Dubai: Wider acceptance and adoption external Sharia audits across the Islamic finance industry will go a long way in preserving the stability of Islamic finance markets.
The industry still has some way to go to address the current lack of transparency surrounding internal audits and the absence of public disclosure. Rating agency S&P believes it needs clearly defined, standardised Sharia principles and interpretation.
Although pre-transaction Sharia validation typically rests with internal Sharia boards, an external Sharia audit (currently required in Oman and Pakistan) could strengthen the industry’s credibility. Similar to international financial reporting standards and external audit exercises at conventional banks.
“In our opinion, this would require a clear definition of the standards external auditors would need to measure. Although the AAOIFI has published numerous standards, Sharia boards appear to have significant leeway in making decisions regarding compliance,” said Mohammad Damak, Director - Global Head of Islamic Finance
Lack of standardisation has resulted in variations in Sharia requirements across the industry, with Malaysia being seen by market participants as the least conservative jurisdiction and Saudi Arabia as the most conservative. But it has not hindered the industry’s sustained growth over the past few years.
“Given the current slowdown of Islamic finance activity, we believe some standardisation could help reposition the industry for future growth, increase its attractiveness to new players, and support the integration of economies where Islamic finance is prevalent. Decision makers would need to choose between trying to establish a truly global industry or optimising the current structure of a collection of small industries” said Damak.
Relevance of compliance
Although rating agencies do comment on Sharia compliance and restricts its role to providing independent and objective credit opinions on rated Islamic finance institutions and issues Sharia compliance is important in their analysis in that the effect of non-compliance could strain an issuer’s capacity to honour its financial obligations.
For example, a bank that is perceived as non-Sharia compliant could lose some of its deposits, especially from corporate and retail clients that are sensitive to Sharia in their business dealings. This, in turn, could lead to significant pressure on the bank’s funding and liquidity profiles.
“To capture this risk, we look more carefully at Islamic banks’ funding structures and whether they have set aside sufficient profit equalisation and investment risk reserves. We also look at the bank’s liquidity profile and its access to central bank funding in a stress scenario. Although we use the same indicators as for conventional banks, we may make qualitative adjustments to our assessment,” he said.
