Question

Corporate governance is an essential ingredient for the development of a sound Islamic finance industry. It abides Islamic financial institutions with a set of Sharia compliance rules to govern their operations and transactions as well as to monitor and supervise the roles of all players within the banking system.

To ensure that Islamic banks comply with the appropriate Sharia rulings, the services of religious boards known are employed. The Sharia board plays a vital role of supervision and consultation.

Critically evaluate the role of the Sharia Board in Islamic banks and provide examples of the tasks they carry out. (850 words)

Answer 1

Corporate governance in Islamic banks

Corporate governance is an essential ingredient for the development of a sound Islamic finance industry. It abides Islamic financial institutions with a set of Shari’ah compliance rules to govern their operations and transactions as well as to monitor and supervise the roles of all players within the banking system. Islamic financial institutions are subject to an additional layer of governance since the suitability of their investment and financing must be in strict conformity with Islam and the expectations of the Muslim community. Transparency and adherence to accepted standards is crucial to the success of good governance in Islamic banks as they would help to the innovation and progress of new and complex financial products in a more regulated environment. Therefore, all Islamic banks must follow standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) to take account of good corporate governance and risk management.

Islamic banks have special characteristics and special risks inherent to the multitude of their stakeholders and the nature of their activities and products which require particular care in designing their corporate governance mechanisms. The adoption of sound corporate governance standards and practices ensures that Islamic banks are managed safely and soundly where risk taking activities and business prudence are appropriately balanced so as to maximise shareholders’ returns and protect the interests of all stakeholders. The broad range of financial activities of Islamic banks that cover equity holding, leasing and credit purchase finance on a mark-up basis imposes additional constraints such as sitting on the Board of Directors of firms where they hold equities. They will be therefore able influence the corporate governance mechanisms of other firms.

Regulation and supervision

Banking regulation and supervision is an important factor for economic development, efficiency, and stability. Banking regulations enclose all mechanisms to conduct and structure banking activities, this includes the requirements regarding different processes such as entry into banking, internal/external auditing, liquidity and diversification, provisioning, etc.; While the role of supervision of banking activities is to prevent crises or to mitigate their effects and to strengthen public confidence in the banking system, by defining the objective means to support sound and safe discipline for the development of banks. The supervisory objectives may cover functions like inspection programme to ascertain whether the financial strength of the bank is being maintained on an ongoing basis, industry sound practices, examination procedures and examination of trading operations, capital-markets banking activities and risk management issues encountered in trading and dealer operations (Regulation and Supervision, Corporate Governance and Financial Accounting of Islamic Banks; IIBI; 2009). The supervisory authority carries out persistent checks on compliance with the regulations. The supervisory authority obliges uncovers the bank to correct any revealed shortcoming; otherwise it could revoke the bank´s licence or impose conservatorship. Therefore, some countries make bank directors legally liable if information is erroneous or misleading. Some supervisory agencies also compel banks to produce accurate, comprehensive and consolidated information on the full range of bank activities and risk-management procedures.

Similar to the conventional banking system, regulation in the Islamic banking industry is needed to maintain confidence in that new system as a whole; it helps increasing the information available to investors, protecting interests of savers and ensuring the safety and soundness of the financial system. Conventional regulations may be reformed to ensure development of a financial market infrastructure for Shari´ah-compliant investment instruments, to provide cost-effective alternative funding in conformity with best international practices; and to enforce the role of central bank as lender of last resort (Regulation and Supervision, Corporate Governance and Financial Accounting of Islamic Banks; IIBI; 2009). In fact, central banks and regulators can play a key role for the development of a framework for monetary policy that is conform with Shari’ah principles to enable Islamic banks to operate within a fair playing field. External regulators also need be flexible and to work with actors of the industry in order to familiarize with their specific needs. Supervisors have also to position themselves to recognise the new dimensions and types of risks in Islamic financial transactions and encourage appropriate risk mitigation that is coherent with the faith-driven feature in the Islamic banking.

In addition, recent national and international reforms implemented in bank regulation and supervision, such as Basel II regime, developed an extensive list of best practices that have huge implications for Islamic banks. Islamic banking risks come within the recognition of Basle II pillar covering credit risk, market risk, operational risk and the pillar covering governance, capital management, liquidity risk. However, the challenge for Islamic banks is how should other Islamic banking risks, such as Shari’ah compliance risk, fiduciary risk and the rate of return risk, be deal with in an overall Basel II framework to improve the safety and soundness of the system.