Chapter 15

Considering Corporate Governance

In This Chapter

arrow Defining corporate governance

arrow Noting why governance is especially crucial in the finance industry

arrow Identifying the stakeholders in an Islamic finance venture

arrow Distinguishing Islamic from conventional corporate governance

arrow Putting governance concepts into action

Corporate governance has been a topic of (sometimes heated) public discussion in recent years, starting in 2001 and 2002 with the collapses of Enron and WorldCom. The widespread impact of corporate fraud has the power to rile up virtually everyone, but especially the shareholders in these corporations — who lost a bundle. (For example, the approximately 20,000 Enron employees who held mostly company stock in their retirement plans lost about $1.1 billion when the company declared bankruptcy; its stock price fell from a high of about $90 to less than $1 per share.)

The concept of corporate governance has existed for a long time in the financial world, but it gained a new level of global attention after these unprecedented scandals occurred and government regulators intervened to bolster stakeholder confidence. The best-known intervention was the U.S. Sarbanes-Oxley Act of 2002, which set new standards for the management of public corporations, corporate boards, and public accounting firms in the U.S.

In this chapter, I examine the concept of corporate governance as it applies specifically to the Islamic finance industry. But before I get there, I define corporate governance in general to make sure you and I are on the same page. I then explore the importance of corporate governance for any financial institution before turning my focus to how the concept of corporate governance applies to Islamic institutions.

The Cadbury Report

If you know very little about corporate governance, you may want to read about the Cadbury Report, which resulted from the work of a U.K. committee chaired by Sir George Adrian Hayhurst Cadbury in 1991–1992. The committee’s efforts were prompted by two events:

check.png Mirror Group pension fund scandal: In 1991, media mogul (and one-time parliament member) Ian Robert Maxwell died after falling off his luxury yacht at age 68. (Some people believe he committed suicide.) After his death, news broke that he had misappropriated millions of pounds from his newspapers’ pension fund in order to shore up the finances of the companies themselves.

check.png BCCI collapse: Also in 1991, the Bank of Credit and Commerce International (BCCI) collapsed. The bank, which had head offices in Pakistan and in London, had for years been investigated for financial crimes including money laundering. In addition to using bribery to hide its activities, the bank employed two distinct auditors, neither of which had access to all its financial records.

Similar to what Enron and WorldCom accomplished a decade later in the United States, these incidents prompted a high-level discussion of how to prevent similar incidents (which had a far-reaching impact on investors and depositors). The Cadbury committee recommended changes that affected, among other things, how U.K. and other European corporations reported on their internal controls and their financial position in an effort to achieve better transparency.

remember.epsTo be fair, because the Islamic finance industry is so young (see Chapter 3), I fully expect that models of corporate governance will morph and adapt to this industry’s needs in years to come. So keep in mind that some of the words I’m writing today may not entirely apply a few years or a decade down the road. That said, I focus primarily on big-picture elements of corporate governance that are likely to remain intact no matter how the details change. These elements include the involvement of sharia boards and the effort to achieve transparency so that all stakeholders are aware of a particular institution’s policies, transactions, and fiscal status.

Clarifying What Corporate Governance Looks Like

The definition of corporate governance has evolved from a function designed primarily to protect investors to a critical element of business leadership that’s stationed to protect all the interested parties of a corporation. Another way to put it is that corporate governance today promotes accountability by corporate senior management to all company stakeholders inside and outside the corporation, including employees, suppliers, customers, shareholders, government regulators, financial institutions that have extended loans to the company, and so on.

remember.epsThink of it this way: Corporate governance is a set of policies, procedures, and rules that a corporation’s management must follow in order to be accountable and transparent to all stakeholders. The concept of corporate governance recognizes that a corporation’s stakeholders have rights. Depending on the specific type of stakeholder, these rights may include access to information about corporate transactions and fiscal status, access to a share of corporate profits, or control over corporate leadership (by electing the board of directors).

realworldexample.epsMany models of conventional corporate governance exist in theory. In reality, a few core models are adapted to fit the needs of a specific country or region. Here are just two examples of core models:

check.png The Western model: The Anglo-Saxon model of corporate governance, also known as the principal-agent model, is used in the U.S. and U.K. The model is based on a fiduciary relationship between a corporation’s manager and its shareholders; the corporation operates for the financial benefit of the shareholders, and shareholders wield control by appointing the board of directors.

check.png The European model: Also referred to as the Germanic model, this model views the corporation more broadly than the Western model does; the corporation exists to serve purposes in addition to creating wealth for its shareholders. Practiced in European countries such as Germany, France, and Greece, this model sees the corporation as a coalition of participants who share a common goal: the continued operation of the company. A company governed by this model usually has two boards: a management board and a supervisory board that oversees the management board (and takes action if the management board isn’t doing a good job).

