Bank Negara Malaysia. The appointment shall be valid for a renewable term of two years. (Guidelines on the Governance of Shariah Committee for the Islamic Financial Institutions, p.3)

BNM guidelines also provide detailed provisions on the restriction imposed on the serving syariah board members. The Part D of the provides that

(a) In line with section 16B(6) of the Central Bank of Malaysia Act 1958, an Islamic financial institution is not allowed to appoint any member of the SAC to serve in its Shariah Committee; and (b) To avoid conflict of interest and for reasons of confidentiality within the industry, an Islamic financial institution shall not appoint any member of shariah Committee in

9 another Islamic financial institution of the same industry. For this purpose, Islamic financial institutions which are regulated under the IBA, BAFIA and DFIA are classified as of the "Islamic banking industry", whilst Islamic financial institutions that are regulated under the TA are classified as of the "takaful industry". Memberships in other categories of industry are excluded from the restriction. (Guidelines on the Governance of Shariah Committee for the Islamic Financial Institutions, p.6) With regard to the reporting structure, the Shariah Committee will report functionally to the Board of Directors of the Islamic financial institution. This reporting structure reflects the status of the Shariah Committee as an independent body of the Islamic financial institution.

7.

Duties and responsibilities of SSB & IFI

7.1. Shariah Supervisory Board

All Shariah Committee members are expected to participate and engage themselves actively in deliberating Shariah issues put before them. The BNM document that lays down guidelines for Syariah board stipulates following duties and responsibilities of the Syariah Committee:

To advise the Board on Shariah matters in its business operation The Shariah Committee shall advise the Board on Shariah matters in order to ensure that the business operations of the Islamic financial institution comply with Shariah principles at all times.

To endorse Shariah Compliance Manuals The Islamic financial institution shall have a Shariah Compliance Manual. The Manual must specify the manner in which a submission or request for advice be made to the Shariah Committee, the conduct of the Syariah Committee's meeting and the manner of compliance with any Syariah decision. The Manual shall be endorsed by the Shariah Committee.

To endorse and validate relevant documentations

10 To ensure that the products of the Islamic financial institutions comply with Shariah principles in all aspects, the Shariah Committee must endorse the following: i) the terms and conditions contained in the proposal form, contract, agreement or other legal documentation used in executing the transactions; and ii) the product manual, marketing advertisements, sales illustrations and brochures used to describe the product.

To assist related parties on Shariah matters for advice upon request The related parties of the Islamic financial institution such as its legal counsel, auditor or consultant may seek advice on Shariah matters from the Shariah Committee. The Shariah Committee is expected to provide assistance to them so that compliance with Shariah principles can be assured completely.

To advise on matters to be referred to the SAC The Shariah Committee must advise the Islamic financial institution to consult the SAC on any Shariah matters which have not been resolved or endorsed by the SAC.

To provide written Shariah opinion The Shariah Committee is required to record any opinion given. In particular, the Committee shall prepare written Shariah opinions in the following circumstances: i) where the Islamic financial institution make reference to the SAC for advice; or ii) where the Islamic financial institution submits applications to Bank Negara Malaysia for new product approval in accordance with guidelines on product approval issued by Bank Negara Malaysia.

To assist the SAC on reference for advice The Shariah Committee must explain the Shariah issues involved and the recommendations for a decision. It must be supported by relevant Syariah jurisprudential literature from the established sources. The Syariah Committee is also expected to assist the SAC on any matters referred by the Islamic financial institution. Upon obtaining any advice of the SAC, the Shariah Committee shall ensure that all SAC's decisions are properly implemented by the Islamic financial institution.

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7.2 Islamic Financial Institution To ensure the smooth running of the Shariah Committee, an Islamic financial institution is responsible: To refer all Shariah issues to the Shariah Committee The Islamic financial institution must refer all Shariah issues in its business operations to the Shariah Committee for advice. The submission for an advice or a decision must be made in a comprehensive manner for an effective deliberation by the Shariah Committee. This will include explaining the process involved, documents to be used and other necessary information.

To adopt the Shariah Committee's advice The Islamic financial institution is required to adopt and take necessary measures for implementation of Shariah Committee's advice.

To ensure that product documents be validated The Islamic financial institution shall obtain validation of the Shariah Committee relating to Shariah issues in all product documentations.

To have a Shariah Compliance Manual The Islamic financial institution shall ensure that the Shariah Compliance Manual referred to in Paragraph 20(b) is endorsed by the Shariah Committee.

