Corporate Governance and Islamic Finance

The capital markets in most of the emerging financial markets are undertaking regulatory reforms with a view to making capital markets more attractive for domestic and foreign investments. Islamic financial institutions are taking serious initiatives to ensure higher transparency and accountability within the financial markets, particularly regarding publicly traded companies.

Good corporate governance is essential for the development of a vibrant and sound Islamic finance industry. Corporate governance has mainly to do with transparency, accountability and fairness. The concept of corporate governance was proposed as a result of increasing awareness about the importance of the need to protect the rights of all stakeholders, including minority shareholders. Whilst the term "corporate governance" has gained importance only in the last two decades, the concept is not essentially strange to Islam.
Good Corporate Governance
Good corporate governance is more than a good idea. It encourages flow of investments, lowers the cost of capital and supports strong capital markets.
Corporate governance represents structures and processes that entail individuals carrying out business whilst exercising professional discretion in a way that exhibits integrity, judgment and transparency. These principles are essential to Shari'ah and Islamic finance.
The Organization for Economic Cooperation and Development (OECD) Principles of Corporate Governance focus on:
Accountability: Ensuring that management is accountable to the Board and the Board is accountable to shareholders.
Fairness: Protecting shareholders' rights; treating all shareholders - including minorities - equitably and providing for effective redress for violations.
Transparency: Ensuring timely and accurate disclosure on all material matters, i.e., financial situation, performance and ownership.
Responsibility: Recognizing the legal rights of stakeholders.
The teachings of Shari'ah bind fairness and honesty to the main principles of any conduct, including transactions. We may strongly argue that good corporate governance is consistent with Shari'ah compliant financial conduct which prohibits fraud, embezzlement, misstatement and other patterns of dealings that cause abuse, injustice and gharar (risk, uncertainty, and hazard).

Is the Islamic Corporate Governance Model Different?

The question remains: How is the corporate governance of an Islamic financial institution different from that of a conventional counterpart? The Islamic model of corporate governance would first look at the transactional structure to see whether the transaction involves elements that invalidate the gains or profits. Conventional governance practices do not perform a similar function (except for transactions with related parties, self-dealing, etc.) On the other hand, it ensures that the transactions do not contravene the corporate code of business ethics and cross the line that the law has drawn.

Since Shari'ah represents a major source of legislation in most of the Muslim countries, it plays an important role in the legislative and regulatory development in such countries. It is not unlikely that some Muslim countries would rely on Shari'ah for possible future implementation of corporate governance, whether in the form of code or regulations.

For example, Shari'ah provides the proper platform for codifying fiduciary duties and related ethical practices. These practices are the foundation of good corporate governance as outlined in the OECD Principles of Corporate Governance.
Therefore, we believe that modern corporate governance practices are consistent with Shari'ah.

The OECD Corporate Governance Principles emphasize more disclosure and rights to shareholders.

Protection of minority interest is considered crucial for stronger capital markets. For that reason, legal protections for minority shareholders and their strong enforcement encourage local and international investors to invest in emerging markets.
Shari'ah has mandated similar or higher importance to such issues for doing business. Like modern governance practices, the Islamic corporate governance model requires application of modern and higher standards of minority protection against expropriation, more disclosures and transparency and effective accountability.
With this outlook, and as Shari'ah does not indicate any upper limit for better regulation, the contemporary drive for achieving higher standards in corporate governance does not appear to conflict with Shari'ah. Consequently, Islamic financial institutions would have no problem in meeting modern corporate governance practices.
Who Are the Major Stakeholders in Islamic Financial Institutions?

There are a number of key players and stakeholders in Islamic financial Institutions:

Shareholders would be interested in protecting the value of their equity in the financial institution and obtaining a good rate of return.

Demand Depositors would be interested in guaranteeing the value of their deposits and having ready access to their funds.
Investment Depositors are murabaha contract holders with Islamic banks who supply funds to banks to invest properly. They would be interested in protection of principal and obtaining a good rate of return.

Regulators have legal power to monitor the daily activities of Islamic financial institutions.
They would be interested in preventing systemic problems and crises, protection of the quality of financial products and efficiency of the financial system.

