The Importance of Corporate Governance for Islamic Financial Institutions

he importance of CG

2001, the corporate community and

imprudent lending, and excessive risk

Corporate governance is the

the authorities internationally have

taking by management.

system by which business

commenced

way

Good corporate governance is crucial

corporations are run from many

to the ability of a business to protect

perspectives, including:

the interests of the stakeholders, and

corporations controlled

are with

directed the

and

structure

signifying the sharing of rights and

Why the interest in CG

in the case of Islamic institutions

effectiveness

efficiency,

•

Executive compensation

operations to be carried out in

•

Role of the investment banking

compliance with the principles of the

community

Shariah. A corporate structure that

Stock exchange listing

enables an institution to implement

requirements

good governance through Shariah-

Role of the accounting and

compliant operations is therefore

auditor’s  professions

fundamental.

Voting patterns of institutional

Good Islamic corporate governance

investors

principles

include

integrity,

openness,

•

There has been an increased interest in

corporate

governance

as

•

a

consequence of events such as the

the

Board composition and

•

duties among the unique members in the corporation. [OECD April 1999]

examining

•

Exxon Valdez disaster, or the Ford Pinto scandal sparking debates about

stakeholders

expect

honesty,

trust,

performance

the roles of large corporations in

Islamic Financial Institutions

orientation,

society and raising questions about

Ihlas Finance House (IFH) of Turkey,

accountability to Allah and the people,

their ethical standards, management

the largest of the Turkish IIFS, with

mutual respect, and commitment to

decisions and corporate governance

over 40% of the sector deposits

the corporation and all in harmony

practices (Kiel and Nicholson, 2003).

collapsed in 2001 after it illegally

with the Islamic Shariah.

The

misappropriated

Islamic and conventional CG

development

of

corporate

almost

$1billion,

governance systems conventionally

with concentrated ownership and

has been in response to corporate

control allowing an incentive system

failures or systemic catastrophes. One

biased in favour of shareholders.

of the original failures of governance

(Starr and Yilmaz (2004). The failure of

was the South Sea Bubble of the

IFH revealed the risks to the financial

1700s, which revolutionized business

stability and reputation of other

laws and practices in England. The

institutions offering Islamic financial

securities

services

law

in

the

U.S.

was

(IIFS)

because

of

poor

and

their

•

responsibility

and

Rights and equitable treatment of shareholders as per the Shariah

▪

Interests of other stakeholders, as dictated by law and according to the Shariah

commissioned due to the stock

corporate

market crash of 1929, and the

inability to manage liquidity in the

secondary banking crisis of the 1970’s

absence

in the United Kingdom and the United

secondary markets.

States of America; the savings and

The

loans debacle of the 1980’s are

stakeholders

examples of the responsive nature of

principles

corporate governance.

granted, and indeed the Islamic

The history of corporate governance

Commonly accepted principles of

Financial Institutions are no less

has been scattered by an arrangement

conventional corporate governance

disposed to suffering violations of

of well-known company disasters, for

include:

fiduciary responsibilities. The history

instance, the collapse of the Bank of

1.

of Islamic finance shows that cases of

Credit and Commerce International,

efficient markets steady with the

corporate governance failures have

Barings Bank, Enron, WorldCom, HIH,

rule of law

features

OneTel and Parmalat, with each of

conventional

these cataclysms being a result of

including amongst others, collusion of

incompetence, fraud and abuse as

the board with management, external

much as from an absence of oversight

and internal audit failures, neglect of

rules.

minority

Since Enron’s failure in December Page 1

governance, of

Shariah

commitment to

cannot

in

▪

complaint

board) to Allah and the people ▪

of

concerned

Islamic be

religious

taken

common banking

shareholders’

Role and responsibilities (of the Integrity and ethical behaviour, in compliance with the Shariah

▪

Disclosure and transparency

for

Promoting transparent and

with

2.

Protecting shareholders’ rights

scandals,

3.

