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PART 1
Introduction
Strategic Importance Of Shariah Compliance
Rulings Of OIC Islamic Fiqh Academy
Globally Acceptable Shariah Standards
AAOIFI Shariah Standards: What Is The Significance?
Shariah Advisors Or Shariah Supervisors & their Roles
PART 2
Shariah Compliance – A Theoretical Perspective
Levels of Shariah Compliance
Categories of Shariah compliance
Banks’ Internal Shariah Controls
Mode Based Shariah Compliance Controls
Q & A
 Shariah is the body of Islamic religious law.
 The term means "way" or "path to the water source“.
 It is the legal framework within which the public and
private aspects of life are regulated and controlled based
on Fiqh (Islamic principles of jurisprudence).
 According to the modern definition, Shariah is the
comprehensive body of Islamic laws that regulates the
public and private aspects of the lives of the Muslims.
O you who have
believed, enter into Islam completely [and
perfectly] and do not follow the footsteps
of Satan. Indeed, he is to you a clear
enemy.
ْ‫ن‬َ‫ع‬‫ي‬ِ‫ب‬َ‫أ‬ْ‫د‬َّ‫م‬َ‫ح‬ُ‫م‬ِْ‫د‬‫ب‬َ‫ع‬ِْ َّ‫اَلل‬ِْ‫ن‬‫ب‬‫و‬ ِ‫ر‬‫م‬َ‫ع‬ِْ‫ن‬‫ب‬ِْ‫اص‬َ‫ع‬‫ال‬َْ‫ي‬ ِ‫ض‬َ‫ر‬ُْ َّ‫اَلل‬ْ‫ن‬َ‫ع‬،‫ا‬َ‫م‬ُ‫ه‬َْ‫ل‬‫ا‬َ‫ق‬:
َْ‫ل‬‫ا‬َ‫ق‬ُْ‫ل‬‫و‬ُ‫س‬َ‫ر‬ِْ َّ‫اَلل‬‫صلى‬‫هللا‬‫عليه‬‫و‬‫سلم‬"َْ‫ل‬ْ‫ؤ‬ُ‫ي‬ُْ‫ن‬ِ‫م‬ْ‫م‬ُ‫ك‬ُ‫د‬َ‫ح‬َ‫أ‬‫ى‬َّ‫ت‬َ‫ح‬ُْ‫ك‬َ‫ي‬َْ‫ون‬
ُْ‫ه‬‫ا‬ َ‫و‬َ‫ه‬‫ا‬ً‫ع‬َ‫ب‬َ‫ت‬‫ا‬َ‫م‬ِ‫ل‬ُْ‫ت‬‫ئ‬ ِ‫ج‬ِْ‫ه‬ِ‫ب‬".
ْ‫يث‬ِ‫د‬َ‫ح‬ْ‫ن‬َ‫س‬َ‫ح‬،‫يح‬ ِ‫ح‬َ‫ص‬ُْ‫ه‬‫َا‬‫ن‬‫ي‬ َ‫و‬ َ‫ر‬‫ي‬ِ‫ف‬َْ‫ت‬ِ‫ك‬ِْ‫ب‬‫ا‬"ِْ‫ة‬َّ‫ج‬ُ‫ح‬‫ال‬"ْ‫َاد‬‫ن‬‫س‬ِ‫إ‬ِ‫ب‬َْ‫ص‬ْ‫يح‬ ِ‫ح‬.
The Messenger of Allah (peace and blessings of Allah be
upon him) said, “None of you [truly] believes until his
desires are subservient to that which I have brought.”
Shariah Compliance means “ Adherence to the guidelines and
rulings of Shariah in all aspects and manners”.
An organization or person who claims to be a “Shariah
Compliant” has to follow Shariah in its all Operations and all
Activities.
Shariah requires a Comprehensive Adherence as
mentioned in above Ayah and Hadith and not a
symbolic one.
Compliance is “ The state of being in accordance with the laws of
relevant Federal or Regional Authorities”
In the context of Islamic finance, “ The state of the business
operations of an IFI being in accordance with the relevant
Shariah Rules and Guidelines issued by:
1. Shariah Ruling Body (AAOFIF) and formalized by a
regulatory authorities (SBP)
2. Rulings of Shariah Adviser or Shariah Supervisory Boards.
Adherence to Shariah is WAJIB on every Muslim
and Islamic Financial Institution.
Failure leads to disobedience of Allah and His
Messenger (Peace be Upon Him).
Failure leads to loss of income i.e. charity.
Failure leads to reputational risk.
12
13
(IFSB), which is based in Kuala Lumpur, was officially inaugurated on 3rd
November 2002 and started operations on 10th March 2003. It serves as
an international standard-setting body of regulatory and supervisory agencies
that have vested interest in ensuring the soundness and stability of the Islamic
financial services industry. Since its inception, the IFSB has issued twenty-
four Standards, Guiding Principles and Technical Note for the Islamic
financial services industry.
 AOIFI is an Islamic international autonomous non-for-profit corporate body that
prepares accounting, auditing, governance, ethics and Sharia standards for
IFIs and the industry.
 AAOIFI has gained assuring support for the implementation of its standards, which
are now adopted in the Kingdom of Bahrain, Dubai International Financial Centre,
Jordan, Lebanon, Qatar, Sudan and Syria.
