Corporate governance requires corporations to exercise accountability to their shareholders and the public, and also monitors management. Corporate governance is normally divided into two categories: self-governance and statutory regulation. Self-regulation involves the aspects of corporate governance that are difficult to legislate for, especially those involving a human element, such as the independence of the Board of Directors, its relationship with management and appraisal of directors’ performance (Nordin, 2002). Statutory regulation is the framework of corporate governance that can be explained in legal terms. Legislative and regulatory rules include:
(a) Duties, obligations, rights and liabilities of directors, controlling shareholders and company officers.
(b) Disclosure and transparency.
In Malaysia, statutory regulations covering corporate governance are:
Good corporate governance is considered essential because it promotes morality, honesty, integrity, trust, openness, performance orientation, responsibility and accountability, mutual respect and commitment to the organization from everyone involved. Corporate governance does not only apply to directors and executives, but to all players in an organization.
When banks employ sound governance mechanisms, they efficiently mobilize and allocate funds, thus lowering the cost of capital to firms, boosting capital formation and thus stimulating productivity growth. In contrast, weak governance of banks reverberates throughout the entire economy, with negative ramifications for economic development. (Claessens, 2003).
Islam and corporate governance
Strong corporate and bank governance are essential ingredients for the development of a vibrant and sound Islamic finance industry. Corporate governance is not new to Islam. As pointed out by Mustapha and Salleh (2002), the Islamic concept of corporate governance emphasizes the three main areas of accountability, transparency and trustworthiness (Mustapha and Salleh, 2002).
The Holy Prophet Muhammad said (as related by Bukhari and Muslim): “Each one of you is a guardian and each guardian is accountable to everything under his care.” This underlines the importance of people being accountable for their actions.
As for transparency, Surah Al-Baqarah (verse 282) of the Holy Qu’ran states:
“O you who believe! When you contract a debt for a fixed period, write it down. Let a scribe write it down in justice between you. You should not become weary to write your contract down, whether large or small, for its fixed term, that is more just with Allah, more solid as evidence and more convenient to prevent doubts among yourselves… Take witness whenever you enter into a commercial contract.”
This verse emphasizes the need to record every transaction in order to avoid injustice and to conceal any details that might lead to further injustice.
In highlighting trustworthiness, the Qu’ran states in Surah Al-Anfal (verse 27): “O ye that believe! Betray not the trust of God and the Apostle, nor misappropriate knowingly things entrusted to you.”
Islam looks into the essence of responsibility, the concepts of work, dedication to work and vicegerency or trusteeship. This gives Islamic corporate governance a very comprehensive coverage. Responsibility not only involves being responsible towards other people, but also in performing one’s role in life. This role is given as an amanah (trust) from God and should this responsibility be neglected, it is a form of khianat (betrayal) to God. The concept of work and dedication to work is a form of ibadah (worship) and amal salih (virtuous act). In addition, khilafah (trusteeship) emphasizes that the qualities of a good Islamic manager are also the qualities of a practising Muslim.
The need to follow these corporate governance requirements is given greater weight, especially for god-fearing persons, by linking the practices to God.
In relation to trusteeship, the Holy Prophet Muhammad once said:
“Every one of you is a keeper or a shepherd and will be questioned about the well-being of his fold. So, the Head of the State will be questioned about the well-being of the people of the State. Every man is a shepherd to his family and will be answerable about every member of it. Every woman is a shepherd to the family of her husband and will be accountable for every member of it, and every servant [employee] is a shepherd to his master [employer] and will be questioned about the property of his master.” (Abod, 2002)
Three basic elements of faith provide the foundation for Islamic banking (Haron and Shanmugam, 1997):
Aqidah: concerns all forms of faith and belief in Allah.
(b) Shariah: concerns practical actions taken by a Muslim in manifesting his faith and belief.
(c) Akhlaq: covers all aspects of a Muslim’s behaviour, attitude and work ethics.
Corporate governance within Islamic banking is therefore covered by Shariah, which has a crucial role not only in governing bank transactions and operations, but also in monitoring and supervising the roles of all players within the banking system.
The concept of Shariah governs the way a man conducts his life and behaviour, including the spiritual, mental and physical. Shariah is a blueprint for Islamic banks to operate in accordance with the laws outlined, for instance, in eliminating riba (interest) in all its forms and ensuring that banking procedures do not exploit nor do injustice to the bank’s shareholders.
