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Corporate Governance

for Islamic Financial
Institutions

IF. Major corporate scandals of the past have had a detrimental effect on conventional finance2.   The long-term sustainability of IF must therefore be based upon the public's trust and confidence and aim to avoid systematic risk through the establishment and implementation of regulatory frameworks that embrace transparency. where the industry has been invigorated by liquidity owing to inflows of petrodollars from record high oil prices.Over the past four decades. It has done so by reconciling the financial and theological needs of an expanding Muslim population. accountability and enforceability.   . Islamic finance (IF) has successfully carved out a niche within the global financial system. has a responsibility to enact preventative measures that are specific to its unique structure. by its very nature. One of the largest concentrations of this growth has been in the Middle East.

  . This confidence has. ensured relative financial stability in an emerging marketplace that is still considered politically unstable1. in turn. However.Excess liquidity has so far been a major contributor to the success of IF in the Middle East and investor confidence has correspondingly grown. Liquidity cannot be indefinitely relied upon as a foundation for growth and IF must instead focus on fundamentals if it is to offset the effects of an economic downturn. Islamic financial institutions (IFIs) should remain conscious of the economic boom-and-bust cycles that have historically plagued development in a region that continues to rely heavily upon petroleum for much of its GDP.

documentation. to sustain and enhance value." Organization for Economic Cooperation and Development (OECD)   Conventional governance standards seek to address the separation of ownership and management ‘the agency problem’ by ensuring that actions of the management are kept inline with the interests of shareholders and stakeholders.A Mismatch in the Role of Corporate Governance   "Corporate governance is the system by which companies are directed and controlled. too. in the interest of shareholders and other stakeholders. transparency. emphasise the importance of honesty. accountability and ethics. The conventional governance standards can therefore be paired with Shari'a requirements essential to IFIs to create a corporate governance structure that is suited to IF. the fundamental teachings of the Qur'an and the Sunnah.   . which form the basis of the Shari'a and Islamic jurisprudence that governs IF. Within IF.

Core Attributes of Corporate Governance in Islamic Finance   .

  . in which participants (the investment account holders) have authorised their fund manager (the IFI) to manage their investments. on which the relationship between the investment account holder and IFI is based. In IFIs there are two types of owners. albeit under restrictions delineated by the nature of the account (i.   This is because the mudaraba contract. have an agency (mudarib) relationship with the IFI. The depositors are risk/reward-sharing and therefore provide quasi-equity to the bank.There is a difference between conventional and IF that adds another dimension to corporate governance and relates to the equally weighted importance of 'other stakeholders'. The relationship between the investment account holder and IFI can be compared to that of a collective investment scheme. or depositors. unrestricted investment accounts (URIA) and restricted investment accounts (RIA).e. specifies that investment account holders. as in conventional institutions. and the investment account holders. as owners of capital (rab-al-maal). the shareholders.

Collective Investment Schemes and Islamic Financial Institutions   .

As a result.   Corporate governance in IFIs must therefore be customised to address such issues and protect the rights and needs of the investment account holders.   . have adopted a process of smoothing out returns to their unrestricted investment account holder through the use of a profit equalisation reserve (PER). as provided by equity from the shareholders in conventional institutions. IFIs. in some jurisdictions. the transparency of such practices is somewhat questionable. even when the IFI's earnings are below the market rate (IFIs are competing against the guaranteed returns offered by conventional banks). To counter such uncertainties. particularly with regard to risk and reward. investment account holders are liable to incur unexpected losses in the same way as shareholders because there is effectively no cushion. However. This reserve aims to offset poor performance and maintain a rate of return that is consistently competitive.

Bearers of Risk in Conventional and Islamic Financial Institutions   .

These recommendations examine issues beyond the scope of this discussion.   Shari'a compliance   Both organisations mentioned above emphasise the need for IFIs to attain Shari'a advisory and supervisory functions that can guide their business operations. the Islamic Financial Services Board (IFSB)6 and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)7 have both issued guiding principles on corporate governance for IFIs8.Tailoring Corporate Governance to Suit Islamic Finance   In response to the issues set out above. To this end. AAOIFI states that every IFI shall have an independent Shari'a supervisory board. recommended by the board of directors and appointed by its shareholders.   . but also focus on both Shari'a compliance and the importance of investment account holders. consisting of at least three specialised jurists in Islamic commercial jurisprudence (fiqh almua'malat).

