metadata: authors: 0: author: Grais,Wafik
1: author: Pellegrini,Matteo
count: World
docna: 0: docna: Corporate governance and Shariah compliance
            in institutions offering Islamic financial services
docty: Policy Research Working Paper
subtopic: Judicial System Reform,Multinational & Corporate Governance,Corporate Governance,Legal Institutions of the Market Economy,Capital Markets and Capital Flows,Capital Flows,Islamic Finance,Civic Participation and Corporate Governance
teratopic: Law and Development,Governance,Finance and Financial Sector Development
abstracts: cdata!: The structures and processes established
            within an institution offering Islamic financial Services
            (IIFS) for monitoring and evaluating Shariah compliance rely
            essentially on arrangements internal to the firm. By being
            incorporated in the institutional structure, a Shariah
            supervisory board (SSB) has the advantage of being close to
            the market. Competent, independent, and empowered to approve
            new Shariah-conforming instruments, an SSB can enable
            innovation likely to emerge within the institution. The
            paper reviews the issues and options facing current
            arrangements for ensuring Shariah compliance by IIFS. It
            suggests a framework that draws on internal and external
            arrangements to the firm and emphasizes market discipline.
            In issuing its fatwas, an SSB could be guided by
            standardized contracts and practices that could be
            harmonized by a self-regulatory professionals'
            association. A framework with the suggested internal and
            external features could ensure adequate consistency of
            interpretation and enhance the enforceability of contracts
            before civil courts. The review of transactions would mainly
            be entrusted to internal review units, which would
            collaborate with external auditors responsible for issuing
            an annual opinion on whether the institution's
            activities has met its Shariah requirements. This process
            would be sustained by reputable entities such as rating
            agencies, stock markets, financial media, and researchers
            who would channel signals to market players. This framework
            would enhance public understanding of the requirements of
            Shariah and lead to more effective options available to
            stakeholders to achieve improvements in Islamic financial services.
repnme: repnme: Corporate governance and Shariah compliance
            in institutions offering Islamic financial services
display_title: Corporate governance and Shariah
            compliance in institutions offering Islamic financial services
listing_relative_url: /research/2006/11/7186425/corporate-governance-shariah-compliance-institutions-offering-islamic-financial-services
topicv3: Justice m1326106 840,Education, Skills Development and Labor
            Market m1326135 1484,Corporate Governance m1326968 417,Islamic Finance m1327451 324,Financial Institutions m1505015 3797
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Law and Development,Governance,Finance and Financial Sector Development
no_of_pages: 38
author_keys: 0: author_key: 90957
1: author_key: 758255
model_extractions: # WPS4054

Corporate Governance and _Shariah_ Compliance

# in

Institutions Offering Islamic Financial Services Wafik Grais and Matteo Pellegrini

## World Bank Policy Research Working Paper 4054, November 2006

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._
# Abstract Corporate Governance and S _hariah_ Compliance in Institutions Offering Islamic Financial Services

The structures and processes established within an Instiution Offering Islamic financial Services (IIFS) for monitoring and evaluating _Shariah_ compliance rely essentially on arrangements internal to the firm. By being incorporated in the institutional structure, a Shariah Supervisory Board (SSB) has the advantage of being close to the market. Competent, independent, and empowered to approve new _Shariah-_ conforming instruments, an SSB can enable innovation likely to emerge within the institution. The paper reviews the issues and options facing current arrangements for ensuring Shariah compliance by IIFS. It suggests a framework that draws on internal and external arrangements to the firm and emphasizes market discipline. In issuing its _fatwas_ , an SSB could be guided by standardized contracts and practices that could be harmonized by a self-regulatory professionals’ association. A framework with the suggested internal and external features could ensure adequate consistency of interpretation and enhance the enforceability of contracts before civil courts. The review of transactions would mainly be entrusted to internal review units, which would collaborate with external auditors responsible for issuing an annual opinion on whether the institution’s activities met its _Shariah_ requirements. This process would be sustained by reputable entities such as rating agencies, stock markets, financial media, and researchers who would channel signals to market players. This framework would enhance public understanding of the requirements of _Shariah_ and lead to a more effective utilization of options available to stakeholders to achieve continuing improvements in Islamic financial services.
# **<u>List of Abbreviations</u>**

AAOIFI: Accounting and Auditing Organization for Islamic Financial Institutions BCBS: Basel Committee on Banking Supervision CG: Corporate Governance CIBAFI: General Council of Islamic Banks and Financial Institutions ICFS: Institutions offering Conventional Financial Services IIFS: Institutions offering Islamic Financial Services IFSB: Islamic Financial Services Board. IIRA: International Islamic Rating Agency FTSE: Financial Times Stock Exchange FSA: Financial Sector Assessment OECD: Organization for Economic Cooperation and Development SSB: _Shariah_ Supervisory Board
# I. **Introduction: Corporate Governance and** **_Shariah_ Compliance**<sup>1</sup>

Islamic finance helped sustain economic growth throughout the Muslim world during the Middle Ages. The last three decades witnessed its revival, notably following the first oil price shock of 1973-74. Beyond the surge in liquidity, its reemergence was prompted by the introduction of innovative Islamic financial products and a demand by Muslim populations for financial services compatible with their religious beliefs. More recently, the industry has received a new impetus. It can be ascribed to an uncertain performance of western financial markets, a perception of increased risk for Gulf Cooperation Council capital in traditional financial markets, a renewed surge in oil prices, an expressed demand from Muslim communities in Western countries, and the development of managerial skills specific to Islamic financial services.<sup>2</sup> As a result, the global Islamic financial services industry now includes 284 institutions offering Islamic financial services (IIFS) operating in 38 countries, both Muslim and non-Muslim.<sup>3</sup> Islamic capital markets, mutual funds and insurance services are also developing.

The Governor of the Bahrain Monetary Agency conveyed the sense of the roots of the IIFS when he stated that “Islamic banks have grown primarily by providing services to a captive market, to people who will only deal with a financial institution that strictly adheres to Islamic principles”.<sup>4</sup> Conducting activities in accordance with _Shariah_ entails that the institution pledges: i) not to engage in interest-based debt transactions, ii) not to

> 1 The authors would like to thank Arun Adarkar, Stijn Claessens, Dahlia El-Hawary, Zamir Iqbal, Luigi Passamonti, Leila Triki, and participants to meetings of the Islamic Financial Services Board and the Accounting and Auditing Organization for Islamic Financial Services for helpful comments on the issues discussed.  All remaining errors are the authors’.