To ensure that Islamic banks comply with the appropriate Shariah rulings, the services of religious committees known as Shariah boards are employed. The boards comprise Shariah scholars or a committee of ulamas (religious scholars) and play the dual role of supervision and consultation.
The Islamic scholars or ulamas employed by Islamic banks have played a crucial role in the movement of Islamic finance and investment. They derive the principles of Islamic finance and investment from sources of Islamic law, which include:
(a) The Qu’ran.
(b) Hadith texts (statements and practices of the Prophet Muhammad).
(c) Ijma (consensus of ulama).
(d) Qiyas (analogies from the Qu’ran and Hadith texts).
(e) Ijtihad (scholar’s own reasoning).
Islamic banks operate on the concept of interest-free banking, with Shirkah or Musharakah (partnership) and Mudarabah (profit-sharing) as its basic products. Mudarabah financing involves projects managed by a client and the bank shares the risk with the client. The bank acts as a partner and is entitled to monitor, supervise and access books and records. Thus an ethical dilemma can arise when the management of Islamic banks is faced with a conflict of interest between shareholders and Mudarabah “partners”. However, the company’s management still has the authority to conduct the company’s affairs.
However, in a Musharakah set up, losses are borne in proportion to the capital invested, with Islamic banks providing funds that are combined with the funds of the enterprise. Profits are distributed in pre-determined ratios among the partners and contributors have the option to be involved in the project management.
In Islamic banking, the stakeholders are shareholders, account holders, Musharakah financing partners, Mudarabah investment account holders, its employees and the Islamic community (ummah). Agency problems arise from differences in economic interests between the agent (bank’s management) and the principal (bank’s investor). However, conscientious adherence to the Shariah can counter agency problems, allowing Islamic banks to maintain investors’ confidence and assist in the establishment of a stable and secure financial system.
Corporate governance principles and codes in Islamic banks have been developed in different countries and issued from stock exchanges, corporations, institutional investors, or associations of directors and managers with the support of governments and international organizations. As a rule, compliance with these governance recommendations is not mandated by law, although the codes linked to stock exchange listing requirements may have a coercive effect. There is no single recognized best model of corporate governance.
On the 30th July 1981, a 20-member National Steering Committee of Islamic Banks was established and proposed recommendations to the government on the 5th July 1982:
(a) An Islamic bank should operate on Shariah principles.
(b) The Islamic bank should be incorporated as a limited company under the Companies Act 1965.The Central Bank should monitor and supervise the Islamic bank.
(d) The Islamic bank should have a Religious Supervisory Council to ensure that the bank’s operations are in accordance with the Shariah.
Following these recommendations, the Islamic Banking Act 1983 was promulgated. Under this Act it became compulsory for Islamic banks to have their own Religious Supervisory Council with a minimum of three and a maximum of seven Muslim religious scholars. The Council’s role is to advise the Islamic banks on its operations and transactions.
The first Islamic bank in Malaysia, Bank Islam Malaysia, was established in July 1983. The distinct Islamic principles that govern its operations are as follows:
(1) Prohibition of riba: the profit–loss sharing concept replaces interest as the central mechanism governing the deposit taking and loan making transactions.
(2) Muamalah (Islamic transaction): all banking transactions and management efforts must comply with Shariah.
(3) Avoidance of contradictory activities.
Bahrain has over 30 Islamic financial institutions offering a wide range of activities, including Islamic insurance. Bahrain is a major player in the world of Islamic banking and finance. To maintain the strong, stable and secure financial systems, all Islamic banks in Bahrain need to comply with Shariah supervisions.
All Shariah boards conduct annual reviews and produce reports to shareholders. The shareholders in turn provide input on the satisfaction level of their investments and the manner in which projects were handled by the bank. Should a bank breach the Shariah tenets, the board will:
(a) find Shariah compliant alternatives to the transactions;
(b) if no alternative is found, the transaction will not be allowed to proceed further; and
(c) if the transaction has already been executed and the breach is found at a later stage, the board will advise the management and shareholders to distribute the income generated from the breached transaction to a charity account.
