Applied Islamic Banking

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has issued and published number of accounting and auditing standards that all Islamic financial institutions should comply with and implement, as the Auditing standards for Islamic Financial Institution No. 4 and No. 5 specifically focus on Shari’ah Supervisory Board (SSB) and Shari’ah review

The definition of Shari’ah Supervisory Board according to AAOIFI is “An independent body of specialized jurists in fiqh almu’amalat (Islamic commercial jurisprudence). However, the Shari’ah Supervisory Board may include a member other than those specialized in fiqh almuamlat, but who should be an expert in the field of Islamic financial institutions and with knowledge of fiqh almu’amalat. The Shari’ah Supervisory Board is entrusted with the duty of directing,reviewing, and supervising the activities of the Islamic financial institutions in order to ensure that they are in compliance with the Islamic Shari’ah Rules and Principles. The Fatwa and rulings of the Shari’ah Supervisory Board shall be binding on that Islamic financial institution.”

Unlike the other financial institutions, Islamic banks have in-house religious advisers commonly known as the Sharia’h Supervisory Board. In principle, Islam does not recognize any separation between business and religion. As Allah S.A.W has mentioned in His Holy Quran in surah al-Baqarah:

Thus, the existence of Shari’ah Supervisory Board becomes an adviser to ensure that all business transactions are measured, recorded and reported in accordance with Islamic precepts or Shari’ah compliance. That is because the nature of the Islamic Banks’ business which involve daily operational activities.

Meanwhile, the objective of Auditing Standard for Islamic Financial Institutions No. 5 is to establish standards and provide guidance to assist Shari’ah Supervisory Boards of Islamic Financial Institutions in performing Shari’ah reviews to ensure compliance with Islamic Shari’ah Rules and Principles as reflected in the fatwa, ruling and guidelines issued by them. (See Appendixes II & III)

The Establishment, & some Products approved by the SSC

According to Section 124 of Banking and Financial Institution Act (Amendment Act) 1996, provides that:

“For the establishment of a Shari’ah Advisory Council whose function is to advise the licensed institutions on the operations of their Islamic financing business with a view that they abide with Islamic principles. The advice of the Shari’ah Advisory Council shall be translated into written directions issued by the Bank Negara which are required to be complied by the relevant institutions.”

The development of a comprehensive Islamic financial system in Malaysia first started with the establishment of Bank Islam Malaysia Berhad (BIMB) in 1983. Therefore, the establishment of the religious board known as Shari’ah Supervisory Council (SSC) was established concurrently with BIMB. In other words, the role of the SSC was formed from the moment the financial institution is incorporated due to the need to provide continued supervision, and permanent checking of contracts, transactions and procedures. This religious board is well-chosen and experienced to advise the management of BIMB to establish a powerful system for the conduct of business in compliance with the provision of the Shari’ah.

As the only 100% Islamic bank incorporated in Malaysia, BIMB provides more than hundred types of Islamic financial products and services activities including banking, takaful, stock broking, leasing and other related services. The main source of funds of BIMB finance is through customer deposits or deposit accounts. The customer deposits can be divided into two categories, namely Al-Wadiah Saving Account and Al-Mudharabah Investment Account.

In brief, an Al-Wadiah Saving account operates on the Islamic principle of Al-Wadiah Yad Dhamanah (guaranteed safe custody). A customer who deposits in the Al-Wadiah saving account is not only safe custody services but also a guarantee that his funds will be available as and when requested. And the minimum deposit to open the account is only RM10.

Moreover, BIMB also accepts deposits or investments from the depositors or investors on the basis of Al- Mudharabah. The Mudharabah Investment Account is for a specific period with an agreed profit sharing ratio. It means that at the end of the period of investment, the investor will receive profit based on the agreed profit sharing ratio with the bank.

On the other hand, the main application of funds of BIMB are financing the acquisitions of asset, and financing the use of services of asset. The former type of financing uses the Islamic principle of Al-Bai Bithamin Ajil (BBA) contract while the latter type of financing uses Al-Ijarah contract.

