Financial Ratio’s And Risk Analysis of Islamic Banks
Financial analysis of a company should include an examination of the financial statements of the company, including notes to the financial statements, and the auditor’s report. The auditor’s report will state whether the financial statements have been audited in accordance with generally accepted auditing standards. Key financial statement ratios for analyzing financial statements the nature of the various important risks of Islamic Banks
Financial Analysis
Financial analysis of a company should include an examination of the financial statements of the company, including notes to the financial statements, and the auditor’s report. The auditor’s report will state whether the financial statements have been audited in accordance with generally accepted auditing standards. The report also indicates whether the statements fairly present the company’s financial position, results of operations, and changes in financial position in accordance with generally accepted accounting principles. Notes to the financial statements are often more meaningful than the data found within the body of the statements. The notes explain the accounting policies of the company and usually provide detailed explanations of how those policies were applied along with supporting details. Analysts often compare the financial statements of one company with other companies in the same industry and with the industry in which the company operates as well as with prior year statements of the company being analyzed.
Comparative financial statements provide analysts with significant information about trends and relationships over two or more years. Financial statement ratios are additional tools for analyzing financial statements. Financial ratios establish relationships between various items appearing on financial statements. The key ratios can be classified as follows:
1 Capital Adequacy ratios: Measure for risk taking and the protection for long-term creditors and investors.
2 Liquidity ratios. Measure the ability of the enterprise to pay its debts as they mature.
3 Activity (or turnover) ratios. Measure how effectively the enterprise is using its assets.
4 Profitability ratios. Measure management’s success in generating returns for those who provide capital to the enterprise.
Financial statement analysis has its limitations. Statements represent the past and do not necessarily predict the future. However, financial statement analysis can provide clues or suggest a need for further investigation. What is found on financial statements is the product of accounting conventions and procedures that can sometimes distort the economic reality or substance or the underlying situation. Financial statements say little directly about changes in markets, the business cycle, technological developments, laws and regulations, management personnel, price-level changes, and other critical analytical concerns.
Shari’ah Audit of Financial Statements of Islamic banks
Islamic banks operations are examined yearly by external auditors in accordance with International Accounting Standards. There is no statutory requirement for external auditors to undertake a review of Shari’ah audit, over and above the normal financial audit. While the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has provided certain supervisory guidelines, these along with others are usually applied internally by a Shari’ah committee appointed by the Shari’ah Board of individual Islamic banks.
ACCOUNTING STANDARDS
The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) based in Bahrain has issued guidelines for accounting standards in order to render the financial statements of Shari’ah-compliant transactions and Islamic banks more comparable and transparent. This takes into consideration the national financial environment, and also includes the adaptation of the international accounting standards, core principles, and good practices to the specific needs of the Islamic finance. For strengthening the regulatory setup and making it acceptable for multinational financial institutions, development of Shari’ah compliant liquid money market instruments, designing prudential rules to reflect the specific risk characteristics of Islamic financial contracts (which is presently considered by Islamic Financial Services Board based in Malaysia), and development of internationally accepted accounting standards are essential.
AAOIFI Accounting Standards
AAOIFI has set out Objectives and Concepts of Financial Accounting for Islamic Banks and Financial Institutions (IFIs) as a prelude to its financial accounting standards so that varying accounting policies can be harmonised. These statements are in addition to the accounting standards, auditing standards, governance standards and code of ethics published till June 2008.
A major achievement in the area of establishing concepts of financial accounting for Islamic banks and financial institutions, which improved disclosure, is the clarification of the position of investment account holders (depositors). Not a long ago, third party investment accounts were treated by IFIs either as deposits (similar to conventional bank deposits) or as funds under management, reported off balance sheet with no or little disclosure.
