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Opalesque Islamic Finance Intelligence

Editor’s Note The Shariah Compliance Toolkit Bernardo Vizcaino, CAIA

Monday, July 27, 2009

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
A suggested starting point can be the IFSB itself, as it has set out guiding principles for 'corporate governance' and much more recently for 'Islamic collective investment schemes' (which specifically address capital market instruments). They are readily available and most importantly should be regarded as prudential in nature - thus useful from a top-down perspective to setup the initial groundwork. However, they are also meant to be inclusive of all schools and approaches and hence they have been criticized for not being descriptive enough. On the other end of the spectrum we have AAOIFI standards, which are instrument-specific and deal with the actual financial instruments and contractual specificities (such as setting up a Shariah board of review). While only available in hardcopy format they explore in ample detail the range of Islamic instruments, although it is left to institutions themselves to determine the ultimate purpose and how they should be used (this requires a separate and extensive discussion as well).

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):

  • Complete Segregation of Funds - not comingling investor funds with those of conventional ones.
  • Shariah Supervisory Board (SSB) - this should be clearly stipulated in the articles of association, prospectus or statutes.
  • Management Fully Convinced of Islamic Concepts - as opposed to compartmentalizing the carrying out and application of principles.
  • Safeguarding Investors against Negligence, Trespass and Fraud - while capital is not guaranteed the investor interest should be catered for (and beyond the construct of an Islamic window)
  • Compliance with Standards (of AAOIFI) - in order to avoid confusion, misunderstanding and ambiguity, and to seek clarity and sound business activities.

While there is no specific approach for doing so, the market does exhibit a variety of models that can be emulated. This very much depends on the type, number and complexity of the product to be developed as well as the strategic objectives of the parties involved. Nevertheless there will be two core steps: the initial setup and the periodic review.

The initial setup can be broken down into the following (predominantly a legal exercise where documentation is examined by Scholars, lawyers and manufacturers):

  • Stipulating Shariah compliance in the legal context (documentation stipulating this internally as in the articles of association and externally as in the prospectus or offering document).
  • Developing Shariah investment guidelines(which funds, objectives, mechanics, and crucially the internal compliance function, etc).
  • Drafting a Shariah compliant manual (addressing steps, resolutions, non-compliance events, purification of non-permissible income, etc).
  • Formation of the Shariah board (which issues a fatwa for the product/service being considered).

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:

  • an internal Shariah audit (which can be carried out by the existing internal compliance officer provided they are knowledgeable of the requisite Islamic banking principles) and
  • an external Shariah audit (which can be supported by an audit firm with Islamic finance expertise such as Deloitte, PWC, E&Y, etc).

SSB - Business Models
Once again there are options, with some providers having retained the services of a single Shariah advisor (for plain vanilla or standalone products) whilst others have multiple-scholars attached to their boards (in case of having an extensive product suite). Another prominent scholar has clearly outlined that it is completely acceptable to have a single scholar in place but at the same time “the presence of a full board would undoubtedly be more assuring to investors, and quite possibly more effective as well.” IFSB guidelines also stipulate that a Shariah Supervisory Board or Advisory Company should be in place, although there is no mention of multiple scholars (it is left instead to the discretion of the institution and to ‘market forces’).

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:

  • Internal SSB: most likely to be used in the case of a fully-fledged Islamic Financial Institution that requires a wide range of products/services.
  • External advisor (standalone - independent): a single advisor where the product in itself might be vanilla, straight-forward and/or to be offered locally.
  • External advisor (company - consultancy): external advisory firms have proliferated in recent years, arguing they can support more complex or sophisticated solutions and provide a board that has regional/global representation.
  • Hybrid Model - External SSB (country board): certain jurisdictions will provide blanket approval of pre-approved products or acceptance of generic business practices, albeit this is recognized for their local market.
  • Hybrid model - External SSB (strategic partners): a more recent development where Islamic banks (with an SSB already in place) partner with conventional institutions and each contributes their respective expertise to bring a product to market.

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....

Price discovery is a fine art in Islamic finance, and as a provider put it “the market is relatively nascent and pricing points are yet to stabilise. Further, client requirements are varied in terms of: the number of funds / assets they need the system for, the level of criteria specification they require, and the sophistication of integration work they need for their systems.”

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:

  • Structuring: for instance in considering an investment fund, this one-off fee can range from US$20,000 to US$60,000 (median of US$40,000) for preparing the structure, legal documentation, issuance of fatwa, etc.
  • Review: for the supervisory and monitoring function to ensure that the fund complies with Shariah principles, this retainer fee can range from US$20,000 to US$55,000 (median of US$40,000). Thus, some recent Islamic fund launches have seen approximately US$80,000 spent on the first year of operation alone.

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.

The range of costs is wide since there are multiple products to be considered. For instance, if a single vehicle is setup then a single (and in some cases external) Shariah advisor would suffice, whereas if a master-feeder type structure where to be considered (with subsequent sub-funds being launched) then a more comprehensive SSB should be considered to look into the underlying structures and issue a Shariah compliance certificate for all the underlying assets/funds. In this case having an SSB for every single fund may be more expensive.

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.

Launching a specialized fund, even in a stringent jurisdiction (a Hong Kong based hedge fund for example), can cost anywhere between US$5,000 to US$16,000, so in comparison the above figures are receiving downward pressure. Nevertheless, pricing is in practice expected to broaden: on one hand one must consider the growing calls for country Shariah boards (which would help streamline the development of vanilla products) and on the other you have advisory consultancies increasingly engaging in more complex structures (i.e. more expensive).

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).

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