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Shariah Governance Practices in Malaysian Islamic Financial Institutions

Article  in  SSRN Electronic Journal · March 2015

DOI: 10.2139/ssrn.2579174

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SHARIAH GOVERNANCE PRACTICES IN MALAYSIAN ISLAMIC FINANCIAL
INSTITUTIONS
!
Zulkarnain Muhamad Sori (PhD), Shamsher Mohamad (PhD) and
Mohamed Eskandar Shah Mohd Rashid (PhD)
International Centre for Islamic Finance (INCEIF)
The Global University of Islamic Finance
Kuala Lumpur, Malaysia
!!
Abstract
The Central Bank of Malaysia (Bank Negara Malaysia or BNM) introduced the Shariah Governance
Framework (SGF) in 2010 and required all Islamic Financial Institutions (IFIs) to fully implement in
2011. The objective is to provide a proper regulatory framework for IFIs to function within the
required Sharia framework that will help further strengthen the international investor confidence in
the fast growing Islamic Finance Industry in the country. However, to realize this objective, the IFIs
must ‘buy-in’ and provide the necessary infrastructure to effectively implement the requirements of
the framework. This paper deliberates on the level of commitment and implementation of the
requirements of the framework by IFIs in the country, and highlights the success factors, challenges
and suggestions for effective implementation of this framework.
!Sixteen Shariah committee members from 16 different IFIs were interviewed on the issues of interest
and the findings suggest that IFIs perceive that SGF is not only relevant but necessary to ensure that
Shariah committees to keep the gates on the IFIs business operations. It has provided an avenue for
Shariah experts to actively participate in the Shariah Risk Management Control Function, Shariah
Review Function, Shariah Research Function and Shariah Audit Function.
!!
!!
Keywords: Shariah Governance Framework, Banking, Director, Risk Management, Audit
!!

!1

Electronic copy available at: http://ssrn.com/abstract=2579174

! SHARIAH GOVERNANCE PRACTICES IN MALAYSIAN ISLAMIC FINANCIAL
INSTITUTIONS
!Introduction
The system of corporate control, effective and efficient governance that is consistent with Shariah
guidance has been an important agenda for Islamic Financial Institutions 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. For example, the global total assets of the industry as of
end 2014 has exceeding USD2.0 trillion or a compounded annual growth rate (CAGR) of 17.4%
between 2009 and 2014 (Ernst & Young, 2014). The well-functioning Islamic Finance industry can
only be sustained if there is good corporate governance practice by IFIs that comply with the Shariah
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 Shariah compliant socially
responsible investment. Even in countries like Hong Kong, the Philippines, Singapore and the 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 Shariah
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 whole
financial system will collapse.
This paper explores the effectiveness of implementation of Shariah Governance Framework
among Malaysian IFIs with the focus on their level of commitment, the challenges and suggestions to
further improve the effectiveness of implementation of this framework.
!Shariah Based Corporate Governance
There is a dearth of literature on Shariah governance as compared to its counterpart in conventional
corporate governance though there is significant development in Islamic finance industry over the last
few decades (Abdullah, Alnasser and Joriah, 2012). Islamic Finance practices have been structured in
a way to strictly follow the Shariah principles by observing its tenets, conditions and principles.
Through this approach, business transactions of IFIs are expected to be consistent with Islamic
teaching or Shariah compliant. Shariah governance is a governance system that ensures all activities
and business transactions by IFIs are free from non-allowable elements such as riba, gharar, maisir
and other similar attributes. Grassa and Matoussi (2014) pointed out that the major differences
between conventional corporate governance and Shariah governance are that IFIs must undertake
their activities only on the basis of Shariah law, Ahmad and Chapra (2002) points out that
conventional corporate governance is different than Shariah corporate governance in the sense that the
latter emphasize on fairness to all stakeholders through greater transparency and accountability that
comply with Shariah principles. Literature on Shariah governance failed to clearly define the term,
but, 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 Shariah based corporate governance is more involved than conventional corporate
governance, in the sense that board of directors, Shariah committee, depositors @ account holders,
investors and regulators have direct interests in the IFIs’ business operations and performances.
Therefore, 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.
!In view to further improve the corporate governance framework of IFIs in the country, Islamic
Financial Services Act 2013 (IFSA 2013) took effect in 2013 and the brief details of this Act and other
regulations pertaining to the governance issues of IFIs is summarized in Appendix of this paper.
!!
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Electronic copy available at: http://ssrn.com/abstract=2579174

