Supervisory Functions That The Shari’ah Boards of Islamic Banks

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The experience of Islamic banking in various countries has shown that Shari’ah Boards/Advisors of Islamic Financial Institutions (IFIs) should have a proactive role in supervision of Islamic banks’ transactions for the purpose of Shari’ah compliance. Islamic banks are generally using modes involving fixed rates of return.  Non fulfilment of any of the Shari’ah essentials of such modes may render the transactions un-Islamic. The passive role for approving the products or their procedures and leaving their applications totally on the banks opens door to interest in the garb of asset-based transactions like Murabaha, Tawarruq, Hire-purchase, etc. Therefore, experts deem it necessary Shari’ah Boards should thoroughly inspect at least once a year the activities of Islamic banks to ascertain their Shari’ah compliance.
Similarly, a large part of Islamic banks assets comprises investments in equities/capital markets. Shari’ah Boards must ensure compliance of criteria for Islamic banks investments in shares, equities, Sukuk and other avenues of business. This aspect of Shari’ah controls would include prohibition of investment in companies with unacceptable business lines which produce prohibited products and provide prohibited services like:
  Alcoholic beverages and tobacco products
  Grocery stores dealing in Haram goods
  Restaurants, casinos and hotels with bars for prohibited activities
  Amusement and recreational services
  Financial institutions which deal with interest 
  Companies of which:
  Interest income ratio is more than (5)%
  Debt ratio (leverage) is less than (10 – 33)%
  Total illiquid assets less than 10 % of its total assets
If investment is made in equities of such companies, Haram or interest related income will have to be given in charity and the Shari’ah Boards must ensure its credit to charity Accounts.


In order to ensure Shari’ah compliance, Shari’ah Boards should specify detailed controls for modes which respective banks are using particularly in respect of  commonly used modes like Murabaha and Ijarah which are susceptible to be used as back-door to interest. Murabaha in various goods may involve different aspects that may need close monitoring.  For example, Murabaha in perishable goods, shares of Joint Stock Companies, particularly when the transactions involve dual side agency agreements, Tawarruq and other by – products of major Islamic modes. We give internal control in respect of some modes as hereunder:-


1 Shari’ah Board should ensure that accounting in Murabaha is made similar to that of a trade transaction instead of financial transaction. In this respect, AAOIFI’s Accounting Standard on Murabaha may be consulted. Some banks record only the disbursement of the total amount including mark-up. This is against the substance of Shari’ah compliant Murabaha.
2 To ensure that banks are not involved in Rollover of Murabaha transactions, strict internal controls be applied.  Price of the goods cannot be changed if the customer does not pay on time. Accordingly, there is no opportunity for a rollover of Murabaha transactions. Nevertheless, it should also be kept in mind that a Master Murabaha facility entails multiple Murabaha transactions, and in case it is necessary to extend credit, a new Murabaha should be initiated against new goods with a complete process of purchase offer and acceptance. Against this, some banks resort to arrangement in which they disburse the amount payable by their client against a new Murabaha, credit the amount to the client’s account; and then debit his account against the old Murabaha. This is merely a book entry.  In some cases, banks might not be making even the book entry and there might be simple rollover of the previous Murabaha including the previous receivable plus mark-up for the new term.  Shari’ah Board will have to restrict the bank from such operations. Return on such Roll-overs must go to charity fund.
3 The client who is being paid the amount for purchase of the commodity on behalf of the bank may not purchase the commodity for a long time and use it for any other asset that might not be permissible e.g. for purchase of interest-based securities or shares of interest based companies.  Therefore,  there must be effective controls that client purchases the commodity within a given minimum time and gives declaration to the bank followed by acceptance by the bank and sale to the clients.  For effective control, Shari’ah Board may also advise the bank to make payment directly to the supplier.
1 For genuine Murabaha, it is necessary that legal title of ownership is transferred to the bank before it sells the commodity to the client on Murabaha basis. But banks, in order to avoid payment of transfer charges, purchase the goods in the name of the client; thus the banks do not become owner of the goods in any way.  Shari’ah Board must ensure that not only title of goods is in the name of the bank at the time of its sale to client, but also that bank retains all risk and rewards related to ownerships till the goods are sold to the client.
2 Shari’ah Board must ensure that all documentation requirements particularly in case the client is also agent of the bank are being fulfilled properly. The Board should not allow any change in the Master Agreement without its prior approval.
3 Mark-up should be charged from the time bank sells the commodity on credit to the client.  Shari’ah Board must ensure that it is not charged from the date of disbursement to the supplier or to the client (as agent).  Any part of the mark-up should not be referable to the intervening period i.e. between disbursement and declaration/acceptance by the bank.  Islamic banks should calculate their Murabaha profit from the date they sell the commodity to the client.
4 Bai al Inah/Buy-back arrangement is not allowed in Shari’ah. The Shari’ah Board should put in place effective controls that banks do not resort to buyback technique in case of Murabaha transactions.
Banks, upon financing, normally take Demand Promissory Notes (DP Note) from the client. As Islamic banks financing is based on the underlying trading/leasing contracts, they should get DP Notes only after executing the Murabaha sale and creation of liability e.g. after the sale of goods.  Shari’ah Boards should ensure that banks do not take DP Note at the time of disbursement to the client/agent.  If such Note is necessary at the time of disbursement for the sake of Security, it can be of the principal amount only i.e. excluding the mark-up or profit margin.
Some Shari’ah Boards have also allowed in Murabaha structure the use of Tawarruq  i.e. the client selling the goods purchased from bank on Murabaha to get cash for any other business activity.  In this case, Shari’ah Board must ensure that the process of genuine Murabaha is completed fulfilling the Shari’ah essentials and that the cash realised by the client is used for any Halal business/purpose.


