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Governance and Corporate Disclosure: A Study in Bank Muamalat Indonesia and Bank Syariah Mandiri

Irma Aulia R. Kasri Department of Accounting, Andalas University Kampus Unand Limau Manis Padang, West Sumatra, Indonesia Email: irma.kasri@gmail.com Niki Lukviarman Department of Accounting, Andalas University Kampus Unand Limau Manis Padang, West Sumatra, Indonesia Email: niki.lukviarman@yahoo.com

ABSTRACT
This study analysis the governance implementation and disclosure practices in Bank Muamalat Indonesia and Bank Syariah Mandiri. The Bank Indonesia Regulation PBI No.8/4/PBI/2006 concerning the implementation of corporate governance for commercial bank and Islamic Financial Services Board (IFSB) Exposure Draft No. 4/2006 concerning the implementation of corporate governance in Institution Offering Financial Services are used as the indicators for compliance of regulation and practice in both bank. The result indicate that both bank already implement the corporate governance practice and have good tendency to disclose information regarding the corporate governance implementation.

Keywords: Governance, Disclosure, Islamic Bank

1. INTRODUCTION Islamic banking is a worldwide phenomenon involving a variety of instutitions and instrument, not one “project” or institution. Its all part of a trend in which the financial products comply with the set of Qur’anic laws that govern daily life, or Sharī`ah, are evolving from novelty to normal part in doing business in much of developing world. Islamic banks were set up as an alternative to conventional banks. Muslim depositors who believe that interest (riba) is incongruent to their religious tenets have no choice but to resolve this conundrum by depositing their funds into Islamic banks or banks which have services that comply with Islamic law (Satkunasingam and Shanugam, 2004). Islamic bank is defined as banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good corporate governance and risk management rules, by the principles laid down by Islamic laws (Sharī`ah). Islamic banking, the more general term is expected not only to avoid interest-based transaction which are prohibited in Sharī`ah, but also to avoid unethical business practices and participate effectively in achieving the goals and objectives of the Islamic economy. Good governance is crucial to the ability of a business to protect the interests of its stakeholders. In the case of an institution offering financial products and services such as Islamic banks, the stakeholders expect that its operation be carried out in compliance with the principles of Sharī`ah. A corporate structure that enables such as institution to implement good governance through Sharī`ah-compliant operations is therefore essential (Grais and Pellegrini 2006). It is also recognized that good corporate governance reinforces sound regulation and supervision. It contributes towards maintaining market confidence, and strengthening transparency and accountability. Its emphasis is to be value oriented and promote fairness and justice with respect to all stakeholders of the banking institution. For corporate governance to work, good corporate practices need to be instilled and embedded in all aspects of the operation and at all levels within the organization.

Indeed, Islam strongly advocates all form of positive governance. These values and ethical conducts have already been inbuilt and have become inherent in the Islamic community. Islamic corporate governance serves through the underlying principle of economic well-being of the Ummah, universal brotherhood, justices, accountabilities and equitable distribution of income. Therefore, while the virtues of Islam have always advocates good corporate governance, the challenge to us lies in its application. Closely linked to the corporate governance issue is the role of market discipline. Transparency and disclosure are essential particularly in a rapidly changing environment. While comprehensive and timely availability of financial information will increase market discipline, the disclosure of information needs to be complemented with the ability of the market players to analyze and appropriately interpret the information. Transparency and disclosure are even more relevant in multi-facet role played by the Islamic Financial Institutions in dealing with Islamic banking customers. This is relevant as the Islamic financial transactions are not merely based on lender and borrower relationship as is in the case of conventional banking (Aziz, 2004). With reference to principles of corporate governance and the greater need for disclosure, the study will look broadly to the Good Corporate Governance implementation in Islamic Bank. The study also examines the corporate disclosure whether the Islamic Bank in Indonesia has have a good standard for general governance and Sharī`ah governance disclosure. The rest of the study is structured as follow. Section 2 reviews literature on corporate governance in Islamic bank and governance disclosure. Section 3 discusses the research design of the study. Section 4 presents and discusses the findings of the study and section 5 concludes. 2. LITERATURE REVIEW 2.1 Corporate Governance in Banking Institution In between 1980 to 1997, over 130 countries, comprising almost three fourths of the member countries of the International Monitory Fund (IMF) have

experienced important problems with their bank (Ciancanelli & Gonzales, 2000; Lindgren & Garcia, 1996; Saal, 1996). The facts that this crises occurred after implementation of far reaching reforms of the financial system revived long standing debates in Economic and Finance on role of bank regulation (Ciancanelli & Gonzales 2000; Mishkin 1992; McKinnon, 1993). Notably absent in the debate is the consideration of the corporate governance of banks who recently growing faster than before (Macey and O’hara, 2003; Caprio and Levine. 2002; Levine, 2003; Charkam, 2003). Banks are in the unique position of effectively collecting and allowing the use of fund in given manner or enterprises as well as engaged in the business of financial intermediation between savers and investors. Bank is not similar with other financial institutions, and indeed from all sectors, due to the possibility of bank system instability leading to credit contraction for all other sectors. Charkham (2005) wrote that “Banks are different from the generality of companies in that their collapse affects a far wider circle of people and moreover may undermine the financial system itself, with dire effect for the whole economy.” According to Levin (2003), the need for a separate analysis of the corporate governance of bank is not self evident and requires justification. Caprio and Levine (2002) and Levin (2003) identify three characteristic of bank. They argue that banks are generally more opaque than other financial institution, which fundamentally intensifies the agency problem. Although information asymmetries plague all sectors, evidence suggests that these informational asymmetries are larger with banks (Furfine, 2001). Second, banks are exposed to heavy regulation. Because of the importance of banks in the economy, because of the opacity of bank assets and activities, and because banks are a ready source of fiscal revenue, government impose an elaborate array of regulations in banks. Third, the widespread government ownership of banks raises specific governance issue. Corporate governance of banks is of fundamental importance for those who are concerned with or have the responsibility for financial regulation and for developing market and economies. Banking supervisors have long recognized the importance of good governance; supervision can not function properly if sound