 The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom of
Saudi Arabia, and South Africa have issued guidelines that are based on AAOIFI’s
standards and pronouncements.
 AAOIFI was established in accordance with the Agreement of Association
which was signed by Islamic financial institutions on 1 Safar, 1410H
corresponding to 26 February, 1990 in Algiers. Then, it was registered on
11 Ramadan 1411 corresponding to 27 March, 1991 in the State of
Bahrain.
 Total of 88 standards issued: (a) 48 on Shari’a, (b) 26 accounting, (c) 5
auditing standards, (d) 7 governance, (e) 2 codes of ethics.
They now carry global status and acceptability and many financial regulatory
authorities have adopted these standard.
SBP has also adopted some standards after thorough
discussions on variable forums (SAF, SBP SB, other
department of SBP).
Therefore, the Shariah compliance mechanism is done
on the basis of these standards.
The explanation of the standard and areas which are
not covered in these standards, are covered by Shariah
Board / Shariah advisers of the institutions.
 The SB is to consider, decide and supervise all Shariah related
matters of the IBI.
 The SB is to develop a comprehensive Shariah Compliance
Framework with in IBI.
 Ensure prior approval for all products and services.
 Ensure Shariah conformity for all SPMs, product structures, process
flows and marketing tools.
 SBMs have to review all internal Shariah audit and Shariah
compliance reports for considering appropriate action.
 SB’s decisions and rulings are in conformity with AAOIFI Shariah
standards and Regulator.
17
There are three levels of Shariah compliance:
►Top level (Strategic)
►Middle level (Tactical)
►Lower level (Operational)
Top level
Tactical level
Operational level
Strategic Level Or Top Level
An important level where Shariah compliance becomes very crucial.
In fact Shariah compliance is initiated from this level.
Includes shareholders and top management relations.
Cultural and behavioral issue of management.
Shareholders engagement with other Haram businesses – lack of
seriousness in Shariah compliance.
○Examples are foreign banks and local banks with Islamic
windows.
Top Level (Strategic):
HR policies and other relationships.
■Marketing Strategies - Techniques
■Shariah governance – Shariah quality improvement
system (Check lists & MISs for Products)
■Readiness for change.
Middle Level (Tactical):
■Customer relationship
○Cheating and Lying
○Unattainable Promises
■Right and Obligation (customers and subordinates)
○Feeling of this responsibility
■Ethical motivation of employees
Lower Level (Operational)
■Ethical responsibilities
○Very important here
■Behavior
■Awareness about the Islamic financial system;
○Product information
■Knowledge of pros and cons of the system
■Dealing with religious minded people
23
CEO
Share holders
Board of Directors
Operational
Level
Tactical
LevelTopLevel
Head of department
Vice HOD Vice HOD
Employee Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Head of department
Vice HOD Vice HOD
Employee Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Head of department
Vice HOD Vice HOD
Employee Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Head of department
Vice HOD Vice HOD
Employee Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
Employee
 Includes:
►All the financial services and products offered on asset side
(customers to bank relation);
■Corporate, Commercial and Consumer structured assets – vanilla
products;
■Specially structured products – Sukuk, syndicated transaction etc.;
►The general banking operations of Islamic banks on liability side
(Depositors to bank relationship), and
►Interbank relationships with Islamic and non-Islamic financial
institutions;
►Relationship with regulators;
24
The relationship with all these fall in ambit of Shariah compliance.
Funds placement with or funds reception from these stockholders must
be Shariah compliant.
Islamic modes of financing should be executed according to
recommended methods, process-flows and manuals. 25
Islamic Financial
Intermediary – Bank
or Insurance Co.
Islamic Funds
Depositors
Takaful
SBP (SLR & CRR + IERS)
Customers
Conventional banks Conventional
funds and
Insurance cos
Shariah compliance may be divided into three categories
This division is just for the purpose of continuous practical
application:
(1)-Acceptable level:
■It is the minimum level that is required to become Shariah
Compliant and Acceptable.
■Failure results non-Shariah compliant (Haram) status of the
organization or activities
26
Elements of Acceptable Level:
○Restraining from impermissible business activities
The institution should not involve in any business or
management activity which is not Halal
○Elimination of RIBA
The institution should not go for an option where interest
exists;
○Elimination of Gharar and all types of gambling;
No involvement in Gharar is permissible;
○Implementing the Islamic laws of contract in normal
course of business;
27
Acceptable Level (Cont'd);
■Although at acceptable level Islamic banks remain in the
ambit of Halal and Haram but some reservations in
qualitative matters remain there in scholarly circles.
○Mimic transactions are example of this level.
○Some of transactions are in gray area although we can
not call these transactions Haram.
○Examples are: Commodity Murabahah, Some credit card
structures, Islamic lotteries etc.
28
(2)-Satisfactory Level;
■This is a step forward level in assurance of Shariah
compliance.
■The satisfactory level means the level of adherence to
laws and rules that shows their identity as separate
system;
■Failing to assure this level usually results in lack of
acceptability and creates differences and debates both
valid and invalid;
29
Satisfactory Level (Cont'd);
■Comprehensive Shariah training;
○General Islamic banking training;
○Specific trainings – product wise trainings;
○Workshops and conferences;
■Shariah compliant marketing strategies and tactics;
○Advertisement themes;
○Wordings of advertisements;
30
■Satisfactory Level (Cont'd);
■Internal and external Shariah compliance;
○Revision of processes and system on continuous
basis;
○Periodic revision of existing agreements and
processes to ensure Shariah quality;
○The satisfactory level should always be preference
of Islamic banks;
►3- Desirable Level:
■The desirable level for Islamic financial
institutions means the level of adherence to
guidelines o Islam that reflects Islamic values and
features.