Al-Bai Bithamin Ajil can be defined as sales with deferred payments or installments, where the bank is the seller and the customer is the buyer of the asset. At the beginning, the bank will buy the asset or property from the owner and then sells it to the customer so that the buyer or customer is able to pay by installment.

We also would like to point out that the Shari’ah Supervisory Council in BIMB plays an effective role in increasing halal (permissible) activities in Islamic bank by ensuring all the products and services are compliant with the shari’ah rules and they are carried out correctly.

In practice, SSC will make sure all shari’ah aspects are addressed before launching the new products and services to the customers. Moreover, the board also requires coming out with report of the Shari’ah Supervisory Council which will be attached to the annual report of Bank Islam Malaysia Berhad at every end of the financial year.

Members of the Council

The Shari’ah Supervisory Council has both supervisory and consultative functions. Since the Shari’ah scholars on the religious board carry great responsibility, it is important that only high level scholars are appointed to such board. The board also should consist of trustworthy scholars who are highly qualified to issue fatwa (religious decision) on financial transactions. In addition, they must have considerable experience with knowledge of modern dealing and transactions.

All of the members in SSC were appointed from the managing director of BIMB. The election begins with submission of the suggested names by the bank to central bank; Bank Negara. Then Bank Negara will rise up the names to the Finance Minister who currently is our Prime Minister, to elect the members. They can be re-elected or nominated again. They can stay in their position for 2 years after the election.

Below is a brief idea regarding the appointment of Shari’ah Supervisory Board according to Auditing Standard for Islamic Financial Institutions (ASIFI) No.5:

Every Islamic Financial Institution should have an SSC appointed by the shareholders in the Annual General Meeting (AGM). The board of directors normally recommends some names (nominees) to the shareholders in the AGM; they choose the board taking into consideration the local legislation and regulations. Shareholders may authorize the board of directors to fix the salary of the SSC.

SSC should include at least three members. They can ask for help from consultants who have the expertise in business, economics, laws, accounting, and others.

SSC should not include directors or significant shareholders of the Islamic Financial Institution.

Dismissal of a member is possible subject to the approval of shareholders in the annual general meeting. However, before it reaches the shareholders, it needs a recommendation from the board of directors.

The SSC carries out their duties on a part time basis. They usually meet every one week, two weeks or one month. It depends on the importance of the meetings and the work load.

Based on our interview with the secretary of BIMB’s Shari’ah Supervisory Council; Ustaz Abdul Ghani Endut, he mentioned that there are 6 members (including secretary) in the council who are among the popular scholars in Shari’ah, law, economics and banking sectors. Those top members in the BIMB’s Shari’ah Supervisory Council are as follow:

Chairman of SSC since July 1 st 2002 to June 30 th 2003. He is also member of SSC of Syarikat Takaful Malaysia Berhad, Syarikat Takaful Indonesia, Syarikat Takaful Singapura nd Labuan Offshore Financial Services Authority (LOFSA) since 2001.

Member of SSC since its inception 1983. He represents Malaysia Government in the Fiqh Academy of the Organization of Islamic Conference (OIC) from 1996.

Member of SSC in 1989, also a Mufti of the Federal Territory of Kuala Lumpur and member of the Shari’ah Council of Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) since 2001.

Member of SSC since 1999, a Director General and Shar’ie Chief Justice of Shariah Law Division Malaysia and also a member of AAOIFI since 1998.

Appointed as a member of the SSC on 1 st June 2002 and now works as an Internal Research Fellow at the Centre of Fiqh Muamalat, Islamic Banking and Finance Institute Malaysia (IBFIM).

Secretary of BIMB’s Shari’ah Supervisory Council and currently is the Deputy Manager in the Shari’ah Department.

Aims / Objectives of Shari’ah Supervisory Council

The main aim or objective of Shari’ah Supervisory Council of BIMB is to ensure that the products and services rendered by BIMB are in compliance with the Shari’ah principles and regulations. There should not be any queries or doubt about that particular products or services when it is introduced to the customers. It is the responsibilities of Shari’ah Supervisory Council (SSC) to make sure that the products and services are permissible.

