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Ensuring good Governance

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Zulkarnain Muhamad Sori, PHD, INCEIF, Writes for IB&F about the Malaysian experience in ensuring Shari’ah governance in Malaysia

editor's pickThursday 02, August 2018

The system of corporate control, effective and efficient governance that is consistent with Shari’ah guidance has been an important agenda for Islamic financial institutions (IFIs) since the existence of Islamic finance in Malaysia. This is especially important in light of rapid growth in Islamic finance industry not only in Malaysia but globally. The well-functioning Islamic finance industry can only be sustained if there is good corporate governance practice by IFIs that comply with the Shari’ah guidance.

To this objective, the Islamic Financial Services Act 2013 has been enacted, where the law provides greater regulatory clarity and focus has also been put on Shari’ah compliant socially responsible investment. Even countries like Hong Kong, The Philippines, Singapore and UK have initiated regulatory reforms with the aim to build Islamic banking and capital markets. All these developments indicated that there is a dire need to make sure strong and well-functioning Shari’ah governance is in place to protect the interests of players and stakeholders of Islamic finance. Weak governance system would result in market failure and capital market dry up, and finally, the collapse of the whole financial system.

Shari’ah based corporate governance

Islamic finance practices have been structured in a way to strictly follow the Shari’ah principles by observing its tenets, conditions and principles. Through this approach, business transactions of IFIs are expected to be consistent with Islamic teaching or Shari’ah compliant. Shari’ah governance is a governance system that ensures all activities and business transactions by IFIs are free from nonallowable elements such as Riba, gharar, maisir and other similar attributes. The major differences between conventional corporate governance and Shari’ah governance are that IFIs must undertake their activities only on the basis of Shari’ah law. Conventional corporate governance is different than Shari’ah corporate governance in the sense that the latter emphasise on fairness to all stakeholders through greater transparency and accountability that comply with Shari’ah principles.

Literature on Shari’ah governance failed to clearly define the term, but the Islamic Financial Services Board (IFSB) Standard 3 defines corporate governance of IFIs as: “…a set relationship between a company’s management, its board of directors, its shareholders and other stakeholders which provides the structure through which the objectives of the company are set; and the means of attaining those objectives and monitoring performance are determined.” Therefore, the Shari’ah based corporate governance is more involved than conventional corporate governance, in the sense that board of directors, Shari’ah committee, depositors @ account holders, investors and regulators have direct interests in the IFIs’ business operations and performances. It is interesting to ascertain whether this is a true fact in practice, especially when the infrastructure the IFIs have to work with is all conventional.

 ISSUE 1: Definition of Shari’ah governance

The ultimate objective of Shari’ah governance is to serve the purpose of establishing IFIs i.e. to upheld Islamic values that is guided by Islamic teachings and guidelines known as Shari’ah principles. In Shari’ah governance, Shari’ah compliance could bring strategic advantages to the IFIs, Islamic finance industry and to stakeholders who are committed to Shari’ah based banking and finance activities. Indeed, the Shari’ah compliance of items in both side of IFIs balance sheet i.e. deposits and financings start from designing the contract to marketing and implementation of the product.

In a market survey conducted with 16 Islamic finance practitioners in Kuala Lumpur, Malaysia, all respondents believed that Shari’ah governance refers to the rules and regulation introduced by Bank Negara Malaysia to ensure all IFIs activities are consistent with Shari’ah principles while operating in a modern banking and finance setting. Shari’ah governance framework is adapted based on Malaysian conditions, which might not be applicable in other economies. The respondents reiterated that Shari’ah is the backbone of Islamic finance industry and the absence of Shari’ah principles in IFIs operations would justify the closure of Islamic finance industry. Having a Shari’ah governance framework is a boost to the industry because Shari’ah did not prescribe in detail every step of Islamic finance practices; it only provides general guidelines on how to conduct the operations.

ISSUE 2: The importance of Shari’ah governance

Respondents of the survey agreed that the mandate for Islamic banks and other relevant financial institutions is to operate their Islamic finance business within the context of Shari’ah rules and principles. Thus, the depositors, investment account holders, shareholders and other stakeholders put their trust in the financial institutions to ensure that their conduct and practices are within the label or brand of Islam or Shari’ah. Indeed, the Islamic branding or the Shari’ah branding will facilitate the preparation of the market towards Shari’ah compliance and will pull the various group of stakeholders together in support of the Islamic finance industry. However, there is a significant challenge to conduct Islamic finance business especially in the segment of Islamic finance entity that operates in conventional space. With the introduction of the Shari’ah governance framework, various mechanisms were introduced to ensure the process is properly performed in accordance to Shari’ah principles.

