Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 11

Shari’ah–Non-compliance Risk

Mohamad Akram Laldin

1. INTRODUCTION

Risk is an inseparable element of life and business. Islamic financial institutions (IFIs), being commercial entities, face risk just as their conventional counterparts do, and they too must attempt to mitigate and avoid it. Being premised on Shari’ah principles does not at all mean that they are risk free. In fact, IFIs share many types of risk with their conventional counterparts, such as credit risk, market risk, and liquidity risk, and they are additionally exposed to certain risks that are unique to the nature of their business. This is due to the three following facts:

1. Islamic financial instruments are structured upon specific models and certain Islamic structures that distinguish them from their conventional instruments;

2. IFIs have a unique balance sheet as compared to their conventional counterparts; and

3. IFIs have their own specific regulations, governance framework, and liquidity infrastructure.1

One of the unique risks faced by IFIs is Shari’ah–non-compliance risk triggered by failure to adhere to Shari’ah principles. Understanding Shari’ah–non-compliance risk is very important, as it will provide the framework for dealing with and managing that risk. This chapter will deliberate Shari’ah–non-compliance risk in IFIs by providing an overview of the concept of risk from an Islamic perspective, the concept of Shari’ah–non-compliance risk and its measurement, the impact of Shari’ah–non-compliance ...