Perspective of corporate governance and ethical issues with profit sharing investment accounts in Islamic banks

Author:Salah Alhammadi, Simon Archer, Carol Padgett, Rifaat Ahmed Abdel Karim
Position:Islamic Economics and Finance, Al-Maktoum College of Higher Education, Dundee, UK, and Department of Islamic Finance, Durham University Business School, Durham, UK
Pages:406-424
SUMMARY

Purpose The purpose of this paper is to examine the practices of Islamic banks in managing the so-called profit sharing investment accounts (PSIA) which they offer as a Shari’ah-compliant alternative to interest-bearing deposit accounts using an unrestricted Mudarabah contract. In particular, the paper aims to examine the risk-return characteristics of such accounts and to compare these to the returns and risks of shareholders in the same banks. It is relevant that PSIA holders (unrestricted investment account holders - UIAH) are exposed to losses on the assets in which their deposits are invested, while the bank as asset manager (Mudarib) does not bear these losses and as Mudarib typically receives more than 50 per cent of the profits earned on the PSIA. The ... (see full summary)

 
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Perspective of corporate
governance and ethical issues
with prot sharing investment
accounts in Islamic banks
Salah Alhammadi
Islamic Economics and Finance, Al-Maktoum College of Higher Education,
Dundee, UK, and Department of Islamic Finance,
Durham University Business School, Durham, UK
Simon Archer
ICMA Centre, University of Reading, Reading, UK
Carol Padgett
ICMA Centre, University of Reading, Reading, UK, and
Rifaat Ahmed Abdel Karim
INCEIF, Kuala Lumpur, Malaysia
Abstract
Purpose The purpose of this paper is to examine thepractices of Islamic banks in managing the so-
called prot sharing investment accounts (PSIA) which they offer as a Shariah-compliant alternative
to interest-bearing deposit accounts using an unrestricted Mudarabah contract. In particular, the
paper aims to examine the risk-return characteristics of such accounts and to compare these to the
returns and risks of shareholders in the same banks. It is relevant that PSIA holders (unrestricted
investment account holders UIAH) are exposed to losses on the assets in which their deposits are
invested, while the bank as asset manager (Mudarib) does not bear these losses and as Mudarib
typically receives more than 50 per cent of the prots earned on the PSIA. The issue is whether the
UIAH are being treated equitably. The inuence of a set of corporate governance variables on this
issue was also analyzed.
Design/methodology/approach A sample of 28 Islamic banks was selected from ve countries for
the period 2002-2013, with data being obtained from Bankscope and Bloomberg and, where necessary,
from the banksannual reports. First, the risk-return characteristics of the UIAHsrates of return and
shareholdersratesofreturnonequity(ROE)werecompared by calculating for each bank the
coefcients of variation (CV) of the two series of rates of return. Second, a panel data approach was used
to evaluate the effectiveness of corporate governance by examining the extent to which the size of the
difference between the rates of return for shareholders and for UIAH was associated with a set of
corporate governance variables. Third, a comparison was made between the risk-return characteristics
of UIAHs rates of return and shareholdersdividend yield rate for a sub-sample of 20 banks for which
the information was available.
Findings For a signicant proportion of the banks (9 out of 28), the CVs of the PSIA returns were
higher than those of the shareholdersROEs, which suggested that in these cases the PSIA holders were
receiving inequitable treatment. Likewise, for 7 out of the 20 banks in the sub-sample, the CVs of the
This paper is substantially based on a thesis submitted by Salah Al Hammadi as a PhD candidate at
the ICMA Centre, Henley Business School, University of Reading, UK, supervised by Simon Archer
and Carol Padgett. Rifaat A.A. Karim is a Visiting Professor at the ICMA Centre.
JFRC
26,3
406
Journalof Financial Regulation
andCompliance
Vol.26 No. 3, 2018
pp. 406-424
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-01-2017-0014
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
PSIA holdersrates of return were higher than those of the shareholdersdividend yield rate. In
explaining the size of the differences between the rates of return on PSIA and the shareholdersROEs,
the variable with the greatest explanatory power was the return on assets, implying that when this was
high the bank took a maximum Mudarib share of prots. Some other corporate governance variables
had the expected signs, as did a country dummy representing the maturity of the market for Islamic
banking, but there was little evidence of the effectiveness of corporate governance in protecting the
interests of the UIAH.
Research limitations/implications A limitation of the research was that the inefciency of the
stock markets in the relevant countries and the fact that a few of the banks were not listed made it
impossible to use shareholdersstockmarket returns. ROE is not a very good proxy, as it is unclear how
much value should be placed on retained earnings. Dividend yield rates provide a better comparison
with UIAH rates of return, but the data were availablefor only 20 of the banks. Nevertheless, the results
of the analysis strongly suggest that in a signicant proportion of cases, UIAH are not being treated
equitably.
Practical implications The implication is thatthe regulation of Islamic banks needs to be improved to
provide betterprotection to UIAH.
Social implications Islamic banks operate mainly in emerging markets where the effectiveness of
regulation is limited. The ethical basis of Islamic nance provides some mitigation of this problem but
apparentlyfails to do so in a signicantproportion of cases. This should be borne inmind when assertions are
made about the ethicalbasis of Islamic nance.
Originality/value There is a dearth of empirical studies of the practices of Islamic banks and in
particular of their treatment of their customers. This is because of various factors: the relative novelty of
Islamic nance, the paucity of data and the relativelysmall size of the body of researchers in the eld. This
paper aims to contributeto lling this gap.
Keywords Islamic banking, Corporate governance, Equitable treatment, Prot-sharing
Paper type Research paper
1. Introduction
Islamic Banks (IBs) have developed prot sharing investment accounts (PSIA) for
customerssavingsand repository accounts in place of conventional interest-bearing deposit
accounts to mobilize funds on which IBs and their customers can earn Shariah-compliant
returns (Archer et al.,2010). Customers deposit their funds in so-called prot sharing
investment accountsas capital providers, and the bank invests these funds on the
customersbehalf in return for a share of the prot or for a fee as remuneration for
management. Thereare two types of PSIAs:
(1) A restricted PSIA (RPSIA), a separately managed fund that is not commingled
with other funds of the IB. This is similar to mutual funds and is generally
considered by IBs for the purpose of nancial reporting as off-balance sheet
fundsunder management.
(2) An unrestricted PSIA (UPSIA) is an account such that an IB has full discretion to
use and invest the UPSIA funds. These accounts are widely used by IBs in place of
conventional interest-bearing deposits.
The contractual bases for these types of accounts are the Mudarabah or Wakalahcontracts,
where in a Mudarabah the customers as Rabb al Mal provide capitaland the bank provides
work as Mudarib (entrepreneuror asset manager) and shares prot, or the bank in Wakalah
acts as Wakeel (agent) and receives a fee plus (typically) a performance related bonus
(Archer et al.,1998).
The Mudarabah contract, like the Commenda contract used by medieval Italian
traders, was used originally for nancing trade ventures in which the trader
Perspective of
corporate
governance
407

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