Sharī`ah non-compliance risk is a unique aspect of Islamic finance that deserves specific focus. Research and studies should be dedicated to this topic in order to further expand its scope and depth, as it is still at its early stage and there is not much written about it. This book tries to lay down the first pillars and foundation in this emerging area of Islamic finance. Sharī`ah non-compliance risk means that the terms, conditions, and other related aspects agreed on in the contract do not effectively comply with the Sharī`ah rules and principles. In other words, the terms and conditions in the financial contract do not fulfill the Sharī`ah requirement, hence making the existing contract concluded invalid, or in need of rectification. It is very important to note that the risk management cycle and process should start from this point, because Sharī`ah non-compliance risk might be challenged at any point of the Islamic banking business activities, which may lead to legal conflicts, disputes, or litigations. Sharī`ah non-compliance risk may increase the risk portfolio of the Islamic Finance Industry (henceforth IFI), which may result in financial losses and reputational damages. In the context of this scenario, the present book tries to address this issue by discussing a few aspects related to the subject of Sharī`ah non-compliance risk management, which include but are not limited to the examination of legal documentations used in Islamic finance to make sure that they represent the Sharī`ah in its form, substance, and spirit. The Sharī`ah non-compliance risk and the methodology used within its process will identify the gaps between theory and practice.
1. PROBLEM STATEMENT
The main concern of this book is Sharī`ah non-compliance risk; it addresses the issues for the following questions:
- What are the types of Sharī`ah non-compliance risk in Islamic finance?
- What are the causes of Sharī`ah non-compliance risk in IFI?
- What are the tools and techniques used to identify the Sharī`ah non-compliance risk in Islamic finance?
- What is the methodology and process used to address the Sharī`ah non-compliance risk management in Islamic finance?
- What are the types of issues in the legal documentation used by IFI in offering Islamic facilities?
- What are the terms and conditions agreed on in the legal documentations that may trigger Sharī`ah non-compliance risk?
2. OBJECTIVES OF THE RESEARCH
This book aims to achieve the following objectives:
- Introduce the framework of Sharī`ah non-compliance risk management in Islamic finance.
- Identify the Sharī`ah non-compliance risk in Islamic finance.
- Present the tools and techniques used to identify the Sharī`ah non-compliance risk management in Islamic finance.
- Highlight the methodology used in Sharī`ah non-compliance process.
- Elaborate on the Sharī`ah rules and principles required in mitigating the Sharī`ah non-compliance risk.
- Identify the Sharī`ah non-compliance risk in legal documentation and operation.
- Eliminate Sharī`ah non-compliance risk pertaining to legal documentations in Islamic banking facilities.
- Ensure Sharī`ah compliance in legal documentation pertaining to Islamic financial contracts implemented by the Islamic banks.
3. METHODOLOGY
This research will use the following methodology:
- Induction methodology through collecting and checking the available legal documents and practices of the Islamic facilities offered by Islamic Financial Institution (IFI) in Malaysia.
- Analysis and comparative study methodology through the examination of the legal documents of selected financial transactions implemented by the Islamic banks.
4. THEORETICAL FRAMEWORK
This book tries to identify the area of Sharī`ah non-compliance in Islamic finance, by introducing the Sharī`ah non-compliance risk management framework particularly in legal documents/contracts and practices of Islamic banks in various banking applications.
In order to achieve the objectives mentioned, the study has adopted the following approach.
4.1. Platform/Foundation of the Research
This platform is demonstrated in a discussion on the concept of Sharī`ah non-compliance risk, followed by the nature of Sharī`ah non-compliance risk in Islamic banking and finance, along with the Islamic tools and instruments to identify incongruence in Sharī`ah non-compliance. In addition, there are some major elements of Sharī`ah non-compliance risk in Islamic banking and finance that have been observed, such as gharar (uncertainty), ghubn (inequality), and others. There are also other factors that can cause Sharī`ah non-compliance risk, such as human error, concept of risk, features of Sharī`ah non-compliance risk, Sharī`ah non-compliance risk events, and the Sharī`ah basis for Sharī`ah compliance.
4.2. Fundamental Blocks of the Research
The fundamental blocks represent the major pillars of the research; they form the Sharī`ah fundamental requirements in contracts and the legal framework of the Islamic finance facility. These blocks are as follows:
4.2.1. Sharī`ah Building Block/Sharī`ah Rules
Sharī`ah rules are the first building block in this research; Sharī`ah rules govern the fundamental Islamic principles and requirements in contracts and legal documentation in the Islamic finance facilities in the bank. The major elements of the contract are sighah of the contract (offer and acceptance), the contracting parties (seller and buyer), and the subject matter of a contract (goods and price). This Sharī`ah building block enables the bank to structure the Islamic finance facility in a Sharī`ah-compliant manner.
4.2.2. Legal Building Block/Legal Framework
The legal framework is the second building block, which is based on the incorporation of Sharī`ah requirements into the legal documentations. It includes the functions of the legal documentations, determining the specific prohibitions that should be avoided in the terms and conditions of the legal documentation, and so forth. The purpose of incorporating Sharī`ah requirements in legal documentation is to ensure Sharī`ah compliance and monitor the Sharī`ah non-compliance risk in the Islamic facilities. The critical areas in legal documentation are the terms and conditions (T&C) that affect the rights and liabilities of the parties in the Islamic financial contract. In addition to that, the T&C govern the Islamic finance facility and represent a point of reference in case of dispute and litigation. The T&C include clauses such as right to recall, cross default, consolidation and set-off, prepayment clause, and others.
4.2.3. The Tools and Techniques Used for Sharī`ah Non-Compliance Risk
The tools include accounting, financial statements, and cash flow. The techniques include observation, sampling, interviewing, and testing. The tools and techniques are both important to identify Sharī`ah non-compliance risk.
4.2.4. The Process of Risk Management and Lines of Defence
This is related to the process and management of Sharī`ah non-compliance risk, when the lines of defence have been used to screen Sharī`ah non-compliance risk. The lines of defence, in order, are:
These lines of defence play a crucial role in preserving the interest of Sharī`ah in Islamic finance.
4.3. The Application of the Banking Facility
The Islamic finance application taken into consideration in this book represents various Islamic banking facilities in deposit and financing and other banking products and services.
5. THE TERMS USED IN THIS BOOK
- Sharī`ah committee, Sharī`ah supervisory board, and advisory board are used interchangeably. Sharī`ah Advisory Council (SAC) refers to the Sharī`ah Advisory Council of Bank Negara Malaysia.
- Sharī`ah non-compliance risk and Sharī`ah risk are used interchangeably.
- Sharī`ah management, Sharī`ah department, and Sharī`ah advisory are used interchangeably.