The other major mode Islamic banking are using is ijarah alongwith its variants. Following may be some of its controls:
1 The Shari’ah Board should ensure that ownership title of the leased asset is transferred to the bank i.e. Lessor. In case it involves import, banks should import in its name directly or through agent/client.  It has been observed that to avoid some taxes/charges the assets are imported in the name of client/lessee. It is not permissible and the minimum that should be ensured is that a Counter Deed should be signed between the Bank (Lessor) and the Client (Lessee) for transfer of ownership to the Lessor.
2 Ijarah and Bai are entirely different types of transactions in terms of their implications for the parties involved.  Therefore, the two transactions should not be mixed in such a way that their respective Shari’ah essentials are not fulfilled. Transfer of ownership to lessee should not be an integral condition of the Lease Agreement. It could be a unilateral promise, not binding on the other party.
3 Shari’ah Board should ensure that expenses relating to purchase and ownership of the asset are borne by the bank.  As such, expenses that are necessary to maintain the overall corpus of the asset are lessor’s responsibility.
1 As per AAOIFI’s accounting standard for Ijarah, accounting for Ijarah based financing should be similar to that of the operating lease and not that of finance lease.
2 It should be ensured that if rentals are received in advance, the same should not be treated as a liability.  This is because no rentals will be due before the asset is handed over to the client capable of being used by him.
Similarly, for all other modes which an Islamic bank is using, Shari’ah Board should identify the Shari’ah controls which must be ensured so as to maintain sanctity of Islamic business products. For example, in
Diminishing Musharakah different documents relating to creation of partnership, leasing and sale of units to the other party must be independently enforceable.  All expenses relating to ownership must be borne by the parties in the proportion of their ownership. The rate of Musharakah payments should be net of such expenses and not directly linked to any benchmark like LIBOR. If the jointly purchased asset is not capable of being leased (like an unused plot of land), no rental should be charged because it is only a commercial asset and can give profit only upon its sale. Commercial asset or its units can be revalued only keeping in view its actual value/per units value. If it is pre-stipulated that units would be revalued by ( X )% per month/annum, without regard to actual value, the transaction would become usurious.
In case of Musharakah agreements, expected profit rates are projected in the agreements. Shari’ah Boards will have to ensure that payments to banks under projected rates have been subjected to final adjustment procedure as approved by it and the bank’s management treatment of loss, if any, is also very important and it must be ensured that loss is borne by the partners exactly in proportion of their share in the joint investment. It should also be ensured that Islamic banks investments in shares of joint stock companies is subject to the screening criteria approved by the Shari’ah Board and in case of any non-compliance, the dividend income or the capital gain from non-Shari’ah compliant investments must go to the Charity Fund.
Shari’ah Board must also ensure that Islamic bank’s placements with other institution are only on any of the Shari’ah-compliant basis and any income from non-Shari’ah compliant placements must go to charity.  It also should be ensured that the bank fulfils necessary disclosure requirements and profits are distributed among shareholders and various categories of depositors according to already disclosed criteria/ratios/weightages. 


