SHARIA AUDIT IN ISLAMIC FINANCIAL INSTITUTIONS.

INTRODUCTION

Sharia compliance audit or Sharia Audit is an important function within the Sharia Governance Framework of Islamic Banks. The audit is carried out to assess adequacy and efficiency of internal Sharia controls as well as assessing Sharia compliance status of the activities conducted by the bank.

SHARIAH AUDIT

Shariah Audit is a periodic activity. It is designed as a formal, structured process based on standard operating procedures and programs. It involves review of documents which entails going over a checklist to see whether or not documents are genuine and their entries are correct. The aim of the Shariah Audit is not to penalize for mistakes but in fact to ensure mistakes are learned from and improvements made accordingly and timely.

The Shariah Audit includes an evaluation of the product offerings, process flows, bank’s branch and head office environment, customer reading materials, staff knowledge, bank's communication channels and staff dress-code to see if it all complies with the Shari'ah guidelines issued by the Sharia supervisory board or Sharia Department. It entails staff interviews, particularly the branch staffs and operation manager’s to determine their knowledge and understanding of Islamic banking.

It also include a check on the methods of profit distribution and assigning weightages. At a financing/credit department, the audit determines the degree of Shariah compliance of financing transactions mainly execution of various Sharia'h documentations related to financing. At branch level, the audit focus on customer stransactions executed at branches, branch environment, customer reading materials, customer complaints and resolutions, staff knowledge and awareness with regards to function related Sharia guidelines and Islamic banking in general. Where need arises, the audit team may visit clients to determine whether or not customer are made aware of proper procedures which are in place and relates to Sharia'h.

Errors or weaknesses spotted during the audit if any are presented in the Shariah Audit Report. Errors or weaknesses or failure to comply with relevant Sharia guidelines when spotted by staffs prior to audit must also be reported to the Product Development and Shariah Compliance team which will examine the cases and report accordingly and timely to relevant authority. If Staffs are not able to freely communicate to errors or weaknesses to Sharia Department, then it is likely that the problem never may get to be resolved and the bank may suffer strategic and reputation risk.

Once reported, the error or weaknesses serves as a precedent to help avoid similar mistakes in the future and whenever it is shared to other branches it informs other branches on measures to prevent them from repeating the same errors.

This is the synergy required between the different teams within the departments that enables the Islamic bank to function effectively as a whole — its perspective, objectives and activities directed to one goal — ensuring 100% Shariah compliance and ultimately 100% customer satisfaction.

As an industry best practice and as guideline given by top scholars in the field, it is strongly recommended that every year a Shariah Audit must be conducted for all the financing units, departments or branches in a bank. Transactions or activities within each unit must be checked via sampling. It is also recommended that a Shariah review is conducted at the time when the financing limits are renewed annually.

The Product Development and Shariah Compliance unit has responsibility to check on selected sample transactions for each client to determine their conformity to Shari'ah guidelines. This process of review exists to avoid mistakes that would otherwise show up in an audit.

Post Audit Corrective Measures

If the Shariah Audit report discloses a serious error or weakness that requires fixing, the transaction should be stopped or put on hold. The transaction may be allowed to continue but only after the correction of error or with a revised process flow as advised by Product Development and Sharia'h compliance Department.

The cause of the error or weakness must be investigated by respective staff/manager/ head of the department to determine the appropriate course of action — was it the bank officer’s mistake? Was the financing mode prescribed inappropriate? Was there inadequate descriptions on the process to be followed?

If the transaction is impermissible and confirmed to be so by the Sharia Supervisory Board (or Sharia Advisor with such a mandate), the corresponding income should be transferred to the charity account. Ideally, disciplinary measures must be prescribed if the mistake is intentional. In case the error is the client’s, it should be investigated whether it occurred out of a lack of awareness or the client’s indifference to Shariah prescriptions.

Disclosures & Annual Shariah Report

All the major activities of the bank’s audited by Shariah department and the results of the Shariah audit are disclosed to the management and in the Shariah Board’s or Shariah Advisor’s which later on issue Shariah report published within the bank’s Annual Report. The format of such report is provided by Auditing and Accounting Organization for Islamic Financial Intitutions (AAOIFI) Governance Standard No 1.

