Shari’ah Frameworks of Islamic Corporate Governance

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

INTRODUCTION

Corporate governance in financial institutions has been analyzed almost exclusively in the context of conventional commerce industry. For example, there has recently been some discussion of the role 'market discipline' exerted by bank shareholders and depositors in constraining the risk taking behavior of bank management. At the same time, according to Nasser M. Suleiman (2000) there is growing interest in banks as stockholders in companies themselves playing a central role in corporate governance, in countries with universal banking structures of the traditional type.

By contrast, little is written on governance structures in Islamic banking and other Islamic financial institutions, despite the rapid growth of Islamic banks since the mid 1970s and their increasing presence on world financial markets. There are now over 180 financial institutions world-wide which adhere to Islamic banking and financing principles. These banks operate in 45 countries encompassing most of the Muslim world, along with Europe, North America and various offshore locations.

Islamic banking represents a radical departure from conventional banking, and from the viewpoint of corporate governance, it embodies a number of interesting features since equity participation, risk and profit-and-loss sharing arrangements from the basis of Islamic financing. Quoting the definition by D r Zeti Akhtar Aziz (2002), “corporate governance involves the manner in which the business and the affairs of the individual banking institutions are being governed by their board of directors and senior management, how the economic returns are generated to the owners, the day-to-day running of the operations of the business and the consideration of the interests of recognized stakeholders including depositors; and how they behave in a safe and sound manner, in compliance with applicable laws and regulations.”

2.0 CORPORATE GOVERNANCE

Corporate Governance is a set of organizational arrangements whereby the actions of the management of a corporation are aligned as far as possible with the interests of its stakeholders.

The definition of corporate governance as adopted by Malaysia is “the process and structure used to direct and manage the business and affairs of the company toward enhancing business prosperity and corporate accountability with the ultimate objective of realizing long-term shareholder value, while taking into account the interest of other stakeholders”.

These arrangements include:

Stakeholders are those who have certain rights with respect to the corporation

ECD Principles of Corporate Governance defines Corporate Governance as involving “a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate Governance also provide the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.

Stakeholders are groups or individuals who can significantly affect or are significantly affected by an organization’s activities. 1 Stakeholders include employees, customers, supplies and the community. Due to the unique role of banks in national and local economies and financial systems, supervisors and governments are also stakeholders.

Transparency, accountability and disclosure are three important matters in corporate governance. The concept of corporate governance was put forward as a result of increasing awareness on the importance of the need to protect the rights of all stakeholders, including minority shareholders.

Islam is comprehensive religion. Thus, the term corporate governance is relatively new; however, the concept is not alien to Islam.

The Qur’an mentioned in the verses 282 and 283 of Surah al-Baqarah. It is detailed justification about step-by-step process that should be taken when carrying out a transaction.

“O ye who belive! When we deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writting let a scribe write down faithfullyas between the parties let not scribe refuce to write. Let him who incurs the liability dictate, but let him fear his Lord God, and not diminish aught of what he owes”

(al-Baqarah 282)

“And if one of you deposits a thing on trust with another let the trustee (faithfully) discharge his trust, and let him fear his Lord. Conceal not evidence, for whoever conceals it – his heart is tainted with sin. And God knoweth all that ye do”.

(al-Baqarah 283)

The verses mentioned the essential of proper record-keeping (book keeping) so no party involved suffers unfairness. The message implicit behind this verses is the need for transparency and disclosure in business dealings.

This is an essence two of the important underlying principles of contemporary corporate governance.

Another important aspect of corporate governance is accountability. According to Oxford, accountability means liability to give account for something to somebody or duty to provide an account reckoning those action for which one is held responsible. On this matter, the Prophet Muhammad SAW was reported in one Hadith as saying that :

“Each one of you is a guardian, and each guardian is accountable to everything under his care”.

As such, if this tradition of the Prophet were to be translated into modern business dealings, all persons involved in business transactions are indeed accountable or responsible for all their behaviors.

In the practical sense, corporate governance involves the tools of how corporations should perform their responsibilities to their shareholders as well as other stakeholders.

3.0 ISLAMIC CORPORATE GOVERNANE

THE ISLAMIC FINANCIAL INSTITUTIONS

Governance structures are quite different under these Islamic banking because the institution must obey a different set of rules - those of the Holy Qur'an - and meet the expectations of Muslim community by providing Islamically acceptable financing modes. These profit-and-loss sharing methods, in turn, imply different relationships than under interest-based borrowing and lending of conventional banking.

There are two major differences from the conventional framework. First, and foremost, an Islamic organization must serve God. It must develop a distinctive corporate culture, the main purpose of which is to create a collective morality and spirituality which, when combined with the production of goods and services, sustains the growth and advancement of the Islamic way of life.