Prior Studies on Shariah Based Corporate Governance
Modern Islamic finance industry has emerged since the last 4 decades and it has been recorded that
the Islamic banking assets with commercial banks globally has shown remarkable achievement that
has passed USD2 trillion in 2014 (Ernst & Young, 2014). In light of the rapid growth of the industry
and the need to sustain this growth requires a strong control of practices and in compliance with
Shariah rules and principles. Despite the exceptional achievement recorded by Islamic finance
industry, there is not much documented evidence on the issues of Shariah governance of IFIs in
practice. For example, Abdullah et al. (2012) discussed the relationship of different governance
structures of Islamic and conventional banks. Chapra and Ahmed (2002) found that the majority of
depositors in IFIs would withdraw their money when there is noncompliance with Shariah principles,
and the development of Islamic finance industry seems much faster in emerging markets like South
East Asia and Middle East, where the governance structure is very much different in the other markets
and high capital ownership and family business are significant features of these market. The result is
protection for minority shareholders and investment account holders (IAHs) for IFIs is weaker in
these markets (Darmadi, 2013; Claessens, 2006). Perhaps, the agency problems like monitoring costs
and information asymmetry are much higher in these capital markets than their counterpart in
developed markets.
Garas (2012) investigated the conflict of interests in the Shariah Committee, the conflict of
interest between Shariah Committee and board of directors and other third parties, and they
discovered that the executive position held by Shariah Committee members has resulted in conflict of
interests in the Shariah Committee. Grassa and Matoussi (2014) examined the governance practices
and governance structure of Islamic banks in Gulf Cooperation Council and Southeast Asian countries
and concluded that there exist shortcomings to the current governance framework for Islamic banks
which needs further improvement and standardization. Hassan (2014) examined the Shariah
governance system practices in IFIs particularly in six major areas namely issues of Shariah
governance, internal framework, roles and functions of Shariah board, attributes of Shariah board
members on independence, competency, transparency and confidentiality, operational procedures and
assessment of the Shariah board’s performance. The findings indicated conflicting perceptions among
the respondents on several issues and disclosed that exist serious gaps and weaknesses in the existing
governance framework that require further enhancement and improvement.
!!
Methodology
A total of sixteen Shariah committee members that had years of experience in the Islamic banking and
finance industry were interviewed from various IFIs and regulatory agencies. The sample institutions
comprised of Islamic Banks (10 respondents), Development Financial Institutions (2), Takaful
Operators (2) and regulatory bodies (2).
!!
Findings
This section summarizes the findings based on the questions that were asked during the interview.
!Question 1: How do you define Shariah Governance?
The idea was to ascertain the practitioners view of ‘Shariah governance’ and its function to facilitate
the governance practice, that is its relevance to the basic structure of modern Islamic banking and
finance that involves product development, marketing, operation and employees conduct of IFIs.
!Indeed, all of the interviewees posited that the ultimate objective of Shariah 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 Shariah principles. In Shariah governance, Shariah compliance could bring
strategic advantages to the IFIs, Islamic finance industry and to stakeholders who are committed to
Shariah based banking and finance activities. Indeed, the Shariah compliance of items in both side of
IFIs balance sheet i.e. deposits and financings start from designing contract to marketing and
implementation of the product. All of the interviewees believed that Shariah governance is concerning

!3
the rules and regulation introduce by the Central Bank to ensure all IFIs activities are consistent with
Shariah principles. One of the respondents pointed out that:
! “Shariah governance is where you govern the whole Islamic Finance activities in the sense
that in addition to the corporate governance that any Islamic Financial Institutions has to
establish, they need to establish the governance for Islamic activities as well. In this context,
Islamic financial institutions as compared to conventional, they have specific function to
perform that differ than their counterpart… for example risk management, you have to look
at it from Shariah perspective as well.”
!It is important to note that Shariah governance is formalization on how IFIs should implement Shariah
requirements in a modern banking and finance setting and the Malaysian version of Shariah
governance put up by the Central Bank i.e. Shariah Governance Framework is adapted based on
Malaysian condition, which might not be applicable in other economies. The respondents reiterated
that Shariah is the backbone of Islamic finance industry and the absence of Shariah principles in IFIs
operations would justify the closure of Islamic finance industry. Shariah did not prescribe in detail on
every step of Islamic finance practices, but, it only provides general guidelines on how to conduct the
operations. An interviewee questioned the following, “So, how do you ensure that there is at least a
certain level of Shariah compliance?” He further continues, “I think that is where Shariah
Governance Framework comes in. It is standardize for everybody.” Another Shariah committee
stressed that Shariah governance is referring to making sure that true Islamic label of IFIs business
and be seen reflected in the business. It is about control that being put in place in IFIs so that any
decision made and how it is made, and how it is put in practice.
In summary, the Shariah committee members had a thorough understanding on the concept
and practice of Shariah governance.
!Question 2: In the context of Shariah Governance Framework and IFSA2013, why Shariah
Governance is important?
In general, the Interviewees achieved consensus that the mandate for Islamic banks and other relevant
financial institutions is to operate their Islamic finance business within the context of Shariah rules
and principles. Thus, the depositors, investment account holders, shareholders and other stakeholders
put their trust to the financial institutions to ensure that their conduct and practices are within the label
or brand of Islam or Shariah. Indeed, the Islamic branding or the Shariah branding will facilitate the
preparation of the market towards Shariah compliance and will pull the various group of stakeholders
together and support the Islamic finance industry. An interviewee pointed out that:
“…we have to provide a degree of satisfaction and assurance to the stakeholders because the
depositors at the end of the day just put their money and go home or go to work and there is
no one basically that give assurance that the operations is in compliance with the Shariah
principle unless we have a strong Shariah Governance within the financial institution.
Because stakeholders they are not allow to access to the business operation and there is no
way to allow the stakeholders to perform kind of audit, review, checking unless basically
there is a legitimate body appointed by the regulator that have this responsibility,
accountability to give that kind of degree of satisfaction to the stakeholders.”
!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
Shariah Governance Framework, various mechanisms were introduced to ensure the process is
properly performed in accordance to Shariah principles. An interview speculates the following:
“To me if you have a loose Shariah Governance, you may have loophole and therefore the
Shariah compliance risk could be very high. As a result, the stakeholders trust will go down
and they might lose the business and the idea will evaporate. But if you have a very strong
Shariah Governance or basically you keep the trust of the stakeholders of financial
institutions...the support will be there and of course the business will flourish and expand.”

