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The Need for Credible Reporting of Shariah Non-Compliance Event by Islamic banks in Malaysia

Syahiru bin Shafiai
By Syahiru bin Shafiai
2 months ago
The Need for Credible Reporting of Shariah Non-Compliance Event by Islamic banks in Malaysia

Islamic banking, Shariah

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  1. THE 2nd ISLAMIC MANAGEMENT DEVELOPMENT CONFERENCE (IMDeC 2018) The Need for Credible Reporting of Shariᶜah Non-Compliance Event by Islamic banks in Malaysia Syahiru bin Shafiai1, Engku Rabiah Adawiah Engku Ali2 Graduate Fellow, Islamic Science University of Malaysia1 IIUM Institute of Islamic Banking and Finance Kuala Lumpur, Malaysia syahirushafiai@yahoo.com Professor, International Islamic University Malaysia2 IIUM Institute of Islamic Banking and Finance Kuala Lumpur, Malaysia Abstract—The paper discovers the issue of Shariᶜah noncompliance event disclosure as reported in the annual reports and Basel II Pillar 3 disclosure by Islamic financial institutions in Malaysia. The extent to which shareholders trust on the information reported in financial statements depends on the credibility of those annual reports. This Shariᶜah non-compliance event disclosure has value-relevance to investors and the public interest, but previous studies lack the reasons that affect Islamic financial institutions’ decisions to willingly disclose the event. The paper aims to discuss whether the advisory role constrains the Shariᶜah Committee members to improve disclosure which can increase the accountability of the company and market confidence. Shariᶜah Committees are the backbone of Islamic financial structure and they play a substantial role in the efficient functioning of the system. Financial institutions establish the credibility of their annual report by having an independent Shariᶜah Committee to verify the accuracy of those disclosures. This study also wants to provide understandings as to whether current Shariᶜah non-compliance event disclosure practices of Islamic banks can achieve the anxieties of shareholders to assist them improving transparency. This paper aims to uncovers the information released in the report for the year 2016 and 2017 of 16 Islamic banking in Malaysia. The paper discusses the need for improving transparency through sufficient, valid and pertinent disclosure of Shariᶜah non-compliance event in the reports. What is required is not necessarily only the disclosure of the Shariᶜah non-compliance event per se, but it should be consisted of an explanation, in plain and comprehensible language to mitigate the risk. 2016 [1], the accumulation profit of world Islamic banking industry is anticipated to achieve USD$30.3 billion by 2020. Approximately 92% of international banking assets are based in the QISMUT markets (Qatar, Indonesia, Saudi Arabia, Malaysia, United Arab Emirates and Turkey. Malaysia’s capabilities in the Shariᶜah - compliant asset management industry has developed strength to strength. Hanadzlah [2] said the Malaysian government will continue to ensure that Malaysia will become a global leader in Islamic asset management. As Malaysia i s moving progressively to a highincome economy, 60 percent of Malaysian Gross Domestic Product (GDP) by the year 2020 is contributed by service sector. By the w ay, the Malaysia’s financial industry is predicted to be a crucial element in the nation’s service economy with Islamic finance industry as one of Malaysia’s largest competitive value propositions [3]. Every year, financial institutions will publish their annual report to the public on their business achievement and performance. Hence, it helps to strengthen the transparency of the company. Nowadays, from the community awareness, the financial institutions are under pressure, they begin to release several information including risk exposures, management policies and risk management practices [4]. However, every company have their own degree of transparency through the firm's disclosure policy to ensure the report depicts the relationship between the strategic objectives of the firm and the key performance indexes [5], [6]. The annual report should disclose to the public on both financial and non-financial performance measurement, the operation of base pay, bonuses, and short and long-term incentives in link to the execution of the firm [6]. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) state that a key purpose of financial statements is to improve decision-making by lenders, shareholders, potential investors and other providers of capital and investment. Keywords— disclosure, risk management; shariᶜah committee; shariᶜah governance; effectiveness; shariᶜah reporting; shariᶜah non-compliance event Introduction Islamic banking and finance has grown up globally, according to World Islamic Banking Competitiveness Report 105
