Implementing Corporate Governance for Islamic Finance
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 expanding Muslim 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.
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 unstable.1 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 is to offset the effects of an economic downturn.
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 finance;2 IF, by its very nature, has a responsibility to enact preventative measures that are specific to its unique structure.
“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 standards3 seek to address the separation of ownership and management – the agency problem4 – 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.
However, there is a difference between conventional and IF that adds another dimension to corporate governance and relates to the equally weighted importance of ‘other stakeholders’. In IFIs there are two types of owners, the shareholders, as in conventional institutions, and the investment account holders, 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 fund manager (the IFI) to manage their investments.
This is because the mudaraba contract, on which the relationship between the investment 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) and restricted investment accounts (RIA))5.
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 account holders.
In response to the issues set out above, the Islamic Financial Services Board (IFSB)6 and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)7 have both issued guiding principles on corporate governance for IFIs8. 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.
Both organisations mentioned above emphasise the need for IFIs to attain Shari’a advisory and supervisory functions that can guide their business 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). 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 post aspects 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’a supervisory 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.
As previously discussed, the investment account holder is considered a stakeholder 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 audit committee, a non-executive director (selected based upon experience and ability to contribute) and a Shari’a scholar (possibly from the IFI’s Shari’a supervisory board). The 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 their funds, 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 proportionate rewards.
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 holder from properly assessing the implications of the IFI’s investment strategy. 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 their investment 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 the Shari’a supervisory board, and ensure disclosure and the proper implementation of investment contracts.
In light of the requirements and suggestions outlined above, an indicative corporate governance structure for an IFI should include the following:
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 of corporate 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 implemented as the predominantly ex ante role played by the Shari’a supervisory board. The role of the ISCU is to address such failings and its establishment should therefore be considered essential.
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 IFIs should 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 independent directors that have dual responsibilities to the shareholders and investment account holders, another would require structures that ensure management are held accountable to investment account holders. Nevertheless, the structure that is implemented must not be subservient to 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.
IF has thus far experienced unprecedented growth, but as mentioned at the beginning of this article, the enactment and implementation 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 be addressed 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.
The author would like to thank the following people for their input:
Disclaimer – Any views and opinions expressed above are solely those of the author and do not necessarily represent those of Ernst & Young.
1Consider the sharp corrections to Middle Eastern bourses in early 2006, the ongoing instability in Iraq and the uncertainty surrounding Iran’s Nuclear Program.
2 For example, the collapse of the Bank of Credit and Commerce International (BCCI), arguably the most notorious example of corporate scandal to effect the Middle East region – please see “The BCCI affair”by John Kerry and Frank Brown (1992).
3 For example, the widely recognised Principles on Corporate Governance issued by the OECD (revised in 2004) and the Basel Committee on Banking Supervision’s paper entitled “Enhancing Corporate Governance of Banking Organisations”(revised in 2006).
4 Also referred to as the Principal-Agent problem, where the management is the Agent for the investor (the Principal). Different expectations and incentives for the Agent and Principle can lead to conflicts in operational strategies.
5 Restricted investment accounts will, as their name suggests, allow investors to impose restrictions on the way in which their funds are invested. The bank will act as a non-participating Mudarib and the investment account holder is therefore liable for all potential losses incurred (providing the bank has not acted negligently). Investors in the Unrestricted investment accounts will authorise the IFI to invest their funds in any way they seem appropriate. The institution is also permitted to commingle the funds with its own (thus constituting the equity portion in Figure 3) and any others available to it (e.g. current accounts). Restricted investment accounts will, as their name suggests, allow investors to impose restrictions on the way in which their funds are invested. The bank will act as a non-participating Mudarib and the investment account holder is therefore liable for all potential losses incurred (providing the bank has not acted negligently).
6 The IFSB, established in Kuala Lumpur in 2002, aims to introduce new, or adapt existing international standards consistent with the principles of Islamic Shari’a and recommend them for adoption.
7 AAOIFI, established in Bahrain in 1991, prepares accounting, auditing, governance, ethics and Shari’a standards for Islamic financial institutions and the industry.
8“Guiding principle on corporate governance for institutions offering only Islamic financial services (Excluding Islamic insurance (Takaful) institutions and Islamic mutual funds)”by IFSB (December, 2006).