AAOIFI upholds that unrestricted investment accounts, the largest funding source for the IFIs, are part of the financial position (balance sheet) of an IFI to be classified between a liability and equity capital. It is maintained that these investment accounts are not a liability for an IFI because an IFI is not obligated in case of loss to return the original amount of funds received from the account holders unless the loss is due to negligence or breach of contract. This fact alone has a substantial impact on the risk profile of IFIs. As investment deposits are not treated equivalent to conventional bank deposits, where banks are obligated to return principal amount of the deposit to the deposit holders, the risk to the IFI, as an institution, is considerably reduced. Consequently, shareholders’ capital has now to absorb only that part of losses which arise as the share of IFI’s own funds in lending and investing. At the same time, however, unrestricted investment accounts, despite being a partner in profit and loss sharing with the IFI, are not treated similarly to the shareholders of the IFI. This is because holders of investment accounts do not enjoy the same ownership rights (voting rights and entitlement to an IFI’s profits in the form of dividends). The standards only recognise current accounts and other non-investment accounts as guaranteed by an IFI’s owners’ equity.
Funds provided by restricted investment accounts holders are not reflected as part of an IFI’s financial position. The relevant information about such accounts is provided in the statement of changes in restricted investments and their equivalent or as a footnote to the statement of financial position (balance sheet), a treatment similar to that for funds under management.
AAOIFI has also clarified concepts and provided guidance for accounting policies to be followed with regard to different financing and investment modes (Murabaha and Murabaha to the Purchase Orderer, Mudarabah Financing, Musharakah Financing, Salam and Parallel Salam, Ijarah and Ijarah Muntahia Bittamleek (ijarah wa iqtina), Istisna’a and Parallel Istisna’a). The assessment of disclosures with regard to credit, market and liquidity risks were key focus while examining the standards related to above mentioned modes.
Disclosure of Credit Risk
With regard to credit risk, information on concentrations of financing assets by sectors/industries, geographical distribution, maturity and currency profile of the financing portfolio together with break up of financing facilities by collectability is considered important. General disclosure in the financial statements of IFIs, as required by AAOIFI standard, cover concentration of assets risks (economic sectors, geographical areas), distribution of assets in accordance with their respective period to maturity or expected periods to cash conversion, disclosure of related party transactions.
However, the standard is ambiguous on the most critical information from collectability point of view, which helps the reader of financial statements to determine the extent of doubtful (non-performing) financing assets (sales receivables). The related disclosure that standard requires is that accounting policies adopted by the IFI’s management for the recognition and determination of doubtful receivables and policies of writing off debts be disclosed.
Under AAOIFI standards, disclosure regarding Murabaha sales receivables, the major type of financing conducted by IFIs, is largely focused on two factors. One, on the separation between financing jointly financed by the IFI’s and unrestricted investment account holders’ funds and financing exclusively financed by the IFI’s own funds. The purpose of this disclosure requirement is to separate an IFI’s own assets from the assets managed for others (investment account holders) and thereby helping in the assessment of fiduciary risk, to some extent. Second, on the maturity profile of assets and liabilities, to help in the estimation of liquidity risk taken by the IFI by identifying maturity mismatches.
Disclosure of Investment / Market Risk
The assessment of risk that arises from investments in equities or other investments (e.g., property) is as important as financing or credit risk due to the high proportion of such assets in the financial position of IFIs. This is because these investments are
Structure of Monetary Statements of Islamic Banks
Structure of Financial Statements of Islamic Banks
For Islamic financial institutions, the nature of financial intermediation, including the function of banking, is different from that of conventional financial institutions. This difference is key to understanding the difference in the nature of risks in conventional and Islamic banking. For Islamic banks, themudarabah contract is the cornerstone of financial intermediation and thus of banking. In a mudarabah contract, the owner of the capital forms a partnership with the entrepreneur or a manager who has certain business skills and both agree to share the profit and loss of a venture undertaken. Such a structure can be applied by an Islamic bank to raise funds in the form of deposits as well as to deploy funds on the asset side.
The basic concept is that both the mobilisation and (in theory) the use of funds are based on some form of profit sharing, among depositors, the banks and entrepreneurs (users of funds). A typical Islamic bank performs the functions of financial intermediation by screening profitable projects and monitoring the performance of projects on behalf of the investors who deposit their funds with the bank.