  2. THE 2nd ISLAMIC MANAGEMENT DEVELOPMENT CONFERENCE (IMDeC 2018) Purpose of Study Given the importance of Shariᶜah governance, this conceptual paper discovers the disclosure of Shariᶜah noncompliance event as reported by the financial institutions in the annual reports of Islamic banks in Malaysia. International accounting standard practiced by conventional banking practices usually issues some obligatory and voluntary supply of information concerning the level of disclosure in an annual report [7]. Hence, the disclosure practiced by Islamic banks are able to meet the requests of shareholders to support them in enlightening the transparency to enhance corporate governance [8]. Shariᶜah Advisory Shariᶜah Compliance and Review Management Transparency and Disclosure In 2012, Minhas published a paper in which he discussed the transparency and disclosure. The discussion is not only influence to the cost of capital but also on the reputation of the company, shareholders’ decision and to the fluctuation in share prices. The information is of two categories, financial and nonfinancial. A quality and timely information on the matters of the company makes them a good return shares and it helps the company to generate capital from the public. In a study into disclosure issue, shareholder and the public are always concerned with useful and correct information about a company in their decision-making process and investment strategy. Hence, the consumers’ confidence would also help to promote Malaysia as an Islamic financial centre. Transparency Transparency is defined as “the public disclosure of reliable and timely information that enables users of that information to make an accurate assessment of a bank’s financial condition and performance, business profile, risk profile and risk management” [9]. The guidelines on disclosures and financial reporting also should be covered by Malaysian Islamic banking and finance ecosystem. For instance, Guidelines on Financial Reporting for Islamic Banking Institutions has been reviewed to improve and facilitate users of financial statements to evaluate and measure different risks profiles and characteristics. Moreover, it is also to confirm that it is in line with the Malaysian Financial Reporting Standards (MFRS). The guideline is effective from 5 February 2016 and is estimated to inspire more quality, transparency and significance of Islamic finance system [10]. The Islamic Financial Services Board (IFSB) is an international standard-setting organisation that promotes and enhances the soundness and stability of Islamic finance defines the Shariᶜah governance system in IFSB-10 [11] as “a set of institutional and organizational arrangements through which IFIs ensure that there is effective independent oversight of Shariᶜah compliance over the issuance of relevant Shariᶜah pronouncements, dissemination of information and an internal Shariᶜah compliance review”. Legitimacy Theory Suchman [14, p. 574] deliberates that “legitimacy is a generalized perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs, and definitions.” In this paper, legitimacy theory has the part of clarifying the organizations behaviour in fulfilling voluntary social disclosure of information to meet shareholder requirements. Public perception toward the financial institutions undertakings are disclosed in reported in line with the requirements of industry players [15]. AAOFI, BASEL, IFSB and BNM The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has set up Islamic accounting standard that comprises a different type of disclosure requirements and regulations on the Islamic financial institutions. Islamic accounting can be extensively defined as a system of information that provides result of operation of institutions and make sure that the data and statistics disclosed are valid, justifiable, Shariᶜah compliance, and the most important is - it must be free from any false corporate information [7]. Hence, the perspectives of legitimacy theory and corporate governance structures are entreated in this paper. The scenario in Malaysian capital market and public ownerships make this conceptual paper has more importance towards the Islamic finance industry. They will be able to value the present Shariᶜah regulatory framework in improving the level of revelation Shariᶜah non-compliance event disclosure by IFIs in the annual reports. This Shariᶜah non-compliance event disclosure has value-relevance