CORPORATE GOVERNANCE IN
ISLAMIC BANKS (IBs)
Tariqullah Khan
IRTI/IDB
Disclaimer: Views expressed are those of the presenter and do not necessarily reflect those of IDB/IRTI or any other entity quoted.
GDLN IRTI Distance Learning Lecture, April 22, 2008
Lecture Outline
Part 1: Corporate Governance – General Background
Part 2: Corporate Governance in Islamic Banks – Current State and Special Issues
Part 3: Corporate Governance in Islamic Banks – Looking Ahead
Background
The new firm—Corporation; separation of ownership and control; asymmetric information problem and conflict of interest
Fundamental Problems of Corporate Governance: US—dispersed shareholders: “alleviate the conflict of
interest between dispersed small shareholders and powerful controlling managers”
Europe—one dominant shareholder: “align the interests of controlling and minority shareholders”
Corporate Governance refers to a set of formerly defined relationships between a company’s Management, its Board of Directors, its Shareholders and other Stakeholders
These set of relationships provide the corporate structure as well as culture through which:
the objectives of the company are set; and the means of attaining those objectives and
monitoring performance are determined.
What Is Corporate Governance?
Why Corporate Governance? Resolve conflicts of interest among Management, Board,
Shareholders and other stakeholders and protect all stakeholders’ interests
Set vision and mission statements and strategic targets for the company
Achieve the strategic targets set by ensuring application of best practices in:
Internal control systems Regulatory compliance Accounting and Auditing Risk Management Information disclosures Shariah compliance Socially Responsible Businesses
Who Are the Stakeholders?
Management, Board, Shareholders and Employees Users of services Suppliers of funds Due to the unique role of banks in national and local
economies and financial systems, policy makers, regulators and government agencies are also stakeholders
Communities
Key Institutions/Players—External-Environment
Provide uniform, clear and transparent accounting standards
Accounting and audit standards for clear and transparent communication of information
Accounting Systems
Provide governance structures
Laws catering to the needs of IFIs
Corporate law
Disclosure/transparency Laws
Laws facilitating operations of Islamic financial institutions (IFIs)
Government and Laws
Promote strong business and legal environment that support CG
Efficiency of the Legal System
Enforceability of Contracts
Rule of Law
Overall economic, financial and legal systems
Objectives/ Responsibilities
Important IssuesInstitutions/ Players
Key Institutions/Players—External-Public Institutions
Set Principles and Sound practices
Minimum standards of CGBanking Associations
Provide Guidelines for FIs Monitor overall operations in general and risky behavior in particular
Stability and soundness ofthe financial system(eliminate systemic risk)Develop internal controls,risk management procedures, and standards oftransparency
Supervisors/
Regulators
Objectives/ Responsibilities
Important IssuesInstitutions/ Players
Key Institutions/Players—Internal—Governance
Implement the policies set by the board in a sound and responsible mannerOperate the institutionefficiently.
Right balance between riskand returnEfficient incentive-structure
Senior Management
Set overall policy and strategy Accountability of themanagement
Protect shareholders andinvestment depositors rightsEnsure good managementteamOversight of management
Board of Directors
Elect board members Shareholder RightsShare in profit
Shareholders
Objectives/ Responsibilities
Important IssuesPlayers
Key Institutions/Players—Internal—Operational
Oversee compliance with Shari’ah rules and principles
Appropriate Shari’ah relatedrules and principles
Shari’ah Boards
Ensure that the policies setby Board are followed by themanagement (Compliance)
Quality and quantity of
information
Transparency of information
Internal Audit
Meet the goals set by the
management
Minimize operational risks
Skills and work ethics
Right incentive-structure
Employees
Objectives/ Responsibilities
Important IssuesPlayers
Key Institutions/Players—Other Stakeholders
Evaluate compliance with Shari’ah
Adherence to Shari’ah rulesand principles
Shariah Audit
Evaluate the accuracy of thequality and quantity ofinformation
Quality and quantity of
information
Transparency of information
External Audit
Act responsiblyMonitor the performance
Good serviceComparable returns
Depositors
Objectives/ Responsibilities
Important IssuesPlayers
Approaches to Corporate Governance
Models that focus on maximizing shareholders’ value
Models that balance between shareholders’ value as well as stakeholders’ interests
Recent emphasis on corporate social responsibilities
How to Protect the Interests of Stakeholders?