Liabilities
The liabilities side of the balance sheet is based on the “two-window” theoretical model of an Islamic bank. In addition to equity capital, this model divides the liability or funding side of the bank balance sheet into two windows, one for demand deposits and the other for investment or special investment accounts. The choice of the window is left to the depositors. Unlike conventional commercial banks, the investment accounts of an Islamic bank are not liabilities in the strictest sense because depositors in a conventional bank create immediate claims on the bank, whereas investors-depositors in Islamic banks are like partners.
In addition, special or restricted investment accounts are often shown as off-balance sheet funds under management. A 100 percent reserve is required for demand deposits (but no reserve is stipulated for the second window). This 100 percent requirement is based on the presumption that the money deposited as demand deposits is placed as amanah (trust): they yield no returns and are repayable on demand and at par value.
Money deposited in investment accounts, in contrast, is placed with the depositors’ full knowledge that their deposits will be deposited in risk-bearing projects; no guarantee is needed or justified. Investment account holders are investors or depositors who enter into a mudarabah contract with the bank, where investors act as supplier of funds (rab al mal) to be invested by the bank on their behalf, as agent or manager of the funds (mudarib). The investors share in the profit accruing to the bank’s investments on the asset side. Therefore, such profit-sharing investments are not guaranteed, and they incur losses if the bank does. Some Islamic banks also offer special-investment accounts developed on the basis of a special-purpose or restricted mudarabah or on profit and loss sharing (musharakah). These special investment accounts, which are similar to closed-end mutual funds, are highly customized and targeted towards high-net-worth individuals.
Assets
On the asset side Islamic banks have more choice of instruments with different maturities and risk-return profiles. For short-term trade financing or financial claims resulting from a sales contract – that is murabaha, salam, and so forth – are available. For medium term investments, leasing (ijarah), manufacturing (istisna’a), and various partnerships are possible; for long-term investments, partnerships in the form of musharakah can be undertaken. An Islamic financial intermediary may also engage an external entrepreneur – on amudarabah basis in which the bank acts as principal and the entrepreneur (user of funds) acts as agent. In this capacity, an Islamic bank can form a syndicate with other financial institutions or non-financial institutions to provide entrepreneurs with medium-to long-term capital. Finally, like conventional banks, Islamic banks also provide customized services, guarantees, and underwriting services for a fee.
Disclosure and Transparency
Public disclosure through the publication of financial statements has long been the source of information on business performance of financial institutions. In recent years, however, financial institutions, under pressure from market forces, have started focusing on the disclosure of a wide range of information, including management policies, risk exposures and risk management practices. Given that disclosure disciplines management of financial institutions and helps to enhance the efficiency and transparency of the markets, it has acquired great significance in promoting the stability of financial system.
Moreover, its importance in enabling investors and parties to assess risks and returns of investing in, or dealing with, a particular institution has grown due to the increasing number of risks that financial institutions now take. The expansion in the role of disclosure also encouraged regulatory authorities in various jurisdictions to make it legally binding on financial institutions to follow a set of certain minimum disclosures in their annual reports.
Like conventional banks/financial institutions, Islamic banks and financial institutions are engaged in the business of dealing in money (collection of deposits and lending and investing). However, the fact, which distinguishes them, is that their dealings with depositors are based on profit and loss sharing rather than a fixed predetermined interest. This signifies an Islamic bank’s fiduciary role where it is considered to be dealing in trust money. Thus depositors’ / investment account holders’ trust in an Islamic bank’s ability to achieve investment goals (to record profit) and make a fair distribution of the revenues between itself and the investment account holders (according to the mudarabah agreement) become paramount in the continuity of the Islamic bank’s business.
Given this importance, Islamic banks are obliged to be transparent by making adequate disclosures to their investment account holders, not only with regard to their own financial condition as is the case with conventional banks but also in respect of the management of trust money. This is the area, going beyond disclosure, where topics such as participation of stakeholders in the corporate governance of Islamic banks and developing effective control and accountability mechanisms to enhance fiduciary relationships in Islamic banks become relevant.
Qualitative characteristics of accounting information
Conventional accounting theory discusses the qualities of relevance, reliability, comparability and understandability essential for accounting information, although these characteristics are quite general they are equally applicable to the Islamic accounting framework.
