Islamic Finance : Opportunities & Challenges

Corporate Governance IssuesWorld Bank Seminar,

Washington DC, April 24 2006

Simon Archer

Professor, University of Surrey, UK

Consultant, IFSB

2

Corporate Governance Issues

Focus of this talk:– Banks rather than insurance cos.

• Unrestricted IAH as stakeholders– Ambiguous status – Information rights– Control rights

• Cross-border Shari’a compliance: home-host issues • Operating environment: emerging markets

– Concentrated shareholders, ‘grey’ directors and related party transactions

– Lack of market discipline & weak information environment– Government interference

3

Unrestricted IAH as stakeholders

Ambiguous status • Profit-sharing investors or ‘depositors’?

– Conventional depositors• Don’t need control rights except as creditors in an insolvency• Have very limited information needs as their capital is

guaranteed and their rate of return established by contract• Basically only need to know that bank is solvent

– Unrestricted IAH as Profit-sharing investors• Have same information needs as shareholders

– Risk and expected return• What about their control rights?

– Conventional interpretation of Mudaraba gives them none, except right to withdraw their funds subject to forfeiting share of profits

4

Unrestricted IAH

Assumption that they are passive investors• Can they rely on shareholders to monitor

management on their behalf?– Possible conflicts of interest e.g. re risk appetite

• If not, what is appropriate?– Information rights: similar to those of CIS participants

• Asset allocation, risk & profitability• But also: profit allocation & use of reserves (PER/IRR)

– Control rights: IFSB ED3 Governance Committee suggestion

• Requires no active participation from IAH

5

Cross-border Shari’a Compliance: Home-Host Issues

Applicable Shari’a rulings may differ between the country of the parent bank and that of a foreign operation (branch or subsidiary)

• Which rulings should be valid for the foreign operation?– If host country has a National Shari’a Authority (e.g. Malaysia or

Sudan) then foreign operation is bound to follow its rulings– If home country has a National Shari’a Authority, but host

country does not, does foreign operation have to follow home country rulings?

• Probably yes if branch• But if subsidiary, with own Shari’a Board?

– If both countries have National Shari’a Authorities? • Need for cooperation between the 2 countries to resolve

conflicts

6

Operating Environment (1)Concentrated shareholders• May dominate Board of Directors• Non-execs may not be independent• Risk of related party transactions that may damage the

bank– Danger for minority shareholders and IAH– Need for transparency (financial reporting standards)– How much reliance can be placed on external auditors?– Key role of banking supervisor

• ‘fit & proper’ tests• Monitoring of dominant shareholdings • Risk of pressure on supervisor

7

Operating Environment (2)

Lack of market discipline & weak info. environment• Aggravates problems just mentioned• Need for regulatory authorities to be pro-active to

‘bootstrap’ info. environment and mkt. discipline• May be problematic

– Govt. control of, or pressure on, banks’ commercial activities is likely to impede mkt. discipline

– Conflict between (a) govt. concern with macro & social role of banks in eco dev and (b) development of robust banking system

– Islamic banks not essentially different from conventional banks in this, but may be more vulnerable

• Financing modes may be more risky but can the risk be priced for (e.g. Salam) ?

8

Concluding Remarks

• Burden on banking supervisors & regulators to enable the issues outlined above to be handled successfully

• IFSB’s efforts to provide support– Issued: Standards on Risk Management, Capital

Adequacy, ED on Corporate Governance– In progress: EDs on Supervisory Review Process

and Transparency & Market Discipline; + complementary standards

– Seminars on the above