introduction the advancement of the Islamic financial

introduction

The history of Islamic banks in Malaysia starts with
the establishment of the first Islamic bank in Southeast Asia, Bank Islam
Malaysia Berhad (BIMB). Islamic banking refers to a system of banking that obeys
Islamic law also known as Shariah law. The basic rule that oversee Islamic
banking are mutual risk and profit sharing between parties, the confirmation of
decency for all and that transactions depend on a basic business action or
resource.

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These standards are supported by Islamic banking’s
core values whereby activities whereby exercises entrepreneurship, trade and
commerce and bring societal development or benefit is encouraged. Activities
that involve interest (riba), gambling (maisir) and speculative trading (gharar)
are prohibited.

Through the use of diverse Islamic finance concept
such as ijarah (leasing), mudharabah (profit sharing), musyarakah
(partnership), banks have a great deal of flexibility, creativity and choice in
the creation of Islamic finance products. Besides, by importance and focusing
the need for transactions to be supported by honest trade or business related
activities, Islamic banking sets a higher standard for investments and encourage
prominent responsibility and risk mitigation.

There are over 300 Islamic financial institutions
worldwide across 75 countries as indicated by the Asian Banker Research Group.
Malaysia’s Islamic finance and banking has grown tremendously in over the past
30 years. The enactment of the Islamic Banking Act 1983 empowered the nation’s
first Islamic Bank to be established and from there on, with the advancement of
the Islamic financial system, more Islamic financial institutions have been
established.

Today, Malaysia’s Islamic finance continues to develop
rapidly, upheld by a favourable environment that is renowned for persistent
product innovation, a variety of financial institutions from across the world,
a broad range of innovative Islamic venture instruments, an inclusive financial
infrastructure and adopting global administrative and legitimate best
practices. Malaysia has also stressed on human capital advancement alongside
the growth of the Islamic financial industry to guarantee the availability of
Islamic finance talent. All of these esteem extents have transformed Malaysia
into a standout developed Islamic banking markets in the world.

Rapid growth in the Islamic finance industry, supported
by facilitative business condition has urged foreign financial institutions to settle
on Malaysia as their destination of choice to lead Islamic banking business.
This has created a diverse and extending community of domestic and
international financial institutions.

Corporate governance can be described as the
approaches taken by corporate professionals in carrying out their business activities
with integrity, responsibility and transparency. Adherence to good corporate
governance principles is essential to help the growth of the Islamic finance
industry. As a consequence, the is a need to have a standardised uniform code
of corporate governance that will become a guide for the practice of corporate
governance in corporations as well as other institutions because different
countries practice different codes of corporate governance. In the context of a
company or institutions, the meaning of corporate governance can be described
as a set of relationships between a company’s management, its board, its
shareholders, and other stakeholders. As for corporate governance of financial
institutions or banks, BNM has provided Guidelines on Corporate Governance for
Licensed Institutions (BNM/GP1) to promote sound corporate governance. It
defines corporate governance as the process and structure used to direct and
manage the business and affairs of the institution towards enhancing business
prosperity and corporate accountability with the ultimate objective of
realising long-term shareholder value, whilst taking into account the interests
of other stakeholders.

Similar with conventional institutions, the
standards and guidelines on corporate governance in the IFIs adopted both
domestic regulations as well as guidelines provided at the international level.
Guidelines issued by BNM for IFIs are the Guidelines on Corporate Governance
for Licensed Islamic Banks (BNM/GP1-i) and the Shariah Governance Framework 2011
(SGP 2011).

BNM/GP1-i emphasises the principles that need to be
followed by IFIs to conduct sound corporate governance within institutions such
as duties and responsibilities of the board, shareholders as well as other
employees. As for SGF 2011, it repealed the previous guidelines on governance
by the Shariah Committee which was introduced in 2004. The SGP 2011 provides
comprehensive guidelines by calling for the enhancing of the role of the board,
the Shariah Committee and management to implement the Shariah compliance
process in IFIs.

