Why Islamic Financial Institutions in Need for Corporate Governance Legal Framework - Essay Example

?Why Islamic Financial s Need Improved Corporate Governance Legal Framework By Islamic financial institutions have been feeling the effects of the recent global financial crisis. For instance, the Ihlas Finance House located in Turkey, the Islamic Bank of South Africa and the Islamic Investment Companies in Egypt have suffered closures. One of the major contributing factors appears to be a weak corporate governance framework. The main problems are regulatory flaws, management weakness and insufficient controls within the current corporate governance constructs. This paper analyzes the current corporate governance framework for Islamic financial institutions and identifies weaknesses and strengths. Key areas of improvement are identified in determining the need for an improved corporate governance legal framework for Islamic financial institutions. This research study is divided into three main parts. The first part of this paper provides an overview of Islamic financial institutions and their performance during the recent global financial crisis. The second part of this paper provides an overview and analysis of the current corporate governance framework and the guiding principles of Islamic financial institution. The final part of this research study analyzes the need for improving the corporate governance legal framework of Islamic financial institutions. The final part of this paper will also identify the areas of corporate governance that require improvement. Thus this research study concludes that in order to maintain its genuine distinctiveness from conventional banking, Islamic financial institutions require significant improvements in its corporate governance framework. Contents Abstract 2 Contents 3 Introduction 4 The Recent Global Financial Crisis and Islamic Financial Institutions: An Overview 5 The Recent Global Financial Crisis 5 The Global Financial Crisis and the Performance of Islamic Financial Institutions 8 Corporate Governance of Islamic Financial Instituions 10 The Need to Improve the Corporate Governance Legal Framework of Islamic Financial Institutions 16 Conclusion 18 Bibliography 19 Introduction Islamic finanical systems were particularly sucessful in the pre-colonial era but were methodologicaly replaced by conventional financial institutions during the colonial era. However over the last thirty or so years, Islamic financial institutions have been making a formidible comeback. Today Islamic financial systems have not only been established in Islamic states, but also internationally. Moreover, a number of conventional banks are also offering Islamic financial services evidencing the global acceptance of Islamic financial institutions.1 According to the World Bank, Islamic fiancial services are offered globally via 284 financial institutions in 38 countries which are Islamic and non-Islamic states.2 Like any financial institution, good and effective corporate governance is necessary for the effective and efficient functioning of the institution and for the protection of stakeholder interests. The stakeholder insterest are not always monetary in nature and can include ethics, values and/or religion. For Islamic financial institution, the amin interests of stakeholders is that the institution offering Islamic financial services comply with Shariah principles. Thus Shariah-compliant functioning in an Islamic financial insitution is the key component of corporate governance in Islamic financial institutions.3 The challenge for Islamic financial institutions in formulating good and effective corporate governance constructs is reconciling Shariah-compliant principles with the interests of all stakeholders.4 The stakeholder relationship in Islamic financial institutions is different from conventional financial institutions because profit and risk sharing principles change the nature of the stakeholder relationship.5 Moreover, the definition of property also changes the Islamic financial institution’s perspective on corporate governance.6 This paper identifies and analyzes the current model of corporate governce for Islamic financial institutions and the challenges implicit in it. This paper will determine the need for improving the current corporate governance framework for Islamic financial institutions and how the current corporate goverance framework can be improved. Therefore, this research study is divided into three main parts. The first part of this study provides an overview of the recent global financial crisis and the performance of Islamic financial institutions. The second part of this study analyzes the current model of corporate governance for Islamic financial institutions. The final part of this paper analyzes and identifies the weaknesses of the current corporate governance model for Islamic financial institutions and identifies areas that can be improved for optimal outcomes. The Recent Global Financial Crisis and Islamic Financial Institutions: An Overview The Recent Global Financial Crisis The global financial crisis which began in 2007, resulted in the collapse of many conventional banking systems globally.7 Since 2007, a number of financial institutions were bailed out by governments around the world.8 The global finanicla crisis originated out of the subprime mortgate sector and its corresponding “liquidity squeeze” in the US.9 By the middle of 2008, it was obvious that the subprime mortgage market in the US was having serious effects on financial institutions globally. In the US, JP Morgan with assistance form the Federal Reserve Bank of New York, took over Bear Stearns. In Europe, a number of banks continued to “raise a significant volune of additional capital to finance” significant “realises losses on assets” with the results that sharholding was diluted.10 In the US, government sponsored financial institutions, Fredie Mac and Fanny Mae were taken over by the government when their capital delcined. In the UK Northern Rock’s run resulted in government take-over. In Germany IKB and Sachsenbank, two state-owed banks were bailed out. By the third qaurter of 2008, the crisis had spread likewise globally and general confidence in financial institutions took a severe hit.11 The subprime mortgage crisis in the US was essentially a result of an unprecedented rate of mortage defaults. The rate of defaults began to increase exponentially in 2006 and house prices began to fall while interest rates rose. As