Income statement
The basic elements of the statement include revenues, expenses, gains, losses, return (profit or loss) on unrestricted investment accounts and their equivalent and net income or net loss.
Information to be disclosed in financial statement
The basic principle is that all information that helps to make the financial statement understandable should be disclosed. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has issued standards on disclosure of information desirable in the Islamic financial institutions financial statements.
Accounting definitions for Islamic banks
The following definitions set out a general conceptual framework for the financial statements of Islamic banks.
1. Assets
An asset is anything that is capable of generating positive cash flows or other economic benefits, either itself or in combination with other assets. However, to be recognised as an asset in the balance sheet, it should have the following additional characteristics:
a) It should be recognized as valid from the Shari’ah point of view. It means such “assets” as interest receivable in the conventional banks’ balance sheet will not treated as asset in the balance sheet of Islamic banks.
b) It should be capable of financial measurement with a reasonable degree of reliability.
c) The bank must be able to obtain benefit from it and control the access of others to it.
d) It should not be associated with an obligation or a right to another party.
2. Liabilities
Liability is an obligation arising from a transaction or other event that has already occurred and that involves the Islamic bank in a probable future transfer of cash, goods or services, or the forgoing of a future cash receipt, the date of which and the settlement of which are measurable with reasonable accuracy.
Generally, a liability should be enforceable under the Shari’ah rules. But if an Islamic bank incurs an obligation which is not valid under the Shari’ah it will still have to be recognised as a liability, although disclosed distinctly as such.
3. Equity of unrestricted account holders
The equity of unrestricted account holders refers to funds received by the Islamic bank from depositors on the basis that the bank will have the right to use those funds without restrictions to finance the bank’s investments within the Shari’ah framework. The value of the equity of unrestricted account holders in the balance sheet is equal to the amounts deposited plus any profit or minus any loss or
Supervisory Functions That The Shari?ah Boards of Islamic Banks
SUPERVISORY FUNCTIONS THAT THE SHARI’AH BOARDS OF ISLAMIC BANKS THE SUPERVISION OF ISLAMIC BANKS
INTERNAL CONTROLS FOR SHARI’AH COMPLIANCE
The experience of Islamic banking in various countries has shown that Shari’ah Boards/Advisors of Islamic Financial Institutions (IFIs) should have a proactive role in supervision of Islamic banks’ transactions for the purpose of Shari’ah compliance. Islamic banks are generally using modes involving fixed rates of return. Non fulfilment of any of the Shari’ah essentials of such modes may render the transactions un-Islamic. The passive role for approving the products or their procedures and leaving their applications totally on the banks opens door to interest in the garb of asset-based transactions like Murabaha, Tawarruq, Hire-purchase, etc. Therefore, experts deem it necessary Shari’ah Boards should thoroughly inspect at least once a year the activities of Islamic banks to ascertain their Shari’ah compliance.
Similarly, a large part of Islamic banks assets comprises investments in equities/capital markets. Shari’ah Boards must ensure compliance of criteria for Islamic banks investments in shares, equities, Sukuk and other avenues of business. This aspect of Shari’ah controls would include prohibition of investment in companies with unacceptable business lines which produce prohibited products and provide prohibited services like:
Alcoholic beverages and tobacco products
Grocery stores dealing in Haram goods
Restaurants, casinos and hotels with bars for prohibited activities
Amusement and recreational services
Financial institutions which deal with interest
Companies of which:
Interest income ratio is more than (5)%
Debt ratio (leverage) is less than (10 – 33)%
Total illiquid assets less than 10 % of its total assets
If investment is made in equities of such companies, Haram or interest related income will have to be given in charity and the Shari’ah Boards must ensure its credit to charity Accounts.