Islamic Unit Trusts and Islamic Mutual Funds represent one of the most important avenues for investment available for Muslim investors, including Islamic financial institutions and high net worth individuals.
With standards of service, accountability and transparency risking to keep pace with the market, and with sophistication and expectations rising among Muslim investors Shari’ah Boards need to be more vigilant and proactive in supervising Shari’ahcompliance audits.
Customer Advocacy
The Shari’ah Board supervision as customer advocacy requires the board taking all aspects to ensure that Islamic investments funds represent halal investments for Muslims. Thus, the services of the Shari’ah Board members in their role of supervisors , are director to the investors who should be assured that investors’ funds are being put to use in way that accord with the Shari’ah principles. .
Portfolio Purification: Fiscal and Moral
Shari’ah-compliant investments may often yield a small percentage of income from some form of interest-bearing instruments or from prohibited business activities. All such income is considered impure. The responsibility of Shari’ah Board members is to ensure that the income is calculated by the fund, and that a corresponding percentage is deducted from the earnings, passed on to investors as dividends.  The decision must be given to charity (not to be confused with Zakat). It is therefore essential that the participation of Shari’ah scholars in an Islamic fund’s strategy of proactive engagement with companies. 
Portfolio Diversification
With the aim of mitigating risk through portfolio diversification, an Islamic fund may  require to turn to markets other than the stock markets, or to target other asset classes. Or a fund may want to do something different as part of a defensive strategy in a bearish market as a way to manage short-term liquidity. Whatever the case, fund managers will need the assistance and advice of an effective Shari’ah Boards to manage the portfolio within the Shari’ah precepts.
Portfolio Selection: Screening Stocks
One of the most important functions of the Shari’ah Board is the scrutiny of equities of companies with Shari’ah established criteria. While Islamic funds are now subscribing to Islamic indexes, if the Islamic Index does not have a full independent Shari’ah Board, then it will require the supervision of a Shari’ah Board to oversee its choice of investments that accord with the guidelines for prudent Islamic investing. Shari’ah scholars should work on these issues even after a fund has subscribed to an Islamic Index. It is also important for Shari’ah scholars to keep abreast of developments taking place in each of the investment sectors and work closely with management on policies and guidelines on the company’s ethics which cannot be easily quantified.
Portfolio Monitoring
Beyond selecting stocks it is also important for the Shari’ah Board to monitor stocks. In an every changing business environment, vigilance is required to ensure that all of the fund’s holdings remain within the parameters of the prescribed Shari’ah screening filters. In the case of the Shari’ah Board of an Islamic Index, the Shari’ah supervisor will need to verify the removal of any non-compliant security/asset from the fund investment portfolio.
Monitoring Management
The Shari’ah supervisory function includes vigilance in relation to the management of Islamic investment funds. An important issue is the Cash-to-asset ratio.  Fund managers may retain an amount in cash, if for example, they are bearish about the market, or if possible they are unable to find a an attractive or suitable asset or stock to purchase for the purpose of investment. The concern is that the idle cash amount may be used to temporarily invest in interest bearing money market instruments. Shari’ah supervision must also monitor the purchase of stocks and equities on margin that is payment of part of the purchase price (or without paying the full purchase price). Such purchases are not permitted by the Shari’ah.
Monitoring Fees
The Shari’ah Board must ensure that the investors are made fully aware of the fund’s fees and how these are structured. Here again, the Shari’ah Board funds itself in the role of consumer advocate. It is important as aside from annual fees and different sorts of loads applied, funds will generally also  charge fees for a number of other services that may be associated with the fund manager’s responsibilities. Load in finance terms is the sales fee the manager will require to pay in order to acquire an asset. This fee varies according to the type of asset and the way it is sold. Many investment funds impose a sales charge. As a result of the load, only a portion of the investor’s funds go into the investment itself. 
Monitoring Fund Documentation
The Shari’ah Board should also pay a part in assisting management in the preparation of filing reports to regulatory bodies, subscription agreements, prospectuses and the like. This is because in preparation of such documentation there will need to be references to the Shari’ah and its interpretation.
Shari’ah Boards must prepare reports on the status of the fund it supervises. The purpose of these reports is to promote transparency and full disclosure.
Charity Fund
Income derived from interest-bearing securities and non-Shari’ah-compliant securities that may be allowed to be held in an investment portfolio, must be set aside in a charity fund.  The charity fund must also be overseen by the Shari’ah Board. Generally, it has been left to Islamic banks themselves as to whom and how they disburse such funds. However, if regulators in respective countries do not advise any procedure/avenues for disbursement of Charity funds, Shari’ah Boards must ensure that these are used for uplift of the poor or for social welfare projects in the respective economics/societies and are not used for any other purpose not  conforming to the Shari’ah tenets.
The matter of zakat is complicated by way of factors that lie outside the control of Islamic funds (and for that matter, Islamic banks and other financial institutions as well). While, zakat is a matter for the investors themselves, the fund manager may request the Shari’ah Board to prepare guidelines for calculation of zakat on profits earned through investments in funds. These guidelines should be published and circulated to investors


In most jurisdictions, Islamic banking is to a large extent been governed by the regulatory framework which has been designed for conventional banks. An important element in developing a regulatory framework for Islamic banking involves bridging the twin requirements of Shari’ah compliance and international standards. However, Islamic banking is outside the considerations that inform international standards. 
This raises questions about the relevance of Basel II on Islamic banking, in view of the unique peculiarities of Islamic financial contracts and instruments. 
An important feature of Basle II is the capital allocation for operational risk, which includes legal risk. Legal risk relates to potential loss arising from an unexpected application of law or regulation or because a governing contract cannot be enforced. The implication of the inclusion of legal risk in Basel II is that every bank must now ensure that the systems and controls for the management of operational risk should adequately cover its legal risk. The nature of legal risks involved in financial institutions’ business varies as determined by the particular circumstance of each institution. The Shari‘ah being the foundation of an Islamic financial institution, it delineates its model or business practice and underlines the nature of its legal risk exposure. Recent English court decisions underline the need for financial institutions to identify and mitigate legal risks involved in Islamic financing. While the fact that Islamic banking is based on religious principles is not a supervisory matter of concern to regulators in Europe and the United States, it is capable of threatening the consumer protection objective of banking regulation. It is therefore imperative to assess the established system of Shari’ah compliance against the requirements of Basel II as it relates to managing legal risk.


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