The Shari’ah Compliance Audit in Islamic Banking

NEWHORIZON, IIBI LECTURES

Defining Shari’ah

Mr Alamad opened this lecture by defining Shari’ah compliance. Shari’ah is the divine law as revealed in the Qu’ran and Sunnah, the prophetic traditions of Muhammad (pbuh) consisting of his sayings, practices and tacit approvals and disapprovals of the actions of his companions at that time. That leads us to the sources of Shari’ah, which are important, because they are used by Shari’ah scholars and Islamic jurists to extract Shari’ah rulings or address issues in relation to Islamic finance. They will refer, first and foremost to the primary sources, the Qu’ran and the Sunnah and also to secondary sources.


The Qu’ran and Sunnah contain the constant rules that do not change and are unaffected by time or place. For example, the Qu’ran states clearly that usury is prohibited. There are also some flexible Shari’ah rulings that Islamic scholars can use to address new issues. Sunnah as a primary source of Shari’ah addresses some of the issues raised in the Qu’ran and expands on them to some extent. It provides the tools to address new issues raised by Islamic finance.

The secondary sources of Shari’ah are contained in Ijma, which is the consensus of qualified scholars. There are some Islamic bodies, which to some extent represent the concept of Ijma such as AAOIFI and the Islamic Fiqh Academy. Both of these bodies comprise Islamic scholars representing the Muslim world. They meet on a regular basis to discuss new issues that they need to research and make Shari’ah rulings about them. As a result of their activities around 50 standards have been issued by AAOIFI regarding Islamic financial institutions. Those standards, however, do not address every issue that Islamic banks may face. For example, Islamic banks operating in the UK may face issues different from those faced by their counterparts in the GCC or Malaysia. It is then the role of the bank’s Shari’ah supervisory committee to address those issues based on the constant Shari’ah rules set out in the Qu’ran and Sunnah.

Another instrument is analogical reasoning or qiyas. It is based on taking an existing issue in the Qu’ran and Sunnah, analysing the rationale of this issue and comparing it to the new issue. If the new issue has the same rationale as the existing issue, it will have the same ruling. Take for example the drinking of alcohol. It is clearly forbidden in the Qu’ran. Scholars at the time explored the rationale for forbidding alcohol and concluded that intoxication led to people being unaware of their surroundings, becoming aggressive, etc; drinking alcohol has negative consequences. The Qu’ran, however, recognised that there are some benefits. People trade in it and make profits, but the harm coming from drinking outweigh these benefits and that is why Muslims were forbidden to drink alcohol.

Today there are different kinds of drugs such as heroin and cocaine, but there is no specific ruling in the Qu’ran or Sunnah regarding these drugs. When the rationale was examined, however, it was very similar to alcohol, so scholars applied the ruling relating to alcohol to drugs.

Qiyas could be used in Islamic finance to deduce a Shari’ah ruling say for new products. Islamic banks, for example, have to manage risks. Conventional banks use interest rate swap agreements to manage risk, but on the basis of qiyas Islamic banks cannot use these because of the ban on riba.

There is also ijtihad or personal interpretation. That is basically the ijtihad of a bank’s Shari’ah supervisory committee relating to a particular issue. The committee will issue a fatwa for the bank to follow.

There are some other secondary sources which say that if there are benefits to be derived from a products or service, a social good and there is nothing in Shari’ah specifically forbidding it, then that will be permitted.

Two Types of Shari’ah

Islamic jurists define Shari’ah into two types. The first is called fiqh or jurisprudence and defines the relationship between man and God. The other type relates to transactions, buying and selling and that is the one that relates to Islamic finance.

The difference between the two is that Shari’ah is the law and jurisprudence or fiqh is the understanding of this law. To take a simple example, the NHS bill currently negotiating its way through the UK Parliament will eventually become a law, but that law will not address every single detail of the day-to-day operation of the NHS. When it passes into the hands of NHS Trusts for implementation, they will interpret how this law will affect each Trust and its practices. Shari’ah operates in a very similar way.

Shari’ah Governance in Islamic Banks


The Shari’ah supervisory committee will usually consist of at least three scholars, who are experienced in the field of Islamic financial transactions and in Shari’ah. This is an independent committee; it does not report to the board, the management committee, the executive or anyone else in the business.

There is also a Shari’ah compliance department and that too does not report to anybody in the business. Their direct report is to the Shari’ah supervisory committee. The Shari’ah compliance department monitors the day-to-day operations of the Islamic bank, advising senior management and the different operational departments on Shari’ah and any issues. Part of their role is to conduct a Shari’ah compliance audit. Effectively this means that Islamic banks have an extra layer of compliance compared to conventional banks.

The Concept of Shari’ah Compliance

The concept of Shari’ah compliance is nothing new in Islam; it dates back to the time of the Prophet (pbuh) more than 1,4000 years ago. It is known as al-hisbah and it is in the Qu’ran in Surah al Nisa, verse 82. At the time of the Prophet Muhammad (pbuh), he was the point of reference and he conducted the supervision of markets himself. For example, he was once in a market and saw a man selling wheat. He put his hand in the sack of wheat and found that it was wet. He asked the seller what was wrong with his wheat. The man said it was wet because of the rain. Obviously wet wheat weighs heavier then dry wheat, so it was a way of cheating. The Prophet (pbuh) said, ‘Whoever cheats is not of us’. This is one of the constant rules of Shari’ah and it is very important in Islamic finance, because, if Islamic banks try to mislead their customers or give them a product that is not suitable for them, it is a form of cheating. Auditors need to be aware of such things in any product offered by Islamic banks.

