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Journal of Management and Governance 2: 149–170, 1998. © 1998 Kluwer Academic Publishers. Printed in the Netherlands.


Financial Contracting, Governance Structures and the Accounting Regulation of Islamic Banks: An Analysis in Terms of Agency Theory and Transaction Cost Economics
1 University of Surrey; 2 Accounting and Auditing Organization for Islamic Financial Institutions; 3 Kuwait University

Abstract. Because Islamic banks are prohibited from entering into transactions based on riba (interest), they mobilise funds mainly on the basis of the mudaraba (profit-sharing) form of contract. Thus, in the place of interest-bearing customer deposits, Islamic banks offer investment accounts the return on which depends on the return on the pool of assets in which the customers’ funds are invested by the bank. In contrast to conventional deposits, such investment accounts therefore yield a variable periodic return which may be negative (a loss). Islamic investment accounts are thus a form of limited-duration equity investment. This type of investment account raises a set of issues concerning the contractual relations between the bank and the holders of such investment accounts. These issues may be addressed from the perspectives of both Agency Theory (principal-agent and principal-principal relations) and Transaction Cost Economics (contractual forms and governance structures), and it is the purpose of this paper to do so. In particular, we focus on governance issues such as the monitoring possibilities which may or may not be contractually available to investment account holders. We conclude that, under present contractual arrangements, investment account holders depend unduly upon ‘vicarious’ monitoring by or on behalf of shareholders, a situation aggravated by current shortcomings in financial reporting and limitations of the scope of external auditing. The latter have implications for accounting regulation as applied to Islamic banks. The paper concludes with some suggestions as to how this situation could be ameliorated.

1. Introduction This paper aims to consider the contractual bases on which Islamic banks operate from the standpoint of Transaction Cost Economics (Williamson, 1975 and 1995; Hart, 1995) and Agency Theory (Jensen and Meckling, 1976 and 1990). In particular, consideration will be given to the contractual arrangements under which Islamic banks accept savers’ and other investors’ (but not shareholders’1 ) funds on an Islamic profit-sharing basis, and the related issues pertaining to governance structures. Islamic profit-sharing investment accounts operate on the basis of the



Mudaraba contract, according to which the investors receive the profits or bear their share of the losses from the pool of assets in which the funds are invested, while the bank as entrepreneur (Mudarib) receives a commission which consists of a share of the profit, being zero in case of a loss or zero profit (Karim, 1996a; Archer and Karim, 1997). Such contractual arrangements raise issues to which both Transaction Cost Economics (TCE) and Agency Theory suggest pertinent analyses. As Williamson (1995, ch. 7) and Hart (1995, ch. 6) stress, the two theoretical approaches are complementary. The following is based largely on Williamson’s account (op. cit., pp. 173–183). The form of Agency Theory to which reference is made here is what Williamson (1995, p. 172) refers to (following Jensen, 1983) as ‘the positive theory of agency’. In contrast to the more formal agency theory, which is concerned with efficient risk bearing, the Agency Theory applied here (hereinafter AT) is concerned with “the technology of monitoring and bonding on the form of . . . contracts and organizations” (Jensen, loc. cit.). Both TCE and AT take exception to the standard neoclassical modelling of the firm as a production function to which a profit-maximising objective has been ascribed. Instead, TCE regards the firm as a governance structure and AT considers it as a nexus of contracts. The fundamental behavioural assumptions of TCE are bounded rationality and opportunism (i.e. self-interest plus guile); the former assumption has as a consequence incomplete contracting, while the latter assumption entails additional contractual hazards. AT exponents have been hesitant to adopt the bounded rationality (BR) assumption, but notions of ‘ex post settling up’ in AT as a means of mitigating ex ante incompleteness of contracts are consistent with BR. Moreover, while AT uses the term ‘moral hazard’ rather than ‘opportunism’, the two terms are virtually synonymous. Much the same may be said of ‘information asymmetry’ (used in the AT literature) and ‘information impactedness’ (as used by Williamson), the difference being that AT is concerned with principal-agent relations while TCE addresses all types of contracting relations. Finally, both theories normally assume risk neutrality on the part of contracting parties. With regard to efficient contracting, TCE examines alternative forms of economic organisation with reference to their capacity (a) to economise with respect to the consequences of bounded rationality, while (b) safeguarding the transactions in question against the hazards arising from opportunism. The focus of AT has been more on the latter. Additionally, while AT examines contracting primarily from the perspective of ex ante alignment of incentives, TCE is more concerned with developing governance structures that offer ex post measures to achieve the integrity of the contract. Moreover, for both theories, the Board of Directors has a function that arises endogenously, as an instrument of the residual claimants. This point is important for our analysis below.



Differences between the two approaches arise from the fact that for TCE the basic unit of analysis is the transaction or contract, while for AT it is the (contracting) agent. The implications of the two approaches may thus be somewhat different, with regard to the role in TCE of the specificity (non-redeployability) of assets, both physical and human. In particular, human asset specificity (the development by managers of firm-specific intellectual capital) has important implications for the theory of managerial labour markets. Asset specificity may lead to a condition of bilateral dependency by contributing to what Williamson terms the Fundamental Transformation, i.e. the transformation of a bidding situation which ex ante would seem to involve a large numbers of bidders into an effective ex post situation of bilateral dependency between the contracting parties. This greatly complicates the governance of ex post contractual relations. Another difference arises from the ex ante focus of AT compared with the ex post concerns of TCE. Thus, AT has little concern with mechanisms for ex post conflict resolution (avoiding recourse to the law courts) which are central to TCE. There are other important differences between TCE and AT, but they are not relevant to the subject-matter of this paper. The analysis in this paper is of a pre-formal kind. In this, we follow Williamson (1995, p. 357), who comments: “[A]lthough full formalization is always the ultimate objective, premature formalization – sometimes operating under the guise of the ‘honest poverty’ of mathematics – is a dubious undertaking. Premature formalization reflects impatience, perhaps even intolerance, with the question, ‘What’s going on here?’ ”. We are concerned in this paper with a number of ‘what’s going on here’ questions concerning Islamic banks. The remainder of the paper is set out as follows. Section 2 summarizes the relevant characteristics of Islamic banks. Section 3 examines the issues of financial contracting in Islamic banks from an AT perspective, while Section 4 applies a TCE perspective. Section 5 sets out some conclusions for financial contracting and governance in Islamic banks, using insights from both the AT and the TCE perspectives. Section 6 discusses the implications for, and current developments in, the accounting regulation of Islamic banks. Some concluding remarks are given in Section 7.