To provide access to relevant documents The Islamic financial institution must provide necessary assistance to the Shariah Committee. The Shariah Committee must be given access to relevant records, transactions, manuals or other relevant information, as required by them to perform their duties. For this purpose, the Shariah

12 Committee members are granted exemptions from the secrecy provisions under the respective legislations.

To provide sufficient resources The Islamic financial institution must provide the Shariah Committee with sufficient resources, such as budget allocation, independent expert consultation, reference materials and trainings. It is also the duty of the Islamic financial institution to familiarize the Shariah Committee on its operation and business.

To remunerate the members of the Shariah Committee accordingly The Board shall determine the remuneration of the Shariah Committee members (through its Remuneration Committee). The remuneration shall commensurate and reflect the roles and functions of the Shariah Committee.

8. Essential Elements of Shariah Supervisory Board 8.1 Composition Shariah supervision may be performed by an individual supervisor/advisor, or by aboard of supervisors/advisors,commonly known as a Shariah Supervisory Board (Lahsasna).IFI could choose a board or a single advisor. However, such a choice should take several factors in to considerations before deciding a number. Chief among these factors is the product or operation itself. An Islamic home financing alternative, for example, is a complex affair and will undoubtedly benefit from the collective opinions of a diversified Shariah Board (DeLorenzo). The same will be true of a commercial or investment banking operation. An Islamic mutual fund, on the other hand, may require a single supervisor, especially if it has licensed itself to an index provider like the Dow Jones Islamic Market Indexes (DeLorenzo). An actively managed fund, however, even if it is licensed to an index, may require more than one supervisor. These are considerations that have to do with the nature and requirements of the supervision itself. If the IFI intends to operate in international arena, for instance in South Asia and Gulf region it would be better to appoint members from each region (DeLorenzo). However Ramal (2006), points out that a Shariah board should be formed of a number of members chosen from among Jurists and men of Islamic jurisprudence and of comparative law who have conviction and firm belief in the idea of Islamic Banks. To ensure freedom of initiating

13 the boards opinion, members of the board must not be working as personnel in the bank, and are not subject to the authority of the board of directors. Prudence dictates that there be at least three supervisors for any Islamic financial undertaking (Lahsasna). Moreover, experience has shown that at least one of the members needs to reside in the same country or region as the operation, so as to be readily available for consultation, even on short notice (Lahsasna) . In some cases, too, a Shariah supervisor will maintain an office and keep regular hours at the bank or financial institution.

8.2 Qualification

The proposed member of the shariah committee shall be an individual. In Malaysia, the proposed member of the shariah committee shall at least have qualification possess necessary knowledge, expertise or experience in the following areas (Lahsasna). a) Islamic jurisprudence (Usul al-fiqh) b) Islamic Transaction/ commercial law (Fiqh al-muamalat)

The qualification to serve in SSB may differ among countries. In Pakistan, the qualification is emphasized in a rigorous manner and require following (Hassan):

Educational Qualification a) Degree from any recognized Waffaqul Madaris(Darse-e-Nizami)with a minimum of 2ndClass Bachelor Degree with Economics; b) Degree from any recognized Waffaqul Madaris(Darse-e-Nizami)with Takhassus Fil Fiqh and sufficient understanding of banking and finance; or c) Post Graduate Degree in Islamic Jurisprudence / Usuluddin, LL.M (Shariah), etc from any recognized university with exposure to banking and finance Experience and Exposure a) Must have at least 3 years experience of giving Shariah rulings;or b) At least 5 years experience in research and development in Islamic banking and finance c) Reasonable knowledge of Arabic and English languages is necessary

14 Additionally, State Bank of Pakistan, at its sole discretion, can give relaxation in respect of educational qualification and experience in exceptional cases where the person is otherwise qualified for giving Shariah rulings on banking and financial matters (Hassan). Obviously, a Shariah supervisor will be someone with a background in the classical Shariah sciences. In particular, however, supervisors need to have studied the fiqh al mu`amalat or rules concerning transactions developed by the classical jurists and expanded upon by later generations of Shariah scholars. Most Shariah supervisors have produced academic work or studies on one aspect or another of these rules. In addition, such a background presupposes facility in the classical Arabic language and the ability to deal directly with legal texts, glosses, and commentaries in that language. In Addition to all this, an understanding of modern finance, markets, and economics is also clearly required. Finally, an effective Shariah supervisor must be familiar with international Business practices (`urf) and have an appreciation for regulatory environments. For these reasons, the English language is especially important. One more point that should be kept in mind is the supervisors ability to work with a team, oftentimes in a cross-disciplinary and crosscultural environment. Generally speaking, todays Shariah supervisors possess the qualifications and characteristics discussed above. In addition, many Shariah supervisors have benefited from the exposure afforded by multiple board membership. Then, while at the present time there are no standard qualifications for Shariah supervisors, it is to be hoped that, in the future, and as the Islamic financial sector grows, graduate level programs will be developed for the specific purpose of preparing new generations of scholars with all of the requisite skills. At present, however, the number of people qualified to serve as Shariah supervisors is limited. Author Lahsasna suggest that in regard to preparing scholars for a future in Shariah supervision is twofold. Firstly, Islamic financial operations may appoint, in addition to its full Shariah Board members, junior members who will participate in discussions, prepare memos and briefs, take notes, and perform research and other tasks for the Shariah Board, but who will not have full status as voting Shariah Board members. Secondly, junior members may be appointed on a rotating basis, such that each will serve, much like a law clerk for a serving judge in the United States, for a period of one year. By means of this rotating arrangement, many scholars will have an opportunity to learn first hand about the workings of Shariah supervision.

