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Dr. Abdullah Mohd Ayedh

Lesson Outcome
Explain the Shariah Governance Framework for Islamic
Financial Institutions issued by Bank Negara Malaysia in 2011.

Identify the main organs of an IFIs Shariah governance


Explain the main functions of each of the parties involved in

the Shariah governance.

Elaborate on the interrelationships among the important

organs of the Shariah governance.
BNM issued a guideline on Shariah Governance Framework
(SGF) for Islamic Financial Institutions (IFIs) - effective for
implementation in January 2011 by all IFIs regulated and
supervised by the BNM.

SGF superseded (replaced) the BNM/GPS1 that was issued in


To meet high expectation of the key stakeholders of the IFI in

relation to Shariah compliance process.
IFIs Shariah Governance Structure



Shariah Risk
Shariah Review Shariah Research Shariah Audit
Management Control
Function Function Function Function
IFIs Shariah Governance Structure
Shariah Governance Framework
The Framework provides guidelines for all IFIs to properly
structure, develop and practice Shariah compliance activities.

The Framework emphasized that the Board of Directors is

responsible to provide overall oversight of Shariah
governance structure and Shariah compliance.

The Framework also reiterated that the Management is

responsible to ensure the executions of business and
operations must be in accordance with the Shariah principles;
and provide necessary support to the Shariah Committee.

Part of Shariah Governance of IFIs is the role of Shariah

Committee to provide oversight and accountability on
Shariah related matters.
Main Organs of Shariah Governance

Board of Directors Management Shariah Committee

Overall oversight on Ensure executions of Oversight accountability
Shariah governance business and on Shariah related
structure & Shariah operations are in matters
compliance accordance with The Board is expected
Ensure effective Shariah principles to rely on Shariah
communication policy Provide necessary Committee on all
among the key support to the Shariah Shariah decisions, views
functions of the IFIs Committee and opinions
Shariah Compliance Functions
Identify, measure, Review business
monitor, report & operations on regular
control Shariah non- basis to ensure
compliance risk Shariah compliance
Risk Shariah
Mngmt. Review
Control Function

Shariah Shariah
Research Audit
Conduct in-depth Function Function Provide independent
Shariah research assessment & objective
prior to submission assurance designed to
to the Shariah value add & improve
Committee IFIs Shariah compliance
IFIs Shariah Governance Structure

A sound and robust Shariah governance framework should be

reflected by:
Effective and responsible board and management,
an independent Shariah Committee (SC) that is both
competent and accountable,
supported by a strong internal Shariah research capacity,
and monitored through active Shariah review, Shariah audit
and Shariah risk management process
Board of Directors: Main Duties
Accountable and overall Shariah governance framework and Shariah compliance of
the IFI.

Consult the SC before approving all policies relating to Shariah matters and must
ensure that such policies are implemented effectively;

Appoint the SC members based on the recommendation of the Nomination

Committee. Number of SC members must not be less than five and majority of its
members must possess strong knowledge in Shariah;

Effective communication policy to ensure that information on Shariah is forwarded

to the board.; and

Remunerate the SC members based on advice given by the Remuneration

Committee. The remuneration should reflect and commensurate with the
accountability, duties and responsibilities of the SC.
Shariah Committee

Oversee Shariah related matters

Shariah Shariah Shariah
Review Research Audit

Shariah Committee (SC) position in the SGF can be seen as higher than
management and nearly at par with the Board of Directors (BOD).
Responsibilities & accountabilities of SC

Responsible and accountable for all its decisions, views and

opinions related to Shariah matters.

Perform an oversight role on Shariah matters related to the IFIs

business operations and activities.

Provide sufficient disclosure in the IFIs annual financial report

on the state of compliance of the IFI Shariah Committee
Additional guidelines on duties, responsibilities
& accountability

Responsibility & accountability

Advise the Board & IFI
Endorse Shariah policies & procedures
Endorse and validate relevant documentations
Assess work carried out by Shariah review & audit
Assist related parties on Shariah matters
Advise on matters to referred to the SAC
Provide written Shariah opinions
Independence of SC
Independence = being free from any influence;
exercise objective judgment.

Their position or rank the same level of the Board of

Directors (BOD) or in other words any decision made
by the SC could not be overruled by the BOD.

BOD need to ensure that the decisions made by the SC

are implemented by the IFI and ensure that decisions
made by the SC are not modified without their
Independence of SC

Access to accurate, timely and complete information from the

management to effectively perform their duties.

Shariah non-compliant activities are not effectively or

adequately addressed or no rectification were made by the IFI
SC to report such matter to the BNM
Independence of SC
Reappointment, resignation and removal of the SC are made by
the BOD.

This decision is subjected to the approval by the BNM and

National Shariah Advisory Council of BNM.