■This is although a difficult and a long run task
but it is the main target for which whole system
is developed.
32
Desirable Level Cont:
Features and Elements of Desirable Level:
○Product Innovation
Copying and mimicking the conventional
products does not reflect contribution of
Islam financial system.
33
○Desirable Level Cont:
○Real involvement in trade and business activities.
Symbolic and artificial involvement creates doubts about
claims of Islamic banks.
○Less role of Agency, Gift and Rebates.
○Islamic values of equitable distribution of wealth in
society.
○A very Longley waited change that is dream of ours.
34
“Internal Sharia Control Mechanism” assures the compliance of
Shariah guidelines and minimizes the risk of deviation in day to
day transactions.
Shariah department in coordination with compliance
department should ensure that effective Shariah control
mechanism is in place.
The Management should be attentive to implementation of the
recommended Shariah controls and to proper training of the
staff.
35
The Shariah control or compliance mechanism consists:
►(A)-Operational Control Strategy
■Involvement of SCD in approvals of the transactions.
■Credit and CAD processing / approval linkage with SCD
approvals;
►(B)-Systematic Control Strategy
■Manuals, Process flows, SOPs, Check lists and forms.
■Quarterly, Monthly or weekly reporting of transactions.
■Assessment of possible deviations and their control.
36
The SCM may vary with regards to:
►the nature of modes of financing.
►the nature of transaction (Consumer or Syndicate)
►the nature of business (easy or complex process
business)
37
The SCM may be divided with regards to modes of financing
into FOUR categories:
A. Trade-based mode of financing and their controls.
■Four modes fall under this:
○Murabahah
○Musawamah
○Salam
○ Istisna'a
B. Rental-based mode of financing and its control:
■Ijarah comes under this header.
C. Partnership based modes of financing and their
control:
■Mudarabah and Musharakah come under this
header;
D. Combined modes of financing:
■DM falls in this category.
39
 Murabahah
being a vastly used mode of financing by Islamic banks,
a detailed SCM is outlined here for it:
►Murabahah is a kind of sale where the seller (Islamic
bank) discloses the cost of the sold goods and the
added profit to customer.
40
►Points for Shariah Compliance of Murabahah Transaction;
■A list of Murabahah transaction executed by the Islamic Bank
during the period under review.
■A representative sample of the transactions executed during the
period and their documentation.
■Review the process flow and agreement prepared by the bank
and approved by the Sharia Advisor.
■Ensure that all the agreements executed with customer are in
compliance with the process flow and agreement approved by
the Sharia advisor.
41
Methodology and Approach of Shariah compliance assurance in Murabahah:
►Following are major steps of correct execution of Murabahah transaction:
■Pre Disbursement:
○Business analysis: Halal or Haram status.
■Business Structure Of The Parties:
○Ownership structure – both companies are not owned by one party
who ultimately becomes buyer and seller in one time.
■Processing Difficulties (Transaction Is Not Possible In Terms Of
Practicality):
○Perishable items and fast moving items have different modalities for
correct Murabahah;
42
■Real Trade Possibility:
○Possibility of possession of goods
○Possibility of delivery of goods
○Possibility of on time offer and acceptance
○Possibility of physical inspection
○Mode of payment
○Possibility of specification and quantification of goods
■Check list & Process flow should be designed and filled properly and
signed
■Specific Shariah approval in case of any exception
■Physical inspection where required
43
Documentation
■Proper process flow of documents
■Standardized formats to avoid confusions
■Approved agreements by Shariah and legal
■Signing of Promise for purchase is essential here
○In case it is not signed, the customer may not be bound
to buy the goods he ordered.
○Similarly bank can not ask him for any compensation of
loss.
44
►Following documents are required for
Murabahah
A. General documents (one time documentation)
and their execution;
○Master Murabahah agreement along with
facility limit, tenure and terms and conditions;
B. Transaction Based Document Execution:
■Purchase requisition
■Offer and acceptance
■Any other detail for transaction such as:
○Payment mode
○Payment tenure (monthly or quarterly etc.)
○The terms of the agreement are not changed
except with the specific approval of the Sharia
Advisor 46
SCM For Murabahah Should Also Ensure That:
►The proper documentation has been executed.
►The charity account is in place to manage charity received from a
customer in case of delayed payments / defaults.
►The Murabahah transaction is not used as buy back facility.
►The correct invoices have been received for the goods.
►The invoices are original and not back dated or conflict with date of
Murabahah declaration.
►The offer & acceptance are correctly executed with details of goods
purchased by agent.
►The sale is concluded correctly and the ownership as well as risk is
transferred to the customer. 47
Ijarah is a lease of a non consumable asset.
The difference b/w conventional lease and Ijarah is
segregate arrangement of asset transfer at the end of lease
term.
Shariah Control Mechanism Of Ijarah:
Some processes are same as in Murabahah like document
vetting by Shariah adviser, standardized documentation etc.
48
SCM Of Ijarah Should Ensure :
►The proper documentation of the transaction.
► A charity account in place to manage charity.
►The asset is specified and known.
