GOVERNANCE OF ISLAMIC

BANKS
Volker Nienhaus
 Opaqueness and agency problems in
banking
Usually ownership and management are separated, and managers
who control the resources of a company have a better knowledge
of its status, risks and opportunities than the owners.
The separation of ownership and control combined with
information asymmetries gives rise to various agency problems
The core issue of governance of a corporation is how to ensure that
managers will use a companys resources in the interest of the
shareholders.
Because of banks specifics, governance issues are more relevant in
this sector than in other industries.
It is widely accepted that banks are opaque institutions and that
information asymmetries between insiders and outsiders are
pronounced, especially with respect to the risk characteristics and
the quality of the assets
 The usual remedy for agency problems incentive contracts does
not go well in banking: not only are outcomes difficult to measure,
but they are also relatively easy to influence or to manipulate by
managers.
However, not only may the shareholders capital be put at risk by
management decisions, but in the case of insolvency also
outside capital provided by debt holders (creditors) and, in
particular, depositors.
Corporate governance shall be seen as the methods by which
suppliers of finance control managers in order to ensure that their
capital cannot be expropriated and that they earn a return on their
investment .
Because of the peculiar contractual form of banking, corporate
governance mechanisms for banks should encapsulate depositors
as well as shareholders (Arun and Turner, 2003, p. 5).
 Governance structures of conventional and
Islamic banks do not only differ with respect
to the status of the depositors. In most Islamic
financial institutions, an additional body is
part of the governance structure which has no
counterpart in conventional banks, namely the
Sharia Supervisory Board (SSB). Figure 1
summarizes the stylized governance structures
of conventional and Islamic banks.
 Profit-and-loss sharing deposits
(investment accounts)
In a conventional banking system with effective
competition for depositors funds, the income interests
of depositors are safeguarded by this competition, and
regulations dealing with capital adequacy and deposit
insurance protect the principal amount of their
deposits. Thus the resolution of conflicts of interest
between depositors and management on the one hand
and depositors and shareholders on the other hand
does not require too many benevolent discretionary
decisions by managers and shareholders but is widely
enacted by market forces and state regulations.
 This is very different in Islamic banks. First, there is a
fundamental conflict of interest between Islamic depositors
and shareholders: both parties share (substantial parts of)
the banks profit, and this implies a distribution conflict.
In many Islamic countries where conventional and Islamic
financial institutions coexist, the market is dominated by
conventional banks, the number of domestic Islamic
financial institutions is very small (often fewer than five),
and the regulated financial markets are not open for an
outflow of funds or for an inflow of international
competitors (with only a few exceptions such as Bahrain,
the United Arab Emirates and Pakistan).
Very often the benchmarks for Islamic products, including
Islamic deposits, are taken from the conventional interest-
based sector and are applied in analogy to Islamic products.
For example, the return on Islamic deposits is roughly kept
in line by management decisions with interest earned on
conventional deposits
 Smoothing returns
Another practice deserves attention from a
governance perspective: the returns for Islamic
deposits seemingly fluctuate less than the income
generated by the employment of the funds on
Islamic deposit accounts. The reason is that the
management has recourse to smoothing
techniques which allow it to delink the profits
allocated to depositors in a given period from the
investment returns of the same period and to
keep the Islamic returns in line with movements
of the benchmark interest rate.
 Smoothing techniques: the variation of
reserves and the commingling of funds
Islamic banks can create a profit equalization reserve. In a
period of high returns, the management can decide to transfer
parts of the income and profits from the investment of Islamic
deposits to the reserve in that period. In the opposite case,
that is, in a period of low returns, the management can decide
to reduce the reserve, thus increasing the amount available for
distribution in that period.
Many Islamic banks dispose of a relatively large volume of
return-free deposits on current accounts. After catering for a
sufficient liquidity reserve, the bank may invest the remainder
and generate an income. This income is not due to the
depositors; rather it increases the profits due to the
shareholders. The current account deposits must not be
invested separately but can be commingled with investment
account deposits or/and shareholders funds.
 Erosion of Islamic distinctiveness and
systemic opaqueness
Smoothing of investment account returns implies a governance
problem at the systemic level, assuming that shareholders and
Islamic depositors are interested in an Islamic financial system
which is clearly distinct from conventional banking and which
follows its own logic.
A core concept of Islamic finance is that of an equitable sharing of
profits and losses or of risks and chances between the providers
and the users of funds. The practice of smoothing returns moves
the system in the opposite direction. It is not only that smoothing
emulates fixed returns on deposits, it also links the Islamic deposit
business economically to the interest-based system.
If Islamic banks expand from small niche markets and develop
highly profitable new investment avenues, conventional banks will
soon be attracted, and any competitive advantage of Islamic banks
will be eroded.
Indications for increasing emulation of
conventional finance
The State Bank of Pakistan had published an exclusive list of all
permissible sharia-compliant modes of finance. The banks
combined two individually approved modes of financing which
were intended for very different purposes, namely mark-up
financing (intended for trade financing) and the purchase of
property with a buy-back agreement (intended for the creation of
securities in long-term fixed asset and real estate financing), in such
a way that they clearly circumvented the prohibition of riba (Akhtar,
1988, p. 185):
Islamic banking was introduced in Iran by the Law on Usury-Free
Banking in 1983 (Aryan, 1990; Taheri, 2004). This law allows
transactions which are deemed interestbased in other parts of the
world, as the discounting of trade bills, the charging of service fees
proportional to the amount of a financing, the obligation of banks
to repay the principals of interest-free savings deposits and the
possibility to insure the principals of term investment deposits.
 Banks in Sudan applied for a couple of years murabaha financing without
a fixed respondent with a variable mark-up and with flexible redemption
periods so that the costs of financing were determined by the length of
time to maturity, which comes close to interest-based loans (Stiansen,
2004).
The sharia framework is set by a National Sharia Advisory Council at the
Bank Negara Malaysia (the central bank). This sharia council has approved
several financing techniques and capital market instruments which are
very controversial and rejected by many sharia experts in the Arab world.
A new financial product is gaining rapidly in popularity amongst Islamic
banks in the Arab world and the Islamic departments of Western financial
institutions: sukuks. The idea behind sukuks is to create standardized
asset-backed securities with predictable nominal returns to be issued by
private or public entities and traded on a secondary market. Obviously
there is a need for a sharia-compliant substitute for interest-bearing
bonds (Al-Amine, 2001).
 Independence of sharia supervisory
boards
The answer to this puzzle requires a more
detailed assessment of the role of the sharia
supervisory boards (SSBs) in the governance
structure of Islamic banks (Bakar, 2002).
The Accounting and Auditing Organisation for
Islamic Financial Institutions (AAOIFI) has
issued the Governance Standard.
 According to this standard, every
Islamic financial institution will
1.
have an SSB which
is an independent body of specialized jurists in fiqh almuamalat (Islamic
commercial jurisprudence),
2. is entrusted with the duty of directing, reviewing and supervising the activities
of the Islamic financial institution in order to ensure that they are in compliance
with Islamic Sharia rules and principles,
3. can issue fatwas and rulings which shall be binding on the Islamic financial
institution,
4. shall consist of at least three members who are appointed by the shareholders
. . . upon the recommendation of the board of directors (not including directors
or significant shareholders of the Islamic financial institution),
5. shall prepare a report on the compliance of all contracts, transactions and
dealings with the sharia rules and principles,
6. shall state that the allocation of profit and charging of losses related to
investment accounts conform to the basis that has been approved by the SSB;
finally,
7. shareholders may authorize the board of directors to fix the remuneration of
the Sharia Supervisory Board.