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UNIQUE RISK
TOPIC 3 IN ISLAMIC FINANCIAL SERVICES

F
our generic risks for financial institution, namely credit, market, liquidity and operational
risk is not straightforward in Islamic finance. Any position taken up by the Islamic bank
will expose it to potential losses of risk, usually in the form of
financial risk. To create value for their participants, senior managements and boards of directors
at Islamic financial institutions must take necessary steps to manage their unique risks. Islamic
financial institutions face some risks that conventional financial firms don’t. The additional of
generic risks in Islamic financial institutions that they have to deal are:

Shariah Non Compliance Risk

E-Shariah Risk
Rate of Return Risk
Displaced Commercial Risk
Equity Investment Risk
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SHARIAH NON-COMPLIANCE RISK

Shariah compliance is the reason Islamic financial institutions exist. If a firm isn’t adhering to
shariah principles and guidelines, the impact can be severe. If one or more Islamic scholars
indicate that an Islamic firm is veering away from compliance, its reputation will sink

Shariah non-compliance risk has been defined as ‘the risk that arises from the bank’s failure to
comply with the Shariah rules and principles determined by the relevant Shariah regulatory
councils.’ (Islamic Financial Services Board, IFSB)

It asserts that Islamic financial institutions should ensure that their

contract documentation complies with Shariah rules and principles
with regards to the formation, termination and elements possibly
affecting contract performance such as fraud, misrepresentation, duress
or any other rights and obligations.
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By offering Islamic banking, investment and risk

management and protection products, Shariah non-
compliance is a fundamental, inherent and key risk for
Islamic financial institutions of all kinds. The concept of
non-compliance, and the onus it creates has recently
become more significant by being explicitly tied to
important Islamic banking legislation, such as Islamic
Financial Services Act 2013.

Very briefly, here’s what compliance with Shariah principles looks like:

Complying with minimum requirements from the start: An Islamic firm must do
a few key things to distinguish itself from a conventional financial institution: avoid
interest, gambling, and speculation; steer clear of investing in prohibited industries; and
include a Shariah board in its corporate governance structure.

Keeping transactions and operations in compliance:

Even if a firm starts out in compliance, its internal controls must ensure that transactions and
operations are analyzed on an ongoing basis. A Shariah board is responsible for
conducting regular Shariah audits to look for any possible noncompliance that may
undermine the firm’s reputation.

Developing compliant products:

Every product developed by an Islamic financial institution must go through the
institution’s Shariah board for approval. When internal approval is secured, the
product goes to outside regulators, who also consider its Shariah compliance and may
reject it if they have compliance concerns. The firm’s internal controls must outline
this process carefully so that any product sent to regulators for consideration is,
without a doubt, Shariah-compliant.
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IMPLICATION OF SHARIAH NON-COMPLIANCE
IMPLICATION
1. Violation of Islamic Financial
Services Act 2013:
2. Business reputation :
(Loss of reputation)
3. Invalidation of contract:
4. Capital adequacy ratio (CAR)
impact:
(Loss of earnings and capital)
D P F 6 0 2 3 R I S K I N F I N AN C I A L S E R V I C E S
EXPLANATION
Shariah non-compliance contravene the provision of
Section 28 (3) of IFSA 2013 sets out clearly the
obligations and responsibilities of a financial
institution in the case Shariah non-compliance, and the
subsequent reporting and disclosure process. Penalties
and consequences of not following Shariah
non-compliance reporting procedures can be severe.
Any Shariah non-compliance will tarnish
the
reputation of the bank as an Islamic entity
Shariah non-compliance with regards to the aqad, its
documentation and execution will render the contract
null and void (batil/fasid). This also means that profit
collected from the financing activities would be
considered non-permissible
Shariah non-compliance may see the erosion of profit
and capital as well since non-recognition of haram
profit will reduce earnings. A resultant loss will
adversely impact capital.