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Principle 3.0: Banks shall have in place adequate systems and controls, including Shari'ah Committee, Shari’ah Compliance and Shari’ah Audit to ensure compliance with Shari'ah rules and principles.
6.2
Operational risk is inherent in all activities, products and services of Banks and can transverse multiple activities and business lines within Banks. Operational risk may result in direct financial losses as well as indirect financial losses (e.g. loss of business and market share) due to reputational damage.
6.3
In addition to the usual form of operational risks, the Shari'ah compliant Banks and Islamic Windows are exposed to risks relating to Shari'ah non-compliance and risks associated with the Banks’ fiduciary responsibilities towards different fund providers. These risks expose Banks to fund providers’ withdrawals, loss of income or voiding of contracts leading to an impairment of reputation and/or the limitation of business opportunities.
6.4
Banks shall consider the full range of material operational risks affecting their operations, including the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Banks shall also incorporate possible causes of loss resulting from Shari'ah non-compliance and the failure in their fiduciary responsibilities.
Shari'ah Non-Compliance Risk:
6.5
Principle 4.0: Banks shall ensure that the policies and related procedures shall be in place to measure, mitigate and monitor the Shari'ah non-compliance risk. Shari'ah compliance is critical to a Bank’s operations and such compliance requirements must be communicated throughout the Bank and their products and activities.
6.6
In Shari’ah compliant Banking, a majority of the fund providers use Shari’ah compliant Banking services. As a matter of principle, their perception regarding the Bank’s compliance with Shari’ah rules and principles is of great importance to the sustainability of the Bank. In this regard, the Bank must consider Shari'ah compliance as falling within a higher priority category in relation to other identified risks.
6.7
Banks are also exposed to reputational risk arising from failures in governance, business strategy and process. Negative publicity about a Shari'ah compliant Banking business practices, particularly relating to Shari'ah non-compliance in their products and services, could have an impact upon their market position, profitability and liquidity.
6.8
Banks shall ensure that they comply at all times with the Shari'ah rules and principles as approved/instructed by the Banks’ Shari'ah Committee with respect to its products and activities. This means that Shari'ah compliance considerations are taken into account whenever the Banks accept deposits and investment funds, provide finance and carry out investment services for their customers.
6.9
Banks shall ensure that their contract documentation complies with Shari'ah rules and principles - with regard to formation, termination and elements possibly affecting contract performance such as fraud, misrepresentation, duress or any other rights and obligations.
6.10
Banks shall undertake a Shari'ah compliance review at least annually, performed either by a separate a Shari'ah audit department or as part of the existing internal audit function by persons having the required knowledge and expertise for the purpose. The objective is to ensure that (a) the nature of the Banks’ financing and equity investment and (b) the operations relating to all Shari'ah compliant products and services are executed in adherence to the applicable Shari'ah rules and principles, policies and procedures approved by the Bank’s Shari'ah Committee.
6.11
Banks shall keep track of income not recognized arising out of Shari’ah non-compliance and assess the probability of similar cases arising in the future. Based on historical reviews and potential areas of Shari'ah non-compliance. Banks may assess potential profits that cannot be recognized as eligible Banks’ profits, the Bank shall seek its Shari’ah Committee ruling and direction with regard to the appropriate cleansing and disposal of Non-Shari’ah Compliant income.
Fiduciary risk:
6.12
Principle 5.0: Banks shall have in place appropriate mechanisms to safeguard the interests of all fund providers. Where Profit & Loss Sharing depositors’ funds are comingled with the Banks’ own funds, Banks shall ensure that the bases for the asset, revenue, expenses and profit allocations are established, applied and reported in a manner consistent with the Banks’ fiduciary responsibilities.
6.13
Banks failure to perform in accordance with their fiduciary responsibilities could result losses in investments, the Bank may become insolvent and therefore unable to (a) meet the demands of current account holders for repayment of their funds; and (b) safeguard the interests of their Profit & Loss Sharing deposit holders. The Bank may fail to act with due care when managing investments resulting in the risk of possible forgone profits to Profit & Loss Sharing deposit holders.
6.14
Banks shall establish and implement a clear and formal policy for undertaking their different and potentially conflicting roles in respect to managing different types of investment accounts. The policy relating to safeguarding the interests of their Profit & Loss Sharing deposit holders may include the following:
i.
Identification of investing activities that contribute to investment returns and taking reasonable steps to carry on those activities in accordance with the Banks' fiduciary and agency duties and to treat all their fund providers appropriately and in accordance with the terms and conditions of their investment agreements, if any;
ii.
Allocation of assets and profits between Banks and their Profit and Loss Sharing deposit holders will be managed and applied appropriately to Profit & Loss Sharing deposit holders having funds invested over different investment periods; and
iii.
Limiting the risk transmission between current and investment accounts.
6.15
A reliable IT system is necessary for profit & loss sharing mechanism, failure of which may lead to Shari'ah non-compliance risk. The Bank should identify key risk indicators and should place key control activities like Code of Conduct, Delegation of authority, segregation of duties, succession planning, mandatory leave, staff compensation, recruitment and training, dealing with customers, compliant handling, record keeping, MIS, physical controls etc.
6.16
Banks shall adequately disclose information on a timely basis to their Profit & Loss Sharing deposit holders and markets in order to provide a reliable basis for assessing their risk profiles and investment performance.
