The Shariah Compliance Report (Part 1 of 3) 

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The Shariah Compliance Report (part 1 of 3)

Ethica sits down with Shariah department experts to identify industry best practices for Shariah compliance at the bank


Ethica works with Islamic finance scholars, product developers, Shariah auditors, and bankers across the Islamic banking world and one theme consistently emerges: there are a broad range of opinions on what exactly constitutes ‘Shariah compliance.’ Shariah boards often frown on what they see as expedience on the part of bankers, while bankers bemoan what they see as over precise meddling on the part of Shariah boards. Are interests to remain mutually exclusive? What is the common ground between bankers and scholars where Shariah compliance matters? Does a strong Shariah compliance policy improve customer retention? What is the remit of the Shariah department?

The purpose of Ethica’s Shariah Compliance Report is to answer some of these questions and identify industry best practices. We sat down with experts who bring experience working inside Shariah departments, have executed transactions with scholars and bankers, and are experts in AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) standards, the most widely followed standard-setting body in the industry, and discuss Shariah compliance issues facing Islamic banks around the world.


Islamic banks vary in their approach to Shariah compliance – most take a limited view where their Shariah department exists only to vet contract language alone. It has little real say over how they are implemented, how transactions are recorded, and whether or not employees are trained well enough. Moreover, product development at these banks is often a function completely independent of the Shariah department and causes business interest to prevail over Shariah compliance.

Most Islamic banks have very small — sometimes only two member — Shariah departments to oversee the workings of over one hundred branches. Shariah departments here are either excluded from the bank’s main activities or lack the commitment or resources to get actively involved.

Generally bank management and stakeholders view Shariah departments as an expense that hinders progressive banking. They fear Shariah audits highlight banking errors and add unnecessary hurdles. But talking to customers shows that a proactive Shariah department is what creates the solutions and goodwill for the bank and the resulting increase in business volume. When speaking of risk, risks such as liquidity risk, interest rate risk, and market risk are always highlighted, while the main risk an Islamic bank faces is the risk to its reputation.

When an Islamic bank launches or when a conventional bank decides to become Islamic, one of its first priorities must be to create a product development and Shariah compliance department. This function coordinates with the Shariah Advisor, the Shariah Supervisory Board, and Management to perform the key role of ensuring that all of the bank’s functions are Shariah-compliant.

In an ideal Islamic bank, the department performs the following functions:

1. Product Development, Shariah Compliance and Research
2. Shariah Audit
3. Additional Services

Sample Shariah Department Organizational Chart

Source: Pages 63 and 64 of Meezan Bank Annual Report 2012 (Section: Operations Review)


This function includes all the product development activities for corporate, commercial, retail, investment banking, and treasury. The research team must visit corporate and SME clients, interact actively with them on a routine basis along with business teams to ascertain their requirements and design processes accordingly. It must identify the ideal Islamic banking solution and structure it to meet the client’s need in a Shariah compliant manner.

Designing Shariah-compliant solutions for businesses entails analyzing certain crucial aspects of a client’s business which includes but is not restricted to the following:

▪ The business cycle
▪ The tenure (short term or long term)
▪ The rate of financing (fixed or variable)
▪ Existing market alternatives
▪ Payment flexibility (possibility of early repayment)
▪ The mode and nature of assets
▪ Adherence to basic Shariah principles
▪ Tax concerns
▪ Accounting treatment
▪ Regulatory framework
▪ Risk mitigation procedures

Product Development and Research personnel must know the Shariah and product requirement and also possess accounting expertise to equip them to customize and implement adequate solutions.

The benefit of a joint Product Development and Shariah Compliance Department is that combining the two functions creates a synergy that facilitates the bank’s overall operations and fulfillment of objectives. When product departments are independent, business teams review transactions and the clients from a business perspective alone, they come up with solutions on their own, and put them before the Shariah experts — more often than not, these solutions are not the best alternatives or even not Shariah-compliant since the business department is focused primarily on the commercial side of the transaction.

The wrong solutions mean numerous process cycles before the solutions are consistent with the client’s demand and Shariah principles. On the other hand, when the product development team has a Shariah background in addition to product development expertise, it is in a much better position to customize solutions that are effective and fall within Shariah parameters. It also increases the time to market aspect of the solution to the customers.

Another limitation with business teams is that Shariah-compliant product development expertise never really thrives because of high employee turnover. Every few years an employee leaves the bank with all his learning and is replaced with a new individual usually from a conventional banking background who needs to be trained all over again. In order to ensure quicker turnaround times and quicker solutions a combined product development and Shariah compliance and research department is key. It allows solutions to be delivered in as little as two to three days whereas two separate departments using a hit and miss approach fail to adequately serve clients. The joint product development and Shariah compliance department ensures consistent Shariah-compliance because the team not only structures the products but also the process flows with the business team’s help. These processes get documented as a step by step guide for future reference.

There is a general misconception that a Shariah department must only be represented by a Shariah scholar or group of scholars. The right approach is to include a variety of experts on the panel such as chartered accountants, business management specialists, and lawyers, to name a few, who work alongside the scholars to create and deliver effective solutions. These specialists must also be well versed in AAOIFI Standards and all the laws of sale and contracts in order to be strong supports to the business. Such a proactive approach means fewer errors and, therefore, fewer charity penalties post audit. It is a tried and tested method that promotes the bank’s growth by turning around solutions in a matter of days.

The main concepts of all new products must be approved by the Shariah Board, an entity separate from the Product Development and Shariah Compliance Department. Thereafter, the Shariah Advisor is entitled to approving any other products based on an already approved theme. For existing products, the involvement of the Shariah Advisor and/or the Shariah Board depends on the level of change required. If the modification is a repetition or a change undertaken earlier, then the bank already has the approval in place to execute the transaction. If it is a minor change which does not affect the Shariah essence of a contract it need not be referred back to the Shariah Advisor or Shariah Board. For major changes, the Shariah Advisor must be referred to and upon his discretion the Shariah board may or may not be involved.

Importantly, neither the Shariah Advisor nor the Shariah Board are the bank’s employees. The Shariah Advisor serves the bank in an advisory capacity only, however, he must visit the bank almost daily to ensure regular interaction. The Shariah Board should consist of at least three members with a senior scholar serving as its Chairman. The Shariah Board should ideally meet every quarter or at least twice a year to review overall matters related to the Shariah, approve new products and ideas, examine the issues highlighted during Shariah audits, and provide direction to the bank for enhancing Shariah compliance. The Product Development and Shariah Compliance Department must report to the Shariah Advisor and the Shariah Board to have continuous supervision.

In addition to monitoring specialized product design, the Shariah compliance team’s role includes reviewing and monitoring the Islamic bank’s:

▪ Pool Management and profit distribution procedures
▪ Investment banking transactions
▪ Funding, financing, investment and foreign exchange related activities

To be continued...

© Ethica Institute of Islamic Finance

In Collaboration with Meezan Bank

Acknowledgements: Ethica Institute of Islamic Finance wishes to extend a special thanks to Ahmed Ali Siddiqui and his colleagues at Meezan Bank for generously sharing their time and expertise to make this Shariah Compliance Report possible.

Click here to download "The Shariah Compliance Report”


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