Need for Better Corporate Governance in Islamic Finance

Muneer Khan and Omar Shariff

The Islamic finance industry continues to grow exponentially worldwide and latest estimates show that global Shariah-compliant assets have crossed the US$500 billion mark. Since its modern-day re-emergence nearly 35 years ago, this religion-based financial system has positioned itself as a growing force to be reckoned with in the global financial arena.

According to current estimates, there are about 300 Islamic financial institutions (IFIs) operating in over 75 countries worldwide. The number of such institutions and the products they offer to their investors continues to grow at a phenomenal rate.

It could be argued that the level of good governance actually required by Shariah principles transcends the levels usually required under conventional financial systems. This is because Islamic financial principles categorize an IFI as a trustee of its investors. As such, the IFI must be transparent, act fairly and be held accountable to the investors.

Considering other matters, the significant amount of wealth currently entrusted to IFIs and their role as the trustees of their investors, is it time for the introduction of more robust corporate governance practices tailored specifically for IFIs?

Regulatory authorities’ approaches
In general, regulators charged with the responsibility of supervising IFIs have thus far taken a non-prescriptive approach. Rather than setting criteria and standards, which IFIs have to fulfil and comply with in order to be authorized and licensed to carry out Shariah-compliant activities, the onus is placed on the individual IFIs to put adequate measures in place to ensure that the services and products they offer are in accordance with Islamic principles.

Both the Dubai Financial Services Authority and the Qatar Financial Centre Regulatory Authority have taken this approach.

The UK Financial Services Authority (FSA), however, takes a different approach in relation to the regulation of IFIs. It makes no distinction between IFIs and conventional financial institutions so far as their regulation is concerned, based on the principle that all financial institutions should expect the same treatment and be subjected to the same stringent standards.

Among the “potential difficulties” the FSA has identified in relation to the authorization and regulation of IFIs, is the role of the Shariah Scholars’ Boards (SSB). The FSA takes the view that as a secular, rather than a religious regulator, it should not concern itself with the different interpretations of Shariah principles.

Nonetheless, for the FSA to regulate the industry properly, it must fully understand the SSB’s role in each authorised IFI, and in particular, whether the role is executive or advisory. The implication is that, if it is an executive role, the SSB should be subjected to the usual standards for directors, including the “fit and proper person test”.

However, the shortage of Shariah scholars adequately experienced in modern-day Islamic finance practices is leading to a number of problems, including a heightened potential for conflicts of interest.

There are two key independent standards setting organizations in the Islamic finance industry: the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB). Both have recognised the need for more specific governance for IFIs and have in recent years started to issue standards and guidelines on corporate governance practices.

AAOIFI’s standards
AAOIFI has thus far issued standards on accounting, auditing, governance and Shariah. To date, AAOIFI has issued six governance standards covering:
the appointment and composition of SSBs;
the checks and balances brought about through external Shariah reviews;
the functions of internal Shariah reviews;
the objective monitoring of Shariah compliance by audit and governance committees;
the independence of SSBs; and
a general statement on governance principles for IFIs.
As a result of this, some regulatory authorities are beginning to rely upon AAOIFI standards for the specific regulation of IFIs.

IFSB guiding principles
In December 2006, the IFSB issued its comprehensive guiding principles paper on corporate governance for IFIs. These far-reaching guiding principles are intended to help IFIs with the establishment and improvement of their corporate governance frameworks and assist regulators with their assessment of such frameworks.

The IFSB takes the view that there is no ‘single model’ that suits all IFIs globally; rather, the effectiveness and soundness of a corporate governance framework will depend on the specificity of individual IFIs.

To that extent, the IFSB recommends that the implementation of the guiding principles should be “proportionate to the size, complexity, structure, economic significance and risk profile of the IFI”.

Shariah scholars’ role
Considering the non-prescriptive approach taken by regulators in regulating IFIs, which is firmly based on the internal controls of IFIs, the importance of the role played by SSBs in assisting to establish and maintain a good governance policy framework cannot be underestimated.

In order to discharge such a role to the best of their abilities and according to the relevant religious precepts, Shariah scholars sitting on SSBs and particularly those sitting on governance committees are required to be fair, impartial, unbiased and objective.

According to the AAOIFI governance standards, Shariah scholars must also strive to deal with Shariah compliance issues faced by IFIs to the best of their capability, without neglecting the ethics of their profession and with due consideration for accountability to God as well as to the public.

Shariah scholars should, therefore, at all times act independently and free from conflicts of interest. In the event that a conflict of interest arises, the AAOIFI governance standards state that the relevant Shariah scholar should review the issue with the SSB and if the issue is not resolved, the Shariah scholar concerned should resign and no longer take part in the functions of the relevant SSB.

Key Islamic finance industry players feel that although IFIs should be able to compete on a ‘level playing field’ with their conventional counterparts and demonstrate that they can meet the same regulatory standards, there is also a need to continue to develop more tailored regulations for IFIs.

These regulations need to address concerns which are more specific to IFIs, such as the role and operation of SSBs and, in doing so, will help to grow the level of trust and confidence increasingly being placed in the Islamic finance industry as a whole.

Muneer Khan, partner and global head of Islamic Finance of international law firm Simmons&Simmons and Omar Shariff is the firm’s associate of Islamic Finance. For more information please contact sarah.green@simomons-simmons.com