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BETWEEN LEGAL RISK AND SHARIA RISK IN ISLAMIC BANKING: HOW SHARIAH GOVERNANCE ADDRESS THE PROBLEM

Islamic Bank has unique risk due to its Sharia-compliance principles. Two of risks known in Islamic Banking are legal risk and sharia risk. This paper aims to explain the legal risk and sharia risk faced by Islamic Banking in Indonesia. Moreover, this paper also will discuss the cause of these risks and its mitigation strategy using Shariah Governance concept. This paper using literature studies from previous research and existing regulation in Indonesia. This research shows that Islamic Banking in Indonesia has unique legal risks and sharia risk due to its adherence to a dual law system: shariah law and national law. There are several causes of legal risk and sharia risk in Islamic Banking in Indonesia, such as lack of supporting legal system and regulation, lack of standardization contract in Islamic Banking, and lack of Court Systems to resolve Islamic Banking’s problem. Moreover, there are several issues on the product development process in Islamic Bank. In addition, this paper explores the role of Shariah Governance such as Sharia Supervisory Body and National Shariah Board as a solution to address the problem stemming from legal risk and sharia risk.


Introduction
Islamic Banking has distinctive characteristics from their conventional counterparts due to its compliance with Shari'ah principle, derived from Islamic Law sources in Al-Qur'an, Sunnah, and Hadits. Since its character is unique, the Islamic Bank also has a slightly different risk than those in a conventional bank. One of the significant risks is legal risk, which will arise when the Islamic bank contract is unenforceable due to non-compliance with the country's law and regulation. Since the Islamic Banking contract uses Islamic Law as the source of law, it is possible there will be a condition where shariah rules conflicting with the laws and regulations in the operating countries, thus create the legal risk. Besides, the legal risk may be conflicting with sharia risk, where the contract is non-compliance with sharia principle. 1 Previous research by Djojosugito (2008) points out the legal risk faced by Islamic Banking due to the regulation that not fully accommodated Sharia requirements in Islamic Banking. When a legal rule makes the bank should sacrifice the shariah aspect, it can harm the sharia spirit in Islamic Banking.
Diponegoro Law Review, April 2022, Volume 07, Number 01 Indonesia, as Muslim majority country, has been providing the regulatory frameworks for the operation of Islamic Bank. Since 1992, Act Number 7 of 1992 of Banking has allowed the bank with profit-sharing principle operated in Indonesia. Furthermore, its amendment in Act Number 10  Banking in Indonesia. However, the existing regulation is not sufficient to accommodate Islamic Banking's need. The rigid character of Civil Law system in Indonesia makes a loophole in the Islamic Banking regulation, where the transactions aspect in Islamic Banking has not been accommodated yet in the existing regulations. Therefore, this circumstance may cause a conflict between legal interest and shariah interest. This paper explores the extent of legal risk and shariah risk in Islamic Banking practice in Indonesia and the Shariah Governance aspect, which can prevent those risks, particularly in Indonesia.
This paper will describe the legal risk and shariah risk in Islamic Banking and how proper Shariah Governance can address this issue. Firstly, this essay will describe the legal risk and shariah risk in Islamic Banking. Secondly, this essay will analyze the cause of conflict between both risks. Last, this essay will suggest Shariah governance as a tool to mitigate legal risk and shariah risk. This essay concludes that legal risk and shariah risk can be mitigated by using internal factors such as lawyer and Sharia Supervisory Body, and external factors by Government role in regulation and the involvement of legal institution.
The research methodology of this paper is doctrinal legal research approach. Doctrinal research is research which provides a systematic exposition of the rules governing a particular legal category, analyses the relationship between rules, explains areas of difficulty and, perhaps, predicts future developments. 3 This approach is used to identify legal risk and sharia risk in 2. Discussion

