Tighter corporate governance structures key to success of Islamic Finance

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corporate governance and related words

By Jaafar S. Abdulkadir

Corporate governance continues to be a relevant subject of discussion globally owing to the deregulation of markets, the rise of institutional investors and the continuing integration of world economies. There has never been stronger emphasis on promoting the collective interests of stakeholders, and not just the narrow interests of shareholders, than there is now.

The economic and financial crisis that plagues the markets from time to time may be attributed to loose governance, which blurs the separation of roles between those who own the business entities and those who manage these entities. Good corporate governance helps to enhance efficient allocation of resources and inspires prudence in the management of businesses. The benefits that stem from good corporate governance include lowering the cost of capital, formation of capital and the facilitation of productivity and meaningful growth.

Poor corporate governance undermines the confidence of the stakeholders, creates instability, raises the cost of capital, intensifies poverty and precipitates economic and financial crises. It discourages innovation and makes the business environment uncompetitive.

The relentless focus on profit maximisation at all costs undermines the collective well being of all stakeholders by   privatising gains for the benefit of the business owners to the exclusion of other stakeholders, who often bear the brunt of unfair and unethical business practices. The enterprise that aims to privatise gains and socialise risks shall, in a matter of time, lose relevance.

Corporate governance is defined as a set of relationships between a company’s management, its board, shareholders and other stakeholders, according to the Organization for Economic Cooperation and Development (OECD). In fact, corporate governance affords organisations the framework and structures through which they could realise their set objectives and determine how to monitor their progress.

According to the International Finance Corporation (IFC) and Hawkamah survey of listed companies and banks across the Middle East and North Africa in 2008, there are five elements of good corporate governance: good board practices, control environment and process, shareholder rights, disclosure and transparency, and commitment.

The element of good board practices dwells on the roles, duties, responsibilities and the structure of the boards. Due attention is also given to the appropriate composition and mix of skills of the board membership. Board self-evaluation and training approaches as well as remuneration need to be defined in line with best practices.

Under the control environment and processes element, the risk management framework, the internal control procedures, the internal as well as the independent external audit functions are properly defined. Sound management information systems, the establishment of the independent audit committee and compliance function are also determined.
For the shareholders’ rights to be upheld, this element underscores the need to formalise and balance the minority shareholder rights and promotes the organisation of the general assembly of the shareholders. Issues to do with related party transactions and explicit dividend policies are clearly handled.

The element on disclosure and transparency, which attract the focus of the regulators, calls for the timely and accurate disclosure of financial and non-financial information. Provisions for web-based disclosure and investor sites have to be embedded within the organisational framework.

Without commitment, all the identified elements amount to nothing. This creates the need to have robust commitment to sound corporate governance by having it as the top agenda of the board, devising improvement plans on the same and the development of corporate governance codes and guidelines without failing to allocate the appropriate resources for the promotion of corporate governance.

Islamic financial institutions have to observe the above elements and in addition strongly anchor its operations on the Sharia governance framework that, indeed, informs the very foundation and the value systems of these institutions. Sharia governance helps to augment the confidence and the trust of the stakeholders of the Islamic institutions.

Sharia governance may be defined as the structured system that manages the conformity of the activities and the transactions of the financial institutions to the tenets of the Sharia that exist to regulate the same. These structured system of Sharia governance have both the internal and external components that work in unison to promote compliance to the Sharia precepts.

The Islamic Financial Services Board (IFSB) defines Sharia governance system as “the set of institutional arrangements through which an institution that offers Islamic financial services ensures that there is effective independent oversight of Sharia compliance over its processes and structures.” These institutional arrangements not only involve the financial service providers but other stakeholders who include the regulators and other relevant market players.

These structures and processes may include the issuance of Sharia resolutions, dissemination of the Sharia resolutions, the internal Sharia compliance review as well as audit among others.

The Islamic financial institutions are required to demonstrate good corporate governance with high standards of disclosure and transparency, well-defined and protected stakeholders’ rights, commitment to Sharia and corporate governance, professionally managed control environment and processes and empowered board.

The Islamic finance standard setting bodies like IFSB and the Accounting and Auditing Organisations of Islamic financial Institutions (AAOIFI) have quite elaborate guidelines and standards on structures, mechanisms and systems through which the Sharia governance objectives and the effective and efficient utilisation of resources by the Islamic finance institutions can be monitored and realised. These bodies work to complement the existing internationally accepted standards and best practices while ensuring that Sharia serves as the backbone of the targeted institutions.

Any institution that seeks to offer Islamic financial services have to draw inspiration from the Sharia tenets and embed in its infrastructure a strong Sharia governance framework and demonstrate a high level of commitment to the highest possible standards of corporate governance.

Writer is Managing Director, Aqeel Consulting Ltd