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8/13/2019 IDB Lecture Series IFSB

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GUIDING PRINCIPLES ON CORPORATE

GOVERNANCE OF INSTITUTIONS OFFERINGISLAMIC FINANCIAL SERVICES (IIFS):

An Insight of the Exposure Draft

Madzlan Mohamad Hussain

Project Manager

IDB Lecture Series

23 May 2006


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Presented at the IDB Lecture SeriesCopyright reserved IFSB 2006

23 May 2006

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PRESENTATION OUTLINE

Defining CG and stakeholders in thecontext of institutions offering Islamic

financial services (IIFS)

Corporate Governance (CG) issues

specific to IIFS

An insight of the Exposure Draft of the

IFSB Guiding Principles of CG for IIFS

(ED3)


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DEFINING CORPORATE GOVERNANCEA defined set of relationships between a companysmanagement, its Board of Directors, its shareholders and

other stakeholders which provides the structure throughwhich:

the objectives of the companyare set; and

the means of attaining those objectives and monitoring

performance are determined.

In the context of IIFS, good CG should encompass: a set of organisational arrangements whereby the actions

of the management of IIFS are aligned, as far as possible,

with the interests of its stakeholders;

provision of proper incentives for the organs of

governance such as the Board of Directors, SSB andmanagement to pursue objectives that are in the interests

of the stakeholders and facilitate effective monitoring,

thereby encouraging IIFS to use resources more

efficiently; and

compliance with Islamic Shar`ahrules and principles.


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DEFINING STAKEHOLDERS

BCBS paper:

Stakeholders include employees, customers,suppliers and the community. Due to the unique

role of banks in national and local economies and

financial systems, supervisors and governments

are also stakeholders [of banks].

From Islamic financial services perspective:

Community should particularly connotes theMuslim Ummah.

Customers does not refer to conventionaldepositors and borrowers but to Investment

Account Holders (IAH) and Current Account

Holders.


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ISLAMIC VIEWPOINTS ON IMPORTANCE

OF GOOD GOVERNANCE

The concept of vicegerency - Accountability to

God as well as to others. Ethics of IIFS are set

out not only in contracts and residual contracts

but ultimately accountability to God.

Amongst the code of ethics set out in the

Quran: Honest fulfilment of all contracts (Al-Midah:1)

Prohibition against betraying any trust (Al-Anfl:27)

Prohibition against deriving income from cheating,

dishonesty or fraud (liImrn:29)

Prohibition against bribery to earn unfair advantage (Al-

Baqarah:188)

Prohibition against concealing evidence (Al-Baqarah:283),

for e.g. to manipulate prices


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SPECIFICITIES OF IIFS

In addition to general banking matters, organs of

governance of IIFS also need to attend to: Shar`ahcompliance

Ethics & social responsibility (in line with the

concept of vicegerency)

Interests of IAH, especially unrestricted Potential conflicts of interest between shareholders

and unrestricted IAH especially where the funds

are commingled - issues of asset allocation & riskappetite

Transparency in financial reporting, e.g. calculation

of Murib share (where funds are commingled)and profit distribution


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CORPORATE GOVERNANCE ISSUES

IN IIFS Protection of Investment Account Holders (IAH)

Like investors in Collective Investment Schemes (CIS), IAHare exposed to potential conflict of interest with the

management of an IIFS, which may look after the interest of

shareholders at the expense of IAH.

As in the case of securities regulators, this requires more

emphasis on fiduciary responsibility or establishment of

detailed regulations designed to monitor potential conflicts of

interest.

Furthermore, adequate disclosure of relevant information

about the IIFSinvestment objectives and policies, operationalguidelines that govern the relationship between the IIFS and

IAH, etc. should be made available. Albeit IAH may have no representation in the organs of

governance such as the Board of Directors or Shar`ahSupervisory Board, they have every right to expect

accountability and transparency on investment made on their

behalf.


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Shar`ahSupervisory Board (SSB) SSB is a specific organ of governance. It should be

concerned with monitoring Shar`ah compliance and notjust issuing fatwas.

Since SSB members may lack monitoring skills, auditors and

audit committee should act in concert to assist SSB.

Transparency in financial reporting The current financial reporting practices of IIFS do not

provide adequate information to their IAH regarding the

revenues and expenses accruing to their particular

investment fund

IAH is rightfully entitled to transparency, e.g. calculation ofMuribshare and profit allocation

CORPORATE GOVERNANCE ISSUES

IN IIFS (2)


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CURRENT STATUS OF CG AWARENESS

AMONGST IIFS (1)IDB Survey (2002) highlights:

Majority of the regulators of IIFS share the view that thereis no difference between the risks involved in thebusiness of IIFS and conventional banks. This perceptionmay explain why for most regulators there is no

justification to establish separate regulatory regime and

supporting institutions for IIFS. The status of corporate governance in IIFS is influenced

by internal and external factors.