to stockholders and the public interest, but what previous study is lacking is regarding the reasons that effect IFI’s decisions to willingly disclose the event. In the perspective of IFIs, the definition of corporate governance can be referred to in the IFSB-3 [12], Guiding Principles on Corporate Governance for Institutions Offering Only Islamic Financial Services (excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds). The standard or Shariᶜah governance is required to sustain the trust of clients of IFIs and to safeguard the interest of investors and other stakeholders in the Islamic financial system. To support and reach a certain level of development, regulators of IFIs need to highlight the Shariᶜah regulatory issues by the appropriate and sound Shariᶜah governance model based on the true values of Islam. The model is called Shariᶜah Governance Model (SGM) introduced by Minhas [13] which is consisted of four basic pillars. TABLE I. Management and Supervision On the other hand, Bank of International Settlements (Basel) Committee on Banking Supervision Standards [16] has discussed five (5) guiding principles for banks’ Pillar 3 disclosures which are: SHARIᶜAH GOVERNANCE MODEL Principle 1: Disclosures should be clear Principle 2: Disclosures should be comprehensive 106
  3. THE 2nd ISLAMIC MANAGEMENT DEVELOPMENT CONFERENCE (IMDeC 2018) Principle 3: Disclosures should be meaningful to users Principle 4: Disclosures should be consistent over time Principle 5: Disclosures should be comparable across banks Effects Shariᶜah Non-Compliance Event The failure of the product in the market may cost IFIs severe direct and indirect loss [17], [18]. But Hassan, Izhar & Hassan [17], [18] are much more concerned with reputation. Having a negative reputation to the public will affect the confidence level of investor and the existing or potential customer. The failure to manage the Shariᶜah non-compliance risk effectively can result to invalidation of an Islamic contract. Thus, the income from the contract must be channelled to charity. Of course, as a Shariᶜah Committee, they are trying their very best to ensure the products are following Islamic principles. As a team who has the authority to endorse the product, Shariᶜah Committee should take this as their Key Performance Indicator (KPI) [19]. The approval process of a product needs ample time from the first moment it is tabled until the Shariᶜah Committee make a decision. The entire process cannot be completed automatically. Hence, human rulings are needed to decide on certain issue [20]. Moreover, manual work is still needed to check documentations, surveys on public perception and others. In the case of Islamic finance, the issue of maṣlaḥah (public interest) will also influence the Shariᶜah Committee when issuing the resolutions. On the other hand, the effectiveness of Shariᶜah Committee is not only needed in term of halal or haram but also, the justifications of each product before it is offered to the public. Thus Adam & Bakar [21] suggest getting as many intelligent methodologies to boost Shariᶜah compliance business by changing the technique that the businesses are managed. Shariᶜah non-compliance income must be taken out from the company and be given to the charity and they must be transparent regarding this issue. The requirements in Pillar 3 completes the minimum riskbased capital requirements and other quantitative prerequisites in Pillar 1 and the supervisory review process in Pillar 2. This revised standard intends to develop a market discipline by reporting official information to stakeholders and other interested parties are anxiously waiting news concerning the company, as long as it does not require the disclosure of confidential data or sensitive information. In annual report disclosure, there are Shariᶜah non-compliance event that may be included in the IFIs’ annual financial report statement. Banks are strongly recommended to disclose the basic information, and to articulate as far as possible how they mitigate and handle any possible Shariᶜah non-compliance event according to policy document - Financial Reporting for Islamic Banking Institutions (Minimum Disclosure Requirements) issued by Bank Negara Malaysia [10], Part 10.5 “The explanatory notes to be disclosed in the annual financial statements of a licensed person shall include the information specified in 10.6 to 10.21” On the other hand, this conceptual paper seeks to make sure that every IFI is conducting its business in full compliance with all Shariᶜah governance disclosures standards as stated in Capital Adequacy Framework for Islamic Banks issued by Bank Negara Malaysia [30], Part C, Specific Disclosure Requirements (11) TABLE II. Type of Disclosures Qualitative Quantitative In the same vein, Akkizidis & Khandelwal [22] in their book Financial Risk Management for Islamic Banking and Finance note that the risk can arise due to people, processes, systems, as well as several other factors. In this research, the researchers are trying to figure out the involvement of people which is Shariᶜah Committee towards the Shariᶜah non-compliance event in the institutions. Hassan [23] stated that the term “people” is referred to groups of stakeholders who are included in the operations of IFIs. These include Board of Directors (BOD), Shariᶜah Committee and management officers of IFIs. It is opposed that the obedience of ensuring Shariᶜah compliance of Islamic banking products not be solely relied to Shariᶜah Committee, but also to another department in IFIs. While certain researchers focus on other factors, Akkizidis & Khandelwal [22] are more concerned with people factor, it discusses the losses which come from events such as human errors, frauds, violations of internal rules and procedures. Nowadays, the issues are more complex for IFIs since the modern Islamic financial activities and the characteristics of the financial contracts are totally different [18]. SHARIᶜAH GOVERNANCE DISCLOSURES Disclosure Requirement 1. Description of the Shariᶜah governance structure, systems, processes and controls employed for the purpose of ensuring Shariah compliance. 2. Description on rectification process of nonShariah compliant income occurring during the year. 3. The amount of non-Shariah compliant income and the number of non- Shariᶜah compliant events occurring during the year. Qualitative and Quantitative Disclosure According to the Basel Committee on Banking Supervision [24], Shariᶜah risk is part of operational risk. The causes of such risk may be of three types of internal causes: (1) people; (2) internal processes; and (3) systems; and one external factor which result from external events [25]. In general, the causes of Shariᶜah non-compliance in practice as outlined by Lahsasna [26] include the following: (a) Lack of knowledge, skills, and 107
  4. THE 2nd ISLAMIC MANAGEMENT DEVELOPMENT CONFERENCE (IMDeC 2018) competency (b) Lack of training (c) Lack of close monitoring and proper supervision (d) Weakness of internal control system (e) Weakness in the information technology and infrastructure of the system (f) Human error and moral hazard (g) Dual banking business activities (h) Miscommunication (i) Logistics. to expose t o t h e market developments and issues in the industry. Despite the Bank Negara Malaysia’s expectation that t h e Shariᶜah committee must ensure compliance with Islamic rules at all times, their part as an advisor. They had to rely on moral persuasion which is inadequate to ensure compliance as lined up by the central bank. Without reinforcement of the task of the Shariᶜah committee, the reports will continue to be highly motivated by the need to align wi t h BNM guidelines. New blueprints will enhance the role of Shariᶜah committee and improve the governance aspect of the Shariᶜah committee decision. Previous studies showed more governmental regulatory intervention is growing and has increased public confidence in companies [28]. Much has been accomplished, but much more still needs to be done. Research Method The extent and nature of Shariᶜah non-compliance event disclosure is gathered from the content analysis of annual reports of 16 Islamic bank [27] for the years 2016 and 2017, prior to a more detailed prescriptive regulatory environment occurring in this topic when Financial Reporting for Islamic Banking Institutions issued by Bank Negara Malaysia became effective in the first quarter of 2016. To clarify the factors that could affect board decisions about the level of discretionary disclosure details concerning Shariᶜah non-compliance event. This study only takes information on financial statement and Syari'ah Committees Report by the financial institutions in the annual reports and Basel II Pillar 3 Disclosure of Islamic banks in Malaysia. TABLE III. No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Acknowledgment I am highly indebted to Islamic Science University of Malaysia (USIM) and Ministry of Education Malaysia (MOE), for their support as well as providing scholarship for me. My thanks and appreciation also goes to my colleagues and lecturers at IIUM Institute of Islamic Banking and Finance (IIiBF). ISLAMIC BANKS Name Affin Islamic Bank Berhad Al Rajhi Banking & Investment Corporation(Malaysia) Berhad Alliance Islamic Bank Berhad AmBank Islamic Berhad