Corporate Governance for Islamic Financial Institutions

8/18/2019 Corporate Governance for Islamic Financial Institutions

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Corporate Governancefor Islamic Financial

Institutions


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Over the past four decades, Islamic finance (IF) has successfully

carved out a niche within the global financial system. It has done so

by reconciling the financial and theological needs of an expandingMuslim population. One of the largest concentrations of this growth

has been in the Middle East, where the industry has been invigorated

by liquidity owing to inflows of petrodollars from record high oil prices.

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, accountability and enforceability. Major

corporate scandals of the past have had a detrimental effect on

conventional finance2; IF, by its very nature, has a responsibility to

enact preventative measures that are specific to its unique structure.


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Excess liquidity has so far been a major contributor to the success of IF

in the Middle East and investor confidence has correspondingly grown.

This confidence has, in turn, ensured relative financial stability in an

emerging marketplace that is still considered politically unstable1.

However, 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. Liquidity cannot be indefinitely relied upon as a

foundation for growth and IF must instead focus on fundamentals if it isto offset the effects of an economic downturn.


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A Mismatch in the Role of CorporateGovernance

"Corporate governance is the system by which companies

are directed and controlled, in the interest of shareholders

and other stakeholders, 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. Within IF, too, the fundamental teachings

of the Qur'an and the Sunnah, which form the basis of the Shari'a and

Islamic jurisprudence that governs IF, emphasise the importance of

honesty, transparency, documentation, 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.


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Core Attributes of CorporateGovernance in Islamic Finance


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There is a difference between conventional and IF that adds anotherdimension to corporate governance and relates to the equally weightedimportance of 'other stakeholders'. In IFIs there are two types of owners, the

shareholders, as in conventional institutions, and the investment accountholders, or depositors. The relationship between the investment account

holder and IFI can be compared to that of a collective investment scheme, in

which participants (the investment account holders) have authorised their fundmanager (the IFI) to manage their investments.

This is because the mudaraba contract, on which the relationship between theinvestment account holder and IFI is based, specifies that investment account

holders, as owners of capital (rab-al-maal), have an agency (mudarib)relationship with the IFI. The depositors are risk/reward-sharing and therefore

provide quasi-equity to the bank, albeit under restrictions delineated by the

nature of the account (i.e. unrestricted investment accounts (URIA) andrestricted investment accounts (RIA).


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Collective Investment Schemes andIslamic Financial Institutions


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As a result, investment account holders are liable to incur unexpected

losses in the same way as shareholders because there is effectively no

cushion, as provided by equity from the shareholders in conventional

institutions. To counter such uncertainties, IFIs, in some jurisdictions,have adopted a process of smoothing out returns to their unrestricted

investment account holder through the use of a profit equalisation

reserve (PER). This reserve aims to offset poor performance and

maintain a rate of return that is consistently competitive, even when the

IFI's earnings are below the market rate (IFIs are competing against the

guaranteed returns offered by conventional banks). However, the

transparency of such practices is somewhat questionable, particularly

with regard to risk and reward.

Corporate governance in IFIs must therefore be customised to address

such issues and protect the rights and needs of the investment accountholders.


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Bearers of Risk in Conventional and IslamicFinancial Institutions


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Tailoring Corporate Governance to Suit Islamic Finance

In response to the issues set out above, the Islamic Financial ServicesBoard (IFSB)6 and the Accounting and Auditing Organisation for Islamic

Financial Institutions (AAOIFI)7 have both issued guiding principles on

corporate governance for IFIs8. These recommendations examine

issues beyond the scope of this discussion, but also focus on both

Shari'a compliance and the importance of investment account holders.

Shari'a compliance

Both organisations mentioned above emphasise the need for IFIs to

attain Shari'a advisory and supervisory functions that can guide theirbusiness operations. 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, consisting of at least

three specialised jurists in Islamic commercial jurisprudence (fiqh

almua'malat).