Bank Negara Malaysia (BNM) introduced the Shariah
Governance Framework (SGF) in 2010 and required all Islamic Financial
Institutions (IFIs) to fully implement in 2011. The objective is to provide a
proper regulatory framework for IFIs to function within the required Shariah
framework that will help further strengthen the international investor
confidence in the fast growing Islamic Finance Industry in the country.
However, to realise this objective, the IFIs must be committed and provide
necessary infrastructure to effectively implement the requirements of the
framework. The challenges and suggestions for effective implementation of this
framework will be discussed further in this paper.

Malaysia aspires to transform the country into
becoming Islamic banking and finance hub and one of the efforts is through
strengthening the Shariah governance in the Islamic financial sector. The
development of Islamic finance industry is strongly needs good Shariah
governance and thereafter the government imposed statutory conditions for the
establishment of the Shariah Committee.

Dynamic and good Shariah governance is the very
essence in the development of Islamic banking and finance sector in Malaysia.
Good Shariah governance guarantees the dynamicity of Islamic financial growth.
In Islamic financial institution, Shariah governance mostly refers to the
management, establishment and affairs of the Shariah Committee. The Shariah
Committee who is normally consisting of fiqh scholars, practitioners and
academicians gas a duty to advise Islamic financial institutions on the Shariah
compliance in all aspects and its operations.

 

 

Issues

Board of Directors

Islamic Corporate Governance (ICG) is corporate governance in the view
of Islamic perspective such as in Islamic banks organization practice. The
Board of Directors (BOD) is very important to explain the corporate governance
of any firm (Hussain and Mallin, 2003). The BOD plays an important role in
effective corporate governance to minimize conflicts between shareholders and
managers (Klein, 1998) and also to avoid conflicts between banks and regulators
(De Andres and Vallelado, 2008). The role of the BOD is important for any
corporation, especially as we can see in agency relationships as it is a
functioning BOD for stakeholders by controlling all company activities and
ensuring shareholder rights are not threatened (Hassan et al., 2009). In
addition, the Board has the power to hire, terminate and offset top management (Johnson
et al, 1996).

Board features include board size, board independence, structure
and effectiveness. According to Klein, 1998; Coles et al., 2008, states that
firms with more complex operations need to have more people serving on the
board although there are some arguments in which firms should have large or
small board sizes. BOD size sometimes tells the level of disclosure and
transparency held by the firm. According to Aktaruddin et al. (2009), the
increase in the number of BODs means increased exposure. Some studies have
revealed that larger boards facilitate effective monitoring and provide banks
with more expertise, knowledge and skills (Chahine and Safieddine, 2011; Klein,
2002). Larger boards are linked to higher performance (Cooper, 2008; Aebi et
al, 2012).

Additionally, it can be an advantage to the firm as it will lead to
better management, as well as broader perspectives and expertise. The existence
of independent board members is also intended to protect the rights of minority
shareholders. However, the positive impression of a larger institution may be
offset by poor communication, coordination and decision-making issues (De
Andres and Vallelado, 2008; John and Senbet, 1998). On the composition of the
board, in particular the proportion of independent members, some studies have
found a strong relationship between the presence of outsiders and the value of
the bank (Ferrero-Ferrero et al 2012). However, according to De Andres and
Vallelado (2008), the excessive executive division of the executive may damage
the role of the consulting board as it may prevent bank executives from joining
the board. Yermack (1996) and Klein (1998) suggested that the high percentage
of independent directors led to poor performance.

The independence of the board can also be analysed by separating
the role of the board chair and Chief Executive Officer (CEO). Jensen (1993)
claims that authorizing a CEO to assume the chairman of the agency to spoil the
agency’s independence, compromise with the power of the board’s authority,
result in supervisory impairment function and increase the likelihood of
manipulation of income. In addition, this situation poses an agency problem and
reduces the strong value. Rechner and Dalton (1991) report that firms with a
Chief Executive Officer structure consistently outperformed firms with a
non-partisan CEO structure. The board’s internal function issues and in
particular the frequency of board meetings have also been highlighted in the
corporate governance review.