Moreover, the objective of SSC is also to help in visualizing the mission of Bank Islam Malaysia:

“Ensure constantly discovering new horizons of excellence. Besides, building on rich heritage as the nation’s premier Islamic Financial Institution. BIMB continuously innovate new Islamic products and services to meet sophisticated customer demands”.

Besides, the objectives of Shari’ah Supervisory Council is also to cooperate with other concerned institutions to define the financial goals in Islam and to choose the appropriate and effective modes of finance and means of control to achieve such goals.

Relationship between BIMB and Bank Negara

From the information that we have gathered through our discussion with the Secretary of BIMB’s Shari’ah Supervisory Council, we found that there are no direct relationship between SSC and Bank Negara (central bank). Therefore there is no regular framework of conducting meeting with Bank Negara such once a month or once a year.

However, if Bank -Islam Malaysia Berhad (BIMB) wants to offer a new invention of product or services, then they have to submit their proposal to Bank Negara in order to get an approval. For example, BIMB proposes to offer new types of savings account such as Al- Wadiah to public; they have to submit the proposal to Bank Negara in order to ensure that the particular product or service is compliant with Shari’ah.

Power of the Shari’ah Supervisory Council Starting from 1999, the quorum of a Shari’ah Supervisory Council (SSC) meeting was reduced from 3 members to 2 members plus the secretary. Therefore, the authority to make decisions either to agree or to reject can be done by 2 members of SSC rather than to wait until all of the members agree. This is due to difficulty to gather all the SSC members in one meeting since most of them are very busy and have lots of commitments. For example, one of the SSC members is the Mufti of Federal Kuala Lumpur. He might be very busy solving local or abroad matter, which is under his responsibility.

Referring to the annual report 2002 of BIMB’s Shari’ah Supervisory Council, Dato’ Md. Hashim Haji Yahaya and Dr. Ahmad Shahbari@Sobri Salamon, reported on behalf of the board. This report is very important as it will prove that the operation of the bank for the year have been conducted in conformity with the Shari’ah principles. (See Appendix I)

This clearly shows that when any 2 members of Shari’ah Supervisory Council plus the secretary agree and approve a decision, it is considered valid and become the decision of the board as a whole.

In practice, the permissibility of transaction or business activities under the Shari’ah is assured by the issue of fatwa of legal matter. This fatwa is issued by the religious board of most Islamic banks across the world. Therefore, those fatwa and resolution by the Shari’ah Supervisory Council should be binding upon the financial institution’s management. Moreover, it should be independent and free to give opinions on proposed contracts and transactions.

The power of Shari’ah Supervisory Council is unlimited on products and services. The board has full authority to approve all the products and services of BIMB. Whatever they decide, the bank will apply. However, SSC has no power in the management of the bank. For example, if BIMB decided not to launch the product, it is up to the management committee. The SSC cannot force the management to launch the product even if they have approved that the product is permissible according to the Shari’ah.

to regulate its meetings and spell out the procedures to be followed in arriving to decisions and recommendations. Such regulations are proposed by the SSC and are approved by the general meeting of shareholders.

the chairman of Shari’ah Supervisory council has the right to attend the General

Meeting of shareholders. He may choose to submit any issue for discussion, yet he has no right to vote in the meeting.

also have the right to access all the financial statements of the financial institutions

As mentioned earlier, the main role and function of Shari’ah Supervisory Council is to ensure that the entire products and services in the Islamic Bank are in compliance with the Shari’ah rules. This means that there is no any single product or service offered by the bank without an approval from the Shari’ah Supervisory Council.

The religious board will review the operations of the bank to ensure that they comply with Shari’ah. This is to a large extent, like an investigating. In the increasing complex and sophisticated world of modern finance, the Shari’ah Supervisory Council try to answer the question whether or not proposals for new transactions or products confirm to the Shari’ah. The council offers appropriate recommendations. So that, no form of investment or business activity is undertaken unless they are approved, in advance, by the religious board.

