Mohammad Damak Image Credit: Supplied

Dubai: Islamic financial institutions’ business activities must comply with Islamic law (Sharia). Rating agency Standard & Poor’s believe that in view of the fast growth of the Islamic finance industry robust Sharia governance structures is very important.

While the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) have already made significant strides in this area with progress made by local regulators in implementing frameworks to ensure the proper conduct of Islamic finance in their respective jurisdictions, and some have created a central Sharia authority.

Despite the progress made in recent year S&P believes the current governance framework shows room for improvement.

“We believe the industry stands to benefit from increased disclosure, as well as clear standardised Sharia principles and interpretation. In that sense, we think the IFSB’s recent proposals to tighten disclosure requirements are a step in the right direction. Well-defined standards could also help the industry become more integrated, thereby unlocking new growth opportunities,” said Mohammad Damak, Director — Global Head of Islamic Finance

Conflicts of interest

Analysts say as Islamic finance industry expands enhanced Sharia governance framework could address risks related to conflicts of interest, which can emerge in several Islamic finance activities.

In theory, holders of Islamic banks’ profit-sharing investment accounts (PSIAs) are entitled to share not only the profits related to activities their deposits finance, but also the losses. In practice principle has not been applied consistently in the past and no Islamic bank has transferred losses to customers over the past 30 years.

A steady progress toward its implementation is underway in recent years. An example of this is the Malaysian authorities’ decision to make such accounts truly loss absorbent from June 2016, by giving customers the option of choosing between loss-absorbent accounts and non-loss absorbent accounts.

“Profit and loss sharing could potentially result in a conflict of interest if shareholders are able to use depositors’ funds to minimise losses on their own investments, hence the importance of checks and balances to mitigate this risk,” said Damak.

Only a handful of Islamic banks disclose their profit and loss sharing formulas, profit equalisation reserves, or investment risk reserves. The latter were created by the industry to help smooth the return on PSIAs during economic downturns and reduce liquidity risks inherent to profit and loss sharing.

Surveillance and disclosures

Generally, internal Sharia auditors have the task of checking whether an Islamic bank’s activity was performed according to the rules set by the institution’s Sharia board. While this model has provided an additional layer of control, strengthened by local regulations regarding the independence of the audit function, actions requested by internal auditors are typically not disclosed to the public. So far only the authorities in Oman and Pakistan have asked Islamic banks to submit themselves to an external Sharia audit.

Sukuk are not generally subject to post-transaction Sharia review, except when they are issued by an Islamic financial institution whose overall activities are subject to ex-post Sharia surveillance. For sukuk issued by Islamic financial institutions, the ex-post surveillance is generally conducted by internal Sharia auditors, resulting in risks from non-disclosure of audit actions.

For sukuk issued by corporate entities or governments, in most cases, there is no post-transaction Sharia audit. This situation creates the risk that the sponsor of a sukuk could go beyond its contractual obligations to avoid triggering the sukuk’s early dissolution when required under Sharia. “We view as positive the IFSB’s proposals to enhance disclosures related to sukuk in its exposure draft 19 on disclosure requirements for Islamic capital market products, published October 31, 2016,” Damak said.