Governance is a method which an organization adopts to ensure that components of the organization follow the set rules, regulations, policies and processes. Governance is said to be good when it primarily ensures achievement of objectives with the existence of effective risk management system, transparency, fairness, responsibility, accountability and independence. Good governance is termed as corporate governance when a business entity is operated, regulated and controlled by the well designed risk management policies, processes, corporate regulations, rules and laws that lead the entity to achieve its ultimate goals.

What is Shari'ah Governance?

Shari'ah governance is simply the alignment of corporate governance according to the Islamic principles. Specifically, Shari'ah governance is "the set of institutional and organizational arrangements, policies, processes, procedures rules, regulations and laws which leads the organization towards Shari'ah compliance". Shari'ah governance applies to Islamic financial institutions (IFIs) with compliance being the only reason for an IFI to exist. Shari'ah Governance is based on four pillars, discussed in the subsequent parts of this article, and is monitored, either through a Shari'ah board or through a dedicated internal Shari'ah Review Department, working under the Board of Directors.

Why Shari'ah Governance?

Since the last three decades, Islamic banking and finance (IBF) has showed a tremendous growth in all parts of the world. It has reached to more than 70 countries of the world which also includes non-Muslim jurisdictions like London, Japan, China, South Korea, Singapore, Germany and Hong Kong. IBF is getting its share in the financial system with a rapid growth rate of over 20%. According to Ernst and Young the assets of Islamic Finance will grow to $1.1 trillion in 2012 from $826 billion in 2010. The analysts from Deutshe Bank have projected the growth of Islamic banking assets to $1.8 trillion by the end of 2016. This growth is confirming that Islamic banking and finance is a feasible alternative to the conventional financial system.

The globalization of Islamic finance has reinforced the mysticism of Islamic Shari'ah and every business activity which demonstrates growth and involves public interest needs to be regulated by a set of rules and regulations. The growth of Islamic finance demands that IFIs are to be regulated through such set standards which are capable of raising early warning signals of Shari'ah non-compliance. The standards or Shari'ah governance is also necessary to maintain the trust of clients of Islamic financial institutions in the IBF and to safeguard the interest of investors and other stakeholders in the Islamic financial system. To achieve a certain level of maturity, regulators of Islamic financial institutions need to address the Shari'ah regulatory issues by the legitimate and sound Shari'ah governance model based on the true principles of Islam. A comprehensive Shari'ah governance model is based on the four basic pillars discussed hereunder.

Four Basic Pillars of a Shari'ah Governance Model

It is believed that political support is a driving force to promote Islamic finance in any country. Yet an accommodative regulatory and supervisory framework for effective Shari'ah governance is also imperative for its growth. It would not be wrong to call Shari'ah governance as a brain of the Islamic financial industry. It provides a complete system to ensure compliance of Islamic principles of doing business. Ignoring the Shari'ah governance, one cannot guarantee that a true and successful Islamic financial system and markets are in place. I believe a comprehensive Shari'ah governance system is based on following four pillars:

1- Management and Supervision

Management is the first pillar of Shari'ah Governance and the Board of directors (BOD) comes first in the management. The BOD, senior management and the organizational structure outline a complete set of behaviors within the organization. The success of any entity, specifically the IFI, entirely depends on the management's willingness to adopt and implement Islamic principles in the organization. The provision of adequate resources, system procedures, infrastructure and code of ethics for acceptance of business and its legitimacy according to Shari'ah governance entirely depends on the management. Providing proper policies and systems will be inadequate if they are not implemented and supervised positively. For better results, bare minimum requirements for management may be prescribed by the regulators, which could include the following:

  • Fit and proper criteria for the BOD and senior management;

  • Shari'ah risk management policies containing a systematic approach to, identify, measure, treat and monitor Shari'ah non-compliance risk;

  • Duties and responsibilities of the Shari'ah Board/Advisors;

  • Introduction of financing agreements and Shari'ah compliance mechanism to ensure that the operations of the IFI are  Halal and free from Riba, Qimar and Gharar;

  • Screening process for investment in shares and securities, process of income purification and management of charity;

