Corporate governance in the Islamic finance industry
(This article was first published in Islamic Finance news Volume 14 Issue 49 dated the 6th December 2017)
The classic definition of corporate governance is found in the first version of the UK Corporate Governance Code, which was produced in 1992 by the Cadbury Committee, and which has influenced the development of corporate governance codes for listed companies in other jurisdictions.
Corporate governance is the system by which companies are directed and controlled to ensure the long-term success of the companies. Safeguarding stakeholders’ interest in conformity with public interest on a sustainable basis is recognized as the primary objective of corporate governance in banking, according to the Basel Committee on Banking Supervision. The rights of stakeholders established by law or through mutual agreements are protected in the G20/OECD Principles of Corporate Governance 2015.
Guidance and regulation for corporate governance should also consider the ethical dimensions of governance mechanisms to be fit for the purpose of supporting the sustainability agenda. Considering ethical perspective and for a broader definition, corporate governance can be viewed as ethical mechanisms or norms to ensure companies act in the interest of stakeholders. It is beyond compliance with rules of law, regulations and code of ethics or best practices. The greatest obstacle to walking this talk is the conflict of interest among stakeholders. The Islamic finance industry is not immune to this problem although it is governed by Shariah law in some parts of the world.
While interest on lending/borrowing is undoubtedly prohibited, the interests of stakeholders in the Islamic finance industry are heterogeneous and ambiguous. Despite continuous criticisms, the profit maximization objective, as the backbone of conventional finance, has fueled global economic growth. Islamic finance on the other hand is often distinguished in the literature for pursuing a social interest objective but this notion has been overshadowed by some controversial aspects of the actual practice.
The following are some critical governance questions in relation to the present state of the Islamic finance industry: how do we assure ourselves that Shariah supervisory boards (SSB) are sufficiently independent from financial incentives and strive purely for Maqasid Shariah? Are we convinced that shareholders and managers of Islamic banks are not solely driven by financial incentives? How do we motivate Islamic banks to be genuinely interested in risk sharing instead of fixed returns? How do we mitigate the moral hazard risk in partnership to make profit/loss/risk sharing a preferred form of financing? How do we ensure that financial capital raised through Sukuk is not misallocated to serve privately organized interest at the expense of widely diff used stakeholders?
The industry that promotes social interest should strive to immune itself from corruption and seriously address the widening gap between the rich and the poor. Corruption and the widening gap between the rich and the poor are common problems of mankind. The ‘financialization’ culture poses a great challenge to governance. The industry should treat money as a medium of exchange (not commodity) and facilitate the circulation of money for productive purposes to benefit the masses instead of it being hoarded and laundered by a few.
The role of education is important to ensure stakeholders really understand the fundamental principles of Islamic finance rather than being overwhelmed by slogans of little significance. Although the different schools of thought that contributed to the diversity in practice can be viewed as a fundamental source of conflicts of interest, it is wise to explore and capitalize on similarities for common benefits rather than ego trips. Effective engagement with non-Muslim stakeholders is also important to convince them that their interest will be better served through Islamic principles.
Failing to practice what is preached will expose the industry to misrepresentation. Islamic instruments should be accounted according to the intended nature instead of being regulated as conventional instruments. Murabahah financing contracts have casually presented obvious symptoms of artificiality, with banks failing to acquire the underlying assets and assuming no business risk. The legal uncertainty of Sukuk questions the governance of the industry. The integrity of the Shariah supervisory board (SSB) is key to mitigating Shariah compliance risk. A failure to mitigate the moral hazard risk will only place the industry’s sustainability at risk.
Transparency is commonly recognized as a key underlying principle of good governance. The adequate transparency of the remuneration of SSB members is important to mitigate unintended consequences of financial incentives – a lesson that can be learned from the global regulatory reform post-crisis 2007-08. SPVs often described as trustees to Sukukholders should be made transparent and sufficiently remote from originating companies. Confidentiality as a guiding principle on Shariah governance is feared to expose the industry to abuse by unknown parties.
The Islamic finance industry needs convincing governance mechanisms to mitigate conflicts of interest and to command the global stage. A well-dressed corporate form does not necessarily imply good governance quality. The prescription is beyond rules, guidance and slogans. The governance should be focused on substance over form and incentivized by the right intentions.
The growing vocabulary in Islamic finance literature will not achieve much if the practice is substantially driven by conventional markets. The industry is undeniably exposed to market competition. The challenge is whether stakeholders are comfortable to use Darurah for convenience, or they will strive hard to be genuinely distinctive and contribute differently. Is Islamic finance a pot of gold or for the purity of soul?