Financial Market Authorities set minimum standards for transparency and disclosure and would be interested in an efficient financial market.

The Islamic Finance Community would benefit from standardising Islamic financial products, contracts and practices.
The Public would be interested in obtaining quality financial services at competitive prices.

In order to have good corporate governance, the board of directors, management and the auditors of an Islamic financial institution should perform their professional duties with the objectives of satisfying the needs of the shareholders and Allah as well. Corporate governance aims to enhance accountability, transparency and trustworthiness.

These values are crucial in Islam.
The Shari'ah Supervisory Board's Role in Corporate Governance
The Shari'ah supervisory board is part of the internal governance structure of the Islamic financial institutions and appointed by shareholders of the institution. Its main function is to review and ensure that all transactions, contracts, products and applications relating to Islamic financial institutions comply with Shari'ah rules and principles according to the specific fatwa, rulings and guidelines that have been issued.

In order to establish a good corporate governance framework, the Shari'ah supervisory board may have to extend its jurisdiction to cover governance issues of this nature.
Actions Louder Than Words

According to The Islamic Financial Services Board (IFSB), there is no "single model" of corporate governance that will work in every country; each country or even each organisation needs to develop its own model.

From the standpoint of Islam, deeds are more significant than rhetoric, as highlighted in one verse of the Quran: "Why do you say that which you do not do?" Corporate governance should be practiced in the form of deeds. Only when actions speak louder than words can a good corporate culture come forward and protect the welfare of all.

About The Author

Hany Abou-El-Fotouh is Director Policy & Corporate Affairs / Board Secretary, CI Capital Holding - the investment banking arm of Commercial International Bank which is the largest private bank in Egypt . He provides advice and direction to the Board and management with respect to corporate governance practices and formulates corporate policies.

Hany is a leading expert on money laundering and terrorist financing controls in the MENA region. Founder of the Middle East Compliance Officers' Forum (MECOF), he has been honored for his work in promoting compliance culture and awareness in the MENA region

Hany writes articles to different newspapers and journals on a variety of subjects. He is a public speaker and professional trainer. Previously, he worked in various senior positions in leading banks in Egypt and GCC countries like HSBC, Oman International Bank, Banque Saudi Fransi among others

Hany is a certified member of the Association of Certified Anti-Money Laundering Specialists (ACAMS) and Certified Director by Egyptian Institute of Directors



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Hi everyone,

It may be of use for you to read this article, Demystifying Muslim Mortgages

Here it is for you:
Some Muslims won't accept the standard loans offered in Australia based on Islamic law forbidding interest payments. They've instead taken on a new way of lending aimed to stay within their beliefs. This unique Islamic finance market is growing internationally to the tune of nearly US$1 trillion, and could soon become a force in Australia as well. Kit Kadlec reports.

"Those who charge riba are in the same position as those controlled by the devil's influence... As for those who persist in riba, they incur Hell, wherein they abide forever" - Qur'an 2:275

This much is clear - the Qur'an has very strong words against "riba," which loosely translates to interest.

This poses a clear difficulty for Muslims in Australia who would want to take out a mortgage while still following Islamic law. There were more than 340,000 Muslims in Australia in 2006, and the population is growing. Many of these residents want to live the Australian dream and own their own home. But in doing so with a local lender, they must pay back interest and thus violate "Sharia" or Islamic law.

"The difference between Islamic and Western banking is the notion of interest rates," says Nail Aykan, marketing manager with the Muslim Community Cooperative of Australia (MCCA). "In the Islamic beliefs, the interest rate is forbidden, hence there must be an alternative."

One way to avoid any interest payments would be to pay entirely in cash for a property, but few could ever afford such a transaction in Australia. Another option would be to borrow from friends, but that also is usually not practical.

In order to get around this challenge, the MCCA has followed the lead of other lenders abroad and offered Islamic finance - essentially a process that avoids interest by entering into a partnership with each homebuyer and sharing the risk of the purchase.

The buyers don't make interest payments, but instead pay rent to the MCCA until a certain point when they are granted full ownership.