Guaranteeing the equitable

interests,

treatment of all shareholders 4.

Recognising the rights of stakeholders recognised by law

5.

Timely and accurate disclosure

6.

The effective monitoring of the

Over the past decade, the world has

The Shariah Supervisory

management by the board

seen a significant change in the role of

Board

The board’s accountability

the

economic

The most common approach at

progress and job creation. As more

present is to establish independent

and more countries have assumed It is clear that there is an overlap

Shariah Supervisory Boards (SSB’s), in-

market-based

between these principles, as both

house religious advisers and Shariah

economic policy, mindfulness of the

Islamic corporate governance and

status of private corporations for the

conventional corporate governance

welfare of individuals has improved.

are concerned with:

The role of the Shariah Supervisory

Corporations create jobs, generate tax

1.

shareholder and stakeholder

Board includes:

income, produce a wide selection of

rights

1.

goods and services at sensible prices,

2.

effective disclosure

and progressively manage our savings

3.

transparency

and secure our retirement income.

4.

accountability of management

Amid growing reliance worldwide on

and the board

the private sector, the issue of

obeying the rule of law

corporate governance has likewise

7.

[OECD, 1999]

5.

private

increased

sector

in

approaches

in

importance

to

(OECD

review units.

Certifying permitted financial instruments through fatawa

2.

Verifying that transactions comply with issued fatawa

3.

Calculating and paying Zakat

4.

Disposing of non-Shariah compliant earnings

5.

Advising on the distribution of

Enhancing stakeholders’ value is a

Principles of Corporate governance,

central purpose for any business,

income or expenses among

2004).

including financial services, whether

shareholders and Investment

Islamic finance from the position of

conventional or Islamic. The stability,

Account Holders (IAH)

corporate governance represents an

financial performances, and ability to

array of fascinating features, as equity

A

intermediate resources will depend on

participation, risk and profit-and-loss

responsibilities will differ according to

stakeholders’ confidence in individual

sharing measures form the basis of

provisions specified in the articles of

institutions

the

Supervisory

Board’s

industry.

A

Islamic financing. The ban on interest

association of the financial institution

feature

in

means that an Islamic bank cannot

or

respect of Islamic financial services is

charge any fixed return in advance,

regulators. In addition to internal

the requirement of conveying to

they, however partake in the profit

corporate

stakeholders

financial

from the usage of the funds. The

regulators and international standard

business is conducted in conformity

depositors also share in the profits

setters

with their religious beliefs. Corporate

according to a pre-set ratio, and are

Shariah Supervisory Boards. These

governance

particular

and

Shariah

confidence

that

their

arrangements

include

those

specified

by

arrangements,

implement

national national

guidelines

for

remunerated with profit earnings for

guidelines frequently refer to Shariah

structures and procedures that should

assuming the risk.

Supervisory

provide sufficient comfort that the

An Islamic bank is a partner with the

responsibility to guarantee Shariah

business is conducted in accordance

banks

the

compliance and also at times indicate

with specified objectives and in

entrepreneurs and these financial

areas of competence, composition

meticulous compliance with Shariah.

arrangements infer rather diverse

and decision-making.

The

Financial

stakeholder relations, and therefore

Institutions to get their house in order

governance structures, as depositors

and

have a direct financial stake in the

need

for

implement

Islamic good

corporate

depositors

and

governance practices, that are in line

bank's

with

expected

participations. This leads to rather

business practice as well as being

diverse governance issues that Islamic

compatible with the Shariah are

banks and financial institutions face as

imperative. The key word being

compared

‘implement’ practices practices and not n ot just pay

institutions.

lip service to the principle.

institution is subject to an added tier

recognized

and

investment

to The

and

equity

conventional Islamic

financial

of governance, compliant with Islamic Peculiarities to IFI

law.