There is the regulation that allows SC member to hold only one

post within the same industry so as to maintain the level of
independence and confidentiality of information amongst the
Independence of SC

SC member should not have any relationship with the following persons that could
interfere with the exercise of independent judgment:
spouse, children or siblings who were employed by the IFIs or any related
companies as chief executive officer or non-independent board members.
substantial shareholder of or a partner or an executive officer or a director
of any for-profit business organization that the IFI or any of its subsidiaries
have received significant payments from the organization

SC member also should not be:

an employee of the IFI or any of its related companies
a SC member of another IFI within the same industry
Competency of SC
Degree in Shariah which includes the study in Usul Fiqh
(i.e. the origin of Islamic law) or Fiqh Muamalat (i.e. Islamic
transaction/commercial law).
Relevant backgrounds such as finance and law - support
Shariah deliberations
Assessment of the performance of the SC members.

Succession planning program for the SC member by

identifying, hiring and nurturing new members
Confidentiality of SC
Supplied by management necessary access to files, records,
draft materials and conversations that is related to the work
undertaken by the SC.

Each SC member is required to observe the principle of

confidentiality at all times.

Refer to list of confidential information in module.

SC is allowed to disclose sensitive information to BNM in good

faith, meaning that it must be disclosed because the IFI do not
comply with Shariah principles

Helping the Board of Directors (BOD) and the Shariah

Committee (SC) to perform their job.

Supporting department that assists the function of the BOD

and SC.

Backbone to the effective functioning of the BOD and SC.

Management: Position



Shariah Risk
Shariah Shariah
Control Research Review
Management: other supporting units

1. Shariah risk management control

2. Shariah research

3. Shariah review Management

Shariah Risk
Shariah Shariah
Control Research Review
Management: Role

1. Observe and implement Shariah rulings and decisions made by SAC & SC.

2. Information and disclosure complete and accurate to the SC.

3. Adequate resources and manpower to support the SGF.

4. Continuous learning and trainings on Shariah and finance matters.

5. Holistic culture of Shariah compliance within the organization.

6. Accessibility of Shariah policies and procedures.

7. Actions to be taken when aware that certain operations do not comply with
Shariah or against the advice of its SC or the rulings of the SAC.
Pitfall No. 1:
Is the BOD ready to function as oversight body of
Shariah Governance?
The Shariah Governance Framework makes it clear that the Board is
responsible to ensure oversight of Shariah compliance for IFIs.
The Board is already heavily burdened to provide oversight on many regulatory
requirements as a financial institution e.g. prudential regulation, risk
management, corporate governance etc.
The Board is also highly expected to provide leadership and full accountability
to the shareholders, regulators and other stakeholders.
The members of the Board i.e. the Directors, however, are not well versed on
The Board expected the Shariah Committee to assist not only to advise but to
supervise the Shariah compliance.
Is it not a requirement for the Board to appoint the Chairman of the Shariah
Committee (or any qualified Shariah scholar) to be a member of the Board to
effectively assisting them?
Functional Gap on the role of the Board

The Shariah Governance Framework prescribed that Shariah audit

function must be answerable to the Board Audit Committee.

However, with the heavily tasked Board Audit Committee to provide

oversight on the external and internal financial and operational audit, is
the Committee able to function effectively to ensure Shariah compliance?

In the absence of any Shariah Committee member or the limited Shariah

knowledge of the Board Audit Committee member, are they capable of
undertaking an additional and heavy task to ensure Shariah compliance?

The functional gap in the role of the Board and the Board Audit
Committee opening up huge responsibilities and accountabilities beyond
their imaginationis it true?
Pitfall No. 2:
The Management & Shariah Non-Compliance Risk

Shariah non-compliance risk is a significant risk for an Islamic financial

services from two perspectives:
1. It impacts the reputation and deteriorates reliance of the depositors,
investors, customers and other stakeholders in the long-term; and
2. It impacts the revenue as well, because in case of an identified Shariah
non-compliance, the income arising from such transaction can be given
to charity.
Shariah compliance is the essence of Islamic financial services.
The management is accountable to ensure proper risk management and
internal control are in place.
Implications of Shariah Non-Compliance Risks

Affects the integrity in the eyes of shareholders and stakeholders

i.e. customers, depositors etc.
Against the commands of Allah and could be impediment from
Allahs blessing.
Invalidation of contract (aqad).
Non-halal income.
The management must not only be aware of Shariah non-
compliance but must be very serious to mitigate and manage the
The management must also be seen by the shareholders,
depositors, customers, the regulators and the public as serious in
managing and mitigating Shariah non-compliance risks.
Pitfall No. 3:
Reasonable vs. Complete Assurance

Report of the Auditors of Report of the Shariah

IslamicBank XYZ: Committee of Islamic Bank XYZ:

