Islamic Finance : Opportunities

1
Islamic Finance Opportunities Challenges
Corporate Governance IssuesWorld Bank
Seminar,Washington DC, April 24 2006

• Simon Archer
• Professor, University of Surrey, UK
• Consultant, IFSB

2
Corporate Governance Issues

• Focus of this talk
• Banks rather than insurance cos.
• Unrestricted IAH as stakeholders
• Ambiguous status
• Information rights
• Control rights
• Cross-border Sharia compliance home-host issues
  
• Operating environment emerging markets
• Concentrated shareholders, grey directors and
  related party transactions
• Lack of market discipline weak information
  environment
• Government interference

3
Unrestricted IAH as stakeholders

• Ambiguous status
• Profit-sharing investors or depositors?
• Conventional depositors
• Dont need control rights except as creditors in
  an insolvency
• Have very limited information needs as their
  capital is guaranteed and their rate of return
  established by contract
• Basically only need to know that bank is solvent
• Unrestricted IAH as Profit-sharing investors
• Have same information needs as shareholders
• Risk and expected return
• What about their control rights?
• Conventional interpretation of Mudaraba gives
  them none, except right to withdraw their funds
  subject to forfeiting share of profits

4
Unrestricted IAH

• Assumption that they are passive investors
• Can they rely on shareholders to monitor
  management on their behalf?
• Possible conflicts of interest e.g. re risk
  appetite
• If not, what is appropriate?
• Information rights similar to those of CIS
  participants
• Asset allocation, risk profitability
• But also profit allocation use of reserves
  (PER/IRR)
• Control rights IFSB ED3 Governance Committee
  suggestion
• Requires no active participation from IAH

5
Cross-border Sharia Compliance Home-Host Issues

• Applicable Sharia rulings may differ between the
  country of the parent bank and that of a foreign
  operation (branch or subsidiary)
• Which rulings should be valid for the foreign
  operation?
• If host country has a National Sharia Authority
  (e.g. Malaysia or Sudan) then foreign operation
  is bound to follow its rulings
• If home country has a National Sharia
  Authority, but host country does not, does
  foreign operation have to follow home country
  rulings?
• Probably yes if branch
• But if subsidiary, with own Sharia Board?
• If both countries have National Sharia
  Authorities?
• Need for cooperation between the 2 countries to
  resolve conflicts

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Operating Environment (1)

• Concentrated shareholders
• May dominate Board of Directors
• Non-execs may not be independent
• Risk of related party transactions that may
  damage the bank
• Danger for minority shareholders and IAH
• Need for transparency (financial reporting
  standards)
• How much reliance can be placed on external
  auditors?
• Key role of banking supervisor
• fit proper tests
• Monitoring of dominant shareholdings
• Risk of pressure on supervisor

7
Operating Environment (2)

• Lack of market discipline weak info.
  environment
• Aggravates problems just mentioned
• Need for regulatory authorities to be pro-active
  to bootstrap info. environment and mkt.
  discipline
• May be problematic
• Govt. control of, or pressure on, banks
  commercial activities is likely to impede mkt.
  discipline
• Conflict between (a) govt. concern with macro
  social role of banks in eco dev and (b)
  development of robust banking system
• Islamic banks not essentially different from
  conventional banks in this, but may be more
  vulnerable
• Financing modes may be more risky but can the
  risk be priced for (e.g. Salam) ?

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Concluding Remarks

• Burden on banking supervisors regulators to
  enable the issues outlined above to be handled
  successfully
• IFSBs efforts to provide support
• Issued Standards on Risk Management, Capital
  Adequacy, ED on Corporate Governance
• In progress EDs on Supervisory Review Process
  and Transparency Market Discipline
  complementary standards
• Seminars on the above