►The Ijarah period is known.
►A proper mechanism is agreed in case of variable rental and
fixed rentals..
►The Ijarah is concluded correctly and the usage right is
transferred to the customer.
►The responsibility of asset risk is clearly known to both bank
and customer.
49
►The nature of rentals is clearly known i.e. advance or arrears.
►The rental shall start after the delivery of the assets
and not from the contract date or disbursement.
►Any evidence for assurance of asset delivery to the
customer is in place e.g. delivery order or.
►The asset is transferred (by mean of sale or gift)
through a separate contract at end of the lease term.
50
DM is a hybrid product that comprises of Shirkah (joint
ownership), Ijarah (Rental agreement) and Bai' (Sale).
Rules of all these mode need be ensured in this product.
Shariah Control Mechanism Of DM:
Some processes are same as in Murabahah and Ijarah
like document vetting by Shariah adviser, standardized
documentation etc.
51
SCM Of DM Should Ensure That:
►The steps of implementation should be defined in advance
i.e. Shirkah first, then Ijarah and then sale.
►This arrangement should not be used for cash financing.
►In a sale and DM back transaction, the sale of units will
start after completion of one year to avoid buyback
arrangement.
►Mechanism for early maturity and balloon payments should
be clearly specified.
52
Documents involved in D M transaction :
1. Offer Letter
2. Musharakah Agreement
■ Description of Asset, Percentage of share
3. Monthly Payment Agreement or Ijarah Agreement.
 Rental Payment Schedule
4. Undertaking to Purchase Musharakah Units
■ Unit purchase price
53
The relationship with fund providers is called Liability side
operation of Islamic banks.
Funds received by banks are of two types:
►Non Remunerative
■They are based on Qard whereby the principle amount is
guaranteed with no return or extra facilities.
54
►Remunerative
►They are of two types:
■General saving and time deposits
■Interbank deposits (Acceptance)
►Remunerative deposits are normally managed under:
► (1) Modarabah + Musharakah
► (2) Musharakah
► (3) Wakalah tul Istismar (see summary in coming
slide)
56
Depositors Bank
Pool of fund
Depositors'
contribution
(Deposits)
Financing & investmentsProfits or Loss
Distribution of profit or loss among multiple depositors
(Arbaabul Amwaal) through weightage system
A B C D E F G H
I J K L M N O P
Portfolio of assets
Share of Rabbul Maal
Share of
Mudarib
Distibuteable Profit (Gross Profit)
Mudarib's
contribution in as
balancing amount
57
Islamic Financial Institution
Mods of Deposits (fund providing) to Islamic bank
Mudarabah:
1. Mudarabah
is similar to
Musharakah
and differes
with it in
some
features;
2. Funds are
provided by
deposit
holders and
bank uses its
expertise;
3. The funds
available for
investment
are totally
provided by
Rabbul Maal;
Musharakah:
1. Bank rceives deposits
and mixes it own fund
with this deposit and
keep it in a pool which is
used to finance assets;
2. This mode is not in
use nowadays because
of some practical issue
in management of
deposits;
3. Bank and depositors
share in profit as per the
agreed PSR (Profit
Sharing Ration);
4. The loss is shared pro
rata in case of real loss;
5. Special facilities may
be offered to these
deposit holders.
Mudarabah +
Mushrakah:
1. This the
vastly used
model as it has
operational
flexibilities;
2. Fund are
provided by
Rabbul Mall(s)
but Mudarib
may add his
cpital to funds
in case of
need;
3. Islamic
banks use this
model to
manage their
deposit;
Amanah:
1. It was an
early mode
which was
used but due
to Shari'ah
issues it is not
in use
anymore;
2. Amanat
can not be
used by
Ameen and
he is not
responsible in
case of real
loss (that is
not caused by
his
negligance;
Qarz:
1. Qarz is used
for reception of
deposit in current
accounts;
2. Deposits in
current accounts
are non-
remunerative and
the return of
principal amount
is guaranteed;
3. No special
facilities are
allowed to these
deposit holders;
Wakalatul
Istithmaar:
1. This model is
in use in Islamic
banks inPakistan.
However Islamic
funds use this
model;
2. The fund
provider
(Muwakkil)
authrises his
agent (Wakeel)
fund user to
invest fund;
3. The agent
receives a fee as
remuneration +
an incentive;
SCM of Deposits should ensure that:
►No fixed return is committed with high value depositors.
►No extra privilege is given to current account holders.
►The actual status of the deposit is clearly mentioned in
the account opening document and in the
correspondence with the customer.
►The profit earned during the period has been distributed
according approved distribution formula.
58
►Profit distribution sheets of every tenure is approved
by Sharia Advisor.
►The profit is allocated using the concept of daily
product and weightages system.
► The relationship b/w bank & depositors and among
pool members are clearly explained and
documented.
See next slide for understanding:
59
60
Islamic Bank
Mudarabah + Musharakah
1. All the pool members are partners among each other.
2. This partnership is a Shirkatul A'qd (business
partnership) and not a Shirkatul Milk (joint ownership).
3. The partners' contribution to pool in different both
in terms of money and duration of investment.
4. The weightage system manages the Musharakah
among partners.
Mudarabah pool (pool of Depositors
Treasury acceptance also follow rules of general deposits.
Another mode of financing is also used for these
acceptance.
The mode “Wakalatul Istithmaar” fall under the rules of
fee based agency.