a result a number of offical international and national organizations issues warnings relative to a liquidity risk. The institutions issuing warnings were the International Monetary Fund (IMF), the Organization for Economic Cooperation and Development (OECD) and the Bank of England.12 Ostensibly, the cause of the recent global financial crisis has been attributed to poor captial constructs and ultimately poor or inadequate corporate governance.13 A number of studies focusing on the causes of the recent financial global crisis concluded that the main cause of the global financial crisis was directly linked to corporate governance issues. Of particular concern was risk management and financing practices and policies. In other words, corporate governance impacted the manner in which financial institutions performed during and leading up to the global financial crisis.14 It is therefore hardly surprising that immediately following the 2008 global financial crisis, analysts, investors, legislators and academic scholars targeted enhanced or effective corporate governance as a means of avoiding another global financial crisis. In this regard, specific attention was turned to accountability and transparency, risk management and prudential controls, supervision and monitoring.15 The main idea was to provide effective and efficient safeguards against excessive risk-taking, particularly in the area of lending. Attention is now turned to the relevance of corporate governance to Islamic financial institutions by reference to how Islamic financial institutions performed during the recent global financial crisis. Therefore the next sections provides an overview of how Islamic financial institutions performed during the recent global fiancial crisis. The Global Financial Crisis and the Performance of Islamic Financial Institutions Theoretically, Shariah-compliant financial institutions which are guided by Islamic principles such as riba (prohibtion on interests) and restraints on lending, the “unrestricted sale of debt” and gharar (prohibitions against excessive risk-taking) should forestall a finacial crisis.16 It is therefore hardly surprising that from the Islamic perspective, the recent global financial crisis was a “crisis of failed morality”. In this regard failed morality is: …the product and cause of greed, exploitation, and corruption. This ethical failure is a coupled with a failure in the relationship between investment originators and investors.17 The global financial crisis provided a unique opportunity for the Islamic financial system to demonstrate that it was far more robust and resistent to the stress factors of conventional financial institutions and systems. Essentially, Islamic fiancial institutions did not take a direct hit from the global financial crisis. This is because Islamic financial institutions: Did not have any direct exposure to toxic assets and, therefore, were immune to the crisis during its early stages.18 Be that as it may, once the global financial crisis penetrated the real economy and there was an economic downturn globally, Islamic financial institutions suffered in terms of declining business transactions and profits.19 It is therefore inaccurate to assume that Islamic fiancial systems were able to survive the recent global financial crisis as a result of good corporate governance, genuine financial services and products and tight regulatory and supervisory models. Risks in the financial system such as exchange risks, market conditions, liquidity crises and external factors that cannot be ignored and require Islamic financial istitutions to manage these risks. A study was conducted by the IMF examining bank data for the period 2007-2010 and 120 Islamic and conventional banks in 8 countries. The study focused on profits, lending, assets and bank ratings. The results of the study illustrated that Islamic banks had better profits than coventional banks in 2008.20 In 2009, when the global financial crisis spilled over to the real economy, conventional banks showed better profits than Islamic banks. However, credit and assets growth continued to remain better for Islamic banks than for coventional banks. As for risk assessment, Islamic banks rated better or equal to conventional banks. It is therefore possible to conclude that Islamic banks were more resistent to the global financial crisis than conventional banks.21 It is therefore fair to state that Islamic financial institutions generally fared better than conventional financial institutions during the recent global financial crisis. However, Islamic financial institutions did not escape the recent global financial crisis unscathed since there were bank failures and profits did drop below those of conventional banks in 2009. Realistically, Islamic financial institutions are a part of the global economy and as demonstrated by the recent global financial crisis, they can expect some spill over for a global financial crisis. Since the global financial crisis is generally attributed to weaknesses in corporate governance, it is necessary to determine whether or not corporate governance improvements for Islamic financial institutions can safeguard against the spillover impact of a global financial crisis. Corporate Governance of Islamic Financial Instituions Corporate governance is defined as a system of principles and rules for organizations to follow for implementing and following sound practices and management of the relevant organization. Essentially, corporate governance: Has come to mean the whole process of managing a company and the incentrive structure to address principal-agent issues and ensure that executive management serves the long-term best interests of the shareholders and sustainable value of the company in conformity with the laws and ethics of the country.22 In Islamic financial institutions, corporate governance constructs consist of a criterion by which Islamic financial institutions adhere to Shariah laws and principles.23 Thus the corporate culture of the entire financial institution purporting to be Shariah-compliant must be Islamic in nature. As Janahi informs, all staff members within an Islamic financial institution: Must be reformed Islamically and act within the framework of an Islamic formula, so that any person approaching an Islamic bank should be given the impression that he is entering a sacred place to perform a religious ritual, that is the use and employment of capital for what is acceptable and satisfactory to God.24 Corporate