However, Sharia Supervisory Board or Sharia'h Advisor may construct this report in a different format as it deems fit or based on best practices. For example, the Shariah Report may state the number of Department and branches audited and the resultant findings. It may also mention the amounts transferred to the charity account owed to flawed transactions and where the charity is distributed. Major errors too may be disclosed along with the actions recommended to rectify them. The report may also disclose the research undertaken, the new products developed, the number of employee and client training sessions conducted. It may also disclose the scope of the audit; the transactions covered. It may include an overall branch assessment and a review of how profit was distributed and the employees’ level of Islamic banking knowledge.

All these disclosures offer transparency and keep the bank’s clients and shareholders informed of the bank’s activities and the measures it takes to ensure continued Shariah-compliance. The Sharia Department is responsible to follow up on his recommendations or agreed actions in the subsequent audit.

Rating

As part of the industry best practice an Islamic bank must have two rating processes Shariah Audit rating and employee rating.

Shariah Audit Rating

The bank’s branches/departments/functions must be rated after Shariah Audits using an efficient rating system, like a five tier rating system (e.g. Excellent, Above Average, Good, Below Average, Poor) and the result of the Shariah audits should be linked to the annual appraisal of the branch and concerned staff.

For instance if a unit is rated “Poor” it affects its appraisal, promotions and increments and if a unit is rated “Excellent” it earns some type of reward or other performance enhancement incentive. A unit rated “Poor” is also given extra support to bring it up-to-date with the latest training and performance improving activities.

Employee Rating

Starting from the CEO to the cashier at the front desk, ensuring Shariah-compliance is everyone’s job. And it is strongly suggested that in the employees’ annual appraisals due weightage must be given to the Shariah compliance mindset, knowledge and commitment to Shariah compliance. Institutionalizing a penalty and reward system is a must to ensure good performance at both the branch and employee level.

Note:
This article was written with inputs from Sharia Compliance Report published by Ethica Institute of Islamic Finance.

Tanzania featured in IRTI Islamic Social Finance Report 2015

Today, IRTI released the report during a conference on "Awqaf, Zakah and Ethical Microfinance as tools for Empowerment", organised by the South African National Zakah Fund (SANZAF) in Pretoria, South Africa.

This edition of the ISFR focuses on the Sub-Saharan Africa, outlining the regional trends and prospects as well as proposing policy recommendations for the Islamic social finance sector, which includes Zakat, Waqf and Islamic microfinance.

It analysed the regulatory environments and practices in six selected countries, namely Sudan, Nigeria, Kenya, Mauritius, South Africa and Tanzania.

Findings show that Sudan, Nigeria and South Africa can easily generate adequate resources for poverty alleviation through Zakat, while Islamic social finance also has great potential for curbing poverty in the three other countries studied.

The report estimates the annual Zakat potential in Sudan, Nigeria and South Africa at about $1,843.51 million, $8,776.45 million and $178.87 million respectively. However, the actual collection in 2013 was $220 million, $3 million and $100 million respectively.

Key recommendations include enhancing the legal frameworks for Islamic social finance; institutionalizing zakah collection and distribution; offering unique microfinance products for smallholder farmers; and allowing waqf creation by non-Muslims.

The report notes that collection of in-kind Zakat from locations like farms comes with high costs, and therefore recommends a review of the cap on operational costs, given the predominance of agriculture in the countries studied.

Findings further show that while compulsory Zakat remittances obviously boost collection levels, as in Sudan, such policy has not been successful in parts of Nigeria because of lack of enforcement mechanism. Incentives in the form of tax rebates for Zakat payments have also helped in Sudan.

In his comments on the report, IRTI Director General Prof. Mohamed Azmi Omar said, "By focusing on Sub-Saharan Africa, we hope that this issue of the ISFR will satisfy a long-felt need for adequate and relevant information that will help towards instituting an enabling environment for the Islamic social finance sector in the region."

IRTI instituted the ISFR series last year with the aim of providing relevant data and policy roadmaps that could assist the campaign to end poverty in all its forms globally.

The maiden edition focused on South Asian and South East Asian countries, including Indonesia, Malaysia, Singapore, Brunei Darussalam, India, Pakistan and Bangladesh. Subsequent editions will study other regions, the IRTI Director General said.

End.

In sha Allah, I shall bring to you specific details on Tanzania once i get the full report.