corporate governance is not in place. The focus of it is mainly of those elements that relate to the manner in which the business and affairs of an organization are governed by its board and managers. This means the decision making process within the bank, the respective responsibilities and accountabilities of the board and managers, the control functions that provide assurance to the monitoring processes and the structures that support all these function (Caruana, 2005). The control function is also done through their monitoring function of their client: evaluating the creditworthiness of new projects; monitoring of ongoing performance of the project and the company; and assisting in restructuring of client firm in distress. Effective monitoring requires that the bank be independent of the borrower, and also of government pressures, so as to make objective lending decisions. It must have sufficient access to information about the borrower’s capabilities and performance; collateral alone is not enough. The bank itself must also engage in good corporate governance practices, including disclosure rules and transparency. 2.2 Corporate Governance in Islamic Bank The Corporate Governance (CG) for Islamic Financial Institutions (IFIs) is assuming growing significance with the steep growth in Islamic Finance system both regionally and now globally. This industry has become a major source of wealth creation and financing of investment projects world wide and cumulative worth of its transactions are reaching a trillion dollar. IFIs provide a viable option to savers and investors who are inclined to deal with exclusively Islamic financial system given their religious and ideological stance (Aziz, 2006) In the context of an Islamic bank, good corporate governance should encompass: • A set of organizational arrangements whereby the actions of the management of Islamic bank are aligned, as far as possible, with the interest of its stakeholders • The provision of proper incentives for the organs of governance such as board of directors, the Sharī`ah board and management, to pursue

objectives that are in the interests of the stakeholders and facilitate effective monitoring, thereby encouraging Islamic banks to use resources more efficiently • Compliance with Islamic Sharī`ah rules and principles. In place of interest-bearing deposit, Islamic bank mobilize funds through profit-sharing and loss-bearing investment accounts whose return are, as a matter of Sharī`ah jurisprudence (that is, that of the mudaraba concept), based on performance of the assets portfolios in which their funds are invested. In the majority of Islamic banks, such investment accounts contribute the preponderant amount of funds available to the bank for investment. However, investment account holders (IAHs) lack rights of governance such as shareholders enjoy, although like shareholders they are (legally speaking) a type of equity holder with residual claims to their share of the bank’s assets (Archer et al., 1998). While debt holders, with fixed contractual claims to the firm’s cash flows and are met, residual claimants by definition have no such contractual rights and thus require a governance structure to protect their interest (Williamson, 1996). As Williamson points out, the law typically provides a governance structure for debt holders in case of default. In case of IAHs, neither the Sharī`ah nor secular law make any such provision (Archer, 2007). The absence of any governance structure in the case of IAHs is thus an anomaly, and raises fundamental corporate governance issues – for example, possible conflicts of interest between the two classes of equity holders, disclosure of adequate information to enable IAHs to protect their interest, and so on. It also draws attention to market discipline, which is emphasized for the first time by the Basel Committee on Banking Supervision (BCBS) in its new capital adequacy framework (2004), and raises the issue of the extent to which IAHs have the necessary mechanism to exercise effective discipline on the management of the bank, given their lack of governance rights. Furthermore, the mobilization of funds through IAHs highlights the need to examine the approach adopted by central banks to regulate Islamic banks in order to help sustain the soundness and stability of the financial systems in the countries in which these banks operates.

2.3 Transparency and Governance Disclosure Transparency as well as corporate governance became a highlight issue in Asian market following the Asian Financial crisis in 1997. Since that time, foreign investors and regulators have become wary of corporate financial reporting in these countries, and the OECD (2004) has obliged increased transparency, a better framework for financial market integrity and greater accountability in the region (Aksu & Kosedag, 2005). A good standard of transparency and market discipline are closely interlinked with good standards of corporate governance (Vicary, 2007). Bushman, Piotroski and Smith (2004) define corporate transparency as the availability of firm-specific information to outside investors and stakeholders. Transparency is an intuitively appealing idea. It should assist investors in making better decisions regarding their investments and therefore, result in better resource and capital allocation. Transparency also regarded as a corporate governance mechanisms and therefore essential for the development of emerging economies (Leung and Morris 2005). The expected benefits of transparency and disclosure are more important in emerging market because they are dire need of external capital as their economies are growing faster than that of more developed nations. Transparency of financial information is vital components of the corporate governance framework (OECD, 1999) and is regarded as an important indicator of corporate governance quality (Aksu & Kosedag 2005). Beeks and Brown (2005) find that firm with higher corporate governance quality make more informative disclosures. Advantages of good transparency and disclosure practices are: 1. Minimize information asymmetry in the firm and probability of fraud 2. Increase investor awareness which will reduce the uncertainty of the returns to the capital suppliers, which again is expected to reduce the firm’s cost of external capital and hence increase its value. Mitigates the political cost of non-compliance and hence reduce the risk of litigations.

