Corporate Governance and Regulation

A functioning economy requires a stable and reliable banking and financial services sector. Banks cannot be relegated to a totally laissez-faire market where all transactions are free of regulation and supervision. A set of restrictive and injunctive regulations is used to supervise the banks in the modern economy. These regulations oversee the operations, development, discipline, and competition among the banks. The supervision and regulation is needed to avoid crises and to maintain the public trust.

The supervision does not and cannot prevent individual bank failures or complaints of individual customers against a particular bank. The operations and control is the domain of the bank managers, boards, and the shareholders. The external supervision only ensures functioning of control mechanisms and risk management. The regulators carry out periodic audits to check for adherence to the laws. The regulatory powers include ownership, capital and liquidity requirements, external and internal controls, operations, customer protection, and supervision. The supervisory functions may include inspections, review of compliance programs, branch setups, trading operations related to capital markets, and assessment of information technology.

In the modern economy where overwhelming majority of banks are conventional, Islamic banks are subject to similar regulatory regime as other banks. The regulators need to assure that the Islamic banks provide transparent information to the investors, have mechanisms in place to protect the customers, and also play their role in maintaining a sound financial system. They also have the additional requirements of Shari’ah compliance, development of financial market infrastructure, provision of cost-effective Islamic financial products, conformity to best practices, and using the central bank as a lender of last resort without the involvement of Riba.

The central banks and regulators dealing with Islamic banks need to provide a level playing field for Islamic banks. This requires development of a monetary policy, which can accomodate Shari’ah principles. The regulators need to be conversant in Shari’ah based products and work diligently to lessen the burden of undue regulation on Islamic banks. The key tasks for regulators in this area include the following:

• Support inter-dependencies and inter-linkages among different segments of Islamic Financial Institutions.
• Allow the banks to offer a variety of services besides traditional deposits and loans. These may include Takaful insurance and mutual funds.
• Support Islamic banks’ move away from fixed return products of Murabaha and Ijarah to more profit and loss sharing schemes of Mudarabah and Musharakah. This will push these banks towards a universal banking model to manage portfolio profitability through equity and Sukuk in the capital markets and Islamic trade contracts.
• Create a regulatory framework that can accommodate the principal loss to account holders, which is a Shari’ah requirement.
• Work with Islamic Financial Services Board (IFSB) that provides guidance on the effective supervision and regulation of Islamic Financial Institutions.

What differentiates an Islamic bank from a conventional bank is the adherence to Shari’ah. This includes prohibited transactions that involve Riba (usury and interest), Gharar (uncertainty), and Maysir (wagering or speculation). This also covers avoiding prohibited business activities such as alcohol; tobacco; pork products; defense/weapons; entertainment (such as hotels, casinos or gambling, cinema, pornography and music). Today’s complex economies contain a mix of financial products and services. There are formidable challenges for Islamic banks to operate in a secular economy yet offer Shari’ah compliant products. Independent Shari’ah Boards play that crucial role of checking for Shari’ah compliance on all products and services offered by a bank. They should be independent and carry veto power to rule against any transactions that they believe contravene Shari’ah principles. This is necessary to earn the confidence of customers, regulators, and general public that Islamic banks are indeed different and are addressing a unique niche market.

Islamic banks are becoming mainstream in many countries and are being recognized as an alternative means of provision of financial services. In order to maintain their identity they need a framework to ensure the governance of the Shari’ah compliance rules. This is the role provided by the independent Shari’ah boards. The boards must implement a review process to provide proactive guidance to management on compliance issues. The board should not be lenient in application of Shari’ah principles and must not allow income from any source that involves Riba or Gharar. Any such activities must be identified early on to avoid backtracking of a prohibited transaction. This will also ensure that before any transaction or service offered by the bank is Shari’ah compliant.

The Islamic banks are established to service not only Muslims but also any one in general population who considers the Islamic financial system as a more just and humane system. The banks serve the needs of all stakeholders including shareholders, depositors, and employees and the developing the professional and ethical qualities of management and staff. Shari’ah compliance through supervisory boards ensures the business is conducted in conformity with Shari’ah, thus furthering Islam’s social objectives and promoting social benevolence. This also helps in evolution of a comprehensive and integrated Islamic financial system based on the rules of Islamic Shari’ah.

A standard setting body on Corporate Governance, The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), provides guidance to Islamic financial institutions on the structure of the Shari’ah Supervisory Board, the internal Shari’ah review process, and the relationship between the Supervisory Boards and the external auditors. A standard Shari’ah review process is necessary for compliance across all Islamic banks. The standards should be the benchmark for all such banks to follow and for Shari’ah boards to implement. This will promote further growth of Islamic finance industry by increasing transparency and thus improving credibility.