2- Shari'ah Advisory Board

An Independent Shari'ah advisory board or Shari'ah Advisor is the second important pillar of the Shari'ah Governance model. Preferably the Shari'ah Board is established in two tiers, first at the regulatory level, the central Shari'ah Advisory Body and the other at internal level of the IFI, the In-house Shari'ah Advisor/Board. The role of both advisory boards is discussed hereunder, separately:

Central Shari'ah Advisory Body (CSAB) -The apex Shari'ah Advisory body of the country, which defines basic structure of Islamic financial system in the country. This body may be assigned the task of approving the code of Shari'ah-compliant business activities, financing agreements, policies, directions of IFIs in the country, as a final authority for Shari'ah matters and disputes.

Shari'ah Advisory Board of IFIs - The management of IFIs does not possess the in-depth knowledge of Shari'ah and is unable to interpret the day to day sensitive Shari'ah issues. To cope with this deficiency, another tier of qualified and independent Shari'ah Boards or Shari'ah Advisors is required to be engaged by the IFI for Shari'ah interpretations, ruling, fatwas, product development, review of business process and agreements. The Shari'ah board may also be given the task to conduct research and arrange training programs for the IFI's staff in accordance with the principles of Shari'ah and objectives of Islamic Law i.e. Maqasad Ash-Shari'ah.

3- Shari'ah Compliance and Review

Shari'ah compliance and review is the third important pillar of the Shari'ah Governance Model. Shari'ah review and assessment of adequacy of internal controls is a regular feature of the Shari'ah compliance. For this purpose, an internal Shari'ah audit department, under the internal audit committee of the Board, is to be established with the objectives to ensure compliance and to develop a Shari'ah non-compliance risk awareness culture in the organization.

However, due to various reasons, the internal audit is not considered a sufficient and reliable tool by the external users. Therefore, to give greater confidence to stakeholders of IFIs, an independent external Shari'ah audit is to be conducted by the statutory auditors, for which they are required to build up their capacity by engaging qualified Shari'ah auditors in their teams.

Till the time the audit firms develop a reliable Shari'ah audit system, Shari'ah review of the operations and transactions of IFIs may be conducted by their in-house Shari'ah board or Advisor on periodical basis.

4- Transparency and Disclosure

The fourth pillar, transparency and disclosure, is a critical part of the Shari'ah Governance Model. Transparency and disclosure always have material impact on the cost of capital, reputation, investors' decision and stock prices. Stakeholders, shareholders and the general public are always interested in correct and timely information of a company for their investment decisions. Information is of two types: financial and non-financial. Positive information on the affairs of the organization makes them a blue chip and it becomes easy for the organization to raise funds from the general public or financial institutions at the lower cost.

A well planned management information system is also essential for top management. Timely and correct information allows management to take corrective actions and future decisions which may ultimately affect their business, profitability, competition and growth.

Major areas of disclosure:

  • Information about the IFI, business strategy, business trends, major business plans, major shareholding, ownership and voting rights.

  • Information about the management i.e. composition of board of directors and key executives, compensation.

  • Information about Governance structure- good practices, delegation of authority, risk areas, policies, key performance indicators etc.

  • Information about the financial position, key financial indicators,

  • Material issues affecting employees and other stakeholders

  • Foreseeable risk factors

  • A Shari'ah compliance certificate duly issued by the External Auditor, Shari'ah Board/ Advisor.

To maintain the confidence and trust of the customers in Islamic banking it is imperative to introduce and implement the Shari'ah Governance mechanism for the growth and stability of IFIs and to minimize Shari'ah non-compliance risk. A reliable Shari'ah governance system can ensure Shari'ah compliance in addition to enabling regulators to regulate the Islamic industry in the least manner of running into the risk of Shari'ah non-compliance.

Imran Hussain Minhas is a professional banker and is serving as Joint Director Modarabas (Islamic Financial Institutions), SEC Pakistan. He has also served in the visiting faculty of International Islamic University, Islamabad, Pakistan, as Associate Professor. He can be reached at hussain.minhas@gmail.com.

© Business Islamica 2012