2. Relevant Characteristics of Islamic Banks Islamic banks are ethically funded organizations. They are established with the mandate to carry out their business and financial transactions in strict compliance with Islamic Shari’a2 rules and principles. Almost every Islamic bank has a board of Shari’a scholars, commonly known as its Shari’a supervisory board (SSB), to review the juristic correctness of the bank’s transactions.3 The SSB is one of the main monitoring systems developed by Islamic banks to assure the stakeholders of the banks’ adherence to Shari’a precepts. Recent standards promulgated by the Accounting and Auditing Organization for Islamic Financial Institutions (here-



after AAOIFI) – the body established in 1991 by Islamic financial institutions to self-regulate their financial reporting and auditing – require both the SSB and the financial auditors of Islamic banks to report on these banks’ compliance with Shari’a doctrines (AAOIFI 1996a, 1997a). As an alternative to the payment of riba (interest),4 which among other things is strictly prohibited by the Shari’a, Islamic banks use a version of the mudaraba contract to mobilise funds in investment accounts. (The orginal form of the mudaraba contract is very similar to that of the commenda contract5 in general use by Italian and other merchants in the late middle ages and early modern period; see Bryer, 1993)6 The mudaraba contract has detailed juristic rules that are derived from the Shari’a7 and which regulate the relationship between investment account holders (IAH) as providers of funds and the bank in its capacity as mudarib (entrepreneur). This raises the issue of the relationship between the IAH and the bank’s shareholders, given that Islamic banks are normally incorporated with limited liability and the contractual relations from the standpoint of secular law are between the IAH and the bank (as a legal person) and not between the IAH and the shareholders. The mudaraba contract is a profit sharing financial instrument that is neither a financial liability nor an equity instrument. Unlike equity instruments, Islamic investment accounts are redeemable at maturity or at the initiative of their holders, but (usually) not without the prior consent of the bank. Islamic banks can refuse to pay IAH until the results of the investments financed by IAHs’ funds are determined.8 On the other hand, unlike debt instruments, investment accounts are not a liability of the bank because (as explained later) they share in the profits generated from their funds, and also bear their share of any losses incurred. Thus, they have a claim on the bank’s earnings or assets which ranks pari passu with that of the shareholders.9 In the unrestricted type of mudaraba, IAH authorise the bank to invest their funds at its discretion including commingling the IAHs’ funds with those of shareholders. In the restricted mudaraba, IAH specify to the bank, among other conditions,10 the type of investment in which their funds should be invested e.g., real estate, currencies, leasing etc., but the IAH do not have the right to interfere in the management of the fund. Violation of the latter condition can nullify the contract. Hence, although holders of both types of investment accounts are exposed to different degrees of risk, their relationship with the management of the bank is subject to the same monitoring arrangements, albeit with some exceptions which are noted below. The relationship between IAH and the Islamic bank is not similar to the fiduciary services that are provided by traditional banks or similar organisations acting in a position of trust to administer assets or discharge other responsibilities on behalf of another party. As noted above, the Islamic bank does not undertake to give priority to meeting the IAH’s financial claims over those of its shareholders. In addition, unlike traditional banks where there is (at least in principle) a sharp



division (or what is known as a “Chinese wall”) between the fiduciary service function and other areas of the bank, in the majority of Islamic banks the IAHs’ funds are commingled with shareholders’ funds and are invested in the same investment portfolios. However, there are reasons (analysed below) why such commingling is likely to be beneficial in governance terms. The aggregate investment portfolio or asset pool of an Islamic bank is usually financed by IAHs’ funds, plus some of the shareholders’ equity and other sources of funds (e.g., current accounts), the latter being mobilised on bases other than the mudaraba contract. If the aggregate investment portfolio yields a positive return, then the shares of profit are allocated between the parties to the contract, IAH and the bank, according to the proportionate shares of their respective investments in the portfolio. The bank’s share of profit relates to both its shareholders’ own funds and to other funds invested in the investment portfolio that do not participate in profit-sharing (e.g. current accounts which are capital-protected but non-participating).11 It is to be noted that shareholders’ funds invested in the investment portfolio (and elsewhere) and the other non-participating funds are not covered by the mudaraba contract, and are not governed by its rules. Hence, the bank’s shareholders receive the entire profit from these sources, and IAH cannot claim any profit share from them. The bank also receives what is called the mudarib share of profit, based in principle on a predetermined percentage of the profit attributable to the IAH which is specified in the contract. This is a reward for the managerial effort of the bank in managing the funds of IAH. The total of the shares of profit allocated to the bank (subject to certain deductions for directors’ and auditors’ remuneration) including the mudarib share, constitutes a return to the bank’s shareholders. If the bank’s aggregate investment portfolio yields a negative return, then this loss is borne by IAH and shareholders pro rata their respective investments in this portfolio, bearing in mind what was said in the previous paragraph. Like that of shareholders, the liability of IAH is limited to the amount of their investment and no more. In the case of a negative return, in addition to the shareholders’ proportion of the loss which is determined pro-rata as indicated above, the bank in its capacity as mudarib receives no profit on behalf of its shareholders (the mudarib share having a lower bound of zero). However, according to the mudaraba contract, if the loss is due to misconduct or negligence of the mudarib, then the Islamic bank has to make good the loss.12 Islamic banks tend to use two methods of profit allocation: the pooling method and the separation method.13 According to the pooling method, almost all revenues and expenses are shared between providers of the bank’s own capital (shareholders’ funds) and IAH. The separation method calls for segregating the revenues and expenses of investment operations from those of other banking services. IAH only partake in the revenues and expenses related to those investment operations in which their funds are utilised. The method used may be related to the terms of the bank’s contract with its IAH: an unrestricted contract which allows the bank