In Basel Core Principle 21 also asks for better disclosure by banks and to allow the counterparties of the banks to price and deal appropriately. More disclosure should reduce information asymmetry between those with privileged information and outside small investors, and facilitate more efficient monitoring, because sufficient information is necessary for market participants to exert effective disciplinary roles (Huang, 2007). 2.3.1 General Governance Disclosure The implementation of corporate governance in Indonesia is supervised by central bank (Bank Indonesia). Bank Indonesia has issued some policies to support the regulations related to bank operational and corporate governance. Bank Indonesia has its own division for Islamic Banking that supports the implementation of Sharī`ah governance in Islamic bank in Indonesia should follow the regulations and policies that set by Islamic Financial Service Board (IFSB). As a banking regulator and banking supervisor in Indonesia, Bank Indonesia found that there is increasing risk complexity faced by banks demands an increased need for good corporate governance practice by banks. Whereas in order to improve Bank performance, protect stakeholders’ interests and increase compliance to prevailing regulations and general code of conduct in the banking industry, good corporate governance implementation is considered necessary. Improvement in the quality of good corporate governance implementation is among the efforts to strengthen the internal condition of national banks pursuant to the Indonesian Banking Architecture (IBA). Based on considerations above, Bank Indonesia has issued Bank Indonesia Regulation (PBI) Number 8/4/PBI/2006 concerning good corporate governance implementation by Commercial Bank, include Sharī`ah based Bank. This regulation should be followed by Commercial Bank as referred to in Act Number 7 Year 1992 concerning Banking as amended by Act Number 10 Year 1998, including branch offices of foreign banks. It’s stated that Good Corporate Governance shall be Bank governing procedures through the application of transparency, accountability, responsibility, Independency, and

fairness principles. And its focus to give information for the stakeholders includes all parties having direct or indirect interests in Bank business activities. This implementation of corporate governance in this study will refer to this regulation. 2.3.2 Sharī`ah Governance Disclosure The Islamic Financial Services Board (IFSB) was launched in 2002 by a consortium of central banks and the Islamic Development Bank (with the support of IMF) with the mandate including the provision of prudential standards and guideline for international application by banking supervisors in the supervision of Islamic banks. In December 2006 the IFSB issued two prudential standards for Islamic banks that are designed to help supervisors of such banks meet the challenge of implementing Basel II, one on guiding principles on corporate governance for institution offering only Islamic financial services and an Exposure draft for disclosures to promote transparency and market discipline for institution offering Islamic financial services. Guiding principles on corporate governance designed to facilitate IIFS in identifying areas where appropriate governance structures and processes are required, and to recommend best practices in addressing these issues. The Guiding Principles are divided into four parts: (i) general governance approach of IIFS; (ii) rights of investment account holders (IAH); (iii) compliance with Sharī`ah rules and principles; and (iv) transparency of financial reporting in respect of investment accounts. General Governance Approach of IIFS shall establish a comprehensive governance policy framework which sets out the strategic roles and functions of each organ of governance and mechanisms for balancing the IIFS’s accountabilities to various stakeholders. IIFS shall ensure that the reporting of their financial and non-financial information meets the requirements of internationally recognized accounting standards which are in compliance with Sharī`ah rules and principles and are applicable to the Islamic financial services industry as recognized by the supervisory authorities of the country. There are two principles related to IAH in this guide. First, IIFS shall acknowledge IAHs’ right to monitor the performance of their investments and the

associated risks, and put into place adequate means to ensure that these rights are observed and exercised. Second, IIFS shall adopt a sound investment strategy which is appropriately aligned to the risk and return expectations of IAH (bearing in mind the distinction between restricted and unrestricted IAH), and be transparent in smoothing any returns. IIFS shall have in place an appropriate mechanism for obtaining rulings from Sharī`ah scholars, applying fatāwā and monitoring Sharī`ah compliance in all aspects of their products, operations and activities. IIFS shall comply with the Sharī`ah rules and principles as expressed in the rulings of the IIFS’s Sharī`ah scholars. The IIFS shall make these rulings available to the public. It’s a part of the compliance of corporate governance with Islamic Sharī`ah rules and principles. Transparency of financial reporting in respect of investment accounts for IIFS shall make adequate and timely disclosure to IAH and the public of material and relevant information on the investment accounts that they manage. The exposure draft states that disclosure of general and Sharī`ah governance are designed to provide information on the structure, processes and functioning of such governance in an IIFS to ensure transparency regarding Sharī`ah compliance by IIFS (Appendix 4.B). Such disclosure shall include the rights of IAH compliance with Sharī`ah rules and principles, and transparency of financial reporting in respect of investment account. 3. RESEARCH DESIGN This study is qualitative in its form. It is a descriptive study which emphasized more on estimating rather that testing. There are two general reasons why the writer chooses the descriptive study, namely (1) to provide information regarding this issue and (2) to identify areas for further research since the application of the regulation will start being implemented on 2007. In this study, the writer investigates Islamic Commercial Banks that have already published their annual report to the public. The banks chosen for this study are required to have a published annual report where the implementation of corporate governance is being mentioned. The population of the research is the