To quote Janahi (1995), “Islamic banks have a major responsibility to shoulder ....all the staff of such banks and customers dealing with them 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”.

There are equivalent obligations upon employees. “The staff in an Islamic bank should, throughout their lives, be conducting in the Islamic way, whether at work or at leisure” (Janahi, 1995, p.28).

Further, obligations also extend to the Islamic community. According to him, “Muslims who truly believe in their religion have a duty to prove, through their efforts in backing and supporting Islamic banks and financial institutions, that the Islamic economic system is an integral part of Islam and is indeed for all times ... through making legitimate and halal profits”.

Second, interest-free banking is based on the Islamic legal concepts of mudaraba (profit-sharing) and musyaraka (partnership). An Islamic bank is conceived as financial intermediary mobilizing savings from the public on a mudaraba basis and advancing capital to entrepreneurs on the same basis.

A mudaraba can be defined as contract between at least two parties whereby one party, the financier (sahib al-mal), entrusts funds to another party, the entrepreneur (mudarib), to undertake an activity or venture. This type of contract is in contrast with musharaka.

vcIn arrangements based on musharaka there is also profit-sharing, but all parties have the right to participate in managerial decisions. In mudaraba, the financier is not allowed a role in management of the enterprise. Consequently, mudaraba represents a profit and loss sharing contract where the return to lenders is a specified share in the profit/loss outcome of the project in which they have a stake.

In interest lending, the loan is not contingent on the profit or loss outcome, and is usually secured, so that the debtor has to repay the borrowed capital plus the fixed interest amount regardless of the resulting yield of the capital.

Under mudaraba, the yield is not guaranteed in profit-sharing and financial losses are borne completely by the lender. The entrepreneur as such losses only the time and effort invested in the enterprise. This distribution effectively treats human capital with financial capital equally.

Under musharaka, the entrepreneur adds some of his own to that supplied by the investors, so exposing him to the risk of capital loss. Profits and losses are shared according to pre-fixed proportions, but these proportions need not coincide with the ratio of financing input. The bank sometimes participates in the execution of the projects in which it has subscribed, perhaps by providing managerial expertise.

The two methods according to Nasser M. Suleiman (2000), conform fully to Islamic principles, that under both arrangements lenders share in the profits and losses of the enterprises for which funds are provided and partnership is involved. The musharaka principle is invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership.

4.0 GOVERNANCE STRUCTURES

A distinct feature of Islamic banks vis-à-vis conventional banking is the requirement to set-up a Syariah Advisory Council (SSC) within the Islamic bank. From the perspective of corporate governance, the establishment of Syariah advisory council is important to instill public confidence on the purity of the operations of the Islamic banking institutions.

According to Dr. Zeti (2002), the SSC serves as a check and balance to ensure that the management and operations of the Islamic banking institutions does not deviate from the Islamic principles in the formulation of the policies. Towards this end, Bank Negara Malaysia for instance, has drawn up the guidelines to strengthen further the existing Syariah advisory committees at Islamic banking institutions. Amongst others, the guidelines outline the role and responsibilities of the Syariah advisory committee of the Islamic banking institutions with the view to ensuring that the decision-making process that require Syariah inputs have undergone the necessary thorough and rigorous process.

On the other hand, Nasser M. Suleiman (2000) has outlined a conceptual framework of corporate governance for Islamic banks. Central to such a framework is the SSC and the internal controls which support it.

The SSC is vital for two reasons. First, those who deal with an Islamic bank require assurance that it is transacting with Islamic law. Should the SSC reports that the management of the bank has violated the sharia, it would quickly lose the confidence of the majority of its investors and clients. Second, some Islamic scholars argue that strict adherence to Islamic religious principles will act as a counter to the incentive problems outlined above.

The argument is that the Islamic moral code will prevent Muslims from behaving in ways which are ethically unsound, so minimizing the transaction costs arising from incentive issues.

5.0 SUMMARY

Our mission is to build up a dynamic Islamic financial system which to realize the ultimate objective for Islamic finance that contributes significantly toward the overall development of our economies. The Shariah framework as guidelines should be followed as well as achieving through implementation process to facilitate trade, business and investment. The Shariah is one of the issues towards developing a dynamic Islamic financial.

Thus, the Shariah should always be looked as an enabler to innovation and creativity rather than constraint. Islamic finance is still at its early stage of development. Therefore, there is a need of efforts to be enhanced to fully appreciate and maximize the true potential and wisdom of the Shariah. The collaboration among the Shariah scholars, practitioners, researchers, and regulators to undertake in-depth studies and research to create new product will provide the basis towards the development of a dynamic Islamic financial system.

Finally, the good framework of Islamic corporate governance implements sound regulation and supervision. It gives contribution towards giving confidence and strengthening transparency and accountability. Its emphasis is to be value-oriented and promoted justice and fairness with respect to all stakeholders.