Recent financial events have brought back arguments relating to financial regulation and supervision. The need for regulators to establish adequate rules for financial players has once again been pushed into the spotlight. With the apparent failures of regulatory and supervisory roles being blamed for the recent financial crisis (see Crotty, 2009), the need for sound financial supervision in order to establish market confidence amongst the financial marketplace is of significant importance. This need stretches from conventional finance into
129 the spectrum of Islamic finance as well. These regulatory challenges will invariably have an impact on the overall spectrum of Islamic financial corporate governance, which would have a substantial underlying effect on the confidence of Islamic financial participants. As we shall discuss in the following paragraphs issues of institutional and systemic regulation, transparency, uniformity and stakeholder rights these facets are very much similar to conventional corporate governance concerns. Abu-Tapanjeh (2009) provides an insight into the Islamic financial issues pertaining to corporate governance and compares OECD and Islamic Corporate Governance Principles (see Table 7).
130 Principle
Number OECD Principles and Annotation Islamic Principles
1 Insuring the basis for an effective corporate governance framework
Promotion of transparent and efficient markets with rule of law and division of responsibilities.
Promotion of business within ethical framework of Shariah
Believes in profit and loss
Primacy of Justice and social welfare with social and spiritual obligations
Prohibition of interest 2 The Rights of Shareholders and Key Ownership Functions
Basic shareholder rights
Participation in Decision-making at the general meetings
Structures and arrangements markets for corporate control
Ownership rights by all shareholders including institutional shareholders
Consultative process between shareholders and institutional shareholders
Property as trust from God
Sole Authority is God
Society as stakeholders
Accountability not only to stakeholders but also to God, the ultimate owner
3 The equitable treatment of shareholders
Protection to minority and foreign shareholders Just and fairness of value
Equitable distribution of wealth to all stakeholders and disadvantaged members in the form of Zakat and Sadqa
Social and individual welfare with both spiritual and moral obligation
131 Table 7: Comparison of OECD and Islamic Corporate Governance Principles (Source: Abu-Tapanjeh, 2009)
4 The role of stakeholders in corporate governance
In creating wealth, jobs and sustainability of financially sound enterprises
Islamic accountability to Falah and social welfare orientation
Haram/ Halal dichotomy in transaction
Social & individual welfare from both spiritual and material
Consideration to whole community 5 Disclosure and Transparency
Matters regarding corporation
Financial situation
Performance, ownership and governance
Accountability with Shariah compliance
Socio-economic objectives related to firms' control and accountability to all its stakeholders
Justice, equality, truthfulness transparency
wider accountability with written as well as oral disclosure
6 The responsibilities of the board
Strategic guidance
Monitoring of management
Accountability to company and stakeholders
Accountability not only to company or board or stakeholders but also to Allah the ultimate authority who leads to welfare and success
Holistic and integrative guidance
Negotiation and co-operation
Consultation and consensus seeking for each decision with related stakeholders
132 The growth of Islamic finance, not only as a financial system for Muslims, but as a financial system for all mainstream customers has meant that there is a greater demand for the development of more a transparent and uniform set of rules and regulation.
The need for adequate financial regulation and supervision stems from the want of a stable financial system. The consolidation of stability within any financial system has a powerful influence on the determinants of economic growth and development (Llewellyn, 2006; Taylor and Fleming, 1999). Economic aspects such as market confidence, capital generation and efficient resource allocation are seen as vital towards the development of any economy however their existence depends extensively on the initial systemic stability of the financial system which is back by a concise and consistent regulatory standard (Llewellyn, 2006). The recent global financial crisis along with the Asian financial crisis of 1997 illustrates how poor regulation could lead to market instability and could impact upon annual economic growth and development in the short to medium term. Additionally, market instability introduces elements of uncertainty that could be detrimental to the economy as a whole over the long term period (Eisenberg and Noe, 2001).
Financial regulation and supervision has always been a topic, which has echoed throughout many an academic and professional arena. The fine art of striking a balance between over- regulation of financial systems against an over-relaxed financial system has always been a subject of debate (Llewellyn, 1999). What justifies good regulation and governance? What should be regulated and how? Moreover, there is also the issue of who should bear this regulatory undertaking. Should this responsibility belong to a centralized body or should it be enforced at an institutional level?
