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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 2 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 3 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 4 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 5 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 – – – – 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 6 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) ? 7 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 8