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Islamic Finance

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Islamic FinancePrinciples, Performance and Prospects

Edited by

Tina HarrisonUniversity of Edinburgh Business School, UK

and

Essam IbrahimUniversity of Edinburgh Business School, UK

EditorsTina Harrison Essam IbrahimUniversity of Edinburgh University of EdinburghUK UK

ISBN 978-3-319-30917-0 ISBN 978-3-319-30918-7 (eBook)DOI 10.1007/978-3-319-30918-7

©The Editor(s) (if applicable) and the Author(s) 2016The author(s) has/have asserted their right(s) to be identified as the author(s) of this work in accordance with the Copyright, Designs and Patents Act 1988.This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed.The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use.The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made.

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v

List of Figures and Tables vii

Notes on Contributors x

Introduction 1Tina Harrison and Essam Ibrahim

1 Toward a Comprehensive Theoretical Framework for Shariah Governance in Islamic Financial Institutions 10

Siti Normala Sheikh Obid and Babak Naysary

2 Do Customers Patronize Islamic Banks for Shari’a Compliance? 32

Shakir Ullah and Kun-ho Lee

3 Bank Image in the UAE: Comparing Islamic and Conventional Banks 46

Hussein A. Hassan Al-Tamimi, Adel Shehadah Lafi and Md Hamid Uddin

4 Bankers’ Perception towards Bai Salam Method for Agriculture Financing in Pakistan 66

Ahmad Kaleem and Saima Ahmad

5 Bank-Level Stability Factors and Consumer Confidence – A Comparative Study of Islamic and Conventional Banks’ Product Mix 86

Kassim Hussein

6 A Comparative Performance of Conventional and Islamic Unit Trusts: Market Timing and Persistence Evidence 105

Nafis Alam, Kin Boon Tang and Mohammad Shadique Rajjaque

7 Shariah-Compliant Equities: Empirical Evaluation of Performance in the European Market during Credit Crunch 122

Nafis Alam and Mohammad Shadique Rajjaque

8 Awareness of Islamic Banking Products among Muslims: The Case of Australia 141

Hussain Gulzar Rammal and Ralf Zurbruegg

Contents

9 Challenges and Opportunities for Islamic Retail Banking in the European Context: Lessons to Be Learnt from a British–German Comparison 157

Stefan Volk and Markus Pudelko

10 Developing the Islamic Financial Services Sector in Italy: An Institutional Theory Perspective 174

Barbara Petracci and Hussain G. Rammal

Index 190

vi Contents

vii

Figures

1.1 Integrated theoretical framework 25

2.1 Factor plot in rotated space 41

5.1 Consumer confidence in the United States 88

7.1 Annual and overall return of the portfolios. The last cluster of columns show the overall return of the portfolios for the entire three-year period 132

7.2 Cumulative weekly return of the three portfolios over the three-year period from July 2006 to June 2009 133

7.3 Beta of the Shariah and S & P-Fin portfolios. The last set of columns shows the value for the entire three-year period 135

9.1 The determinants of Islamic retail banking (IRB) 163

10.1 Potential operating models of Islamic banking in Italy 182

Tables

1.1 Fundamental assumptions in CG theories and ICG 21

2.1 List of variables 36

2.2 Total variance explained 38

2.3 Rotated factor matrix 40

2.4 Ranking means of the factors 41

3.1 Respondents’ characteristics 54

3.2 Reliability of the categories that influence bank image 55

3.3 Descriptive statistics 56

3.4 Bank preferences of UAE customers 57

3.5 The correlation coefficients between independent variables 57

3.6 Summary of regression results 58

3.7 The results of analysis of variance for Islamic banks and conventional banks 59

List of Figures and Tables

viii List of Figures and Tables

3.8 One-way ANOVA test: the UAE Islamic banks’ customer image and demographic variables 60

3.9 One-way ANOVA test: the UAE conventional banks’ customer image and demographic variables 60

3.A1 Comparison of conventional and Islamic banks 64

4.1 Conventional financing options versus Bai Salam (forward sale contract) 70

4.2 Respondents’ profile 75

4.3 Major hurdles or problems faced by the farmers at the time of obtaining agriculture loans 76

4.4 Eligibility criteria for the loan seekers 77

4.5 Acceptable securities for agriculture financing 78

4.6 Bankers views about Bai Salam (advance purchase of crops) as an agriculture financing model 79

4.7 Bankers views towards the possible risks involved in case of Bai Salam contracts (advanced purchased of crops) 79

4.8 Possible mechanisms to facilitate Bai Salam (advance purchase of crops) 80

4.A1 Supply of agriculture credit by institutions (US $ in millions) 84

5.1 Differentiating features in bank’s product mix 90

5.2 Summary of statistics 97

5.3 Results of fixed effect regressions for GCC countries for 2000–2007 99

6.1a Overall risk-adjusted return of unit trusts applying the Jensen measure 114

6.1b Risk-adjusted return of unit trusts applying the Jensen measure during sub-prime crisis period (October 2007–March 2009) 115

6.2a Overall market timing abilities of unit trust applying the Treynor–Mazuy model 116

6.2b Market timing abilities of unit trust applying the Treynor–Mazuy model during sub-prime crisis period (October 2007–March 2009) 116

6.3 Overall persistence of unit trust performance 117

List of Figures and Tables ix

7.1 Sharpe ratios for the three portfolios 134

7.2 Value of Jenson’s alpha for the three portfolios 135

7.A1 Three-year analysis of data set 140

7.A2 Aggregate return of portfolios 140

8.1 Proportional responses to survey queries 146

8.2 Positive conditional responses to specific queries 147

8.3 Negative conditional responses to specific queries 148

8.4 Cross correlations 150

8.5 Logit regression results 151

9.1 Muslim population in large European countries 160

10.A1 Glossary of Arabic words used in the paper 189

x

Editors

Tina Harrison joined the University of Edinburgh in 1993. Earlier she was a researcher at the Financial Services Research Centre, UMIST, Manchester, where she conducted segmentation research funded by the Trustees Savings Bank. She is Professor of Financial Services Marketing and Consumption. Her current research interests are in the area of financial services market-ing, specifically associated with consumer use and understanding of finan-cial services and the role of technology. She has led several large research projects, including a three-year ESRC-funded project on the impact of the Internet on the pensions industry as well as a range of industry-funded projects. Over the last two years she has led the ESRC-funded Seminar Series Financial Services and Consumers: Issues and Challenges in a Context of Change. Her research has been presented widely at conferences and in academic journals. She is the co-editor of The Routledge Companion to Financial Services Marketing, author of Financial Services Marketing and long-standing Editor-in-Chief of the Journal of Financial Services Marketing.

Essam Ibrahim joined the University of Edinburgh Business School in 2007 as Senior Lecturer in Marketing, and later was appointed the Director of the Doctoral Programme in the School. Prior to this, Essam taught and researched marketing at Strathclyde University, Manchester Metropolitan University, Huddersfield University and Cairo University. Before joining academia, he worked as a market analyst for five years. He completed his PhD from University of Huddersfield in 2000. The thesis examined the competitive marketing strategies in the UK Automobile market, and won the Prize for the best Doctoral Dissertation at the 2001 Academy of Marketing Science Doctoral Dissertation Competition in the USA. His research has been published and presented in a number of national and international outlets. He is a co-author (with John Ford and Douglas West) of Strategic Marketing: Creating Competitive Advantage (3rd edition).

Contributors

Saima Ahmad is a doctoral candidate at Monash Business School, Monash University, Australia. She completed her masters from the

Notes on Contributors

Notes on Contributors xi

University of Malaya, Malaysia, and MPhil from the University of Manage-ment and Technology, Pakistan. Earlier she was a lecturer at Asia Pacific Institute of Information Technology (now Asia Pacific University), Malaysia. Her research has been published in Non-Profit and Voluntary Sector Quarterly, Journal of Business Systems, Governance and Ethics, Pakistan Economic and Social Review, International Journal of Electronic Finance, Journal of Financial Services Marketing and Journal of Internet Banking and Commerce. She is also a member of the Australian Business Ethics Network and an associate member of CPA Australia.

Nafis Alam is Associate Professor and Director for the Centre for Islamic Business and Finance Research (CIBFR) at University of Nottingham Malaysia Campus. He has published quite extensively in the area of finance and his scholarly research has featured in leading journals like Emerging Markets Review, Pacific Basin Finance Journal, Journal of Asset Management, Journal of Banking Regulation and Review of Islamic Economics among others. He has also co-authored three books in Islamic Finance, including the Encyclopedia of Islamic Finance which is first of its kind. He has also participated in leading Islamic finance conferences worldwide, significant among them was his participation in Harvard Islamic Finance forum at Harvard Law School. Recently, he was featured as Professor of the month in the Financial Times.