Risk Management in Islamic Banking
The sustainability of financial organisations depends on their risk management. Risk management is a process to identify, quantify, understand, and control the risk faced by a financial institution. 4 Islamic Banking, like any other financial institution, has its own risk. There are two types of risk faced by Islamic Banking. The first type of risk is similar to the conventional banks, while the second type is the unique risk due to its compliance with Shari'ah principle. Moreover, Khan and Ahmed (2001) divided the unique risk into two categories: financial risk (including market risk and credit risk) and non-financial risk (consist of operational risk, regulatory risk, and legal risk). 5 Therefore, risk management is crucial for the development of the Islamic Banking industry.
One of Islamic Banking's primary concern is an operational risk, which is the risk resulting from inadequate or failed internal processes, people and systems, or external factors. 6 Djojosugito (2008)

Legal Risk in Islamic Banking
Legal risk is the risk in the enforceability of a financial contract or the legality of financial instruments that are affected by law and regulation related to the contract and transaction. 11 It may be caused by external factors such as uncertainty in laws and regulations, or internal factors in the bank, such as fraud or violation of law and regulation. Legal risks also can be considered as a part of the operational risk. Since Islamic Banking has unique nature due to its adherence to shariah principle, it is exposed to a particular legal risk. Islamic banks face legal risks due to the differences between principles of Shariah and law. Although Islamic Bank is obliged to comply with shariah principle, the law regulating Islamic Banking is not fully accommodated Shariah requirement. Therefore, in the case of conflict, sometimes the implementation of Shari'ah principle at the contract may need to be compromised due to limitation from the legal and regulatory framework in which Islamic Banking is operated. 12

Sharia Risk in Islamic Banking
Shari'ah risk is one of the unique operational risks of IB. Sharia risk is the risk where the contract is void for being invalid due to non-compliance with Islamic law. 13 There are two categories of the Shari'ah risk: risk due to different standard of contracts in different jurisdictions and the risk due to the failure to comply with Shari'ah rules. 14 The first type of shariah risk is related to the legal risk, while the second type of Shari'ah risk arises from the failure of Islamic Banking to comply with the Sharī`ah rules and principles determined by its Sharī`ah board.

15
Shari'ah risk may lead to legal risk; for instance, the Islamic Bank that claims its product adheres to shariah requirement yet failed to comply may face a lawsuit from stakeholders that demand the fulfillment of its claim. 16  can harm the others' reputation, thus affect the long-term integrity and growth of the industry. 27 It can be concluded that Shari'ah non-compliance risk could be a severe risk that will affect the profit and reputation, thus harm the sustainability of Islamic Banking.

Legal Risk and Shariah Risk in Islamic Banking in Indonesia
As discussed above, Islamic Banking may be exposed to several operational risks, such as legal risk and shariah risk. There are several causes of legal risk and shariah risk in Islamic Banking:

