The Shariah Compliance Toolkit
This must be clear from the outset: Shariah compliance is not a label or a marketing gimmick, it must be regarded as a companywide framework which - as the IFSB puts it - "reinforces good governance and integrity, but also influences the way governance structures and procedures are implemented." In other words, Shariah compliance is not an end by itself; instead it should be understood as a process which provides guidelines for corporations to increase their benefit to society. How can this be done? What are the steps required?
From A to Z
These industry bodies can be viewed as promoting two different approaches: principle based (IFSB) and rules-based (AAOIFI). Although his might be an over-simplification, taking on a dual-approach can go a long way in establishing a solid Shariah compliance framework. Crucially though, both IFSB and AAOIFI are not enforceable and they are only recognized by specific jurisdictions (for instance Bahrain where the latter is headquartered), ultimately observance rests on the individual financial institutions themselves. Despite the fact that their application is not universal and membership is not a pre-requisite, they do provide a sensible starting point. Currently though, AAOIFI has 180 members and IFSB 185 members (for both a substantial percentage being central banks and/or regulatory agencies), so there are growing calls to increase the number of institutions representing the private sector.
The crux of the matter is connecting the initial prudential framework (i.e. IFSB) with the final mechanics (i.e. AAOIFI) and this is open to various approaches. Nevertheless, in the context of an Islamic investment fund the following key conditions should be highlighted (as outlined by Sheikh Nizam Yacuby):
The initial setup can be broken down into the following (predominantly a legal exercise where documentation is examined by Scholars, lawyers and manufacturers):
The periodic review is equally important as it solidifies compliance of the product/service as a going concern (i.e. compliance function, problem/ dispute resolution, and continuous guidance of the SSB). More specifically the following would be required:
SSB - Business Models
What is imperative is the establishment of an SSB and incorporating this function into the organization. Sheikh Nizam is unambiguous in this regard: "the Articles of Association or the prospectus, or statutes, depending on the type of activities, should provide for the existence of the Sharia Supervisory Board." This SSB though, can come into existence in various forms:
At the end of the day flexibility (and perhaps confusion) remains - even in their nomenclature: Shariah Committee, Shariah Board, Religious Supervisory Board, Shariah Advisor, Shariah Supervisory Council....
Considering this is a crucial component of the toolkit we tackle costs as openly as possible. Since the methods vary tremendously so does the pricing range: For instance, some criterion used is for a monthly retainer fee but this can be anywhere between US$300 to US$10,000 (and is subject to the understanding of the parties involved).
Nevertheless, pricing is usually broken down into the two components mentioned earlier (setup and review). More specifically:
There are other quotes available and it must be noted that full-fledged Shariah boards will require payment for each board member (sometimes along the lines of 25k to 50k per advisor) and that intricacies such as travel expenses and ancillaries will have to be absorbed as well.
Furthermore, there are additional products/services that might be required and that should be taken into account as well, a case in point being Shariah screening mechanisms. In certain instances stock screening will be an integral part of the investment process, and some advisors might not be able to provide this specific service or there might be more sophisticated/ superior screening from specialized providers.
Pricing varies due to client specifications: some screening systems stipulate a pricing of three basis points of AUM, whereas a global universe screening might command from US$20,000 to US$150,000, although a passive product (i.e. ETF) would be significantly cheaper. Once again, permutations exist where a combination of an upfront fee and basis points thereafter can be established. In other cases some providers aim for a revenues haring approach (say 30% to 50% of revenues) in particular where the solution is a passive product or an index/benchmark that would be used for public dissemination.
Another development is the increased scrutiny of the compliance process itself, namely the specific role a Shariah advisory firm can undertake (i.e. what they should and shouldn’t do) and the independence/impartiality of these boards. With current industry efforts focusing on corporate governance, these issues are bound to take centre stage.
Specifically, some observers and practitioners (INCEIF for instance) recommend that separate entities should be used for the Shariah setup and Shariah review. The fact that it is called a review (rather than an audit) gives rise to questions of how enforceable and critical a Shariah Board might be - in particular when there are breaches (of standards/rules) or deviations (from principles/ guidelines). Similarly, there are circumstances where the body that drafts the procedures/manuals then proceeds to audit/review the same, such “self-review” questions the independence and impartiality of the process.
Independence of the board members themselves has been further scrutinized, with research by Funds@Work being particularly noteworthy (see “Shariah Scholars in the GCC – A Network Analytic Perspective”). For instance, they find that three specific Scholars are members of 26% of all Shariah boards in the GCC. There is also differing levels of activity between Scholars (from a total of 121 studied): approximately 56 Scholars holding less than 3 board positions, whereas the top 10 Scholars hold on average more than 25 board positions.
The fact that they are highly interlinked might not come as a surprise (to an extent this is to be expected). As a matter of fact, it they are indeed so inter-linked this substantiates the logic behind having a country or even a regional Shariah board (since so much commonality already exists between the various Islamic banks). Nonetheless, the onus remains with the IFIs themselves to mitigate conflicts of interest, ensure confidentiality and protect intellectual property.
In any case, all the above components must be taken into consideration for comprehensive Shariah compliance to be achieved. The hope is that more and more information is available on this subject and this will in turn encourage more institutions to consider the benefits of Shariah compliant products and of Islamic finance as a whole (as these benefits are increasingly out weighting the costs).
Opalesque Islamic Finance Intelligence
Monday, July 27, 2009
Editor’s Note The Shariah Compliance Toolkit Bernardo Vizcaino, CAIA