Appreciating the Role of Corporate Governance in Financial Institutions

Strong corporate governance is important in any industry. But the corporate governance of financial institutions is especially important for these reasons:

check.png Lots of people stand to lose money if the company fails. Financial institutions deal with huge amounts of money collected from lots of investors and depositors. They also have a widespread impact on the economy by extending credit to individuals and businesses. Therefore, the failure of such an institution has a big impact on public interest. (Consider the fallout of the 2008 bankruptcy of Lehman Brothers, for example, and the collapse of Bernard L. Madoff Investment Securities in the same year.)

Another way to explain this idea is to say that financial institutions have more and different stakeholders than other corporations do. These stakeholders include depositors, investors, borrowers, regulatory bodies, and in some cases entire communities.

remember.epsKeep in mind that the people who stand to lose money if the financial institution fails aren’t necessarily people who would lose only excess funds. If a bank collapses, it may take with it the modest life savings of many depositors. The immediate impact on these people’s daily lives — not just on their future retirement plans — can be dire.

check.png Financial managers must be managed. In any corporation, the governing board has an obligation to manage the people running the company. Depending on the type of company, board members may be clued in to potential problems when product manufacturing decreases, shipments to customers decline, vendors complain of nonpayment, employees alert them to changes in the volume of business, and so on.

In a financial institution, the nature of the business makes the board’s job just a bit tougher. Reports on the institution’s financial transactions are the board’s primary source of information for determining whether management is doing its job well. (See Chapter 14 for a detailed look at financial statements.) If information asymmetry exists — if managers know things about the business that the board doesn’t know — the board can’t assess management’s performance accurately. Therefore, the board must make every effort to ensure that management is being transparent and thorough in its reporting.

check.png The corporate governance of financial firms impacts other firms. Most corporations interact with financial firms in substantial ways. A bank may provide loans, for example, or a financial firm may acquire or provide equity to start a corporation, making the financial firm a major stakeholder. When a financial institution fails, the ripple effect on other corporations is substantial.

check.png Financial institutions are more leveraged than most other businesses. Banks and other kinds of financial firms may have lots of assets on paper but relatively few assets actually sitting in their vaults. After all, money must be invested in order to make more money. In a situation in which lots of depositors begin making claims on their money in a short period of time, the firm may experience a serious liquidity problem, which can lead to a panic (a run on the bank). The financial institution’s board must pay close attention to the percentage of its leveraged funds and carefully weigh the risk of investments versus having cash sitting in a vault and not increasing in value.

Meeting the Stakeholders of Islamic Financial Institutions

The term stakeholders refers to all the people who are formally or informally involved with — and affected by — the corporate governance of a business. Here are the stakeholder groups for an Islamic financial institution:

check.png Shareholders: Without the shareholders, Islamic banks and other kinds of corporations would not exist. Shareholders provide capital needed to run a business, and they expect a return for their investments. The shareholders of an Islamic financial institution appoint the board of directors for corporate governance.

check.png Board of directors: These folks are the topmost responsible people in a corporate body. Selected by the shareholders, the board members are responsible for developing corporate policies, strategies, procedures, and more to guide the institution toward success. To do so, the board of directors of an Islamic financial firm must have demonstrated competency in the finance industry, particularly Islamic finance.

check.png Executive level managers: These are the senior managers — the CEO, COO, and CFO — who are appointed directly by the board of directors. Their jobs focus on implementing the board’s policies, strategies, and procedures.

check.png Depositors and investors: The depositors and investors of an Islamic bank put their money into the bank on an equity participation basis, but they aren’t the true owners of the bank and don’t enjoy the same rights that the shareholders do. Still, depositors and investors need transparent information so they know how their funds are being managed and can make informed decisions. I focus on these individuals in the later section “Recognizing why account holders care about corporate governance.”