According to De Andres and Vallelado (2008), more frequent
meetings, closer control over managers, more relevant advisory roles, factors
that have a positive impact on performance. The number of internal committees
within the board has also been analysed in literature. The Board may establish
board committees (nominating committees, remuneration committees, audit
committees, risk monitoring committees, etc.) to support its function and
conduct independent monitoring of the firm. Klein (1998) suggested that due to
the information needs the expert provided about the firm’s activities, several
committees were created to assist the board in the decision-making process.

Based on the model proposed by Nicholson and Kiel (2004), the BOD
affects the board’s effectiveness. They also agree with the author that the
role of monitoring and regulation should be on the list as it measures the
performance of decision-makers (Fama and Jensen, 1983). This role does not
include many audits or internal controls, but is assured that the board
controls the situation and is not controlled by management (Van del Berghe and
Baelden, 2005). This role can be achieved through the basis of an institution
delegation that serves as an important determinant of the role of the
monitoring of the institution. On the one hand, agencies should monitor
assigned tasks and, on the other hand, the institution should prevent high
concentration of power in the hands of management as it controls the board’s
control.

 

 

 

 

Audit Committee

The audit committee (AC) is one of the most important governance
mechanisms that is responsible to ensure that banks produce timely, relevant
and timely information to shareholders, creditors, investors and other
stakeholders (Sarkar et al. 2012). AC has many responsibilities. It supports
the position of the internal audit function and submits management’s
irregularities and other relevant managerial and financial issues to the board
of directors (Pathan et al. 2007). It is also responsible for enhancing and
maintaining the internal auditors’ independence in order to enable them to
carry out their duties.

In addition, according to Sarkar et al. (2012) AC ensures that the
external auditors receive all necessary information to perform the audit
process independently and effectively and that the external auditors’ functions
are not subject to internal management’s pull and pressure. Audit ensures that
every activity within the company is conducted in a Shariah-compliant manner.
It informs the management and BOD of Shariah rules, in particular financial and
economic decisions. It also reports to show shareholders whether the management
complies with Shariah rules or not. It also ensures that zakat is distributed
fairly (Lewis, 2005). To play this role, independence, size and financial
expertise are critical issues of this committee. In most countries, the rules
require AC to have at least two-thirds of its members as independent directors.
Banks with larger AC are committed to seeing that a quality accounting process
has been set up.

In consequence, a larger AC could lead to a higher level of
transparency, thus providing strong monitoring (Anderson et al. 2004). It is
also mandatory that the committee members, or at least one of them, should have
the financial or accounting expertise in order to understand the technical and
control issues related to internal and external audit. In the literature, the
relation between audit-related governance factors and firm performance is
mixed. Klein (2002) finds a negative association between earnings management and
audit-committee independence. Frankel al. (2002) also reveals the same
findings. However, the study of Brown and Claylor (2004) indicates that
independent audit committees are positively related to dividend yield, but not
to operating performance or firm valuation.

 

 

 

Shariah Supervisory Board

Each Islamic financial institution must initiate a supervisory
board called Syariah supervisory board (SSB), which acts as an additional layer
of governance. The first role of SSB is to ensure that banks operate under
Shariah law. In addition, according to Hassan and Mollah (2012), SSB acts as an
independent control mechanism in preventing board or other administration
agents from taking excessive risks. Subsequently, SSB as an internal governance
mechanism will encourage management to become transparent, including in
corporate governance disclosure. Farook et al (2011) in investigating the
determinants of corporate social responsibility disclosures of Islamic banks
found that SSB’s characteristics influence the level of social disclosure. Like
external auditors, SSB acts as an independent reporter on bank operations. It
is not subject to direction and influence by management, board of directors, or
shareholders (Nienhaus, 2007).

