Sharia Non-Compliance Risk
Sharia non-compliance risk is the legal, financial and reputational risk an Islamic financial institution faces if it fails to comply with the Sharia rules that apply to it — through a flawed product, a contract executed out of sequence or income it cannot keep.
Also called: SNC risk · Shariah non-compliance risk · Sharia compliance risk
The risk usually materialises in execution rather than design. A murabaha signed before the bank owned the commodity, an ijarah where the bank never bore ownership risk, or a fund holding a non-compliant asset can all mean that the transaction is void or voidable under the institution's own rules and the income from it must be given away, as well as the reputational damage of having sold a non-compliant product to customers who chose the bank for its compliance.
Regulators treat it as a category of operational risk. The IFSB standards address it, and some regulators, including Bank Negara Malaysia, require institutions to identify, report and rectify Sharia non-compliance events, with a Sharia Supervisory Board, Sharia review and Sharia audit forming the control framework.
In practice
A Sharia non-compliance event is not only a religious issue. Depending on the jurisdiction it can make a contract unenforceable, trigger regulatory action, and require income to be removed from the institution's profit.
Example
A Sharia audit finds that 40 commodity murabaha transactions worth US$12 million were signed with customers before the bank's commodity purchase had settled. The profit on those deals, US$180,000, is set aside for charity, the cases are reported to the regulator, and the operations process is changed.
See also
- Sharia Supervisory BoardA Sharia Supervisory Board is the panel of scholars responsible for reviewing and overseeing an Islamic financial institution's compliance with Sharia — approving products and contracts, issuing rulings and reviewing whether operations follow them.
- Income PurificationIncome purification is the process of identifying income that is not Sharia-compliant — such as interest earned incidentally or the share of a dividend from prohibited activities — and giving it away, usually to charity, instead of treating it as profit.
- IFSBThe IFSB, the Islamic Financial Services Board, is a Kuala Lumpur-based international body that issues prudential and supervisory standards for Islamic banking, Islamic capital markets and takaful, much as the Basel Committee does for conventional banks.
- Islamic WindowAn Islamic window is a Sharia-compliant business run inside a conventional financial institution — a division, branch network or product line — usually with segregated funds, accounts and Sharia governance.