governance of Islamic financial institutions is guided by the Sharia principle of shirkah (partnership) and mudaraba (profit-sharing).25 Islamic financial institutions are guided in corporate governance constructs by the Islamic perception that financial institutions are intended to serves as mediators for allocating capital on the basis of the mudaraba principle to entrepreneurs.26 Likewise a profit and risk sharing contract functions under a system of rules.27 The first rule applicable to the profit and risk sharing contract is that funds are received from members of the public under the premise of an unlimited mudaraba. Banks are free to use the funds for any transaction, for any length of time and for any location provided the funds are used for activities that are approved by the Shariah.28 Secondly, Islamic financial institutions are at liberty to amass and amalgamate profits from diverse investments and to share the profits with investors pursuant to a certain formula. If there are losses, those depositing the funds/investors lose a share that is porportionate to their shares or they may lose all of the funds, provided the loss does not exceed the depositor’s actual investment.29 This principle of Islamic financial institutions requires little if any corporate governance outside of transparency. The financial institution’s freedom to make and pool profits provided they are consistent with Shariah principles requires that investors know what activities are consistent with Shariah principles. However, the freedom conferred on Islamic financial institutions also means that they are only accountable for losses if the investment is inconsistent with Shariah principles and laws. Looked at this way, a lot can go wrong at the expense of depositors and investors generally. Since the loss is that of the depositor or the investors and the financial institution is free to use the funds in a manner that is consistent with Shariah principles and laws, the financial institution can make poor decisions without having to account to the depositor or the investor when a loss is incurred. In other words, Islamic financial institutions have a corporate governance construct that assumes that these institutions are sacred and will not be deceptive. A third rule in Islamic financial systems guiding corporate governance is the fact that financial institutions are required to apply mudaraba in a restricted way when those funds are allocated to entrepreneurs. Although the financial institution is at liberty to identify the activities, the time and location of the activities or projects and to monitor the funds applied, the bank may not take any action that would injure the entrepreneur’s performance. Moreover, the financial institution may no intervene in investment management. 30 It would therefore appear that entrepreneurs are accorded greater protection than mere depositors of funds under Islamic corporate goverance of financial institutions. The distinctive approaches to these classes of investors may be motivated by a need to support economic growth and development. However, protection of deposits would appear to be just as important since depositors who do not have a guarantee of interest paid on savings and confront the risk of loss may be less inclined to save in financial institutions. Another Islamic principle reflected in the corporate governance constructs of Islamic financial institutions is the issue of security and collateral. Islamic financial institutions may not demand guarantees which include security and collateral in respect of an entrepreneur for the purpose of safeguarding funds against a future loss.31 Certainly this precaution provides a safeguard against excessive lending which was seen to be one of the main causes of the subprime mortgage crisis in the US which catapulted to create the global financial crisis. The absence of security and collatoral against loans means that persons who would not ordinarily satsify the qualifications for obtaining a loan will be denied a loan with the result that fewer non-performing and default loans will occur and the value of assets will not fall as a result of non-performing loans. Another rule of thumb directing the corporate governance of Islamic financial institutions is the fact that the financier’s liabilit is constrained by the capital put up. The entrepreneur’s liability is limited to work and resoruces used. However, if there is negligence or poor management on the part of the entrepreneur, the latter will be liable to redeem the economic loss to the financier. 32 In this regard, corporate governance in Islamic financial institutions go beyond imposing obligations on the financial institution by placing responsibilities for the governance of funds to those who receive them for a specific purpose. This aspect of the corporate governance of Islamic financial institutions lowers the risk associated with default repayment of loans. An entrepreneur who is aware of potential liability will ensure that he or she manages and uses the funds obtained from the financial institution in a manner that is efficient, lawful and effectie. Thus the risk of default laons is reduced. Essentially, Islamic financial institutions are required to implement and follow the “best practices of corporate governance” and they are also accountable to the Shariah Supervisorry Board.33 The Shariah Supervisory Board is both “supervisory and consultive” and only highly qualified scholars are permitted to sit on the board.34 Under the supervision and with consultation with the Shariah Supervisory Board, financial institutions are required to ascertain that all investments and business transactions are first approved by the Shariah Supervisory Board. Managers and directors of Islamic financial institutions are also required to report to and ascertain to the Shariah Supervisory Board that the investment and/or business transactions previously approved by the board adhere to the “forms previously approved by the religious board”.35 In this regard, the Shariah Supervisory Board can be seen as an independent audit of financial institutions. However, the audit goes further to approve an initial project and then follows up with periodic checks and balances. In addition to following Shariah Supervisory Board’s guidance for corporate governance, Islamic financial institutions are required to adhere to a the Accounting and Audition Organization for Islamic Fiancial Institutions, accounting standards for the jurisdiction in