Islamic Commercial Banks in Indonesia that have already implemented the corporate governance principles since 2002. To answer research questions of this study, the writer takes two banks as sample: Bank Muamalat Indonesia (BMI) and Bank Syariah Mandiri (BSM). The principles of this study are Bank Indonesia Regulation No. 8/4/2006 concerning Good Corporate Governance Implementation by Commercial Bank and IFSB Standard concerning General Governance and Sharī`ah Governance Disclosure. 3.1 Variable Identification and Measurement This study analyzes the implementation of corporate governance in two Islamic banks in Indonesia i.e. BMI and BSM and the banks’ governance disclosure practices. The analysis of the implementation is based on the corporate governance implementation list in Bank Indonesia Regulation Number 8/4/PBI/2006 concerning Corporate Governance Implementation by Commercial Bank. Independent variable in this study is governance disclosure practices. It is analyzed by using the disclosure indicators from Bank Indonesia regulation and the indicators used by the Islamic Financial Services Board for Sharī`ah governance disclosure. Based on appendix 4.A disclosure of the issues above are examine: A. Share ownership 1. Whether Board of Commissioners and Board of Directors have share ownership at the bank and other banks and companies domiciled domestically and abroad 2. Whether Board of Commissioners and Board of Directors have financial relationship and family relationship with other members of the Board of Commissioners, members of the Board of Directors and /or Bank Shareholders. B. Remuneration Package 3. Procedure of remuneration package/policy and other facilities for the Board of Commissioners and the Board of Directors C. Share Option 4. The share option owned by Commissioners, the Board of Directors, and

Executive Officers D. Ratio of Highest Salary to the Lowest Salary 5. The ratio of highest salary to the lowest salary E. Frequency of Board of Commissioners Meeting 6. Whether the Board of Commissioner have held meeting at least 4 (four) times a year 7. Whether Board of Commissioners physical meeting attended by all members of the Board of Commissioners no less than 2 (two) times a year. F. Internal Fraud 8. Number of internal fraud and Bank’s efforts to handle them G. Legal Problem 9. Number of legal problems and Bank’s settlement efforts H. Conflict of Interest 10. Transactions containing conflict of interest I. Buy Back Share/Bond 11. Buy back of Bank shares and /or bonds J. Provision of Fund for Social Activities 12. Provision of funds for social activities and political activities, stating both the nominal value and the recipients This study also examines disclosure of Sharī`ah compliance in Islamic Bank (Appendix 4.B): A. Qualitative Disclosure 1. Governance Arrangements, System and Control Employed to Ensure Sharī`ah Compliance 2. Non- Sharī`ah Compliance Earning and Expenditure Occur B. Quantitative Disclosure 3. The Nature, Size and Number of Violations of Sharī`ah Compliance 4. Annual Zakat Contribution 5. Remuneration of Sharī`ah Board Members

4. RESEARCH AND ANALYSIS 4.1 Bank Overview 4.1.1 Bank Muamalat Indonesia PT Bank Muamalat Indonesia Tbk (BMI) was established in 1991, endorsed by the Indonesian Council of Ulamas (MUI) and the Government of Indonesia, and commenced operations in May 1992. On October 27, 1994, barely two years from its founding date, Bank Muamalat Indonesia received its license to operate as a Foreign Exchange Bank. This recognition strengthened the Bank’s position as the first and leading Sharī`ah (Islamic) bank in Indonesia with a growing array of products and services. The vision of BMI is to become the premier Sharī`ah bank in Indonesia, dominant in the spiritual market, admired in the rational market. Moreover, the mission is to become a role model among the world’s Sharī`ah financial institutions, emphasizing in entrepreneurial spirit, managerial excellence, and innovative investment orientation to maximize value to stakeholders (BMI, 2007) 4.1.2 Bank Syariah Mandiri PT Bank Syariah Mandiri (BSM) was established as PT Bank Susila Bakti on August 10th 1973. Due to the changes of Government regulation No. 1 year 1995 concerning the limited company (PT), the basic regulation of the bank has reviewed. In 1999, the bank agreed to change their operational from conventional bank into Sharī`ah based and followed with the change of the bank name into PT Bank Syariah Mandiri. The vision of BSM is to be a reliable Sharī`ah bank chosen by the partners. In 2002, BSM established Bangun Sejahtera Mitra Ummat foundation (BSM Ummat) which controlling the Lembaga Amil Zakat (LAZ). BSM Ummat is established as the bank’s commitment to have good zakat, infaq and shadaqah management. It is also a part of the bank’s corporate responsibilities. The bank has given the collectable zakat to the LAZ division, so bank is do managing zakat, infaq and shadaqah and qardhul hasan function indirectly.

4.2 Governance Standard in Islamic Bank Understanding of governance standard is important in implementing the good corporate governance in an institution. Islamic bank as part of Islamic financial institution has separated governance standard to ensure the compliance of corporate governance implementation with the Sharī`ah rules and principles. The Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) has been stated the Governance Standard for Islamic Financial Institution (GSIFI) in 1999. The standard classified into 3 (three); first, GSIFI No.1 concerning Sharī`ah Supervisory Board: Appointment, Composition and Report. Second, GSIFI No. 2 concerning the Sharī`ah Review; and third, GSIFI No. 3 concerning Internal Sharī`ah Review. A Sharī`ah Supervisory Board (SSB) as stated in GSIFI No. 1 is the organ of governance for ensuring compliance of the Islamic Financial institution in all its dealings and transaction with Islamic Sharī`ah Rules and Principles. It is an independent body that specialised jurist in fiqh almua’amalat (Islamic commercial jurisprudence) who entrusted with the duty of directing, reviewing, and supervising the activities of the Islamic Financial institution. Every Islamic financial institution, including Islamic Bank, shall have a Sharī`ah Supervisory Board to be appointed by shareholders in their annual general meeting upon the recommendation of the board of directors taking into consideration the local legislation and regulation. Shareholders also may authorise the board of directors to fix the remuneration of the SSB. The Sharī`ah Supervisory Board shall consist of at least three members who expertise in business, economics, law, accounting and/or other. The SSB should not include directors or significant shareholders of the Islamic financial institution. The SSB should give a report to explain the confirmation that Sharī`ah Supervisory Board has performed appropriate test, procedures and review work as appropriate. The SSB should also state whether the example Islamic Financial Institution’s contracts and related documentation are in compliance with the

