The Islamic Financial Services Board (IFSB) has brought out a number of draft exposures. In the first of a two part series, Mike Gallagher takes a look at the key points of the Exposure Draft Guiding Principles on Conduct of Business for Institutions Offering Islamic Financial Services and the Exposure Draft Guiding Principles on Shari'ah Governance System
The sound functioning of a financial system depends, inter alia, on the users of the system having confidence in the quality of the conduct of business by the participants offering financial products and services, and that there are adequate systems of control over the conduct of business, according to the IFSB draft. It says that a framework of the principles and rules that govern effectively the conduct of business of Islamic financial services industry (IFSI) participants, whether mandatory or voluntary, can play a significant role in supporting the growth of the IFSI.
In consideration of the above, and in line with its mandate to promote the soundness and stability of the Islamic financial system, the Council of the IFSB at its ninth meeting held on 29 November 2006 in Jeddah, Saudi Arabia, supported the formation of a Conduct of Business Working Group (CBWG), intended to complement existing and future Islamic Financial Services Board (IFSB) standards and guidelines in the IFSI.
The Guiding Principles on Conduct of Business for Institutions offering Islamic Financial Services are applicable to all firms operating in the IFSI - that is, to fully fledged institutions offering Islamic financial services (IIFS) in the Islamic banking, Takaful or capital market segments, and to Islamic 'windows' of conventional firms. In what follows, the term IIFS should therefore be understood as applying also to Islamic 'windows'.
In accordance with the objectives of the IFSB, the Guiding Principles will not "reinvent the wheel" but will instead, wherever appropriate, reinforce the existing internationally recognised frameworks or standards for the conduct of business so that institutions that fall within the scope of these Guiding Principles operate on a level playing field with their conventional counterparts. However, in order to avoid putting them at any competitive disadvantage, due consideration shall be given to their specificities.
It is acknowledged that many regulators may have established their own conduct of business regulations that are mandatorily imposed on entities licensed by them. Accordingly, these Guiding Principles seek to complement and strengthen those codes of business conduct that are already in place as part of the general regulation of financial services firms, by highlighting appropriate perspectives on certain conduct of business issues specific to Islamic finance.
Below is a selection of the main principles with supporting notes.
Principle 1:'Honesty and Fairness'
The IFSB notes that an IIFS shall aspire to the highest standards of truthfulness and honesty in all its statements and dealings, and must treat its customers fairly.
It suggests that an IIFS should not, either deliberately or through negligence, issue information that is misleading to stakeholders or the market regarding the Shari'ah compliance of its products or services, or of Sukuk issuances with which it is involved. Nor should an IIFS mislead clients or the market through the withholding of material information.
A further key requirement implied by this principle is the existence of appropriate procedures whereby whistle-blowers are treated honestly and fairly, with no cover-ups or victimisation. With regard to fairness, IIFS should follow best practice in establishing procedures for handling complaints from clients.
Principle 2:'Due Care and Diligence'
This notes than an IIFS shall exercise care and diligence in all its operations, including the way it structures and offers its products and provides financing, with particular regard to Shari'ah compliance, and to the thoroughness of research and risk management.
Where an IIFS has not exercised due diligence in extending a financing facility, it has a share of the responsibility for any resultant financial distress. The IIFS must avoid taking steps to recover an amount owed to it that would inflict hardship on a debtor whose financial distress is not due to the debtor's misconduct.
The Shari'ah compliance of certain Sukuk structures is a matter of disagreement, but in general a majority opinion may be identified. Features of Sukuk structures that may not be widely agreed upon include, inter alia:
A purchase agreement from the originator to repurchase assets from the issuer at a pre-agreed price so as to repay the Sukuk holders the amount of their original investment at maturity;
An arrangement in a Sukuk Mudarabah structure whereby, if the available profit falls below a benchmark, the Mudarib will make an interest-free loan to the issuer in order to pay a return to the Sukuk holders that is higher than the available profit and, if possible, equal to the benchmark; and
A tranched structure in which the senior tranches have priority rights to the available cash flows from the underlying investment, the rights of the junior tranches to the available cash flows being subordinated.