Hussein A. Hassan Al-Tamimi is Professor of Finance and Chair of the Finance and Economics Department, College of Business Administration, University of Sharjah, UAE. He has taught more than 10 different finance courses at both graduate and undergraduate levels. He has published 5 books and over 35 articles in international and regional ref-ereed Journals. His major research interests include corporate finance, financial performance, financial regulation, risk management, invest-ments, corporate social responsibility and corporate governance.

Kassim Hussein retired from the Institute of Finance Management (Tanzania) in 2002 where he taught postgraduate courses in bank-ing and finance and was also Dean of the Faculty of Economics and Management Sciences. He achieved an MBA at Oklahoma City University in the USA as a Fulbright scholar, and obtained his PhD from Bangor University, UK. He currently runs executive courses for bankers in the Southern Africa region. Since 2010, he has been a member of the Board of the National Bank of Commerce and serves as the Chairman of the Lending Committee. He had served on a number of Editorial Boards of journals including The African Journal of Finance and Management,

xii Notes on Contributors

Business and Management Review and International Journal of Islamic and Middle Eastern Finance and Management.

Ahmad Kaleem is Dean at the Institute of Investment Banking Business School, Australia. Before this, he was Professor and Head of Department at COMSATS Institute of Information Technology, Lahore, Pakistan. Overall he has more than 15 years of experience in teaching, research and administration. He holds his PhD in Islamic Finance from the University of Malaya, Malaysia and MSc in International Securities, Investment and Banking from the University of Reading, UK. He was also a recipient of the prestigious Endeavour Fellowship Award from the Australian government in 2010. He has published around 40 research articles in journals of international repute such as British Food Journal, Journal of Financial Services Marketing and Non-Profit and Voluntary Sector Quarterly.

Adel Shehadah Lafi is a chief financial officer at Al Habtoor Engineering Enterprises Company. His current research interest focuses on capital budgeting, service quality and Islamic finance.

Kun-Ho Lee is President, Chief Executive Officer and Director of KB Kookmin Bank and is on the Board of Directors at KB Kookmin Bank. He was previously employed as an analyst by Tong Yang Securities Inc., Head-Bank Industry by Korea Institute of Finance, President and Chief Executive Officer by Kookmin Bank, and as Professor by KDI School of Public Policy and Management. He received his undergraduate and postgraduate degrees from Seoul National University, Korea and a doc-torate degree from the University of Minnesota, USA.

Babak Naysary is a PhD candidate in the Department of Accounting, International Islamic University Malaysia.

Siti Normala Sheikh Obid is an Associate Professor at the Department of Accounting, Kulliyah Economic and Management Sciences (KENMS), International Islamic University Malaysia, Malaysia. She is also a member of the Board of Governors, a Senate member and a University Board member at Islamic University Malaysia (UIM). She also serves as a member of the Board of Trustees, an Executive Board member and an Internal Auditor at Lembaga Kolej Islam Malaya (LAKIM), Malaysia. She has published more than 100 articles in both referred and non-referred journals. She was awarded the Darjah Setia Negeri Sembilan (DNS) by the State of Negeri Sembilan, Malaysia and features in Who’s Who in the World 2013.

Notes on Contributors xiii

Barbara Petracci is Associate Professor of Corporate Finance at the University of Bologna, Italy. From 2002 to 2003, she was a visiting scholar at the Accounting and Finance Department, Strathclyde University, Glasgow. In 2005, she received her PhD in Corporate Finance from the University of Trieste, Italy. Her main research interests are in the areas of corporate governance, entrepreneurial finance, ethical finance, insider trading and islamic finance.

Markus Pudelko is Director of the Department of International Business at Tübingen University School of Business and Economics and Vice Dean of the Faculty of Economics and Social Sciences, Germany. He holds a masters degrees in Business Studies (University of Cologne, Germany), Economics (Sorbonne University, France) and International Management (Community of European Management Schools – CEMS) and a PhD (University of Cologne, Germany). His current research is on headquarters–subsidiary relationships, multinational teams, the impact of language on international business, international HRM and cross-cultural management. He has published on these topics in journals such as Academy of Management Journal, Journal of International Business Studies, Human Resource Management, Leadership Quarterly and Journal of World Business.

Hussain G. Rammal is Senior Lecturer in International Business Strategy at UTS Business School, University of Technology Sydney, Australia. He is co-editor of the Review of International Business and Strategy and area editor for Journal of Asia Business Studies. He is co-author of a leading International Business textbook, and his research has been published in leading business journals.

Mohammad Shadique Rajjaque has research interests in socially responsible investment and risk management from an investment management point of view. Previously, he has worked in Banking and Micro Finance industries and is now based in Sheffield University Management School, UK. He teaches on a number of accounting and finance modules and is Program Director for two PG courses there. He has a Bachelor’s degree in Economics, an MBA and a masters degree in Accounting and Finance. He is also a Fellow of HEA, UK

Kin Boon Tang teaches a variety of finance modules for both post-graduate and undergraduate programs at the University of Nottingham Malaysia Campus. His areas of teaching include investments, financial risk management and international finance. His research interests are in the field of derivative markets, financial economics, quantitative

xiv Notes on Contributors

economics and international finance. His most recent research inquir-ies involve a comprehensive analysis of investors’ distinct risk-averse behavior towards optimal future hedging strategy. He authored and co-authored several research articles that were published in leading academic journals such as Economic Modelling, Journal of the Asia Pacific Economy and Journal of Financial Services Marketing, among others.

Md Hamid Uddin has been working at the University of Sharjah, United Arab Emirates since 2007. He has many years of academic experience in the field of finance and investment, and has conducted substantive research on the topics of government share ownership, cor-porate risk taking, corporate governance, initial public offers, mergers and acquisitions, corporate disclosure, corporate spin-offs, dividends, capital structure, and securities price behavior. He earned his PhD in Finance from the National University of Singapore.

Shakir Ullah is Professor of Finance and Islamic Banking at Stratford University, USA. Previously, he worked as Assistant Professor of Finance at the Institute of Management Sciences, Pakistan, and as a lecturer at the University of Southampton, UK. He also worked as a global business analyst with Euromonitor International, Singapore, and research associ-ate with the KDI School of Public Policy and Management, Korea. He has a PhD from the University of Southampton, UK and an MBA from the KDI School of Public Policy and Management.

Stefan Volk is Senior Lecturer in Management at the University of Sydney Business School in Australia. He received his PhD in Management from the University of St. Gallen in Switzerland. His research focuses on the biological foundations of employee performance, productivity and well-being in the workplace.

Ralf Zurbruegg is Professor of Finance in the University of Adelaide Business School, Australia. He is a director of a quantitative solutions company for the fund management industry, has served on five edito-rial boards of journals, including as an editor, and has written numer-ous technical articles published in business journals. He has a particular interest in behavioral issues surrounding client choices of financial services products.

1

The global market for Islamic financial services has shown strong growth in recent years and has demonstrated remarkable resilience fol-lowing the global financial crisis in 2007. Although Islamic financial assets currently make up only a fraction of the world’s financial assets at 1 percent, many Islamic banks have experienced double-digit growth rates in recent years, surpassing their conventional peers (ATKearney, 2012). Indeed, global Islamic financial assets have tripled since the start of the economic slowdown in 2007 (TheCityUK, 2015) and are forecast to reach $4 trillion by 2020 (Karim, 2012).

Islamic finance is a distinctive financial arrangement that follows Shariah (Islamic laws) as the core value system. Through the use of financial instruments that adhere to Islamic principles and comply with Shariah rules, Islamic financial institutions seek to promote inclu-sive growth, equitable risk-sharing, social justice and a fair distribution of wealth. As such, Islamic finance and Islamic financial institutions can be regarded as an ethical alternative to conventional banking and financial systems.

Several principles differentiate Shariah compliant finance from con-ventional finance. Essentially, Shariah prohibits riba (usury) which is generally understood as interest or excessive interest; gharar (risk or uncertainty) which is generally understood as excessive risk due to uncertainty; maisir (gambling); and the financing of activities deemed incompatible with Shariah (such as drugs, alcohol, pornography and pork) (Wilson and Abdul Rahman, 2015). At the same time, Shariah pro-motes the principle of profit and loss sharing and the principle that all transactions must be backed by a real economic contract that involves a tangible asset.

IntroductionTina Harrison and Essam Ibrahim

2 Tina Harrison and Essam Ibrahim

Therefore, in the Islamic economic system money is treated as a means of exchange and does not hold an intrinsic value (Rammal, 2015). In practice, this means that Islamic financial institutions are not permitted to make a return simply by lending money and charging interest in the conventional way. Instead, they are expected to share in the risks associated with a commercial venture by participating in the investment of physical assets. By contrast, conventional finance tends to be disconnected from the “real sector” as it involves making loans to clients without taking a trading position. The Islamic financing system is therefore an asset-backed system. Any return made by an Islamic financial institution without participating in a share of the risk is con-sidered to be similar to interest and is therefore prohibited.