15 Moreover, as junior members become increasingly more familiar with modern business norms and practices, it will become easier for them to analyze situations and think through options, with the result that their contributions to the work of the Shariah Supervisory Boards will become increasingly valuable. Obviously, such junior members will be compensated for their efforts, though not at the same level as the full board members.

4.3 Communication An essential element in the success of any undertaking is communication. This is equally true in regard to Shariah supervision. To begin with, there must be clearly delineated lines of communication between management and Shariah supervision. Oftentimes, an Islamic financial institution will appoint one of its executives, whether from business operations, finance, or legal, to act as liaison with the supervision. This person will be responsible for coordinating and Documenting regular meetings, arranging for the requirements of Shariah supervision, following up on decisions and suggestions, and processing and channeling communications to and from supervision. When board members live on different continents and work in different time zones, the work of such a coordinator can be challenging.

9. The Corporate Governance and related issues In the modern business world, corporate governance is regarded as an essential element that upholds the accountability and transparency. History shows many scandals and bankruptcies in the absence of proper corporate governance structures. It is paramount in Islam to conduct business activities in line with shariah parameters that ensures the good governance is practiced in the business. SSB is a clearly a part of this process that ensures IFI does not deviate from its prime objectives. Good governance is crucial to the ability of a business to protect the interests of its stakeholders. These interests may extend beyond the purely financial to the stakeholders ethical, religious, or other beliefs. In the case of an institution offering Islamic financial services, its operations are required to be carried out in compliance with the principles of Shariah (Grais and Pellegrini, 2006). A corporate structure that enables a financial institution to implement good governance through Shariah-compliant operations is therefore essential for the stability and efficiency of Islamic financial services.

16 The SSB that is a very part of corporate governance has seen some inconsistencies. This could impede the confidence on IFIs operations if not addressed properly. Following is a discussion that highlights major issues related to SSB.

9.1 Independence The independence of the SSB from management is highly essential. Generally members of the SSB are appointed by the shareholders of the bank, represented by the Board of Directors (Grais and Pellegrini, 2006). As such, they are employed by the financial institution, and report to the Board of Directors. Their remuneration is proposed by the management and approved by the Board. According to Grais and Pellegrini, (2006) the SSB members dual relationship with the institution as providers of remunerated services and as assessors of the nature of operations could be seen as creating a possible conflict of interest. There seems to exist a potential for conflict of interest (Rammal, 2006). The concern is that members of the SSB may legitimize dubious operations to ensure that they remain active on the board. In principle, SSB members are required to submit an unbiased opinion in all matters pertaining to their assignment. However, their employment status generates an economic stake in the financial institution, which can negatively impact their independence. The opinions of the SSB may, for example, prohibit the bank engaging in certain profitable transactions or impose a reallocation of illicit income to charity, resulting in a poorer overall financial performance. Under these circumstances, the bank managers may be tempted to use their leverage to influence SSB members, producing what is commonly referred to as Fatwa shopping (Grais and Pellegrini, 2006) . In practice, the risk of such conflict of interest is mitigated by the ethical standards of the SSB members, and the high cost that a stained reputation would inflict on them and on the financial institution. Generally, members of SSBs are highly regarded Shariah scholars and guardians of its principles. Therefore, a less than truthful assessment and disclosure of Shariah compliance by an SSB would seem to be highly unlikely. In the event that it does occur and comes to light, it would seriously damage the concerned scholars reputation and the prospect for further recourse to their services. Similarly, managerial interference in compliance assessments can lead to a loss of shareholders and stakeholders confidence. Management may be penalized and face