133 Regulatory and supervisory development within conventional, Western finance has had decades to grow, evolve and form to sufficiently appease the needs of the modern economy. Numerous problems have been encountered, financial crises have been experienced and financial scandals have been exposed. Lessons have been learnt about the damage poor financial regulation can inflict upon any financial system (see Boyd et al., 2000; Caprio and
Klingebiel, 2002). So how does this translate to the Islamic financial spectra?
The unique characteristics of Islamic finance do not absolve it from the usual problems that plague the regulatory and supervisory facet of a financial system (El-Hawary et al., 2007). On the contrary more emphasis is placed upon the development of an adequate regulatory standard within the context of Islamic finance. Islamic banks and financial service providers, like their Western, conventional counterparts, experience the same issues relating to regulation and governance. Barth et al. (2002) highlights these as:
i) regulating banking activities and commerce links ii) regulating domestic and foreign bank entry iii) regulations on capital adequacy
iv) deposit insurance design v) supervision
vi) private-sector monitoring of banks and vii) government ownership of banks.
The experiences of Western finance have helped many a developing financial system to learn and identify weaknesses within any economic system and the framework by which to
134 succinctly deal with these problems has been established. Additionally, there exist instances where the emphasis of conventional regulatory standards may differ from that of Shariah finance. In cases such as these, whilst the emphasis maybe different, the regulatory standard remains the same. For example Islamic banking is also known as non-interest banking with the financial system’s disregard for usury. Gharar and maysir also place additional stipulations upon all financial dealings within Islamic finance. These impositions mean that there is less emphasis on the regulation of credit/ interest rate risk as transactions that bear these risks are specifically disallowed under the rules of Islamic finance (Akhtar et al., 2011). With more prominence placed upon ‘real’ transactions, the emphasis on regulation shifts towards default risk (Sundararajan, 2007). The problem of regulation and governance within Islamic finance lies firmly with adapting existing regulations to protect clients to a similar level to that of their Western counterparts, whilst at the same time maintaining a balanced playing field so that neither Islamic finance nor conventional finance are disadvantaged (Wilson, 2000).
The issues of governance in Islamic finance can be argued on two fronts – Shariah- compliance and the uniformity of Shariah-compliant standards. As stated before (Hersh, 2011) there exist three categories of Islamic Banks
i) Banks who belong to a wholly Islamic financial system
ii) Islamic banks who belong to a conventional financial system and exist alongside conventional banks
iii) Conventional banks who offer Shariah-compliant products and services through Islamic windows
135 Whilst banks belonging to categories i & ii have to apply, staunchly, the strict Islamic code towards their financial activities, there exist problems of regulating Shariah-compliance in the third category of banks. The offer of Shariah-compliant products and services through Islamic windows was a significant development towards the growth of the Islamic financial system in mainstream finance. It allowed trusted mainstream banking and financial brands the opportunity to offer products to not only Muslims but also conventional consumers. By using established names in the economy, it was a significantly easier task building consumer confidence in these new products (Alserhan, 2010). However, as the Islamic financial system has seen substantial growth over the past decade, the products on offer blurred the line between Shariah-complaint and conventional interest bearing instruments but this was only to be expected (El-Gamal, 2005; Derigs and Marzban 2008). Initial Shariah-compliant products on offer comprised mainly of Islamic mortgages (murdarabah) and deposit taking activities.
However, with the growth of the Islamic financial system, there came a demand for more evolved products that would meet the needs of Islamic risk management and investment. This development has led to the inception of Islamic instruments such as multiple wa’ad and layered murabaha. Whilst the underlying edict behind these products claims to be Shariah-
compliant they are not in essence inherently Islamic. This has resulted in arguments between Shariah-based and Shariah-backed banking where the instruments described above belong to a Shariah-based category (see El-Gamal, 2006; Errico and Farahbaksh, 1998; Khatkhatay and Nisar, 2007a and 2007b). Moreover, whilst these products are Shariah-compliant, they are not entirely accepted amongst the different Islamic financial systems.