Islamic Sharī`ah Rules and Principles. This report shall be published in the annual report of Islamic Financial Institution. Governance Standard for Islamic Financial Institution (GSIFI) No. 2 is the standard and guideline that purpose to assist SSB of Islamic Financial Institution (IFI) in performing the Sharī`ah review to ensure compliance with Islamic Sharī`ah Rules and Principles as reflected in the fatwas, ruling and guideline issued by IFI. Sharī`ah review is an examination of the extent of an IFI’s compliance, in all its activities, with the Sharī`ah. This examination includes contracts, agreements, policies, products, transactions, memorandum and articles of association, financial statement, report (especially internal audit and central bank inspection), circulars, etc. The SSB shall have complete and unhindered access to all records, transactions, and information from all sources including professional advisers and the IFI employees. The procedure of Sharī`ah review are planning review procedures; executing review procedures and preparation and review of working papers; and documenting conclusion and report. The SSB shall implement adequate quality control policies and procedures to ensure that the review is conducted in accordance with this standard. The report to shareholder shall be based on GSIFI No. 1. The purpose of GSIFI No. 3 is to establish standard and provide guideline on the internal Sharī`ah review in institutions which conduct business in conformity with Islamic Sharī`ah rules and principles. The standard covers the objectives, internal Sharī`ah review, independence and objectivity, professional proficiency, scope of work, performance of the internal Sharī`ah review work, management of the internal Sharī`ah review, quality assurance and elements of an effective internal Sharī`ah review control system. The standard also covers responsibility for its implementation. The internal Sharī`ah reviewers shall plan each internal Sharī`ah reviews assignment. They shall collect, analyse, interpret and document information to support their internal Sharī`ah review result. The head of internal Sharī`ah review

shall discuss conclusions and recommendations with appropriate levels of management before issuing final written report. On completion of internal Sharī`ah review, at least a quarterly written report addressed to the board of directors and copied to the SSB and management. The internal Sharī`ah reviewers shall follow up to ascertain that appropriate action is taken on their reported internal Sharī`ah review findings. In addition any other recommendations relating to Sharī`ah shall also be followed up. The management is responsible for rectification of non-compliance, prevention of non-recurrence of no-compliance and ensuring that the agreed upon action were carried out including their timing and extent follow up These governance standard should applied in all Islamic financial institution including Islamic bank to ensure the compliance with the Sharī`ah rules and principles. The implementation of corporate governance itself is depend on the country regulation, in this study the implementation is based on the Bank Indonesia regulation which will discuss in next section. Also by knowing the governance standard of Islamic financial institution, the study will examine the importance of disclosure in Islamic bank. 4.3 Identification of Corporate Governance Implementation in Islamic Bank

A bank with Sharī`ah basis has an obligation to follow the Bank Indonesia regulation as the regulator including the regulation Number 8/4/PBI/2006 concerning the Good Corporate Governance Implementation by Commercial Bank. Both Bank Muamalat Indonesia (BMI) and Bank Syariah Mandiri (BSM) have been implemented the corporate governance since 2002. BSM has started the commitment to implement the good corporate governance to their majority shareholder based on the guideline issued by the Forum for Corporate Governance in Indonesia (FCGI). Following the industry regulation, on March 2004 BSM adopted the guideline issued by Komite Nasional Corporate Governance concerning the guideline of Corporate Governance for Indonesian Banking Industry (Indonesia Banking Sector Code). With the new

regulation from Bank Indonesia, Number 8/4/PBI/2004, BSM has to complete the entire requirement needed before the end of year 2007. BMI started the implementation of Good Corporate Governance in 2002. In 2003, the bank implemented some policies for risk management as a part of corporate governance in BMI. The risk management practices followed include financing risk, market risk, liquidity risk, operational risk, legal risk, reputation, strategic and compliance management. To support the implementation process, Management Risk division of BMI created the Code of Conduct to serve as guidance for all the bank’s personnel on how to interact with consumer, business partner and vendors. The code of conduct clearly states that all of its employees are not allowed to receive gifts from customers or other parties since that would be considered as conflict of interest. The code of conduct also includes guidance on the prevention of misuse of authority and information. Furthermore, the BMI established the Corporate Governance Principles which represent regulations, principles and policies that should be complied with by all the bank’s employees, to maintain responsibility and un-deviated work, and at the same time motivate the employees to perform effectively and efficiently, to produce continuous economic value for the stockholders and stakeholders using the guidelines of justice, principles, transparency, accountability and responsibility. To strengthen the implementation of corporate governance, BMI also follow the Bank Indonesia Regulation Number 8/4/PBI/2006 concerning the implementation of corporate governance for commercial bank. 4.4 Analysis of Corporate Governance Implementation in Islamic Bank in Indonesia According to article 2 of Bank Indonesia Regulation PBI No. 8/4/PBI/2006, the implementation corporate governance principles must at least be realized in seven items. The items are: a. Implementation of tasks and responsibilities by the Board of Commissioners and the Board of Directors; b. Completeness and implementation of the tasks of committees and the work unit performing bank internal audit function;

c. Performance of compliance, internal auditor and external auditor functions; d. Risk management implementation, including the internal control system; e. Provision of funds to related parties and provision of funds in large amount (large exposures); f. Strategic plan of the Bank; g. Transparency in Bank financial and non financial conditions.