Apply best practice standards and effective systems of accountability and incentives
Unambiguous contracts and documented rights and responsibilities of parties
Information disclosure and market discipline Institutional checks and balances Regulation and supervision Moral suasion Enabling environment
Good Governance in Islam
Accountability to God as well as to other fellow beings and environment
Ethical foundations of socially responsible businesses Compliance to Shariah Amongst the code of ethics set out in the Qur’an:
Documenting contracts Prohibition of Gharar and ambiguous contract conditions Honest fulfilment of all contracts Prohibition against betraying any trust Prohibition against deriving income from cheating, dishonesty
or fraud Prohibition against bribery to earn unfair advantage Prohibition against concealing evidence
Corporate Governance: Special Case of Islamic Banks
Shariah compliance Ethics & social responsibility Interests of Investment Deposit Holders (IAHs),
especially the unrestricted deposits Potential conflicts of interest between shareholders
and unrestricted IAHs especially where the funds are commingled
Transparency in financial reporting, e.g. calculation of Muḍārib’s share (where funds are commingled) and profit distribution
Muḍārib’s share in profits from assets financed by current accounts
Potential conflict of interest between IAHs vis-à-vis Management (Shareholders)
o Fiduciary responsibilities: Proper systems and processes to avoid potential conflicts of interest.
o Adequate disclosures: About the IB’s investment objectives and policies, operational guidelines that govern the relationship between the bank and IAHs.
o Issue of IAHs representation in Management, Board, and Shariah Supervisory Board
Protection of Investment Account Holders (“IAH”)
SSB is a specific organ of governance. It should be concerned with monitoring Shariah compliance and not just issuing fatwas.
Since SSB members may lack monitoring skills, auditors and audit committee should act in concert to assist SSB.
Sharī`ah Supervisory Board (“SSB”)
Transparency in Financial Reporting
The current financial reporting practices of IBs do not provide adequate information to their IAH regarding the revenues and expenses accruing to their particular investment fund
IAH is rightfully entitled to transparency, e.g. calculation of Muḍārib share and profit allocation
2002 IRTI SURVEY ON CORPORATE GOVERNANCE IN IBs— INTERNAL FACTORS
Good82Internal Factors Average
Fair76.2Management of Bank Operations
Good87.9Disclosure and Transparency
Good87.9Responsibilities of the Board
Fair72.4Rights of Other Stakeholders
Good87.7Rights and Equitable Treatment of Shareholders
Rankings Average Percentage
Score
Fair78.5External Factors Average
Good 82.5Ethical Overlay
Fair76.9Legal Procedures
Good81.3Regulatory Regime
Rankings Average Percentage Score
2002 IRTI SURVEY ON CG IN IBs— EXTERNAL FACTORS
Strong awareness amongst IBs on the importance of good governance.
Majority IBs offer only unrestricted IA, and even for those offering restricted IA they do not address the IAH’s risk appetite.
“Smoothing of returns” has not been proven as a widespread practice, however it is appropriate that the practice be accepted with caution in order to avoid it being used to mislead the IAH on the performance of the IA.
SSB have become almost a compulsory feature of Islamic finance. However their cost and efficiency continue to be a major concern.