The risk and reward mechanism should be clearly
defined.
61
Q & A
62
‫ا‬ً‫کر‬ُ‫ش‬
63

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Shariah Compliance Guide

  • 1.
  • 2.
  • 3.
  • 4. PART 1 Introduction Strategic Importance Of Shariah Compliance Rulings Of OIC Islamic Fiqh Academy Globally Acceptable Shariah Standards AAOIFI Shariah Standards: What Is The Significance? Shariah Advisors Or Shariah Supervisors & their Roles
  • 5. PART 2 Shariah Compliance – A Theoretical Perspective Levels of Shariah Compliance Categories of Shariah compliance Banks’ Internal Shariah Controls Mode Based Shariah Compliance Controls Q & A
  • 6.  Shariah is the body of Islamic religious law.  The term means "way" or "path to the water source“.  It is the legal framework within which the public and private aspects of life are regulated and controlled based on Fiqh (Islamic principles of jurisprudence).  According to the modern definition, Shariah is the comprehensive body of Islamic laws that regulates the public and private aspects of the lives of the Muslims.
  • 7. O you who have believed, enter into Islam completely [and perfectly] and do not follow the footsteps of Satan. Indeed, he is to you a clear enemy.
  • 8. ْ‫ن‬َ‫ع‬‫ي‬ِ‫ب‬َ‫أ‬ْ‫د‬َّ‫م‬َ‫ح‬ُ‫م‬ِْ‫د‬‫ب‬َ‫ع‬ِْ َّ‫اَلل‬ِْ‫ن‬‫ب‬‫و‬ ِ‫ر‬‫م‬َ‫ع‬ِْ‫ن‬‫ب‬ِْ‫اص‬َ‫ع‬‫ال‬َْ‫ي‬ ِ‫ض‬َ‫ر‬ُْ َّ‫اَلل‬ْ‫ن‬َ‫ع‬،‫ا‬َ‫م‬ُ‫ه‬َْ‫ل‬‫ا‬َ‫ق‬: َْ‫ل‬‫ا‬َ‫ق‬ُْ‫ل‬‫و‬ُ‫س‬َ‫ر‬ِْ َّ‫اَلل‬‫صلى‬‫هللا‬‫عليه‬‫و‬‫سلم‬"َْ‫ل‬ْ‫ؤ‬ُ‫ي‬ُْ‫ن‬ِ‫م‬ْ‫م‬ُ‫ك‬ُ‫د‬َ‫ح‬َ‫أ‬‫ى‬َّ‫ت‬َ‫ح‬ُْ‫ك‬َ‫ي‬َْ‫ون‬ ُْ‫ه‬‫ا‬ َ‫و‬َ‫ه‬‫ا‬ً‫ع‬َ‫ب‬َ‫ت‬‫ا‬َ‫م‬ِ‫ل‬ُْ‫ت‬‫ئ‬ ِ‫ج‬ِْ‫ه‬ِ‫ب‬". ْ‫يث‬ِ‫د‬َ‫ح‬ْ‫ن‬َ‫س‬َ‫ح‬،‫يح‬ ِ‫ح‬َ‫ص‬ُْ‫ه‬‫َا‬‫ن‬‫ي‬ َ‫و‬ َ‫ر‬‫ي‬ِ‫ف‬َْ‫ت‬ِ‫ك‬ِْ‫ب‬‫ا‬"ِْ‫ة‬َّ‫ج‬ُ‫ح‬‫ال‬"ْ‫َاد‬‫ن‬‫س‬ِ‫إ‬ِ‫ب‬َْ‫ص‬ْ‫يح‬ ِ‫ح‬. The Messenger of Allah (peace and blessings of Allah be upon him) said, “None of you [truly] believes until his desires are subservient to that which I have brought.”
  • 9. Shariah Compliance means “ Adherence to the guidelines and rulings of Shariah in all aspects and manners”. An organization or person who claims to be a “Shariah Compliant” has to follow Shariah in its all Operations and all Activities. Shariah requires a Comprehensive Adherence as mentioned in above Ayah and Hadith and not a symbolic one.
  • 10. Compliance is “ The state of being in accordance with the laws of relevant Federal or Regional Authorities” In the context of Islamic finance, “ The state of the business operations of an IFI being in accordance with the relevant Shariah Rules and Guidelines issued by: 1. Shariah Ruling Body (AAOFIF) and formalized by a regulatory authorities (SBP) 2. Rulings of Shariah Adviser or Shariah Supervisory Boards.
  • 11. Adherence to Shariah is WAJIB on every Muslim and Islamic Financial Institution. Failure leads to disobedience of Allah and His Messenger (Peace be Upon Him). Failure leads to loss of income i.e. charity. Failure leads to reputational risk.
  • 12. 12
  • 13. 13 (IFSB), which is based in Kuala Lumpur, was officially inaugurated on 3rd November 2002 and started operations on 10th March 2003. It serves as an international standard-setting body of regulatory and supervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry. Since its inception, the IFSB has issued twenty- four Standards, Guiding Principles and Technical Note for the Islamic financial services industry.
  • 14.  AOIFI is an Islamic international autonomous non-for-profit corporate body that prepares accounting, auditing, governance, ethics and Sharia standards for IFIs and the industry.  AAOIFI has gained assuring support for the implementation of its standards, which are now adopted in the Kingdom of Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria.  The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom of Saudi Arabia, and South Africa have issued guidelines that are based on AAOIFI’s standards and pronouncements.