> 2 According to the General Council of Islamic Banks and Financial Institutions (CIBAFI), total assets have roughly doubled in the period 1998-2001, soaring from $134 to 261 Billion. Source: http://www.islamicfi.com (last visited April 04, 2005). The figures were reported in a press release by CIBAFI dated May 8, 2005, (“CIBAFI Raises the Glance toward IFSI Growth with a Unique StatisticBased 10-Year Strategic Plan”).

> 3 The term IIFS refers to Islamic financial businesses and includes finance houses, that offer retail commercial and investment services. The paper does not deal with _Takaful_ (insurance) companies.

> 4 As reported by _Middle-East-Online.com_ on February 17, 2004. <u>http://www.middle-eastonline.com/english/bahrain/?id=8922=8922&format=0</u> (last visited April 11, 2005).

1
conduct pure financial transactions disconnected from real economic activity, iii) not to participate in transactions where there is exploitation of any party, and iv) not to participate in activities regarded as harmful to society.<sup>5</sup> . Initially, IIFS developed without a clear view on the legislative and regulatory framework that would apply to them.<sup>6</sup> However, their conceptual foundations and operational practices derived from the principles outlined above have specific features that pose challenges to regulators and call for solutions beyond the simple extension of existing legislation and regulation applying to institutions offering conventional financial services (ICFS). To that effect, a number of countries have put in place laws and regulations for IIFS, and international bodies have been established to adapt standards applying to conventional financial services and promote harmonization of practices.<sup>7</sup> Enhancing stakeholders’ value is a central purpose for any business including financial services, whether conventional or Islamic. Their stability, financial performances and ability to intermediate resources will depend on stakeholders’ confidence in individual institutions and the industry. A particular confidence feature in respect of Islamic financial services is the requirement of conveying to stakeholders that their financial business is conducted in conformity with their religious beliefs. Corporate governance arrangements, internal and external to the corporate entity include structures and procedures that should provide sufficient comfort the business is conducted in accordance with stated objectives, in particular compliance with _Shariah_ .<sup>8</sup>

> 5 _Shariah_ is Islamic Law extracted from the _Qur’an_ and _Sunna_ (sayings and deeds of the Prophet). Not to conduct financial transactions disconnected from real economic activity is sometimes referred to as “materiality”. A glossary of Arabic terms is provided in Annex I.

> 6 For example, in some cases the general prudential regime was extended to IIFS without recognizing any specific feature.  In other cases, IIFS registered as non-bank commercial businesses. For an introduction to the principles and instruments of Islamic finance as well as regulatory arrangements applying to IIFS, refer to El-Hawary, Grais, and Iqbal (2004).

> 7 These include the Islamic Financial Services Board (IFSB), the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the International Islamic Rating Agency (IIRA), the International Islamic Financial Market (IIFM) and the Liquidity Management Center (LMC). Rather than seeking to replace existing regulation, these bodies propose solutions whenever conventional regulation fails to address the distinctiveness of the Islamic financial industry.

> 8 This paper deals with CG arrangements that address issues of _Shariah_ compliance. Grais and Pellegrini (2006a) provides an overview of the issues and challenges of CG for IIFS. Grais and Pellegrini (2006b) deals with IIFS’ CG that address stakeholders’ financial interests.
A widely adopted approach is to have independent bodies certify _Shariah_ compliance by the IIFS. The reliance on independent bodies reflects the currently limited role that market discipline can play in ensuring such compliance. Hirschman contended that stakeholders generally have two ways of reacting to performance deterioration in business organizations.<sup>9</sup> The first is for the stakeholder to quit the organization. The other is for the stakeholder to agitate and exert influence for change from within the organization. The potential role that these two mechanisms can play in upholding conformity with _Shariah_ is constrained by the perceived complexity of Islamic financial instruments and their limited “commoditization”. The diversity of jurisprudence on permissible transactions, and the limited disclosure of relevant and reliable financial information compound the difficulty. In addition, market participants and other stakeholders are likely to lack sufficient knowledge of _Shariah_ or of financial principles, or of both, to judge the transactions of IIFS. In line with the foregoing, compliance with _Shariah_ is primarily ensured through organs internal to the IIFS. At the same time, a broader enabling institutional environment, sometime referred to as external corporate governance is being put in place.

In the following the paper reviews in section two, prevailing internal arrangements that deal with _Shariah_ compliance in individual IIFS; it examines the CG issues involved, and proposes measures to strengthen their effectiveness. Section three considers external arrangements that complement the ones adopted by individual institutions to promote compliance with the _Shariah_ . The concluding section summarizes the overall strengths and weaknesses of existing arrangements.

# II. **Internal CG Arrangements for** **_Shariah_ Compliance**

The approach most widely adopted currently is to establish independent bodies of knowledgeable agents. These bodies are usually _internal_ to the institution and part of its

> 9 Hirschman, A.O. (1970)
governance structure. They include _Shariah_ Supervisory Boards and _Shariah_ review units. The following first analyzes existing arrangements and then considers options to strengthen them.

# _A._ _<u>Internal Arrangements</u>_

Each institution offering Islamic financial services has in-house religious advisers, who are collectively known as the _Shariah_ Supervisory Board (SSB).<sup>10</sup> In principle, the role of the SSB covers five main areas: certifying permissible financial instruments through _fatwas_ (ex-ante _Shariah_ audit), verifying that transactions comply with issued _fatwas_ (ex-post _Shariah_ audit), calculating and paying _Zakat,_ disposing of non- _Shariah_ compliant earnings, and advising on the distribution of income or expenses among shareholders and investment account holders.<sup>11</sup> The SSB issues a report to certify that all financial transactions comply with the above-mentioned principles. This report is often an integral part of the Annual Report of the Islamic financial institution.

In practice an SSB’s tasks may vary according to provisions stipulated in the articles of association of the financial institution or those stipulated by national regulators. A review of 13 IIFS shows that all SSBs were entrusted with ex-ante monitoring and the calculation of _Zakat_ .<sup>12</sup> However, ex-post monitoring was within the exclusive competence of _Shariah_ review units in at least two cases.<sup>13</sup> In another case, the

> 10 They exist in all Islamic countries with the exception of Iran, where compliance of the whole banking system with _Shariah_ is guaranteed and monitored by the central bank.

> 11 A _Fatwa_ is a religious edict or proclamation. It is a legal opinion issued by a qualified Muslim scholar on matters of religious belief and practice. The social nature of Islamic finance emerges most clearly in the practices of _Zakat_ and _Qard Hassan_ . _Zakat_ is a tax on wealth, while _Qard Hasan_ refers to zero-return beneficence loans made to the needy. The objective, according to the Meezan Bank of Pakistan is the “implementation of an equitable economic system, providing a strong foundation for establishing a fair and just society for mankind”.See also Briston and El-Ashker (1986) and Abdel Karim (1990).