SHARI’AH CONTROLS IN RESPECT OF VARIOUS MODES
In order to ensure Shari’ah compliance, Shari’ah Boards should specify detailed controls for modes which respective banks are using particularly in respect of commonly used modes like Murabaha and Ijarah which are susceptible to be used as back-door to interest. Murabaha in various goods may involve different aspects that may need close monitoring. For example, Murabaha in perishable goods, shares of Joint Stock Companies, particularly when the transactions involve dual side agency agreements, Tawarruq and other by – products of major Islamic modes. We give internal control in respect of some modes as hereunder:-
MURABAHA
1 Shari’ah Board should ensure that accounting in Murabaha is made similar to that of a trade transaction instead of financial transaction. In this respect, AAOIFI’s Accounting Standard on Murabaha may be consulted. Some banks record only the disbursement of the total amount including mark-up. This is against the substance of Shari’ah compliant Murabaha.
2 To ensure that banks are not involved in Rollover of Murabaha transactions, strict internal controls be applied. Price of the goods cannot be changed if the customer does not pay on time. Accordingly, there is no opportunity for a rollover of Murabaha transactions. Nevertheless, it should also be kept in mind that a Master Murabaha facility entails multiple Murabaha transactions, and in case it is necessary to extend credit, a new Murabaha should be initiated against new goods with a complete process of purchase offer and acceptance. Against this, some banks resort to arrangement in which they disburse the amount payable by their client against a new Murabaha, credit the amount to the client’s account; and then debit his account against the old Murabaha. This is merely a book entry. In some cases, banks might not be making even the book entry and there might be simple rollover of the previous Murabaha including the previous receivable plus mark-up for the new term. Shari’ah Board will have to restrict the bank from such operations. Return on such Roll-overs must go to charity fund.
3 The client who is being paid the amount for purchase of the commodity on behalf of the bank may not purchase the commodity for a long time and use it for any other asset that might not be permissible e.g. for purchase of interest-based securities or shares of interest based companies. Therefore, there must be effective controls that client purchases the commodity within a given minimum time and gives declaration to the bank followed by acceptance by the bank and sale to the clients. For effective control, Shari’ah Board may also advise the bank to make payment directly to the supplier.
1 For genuine Murabaha, it is necessary that legal title of ownership is transferred to the bank before it sells the commodity to the client on Murabaha basis. But banks, in order to avoid payment of transfer charges, purchase the goods in the name of the client; thus the banks do not become owner of the goods in any way. Shari’ah Board must ensure that not only title of goods is in the name of the bank at the time of its sale to client, but also that bank retains all risk and rewards related to ownerships till the goods are sold to the client.
2 Shari’ah Board must ensure that all documentation requirements particularly in case the client is also agent of the bank are being fulfilled properly. The Board should not allow any change in the Master Agreement without its prior approval.
3 Mark-up should be charged from the time bank sells the commodity on credit to the client. Shari’ah Board must ensure that it is not charged from the date of disbursement to the supplier or to the client (as agent). Any part of the mark-up should not be referable to the intervening period i.e. between disbursement and declaration/acceptance by the bank. Islamic banks should calculate their Murabaha profit from the date they sell the commodity to the client.
4 Bai al Inah/Buy-back arrangement is not allowed in Shari’ah. The Shari’ah Board should put in place effective controls that banks do not resort to buyback technique in case of Murabaha transactions.
Banks, upon financing, normally take Demand Promissory Notes (DP Note) from the client. As Islamic banks financing is based on the underlying trading/leasing contracts, they should get DP Notes only after executing the Murabaha sale and creation of liability e.g. after the sale of goods. Shari’ah Boards should ensure that banks do not take DP Note at the time of disbursement to the client/agent. If such Note is necessary at the time of disbursement for the sake of Security, it can be of the principal amount only i.e. excluding the mark-up or profit margin.
Some Shari’ah Boards have also allowed in Murabaha structure the use of Tawarruq i.e. the client selling the goods purchased from bank on Murabaha to get cash for any other business activity. In this case, Shari’ah Board must ensure that the process of genuine Murabaha is completed fulfilling the Shari’ah essentials and that the cash realised by the client is used for any Halal business/purpose.
IJARAH
The other major mode Islamic banking are using is ijarah alongwith its variants. Following may be some of its controls:
1 The Shari’ah Board should ensure that ownership title of the leased asset is transferred to the bank i.e. Lessor. In case it involves import, banks should import in its name directly or through agent/client. It has been observed that to avoid some taxes/charges the assets are imported in the name of client/lessee. It is not permissible and the minimum that should be ensured is that a Counter Deed should be signed between the Bank (Lessor) and the Client (Lessee) for transfer of ownership to the Lessor.