full discretion in investing the IAHs’ funds is consistent with (but does not require) the pooling method, while a restricted contract which limits the bank to investing the IAHs’ funds in some pre-specified category of asset may imply the setting up of more than one asset pool and the use of the separation method. From the point of view of the IAH, the mudaraba contract as currently used by Islamic banks presents a number of potential hazards due to: (a) the nature of the governance structure applicable to IAH, as analysed in Sections 3 and 4 below; (b) the fact that the form of the mudaraba contract currently used leaves the bank’s management a degree of discretion in a number of areas described below; combined with (c) the lack of transparency in financial reporting. In particular, the terms of the contract typically allow the bank: (a) some discretion to invest shareholders’ funds in restricted IAH funds,14 and to invest IAH funds elsewhere; (b) to require that a significant portion of IAH funds be treated as current accounts, in order to provide liquidity, no profit or loss share being due to IAH in respect of this portion of the funds; (c) to specify the mudarib’s share of profit as manager as a maximum percentage, thus leaving discretion to vary the percentage from period to period up to that maximum. Consequently, given the lack of transparency in financial reporting, the bank’s management has various opportunities to ‘manage’ the share of profit attributed to the IAH. These contractual hazards are examined further below. 3. Analysis of Financial Contracting in Islamic Banks in Terms of Agency Theory As described in Section 2 above, the form of the mudaraba contract used by Islamic banks for mobilising and managing investors’ funds may be seen as involving a complex agency problem (Archer and Karim, 1997). The bank’s management acts as agent for the shareholders, while the bank as mudarib acts as an agent for the investment account holders. This gives rise to the possibility of conflict of interest facing the bank’s managers, not just in their dealings with the shareholders and in those with the investment account holders, but also as between the interests of the two categories of investor (shareholder and investment account holder). As we noted in Section 1, one of the fundamental assumptions on which the principal-agent model of AT is based is self-interest, which, combined with guile, results in moral hazard or opportunism. The economic and financial analyses of the basic agency model are based on the premise that shareholders (as principal) and management (as agents contracted by shareholders to act on their behalf in return for some reward) both want to appropriate as much of the residual value of the firm for themselves as possible. It is also assumed that the shareholders as principal cannot trust the management as agent to take decisions that are in the interest of shareholders if such decisions are not also in the interest of management. There are three types of agency problems that are considered in the AT literature.15 These are:



1. The nonpecuniary benefits or perquisites which the owner-managers of a firm that they only partially own are likely to consume beyond those which a sole owner would consume. 2. The problem of adverse selection arising from the use of debt financing under limited liability of shareholders, given that there is an incentive to the latter: (a) to undertake high risk projects that effectively transfer wealth from lenders to shareholders; and (b) to forgo new profitable investments which benefit only lenders.16 Debt financing may also result in a reduction in the market value of the firm when disputes between shareholders and bondholders are resolved through the process of costly bankruptcy. 3. Information asymmetry, namely that the principal cannot observe the actions of the agent, whereas the latter is better informed of the firm’s performance and prospects. AT is concerned with, among other things, how to develop a proper system of ex ante incentives as well as examining the set of ex ante conditions that produce goal congruence (or reduce the divergence) between the interests of shareholders and those of management through appropriate specification of the employment contract. This includes the incorporation in contracts of bonding and monitoring arrangements. According to Moe (1984, p. 756), “The agent has his own interests at heart, and is induced to pursue the principal’s objectives only to the extent that the incentive structure imposed in their contract renders such behavior advantageous”. The theoretical work within the AT paradigm has also focused on how to develop an optimal level of monitoring that would enable shareholders to ascertain if management is acting in their interests. One of the basic conditions of the mudaraba contract (whether restricted or unrestricted) is the separation of ownership from management of funds. Like shareholders, therefore, IAH have no right to interfere in the management of their funds which is the sole prerogative of the mudarib, i.e., the Islamic bank. However, unlike shareholders, at present the corporate governance of Islamic banks does not give IAH any power to appoint (or dismiss) the management, the SSB or the external auditor.17,18 In addition, whereas the capital of both shareholders and IAH is at risk, unlike shareholders IAH neither have control over the management nor are they in a position to enforce monitoring measures on the management. In the last resort, they can withdraw their funds. Whether this, combined with other conditions which create a degree of common interest between them and shareholders, serves adequately to protect their interests is a major issue for this paper. The relationship between IAH and the Islamic bank presents a unique type of agency problem that is hardly paralleled in the finance and economics literature. The fact that the mudaraba contract does not allow IAH to interfere in the management of their funds raises the issue of possible conflict of interest between IAH and the Islamic bank, a problem that also exits in the principal-agent relationship in conventional firms. However, whilst in the latter relationship the principal has the right of access to monitoring mechanisms that are intended to mitigate potential



conflict of interest between the principal and the agent, the existing governance structures within Islamic banks deny IAH any such monitoring mechanism. This poses the question: how may IAH influence the behaviour of the bank’s management in order to safeguard their own interest within the terms of the mudaraba contract? In TCE terms, what is the governance structure associated with the mudaraba contract? It would seem that, given the ex ante contractual relations established by the mudaraba contract, IAH must place trust in the monitoring of management exercised by the shareholders.19 The efficacy of such reliance depends on there being no significant conflict of interest between shareholders and IAH, i.e. that the terms of the mudaraba contract which regulates the relationship between these two parties produces goal congruence rather than conflict of interest between them. In the absence of such goal congruence, there is the problem indicated by the basic behavioural assumption of self-interest on which agency theory in a conventional firm is based, namely that individuals “act unreservedly in their own narrowly defined self-interest with, if necessarily, guile and deceit” (Noreen, 1988, p. 359). This applies to conflicts of interest both between agents and principals and between the principals themselves. The proposition that IAH can safeguard their own interest by relying on shareholders’ monitoring to operate on their behalf, because it is assumed that there is no significant conflict of interest between the two parties, is not unfounded. In many cases, both shareholders and IAH face the same portfolio investment risk insofar as the funds of both parties are commingled and invested in the same investment portfolio, this being so in almost all Islamic banks. Accordingly, it would seem that the IAH could expect a rate of return not less than the minimum which shareholders expect to earn from investing their funds in a portfolio of projects of the same degree of risk.20 On the other hand, if the aggregate investment portfolio yields a negative return both parties lose part of their equity. In addition, shareholders lose their mudarib share of profit, although this can never be negative. (Assuming riskneutrality of both parties, this asymmetry with respect to the mudarib share would not result in any conflict of interest.) Moreover, even if the two sources of funds are neither commingled nor invested in the same investment portfolio, the characteristics of the mudaraba contract would arguably tend to produce goal congruence rather than conflict of interest between the two parties, notably because the IAH can ‘vote with their feet’ and withdraw their funds if dissatisfied with their return. Through the mudarib share of profit mechanism, shareholders stand to gain from any profit earned from investing IAH’s funds. The mudarib share of profit constitutes a valuable source of earnings to shareholders, particularly as it is a reward for the managerial effort of the bank which shareholders earn without incurring any risk to their equity. This suggests that in order to maintain their return from this source of earnings, shareholders would have an interest in employing a performance measure whereby the management of the bank would be expected to achieve a satisfactory rate of return on



