corporate governance transparency and market discipline in islamic banks2

8/6/2019 Corporate Governance Transparency and Market Discipline in Islamic Banks2

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GUIDING PRINCIPLES ON CORPORATEGOVERNANCE OF INSTITUTIONS OFFERING

ISLAMIC FINANCIAL SERVICES (IIFS):

An Insight into IFSB-3

Madzlan Mohamad HussainSenior Project Manager

Guest Lecture

Islamic Development Bank

22 April 2008


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Presented at IDB Lecture Series - Copyright reserved IFSB 2008

22 April 2008

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PRESENTATION OUTLINE

Understanding the motivating factors Defining corporate governance (CG)

and stakeholders in the context of

institutions offering Islamic financialservices (IIFS)

CG issues specific to IIFS

An insight of the IFSB Guiding Principles

of CG for IIFS (IFSB3)


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UNDERSTANDING THE MOTIVATING FACTORS

Separation of ownership & control

Agency problems occur when the principal (investors)lacks the necessary power or information to monitorand control the agent (managers) and when theincentive of the principal and agent is not aligned.

When contracts are incomplete and managerspossess more expertise than investors, managerstypically end up with the residual rights of control,giving them enormous latitude for self-interestedbehaviour.

The challenge for good CG is in ensuring how theproviders of capital can influence the managers tomeet such wider obligations as may in thecircumstances be pertinent.


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Information asymmetries In the case of financial institutions there are particular

issues - the ability of outsiders to monitor and inparticular evaluate the performance and conduct of themanagers may well be difficult.

This opaqueness makes it easier and more likely formanagers and large investors to manipulate board ofdirectors and exploit the private benefits of control.

In such circumstances suspicions of insider dealingand abuse may be detrimental not only the institution in

question and those responsible for management, butthe market as a whole.

UNDERSTANDING THE MOTIVATING FACTORS (2)


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Balancing stakeholders protection The conventional approach - Anglo-American model vs.

Franco-German model.

In the context of IIFS, their duties and responsibilities asMurib are set out not only in contracts and residual

contracts but ultimately accountability to God. IIFS must carefully manage potential conflicts of interest

between its various stakeholders, particularly betweenits shareholders and the investment account holders(IAH), bearing in mind the parameters set by theSharah.

Concerns of anti-money laundering, fraud andmisconduct.



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Transparency and Market Discipline Transparency in providing timely and adequate

information to IIFS investors, for example in thecalculation of Murib share and profit allocation, isnot only important for protecting the interest of

investors but to enforce market discipline on IIFS. Furthermore, it would contribute in bringing about

systemic stability.

It is necessary therefore, to enhance transparency and

comparability of IIFS through suitable disclosures.



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DEFINING CORPORATE GOVERNANCEA defined set of relationships between a companys

management, its Board of Directors, its shareholders andother stakeholders which provides the structure throughwhich:

the objectives of the company are set; and

the means of attaining those objectives and monitoringperformance are determined.

In the context ofIIFS, good CG should encompass: a set of organisational arrangements whereby the actions of

the management of IIFS are aligned, as far as possible, withthe interests of its stakeholders;

provision of proper incentives for the organs of governance

such as the Board of Directors, SSB and management topursue objectives that are in the interests of thestakeholders and facilitate effective monitoring, therebyencouraging IIFS to use resources more efficiently; and

compliance with Islamic Shar`ah rules and principles.


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DEFINING STAKEHOLDERS

BCBS paper:

Stakeholders include employees, customers,suppliers and the community. Due to the uniquerole of banks in national and local economies andfinancial systems, supervisors and governments

are also stakeholders [of banks].

From Islamic financial services perspective:

Community should particularly connotes theMuslim Ummah.

Customers does not refer to conventionaldepositors and borrowers but to Investment

Account Holders (IAH) and Current AccountHolders.


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ISLAMIC VIEWPOINTS ON IMPORTANCEOF GOOD GOVERNANCE

The concept of vicegerency - Accountability toGod as well as to others. Ethics of IIFS are setout not only in contracts and residual contractsbut ultimately accountability to God.

Amongst the code of ethics set out in theQuran: Honest fulfilment of all contracts (Al-Midah:1)

Prohibition against betraying any trust (Al-Anfl:27)

Prohibition against deriving income from cheating,dishonesty or fraud (li Imrn :29)

Prohibition against bribery to earn unfair advantage (Al-Baqarah :188)

Prohibition against concealing evidence (Al-Baqarah :283),for e.g. to manipulate prices


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SPECIFICITIES OF IIFS

In addition to general banking matters, organs of

governance of IIFS also need to attend to: Shar`ah compliance

Ethics & social responsibility (in line with theconcept of vicegerency)

Interests of IAH, especially unrestricted Potential conflicts of interest between shareholders

and unrestricted IAH especially where the fundsare commingled - issues of asset allocation andrisk appetite

Transparency in financial reporting, e.g. calculationof Murib share (especially where funds arecommingled) and profit distribution


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Protection of Investment Account Holders (IAH) Like investors in Collective Investment Schemes (CIS), IAH

are exposed to potential conflict of interest with themanagement of an IIFS, which may look after the interest ofshareholders at the expense of IAH.

As in the case of securities regulators, this requires more

emphasis on fiduciary responsibility or establishment ofdetailed regulations designed to monitor potential conflicts ofinterest.

Furthermore, adequate disclosure of relevant informationabout the IIFS investment objectives and policies, operationalguidelines that govern the relationship between the IIFS and

IAH, etc. should be made available. Albeit IAH may have no representation in the organs of

governance such as the Board of Directors or Shar`ahSupervisory Board, they have every right to expectaccountability and transparency on investment made on theirbehalf.