12 The sample reflects the accessibility of relevant information in these IIFS. Source: annual reports, articles of association, and all information posted on the websites of the following BIFSs: Bahrain Islamic Bank, Al Rajhi Banking Corporation, Bank Islam Malaysia Berhad, Jordan Islamic Bank, Kuwait Finance House, Bank Muamalat Malaysia, Shamil Bank, Bahrain, Islamic Bank of Britain, Emirates Islamic Bank, Dubai Islamic Bank, Islamic Bank Bangladesh Limited, First Islamic Investment Bank and Bank Rakyat Malaysia. Iranian IIFSs were not considered.

13 This is the case of Al Rajhi Banking Corporation of Saudi Arabia and Dubai Islamic Bank. Such decisions may reflect the difficulties that SSBs may encounter in assessing volumes of transactions in large IIFS.
SSB could issue recommendations on how the institution could best fulfill its social role as well as promote Islamic finance.<sup>14</sup> In addition to internal corporate arrangements, national regulators and international standard setters implement guidelines for SSBs. These often refer to SSBs’ general duty to ensure _Shariah_ compliance of transactions and, less frequently, indicate areas of competence, composition and decision-making. Table I provides an overview of practices in selected countries that have introduced guidelines or legislative references on the functioning of SSBs.<sup>15</sup> Table I - Regulations on Internal _Shariah_ Advisory**

|Country|SSB terms<br>of reference|SSB<br>composition|SSB<br>decision-<br>making|SSB<br>appointment<br>& dismissal|SSB Fit and<br>Proper<br>Criteria|
|---|---|---|---|---|---|
|**_Bahrain_**|�|�|unspecified|�|�|
|**_DIFC*_**|�|�|unspecified|�|�|
|**_Indonesia_**|�|unspecified|unspecified|�|�|
|**_Jordan_**|�|�|�|�|unspecified|
|**_Kuwait_**|�|�|�|unspecified|unspecified|
|**_Lebanon_**|�|�|unspecified|�|unspecified|
|**_Malaysia_**|�|unspecified|unspecified|unspecified|�|
|**_Pakistan_**|�|�|unspecified|�|�|
|**_Philippines_**|�|�|unspecified|unspecified|�|
|**_Thailand_**|�|�|unspecified|�|�|
|**_U.A.E._**<br>∗Dubai Internat<br>** See Annex I f|�<br>ional Financial Cen<br>or details of the lega|�<br>tre<br>l bases and theprovi|unspecified<br>sions of these regul|�<br>ations|unspecified|

∗ Dubai International Financial Centre ** See Annex I for details of the legal bases and the provisions of these regulations _Source: Official Government websites and Central banks’ Annual Reports._ The functioning of SSBs raises five main issues of corporate governance: independence, confidentiality, competence, consistency, and disclosure. The first

> 14 The 2002 Annual SSB report of Islamic Bank Bangladesh Ltd contains suggestions on investment strategies, such as housing schemes, to help the poor and on research policy, such as the publication and translation of Islamic banking books. (www.islamibankbd.com, last visited April 18, 2005). 15 Only those countries are included where authorities have implemented laws, acts or issued circulars and regulations on internal _Shariah_ Supervisory Boards. Annex I details the legal bases and the provisions of these regulations.
concerns the _independence_ of the SSB from management. Generally members of the SSB are appointed by the shareholders of the bank, represented by the Board of Directors. As such, they are employed by the financial institution, and report to the Board of Directors. Their remuneration is proposed by the management and approved by the Board. The SSB members’ dual relationship with the institution as providers of remunerated services and as assessors of the nature of operations could be seen as creating a possible conflict of interest.

In principle, SSB members are required to submit an unbiased opinion in all matters pertaining to their assignment. However, their employment status generates an economic stake in the financial institution, which can negatively impact their independence. The opinions of the SSB may, for example, prohibit the bank engaging in certain profitable transactions or impose a reallocation of illicit income to charity, resulting in a poorer overall financial performance. Under these circumstances, the bank managers may be tempted to use their leverage to influence SSB members, producing what is commonly referred to as “ _Fatwa_ shopping” or “ _Shariah_ advisory _à la carte_ ”.

In practice, the risk of such conflict of interest is mitigated by the ethical standards of the SSB members, and the high cost that a stained reputation would inflict on them and on the financial institution. Generally, members of SSBs are highly regarded _Shariah_ scholars and guardians of its principles. Therefore, a less than truthful assessment and disclosure of _Shariah_ compliance by an SSB would seem to be highly unlikely. In the event that it does occur and comes to light, it would seriously damage the concerned scholars’ reputation and the prospect for further recourse to their services. Similarly, managerial interference in compliance assessments can lead to a loss of shareholders’ and stakeholders’ confidence. Management may be penalized and face dismissal. All that being said, and the heavy costs of untruthful assessments notwithstanding, a potential conflict of interest is inherent in existing corporate arrangements regarding SSBs.
The issue of _confidentiality_ is intertwined with that of independence. Often, some _Shariah_ scholars sit on the SSBs of more than one financial institution. This association with multiple IIFS may be seen as a strength in as much as it could enhance an SSB’s independence vis-à-vis a particular institution. However, it does give the particular individual access to proprietary information of other, possibly competing institutions. Thus SSB members may find themselves in another type of potential conflict of interest. In the current practice, Malaysia has attempted to deal with this issue by discouraging jurists from sitting on the SSB of more than one IIFS. While this eliminates confidentiality concerns, the practice poses other potential problems. First, it would exacerbate lack of competence where there is a scarcity of _Fiqh al-Muamalat_ jurists.<sup>16</sup> Second, it may prevent the formation of an efficient labor market for _Shariah_ audit, by decreasing the economic appeal of the profession. Lastly, it may create a symbiotic relationship between the auditor and the financial institution that could undermine impartiality.

The third issue relates to the nature of the _competence_ required of SSB members. Due to the unique role that they are called upon to fulfill, SSB members should ideally be knowledgeable in both Islamic law and commercial and accounting practices ( _Fiqh alMuamalat_ ). In practice, it would appear that very few scholars are well-versed in both disciplines. The issue has been addressed by including members from different backgrounds in most SSBs.<sup>17</sup> However, the combination of experts rather than expertise creates the challenge of overcoming different perspectives as well as the risk of potential failure of communication. Over time, the demand gap for combined _Shariah_ and financial skills is likely to be reduced through public policy and normal labor market operations. Progress in this direction is already noticeable in countries where the Islamic financial industry is well established. For instance, the Securities Commission of Malaysia has certified a total of 27 individuals and 3 companies eligible for _Shariah_ advisory on unit

> 16 _Fiqh al-Muamalat_ literally translates into Islamic Commercial Jurisprudence

> 17 AAOIFI (Governance Standard 1) recommends to include jurists of _Fiqh Al-Muamalat._
trust funds, for a total of 24 companies offering such funds.<sup>18</sup> However, in countries where Islamic finance is less developed, other transitional arrangements may be needed.