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Together, these jurists (often referred to as Shari'a scholars) will direct,

review, supervise and provide rulings (fatawa) on activities of the IFI to

ensure compliance with Shari'a jurisprudence. The IFSB emphasises

the need for these scholars to address both ex ante and ex postaspects of financial transactions, thus ensuring an effective review

process.

Furthermore, it is recommended that IFIs conduct an internal Shari'a

review of all activities, executed by a dedicated internal division/

department or as part of the internal audit department, depending on

the size of the institution. According to AAOIFI, the main purpose of this

function, referred to here as the Internal Shari'a Compliance Unit

(ISCU), will be to ensure management of an IFI discharge their

responsibilities in relation to implementing rulings made by the Shari'asupervisory board. 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.


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Investment account holders

As previously discussed, the investment account holder is considered astakeholder in an IFI. As a result, the IFSB has argued for the creation

of a separate committee, the governance committee, to implement

governance policy frameworks that will protect the interests of the

investment account holder. Such a committee will be established by the

board of directors and comprise three members; a member of the auditcommittee, 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).


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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. Investment

account holders are generally perceived as requiring protection of theirfunds, whereas shareholders, who have provided equity, will expect high

returns - the result, for commingled funds, is a conflict of interests, with

investment account holders restricted in their control over investment

strategy. The investment account holder is therefore exposed to the same

risk as the shareholder, but is not expected to receive proportionaterewards.

This problem is then further exacerbated by the arguably controversial

practice of utilising a PER, which effectively obscures the actual return on

investments and prevents the unrestricted investment account holderfrom properly assessing the implications of the IFI's investment strategy.


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Moreover, the PER is subject to what the IFSB refers to as an inter-

generational problem, 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 theirinvestment before such a time when reserves are used. It is this

ambiguity, surrounding the rights of the investment account holder, that

the governance committee will seek to address. The committee will

provide the board of directors with reports and recommendations,

closely liaise with the management, the audit committee, and theShari'a supervisory board, and ensure disclosure and the proper

implementation of investment contracts.


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In light of the requirements and suggestions outlined above, an

indicative corporate governance structure for an IFI should include

the following:


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Addressing Gaps in Corporate Governance

Maintaining customers' confidence in an IFI's Shari'a compliance is of

vital importance.

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

Shari'a supervisory board has become an indispensable aspect ofcorporate governance for IFIs and the demand for reputable Shari'a

scholars has consequently grown.

However, structures that address internal controls and ex post aspects

of Shari'a compliance have not been as comprehensively implementedas 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.


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It is, however, arguably the lack of corporate governance aimed at

ensuring the rights and addressing the risk exposure of investment

account holders that requires immediate attention. The

recommendations put forward by the IFSB are commendable and IFIsshould acknowledge and respond to the need for corporate governance

that addresses these shortcomings.

The establishment of a governance committee may not be the only

solution; one alternative would be a board of directors with independentdirectors that have dual responsibilities to the shareholders and

investment account holders, another would require structures that

ensure management are held accountable toinvestment account

holders.

Nevertheless, the structure that is implemented must not be subservientto the board of directors, must be allowed to operate independently and

must be enforced in order to influence decision-making processes that

affect the investment account holders.


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The Way Forward

IF has thus far experienced unprecedented growth, but as

mentioned at the beginning of this article, the enactment andimplementation of relevant corporate governance structures is

essential if trust and confidence is to be maintained.

External shocks may occur and if they do, the buffer provided by a

solid corporate governance structure, supported by regulatory

authorities, will help to ensure continued stability. IF is becoming

increasingly competitive and clients are becoming increasingly

sophisticated, aware of available product offerings and less

compelled to remain loyal to any given institution.

The ambiguity that affects aspects of the industry will have to beaddressed if respective IFIs are to retain market share and remain

competitive. IF as a whole must not rest on its laurels, it must be

resolute and embrace a proactive, rather than reactive, strategy

towards corporate governance if long-term sustainability is to be

assured.

Documents

Corporate Governance for Islamic Financial Institutions