ISSUE 3: Shari’ah governance framework 2010

It is generally agreed that the SGF is very comprehensive and the first of its kind being issued as a regulation in the world. However, there is concern on the different terms used in Malaysia as compared to the one used in the Middle East, where the Shari’ah Committee is called Shari’ah Board. In terms of the level of importance, Shari’ah Committee is placed slightly lower than the board of directors, board risk management control and board audit committee as in Figure 1 below. Yet, in the newly enacted IFSA 2013, the law basically has increased the responsibility of the Shari’ah Committee to be equivalent to the Board of Directors and the Senior Management. The penalties and liabilities for the Shari’ah Committee is also the same as those imposed on the Board of Director and Senior Management.


 Source: Bank Negara Malaysia (2010)

Furthermore, it was argued that when the Shari’ah Committee only look after the Shari’ah resolution, their existence is not integrated to the overall operation of the bank and could be interpreted as a third party to IFIs. Indeed, the Shari’ah Committee plays a role in product approval, monitoring, trouble shooting and rectification. But, they are not decision makers. The Shari’ah Committee should also be represented in the Board of Audit Committee and Board of Risk Management Control because they have a hand in all of the functions. The appointment could be either as a member of the boards or as a permanent invitee. This way instead of having the Shari’ah Committee exists in isolation, they would be actively involved in deliberating recommendations, developing plans, observing financial reporting, conducting risk management and many significant decisions.

ISSUE 4: Shari’ah risk management control function

In general, the size of IFIs plays an important role in determining whether IFIs would set up a Shari’ah Risk Management Control department. Or have dedicated staff from the group Risk Management division that looks into Shari’ah risk management. There is also a common practice where the Shari’ah risk management role is placed under the compliance function. There is also the issue of the different business models practiced depending the business volume or size of each IFI. A full fledge Islamic bank might have the capacity to establish a Shari’ah Risk Management department. A small size IFI or even an Islamic window of a conventional bank might depend on a risk management staff of the Group Risk Management department.

ISSUE 5: Shari’ah review function

The Shari’ah review function relates to a review of IFIs’ Shari’ah compliance, where the Shari’ah review officer would visit branches or departments that offer Islamic finance products to assess their day-to-day activities or performance. The officer would examine the flow of operation and investigates on noncompliance incidence. The non-compliance detected at this level is different that the non-compliance found at auditing procedures, which is considered serious or critical finding. At the Shari’ah review level, any non-compliance findings would result in the respective branches or departments being asked to rectify the incidence through a process more of a consultative nature.

ISSUE 6: Shari’ah research function

The Shari’ah research function is an important function in assisting the committee in seeking relevant information for them to debate and deliberate Shari’ah issues prior to deciding on relevant resolutions. Indeed, the function provides relevant information on particular Shari’ah issues that the Shari’ah Committee is currently considering. The Shari’ah research teamwould very much assist the Shari’ah committee in collecting and collating information. Indeed, if there is no Shari’ah research function, the Shari’ah committee needs to have full knowledge in various aspects of the IFIs business. Similarly, the Shari’ah research function would assist the Shari’ah committee in updating them on the industry updates. The Shari’ah research function would perform research on new products and principles to overcome issues relating to non-compliance risk.

ISSUE 7: Shari’ah audit function

In general, Shari’ah audit is expected to perform a value-added service that examines operational activities, financial recording and reporting, and adequateness of policies and procedures of IFIs. Its function is more towards providing assurance services in the process of delivering their duties. As indicated earlier, the survey discovered that the size of IFIs will determine the structure of Shari’ah audit department, where the common practices for IFIs is to utilise their internal audit department to perform Shari’ah Audit function. There are instances where the function is performed by the group audit department through a dedicated officer. To be effective, the officer should come from an accounting background with an experience in auditing and exposure to Shari’ah issues either through attending training or work experience.


The topic on corporate governance has been continuously discussed in the wake of never ending corporate scandals and crisis. The Malaysian government has put in place several initiatives to strengthen the practice of corporate governance in the country. In 2000, the Malaysian Code on Corporate Governance was introduced, and this was revised in 2007, 2012 and 2017 with the aim to strengthen the monitoring and other functions in the interest of shareholders. On the other hand, despite the fact that the Islamic finance industry has been around for some 40 years, it took some time for the framework for Shari’ah governance to come into being. The Shari’ah governance framework is an important mechanism to ensure that IFIs carry out their roles in accordance with Shari’ah principles in the interest of depositors, investment account holders, shareholders and stakeholders.

The role played by the Shari’ah committee should however be enhanced by putting them in the other boards such as board of risk management control and board of audit committee. This approach will help the committee understand the mission of the institution, and the issues faced by the board and institution. This way, the committee will be able to make their decision in the context of business issues rather than purely Shari’ah theory. Additionally, regulators should consider changes to the structure of Shari’ah governance framework, where the Shari’ah Committee is placed at par with the other boards’ functions or place the committee higher than the other two boards due to their role in Shari’ah perspectives. The four functions namely Shari’ah risk management control, Shari’ah review, Shari’ah research and Shari’ah audit play a crucial role to support the Shari’ah committee in performing their duties by ensuring the IFIs activities are in compliance with the Shari’ah principles.

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