Chapter 5 Corporate Governance for Islamic Financial Institutions

1. Introduction to Islamic Banking and Finance: Principles and PracticeM. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni Chapter 5Corporate Governance for Islamic Financial Institutions

2. Learning Objectives Upon the completion of this chapter, the reader should be able to: 1.Describe the meaning of corporate governance within the Sharī‘ah framework as practiced in modern Islamic financial institutions 2.Explain the models and key principles of corporate governance, including Sharī‘ah governance 3. Understand the mechanisms of corporate governance and control, including the different organs in Islamic financial institutions 4. Understand the different models of corporate governance and Sharī‘ah governance, and the different approaches adopted by Islamic different financial institutions 5. Understand the dynamics of corporate governance in Islamic insurance entities.

3. Learning Objective 5.1 Describe the meaning of corporate governance within the Sharī‘ah framework as practiced in modern Islamic financial institutions Meaning of Corporate Governance • There is no generally accepted definition for corporate governance that can be applied to all contexts • Corporate governance has been defined in different contexts and jurisdictions according to the goal it is designed to achieve

4. Learning Objective 5.1 Describe the meaning of corporate governance within the Sharī‘ah framework as practiced in modern Islamic financial institutions Meaning of Corporate Governance Defining Corporate Governance “A set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined” (Organization for Economic Corporation and Development [OECD])

5. Learning Objective 5.1 Describe the meaning of corporate governance within the Sharī‘ah framework as practiced in modern Islamic financial institutions Meaning of Corporate Governance Defining Corporate Governance “Corporate governance is the relationship between corporate managers, directors and the providers of equity, people and institutions who save and invest their capital to earn a return. It ensures that the board of directors (BoD) is accountable for the pursuit of corporate objectives and that the corporation itself conforms to the law and regulations” (International Chamber of Commerce [ICC])

6. Learning Objective 5.1 Describe the meaning of corporate governance within the Sharī‘ah framework as practiced in modern Islamic financial institutions Meaning of Corporate Governance Defining Corporate Governance “Corporate governance is the system by which companies are directed and controlled…” (The Cadbury Report) • The definition and description given in the Cadbury Report explains the interrelationship among stakeholders in corporate entities and their responsibilities in ensuring the transparent and fair management of the company based on accountability

7. Learning Objective 5.1 Describe the meaning of corporate governance within the Sharī‘ah framework as practiced in modern Islamic financial institutions Meaning of Corporate Governance Common Features Shared by the Majority of Definitions • A system of relationships defined by structures and processes • Relationships with different and in some cases contrasting interests • Stakeholders’ involvement in the direction and control of the company • Rights and responsibilities are properly distributed among the stakeholders

8. Learning Objective 5.1 Describe the meaning of corporate governance within the Sharī‘ah framework as practiced in modern Islamic financial institutions Meaning of Corporate Governance Corporate Governance in Islam • Sharī‘ah supervisory board: - lays down Sharī‘ah-compliant rules and procedures - supervises/ensures Sharī’ah compliance of new products • Sharī'ah scholars have both consultative and supervisory functions • Sharī‘ah corporate governance structure of IFIs ensures strict compliance with the Sharī‘ah in all activities carried out by other stakeholders

9. Learning Objective 5.2 Explain the models and key principles of corporate governance, including Sharī‘ah governance Models of Corporate Governance: Stakeholder versus Stockholder Conventional Perspective: Two Basic Models • The Anglo-American model • Emphasizes interests of the shareholders • Aims at aligning manager’s interests with shareholders interests • Applies various ways to accomplish aims, including shareholder representation on the BoD, management compensation scheme, and external market discipline • The Anglo-American model has a great relevance for Islamic finance

10. Learning Objective 5.2 Explain the models and key principles of corporate governance, including Sharī‘ah governance Models of Corporate Governance: Stakeholder versus Stockholder Conventional Perspective: Two Basic Models • The Franco-German model • Emphasizes the stakeholder-value system • Incorporates interests of shareholders and non- shareholders with more emphasis on non-shareholders considered to be stakeholders