which the Islamic financial institution operated and any applicalbe laws and regulations of that jurisdiction.36 A Shariah audit or review is conducted by the Shariah Supervisory Board and this review is conducted for the purpose of ensuring that Islamic financial institutions are complying with Shariah laws and principles. The review therefore includes a review of contracts, informa agreements, products, transactions, policies, mergers and acquisitions, financial statements, circular and reports.37 It therefore follows that for Islamic financial institutions the main concern is that practices and policies are Shariah-compliant and this is the main basis of corporate governance frameworks in Islamic financial institutions. As previously noted above, Islamic financial institutions interact with and come into contact with conventional financial institutions. Therefore, it will be necessary for Islamic financial institutions to take an approach to corporate governance that also safeguards against the risks that associated with international finance. As it is now, the emphanis is on risks associated with non-Shariah principles. The Need to Improve the Corporate Governance Legal Framework of Islamic Financial Institutions The corporate governance framework of Islamic financial institutions is built around the stakeholder theory or model of corporate governance. This is manifested by the profit and risk sharing principle which captures and confers upon all stakeholders who bear the risk associated with the business transaction.38 This aspect of corporate governance of Islamic financial institutions is a sound basis for implementing transparency and accountability. It calls upon all participants or users of the funds allocated to be particularly diligent as they are accountable to those who supply the funds and those who supervise the activities. However, the freedom to allocate the funds, the location and the activities provided they are Shariah-compliant activities and the liability for loss accruing to entrepreneurs and depositors are undesirable aspects of the corporate governance of Islamic financial institutions. Although liability for entrepreneurs will only occur in the event of mismanagement or negligence, this could be a factor discouraging entrepreneurship. Likewise, risk-sharing with respect to depositors can be discouraging and thus detrimental to savings. It is difficult to imagine citizens feeling comfortable accepting the risk for pooled profits and investments over which they have no control or input. Despite these shortcomings, Islamic financial institutions’ corporate governance models have come a long way. Originally, Islamic financial institutions did not have an unambiguous legal and/or regulatory framework applicable to Islamic financial institutions. For instance, in a number of countries the conventional prudential regulations were simply used to apply to Islamic financial institutions but did not include any recognition of Islamic features.39 This was unfortunate because the concepts and functional practices and policies of Islamic financial institutions are different from those of conventional financial institutions. However, these special and different features can be problematic for non-Islamic countries offering Islamic financial services. These countries have to comply with local and international standards of corporate governance and at the same time Shariah-compliant corporate governance. Nevertheless, significant progress has been made over the years. To begin with a number of countries have implemented Shariah specific principles for Islamic financial institutions into formal laws and regulatory regimes. In addition a number of international organizations were created for the purpose of adopting traditional standards and for harmonizing policies and practices.40 Some of the notable organizations overseeing and formulating corporate governance for Islamic financial institutions globally are: the Islamic Financial Services Board, the Accounting and Auditing Organization for Islamic Financial Institutions, the International Islamic Rating Agency, the International Islamic Financial Market and the Liquidity Management Center.41 It is important to note that although Islamic financial institutions must focus on Shariah principles since the main function of Islamic financial institutions is to provide Shariah-complaint financial services, there are spillovers from conventional financial services. To state that Islamic financial services need only concern themselves with complying with Shariah principles is an oversimplification of the reality. The reality is that Islamic financial services do not exist in a vacuum. They do co-exist with conventional financial systems. Although Islamic financial institutions on average demonstrated relative resilience to the recent global financial crisis, they did suffer difficulties and losses once the crisis penetrated the real economy. All indications are therefore that, Islamic financial institutions cannot exist risk-free or crisis-free as long as they are tied to and interacting with conventional financial services. Thus there is a dire need to harmonize Shariah-compliant corporate governance with conventional financial services’ corporate governance. This would mean creating independent bodies to monitor, supervise and regulate Islamic financial institutions in a way that makes these institutions more transparent and more accountable to shareholders. Recognizing and accepting that Shariah principles require profit and risk sharing, this feature of corporate governance should be modified to provide greater reassurance to depositors, entrepreneurs and investors generally. This reassurance would be achieved by placing greater responsibilities on management to ensure profits are generated and to safeguard against or at the very least minimize the risk of loss. Unfortunately, risk loss cannot be removed if Islamic financial institutions are offering Shariah-compliant services. However, sufficient safeguards can be put in place to minimize the risk of loss to entrepreneurs, depositors and investors. Conclusion Good corporate governance is a fundamental requirement for the growth and success of Islamic financial institutions.42 It is necessary for Islamic financial institutions to be regulated in a way that facilitates the use of conventional banking services and at the same time, allows for consistency with Shariah principles. 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