!
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Question 3: What is your view on the Shariah Governance Framework 2010?
All of the interviewees pointed out that the SGF is very comprehensive and was the first of its kind
being put as a regulation in the world. However, the significant majority of the interviewees are
concern on the different terms used in Malaysia as compared to the one used in the Middle East,
where the Shariah Committee is called as Shariah Board. Furthermore, Shariah Committee is placed
in a box that is a bit lower than the board of directors, board risk management control and board audit
committee as pointed out by an interviewees as follow,
“The Shariah Committee is not called as Shariah Board as it is in the Middle East or as
mentioned in the AAOIFI standards. …Looking at the implication, the liability, they should
be at par with the others. I’m not saying to lift the Shariah Committee up, but, I may say
lower the two boxes down, the board risk management control and the board audit
committee, at least.”
!When asked on possible improvement to be done on the SGF, an interviewee pointed out that:
“…The board of Shariah audit committee should basically include one member of the
Shariah Committee. At the level of finalizing the report, board of Shariah committee is not
around. Well, in some banks, they invite Shariah Committee to sit in the meeting, but, it is
not a mandatory…in practice they are invited. When they are invited, they don't have a vote,
the weightage is a bit less. …this will ensure more transparency and to ensure more strong
governance... Shariah Committee member should be at least in the Shariah Audit
Committee…”
!The interviewees are of the opinion that the Shariah Governance Structure should be slightly
rearranged either according to ‘liability exposure’ as shown in Figure 1 or according to ‘job function’
as shown in Figure 2. As shown in Figure 1, the board of directors, board risk management control,
board Shariah committee and board audit committee are placed at the same level on the ground that
they share same risk and liability amount as spelled in the Islamic Financial Services Act 2013 (IFSA
2013). On the other hand, Figure 2 rearranged the key players according to their job function, where
the Shariah committee is placed below the board of directors after recognizing the importance of the
board as the leader of the institutions. Shariah committee is located above the other two players i.e.
board risk management control and board audit committee due to their role as Shariah authority that is
in line with the objective of setting up the IFIs. This is to recognize the importance of roles and
functions played by the Shariah committee.
In the newly enacted IFSA 2013, the law basically has increased the responsibility of the
Shariah Committee to be equivalent as the Board of Directors and the Senior Management. The
majority of the interviewees raised their concern on the level of penalties and liabilities. Furthermore,
it was argued that when the Shariah Committee only look after the Shariah resolution, their existence
is not integrated to the operation of the bank and could be interpreted as a third party to IFIs. Indeed,
the Shariah committee plays a role in product approval, monitoring, trouble shooting and rectification.
But, they did not perform the role of making decision.
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Figure 1: Proposed Model Based on Liability Exposure
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Figure 2: Proposed Model Based on Job Function
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! Furthermore, there are suggestions for the Shariah committee to be represented in the board
of audit committee and board of risk management control. It was pointed out that Shariah committee
should have an eye in all of the functions. One of the interviewees believed that the Shariah
committee has enough members to sit in the other board of IFIs. By having this, the members of
Shariah committee will actively involve in questions and answers, deliberating issues, discuss and
debates relevant matters such as issues in risk management, operation and audit that arise in all boards
and their deliberation of fatwas would be in context with the vision and mission of IFIs. Indeed, the
interviewees are of opinion that the appointment could be either as a member of the boards or as a
permanent invitees. This means that their participation would not require the SGF or organizational
structure be amended to reflect their membership, instead, it would be adequate by having a clear
policy of their participation. Their presence in all of the boards is to assist in making the operation or
policy more effective and comprehensive. Instead of letting the Shariah committee exist in isolation
from the others, they would actively involve in deliberating recommendations, developing planning,
observing financial reporting, conducting risk management and many others. By doing this, the
Shariah committee will appreciate the real issues and challenges of the institution. One of the
interviewees conclude with the following,
“…once you make decision, you will combine theory and practice of the issue. If you are not
there, you make decision based on theory. Unless you are convinced otherwise.”
!Question 4: What is your view on Shariah Risk Management Control function?
In general, the interviewees believed that the size of IFIs plays important role in determining whether
IFIs would set up a Shariah Risk Management Control department or a unit or just having a dedicated
staff of the group risk management division that look into Shariah risk management. There is also
common practice where the Shariah risk management role is placed under the compliance function.
Interviewees also pointed out that there are different business models in practice depending of their
business volume or size. A full fledge Islamic bank might have the capacity to establish Shariah risk
management department or division, and, on the other hand, a smaller size IFIs such an Islamic
window of conventional bank might have a risk management staff of the group risk management
department.
To be effective, the officer that perform the Shariah risk management role should come from
the risk management background and have a knowledge, training, and awareness on Shariah. Besides
personal qualities, the interviewees believed that the IFIs’ ecosystem like sound infrastructure,
robustness information technology, effective internal control system and communication network
could play important role in ensuring effective Shariah risk management control function. Another
respondent suggested that the officer must be familiar with the banking business, have knowledge in
Shariah and understand the business or industry such as construction, oil and gas and infrastructure
development. This is due to the existence of risk in all phase of product cycle starting from product