Board’s

general

The functioning of Shariah Supervisory Board’s raises five main issues of corporate governance:

(i)

Independence

The Shariah Supervisory Board member’s dual relationship with the

institution as providers of remunerated services and as assessors of the nature of operations could be seen as creating a possible conflict of interest. Page 2

that is still not in place. The author

Mercy has bestowed upon the human

Some Shariah scholars sit on the

believes that it is the fundamental

intellect, so that we are able to take

Shariah Supervisory Boards of more

view of corporate governance and the

due precautions, plan and prepare for

than one financial institution, this

importance of it that is missing. The

possible future events, and create a

provides the particular individual

author

corporate

means of addressing those needs on

access to proprietary information of

governance is a duty on every Muslim,

our own. Therefore, preventative and

other possibly competing institutions.

as is prayer, hajj and other such du ties

preparative actions are necessary in

(iii)

incumbent

Muslim.

all walks of life, and especially

Shariah Supervisory Board (SSB)

Therefore, the application of it is not a

business. The need for regulation to

members should ideally be

matter of choice, and nor should it be

ensure accountability is necessary,

knowledgeable in both Islamic law

looked at from the benefits of doing

and not just relying on self-regulation

and commercial and accounting

so, although these are important, but

due to the people following the

practices. In reality, it would appear

rather should be considered at from

Shariah of their own accord.

that very few scholars are well versed

the angle of being an obligation.

Therefore, corporate governance is

in both disciplines.

Therefore,

of

not a matter of choice or a matter of

(iv)

corporate governance procedures is a

good practice or a way to ensure that

The activities of Shariah Supervisory

form of worship, and also a duty for

you are following the laws of the land.

Boards (SSB’s) are in the nature o f

which

Corporate

creating jurisprudence by the

accountable.

be

finance is a duty upon everyone who

interpretation of legal sources. It

rewarded for their application and

pronounces the Shahadah, just as

should therefore not be surprising to

held accountable for neglecting them

Salaat is a duty upon the person. This

find conflicting opinions on the

or inadequate application.

approach is what will remove the

admissibility of specific financial

It is not enough to assume that just

problems of corporate governance in

instruments or transactions.

because someone is a Muslim, and by

Islamic finance institutions. When

(v)

Disclosure/Transparency

that very nature is expected to obey

people understand, it is a duty upon

A transparent financial institution

the Shariah, that he / she will ensure

them and that Allah (SWT) will hold

would ideally disclose the duties,

that they do not do anything that will

the accountable for this duty, then a

decision-making process, areas of

be against the Shariah in terms of

change will follow.

competence, and the composition of

corporate

the Shariah Supervisory Board, as well

Although,

as publish all fatawa issued by the

mechanism

Shariah Supervisory Board.

honesty, trust and therefore should be

(ii)

Confidentiality

Competence

Consistency

postulates

a

on

that

every

the

application

Muslim He

will /

she

be will

governance in

theory of

held

there

governance

in

Islamic

duties. is

a

self-accountability,

self-regulatory, the fact of the matter is that, this is just not the case, and a The Islamic Viewpoint

vigilant eye is necessary. One day Prophet Muhammad (peace corporate

be upon him) noticed a Bedouin

governance is inadequate in Islamic

leaving his camel without tying it and

Financial Institutions, and researchers

he asked the Bedouin,

The

problem

is

that

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believe that this is due to the entire approach regarding the subject. Many

"Why don't you tie down your camel?"

Corporate governance structures have been

put

forward,

implemented,

along with principles and codes of behaviour.

The

importance

The Bedouin replied:

"I put my trust in Allah."

of

corporate governance in enhancing

The Prophet then said:

stakeholder value, as well as positive

"Tie your camel first, then put your

effects towards the organisation have

trust in Allah"

been spoken and written about by

[At-Tirmidhi Hadith No: 2517]

many researchers and scholars. However, there is still something

This refers to the common sense and

missing, there is a piece of the puzzle

reasoning that Allah in His Infinite

Page 3

 Arshad Ashraf Researcher & lecturer in Islamic Finance