The task of market supervision continued after the time of the Prophet (pbuh). In the first instance it was his companions, the caliphs, who used the same methods to supervise markets. There is one famous story about a mother and daughter who used to sell milk. One of the caliphs, Umar overheard the mother telling the daughter to add water to the milk. The daughter replied that they should not do that. The mother responded that Caliph Umar was not there, but the daughter said, ‘but God is seeing us’.

It is not just about supervision; it is the conscience of people working within the Islamic finance industry that is important. Supervision can achieve the objective to a certain extent, but if people in Islamic finance are not trained to the right level and made aware of the extent of compliance with Shari’ah and ethical values, they will not have a conscience. This is the problem with the banking system. If we have a banking system with the right ethical values, we would not be where we are now with all the banking scandals and crises.

Part of the Shari’ah-compliance framework is that people joining an Islamic bank must have Shari’ah-compliance training, so that they are aware of the values and ethics to be observed. It is a bank’s duty to train them, because you cannot hold them responsible if you do not train them. After that time the concept of hisbah or market supervision started to be more constitutionalised. The state became responsible for supervision. The supervisor would be chosen by the state on the basis of certain qualifications, which were similar to the qualifications of Shari’ah scholars or jurists, who need to understand Shari’ah and assess what is right or wrong in the market.

When Islamic banks began to emerge 40 years ago, there were no established rules about how Islamic finance should operate and so they needed supervision in the form of a Shari’ah supervisory committee and an internal Shari’ah compliance department to work with the bank’s management and staff on a daily basis, guiding them and ensuring there is a Shari’ah risk framework in place. The biggest risk for Islamic banks is Shari’ah non-compliance.

The concept of Shari’ah supervision is based on the Shari’ah ruling of commanding the good and forbidding the bad, but that can only be done by qualified people. That is why Islamic banks have to have this sort of governance framework.

Shari’ah Compliance Audits

The term Shari’ah compliance audit is a new term and it is derived from the concept of hisbah. The Shari’ah audit process is similar to the normal internal audit process, although they are two different functions with the Shari’ah audit covering issues not covered by the normal audit.

The Shari’ah audit process starts with a plan. The audit is then carried out and the findings and recommendations are discussed with a view to strengthening Shari’ah compliance. The findings are then discussed with the Shari’ah supervisory committee and finally there are follow-up discussions with management and the different departments in the bank. This is a continuous cycle.

The findings will be classified as good, satisfactory, room for improvement or unsatisfactory. To be classified as good the bank needs to demonstrate a proactive approach that identifies issues before they become problems.

Shari’ah Compliance Audit Methods

The first method is financial concentration of undertaken financial transactions. Let us say the bank concentrate on commercial property finance, particularly big deals. This is an area where there might be short cuts or errors on which the auditor can focus. The second method is typical and untypical transactions. A current account is fairly automated and so manual involvement is minimal. This process would be initially signed off and approved for Shari’ah compliance. It will be audited, but the auditor will focus on untypical transactions, e.g. products that are tailored for particular customers, because they are more prone to breaches and errors.

The third method is core and outsource business methods. If a bank, as many financial institutions do, outsource to a third party, the likelihood of breaches is greater than in internal processes, so there is a good reason to focus on this type of transaction.

The Scope of the Shari’ah Compliance Audit

The main scope of the Shari’ah audit is to review all contracts and agreements within the scope of the Shari’ah compliance audit, all regular reporting, internal communication between the department being audited and other business areas, investments and the associated documentation being managed by the department being audited, reports from internal and external auditors, invoices and purchase orders, foreign exchange transactions, investment certificate transactions, review of all shares being purchased, profit calculation and distributions for investment clients and shareholders (this is a particular issue as core banking systems work around the concept of interest payments and the basis of calculation in Islamic banks is obviously very different), disposal of non-Shari’ah-compliant income, review of expenses and fees charged, ensuring new and amended products are signed off and a review of all procedures and policies.

Main Challenges

Regulations in the UK are issued for banks in general. It may, however, be difficult for Islamic banks to comply with some of those regulations. Mr Alamad said that banks had been able to raise some of these issues with the regulator and develop a solution that has then been incorporated into the regulations. There are also legal challenges.

Market constraints are another factor that affects Islamic banks. For example, conventional banks can charge redemption fees of 2-3% on a mortgage; Islamic banks cannot do this, because the structure that they use for home finance is different. At many conferences attendees will hear speakers say that Islamic banks should incorporate Shari’ah objectives, Maqasid, in their products, but they do not tell you how to do this. For example, one Shari’ah objective is protecting the religion of Islam. By offering Shari’ah-compliant alternatives to conventional banking products, Islamic banks are effectively meeting this objective.

Another key challenge is developing the next generation of experts. If we do not have the right experts, Islamic banking will not grow in the right way or at the right pace.

Liquidity is also a big issue for Islamic banks. This is one that is being addressed with the regulator.

Finally, Shari’ah-compliance needs to find a middle way between being too lax and overly inflexible. Scholars and other experts need to understand both Shari’ah and the way the financial system works to understand how best to implement Shari’ah in the world of finance.