Corporate Governance in Islamic Financial Institutions - Hussein Elasrag - ebook
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The book is of value in describing governance in Islamic institutions and how there are many issues under the investigation process, especially issues related to the Shari'ah Supervisory board and its functionality. One of the objectives of this paper is to discuss, and create greater awareness of, some of the crucial issues related to Corporate Governance in Islamic Financial Institutions. A second, but in fact more important, objective is to provide, in the light of this discussion, certain essential guidelines to improve corporate governance in these institutions and thereby enable them to not only maintain their momentum of growth and international acceptance but also safeguard the interests of all stakeholders. The book gives particular attention to the mechanisms for corporate governance, including the Board of Directors, Senior Management, shareholders, depositors, and regulatory and supervisory authorities. It also focuses on the effective management of risks and, in particular, on creating a supporting environment through moral uplift, social, legal and institutional checks, greater transparency, internal controls, and Shari'a as well as external audit. The book also indicates briefly the shared institutions that are needed for effective corporate governance.

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Hussein Elasrag

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Table of Contents

I. Introduction

II. Fundamentals of the Islamic finance

III. Corporate governance in Islamic Financial Institutions

Iv. Effective Corporate Governance

GLOSSARY

References

I. Introduction

Islamic finance is the only example of a financial system directly based on the ethical precepts of a major religion, providing not only investment guidelines but also a set of unique investment and financing products.” Islamic finance is based on Shari'a, the Islamic law that provides guidelines for multiple aspects of Muslim life, including religion, politics, economics, banking, business and aspects of the legal system What Shari'ah compliant financing (SCF) seeks to do is to shape financial practices and accompanying legal instruments that conform to Islamic law. Major financial principles of Shari'ah include a ban on interest, a ban on uncertainty, adherence to risk-sharing and profit-sharing, promotion of ethical investments that enhance society and do not violate practices banned in the Qur’an and tangible asset-backing.( Elasrag, 2011 )

Money, according to Islamic teachings is a measure of value, not a commodity. Debt is a relationship in which risk and responsibility are shared by all parties to a contract. Money must be put to practical use in creating real value for the participants of the transaction. It must be used to create, and not be a commodity in on and of itself. It because of this that the perception of hoarding capital, and the earning of a passive return on capital keyed to the passage of time, -i.e. interest – is prohibited. In short, money must not be made from money.

The establishment of modern Islamic financial institutions started three decades ago. Currently, there are at least 70 countries that have some form of Islamic financial services; almost all major multinational banks are offering these services. The underlying financial principles in Islamic finance have remained unchanged historically since their development over 1,400 years ago. Financial products must be certified as Sharia compliant by an expert in Islamic law. Certification requires that the transaction adheres to a number of key principles that include:( Chapra, 2011 )

● Backing by a tangible asset, usufruct or services, so as to avoid ‘speculation’ (gharar). Prohibition of interest payments (riba).

● Risk to be shared amongst participants.

● Limitations on sale of financial assets and their use as collateral.

● Prohibition of finance for activities deemed incompatible with sharia law (haram), such as alcohol, conventional financial services, gambling and tobacco.

Modern Islamic finance emerged in the mid-1970s with the founding of the first large Islamic banks. Development initially occurred through marketing of a steadily expanding supply of Sharia compliant financial instruments.

This supply-driven model contributed to relatively slow growth until the mid-1990s, since when demand has increasingly driven the development of Islamic financial instruments. Rising awareness and demand for Islamic products, along with supportive government policies and growing sophistication of financial institutions, have together raised the rate of growth.

Two developments have been critical to the expansion of Islamic financial markets. In 1998, the so-called “Dow Jones Islamic Indexes fatwa” played a transformative role because it opened the door to a limited degree of “permissible impurity” in financial transactions and institutionalized a notion of cleansing and purification whereby small amounts of impermissible interest income could be cleansed or purified by donation to charity. In turn, this led to a series of equity investment tests that could be used to evaluate potential investments for Shari'ah compliance. A second critical innovation was the introduction of sukuk – a Shari'ah compliant substitute for bonds – where capital protection is achieved not as a loan but as a binding agreement by the issuer to repurchase certain assets over a period of time.

Sukukhas now become one of the backbones of Islamic capital markets and has enabled the rapid growth of Islamic financial transactions.

While the Islamic finance industry represents a fraction of the global finance market, it has grown at double-digit rates in recent years. By some estimates, total assets held globally under Islamic finance reached $1 trillion in 2010. Islamic banks have appeared to be more resilient than conventional banks to the immediate effects of the international financial crisis and global economic downturn. Some analysts have attributed this to Islamic banks’ avoidance of speculative activities. However, the Islamic finance industry has not been completely immune to the general decline in demand and investor uncertainty.

