Corporate Governance in Islamic Banks

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Corporate Governance in Islamic Banks

Why is Corporate Governance particularly relevant for Islamic Banking? 

Corporate Governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. It provides a structure through which the objectives of the company are set and the means through which these objectives are obtained and performance can be monitored. Such a framework sees corporate governance as a dynamic interplay of internal and external incentives, which affect the performance of a firm.

The internal incentives are the firm’s organisational arrangements that allow owners to direct managers to pursue goals set by the shareholders, while the external incentives on regulatory structures, voluntary standards accepted and followed by the firm and competitive market forces all exert discipline on the performance of owners and managers from the outside. By adhering both to internal and external incentives, a company can reduce its cost of capital, thereby increasing its profits.

Islamic financial institutions have some characteristics that require special care in designing their corporate governance mechanisms.

a) Stakeholders include a large number of depositors whose deposits are not guaranteed.

b) Islamic banks operate on the basis of universal banking, which is close to a deregulated banking environment. Financial activities cover a wider spectrum than is customary in traditional finance, including equity holding, leasing and credit purchase finance on a mark-up basis.

c) Equity-holding by Islamic financial institutions would enable them to sit on the Board of Directors of firms and thereby influence the corporate governance mechanisms of the latter.

Key Aspects in Corporate Governance of Islamic Financial Institutions

Islamic banks, like conventional banks, provide financial services mostly through a licence from regulatory authorities. Therefore, they must be equally accountable. Banks, whether Islamic or conventional, take demand deposits, which enable them, within the fractional reserve system, to issue money collectively through derivative deposits. Such money is a liability against a third party, that is, the government. This is an added reason for accountability through proper governance mechanisms.

Another justification for accountability arises as Islamic banks also accept investment deposits which are, in principle, not guaranteed. The investment activities done on behalf of, and at the risk of, fund-owners can have wide-ranging effects on national wealth, as well as on the wealth of depositors. Therefore this process must be closely monitored.

In addition, Islamic financial institutions are allowed to produce only those financial services, which are in conformity with the Shari’ah. Measures must be taken to assure their customers that their products have been approved by the Shariah authorities.

Investment deposits and shares in mutual funds share the same risks as those of capital, yet there is no mechanism of corporate governance designed so far which allows depositors and mutual fund shareholders to have a special tool to monitor the operations of financial institutions. This is an area, which deserves special attention. Whether special tools to monitor investments made by Islamic financial institutions, including close scrutiny of feasibility studies as well as detailed reviews of contracts made with investors (fund-users), should be developed by regulators, or a certain number of seats on the Board of Directors should be allotted to representa

Agreement on the basic principles of corporate governance is spreading. For instance, through a consultative process, the OECD has distilled a set of widely accepted principles of corporate governance. The IMF and the World Bank have embarked on a number of exercises for each member country, at the government and financial sector levels, through two initiatives: Reports on Standards and Codes (ROSC) and Financial Sector Stability Assessments (FSSA).

Good governance has no borders and fits in very well with Islamic tradition and the Shari’ah. Although governance is only one of the key elements of structural reforms, combined with macro-economic policies it can, and does, foster sustained growth.

The principles underlying prudent corporate governance are important for Islamic financial institutions because of the special risks inherent in Islamic banking and the nature of its products. Three broad trends have emerged.

a) The growth of Islamic banking is reflected not only in the expansion of the market, but also in the generation of new products. But while an increasingly diverse range of Islamic financial institutions has arisen, banks remain the core players in many countries.

b) Islamic banking encompasses short-term instruments, including murabaha, leasing and other trade finance as well as long-term maturity instruments supported asset securitisation: for instance, the IDB-Unit Investment Fund.

c) Development of longer-term financing operations (including musharakah), Shari’ah-consistent Government financing and a secondary market. 

Stakeholders’ value is central to the Islamic financial institutions, and is generally incorporated in mission Statements and focus on two broad sets of objectives (a) compliance with Shari’ah principles, and (b) provision of excellent service that must include service to the community as a whole, referring primarily but not exclusively to the Muslim community, promoting the interests of related parties, including shareholders, depositors, and employees and the developing the professional and

ethical qualities of management and staff. Shari’ah compliance would appear to fall into three categories

(1)        The conduct of financial business in accordance with the prohibition      of riba and gharar.