Table 4.1 Governance implementation of both banks Bank BMI Board of Commissioner and Board of Director Internal Audit Committee External Audit Risk Management Implementation Large Exposure Bank Strategic Plan Bank Financial Transparency Report and Self Assessment X V V V V V V V V BSM V V V V V V V Report obligation is for the end of 2007 4.5 Governance Disclosure in Islamic Bank in Indonesia 4.5.1 General Governance Disclosure The disclosure of corporate governance implementation is a main issue in corporate governance report. As mentioned earlier in previous section regarding to report and self assessment of corporate governance implementation in bank, the

Note

governance disclosure could be the right measurement. The measurement for this study is the completeness of bank disclosure practices with the requirements obligated by the Bank Indonesia Regulation No. 8/4/PBI/2006. This study classifies it as general governance disclosure.

Table 4.2 General Governance Disclosure Disclosure of General Governance BMI Share Ownership Remuneration Package Share Option Board of Commissioners Board of Directors Board of Commissioners Board of Directors Board of Commissioners Board of Directors Executives Officers Ratio of Salary Board Commissioner Meeting Internal Fraud Legal Problem Conflict Interest Buy Provision Activities Share/Bond Ratio of Highest to Lowest Salary Physical Meeting attended by all members Number of Internal Fraud Number of Legal Problem Interest Back Buy back of Bank shares and /or bonds of Provision of funds for social V V V V V V of Transaction Containing Conflict of X X X V X V of Periodically Meeting V V V V X X X X X X BSM V V V V V V V V X X

Fund for Social activities Provision of funds for political activities

4.5.2 Sharī`ah Governance Disclosures in Islamic Bank Disclosures of Sharī`ah governance are designed to provide information on the structure, processes and functioning of such governance in an Islamic bank. An important objective of these disclosures is to ensure transparency regarding Sharī`ah compliance by IIFS. Table 4.3 Sharī`ah Governance Disclosure Disclosure of Sharī`ah Governance BMI Qualitative Disclosure Governance Arrangements, System and Controls Employed to Ensure Sharī`ah Compliance Non- Sharī`ah Compliance Earning and Expenditure Occur Quantitative Disclosure The Nature, Size and Number of Violations of Sharī`ah Compliance Annual Zakat Contribution Remuneration of Sharī`ah Board Members Based on data in table 4.1, the BSM has implemented all of the principles stated in Bank Indonesia regulation No. 8/4/PBI/2006. The table also shows that the BMI has no report and self assessment yet. It might be because when the time this study is taken, the BMI still on progress in making it since according to regulation all bank should implement it for 2007 year report. General governance disclosure of both banks, in table 4.2, shows the BMI only disclose 43.75 % where the BSM has disclose 81.25 % of all the item need to be disclosed based on Bank Indonesia regulation No.8/4/PBI/2006. For Sharī`ah governance disclosure, either BMI or BSM only disclose 40 % from the total item. So, this study find that the BSM has better implementation and disclosure V V V V X X X X X BSM X

practices of their corporate governance and its compliance with Sharī`ah principle rather than the BMI. 5. CONCLUSION 5.1 Conclusion This study comes with the purposes to identify the governance standard in Islamic bank, to analyze the corporate governance implementation, to identify the role of disclosure and the governance disclosure in Islamic bank. The governance disclosure is stress to the indicator provided by the Bank Indonesia regulation No. 8/4/PBI/2006 concerning the implementation of corporate governance in commercial bank and Islamic Financial Service Board (IFSB) Exposure Draft No. 4 concerning the disclosure to promote transparency and market discipline for institution offering financial services The result indicates both banks in this study, Bank Muamalat Indonesia and Bank Syariah Mandiri, have already implemented the corporate governance practices. The implementation process is mainly stated in their annual report. Both banks have shown a good tendency to disclose information regarding the corporate governance implementation. It shows in governance disclosure check box. As the bank operates based on Sharī`ah, the result shows that bank has fulfil the Sharī`ah principle requires in this research. 5.2 Recommendation Further studies can be conducted by increase the number of samples and add the disclosure indicators such as from the financial aspect. The in-depth analysis, from the first report of corporate governance implementation based on Bank Indonesia Regulation No. 8/4/PBI/2006 to recent regulations will complete the research of this study. Thus, further research findings are expected to support current research findings and can contribute to the governance practices in Indonesia.