Principle 3: Capabilities
An IIFS shall ensure that it has in place the necessary systems and procedures, and that its employees have the necessary knowledge and skills, to comply with these principles and other IFSB standards.
Principle 4: Information about clients
An IIFS shall take steps to ensure that it understands the nature and circumstances of its clients, so that it offers those products most suitable for their needs, as well as offering financing only for Shari'ah-compliant projects.
The principle of 'know your customer' (KYC) is well known in banking circles and has particular relevance in the context of avoiding money-laundering and transactions intended to finance criminal or terrorist organisations. In these Guiding Principles, the principle regarding information about clients obviously includes KYC but has a broader import, as it also includes having the capability of understanding a client's needs in order to avoid mis-selling.
Principle 5: Information to clients
An IIFS shall provide clear and truthful information both in any public document issued and to its actual and prospective clients, both during the sales process and in subsequent communications and reports.
A classical example of achieving fairness through transparent business dealing from the Shari'ah perspective is in the requirement that for a Murabaha contract to be valid, the seller has to disclose the original cost (including any discounts received) and the profit margin/mark-up. Best practice requires that similar transparency should apply to commissions and agency fees for financing or Takaful products.
The use of 'small print' to make potentially important information less visible is not compatible with good business conduct, and must be avoided. Likewise, there should be no 'hidden costs' in financing or Takaful products, such as commissions or agency fees that are not disclosed to the client. Good practice requires that all commission and similar arrangements be fully disclosed to clients, and that in selecting a product for recommendation to a client the overriding criterion should be the benefits to the client and not the attractiveness of the commission to the IIFS or its representative.
Principle 6: Conflicts of interest and of duty
An IIFS shall recognise the conflicts of interest between it and its clients that arise from the type of products it offers, and either avoid them, or disclose and manage them.
Principle 7: Shari'ah compliance
An IIFS must be able to demonstrate that its operations are governed by an effective system of Shari'ah governance and that it conducts its business in a socially responsible manner.
An illustration of how the Shari'ah Governance System complements the existing governance, control and compliance functions within an IIFS, comparative to the scenario in a typical financial institution, is provided below:
Part I - General approach to the Shari'ah governance system
Principle 1.1: The Shari'ah governance structure adopted by the IIFS should be commensurate and proportionate with the size, complexity and nature of its business. no 'single model' and 'one-size-fits-all' approach.
A few other supervisory authorities seem to take the view that Shari'ah boards have a significant role to play in monitoring the health of IIFS, similar to other professional advisers such as lawyers, accountants and auditors. They then impose a requirement that each IIFS must have a certain minimum number of members of the Shari'ah board, who must also meet certain 'fit and proper' criteria - similar to the assurance sought when banks are appointing their board of directors (BOD).
At the product design/development stage, an IIFS would want to ensure that its Shari'ah Governance System covers the relevant ex-ante processes, namely issuance of Shari'ah pronouncements/ resolutions, and (ii) compliance checks, before the product is offered to the customers.
Principle 1.2: Each IIFS must ensure that the Shari'ah board has:
clear terms of reference regarding its mandate and responsibility;
Well-defined operating procedures and lines of reporting; and
Good understanding of, and familiarity with, professional ethics and conduct.
In order for the Shari'ah board to have a precise chain of command and accountability towards the respective stakeholders of the IIFS, it has to be equipped with:
a mandate that grants it appropriate powers to carry out its role and functions;
(ii) well-organised operative procedures with regard to meetings, the recording of meetings, decision-making processes and to whom its decisions will be passed for effective implementation, including processes to review those decisions whenever necessary; and
(iii) a sound code of ethics and conduct that would enhance the integrity, professionalism and credibility of the members of the Shari'ah board.