The fourth issue concerns _consistency_ of judgment across banks, over time, or across jurisdictions within the same bank. In essence the activities of SSBs are in the nature of creating jurisprudence by the interpretation of legal sources. It should therefore not be surprising to find conflicting opinions on the admissibility of specific financial instruments or transactions.<sup>19</sup> In reality, however, the diversity of opinions is less widespread than might be expected. The CIBAFI sampled about 6000 _fatwas_ , and found that 90% were consistent across banks. The fact that over one hundred _Shariah_ scholars around the world issued these _fatwas_ would suggest an overall consistency in the interpretation of the sources.<sup>20</sup> Further, this high degree of consistency between the _fatwas_ would also point to a substantial independence of SSBs. Nevertheless, as the industry expands, the number of conflicting _fatwas_ on the permissibility of an instrument is likely to increase. This could undermine customer confidence in the industry and have repercussions on the enforceability of contracts.<sup>21</sup> The last and overarching issue relates to _disclosure_ of all information relating to _Shariah_ advisories. In addition to the positive aspects of thus empowering stakeholders, disclosure could be the means to addressing some of the issues discussed in the preceding paragraphs. A transparent financial institution would ideally disclose the duties, decisionmaking process, areas of competence, and the composition of its SSB, as well publish all _fatwas_ issued by the SSB. This would strengthen stakeholders’ confidence in the credibility of SSB assessments. In addition, public disclosure of such information would

> 18The proportion of advisors to company seems to be quite large. Every management company must appoint at least 3 _Shariah_ advisors for one company. This means that every advisor would serve on the SSBs of about two or more fund management companies. Data on _Shariah_ advisors and approved instruments are available at http://www.sc.com.my (as of March 14, 2005).

> 19 A typical example is the financing of leisure activities, which is frowned upon as _haram_ by some Fiqh scholars. Moreover, Islamic jurisprudence is based on different schools of thought that may vary from country to country (the _Shiah_ branch and the Sunni branch, which in turn includes the _Madhahib, Shafie, Hanafi, Hanbali and Maliki_ traditions).

> 20 As quoted in the proceedings of the Fourth Harvard University Forum on Islamic Finance, available at <u>http://www.hifip.harvard.edu/MoreInfo.asp?news_id=34</u> (last visited March 14, 2005)

> 21 It may be hard to invalidate contracts on grounds of a breach of _Shariah_ law, if _Shariah_ has no legal force in the country and there are no widely acceptable codified standards or contract specimens.
provide a forum for educating the public, thus paving the way for a larger role for market discipline in regard to _Shariah_ compliance. Finally, it would decrease the costs that external agents may face in assessing the quality of internal _Shariah_ supervision.

Despite all these potential benefits, transparency does not currently seem to be widely prevalent. Out of 13 banks reviewed, all declared the existence of an SSB within the organization and disclosed information on its composition.<sup>22</sup> However, only 7 made the annual report of the SSB easily accessible, and 7 did not provide detailed information on the professional background of SSB members.<sup>23</sup> Moreover, only two banks disclosed the _fatwas_ authorizing the provision of financial services and products. Only one disclosed provisions for decision-making and interaction with other bodies of the firm. Finally, only one institution disclosed on its website the duties and obligations of the SSB.<sup>24</sup> The practice of limited disclosure by banks would not support building confidence in _Shariah_ compliance.<sup>25</sup> Besides _Shariah_ Boards, most IIFS, particularly those complying with AAOIFI standards, have established _another internal Shariah review structure_ , generally in the form of review units.<sup>26</sup> These internal _Shariah_ review units are independent from other departments or are an integral part of the Internal Audit and Control Department. The array of tasks that they perform is parallel to those of audit departments -- reviewers generally use all necessary powers to ascertain that all financial transactions implemented

> 22 Source: Annual reports, articles of association, and information posted on the websites of the following IIFS: Bahrain Islamic Bank, Al Rajhi Banking Corporation, Bank Islam Malaysia Berhad, Jordan Islamic bank, Kuwait Finance House, Bank Muamalat Malaysia, Shamil Bank, Bahrain, Islamic Bank of Britain, Emirates Islamic Bank, Dubai Islamic Bank, Islamic bank Bangladesh Limited, First Islamic Investment Bank and Bank Rakyat Malaysia. Iranian IIFS were not considered. Annex II provides an index of _Shariah_ advisory disclosure for the 13 IIFS and compares desirable with effective _Shariah_ related disclosure.

> 23This means that the SSB report was available on either the website or in the annual report. The proportion is 7 out of 11, because the SSBs of two recently established IIFS had not yet issued a report. In Annex III, both are counted as disclosed items.

> 24 While most of this information is usually available through the Articles of Association, the SSB letter of appointment or individual _fatwas_ , these documents are not easily available to customers. This is in stark contrast with BCFS that generally have on their website thorough information on their CG practices

> 25 Annex III provides an index of _Shariah_ advisory disclosure for the 13 IIFS mentioned in footnote 54. It compares desirable with effective _Shariah_ related disclosure.

> 26 AAOIFI recommends internal _Shariah_ review in its Governance guidance 3. In Pakistan for example, this is dealt with in Annexure-III to IBD Circular No. 02 of 2004
by management comply with SSB rulings.<sup>27</sup> In some instances _Shariah_ review units have exclusive competence on ex-post monitoring.<sup>28</sup> These review units and SSBs face similar challenges, relating, in particular, to independence and competence. First, like SSBs and internal auditors, internal _Shariah_ reviewers may be subject to a conflict of interest stemming from their employment status, with their appointment and remuneration determined by management, and their role as assessors of managerial processes and decisions. The scarcity of professionals with combined _Shariah_ knowledge and financial skills also affects internal _Shariah_ review departments. Like SSB members, internal _Shariah_ reviewers should be knowledgeable in _Fiqh al-Muamalat_ . Yet, as already observed, the scarcity of such experts is likely to bear on the quality of _Shariah_ reviews in IIFS. The issue may have greater implications in this case, because _Shariah_ reviewers would also be assigned to the training of other employees on the principles of _Fiqh al-Muamalat._<sup>_29_</sup> Thus, their pronouncements and counsel could have pervasive effects throughout their respective IIFS.

