The element that distinguishes an Islamic Bank from a Conventional one is the compliance of an Islamic Bank with the principles of Shari’ah in all its relations and transactions. The recent growth of Islamic banking demands highly qualified Islamic banking experts to run these banks in line with the rules and objectives of Shari’ah, but unfortunately this sector lacks the professionals to monitor the businesses of these banks as per the objectives of Islamic Law – Maqasid Shari’ah, therefore, proper monitoring of transactions and activities of these banks, by the experts of Shari’ah Audit & Compliance, has acquired more significance. To ensure the compliance with the rules and regulations of Shari’ah, Islamic banks must establish full fledged Shari’ah departments where a number of experts should be involved in the Shari’ah audit and compliance of day to day affairs of the Islamic bank and if this task is not given due consideration, customers and stakeholders may lose their faith in this system. The main theme behind this activity is to ensure complete Shari’ah compliance in all the activities of the Islamic bank, point out Shari’ah repugnancies and transfer of the Shari’ah repugnant income to the charity fund account maintained by the Bank, and the monitoring of Charity Fund Account ensuring full accountability.

AAOIFI and IFSB have already provided concrete definitions to ensure Shari’ah Compliance as mentioned below:

The primary objective of the internal Shari’ah review (carried out by independent division or part of an internal audit department) is to ensure that the management of an ISLAMIC BANK discharges their responsibilities in relation to the implementation of the Shari’ah rules and principles as determined by the Islamic Banks’ Shari’ah Supervisory Board. (AAOIFI)

An appropriate mechanism must be created to ensure the compliance with the Shari’ah principles. Islamic Financial Institutions shall have in place adequate systems and controls, including Shari’ah Board/advisor to ensure compliance with the Shari’ah principles. (IFSB)

Shari’ah non-compliance relates to the matter of impurity in the transactions so the income arising from such transactions is to be deposited in a charity account where failure to do so can adversely impact the income and reputation of the Islamic Bank, deteriorate customer and stakeholder confidence in the system. This leads to Shari’ah non-compliance risk which is the risk that arises from Islamic banks’ failure to comply with the Shari’ah rules and principles. Since the majority of the fund providers use Shari’ah-compliant banking services as a matter of principle and faith, their perception regarding an Islamic bank’s compliance with Shari’ah rules and principles is of great importance to the sustainability of the Islamic banking system. In this regard, Shari’ah compliance is considered as falling within a higher priority category in relation to other identified risks.

Conventional banks accept deposits (Money) from their depositors at some predetermined rate of “Interest (Riba)” and then lend the same money to other customers at some higher rate of interest. The difference after deducting all the expenses becomes the Income of the bank. This excess is termed as “Riba” in Quran and Sunnah. However, we know that there is also an excess during sale transactions (Trade) but this excess is permitted and termed as Profit.

In Quran, Allah (SWT) Says:

“That is because they say, trading is also like Usury; but Allah has permitted trading and forbidden Usury.” [02:275 Al Baqara].

Islamic Banks work in a manner to get this permitted profit and are only eligible to get it if they do business as per Shari’ah requirements i.e.  there should not be any prohibited element, gharar, interest, etcetera, as well as the contracts on the basis of which the trade transactions are performed should possess all the essential elements and that every one of these meets the necessary conditions. It means that Shari’ah compliance cannot be ensured merely on the basis of approval of the products by the Shari’ah Boards and Shari’ah Advisors. Rules, regulations and standards might not work unless and until an effective network of checks and balances are established and towards this Shari’ah auditing plays a key role.

Shari’ah Audit is an examination of Islamic banks’ compliance, in all activities, with the Shari’ah principles. This examination includes contracts, agreements, policies, products, transactions, financial statements, circulars, and others. The objective of a Shari’ah audit is to ensure that the activities carried out by an Islamic Bank do not contravene the Shari’ah rules and regulations, to ensure whether the policies, transactions, processes and products undertaken by Islamic banks are Shari’ah compliant in all aspects, to ensure that the system of internal Shari’ah control is effective in implementation, to ensure that the goals and objectives for Shari’ah compliance are achieved and to ensure that the management of Islamic banks is discharging its responsibilities in compliance with Shari’ah rules and principles. It also ensures that each and every activity of the Islamic Bank is in accordance with the Shari’ah Rules and principles, the accounting standards of the Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) and relevant national accounting standards and practices in the country in which that Islamic bank is operating. Shari’ah audit should be conducted before, during and after the execution of financial transactions. The Shari’ah auditor should be given the right to conduct surprise visits to any of the branches of an Islamic Bank. All necessary documents should be provided to Shari’ah Auditors. No scope limitation and restriction of access to documents, reports etc. shall be placed on Shari’ah auditors and they shall have direct and regular communications with all levels of management and Shari’ah Advisors. There should always be a Shari’ah Audit Plan so that the exercise is completed in an effective and efficient manner. The plan shall be adequately developed to allow comprehensive audit the Islamic bank’s operations in terms of products, operations, corporate strategy, SMEs, consumer, branches, subsidiaries and divisions. During the Audit of executed transactions, the documents must be checked as per Shari’ah Audit Checklists of each and every transaction and as per rulings issued by the Shari’ah Supervisory Board. The plan shall be properly documented including the sample selection criteria and sizes, taking into consideration complexity, and frequency of transactions. During the Shari’ah Audit, it must be taken due consideration that Shari’ah approved transactions and products have been undertaken and all related conditions have been met. Mainly the Shari’ah Audit must contain an understanding of the management’s awareness, commitment and compliance to control procedures for adherence to the Shari’ah, including the review of contracts, agreements, and  transactions, ascertaining whether transactions entered into during the year were for products authorized by the Shari’ah.

The Shari’ah Auditor should review and assess the conclusions drawn from the evidences obtained during the Shari’ah Audit and then present a Shari’ah Audit Report that contain observations and assessment of systems and controls in place for Shari’ah Compliance, recommendations for potential improvements and corrective actions to be taken. The report should contain a clear written expression of opinion that the businesses of the Islamic banks are carried out as per Shari’ah principles and also mention that this statement is based on the Shari’ah Audit executed during the relevant period. The main objective of Shari’ah Audit is to ensure that contracts, documentation, transactions, policies, and activities of an Islamic bank comply with Shari’ah rules and to ensure that an Islamic Bank’s undertaking to operate in accordance with Shari’ah principles are the responsibility of the Management. This will boost the confidence of the shareholders and the public that all the practices and activities are in compliance with the Shari’ah at all times. The non-existence of non-Shari’ah compliant elements would positively affect the confidence of the public to Islamic banking and might also safeguard Islamic Banking to fiduciary and reputational risks.

About the Author

Amjadullah Jan Bangash is working as Shari’ah Auditor with Dubai Islamic Bank Pakistan. He has Masters Degree in Islamic Banking & Finance from the International Islamic University Islamabad. He may be contacted at amjadullah.bangash@dibpak.com