check.png The public: Talk about a broad category! Many people are potentially stakeholders in an Islamic financial institution. Here are some of the groups of people that fall into this category:

• Potential depositors, investors, or customers

• Members of the media who provide financial-related information to their readers and viewers

• Ratings agency representatives

• Staff members of brokerage companies that connect potential customers with financial firms

• Financial advisors who help clients decide on investments

Public stakeholders rely on credible disclosures from financial institutions. However, these people are responsible for their own actions related to the financial firm; they don’t influence the firm directly.

remember.epscheck.png Sharia board: What most clearly sets an Islamic financial institution apart from a conventional financial firm is the presence of a sharia board that’s responsible for the institution’s supervision and guidance. The sharia board supervises business operations, oversees new product development, and more. I discuss sharia boards later in this chapter (see “Ensuring compliance through sharia governance”), and I devote Chapter 16 to exploring the role of a sharia board in an Islamic financial firm.

check.png Internal auditors: The internal auditors are part of the audit committee of the Islamic financial institution. They report directly to top management or to the board of directors. These people are responsible for assessing whether the firm is following accepted accounting practices, internal controls set by the board, and industry regulations.

check.png External auditors: The shareholders appoint external auditors to express an opinion about the financial information that the Islamic financial institution discloses and to assess the firm’s risk and how that risk is being managed. (You can read more about both external and internal auditors in the “Conducting audits” section in this chapter for more information.)

Shaping Islamic Corporate Governance to Meet Specific Needs

You may wonder why the same corporate governance principles that guide conventional financial institutions can’t simply be applied to Islamic financial institutions. Although the two types of organizations share many features, here are Islamic-specific features that set the institutions apart when it comes to corporate governance:

check.png Accountability to God: Various corporate governance models developed by Islamic scholars promote accountability to God — something you won’t find in the governance model of most conventional financial institutions.

check.png Sharia compliance: Islamic financial institutions operate based on sharia principles, which I outline in Chapter 1 and throughout the book. Without sharia, Islamic financial institutions can’t exist.

check.png The relationship between the institution and investment account holders: In Islamic financial institutions, investments are based on equity participation; the firm and the investors enter partnerships based on Islamic contracts (see Chapter 6) and share both risk and returns. Any returns are based on shared profits from investment in economic activities or assets rather than on predetermined interest rates (which are prohibited per sharia). Therefore, Islamic investors have a bigger stake than conventional investors in knowing what types of transactions the firm participates in and how well the firm performs.

check.png The relationship between an Islamic bank and its depositors: The depositors at an Islamic bank have more concern in the bank’s activities and financial status than conventional deposit holders do. That’s because if depositors in an Islamic bank are looking for returns (not just a safe place to keep their money), they enter into investment contracts with the bank in which they share risk and returns. Conventional depositors, in contrast, expect both the safeguarding of their principal and a guaranteed accrual of predetermined interest payments.

check.png Financial reporting requirements: As I spell out in Chapter 14, the financial reports released by Islamic financial institutions don’t exactly mirror those of conventional banks and investment firms. Specifically, the balance sheet and income statement of an Islamic financial firm reflect categories of transactions that don’t apply in conventional corporations, and Islamic firms release four financial reports that don’t exist in the conventional finance industry.

check.png Reserves: Islamic financial firms have two reserves that you don’t find in a conventional institution: the investment risk reserve and profit equalization reserve. These reserves help the institution to ensure that its investment account holders receive smooth returns and to safeguard the investors’ principal. The allocation for these reserves comes from the profits of the investment account holders. Flip to the later section “Setting aside reserves to mitigate investment risk and equalize profit” for more information.

In the following sections, I briefly elaborate on the sharia board’s role (which gets much more attention in Chapter 16). I also explain how the relationships between an Islamic financial firm and its investors and depositors affect the nature of its corporate governance — particularly the need for transparency and public access to the firm’s financial information.

