9.2 Two-Tier Shariah Governance Structure

Two-Tier Shariah Governance Structure

Shariah compliance is the foundational value proposition, moral bedrock, and operational prerequisite of the Islamic financial system. Without absolute adherence to Shariah principles, an Islamic financial institution (IFI) loses its legal legitimacy, breaches public trust, and exposes itself to severe regulatory sanctions, enforceability challenges, and catastrophic reputational damage. To preserve the systemic integrity of Islamic finance, regulatory authorities must establish a comprehensive governance framework that guarantees religious fidelity, operational consistency, and legal certitude.

Globally, the Malaysian Two-Tier Shariah Governance Model is widely recognized by international regulators, jurists, and multilateral standard-setters as the global gold standard for Islamic financial oversight. Established through decades of deliberate legislative evolution, this model creates a seamless, legally enforceable continuum between national statutory policy at the macro level and institutional execution at the micro level.

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Conceptual Architecture: Macro vs. Micro Tiers

The fundamental premise of the two-tier structure is the institutional separation between statutory legislative authority (national standardization and judicial ascertainment) and institutional supervisory execution (product structuring, operational vetting, and day-to-day monitoring):

1. The Macro Tier (National Level): Composed of apex statutory councils—the Shariah Advisory Council of Bank Negara Malaysia (SAC BNM) and the Shariah Advisory Council of the Securities Commission Malaysia (SAC SC). These bodies possess sole legislative authority to ascertain Islamic law for financial business, issue binding national resolutions, and advise the courts and domestic regulators.
2. The Micro Tier (Institutional Level): Composed of the tripartite governance organs within each licensed institution—the Board of Directors (BOD), the Shariah Committee (SC), and Executive Management—supported by dedicated internal control functions.

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The Macro Tier: National Apex Authorities

At the macro tier, two distinct statutory bodies exercise exclusive jurisdictional oversight over Malaysia's dual financial regulatory architecture:

1. Shariah Advisory Council of Bank Negara Malaysia (SAC BNM)

Established in May 1997 as the highest Shariah authority for Islamic financial institutions in Malaysia, the SAC BNM received its present statutory powers under the Central Bank of Malaysia Act 2009 (CBA 2009, Act 701). Its members, currently nine, are appointed by the Yang di-Pertuan Agong on the advice of the Minister of Finance after consultation with BNM. Sections 51 to 58 make the SAC the authority for the ascertainment of Islamic law for Islamic financial business supervised by BNM, including:

• Licensed Islamic commercial banks and investment banks;
• Islamic banking windows operated by conventional financial institutions;
• Takaful operators and retakaful operators;
• Development Financial Institutions (DFIs) offering Islamic financial services; and
• The Islamic interbank money market and foreign exchange operations.

Under Section 52 of the CBA 2009, the SAC's functions are to ascertain Islamic law for Islamic financial business, to advise BNM on any Shariah issue relating to Islamic financial business, and to advise Islamic financial institutions or other persons. In practice, the SAC also specifies the essential Shariah features that underpin BNM's contract-based policy documents on Murabahah, Mudarabah, Musyarakah, Ijarah, Istisna', Tawarruq and others (section 1.4).

2. Shariah Advisory Council of the Securities Commission Malaysia (SAC SC)

Established on 16 May 1996 and now governed by Part IIIC of the Securities Commission Malaysia Act 1993, the SAC SC is the authority for ascertaining the application of Shariah principles in the Islamic capital market (ICM). Its statutory mandate covers:

• Public and private Sukuk issuances and asset securitizations;
• Islamic collective investment schemes, unit trust funds, and wholesale funds;
• Islamic Real Estate Investment Trusts (i-REITs) and Islamic Exchange-Traded Funds (i-ETFs);
• Shariah screening methodology for listed equities on Bursa Malaysia; and
• Islamic digital asset exchanges, tokenized assets, and peer-to-peer (P2P) Islamic financing platforms.