development to product marketing and sales. There are different risk profiles for different products
such as Musharakah loan have different risk profiles than the Mudarabah loan. The officer must be
familiar with the sales contract, product criteria and many other important activities. In summary, all
respondents suggest the importance of Shariah risk management function and qualified personnel to
manage this function.
!Question 5: What is your view on Shariah Review function?
The Shariah review function relates to review of IFIs’ Shariah compliant, where the Shariah review
officer would visit branches or departments that offer respective products or handling a particular
system and make assessment on their day-to-day activities or performance. An interviewee stressed
out that the officer would examine the flow of operation and investigates on non-compliance
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 Shariah review level, any
non-compliance findings would result in the respective branches or departments be asked to rectify
the incidence and this process is considered as more consultative nature. The examination includes
citing of documents or forms relating to business operation, evaluating issues on products through
examining transactions, contracts, products and financial implications on the clients, operation flow
!7
and evaluating marketing exercise by examining picture and wording of an advertisement will be
deliberated to make sure that inexistent of misleading or non-compliance to Shariah.
An interviewee pointed out that Shariah review officer will visit all branches and division and
perform relevant examination and in case the Shariah review function found any non-compliance
incidence, they will provide feedback and require the respective branch or department to rectify the
non-compliance. It is more towards an internal consultative nature as compared to audit findings,
which are more towards reprimanding or penalizing the non-compliance. Indeed, the Shariah review
received their mandate to perform their duties from the Shariah committee resolutions. This is to
ensure that what has been discuss and decided by the Shariah committee are complied with.
When asked on suitable credentials or qualifications for Shariah review personnel, the
interviewees are of opinion that the officer needs to understand accounting and auditing besides
Shariah.
!Question 6: What is your view on Shariah Research function?
All of the interviewees are of opinion that the Shariah research function is an important function in
assisting the committee in seeking relevant information for them to debate and deliberate Shariah
issues before they come out with relevant resolutions. Indeed, the function provides relevant
information on particular Shariah issues that the Shariah committee is currently considering.
The interviews reveal that the Shariah research function would very much assist the Shariah
committee in collecting and collating information. Indeed, if there is no Shariah research function, the
Shariah committee needs to have full knowledge in various aspects the IFIs business. Similarly, the
Shariah research function would assist the Shariah committee in updating them with the circulation or
updates by the profession. The Shariah research function would perform research on new products,
principles, and new prospectus to overcome issues relating to non-compliance risk. On the other hand,
an interviewee has gone further with the expectation that the Shariah research function should extend
their role to cover a wider area like research on IFIs business. The interviewee pointed out that the
Shariah research should also perform research on suitability of a particular product in certain industry
and geographical area where IFIs could promote their product, issues relating to the financing needs
of SME, risk profile of SME, and product risk profile. The interviewee argued that the research should
not only limit to banking, but, should extend to capital market, international issues, and industry
related issues. It was further illustrated that the current Shariah research function is confine to smaller
scope. He pointed out that,
“I was from a conventional bank and I have experience as a member of interest rate
committee. How do we decide on interest rate? Every month we have a meeting to decide on
the level of interest rate that we going to pay our depositors and the level of interest rate that
we going to charge our borrower. Before we come to our decision, we have to review the
world economy like American economy, European economy, Asia Economy. We have to
review the market development including the price of commodities, petroleum and all of
those kinds of things. Then, we look at regional economy. After that we will look at
Malaysian economy and the banking industry especially our competitors. These become our
benchmark and we have to decide our interest rate…All of these exercises is supported by a
strong research team. In the context of Islamic banking, I like to name the research function
as the Economic and Shariah Research Function rather than just Shariah Research.”
!The respondents suggest that the Shariah research function should perform the role of “think tank” for
respective IFIs. Their findings could help the other units of IFIs such as consumer banking,
commercial banking and corporate banking. The interviewees stressed out that the officer of the
Shariah research function should be conversant in area of economics, statistics and Shariah.
!Question 7: What is your view on Shariah Audit function?
In general, Shariah audit is expected to perform a value added services that examine operational
activities, financial recording and reporting, and adequateness of policies and procedures of IFIs.
Their function is more towards providing assurance services in the process of delivering their duties.
Although in ideal situation, personnel that taking charge of Shariah review should be different than
the Shariah audit, the way of practices is largely depend on size of operation of particular IFIs. The
!8
advantage of having the same staff for Shariah audit as well as Shariah review is the staff will be
familiar with the transactions and other relevant issues. However, we need a clear separation and
segregation of duties between the two functions.
As indicated earlier, the interviews discovered that size of IFIs will determine the structure of
Shariah audit department, where the common practices for IFIs is to utilize their internal audit
department to perform Shariah Audit function. There are instances where the function is performed by
the group audit department that dedicates the job to an officer that responsible on Shariah audit. To be
effective, the officer should come from accounting background that have experience in auditing and
exposure on Shariah issues either through attending training or work experience. However, an
interviewee objected the suggestion that the Shariah audit officers are to refer and discuss any audit