  • 15.  AAOIFI was established in accordance with the Agreement of Association which was signed by Islamic financial institutions on 1 Safar, 1410H corresponding to 26 February, 1990 in Algiers. Then, it was registered on 11 Ramadan 1411 corresponding to 27 March, 1991 in the State of Bahrain.  Total of 88 standards issued: (a) 48 on Shari’a, (b) 26 accounting, (c) 5 auditing standards, (d) 7 governance, (e) 2 codes of ethics. They now carry global status and acceptability and many financial regulatory authorities have adopted these standard.
  • 16. SBP has also adopted some standards after thorough discussions on variable forums (SAF, SBP SB, other department of SBP). Therefore, the Shariah compliance mechanism is done on the basis of these standards. The explanation of the standard and areas which are not covered in these standards, are covered by Shariah Board / Shariah advisers of the institutions.
  • 17.  The SB is to consider, decide and supervise all Shariah related matters of the IBI.  The SB is to develop a comprehensive Shariah Compliance Framework with in IBI.  Ensure prior approval for all products and services.  Ensure Shariah conformity for all SPMs, product structures, process flows and marketing tools.  SBMs have to review all internal Shariah audit and Shariah compliance reports for considering appropriate action.  SB’s decisions and rulings are in conformity with AAOIFI Shariah standards and Regulator. 17
  • 18. There are three levels of Shariah compliance: ►Top level (Strategic) ►Middle level (Tactical) ►Lower level (Operational) Top level Tactical level Operational level
  • 19. Strategic Level Or Top Level An important level where Shariah compliance becomes very crucial. In fact Shariah compliance is initiated from this level. Includes shareholders and top management relations. Cultural and behavioral issue of management. Shareholders engagement with other Haram businesses – lack of seriousness in Shariah compliance. ○Examples are foreign banks and local banks with Islamic windows.
  • 20. Top Level (Strategic): HR policies and other relationships. ■Marketing Strategies - Techniques ■Shariah governance – Shariah quality improvement system (Check lists & MISs for Products) ■Readiness for change.
  • 21. Middle Level (Tactical): ■Customer relationship ○Cheating and Lying ○Unattainable Promises ■Right and Obligation (customers and subordinates) ○Feeling of this responsibility ■Ethical motivation of employees
  • 22. Lower Level (Operational) ■Ethical responsibilities ○Very important here ■Behavior ■Awareness about the Islamic financial system; ○Product information ■Knowledge of pros and cons of the system ■Dealing with religious minded people
  • 23. 23 CEO Share holders Board of Directors Operational Level Tactical LevelTopLevel Head of department Vice HOD Vice HOD Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Head of department Vice HOD Vice HOD Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Head of department Vice HOD Vice HOD Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Head of department Vice HOD Vice HOD Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee Employee
  • 24.  Includes: ►All the financial services and products offered on asset side (customers to bank relation); ■Corporate, Commercial and Consumer structured assets – vanilla products; ■Specially structured products – Sukuk, syndicated transaction etc.; ►The general banking operations of Islamic banks on liability side (Depositors to bank relationship), and ►Interbank relationships with Islamic and non-Islamic financial institutions; ►Relationship with regulators; 24
  • 25. The relationship with all these fall in ambit of Shariah compliance. Funds placement with or funds reception from these stockholders must be Shariah compliant. Islamic modes of financing should be executed according to recommended methods, process-flows and manuals. 25 Islamic Financial Intermediary – Bank or Insurance Co. Islamic Funds Depositors Takaful SBP (SLR & CRR + IERS) Customers Conventional banks Conventional funds and Insurance cos
  • 26. Shariah compliance may be divided into three categories This division is just for the purpose of continuous practical application: (1)-Acceptable level: ■It is the minimum level that is required to become Shariah Compliant and Acceptable. ■Failure results non-Shariah compliant (Haram) status of the organization or activities 26
  • 27. Elements of Acceptable Level: ○Restraining from impermissible business activities The institution should not involve in any business or management activity which is not Halal ○Elimination of RIBA The institution should not go for an option where interest exists; ○Elimination of Gharar and all types of gambling; No involvement in Gharar is permissible; ○Implementing the Islamic laws of contract in normal course of business; 27
  • 28. Acceptable Level (Cont'd); ■Although at acceptable level Islamic banks remain in the ambit of Halal and Haram but some reservations in qualitative matters remain there in scholarly circles. ○Mimic transactions are example of this level. ○Some of transactions are in gray area although we can not call these transactions Haram. ○Examples are: Commodity Murabahah, Some credit card structures, Islamic lotteries etc. 28
  • 29. (2)-Satisfactory Level; ■This is a step forward level in assurance of Shariah compliance. ■The satisfactory level means the level of adherence to laws and rules that shows their identity as separate system; ■Failing to assure this level usually results in lack of acceptability and creates differences and debates both valid and invalid; 29
  • 30. Satisfactory Level (Cont'd); ■Comprehensive Shariah training; ○General Islamic banking training; ○Specific trainings – product wise trainings; ○Workshops and conferences; ■Shariah compliant marketing strategies and tactics; ○Advertisement themes; ○Wordings of advertisements; 30
