IFSB, ISRA issue joint WP on Shariah non-compliance risk

Bid to explore implications on capital adequacy of Islamic banks

KUALA LUMPUR, March 31: The Islamic Financial Services Board (IFSB) and International Shariah Research Academy for Islamic Finance (ISRA) are pleased to announce the issuance of a joint IFSB-ISRA Working Paper titled Shariah Non-Compliance Risk in the Banking Sector: Impact on Capital Adequacy Framework of Islamic Banks (WP-05).

The IFSB and ISRA collaboration aimed to study the nature of Shariah NonCompliance Risk (SNCR) and explore its implications on the capital adequacy of Islamic banks. The Working Paper (WP) endeavours to explore the appropriate approach for the application of capital charge for SNCR in the light of available data as well as provide direction for the future studies in this area. The objectives of the WP are:

To study the nature and components of SNCR in the Islamic banking sector;

To evaluate the approaches in identifying SNCR from a contractual perspective and methodologies to deal with SNCR;

To analyse the current level of SNCR faced by Islamic banks and methodologies for its measurement in the calculation of operational risk for capital adequacy purposes; and

To provide policy recommendations and strategies in mitigating SNCR and its consideration for capital adequacy calculation.

The WP 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 used to deal with SNCR. The empirical study focuses on the identification of SCNR resulting from the failure of Islamic banks to satisfy the essential Shariah requirements and conditions as stipulated in the relevant jurisdictions standards, or widely accepted international Shariah standards, the implications of which are reflected in Shariah non-compliance income of Islamic banks that serve as proxy for the SNCR. The WP, however, acknowledges the limitations of using Shariah non-compliance income as a proxy since a majority of Islamic banks do not report, in their financial statements, detailed information about Shariah compliant contracts and the number of events leading to Shariah non-compliance income. Similarly, rectifications or purification of incomes from SNCR events reduces the impact of potential financial loss arising from Shariah non-compliant events.

For the empirical analysis, the WP performs the descriptive and correlation analysis, followed by regression tests to examine the significance of Shariah non-compliance income vis-a-vis bank-specific variables such as the size, profitability and capitalisation as well as macroeconomic indicators by utilising the data of 51 Islamic banks from 11 countries for a five-year period from 2010 to 2014,. 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 of WP-05 subject to qualification in view of continuing limitations in acquiring data lead to the conclusion that instead of applying 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 having a high level of SNCR. WP-05 also illustrates 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.