# _B._ _<u>Strengthening Internal Arrangements for Shariah Compliance</u>_

The actions of SSBs and _Shariah_ reviewers at the individual institutional level have so far been relied upon to provide some degree of comfort in assuring IIFS’s compliance with _Shariah_ . However, in line with the foregoing discussions, IIFS, national regulators and international standard setters could further address the issues of: (a) independence of the SSB, (b) confidentiality of its activities, (c) competence of its members, (iv) consistency of pronouncements and (d) disclosure of _Shariah_ decisions and audit.

> 27 In this respect, the role of the internal review unit is limited to a complementary ex-post monitoring. This makes its task secondary, if more focused and defined, to that of SSB, which is the ultimate arbiter in matters of _Shariah_ compliance.

> 28 This is the case of large Islamic banks where SSB may not be able to assess large volumes of transactions. Therefore, separate _Shariah_ control departments are operational. This seems to be the case in Al Rajhi Banking and Investment Corporation and Dubai Islamic Bank.

> 29 According to AAOIFII Standard 3. In some cases educational activities are delegated to separate units, as for instance, in the Al

> Rajhi Corporation **.** **_(_** <u>www.alrajhibank.com.sa, April 2005).</u>
The issue of _independence_ is common to _Shariah_ review bodies. Prevailing approaches to the regulation of internal audit departments and external audit firms can provide guidance on how to ensure integrity of pronouncements on _Shariah_ compliance. The literature on internal audit independence pinpoints three factors that significantly contribute to the degree of auditor independence: (i) clarity of definition of the auditor’s responsibilities, (ii) the position of the auditor within the organizational structure of the institution, and (iii) the reporting authority for audit results. This would suggest that the independence of both _Shariah_ advisors and reviewers could be enhanced by clearly defining their responsibilities and powers in the articles of association of the company or in a charter of independence. Their powers would include the authority to access all records and staff necessary to conduct the audit and to require management to respond formally, and in a timely manner, to significant adverse audit findings by taking appropriate corrective action. Such powers should not include operational tasks that could impair their independence.<sup>30</sup> Second, the organizational status of internal _Shariah_ bodies should be sufficiently articulated to permit the accomplishment of audit responsibilities. This appears to be fundamental in the case of _Shariah_ review units that have to deal with large volumes of transactions in conducting ex-post assessments. Third, the independence of action of SSB and _Shariah_ reviewers and their ability to withstand pressures from management can be assured only as long as _Shariah_ bodies functionally report, and are accountable, to an individual or entity with sufficient authority to: (a) safeguard their independence, (b) achieve a broad audit coverage, (c) ensure adequate consideration of audit reports, and (d) generate appropriate action on audit recommendations. This role is generally performed by independent directors involved in the audit committee. In the case of those IIFS with concentrated shareholding, this role may be assumed by minority shareholders’ directors.<sup>31</sup> However, following the practice of external auditors in some jurisdictions, _Shariah_ reviewers may be required to report fraud or unexplained breaches of rules directly to supervisory authorities. The latter option could be difficult to

> 30 These may include preparing reports or records, developing procedures, or performing other operational duties normally reviewed by auditors.

> 31Outside directors in concentrated ownership corporations are generally appointed by the majority shareholders themselves and may not be truly independent.
implement in countries where supervisors may regard matters of _Shariah_ compliance to be outside their competence.

The foregoing would require carrying existing international norms into national ones and enforcement monitoring mechanisms. The BCBS and OECD codes contain clear provisions on directors’ independence designed to curb collusion opportunities between management and other internal bodies. Likewise, AAOIFI’s “governance standards on the definition, appointment, composition and report of SSBs” and “Codes of Ethics” contain clear provisions on the duties and powers of SSBs that would limit a bank’s discretion in the definition of SSB prerogatives and thereby deprive managers of one instrument of control.<sup>32</sup> In addition, they contain provisions on fixing remuneration, selection and dismissal of SSB members as well as incompatibility clauses to diffuse conflicts of interest.<sup>33</sup> A number of national regulators have already included such prohibitions in circulars or legislative acts, mostly in the form of fit criteria and prohibited interests for the appointment of SSB members or advisors.<sup>34</sup> Following the practice of periodically rotating external auditing companies, mandatory rotation of SSBs would seem to be desirable. Proponents of this measure argue that a long-term client relationship can impair the auditor’s objectivity. Therefore, by periodically interrupting such a relationship through mandatory rotation, the bank’s management would be deprived of its ability to influence the auditors with the threat of terminating their mandate. In Italy, the only OECD country that implements mandatory 32 The codes are the Code of Ethics for Accountants and Auditors of Islamic Financial Institutions and the Code of Ethics for the Employees of Islamic Financial Institutions. The SSBs’ prerogatives include ex-ante and ex-post evaluation, calculation of _Zakat_ and allocation of profits or charging of losses to unrestricted investment account holders.

33 For instance, dismissal of SSBs may only be prompted by a request of the board of directors approved by the general assembly of shareholders. This will prevent “f _atwa_ -shopping”. Further, the standards’ provisions prohibit the appointment of “directors or significant stakeholders” as SSB members and the prohibition for _Shariah_ review units to carry out operational activities (for instance, a division in the internal audit department). Depending on local circumstances, such provisions may be strengthened by introducing severe sanctions for accepting loans from the audited company, having family relationship with the audit client or having any form of direct or indirect material interest in the business. For instance, in Malaysia, the approval and dismissal of SSBs must be communicated to the central bank.

34 Recent examples include Annexure IV to IDB Circular No. 2 of 2004 of the State Bank of Pakistan on “Fit & proper criteria for appointment of _Shariah_ advisors”; Chapter 5 of Islamic Bank of Thailand Act B.E 2545 on “Advisory Council of the Islamic Bank of Thailand” and Bank Negara Malaysia’s 2004 “Guidelines on the Governance of _Shariah_ Committee for Islamic Financial Institutions”.
rotation of external auditors, a recent review of the practice by the “Galgano Committee”, instituted following the US CG scandals, recommended that “in order to safeguard an auditor’s independence the audit engagement should not be immediately renewed. The exclusion of an immediate renewal of the engagement avoids any influence on the judgment of the auditors driven by a hope for renewal”.<sup>35</sup> Opponents of this measure abound. Summer (1998) argues that “by destroying rents from an ongoing relation, the rotation rule undermines incentives for building up a reputation of honesty”. He therefore suggests that competition in the auditor market may be a better safeguard for auditors’ independence. An independent review of the practice by the Bocconi University concluded that rotation compromises audit quality, which strictly depends on a good knowledge of the business and its management.<sup>36</sup> Transposing such arguments into a _Shariah_ framework, rotation of SSBs may lead to greater independence, but could also produce similar inefficiencies and failures in _Shariah_ compliance verification in the transitional phase. Mandatory rotation of SSBs may also exacerbate inconsistency in the application of _Shariah_ within the same bank. An alternative may be found in the practice of periodically rotating SSB members rather than entire boards. This would infuse fresh approaches in the SSB and may increase independence through peer review; it would not necessarily compromise the audit quality, as the continuing members would assure continuity.

