Compliance and Its Motivations-The Case of Islamic Finance

Compliance is a word that carries various meanings ranging from positive to negative.  It can also be neutral.  How do we figure where a compliance initiative fits one of the three?  To use the analogy of stages of cognitive development, we can use three stages ie fear of punishment, adherence to norm as a duty, and the belief in principles underlying rules.  When we evaluate the compliance of an institution, it is pertinent that we determine which of the three motives determine how boards and top management strategize and implement such compliance. Shariah compliance is no exception. It is part of the governance framework established by the Regulator wherein the role of the Shariah Committees is given prominence. This role has been further underscored by the Malaysian Islamic Financial Services Act of 2013 in that the Shariah Committees are equally liable to hefty fines and jail sentences if non- compliance when discovered is not rectified within a stipulated period.

The cost of non-compliance can be very costly in the case of an Islamic bank. Revenues from transactions or products that are Shariah non-compliant cannot be recognised as such. This will negatively affect the bottom line and its related ratios. The bank concerned may have to inject more capital to accommodate a higher risk weighted capital adequacy ratio.

At the same time, the reputation of the bank may be so tarnished such that it may take a long time to recover. Also no Shariah Committee member will be willing to see their reputation destroyed for breach of such duties. From the above scenario, the self- interested motivation to avoid losses will be strong enough to warrant significant willingness to heed the advice of the Shariah Committee. It is not surprising if the relationship between the boards and the Shariah Committees become strained if self- interest and the financial performance are the criteria of performance for the directors and reputation for the Shariah scholars.

One possible response is to comply purely from Fiqh perspective rather than for the perspective of Shariah writ large. The instruments are compliant but the practice may not promote the Islamic Banking industry in the long run. Expediency in the hsort run can run counter to sustainability in the long run. However, it may not be the right thing to do because the intention is to appear as compliant, though it may not be in the long term interest of the institution.  In other words, it is compliance according to the adage that we follow the letter of the law rather than the spirit of the law.

The other approach is to comply with the proper audit because that is the standard of best practices established by internationally renowned bodies.  Adjustments are made to specific contexts and are usually done with the advice professionals.  This tends to be the case in most organizations. The rationale for top management is that if they had sought the services of professionals, it would at least be a mitigating factor when they have to account for such breach of duties.

However, this is not without problems. If not part of a culture of value creation based on doing the right thing, in this case to promote Islamic banking industry and system, compliance can degenerate into the first stage of self -centred liability avoidance together with box ticking mentality.

To continuously progress with compliance and risk management, boards and top management have to accept the responsibility for the developing a culture and an environment where compliance and controls are developed and practiced because they are the right things to do. In this case they are meant to support the development of risk sharing and asset based financing in their true sense rather than adopting rulings that may lead to convergence with conventional finance in the long run.

To achieve sustainability boards and top management must first have right set of members and with the right attitude, beliefs and values. They ought to know how to balance the financial performance with the long term performance of developing a viable economic system for Islamic banks of the future.

Why then is this positive approach not easily adopted? Firstly, building a culture takes time and the right kind of vision and mission to guide others into the future. It is not easily sustained when top management have no internal compass in promoting Islamic finance and regards it as a variant of conventional finance.

There is so much that the laws, regulations and guidelines can do. There is so much Shariah governance framework can do. There is no short cut to this approach if sustainability is to be an aspect of corporate responsibility in Islamic Finance. Compliance when it is accompanied by a conviction that it is the right thing to do is more effective for the long term than compliance for the sake of compliance. It is in this context that leadership plays a vital role in the development of the Islamic finance industry.

By Prof Syed Abdul Hamid Aljunid, Professor of Ethics & Governance

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