Shari’ah Supervisory Council (SSC) also must issue a report to users of financial statement certifying that the bank has adhered to Islamic precepts in all its financial transactions. In conjunction, the fully independence of SSC is important for those users of financial statements who need assurance that the bank has strictly adhered to such Islamic rules. Otherwise, it may affect the consumers of the Islamic banks when SSC reports management violation of the Shari’ah. Users generally share a commitment to Islamic rules, which is expected that the demand for the bank services by the majority will continue so long as the bank is fully to be adhering to Islamic rules in all its operations. This report is to give credibility to the financial statement from religious perspective.

The Shari’ah Supervisory Council’s report should contain the following basic elements (As per ASIFI Standards):

title
addressee
opening or introductory paragraph
scope paragraph describing the nature of the work

opinion paragraph containing an expression of opinion on

date of report and
signature of the members of Shari’ah Supervisory Board

The detail explanation to prepare the report can be referred to Auditing Standard for Islamic Financial Institutions (ASIFI) No.4. (See appendix II)

The role and duty of Shari’ah Supervisory Council can be summarized as the following:

Draft and approve, in collaboration with other concerned departments and officials, model contracts and agreements to govern and regulate all the bank’s activities and dealings.

Update and improve the models to confirm with Shari’ah principles, rules and spirit (maqasid).

Study and decide on, from Shari’ah point of view, issues and problems submitted by the board of directors and/or the general manager

Provide advice and/or instructions to the management of the bank

To carry out its above duties, the SSC has been entrusted with the authority to inspect the bank’s operations, examine the necessary documents, and summon any official of the bank.

Present, whenever necessary, reports to the general manager and the board of directors conveying the SSC’s views and observations on the bank’s activities.

Submit to the general meeting of shareholders an annual report containing among other things, the SSC’s opinion on the compliance of the bank’s operations with Shari’ah precepts.

The above diagram shows the whole process or procedure of approving new products and services at BIMB.

Firstly, Research and Development Department (R&D) of BIMB will come out with proposal of new products/services. This proposal will be revised by the Organization and Method Department in order to prepare product manual. Then, the management committee from Product Development Department is responsible to decide either to approve or not on that product manual and features. If they give an approval, both product manual and proposal will be submitted to the central bank; Bank Negara.

After Bank Negara gives an approval to launce those product/services, it goes back to the management committee of BIMB. Of course the management has to wait until they get an approval from Shari’ah Supervisory Council. Here SSC plays an important role to evaluate the permissibility of that product according to the Shari’ah as it is also required by the Act. SSC must ensure that it is pure or 100% Islamic products/ services from riba’ or interest free.

One important field that every company is trying to upgrade is the accounting system. Since Bank Islam is an Islamic organization, meaning totally different from the conventional ones, we expected that the SSC has a major involvement in setting the basis and the standards of accounting. We found out that the SSC is totally not involved in making the accounting policies.

However, since Bank Islam is one of the Islamic Banks which have been established everywhere; we knew that the Shari’ah Supervisory Board (SSB), in Middle East has set the accounting policies and standards to be followed by all Islamic Banks. These standards are called AAOIFI standards (Accounting and auditing standards for Islamic financial institution). Bank Islam used to accept only the cash basis concept. That is, recognizing revenue when received, and expenses when paid. Expenses are allowed to be under accrual basis, which means that the expenses could be recognized immediately when incurred.

However, starting from year 2002, the bank had made a decision to implement the accrual basis due to the reason that Bank Negara and AAOIFI standards recommend it.

Due to the constraints faced by the Islamic Banks in Malaysia, or generally the banks which are offering the Islamic products, in term of combining the AAOIFI standards from one side and Bank Negara as well as Companies Act 1965 on the other side, Malaysian Accounting Standards Board (MASB) developed MASBi-1 regarding the presentation of financial statements of Islamic Financial Institutions.

It has been implemented since the 1 st of January 2003. Moreover, they are currently developing MASBi-2 regarding Ijarah Financial lease because it is not recognized by AAOIFI standards.

Auditing the financial statements is generally related to accounting. However, in terms of procedures and objectives, auditing differs significantly from accounting. Accounting is “a process that creates financial statements and other financial information that is useful for management”. Auditing on the other hand, does not create accounting information but “it enhances the creditability of the financial statements or other information that is subject matter of the audit”.