findings with the Shariah committee prior to getting approval from the board of audit committee. He
stressed out that audit findings are classified and sensitive information and should be treated in
confidence with the audit department. Subject to approval by the board of audit committee, any
information will be shared with the Shariah committee before the audit report be presented to the
board of directors.
!Question 8: What is your view on the qualification requirements for Shariah Committee
members as outlined in the Shariah Governance Framework?
The SGF outlined that the majority of the minimum five members of the Shariah committee should
come from those with Shariah background and the balance can be comprised of other disciplines like
legal, accounting and banking. All of the interviewees supported this requirement on the basis that the
subject matter that the committee will discuss, debate and deliberate is relating to Shariah. An
interviewee pointed out that,
“In practice there are people from different background with different qualifications become
a member of the Shariah committee, provided that they show a degree of knowledge and
understanding in Islamic finance and the reason being is this is Shariah matter… In AAOIFI,
they call it as fatwa. Fatwas are issued by Shariah scholars. So, if fatwa issued by economist,
they will not buy the fatwa. To me, it is part of acceptance from the audience on who is
issuing the fatwa.”
!Another interviewee supported and pointed out that,
“…we need the committee member with some other dimension like legal background that
will help us a lot… in term of going through the documents. This is because when you talk
about Shariah resolution, it is not only about the product structure alone, but, it involves the
documentation. If you look at issuance of sukuk… first you need to look at the whole
proposed structure whether it is in compliance with the Shariah. Then you have to look at the
terms and conditions of this particular structure. Whether it is in line with the Shariah and
then lastly you have to look at the whole documentation… If you don’t have any one from
legal background who can spot what is the implication of the issue presented from legal
perspective, then, the committee might overlook on certain issues…”
!The interviewees further reiterated that the Shariah discipline is very wide and only relevant sub-
disciplines are qualified to be members of the Shariah committee of IFIs. The minimum requirement
for Shariah sub-disciplines are those with muamalat, fiqh and usul fiqh background. The other sub-
disciplines such as marriage, divorce, maintenance and custody might not be relevant to perform the
duties of Shariah committee in IFIs. It is important to have the muamalat, fiqh and usul fiqh
knowledge, an interviewee argued that,
“In Shariah, we have a lot of branches of knowledge. We have, Ulumul Quran, Ulumul
Hadith and others. Although we say that one who masters Ulumul Quran will master
everything, but, the way our modules in the university has been structured is that those who
major in Ulumul Quran, they don’t really look at the fiqh issues because they will study more
on the tafsir itself, what is the methodology of mutafsirun, evolution of interpreting the
Quran and mukjizat of the Quran.”
!!
!9
She further added that,
“For me, the first requirement is fiqh and usul fiqh knowledge. Usul fiqh is the knowledge
that the fuqaha has to have before they can issue any fatwa. Because when we talk about
Usul fiqh, we talk about principles. Without knowing the knowledge of Usul fiqh, then, it is
difficult for us to issue any resolutions.”
!In general, the interviewees pointed out that selection of right candidate for the Shariah committee is
utmost important because this will determine whether the committee is functioning towards objective
set form them. A good mixture of relevant discipline should be observe carefully, where candidate
with fiqh, usul fiqh and muamalat should be the majority members of the committee and candidate
from other disciplines like legal, accounting, banking and business could be a helpful source of
information for the Shariah people to understand the business and subsequently come out with
resolutions and fatwas in the context of the business and not only from theoretical perspectives.
!!
Conclusion
The topic on corporate governance has been continuously discussed in the wake of never ending
corporate scandals and crisis. The Malaysian government has indeed had put in place several
initiatives to strengthen the practice of corporate governance in Malaysia, where the Malaysian Code
on Corporate Governance has been introduced in 2000, which was revised in 2007 and 2012 with the
aim to strengthen the monitoring and other functions in the interest of shareholders of respective
organizations. On the other hand, since the starting of Islamic finance industry about some 40 years
ago, the issue of Shariah governance has been slowly taken place to ensure IFIs are well managed and
serve the interests of various parties like the depositors, investment account holders, shareholders and
the other general stakeholders. The difference between Islamic financial institutions and the other
organization like conventional banks and others is the objective of establishing IFIs is to conduct
business activities that is consistent with Shariah, whereas their counterpart objective is to create and
increase shareholder value throughout time. It is the objective of this paper is to examine the
effectiveness of Shariah Governance Framework from the perspective of Shariah committee.
!It was found that the Shariah Governance Framework is an important mechanism to ensure that IFIs
are carrying out their roles in accordance to Shariah principles in the interest of depositors, investment
account holders, shareholders and stakeholders. However, the interviewees are of opinion that the role
played by the Shariah committee should 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 vision and mission of the institution, and the issues faced by the board and
institution, thus, the committee will make their decision in the context of business issues rather than
purely Shariah theory. Furthermore, the interviewees suggesting the regulator to make some changes
to the structure of Shariah governance framework, where the Shariah committee be placed at par with
the other boards functions or place the committee higher than the other two boards due to their role in
Shariah perspectives. The interviewees believed that the four functions namely Shariah risk
management control, Shariah review, Shariah research and Shariah audit play a crucial role in
supporting the Shariah committee in performing their duties in making sure that the IFIs activities are
in compliance with the Shariah principles. Finally, the interviewees supported the move that require
the majority of Shariah experts sit on the Shariah committee and they should possess fiqh and usul
fiqh knowledge.
!