(2)        Furthering of Islam’s social objectives, in particular the promotion of social benevolence. 

(3)        The third is the development and promotion of an integrated Islamic financial system, or the “eventual institution of an elaborate and comprehensive banking system based on the rules of Islamic Shariah”.

Corporate Governance, Transparency and Islamic Banking

The governance structure for Islamic banks should consist of an internal control system, which includes aShari’ah-based structure, both factors ensuring the suitability of transactions and also a reduction of transaction costs. Transparency and adherence to accepted standards is crucial to the success of good governance.

The need to address transparency is based on two elements, both of which are critical for the growth of the financial market.

a) It will allow the development of more complex equity-based and investment-oriented assets of a longer maturity and will thus help financial innovation, and

b) It will allow more efficient prudential supervision and regulation of Islamic financial institutions.

Progress has already been made at the national and international levels, particularly by the Information Management System (IMS), on addressing accounting and disclosure standards.

a) The existing International Accounting Standards are being supplemented by a set of Financial Accounting Standards (FAS) prepared by the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). The FAS have already been implemented by some countries and are being considered by many others.

b) Similarly, AAOIFI’s capital adequacy and standards of governance, including Shariah standards for several transactions, could become important milestones for Islamic banking growth.

c) The Islamic Financial Services Board (IFSB), is constantly reviewing the needs for regulatory and supervisory standards of Islamic financial products and institutions, facilitate further transparency in transactions.

However, greater focus is needed on strengthening internal management and accounting practices to enable individual financial institutions to adhere more closely to established standards. Also, improving the sharing of accurate information between borrowers and financial institutions on the use of funds, profits and losses, and compliance with the implementation of financial contracts between lenders and borrowers, would facilitate further growth. 

These steps would make possible the avoidance of:

a) the continued concentration on short-term assets, and

b) the possible build-up of excess reserves by Islamic institutions.

However, this phase of reform will be more difficult to implement because it will require mechanisms for implementing and streamlining internal management and sharing information on a timely basis at the level of smaller firms.

In addition to the regulatory and supervisory standards and the related institutional developments mentioned earlier, a number of other areas should be focused on.

a) Clarification of lenders’ and borrowers’ rights and obligations

b) Market-based mechanisms for strengthening observation of Islamic business ethics by both entrepreneurs and banks

c) Rationalisation of tax laws and other practices which might be discouraging accurate disclosure

d) Reduction in the cost of information-gathering, monitoring and auditing

e) Reform of disclosure laws

f) Training.

Shari’ah Governance Framework

Corporate Governance arrangements in Islamic Financial Institutions are mostly modeled along those of the conventional shareholder corporation, in spite of the explicit mandate to promote social welfare and pursue stakeholders’ value. This configuration leads to a distribution of rights and responsibilities that essentially leaves control with shareholders. The most notable variation in corporate governance structure is the presence of a Shari’ah supervisory board of scholars and a Shari’ah review unit that ensure compliance with the Islamic law. Shariah compliance decisions affect all Islamic Financial Institution stakeholders. In addition, internal stakeholders such as investment account holders, and external governance structures such as accounting would perhaps be distinctive features of an Islamic financial institution (Corporate Governance in Institutions Offering Islamic Financial Services Issues and Options, Wafik Grais and Matteo Pellegrini)

Corporate governance for Islamic banks requires a distinct treatment from conventional corporate governance requiring them to ensure the consistency of their operations in accordance withShari’ah principles and the protection of the financial interests of a stakeholders’ category, namely depositors holding unrestricted

investment accounts. It must address the issues of independence, confidentiality, competence, consistency, and disclosure that may bear on pronouncements of consistency with Shari’ah principles. The agency problem of depositors holding unrestricted investment accounts also needs to be addressed. 

The Shari’ah Board, Compliance and related Supervisory Issues are discussed in detail in the next lesson.

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