This document discusses Shariah non-compliance risk in Islamic finance. It begins by defining Shariah non-compliance risk as the risk arising from a failure of Islamic banks to comply with Shariah rules and principles as determined by their Shariah boards. This can result in contracts being cancelled and income not being recognized. The document then outlines various measures that can be taken to manage this risk, such as ensuring contracts are structured to fulfill the pillars of a valid Islamic contract. Several examples of potential Shariah non-compliance in contracts like tawarruq, mudharabah and istisna' are also provided.

1. RISK MANAGEMENT
IN
ISLAMIC FINANCE
Mahyuddin Khalid

2. Shariah Non-Compliance Risk
Content
What Is Shariah Non-compliance
Risk?
Measures To Manage Shariah Non-
Compliance Risk
Shariah Non-Compliances Risk
Profile for Certain Shariah Contract
Examples Of Shariah Non-
compliance Events
Learning Outcome
• To clarify Shariah non-compliance risk
in Islamic finance
• To expose the rules and principle of
shariah that required in Islamic finance
• To show the examples of Shariah non-
compliance events in islamic finance
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3. Introduction
There are various opinions and interpretations in the
discussion of Shariah non-compliance risk (SNCR).
The element of subjectivity is unavoidable, some Shariah
advisers may consider a particular activity as being shariah
non-compliant, while others might take a different view.
So, we refer to shariah standards that were accepted as
international standards by the Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI).
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4. What Is Shariah Non-Compliance Risk?
The Islamic Financial Service Board (IFSB) defines the SNCR
as the risk arising from Islamic banks’ failure to comply
with the Shariah rules and principles determined by the
Shariah board or the relevant body in the jurisdiction in
which the Islamic finance operates.
The failure to comply with such principles will result in the
transaction being cancelled, and hence the income cannot
be recognised.
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5. Shariah compliance is a consistent process which should be
maintained at all times, and such compliance requirements
must permeate throughout the Islamic finance’s
organisation, products and activities.
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6. SNC Risk Measurement
SNC Risk can be divided into three (3) types
 Severe
 SNC events lead to invalidation of contracts and non recognition of
income
 Medium
 Defective contract that hinders enforceability
 Tolerable
 Events that do not lead to consequences mentioned under high &
medium type of risk
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7. Shariah Non-Compliance Risk in Islamic Banks
 Islamic banks are exposed to risk relating to Shariah non-
compliance risks and also to reputational risk.
 These risk exposes Islamic banks to fund providers’ withdrawals,
loss of income or voiding contracts leading to a diminished
reputation or the limitation of business opportunities.
 Islamic banks shall at all times comply with the Shariah rules
and principles as determined by the shariah board with respect
to products, activities and contract documentation.
 Islamic banks shall undertake a Shariah compliance review.
 Islamic banks shall keep track of income not recognized arising
out of Shariah non-compliance.
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8. The Condition of Pillars in Contract
 The contracting parties (Buyer & Seller)
 possess legal capacity (ahliyyah)
 Must have legal authority (wilayah) to execute the contract
 For example has sound mind, an adult, rational and able to be held
accountable
 The subject matter (ma’qud ‘alaih)
 should be in the form of a valuable asset
 according to the Sharīʻah
 free from uncertainty (gharar), known by both parties,
 recognised by the Sharīʻah, and
 in existence during the contract’s session.
 Offer and acceptance
 must be clear and understandable, consistent and continuous.
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9.  In addition, the contract should be free from prohibitive
elements such as,
 riba
 duress (ikrah)
 mistake (ghalaṭ)
 inequality (ghubn)
 deception (taghrir)
 illegal goods or illegal assets.
 Failure to satisfy the essential elements of a contract and the
necessary requirements renders the contract invalid
 Hence the risk of Sharīʻah non-compliance will arise.
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10. Measures To Manage Shariah Non-Compliance Risk
Aqad based
Maqasid shariah
Financial reporting
Legal documentation clearly stating elements of riba-free or shariah compliant
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11. Measures To Manage Shariah Non-Compliance Risk
Aqad based
 Fulfil aqad for each transaction; agents of contract (‘aqidani)
objectives of contract, subject matter (ma’qud ‘alaih) and offer
and acceptance (sighah).
Maqasid shariah
 a transaction must produce more benefits than harm to the
society.
 For instance, BBA has become not acceptable due to several
intolerable issues which considered harmful;
 In abandoned housing project, the bank is the seller. However, the buyer
does not have any recourse to the bank, thus need to continue instalments
 When customer first sells the house to the bank, it does not own the
property because he only pays a portion. This actually has violated the
aqad.
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12. Measures To Manage Shariah Non-Compliance
Risk
Financial reporting
 IFI activities should be reflected in their financial reporting
 The aqad performed should be properly recorded in financial
documents
 E.g. in Murabahah transaction, the relevant inventories should be
reflected in financial reporting before sales to third parties
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13. Measures To Manage Shariah Non-Compliance Risk
 Legal documentation clearly stating elements of riba-free or
shariah compliant
 Islamic banking cases have been published in various law reports, also
been quoted and reported e.g. BBA financing
 1st phase: 1994-2002-- jurisdictions favour Islamic banks
 e.g. the case of BBA facility of BIMB vs. Adnan Omar, the court ruled on the basis
that contracting parties are bound to terms & condition of contracts, overlooked
on the issue of non-shariah elements in BBA.