  • 31. ■Satisfactory Level (Cont'd); ■Internal and external Shariah compliance; ○Revision of processes and system on continuous basis; ○Periodic revision of existing agreements and processes to ensure Shariah quality; ○The satisfactory level should always be preference of Islamic banks;
  • 32. ►3- Desirable Level: ■The desirable level for Islamic financial institutions means the level of adherence to guidelines o Islam that reflects Islamic values and features. ■This is although a difficult and a long run task but it is the main target for which whole system is developed. 32
  • 33. Desirable Level Cont: Features and Elements of Desirable Level: ○Product Innovation Copying and mimicking the conventional products does not reflect contribution of Islam financial system. 33
  • 34. ○Desirable Level Cont: ○Real involvement in trade and business activities. Symbolic and artificial involvement creates doubts about claims of Islamic banks. ○Less role of Agency, Gift and Rebates. ○Islamic values of equitable distribution of wealth in society. ○A very Longley waited change that is dream of ours. 34
  • 35. “Internal Sharia Control Mechanism” assures the compliance of Shariah guidelines and minimizes the risk of deviation in day to day transactions. Shariah department in coordination with compliance department should ensure that effective Shariah control mechanism is in place. The Management should be attentive to implementation of the recommended Shariah controls and to proper training of the staff. 35
  • 36. The Shariah control or compliance mechanism consists: ►(A)-Operational Control Strategy ■Involvement of SCD in approvals of the transactions. ■Credit and CAD processing / approval linkage with SCD approvals; ►(B)-Systematic Control Strategy ■Manuals, Process flows, SOPs, Check lists and forms. ■Quarterly, Monthly or weekly reporting of transactions. ■Assessment of possible deviations and their control. 36
  • 37. The SCM may vary with regards to: ►the nature of modes of financing. ►the nature of transaction (Consumer or Syndicate) ►the nature of business (easy or complex process business) 37
  • 38. The SCM may be divided with regards to modes of financing into FOUR categories: A. Trade-based mode of financing and their controls. ■Four modes fall under this: ○Murabahah ○Musawamah ○Salam ○ Istisna'a
  • 39. B. Rental-based mode of financing and its control: ■Ijarah comes under this header. C. Partnership based modes of financing and their control: ■Mudarabah and Musharakah come under this header; D. Combined modes of financing: ■DM falls in this category. 39
  • 40.  Murabahah being a vastly used mode of financing by Islamic banks, a detailed SCM is outlined here for it: ►Murabahah is a kind of sale where the seller (Islamic bank) discloses the cost of the sold goods and the added profit to customer. 40
  • 41. ►Points for Shariah Compliance of Murabahah Transaction; ■A list of Murabahah transaction executed by the Islamic Bank during the period under review. ■A representative sample of the transactions executed during the period and their documentation. ■Review the process flow and agreement prepared by the bank and approved by the Sharia Advisor. ■Ensure that all the agreements executed with customer are in compliance with the process flow and agreement approved by the Sharia advisor. 41
  • 42. Methodology and Approach of Shariah compliance assurance in Murabahah: ►Following are major steps of correct execution of Murabahah transaction: ■Pre Disbursement: ○Business analysis: Halal or Haram status. ■Business Structure Of The Parties: ○Ownership structure – both companies are not owned by one party who ultimately becomes buyer and seller in one time. ■Processing Difficulties (Transaction Is Not Possible In Terms Of Practicality): ○Perishable items and fast moving items have different modalities for correct Murabahah; 42
  • 43. ■Real Trade Possibility: ○Possibility of possession of goods ○Possibility of delivery of goods ○Possibility of on time offer and acceptance ○Possibility of physical inspection ○Mode of payment ○Possibility of specification and quantification of goods ■Check list & Process flow should be designed and filled properly and signed ■Specific Shariah approval in case of any exception ■Physical inspection where required 43
  • 44. Documentation ■Proper process flow of documents ■Standardized formats to avoid confusions ■Approved agreements by Shariah and legal ■Signing of Promise for purchase is essential here ○In case it is not signed, the customer may not be bound to buy the goods he ordered. ○Similarly bank can not ask him for any compensation of loss. 44
  • 45. ►Following documents are required for Murabahah A. General documents (one time documentation) and their execution; ○Master Murabahah agreement along with facility limit, tenure and terms and conditions;
  • 46. B. Transaction Based Document Execution: ■Purchase requisition ■Offer and acceptance ■Any other detail for transaction such as: ○Payment mode ○Payment tenure (monthly or quarterly etc.) ○The terms of the agreement are not changed except with the specific approval of the Sharia Advisor 46
  • 47. SCM For Murabahah Should Also Ensure That: ►The proper documentation has been executed. ►The charity account is in place to manage charity received from a customer in case of delayed payments / defaults. ►The Murabahah transaction is not used as buy back facility. ►The correct invoices have been received for the goods. ►The invoices are original and not back dated or conflict with date of Murabahah declaration. ►The offer & acceptance are correctly executed with details of goods purchased by agent. ►The sale is concluded correctly and the ownership as well as risk is transferred to the customer. 47
  • 48. Ijarah is a lease of a non consumable asset. The difference b/w conventional lease and Ijarah is segregate arrangement of asset transfer at the end of lease term. Shariah Control Mechanism Of Ijarah: Some processes are same as in Murabahah like document vetting by Shariah adviser, standardized documentation etc. 48
