Corporate Governance and Shariah Compliance in Institutions Offering Islamic Financial Services
| Author | Wafik Grais; Matteo Pellegrini |
| Pages | WPS4054 |
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- AAOIFI
- BCBS
- CG
- CIBAFI
- ICFS
- IIFS
- IFSB
- IIRA
- FTSE
- FSA
- OECD
- SSB
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Islamic finance helped sustain economic growth throughout the Muslim world 1 during the Middle Ages. The last three decades witnessed its revival, notably following the first oil price shock of 1973-74. Beyond the surge in liquidity, its reemergence was prompted by the introduction of innovative Islamic financial products and a demand by Muslim populations for financial services compatible with their religious beliefs. More recently, the industry has received a new impetus. It can be ascribed to an uncertain performance of western financial markets, a perception of increased risk for Gulf Cooperation Council capital in traditional financial markets, a renewed surge in oil prices, an expressed demand from Muslim communities in Western countries, and the development of managerial skills specific to Islamic financial services.2 As a result, the global Islamic financial services industry now includes 284 institutions offering Islamic financial services (IIFS) operating in 38 countries, both Muslim and non-Muslim.3 Islamic capital markets, mutual funds and insurance services are also developing.
The Governor of the Bahrain Monetary Agency conveyed the sense of the roots of the IIFS when he stated that "Islamic banks have grown primarily by providing services to a captive market, to people who will only deal with a financial institution that strictly adheres to Islamic principles".4 Conducting activities in accordance with Shariah entails that the institution pledges: i) not to engage in interest-based debt transactions, ii) not to Page 3 conduct pure financial transactions disconnected from real economic activity, iii) not to participate in transactions where there is exploitation of any party, and iv) not to participate in activities regarded as harmful to society.5
Initially, IIFS developed without a clear view on the legislative and regulatory framework that would apply to them.6 However, their conceptual foundations and operational practices derived from the principles outlined above have specific features that pose challenges to regulators and call for solutions beyond the simple extension of existing legislation and regulation applying to institutions offering conventional financial services (ICFS). To that effect, a number of countries have put in place laws and regulations for IIFS, and international bodies have been established to adapt standards applying to conventional financial services and promote harmonization of practices.7
Enhancing stakeholders' value is a central purpose for any business including financial services, whether conventional or Islamic. Their stability, financial performances and ability to intermediate resources will depend on stakeholders' confidence in individual institutions and the industry. A particular confidence feature in respect of Islamic financial services is the requirement of conveying to stakeholders that their financial business is conducted in conformity with their religious beliefs. Corporate governance arrangements, internal and external to the corporate entity include structures and procedures that should provide sufficient comfort the business is conducted in accordance with stated objectives, in particular compliance with Shariah.8
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A widely adopted approach is to have independent bodies certify Shariah compliance by the IIFS. The reliance on independent bodies reflects the currently limited role that market discipline can play in ensuring such compliance. Hirschman contended that stakeholders generally have two ways of reacting to performance deterioration in business organizations.9 The first is for the stakeholder to quit the organization. The other is for the stakeholder to agitate and exert influence for change from within the organization. The potential role that these two mechanisms can play in upholding conformity with Shariah is constrained by the perceived complexity of Islamic financial instruments and their limited "commoditization". The diversity of jurisprudence on permissible transactions, and the limited disclosure of relevant and reliable financial information compound the difficulty. In addition, market participants and other stakeholders are likely to lack sufficient knowledge of Shariah or of financial principles, or of both, to judge the transactions of IIFS. In line with the foregoing, compliance with Shariah is primarily ensured through organs internal to the IIFS. At the same time, a broader enabling institutional environment, sometime referred to as external corporate governance is being put in place.
In the following the paper reviews in section two, prevailing internal arrangements that deal with Shariah compliance in individual IIFS; it examines the CG issues involved, and proposes measures to strengthen their effectiveness. Section three considers external arrangements that complement the ones adopted by individual institutions to promote compliance with the Shariah. The concluding section summarizes the overall strengths and weaknesses of existing arrangements.
The approach most widely adopted currently is to establish independent bodies of knowledgeable agents. These bodies are usually internal to the institution and part of its Page 5 governance structure. They include Shariah Supervisory Boards and Shariah review units. The following first analyzes existing arrangements and then considers options to strengthen them.
Each institution offering Islamic financial services has in-house religious advisers, who are collectively known as the Shariah Supervisory Board (SSB).10 In principle, the role of the SSB covers five main areas: certifying permissible financial instruments through fatwas (ex-ante Shariah audit), verifying that transactions comply with issued fatwas (ex-post Shariah audit), calculating and paying Zakat, disposing of non-Shariah compliant earnings, and advising on the distribution of income or expenses among shareholders and investment account holders.11 The SSB issues a report to certify that all financial transactions comply with the above-mentioned principles. This report is often an integral part of the Annual Report of the Islamic financial institution.
In practice an SSB's tasks may vary according to provisions stipulated in the articles of association of the financial institution or those stipulated by national regulators. A review of 13 IIFS shows that all SSBs were entrusted with ex-ante monitoring and the calculation of Zakat.12 However, ex-post monitoring was within the exclusive competence of Shariah review units in at least two cases.13 In another case, the Page 6 SSB could issue recommendations on how the institution could best fulfill its social role as well as promote Islamic finance.14 In addition to internal corporate arrangements, national regulators and international standard setters implement guidelines for SSBs.
These often refer to SSBs' general duty to ensure Shariah compliance of transactions and, less frequently, indicate areas of competence, composition and decision-making. Table I provides an overview of practices in selected countries that have introduced guidelines or legislative references on the functioning of SSBs.15
[NO INCLUYE TABLA]
The functioning of SSBs raises five main issues of corporate governance: independence, confidentiality, competence, consistency, and disclosure. The first Page 7 concerns the independence of the SSB from management. Generally members of the SSB are appointed by the shareholders of the bank, represented by the Board of Directors. As such, they are employed by the financial institution, and report to the Board of Directors.
Their remuneration is proposed by the management and approved by the Board. The SSB members' dual relationship with the institution as providers of remunerated services and as assessors of the nature of operations could be seen as creating a possible conflict of interest.
In principle, SSB members are required to submit an unbiased opinion in all matters pertaining to their assignment. However, their employment status generates an economic stake in the financial institution, which can negatively impact their independence. The opinions of the SSB may, for example, prohibit the bank engaging in certain profitable transactions or impose a reallocation of illicit...
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