2 Ijarah and Bai are entirely different types of transactions in terms of their implications for the parties involved. Therefore, the two transactions should not be mixed in such a way that their respective Shari’ah essentials are not fulfilled. Transfer of ownership to lessee should not be an integral condition of the Lease Agreement. It could be a unilateral promise, not binding on the other party.
3 Shari’ah Board should ensure that expenses relating to purchase and ownership of the asset are borne by the bank. As such, expenses that are necessary to maintain the overall corpus of the asset are lessor’s responsibility.
1 As per AAOIFI’s accounting standard for Ijarah, accounting for Ijarah based financing should be similar to that of the operating lease and not that of finance lease.
2 It should be ensured that if rentals are received in advance, the same should not be treated as a liability. This is because no rentals will be due before the asset is handed over to the client capable of being used by him.
Similarly, for all other modes which an Islamic bank is using, Shari’ah Board should identify the Shari’ah controls which must be ensured so as to maintain sanctity of Islamic business products. For example, in
Diminishing Musharakah different documents relating to creation of partnership, leasing and sale of units to the other party must be independently enforceable. All expenses relating to ownership must be borne by the parties in the proportion of their ownership. The rate of Musharakah payments should be net of such expenses and not directly linked to any benchmark like LIBOR. If the jointly purchased asset is not capable of being leased (like an unused plot of land), no rental should be charged because it is only a commercial asset and can
Corporate Governance in Islamic Banks
Corporate Governance in Islamic Banks
Why is Corporate Governance particularly relevant for Islamic Banking?
Corporate Governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. It provides a structure through which the objectives of the company are set and the means through which these objectives are obtained and performance can be monitored. Such a framework sees corporate governance as a dynamic interplay of internal and external incentives, which affect the performance of a firm.
The internal incentives are the firm’s organisational arrangements that allow owners to direct managers to pursue goals set by the shareholders, while the external incentives on regulatory structures, voluntary standards accepted and followed by the firm and competitive market forces all exert discipline on the performance of owners and managers from the outside. By adhering both to internal and external incentives, a company can reduce its cost of capital, thereby increasing its profits.
Islamic financial institutions have some characteristics that require special care in designing their corporate governance mechanisms.
a) Stakeholders include a large number of depositors whose deposits are not guaranteed.
b) Islamic banks operate on the basis of universal banking, which is close to a deregulated banking environment. Financial activities cover a wider spectrum than is customary in traditional finance, including equity holding, leasing and credit purchase finance on a mark-up basis.
c) Equity-holding by Islamic financial institutions would enable them to sit on the Board of Directors of firms and thereby influence the corporate governance mechanisms of the latter.
Key Aspects in Corporate Governance of Islamic Financial Institutions
Islamic banks, like conventional banks, provide financial services mostly through a licence from regulatory authorities. Therefore, they must be equally accountable. Banks, whether Islamic or conventional, take demand deposits, which enable them, within the fractional reserve system, to issue money collectively through derivative deposits. Such money is a liability against a third party, that is, the government. This is an added reason for accountability through proper governance mechanisms.
Another justification for accountability arises as Islamic banks also accept investment deposits which are, in principle, not guaranteed. The investment activities done on behalf of, and at the risk of, fund-owners can have wide-ranging effects on national wealth, as well as on the wealth of depositors. Therefore this process must be closely monitored.
In addition, Islamic financial institutions are allowed to produce only those financial services, which are in conformity with the Shari’ah. Measures must be taken to assure their customers that their products have been approved by the Shariah authorities.
Investment deposits and shares in mutual funds share the same risks as those of capital, yet there is no mechanism of corporate governance designed so far which allows depositors and mutual fund shareholders to have a special tool to monitor the operations of financial institutions. This is an area, which deserves special attention. Whether special tools to monitor investments made by Islamic financial institutions, including close scrutiny of feasibility studies as well as detailed reviews of contracts made with investors (fund-users), should be developed by regulators, or a certain number of seats on the Board of Directors should be allotted to representa
Agreement on the basic principles of corporate governance is spreading. For instance, through a consultative process, the OECD has distilled a set of widely accepted principles of corporate governance. The IMF and the World Bank have embarked on a number of exercises for each member country, at the government and financial sector levels, through two initiatives: Reports on Standards and Codes (ROSC) and Financial Sector Stability Assessments (FSSA).