To enhance the functionality of this institution, Accounting and
Auditing Organizations of Islamic Financial Institutions (AAOIFI) (2010) has
published a set of standard governance in relation to the composition and role
of SSB (1). For example, each board must consist of at least three members. The
Board must submit an annual report, which must be issued with the financial
statements of the bank (Vinnicombe, 2010). However, the absence of mandatory
implementation of such standards across the industry, SSB’s roles and
responsibilities differ from banks to other banks. Since SSB’s role is limited
to reviewing bank contracts prior to its implementation, AAOIFI is recommended
for banks to install an internal audit function known as an Internal Syariah
Review (ISR). This structure confirms the execution of contracts and SSB will
depend on the ISR’s findings to issue their reports to shareholders.

Unique agency relationship in Islamic Financial Institutions

Agency problems in Islamic financial institutions are unique to
other financial institutions and they need separate and different ways to
research and resolve such issues. There are many reasons for this but the most
important reason is the different types of operations and contracts in Islamic
banks that result in more problems of separation and control that lie under
agency theory. Managers at Islamic banks not only maximize shareholders’
profits but they are also required to work under Shariah rules and regulations
(Archer et al., 1998). The need to accept by Shariah basically makes the
difference between Islamic finance and other modes (Sarker, 1999).

Investment account holders (IAHs) and Islamic banks have contracts
between those that allow banks to not involve IAH in their decision-making
process and fund management; therefore, managers have the opportunity to share
profits rather than losses. Hence, the terms and conditions and contracts in
Islamic banks raise issues related to the agency (Karim, 2001). Banks that
provide Shariah-compliant services should be given separate inspection
departments as they are institutions not only focusing on efforts to maximize
their shareholders’ investment funds but also to take all actions in the
Shari’ah way (Safiddine, 2009).

Another reason to study and find solutions to agency problems in
Islamic financial institutions is described by Hassoune and Volland (2005): the
unbeatable growth rate of Islamic banking. This rate has surpassed the
conventional banking growth rate that allows international finance to move
towards it. The growth rate of Islamic banks is expected to increase from 10
percent to 15 percent annually, which pushes the world to study its structure
more deeply and find solutions on agency issues in particular (El-Hawary et
al., 2007). Islamic banks experienced the highest growth rate and their
expansion has reached 50 countries and these figures represent not only Islamic
countries. These reasons highlight the fact that larger agency issues and their
dynamics should be addressed separately from other institutions (Safieddine,
2009).

Separation of Ownership and Control Rights in Islamic Financial
Institutions

As mentioned above, Islamic financial transactions are different
from the conventional banking sector in the sense that instead of giving a
certain amount of money to customers, Islam has introduced contracts including
equity participation, profit sharing, and profit and loss sharing. Bank Islam
provides their investment holders with profits on their investments that depend
on the profit gained by banks which involve the risk of account holders (Errico
and Farahbaksh, 1998). The Investment Account Holders (IAH) and shareholders
are two types of capital providers in Islamic banks. Among these two, IAH
provides resources to agents who are management appointed by the shareholders
(Grais and Pellegrini, 2006). Although both IAH and shareholders are
principals, the first is not given the right to monitor the agency’s actions.
This creates a unique agency issue between a larger agent and principal
compared to the conventional banking sector (Safieddine, 2009).

 

In such cases, there are more possibilities for agents to think
about their own interests and work for their own benefits. They will be given a
greater opportunity to show less bank profit as a whole to account holders who
have no way to investigate and find out about their returns. Archer et al.
(1998) states that the separation of IAH’s ownership and control right causes
the lack of disclosure and transparency of information between agents and
principals that add up to issues related to the agency. This lack of
transparency often leads to less credibility in the part of the bank as account
holders cannot see the performance of the bank (Grais and Pellegrini, 2006).

Karim (2001) raises another very strong point stating that some
Islamic banks use off-balance sheet items for investment accounts and in this
way they can easily hide information from IAH. Islamic banks hide the money
that represents the income and expenditure of the investment account. In
conclusion, the uniqueness of the issue of Islamic bank agencies comes from the
separation of IAH’s ownership and control rights and the possibility and
authority of managers to maximize their own profits by not fulfilling the
promise to its customers to undertake all activities according to Islam
(Edition, 2009)

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