In order for Islamic financial institutions and their clients to comply with Shariah, specific Islamic financial products have been developed that avoid the concept of interest and instead imply a certain degree of risk-sharing. The vast majority of Islamic financial products are banking products. Islamic banking makes up almost 80 percent of global Islamic finance assets. Sukuk or Islamic bonds account for just 16 percent of total global assets but represent the fastest growing Islamic financial product. Funds and Takaful (Islamic insurance) account for the remain-der at 4 percent and 1 percent respectively (TheCityUK, 2015). Islamic financial institutions generate an income through the provision of fee-based services (Takaful, Zakat, Udhia, etc.) or through a form of part-nership with clients in which both the risk and the profits (or losses) are shared between the financial institution and the client according to pre-agreed conditions. This has led to the recent use of the terms ‘participation banking’ or ‘participation finance’ to describe the nature of the activities of Islamic financial institutions (EY, 2014).

The emergence of Islamic financial institutions is relatively recent, dating from around the 1960s. Yet, the practice of Islamic finance according to the religious principles of Islam is ancient, having existed for fourteen centuries prior to this. Since the establishment of the mod-ern Islamic finance industry, hundreds of Islamic financial institutions have been launched. The industry has been further strengthened by the establishment of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in 1990 to oversee accounting and auditing standards, and the establishment of the Islamic Financial Services Board (IFSB) in 2002, an international standard-setting organi-zation that issues global prudential standards and guiding principles.

Islamic financial institutions serve a considerable and expanding Muslim population around the globe. There are an estimated 1.6 billion

Introduction 3

Muslims around the world, representing 23 percent of the world’s popu-lation (Pew Research Center, 2015). Muslims are the fastest-growing and the youngest population globally that is forecast to grow at twice the rate of the non-Muslim population over the next two decades (TheCityUK, 2015) and is estimated to reach 2.8 billion or 30 percent of the world’s population by 2050 (Pew Research Center, 2015). Islam is currently the second-largest religion worldwide after Christianity, but is also the fastest growing religion. By 2050 it is estimated that Muslims and Christians will make up almost equal shares of the global popula-tion and, if current trends continue, the number of followers of Islam is expected to exceed the number of Christians by 2070 (Pew Research Center, 2015). Thus, there is considerable potential for the expansion of Islamic finance into the future.

The production of this book is timely, permitting a body of existing knowledge to be drawn together to reflect on the challenges and oppor-tunities facing the Islamic finance industry and to inform future research directions. Based on a meticulous selection of articles published in the Journal of Financial Services Marketing, the book discusses the principles, performance and prospects of Islamic finance. Under the first theme of principles, we discuss the challenges and issues associated with Shariah governance and Shariah compliance. Under the second theme of per-formance, we examine the financial and competitive performance of Islamic financial institutions and specific financial instruments relative to their conventional counterparts. Under the final theme of prospects we discuss the potential for the expansion of Islamic finance models to other geographic regions and non-Muslim majority countries, as well as the mechanisms for such expansion.

Starting with the theme of principles, the first four articles dis-cuss Shariah governance and what it means to be Shariah compliant. Contrary to popular belief, Islam is not a homogeneous religion unified under one Shariah law. Due to the variation in interpretation of Islamic teachings by different Islamic schools of thought, there is not one single implementation of Shariah law amongst the world’s Muslim population, but variations in interpretation. The differences among the schools of thought are further exacerbated by the lack of an international central governing body. Whilst the standards issued by AAOIFI and IFSB are designed to promote standard practices across global Islamic financial institutions, they are not mandatory. Instead, Islamic banks are required to follow the standards issued by their national central bank and their own Shariah advisory/supervisory boards. Whilst the central banks are attempting to incorporate some of the AAOIFI and IFSB standards into


their regulations, there is no currently agreed time frame for when this will be achieved (Rammal, 2015).

Variation in interpretation of Shariah law is a key reason why some Islamic finance instruments are permitted in one country but not in another. The trading of debt is an example: due to varying interpreta-tion of fiqh by Malaysian jurists the sale of debt (bai-al-dayn) at a nego-tiated price is permitted in Malaysia but not in some other countries (such as Saudi Arabia). Hence, it is possible to observe different norms between Islamic countries (such as between Saudi Arabia and Turkey or Malaysia) and even within countries (such as differences between North West Pakistan and other parts of the country).

In an attempt to harmonize the approach to Shariah governance, the first article (Chapter 1), by Siti Normala Sheikh Obid and Babak Naysary, presents a comprehensive theoretical foundation for Shariah governance as a means by which to implement Shariah principles and to monitor the activities of Islamic financial institutions to ensure their ongoing Shariah compliance. The authors synthesize and integrate agency theory, stewardship theory and stakeholder theory into a pro-posed theoretical framework that includes five key concepts: account-ability; disclosure and transparency; competency; confidentiality; and independency among the key functionaries in Shariah governance. The five concepts are presented as the key principles on which Shariah governance is founded. The authors suggest that the framework can be used both by Islamic financial institutions and by conventional finan-cial institutions as a means by which to analyze and compare existing governance arrangements with a potentially ideal arrangement.

In the second article (Chapter 2), Shakir Ullah and Kun-ho Lee explore the relative importance of Shariah compliance compared with other potential motives for bank selection among Islamic bank custom-ers. The study suggests that customers of Islamic banks consider Shariah compliance and conventional banking services as two distinct and dif-ferent sets of bank patronage factors. Interestingly, the research reveals that conventional banking services are considered slightly more impor-tant than Shariah compliance by Islamic bank customers. This finding highlights the importance of Shariah compliance and governance as a discrete threshold factor for bank selection but above all points to the need for Islamic financial institutions to remain competitive with con-ventional banks to ensure sustainability. These findings are also echoed by Hussein A. Hassan Al-Tamimi, Adel Shehadah Lafi and Mohammed Hamid Uddin (Chapter 3) in their study in the United Arab Emirates which shows that the most important factor determining selection of

Introduction 5

a bank seems to be bank products followed by service quality and lastly religious factors. The authors recommend that Islamic banks devote greater efforts to improving their perceived image, in particular empha-sizing service quality and reliability.

In the final article (Chapter 4) in this set exploring the principles of Islamic finance, Ahmad Kaleem and Saima Ahmad examine the per-ception and understanding of bank staff of Bai Salam, a forward sale agreement used in agriculture finance. Bai Salam is a trading contract rather than an interest-based loan, encouraged as an acceptable Islamic alternative mode of agriculture finance. The use of Bai Salam is critical to the financial inclusion of small-scale farmers who require access to funds to develop and grow their business. Yet, the study finds that the use of Bai Salam has been limited owing to poorly kept land records, wide spread illiteracy and restrictive government policies. The authors make a number of recommendations aimed at removing the restric-tions and barriers, thus ensuring that small-scale farmers have access to Shariah compliant finance.

The second theme explores the performance of Islamic finance. The recent global financial crisis has not only exposed weaknesses in the con-ventional financial system, but also increased attention on the Islamic financial system, suggesting superior performance of Islamic financial institutions relative to their conventional counterparts. Indeed, research comparing the business model, efficiency, asset quality, and stability of Islamic and conventional banks, across a sample of 22 countries with both types of banks, has shown that Islamic banks are better capitalized, have higher asset quality and are less likely to disintermediate during crises (Beck et al., 2013).

In the first of the following set of three articles, examining the per-formance of Islamic finance (Chapter 5), Kassim Hussein observes the behavior of key bank-level stability factors of liquidity, capital and risk-taking in Islamic and conventional banks operating in the Gulf Cooperating Countries (GCC) during the financial crisis, and links these to consumer confidence. He finds that Islamic banks generally provide higher consumer confidence due to the fact that they are more capital-ized than conventional banks, have a positive and significant relation-ship with liquidity, and tend to follow stringent risk strategies compared to conventional banks.

Similarly favorable results are observed by Nafis Alam, Kin Boon Tang and Mohammad Shadique Rajjaque (Chapter 6) among Islamic funds during the subprime crisis period in Malaysia. In the sample studied, Islamic funds performed better than conventional funds suggesting


that Islamic unit trusts are better hedging investments against market downside risk. In the European market (Chapter 7), Nafis Alam and Mohammad Shadique Rajjaque also compared the performance of Shariah compliant equities with equities in the wider general market to find that Shariah compliant equities outperformed other portfolios and showed less variability leading them to be considered less risky.