Shariah risk: Measurement and treatment

By: Hassan Ahmed Yusuf is the operational risk manager at Masraf Al Rayan.

Islamic banking and finance has experienced tremendous multidimensional growth in the last 30 years and this is clear from the product engineering that has fl ooded the market. Since the inception of Islamic banking and fi nance, the focus has been on removing interest from the system, as some outlook changes and many operational changes were left intact based on the conventional system.

As we have seen from recent court cases and defaults, there is a clear shift taking place in the Islamic fi nance industry, to focus on the robust development of operational matt ers to align with Islamic finance requirements. Part of this includes understanding the risks in Islamic fi nance from a Shariah point of view as Shariah has its own mechanism to address and mitigate risks.

Sound and proper Shariah risk management starts with understanding the basic concepts of managing risks; Shariah guidelines that relate to ‘muamalat’; and how to deal with risks and its impact.

Clear and accurate understanding of these concepts and the correction of any misconception surrounding the fundamentals and assumptions of Shariah risk provides clear procedural guidelines in eliminating, mitigating or transferring Shariah risk and off ers robust, effective and efficient oversight management of Shariah risk.

Risk is an event that relates to an uncertainty with a measurable impact and risk constitutes the level of uncertainty of the event which has an unfavorable outcome or adverse consequences. In other words, the measurement of risk is essential and quantifiable; it is impractical to mitigate risk if risk cannot be measured.

Shariah risk treatment
Shariah risk is the risk that arises from a lack of compliance to Shariah rules and regulations in relation to Islamic financial institutions or any entity that undertakes Islamic financial services. Shariah is the basis of Islamic financial institutions to undertake and process their operations through binding contracts and specific formats dictated by Shariah guidelines and it is one of the fundamental distinctions between Islamic financial institutions and their conventional counterparts.

Shariah risk can appear in different places and stages throughout the process of product implementation and the intensity of the impact of Shariah risk depends on the degree of Shariah divergence in a particular stage or place in the life cycle of the product.

For example, a receivable commission was discovered to be part of a particular project approved by a Shariah board, but the commission itself was not part of the approved fees allowed by the Shariah board (there are certain fees that are not allowed by Shariah boards: including management fees, early sett lement fees, commitment fees, extension fees, administration fees and non-utilization fees). The treatment of such a violation involves cancelling the commission only, and it does not affect the rest of the transaction or project involved, as this type of risk has a minimum impact at this stage. However, there are certain cases that
can bring a whole institution to its knees and have a high reputational impact, although this rarely happens.

Even if this type of risk is realized (depending on the stage of risk occurrence), there are techniques and methods in Shariah for its treatment, as Shariah has an embedded mechanism to protect from adverse and negative consequences that can affect the general interests of society.

There are certain principles in Shariah that provide a direction for certain situations, based on the well-known legal maxim that necessity permits prohibitions. It is part of the fiqh to understand and deduce accordingly from the circumstances that surround the whole case. Another Shariah mechanism which is frequently used is the fiqh principle based on the famous narration “no
harm and no reciprocating harm.” Maslahaor public interest is involved to permit or prohibit something based on public benefit. For example, this can be applicable where the wealth of shareholders is wiped out or reduced to a low level due to lack of conformation to a Shariah principle. In a practical sense, this can be used for certain risks that have adverse consequences for a larger segment of society.

Another fi qh ruling that can be used is where the risk is inevitable but the effect varies depending on the outcome, and in this case Shariah encourages the acceptance of a type of risk, based on choosing the risk that has the least impact. In Islamic fi nance, this could be applied to a transaction where the acceptance of certain risks are unavoidable: such as penalty fees where the fees must be paid or the project risks cancellation.

There is another fi qh understanding where if there is a part of the transaction that is deemed impure, fiqh will judge based on the quantity that is considered impure or deemed illegal. This is based on a well-known fi qh ruling that purity, ‘tahara’, is not aff ected by a small level of impurity if it is restricted to a certain level (a known quantity).

Thus in Islamic finance, regarding investing in mutual or equity funds, if riba interest involvement is 1-5%, it doesn’t aff ect the other 95% which is considered permissible: based on the above explanation that a small impurity does not influence or affect the larger part of purity and since the percentage of impurity is well-known in financial terms, it is taken out of the transaction and it can be segregated from the rest of the transaction.