Ensuring compliance through sharia governance

When it comes to corporate governance, the feature of Islamic financial institutions that most distinguishes them from their conventional counterparts is this: Islamic firms have sharia boards that are responsible for ensuring compliance with Islamic law.

remember.epsSharia boards are considered important ambassadors of the Islamic finance industry. Investors, bank depositors, and corporate shareholders put their money into Islamic finance corporations, believing that those corporations will adhere to sharia principles. The sharia board is responsible for ensuring that the moral standards of customers are upheld in the firm’s actions — that all transactions and investments are indeed sharia-compliant. Therefore, sharia governance is part of the overall corporate governance of an Islamic financial institution. Specifically, sharia governance refers to any policies and arrangements through which the firm ensures that it’s sharia-compliant.

The competencies of the sharia scholars serving on the board have a significant impact on a firm’s sharia governance. Sharia board members are expected to be experts in Islamic business law and have knowledge of conventional finance, accounting, and economics. This background is essential in order for the scholar to guide the firm toward market success through sharia-compliant and innovative products. (After all, a sharia-compliant entity serves no one if it can’t keep its doors open!)

realworldexample.epsIn theory, sharia board members should be independent from the Islamic firm’s organizational structure. In practice though, the board of directors recruits and pays the sharia board. Industry insiders are very aware that this arrangement has the potential to diminish the sharia board’s independence and therefore impact the quality of its governance. But qualified scholars are highly sought after and must be rewarded for their knowledge and efforts.

Another issue that Islamic financial institutions face is that some sharia scholars sit on the board of multiple Islamic firms. (Locating enough qualified scholars to avoid this situation is difficult.) So the possibility of a scholar breaching confidentiality, whether intentionally or accidentally, exists. I cover these topics in more depth in Chapter 16.

Recognizing why account holders care about corporate governance

Conventional financial institutions have one type of owner: shareholders. In Islamic financial institutions, two types of owners exist: shareholders and account holders. Their roles aren’t equivalent, but both groups have a vested interest in the corporate governance of Islamic firms. Account holders with Islamic financial firms are similar to equity holders (shareholders) due to the nature of the contracts used by these firms.

tip.epsTo streamline this information, I focus on account holders with Islamic banks. Keep in mind that the issues I bring up here also relate to customers who place their money in Islamic investment funds, sukuk (the Islamic equivalent of bonds), and takaful (insurance) funds — all of which employ contracts similar to those I describe in this section.

As I explain in Chapter 9, two main categories of account holders exist with Islamic banks: current account holders and investment account holders. In this section, I detail the relationship that each type has with the bank. In doing so, I point out why these account holders demand strict corporate governance. (Hint: They want to know where their money is and how it’s being used!)

Current account holders

In some ways, an Islamic bank’s relationship with its current account holders is very similar to a conventional bank’s relationship with its checking account holders. The bottom line is that the bank needs to return the account holders’ money when they demand it. The difference between the conventional and Islamic financial systems lies in the contracts used by Islamic banks to establish these accounts:

check.png Qard hasan: Islamic bank depositors who want their money to be safeguarded often enter a qard hasan contract, which is an interest-free loan. The customer, who is loaning money to the bank, doesn’t receive any payment in return for his deposit (unless the bank chooses to offer him a gift for allowing the bank to use the money).

check.png Wadia: This contract also involves the customer giving the bank money for safeguarding and allowing the bank to invest the money. It isn’t considered a loan contract, but the bank must return the money without limitations when the customer demands it.

remember.epsThough depositors don’t get any returns for their demand deposits, they do get a guarantee that the bank will return their money when they need it. This is where the corporate governance link comes in: These depositors require assurance that the bank isn’t involved in risky investments that will result in a loss of their principal or in investments that don’t comply with sharia (if the customer is Muslim). Only banks that conduct their business in a forthright, transparent way can assure depositors that their money is being used wisely.

Profit and loss sharing investment account holders

For conventional financial institutions, investment holders are liabilities. No matter what happens to the bank, the investment fund, or the project being funded, the investor needs to get back her principal along with a fixed amount of return. If you’re an investor in this situation, all you really need to know is that the institution is making money; how it makes the money is less important to you (if it’s important at all).

remember.epsBut if you’re an investment account holder with an Islamic financial institution, your interest in the company’s business goes deeper. That’s because your relationship with the company is based on equity participation. Whether you have a savings account, a fixed-term account, or any other type of investment account, you and the firm share any profit or loss related to the firm’s use of your money. So even though you don’t have the same privileges and responsibilities as a shareholder (you don’t elect the board of directors or attend the annual meeting), your concerns with corporate governance are quite similar to those of a shareholder. You need access to information about what the firm is doing with your money and whether its efforts are reaping profits or generating losses.