 2nd phase: 2003-2007 – jurisdictions examine underlying principles of
offered facility
 e.g. earlier jurisdiction is criticised for applying classic common law approach
whereas Islamic banking is different. Critical examination of contracts is presented
from both legal and shariah aspects.
 3rd phase: 2008 onwards –
 Issue: Defendants were asked to pay full amount of selling price in case of default.
The court ordered the plaintiffs to seek price closest to the market price and o
return original facility they had extended
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14. Shariah Non-Compliances Risk Profile for Certain
Shariah Contract
Basically vary from one contract to another, because each
contract has a specific feature, nature and requirement.
TAWARRUQ
MUDHARABAH
ISTISNA’
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15. Shariah Non-Compliances Risk in Tawarruq
 Al-Ghazali identified potential incidents of Shariah non-compliance in the tawarruq
transaction as follows:
 The tawarruq arrangement is used to grant financing facilities to individual or non-individual
entities whose activities explicitly involve Shariah non-compliant elements, such as riba-
based transactions, liquor production, gambling and brothels.
 While using the bank’s name, the bank’s staff are engaged in Sharīʻah noncompliant activities
with clients.
 The commodity and/or collateral used for the tawarruq arrangement is Sharīʻah non-
compliant.
 The contract is executed before the bank possesses the commodity.
 The series of sale transactions does not follow the sequential process appropriately.
 The terms and conditions are not properly and clearly stated, which may lead to
misinterpretation during the contract process.
 The appointment of an agent is arranged prior to the commodity possession, which may
lead to fictitious issues.
 The disbursement of facility is done before the contract is executed.
 The compensation (taʻwīḍ) for late payment does not reflect actual losses.
 The execution of debt rollover in restructuring and rescheduling.
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16. Shariah Non-Compliances Risk in Istisna’
 The parties entered are ineligible to execute the contract.
 The asset is not properly specified in the agreement.
 The istiṣnāʻ asset to be constructed and/or its purpose is not
Sharīʻah compliant.
 The istiṣnāʻ asset is already available or completed at the time
of execution of the istiṣnāʻ contract.
 The parties have failed to determine or agree on the price at
the time of execution of the istiṣnāʻ contract.
 The manufacturer unilaterally increases the price of the istiṣnāʻ
asset as a result of a request for extension of the payment
period.
 The manufacturer fails to adhere to the conditions stipulated by
the buyer.
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17.  The time of delivery is not specified and agreed at the time of
execution of the istiṣnāʻ contract.
 The punitive condition imposed by the buyer on the
manufacturer due to late delivery is not based on the estimated
loss incurred.
 The manufacturer stipulates a condition to waive his liability for
an incomplete istiṣnāʻ asset or a defective asset.
 The buyer sells to another party the istiṣnāʻ asset before he
takes possession of the asset to another party.
 The seller (bank) grants a financing facility under an istiṣnāʻ
contract for the completed asset.
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18. Shariah Non-Compliances Risk in Mudharabah
 The muḍārib does not adhere to the terms and conditions stipulated
by the capital provider (rabb al-māl).
 The muḍārib does not act in the interest of the capital provider.
 The capital provider stipulates a condition to guarantee the capital
and/or profit.
 The capital value is not determined and agreed at the time of
execution of the contract.
 The profit-sharing ratio is not agreed and determined at the time of
execution of the contract.
 The profit is linked to the amount of muḍārabah capital.
 The muḍārabah contract stipulates that any loss in the project will be
borne by the capital provider, or by some capital providers in the
case of multiple capital providers.
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19. Examples Of Shariah Non-compliance Events
Shariah Contract
Involved
Description of Event
Tawarruq • The asset is sold to the customer before the bank purchases the asset from
the broker/platform.
• The facility is disbursed before the contract is executed.
• There is no wakālah arrangement involved in the commodity murābaḥah
transaction.
• The price is mistakenly disclosed to the customer.
• The legal document involves a provision that restricts the customer, as the
purchaser, from taking delivery of the commodity.
• The financing facility is used for Shariah non-compliant purposes.
• There is no evidence of commodity trading.
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20. Shariah Contract
Involved
Description of Event
Istisna • In some legal documentation, it is found that the bank as the seller has
required the customer to accept the constructed project/property under
istiṣnāʻ contract on an “as is, where is” basis
Mudarabah • The documents contain a clause indicating the capital guarantee to the
capital provider.
• The profit is distributed based on an indicative rate, not on the actual
performance of the venture or the actual profit realised.
• Client activities are proven to be Shariah non-compliant.
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21. Some Impact of Shari’ah Non-Compliance Risk
 Slowdown of global Sukuk issuance.
 By the end of 2008, global Sukuk issuance had declined by
more than 50% compared to 2007.
 Chairman of the AAOIFI Shari’ah board- criticized a common
form of sukuk that apparently violates the Sharia-compliant
principles surrounding risk and profit-sharing. He estimated
that up to 85% of Gulf Sukuk structures were not Shari’ah-
compliant.
 AAOIFI made a recommendation to Islamic finance market
participants to refrain from issuing Sukuk structures that have a
purchase undertaking or guarantee from the Sukuk issuer to
repurchase at a future date at a specific price.
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22. Mahyuddin Khalid
End of Chapter
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