IAHs’ funds, i.e. a rate commensurate with the market rate of return earned by similar financial instruments. This would tend to motivate present IAH to continue their investments with the bank as well as to attract other potential IAH. On the other hand, if the aggregate investment portfolio yields a negative return, then shareholders would receive a mudarib profit share of zero. This would also tend to affect negatively the returns of shareholders in future periods, because existing IAH would be tempted to shift to other investment opportunities and potential IAH would be discouraged from investing in the bank. Notwithstanding these possibilities regarding goal congruence, the apparent absence of moral scrutiny in the economics and finance literature on agency relationships has prompted growing concern about the central role that the selfinterest assumption plays in the analysis of the principal-agent model. Duska (1992, p. 147) argues that “as economists began to address the concept of agency . . . they adopted . . . the view of a self-interested rational maximizer, a view incompatible with any notion of a loyal agent”. Others also argue that “the adoption of this assumption in a wholesale manner is problematic” (Bowie and Freeman, 1992, p. 4), and that attributing all human behaviour to self-interest is adopting a worst case scenario (Dees, 1992). Furthermore, it is claimed that whether a person should pursue self-interest in a given case is a matter for ethical analysis (DeGeorge, 1992). Dees (1992) claims that when the ethical dimensions of contracting are taken into consideration, the principal-agent analysis as applied to the issues of ex ante contractual relations tends to suffer from biases that include, among others, overlooking ethical constraints such as fairness. He argues that “fairness of a contractual relationship can be raised in four areas: the process used to reach agreement, the terms of the agreement, the way in which it is implemented, and the outcomes it creates” (p. 41). Dees elaborates on fairness with regard to outcomes by explaining that “[It] has to do with the distribution of benefits and burdens affected by the contract. In particular, there is a question about how the surplus is divided and a question about effects on third parties. The concern about distributive justice becomes more pressing when there is a significant disparity in relative wealth positions and bargaining power of the parties. Contracts that enhance that disparity may be objectionable on ethical grounds. The standard principal-agent models, with their bias in favor of the principal, may yield an unfair distribution of benefits and burdens if the standard assumptions are not modified to reflect this concern” (p. 42). While some of these apparent deficiencies, i.e. those that relate to ex post problems and costs, might be remedied within a TCE model, as suggested below, in more general terms there is arguably a need for a model that could bridge the gap between ethical and financial considerations or what Dees describes as the challenge “to strike the right balance, to encourage the right amount of model and the right amount of more general ethical reasoning” (p. 52). Noreen (1988), for example, suggests that an agreement via an ethical code to abstain from oppor-



tunistic behaviour can be beneficial for everyone if internalised. He stresses that the resulting gains from an ethical code will reduce transaction costs and lead to more efficiency. Such considerations seem particularly relevant in the case of Islamic banks as ethically funded institutions. Objections have been raised to Noreen’s approach in that “its appeal to altruism or loyalty runs counter to the assumption of humans as exclusively self-interested, and hence looks naive to those adopting an opportunistic view of human beings” (Duska, 1992, p. 153). Williamson (1995, p. 270) makes a similar point as follows: “Just as it is mind-boggling to contemplate hyperrationality of a comprehensive contracting kind, so it is mind-boggling to contemplate the absence of calculativeness”. However, self-interest with guile does not necessarily entail a myopic or shortterm approach to contractual relations. The form of analysis provided within TCE combines bounded rationality (i.e. behaviour that is intendedly rational but only limitedly so) with farsighted contracting (Williamson, 1995, pp. 9, 36 and 46), and, via notions such as credible commitments and reputation effects, can take account of the possibly detrimental effects of short-term opportunism on longer-term selfinterest. Williamson (op. cit., p. 259) quotes Kreps’ (1990) version of the Prisoner’s Dilemma game in which Party X must first decide whether to risk trusting Party Y, then Party Y decides whether to achieve an immediate gain by taking advantage of X’s trust. The payoffs are such that the joint game is maximised by trust being given and honoured, but Y’s immediate gains are maximised by abusing X’s trust. Thus, in a one-round game X will know that Y has no incentive to honour his trust, and a no trust/no play outcome will result. If the game is converted to a repeated game, in which there is a high probability that each round will be followed by another, the change in the analysis is “dramatic”, since the trust-honour arrangement becomes self-reinforcing. As Dasgupta (1988, pp. 49–59) quoted by Williamson (1995, p. 259) remarks: “Trust is central to all transactions and yet economists rarely discuss the notion. . . . For trust to be developed between individuals they must have repeated encounters, and they must have some memory of previous experiences. Moreover, for honesty to have potency as a concept there must be some cost involved in honest behavior. And, finally, trust is linked with reputation, and reputation has to be acquired.” The focus on opportunism and calculativeness in the economics and finance literature may indeed seem objectionable, especially in teaching contexts, in that it may present a picture of commercial relations as ethically shoddy and risk undermining the ethical beliefs of students. Nevertheless, it is surely crucial to study the conditions, both macro (societal) and micro (contractual and organizational), that are likely to elicit trustworthy behaviour. 21 The focus may thus be shifted to self-interest of the enlightened kind.