Preserving _confidentiality_ of information may require solutions that echo those applied to the auditing profession. For instance, _Shariah_ auditors may be required to abide by codes of professional conduct. AAOIFI’s Code of Ethics for Accountants and

> 35 The report grants the possibility of renewal six years after the end of the engagement. Quoted in English in FEE (2004).

> 36 This report quantified the quality of audit services by the number of suspensions of partners imposed by the Consob (the Italian national commission for the 20 audit firms of listed companies). Cases of suspension normally arise when auditors do not pinpoint material misstatements. As the report states: “The number of partner suspensions in Italy, imposed during the period between 1992 and 2001 amounted to 40. The analysis of the distribution of suspensions shows how they are mainly concentrated in the first year of an appointment with a total number of 13. The number of suspensions imposed over the following years drops dramatically, from one to three a year. For more, FEE (2004).
Auditors for Islamic banks and Financial Institutions provide conduct guidelines tailored to _Fiqh al-Muamalat_ professionals. Nevertheless, the applicability of such code in nonIslamic countries may be constrained by direct references to Islamic morals and _Shariah_ law. A viable alternative might be for regulators to extend standard auditing profession requirements to _Shariah_ auditors.

Ensuring the _competence_ of SSB members and _Shariah_ reviewers requires a multi-pronged approach. Short-term policies to increase the number of qualified _Shariah_ advisors would include training activities in _Fiqh al-Muamalat_ at the bank level, in specialized training institutes and other government-recognized or related organizations such as central banks.<sup>37</sup> _Fiqh al-Muamalat_ degrees could be created and promoted by providing grants and certifying universities. Concurrently, the abilities of _Shariah_ advisors and reviewers would be certified. The process of certification would begin at the IIFS level where managing bodies would appoint SSB members according to established criteria on expertise, education and track record that would be spelled out in the articles of association. The background of SSB members would also be disclosed in accessible information venues, such as websites and annual reports. This process may be complemented by self-regulatory professional associations or national authorities who would enforce nationwide mandatory criteria.<sup>38</sup> Similarly, a national registration process might be established along the lines of the certification of _Shariah_ advisors implemented by the Securities Commission of Malaysia. This would have the additional advantage of a centralized and therefore standardized assessment of _Shariah_ experts’ skills. Besides safeguarding competence, this option may increase independence in _Shariah_ audit.

_Disclosure_ of the processes leading to _Shariah_ pronouncements and related information needs to be the cornerstone of _Shariah_ governance. These issues may not have received sufficient attention either from IIFS themselves or their regulators and supervisors. Therefore, policies need to be put in place that would ensure adequate

> 37 Some examples include the Islamic Banking and Finance Institute of Malaysia, the Bahrain Institute of Banking and Finance, the Bangladesh Bank Training Academy and Iran’s Training and Human Resource Studies Department.

> 38 This is the Case of Pakistan’s “Fit & proper criteria for appointment of _Shariah_ advisors” that explicitly require “minimum qualification and experience”.
disclosure, terms of both quality and ease of retrieval, such as through IIFS websites and annual reports. Of particular importance would be, inter alia, the SSB annual report and its _fatwas_ . Informing IIFS’s stakeholders on the composition, powers, competence and decision-making of SSBs would also enhance the transparency of the processes leading to _Shariah_ pronouncements.

# **III. External Arrangements for** **_Shariah_ Compliance**

Under the prevailing current decentralized system of _Shariah_ advisory, the flexibility in _Fiqh_ opinions has encouraged innovation in Islamic financial products, contributing significantly to the dynamism of the industry. Nevertheless, because of the very nature of jurisprudence, interpretation of the _Shariah_ by a large number of independent scholars, notably in the various SSBs gives rise to inconsistencies in the _fatwas_ across SSBs, or even over time in the same SSB. Internal systems and procedures could be developed in IIFS to limit inconsistencies and explain different pronouncements. External arrangements, including mechanisms of market discipline can provide complementary channels inducing compliance with rulings and their harmonization. The following first analyzes existing external arrangements and then considers options to strengthen them.

## _A._ _<u>Existing External Arrangements</u>_

The broad _Shariah_ governance framework may feature (a) arrangements put in place by regulators, and (b) the presence of providers of financial information services external to the firms. Among regulatory arrangements, _centralized SSBs_ are the most noteworthy. While there are significant differences across countries, centralized SSBs are usually concerned with ex-ante monitoring, mostly understood as standardization of _Shariah_ interpretation, and ex-post monitoring of _Shariah_ compliance. They also offer arbitration to settle _Shariah_ disputes arising between members of the same SSB. In addition, a few countries have set up public rating agencies that assess financial instruments and institutions. These are meant to create a positive climate for _Shariah_
compliant investments. Table II offers an overview of such regulatory institutions in key jurisdictions where Islamic finance services are offered.

||Table II - External_Shariah_CG i<br>|nstitutions by country*<br>|
|---|---|---|
|Country|Centralized SSB or High_Shariah_<br>Authority or Fatwa Board|Islamic Rating Agency|
|**_Jordan_**|No|No|
|**_Malaysia_**|�|�|
|**_Sudan_**|�|No|
|**_Bahrain_**|No†|No†|
|**_Kuwait_**|�|No|
|**_Pakistan_**|�|No|
|**_UAE_**|�|No|
|**_Indonesia_**|�|No|
|* See Annex III fo<br>† Bahrain is the se<br>an international sc|r the names and powers of these departments/authorities.<br>at of the IIFM and the IIRA that respectively set standar<br>ale.|ds for Islamic jurisprudence and rate Islamic instruments on|
|_Source: Official G_|_overnment websites and Central Banks’ Annual Reports._||

One of the distinctive goals of these bodies is the standardization of _Shariah_ practices within their jurisdictions. Countries such as Kuwait, Malaysia or Pakistan have taken significant actions in this respect, while others have not followed this route. The standardization of Islamic instruments may be a major determinant in ensuring the enforceability of Islamic financial contracts in disputes brought before civil courts that are not legally bound by the _Shariah_ . Accordingly, standardization of practices would support property rights of involved stakeholders as well as sustain the development of IIFS in non-Islamic countries. However, the practice of centralized SSBs creates the possibility that one IIFS group operating in different jurisdictions may have products deemed _Shariah_ compliant in one place and not in another. In addition, regulators in non-
Islamic jurisdictions would consider that matters relating to the _Shariah_ are not in their purview (e.g., the UK FSA).<sup>39</sup> Private mechanisms for the external governance of _Shariah_ compliance are equally limited. In particular, private rating agencies have not yet developed the necessary skills or found enough incentives to monitor the IIFS’ _Shariah_ compliance. “Islamic rating” has so far been the exclusive domain of government-sponsored organizations such as the IIRA and the Malaysian Rating Corporation. Likewise, other external entities with an interest in Islamic finance, such as the financial media and external auditors, are still generally less concerned with assessments of _Shariah_ compliance.