TheCityUK estimates that the global market for Islamic financial services ,as measured by Sharia compliant assets, reached $1,460bn at the end of 2012, up a fifth on the previous year. This means that global assets of Islamic finance have doubled since the start of the economic slowdown. The industry is set to grow significantly in the years ahead. At the current rate of growth of around 20% per year, the market could top $2 trillion in assets by the end of 2014.( UK Islamic finance secretariat UKIFS, 2013 )

Assets that can be allocated to individual countries from The Banker’s survey reveals that the leading countries for Sharia compliant assets are Iran which accounts for around 36% of the global market, Malaysia (17%) and Saudi Arabia (14%). These are followed by other Gulf states including UAE, Kuwait, Bahrain and Qatar, and then Turkey.The UK, in ninth place, is the leading Western country with $19bn of reported assets.There are over 700 institutions registered globally as sharia-compliant organisations in financial services. Of these, around 500 are fully compliant, and the remainder operate sharia-compliant products within a conventional institution. Countries with most of the 430 firms reporting to The Banker’s survey include Bahrain and Indonesia with 74 and 71 firms respectively. Malaysia, Iran, Kuwait and Saudi Arabia were in a group of countries with more than 50 firms.( UK Islamic finance secretariat UKIFS, 2013 )

The multiple reasons for the growth of the Islamic financial sector in recent years:( Alasrag, 2010 )

(1) The flow of funds into Muslim oil-producing states;

(2) Growing political and social desire in the Muslim world for financial alternatives to banking and investment institutions that have been historically dominated by the West;

(3) The spreading credit crisis in global financial markets and the need to access new sources of investment capital;

(4) The growth of sovereign wealth funds and the desire to have Shari'ah compliant instruments through which to invest them; and,

(5) The rapidly accelerating number of cross-border multi- jurisdictional financial transactions that are possible and required in a globalized world economy Assets held by Muslim investors worldwide now exceed $1.6 trillion, and that amount is expected to grow to $2.7 trillion by 2010.

shari‘ah compliant finance has become an accepted and vibrant element in international financial transactions. It offers a fresh opportunity to emphasize the moral and ethical aspects of business and finance that reaches beyond the Arab and Islamic worlds to prompt a reexamination of the core values underlying all global financial transactions – making available the financial resources needed to develop the human capital that will sustain economic and social progress. The main principles of Islamic finance include:

(1)The prohibition of taking or receiving interest;

(2) Capital must have a social and ethical purpose beyond pure,unfettered return;

(3) Investments in businesses dealing with alcohol, gambling, drugs or anything else that the Shari'ah considers unlawful are deemed undesirable and prohibited;

(4)A prohibition on transactions involving maysir (speculation or gambling); and

(5)A prohibition on gharar, or uncertainty about the subject- matter and terms of contracts – this includes a prohibition on selling something that one does not own.

Because of the restriction on interest-earning investments, Islamic banks must obtain their earnings through profit-sharing investments or fee-based returns. When loans are given for business purposes, the lender, if he wants to make a legitimate gain under the shari‘a, should take part in the risk. If a lender does not take part in the risk, his receipt of any gain over the amount loaned is classed as interest. Islamic financial institutions also have the flexibility to engage in leasing transactions, including leasing transactions with purchase options.

It may be asked why non-Muslims would agree to use Islamic finance structures. The principal answer is that Islamic finance provides an opportunity to tap into the significant funds of Islamic investors seeking Shari'ah compliant investments. In addition, Islamic finance can be combined with conventional funding sources and export credit agency (ECA) support.

Good governance is crucial to the ability of a business to protect the interests of its stakeholders. These interests may extend beyond the purely financial to the stakeholders’ ethical, religious, or other values. In the case of an institution offering Islamic financial services, stakeholders expect its operations to be carried out in compliance with the principles of Shari'ah(Islamic Law). A corporate structure that enables such an institution to implement good governance through Shari'ah -compliant operations is therefore essential.

As the Islamic finance industry develops further, there is a growing need for standardisation and professionalism across the industry. Coupled with this is the importance of adopting robust corporate governance systems of internationally recognised standards incorporating transparent, fair and ethical working practices. Islamic financial institutions are well-placed in this context, since at the heart of Islamic law is a vision of social development which requires all individuals and businesses to conduct themselves ethically and in a socially responsible manner. The Guiding Principles demonstrate how closely aligned are the basic principles of corporate governance with Shari'ah rules and doctrines, and consequently how IFIs are well-placed to offer shareholders opportunities to participate in a broader goal of corporate social responsibility. The design of a corporate governance system in Islamic economic system entails implementation of a rule-based incentive system such that the compliance with the rules ensures an efficient governance system to preserve social justice and order among all members of society. This would imply the design of institutions and rules that induce or, if needed, compel managers to internalize the welfare of all stakeholders. The rights that are claimed for stakeholders are not ends in themselves-- which ought to be recognized in any form of economic organization--but means for protecting constituency rights. In an Islamic system the observance of rules of behavior guarantees internationalization of stakeholder rights (including those of the society at large). No other institutional structure would be needed if there were complete adherence to Islamic rules. However, to ensure compliance to the Islamic rules, there is need for institutional arrangements. Therefore, it would be the Islamic government that should specify appropriate corporate governance structure, “incorporating all stakeholders’ rights into fiduciary duties of managers” of the firm on behalf of none-- investors or stakeholders. So no other institutional arrangement that would allow individual non-investor stakeholders to negotiate directly with the firm would be necessary. Incorporating all stakeholders’ right into fiduciary duties of managers would be counter-productive and would lead to suboptimal results. The important point is that each stakeholder is given freedom of bargaining to protect its rights and there are systematic institutional arrangements in place to provide protection and to mediate where disputes and disagreements arise.