We conducted our audit in The duties and responsibilities of

accordance with approved Shariah Supervisory Council (SSC) are
Standards on Auditing in Malaysia. to review, appraise and advise the
These standards require that we Directors on the operations of the
plan and perform the audit to Group and of the companys business
obtain all information and in order to ensure that they do not
explanations which we consider involve any element which is not
necessary to provide us with approved by Islam. () We,..and..,
evidence to give reasonable being two members of the SSC, do
assurance that the financial hereby confirm on behalf of the
statements are free from material Council, that in our opinion, the
misstatements. operations of the Group and of the
company for the year endedhave
been conducted in conformity with
Shariah principles.
Reasonable vs. Complete Assurance
The Report of the Auditors - an independent assurance on the
integrity and fairness of financial information.
Financial statement audit - an opinion as to whether the financial
statements are prepared in accordance with an identified
financial reporting framework and standards.
Since the transactions are too many, evidences will be
accumulated on a sampling basis - thus, the auditors only
expressed reasonable assurance.
The Report of Shariah Committee indicates a statement of
opinion reflecting a complete assurance of shariah principles but
the Shariah Committee never conduct an audit?
Is it appropriate for Shariah Committee to make such a `strong
statement to indicate a complete assurance?
Reasonable vs. Complete Assurance
Financial auditors are independent professionals with sufficient
education and experience to qualify to perform the audit.
Members of Shariah Committee are qualified Shariah scholars
but their responsibility is only to advise.
The responsibility of Shariah compliance actually lies with the

The Report of Shariah Committee indicates they have taken the

responsibility not only to advise but also to provide complete
To what extent the Shariah Committee is legally liable in the case
of Shariah non-compliance and irregularities?
The Report of Shariah Committee is of great value to the
management to ensure credibility
Pitfall No. 4:
Competency & Limited Roles of Shariah Supervisors

Without any disregard to the individuals, and not as a generalized

rule, the jurists sitting on Shariah Committee possess little
knowledge about the operations of the financial institutions.

Consequently, their compliance review generally remains limited

to the extent of assurance of the legal form of transactions i.e.
vetting of agreements and documents etc.

On the contrary, the operational matters which include the

substance of the transactions might remain unattended because
it is not the core competence of these respectable jurists.
Competency & Limited Roles of Shariah
Generallythe management does not wish to bring each and
every matter in the attention of the Board or the Shariah

Accordingly, unless they have enough time to review things on

their own, and they take reasonable interest in the same, it is not
possible for the Shariah Committee to have a look on most of
the operational matters.

Although we are not questioning the personal independence and

integrity of respectable jurists in the Shariah Committee, they
would appreciate that the work performed under ones guidance
should always be counter checked by an independent person.
Pitfall No. 5:
Ex-Ante vs. Ex-Post Shariah Compliance
Ex-ante Shariah compliance - the Shariah Committees
supervision, monitoring and control tasks to comply with the
Shariah rules and guidelines during the designing of the contracts
and agreements up to the implementation of the terms of

Ex-post Shariah compliance - a comprehensive Shariah audit to

review and check the transactions that took place after the
execution of the contracts.

Ex-post Shariah compliance (Shariah audit) perform random

samples of completed transactions to ensure Shariah compliance.

Shariah supervisors did not carrying out Shariah audit on the

operations of Islamic banks due to their restricted scope of work.
Why do IFIs need Shariah Audit?

Responsibilities of SAC or SSB Context

Evaluating and approving Islamic financial products, Shariah Committee of the IFIs normally expressed
prepare draft of Shariah opinions, prepare contracts their opinions on the Shariah compliance of the
in collaboration with legal advisor of the bank etc. products and services offered (ex-ante compliance).

So far Shariah advisors are not carrying out thorough However, a comprehensive and well-guided audit of
and comprehensive internal Shariah review or audit the Shariah legal contracts, documentations and
on the operations of IFIs due to their restricted scope operations so far has not been properly conducted
of work. (ex-post compliance).

As required by the Companies Act, IFIs are

also subjected to financial audit conducted Without such auditing function, there is
by external auditors which are normally a functional gap of Shariah compliance
carried out by professional accounting firms. in the Islamic financial system.
Shariah Audit

Perform by internal or external auditors, whom have acquired

Shariah related knowledge and training.

Flexibility in seeking expertise from the IFIs Shariah officers in

performing the audit as long as the objectivity of the audit is
Independent assurance:
Functionally report to the Board Audit Committee (BAC) and
provides input on Shariah non-compliance matters to the
Shariah Committee (SC).
Independent from management - not involved with the day-
to-day operations of the IFI
What is Shariah audit?

The accumulation and evaluation of evidence to determine and report on the degree of
correspondence between information and criteria for Shariah compliance purposes.
Broad Shariah auditors perform audits on both information (financial information/standard e.g. profit
definition distribution) and subjective information (Shariah opinion/fatwa/standard) to ensure Shariah

Shariah audit of the IFIs that involved Shariah matters (e.g. profit distribution policy).
Shariah audit of the operational aspects of the IFIs (e.g. policy on penalty charge for late payment).
General Shariah audit of the products compliance according to the established Shariah criteria recognised by
the bank and the regulatory authorities.

Shariah auditors need to understand the business of the IFIs including the nature of contracts used
for different types of Islamic financial services.
This auditing process can be undertaken internally by the internal auditors with the help of Shariah
Effective officers.
Implementa Externally, it can be undertaken by Bank Negara Malaysia (BNM), or/and a dedicated independent
tion institution to be established either by the industry or by BNM.


(by Prof. Dr. Abdul Rahim Abdul Rahman)
Why do we need Shariah Audit?
How do we address the challenges in performing
Shariah Audit?
In your opinion, do we really need Shariah Audit?