Islamic Banks and Trade Compliance Expectations

Question: When it comes to Islamic trade finance transactions, are Islamic banks at a higher risk for trade compliance/TBML violations as they are dealing directly with the underlying goods? And how can Islamic banks mitigate these risks to comply with trade compliance requirements?

Answer: An extensive system of regulatory compliance has been introduced to today’s trade finance day-to-day operations in most jurisdictions. Unfortunately, it operates without much recognition of the comparatively limited role financial institutions have in trade transactions and the relatively limited knowledge possessed by banks of these underlying trade transactions. Moreover, the adding of new compliance regulations to existing structures is unpredictable and intense and expansive regulations are largely negatively impacting trade. Banks are increasingly shying away from offering trade products, ceasing to deal with certain geographies or customers deemed high risk, and facing shrinking profit margins due to the higher cost of compliance obligations. These constraints add more pressures to the existing ones such as increased capital adequacy requirements. Therefore, these circumstances have prompted many players to cut back or exit the trade finance space entirely. However, trade is the backbone of Islamic banking and Islamic banks have engaged in this area with appropriate risk mitigants to handle trade business with great passion and expertise.

Islamic banks follow strict trade compliance programs, irrespective of dealing with goods of underlying transactions. In my opinion, unlike conventional banks, Islamic banks are in a better position to comply with trade compliance as they are dealing with the underlying goods of transactions mainly to satisfy Shariah compliance standards. They deal in goods at some stage of the transaction and also comply with appropriate ICC rules. If an Islamic bank follows strict Islamic banking policies properly, it has fulfilled or complied with a major portion of trade compliance expectations. Once an Islamic banker witnesses the underlying goods of the transaction by inspecting the goods, they are definite that the trade deal is not a fictitious transaction and is legitimate. The rest of the check is to ensure the parties involved are legitimate and the traded goods are in line with the customer’s business.

Since Islamic banks work on a concept of buying and selling goods to make a profit, they take on a wide range of assessments. Islamic banks ensure the goods that they are buying are legitimate and not over- or under-priced. Islamic banks affirm the goods are sellable, as per the specifications of the buyer, have value, are without defects, are Shariah-compliant, and that the goods can be specifically identified and known to the ultimate buyer (customer). Therefore, Islamic banks follow a rigorous process before they advance an Islamic trade financing facility from a credit, compliance and Shariah compliance perspective.

Since an Islamic bank first buys the goods, they will perform strict due diligence checks on the seller (supplier) and the goods involved. There is no exception or leniency for Islamic banks when it comes to adherence to compliance requirements. They follow the same compliance programs as conventional banks do. World-Check, Dow Jones, and other tools are used extensively by Islamic Banks as well. In addition to conducting pre-inspection of goods, they also check IMB and container/shipping tracking to ensure proper tracking of goods to fulfill compliance requirements.

Furthermore, Islamic banks are also subject to strict Shariah compliance standards for transactions. This will safeguard the ethical aspect of transactions and will automatically cover many so-called compliance issues. Non-compliance of Shariah mandates will result in an Islamic bank’s forfeiture of profit from the transaction which would then be given to a charity. Islamic banks take very high precautions when it comes to trade financing transactions as they initially buy the goods and sells them on to their customer.

Therefore, Islamic Banks exert maximum care and attention especially when on-boarding a trade finance customer. They ensure that they understand the customer’s line of business and acquire adequate information of the customer’s business model as well. It is purely at an Islamic bank’s discretion to decide what type of goods they will deal or finance. Current compliance trends may lessen this list of goods as banks may not be comfortable with certain items and commodities due to stringent compliance issues.

Islamic banks have been using the RBA (risk-based approach) from its inception to ascertain risk involved in Islamic trade finance transactions. Islamic banks visit customers’ premises to verify their line of business and will conduct credit checks on their sellers through sellers’ bankers to ensure that the beneficiary is capable of performing as well. As Islamic banks inspect goods, customers who seek to engage in fictitious transactions are unlikely to deal with Islamic banks. Further, money launderers and other criminals will avoid Islamic banks as they will not receive cash against paper documents which are not tied to underlying goods.

As a last line of defense, all transactions are subject to additional reviewing and screening on a selective basis by Shariah auditors for Shariah compliance. Moreover, Islamic banks have digitized most of the compliance requirements (including Shariah compliance measures, where possible) which has enhanced their capabilities and turnaround times.

A few Islamic banks are using Blockchain capabilities to inspect goods and effect payments with appropriate compliance requirements automated to the maximum extent.

— K. Nizardeen, CDCS & CCTFC