In the final set of three articles, we explore the theme of prospects for Islamic finance. The Islamic finance market is currently most developed in the Muslim-majority countries of Malaysia, Saudi Arabia, Iran, and the countries that form the GCC. In a small number of these countries Islamic finance is now mainstream: for example, in Saudi Arabia and Kuwait Islamic banking accounts for 49 percent and 45 percent of the market share respectively (EY, 2015). However, it is also estimated that around 80 percent of Muslims globally have no access to Islamic bank-ing (TheCityUK, 2015). Thus, there is huge potential to extend Islamic finance to other geographic regions, in particular to non-Muslim major-ity countries.

Europe is a prime target for expansion of Islamic finance, not least because the Muslim population is growing in Europe: it is estimated that by 2050 10 percent of all Europeans will be Muslims (Pew Research Center, 2015). The UK has one of the most developed Islamic finance sectors outside the Muslim world. Over 20 Shariah compliant banks are licensed to operate in the UK, which is nearly double that of any other Western country (TheCityUK, 2015). Moreover, the customer base of Islamic financial institutions is not restricted to Muslims; many custom-ers may be attracted by the ethical values of Islamic finance and the participation and risk-sharing finance model.

The final three articles in this book explore the challenges, oppor-tunities and barriers to extending the Islamic finance model to other counties. A key hurdle to overcome is that of limited awareness and understanding of Islamic finance among not only non-Muslims but also Muslims in non-Muslim majority countries. In the context of Australia, Hussain Gulzar Rammal and Ralf Zurbruegg (Chapter 8) find that whilst Muslims generally are favorably disposed towards using Islamic bank-ing products, they are not adequately informed about how they work and the principles on which profit- and loss-sharing Islamic products are based. They suggest that to extend their reach into Australia (and other countries where awareness is low) Islamic banks need to widen their communication and educate consumers to ensure they are aware of how Islamic banking products operate. Focusing on the concept of

Introduction 7

participation and risk-sharing as a unique proposition may provide a particularly appealing contrast to conventional institutions.

Other challenges to expansion relate more to the structural and regulatory environments of countries. In this context, Stefan Volk and Markus Pudelko (Chapter 9) identify the major challenges and opportu-nities for Islamic retail banking in Europe. The authors compare the two European markets of the UK and Germany and propose a framework to aid the evolution of a domestic market for Islamic banking. The frame-work consists of four attributes: demand conditions, supply conditions, regulatory conditions and societal conditions. The article suggests that further expansion of Islamic banking in Europe would require changes in the regulatory environment to allow implementation of Islamic banking schemes and comparable tax treatment to conventional bank-ing. Moreover, consumers need to play a proactive role in aiding the growth of Islamic banking in Europe.

In a further elaboration of the structural context, Barbara Petracci and Hussain G. Rammal (Chapter 10) use Italy as the case context to highlight the potential for Islamic financial services to be introduced and promoted in countries in the wider European area. Taking an institutional theory perspective, the authors analyze the local legal and regulatory environment to understand the opportunities and chal-lenges facing the development of the Islamic financial services sector specifically in Italy as well as the wider EU context. The article discusses the regulatory, normative and cultural-cognitive elements that must be addressed for the successful development and reveals a roadmap for Islamic institutions considering expansion.

Whilst there has been considerable research attention to Islamic finance, there are a number of areas where further research can make a useful contribution. In reviewing the articles for this book, we have observed several gaps in understanding of Islamic finance and key trends where future research can have an impact. In particular, there remains limited awareness of the Islamic finance system among the general population and further research is needed to understand how to increase awareness, understanding and uptake of Islamic finance. There is huge potential for growth globally. Even in some of the established markets penetration remains low relative to conventional banks. Several markets with large Muslim populations (such as India and China) remain relatively untapped.

A key challenge facing Islamic finance is how to develop the industry from its current position as a collection of domestic banks to a truly


global finance industry. To achieve this it is required that inconsisten-cies in the application of the Islamic finance system are addressed to realize greater consistency between financial institutions at a global level. Future research is needed to understand how to address this, considering in particular the role of various stakeholders in the Islamic finance ecosystem such as central banks, standard setting bodies and Shariah advisory boards.

There are both challenges and opportunities for Islamic banks in considering their strategic position relative to conventional banks which, thus far, has been based largely on providing an Islamic alterna-tive to the conventional finance system. Research is needed to explore and understand how best Islamic financial institutions can compete going forward. Research can assist in understanding the implications of remaining a niche player versus competing more directly with conventional financial institutions. Insights from the articles in this book clearly show that simply being Sharia compliant is not a major differentiator for a niche player. Hence research can usefully explore additional means of competitive advantage that can drive value, in particular emphasizing the unique business model of participation and risk-sharing and corporate social responsibility.

To compete more directly with conventional financial institutions, Islamic financial institutions need to consider their cost base. Due to differences in the operations of Islamic and conventional financial institutions, research can usefully analyze and understand the cost bases and how to drive greater efficiency in the value chain. To compete effec-tively alongside global conventional financial institutions also requires that Islamic institutions address current gaps in the provision of finan-cial product offerings and seek to develop new products and innovate. Hence, research can usefully assist in understanding and exploring con-cepts for new innovative Sharia compliant financial products and how best to develop them and bring them to market.

Much of the above relies on a steady stream of qualified professionals and Shariah scholars to support the management and development of Islamic financial institutions. Research has noted a potential shortage of Shariah scholars and the lack of adequate training and skills. Moreover, Shariah scholars are qualified primarily in matters of religious juris-prudence rather than in finance, banking, marketing or management. Further work is needed to understand how best to develop and train Shariah scholars and equip them with relevant financial understanding and competence so that they are equally conversant with Shariah law and financial understanding.

Introduction 9

References

ATKearney (2012). The Future of Islamic Banking. A. T. Kearney Korea LLC. http://www.atkearney.co.uk/documents/10192/654853/Future+of+Islamic+Banking.pdf/27167edf-a96d-4465-b88a-83beb25ed4bd (accessed 6 January, 2016).

Beck, T., Demirgüç-Kunt, A. and Merrouche, O. (2013). Islamic vs. conventional banking: Business model, efficiency and stability, Journal of Banking and Finance, 37(2): 433–447.

EY (2014). World Islamic Banking Competitiveness Report 2014–15: Participation Banking 2.0. EYGM Limited. www.islamicfinance.com/wp-content/uploads/2014/12/EY-world-islamic-banking-competitiveness-report-2014-151.pdf (accessed 21 December, 2015).

EY (2016). World Islamic Banking Competitiveness Report 2016. EYGM Limited. http://www.ey.com/Publication/vwLUAssets/ey-world-islamic-banking- competitiveness-report-2016/$FILE/ey-world-islamic-banking-competitive-ness-report-2016.pdf (accessed 13 April, 2016).

EY (2016). World Islamic Banking Competitiveness Report 2016. EYGM Limited. http://www.ey.com/Publication/vwLUAssets/ey-world-islamic-banking- competitiveness-report-2016/$FILE/ey-world-islamic-banking-competitiveness-report-2016.pdf (accessed 13 April, 2016).

Karim, D. R. A. (2012). Islamic finance: An alternative funding source for the African Development Bank? African Development Bank, 3(3): 1–8.

Pew Research Center (2015). The Future of World Religions: Population Growth Projections, 2010–2050. April 2, 2015. http://www.pewforum.org/files/2015/03/PF_15.04.02_ProjectionsFullReport.pdf (accessed 22 December, 2015).

Rammal, H. (2015). Islamic banking. In T. Harrison and H. Estelami (eds.) The Routledge Companion to Financial Services Marketing, pp. 399–410. New York: Routledge.

TheCityUK (2015). The UK: Leading Western Centre for Islamic Finance. TheCityUK Islamic Finance Market Advisory Group, November 2015. www.islamicfinance.com/wp-content/uploads/2015/11/TheCityUK-Islamic-Finance-2015-report.pdf (accessed 21 December, 2015).

Wilson, A. J. and Abdul Rahman, Z. (2015). Islamic perspectives on risk and insurance marketing. In T. Harrison and H. Estelami (eds.) The Routledge Companion to Financial Services Marketing, pp. 411–422. New York: Routledge.

10

1Toward a Comprehensive Theoretical Framework for Shariah Governance in Islamic Financial InstitutionsSiti Normala Sheikh Obidis an Associate Professor at Department of Accounting, International Islamic University Malaysia.

Babak Naysaryis a PhD Candidate at Department of Accounting, International Islamic University Malaysia.