5.3 Limitation of Study This study found some limitation. They are: 1. Data limitation because this study examines the new regulation that started to be implemented in 2007 and not all Islamic banks have already had the report for the focus problem of this study 2. This study uses only two commercial Islamic banks, therefore it can not stand as the generalization of the Islamic banking condition in Indonesia 3. This study has found limited reference regarding to Islamic banking research in Indonesia and the governance disclosure literature. BIBLIOGRAPHY AAOIFI, 1999. Governance Standard for Islamic Financial Institution No 1 – 3, Bahrain. AAOIFI, 1999. Code of Ethics for Accountant and Auditors Islamic Financial Institution, Bahrain. Akhtar, A. Aziz, 2004. Ensuring Stability in Islamic Financial System, London. Akhtar, A. Aziz, 2006. Syariah Compliant Corporate Governance, Annual Corporate Governance, Dubai. Archer, S. and Abdel Karim, R.A. 2007. Specific Corporate Governance Issues in Islamic Banks in Archer, S and Abdel Karim, R.A (eds), 2007, Islamic Finance: The Regulatory Challenge, Singapore: John Wiley & Sons. Bank Indonesia, 2002. The Blue Print in Islamic Banking Development in Indonesia, www.bi.go.id. Bank Indonesia, 2005. Report on the Development of Islamic Banking Year 2005, www.bi.go.id. Bank Indonesia, 2006. Bank Indonesia Regulation Number 8/4/PBI/2006, Indonesia. Bank Muamalat Indonesia, 2007. Annual Report 2002 - 2006, Indonesia, www.muamalatbank.com Bank Syariah Mandiri, 2007. Annual Report 2002 - 2006, Indonesia, www.banksyariahmandiri.com

Basel Committee on Banking Supervision 2005. Enhancing Corporate Governance for Banking Organizations, Bank for International Settlements. Blair, M.M. 1995, Ownership and Control: Rethinking Corporate Governance for the Twenty-first Century, The Booking Institution, New York. Caprio, G., Laeven, L. and Levine, R. 2006. Governance and Bank Valuation, http://www.ssrn.com. Caruana, James, 2005. Basel II and Corporate Governance Issue. www.ifsb.com Ciancanelli, Penny and J.A.R. Gonzales, 2000. Corporate Governance in Banking: A Conceptual Framework, www.ssrn.com. Grais and Palegrini, 2006. Corporate Governance and Stakeholders’ Financial Interest in Institution Offering Islamic Financial Services, World Bank Policy Research Working Paper. www.ssrn.com. Grais and Palegrini, 2006. Corporate Governance and Syariah Compliance, World Bank Policy Research Working Paper. www.ssrn.com. Grais and Palegrini, 2006. Corporate Governance in Islamic Financial Services, World Bank Policy Research Working Paper. www.ssrn.com. Greuning and Iqbal, 2007. Banking and Risk Environment, John Willey & Sons (Asia), Malaysia. Islamic Financial Services Board (IFSB), 2006a. Guiding Principle of Corporate Governance for Institution Offering Only Financial Services (Excluding Islamic Insurance (Takaful) Institution and Islamic Mutual Funds), www.ifsb.com. Islamic Financial Services Board (IFSB), 2006b. Exposure Draft No. 4 Disclosure
to promote transparency and Market Discipline for Institutions Offering Only Islamic Financial Services (Excluding Islamic Insurance/Takaful Institutions and Islamic Mutual Funds), www.ifsb.com.

National Committee for Corporate Governance, 2006. Indonesians Code of Good Corporate Governance, Indonesia. Kurniawan and Indriantoro, 2000. The Role of Disclosure in Strengthening Corporate Governance and Accountability. OECD. Levine, 2003. The Corporate Governance of Bank: A Concise Discussion of Concepts and Evidence, www.ssrn.com.

Lukviarman, N. 2004, Ownership Structure and Firm Performance: The Case of Indonesia, DBA Thesis, Graduate School of Business, Curtin University of Technology, Perth. Mahmod, 2005. Islamic Bank Corporate Governance and Regulation: A Call for Mutualization, Rice University. Nakajima and Rider, 2007. Corporate Governance and Supervision, in Archer, S and Abdel Karim, R.A (eds), 2007, Islamic Finance: The Regulatory Challenge, Singapore: John Wiley & Sons. Ningsi, Lidya U., 2006, Board Monitoring Effectiveness and Financial Disclosure; the view of Corporate Governance, Undergraduate Degree Thesis, Andalas University of Indonesia. Noor, Zainulbahar, 2006. Bank Muamalat: Sebuah Mimpi, Harapan dan Kenyataan, Fenomena Kebangkitan Ekonomi Islam, Jakarta , Bening. Organization for Economic Co-operation and Development/OECD, 2004. OECD Principles for Corporate Governance. Oxford University, 2007. The New Shorter Oxford English Dictionary, New York: Oxford University Press. Patrick, 2001. Corporate Governance and Indonesia Financial System: A Comparative Perspective, APEC Study Center Colombia Business School. Saleiman, 2006. Corporate Governance in Islamic Bank, www.google.com. Satkunasingam and Shanmugan, 2004. Disclosure and Governance of Islamic Bank: A Case Study in Malaysia, University Islam International Malaysia. Sekaran, Uma, 1998, ‘Research Methods for Business’, 4th (ed), New York: John Wiley and Sons Inc. Shleifer, A. & Vishny, R.W, 1997. Agency problems and Dividend Policies around the World, http://www.ssrn.com Timberg, 2003. Risk Management : Islamic Financial Policies Islamic Banking and Its Potential Impact, Bank Indonesia, Indonesia. UFJI & FCGI 2005. Corporate Governance of Banks in Indonesia, PT UFJ Institute Indonesia – Forum for Corporate Governance in Indonesia. Vicary, David, 2007. Transparency and Market Discipline, John Willey & Sons (Asia), Malaysia.

Yunis, 2007. Corporate Governance for Bank, John Willey & Sons (Asia), Malaysia.