!10
!References
Abdullah, S., Alnasser, A. S. and Muhammed, J. (2012). Introduction to corporate governance from
Islamic perspective. Humanomics, 28 (3), 220 - 231
Ahmed, H. and Chapra, U. (2002). Corporate governance in Islamic financial institution, periodical
document No. 6, Islamic Research and Training Institute Sector Network, The Islamic Financial
Services Board, Kuala Lumpur.
Chapra, M. U. and Ahmed, H. (2002). Corporate Governance in Islamic Financial Institutions.
Occasional Paper No. 6. Jeddah: IRTI/IDB.
Claessens, S. (2006). Corporate Governance of Islamic Banks: why is important, how is it special and
what does this imply?, The World Bank Financial Sector Network, The Islamic Financial Services
Board, Kuala Lumpur.
Ernst & Young (2014). World Islamic Banking Competitiveness Report 2013-2014: The Transition
Begins. Available online at http://emergingmarkets.ey.com/wp-content/uploads/downloads/2013/12/
World-Islamic-Banking-Competitiveness-Report-2013-14.pdf (accessed on 10th December 2014)
Garas, S.N. (2012). The conflicts of interest inside the Shari’a supervisory board, International
Journal of Islamic and Middle Eastern Finance and Management, Vol. 5 No. 2, pp. 88-105.
Grais,W. and Pellegrini,M.(2006). Corporate governance and Shari’ah compliance in institutions
offering Islamic financial services, World Bank Policy Research Working Paper No. 4054, available
at: www-wds.worldbank.org (accessed on 10th June 2014).
Grassa, R. and Matoussi, H. (2014). Corporate Governance of Islamic Banks. International Journal of
Islamic and Middle Eastern Finance and Management, 7 (3), 346-362.
Grassa, R., Matoussi, H. and Trabelsi, S. (2010). The impact of Shariah supervisory board
characteristic’s on Islamic bank performance, Corporate Governance and the Global Financial Crisis
Conference, Wharton, University of Pennsylvania, Philadelphia.
Hasan, Z. (2014). In search of the perceptions of the Shari'ah scholars on Shari'ah governance system,
International Journal of Islamic and Middle Eastern Finance and Management, 7 (1), 22-36.
Hasan, Z. (2011). A survey on Shari'ah governance practices in Malaysia, GCC countries and the UK:
Critical appraisal, International Journal of Islamic and Middle Eastern Finance and Management, 4
(1), 30-51.
Islamic Financial Services Board (IFSB) (2009). Guiding Principles on Corporate Governance For
Institutions Offering Only Islamic Financial Services (Excluding Islamic Insurance (Takaful)
Institutions And Islamic Mutual Funds). Available online at http://www.ifsb.org/standard/ifsb3.pdf
(accessed on 10th December 2014).
Lewis, M.K. (2007). Islamic banking in theory and practice, Monash Business Review, 3 (1), 1-8.
Malekian, E. and Daryaei, A.A. (2010). Islamic values forward into better corporate governance
systems, available at: www.globalresearch.com.my/proceeding/icber2010_proceeding/
PAPER_113_IslamicCorporate.pdf (accessed on 12 October 2014)
Quttainah, M.A. (2011). Do Islamic banks employ less earnings management?, Economic Research
Forum working paper series No. 645, Cairo.
Salim Darmadi, (2013). Corporate governance disclosure in the annual report: An exploratory study
on Indonesian Islamic banks, Humanomics, 29 (1), 4 - 23
Siddiq, M.N. (1981), Muslim Economic Thinking: Survey of Contemporary Literature, The Islamic
Foundation, Leicester.
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!11
 Appendix
! Rules and Regulation on Shariah Based Corporate Governance in Malaysia
!!
Islamic Financial Services Act 2013 (IFSA 2013)
The Malaysian Central Bank (i.e. Bank Negara Malaysia) is the regulatory body that supervises the
practices of local and international financial institutions that operate in Malaysian territory, where the
Bank enforces two important acts that were enacted by the Parliament namely the Banking and
Financial Institutions Act 1989 (BAFIA 1989) and the Islamic Financial Services Act 2013 (IFSA
2013). Besides these acts, listed Islamic financial institutions have to carefully observe the Bursa
Malaysia Listing Requirements (BMLR) and the Malaysian Code on Corporate Governance (MCCG).
BAFIA 1989 provides guidelines, rules and regulations in the licensing and regulation of institutions
carrying on banking, finance company, merchant banking, discount house and money-broking
businesses. Initially, the act supervises the practices of both conventional and Islamic financial
institutions, however, in light of the rapid growth of the Islamic Finance industry, the IFSA 2013 was
introduced to mitigate potential Shariah and Islamic Finance business risks, providing better
supervision and regulatory framework for Islamic Financial Institutions, payments systems and other
relevant entities and the oversight of the Islamic money market and Islamic Foreign exchange market.
The IFSA 2013 categorically stated that all Islamic financial institutions should comply with Shariah
requirements through compliance with any ruling of the Shariah Advisory Council (SAC) of the
Central Bank with respect to aim, operation, business, affair or activity. The Central Bank of Malaysia
Act 2009 pointed out that the SAC is the authority for the ascertainment of Islamic law for the
purposes of Islamic financial business (Section 51 (1) of the Act). The roles and functions of SAC
cover the ascertainment of the Islamic law on financial matters and issues the relevant rulings1,
advising the Central Bank on Shariah issues relating to Islamic financial business, activities and/or
transactions of the bank, providing advice to Islamic financial institutions and any other functions as
may be determined by the Bank.
!Shariah Governance Framework by the Malaysian Central Bank
The Central Bank has mooted a significant effort to ensure the overall Islamic financial system in
Malaysia operates in accordance with Shariah principles by introducing the ‘Shariah Governance
Framework for Islamic Financial Institutions’ (SGF) that take into effect from 1 January 2011. The
framework was developed with the expectation to enhance the role of the board, Shariah Committee
and management in relation to Shariah matters, including enhancing the relevant key organs in
executing the Shariah compliance and research functions. Two-tier Shariah governance infrastructure
comprising of two (2) vital components namely the centralised Shariah Advisory Council (SAC) at
the Central Bank and an internal Shariah Committee established in each of the IFIs are in operation.
The SAC was given the ultimate authority in the determination of Islamic law on any financial matter
relating to Islamic business operations, activities or transactions. On the other hand, the Shariah
Committee is given a mandate to provide guidance to the respective IFIs on Shariah matters.
The key players of Shariah Governance as shown in Figure 3 are Board of Directors, Board
Risk Management Committee, Board Audit Committee, Management and Shariah Committee in
ensuring that Shariah as overarching principle in Islamic finance. To ensure the key players of Shariah
Governance properly deliver their duties, the framework outlines 4 main functions such as Shariah
Risk Management Control Function, Shariah Review Function, Shariah Research Function and
Shariah Audit Function. Besides the key players of Shariah Governance and the 4 functions, Figure 3
also showed the line of communication or reporting between key players and main functions.
!