4. Financial Contracting in Islamic Banks from the Perspective of Transaction Cost Economics As Williamson (1995, p. 183) notes: “The TCE approach to corporate finance examines individual investment projects and distinguishes among them in terms of their asset specificity characteristics. It also regards debt and equity principally as governance structures rather than as financial instruments” (emphasis added). Evidently, this raises the questions of how TCE would regard IAH as a governance structure, and what insights could be gained from this for our purposes in this paper. Before seeking to answer these questions, we review briefly (again following Williamson, op. cit., pp. 184–187) how the TCE rationale views debt and equity, and the role of asset specificity (specificity being lack of re-deployability). The latter may range from that of general purpose mobile equipment (low specificity), through that of a general purpose plant situated in a manufacturing centre (medium specificity), to that of market and product development costs (high specificity). The purpose of the review is to show inter alia why, if equity did not exist, there would be reasons for inventing it. Debt is modeled as a governance structure that “works almost entirely out of rules”. We assume, specifically, the following: (1) contractually stipulated interest payments will be made at stipulated intervals; (2) the borrower will continuously meet contractually stipulated liquidity tests; (3) principal will be repaid at the due date and a sinking fund will be set up for this purpose; (4) in the event of default (i.e. non-observance of any of the contractually stipulated conditions 1–3 above) the debt-holders will exercise pre-emptive claims against the assets in question. So long as everything goes well, this is a very simple and cheap governance structure. But if things go badly, debt is unforgiving, since default triggers liquidation or financial administration (the latter placing limits on management discretion in favour of rule-bound behaviour). Moreover, the value of a pre-emptive claim declines, and so the terms of debt financing will be adjusted adversely, as the degree of asset specificity increases. A firm using debt and wishing to make specialised investments might therefore respond by sacrificing some of the specialised features in favour of greater deployability. But an alternative might be to seek a new governance structure which provides reassurance for suppliers of finance, so that the sacrifice of value-enhancing investments in specialised assets could be avoided. Equity provides such a governance structure, by virtue of the following governance properties: (1) it has the status of a residual claimant of the firm in respect to both earnings and asset liquidation; (2) it contracts for the duration of the firm (no repayment of principal); (3) it has the benefit of a board of directors which (a) is elected by the holders of equity by votes pro-rata to their holdings, (b) has the powers to replace management and to decide on management’s compensation, (c) has access to internal performance measures on a timely basis and can authorise audits in depth for special follow-up purposes, (d) is informed of impor-



tant investment and operating proposals before they are implemented, and (e) in other respects exercises a decision-review and monitoring function over the firm’s management. This governance structure, and the board of directors in particular, may thus be seen as ‘evolving’ as a way by which to reduce the cost of financing projects that involve limited redeployability. As well as offering better assurance properties, equity is more forgiving than debt; when things go badly, the structure permits efforts to be made to work things out and preserve the value of a going concern. The governance structure associated with equity is thus more akin to a hierarchy or vertical integration, while that associated with debt is more market-like (c.f. outside procurement). To sum up: debt is a simple, rule-bound governance structure that is cheap to implement when asset specificity is low and things go well, but expensive when asset specificity is high and inflexible (and hence costly) when things go wrong. Equity is more cumbersome and intrusive, and more expensive when asset specificity is low, but more flexible and hence less costly when things go badly. How does the Islamic mudaraba-based investment account fit into this framework? At first sight, it may seem to have features in common with Williamson’s hypothetical hybrid instrument ‘dequity’. The latter has the characteristics of debt, except that management may exercise its discretion in relaxing the contractually specified rules if this permits value-enhancing investment decisions. Islamic investments accounts are rule-bound and avoid the intrusiveness and costs of hierarchy, while having the status of a residual claimant of the firm in respect to both earnings and asset liquidation. They thus offer flexibility as well as suitability for financing projects involving high asset specificity. However, ‘dequity’ is not the financial panacea it might appear, as a result of the problems arising from the power of selective relaxation of the rules governing debt (selective intervention) given to management. This selective intervention will be subject to errors of both commission (non-observation of the rules to suit the interests of management, even though value-reducing) and omission (mistaken, value-reducing observation of the rules). In general, Williamson concludes, simple governance structures are able to cope well with the needs of simple, straightforward transactions, but they experience stress as the contractual hazards ramify. A switch to more complex and costly governance structures which replace rules by discretion can then be more cost-effective (Williamson, 1995, p. 193). Moreover, mudaraba differs from ‘dequity’ in some crucial respects; in fact, it is somewhat like ‘dequity’ in reverse. Thus, rather than being like debt with management discretion to relax contractual rules so as to preserve value-enhancing investment projects, mudaraba is like equity (share capital) in giving a residual (profit and loss sharing) claim, and differs from it by neither (a) contracting for the duration of the firm nor (b) having the benefit of a board of directors to monitor management on its behalf. This raises the question of whether mudaraba (at least



as currently practiced) “experiences stress when contractual hazards ramify”. In other words, how efficient is it as a governance structure? Given the need of Investment Account Holders to rely on the monitoring mechanisms set up for shareholders (as explained in Section 3 above), how are IAH equipped to deal with the situation “when things go badly” with the assets in which their funds have been invested? What are the implications for the asset specificity of investments made on their behalf? Does their right to withdraw their funds (not having contracted for the duration of the firm) adequately compensate for their reliance on ‘vicarious monitoring’?

5. Governance Structures and Financial Contracting in Islamic Banks The preceding analysis, especially given the prevalence of commingling of shareholders’ and IAH’s funds and the fact that profit is earned for shareholders on the investments of the IAH through the mudarib role of the bank, has implications for the capital structure of an Islamic bank. Given that shareholders can in principle increase their rate of return at no extra risk to their equity by increasing their return from the mudarib share, it would seemingly be in their best interests to maintain their equity at a minimum and increase investment account financing to the highest level possible.22 This theoretical proposition has support in a study by Al-Deehani, Karim and Murinde (AKM) (1996) who provide empirical evidence for their claim that if an increase in investment account financing yields positive shareholder income, it will increase the Islamic bank’s rate of return on equity at no extra financial risk, 23 so that the bank’s cost of capital will remain constant and its market value will increase. The implications of the AKM argument is that the management of an Islamic bank can pursue a strategy of increasing investment account financing to the upper limit while keeping shareholders’ equity capital at a minimum. As shown by AKM, in a arbitrage process between investment account financing and shareholders’ equity financing such that investment account financing is increased and shareholders’ equity financing is reduced simultaneously by the same magnitude so as to maintain the overall level of investment and the return on the bank’s assets constant, while the percentage fee due to the bank as mudarib also remains constant, the rate of return of shareholders including the mudarib share will continue to increase while that of IAH will remain constant. As this does not involve any change in the bank’s assets, there will be no increase in the financial risk of the bank. It is worth noting that the increase in the rate of return to shareholders, as AKM point out, is solely due to the leverage effects of the mudarib share. Hence, in order to maintain such an increase in the rate of return to shareholders, the management of the bank needs equally to maintain the level of earnings of IAH, the source from which the mudarib share is derived. However, one possible constraint on the above strategy is that Islamic banks may have to maintain a ratio of shareholders’ equity to IAH funds that is perceived