IFSB (2004) AWARENESS SURVEY ON CG IN IBs
PART 3: CORPORATE GOVERNANCE IN ISLAMIC BANKS – LOOKING AHEAD
Islamic Financial Services Board (IFSB), “Guiding Principles on Corporate Governance of Institutions Offering Islamic Financial Services (IIFS)”: Scope and Related Issues
SCOPE OF IFSB GUIDELINES
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FRC/FSA
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IOSCO
√Disclosure and Transparency
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Other Stakeholders
Employees/Manager
Regulator/Supervisor
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Shareholders
Rights and Key functions
Equitable Treatment
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Companies
Directors/The Board
Remuneration/Compensation
Accountability and Audit
Relations with Shareholders
BCBSOECDCG aspects already covered
The issue of IBs accountability and transparency to its customers, particularly IAH, as well as Shariah compliance, have not been covered or contemplated in any of the above documents.
Coverage: Information environment and transparency:
specifying and enforcing appropriate disclosure requirements
fostering auditors independence and enforce the relevant and applicable auditing standards
the focus is very specifically on protection of the IAH’s interests – not to overlap with general transparent reporting which would be covered by the Transparency and Market Discipline Standard
Organs of governance: safeguarding interests of IAH, especially the
unrestricted adequate monitoring of Shariah compliance
SCOPE OF IFSB GUIDELINES
IFSB PRINCIPLES OF CORPORATE GOVERNANCE
Principle 1.1
IBs shall establish a comprehensive governance policy framework which sets out the strategic roles and functions of each organs of governance and mechanisms for balancing their accountabilities to various stakeholders.
Principle 1.2
IBs shall ensure that the reporting of their financial and non-financial information meets the requirements of internationally recognised accounting standards which are in compliance with Shariah rules and principles and are applicable to the Islamic financial services industry as recognised by the supervisory authorities.
IFSB PRINCIPLES OF CORPORATE GOVERNANCE
Principle 2.1
IBs shall acknowledge the IAH’s rights 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.
IFSB PRINCIPLES OF CORPORATE GOVERNANCE
Principle 2.2
IBs 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.
IFSB PRINCIPLES OF CORPORATE GOVERNANCE
Principle 3.1
IBs shall have in place an appropriate mechanism for obtaining Shariah rulings, application of fatwas and monitoring of Shariah compliance in all aspects of their products and operations.
IFSB PRINCIPLES OF CORPORATE GOVERNANCE
Principle 3.2
IBs shall comply with the Shariah rules and principles as expressed in the rulings of the IBs Shariah scholars. The IBs shall make these rules and principles available to the public.
IFSB PRINCIPLES OF CORPORATE GOVERNANCE
Principle 4.1
IBs shall make adequate and timely disclosure to IAH and the public, of material and relevant information on the investment accounts that they manage.
IFSB PRINCIPLES OF CORPORATE GOVERNANCE
The IFSB understands that: Adoption of OECD and BCBS recommendations will improve
IBs’ Board and Directors’ and Management’s awareness of the importance of good governance
Due recognition of IAH’s rights and risks as residual claimants will lead to appropriate protection of IAH
More professional approach for Shariah compliance will mitigate compliance and reputational risks of IBs
Increased transparency in financial and non-financial reporting by IBs will inculcate better risk management structure and discipline culture amongst IBs
Looking Ahead
Looking Ahead – Need to Strengthen CG Architecture for IBs Credit-rating agencies Centralized Shariah boards Shariah Courts and Banking tribunals AAOIFI and other Audit organizations Training in Islamic banking Islamic financial market IFSB, Islamic Financial Services Board IIFM, International Islamic Financial Market CIBAFI and Corporate Social Responsibility of IBs Lender of Last Resort Reform of the Stock Market
Acknowledgments and References
Ahmed, Habib (2007), presentation on “Corporate Governance in Islamic Banks”
Hussain, Madzlan Mohamad (2006) Presentation on IFSB Guidelines on Corporate Governance in IIFS
Chapra, M. U and Habib Ahmed (2002) Corporate Governance in Islamic Financial Institutions, Jeddah IRTI
IFSB (2007) “Guiding Principles on corporate Governance of Institutions Offering Islamic Financial Services (IIFS)”