1According to Section 51 (2) of the Central Bank of Malaysia Act 2009, “rulings” means any ruling made by the Shariah
Advisory Council for the ascertainment of Islamic law for the purposes of Islamic financial business.
!12
 !
!
Source: Bank Negara Malaysia (2010)
!Figure 3: Shariah Governance Framework Model for Islamic Financial Institutions
!There are 7 principles in the framework: Principle 1 of the framework pointed out that the Board of
Directors should establish their own IFI’s Shariah Governance Framework, where they are expected
to understand the Shariah non-compliance risks associated with Islamic finance business and its
possible implications to the respective IFIs. Principle 2 of the framework pointed out that the ultimate
responsibilities on Shariah compliance lies on the Board of Directors though the Shariah Committee
plays key role to ensure its compliance, where the Shariah Committee should comprised of minimum
5 members of which the majority is Shariah experts. Principle 3 of the framework outlines the
importance of observing independence of Shariah Committee in exercising their duties to make
objective and informed decisions. Principle 4 pointed out the importance of right competency,
understanding and continuous knowledge enhancement on the Shariah as well as keep abreast on the
latest developments in Islamic finance. Principle 5 outlines the importance of confidentiality
treatment of information obtained by the Shariah Committee. Principle 6 illustrated on professional
ethics, judgement and consistency to be maintained in ensuring Shariah compliance. Principle 7
outlines on the need for a robust Shariah compliance function that comprised of review and audit
functions, supported by risk management control process and internal research capacity.
!Other Relevant Rules and Regulations
Besides the IFSA 2013 and the SGF 2011, the other laws that directly or indirectly related to Islamic
finance that might have influence on the development of Shariah Governance is Islamic Banking Act
1983 (IBA 1983), Banking and Financial Institutions Act 1989 (BAFIA 1989), (Development
Financial Institutions Act 2002 (DFIA 2002), Companies Act 1965 (CA 1965), the Bursa Malaysia
Listing Requirements and the Malaysian Code on Corporate Governance.
The IBA 1983 was gazetted with the aim to provide supervision on licensing and regulation
of Islamic banking business. Though a large majority of the provisions in the IBA 1983 concerning
licensing and control of Islamic finance business by the Central Bank, some of the provisions provide
power to the regulator in observing the practice of good Shariah governance. The section 53A of the
Act has given full power to the Central Bank to issue relevant guidelines, circulars or notes from time
to time when it deem necessary with the aim to provide supervision that is consistent with the spirit of
the Act. This section has made the issuance of the SGF 2011 is legal and become mandatory for all
IFIs to carefully observed and comply with. In addition, all IFIs shall comply with all advice issued
by the SAC as specified by the section 13A of the IBA 1983.