Introduction

The industry of Islamic banking is one of the fastest growing industries in the world with the annual growth rate of 17.6 per cent and total global assets of US$1.7 trillion in 2013 (Ernst and Young Report, 2014). Despite this remarkable growth, the issue of corporate governance in Islamic financial institutions (IFIs) has not received due attention in the academic as well as the professional fields of Islamic finance (Alnasser and Muhammed, 2012). It is worth noting that there are inherent dif-ferences between Islamic and conventional banking systems due to the fact that the functions of Islamic banks must be compliant with Islamic rules and principles (Shariah) which comes from the Holy Quran and Sunnah according to which the payment of interest, speculation and financing of specific illicit transactions such as pork and alcohol is pro-hibited (Bhatti and Bhatti, 2009). Islamic banks operate also based on the profit and loss sharing principle which stipulates that banks as well as the investors share the risks associated with business ventures (Beck et al, 2013). Nevertheless, the scope of Islamic corporate governance

Journal of Financial Services Marketing, 19, 304–318, 2014, DOI:10.1057/fsm.2014.26, ‘Toward a comprehensive theoretical framework for Shariah governance in Islamic fi nancial institutions’, by Siti Normala Sheikh Obid and Babak Naysary. With kind permission from Palgrave Macmillan Ltd. All rights reserved.

Toward a Comprehensive Theoretical Framework 11

(ICG) extends beyond the conventional corporate governance (CCG) which operates largely in the interests of management and shareholders to include the spiritual aspects as well as the worldly needs of people. In other words while the western systems of corporate governance are based on self-interest, the ultimate goal in ICG is Maqasid al Shariah (objectives of Islamic law) (Bhatti and Bhatti, 2009). Maqasid al Shariah is defined as a tool to protect and preserve the benefits and interests of society. It is also to facilitate the needs of human beings and ensure that wealth is circulated among as many as possible in a fair way. Therefore Maqasid al Shariah requires that Islamic banks, apart from maximiza-tion of profit, take into account the justice as well as welfare of members of society (Chapra, 2000).

However, restricted view and misunderstanding of Shariah principles can hinder the proper implementation of these principles (Dusuki and Abozaid, 2007), for example, Beck et al (2013) mentioned that still there is a lack of clarity in Islamic banking as to whether the products in Islamic banks follow Shariah principles in form or in content.

Therefore the purpose of this research is to provide a comprehensive theoretical foundation for Shariah governance as it is perceived to be the main tool to ensure the implementation of Shariah principles and monitor the functions of IFIs to continuously ensure its Shariah compliance that consequently can bring about justice and welfare for society (Lewis, 2005).

Most of the studies on CCG are based on agency theory (Shleifer and Vishny, 1997; Daily et al, 2003; Clarke, 2004; Carney, 2005), according to which managers (agents) who are appointed by owners (principal) to carry on the business seek their own interest rather than trying to achieve corporate goals ( Jensen and Meckling, 1976; Hart, 1995). But this perception of the relationships in business has been challenged by stewardship theory that views the leaders in a firm as stewards who perform their duties in line with the goals of the firm to maximize the profit for its shareholders (Donaldson and Davis, 1991). But while the responsibility of leaders according to agency theory and stewardship theory is restricted to owners and shareholders, another widely dis-cussed theory in CCG called stakeholder theory argues that firms as a whole and leaders in particular are accountable for the well-being of a wider range of individuals who are affected by its functions in society (Donaldson and Preston, 1995; Rowley, 1997).

While each of these theories can be explanatory in the case of CCG, they come short to explain different aspects of ICG (Lewis, 2005); there-fore, this article seeks to develop an integrated theoretical framework based on the existing theories of CCG due to the fact that despite the

12 Siti Normala Sheikh Obid and Babak Naysary

differences between ICG and CCG both face similar issues and must meet similar standards (Bhatti and Bhatti, 2009).

In order to identify the related theories and also to interpret and justify their relevance to Shariah governance on one hand and to point out the interrelated concepts among the theories themselves on the other hand, the qualitative content analysis (QCA) approach is employed in this study. QCA is defined by Holsti (1968, p. 608) as ‘any technique for making inferences by systematically and objectively identifying especial character-istics of contexts’. In fact QCA is an interpretation method that analyses the frequency of keywords and identifies the substantive statements with an emphasis on allowing categories to emerge out of data (Kohlbacher, 2006). Hence QCA can help to identify the key concepts in the related theories, analyze their relationship with Shariah governance and also explain the interrelated concepts among these theories in this study.

Conventional versus Islamic corporate governance

Islam is way of life that promotes good ethics and moral values. This concept can also be applied and incorporated in the mechanism of Corporate Governance (CG) (Lewis, 2005). During the last decade Islamic finance standard setting bodies such as AAOIFI (Accounting and Auditing Organization for Islamic Finance Institutions), IFSB (Islamic Financial Services Board) and BNM (Bank Negara Malaysia) made an attempt to issue guidelines on corporate governance and Shariah governance in IFIs; however, the fact cannot be denied that these guidelines are still based on the CCG standards such as OECD’s and Basel committee on Banking Supervision (BCBS’s) with some adjustments to Shariah principles (Kasri, 2009). The OECD (2004) has established CG principles which act as an international benchmark for policy makers, investors, corporations and other stakeholders (Abu-Tapanjeh, 2009). These principles are the basis for CG in IFIs too and can be considered as common concerns in both ICG and CCG; however, IFSB (2006) made some adjustments to these principles for IFIs by including some Shariah aspects of CG. Shortly after that IFSB (2009) and BNM (2010) issued guidelines on Shariah govern-ance and the role of Shariah Supervisory Board (SSB) in IFIs.

The distinctive aspects of ICG compared with CCG can be described as follows:

1. While CCG focuses on the economic per formance of the firm, ICG calls for taking into account the spiritual needs and religious values. Furthermore IFIs must comply with Shariah rules while abiding by the state laws and regulations. And finally SSB is an addi tional key


player in IFIs whose main responsibility is to ensure the compliance of IFIs functions with Shariah principles.

2. The second principle in OECD (2004) is concerned with the rights of shareholders and key ownership functions. In Islamic banking, Investment Account Holders (IAHs) bear the same investment risk as shareholders; therefore IFI has a fiduciary duty toward the IAHs too. Accordingly in ICG, IAHs have the right to monitor the performance of their investments and the associated risks, which must be consid-ered and respected by IFIs.

3. Normally IFIs appropriate a certain amount of IAH’s income as Investment Risk Reserve (IRR) and Profit Equalization Reserve (PER). Because of the fiduciary duty of IFIs toward IAHs, the information on IRR and PER should be disclosed to IAHs and they should be allowed to partici pate in decision makings on PER.

4. While OECD (2004) limits the responsibility of the corporation to stake-holders whose rights are stipulated in law or mutual agreement with the main focus on employees and creditors, the Shariah rules mandate the IFIs to be accountable to welfare and well-being of a wider range of stake-holders. Accordingly IFIs should establish a Governance Committee to protect the interest of stakeholders other than shareholders.

5. While OECD (2004) requires firms to disclose any material financial and non-financial information with high quality in line with account-ing standards, because of high sensitivity to Shariah compliance in IFIs, they are also required to disclose the Shariah pronouncements and/or resolutions and provide a report on Shariah compliance.

6. The last principle in OECD (2004) is concerned with the roles and responsibilities of the board who must be competent and independ-ent enough to continuously and effectively monitor the functions of the firm. An additional key functionary in IFIs is SSB whose main responsibility is to continuously monitor the functions of IFI to ensure the Shariah compliance. In the guidelines in Shariah governance both IFSB (2009) and BNM (2010) emphasized on the competence of SSB in Fiqh Muamalat as well as the finance, its inde-pendence, confidentiality, consistency and continuous and effective internal Shariah review performed by SSB.

Theoretical background for Islamic corporate governance

Throughout the history of corporate governance there has been a never-ending evolution of theories and models used to explain its mechanism. This is due to the fact that the subject of corporate governance itself is


continuously changing and evolving. Thus many researchers attempted to develop theories and models which best fit into the context of corporate governance in its most current form.

Although there are many theories employed by researchers to explain the concept of corporate governance such as transaction cost theory (Williamson, 1979), political theory (Macey, 2004), legitimacy theory (Deegan et al, 2002), constitutional contract theory (Sacconi, 2006) and resource dependence theory (Clarke, 2004), there are mainly three fundamental theories which have been predominantly regarded as explanatory in this field namely agency theory, stewardship theory and stakeholder theory (Donaldson and Davis, 1991; Donaldson and Preston, 1995; Rowley, 1997; Shleifer and Vishny, 1997; Daily et al, 2003; Clarke, 2004; Carney, 2005). Hence the focus of this article throughout the following sections is on the application of these theo-ries to explain their main concepts and how they can be integrated into Shariah governance.