A notable exception is the multiplication of stock market Islamic indices whose major contribution is the identification of _halal_ investments.<sup>40</sup> Islamic stock market indices, like the FTSE Global Islamic Index, the Dow Jones Islamic Indexes and the Indonesian _Shariah_ Index, may contribute to better _Shariah_ governance for publicly traded IIFS. By filtering out companies with activities that are incompatible with _Shariah,_ as well as firms with unacceptable levels of debt or interest income, they contribute to reducing adverse selection in investments by IIFS, and give additional comfort on the _halal_ nature of IIFS activities.<sup>41</sup> However, current practice is not likely to meet with a full consensus of _Shariah_ scholars. Usually, these indices include companies that deal in interest because of the lack of a fully interest-free international market. While some Islamic finance scholars may find this approach acceptable, others will not, thus limiting the role of these indices in enhancing _Shariah_ governance.

> 39 In Malaysia, for instance, the judicial system has agreed to resort to the Central Bank’s _Shariah Council_ for opinions on the permissibility of Islamic financial instruments, whenever a court case brought before it may require it. It would be hard to replicate such a scheme in other countries, where regulators may not want to get involved in _Shariah_ issues.

> 40 _Halal_ conveys goodness and by extension has taken the meaning of “permissible”.

> 41 In the case of Dow Jones Islamic Indexes, excluded businesses include: alcohol, conventional financial services (banking, insurance, etc.), entertainment (casinos/gambling, cinema, pornography, hotels, etc.), tobacco manufacturers, pork-related products and defense and weapons companies. Companies classified in other industry groups may also be excluded if they are deemed to have material ownership of or revenues from the businesses mentioned above.
# _B._ _<u>Strengthening External Arrangements for Shariah Compliance</u>_

Recent literature and practice have focused on establishing external CG structures to ensure effective _Shariah_ audit. In proposing the externalization of _Shariah_ advisory, Chapra and Habib (2002) suggest that chartered audit firms should acquire the necessary knowledge to undertake _Shariah_ audit. This process is already underway as evidenced by the increasing number of independent consulting companies and law firms offering _Shariah_ advisory services.<sup>42</sup> In addition to reducing internal audit costs in the Islamic financial institution, the use of such services would possibly give the institution access to a broader range of expertise. In addition, the public may perceive chartered _Shariah_ audit companies as more independent from the institution’s management. It is not certain, however, that switching to external _Shariah_ audit would bring tangible guarantees of _Shariah_ compliance. Potential for “ _Shariah_ advisory _à la carte_ ” would not end with the externalization of services. In addition, externalization will not improve, and may in fact worsen, the accuracy of _Shariah_ audit. Internal auditors are generally familiar with the records systems, policies and procedures of the institution and can provide quick responses to managers. The result could be a more detailed and exhaustive internal audit.

. The idea of external firms undertaking _Shariah_ audit presents some advantages if it is viewed as complementing internal _Shariah_ audit. _Shariah_ audit firms would perform a role similar to that of their counterparts in conventional finance, thus introducing an additional layer in the _Shariah_ verification process. Such a system would obviously entail a clear separation of pre-audit and post-audit functions. Complementary internal and external audit would apply only to post-audit, while the internal pre-audit unit, the SSB, would have the sole authority to issue _fatwas_ . Internal audit by the SSB would have an independent appraisal function, including the review of _Shariah_ verification systems and controls, while external _Shariah_ auditors would have a statutory responsibility to express an independent opinion on _Shariah_ compliance. To avoid duplication, the latter function could be performed by _Shariah_ departments set up by existing chartered auditors. (Table

> 42 For example: <u>http://www.yasaar.org/rationale.htm, & http://www.islamic-banking.com/shariah/index. php</u>
III shows how internal and external _Shariah_ review may be differentiated and illustrates the merit of specialization.

||Table III – Comparison of Internal and|External_Shariah_Review|
|---|---|---|
||Internal_Shariah_Review Unit|External_Shariah_auditing firm|
|**_Focus_**|Provides exhaustive internal review, and train<br>employees on_Shariah_related matters. It<br>responds to managerial concerns over<br>upholding_Shariah_conformance of all<br>transactions|Primarily provides an independent<br>certification as to the reasonableness of<br>financial information provided to<br>shareholders and stakeholders. It responds<br>to regulators’ and stakeholders’ desire for<br>an independent appraisal of_Shariah_<br>compliance|
|**_Activities_**|Assess compliance of_all_transactions with the<br>_fatwas_issued by the SSB. To this effect, it<br>creates systems of control and assessment.|Assess the information provided by the<br>managers and present statements according<br>to relevant_Shariah_accounting standards.<br>It uses_samples_of transactions to evaluate<br>truthfulness of compliance and expresses<br>an opinion on financial statements|
|**_Manage-_**<br>**_ment_**|Reports to management administratively.<br>Builds relationships throughout the<br>organization to ensure concerns are identified<br>and resolved in a timely manner.|Primarily reports to the audit committee<br>on financials and internal control.|
|**_Board of_**<br>**_directors/_**<br>**_Audit_**<br>**_Committee_**|Reports directly to the audit committee.<br>Provides opinions on the organization’s<br>business risks, financial statements, system of<br>internal control, and level of compliance with<br>laws, regulations, and policies.|Attests to the audit committee the accuracy<br>of the financial reports and attests on<br>management’s assessment on internal<br>controls over financial reporting. Provides<br>updates on pending accounting<br>pronouncements and their potential impact<br>on the organization.|
|**_Independ-_**<br>**_ence_**|Should demonstrate organizational<br>independence and objectivity in work<br>approach, but is not independent of the<br>organization. (Is independent of the activity<br>audited, but is integral to the organization.)|It is organizationally and managerially<br>independent of the organization.|
|**_Results_**|Identifies problems, make recommendations,<br>and helps facilitate resolutions.|Meets statutory requirements and provides<br>necessary adjustments to meet financial<br>accuracy.|
|**_Risk_**|Identifies and qualifies key business risks to<br>estimate probability of occurrence and impact<br>on business. Makes appropriate<br>recommendations as a result of the risk<br>assessment.|Identifies key transactions and exposures<br>for financial statements.|
|**_Fraud_**|Includes fraud detection steps in audit<br>programs. Investigates the allegations of fraud.<br>Reviews fraud prevention controls and<br>detection processes put in place by<br>management and makes recommendations for<br>improvement.|Includes fraud detection steps in audit<br>plan. Gathers information necessary to<br>identify risks of material misstatement due<br>to fraud, by inquiring of management and<br>others within the entity about the risks of<br>fraud. Considers the results of the<br>analytical procedures performed in<br>planning the audit and fraud risk factors.|
|---|---|---|
|**_Recomm-_**<br>**_endations_**|Communicates to management in the audit<br>reports recommendations for corrective action.|Communicates recommendations for<br>corrective action.|

*Adapted from table in Richards (2002).

