The paper aims to study the nature of Sharīʻah Non-Compliance Risk (SNCR) and explore its implications on the capital adequacy of Islamic banks. This paper endevauors to describe an appropriate approach for the application of capital charge for SNCR in the light of currently available data as well as provide a direction for future studies in this area. It provides an overview on the nature of operational risk and associated capital adequacy requirements for both conventional and Islamic banks. It further explores the identification process of SNCR from a contractual perspective and the methodologies adopted in dealing with SNCR.
The empirical study focuses on the identification of SCNR resulting from the failure of Islamic banks to satisfy the essential Sharīʻah requirements and conditions as stipulated in the relevant jurisdiction’s standards, or widely accepted international Sharīʻah standards, the implications of which are reflected in SNCI of Islamic banks that serve as ‘proxy’ for the SNCR.
Utilising the data of 51 Islamic banks from 11 countries for a five-year period from 2010 to 2014, the paper performs the descriptive and correlation analysis, followed by regression tests to examine the significance of Sharīʻah non-compliance income vis-à-vis bank-specific variables such as the size, profitability and capitalisation as well as macroeconomic indicators. This analysis is supplemented by stress testing in the form of outlining two scenarios to analyse SNCR as a tail risk under extreme but plausible events.
The findings, with its limitations of availability and acquiring of data, lead to the conclusion that instead of applying an additional capital charge to cover SNCR in Islamic banks, tools available under the supervisory review process provide a more effective mechanism for dealing with individual instances of a high level of SNCR. The study proposes some policy options and guidance for regulatory and supervisory authorities to address SNCR. In this context, it suggests to collect adequate information on material developments of SNCR in the Islamic banks, including pertinent information on the current and emerging SNCR exposures and vulnerabilities to undertake an effective supervisory review process. Similarly, it suggests that Islamic banks should be aware of the implications of SNCR for the overall enterprise risk management. The study also emphasises the significance of implementing an effective and comprehensive Sharīʻah governance system, which is the distinctive feature of Islamic finance. It also highlights the issues and challenges in the disclosure practices of Islamic banks in relation to SNCR, in which consistent and elaborate regulatory disclosure requirements could provide sufficient information to the stakeholders for assessing the level of SNCR in individual institutions.