Here are the two broad types of investment account holders, whose governance concerns differ slightly:

check.png Restricted investment account holders: Islamic banks offer restricted investment accounts, which means the bank doesn’t mix the funds with any other type of funds in the bank, and investments made with the funds focus on a specific project, business, or venture. The bank is the fund manager or working partner in this situation, and investment holders are the fund providers or silent partners. Both partners share the profit, and the bank earns a fee for fund management. (If a loss occurs, the bank doesn’t bear any part of it unless the loss is a result of bank negligence.) The bank carries a substantial reporting and transparency obligation to restricted account holders.

Before putting their money into a restricted investment account, restricted investors require specific information about the investment to be made, including the risks and potential returns involved. After they’ve made an investment commitment, they need ongoing transparency so they’re aware of how the project, business, or venture is faring; how much profit they’re sharing with the bank; what new risks (if any) have emerged since the initial investment date; and any other information that can help them understand how their money is being used. In addition, they need continued assurance that their money is segregated from other funds and not mixed into a general pool of investment dollars.

check.png Unrestricted investment account holders: In unrestricted investments, depositors don’t make a specific choice of investment; they let the bank make any sharia-compliant investments it deems appropriate in order to create returns for them. Funds invested by multiple depositors are mixed together and possibly with funds from shareholders as well.

A possible conflict of interest can arise between the needs of the shareholders and the unrestricted investors. Most investors (putting their savings into the bank’s hands) may seek fairly safe returns for their investments and therefore prefer less-risky investment vehicles. Shareholders, who may be using excess funds (not regular savings) in this venture, tend to prefer a more aggressive approach with more risk and higher potential returns.

remember.epsUnrestricted investment account holders don’t share the same rights as shareholders to influence the bank’s management (by electing bank board members, for example). In other words, they lack the control rights that shareholders have. Therefore, the bank has a responsibility to govern itself in a way that protects unrestricted investment account holders’ rights, including the right to transparent, easily accessible information about how their investments are faring. For this reason, most Islamic banks establish a board committee that specifically manages unrestricted investment accounts.

Setting aside reserves to mitigate investment risk and equalize profit

I devote Chapter 17 to exploring the various risks faced by Islamic financial institutions, which strong corporate governance can mitigate. One risk that all corporations face is commercial risk: losing customers to the competition. In this section, I explain the steps that Islamic banks take to help mitigate this risk, especially for its unrestricted investment account holders.

Obviously, a bank wants to hold onto its account holders by offering decent returns and protecting their principal. If another bank boasts higher returns, depositors are likely to start jumping ship. In the long run, a bank can work to improve its research in order to make better investment decisions, but what steps can it take in the short run to hold onto its customers when a profit-and-loss-sharing contract is weighing heavily on the loss side?

remember.epsAn Islamic bank generally creates two types of reserves to protect unrestricted investment account holders’ principal and to smooth the flow of returns. This tactic is important to allow the bank to be competitive not only within the Islamic finance industry but also with conventional financial institutions. Here’s how these two reserves work:

check.png Profit equalization reserve (PER): Generally, unrestricted investment account holders expect a decent profit when other Islamic banks are giving good returns on their investments. (This expectation is natural, right?) In case a bank’s investments may have subpar performance in a given period, the bank creates the PER by allocating a percentage of profits from the previous year(s) before it distributes profits between itself and its account holders. That way, when profits fall below an average level in a particular year, the bank taps into the reserve to boost investor returns and try to keep them happy.

check.png Investment risk reserve (IRR): The bank creates this reserve (again, from a portion of previous years’ profits) to alleviate losses due to poor investment performance in a given year. The IRR mitigates the account holders’ risk of facing a loss as well as the bank’s risk of subsequently losing its customers.

The existence of such reserves is part of a bank’s governance strategies. But some concerns exist that these reserves muddy the waters and don’t allow account holders to understand a given year’s performance with perfect clarity. In a very profitable year, part of the profit is retained for the reserve accounts. In a less successful year, anemic profits are bolstered or the losses are mitigated. Therefore, the bank may have more information about the fund’s performance in a given year than an investor has, which means that a situation of asymmetrical information (rather than perfect transparency) exists.

