Scholars and scale

Few parts of the global financial sector can claim to have continued growing in the past two years, but Islamic financial institutions recorded an aggregate increase of 64% in their assets according to The Banker's Top 500 Islamic Financial Institutions rankings. With rapid expansion, however, comes the growing pains of ensuring that processes run smoothly, particularly for the high-volume retail banking segment.

For Islamic financial institutions, this means ensuring strict adherence to sharia (Islamic law). This is a tall order in a relatively new industry, especially one where the number of widely recognised sharia scholars who also have the necessary grasp of a fast-changing financial sector remains small.

"At the moment, it is painful because banks only feel comfortable with the best scholars to avoid any reputational risk. But in five or 10 years from today, there will be many more fully trained sharia scholars with sufficient knowledge of finance, who have built their reputation by working in the sector," says one senior Islamic banker.

The banks are looking to build that pipeline, hiring staff trained in the relevant branches of fiqh (Islamic jurisprudence) to work in internal sharia review and audit teams. This will provide them with the direct knowledge of finance that can help them make the step up to sharia supervisory boards (SSBs) later in their career.

The Malaysian regulators have already instituted a rule that no scholar may sit on the SSB of more than one Islamic bank licensed in Malaysia, which has obliged international Islamic banks such as HSBC Amanah and Standard Chartered Saadiq to recruit separate local SSBs.

Mannan Mansoor, head of the central sharia group at HSBC Amanah, says the bank's global sharia advisory committee works on strategic research into the market. In addition, central and regional sharia committees provide advice to specific geographies.

"In many cases these are a requirement of local regulatory frameworks. But they also mean that HSBC Amanah and the sharia advisors on its boards remain as close as possible to individual markets, allowing us to provide the most appropriate sharia-compliant offering for that market," says Mr Mansoor.

Skills for the job

But there is consensus that the industry is not yet ready to operate globally with separate scholars for every institution. "Rapid expansion of the industry together with the increasing complexity of Islamic finance transactions has necessitated some sharia scholars to serve on a number of sharia supervisory boards. It will be up to the sharia scholars to decide on the number of SSBs that they feel they can serve effectively," says Mohamad Nedal Alchaar, the secretary-general of the Accounting and Auditing Association for Islamic Financial Institutions (AAOIFI).

Sheikh Mohammad Daud Bakar, a Malaysian sharia scholar and CEO of Dubai-based training consultancy Amanie, says Islamic banks could tailor the structure of their SSBs to meet the twin needs of developing new scholars and processing growing business volumes.

"What is useful is for the bank to have one or two anchor scholars and several junior scholars working together. This way, the junior scholars can be trained for the future, and they can dedicate more time to that bank than the anchor scholars who serve on several sharia boards," says Mr Bakar.

With SSBs largely composed of scholars who are not working full-time for an individual bank, the relationship between the bank's own sharia department and the SSB is crucial. Badlisyah Abdul Ghani, the CEO of CIMB Islamic in Malaysia, says the 1983 Islamic banking act in his country focuses bankers' minds because an Islamic bank can lose its licence for a breach of sharia compliance. For Islamic banks, this puts adherence to sharia on an equal footing to conventional bank regulation, and the central bank has also issued guidelines on the sharia compliance management framework.

"Each bank is required to provide a secretariat to the sharia committee, to be staffed by people with similar qualifications as those on the committee - conversant in both sharia and financial matters," says Mr Badlisyah.

He firmly believes that the central bank's decision to build a national regulatory framework for Islamic financial institutions gives comfort to customers that all the banks' obligations to them are being effectively discharged - including sharia compliance. Similarly, the Bahraini authorities have adopted AAOIFI standards as a legal requirement for Islamic banks in the country.

But rules alone do not ensure effective interaction between the bank and its SSB. The Islamic International Rating Agency (IIRA) produces ratings on 'sharia quality' for Islamic financial institutions, and acting IIRA CEO Nasir Ali Merchant says they examine a wide range of operational elements.