17 dismissal. All that being said, and the heavy costs of untruthful assessments notwithstanding, a potential conflict of interest is inherent in existing corporate arrangements regarding SSBs. The recommendation of AAOIFI is that Shariah supervision must serve at the pleasure of the companys Board of Directors, and not be subject to management. Under such an arrangement, the Board will be free to approve or disapprove of what management does, or proposes to do, solely on the basis of Shariah/legal considerations (DeLorenzo). This is not to say that a Shariah Board will automatically become a barrier in the side of management. On the contrary, most Shariah Boards operate in the spirit of cooperation and accommodation. Vizcaino (2009) makes a valid view by informing the following:

Specifically, some observers and practitioners (INCEIF for instance) recommend that separate entities should be used for the Shariah setup and Shariah review. The fact that it is called a review (rather than an audit) gives rise to questions of how enforceable and critical a Shariah Board might be - in particular when there are breaches (of standards/rules) or deviations (from principles/ guidelines). Similarly, there are circumstances where the body that drafts the procedures/manuals then proceeds to audit/review the same, such self-review questions the independence and impartiality of the process (p. 1)

9.2 Confidentiality The issue of confidentiality is intertwined with that of independence. Often, some Shariah scholars sit on the SSBs of more than one financial institution. This association with multiple IIFs may be seen as strength in as much as it could enhance an SSBs independence in respect of a particular institution. However, it does give the particular individual access to proprietary information of other, possibly competing institutions. There are confidentiality concerns and potential conflicts of interest if inside information from one financial institution is used by another (Wilson, 2009). Thus SSB members may find themselves in another type of potential conflict of interest. Findings show that three specific Scholars are members of 26% of all Shariah boards in the GCC. There is also differing levels of activity between Scholars (from a total of 121 studied): approximately 56 Scholars holding less than 3 board positions, whereas the top 10 Scholars hold on average more than 25 board positions (Vizcaino, 2009) . In the current practice, Malaysia has attempted to deal with this issue by discouraging jurists from sitting on the SSB of

18 more than one IIFS. While this eliminates confidentiality concerns, the practice poses other potential problems. First, it would exacerbate lack of competence where there is a scarcity of Fiqh alMuamalat jurists (Grais and Pellegrini, 2006). It may prevent the formation of an efficient labor market for Shariah audit, by decreasing the economic appeal of the profession (Grais and Pellegrini, 2006). Authors Grais and Pellegrini, (2006) state that it may create a symbiotic relationship between the auditor and the financial institution that could undermine impartiality. The potential conflict arising between SSB and external auditors disagreements has been the discussion of the industry. external auditors are necessary since they act as an external control body that ensures that the financial institutions are adhering to Shariah (Usmani 2001). In studies conducted by Algaoud and Lewis (1997, 1999) it was revealed that the Islamic banks had no formal interaction between the SSBs and the external auditors.

9.3 Competence The third issue relates to the nature of the competence required of SSB members. Due to the unique role that they are called upon to fulfill, SSB members should ideally be knowledgeable in both Islamic law and commercial and accounting practices (Fiqh alMuamalat). In practice, it would appear that very few scholars are well-versed in both disciplines (Grais and Pellegrini, 2006). The issue has been addressed by including members from different backgrounds in most SSBs. However, the combination of experts rather than expertise creates the challenge of overcoming different perspectives as well as the risk of potential failure of communication. Over time, the demand gap for combined Shariah and financial skills is likely to be reduced through public policy and normal labor market operations. Progress in this direction is already noticeable in countries where the Islamic financial industry is well established. Authors Grais and Pellegrini (2006) findings show that the Securities Commission of Malaysia has certified a total of 27 individuals and 3 companies eligible for Shariah advisory on unit trust funds, for a total of 24 companies offering such funds.18 However, in countries where Islamic finance is less developed, other transitional arrangements may be needed.

9.4 Consistency

19 The fourth issue concerns consistency of judgment across banks, over time, or across jurisdictions within the same bank. In essence the activities of SSBs are in the nature of creating jurisprudence by the interpretation of legal sources. It should therefore not be surprising to find conflicting opinions on the admissibility of specific financial instruments or transactions. Nevertheless, as the industry expands, the number of conflicting fatwas on the permissibility of an instrument is likely to increase. This could undermine customer confidence in the industry and have repercussions on the enforceability of contracts. 9.5 Disclosure Another issue relates to disclosure of all information relating to Shariah advisories. In addition to the positive aspects of thus empowering stakeholders, disclosure could be the means to addressing some of the issues discussed in the preceding paragraphs. A transparent financial institution would ideally disclose the duties, decision making process, areas of competence, and the composition of its SSB, as well publish all fatwas issued by the SSB. This would strengthen stakeholders confidence in the credibility of SSB assessments. The quality and transparency of financial reporting and disclosure in the Islamic finance industry differs significantly from one regulatory jurisdiction to another (KPMG, 2007). There is a general concern in the market and among those interviewed that IFIs, with the notable exceptions of those operating in the U.K., Malaysia, Bahrain and perhaps Turkey, should have more rigor in their disclosure and financial reporting, especially to the general market (KPMG, 2007). In addition, public disclosure of such information would provide a forum for educating the public, thus paving the way for a larger role for market discipline in regard to Shariah compliance. Finally, it would decrease the costs that external agents may face in assessing the quality of internal Shariah supervision. 9.6 Cost of Maintaining SSB Many quarters of public question the high cost of maintaining shariah boards which will be passed on to the customers. This has contributed to increase in cost of Islamic banking products. SSB is an alien element in banking that distinguishes Islamic banks from rest of the system. Such pricing practices could be justified by stressing the costs of shariah compliance, which include the fees paid to shariah board members, the costs of convening board meetings and the legal charges in structuring Islamic financial products (Wilson, 2009). However, high