Appendix 4.A Bank Indonesia Regulation No. 8/4/PBI/2006 Concerning Good Corporate Governance Implementation by Commercial Bank Article 2 (1) Each bank must implement Good Corporate Governance principles in any of its business activity on all organizational levels or hierarchy of the. (2) Implementation of Good Corporate Governance principles as referred to in Paragraph (1) must at least be realized in: a. Implementation of tasks and responsibilities by the Board of Commissioners and the Board of Directors; b. Completeness and implementation of the tasks of committees and the work unit performing bank internal audit function; c. Performance of compliance, internal auditor and external auditor functions; d. Risk management implementation, including the internal control system; e. Provision of funds to related parties and provision of funds in large amount (large exposures); f. Strategic plan of the Bank; g. Transparency in Bank financial and non financial conditions. Every end of book year, starting for year 2007, each bank should prepare the implementation report and result of self assessment on Bank Corporate Governance Implementation. Exclude the contents stated in article 2, PBI No. 8/4/PBI/2006 also arrange bank to disclose all the following corporate governance aspects: 1. Share ownership by members of the Board of Commissioners and financial relationship and family relationship among members of the Board of Commissioners with other members of the Board of Commissioners, members

of the Board of Directors and /or Bank’s Shareholders. Members of the Board of Commissioners must disclose: a. Share ownership at the bank and other banks and companies domiciled domestically and abroad; b. Financial relationship and family relationship with other members of the Board of Commissioners, members of the Board of Directors and /or Bank Shareholders. 2. Share ownership by members of the Board of Directors and financial relationship and family relationship among members of the Board of Directors and members of the Board of Commissioners, other members of the Board of Directors, and /or Bank Shareholders. Members of the Board of Directors must disclose: a. Share ownership at the bank and other banks and companies domiciled domestically and abroad; b. Financial relationship and family relationship with members of the Board of Commissioners, other members of the Board of Directors and /or Bank Shareholders, in the Good Corporate Governance implementation report 3. Remuneration package/policy and other facilities for the Board of Commissioners and the Board of Directors; 4. Share options owned by Commissioners, the Board of Directors, and Executive Officers; 5. Ratio of the highest salary to the lowest salary; 6. Frequency of Board of Commissioners meetings as referred to in a. Board of Commissioners meeting must be held periodically at least 4 (four) times a year. b. Board of Commissioners meeting must be physically attended by all members of the Board of Commissioners no less than 2 (two) times a year. 7. Number of internal fraud and Bank’s efforts to handle them; 8. Number of legal problems and Bank’s settlement efforts; 9. Transactions containing conflict of interest;

10. Buy back of Bank shares and /or bonds; and 11. Provision of funds for social activities and political activities, stating both the nominal value and the recipients. Appendix 4.B Exposure Draft No. 4 Disclosures to Promote Transparency and Market Discipline for Institution Offering Islamic Financial Services (Excluding Islamic Insurance Institution and Islamic Mutual Funds) Section 6 General Governance and Sharī`ah Governance Disclosure 67. Disclosures of general and Sharī`ah governance are designed to provide information on the structure, processes and functioning of such governance in an IIFS. An important objective of these disclosures is to ensure transparency regarding Sharī`ah compliance by IIFS. 68. International standards, codes and best practices of corporate governance, such as Principles of Corporate Governance by the OECD, Enhancing Corporate Governance for Banking Organisations by the Basel Committee on Banking Supervision, and the AAOIFI’s governance standards, are congruent with these aims and, where relevant, are complementary in terms of guidance for appropriate disclosures. 69. The IFSB’s Corporate Governance Standard deals with four areas: general governance; rights of IAH; compliance with Islamic Sharī`ah rules and principles; and transparency of financial reporting in respect of investment accounts. 70. Various corporate and Sharī`ah governance practices are adopted by different IIFS in different countries. In particular, some countries have a national Sharī`ah authority that issues or approves the applicable fatawa, while in other countries, each IIFS has a Sharī`ah board which issues the applicable fatawa for that IIFS.

71. An IIFS shall make disclosures of the structure, processes and functioning of its general and Sharī`ah governance. Such disclosures shall include the rights of IAH, compliance with Islamic Sharī`ah rules and principles, and transparency of financial reporting in respect of investment accounts. Table 16: General Governance Disclosure Qualitative Disclosure 2 1 Disclosure of any departure from complying with the applicable financial reporting standard Disclosure of the IIF’s corporate governance arrangements and practices, including whether the IIFS complies in full with the IFSB’s Corporate Governance Standard, and if it does not so comply, an explanation of any non-compliance. 3 4 5 Disclosure of any related party transaction and treatment of material evens by the IIFS. Disclosure of any investors/consumer education programs for information on new products and services. Information on mediation and advice bureaus for investors and customers set up by the IIDS, including clearly written procedures for lodging of complaints. 6 Disclosure of social functions and charitable contributions of the IIFS, such as sadaqah, qard, etc. Table 17 Sharī`ah Governance Disclosures 1 A statement on the governance arrangements, systems Qualitative Disclosure and controls employed by the IIFS to ensure Sharī`ah compliance and on how these meet applicable national or international standards, an explanation of the reasons for non-compliance. In countries where national guideline Sharī`ah governance in IIFS exist, and the related governance requirements of the IIFSB’s Corporate Governance Standard are followed, a statement of

compliance with these standard (and reasons for any noncompliance) shall be provided. 2 Disclosure of how non-Sharī`ah-compliant earnings and expenditure occur and the manner in which they are disposed of. Quantitative Disclosure 4 3 Disclosure of the nature, size and number of violations of Sharī`ah compliance during the year. Disclosure of annual zakat contributions of the IIFS, where relevant, according to constitution, general assembly or national requirements 5 Remuneration of Sharī`ah board members, if applicable.