Lack of support from legal system and regulation
The elements that support the legal system are called legal infrastructure, which consists of the regulation and law that define the formal rules, the regulator who creates and supervises the law's application, and the court's system to enforce the law itself. In the Islamic Banking industry, not all countries have legal infrastructure that acknowledges and accepts Sharia law.
Almost all Muslim countries adopted Western legal system. Specifically, ex-British colonies have adopted the English common law system, while the ex-French colonies adopted the civil law system. 28 Therefore, most Islamic banks have to operate within the conventional Western legal systems, either civil law or common law, which most Muslim countries have adopted either due to colonization or imitation. Unfortunately, both legal system does not fully conform to the Islamic value. Their legal systems and regulation do not have specific regulation that supports the unique features of Islamic financial products.
Furthermore, legal risks appear as a result of legal uncertainty, either in regulation or legal action. Legal uncertainty will cause the law interpretation of some transactions are not following sharia principle. Even though Islamic Banking is recognized in many jurisdictions, not all countries acknowledge and accept Islamic Law (Shari'ah). Compared to its conventional counterpart, the development of Islamic Banking laws are still in early period. Currently, most Islamic banks must operate in a conventional legal environment. As the impact, some aspects of Islamic Banking are not accommodated by laws, especially those related to Islamic Banking's operational aspects. In addition, shariah law is supposed to be the regulating law in the Islamic Banking contract. However, there may be a possibility that Islamic Banking cannot fully apply the shariah principle in its contract or transaction due to the conflict between shariah law and regulating law in the country. In regimes where Islam is not the state faith, the problem may arise when Shariah conflicts with the country's laws. Although Islamic Banking contracts are made using shariah principles, it is created in the legal environment which highly supported conventional bank operation. Sometimes, even if individuals agree to use Islamic contracts, the laws and courts may not interpret and enforce the Islamic Banking contracts. 30 Thus, in some cases, the ideal implementation of Shari'ah principle may need to be compromised due to limitations from conventional legal and regulatory framework in which Islamic Bank is operated.
In Indonesia's case, this country uses civil law system due to Netherland's long history of colonialization. The civil law system emphasizes the codification of laws and written law. This system dictates that lower-level laws/regulations cannot contradict higher-level laws/regulations. 31 This type of legal system leave no room for the innovation or improvement of law due to its rigid nature. According to, Islamic Banking who operates in a country with a rigid civil law system has a higher probability of having legal issues than in a country with a common If there is a conflict between the shariah law and national law, there is at least the possibility that a defaulting party can try to evade his responsibilities by claiming noncompliance with Shari'ah. Moreover, the absence of any state involvement makes it more difficult to impose Islamic Banking transactions and contracts in the case of disputes. Therefore, this may cause the parties in transaction avoid using Islamic law in contracts to hinder the legal uncertainty in Islamic contract law. 48 Fortunately, in Indonesia, there are specific court that in charge for the dispute on Islamic

Issues on the Product Development Process in Islamic Bank
Before issued an Islamic product or contract, the compliance department on Islamic Financial Institution needs to understand the implications of the laws and regulations of the country on the Islamic mode used in a product. From an external factor, there is a legal and regulatory requirement that affects Islamic products. 50 As a part of the corporate governance system, Shariah governance affected by the existing regulation in operation country. 51 However, sometimes the disparity of laws/regulations at the national level and the Islamic law used at the product level can create situations in which the latter is not compatible with the former. 52 In such cases, the modes in the potential set that do not conform to national laws and statutes cannot be used in developing products. Therefore, to overcome such external constraints, sometimes the activities, both before the transaction (ex-ante) and after the transaction (ex-post). 58 This governance system is needed by Islamic Financial Institution in order to foster trust from stakeholders and the public in general, and to assure that all practices and activities carried out in this institution are in accordance with sharia. Additionally, proper sharia governance system is also needed to avoid the occurrence of Sharia risk. 59 The sharia governance model is different from each country. This occurs due to differences in regulatory frameworks that govern the sharia governance system in each jurisdiction. 60 Ahmed identified four types of Shari'ah governance regime, namely legal construction, robust Shari'ah governance, passive Shari'ah governance, and market-driven. 61 In the legally constructed regime, shari'ah framework is determined by regulation, yet no Shari'ah Board at national or organisational levels. In robust Shari'ah governance, the country has a regulation to support the Islamic Banking industry and an active Shari'ah governance system both at national and organisational levels. A country with a passive Shari'ah governance regime has Islamic Banking regulations, yet the Shari'ah governance at national level is passive. However, they have active Sharia Supervisory Body at organisational level. In market-driven regime, there are no specific regulatory framework or national body for Islamic banks. Shari'ah governance system is selfregulated by Islamic banks.