Bank Islam Malaysia Berhad Bank Muamalat Malaysia Berhad CIMB Islamic Bank Berhad HSBC Amanah Malaysia Berhad Hong Leong Islamic Bank Berhad Kuwait Finance House (Malaysia) Berhad MBSB Bank Berhad Maybank Islamic Berhad OCBC Al-Amin Bank Berhad Public Islamic Bank Berhad RHB Islamic Bank Berhad Standard Chartered Saadiq Berhad Ownership L F L L L L L F L F L L F L L F References L-Local F-Foreign [27] Conclusion This study focuses on the disclosure of Shariᶜah noncompliance event as reported by the Islamic financial institutions in the annual reports and Basel II Pillar 3 Disclosure in Malaysia. Ultimately, this study offers and formulate some recommendations for enhancing and improving present Shariᶜah non-compliance event disclosure and Shariᶜah governance in Islamic banks. Hence, for future research, the aim to know the responsibilities by Shariᶜah Committee in mitigating the operational risk. To achieve a good governance practice, the financial institutions should invest funds on the bank’s Shariᶜah risk management as a long-term investment in order to obtain high confidence level from the depositors or shareholders. The bank’s risk management should encourage the Shariᶜah Committee to attend trainings, conferences, meetings and forums across the globe as a method for them [1] EY, “World Islamic Banking Competitiveness Report 2016 (New realities, New opportunities),” 2015. [2] A. H. Hanadzlah, “Malaysia as an Islamic financial hub,” in Catalyzing for Change: A Financial Perspective, Kuala Lumpur: MPH Pubishing, 2012, pp. 123–125. [3] A. H. Hanadzlah, “Powering the heart of Malaysia: Islamic banking’s new frontier,” in Catalyzing for Change: A Financial Perspective, Kuala Lumpur: MPH Pubishing, 2012, pp. 113–117. [4] M. Shabbir, “Adequacy of Disclosure in Islamic Financial Institutions,” 1999. [Online]. Available: http://www.islamicbanking.com/iarticle_5.aspx. [Accessed: 11-Mar-2017]. [5] R. Hauswald and R. Marquez, “Governance Mechanisms and Corporate Transparency,” pp. 1–39, 2009. [6] Deloitte, “Second time around - Renewing your remuneration policy,” Deloitte LLP, no. March, London, 2016. [7] S. S. Harahap, “The disclosure of Islamic values - Annual report: The analysis of Bank Muamalat’s annual report,” IQTISAD J. Islam. Econ., vol. 3, no. 1, pp. 35–45, 2002. [8] N. A. A. Kasim, “Disclosure of Shariah compliance by Malaysian takaful companies,” J. Islam. Account. Bus. Res., vol. 3, no. 1, pp. 20– 38, 2012. [9] P. M. Linsley and P. J. Shrives, “Transparency and the disclosure of risk information in the banking sector,” J. Financ. Regul. Compliance, vol. 13, no. 3, pp. 205–214, 2005. [10] BNM-FRIBI, Financial Reporting for Islamic Banking Institutions, no. BNM/RH/STD 033-4. Malaysia: Bank Negara Malaysia, 2016, pp. 1– 34. [11] IFSB-10, Guiding Principles on Shari’ah Governance Systems for Institutions Offering Islamic Financial Services, no. December. 2009, pp. 1–31. [12] IFSB-3, Guiding Principles on Corporate Governance for Institutions Offering only Islamic Financial Services (Excluding Islamic Insurance 108
  5. THE 2nd ISLAMIC MANAGEMENT DEVELOPMENT CONFERENCE (IMDeC 2018) [18] H. Izhar and Z. S. A. Hassan, “Applying core principles of risk management in Islamic banks’ operational risk analysis,” Afro Eurasian Stud., vol. 2, no. 1&2, pp. 15–40, 2013. (Takaful) Institutions and Islamic Mutual Funds), no. December. 2006, pp. 1–33. [13] I. H. Minhas, “Shariah governance model and its four basic pillars,” Islamic Finance News Malaysia, vol. 9, no. 15, pp. 1–3, 2012. [19] BNM-SGF, Shariah Governance Framework for Islamic Financial Institutions 2011, no. BNM/RH/GL_012_3. Malaysia: Bank Negara Malaysia, 2010, pp. 1–48. [14] M. C. Suchman, “Managing Legitimacy: Strategic and Institutional Approaches.,” Acad. Manag. Rev., vol. 20, no. 3, pp. 571–610, 1995. [15] S. O. Idowu, N. Capaldi, L. Zu, and A. Das Gupta, Encyclopedia of Corporate Social Responsibility. London: Springer-Verlag Berlin Heidelberg, 2013. [20] M. Donia and S. Marzban, “Patching Holes in the net,” Islamic Banking & Finance, 2008. [Online]. Available: https://www.thefreelibrary.com/Patching+holes+in+the+net.a0212384951. [Accessed: 11-Aug-2016]. [16] BCBS, Basel Committee on Banking Supervision (Standard) - Revised Pillar 3 disclosure requirements, no. December. Bank For Internaional Settlements, 2015, pp. 3–4. [21] N. L. Adam and N. A. Bakar, “Shariah Screening Process in Malaysia,” Procedia - Soc. Behav. Sci., vol. 121, pp. 113–123, 2014. [17] R. Hassan, “Shariah Non-Compliance Risk and Its Effect on Islamic Financial Institutions,” Al-Shajarah J. Int. Inst. Islam. Thought Civiliz., vol. 21 (3), no. Special Issue, pp. 21–25, 2016. 109