136 Shariah-compliance is an important underlying regulatory issue in modern Islamic finance. As stated before, consumer confidence builds stability, which is pivotal towards the growth of a financial system. A feature of Islamic finance is that consumer confidence is built upon the fact that financial aspects of the system conforms to their religious beliefs. Should this fail the pillars upon which Islamic finance was built would crumble (Grais and Pellegrini, 2006). As such the governance and regulation of Shariah-compliance standards are an essential part of modern Islamic finance. The job of assessing the validity of Shariah-compliance takes place at institutional level with each institution who offers Islamic financial services having in- house religious advisors, collectively known as the Shariah Supervisory Board (Grais and Pellegrini, 2006). Whilst the name might suggest that the composition of these SSBs be entirely of religious, pious individuals, they are in-fact made up of a mix of religious scholars and financial practitioners whose job is to debate both the religious and financial underpinnings of each new service and/or product (Errico and Farahbaksh, 1998). The composition and running of these SSBs raises five main issues of a regulatory nature, namely independence, confidentiality, competence, consistency and disclosure. Each of these aspects will be examined in relation to regulatory issues that were raised in the empirical literature.
With regards to independence, members of the SSB are appointed by Board of Directors and are supposed to hold an unbiased opinion of every potential product or service, which requires their judgement (Grais and Pellegrini, 2006). However, the employment relationship between SSB and institution, along with respective remuneration packages, paint a faint and slightly negative picture of their independence. Situations may arise whereby stakeholders attempt to exert a certain influence on members of the SSB also known as ‘Fatwa shopping’ (Grais and Pellegrini, 2006). While this arrangement maybe frowned upon in a conventional
137 financial environment the argument that the ethical standards of SSBs should and would prevent such events from occurring is widely accepted. Should any underhand activities occur, this would severely damage the reputation and lead to due recourse. The argument that the benefits of influencing your SSB are outstripped by the detriments should deter or mitigate the regulatory problems of independence.
This leads on to the issue of confidentiality. Another aspect of SSBs is the fact that members are allowed to sit on the SSBs of different companies. It is argued that this might lead to a possible transfer of information but once again the morality of SSB members should prevent this (Grais and Pellegrini, 2006). However, it does bring about the next problem of competence. The lack of Shariah scholars has meant that there is a distinct lack of man power and new talent in the profession. Regulators have been busy promoting and establishing new incentives and schemes for training and recruitment to such a field.
The consistency of judgements of SSBs has also been scrutinised, considering that assessing the viability if Shariah-compliant products and services is such a subjective science. However, empirical research conducted by the Council for Islamic Banks and Financial Institutions (CIBAFI) has shown that the diversity of judgements on Shariah-compliance is less that first anticipated. Out of 6000 fatwas sampled, it was found that 90% were consistent across banks (CIBAFI, 2009). However, consistency not only entails consistency of judgements but also adoption of rules and regulation. By and large Islamic financial systems are left to govern themselves. Whilst there exists a set of generalised religious beliefs that are implemented to each financial system, much is down to the precepts of individual religious scholars belonging to that particular region. The interpretation of Shariah, differs from the
138 Gulf Co-operation Council (GCC) countries and the Middle East to that of South East Asia and even that of Western economies (Chapra and Ahmed, 2002; Chapra and Khan, 2000). This has meant that while some products are allowed in one Islamic financial system, it might be disallowed under another. The lack of uniformity results in confusion and a potential problem of double standards, which could and would hurt the development of new implements in Islamic finance. While this issue might be difficult to tackle at institutional level, there have been calls for a central governing body to be established (Chapra and Ahmed, 2002; Chapra and Khan, 2000; El Sheikkh, 2000).
Finally, we consider the issue of transparency. Every financial system prides itself on being open and disclosing the nature of most deals. While it may seem like a naive and overreaching ideal to have complete transparency, an adequate level would suffice to satisfy most market participants (Merton, 1990 and 1995). Regulatory standards in conventional finance require that all institutions publish annual reports pertaining to company performance over the year. Moreover, additional effort is placed into exposing all information pertaining to large trades and mergers and acquisitions. Board members are made known to stakeholders and the entire Western financial system attempts to portray itself as an open, ‘nothing-to- hide’ economy.
