The Global Islamic Financial Report 2017 projected the assets of the Islamic finance industry to be somewhere between US$3 trillion and US$4.3 trillion by the end of 2020. Islamic banks (IBs) have been able to establish their foothold in the global financial industry owing to the Shariah-compliant nature of their products. This gives them legitimacy amongst the more conservative global Muslim populace because the profit-and-loss-sharing characteristic of products provides an alternative for the fixed-interest (Riba) based products offered by conventional banks. Islamic banking products, however, have also brought to the fore a new type of risk that the regulators and the banks themselves have to manage. The new risk is the Shariah non-compliance risk (SNCR), which potentially can hamper the bank’s ability to meet capital adequacy ratio (CAR) requirements.
SNCR is the risk of loss that arises from the “failure of the IBs to comply with the Shariah rules and principles determined by the Shariah board or the relevant body in the jurisdiction in which the IB operates” (Islamic Financial Services Board, IFSB, definition). It is a component of the operational risk. For conventional banks, the Basel Committee on Banking Supervision (BCBS) defines operational risk as “the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events”. The BCBS, however, recognizes that operational risk is a wide category and allows banks to adopt their own internal definitions, as long as the minimum elements of the definition provided by the BCBS are covered. So, the definition of operational risk for IBs consists of losses resulting from Shariah non-compliance, legal risk and failure to meet fiduciary responsibilities alongside the components of general operational risk already provided by the BCBS definition.
Whereas on the one hand, the profit-and-loss-sharing nature of Islamic products ameliorates certain risks for banks, on the other hand, it also exposes banks to new ones. Process and legal risks in IBs are enhanced because of their emphasis on contract drafting and the requirement that all of the steps in a transaction invariably take place in a certain order. People risk is also increased in IBs as a different type of relationship is established with the clients, which needs better diligence—for instance, in the case of partnership in the Musharakah contract. More specifically, SNCR adds concern for the risk managers of a bank. The Shariah compliance of a product is determined primarily by looking at the Shariah-compliant status of its underlying contract. Once a product or transaction is flagged as potentially Shariah non-compliant in a Shariah audit, it is referred to the bank’s Shariah board to determine if the transaction is Batil or Fasid. If it is determined to be Batil, it means that there was something contrary to Shariah in the fundamentals (Asl) of the product that cannot be redeemed. The income from that product will have to be donated to a charitable cause, and the contract will have to be made anew. However, if the product is declared Fasid, it means that there is a contradiction with Shariah principles in the “add-ons” of a contract, which can be cured in two ways: 1) removing the contradiction; 2) redrafting the contract. Both options, however, add to the operational costs of the bank. Compliance to Shariah principles is a continuous process that requires compliance to permeate through processes, activities and products. Finally, SNCR, if heightened to a significant degree, can expose the bank to reputational and insolvency risks.
Measuring SNCR is different compared to conventional banking. Conventional banking uses gross income or similar indicators to measure operational-risk capital charges. In contrast, Shariah non-compliant income (SNCI) is used to measure SNCR.
However, measuring SNCI possesses its own challenges. When SNCI is mentioned by a bank, its source and details may be omitted. SNCI figures depend on the vigilance of the local Shariah authorities. In contrast, conventional banking has set standards for institutional governance that can be used to compare banks on a cross-sectional basis. Furthermore, extreme SNCI values have been rare events in the history of IBs. This reduces the number of observations when using SNCI as an alternative for SNCR.
Impact of SNCR on CAR
The capital adequacy ratio (CAR) ensures solvency by backing risk exposures with assets. The Islamic Financial Services Board (IFSB) has decoupled strategic and legal risks from operational risk. Instead, it levies an additional capital charge for Shariah non-compliance. However, such a charge may not translate to significantly higher CAR requirements. That is because Islamic banks face less financial exposure owing to their risk-absorbing assets. Moreover, an International Monetary Fund (IMF) study found similarity between Islamic and conventional banks because of similarity of products (conventional products can be redrafted as Shariah products) and Islamic banks pegging returns on investment accounts with conventional banks, which is why it is still important to consider the impact that SNCR may have on CAR requirements.
IFSB-2, 15 and 16 allows RSAs (regulatory and supervisory authorities) to impose justified additional CAR requirements to accommodate SNCR. An empirical exercise has found that SNCI, as a proxy for SNCR, has insignificant effects on the overall CAR requirements. The study included data from 51 Islamic banks in 11 jurisdictions. The study found no correlation between SNCI, total assets, total equity and net income. Regression analysis of 28 banks in a five-year dataset showed SNCI to have non-significant impact on the size of bank (TA), profitability (ROA) and capitalization (total equity/total assets).
Because of the tail-risk nature of SNCR, stress testing was also performed. It revealed that even if current SNCI increases by three times the standard deviation of SNCI/income from investing and financing activity, the minimum CAR was still 10.6 (higher than the 8-percent benchmark). Furthermore, if 20 percent of contracts become Batil, leading to a 10-percent increase in operational costs, only two data points (out of 202) fell below 8 percent. Even then their values were 7.14.
Current benchmarks for CAR cover SNCR. Hence, additional capital charge is not required. Instead, RSAs can better deal with SNCR by using their existing tools. SNCR is best dealt with by using an individual approach. However, one must realise that SNCR may lead to reputational risk, which is not part of operational risk under the IFSB but has the potential to hurt profitability of IBs severely. In this vein, Shariah regulatory authorities can take other additional measures, such as standardising SNCI-reporting values and facilitating effective and comprehensive Shariah-governance systems.