Majority of the IIFS (57.1%) are good in their overallcorporate governance status. 14.3 % are excellentwith21.4% are fair and only 7.1% are poor in their overallcorporate governance status.

[Note: This may be a rather flattering characterisation. Itdepends on the criteria for this judgement. The IFSBs criteriaare surely more demanding.]


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CURRENT STATUS OF CG AWARENESS

AMONGST IIFS (2)IFSB Survey (2004) highlights:

Strong awareness amongst IIFS on theimportance of good governance.

Majority IIFS offer only unrestricted IA, and evenfor those offering restricted IA they do not address

the IAHsrisk appetite. Smoothingof returnshas not been proven as a

widespread practice, however it is appropriatethat the practice be accepted with caution in orderto avoid it being used to mislead the IAH on the

performance of the IA. SSB have become almost a compulsory feature of

Islamic finance. However their cost and efficiencycontinue to be a major concern.


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SCOPE OF THE ED (1)

CG aspects already covered OECD BCBS IOSCO FRC/FSA

Companies

Directors/The Board

Remuneration/Compensation

Accountability and Audit

Relations with Shareholders

Shareholders

Rights and Key functions

Equitable Treatment

Other Stakeholders

Employees/Manager

Regulator/Supervisor

Disclosure and Transparency

The issue of IIFS accountability and transparency to its customers,

particularly IAH , as well as Shar`ahcompliance, have not been covered or

contemplated in any of the above documents.

Filling in the Gaps


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The ED aims to cover these aspects:

Information environment and transparency: specifying and enforcing appropriate disclosure

requirements

fostering auditors independence and enforce therelevant and applicable auditing standards

the focus is very specifically on protection of theIAHs interests not to overlap with generaltransparent reporting which would be covered bythe Transparency and Market Discipline Standard

Organs of governance:

safeguarding interests of IAH, especially theunrestricted

adequate monitoring of Shar`ahcompliance

SCOPE OF THE ED (2)


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General Governance Approach in IIFS 1

Principle 1.1IIFS shall establish a comprehensive

governance policy framework which

sets out the strategic roles andfunctions of each organs of

governance and mechanisms for

balancing their accountabilities to

various stakeholders.


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General Governance Approach in IIFS 2

Principle 1.2IIFS shall ensure that the reporting of

their financial and non-financial

information meets the requirements of

internationally recognised accountingstandards which are in compliance with

Shar`ah rules and principles and are

applicable to the Islamic financialservices industry as recognised by the

supervisory authorities.


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Rights of IAH 1

Principle 2.1IIFS shall acknowledge the IAHsrightsto monitor the performance of their

investments and the associated risks,and put into place adequate means to

ensure that these rights are observed

and exercised.

An example of such means is the proposed Governance

Committee.


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Rights of IAH 2

Principle 2.2IIFS shall adopt a sound investment

strategy which is appropriately aligned

to the risk and return expectations ofIAH (bearing in mind the distinction

between restricted and unrestricted

IAH), and be transparent in smoothing

any returns.


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Sharia Compliance 1

Principle 3.1IIFS shall have in place an appropriate

mechanism for obtaining Shar`ah

rulings, application of fatwas andmonitoring of Shar`ah compliance inall aspects of their products and

operations.


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Sharia Compliance 2

Principle 3.2

IIFS shall comply with the Shar`ahrules and principles as expressed in

the rulings of the IIFSs Shar`ahscholars. The IIFS shall make these

rules and principles available to the

public.


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Transparency of Financial Reporting

Principle 4.1

IIFS shall make adequate and timely

disclosure to IAH and the public, ofmaterial and relevant information on

the investment accounts that they

manage.


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OUTCOMES EXPECTED FROM THE ED

SPECIFICALLY,

Adoption of OECD and BCBS recommendations willimprove IIFS Board and Directors andManagementsawareness of the importance of goodgovernance

Due recognition of IAHsrights and risks as residualclaimants will lead to appropriate protection of IAH

More professional approach for Shar`ahcompliancewill mitigate compliance and reputational risks of IIFS

Increased transparency in financial and non-financial

reporting by IIFS will inculcate better risk

management structure and discipline culture

amongst IIFS


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