CORPORATE GOVERNANCE IN ISLAMIC BANKS (IBs)

Tariqullah Khan
IRTI/IDB
GDLN IRTI Distance Learning Lecture, April 22, 2008

Disclaimer: Views expressed are those of the presenter and do not necessarily reflect those of IDB/IRTI or any other entity quoted.

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

PART 1: CORPORATE GOVERNANCE: GENERAL BACKGROUND

Background
The new firmCorporation; separation of ownership and control; asymmetric information problem and conflict of interest Fundamental Problems of Corporate Governance:

USdispersed shareholders: alleviate the conflict of interest between dispersed small shareholders and powerful controlling managers Europeone dominant shareholder: align the interests of controlling and minority shareholders

What Is Corporate Governance?

Corporate Governance refers to a set of formerly defined relationships between a companys 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.

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/PlayersExternalEnvironment
Institutions/ Players Important Issues Objectives/ Responsibilities
Promote strong business and legal environment that support CG Provide governance structures Laws catering to the needs of IFIs Overall economic, financial Efficiency of the Legal and legal systems System Enforceability of Contracts Rule of Law Government and Laws Corporate law Disclosure/transparency Laws Laws facilitating operations of Islamic financial institutions (IFIs) Accounting and audit standards for clear and transparent communication of information

Accounting Systems

Provide uniform, clear and transparent accounting standards

Key Institutions/PlayersExternalPublic Institutions

Institutions/ Players
Supervisors/ Regulators

Important Issues Objectives/ Responsibilities

Stability and soundness of the financial system (eliminate systemic risk) Develop internal controls, risk management procedures, and standards of transparency Minimum standards of CG Provide Guidelines for FIs Monitor overall operations in general and risky behavior in particular

Banking Associations

Set Principles and Sound practices

Key Institutions/PlayersInternal Governance

Players
Shareholders

Important Issues Objectives/ Responsibilities

Shareholder Rights Share in profit Protect shareholders and investment depositors rights Ensure good management team Oversight of management Right balance between risk and return Efficient incentive-structure Elect board members

Board of Directors

Set overall policy and strategy Accountability of the management

Senior Management

Implement the policies set by the board in a sound and responsible manner Operate the institution efficiently.

Key Institutions/PlayersInternal Operational

Players
Employees

Important Issues Objectives/ Responsibilities

Skills and work ethics Right incentive-structure
Quality and quantity of information Transparency of information Appropriate Shariah related rules and principles

Meet the goals set by the management Minimize operational risks

Ensure that the policies set by Board are followed by the management (Compliance) Oversee compliance with Shariah rules and principles

Internal Audit

Shariah Boards

Key Institutions/Players Other Stakeholders

Players
Depositors

Important Issues Objectives/ Responsibilities

Good service Comparable returns Quality and quantity of information Transparency of information Adherence to Shariah rules and principles Act responsibly Monitor the performance Evaluate the accuracy of the quality and quantity of information Evaluate compliance with Shariah

External Audit

Shariah Audit

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

PART 2: CORPORATE GOVERNANCE IN ISLAMIC BANKS: CURRENT STATE AND SPECIAL ISSUES

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 Quran: 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 Muribs share (where funds are commingled) and profit distribution Muribs share in profits from assets financed by current accounts

Protection of Investment Account Holders (IAH)

Potential conflict of interest between IAHs vis--vis Management (Shareholders)

o

Fiduciary responsibilities: Proper systems and processes to avoid potential conflicts of interest. Adequate disclosures: About the IBs investment objectives and policies, operational guidelines that govern the relationship between the bank and IAHs. Issue of IAHs representation in Management, Board, and Shariah Supervisory Board

Shar`ah Supervisory Board (SSB)

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.

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 Murib share and profit allocation

2002 IRTI SURVEY ON CORPORATE GOVERNANCE IN IBs INTERNAL FACTORS

Average Percentage Score 87.7 Rankings

Rights and Equitable Treatment of Shareholders Rights of Other Stakeholders

Responsibilities of the Board Disclosure and Transparency Management of Bank Operations Internal Factors Average

Good Fair
Good Good Fair Good

72.4
87.9 87.9 76.2 82

2002 IRTI SURVEY ON CG IN IBs EXTERNAL FACTORS

Average Percentage Score Regulatory Regime Legal Procedures Ethical Overlay External Factors Average 81.3 76.9 82.5 78.5 Rankings Good Fair Good Fair

IFSB (2004) AWARENESS SURVEY ON CG IN IBs

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 IAHs 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.

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

CG aspects already covered Companies Directors/The Board Remuneration/Compensation Accountability and Audit Relations with Shareholders Shareholders Rights and Key functions Equitable Treatment OECD BCBS IOSCO FRC/FSA

Other Stakeholders Employees/Manager Regulator/Supervisor

Disclosure and Transparency

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.

SCOPE OF IFSB GUIDELINES

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 IAHs 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

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.

IFSB PRINCIPLES OF CORPORATE GOVERNANCE

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 IAHs 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.

Looking Ahead
The IFSB understands that: Adoption of OECD and BCBS recommendations will improve IBs Board and Directors and Managements awareness of the importance of good governance Due recognition of IAHs 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 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)