CG ISSUES IN IIFS


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Shar`ah Supervisory Board (SSB) SSB is a specific organ of governance. It should be

concerned with monitoring Shar`ah compliance and notjust issuing edicts (fatwa).

Since SSB members may lack monitoring skills, auditors andaudit committee should act in concert to assist the SSB.

Transparency in financial reporting The current financial reporting practices of IIFS do not

provide adequate information to their IAH regarding therevenues and expenses accruing to their particularinvestment fund.

IAH is rightfully entitled to transparency, e.g. calculation ofMurib share and profit allocation.

CG ISSUES IN IIFS (2)


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CURRENT STATUS OF CG AWARENESSAMONGST IIFS

IFSB Survey (2004) highlights: Strong awareness amongst IIFS on the

importance of good governance. Majority IIFS offer only unrestricted IA, and even

for those offering restricted IA they do not address

the IAHs risk appetite. Smoothing of returns has not been proven as a

widespread practice, however it is appropriatethat the practice be accepted with caution in orderto 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 efficiencycontinue to be a major concern.


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SCOPE OF IFSB3 (1)

CG aspects already

covered

OECD BCBS IOSCO FRC/FSA

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

The issue of IIFS accountability and transparency to its customers,particularly IAH , as well as Shar`ah compliance, have not been covered orcontemplated in any of the above documents.

Filling in the Gaps


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IFSB3 aims to cover these aspects: Information environment and transparency:

specifying and enforcing appropriate disclosurerequirements

fostering auditors independence and enforce therelevant and applicable auditing standards

the focus is very specifically on protection of the IAHsinterests not to overlap with general transparentreporting which would be covered by theTransparency and Market Discipline Standard

Organs of governance: safeguarding interests of IAH, especially the

unrestricted adequate monitoring ofShar`ah compliance

SCOPE OF IFSB3 (2)


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General Governance Approach in IIFS (1)

Principle 1.1: IIFS shall establish acomprehensive governance policyframework which sets out the strategic rolesand functions of each organ of governanceand mechanisms for balancing theiraccountabilities to various stakeholders.

Main recommendations

The adoption of OECD and BCBSrecommendations through comprehensive

governance policy framework. Establishment of a Governance Committee

to implement the governance policyframework.


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General Governance Approach in IIFS (2)

Principle 1.2: IIFS shall ensure that thereporting of their financial and non-financialinformation meets the requirements ofinternationally recognized accountingstandards which are in compliance withShar`ah rules and principles and areapplicable to the Islamic financial servicesindustry as recognized by the supervisoryauthorities of the country.

Main recommendation

Establishment of an Audit Committee toensure good implementation of internationallyrecognized accounting standards.


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Rights of IAH

Principle 2.1: IIFS shall acknowledgeIAHs right to monitor the performance oftheir investments and the associated risks,and put into place adequate means toensure that these rights are observed andexercised.

Main recommendation

Establishment of an internal guideline thatsets out adequate protection of the IAHinvestments, including the disclosure ofrelevant and material information to the IAHsuch as on profit allocation and investmentpolicies.


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Rights of IAH (2)

Principle 2.2: IIFS shall adopt a soundinvestment strategy which is appropriatelyaligned to the risk and return expectationsof IAH (bearing in mind the distinctionbetween restricted and unrestricted IAH),and be transparent in smoothing anyreturns. Main recommendations

Distinguishing between profits earned andactual dividends payout through

appropriate disclosure. The Governance Committee to oversee the

utilization of any reserves for thesepurposes.


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Compliance with Sharàh Rules and Principles

Principle 3.1: IIFS shall have in place anappropriate mechanism for obtaining rulingsfrom Sharàh scholars, applying fatw andmonitoring Sharàh compliance in allaspects of their products, operations andactivities.

Main recommendations

Emphasis on ex-post and ex-ante roles ofSharàh scholars beyond just issuingedicts.

Ensuring appropriate qualifications andaccountability ofSharàh scholars.


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Compliance with Sharàh Rules and Principles (2)

Principle 3.2: IIFS shall comply with theSharàh rules and principles as expressedin the rulings of the IIFSs Sharàhscholars. The IIFS shall make these rulingsavailable to the public.

Main recommendations Encouraging transparency in the process of

issuing, applying or abandoning of fatwathrough appropriate disclosure andpublications.

Check on the activity offatwa-shopping.


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Transparency of Financial Reporting i.r.o. IAH

Principle 4: IIFS shall make adequate andtimely disclosure to IAH and the public ofmaterial and relevant information on theinvestment accounts that they manage. Main recommendation

Making adequate and timely publicannouncement in annual report, websiteand in mainstream media organs in respectof profit calculation, asset allocation,investment strategies and mechanics ofsmoothing the returns (if any) in respect ofthe investment accounts that the IIFSmanage.


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OUTCOMES EXPECTED FROM IFSB3

SPECIFICALLY,

Adoption of OECD and BCBS recommendations willimprove IIFS Board of Directors and Managementsawareness of the importance of good governance, atpar with international best practices

Due recognition of IAHs rights and risks as residualclaimants will lead to appropriate protection of IAH

More professional approach forShar`ah compliancewill mitigate compliance and reputational risks of IIFS

Increased transparency in financial and non-financialreporting by IIFS will inculcate better riskmanagement structure and discipline cultureamongst IIFS


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THANK YOU FOR LISTENING

Contact details:

E-mail: [email protected]/ [email protected] Website: www.ifsb.org

corporate governance transparency and market discipline in islamic banks2

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