Agency theory

Agency theory was developed by Jensen and Meckling (1976) based on the statements of Adam Smith who argued that it cannot be well expected that managers watch over the company with the same anxious vigilance as the owners. This issue is called the agency problem and occurs when the principal engages an agent to perform some services on his behalf which involves delegating some decision-making authori-ties to the agent ( Jensen and Meckling, 1976). This decision-making authority given to the manager as an agent creates an informational advantage for the manager and consequently an informational disad-vantage for the owners which is called information asymmetry ( Jensen and Meckling, 1976).

Information asymmetry creates the opportunity for managers to pur-sue their own interest rather than the owner’s that causes a conflict of interest between the owner and the manager. This is the basis of agency theory and is due to the following underlying assumptions:

1. People are opportunistic and seek to max imize their own profits.2. Because of this, the managers’ aim is to pursue his own interest which

might not be aligned with the interest of the owner (Eisenhardt, 1989).

Bearing in mind the assumption of self-interest seeking behavior in human actions and also considering the technical impossibility of developing a perfect contract to cover for each and every possible


conflict of interest between managers and owners, it is essential for the owners to establish a monitoring system in the firm for the management (Hill and Jones, 1992).

Agency theory and Shariah governance

One of the principles in Islamic banking is the concept of profit and loss sharing which transfers some of the risks associated with the busi-ness venture to its investors (Siddiqui, 2001). On the other hand it does not allow the investors to participate in the process of decision mak-ing which creates an environment where managers can easily pursue their own interest with investors bearing the cost (Karim, 2001; Iqbal and Llewellyn, 2002). Therefore we can observe a separation between ownership and control in Islamic banks (Safieddine, 2009) which is argued in agency theory as the agency problem (Hill and Jones, 1992). The agency problem is even more intense for Islamic banking where the profit and loss as well as the risk is shared between the bank and its investors, while investors in conventional banks have a level of cer-tainty in their returns (Siddiqui, 2001). Thus this issue in Islamic banks is not limited to the separation of ownership and control but extends to the separation of cash flow and control which makes the agency problem in Islamic banks even more complicated than conventional banks (Safieddine, 2009).

As mentioned in the studies of Shariah governance, in IFIs managers should be held accountable not only to the company or shareholders but also to Allah (SWT) with the ultimate goal of welfare and success for society (Abu-Tapanjeh, 2009) which is a deviation point from the self-interest assumption in agency theory. However, it does not mean that the interest of owners is neglected in Islam as even Shariah law empha-sized property right and Islamic financial contractual rights (Bhatti and Bhatti, 2009). Therefore the outcome of the unique monitoring system in ICG which is Shariah governance is to ensure the compliance of IFI with Shariah principles and to produce report which can contribute to owners as well as a wider range of stakeholders including society (Grais and Pellegrini, 2006); Shariah governance is defined as ‘a set of insti-tutional and organizational arrangements through which IFIs ensure that there is an effective independent oversight of Shariah compliance over the issuance of relevant Shariah pronouncements, dissemination of information and an internal Shariah compliance review’ (IFSB, 2009). This can decrease the information asymmetry between managers and other parties who have interest in the business including sharehold-ers, investors and even society. Shareholders and investors must have


access to reliable and accurate information; therefore transparency is highly demanded in IFIs especially when Shariah issues are concerned (Haniffa and Hudaib, 2007). According to Toutounchain (1998) indif-ference of Muslims about the performance of Islamic banks can cause disastrous consequences which cannot be mended easily. On the other hand Chapra and Ahmed (2002) mentioned, the agency problem can affect the bank’s credibility as well as ability to attract investors. In line with the concepts of agency theory, Shariah governance is a monitoring mechanism in IFIs to address the agency problem in Shariah matters. Therefore providing transparent and accurate information regarding the compliance of IFI functions with Shariah principles can reduce the information asymmetry and subsequently increase the trust and confidence of public and investors.

Stewardship theory

Although agency theory has been the basis for many of the studies on corporate governance, it has its own shortcomings as well (Perrow, 1986; Eisenhadt, 1989; Donaldson, 1990), especially with regard to its view of human behavior and motivation. In order to include psycho-logical aspects of human beings stewardship theory was introduced by Donaldson and Davis (1991). This theory states that ‘a steward protects and maximizes shareholders’ wealth through firm performance, because by doing so the steward’s utility function is maximized’ (Davis et al, 1997). Stewardship theory suggests that the steward’s behavior is more inclined to satisfying the principal by improving the performance of the organization (Arthurs and Busenitz, 2003). This motivation is justified by the fact that managers as humans have higher order needs of self-esteem and fulfillment as presented in Maslow’s Hierarchy of needs (Pande, 2011). In other words by fulfilling the needs and objectives of the firm the needs of managers are also satisfied (Donaldson and Davis, 1991).

On the basis of the above discussions two main features can be con-cluded for stewardship theory in terms of its view on individuals and their interaction with the firm:

1. Stewardship theory views managers as indivi duals who are altruistic rather than self-inter est seeking and sees their satisfaction in fulfill-ment of objectives of the firm. There fore managers see themselves accountable for the improvement in performance of the firm.

2. The success of the firm can be achieved through strong leadership and utilizing the expertise and competence of individuals who act as stewards in the firm.


In order to increase the stewardship behavior among leaders, they must be given a certain level of independence (Gibson, 2000; Aduda et al, 2013). This idea is supported by Hofstede (1980) (cited in Lickers, 2007) who argues that in organizations where the power distance is lower individuals tend to have more self-assessment attitude and feel more responsible for the consequences of their actions.

Stewardship theory and Shariah governance

The concept of ownership in Islam comes from the concept of stew-ardship (Khilafah) implying that Allah (SWT) is the sole owner of the property and that man is merely a trustee and custodian (Iqbal and Mirakhor, 2004). Therefore in ICG, the behavior of stewards toward improving the performance of the firm can be due to stronger causes than merely fulfilling the need of self-esteem. One of these strong causes to push stewards forward to excellence in performance is faith as stipulated in the Holy Quran:

Believe in Allah (SWT) and His Messenger and spend out of that in which He has made you successors (57:7)

Hence Bhatti and Bhatti (2009) and Lewis (2005) believe ICG to be more based on the idea of stewardship according to which significant players in the institution are viewed as stewards who are more inclined to perform their duties in the spirit of partnership in line with Islamic beliefs. As argued by Turnbull (2000) stewardship theory calls for employing the expertise and experience of stewards in the corporation. As such many powerful leaders of big corporations came to this conclu-sion that there is an increasing need for an independent council in the organization comprising senior directors. This notion has resulted in the formation of Council of institutional investors in the United States, the Cadbury (1992) in the United Kingdom and Australian institutional investors (1995). In this regard Islam emphasizes on what is called ‘Shuratic (collective) decision making’ (Lewis, 2005). It is based on the instructions which are stipulated in the Holy Quran and Sunnah. The following verses of the Quran imply this notion in Islamic principles:

And consult them on affairs (of moment), then when Thou has taken a decision, put thy trust in Allah (SWT) (3:159)

In this regard IFIs are required to employ high caliber scholars in Fiqh Muamalah (Islamic law in finance) and Islamic finance as the Shariah


board who are entrusted with the duty of directing, reviewing and supervising the functions of IFIs in order to ensure their compliance with Shariah (IFSB, 2009). One of the responsibilities of the Shariah board is to make sure the implementation of Shuratic decision mak-ing (Lahsasna, 2011). Accordingly the expertise and competence of the Shariah board is of great importance as DeLorenzo (2012) indicated that unless financial products and services can be certified as Shariah com-pliant by a competent Shariah advisor, the authenticity of that product is dubious. On the other hand Lahsasna (2011) points out the shortage of experts both in Shariah and finance.

Stakeholder theory

Stakeholder theory which was developed by Freeman (1984) argues that corporations are a part of a wider range of entities in a social sys-tem where they operate; therefore they are accountable for the welfare and well-being of these parties (Donaldson and Preston, 1995; Rowley, 1997). This theory refers to the relationship between managers and stakeholders and holds that this relationship is of a greater importance than solely the owner—manager—employee relationship (Elena, 2012). This importance is due to the fact that there is a mutual influence between the stakeholder and company and both can affect each other through different means and procedures (Freeman, 1994). In this regard Guthrie et al (2006) argued that:

According to the stakeholder theory, an organization’s manage-ment is expected to undertake activities deemed important by their stakeholders and to report on those activities back to the stakehold-ers. Stakeholder theory highlights the organizational accountability beyond simple economic or financial performance.

From the above discussions it can be concluded that there are two main points while considering stakeholder theory in CCG including:

1. The responsibility of the firm is of fiduciary nature. Hence they must be held accounta ble not only to the owners but to all the stakeholders.