On the other hand however, transparency in Islamic finance is becoming an increasingly important issue (Honohan, 2001; Grais and Pellegrini, 2006). Many large transactions within the Islamic financial system are largely kept confidential. The recent near default by Dubai World on its sukuk (Islamic bond) placed great emphasis on transparency and regulation of
139 the value of a sukuk is very much dependent upon the tangible underlying asset. This default was due to unfavourable market conditions impacting the value of the underlying asset. The issue of regulation that presented itself in the wake of this default was the lack of protection for sukuk holders as these bond holders have no explicit claim to the worth of the underlying asset and are unable to force a company to liquidate its position as a mode of recourse (Permatasari and Manurung, 2010).
A major concern emphasized on the issue of transparency of Shariah finance would be that so far scandals and regulatory demises of any kind have yet to be tested within the courts (IFSL, 2010). There is no fixed legislation and precedence to deal with these incidents. Moreover, it is surprising that most legal documentation pertaining to Islamic transactions are governed by English law, which may or may not be accepted in the country the agreement originated within (IFSL, 2010). Consumers have little or no access to information about how certain products are structured, how they are financed or the level of involvement of participants. Moreover, there is no fixed regulation that requires banks, even those providing Shariah- compliant services, to publish reports about SSBs and the fatwas that have been granted. This only serves to dampen consumer confidence and should be an area that is tackled at a centralized level rather than an institutional level.
The analysis on regulatory issues in this research study has so far focused on regulation and supervision at an institutional level. However, there persist issues on a broader scale that involve the entire Islamic financial system as a whole. As stated earlier, the adoption of certain Islamic products into specific Islamic financial systems is diverse. While markets such as that of Malaysia and the United Kingdom have a more liberal stance towards the inception
140 of new and more “Western” products, Islamic markets in the GCC adopt a stricter view on financial innovation (Smorlaski et al., 2006). This divergent view illustrates the differences in regulatory standards across the various Islamic financial systems.
With each of the centralised Islamic financial hubs there exists a different interpretation of Shariah laws. This is put down to the fact that there exist 5 different schools of thought within Islam and each has its own understanding of Islamic law (see Table 8 and 9). This therefore creates different interpretations, which lead to different Islamic regulatory standards depending, on which Islamic financial market participants exist in.
141
Branch Numbers Belief
Sunnis (can be further broken up into 4 subsets of teaching beliefs in Table 7 below)
1 billion plus Follow the sayings, deeds and practices (Sunnah) of Muhammad. Emphasis on texts and legal interpretation.
Shias 100million plus Believe Muhammad’s kin were his rightful successors, and that the last of a line of 12 imams may reappear soon. Embittered by repression and terrorist attacks.
Sufis Unknown (many Sufis
practice in secret)
Adhere to Islam’s mystical tradition; cultivate remembrance (dhikr) of God through asceticism and recitation of prayers. May be either Sunni or Shia
Salafist/ Wahhabis 17million
Imitate the earliest generations of Muslims and distrust later interpretations. Strict, austere Sunnis, maybe peaceful or violent, pietistic or political. Often followers of
al-Wahhab, 18th century Salafist teacher. Prevalent in Saudi Arabia.
Ismailis 15million Disagree with other Shias about the line of spiritual succession after 8
th
century, notable do-gooders, relaxed about religious rules.
Alevis 10million Downplay formal Muslim rituals, stress sexual equality, overlap with the Bektashi mystical movement, leftist, fear Sunni majority. Based in Turkey.
Ahmaddiyas 4million Revere a 19
th
century Indian Muslim revivalist. Vigorous but oppressed in Pakistan and South Asian diaspora, keen builders of schools and hospitals.
Alawaites 3million Emphasise the Shia imams, esoteric offshoot of Ismaili Shiism. Some rights overlap with Christianity. Rulers of Syria.
142
School Geographical Distribution
Hanafi Iraq, Turkey, Iran, Afghanistan, Jordan, China and Egypt Maliki North Africa, Kuwait, United Arab Emirates and Bahrain
Shafi’i Yemen, Somalia, South East Asia, Jordan, Egypt and southern parts of India