20 costs incurred in top-down supervision process by Islamic banks have made them less competitive in the financial market. Pricing is usually broken down into two components in Islamic funds and products (Vizcaino, 2009):
y

Structuring: for instance in considering an investment fund, this one-off fee can range from US$20,000 to US$60,000 (median of US$40,000) for preparing the structure, legal documentation, issuance of fatwa, etc.

Review: for the supervisory and monitoring function to ensure that the fund complies with Shariah principles, this retainer fee can range from US$20,000 to US$55,000 (median of US$40,000). Thus, some recent Islamic fund launches have seen approximately US$80,000 spent on the first year of operation alone.

There are other quotes available and it must be noted that full-fledged Shariah boards will require payment for each board member (sometimes along the lines of US$ 25,000 to US$ 50,000 per advisor) and other expenditure such as travel expenses and ancillaries will have to be absorbed as well (Vizcaino, 2009) . The range of costs is wide since there are multiple products to be considered. For instance, if a single vehicle is setup then a single (and in some cases external) Shariah advisor would suffice, whereas if a master-feeder type structure where to be considered (with subsequent sub-funds being launched) then a more comprehensive SSB should be considered to look into the underlying structures and issue a Shariah compliance certificate for all the underlying assets/funds. In this case having an SSB for every single fund may be more expensive. Furthermore, there are additional products/services that might be required and that should be taken into account as well, a case in point being Shariah screening mechanisms. In certain instances stock screening will be an integral part of the investment process, and some advisors might not be able to provide this specific service or there might be more sophisticated screening from specialized providers. Nevertheless, pricing is in practice expected to broaden: on one hand one must consider the growing calls for country Shariah and on the other you have advisory consultancies increasingly engaging in more complex structures which are more expensive.

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10. Standardization of SSB Opinions 10.1 Issue of Non-Standardization There have been critics of the lack of standardization of the fatwa of different shariah boards, and even an assertion that it can result in shariah arbitrage (El Gamal 2006). There is little evidence of such arbitrage in practice, and indeed it could be regarded as implausible that the sort of bank clients or investors wanting shariah compliance would shop around for the least restrictive fatwa. However, bank management, often get the fatwa they want approved, most notably in the case of sukuk, where some scholars have been having second thoughts about structures they previously approved. These issues will be considered later in the section on sukuk. In the UAE consideration is being given to the introduction of a new law establishing a higher Shariah Council which could oversee the work of the shariah boards of the seven Islamic banks now operating in the country (Elewa 2008). This would be similar to the Malaysian system, where there are national shariah boards serving both the Central Bank and the Securities Commission.6 Only these bodies have the power to issue fatwa, the remit of the shariah boards of each financial institution being confined to ensuring that activities within the institutions comply with the fatwa. This contrasts with the position in the GCC, where in the absence of national shariah authorities, the boards of each financial institution can issue their own fatwa. Inevitably there are conflicting fatwa reflecting different interpretations of shariah as each board preserves its power to make independent pronouncements. Appointments to shariah boards in the GCC are usually the responsibility of the board of directors of each institution, which will approve the terms and conditions of service, including remuneration. Normally qualifications in fiqh muamalat will be