to be adequate. Quite apart from regulatory considerations of capital adequacy (Karim, 1996b), market forces may drive Islamic banks to maintain at least a certain minimum acceptable ratio of shareholders’ equity to IAH funds. Although IAH would not have a direct financial benefit from the increase of the bank’s equity (because they do not share in the profits generated from these funds), IAH are likely to expect a level of equity capital which they would perceive as commensurate with the level of their investments. This would assure IAH that shareholders have adequate capital at stake that would motivate them to be equally cautious of IAHs’ funds in ‘vicarious monitoring’. According to Udovitch (1970), in medieval Islam the chief importance of the agent’s (i.e., the mudarib’s) contribution to capital “is that the willingness of the investor [i.e. investment account holders] to conclude the contract may be contingent on the agent’s providing some capital as well. In view of the fact that the investor receives no direct financial benefit from imposing such a condition, the rationale behind it was probably less direct; e.g., the investor might calculate that a larger total sum in the venture would increase the opportunities of profitable trading activities, or he might feel that the agent’s direct financial stake in the transactions would make him at once more cautious and more enterprising” (p. 170, note 2). In the TCE literature, investments made for this type of reason are referred to as ‘posting of hostages’ in order to create ‘credible commitments’ (Williamson, 1995 ch. 5). Williamson points out that ‘hostages’ can have both ex ante (screening) and ex post (bonding) effects. Thus, a ratio of shareholders’ funds to IAH funds perceived as adequate by the market would both encourage potential IAHs to invest (screening) and reassure existing IAHs that they do not need to withdraw their funds (bonding) as they can rely on ‘vicarious monitoring’. The reverse would be true if the ratio were perceived to be inadequate. Another factor that is most likely to affect the level of shareholders’ equity to be maintained by Islamic banks, whether determined by regulatory agencies or by the market, is the possibility that the bank could incur a loss relating to investment accounts which may be due to the negligence or misconduct of the bank’s management. According to the mudaraba contract, such a loss, if established, would be borne by the Islamic bank, i.e. by the shareholders. Given that investment accounts are not a liability (AAOIFI, 1993) and hence are given only a residual claim to the bank’s earnings or assets ranking pari passu with that of shareholders, the preceding analysis relating to the commingling of shareholders’ and IAH’s funds and the profit earned for shareholders through the mudarib mechanism has important implications for financing and investment. In contrast to debt financing which creates an impediment to profitable investments when these involve high asset specificity (Williamson, 1995, ch. 7), with IAH funds the management of an Islamic bank, like that of an all-equity firm, would tend to accept any value-enhancing investment irrespective of asset specificity. Furthermore, unlike the agency problem in debt financing which is reflected in an incentive to shareholders to bear unwarranted risk, the preceding analysis



implies that shareholders of Islamic banks would be unlikely to have incentives to engage in overly high-risk projects, since the ‘up-side’ as well as the ‘downside’ risk is shared with the IAH as residual claimants. 24 On the other hand, since investment accounts bear equally with shareholders the risk of loss, they do not trigger bankruptcy. This implies that the upper limit placed on the level of financial leverage using debt financing by expected bankruptcy or financial distress costs has no equivalent in deciding the ratio of IAH funds to shareholders’ funds.25 Another issue which affects the relationship between shareholders and IAH is the problem of nonpecuniary benefits. Although this is generally treated as a principal-agent issue between shareholders and management, in the case of an Islamic bank the IAH are also potentially concerned. The impact of this problem on the IAH and their response to it would depend on the profit sharing method used by the bank. Since in the pooling method IAH and shareholders share in virtually all revenues and expenses according to the proportion of invested funds provided by each party (subject to the mudarib share and the treatment of current accounts noted above), the accounting system should prevent the management of the bank from favouring shareholders over IAH by charging the latter with a larger pro-rata share of nonpecuniary benefits than the shareholders. In principle, therefore, IAH should be able to depend (via vicarious monitoring) on the measures taken by shareholders in curbing management from consuming excessive nonpecuniary benefits. Note, however, that this conclusion depends on the proper functioning of the accounting system, which is controlled by management, and whether the scope of the independent audit includes examining the correct allocation of the costs of management’s non-pecuniary benefits. Recall also that, under the existing governance structure of mudaraba, independent auditors act on behalf of the shareholders, not the IAH. Hence, while reliance by IAH on ‘vicarious monitoring’ by or on behalf of shareholders would be effective with regard to the performance of management in producing satisfactory returns on the assets in the pool, such reliance might be problematic as regards the correct allocation of costs to be borne by IAH and shareholders on a pro-rata basis. This caveat applies not just to the costs of management’s non-pecuniary benefits, but more generally to any allocations which are not subject to disclosure in the bank’s published financial statements. Turning to the Islamic banks that use the separation method, we may note that in the first place there is not the same incentive for ‘vicarious monitoring’ by or on behalf of shareholders in regard to such matters as management’s nonpecuniary benefits, since there is no pooling of revenues and expenses. Moreover, in the case of banks which do not commingle shareholders’ funds with those of IAH (or only do so to an insignificant degree), there is no effective ‘posting’ of a ‘hostage’ to support the bank’s commitment to IAH. In addition, the current financial reporting practices of Islamic banks do not provide adequate information to their IAH regarding the revenues and expenses accruing to their particular investment fund. Fourthly, the contracts used by these Islamic banks which govern