"We look at whether the sharia board is spending time on the right issues, is it checking that the requirements laid down at previous meetings have been implemented, does it interact with senior management as well as technical staff," says Mr Merchant.

Asim Khan, executive director of Islamic finance advisory firm Dar Al Istithmar, says sharia reputational risk can crop up in unexpected places, especially for conventional banks with Islamic windows. One compliance review he conducted highlighted the operational risk of using the same IT platform for conventional and sharia banking: Islamic investors were receiving statements carrying the phrase "interest earned", but interest (riba) is forbidden under sharia.

"The number was right, and the way the profit had been earned was right, but sharia compliance is not just about the financial structures," says Asim Khan.

Mr Bakar, who has served on the SSBs of the Malaysian central bank and numerous financial institutions, including BNP Paribas' Islamic finance unit Najmah, says the largest Islamic banks have built internal sharia departments capable of reviewing the products they have in the market and identifying cases of non-compliance.

"We can learn from the sharia department's findings the bank's soft spots or strong spots for compliance, which helps them to readjust their focus, for example on IT, accounting, debt recoveries, the branch office staff and so on," says Mr Bakar.

Mannan Mansoor, head of the central sharia group, HSBC Amanah

Afaq Khan, CEO, Standard Chartered Saadiq

Speaking the same language

Even when the infrastructure is in place, there can be gaps in understanding between financial professionals and scholars. A generation of what one practitioner calls "hybrid professionals", experienced in both finance and sharia, is gradually emerging. Natalie Schoon, the head of product research at Bank of London and the Middle East, teaches for the Islamic Finance Qualification at the UK Chartered Institute of Securities and Investment. She sees a growing number of candidates entering Islamic finance directly, rather than transferring from conventional finance.

In the meantime, Asim Khan says technical issues such as the financial leverage ratio - which most sharia boards rule should not exceed 30% - can throw up differences of interpretation that lead to accidental compliance breaches.

"To calculate the leverage ratio, you need to look at accounts receivable, but the accountant's definition can be narrower than that of the scholar, who understands it to include all assets without tangibles underlying - including pre-payments, interest-free loans and loans to associate entities. So the accountant believes the bank is within the leverage threshold, but he is looking at the wrong columns in the accounts," says Asim Khan.

For this reason, the Islamic finance team at accountancy firm Deloitte has recruited an in-house sharia scholar, to offer sharia advisory services alongside their corporate finance and consulting advice. "We have found that, instead of having a lawyer or a banker sit down with the sharia board, it is better to have scholar-to-scholar communication," says Dawood Ahmedji, European head of Islamic finance at Deloitte.

The SSB of the UK's Gatehouse Bank has adopted an extra refinement, making one of its members, Mufti Muhammad Shikder, head of sharia compliance within the bank. "The SSB appointed me as an executive member to execute simple and uncontroversial transactions on a daily basis. If there are transactions where there are possible differences of opinion, I would immediately contact the other SSB members," says Mr Shikder, who is also on the SSB of Lloyds Bank, and previously headed the internal sharia department of Dubai Islamic Bank (DIB).

Building capacity

As sharia boards typically meet only four times per year, the largest retail banking operations embed sharia compliance into staff training and core technology platforms to handle daily business. Afaq Khan, Standard Chartered Saadiq CEO, says the bank always embarks on suitable product and sharia training for front-, middle- and back-office staff, especially sales staff, before rolling out a product. And Saadiq aims for a high level of automation on the operations side to ensure sharia compliance.

"When we write product programmes, there is a sequence so that each operation desk knows what is required in the execution phase to ensure sharia compliance. Wherever possible we have tried to automate the end-to-end process for volume transactions such as commodity murabaha, so if something is blank or non-compliant on-screen, you cannot proceed."

This systematic approach also allows auditing by staff without high levels of sharia training, as they are given a checklist of the correct procedures and order that should have been followed for each product. "If they find that step five was carried out before step four, then they can refer that breach of compliance to the internal sharia team for review, and to the sharia board if necessary, but otherwise the sharia audit can be carried out as part of the normal audit process," says Afaq Khan.