2. All the stakeholders must uphold the right to participate in the process of decision making which could affect them. This calls for transparency and reporting of the firm to the stakeholders.

Stakeholder theory has been criticized for being single-valued (Jensen, 2001), deviating the firm from its goals by focusing on stakeholders (Ansoff, 1987) and creating competitive problems by flow of information to other working environments (Yusoff and Alhaji, 2012). In response


to these arguments Roberts (1992) suggested that organizations prior-itize their stakeholders based on their significance, power and depend-ence and formulate their strategy accordingly.

Stakeholder theory and Shariah governance

In line with the concepts of stakeholder theory which calls for account-ability toward stakeholders, Shariah governance is considered as a significant tool for IFIs to discharge this accountability particularly with regard to Shariah issues (Grais and Pellegrini, 2006). In this regard various studies (Akhtar, 2006; Grais and Pellegrini, 2006; Abu-Tapanjeh, 2009; Bhatti and Bhatti, 2009; Kasim et al, 2013) suggested that informa-tion and transparency on Shariah compliance is increasingly demanded by various stakeholders in society including Muslim ummah.

Some studies in ICG indicated the relevancy of stakeholder theory to this particular area (Iqbal and Mirakhor, 2004; Azid et al, 2007; Chapra, 2007; Bhatti and Bhatti, 2009; Hasan, 2009; Bhatti and Bhatti, 2010); apart from that Asutay (2007) stated that one of the remedies to fill the gap between Islamic finance aspirations and the current status of Islamic banking is to move toward a social banking system. His findings show the high dependence of Islamic banking success on its interac-tions with the Muslim society.

According to Hasan (2009) there are four main features distinguish-ing ICG and CCG including episteme, corporate objective, nature of management and board and finally the capital related ownership struc-ture. The principle of Tawhid in Islamic episteme implies that Allah (SWT) is the creator of everything and the ultimate accountability must be to him (Hasan, 2009). This in turn puts the Maqasid al Shariah as the objective of Islamic corporations according to which the interest and well-being of all members of society must be protected (Dusuki and Abdullah, 2007). The nature of management and board in ICG is founded on the principle of Shuratic decision making the apex level of which is Shariah board that is responsible to supervise the corporate activities and ensure its compliance with Shariah rules. With regard to ownership structure Islam views shareholders and IAHs as the owners rather than merely shareholders.

According to Iqbal and Mirakhor (2004) the roots of the stakeholder model can be found in the principles of property right and commitment to contractual agreements. The concept of property right is recognized, respected and protected in Shariah principles as Prophet Muhammad (pbuh) stated:

So give to everyone who possess a right his right


But the concept of property right in Islam has its own differences with western concepts. As mentioned by Iqbal and Mirakhor (2004) the abso-lute owner of everything is Allah (SWT) and man is only his vicegerent whose possession of things is restricted by time and they can only earn priority to possess them. The following verses imply these statements:

He it is who has created for you all that is on earth (2:29)AndDo not give your resources that Allah (SWT) has made you its preservers on to the foolish (4:5)

According to Islam the property right is given to man as long as it does not conflict with the interest and well-being of society. By these principles Islam portrays a balance between the rights of individuals, society and state which clearly justifies the relevance of stakeholder model in ICG (Iqbal and Mirakhor, 2004).

With regard to contractual obligations, Islam emphasizes the concept of contract in economic relations and the obligations to abide by it. As Allah (SWT) mentioned in the Holy Quran:

O you who believe fulfill contracts (5:1)

In this regard Bhatti and Bhatti (2009) argued that Shariah govern-ance is a significant part of ICG to avoid stakeholders losing their confidence in IFIs and also to ensure the fulfillment of Shariah require-ments and ethical standards. They also pointed out that ICG is more in line with the stakeholder model of corporate governance and it emphasized ethics, accountability and transparency which is consistent with the OECD principles of corporate governance. Table 1.1 shows the fundamental assumptions for each theory and its relevance to ICG as discussed above.

Construction of the integrated theoretical framework for Shariah governance

The concept of corporate governance has been subjected to evolution over the period of time. The wave of changes though was always mov-ing between two extreme ends which are whether to view the firm as a mechanism to achieve its shareholder’s objectives or to act as an advo-cate for a wider range of stakeholders. Merely adhering to one single


theory to explain CG has proven to be inefficient hence it is suggested that a combination of various theories is best to describe effective and good governance practices (Turnbull, 2000; Dühnfort et al, 2008; Elena, 2012; Yusoff and Alhaji, 2012).

Therefore in order to develop an integrated theoretical framework based on the preceding theories we must first integrate the key concepts identified in each theory and explain their relationship with concepts in other theories.

The relationship between key concepts among theories

Agency theory and stakeholder theory

The assumption in agency theory is that individuals whether as agent or principal seek their own interest; therefore there is always a conflict of interest in this relationship with each one trying to maximize his own profit which creates agency problem. One of the main issues creating agency problem is information asymmetry. As discussed in the previous sections the outcome of Shariah governance is to produce a report on the Shariah compliance of IFIs which reduces information asymmetry among management, shareholders, investment account holders and the Muslim community as a whole with regard to Shariah matters.

Table 1.1 Fundamental assumptions in CG theories and ICG

Agency theory Stewardship theory

Stakeholder theory

ICG

Board role Safeguard ‘owners’ interestsOversee managementCheck compliance

Add value to top decisions/strategyPartner/supportmanagement

Balancing stakeholder needsMake policyControl management

Shuratic decision making Consultation and consensusseekingCheck Shariah compliance

Board members

Owner/members representatives

Experts Stakeholder representatives

Stakeholder representatives

Individual actions

Self-interest -opportunistic

Stewards Altruistic

Fiduciary Altruistic

Fiduciary Altruistic God fearing

Main goal Resolving agency problem and information asymmetry

Optimizing performance of the firm

Accountability to stakeholders

Accountability to Allah (SWT) Optimizing welfare Disclosure and transparency


On the other hand stakeholder theory is concerned with the relation-ship between the firm and other interested parties which are known as stakeholders. Because of the mutual influence which firms and their stakeholders have on each other, firms must be held accountable toward them. It was argued in the previous sections that one of the ways to dis-charge this accountability is through transparency and reporting on the functions of the firm. However, stakeholder theory does not mention information asymmetry as described in agency theory but it argues that it is the right of stakeholders to participate in the decision-making process; therefore reporting and transparency is imperative to discharge the accountability of the firm toward its stakeholders. It is worth not-ing that the concept of transparency and disclosure has been one of the concerns in ICG as it is mentioned in the Holy Quran that ‘O you who believe, when you deal with each other in transactions involving future obligations in a fixed period of time, reduce them to writing. Let a scribe write it down between the parties’ (2:282). Therefore both these theories can be integrated to state that the Shariah governance mechanism can reduce information asymmetry with regard to Shariah issues between the IFIs and various stakeholders and as a result improve the relation-ship between them. However, it was argued in both theories that the flow of confidential information to other parties can create competitive risk for the firm; hence while reducing information asymmetry the issue of confidentiality must be taken into account by providers of infor-mation. The concept of confidentiality has received much interest in Islamic resources as well. In fact keeping a secret (hifdh al sir) (including business secrets), entrusted to you in confidence is considered as a sign of good Islamic character (Omar Hasan, 2001).

Stakeholder theory and stewardship theory

Stewardship theory argues that managers have higher order needs of self-esteem and self-fulfillment; therefore they act as stewards in the organization as such by improving the performance of the organiza-tion their needs are also met. Because of this altruistic view, stewards see themselves accountable to the improvement of firm performance. Similarly Islam views individuals as faithful and God-fearing therefore this accountability in Shariah governance is even stronger.

As stated previously, in stakeholder theory the issue of account-ability goes even beyond simple economic and financial performance. Both stakeholder theory and stewardship theory take an altruistic view on individuals and assume a fiduciary duty for them which calls for accountability. In the Holy Quran the word hesab or account is repeated


eight times in different verses which refers to one’s obligation toward Allah (SWT) on all matters related to human behavior for which every Muslim is accountable. The significance of accountability is described best by Prophet Muhammad (pbuh) who said: ‘each of you is a guard-ian and each guardian is accountable to anything under his care’. This hadith implies the fact that no matter what activity the Muslims do, whether it is ibadah (prayer) or banking, they must abide by the Shariah framework carefully. Therefore while explaining Shariah governance both of these theories can be integrated. Consequently we can suggest that the greater accountability in Shariah governance can lead to better performance of the firm and improve the confidence and trust in IFIs.

Agency theory and stewardship theory

The nature of agency theory is that the principal hires the agent to perform a task which he is unable or unwilling to do; therefore in the first place the principal sees the agent as knowledgeable and compe-tent for the task. Bearing this fact in mind, this principle assumes that higher competence of managers leads to better performance of the organization.