!13
 The BAFIA 1989 was gazetted with the aim to provide guidelines on the licensing and
regulation of institutions carrying on banking, finance company, merchant, banking, discount house
and money-broking businesses, for the regulation of institutions carrying on certain other financial
businesses, and for matters incidental thereto or connected therewith. Although, all IFIs are
specifically regulated under the IBA 1993, they are bound to all provisions under the BAFIA 1989 as
stipulated by the section 124. Thus, all rules relating to corporate governance referred to by the
BAFIA 1989 are applicable to participants in Islamic finance industry.
The DFIA 2002 provides guidelines on the regulation and supervision of development
financial institutions and for matters connected therewith. Specifically, only 2 (two) parts of the Act
that address the governance issue namely Part II and Part VII. Part II deals with Management,
Ownership and Control, where it specifies the role of the Board of Directors, appointment of Chief
Executive Officers and directors, disqualification of Chief Executive Officer and director, disclosure
of director’s interest. Part VII of the Act outlines issues on auditor and accounts such as appointment
and disqualification of auditors, auditor’s report, annual accounts, accounting standards and relevant
matters. Consistent with the other acts, the DFIA 2002 give power to the Central Bank to issue
guidelines, circulars or notices for the supervision of development of financial institutions.
The CA 1965 which was amended in 2007 include current and contemporary issues in
corporate governance that provides guidelines relating to incorporation, operation and liquidation for
incorporated body in Malaysia. It is divided into 12 parts, where specific rules on corporate
governance contained in Part V and VI of the Act. Though the CA 1965 governs overall incorporated
bodies regardless whether Islamic or non-Islamic financial institutions, the governance provisions
contained in the Act become underlying rules and governance structure of IFIs. Consistent with
provisions in the other Acts, the CA 1965 recognised the importance of role played by the Board of
Directors and therefore, they be held responsible on the overall operation of the company.
The Financial Reporting Act 1997 (FRA 1997) specifically pointed out that the applicable
accounting standards for financial reporting in Malaysia are those standards issued by the Malaysian
Accounting Standards Board (MASB) namely MASB Standards, Financial Reporting Standards
(FRS) and Malaysia Financial Reporting Standards (MFRS). This does not mean that the regulators in
Malaysia rejecting standards issued by the AAOIFI, instead, in the case the applicable standards did
not clearly or truly explain any Islamic financial transactions, the reporting body is allowed to provide
separate disclosure indicate the impact and alternative information for the said problem in their notes
to the accounts. Indeed, the MASB has continuously review the applicable standards that is not
consistent with the Shariah and continuously communicate and lobbying the International Accounting
Standard Committee (ISAC-the body that issue the IFRS) to make changes to the relevant standards
for IFIs.
The Bursa Malaysia Listing Requirement (BMLR) is a comprehensive and accessible rule
which govern, among others, the listing of issuers and products on the stock exchange, and the
obligations of the issuers post-listing, the trading, clearing and settlement of the exchange products,
the admission and post admission obligations of participants. Though the BMLR did not specifically
dedicate to IFIs, the regulations are made compulsory for all companies that listed and aim to be
member of the Bursa Malaysia. Indeed, many of the parent, anchor or associated companies to the
IFIs are listed on the Bursa Malaysia and need to carefully observe on the requirements imposed on
them. The BMLR is divided into 16 chapters and requirement on corporate governance is specifically
laid down in Chapter 15, where issues relating to directors, audit committee and auditors are clearly
outlined.
The Malaysian Code on Corporate Governance (MCCG) was introduced with the aim to
strengthen corporate self and market discipline and promoting good compliance and corporate
governance culture as a result of the damage of investors’ confidence in Malaysian capital market
during the 1997/98 Asian Financial Crisis. It was first introduced in March 2000, which marked a
significant milestone in corporate governance reform in Malaysia. The Code was later updated to
improve the roles and responsibilities of the board of directors, audit committee and the internal audit
function. Recent amendment to the code to update with contemporary issues contained in the MCCG
2012 that focuses on strengthening board structure and composition recognising the role of directors
as active and responsible fiduciaries. Indeed, the MCCG 2012 recognised the director’s roles as an
effective stewards and guardians of the company to ensure best practices like compliance with laws
!14
 and ethical values, and maintains an effective governance structure to ensure the appropriate
management of risks and level of internal control as shown in Figure 4 below.
!
!
Company & Shareholders Establish Clear Roles &
Responsibilities of Board of Strengthen Composition
!
Relationship
Directors

!
Timely & High Quality
MCCG 2012 !
Disclosure
Reinforce Independence
!
!
Risk Management
Integrity in Financial
Reporting
Commitment of Directors !!
Figure 4: Eight Principles of the Malaysian Code on Corporate Governance
!
!!
Though the code is a voluntary move, it become mandatory for all companies that listed on
the Bursa Malaysia, where the Listing Requirement requires them to comply with the code or explain
when there is non-compliance incidence. For IFIs that is subsidiary or related companies to a parent
that listed on the exchange, they will be at least reflected with the requirement in the MCCG 2012
through the parent status as listed company. On the other hand, most of the applicable laws discussed
above did not clearly prescribe on the mechanics of good governance such as the need for effective
and independent board, competent audit committee, the role of nomination committee, the importance
of risk management and effective financial reporting, timely and high quality disclosure and
shareholders and company relationship. Thus, the MCCG 2012 could be a good reference to the
market players in Malaysian Islamic finance industry.

!15

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