62
The problems of shariah implementation in Islamic Banking usually occurs in in countries without regulatory oversight (that either has the passive Shari'ah governance or market-driven regimes). Therefore, a framework for Sharia governance in the form of laws/regulations which is also supported by a national Sharia oversight mechanism is essential. The Sharia governance framework will protect the interests of the sharia industry. Therefore, shariah governance as regulatory framework in both organizational and institutional level is important for product development in Islamic Banking. Suitable regulatory framework for Islamic Banking will ease the creation of Shari'ah compliant products and minimize the risks arising from Shari'ah principles in banking operations. At the national level, the regulatory framework's role is essential to ensure that Islamic banks activities comply with the Shari'ah principle. Moreover, the dilution of Shari'ah principles is most likely to occur in countries without Shari'ah regulatory framework, as in the country with passive Shari'ah governance or market-driven regimes. 64 In organizational level, there is the possibility of friction between Shari'ah compliance and economic incentive. 65 The National Sharia Board have duty to handling issues related to Sharia/fiqh fatwas, harmonizing Sharia interpretations, and ensuring banking institution compliance with Sharia principles. In addition, the National Sharia Board can also reduce legal risks by carrying out its role in providing fatwas to banking products according to sharia. Thus, this role will build trust and trust among stakeholders and ensure the industry's long-term sustainability and growth. 66 Furthermore, in institutional level, Shari'ah Supervisory Board (SSB), which comprises Islamic scholars, has an essential role in safeguarding the Shari'ah aspects in product and the operation of Islamic bank. This SSB consists of Shariah advisors who are employed by financial institutions and act as internal supervisory bodies within the organization, thereby increasing the institution's credibility, and strengthening their Islamic credentials. 67 Particularly in Islamic product, SSB is responsible as a gatekeeper to assuring the compliance of product with the Shari'ah principles and objective before its releases to the consumer. The role of SSB is essentials in Shariah Governance approving Shari'ah-compliant products and avoiding pseudo-Islamic products, thus avoid the products that have potential to create legal risk or sharia risk. Therefore, there is some strategy to mitigate legal risk and shariah risk by using Shariah Governance in internal and external of Islamic Banking operations: a. From internal of Islamic Bank, the legal risk must be prevented by preparing proper document, complying with regulation, and legal risk audit that involves lawyer. Moreover, Ahmed (2006) suggested that in country without Islamic courts, the parties should include choice-of-law and dispute settlement clauses in the Islamic contracts. There are two possibility option in such case. First, by using Sharia as the applicable law since the legitimacy of Islamic financial contracts must be based on Sharia principles. For this reason, the contract must include a clause which states that if there is a dispute, Islamic law will be used. The second approach is by using choice of law national law to resolve disputes. In this approach, clause of dispute resolution must be 68  Body is essential to filter non sharia-compliance contracts or products.
b. From external factors, the government must provide a regulatory regime that facilitates dispute resolution. In addition, to support the growth of the Islamic financial industry, there needs to be an Islamic dispute resolution institution or court that understands the form of a contract so that it can be interpreted and enforced accordingly. For example, Indonesia already has a Sharia Court as a separate court to resolve sharia disputes. Since it is difficult to expect changes in the entire court system, the solution is to call in legal experts who understand the issues of Islamic economics. 73 In addition, this industry requires a codification of law covering all activities of Islamic Banking. This can be done through standardization of Sharia rules, with harmonization between several Sharia scholars. With the codification, judges have specific guidelines for resolving disputes in court.

Conclusion
Islamic Banking is expected to fulfil the compliance with the shariah rules as its distinguish character. However, there is a possibility of conflict between the legal and Sharia rule rules in Islamic Bank implementation, which will cause either legal risk or shariah risk. Both risks is crucial because it has severe impact, which may damaging reputation and can create systemic risk which harms the whole the industry. The role of Shariah Supervisory Body is essential to ensure the product is fully comply with both legal principle and shariah principle.
However, Shari'ah governance at the organizational level is not sufficient to manage and mitigate overall Shari'ah risk. Establishment of a complementary Shari'ah supervision mechanism at the regulatory level is also required to accomplish the broader Shari'ah requirements of the industry, minimize the reputation and legal risks, thus ensure the stability of the sector.
The strategy to mitigate legal risk and shariah risk in Islamic banking operations can use internal and external approaches. From internal, the legal risk is prevented by involving a lawyer 72 Ahmed, "Islamic Law, Adaptability And Financial Development." 73 Ibid.