22 required, together with some knowledge of banking and finance, but there is no accreditation system. By contrast, in Malaysia all those appointed to the shariah boards of Islamic banks have to apply to the central bank and obtain accreditation. There is no comparable system in the GCC, where some argue that the lack of standardization has caused confusion and uncertainty, although, as indicated above, it has also resulted in healthy discussion, which in many respects has been helpful for Islamic financial development. In reality, however, the diversity of opinions is less widespread than might be expected. The General Council of Islamic Banks and Financial Institutions sampled about 6000 fatwas, and found that 90% were consistent across banks. The fact that over one hundred Shariah scholars around the world issued these fatwas would suggest an overall consistency in the interpretation of the sources (Grais and Pellegrini, 2006). Further, this high degree of consistency between the fatwas would also point to a substantial independence of SSBs. Nevertheless, as the industry expands, the number of conflicting fatwas on the permissibility of an instrument is likely to increase. This could undermine customer confidence in the industry and have repercussions on the enforceability of contracts. Scholar Elawleed (2007) highlights the following: The absence of a universally accepted central religious authority is largely a result of the lack of uniformity in religious principles applied in different Islamic countries across the world. Shariah boards at individual banks have their own way of defining what is and is not Islamic banking. This results in different transactions being interpreted differently and causes uncertainty about what is the acceptable way to do business in the Islamic banking and finance system. Furthermore, because of this lack of consistency, an accurate assessment of risk for both the financial institution and the customer can be difficult to make. The differences in interpretation of Shariah laws also means that one Islamic bank may not be able to copy another Islamic banks products, and this can stifle the growth and integration of Islamic finance at both national and international levels. Lack of standardization is also a contributory factor in the sluggish trading levels on the Sukuk market. It prevents investors from knowing what risks they are assuming when they invest and increases the costs associated with Sukuk issuance. 10.2 Harmonization of Opinions

23 Conformity among the Shariah supervisory boards of IFIs is urgently required through standardization that will extend the possibility of concept and application in the industry. Establishing Shariah boards at a global and central bank level is needed to accelerate and develop some standard guidelines on the conduct of Islamic financial transactions. Standardization will help avoid contradictions or inconsistencies between different Fatwa rulings and their application by these institutions (Elawleed, 2007). One of the distinctive goals of the existing bodies pertaining to Islamic finance is the standardization of Shariah practices within their jurisdictions. Countries such as Kuwait, Malaysia or Pakistan have taken significant actions in this respect, while others have not followed this route (Grais and Pellegrini, 2006). The standardization of Islamic instruments may be a major determinant in ensuring the enforceability of Islamic financial contracts in disputes brought before civil courts that are not legally bound by the Shariah. Accordingly, standardization of practices would support property rights of involved stakeholders as well as sustain the development of IFIs in non-Islamic countries route (Grais and Pellegrini, 2006). However, the practice of centralized SSBs creates the possibility that one IIFS group operating in different jurisdictions may have products deemed Shariah compliant in one place and not in another. In addition, regulators in non Islamic jurisdictions would consider that matters relating to the Shariah are not in their purview. An important factor is the mutual recognition of financial standards and products across jurisdictions. The progressive harmonization of Shariah, in this respect, needs to be viewed as a step towards greater international financial integration (Elawleed, 2007). Moreover, supervision and regulation at the national and regional levels are necessary safeguards against potential improper practices, which can cast doubt on the credibility of all participants. Shariah scholars from around the world should contribute towards greater understanding and international convergence (Elawleed, 2007). Such convergence and harmonization can only happen with greater engagement among the regulators, practitioners and scholars in Islamic finance in the international community. The existence of a unified Shariah board via council representing different Islamic schools of thought, nationally and internationally, would facilitate the conformity of different types of financial services to Islamic law (Elawleed, 2007). This would also define cohesive

24 rules to expedite the process of introducing new products. The early engagement of a Shariah supervisory board in the creation of a new Sukuk is of utmost importance so as to build a solid Islamic foundation. It also paves the way for speedier creation of the Sukuk. It is crucial that the Shariah board actively participates in the creation of Sukuk, in addition to its supervisory role (Elawleed, 2007).In order to promote a global standard for Islamic finance instruments, there are a couple of key steps that must be taken.The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has taken the lead by preparing Shariah standards. These have been adopted by a number of government authorities and central banks, which provides an avenue for Shariah compliance as well as product innovation. Collective efforts towards international collaboration among major Islamic financial regulatory bodies such as the Islamic Financial Services Board (IFSB), AAOIFI and the central banks in Islamic countries is important in strengthening the fabric of Islamic finance. Islamic finance instruments, particularly Sukuk, are becoming an increasingly important consideration for both Muslims and non-Muslims from the perspective of investment and product innovation. Shariah boards need to keep up with the growth and sophistication of the industry and make sure they are as effective as possible. Author (Elawleed, 2007) make following recommendations:
y

More training in economics, investments and legal issues related to investments and product innovation. The lack of knowledge about modern economic and legal issues can weigh down the ability of Shariah scholars to issue well-informed rulings on financial products and investment activities.

