Reporting Of Shariah Non-Compliance Events: The Case Of Some Islamic Financial Institutions In Malaysia

 


Shariah non-compliance (SNC) refers to the failure of Islamic financial institutions (IFIs), particularly Islamic banks and takaful operators, to comply with the Shariah resolutions issued by their respective Shariah committees and/or the Shariah Advisory Council (SAC) of Bank Negara Malaysia (BNM). SNC falls under the framework of operational risk as SNC risks arise from insufficient or failed internal processes and procedures in the system or the errors of people conducting those procedures. SNC incidences may expose IFIs to unfortunate implications. If no proper remedial actions are taken, such incidents might breach the Islamic Financial Services Act (IFSA) 2013, exposing the responsible persons to fines and/or imprisonment and the institution to fines and/or revocation of its license, as outlined in Section 28 (5). This article briefly highlights some policies and guidelines for mitigating SNC risks, issued by Bank Negara Malaysia (BNM) in its capacity as the regulator. It then explains how some IFIs in Malaysia have complied with those guidelines in reporting their SNC incidents.

Regulator’s initiatives in mitigating SNC risks

To mitigate SNC risks, BNM introduced the Shariah Governance Framework (SGF) in 2010 (effective in January 2011), which requires IFIs to effectively communicate and execute Shariah risk management across different functions in the organization. The latest policy document on Shariah governance (SGP), issued by BNM in September 2019, ingrains the same requirement but in a more comprehensive manner. It aims at further strengthening effective Shariah governance practices and integrating Shariah considerations over all business and risk strategies of IFIs (BNM, 2019). Both SGF and SGP emphasize that the board of directors, Shariah committee and management all play significant roles in ensuring adherence to Shariah in Islamic finance. To achieve this purpose, four main functions should be established: Shariah risk management, Shariah compliance, Shariah secretariat and Shariah audit.

IFSA 2013 has also specified some provisions on SNC events. Section 28 states:

Where an institution becomes aware that it is carrying on any of its business, affair or activity in a manner which is not in compliance with Shariah or the advice of its Shariah committee or the advice or ruling of the Shariah Advisory Council, the institution shall—

  • (a) immediately notify the Bank and its Shariah committee of the fact;
  • (b) immediately cease from carrying on such business, affair or activity and from taking on any other similar business, affair or activity;
  • (c) within thirty days of becoming aware of such noncompliance or such further period as may be specified by the Bank, submit to the Bank a plan on the rectification of the non-compliance.

In addition, BNM issued two policies on financial reporting in February 2018:

  1. Financial Reporting for Islamic Banking Institutions
  2. Financial Reporting for Takaful Operators

Both policies set minimum expectations and requirements on the IFIs for financial reporting based on the Malaysian Financial Reporting Standards (MFRS). One of these relates to the disclosure of income from Shariah non-compliant sources. Section 11 (6) of the first policy mentions that any revenue generated from Shariah non-compliant operations and activities must be disclosed under the Director’s Report or Shariah Committee’s Report. It should contain relevant information concerning number, amount, nature and rectification process (BNM, 2018). Likewise, section 13 (5) in the second policy asserts that the Shariah Committee’s Report should contain certain relevant information, including any known SNC activities and the mitigation actions for them.

All these regulatory initiatives are meant to create a resilient and organized process for identifying, measuring, monitoring and controlling SNC risks and promoting end-to-end Shariah compliance in the industry. Figure 1 summarises these key regulatory initiatives.

Figure 1: Key Regulatory Initiatives to Mitigate SNC Risk

 

SNC Event Reporting by IFIs in Malaysia

In exploring the extent of the industry’s compliance with the regulatory requirements on SNC disclosure, this article examines the 2018 financial statements of 16 Islamic banks and 15 takaful operators in Malaysia. The objective is to identify the practices adopted by these institutions, specifically whether they disclose all four of the relevant items (number, amount, nature and rectification process) in the SNC reporting structure. The overall result of the analysis of SNC event reporting by IFIs is presented in Table 1.

Table 1: Disclosure of SNC Events Reported by IFIs in Malaysia (2018)

Source: Financial Statements of IFIs in 2018

In general, most of the IFIs complied with the regulation by disclosing SNC events and earnings in the annual financial report under the Shariah Committee’s report. Seven Islamic banks and thirteen takaful operators reported that they had encountered no SNC events throughout the financial year. The rest identified certain SNC incidents and disclosed them. Four Islamic banks published all four items in the report while the others did not. 

In term of number and amount, five Islamic banks disclosed both items in their financial reports whereas two takaful operators disclosed one item only; i.e., the number of SNC events, as illustrated in Table 2.

Table 2: Number of SNC Events and Their Amounts

Name of Institution

Number of SNC events

Amount of SNC events (RM)

Bank Islam

8

9,852.53

Maybank Islamic

1

28,000

Alliance Islamic

2

2,797

Ambank Islamic

1

3,699

OCBC Al-Amin

1

3,000

Hong Leong MSIG

1

Not disclosed

Zurich Takaful

1

Not disclosed

Source: Financial Statements of IFIs in 2018

With regard to nature and rectification plan, it is found that out of six Islamic banks that disclosed the items, four of them illustrated the nature or reason of the SNC events along with the remedial actions whereas the others did not. Only one bank displayed solutions without stating the nature of or reasons for its SNC activities. For the takaful operators, none of them disclosed the reasons for their SNC events. However, they mentioned the corrective measures for rectifying those SNC incidents. Table 3 shows the details on the nature and rectification plans for the respective institutions:

Table 3: Nature and Rectification Process of SNC Events by IFIs

Name

Nature / Reasons

Rectification process

Bank Islam

  1. Absence of wakalah ‘aqad execution for term-deposit tawarruq-i
  2. Payment of late payment charges due to delay in rental payment
  3. Overcharged profit during abandoned period of house financing
  4. Income recognition of interchange fee received from Non-Halal Merchant Category Code
  5. Absence of tawarruq commodity trading for Islamic Credit Card
  1. All SNC income realize has been disposed to charitable causes
  2. A few preventive measures

Ambank Islamic

  • Lack of awareness among the staff in handling extension cases for Islamic financing

 

  1. Reinforced staff awareness
  2. Reviewed the process

Alliance Islamic

  1. Delays in performing commodity trading for Commodity Murabahah Revolving Credit-i
  2. The execution of rescheduling & restructuring of Cash Vantage Personal Financing-I without an underlying asset
  1. Enhanced the current process flow
  2. Conducted training
  3. System controls

OCBC Al-Amin

  • Non-compliance to Guidelines on Late Payment Charges for Islamic Financial Institution (IFI)
  • Strengthened internal processes and operations

Hong Leong Islamic

 

Not disclosed

  1. Tightened the process flow
  2. Enhanced all related procedures

Hong Leong MSIG

Not disclosed

  1. Secured the process flow
  2. Augmented the current takaful procedures

Zurich Takaful

Not disclosed

  • Reported to the regulator within the shortest time-period

Source: Financial Statements of IFIs in 2018

Conclusion    

In a nutshell, only a few IFIs in Malaysia have fulfilled all the requirements stated in the policies issued by BNM regarding detailed disclosure of SNC income and activities. The relevant information regarding number, amount, nature and rectification process has yet to be fully disclosed in the financial reports of some Islamic banks. There are also some Islamic banks that have been completely silent on this issue. Moving forward, it is hoped that more IFIs will embrace these guidelines and policies to ensure more effective management on SNC risks in the future.


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