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Islamic Finance :
Opportunities & Challenges
Corporate Governance Issues
World Bank Seminar,
Washington DC, April 24 2006
Simon Archer
Professor, University of Surrey, UK
Consultant, IFSB
Corporate Governance Issues
Focus of this talk:
– Banks rather than insurance cos.
• Unrestricted IAH as stakeholders
– Ambiguous status
– Information rights
– Control rights
• Cross-border Shari’a compliance: home-host issues
• Operating environment: emerging markets
– Concentrated shareholders, ‘grey’ directors and related party
transactions
– Lack of market discipline & weak information environment
– Government interference
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Unrestricted IAH as stakeholders
Ambiguous status
• Profit-sharing investors or ‘depositors’?
– Conventional depositors
• Don’t need control rights except as creditors in an insolvency
• Have very limited information needs as their capital is
guaranteed and their rate of return established by contract
• Basically only need to know that bank is solvent
– Unrestricted IAH as Profit-sharing investors
• Have same information needs as shareholders
– Risk and expected return
• What about their control rights?
– Conventional interpretation of Mudaraba gives them
none, except right to withdraw their funds subject to
forfeiting share of profits
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Unrestricted IAH
Assumption that they are passive investors
• Can they rely on shareholders to monitor
management on their behalf?
– Possible conflicts of interest e.g. re risk appetite
• If not, what is appropriate?
– Information rights: similar to those of CIS participants
• Asset allocation, risk & profitability
• But also: profit allocation & use of reserves (PER/IRR)
– Control rights: IFSB ED3 Governance Committee
suggestion
• Requires no active participation from IAH
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Cross-border Shari’a Compliance:
Home-Host Issues
Applicable Shari’a rulings may differ between the country of
the parent bank and that of a foreign operation (branch
or subsidiary)
• Which rulings should be valid for the foreign operation?
– If host country has a National Shari’a Authority (e.g. Malaysia or
Sudan) then foreign operation is bound to follow its rulings
– If home country has a National Shari’a Authority, but host
country does not, does foreign operation have to follow home
country rulings?
• Probably yes if branch
• But if subsidiary, with own Shari’a Board?
– If both countries have National Shari’a Authorities?
• Need for cooperation between the 2 countries to resolve
conflicts
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Operating Environment (1)
Concentrated shareholders
• May dominate Board of Directors
• Non-execs may not be independent
• Risk of related party transactions that may damage the
bank
–
–
–
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Danger for minority shareholders and IAH
Need for transparency (financial reporting standards)
How much reliance can be placed on external auditors?
Key role of banking supervisor
• ‘fit & proper’ tests
• Monitoring of dominant shareholdings
• Risk of pressure on supervisor
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Operating Environment (2)
Lack of market discipline & weak info. environment
• Aggravates problems just mentioned
• Need for regulatory authorities to be pro-active to
‘bootstrap’ info. environment and mkt. discipline
• May be problematic
– Govt. control of, or pressure on, banks’ commercial activities is
likely to impede mkt. discipline
– Conflict between (a) govt. concern with macro & social role of
banks in eco dev and (b) development of robust banking system
– Islamic banks not essentially different from conventional banks in
this, but may be more vulnerable
• Financing modes may be more risky but can the risk be
priced for (e.g. Salam) ?
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Concluding Remarks
• Burden on banking supervisors & regulators to
enable the issues outlined above to be handled
successfully
• IFSB’s efforts to provide support
– Issued: Standards on Risk Management, Capital
Adequacy, ED on Corporate Governance
– In progress: EDs on Supervisory Review Process
and Transparency & Market Discipline; +
complementary standards
– Seminars on the above
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