Transcript 1st CGWG Presentation - Islamic Development Bank

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 firm—Corporation; separation of
ownership and control; asymmetric information
problem and conflict of interest
 Fundamental Problems of Corporate Governance:


US—dispersed shareholders: “alleviate the conflict of
interest between dispersed small shareholders and
powerful controlling managers”
Europe—one 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 company’s
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/Players—ExternalEnvironment
Institutions/
Players
Important Issues Objectives/
Responsibilities
Overall economic, financial Efficiency of the Legal
and legal systems
System
Enforceability of Contracts
Rule of Law
Promote strong business and
legal environment that
support CG
Government and Laws
Corporate law
Disclosure/transparency
Laws
Laws facilitating operations
of Islamic financial
institutions (IFIs)
Provide governance
structures
Laws catering to the needs
of IFIs
Accounting Systems
Accounting and audit
standards for clear and
transparent communication
of information
Provide uniform, clear and
transparent accounting
standards
Key Institutions/Players—ExternalPublic Institutions
Institutions/
Players
Important Issues Objectives/
Responsibilities
Supervisors/
Regulators
Stability and soundness
of
the financial system
(eliminate systemic risk)
Develop internal controls,
risk management
procedures, and
standards of
transparency
Provide Guidelines for FIs
Monitor overall operations
in general and risky
behavior in particular
Banking Associations
Minimum standards of
CG
Set Principles and Sound
practices
Key Institutions/Players—Internal—
Governance
Players
Important Issues Objectives/
Responsibilities
Shareholders
Shareholder Rights
Share in profit
Elect board members
Board of Directors
Protect shareholders and
investment depositors
rights
Ensure good management
team
Oversight of management
Set overall policy and
strategy
Accountability of the
management
Senior Management
Right balance between risk
and return
Efficient incentive-structure
Implement the policies set
by the board in a sound
and responsible manner
Operate the institution
efficiently.
Key Institutions/Players—Internal—
Operational
Players
Important Issues Objectives/
Responsibilities
Employees
Skills and work ethics
Right incentive-structure
Meet the goals set by the
management
Minimize operational risks
Internal Audit
Quality and quantity of
information
Transparency of
information
Ensure that the policies
set
by Board are followed by
the
management
(Compliance)
Shari’ah Boards
Appropriate Shari’ah
related
rules and principles
Oversee compliance with
Shari’ah rules and
principles
Key Institutions/Players—
Other Stakeholders
Players
Important Issues Objectives/
Responsibilities
Depositors
Good service
Comparable returns
Act responsibly
Monitor the performance
External Audit
Quality and quantity of
information
Transparency of
information
Evaluate the accuracy of
the
quality and quantity of
information
Shariah Audit
Adherence to Shari’ah
rules
and principles
Evaluate compliance with
Shari’ah
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 Qur’an:
 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 Muḍārib’s share (where funds are commingled)
and profit distribution
 Muḍārib’s share in profits from assets financed by
current accounts
Protection of Investment Account
Holders (“IAH”)

Potential conflict of interest between IAHs
vis-à-vis Management (Shareholders)
o
o
o
Fiduciary responsibilities: Proper systems and
processes to avoid potential conflicts of
interest.
Adequate disclosures: About the IB’s
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
Sharī`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
Muḍārib share and profit allocation
2002 IRTI SURVEY ON CORPORATE
GOVERNANCE IN IBs— INTERNAL FACTORS
Rights and Equitable Treatment of
Shareholders
Average
Percentage
Score
87.7
Rankings
Good
Rights of Other Stakeholders
72.4
Fair
Responsibilities of the Board
87.9
Good
Disclosure and Transparency
87.9
Good
Management of Bank Operations
76.2
Fair
82
Good
Internal Factors Average
2002 IRTI SURVEY ON CG IN IBs—
EXTERNAL FACTORS
Average Percentage
Score
Rankings
Regulatory Regime
81.3
Good
Legal Procedures
76.9
Fair
Ethical Overlay
82.5
Good
External Factors Average
78.5
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 IAH’s 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
OECD
Companies
Directors/The Board
Remuneration/Compensation
Accountability and Audit
Relations with Shareholders
√
√
√
√
Shareholders
Rights and Key functions
Equitable Treatment
√
√
Other Stakeholders
Employees/Manager
Regulator/Supervisor
√
√
Disclosure and Transparency
√
BCBS
IOSCO
√
√
√
√
FRC/FSA
√
√
√
√
√
√
√
√
√
√
√
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
IAH’s 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 IAH’s 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 Management’s awareness of
the importance of good governance
 Due recognition of IAH’s 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)”