Slow start in Australia

Founded in 1989, MCCA is the first and one of the leading providers of Islamic finance in Australia, a small but growing market. There's little competition other than a few others such as Sydney-based Iskan Home Finance. While Islamic finance has taken off in some Western countries such as Britain and the United States, it's still relatively small here. Aykan says there are about 1,500 MCCA members, which is slightly under 2% of the estimated 80,000 Muslim families across the country.

Part of the problem in drawing in customers is that the MCCA does not offer the multitude of services as larger banks do.

"If we had real banking services, I believe we could easily penetrate 20% of the Muslim market," says Aykan, going as far as to say 50% of the Muslim market eventually be committed to Islamic finance eventually in Australia. The MCCA also aims to reach non-Muslim customers as well.

While the Muslim community is growing, it is not completely accurate to describe it as one homogenous group. There are more than 60 countries of birthplace and 55 languages spoken, according to the MCCA.

Another major reason Australia has lagged in growth of its Islamic finance sector is that it doesn't have the connections to the Arab world like the U.S. and U.K., says Bala Shanmugam, a professor and chairman of accounting and finance at Monash University's Malaysian campus.

"Britain and the United States have always viewed themselves as a major destination for petro dollars - a repository for Arab funds," says Shanmugam. "Hence they are taking steps to do what is necessary to maintain their stand. Australia on the other hand is not exactly a centre for such funds, so I do not see a rapid take-off in that direction."

Perhaps the largest issue, however, is the fact many Australian Muslims, while growing in number, see the traditional lending method with banks here to be both easier and cheaper.

"Research shows that Muslims as well as non-Muslims view returns as a more important factor in a financial transaction," says Shanmugam. "This variable outweighs religion in terms of importance for patronising types of banking. Therefore, unless people see actual benefits in terms of returns, the extent of patronisation will be nominal."

Case study

There are some Muslims in Australia who place religion first, however. Mohammad Tabiaat, of Lebanese descent, is one who chose to borrow through MCCA for his first family home.

He bought a three bedroom home in Campbellfield, outside of Melbourne, in December for $270,000, paying a 20% deposit. That part is not unlike anything other Australians would do in purchasing such a home.

The difference is that Tabiaat is not paying interest back. Instead, he's paying about $1,600 per week in rent through "Murabaha." It can be described as a lease-to-own agreement, where the borrower is offered a fair market rent.

Murabaha, an Islamic term, is defined as a transaction where the seller (in this case MCCA) discloses the cost of its commodity, then adds some profit thereon, which is either a lump sum or based on a percentage. This payment must be a fixed amount.

In another option, Ijarah Muntahia Bittamleek, the payments can be either fixed or variable, and the end ownership of the property is transferred to the client with the last instalment. There are another three products as well, and other lenders such as Iskan Home Finance have other offers as well, although all aim to be Sharia compliant.

In his own particular case, Tabiaat will be paying back his rent for 180 weeks, which ultimately equates to $288,000, plus the $54,000 deposit. While not everyone can afford such high weekly rents of $1,600, it is common to have borrowers pay off the amount owed quickly with Islamic finance, says Aykan.

The MCCA has also taken on some of the risk in this transaction, as it essentially has made the purchase on behalf of Tabiaat. According to the MCCA, the mortgage can either be seized by the funder or left with the borrower given that it is registered for full mortgage securities entitlement to the funder. It is also permissible to use a third party property as a security mortgage.

Tabiaat says he realises it would have perhaps been easier to use a traditional bank, but he prefers to follow the Islamic law.

"It's an individual choice," he says. "Some people are really conscious about what rate they are paying, whereas others don't mind paying the extra amount to do it in a compliant way."

How much more is it that one must pay in Islamic finance? Aykan says it often is a very similar bottom line.

"A normal bank and a traditional bank may be offering the same rates, but it's how it's processed that is the difference," he says.

Profit or interest?

The MCCA and other Islamic finance lenders often define the amount of money they take above the purchase price as profit. Since "interest" is forbidden, the word is avoided in most cases, although the Australian government still requires it to be used in the paperwork.

Aykan says while the MCCA aims to offer something under religious guidelines, in the end, they cannot offer loans without making their own profit.

"You have to remember it is a business at the end of the day, it's not a charity," he says. "But it's a more ethically, morally-based banking than just interest-based, where it's just greed. Islamic banking has certain religious values and guidelines."