their relations with their IAH typically leave the bank discretion in various matters, such as investing the bank’s (i.e. shareholders’) funds in the IAHs’ investment fund, investing some of the IAHs’ funds elsewhere, and varying the percentage share of the fund’s profit payable to the bank as mudarib (i.e. stating what is in effect a maximum percentage in the contract, and leaving the bank discretion to vary the percentage from period to period). Such information asymmetry suggests that there are genuine grounds for IAH to be concerned about the nonpecuniary benefits with which they may be charged compared to shareholders. Thus, IAH that invest funds in restricted investment accounts must rely for a governance structure on the likelihood of their withdrawing their funds if they perceive the return on their investment to be inadeqate in relation to the level of risk incurred (however, withdrawal of funds at short notice typically leads to some loss of profit share).26 Reliance on ‘vicarious monitoring’ by or on behalf of shareholders would thus depend on the assumption that, given the implications of the level of IAH investment for the profits available for shareholders as noted above, the latter or their representatives on the board of directors would act in order to safeguard the level of investment in IAH. This would be ‘vicarious monitoring’ of an indirect kind, and how much reliance could be placed on it is a matter that needs further inquiry. The relationship between IAH and shareholders exhibits some features of bilateral dependency (Williamson, 1995, p. 103), in that the IAH depend on shareholders for monitoring while the shareholders depend on IAH as a source of profits via the mudarib share. There is evidence suggesting that the management of some Islamic banks have used the discretion given them by flexible rules and limited disclosure in order to ‘enhance’ or ‘smooth’ the returns payable to IAH at the expense of shareholders. Presumably, the rationale behind such behaviour is that shareholders are in fact compensated by the maintenance of a higher level of IAH investment (and of profit thereon for them via the mudarib share) than would otherwise be the case. Such as it is, therefore, this evidence suggests that ‘indirect vicarious monitoring’ can operate for the benefit of IAH, but only behind the veil of inadequate disclosure in financial reporting (which prevents more direct monitoring).

6. Accounting Regulation Accounting standards are a form of regulation of the financial reporting process. As such, they may be provided, at least in part, by self-regulation. Islamic banks, for example, may have an incentive to collaborate in the development and promulgation of accounting standards. However, there may also be limits to what can be achieved by self-regulation. The main reason for believing this is the ‘market failure’ argument. Financial accounting information is published in annual reports which are accessible to any interested party at no cost; they are a ‘free good’. Moreover, a company’s or bank’s management has a monopoly over the production of this information. In these conditions, the economic forces of supply and demand do



not operate so as to result in the production of an appropriate quantity and quality of financial accounting information; there is a strong tendency to underproduce. The existence of this tendency can be seen from the history of financial reporting. For example, prior to the passage of the UK 1967 Companies Act, UK companies did not publish a sales turnover figure. Moreover, in the case of Islamic banks, hardly any information is disclosed about the bases of profit allocation between shareholders and investment account holders. For this reason, while the supply of financial accounting standards may be left partly to self-regulation, this raises the question of the power of enforcement. Self-regulatory accounting standards bodies have little, if any, power to enforce observance of their standards. The acceptance by the regulatees of the rules proposed by the self-regulatory body, and hence the effectiveness of selfregulation, depend on consensus between the self-regulatory body and regulatees, which the latter will withhold if the former is perceived as ‘too demanding’. For the reasons given above, the consensus levels of the quantity and quality of financial accounting information may tend to be unsatisfactorily low. Hence, it is a field in which regulation by governmental or public sector bodies with enforcement powers may play an important part. On the other hand, a wish to avoid governmental regulation is one incentive for self-regulation. Karim (1990) notes that this was a reason for the setting up of the body now known as the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in 1991. As of the time of writing, AAOIFI has issued ten accounting standards (with two exposure drafts currently under consideration) and four auditing standards. In common with the International Accounting Standards Committee (IASC), AAOIFI lacks enforcement powers for its standards. However, in view of our remarks above, and the related strictures expressed by Carlson (1997) regarding the efficacy of the IASC, it is noteworthy that AAOIFI is working to have its standards adopted as mandatory requirements by banking supervisors in a number of countries, some of which (e.g. Bahrain, Sudan) are in the process of doing so. In addition, there is evidence of market forces operating in favour of the adoption of AAOIFI standards by the more internationally-orientated Islamic banks, since international credit rating agencies have started including compliance with AAOIFI standards as a criterion in their ratings of Islamic banks (see, for example, Capital Intelligence, 1996).

7. Concluding Remarks The preceding sections have analysed the current situation of Islamic banks as recipients of investment funds from the standpoints of AT and TCE. A central issue has been the efficiency of the governance structure provided to IAH by the mudaraba contract. This comprises the right to withdraw funds (unlike share capital) and the right to be indemnified against any loss due to misconduct or negligence on the part of management. In addition, ‘vicarious monitoring’ may



be exercised by shareholders or their representatives on behalf of IAH, and we identified some important incentives for such behaviour, some of which are associated with ‘hostage posting’ in the form of investments by shareholders in the same funds as IAH. In the absence of ‘vicarious monitoring’, however, the governance structure offered by the mudaraba contract as currently practiced by Islamic Banks looks quite thin from the investor’s (IAH) point of view. Moreover, in the case of restricted IAH, ‘vicarious monitoring’ by shareholders or their representatives is of an indirect kind which is feasible only behind the veil of flexible rules and limited disclosure in financial reporting. It is doubtful whether such a reliance on ‘vicarious monitoring’ would be acceptable in a more competitive and critical market. On the credit side, the equity nature of IAH financing means that, unlike debt, it does not constitute an impediment to value-enhancing investment characterised by high asset-specificity. Finally, but most importantly, profit-sharing and avoidance of interest mean that mudaraba is acceptable internationally in religious terms as an investment vehicle to hundreds of millions of Muslim believers. The strictures on the system expressed above also need to be considered in the light of existing market imperfections. Whilst Islamic banking is growing at a steady rate (International Herald Tribune, 1995; Middle East Economic Digest, 1996), it is still a young industry sector and, in competitive terms, a thin market. This is evidenced by the fact that the average number of Islamic banks in most of the countries in which they operate does not exceed three, with the exception of Sudan, Pakistan and Iran which have Islamised their banking industry (or Bahrain which has a number of ‘off-shore’ Islamic banks which do not operate in the local market). Such market characteristics may help to explain why the deficiencies in the current governance structures of IAH, as analysed in the previous sections, have not yet been made good. It seems to us that there are three main ways in which these deficiencies could be mitigated. The first would be that IAH would ‘work more out of rules’ as a result of the ex ante contractual conditions being more tightly specified, thus reducing the Islamic bank’s discretion in such areas as ‘managing’ the IAHs’ return and investing funds of restricted IAH in another fund. The second way, without which the first might be of little avail, recognises that a form of bilateral dependency exists between shareholders and IAH and that bilateral dependency “introduces an opportunity to realize gains through hierarchy” (Williamson, 1995, p. 103). The use of ‘hierarchy’ implies a strengthening of the monitoring capabilities in the governance structure of IAH, which could be achieved in a number of ways: (a) improvement of the transparency of financial reporting; coupled with (b) extension of external audit to all mudaraba funds, whether reported on or off the bank’s balance sheet; (c) granting of some representation of IAH on the board of directors or on the audit committee of the board, and/or at the annual general meeting of Islamic banks (bearing in mind that the mudaraba contract does not permit interference by investors in management, the