Stewardship theory suggests that the success of an organization can be achieved by utilizing the expertise and experience of individuals who act as stewards in the organization. Accordingly stewards ought to rely on their expertise and competence in order to improve the firm’s performance.

Taking into account the above points, agency theory and stewardship theory can be integrated in such a way to explain that regardless of the view of these theories on behavioral intention of individuals, both of these theories are concurrent on this point that higher level of compe-tence among individuals in the firm can lead to better performance of the firm. The concept of competence and utilizing the expertise and opinions of experts is mentioned in the Holy Quran as well. In this regard Allah (SWT) refers to true believers as persons who ‘their affairs are decided after due consultation’ (42:38); therefore it can be argued that higher level of competence in Shariah governance can lead to better performance of IFIs.

Furthermore as argued by Aduda et al (2013), Licker (2007), Gibson et al (1991) and supported by the ideas of Hofstede (1980) (cited in Licker, 2007), increasing independence leads to more stewardship behaviors in the organization. On the other hand it is argued that although managers are primarily responsible for decision makings in everyday operations, it is the responsibility of the board to control those


functions which involves monitoring and also ratification of manage-rial decisions (Fama and Jensen, 1983). Therefore due to this control-ling function agency theory suggests that the board independence is necessary to maintain the balance between the power of management and controlling their decisions in order to ensure these decisions lead to better performance of the firm (Leung et al, 2014). The concept of independence of opinion and care for justice is one of the concerns of Shariah as the Holy Quran says: ‘O believers, stand for justice and bear true witness for the sake of Allah, even though it be against yourselves, your parents or your relatives. It does not matter whether the party is rich or poor, Allah is well-wisher of both. So let not your selfish desires swerve you from justice’ (4:135). Therefore it can be concluded that a higher level of independence among the key functionaries in Shariah governance leads to better performance of IFIs.

Development of an integrated theoretical framework for Shariah governance

In the preceding section we explained the relationship between the theories. In examining these relationships it was observed that there are some main concepts in these theories which are jointly related to Shariah governance, namely accountability, transparency and disclo-sure, competence, confidentiality and independence. Therefore these principles can be used in explaining the issue of Shariah governance. These main concepts in Shariah governance are explained as follows:

1. To discharge accountability to various stakeholders.2. To increase disclosure and transparency and consequently improve

the confidence and trust of stakeholders.3. To utilize the competence of board mem bers in order to improve the

performance of the IFI.4. To ensure confidentiality is maintained while disclosing information.5. To ensure independence among key func tionaries in Shariah

governance.

As stipulated by IFSB (2009), AAOIFI (2005), BNM (2010) and also many researchers such as Hamza (2013), Kasim and Shamsir (2012), Ullah (2013), Casper (2012), Hasan (2012), Minhas (2012), Grais & Pellegrini (2006) and Abdul Rahman et al (2005) these five factors are the main principles which can ensure the quality of Shariah governance in IFIs. Figure 1.1 illustrates these key concepts and their relationship to the theories in the constructed framework.


As mentioned earlier in this article, despite the similarities between ICG and CCG, the application of individual theories has proved to be insufficient particularly in the case of Shariah governance; hence Figure 1.1 depicts the integrated theoretical framework developed based on the three most commonly used theories in the subject of cor-porate governance and how their interrelated concepts can be explana-tory while considering the issue of Shariah governance.

The concepts of accountability in stakeholder theory and information asymmetry in agency theory both call for transparency and reporting on the operations of the firm; therefore they can be both integrated to explain one of the key points in Shariah governance which is transpar-ency and disclosure. However, both of these theories concur on the point that disclosure of confidential information can face the firm with the threat of competitive risks which refers to the issue of confidential-ity in Shariah governance.

Figure 1.1 Integrated theoretical framework

Transparency and disclosure

Interrelated ConceptsConfidentiality

Com

pete

nce

Inter

rela

ted

Conc

epts

Inde

pend

ence

AccountabilityInterrelated

Concept

Stakeholder theory:-Stakeholder-management

-Responsibility

Agency theory:-Principal-agent

-Informationasymmetry

Stewardship theory:-Steward-shareholder-Leadership Expertise

Shariah governance:-Accountability-Independence-Competence

-Confidentiality-Disclosure andTransparency


The altruistic view of individuals in both stakeholder theory and stewardship theory has led to the concept of accountability to share-holders as well as the stakeholders which is one of the main concerns in Shariah governance as stipulated in Maqasid al Shariah.

The nature of the principal—agent relationship in agency theory implies the reliance of the firm on the expertise and experience of the agent which can be integrated with stewardship theory that sees the success of the firm in utilizing the skills of stewards; therefore both these theories can be explanatory for one of the key concepts in Shariah governance which is the competence of key functionaries in Shariah governance in both Shariah and Islamic finance.

On the other hand both these theories concur on the point that in order for the individuals in the firm to perform their duties and utilize their expertise and also to create a balance of power in the firm they must be given independence which refers to the concept of independ-ence of key functionaries in Shariah governance.

Discussion and conclusion

In order to develop a comprehensive theoretical framework for Shariah governance this study has attempted to demonstrate the underlying assumptions in agency theory, stewardship theory and stakeholder theory and incorporated their interrelated concepts with Shariah gov-ernance. For this purpose a QCA approach was used to systematically and objectively analyze the related studies.

According to the integrated theoretical framework, agency theory and stakeholder theory are both concerned with the problem of information asymmetry. Although they take a different view on the parties affected by this issue, to resolve the issue of information asymmetry both theo-ries suggest transparency and disclosure. However, they describe that the flow of confidential information to various parties can create com-petitive risk for the IFI, hence the issue of confidentiality must be taken into account in this process.

The integrated theoretical framework discusses that both the stake-holder theory and stewardship theory take an altruistic view of the leaders and directors and assume a fiduciary duty for them which calls for more responsibility. Therefore these two theories concur on the point that there is a need for greater accountability in the IFI toward the shareholders as well as the other stakeholders.

It is highlighted in the integrated theoretical framework that regard-less of different views of agency theory and stewardship theory on the


behavioral intentions of individuals, both are equally important to explain that expertise and competence of leaders is essential for the improvement and success of the IFI. On the other hand it has been dis-cussed that a certain level of independence is needed for the individuals to demonstrate their abilities and competence properly. Therefore it can be concluded that a higher level of independence among key function-aries in Shariah governance leads to better performance of IFI.

Given the Maqasid al Shariah and also taking into account the pro-posed integrated framework in this article we can conclude that the ultimate goal in ICG and Shariah governance in particular apart from financial performance is to create a balance between the rights of own-ers and other stakeholders. It is worth noting that most of the Islamic banks across the world are established and controlled by the govern-ment (Abdul Gafoor, 1995). Despite its limitations, this article can serve researchers, executives and policymakers as a basis for further interpre-tations and comparisons on what is the ideal form of governance and what is the practical corporate governance mechanism in IFIs. This can signify the extent to which IFIs are making efforts to comply with Shariah principles.

One of the limitations of the current study is that the integrated theoretical framework is not tested in any practical study therefore its relevance to Shariah governance is not empirically confirmed yet. Hence it is recommended for any future study in this field to empiri-cally examine the relevance of the developed integrated theoretical framework to the subject of Shariah governance and also to measure the extent to which these principles are implemented by IFIs.

References

AAOIFI (2005) Governance Standard for IFIs, No. 1 Shariah Supervisory Board (SSB): Appointment, Composition and Report. Bahrain: AAOIFI.

Abu-Tapanjeh, A.M. (2009) Corporate governance from the Islamic perspective: A comparative analysis with OECD principles. Critical Perspectives on Accounting 20(5): 556–567.

Abdul Rahman, A., Abu Bakar, B. and Sayfie, W. (2005) Syariah Governance of Islamic Banks: Perceptions of Responsibility and Independence of Syarah Advisors. Corporate Governance: An Islamic Paradigm. University Putra Malaysia, pp. 20–34.

Abdul Gafoor, A.L.M. (1995) Interest-Free Commercial Banking. Groningen, Netherlands: Apptec Publications.

Aduda, J., Chogii, R. and Magutu, P.O. (2013) An empirical test of competing corporate governance theories on the performance of firms listed at the Nairobi Securities Exchange. European Scientifi c Journal 9(13): 107–137.


Akhtar, S. (2006) Syariah Compliant Corporate Governance. In: Nasser Saidi, Keynote Address by the Governor of the State Bank of Pakistan at the Annual Corporate Governance Conference, Dubai, United Arab Emirates, November. Hawkamah Institute for Corporate Governance.

Alnasser, S.A.S. and Muhammed, J. (20

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