Placing specialized Shariah scholars on separate Shariah boards for different projects to work more efficiently on projects best suited to their particular areas of expertise. This process will ensure that the right scholars in the right numbers develop, certify and supervise the financial products and services endorsed by Islamic financial institutions.

Shariah boards should be independent from financial institutions in order to ensure transparency and efficiency when giving opinions on proposed contracts and transactions.

Shariah advisors should work closely with financial institutions and lawyers in developing new Islamic financial instruments.

25
y

There is a nagging concern about the availability of suitably qualified Shariah advisors. Their numbers need to be increased. This will allow more Shariah-compliant transactional procedures and more time for advisors to spend with economists and investment practitioners to develop new Islamic financial products.

Financial institutions need to develop operating procedures to ensure that no form of investment or business activity is undertaken that has not been approved in advance by the religious board.

From the outset of structuring a Sukuk, Shariah advisors should scrutinize to ensure that the product concept and its process flow is fully implemented according to Shariah. Shariah advisors and lawyers should work hand in hand to thoroughly review the terms and conditions of the Sukuk contract.

Flexibility is a major strength of Islamic finance, and this implies that a broad variety of products can be tailored to each clients needs. The differences in rulings by different Shariah boards is advantageous in a way, as it brings about more innovation and creates new room for Sukuk structures and Islamic finance instruments. In the process of providing remedies, the principles of Shariah are not to be compromised, as they are essential to a dynamic market. 11. Models of Shariah Governance from Selected Countries Having discussed the operations, practices and issues of SSB in Malaysian context, a concise discussion of the SSB model in other countries would be utterly helpful. This will shed some light on the differences in practices in some prominent Muslim countries that Islamic finance has become a major drive. Following are some of the exisiting models of SSB (Hasan). Pakistan Model y y y y The establishment of Shariah Board at the State Bank of Pakistan (SBP) Shariah Board is the sole authority in matters pertaining to Islamic finance Requirement for the establishment of Shariah advisor for the Islamic financial institution Any member of Shariah Board at the SBP is allowed to serve as Shariah advisor of a financial institution(different from Malaysian situation) y y Restriction imposed a Shariah advisor is allowed to serve only one financial institution No division of industries as in the Malaysian situation has been made

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Kuwait Model Kuwait is practicing self regulation of Islamic financial institutions There is no Shariah Advisory Council at the Central Bank of Kuwait Section 10, Chapter 3, Central Bank of Kuwait Law 32/1968 provides that every Islamic financial institution shall have its own Shariah Supervisory Board In the case of conflict of opinions among members of the Shariah Supervisory Boards concerning a Shariah ruling, the Board of Directors of the designated Islamic FI may transfer the matter to the Fatwa Board in the Ministry of Awqaf and Islamic Affairs (this is not compulsory) The Fatwa Board in the Ministry of Awqaf and Islamic Affairs shall be the final authority on the matter This Fatwa Board is an external body to the Central Bank of Kuwait No restriction is mentioned/found in the law From the existing practice, it can be said that there is no restriction for the members of the Fatwa Board to serve in any Islamic financial institution. Similarly, there is also no limitation to serve as a member of Shariah Supervisory Board of more than one Islamic financial institution

Bahrain Model Establishment of National Shariah Board of the Central Bank of Bahrain to serve and to verify the Shariah compliance of its own products only All other Islamic financial institutions shall establish Shariah Supervisory Committee and comply with the AAOIFI's Governance Standards for Islamic Financial Institutions No. 1 and No. 2 No restriction for the member of National Shariah Board to serve any financial institution, also no limitation to serve only one institution

U.A.E. Model Establishment of Higher Shariah Authority to supervise Islamic banks, financial institutions and investment companies (Art. 5, Federal Law No. 6 of 1985)

27 This Authority shall be accorded the final authority in Shariah matters in Islamic banking and finance Formation of Shariah Supervision Authority at the financial institution level (Art. 6 of the same Law) Nothing is mentioned about any restriction

Qatar Model Practicing self regulation of Islamic banks No Shariah Advisory Board at Central Bank of Qatar. But has Supreme Shariah Council attached to Awqaf Ministry any issue can be directed to the Council for clarification Central Bank of Qatar appoints Shariah scholars to solve any problem encountered on case-to-case basis No restriction on Shariah advisors to be a member of Shariah Board in more than one IFI.

Table 1

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Extracted from: Corporate Governance and Shariah Compliance In Institutions Offering Islamic Financial Services (Wafik Grais and Matteo Pellegrini, 2006).