The above scenarios are given to highlight that Shariah has mechanisms to deal with risks depending on the level or stage, quantity and consequences of the event. Having a comprehensive understanding of this background may help in mitigating the Shariah risk, based on the stage of occurrence. It should not be thought that everything related to Shariah risk can have a ready-made answer. However, it must be stressed that Shariah risk remedies are widely available and there are a variety of options.

Shariah risk measurements
Financial products off ered by Islamic financial institutions are diff erent from those off ered by their conventional counterparts. Shariah risk elements occur in different places, such as pre- and post structuring a product and its life cycle.

The elements that constitute Shariah risk have different levels of impact subject to the article or the clause that is breached, and depend on the stages and places of risk occurrence.

The most frequent risks are in post-implementation, and some of these risk occurrences, such as missing dates in contracts can happen frequently due to of human error. Shariah dates are an essential component in Islamic finance contracts as the ownership
transfer is checked through dates: and in Islamic finance no sale can take place without the ownership right. There are tremendously rich resources available in dealing with all types of risk in Islamic banking finance, but the area urgently needs more research on how Shariah embedded mechanisms can be used by the Islamic finance industry to avoid and mitigate risk.

Making Islamic finance beneficial for future generations.

By Farouk Abdullah Alwyni, the executive director of the international banking and financial institutions division at Bank Muamalat Indonesia.

Islamic finance is now being steadily practiced in many parts of the world, including the Gulf region, Southeast Asia, Europe, America and Australia. Many stand-alone Islamic financial institutions, both banks and non-banks, have been set up; and along with this trend many major western financial institutions have established their own Islamic windows.

The question now is whether the growth of Islamic fi nance is really contributing to the creation of a more ethical financial
sector, more sustainable development, and a more equitable economy? Some Islamic finance researchers have already expressed concern that Islamic finance, especially in the form of Islamic banking, has just become a carbon copy of conventional banking: where most of the dominant types of financing are in actual fact just conventional debt financing structures in Murabahah or Ijarah form.

However, the real debate actually lies in the challenge of integrating the form with the substance of Islamic finance. Without its substance, Islamic fi nance would be just another type of fi nance, losing its moral and ethical spirit. It is also important to note that Islamic finance as practiced by Islamic fi nancial institutions, at the end of the day is still a profi tmaking enterprise.

There are shareholders and depositors who expect to receive profit through using Islamic financial institutions. Here, of course, we cannot contradict between the social and moral mission of Islamic finance and profit-oriented Islamic financial institutions. Without generating profit, Islamic financial institutions would not be able to sustain their existence.

So how can the Islamic financial institutions differentiate themselves from conventional financial institutions? Here,the challenge is how Islamic financial institutions can project themselves as value-based institutions with objectives greater and purer than simply achieving profit.

Profits issue
Actually, under the present circumstances, there is a possibility of convergence between modern conventional financial institutions
and Islamic financial institutions in terms of spirit. Nowadays, we are seeing increasing numbers of major international financial institutions attempting to reconcile the drive for profit with the need for social responsibility. Some major financial institutions are making considerable efforts to walk the fi ne line between conscience and profit, and to recognize that not everything important in the world can be counted.

So it is not necessarily reinventing the wheel for Islamic fi nancial institutions to stay true to the foundations of their establishment, and to be consistent with Shariah principles. By keeping their commitment to the Shariah spirit, Islamic financial institutions will be at the forefront of future financial institutional development. Islamic financial institutions will be the embodiment of the concept of sustainable development and caring economics, and this will give them a long-term advantage as corporations that refuse to compromise their values for short-term profi ts.

Islamic financial institutions should treat profi ts as a by-product, rather than an ultimate goal. The ultimate goal is to add
value, to contribute to the creation of a more sustainable world and to improve human civilization. In short, Islamic financial institutions should aspire to greater goals, and let profit look after itself.

However, in a world dominated by short-term thinking, to realize these aspirations is not that simple. It will need enlightened shareholders and understanding, expert management to subscribe to and achieve these concepts. These are the key people who must understand the idea that establishing Islamic financial institutions as a real and influential force for economic good will need a commitment beyond profit. Again, this concept should be nothing new.

