AAOIFI enhances Shariah compliance and fiduciary ratings of Sukuk

In a new exposure draft (AGEB 2/2022 v.10.0) of the AAOIFI Governance Standard (GS), AAOIFI provided rating agencies with guidelines for evaluating the Shariah compliance and fiduciary rating of Sukuk and other Islamic finance instruments. The exposure draft provides essential guidance on these services’ responsibilities, procedures, reporting and quality assurance. According to the standard, rating agencies can develop their own rating schemes, without ignoring the requirements of this standard. The standard lays emphasis on Shariah compliance, governance, corporate practices, transparency, ethics, values and fiduciary performance.

Rating agencies and the compass of Shariah governance
The standard, which is of a continuation of AAOIFI GS 10 ‘Shari’ah Compliance and Fiduciary Ratings for Islamic Financial Institutions’, aims to strengthen confidence in the Islamic finance and capital markets. The standard also aims to enhance transparency by ensuring that Sukuk and Islamic finance instruments conform to the concepts, regulations, governance, values and obligations prescribed by Shariah.

In this standard, the Shariah governance framework is defined by a number of benchmarks, namely the Shariah governance standards issued by AAOIFI (particularly GS 12 ‘Sukuk Governance’) and the IFSB and the Shariah governance regulations issued by the respective jurisdiction’s regulator.

The IFSB develops Shariah governance standards and enhances the existing framework by promulgating Shariah governance requirements, hence providing further guidance to financial organizations.

The use and significance of the Shariah governance framework are contingent upon the specific financial instrument being examined. Several important factors should be taken into account by rating agencies, namely the following.

The adherence to the framework by institutions should be customized to the unique instrument or originator, with a particular emphasis on the subject instrument. The use of this customized strategy guarantees that the concepts of governance are appropriately linked.

Pivotal significance of the originator’s governance
The risk and reward characteristics of equity and quasi-equity instruments are inherently interconnected with the governance practices of the entities that issue them. Therefore, it is of utmost importance to prioritize effective governance mechanisms at this level.

Assets and obligations managed by trustees
The importance of Shariah governance is evident in situations when a trustee or service provider is designated, as it is crucial for fulfilling the requirements specified in the instrument’s framework.

Intricacies of liability instruments
In the case of liability-type instruments, wherein profits are derived primarily from transactions rather than ongoing operations, the function of Shariah governance is relatively diminished.

Influence of the originator on asset-based instruments
Financial instruments produced by financial institutions, especially those related to assets, place significant importance on the Shariah governance of the originator, as it directly affects the performance of the instrument.

Entity-level focus
In contrast to the instrument-specific nature of Shariah governance, corporate governance procedures are primarily evaluated at the entity level, with a particular emphasis on the originator and trustee/service provider levels.

A Shariah compliant financial instrument, such as a Sukuk, should meet return or repayment expectations while conforming to Shariah standards in its structure. This requires ensuring that monies are properly channeled from the source to the user for permitted objectives, with transparent oversight. Stakeholders like regulators, investors, suppliers, consumers, employees and society deserve to know the extent to which this commitment to Shariah compliance has been met, and the new standard provides a good source of knowledge and guidelines to all of them.

Prof Dr Younes Soualhi is the senior researcher at ISRA RMC (INCEIF University). He can be contacted at [email protected].

*This article first appeared in Islamic Finance News (IFN) on 29th August 2023 (https://www.islamicfinancenews.com/aaoifi-enhances-shariah-compliance-and-fiduciary-ratings-of-sukuk.html)

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