Shari'ah Compliance Risk

I. INTRODUCTION In common parlance, risk equates to uncertainty. Regardless of whether the origin of the word is the Arabic rizg (meaning provision allotted by the Almighty), as suggested by some scholars, or derived from the Italian risciare, to dare, the word "risk" points to an element of uncertainty in the future and especially to the possibility of a variety of outcomes to the decisions that people make for themselves and others.1 Shari'ah compliance risk is the possibility that a financial service or product is not or will not be in compliance with established Shari'ah principles and standards. Financial products and services designed especially for the Islamic financial marketplace are distinguished from their conventional counterparts by their compliance with Shari'ah precepts and principles. While these products and services may appear similar to conventional financial products and services, particularly from an economic perspective, the contractual and structural underpinnings of these products and services comply with the Shari'ah.2 Thus, while a Shari'ah-compliant home finance contract may resemble a conventional mortgage in many ways, the underlying structure is quite different.3 Simply stated, while the economics are the same, the mechanics are different. Shari'ah compliance is what lends a financial product or service its legitimacy in the Islamic marketplace. Ultimately, Muslim consumers, investors, and clients are concerned with compliance because the religion restricts consumption to that which is good and wholesome ("halal 'un tayyib") while prohibiting what is foul, harmful, unjust, or sinful. A fatwa immediately relieves the ordinary consumer of the burden of having to make that determination for himself.4 It is from this perspective that the Shari'ah supervisory board ("SSB") may be viewed as both an auditor (for the company offering the financial service or product) and a consumer advocate (for the company's clients). In the hierarchy of risks established for modern financial institutions, Shari'ah compliance risk may be considered a form of operational and regulatory risk. Certainly though, Shari'ah compliance assumes that a financial product or service is already compliant with conventional financial standards and regulations. Shari'ah compliance should never be understood to mean that a financial product or service falls outside the norms established for its conventional market equivalent; certainly not in terms of regulation. In any case, Shari'ah risk is actually an umbrella risk category beneath which there may be several subcategories; its management effectively enhances industry best practices and compliance with jurisdictional standards and regulations. At a time when interest in Islamic finance is growing, it is important to understand how Shari'ah-based considerations may impact a business or a transaction, as well as measuring, classifying, and quantifying the sorts of risks associated with Shari'ah compliance. Clearly, being able to identify and to understand Shari'ah compliance risk is an important key to providing a consistent framework for managing that risk. Emphasizing this importance is the relatively recent emergence of Islamic finance and its continuing efforts to develop industry standards and best practices. Indeed, as this Article will explain, there is much that remains to be accomplished by the industry internally. Shari'ah compliance risk may be classified in terms of the levels of that risk, the factors that constitute it, and its strategic and tactical management. Management of Shari'ah compliance risk, like other forms of risk management, may also be seen as having a lifecycle. The purpose of this Article is to explore this subject in a preliminary manner, to lay the foundations for its definition, to describe its characteristics and implications, and to examine how it is presently managed by Islamic financial institutions. It is the author's hope that this Article will contribute to an understanding of the subject and lead to more systematic studies of this area in the future. …