Above table shows the regulatory framework implemented by the countrys central banks as regards to the various aspects of SSB. Monetary authorities in all mentioned countries have implemented the terms of reference in order to set the right precedence to the industry by establishing SSB. However, countries do not have a uniform regulations for the shariah advisory for own reasons. For example, except for Jordan and Kuwait other countries in the table 1 do not specify the decision making of SSB. On the other hand, except for Malaysia and Indonesia other countries specify the number to serve in the SSB.

12. Conclusion The increasing popularity of Islamic finance in the aftermath of financial crisis is an interesting phenomenon. Both western and Islamic schools claim that Islamic financial system

29 could have averted such a crisis amid its shariah framework. The center to operations of any IFI is its Shariah supervision. Indeed its a very part of corporate governance in modern IFIs. Shariah supervision will be an essential part of an Islamic product or service from the time of its development, to its launch, and throughout the period it is offered. At the stage of research and development, or of drafting contracts or offering memorandums, Shariah supervision, in one form or another, should be an active participant. The supervision is periodically carried out by the banks Shariah supervisory body. It is an independent body distinguished from the board of directors that ensures bank is in line with shariah rules. This enables the Muslim investors to identify the financial institutions that are permissible to invest their money. The objectives of Islamic banks may therefore differ greatly from the conventional bank's objectives. Therefore, in order to ensure compliance to the Shariah, IFIs use the service of well-verse Shariah scholars. In Malaysia, Bank Negara Malaysia has actively participated in drawing regulations and guidelines to direct the functions of SSB. It has detailed out various aspects of SSB in IFIs. As an essential element of corporate governance, SSB is expected to function in the best interest of its stakeholders that seek for consistent shariah compliance. However issues exist as to its independence, consistency, confidentiality, competency, disclosure and high costs. These issues question the operations of SSB and need to strengthen the governance structure of IFIs. With different shariah boards announcing diverse standards, IFIs have attracted some criticism due to non-standardization of opinions. Scholars have called for harmonization of opinions that will promote uniformity among the IFIs. The mutual recognition of financial standards and products across jurisdictions is vital. Thus conflicting fatwa could disturb the progress of industry where integrity is the center of Islamic finance. The progressive harmonization of Shariah, in this respect, needs to be viewed as a step towards greater international financial integration. Moreover, many countries that operate well established Islamic financial sectors have introduced regulations to guide the function of SSB. These regulations could be in different approaches but attempt to strengthen the SSB.

References:

30 Algaoud, L.M. and Lewis, M.K. (1999). Corporate Governance In Islamic Banking: The Case Of Bahrain: International Journal Of Business Studies. DeLorenzo, Talal Yusuf. Shari`ah Supervisionin Modern Islamic Finance. El Gamal, Mahmood, 2006. Islamic Finance: Law, Economics and Practice. Cambridge:Cambridge press. ElWaleed, M Ahmed. (2007). A unified voice: the role of Syariah Advisory Boards in Islamic Finance.Accessed: 4th March 2010.

http://theroleofshariahadvisoryboards.blogspot.com/2007/10/unified-voice-role-ofshariah-advisory.html Grais .Wafik, Pellegrini. Matteo. (2006). Corporate Governance and Shariah Compliance in Institutions Offering Islamic Financial Services: World Bank Policy Research Working Paper 4054. Hasan, Bin Aznan. Optimal Shariah governance in Islamic finance. PowerPoint presentation. Knowledge@Wharton. 2004. Islamic Banking Comes of Age - But What's Next? Accessed: 20 February 2010. http://knowledge.wharton.upenn.edu/ /article.cfm.htm KPMG. (2007). Growth and Diversification in Islamic Finance: KPMG publications. Lahsasna, Ahcene. Shariah aspects in business and finance. INCEIF: Kuala Lumpur. Rahman,Abd Hj Zaharuddin.(2007).How Islamic Banks Complying With The Shariah Requirements. Accesed 13 March 2010. . http://zaharuddin.net.htm. Rammal, G. Hussain.(2006) The importance of shariah supervision in Islamic financial institutions. Corporate Ownership and Control Volume 3, Issue 3. Suleiman, Mohammed Nasser. Corporate governance in Islamic banks: The Muslim banking world faces the challenge of expanding internationally while remaining true to Islamic principles. Usmani, M.T. (2001). The Historic Judgement On Interest: Delivered In The Supreme Court Of Pakistan. Karachi, Pakistan: Idaratul Maarif. Vizcaino, Bernardo. (2009). Editors Note: The Shariah Compliance Toolkit. Accessed: 12th March 2010. http://www.opalesque.com/ Shariah_Compliance_Vizcaino_CAIA542.html

31 Wilson, Rodney. (2009). The development of Islamic finance in the GCC: Kuwait Program on Development, Governance and Globalization in the Gulf States.