Corporate Governance in Islamic Banking - Case Study Example

corporate governance in islamic banking Corporate governance is the process and structure in which an organization may use to direct and manage the business objectives, thus enhancing business prosperity and corporate accountability with the aim of meeting long term us shareholder value and interests. It includes the relationships between the management of an institution, the shareholders, and the stakeholders. The primary objective of the corporate governance guidelines is to adopt an effective and high standard practices that aids in governing institutions. In addition, they ensure that Islamic banks have safe management for maximizing shareholder returns and the protection of the shareholders’ interests. Moreover, Islamic finance is one of the ways to accommodate Islamic value in finance, it insists on the importance of the accountability, transparency, and trust. Islamic banking refers to a system where all banking behavior is consistent with Islamic law and guided by the economics of Islam. Since the introduction of Islamic banking, the number of Islamic financial institutions has increased globally. This is because of the increase in Islamic population and the economic development of Islamic nations. Today, there are more than 300 institutions in more than 75 countries. In addition, there is the development of many Islamic financial products used in financial market activities, for example, trading, and investment. Corporate governance in Islamic finance entails the institutions abiding by the Islamic rules also known as Shariah. The rules govern the bank’s operations, according to Islamic principles that are derived from Quran and Hadith. Islamic financial institutions operate in the same space as the conventional banks and perform all functions expected from a financial institution. In addition, savers are able to collect deposits for the purpose of reward from both types of institutions. However, the difference comes in when agreeing on the reward. Under the conventional system, the reward is normally predetermined and fixed while in Islamic system, the reward is variable and the deposits are acceptable through Musharaka (Lewis, 2001). Additionally, the returns under conventional banking are usually higher on long-term deposits and low for short-term deposits. On the other hand, higher profit sharing is assigned to long-term deposits available for investing in long term projects, earning high returns and low weight for deposit that are short-term that cannot be spent in long term projects. Under Islamic banking, the risk and rewards are shared by the depositors while under the conventional banking, the risk is borne by the bank and the reward belongs to the bank after providing service to the depositing in at a fixed rate. In addition, Conventional banks offer fixed reward loans while the Islamic financial institutions do not allow the practice, as they do not charge interest. The three types of loans offered in conventional banking include short term, long term, and overdraft. As for Islamic banking, they do not offer loans apart from interest free loans. Likewise, conventional banks have many avenues to maintain liquidity like the government securities, short-term loans, and investment in shares. The Islamic bank has limited avenues since they do not invest in government securities and short-term loans because of the interest transactions that they do not deal with. The rules that govern Islamic financing are derived from a framework of Islamic Quran and the teachings of Prophet Muhammad by the name Sunnah and other Islamic scripture (Haugen, 2011). This law is known as Shariah and it governs the Muslims in all aspects of life. It Is designed to promote both the economic and social justice. This is the reason the Shariah imposes some restrictions on investment and finance within the community. The two main restrictions are on the (Riba), which is paying excess interest and haraam (Seelye, 2013). Shariah prohibits offensive practices and any speculation of gambling (Maisir) (Seelye, 2013). It is therefore the duty of all Muslims to speculate the kind of business activities and determine whether the business is lawful or not. The unjust business activities involve manufacturing, selling, and promoting products like alcohol and pork products. The religious scholars have guided the Islamic banking institutions on their respective Shariah Supervisory board. The board is responsible for designing the transactions in regards to the principles of Shariah and control of the operations in the institutions. All the problems are presented to the board by the management and after careful consideration, they decide on whether or not the proposed principles are in line with the Shariah law. The board is also responsible for setting up an audit department that is staffed with qualified personnel to perform audit functions and Shariah audit. Shariah is sacred, changes over time, and adapted to the changing circumstances and new issues (Haugen, 2011). The models involved in corporate governance include the Anglo-Saxon that is considered as the most dominant academic view that deals with the sole consideration is given to shareholders (Trost, 2012). In addition, the stakeholder value model focuses on a relationship based model that stresses on the maximizing the interests of a group of shareholders. The Franco- German model also protects the interests of other stakeholders. However, the US doubts whether the corporate governance of the Franco-German model actually protects the interests of other shareholders as they claim. On the contrary, the Islamic model of corporate governance emphasizes on the elements that of ethics as is well put in the Quran. The Islamic ethics are derived from social values that are more transitory in nature. The Quran provides principles and guidelines that are applicable universally regarding corporate governance. In Islam, a standard set of conduct is to be observed in all social interactions. In addition, there are four axioms that reflect the rules of economic behavior in a society. They are the axiom of unity, free will, equilibrium, and responsibility. They provide useful information in identifying the ethical principles in economics. Islamic banks are required to comply with the standardized approach and to measure risk exposure for capital adequacy. This is whereby the capital weighing depends on ratings from other rating agencies like the Standard rating. There should be quality data to estimate the probability of default and loss given default. In addition, the model-based approach is used to measure the credit risk with the utilization of specialized models. Therefore, the Islamic banks will aim to implement standardized risk measurement procedures. Moreover, the use of the dual banking approach, where the Islamic banks are working together with the conventional bank to maintain harmonization of the regulatory platform aids in providing an equal opportunity for the Islamic and conventional financial industry. Also, setting up a Shariah advisory committee to oversee the operations of the institutions to ensure the management and operations of Islamic banking institutions do not diverge from the principles of Islam in the policy formulation. To have strong compliance of the Shariah to ensure that individuals adhere to the rules amongst the banking institutions. Lastly, the use of the internal ratings based approach systems measures credit risk. With this approach, banks have permission to alter the formula risk for small and medium enterprise borrowers. This is to allow the reflection of risk in regards to small and medium enterprises and annual sales figures. In conclusion, the incorporation of Shariah framework to the Islamic financing is important as it provides a guideline on the kind of business that an individual should engage in. I believe that the enhancement of corporate governance would help strengthen the performance and credibility of Islamic financial institutions in the world. I would suggest that the banking sector should implement rules that ensure sound corporate governance and implement practices that would enhance the potential roles of the corporate governance that will contribute towards corporate reform and financial stability worldwide. References Haugen, S. 2011. The foundations of Islamic banking: Theory, practice and education. Cheltenham [U.K.: Edward Elgar. Lewis, M., & Algaoud, L. 2001. Islamic banking. Cheltenham, UK: Edward Elgar. Seelye, G. 2013. Corporate governance in islamic banking and finance. Hoboken: John Wiley. Trost, M. 2012. Shari'ah governance in Islamic banks. Edinburgh: Edinburgh University Press. Read More