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Statutory Mandate and Legal Primacy: Sections 56 & 57 CBMA 2009

The defining feature distinguishing the Malaysian macro tier from virtually all other global jurisdictions is the statutory primacy granted to SAC BNM resolutions under Sections 56 and 57 of the CBMA 2009:

• Section 56 (Reference to the SAC): Where, in proceedings relating to Islamic financial business before a court or arbitrator, a question arises concerning a Shariah matter, the court or arbitrator shall:
  1. take into consideration any published rulings of the SAC; or
  2. refer the question to the SAC for its ruling.
• Section 57 (Effect of Rulings): A ruling made by the SAC on a reference under this Part binds the Islamic financial institutions that sought it under Section 55 and the court or arbitrator that made a reference under Section 56.
• Section 58 (SAC Prevails): Where an institution's Shariah committee ruling differs from the SAC's, the SAC's ruling prevails.

Constitutional Challenges and Landmark Jurisprudence

Prior to 2009, civil court judges—frequently trained strictly in English common law—often attempted to independently interpret classical Fiqh texts, resulting in conflicting, unpredictable legal decisions. In Affin Bank Bhd v Zulkifli Abdullah (2006), for example, the High Court refused to let the bank recover the full deferred sale price under a Bai Bithaman Ajil (BBA) home financing contract. Later BBA decisions went further, until the Court of Appeal restored the contractual sale price in 2009, a period of acute legal uncertainty.

To resolve this, the legislature enacted the CBMA 2009. The binding nature of SAC rulings was subsequently challenged on constitutional grounds in two historic Federal Court decisions:

1. Mohd Alias Ibrahim v RHB Bank Bhd & Anor [2011] 3 MLJ 26 (High Court): The plaintiff argued that Sections 56 and 57 usurped the judicial power vested in the civil courts under Article 121(1) of the Federal Constitution. The High Court rejected this challenge, ruling that the SAC BNM functions merely as an expert statutory ascertainment body that identifies what the applicable Islamic law is. The civil court retains full judicial power to adjudicate the dispute, evaluate evidence, apply the law to the facts, determine liability, and enter final judgment.
2. JRI Resources Sdn Bhd v Kuwait Finance House (Malaysia) Bhd (2019): The Federal Court sat as a nine-judge panel to decide the constitutionality of Sections 56 and 57. By a 5–4 majority (10 April 2019), it upheld the provisions, consistent with Mohd Alias Ibrahim, confirming that the SAC does not exercise judicial power; it acts as a statutory ascertainer of religious principles, ensuring uniformity, stability, and public confidence across the financial sector.

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The Micro Tier: Institutional Governance Triangle

While the macro tier ensures nationwide standardization and legal certainty, the micro tier operationalizes Shariah compliance within each licensed financial institution. Bank Negara Malaysia's Shariah Governance Policy Document (SGPD 2019) structures institutional governance around a tripartite hierarchy:

                    +------------------------------+
                    |      Board of Directors      |
                    | (Ultimate Accountability)    |
                    +--------------+---------------+
                                   |     ^
               Fiduciary Oversight |     | Reports Rulings
               & Resource Support  |     | & Annual Report
                                   v     |
                    +--------------------+---------+
                    |      Shariah Committee       |
                    | (Independent Decision-Maker) |
                    +--------------+---------------+
                                   |     ^
                    Shariah Rulings|     | Submits Products
                    & Sign-offs    |     | & Control Reports
                                   v     |
                    +--------------------+---------+
                    |     Executive Management     |
                    | (Operational Execution)      |
                    +------------------------------+

1. Board of Directors (BOD)

The Board of Directors sits at the apex of institutional governance and bears ultimate accountability for the overall Shariah governance, ethical tone, and Shariah compliance culture of the institution. Under the SGPD, the Board cannot abdicate its responsibilities by delegating them entirely to the Shariah Committee. The Board is legally mandated to approve institutional Shariah governance policies, ensure adequate financial and human resource allocation to control functions, oversee the remediation of Shariah non-compliance, and foster open communication between the Shariah Committee and Board-level committees.

2. Shariah Committee (SC)

The Shariah Committee is an independent, specialized institutional board of qualified Islamic scholars appointed by the institution with prior approval from BNM. The SC operates with intellectual independence from executive management, rendering binding internal decisions on product structures, legal documentation, operational workflows, and corporate practices, while ensuring total alignment with macro SAC resolutions.