11. Learning Objective 5.2 Explain the models and key principles of corporate governance, including Sharī‘ah governance Models of Corporate Governance: Stakeholder versus Stockholder The Islamic paradigm Under the Islamic paradigm of corporate governance, all stakeholders (including shareholders, employees and executive management) should all serve on the board to ensure transparency, accountability, fairness, and mutual consultation

12. Learning Objective 5.2 Explain the models and key principles of corporate governance, including Sharī‘ah governance Models of Corporate Governance: Stakeholder versus Stockholder Role of Corporate Governance in Islamic Financial Institutions • The inclusion of Sharī‘ah governance to emphasize the compliance with the requirements of the Sharī‘ah • Accountability in business transactions to protect interests of all stakeholders, particularly investors • Issues of competitiveness and globalization of IFIs prompted some standard-setting bodies (IFSB, AAOIFI) to issue specific guidelines intended to help such institutions

13. Learning Objective 5.2 Explain the models and key principles of corporate governance, including Sharī‘ah governance Models of Corporate Governance: Stakeholder versus Stockholder The role of corporate governance in IFIs include: • Establishing a harmonious relationship among concerned parties • Promoting prudent and transparent practices in the management of IFIs • Protecting the interest of all stakeholders • Ensuring proper discharge of corporate social responsibility role of the IFIs • Promoting a sound, stable, and competitive Islamic financial industry

14. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governance and Control Principles of Corporate Governance in Islam • Concept of tawhid (unity of God) • Principle of shurah (mutual consultation) • Islamic legal rules on harmonious relationship and mutual benefits in commercial transactions

15. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control Figure 5.1: Functional Roles of Corporations in Islam

16. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control Sharī‘ah Governance • Sharī‘ah governance and corporate governance are inextricable in Islamic corporate entities • Sharī‘ah governance is missing in corporate governance frameworks of conventional financial institutions • Sharī‘ah system of governance introduced to: - complement adaptable standards of corporate governance - streamline non-compatible standards

17. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control Guiding Principles • Corporate Governance for Institutions Offering Only Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds, 2006 (IFSB-3) • Sharī'ah Governance Systems for Institutions Offering Islamic Financial Services, 2009 (IFSB-10) • Governance for Takâful (Islamic Insurance) Undertakings, 2009 (IFSB-8) • Governance for Islamic Collective Investment Schemes, 2008 (IFSB-6)

18. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governance and Control Functions of Sharī‘ah Governance System in IFIs • Advising the Board of Directors on Sharī`ah-related matters • Reviewing/endorsing Sharī`ah-related policies and guidelines • Endorsing/validating documentation for new products and services • Overseeing computation/distribution of zakat and funds for charity • Assisting and advising relevant parties that serve the IIFS • Documenting any opinion it gives on Sharī`ah-related issues (IFSB-10, p. 23)

19. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governance and Control Major areas of the Sharī‘ah Governance System in IFIs • Issuance of relevant Sharī`ah pronouncements/resolutions • Dissemination of the Sharī‘ah resolution to the Sharī‘ah Review Unit •  The ISCU to record and report its findings • Preparation of an Annual Sharī‘ah Compliance Review Report

20. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governance and Control Institutionalization of the Sharī‘ah Governance System • The first Sharī‘ah Board was established in 1976 by the Faisal Islamic Bank of Egypt • The institutionalisation carried out through: - Pre-modern society model (hisbah model) - more emphasis on Sharī‘ah-compliance - Modern scholars model (collective ijtihad model) - Sharī‘ah advisory and consultancy • In modern IFIs, the Sharī‘ah Board is responsible for product development, certification, and issuance of resolutions

21. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governance and Control Fiqh The whole corpus of Islamic jurisprudence. Fiqh may also mean the jurists' understanding of Islamic Law Fiqh al-mu‘malat The jurisprudence concerning transactions regulated by Islamic law Hisbah (market ombudsman) An Islamic institution that guards against infringement of the law in economic, social, and political domains

22. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control Organs of the Sharī‘ah Governance System • Sharī‘ah Supervisory Board at the micro level • Sharī‘ah Supervisory Council of the Central Bank at the macro level • Internal Sharī‘ah Compliance Unit (ISCU)

23. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control Sharī‘ah Supervisory Board at the Micro Level • The Sharī‘ah Supervisory Board (“Sharī‘ah Board”) - the highest organ of an Islamic financial institution - the advisory and supervisory roles ensuring Sharī‘ah compliance in all activities - is based on the traditional concept of hisbah • Hisbah - important organ of the Sharī‘ah governance system • Institutionalization of hisbah led to introduction of the Sharī‘ah Supervisory Board • Utilization of collective ijtihad to establish the Sharī‘ah Board

24. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control Sharī‘ah Supervisory Council of the Central Bank at the Macro Level • The establishment of Sharī‘ah Board at macro level: - A national set up - Al Rajhi - An international set up - HSBC Amanah • Compliance of Sharī‘ah resolutions of the Sharī‘ah Supervisory Boards of IFIs with general standards created by the supreme Sharī‘ah Council of the Central Bank • Resolution of Sharī‘ah Supervisory Council of the Central Bank prevails if any conflict with the Sharī‘ah Board of an IFI

25. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control Internal Sharī‘ah Compliance Unit (ISCU) • ISCU responsible for verification of processes, services, and transactions ensuring compliance with the resolutions and pronouncements of the Sharī‘ah Board • ISCU tasked to report on its Sharī‘ah compliance audit • The report is presented to the Sharī‘ah Board or at the AGM for the stakeholders in the IFI

26. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control The Sharī‘ah Governance Process The Sharī‘ah governance process in IFIs comprises of • Appointment • Composition • Qualification • Sharī‘ah Coordination • Sharī‘ah Compliance Process • The Sharī‘ah Resolution

27. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control The Sharī‘ah Governance Process: Appointment • The appointment of Sharī‘ah scholars is either done by: - the shareholders at the Annual General Meeting (AGM) - the Board of Directors on behalf of the shareholders and subject to their approval at the AGM • The Board of Directors appoint members of the Sharī‘ah Board • The members of the Sharī‘ah Advisory Council are appointed by the relevant government authority

28. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control The Sharī‘ah Governance Process: Composition • Sharī‘ah Boards of IFIs generally put together by scholars who are well-versed in fiqh al-mu‘amalat and usul al-fiqh • Composition of Sharī‘ah Boards of IFIs determined by individual institutions • Composition of Sharī‘ah Boards of international financial institutions vs. national IFIs • Usually between 3 and 6 members in a Sharī‘ah Board • Max number of the Sharī‘ah Board of AAOIFI is twenty members (appointed by the Board of Trustees for four years)

29. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control The Sharī‘ah Governance Process: Qualification • Practical knowledge and considerable expertise in the application of fiqh al-mu‘amalat and usul al-fiqh in modern financial transactions • Non-experts in fiqh al-mu‘amalat and usul al-fiqh - are experts in specific areas of banking and finance operations - may be appointed with the purpose of strengthening the board in complex banking and finance operation

30. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control The Sharī‘ah Governance Process: Sharī‘ah Coordination • Coordinate the Sharī‘ah governance process, consisting of corporate interaction between: - The Sharī‘ah Board and the ISCU - External Sharī‘ah audit review and other organs of the IFI • In some IFIs, there is no clear distinction between the Sharī‘ah compliance officer and the Sharī‘ah coordinator • The secretary of the Sharī‘ah Board or the Sharī‘ah compliance officer may perform the task of Sharī‘ah coordination

31. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control The Sharī‘ah Governance Process: Compliance Process  1. Conducting a standard Sharī‘ah review that includes both internal and external Sharī‘ah audits, to ensure total compliance with the resolutions and specific instructions of the Sharī‘ah Board 2. Carrying out the Sharī‘ah compliance process by an independent division or part of an internal audit 3. Performing an internal Sharī‘ah audit to verify the extent of compliance

32. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control The Sharī‘ah Governance Process: Compliance Process  4. Undertaking an independent Sharī‘ah compliance process by an external Sharī‘ah auditor or Sharī‘ah firm 5. Producing a report indicating whether the IFI has complied with the Sharī‘ah requirements in the financial year under review While the internal audit department of IFIs reports to the Audit Committee, the internal Sharī‘ah audit reports to the Sharī‘ah Board

33. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control The Sharī‘ah Governance Process: The Sharī‘ah Resolution • The Sharī‘ah Board is to produce a Sharī‘ah report periodically or annually to explain its position on: • The overall business and products of the IFI • fatwa on matters brought before the board • The Sharī‘ah report may be in any of the following forms: 1. a fact finding report 2. (an ex-ante) report in relation to product design and development3. (an ex-post) internal Sharī`ah audit/review report on the products offered to customers4. an annual Sharī`ah compliance report

34. Learning Objective 5.3 Comprehend the mechanisms of corporate governance and control including the different organs in Islamic financial institutions Mechanisms of Corporate Governanceand Control The Distribution of the Sharī‘ah Report 1. The fact-finding reports and product design and development reports are submitted to the management of the IFI 2. The internal Sharī‘ah audit/review report on the products offered to customers is submitted to the Audit Committee • The annual Sharī‘ah compliance report is submitted to: - The BOD to be distributed to the shareholders at the AGM - Members of the public including the investment account holders (IAH) 4. The supervisory authority in the jurisdiction may also have access to the report

35. Learning Objective 5.4 Understand the different models of corporate governance and Sharī‘ah governance and the different approaches adopted by Islamic different financial institutions A Different Approach for Islamic Financial Institutions • As there is no universal standard for corporate governance in IFIs, diverse approaches are adopted in different jurisdictions • The Governance Standards for IFIs by IFSB and AAOIFI are: - similar in many aspects - complementary to other prudential standards issued by international standards of corporate governance

36. Learning Objective 5.4 Understand the different models of corporate governance and Sharī‘ah governance and the different approaches adopted by Islamic different financial institutions A Different Approach for Islamic Financial Institutions International standard-setting bodies include: • The Organization of Economic Co-operation and Development (OECD) • The International Organization of Securities Commission (IOSCO) • The Basel Committee on Banking Supervision (BCBS) International standards did not address the specifics of the Islamic finance industry. Therefore, IFSB and AAOIFI Standards are specifically meant for the IFIs

37. Learning Objective 5.4 Understand the different models of corporate governance and Sharī‘ah governance and the different approaches adopted by Islamic different financial institutions A Different Approach for Islamic Financial Institutions 1 Models of Sharī‘ah Governance from Selected Islamic Countries • Malaysia - Islamic capital markets are regulated by the Securities Commission- Legislation aims at harmonizing different Shari‘ah interpretations on Islamic financial issues to strengthen the regulatory and oversight framework •  Pakistan • The State Bank of Pakistan (SPB) has established a Shari‘ah board at the macro level • At the micro level, all IFIs operating in Pakistan are required to appoint a Shari‘ah advisor

38. A Different Approach for Islamic Financial Institutions 1 Models of Sharī‘ah Governance from Selected Islamic Countries • Kuwait - Provision for Shari‘ah boards in IFIs, but no Shari‘ah board at the macro level at the Central Bank of Kuwait- fatwa board in the Ministry of Awqaf and Islamic Affairs, the final authority on Islamic banking business/financial transactions •  Bahrain • The National Shari‘ah Advisory Board has no authority over IFIs but the Central Bank of Bahrain has a board • At the micro level, all IFIs are required to establish a Shari‘ah supervisory committee

39. A Different Approach for Islamic Financial Institutions 1 Models of Sharī‘ah Governance from Selected Islamic Countries • UAE • Establishment of a Higher Shari‘ah Authority to supervise Islamic banks and financial institutions – except in Dubai - At a micro level, all IFIs establish a Shari‘ah supervision authority, or simply a Shari‘ah board •  Qatar - No Shari‘ah advisory board at the Qatar Central Bank (QCB) but there is a Supreme Shari‘ah Council - Two major regulatory frameworks for Shari‘ah governance in IFIs, namely those of the QCB and the Qatar Financial Centre (QFC)

40. Learning Objective 5.4 Understand the different models of corporate governance and Sharī‘ah governance and the different approaches adopted by Islamic different financial institutions A Different Approach for Islamic Financial Institutions Figure 5.2 Sharī‘ah Governance Framework under BNM