powers of the IAH representative might be restricted to approving the bank’s financial statements and the appointment of external auditors and members of the SSB). The third way of mitigating existing deficiencies would be a generalisation of ‘hostage posting’: Islamic banks would be induced to invest non-trivial proportions of shareholders’ funds in all mudarabat, as a bonding measure to extend ‘vicarious monitoring’. As the Islamic banking sector becomes more internationalised, market pressures may be expected to result in the introduction of modifications to the mudaraba as a governance structure along the lines indicated above, as well as in improvements to the transparency of Islamic banks’ financial reporting. In addition, banking regulators and self-regulatory bodies (notably AAOIFI) may be expected to add their authority to such pressures. Acknowledgment The views expressed in this paper are those of the authors and not those of the institutions for which they work. Thanks are due to the Securities House Company in Kuwait for their help and to The Kuwait Foundation for the Advancement of Sciences for financial support. Notes
1 Subject to contractual conditions, the Islamic bank may commingle its own capital (shareholders’

funds) together with funds of other investors in profit-sharing investment funds as described below. In that case, the shareholders will also share proportionately in any losses which such investment funds may make. 2 Shari’a is the sacred law of Islam. It is derived from the Qur’an (The Muslim Holy Book), the Sunna (the saying and deeds of Prophet Mohammed), Ijma (consensus), Qiyas (reasoning by analogy), and Maslaha (consideration of the public good or common need). 3 The SSB also plays a role in setting the accounting policy of the bank (see AAOIFI, 1996; Karim, 1995). 4 Riba is translated strictly as usury, but interpreted by modern Islamic scholars as being equivalent to interest (see Mallat, 1988; Saleh, 1992; Taylor and Evans, 1987). Islamic banks may also use the mudaraba contract (as well as other forms of contract) in their placement of funds, in lieu of interestbearing assets. 5 There is great similarity between the mudaraba contract and the commenda contract which was, by far, the most widespread and popular business partnership practiced in medieval Europe (see Çizakça, 1996 for a review of the debate concerning those who argue that the commenda contract originated in the world of Islam). 6 According to Çizakça (1996), the use of the commenda by banks to mobilize funds dates back to the fifteenth century (see also De Roover, 1963). 7 For a comprehensive coverage of these details see Udovitch (1970). 8 For example, the General Conditions Governing Investment and Current Accounts of Faysal Islamic Bank of Bahrain include the following: 11. In the case of an Investor withdrawing his/her investment during a month, the corresponding profit for that month shall be payable to him/her only after the valuation of assets at the end of that month.

12. Withdrawals before maturity are not permitted. . . .


9 For more details see Al-Deehani, Karim and Murinde (1996). 10 For other types of restrictions see AAOIFI, 1993, para 12, 13. 11 Shareholders receive profit generated from investing the other sources of funds because in case

of loss providers of these funds are compensated from shareholders’ equity.
12 For more details see AAOIFI, 1997b. 13 For more details see Karim (1994) and Al-Deehani, Karim and Murinde (1996). 14 The rationale sometimes given for the bank being allowed to invest its own (i.e. shareholders’)

funds in a restricted mudaraba is that this allows the bank to replace the funds of an investor wishing to withdraw, thereby acting as market-maker to make the investment fund open-ended, given that the fund is not securitised and listed on a public exchange. It is further stated as part of this rationale that the bank’s acquisition and disposal of holdings in the mudaraba investment funds are made on an arm’s length basis at Net Asset Value (NAV). This raises the question of the bases and methods used to value the assets. More generally, neither the rationale nor the requirement that the bank’s acquisitions and disposals be made at NAV appear as restrictions on the bank’s actions in the mudaraba conctract. 15 For more details on these types of agency problems see Jensen and Meckling, 1976; Barnea, Haugen and Senbet, 1985. 16 In TCE, the use of debt raises a different problem, namely a disincentive to invest in projects with high asset specificity. It is this problem which is more relevant in the present analysis. See Section 4 below. 17 One possible explanation for this is that since the management of the mudaraba fund is the sole prerogative of the bank as mudarib, i.e. the shareholders as represented by management, Islamic banks seem to have interpreted this also to include the appointment of the management, SSB and the financial auditor. See also Archer and Karim (1996). 18 Both SSB and the financial auditor address their reports to the shareholders of the Islamic bank (see AAOIFI, 1996a, 1997a). 19 According to the jurisprudence of the mudaraba contract, trustworthiness is a quality assumed of the mudarib (i.e., the Islamic bank). According to Udovitch (1970, p. 203), “Like partnership, the commenda [mudaraba] is classified as a contract of fidelity (’aqd alamàna); like a partner, the agent [mudarib] is considered a trustworthy and faithful party (amìn) with respect to the capital entrusted to him, and therefore not liable for any loss occurring in the normal course of business activities; and, like a partner, the agent becomes liable for the property in his care as a result of any violation of this fidelity (amàna).” 20 For more details on the theoretical underpinning of this proposition see Al-Deehani, Karim and Murinde, 1996). 21 See, for instance, the examples discussed by Williamson (1995, ch. 10). 22 Karim (1996b) and Karim and Ali (1987) show that such a pattern of capital structure is common in Islamic banks except those banks that are forced by certain regulatory constraints to adopt a different capital structure. 23 This is because IAH are neither guaranteed a predetermined fixed return nor do they constitute a liability. Hence, they are not given first claim on the bank’s earnings or assets (see Al-Deehani, Karim and Murinde, 1996). 24 Recently, AAOIFI issued a standard that requires the Islamic bank to seek the opinion of its SSB as to who should bear the loss incurred in investments that are jointly financed by IAH and shareholders (AAOIFI, 1997b). 25 On the other hand, IAH with funds invested under contracts giving the right to withdraw at short notice might bring about the insolvency of the bank by sudden very large withdrawals of funds if the bank had not adequately matched the maturities. 26 The governance structure of the mudaraba contract also includes the right of investors to recover any loss due to the management’s negligence or misconduct. However, the lack of a monitoring



mechanism that is intended to work for their benefit means that IAH would not be well placed in order to find out whether the loss were indeed due to the management’s negligence or misconduct.

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