In addition to the Shariah board, the AAOIFI was established to define Islamic financial instruments and design accounting standards. This organization set up a 15-member Central Shariah Board in 1995 to harmonize and converge concepts and applications amongst boards of various Islamic financial institutions, preventing inconsistencies and assisting with the development of new products. By establishing these bodies Bahrain has moved ahead of many other countries offering Islamic banking services.
It has been reported that of the 39 Islamic banks in Bangladesh, only five operate according to stringent Islamic principles, with Shariah Councils to guide their operations. These Councils consists of fuqahas (Islamic jurists), Islamic economists and lawyers (Sarker, 1999). The monitoring and supervisory roles of these Shariah Councils ensure that all activities operate according to the tenets of Shariah, thus maintaining good corporate governance. In some instances the Councils conduct audit operations and produce a report to highlight any deviations and make suggestions for the further purification of banking transactions.
Saudi Arabia model
The Saudi Arabian Islamic banking scene is dominated by the Islamic Development Bank (IDB), which was established in 1974. The IDB is an international financial institution, similar to the World Bank or the Asian Development Bank (ADB), set up to encourage member countries and Muslim communities to implement policies leading towards Islamic economic development and social progress (Mannan, 1998). It also participates in equity capital and grants loans for project and enterprises. The IDB has diverse operations that are governed by the following Shariah principles.
(1) Dynamic use of resources without riba
Interest charges on loans are strictly prohibited in line with the Holy Qu’ran: “Allah has permitted trade and forbidden riba (interest).” The IDB prides itself for being involved in trade and not in riba.
(2) Constant use of financial resources
Resources should not be wasted, as Islam encourages owners to put resources in a productive process to enable distribution throughout society.
(3) Equitable sharing of risk and gains
As mentioned in the Holy Qu’ran: “Let it be a trading among you by mutual agreement,” financial contracts such as Mudarabah, Musharakah and Murabahah are all based on profit–loss sharing arrangements.
(4) Securing due benefits/income for owner
IDB emphasizes the ethical use of financial resources in a manner that secures maximum benefits in the form of a return or mark-up.
(5) Benevolent loans
The Holy Qu’ran stresses the importance of Qardhasan (benevolent loans) in Surah Al-Mozammil, verse 20: “Attend your prayers, pay your alms and grant benevolent loans.” It is also mentioned in Surah Al-Taghabon, verse 17: “If you grant benevolent loans, we multiply them for you and forgive you.” The IDB provides Qardhasan to achieve Islamic social, moral and spiritual goals for member countries and for Muslim communities of non-member countries.
(6) Lawful investment
The Shariah does not recognize profit maximization as the solitary goal of an enterprise that neglects social and ethical principles. In Islam, operations involving financial profit may need to be sacrificed in the interest of the community at large. Morals and ethics are given greater weight than profit.
Shariah board members must be knowledgeable in the Arabic language to interpret the Holy Qu’ran and Hadith correctly. It may be a good idea to establish a central board to oversee the rulings of independent boards, regulate differing interpretations and advise individual boards as needed.
As for self-regulation, the Shariah boards play an important role in raising awareness on concepts such as tawhid and other Islamic ethics within Islamic financial institutions. Directors, shareholders and staff must all remember that performing their tasks honestly is a form of worshipping God.
Islamic banks should establish training centres where prospective clients are taught to observe aspects of good governance, especially with respect to providing full and honest disclosures of their business dealings and also to run their business in an ethical manner.
Establishing some sound corporate governance rules may help Islamic banking to fulfil its mission.
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S. Archer and R.A.A. Karim, Agency Theory, Corporate Governance and the Accounting Regulation of Islamic Banks (JAI Press Inc, 1997).
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S. Haron and B. Shanmugam, Islamic Banking System: Concepts and Applications (Pelanduk Publications, 1997).
M. K. Lewis and L.M. Algaoud, “Corporate Governance in Islamic Banking” in Islamic Banking (Edward Elgar, 2001).
M. A. Mannan, “The Islamic Development Bank and Economic Development of Southeast Asia” in Islamic Banking in Southeast Asia (Institute of Southeast Asian Studies, 1998).
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A. A. Sarker, “Islamic Business Contracts, Agency Problem and the Theory of the Islamic Firm” (1999) 1(2) International Journal of Islamic Financial Services.