Investors may also be concerned about their cash flow rights related to these reserves. That is, an investor looking for a short-term return from an unrestricted account wants to squeeze every dollar of profit from a given year’s performance. The bank’s decision to funnel a percentage of profits into reserves deprives that short-term investor of the complete profit he’s due. (Long-term investors don’t share quite the same concerns regarding cash flow rights because they have a decent chance of benefiting from the reserves.)

Note that Islamic banks don’t use reserves for restricted investment accounts, which means restricted account holders don’t share this concern. Because restricted funds aren’t mixed with other funds in the bank, more transparency naturally exists regarding how those funds are performing in a given year. Also, investors in restricted accounts tend not to carry the same expectations of consistently high returns that unrestricted investors often have.

Implementing Basic Elements of Good Governance in Islamic Finance

The best concepts in the world can’t help a corporation if they aren’t put into action in the real world. In this section, I explain how corporate governance concepts translate into actual policies and procedures in Islamic financial institutions. I touch on the biggies: accountability and transparency, risk management, effective and efficient internal control systems, and audits.

Striving for accountability and transparency

In finance, the word accountability is another word for responsibility and answerability; when something (specifically a bad something) occurs, the culpable individual or group must accept blame. Transparency in a corporate setting means that certain types of information are accessible to all the relevant stakeholders of the business.

To achieve accountability, companies must develop an organizational structure that clearly defines the roles and responsibilities of each person and identifies who each person is directly accountable to. In many Islamic financial institutions, the shareholders and investment account holders are at the top, followed by the board of directors, senior management, and other operational level employees. See Chapter 7 for an example of what the organizational structure for an Islamic bank may look like.

In terms of transparency, an Islamic firm should aim to provide both quantitative and qualitative information to its stakeholders so they can make truly informed decisions. For example

check.png A potential unrestricted investment account holder needs to know a bank’s past investment performance, reserve policies, and level of investment risk-taking before she can determine whether to trust the bank with her money.

check.png A member of the firm’s senior management team must know the company’s financial position backward and forward in order to make the best decisions regarding investments, personnel, and so on.

check.png The board of directors must have access to complete, accurate information at all times so it knows how the firm managers are performing and whether operational or personnel changes are needed.

To achieve transparency, here are the types of information that stakeholders must be able to locate easily — in printed materials, in electronic communications, or on the firm’s website:

check.png The accounting principles that the firm follows: If the company strictly adheres to principles set forth by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), for example, it should make that fact clear to the stakeholders.

check.png The company’s financial position and performance, including its historical performance: Depending on the institution’s internal policies, it may, for example, routinely show stakeholders its performance over the course of the past three, five, or ten years.

check.png The firm’s risk management and corporate governance policies: That’s right — to meet the corporate governance goal of achieving transparency, the institution must state that goals such as transparency are part of its governance policies!

remember.epsAdequate disclosure regarding accounting treatments and risk management policies is crucial. A financial firm should reveal what types of financial instruments it invests in and what risks these instruments pose. It should also clearly specify the accounting treatment for any credit-based financial instruments and explain what provisions the firm has made to ensure that debt losses are covered. Stakeholders must be able to understand the risks involved in the institutions’ activities, and the notes to financial statements should offer detailed information on these subjects.

Managing risk

Stakeholders must be able to trust that the Islamic financial institution will create value for them. The institution is responsible for managing its many risks to make sure it doesn’t fail. The board of directors and senior level managers are accountable for managing risk, and they are responsible for developing an effective risk management plan that identifies current and potential risks and indicates how those risks will be monitored, measured, controlled, and (if possible) reduced. Because risk management is so important, I devote Chapter 17 to that topic.

Developing internal control systems

remember.epsInternal controls are policies and procedures adopted within an organization to protect its property and assets and to make its accounting system more accurate and reliable. Here are a few examples of possible internal controls:

check.png A firm may take a monthly inventory of office and computer equipment to make sure that none of it walks out the door with employees.

check.png A firm may release interim financial reports to its stakeholders on June 15, September 15, and December 15, with its annual financial report being released on March 15.

check.png A firm may require that any checks issued for more than $1,000 be signed by two people: a staff member and a member of the board.

