Strengthening the governance of Islamic banks

Although the Islamic finance industry is growing at a rapid rate, researchers have highlighted areas of governance that must be reformed.

Islamic financial institutions (IFIs) offer the same products as western banks with the big difference that sharia finance must be free from interest, gambling and investment in prohibited items.

In 2007, the market price of Islamiccompliant bonds – or sukuk – fell sharply after Taqi Usmani of the Accounting and Auditing Organization for Islamic Finance Institutions, a regulatory body in Bahrain, said that 85% of the bonds were not compliant with Islam’s sharia laws, highlighting growing concerns over the governance of Islamic finance.

A decade later, the industry is growing at a rapid rate and its products and services are widely offered across the world. According to the Malaysia International Islamic Financial Centre, the industry had assets of US$2.1 trillion at the end of 2015 and saw a compounded annual growth rate of 17.3% between 2009 and 2014.

Islamic financial institutions (IFIs) offer the same products as western banks with the big difference that sharia finance must be free from interest, gambling and investment in prohibited items.

This means that as well as dealing with conventional risk, IFIs need a sharia governance framework to ensure their practice of Islamic finance follows the tenets, conditions and principles propagated by Islam.

However, researchers at Universiti Teknologi MARA, the International Islamic University in Malaysia and Humber College in Canada have found that issues may arise in governance systems — through which institutions ensure there is effective independent oversight of sharia — that leave IFIs open to sharia-related risk.

One area of concern is that there are four different Islamic legal schools of thought. Since they have different opinions on the same issues, this can lead to variation in the way Islamic finance is structured. On the other hand, this difference in opinions can be positive; Islam has not restricted society to follow only one school of thought if it does not involve the fundamentals.

Even so, this can result in ‘fatwa fishing’, whereby someone chooses between the available schools of thought and picks the one that best meets their immediate need.

Another problem is that different institutes have varying standards and practices. For example, Bahrain has both a sharia governance committee at an institutional level and a sharia advisory board at a national level, whose role is limited to advising the central bank.

Lead researcher Nawal Kasim from Universiti Teknologi MARA says that higher sharia authorities may not be effective if they focus too much on the regular controlling compliance for IFIs, resulting in negative impacts on the stability of the Islamic finance industry.

“If these practices are prolonged, there is no point to Islamic finance and it defeats the purpose of the emergence of IFIs,” she says. The researchers urge IFIs to pay more attention to tackling sharia risk management in order to address legal, reputational and liquidity risks.

They recommend that sharia committee members become actively involved in monitoring the operations of IFIs and that members be liable for breach of contract and negligence.

They also call on IFIs to make disclosures on sharia governance to complement the requirement of conventional governance codes such as the International Financial Reporting Standards and the Generally Accepted Accounting Principles. Another recommendation is to incorporate the findings of sharia audits to add value to the annual reports of IFIs.

“These defects should be rectified soon, or else IFIs will end up with the possibility of bad reputations and losses,” Salman says.

Further information
Associate Professor Dr Nawal Kasim | E-mail: [email protected]
Accounting Research Institute
Universiti Teknologi MARA, Malaysia

Published: 16 May 2017

Contact details:

Chief Information Officer (CIO)

Institute of Research, Development and Commersialisation (IRDC) Universiti Teknologi MARA (UiTM) Shah Alam, 50450 Shah Alam Selangor Malaysia

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