41. Learning Objective 5.4 Understand the different models of corporate governance and Sharī‘ah governance and the different approaches adopted by Islamic different financial institutions A Different Approach for Islamic Financial Institutions Figure 5.3: A Model of Sharī'ah Governance Framework for IFIs

42. Learning Objective 5.4 Understand the different models of corporate governance and Sharī‘ah governance and the different approaches adopted by Islamic different financial institutions A Different Approach for Islamic Financial Institutions Table 5.2: Summary of the Sharī‘ah Governance System in Selected Countries

43. Learning Objective 5.5 Understand the dynamics of corporate governance in Islamic insurance entities Corporate Governance for Islamic Insurance Major requirements for good corporate governance within the context of takāful 1. Set of organisational arrangements 2. Provision of proper incentives for the organs of governance 3. Compliance with the Sharī‘ah rules and principle • The compliance with the Sharī‘ah rules and principles is ensured and sustained through an independent Sharī‘ah Supervisory Board

44. Learning Objective 5.5 Understand the dynamics of corporate governance in Islamic insurance entities Corporate Governance for Islamic Insurance IFSB Guiding Principles on Governance for Takāful (Islamic Insurance) Undertakings • No single model of corporate governance that works well for every country and all types of business • Good governance in securing/preserving public confidence in takaful undertakings necessitated the development of separate guidelines for the takaful industry

45. Learning Objective 5.5 Understand the dynamics of corporate governance in Islamic insurance entities Corporate Governance for Islamic Insurance Objectives of the IFSB Guiding Principles on Governance for Takāful (Islamic Insurance) • To provide benchmarks for use by Takāful supervisors in adapting/improving regulatory regimes or establishing new ones • To address regulatory issues, e.g. risk management and financial stability for the Takāful industry • To provide appropriate levels of consumer protection in terms of risk and disclosure • To support the orderly development of the Takāful industry

46. Learning Objective 5.5 Understand the dynamics of corporate governance in Islamic insurance entities Corporate Governance for Islamic Insurance The IFSB Guiding Principles • Part I: Reinforcement of relevant good governance practices for insurance companies, while addressing the specificities of takāful undertakings • Part II: A balanced approach that considers interests of all stakeholders and calls for their fair treatment • Part III: An impetus for a more comprehensive prudential framework for takāful undertakings

47. Learning Objective 5.5 Understand the dynamics of corporate governance in Islamic insurance entities Corporate Governance for Islamic Insurance Figure 5.4: Summary of IFSB Guiding Principles for Takāful Undertakings

48. Learning Objective 5.5 Understand the dynamics of corporate governance in Islamic insurance entities Corporate Governance for Islamic Insurance The IFSB Guiding Principles Part I: Reinforcement of relevant good governance practices for insurance companies, while addressing the specificities of takāful undertakings - Principle 1.1: Having in place an inclusive governance framework appropriate for takāful business model: (i) clear identification and segregation of strategic and operational roles and responsibilities for each organ governance (ii) mechanisms for observing and addressing the rights and interests of all stakeholders (iii) a compliance mechanism - Principle 1.2: The adoption of an appropriate code of ethics and conduct

49. Learning Objective 5.5 Understand the dynamics of corporate governance in Islamic insurance entities Corporate Governance for Islamic Insurance The IFSB Guiding Principles Part II: A balanced approach that considers the interests of all stakeholders (shareholders and the participants) and calls for their fair treatment Principle 2.1: Takāful Operators shall have in place an appropriate governance structure that represents the rights and interests of takāful participants Principle 2.2: Takāful Operators shall adopt and implement procedures for appropriate disclosures that provide takāful participants with fair access to material and relevant information

50. Learning Objective 5.5 Understand the dynamics of corporate governance in Islamic insurance entities Corporate Governance for Islamic Insurance The IFSB Guiding Principles Part III: A more comprehensive prudential framework for takāful undertakings Principle 3.1: Takaful Operators shall ensure that they have in place appropriate mechanisms properly to sustain the solvency of takāful undertakings Principle 3.2: Takaful Operators shall adopt and implement a sound investment strategy and prudently manage the assets and liabilities of takāful undertakings