A framework of co-existing internal and external _Shariah_ audits as described above does not help to resolve the difficulties caused by inconsistencies in the body of _fatwas._ In an effort to alleviate this problem, some jurisdictions have moved towards a system of centralized SSBs. The latter carry the expectation of harmonization of permissible financial instruments through adjudicating disputes between _Shariah_ advisors and by standardizing existing practices. However, the ongoing globalization of Islamic finance as well as constraints on its applicability in secular countries limits the feasibility of this approach. To circumvent these limitations, Khan and Feddad (2004) recommend the gradual international codification and standardization of _fatwas_ . This duty may be delegated to an existing international organization, whose mission already involves the promotion of harmonization and convergence of _Shariah_ interpretations.<sup>43</sup> Alternatively, a new self-regulating non-profit association of _Fiqh al-Muamalat_ experts may be created. However, despite its apparent advantages, the creation of a global _Shariah_ regulator is likely to meet with resistance, specifically from jurists who regard Islamic _Fiqh_ as a pluralist body of knowledge. Also, the centralization of competences in a global regulator may undermine product innovation and financial engineering.<sup>44</sup>

> 43 AAOIFI’s mission statements declare that  “the powers of (AAOIFI’s) Shari'a Board include, among others, the following: achieving harmonization and convergence in the concepts and application among the Shari'a supervisory boards of Islamic financial institutions to avoid contradiction or inconsistency between the fatwas and applications by these institutions, thereby providing a pro-active role for the Shari'a supervisory boards of Islamic financial institutions and central banks (...)” Likewise IIFM’s “role includes the promotion of harmonization and convergence of Shariah interpretations in developing Islamic banking products and practices that are universally acceptable”.  Sources: <u>www.aaoifi.com</u> and <u>www.iifm.net/</u> 44 This would obviously depend on the degree of powers transferred to such an organization. For instance, the State Bank of Pakistan has issued “Essentials of Islamic modes of financing” to ensure compliance with minimum _Shariah_ standards, which do not present an obstacle to innovation and yet contribute to harmonizing permissible contracts. For more <u>www.sbp.org.pk.</u>
Over-reliance on the public sector for regulating _Shariah_ matters may also present other difficulties, such as the reluctance of authorities in a large number of jurisdictions, to be involved in what they would consider private religious matters. In such situations, the private sector could fill the gap and play a more decisive role in the _Shariah_ compliance process. The focus would be on consolidating the _Shariah_ related information infrastructure by creating new processes or strengthening the exiting infrastructure. Next to external _Shariah_ audit firms, representational agents that normally channel financial information to the public may acquire new skills and assess IIFS’s compliance with Islamic finance rules.

In the future, key players in this field may be the private rating agencies. One may anticipate that they would gradually develop skills to evaluate _Shariah_ compliance and make this information readily available to investors using their existing dissemination infrastructure. Their coverage may also include companies in which IIFS have a stake. This would create a positive climate for _Shariah_ compliant investments, particularly for partnership and venture capital transactions. It is noteworthy that some leading rating companies have included “religious supervision” as an item in their reports on IIFS.<sup>45</sup> However, this is often limited to a summary statement on the existence of a SSB and the conclusions of the SSB annual reports. Eventually, one may envisage a more articulate contribution through the adoption of _Shariah_ compliance indicators that would quantify _Shariah_ disclosure, profit-sharing and Z _akat._<sup>_46_</sup> In addition, Islamic market indices may prove important. One may expect that current criticisms about their use will diminish with the development of the industry. With the progressive increase of _halal_ products, filters may be tightened to meet with greater scholarly approval.

> 45 This is notably the case of Capital Intelligence bank reports.

> 46 Shahul et al. (2004) propose the creation of two (disclosure and performance) “Islamicity Indices”. They quantify, among other things, _Shariah_ compliance, corporate governance practices, social and environmental impact, profit-sharing performance and _zakat_ performance.
# **<u>Section IV. Conclusion</u>**

Overall, current practice to ensure Shariah compliance relies essentially on internal corporate structures, in particular SSBs. These certainly offer stakeholders a level of comfort. Nevertheless, they face a number of challenges relating to their independence, the confidentiality of institution-specific proprietary information, the limited availability of professionals with both _Shariah_ scholarship and financial skills, and the need for consistency in pronouncements between the various SSBs. A few jurisdictions have tried to address some of these issues by introducing an external institutional infrastructure. This, however, creates potential difficulties arising out of inconsistent pronouncements for IIFS groups operating in different jurisdictions, and may be problematic for regulators in non-Islamic countries. Market solutions to offer services that would promote _Shariah_ compliance are still minimal.

**<u>Figure I: Effective framework to monitor and assess</u>** **_<u>Shariah</u>_** **<u>compliance</u>**

<!-- Start of picture text --> Internal External<br>IIFS process<br>Process<br>Standard<br>SSB Setter<br>Shariah<br>Audit Firm<br>Shariah<br>Review Unit<br>Reputable<br>Agents<br><!-- End of picture text -->
Figure 1 summarizes structures and processes internal and external to an IIFS that can jointly provide an effective framework to monitor and assess _Shariah_ compliance. Such a framework can be instrumental in enhancing stakeholders’ confidence. It would enable innovation that can generally be expected to emerge mainly within the firm, where a sufficiently competent and independent SSB would be empowered to approve new _Shariah_ conforming instruments. In issuing its fatwas, the SSB can be guided by standardized contracts and practices consistent with principles emerging from external arrangements, notably from international standard-setting official or self-regulatory bodies. The review of transactions would mainly be entrusted to internal review units, which would collaborate with external auditors, responsible for issuing an annual opinion on whether the IIFS activities meet its _Shariah_ requirements. This process would be sustained by reputable agents, like rating agencies, stock markets, financial media, and researchers who would channel signals to market players. Such a framework including structures and processes internal and external to the IIFS can be expected to enhance public understanding of the requirements of _Shariah._ It would be conducive to the development of market discipline as it would permit an effective utilization of exit and participatory actions.