NH-2016-q2

NEWHORIZON July – December 2016
ANALYSIS
For financial institutions, the importance
of corporate governance lies in the
fiduciary nature of their activities,
because a financial institution is
essentially a fiduciary trustee, which is
entrusted with the assets of investors.
For this reason, it is obliged to act in
their best interest when holding and
investing the trust. Furthermore, banks
are an integral part of the national and
global financial system. They play an
important role in the economy of a
country. By their intermediation role
of borrowing, lending and other related
activities, they facilitate the process of
production, distribution, exchange and
consumption of wealth. In this way, the
banks play an effective partnership role
in the process of economic development.
It has rightly been observed that ‘the
health of the economy is closely related
to the soundness of its banking system’.
The nature of regulatory and
supervisory practices that promote good
performance and stability in banks are
those that force accurate information
disclosure, regulate capital adequacy,
stringent classification and provisioning
and the corporation’s own governance
and control systems to identify, assess,
manage and control risk.
Good corporate governance in a bank,
therefore, helps to ensure stakeholders
satisfaction and confidence in the
banking and financial system. On
the other hand, the absence of good
corporate governance or the negative
impact of weak corporate governance in
a financial institution is far reaching as
the consequences are not only financial
but also entail heavy cost in social and
human terms. The collapse of a bank
arising from financial misconduct not
only creates widespread investment
losses and raises doubt about the
stability of the global financial system,
it also damages the value of all other
stakeholders such as creditors, suppliers,
customers, employees, pensioners and
the community at large. Poor corporate
governance in one bank may create panic
in the industry leading to a run that may
erode the deposit base, which would in
turn threaten the stability and reputation
of the entire industry.
In contrast, sound corporate governance
as pointed out by Grais and Pellegri
(November 2006) facilitates access to
external finance, improves the firm’s
operational performance, enhances
systemic financial stability and contributes
to the welfare of the community. In a
similar vein, Claessens Stijin (Corporate
Governance and Development, 2003)
identifies four empirical examples of the
impact of good corporate governance
on economic development and the
performance of an organisation. Firstly,
it facilitates external finance as lenders
and other investors are more likely to
extend financing to a business if they
are comfortable with its corporate
governance arrangements including clarity
and enforceability of creditors’ rights.
Secondly, good corporate governance
tends to lower the cost of capital by
conveying a sense of reduced risks that
translates into shareholders’ readiness
to accept lower returns. Thirdly, good
corporate governance is proven to lead
to better operational performance and
fourthly, it reduces the risk of contagion
from financial distress. In addition
to reducing the internal risk through
investors’ risk perception, it increases
the robustness and resilience of firms
including banks in particular, to external
shocks.
A connection has been drawn between
failures in corporate governance under
the conventional financial framework and
the 2008 global financial crises. Beyond
the failures in governance structures in
checking the excesses of boards and
senior managements of banks often
driven by profit maximisation and
personal greed, there is the absence
of a set of moral principles within the
structures of banking regulations and
supervision of financial services. Too
often, the root cause of corporate
failures in conventional banks has been
linked only to poor risk management.
In contrast, however, the governance
of Islamic financial institutions have
an additional layer of supervision
extending beyond the purely financial
to the stakeholders’ ethical and
moral values defined by the Shari’ah
moral. As observed by W. Grais and
M. Pellegri, (November 2006) ‘in the
case of an institution offering Islamic
financial services, stakeholders expect
its operations to be carried out in
compliance with the principles of the
Shari’ah’.
The Corporate Governance
Model in Islam
As pointed by scholars, the corporate
governance model under Islam has
its own unique features and presents
distinctive characteristics in comparison
with the conventional model. It
combines the elements of Tauheed
(Islamic doctrine), Shura (Islamic
Consultation concept), Shari’ah rules
and maintains private goals without
ignoring the duty of social welfare. The
uniqueness of corporate governance
in Islamic financial institutions stems
from two principles: a) a faith-based
approach that mandates the conduct of
the business in accordance with Shari’ah
principles and b) a profit motive that
recognises business and investment
transactions and the maximisation of
shareholders’ wealth. At times these
elements could be perceived to be in
conflict with each other, and as such
the corporate governance framework
for Islamic financial institutions has to
treat these tensions effectively, while
providing an enabling framework that
allows ample opportunity for the growth
and strength of the system.
A necessary component of corporate
governance for Islamic financial
institutions is the concept of Shari’ah
governance, which essentially refers
to the mechanism that determines the
compliance of any particular Islamic
business or financial institution. Shari’ah
governance has been defined as ‘a set
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