All Islamic finance institutions must implement internal control systems to ensure their long-term financial health by avoiding problems related to accounting, fraud, or risk. A corporation with weak internal controls takes unnecessary risk.

The board of directors is solely responsible for developing effective and efficient internal control systems. Those systems are passed to the senior management team, which is responsible for implementing them. Internal control systems must be constantly monitored to ensure that rules and procedures are followed.

Conducting audits

All business organizations must conduct audits, and Islamic finance institutions are no exception. Audit reports are important resources that promote transparency. In this section, I describe three types of audits that an Islamic financial firm must conduct: external (statutory) audits, internal audits, and sharia audits. Although the first two are common among conventional corporations, sharia audits are specific to firms that must satisfy the needs of Muslim stakeholders.

External audits

An external audit is the process of determining, based on the collection and review of sufficient evidence, whether a company’s financial reports are accurate. A written report is created based on the auditor’s findings, and the report contains an opinion regarding whether the financial reports are (or aren’t) error-free.

External auditors are appointed by the company’s shareholders in the annual general meeting. Given the importance of the audit report to a firm’s corporate governance, it’s fortunate that shareholders have the right (with a majority vote) to make a change if an auditor doesn’t seem to be doing a suitable job. After all, if an external audit is poorly conducted, then the report can’t be completely reliable, which deprives stakeholders of the information they need and deserve. Many governments require that corporations hire public accounting firms to conduct external audits on an annual basis.

remember.epsExternal auditors working with Islamic institutions must be carefully screened for their qualifications. These auditors must understand not only the unique nature of the particular business but also the specific accounting standards that apply, such as those established by the AAOIFI. As I point out throughout the book, the business transactions of an Islamic financial institution are significantly different from those of a conventional counterpart, so public auditors who are well-versed in the business of conventional financial institutions may not be good candidates for this job.

I’m happy to report that the Big Four audit firms — KPMG, Ernst & Young, PwC (PricewaterhouseCoopers), and Deloitte Touche Tohmatsu — employ specialists who know how to audit in the Islamic industry. Especially in the Middle East, the Big Four are actively involved with the Islamic finance industry by providing audits as well as consulting and underwriting services.

Internal audits

Unlike external audits, internal audits may be conducted at various times during the year. This process explores whether relevant parties are complying with the company’s internal controls. And these same internal controls spell out how often internal audits are required to ensure that good governance is established and stays in play. Internal auditors are appointed by the board of directors. Generally, these auditors come from the board itself, which has an audit committee. If an internal auditor discovers that a necessary control is missing, he proposes that it’s added to the firm’s operational protocol.

Sharia audits

The main reason that Islamic financial institutions exist is so Muslims can conduct business with firms that operate according to sharia law. An Islamic institution has an obligation to assure stakeholders that it operates in adherence with sharia principles. To fulfill this obligation, Islamic financial institutions conduct periodic audits that focus on sharia compliance. (The firm’s internal controls indicate how often such an audit will occur.)

The sharia board is responsible for conducting the sharia audit and provides the stakeholders with its opinion. During a sharia audit, members of the sharia board visit the Islamic firm’s branches and study their operations. Sharia audit reports are published in the annual reports of some Islamic financial institutions, which means that audit results directly affect investor and customer confidence.

Following the Guiding Principles of IFSB

I can’t conclude a description of Islamic financial corporate governance without noting the work of two crucial entities: the AAOIFI, which establishes accounting and auditing standards for the Islamic finance industry, and the Islamic Financial Services Board (IFSB). For an overview of what the AAOIFI does, turn to Chapter 14 or Chapter 22. Here, I focus on the IFSB.

The IFSB was established to promote the soundness and stability of the Islamic finance industry. Since its establishment in 2002, the IFSB has issued 17 standards, guiding principles, and notes. The standards cover such topics as risk management, capital adequacy, transparency and market discipline, and guiding principles of the sharia governance system.

tip.epsI direct your attention specifically to IFSB-3 (the third standard issued), which covers corporate governance. If you intend to work in the Islamic finance industry, I suggest that you get familiar with this and other IFSB standards for corporate governance. Visit www.ifsb.org to start.

If you find an error please notify us in the comments. Thank you!