As the legal framework in most jurisdictions holds the BOD as the body ultimately responsible with regard to the governance of an IIFS, the Shari'ah board has to be clear on the limits of its own power.
Part II - Competence
Principle 2.1: The IIFS shall ensure that any person mandated with overseeing the Shari`ah Governance System fulfils an acceptable fit and proper criteria.
It follows that members of the Shari'ah board and officers of the ISCU and ISRU should at least possess the appropriate knowledge and skills in order for them to adequately execute their duties and responsibilities. IIFS should be diligent by carrying out background checks on candidates to be appointed to the respective positions.
Principle 2.2: The IIFS shall facilitate continuous professional development of persons serving on its Shari'ah board, as well as its ISCU and ISRU, if any. Where appropriate, a mentoring programme whereby the more experienced members of the Shari'ah board and internal Shari'ah officers would provide guidance and tutelage to their less experienced counterparts should be encouraged.
Principle 2.3: There should be a formal assessment of the effectiveness of the Shari'ah board as a whole and of the contribution by each member to the effectiveness of the Shari'ah board.
Part III - Independence
Principle 3.1: The Shari'ah board should play a strong and independent oversight role, with adequate capability to exercise objective judgement on Shari'ah-related matters. No individual or group of individuals shall be allowed to dominate the Shari'ah board's decision-making.
In order to uphold the integrity and credibility of the Shari'ah board, its members must not only be able to exercise independent judgement without undue influence or duress, especially from the management of the IIFS, but also to be seen to be truly independent. In this respect, it would be desirable for an IIFS to formalise the independence of the Shari'ah board and its members by recognising the Shari'ah board's roles and mandate.
The IIFS shall have in place an appropriate and transparent process for resolving any differences of opinion between the BOD and the Shari'ah board. This process may include having direct access (after duly informing the supervisory authority) to the shareholders as a 'whistleblower'. The supervisory authorities may be involved in this process of resolving differences, without compromising the binding nature of the pronouncements/resolutions of the Shari'ah board.
A Shari'ah board can only be deemed 'independent' when none of its members has a blood or intimate relationship with the IIFS, its related companies or its officers that could interfere, or be reasonably perceived to interfere, with the exercise of independent judgement in the best interests of the IIFS by the Shari'ah board. In the case of Shari'ah advisory firms, it can only be deemed independent from the IIFS if they are not related parties, such as in terms of having common shareholders or common directors.
Principle 3.2: In order to fulfil their responsibilities, the Shari'ah board should be provided with complete, adequate and timely information prior to all meetings and on an ongoing basis.
Principle 4.1: Shari'ah board members should ensure that internal information obtained in the course of their duties is kept confidential.
Principle 5.1: The IIFS should fully understand the legal and regulatory framework for issuance of Shari'ah pronouncements/resolutions in the jurisdiction where it operates. It should ensure that its Shari'ah board strictly observes the said framework and, wherever possible, promotes convergence of the Shari'ah governance standards.
Although members of the Shari'ah board and Shari'ah advisory firm should be fully aware that appropriate procedure and process must be adhered to before any Shari'ah pronouncement/resolution is developed and concluded, IIFS also need to be careful as to how the Shari'ah pronouncement/resolution is disseminated or issued to the press or the general public. The intellectual property of such Shari'ah pronouncements/resolutions could actually be owned exclusively by the IIFS, depending on the terms of reference of members of the Shari'ah board and Shari'ah advisory firm.
In this respect, bearing in mind that the Shari'ah board or its members, as free agents, are generally allowed to provide service to any client other than the IIFS without any restriction, each IIFS may need to establish additional safeguards to ensure that Shari'ah pronouncements/resolutions developed based on their business intelligence and internal information would not be exploited by inappropriate parties. In other words, the dissemination of the Shari'ah pronouncements/resolutions might have to be restricted based on terms and conditions set by the IIFS.
In the next edition of Islamic Business & Finance, we take a look at the Draft Exposure Guiding Principals for Takaful.
© Islamic Business and Finance 2009