it is recommended that IFIs conduct an internal Shari'a review of all activities. these jurists (often referred to as Shari'a scholars) will direct. supervise and provide rulings (fatawa) on activities of the IFI to ensure compliance with Shari'a jurisprudence.   Furthermore. executed by a dedicated internal division/ department or as part of the internal audit department. will be to ensure management of an IFI discharge their responsibilities in relation to implementing rulings made by the Shari'a supervisory board.Together. According to AAOIFI. The ISCU is therefore an internal and independent function that assists the Shari'a supervisory board and contributes to ensuring the IFI's Shari'a compliance. The IFSB emphasises the need for these scholars to address both ex ante and ex post aspects of financial transactions. review.   . the main purpose of this function. referred to here as the Internal Shari'a Compliance Unit (ISCU). depending on the size of the institution. thus ensuring an effective review process.

As a result. a member of the audit committee. to implement governance policy frameworks that will protect the interests of the investment account holder. the IFSB has argued for the creation of a separate committee. the investment account holder is considered a stakeholder in an IFI.   .Investment account holders   As previously discussed. a non-executive director (selected based upon experience and ability to contribute) and a Shari'a scholar (possibly from the IFI's Shari'a supervisory board). the governance committee. Such a committee will be established by the board of directors and comprise three members.

but is not expected to receive proportionate rewards. The investment account holder is therefore exposed to the same risk as the shareholder. whereas shareholders.the result. Investment account holders are generally perceived as requiring protection of their funds.   . who have provided equity.   This problem is then further exacerbated by the arguably controversial practice of utilising a PER.The IFSB argue that of particular concern to the governance committee will be the commingling of funds (relating to unrestricted investment accounts) from investors with differing risk expectations. for commingled funds. will expect high returns . which effectively obscures the actual return on investments and prevents the unrestricted investment account holder from properly assessing the implications of the IFI's investment strategy. with investment account holders restricted in their control over investment strategy. is a conflict of interests.

It is this ambiguity. the PER is subject to what the IFSB refers to as an intergenerational problem. surrounding the rights of the investment account holder.   . the audit committee. and ensure disclosure and the proper implementation of investment contracts. and the Shari'a supervisory board.Moreover. The committee will provide the board of directors with reports and recommendations. that the governance committee will seek to address. closely liaise with the management. in that a build-up of reserves during periods of above-average profits may leave unrestricted investment account holders with forgone and unrealised benefits if they withdraw their investment before such a time when reserves are used.

an indicative corporate governance structure for an IFI should include the following:   .In light of the requirements and suggestions outlined above.

  However.   .Addressing Gaps in Corporate Governance   Maintaining customers' confidence in an IFI's Shari'a compliance is of vital importance. structures that address internal controls and ex post aspects of Shari'a compliance have not been as comprehensively implemented as the predominantly ex ante role played by the Shari'a supervisory board. The role of the ISCU is to address such failings and its establishment should therefore be considered essential. The Shari'a supervisory board has become an indispensable aspect of corporate governance for IFIs and the demand for reputable Shari'a scholars has consequently grown.   It is the fundamental differentiator between conventional finance and IF and there has subsequently been significant progress in establishing corporate governance structures that support Shari'a compliance.

The recommendations put forward by the IFSB are commendable and IFIs should acknowledge and respond to the need for corporate governance that addresses these shortcomings. however.   The establishment of a governance committee may not be the only solution.   . another would require structures that ensure management are held accountable toinvestment account holders. one alternative would be a board of directors with independent directors that have dual responsibilities to the shareholders and investment account holders.   Nevertheless. the structure that is implemented must not be subservient to the board of directors.It is. arguably the lack of corporate governance aimed at ensuring the rights and addressing the risk exposure of investment account holders that requires immediate attention. must be allowed to operate independently and must be enforced in order to influence decision-making processes that affect the investment account holders.

IF as a whole must not rest on its laurels. rather than reactive.   External shocks may occur and if they do.   . supported by regulatory authorities. but as mentioned at the beginning of this article. will help to ensure continued stability. aware of available product offerings and less compelled to remain loyal to any given institution. the buffer provided by a solid corporate governance structure.The Way Forward   IF has thus far experienced unprecedented growth. strategy towards corporate governance if long-term sustainability is to be assured.   The ambiguity that affects aspects of the industry will have to be addressed if respective IFIs are to retain market share and remain competitive. IF is becoming increasingly competitive and clients are becoming increasingly sophisticated. it must be resolute and embrace a proactive. the enactment and implementation of relevant corporate governance structures is essential if trust and confidence is to be maintained.