In Jim Collins’ two remarkable researchbased books, ‘Good to Great’ and ‘Built to Last’ (together with Jerr Poras), he demonstrates how many enduring and profitable companies in the US operate by viewing profit not as a sole objective, but instead as a positive result. The research shows that a ‘bigger objective’ orientation can be a successful characteristic of major international companies.

Conclusion
By following this ethos, Islamic financial institutions could position themselves not only as Shariah compliant profit-making entities, but as entities willing and able to contribute to a more sustainable,equitable and caring economic system.

BETTER LIFE NOT POSSIBLE WITHOUT FINANCIAL INCLUSION.

On 12 December 2013, Tanzania launched National Financial Inclusion Framework. Keynote speech was delivered by H.M Queen Maxima of Nerthelands which concluded with 'A Better life for every Tanzanian is not possible without financial inclusion.' Before her, Prof. Ndulu remarked that 'Financial stakeholders realized that financial inclusion couldn’t be achieved with everyone working in silos. Rather it requires a concerted cooperative approach that will be used to address the challenges of financial inclusion in Tanzania systematically and in a coordinated manner.'

This article is a humble attempt to add value to the framework and action plan particularly on sections that addresses what needs to be done and how to do it.

Significance, Proportion and Commitment to Financial Inclusion.

To quote Prof. Ndulu words "Financial inclusion is important to the economy, it enables improving the welfare of the poor, - contribute to financial stability; and to growth of micro-business that ultimately stimulate growth of other sectors in the economy."

"Tanzania has made significant strides to enhance the proportion of adult population who are formally included (adults with accounts in formal financial institutions). In 2006 the proportion stood at 9%, 12% in 2009 and in 2012 it was 17%, or 22% formal inclusion if we include SACCOS. Cognizance of this low rate of formal financial inclusion, we identified a number of barriers that account for such state of affairs. These include: supply side barriers ranging from, high interest rates, services that don’t meet demand side needs, costs, to inefficiencies of service delivery. Demand side barriers include, information asymmetry, irregular income patterns, and financial literacy. Structural and regulatory barriers include, stringent or lack of proportionate requirements for client on-boarding, lack of regulatory framework for broad based micro-finance services, lack of centralized national identification system to mention but a few."

"In order to build impetus and push for acceleration of financial inclusion we made an international commitment under the AFI auspices (the Maya Declaration) to increase formal access of financial services to 50% by 2015."

Key Focus Areas.

According to the Prof Ndulu, in order to attain financial inclusion over the three year period from 2013, the priority areas for implementation include:

1. Proximity: Enhancing and implementing access channels, such as Agent banking, mobile telephony financial services, point of sales, stand alone ATMs, POS and a regulatory framework that creates conducive environment for growth of financial inclusion;

2. Robust Electronic Platforms: Improving, developing ICT payment platforms that facilitate cost effective and secure access to financial services;

3. Robust information and easy client on-boarding: Implementing, monitoring and enhancing use of credit bureaus, proportionate Know Your Customer requirements and improved ID system that is linked to financial systems; and

4. Informed customers and consumer protection: Implement financial consumer protection mechanism and national financial education framework.

Above mentioned key focus areas, partly address each barriers and leave other barriers unresolved. Forexample; supply side barriers such as high interest rates and services that don't meet demand side needs are left in the action plan. While these two among others are major obstacles towards financial inclusion specifically to Muslims that requires urgent action plan to address.

Can Islamic Finance Help?

Islamic finance reduce the role of interest rate to zero buy eliminating it as a price of capital and replace it with trade profits and equity based finance which demands profit and loss share. By getting financial sector involved in business, a direct link between financial economy and real economy is forged yielding stable economic results as well as evenly share of risks between financial institutions and customers.

One of the greatest benefit of Islamic finance is that it meets both social/religious and economic motives of both financial institutions and customers in a way that is beneficial to both. Islamic Finance products attracts both religious sensitive and ethical businesses minds deal with financial institutions in manner that is beneficial to the economy. Products offered by Islamic Finance could to larger extent if offered via effective and efficient delivery platform can bring in significant people to the formal financial sector.

However, it should be noted that much of what Islamic finance institutions appear to have done to increase financial inclusion focused mostly on Urban population and unless there is proper measures to address demand side as well as structural and regulatory barriers, insignificant outcome on financial inclusion will result as the case with conventional financial institutions at present.