The word profit is thus often used in describing the amount paid by an MCCA customer. But that's not what they will see on their official paperwork.

"What the MCCA has experienced, because the whole conventional system is based on the understanding of interest, is that our funders, our regulators, and whole heap of other bodies always use the word interest," says Aykan. "They don't know an alternative word."

Yet he says he's hopeful that in the next few years a new term will be allowed on the official forms for Islamic finance.

"We're not engaging in interest, but that term is still there, whether we like it or not," Aykan says.

There is an explanation given to customers, and Aykan says the term is little more a formality.

Shanmugam says he's unsure why there's even an issue at all with the wording.

"I'm not sure why the mere usage of the world 'interest' can cause a conflict between Sharia and Aussie law," he says. "Islamic finance has devised ways and means of not utilising the interest paying or charging mechanism to undertake financial transactions. However, in places such as the U.K. and Singapore, amendments have been made to existing legislation to cater for Islamic finance."

Tabiaat says he'd like to see Australia adopt the changes in language sooner rather than later.

"Why not adopt these changes and open your heart to it," he says. "Look at it as a benefit. If you change the law, it will bring more investment into this country."

However, no matter how it is worded, not all Muslims see the Islamic finance banking institutions as true followers of Sharia. Instead, say critics, they are the same as the banks they claim to offer an alternative to, still taking in profit and cloaking "interest" under a different name and using external funders that don't practice Sharia. There are numerous websites in Australia even, with authors taking shots at the MCCA and others, claiming they essentially have the same practice as traditional banks, but under a different cloak.

"This is a matter of opinion," says Shanmugam. "The same criticism is often levelled at Malaysia as well, from the Middle East. When religion becomes the guidelines for economic activity, such comments may be expected, as religion can be interpreted differently by liberals and conservatives."

While a uniform regulatory and legal framework supportive of an Islamic financial system has not yet been developed in Australia, there is some oversight. The community-based Islamic co-operative financial institutions were registered and given licences to carry on cooperative businesses under the Cooperatives Act 1992, and they are subject to basically the same rules and regulations as other lending institutions.

A push for a more uniform and greater oversight specifically aimed towards Islamic finance is being pushed, however.

The future

To Shanmugam and other experts, there's no doubt Islamic finance will begin to massively expand in the coming years.

"Islamic finance has been around for a good 40 years, but after 9/11 it has seen astronomical growth, largely due to a consolidation of Muslim interest, sort of an Islamic Renaissance," he says. "With time, it has gained momentum and is progressing at full steam. With complete support from resource rich Arab nations, I do not see Islamic Finance as a passing phase. It is here to stay."

Since there is a greater risk in the lending sense, Islamic finance banks often are more careful in what they invest in. That's no doubt helped push them along while some of the major banks, especially in the U.S., have collapsed or needed billions of dollars in government funds after taking on too many bad loans.

Aykan says the MCCA has its sights set on not just filling a small niche, but eventually taking a stake in the mainstream Australian market in the long run. A lot of it comes with just educating the customers of what Islamic finance is, he says.

"At the moment, there isn't a great awareness about Islamic banking in the Muslim community," he says. "Once you have those resources and services, word will spread, branches will open up in every city and a domino effect will start."

Outside of Australia, Islamic banking is not limited to cooperatives and small businesses. Even some unusual suitors are lining up for Islamic finance. Most recently South Korea and Malta were among those countries expressing strong interest in opening some main branches. Major global banks have also signed on.

"Major global players (HSBC, Citibank) have embraced Islamic Finance in one way or the other," says Shanmugam. "This has come about due to economic demand and supply factors. If Aussie banks see sizeable profit margins or variable critical masses, then they may consider offering this alternate form of financing."

The National Bank of Australia (NAB) has already begun on its effort, although it doesn't yet offer any Islamic financing itself yet. Since 2007 it has been offering an annual $25,000 scholarship to allow young Australian Muslims to continue their studies in finance. The offer includes employment at NAB and has an aim of improving the bank's understanding of Islamic banking.

"There's an incredible potential in this market," says Aykan. "It's growing globally and the only way is up."

Hope you enjoyed.