Institutional arrangements can be part of system-wide infrastructure surrounding the governance structure of the firm. For example, because contracts are invariably incomplete, judicial interpretations can fill in the gaps. It is permissible to regard employment law, consumer law, tort law, as well as judicial rulings and administrative regulations, as part of the contracts that various stakeholders have with the firm. Similarly, the concept of Shari'ah boards is very unique to Islamic financial system. A Shari'ah board, consisting of fuqaha’ (scholars in Shari'ah matters) has been used to oversea the operation of a financial institution to ensure that the operations and code of conduct of Islamic bank is according to the rules of Shari'ah. A Shari'ah board for every firm, which is seen in present architecture of Islamic banking, is not efficient whereas only one set of rules is needed for appropriate corporate governance based on the Shari'ah for all firms. The same idea of Shari'ah board can be extended to a system-level board consisting of scholars from different disciplines including Shari'ah, economics, finance, and commercial law, to ensure that rules are defined and enforced so that economic agents fully comply with contractual obligations to all the stakeholders.

AAOIFI has been actively seeking to reconcile international

accounting standards with the specific Islamic accounting standards, and provides useful guidance on Shari'ah standards. The IFSB provides very valuable standards setting out the regulatory framework and capital issues which are relevant to Islamic finance, again drawing

upon the international standards. The efforts of the IFSB, the IDB and AAOIFI facilitate the move towards greater alignment, standardisation and harmonisation in Islamic finance. ( Saidi, 2008 )

This book reviews IIFS’ corporate governance (CG) challenges and suggests options to address them. Four main concerns motivate this attention to the CG of IIFS:

1. CG is important for economic development;

2. the assets of IIFS are significant and growing,

3. sound CG may be more critical for financial than other organizations, and

4. the CG vulnerabilities of IIFS may not have received adequate attention in conventional CG frameworks

This book is one of few papers that highlight the importance of studying corporate governance for institutions offering Islamic financial services. The book is of value in describing governance in Islamic institutions and how there are many issues under the investigation process, especially issues related to the Shari'ah Supervisory board and its functionality. One of the objectives of this paper is to discuss, and create greater awareness of, some of the crucial issues related to corporate governance in Islamic financial institutions. A second, but in fact more important, objective is to provide, in the light of this discussion, certain essential guidelines to improve corporate governance in these institutions and thereby enable them to not only maintain their momentum of growth and international acceptance but also safeguard the interests of all stakeholders. The paper gives particular attention to the mechanisms for corporate governance, including the Board of Directors, Senior Management, shareholders, depositors, and regulatory and supervisory authorities. It also focuses on the effective management of risks and, in particular, on creating a supporting environment through moral uplift, social, legal and institutional checks, greater transparency, internal controls, and Shari'a as well as external audit. The paper also indicates briefly the shared institutions that are needed for effective corporate governance.

II. Fundamentals of the Islamic finance

One of the most important objectives of Islam is to realize greater justice in human society. According to the Qur’an all the messengers of God were sent to promote justice and any society where there is no justice will ultimately head towards decline and destruction. One of the essential requisites for ensuring justice is a set of rules or moral values, which everyone accepts and complies with faithfully. The financial system may be able to promote justice if, in addition to being strong and stable, it satisfies at least two conditions. One of these is that the financier should also share in the risk so as not to shift the entire burden of losses to the entrepreneur or the borrower, and the other is that an equitable share of the society’s financial resources becomes available to even the poor on affordable terms in keeping with their ability to repay so as to enable them to realize their dream of owning their own homes, pursuing higher education and vocational training, and establishing their own micro enterprises.

To fulfill the first condition of justice, Islam requires both the financier and the entrepreneur to equitably share the profit as well as the loss. For this purpose, one of the basic principles of Islamic finance is: “No risk, no gain.” This should help introduce greater discipline into the financial system by motivating financial institutions to assess the risks more carefully and to effectively monitor the use of funds by borrowers. The double assessment of risks by both the financier and the entrepreneur should help inject greater discipline into the system, and go a long way in not only increasing efficiency in the use of resources but also reducing excessive lending.( Chapra, 2011 )

Islamic finance is based on Shari'ah, an Arabic term that is often translated into “Islamic law”. Shari'ah provides guidelines for aspects of Muslim life, including religion, politics, economics, banking, business, and law. Shari'ah-compliant financing (SCF) constitutes financial practices that conform to Islamic law.( Ilias, 2010 )

Islamic finance was practiced predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities with the development of credit. In Spain and the Mediterranean and Baltic states, Islamic merchants became indispensable middlemen for trading activities. In fact, many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.

In