  • 49. SCM Of Ijarah Should Ensure : ►The proper documentation of the transaction. ► A charity account in place to manage charity. ►The asset is specified and known. ►The Ijarah period is known. ►A proper mechanism is agreed in case of variable rental and fixed rentals.. ►The Ijarah is concluded correctly and the usage right is transferred to the customer. ►The responsibility of asset risk is clearly known to both bank and customer. 49
  • 50. ►The nature of rentals is clearly known i.e. advance or arrears. ►The rental shall start after the delivery of the assets and not from the contract date or disbursement. ►Any evidence for assurance of asset delivery to the customer is in place e.g. delivery order or. ►The asset is transferred (by mean of sale or gift) through a separate contract at end of the lease term. 50
  • 51. DM is a hybrid product that comprises of Shirkah (joint ownership), Ijarah (Rental agreement) and Bai' (Sale). Rules of all these mode need be ensured in this product. Shariah Control Mechanism Of DM: Some processes are same as in Murabahah and Ijarah like document vetting by Shariah adviser, standardized documentation etc. 51
  • 52. SCM Of DM Should Ensure That: ►The steps of implementation should be defined in advance i.e. Shirkah first, then Ijarah and then sale. ►This arrangement should not be used for cash financing. ►In a sale and DM back transaction, the sale of units will start after completion of one year to avoid buyback arrangement. ►Mechanism for early maturity and balloon payments should be clearly specified. 52
  • 53. Documents involved in D M transaction : 1. Offer Letter 2. Musharakah Agreement ■ Description of Asset, Percentage of share 3. Monthly Payment Agreement or Ijarah Agreement.  Rental Payment Schedule 4. Undertaking to Purchase Musharakah Units ■ Unit purchase price 53
  • 54. The relationship with fund providers is called Liability side operation of Islamic banks. Funds received by banks are of two types: ►Non Remunerative ■They are based on Qard whereby the principle amount is guaranteed with no return or extra facilities. 54
  • 55. ►Remunerative ►They are of two types: ■General saving and time deposits ■Interbank deposits (Acceptance) ►Remunerative deposits are normally managed under: ► (1) Modarabah + Musharakah ► (2) Musharakah ► (3) Wakalah tul Istismar (see summary in coming slide)
  • 56. 56 Depositors Bank Pool of fund Depositors' contribution (Deposits) Financing & investmentsProfits or Loss Distribution of profit or loss among multiple depositors (Arbaabul Amwaal) through weightage system A B C D E F G H I J K L M N O P Portfolio of assets Share of Rabbul Maal Share of Mudarib Distibuteable Profit (Gross Profit) Mudarib's contribution in as balancing amount
  • 57. 57 Islamic Financial Institution Mods of Deposits (fund providing) to Islamic bank Mudarabah: 1. Mudarabah is similar to Musharakah and differes with it in some features; 2. Funds are provided by deposit holders and bank uses its expertise; 3. The funds available for investment are totally provided by Rabbul Maal; Musharakah: 1. Bank rceives deposits and mixes it own fund with this deposit and keep it in a pool which is used to finance assets; 2. This mode is not in use nowadays because of some practical issue in management of deposits; 3. Bank and depositors share in profit as per the agreed PSR (Profit Sharing Ration); 4. The loss is shared pro rata in case of real loss; 5. Special facilities may be offered to these deposit holders. Mudarabah + Mushrakah: 1. This the vastly used model as it has operational flexibilities; 2. Fund are provided by Rabbul Mall(s) but Mudarib may add his cpital to funds in case of need; 3. Islamic banks use this model to manage their deposit; Amanah: 1. It was an early mode which was used but due to Shari'ah issues it is not in use anymore; 2. Amanat can not be used by Ameen and he is not responsible in case of real loss (that is not caused by his negligance; Qarz: 1. Qarz is used for reception of deposit in current accounts; 2. Deposits in current accounts are non- remunerative and the return of principal amount is guaranteed; 3. No special facilities are allowed to these deposit holders; Wakalatul Istithmaar: 1. This model is in use in Islamic banks inPakistan. However Islamic funds use this model; 2. The fund provider (Muwakkil) authrises his agent (Wakeel) fund user to invest fund; 3. The agent receives a fee as remuneration + an incentive;
  • 58. SCM of Deposits should ensure that: ►No fixed return is committed with high value depositors. ►No extra privilege is given to current account holders. ►The actual status of the deposit is clearly mentioned in the account opening document and in the correspondence with the customer. ►The profit earned during the period has been distributed according approved distribution formula. 58
  • 59. ►Profit distribution sheets of every tenure is approved by Sharia Advisor. ►The profit is allocated using the concept of daily product and weightages system. ► The relationship b/w bank & depositors and among pool members are clearly explained and documented. See next slide for understanding: 59
  • 60. 60 Islamic Bank Mudarabah + Musharakah 1. All the pool members are partners among each other. 2. This partnership is a Shirkatul A'qd (business partnership) and not a Shirkatul Milk (joint ownership). 3. The partners' contribution to pool in different both in terms of money and duration of investment. 4. The weightage system manages the Musharakah among partners. Mudarabah pool (pool of Depositors
  • 61. Treasury acceptance also follow rules of general deposits. Another mode of financing is also used for these acceptance. The mode “Wakalatul Istithmaar” fall under the rules of fee based agency. The risk and reward mechanism should be clearly defined. 61