3. Executive Management

Executive Management, led by the Chief Executive Officer (CEO), holds operational responsibility for integrating Shariah requirements into daily business operations. Management must establish internal standard operating procedures (SOPs), develop compliance checklists, allocate budget for Shariah personnel, implement effective internal controls, and immediately escalate potential non-compliant events to the SC and Board.

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International Comparative Analysis: Governance Models

Across the global Islamic financial landscape, jurisdictions adopt varying governance philosophies based on their legal traditions, institutional maturity, and regulatory objectives:

1. The GCC Market-Led Framework

Historically, jurisdictions across the Gulf Cooperation Council (e.g., UAE, Saudi Arabia, Bahrain, Qatar) relied on a decentralized, institution-level governance model. Individual Islamic banks appointed private Shariah Supervisory Boards (SSBs) composed of prominent international scholars. While this decentralized approach fostered dynamic financial engineering and product innovation, it generated substantial operational friction: conflicting fatwas between rival banks (such as divergent rulings on Organized Tawarruq or Bay' al-Inah), extensive fatwa shopping by originators, and systemic legal risk when international courts adjudicated disputes under English governing law without recognizing institutional fatwas. In response, GCC jurisdictions have progressively moved toward central bodies—such as the Higher Sharia Authority established by the Central Bank of the UAE (CBUAE) in 2018—yet none feature the deep statutory court integration codified under Malaysia's CBMA Sections 56 and 57.

2. The Sudan and Pakistan Centralized Systems

Sudan historically implemented an absolute, single-tier central model where a national Supreme Shariah Board governed all financial institutions under a state-directed Islamic economic system. Pakistan employs a unique dual judicial-regulatory model: the State Bank of Pakistan (SBP) Shariah Board formulates prudential regulations and standard contracts for Islamic banking institutions, while the Federal Shariat Court (FSC) and the Shariat Appellate Bench of the Supreme Court of Pakistan exercise constitutional jurisdiction to strike down domestic commercial laws deemed repugnant to the injunctions of Islam (as evidenced in the historic 2022 FSC ruling mandating the complete elimination of conventional interest from Pakistan's economy by 2027).

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Multilateral Standard-Setting Bodies: AAOIFI & IFSB

The Malaysian two-tier framework is anchored within and deeply influences the international standard-setting architecture established by two key multilateral bodies:

1. Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

Established in 1991 and headquartered in Manama, Bahrain, AAOIFI formulates international Shariah, accounting, auditing, ethics, and governance standards. AAOIFI's Governance Standards for Islamic Financial Institutions (GSIFI) provide foundational benchmarks for institutional oversight:

• GSIFI 1: Shariah Supervisory Board: Appointment, Composition and Report — defines SSB independence, minimum membership (at least three members), and mandatory annual reporting.
• GSIFI 2: Shariah Review — mandates comprehensive operational examination of contract execution and transactions.
• GSIFI 3: Internal Shari'a Review — internal review of Shari'a compliance carried out within the institution, reporting to management and the board.
• GSIFI 4: Audit and Governance Committee for IFIs — outlines board-level governance structures.

2. Islamic Financial Services Board (IFSB)

Established in 2002 and based in Kuala Lumpur, Malaysia, the IFSB serves as the global prudential standard-setter for Islamic finance, working alongside the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO). The IFSB addresses systemic stability, capital adequacy, liquidity risk, and corporate governance.

The benchmark standard for Shariah oversight is IFSB-10: Guiding Principles on Shariah Governance Systems for Institutions Offering Islamic Financial Services (2009), which IFSB and AAOIFI have been working to update through a joint revised Shariah governance framework. IFSB-10 emphasises four attributes:

1. Competence: Ensuring that Shariah board members and internal control personnel possess rigorous qualifications in Fiqh Muamalat, coupled with thorough understanding of contemporary finance, accounting, and legal mechanisms.
2. Independence: Safeguarding Shariah decision-makers against undue commercial influence, management pressure, or financial conflicts of interest.
3. Confidentiality: Maintaining strict professional secrecy regarding proprietary bank data, customer records, and commercial strategies.
4. Consistency: Minimizing contradictory rulings through transparent decision-making, systematic documentation, and alignment with national regulatory standards.