Measuring Shariah risk : proposal for a new Shariah risk rating model for Islamic banks and allocation of capital for Shariah risk under Basel III

Customers interested in the Islamic banking Industry continue to put a question that whether the bank they wish to do business with is practically implementing Sharīah rules and guidelines despite being registered as an Islamic bank and having fatwá from the competent authority. This paper proposes a set of 14 rating factors that measure the risk of Sharīʿah non-compliance at an Islamic bank. These factors are used as an input to develop Sharīah Risk Rating Model, which can be used by the customers of the Islamic banking industry, the management of an Islamic bank, and the central banks to measure the degree of Sharīah compliance at an Islamic bank. The paper also suggests a methodology towards allocating capital charge against the risk of Sharīah non-compliance under Pillar 2 of Basel III accords. The main strengths of this model are simplicity and relevance towards assessing the Sharīah noncompliance risk because input factors are based on the information derived from published financial statements only. Another key strength is that the end rating can be used on a standalone basis or as an extension to the conventional rating models provided by external agencies such as Fitch, Moody’s, S&P etc. Development of this model is aimed at motivating the banking customers, management of Islamic banks, and central banks to improve the implementation of Sharīah guidelines and hence contribute towards accelerated growth of the Islamic finance industry. The model was applied on three selected banks on unsolicited basis and results reflect discriminating power of the input factors in order to gauge the Sharīah risk.