There are two types of audit: 1) Internal Audit and, 2) External Audit. We are going to write about the relationship between the Shari’ah Supervisory Council SSC and the external audit, since the external auditor is the one who is going to assure the financial statements.

The external audit firm, which is going to audit Bank Islam, should be recognized, by laws, by the Malaysian Accounting Standards Boards MASB. MASB is an approved accounting, standards in Malaysia.

One important step for the auditor to do before the issuance of the audited financial statements is to communicate with the Shari’ah Supervisory Board. Check the Bank Negara Malaysia’s agreement, meaning SSC should provide them with letter of Bank Negara that states that a certain product or service has been agreed upon by Bank Negara Malaysia. That is to assure that the product or service applied is in compliance with the laws of Malaysia. The auditor, then, start to deeply examine the transactions of those products based on sample basis. This process should be done to all products and services in Bank Islam. At the end, the auditor issues the financial statements stating his/her opinion whether the financial statements are true and fare or otherwise.

From the previous discussion, we found that SSC has a powerful hand in making decision about the fairness of the financial statements. In other words, SSC is an important instrument for the auditor to state his opinion about the financial statements.

Moreover, auditor has to state in his report the members of the SSC, how they have been elected and when in order to give the financial statements more creditability to the interested parties or users.

Shari’ah Supervisory Council of Bank Islam has come across many challenging issues throughout their operating. During our interview, we could only find out three issues, they are as following:

Investment in non-Islamic Shares:

Bank Islam is currently investing in Islamic and non-Islamic shares. Ustaz Abdul Ghani Endut justified it, saying that Bank Islam is a profit-oriented company. The reason why Bank Islam invests in non-Islamic shares is that the profitability of the company may decrease due to the current trend. Investors will not invest their money in the bank unless the bank offers them non-Islamic shares.

Due to Al-hajah Wa Al-dharurah, SSC agreed for the bank to invest in non-Islamic shares. However, in order to overcome this problem, the SSC has put a condition that any profit out of this investment would be given to Charity Societies for the public interest (Maslaha ‘Ammah).

In Malaysia, there are certain policies and products not compliant with the laws applicable. However, they are compliant with Shari’ah rules and regulations. One example is the national link code under the state government.

To illustrate the given example, we say, that every state in Malaysia has different rulings. Some laws, which are applicable in the whole country, are not applicable in Kelantan and Trenengganu. If a Malaysian (Indian raced) approaches Bank Islam in Kelantan to ask finance to buy a land in Kelantan, by state law, it is not lawful for non-Malay to own lands. So, Bank Islam cannot finance non-Malay. Here, another question will be raised; Is Bank Islam Malay?

Draft for amendment:

Bank Islam has submitted drafts for amendment regarding the hire purchase contracts (financial) lease, which is not complied with Shari’ah Act to Parliament through Hal Ehwal Pengguna since 1992.

Unfortunately, since 1992 until this point of time, there has been no any response.

According to our opinion, we suggest that the SSC in Malaysia is to be one separate entity, not controlled by the government or any private enterprises. Bank Negara could control it since Bank Negara is the main regulator of the country’s economy.

We see it redundant when every bank has its own SSC. What is the point, as we mention earlier, of the existence of SSC in Bank Islam since the proposals will be raised to SSB in Bank Negara to be approved? Moreover, it is time consuming.

However, if it was the suggested separated entity, who is going to establish the new products and services, study the proposals, and approve them, then offer them to the market (banks sector), it would be less time consuming, more suitable and more applicable.

In the past few pages, we tried to simplify, for the readers, the meaning of Shari’ah Supervisory Council, what they do, and to what extent their authority is to. Our main source was Ustaz Abdul Ghani Endut, whom we really thank for his kind host and hospitality. Through this paper we thank him so much.

Bank Islam as an Islamic organization needs advisors to navigate the entity. These advisors are presented as SSC in Bank Islam.

The task being done by the SSC in Bank Islam is very hard, not only that but it might give them high risk because they act in position as same as the Mufti.

As we have seen, SSC has an important duty to do, which is mainly to check whether the products and services are in compliant with the Islamic Shari’ah rules and regulations.