Good governance has no borders and fits in very well with Islamic tradition and the Shari’ah. Although governance is only one of the key elements of structural reforms, combined with macro-economic policies it can, and does, foster sustained growth.
The principles underlying prudent corporate governance are important for Islamic financial institutions because of the special risks inherent in Islamic banking and the nature of its products. Three broad trends have emerged.
a) The growth of Islamic banking is reflected not only in the expansion of the market, but also in the generation of new products. But while an increasingly diverse range of Islamic financial institutions has arisen, banks remain the core players in many countries.
b) Islamic banking encompasses short-term instruments, including murabaha, leasing and other trade finance as well as long-term maturity instruments supported asset securitisation: for instance, the IDB-Unit Investment Fund.
c) Development of longer-term financing operations (including musharakah), Shari’ah-consistent Government financing and a secondary market.
Stakeholders’ value is central to the Islamic financial institutions, and is generally incorporated in mission Statements and focus on two broad sets of objectives (a) compliance with Shari’ah principles, and (b) provision of excellent service that must include service to the community as a whole, referring primarily but not exclusively to the Muslim community, promoting the interests of related parties, including shareholders, depositors, and employees and the developing the professional and
ethical qualities of management and staff. Shari’ah compliance would appear to fall into three categories
(1) The conduct of financial business in accordance with the prohibition of riba and gharar.
(2) Furthering of Islam’s social objectives, in particular the promotion of social benevolence.
(3) The third is the development and promotion of an integrated Islamic financial system, or the “eventual institution of an elaborate and comprehensive banking system based on the rules of Islamic Shariah”.
Corporate Governance, Transparency and Islamic Banking
The governance structure for Islamic banks should consist of an internal control system, which includes aShari’ah-based structure, both factors ensuring the suitability of transactions and also a reduction of transaction costs. Transparency and adherence to accepted standards is crucial to the success of good governance.
The need to address transparency is based on two elements, both of which are critical for the growth of the financial market.
a) It will allow the development of more complex equity-based and investment-oriented assets of a longer maturity and will thus help financial innovation, and
b) It will allow more efficient prudential supervision and regulation of Islamic financial institutions.
Progress has already been made at the national and international levels, particularly by the Information Management System (IMS), on addressing accounting and disclosure standards.
a) The existing International Accounting Standards are being supplemented by a set of Financial Accounting Standards (FAS) prepared by the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). The FAS have already been implemented by some countries and are being considered by many others.
b) Similarly, AAOIFI’s capital adequacy and standards of governance, including Shariah standards for several transactions, could become important milestones for Islamic banking growth.
c) The Islamic Financial Services Board (IFSB), is constantly reviewing the needs for regulatory and supervisory standards of Islamic financial products and institutions, facilitate further transparency in transactions.
However, greater focus is needed on strengthening internal management and accounting practices to enable individual financial institutions to adhere more closely to established standards. Also, improving the sharing of accurate information between borrowers and financial institutions on the use of funds, profits and losses, and compliance with the implementation of financial contracts between lenders and borrowers, would facilitate further growth.
These steps would make possible the avoidance of:
a) the continued concentration on short-term assets, and
b) the possible build-up of excess reserves by Islamic institutions.
However, this phase of reform will be more difficult to implement because it will require mechanisms for implementing and streamlining internal management and sharing information on a timely basis at the level of smaller firms.
In addition to the regulatory and supervisory standards and the related institutional developments mentioned earlier, a number of other areas should be focused on.
a) Clarification of lenders’ and borrowers’ rights and obligations
b) Market-based mechanisms for strengthening observation of Islamic business ethics by both entrepreneurs and banks
c) Rationalisation of tax laws and other practices which might be discouraging accurate disclosure
d) Reduction in the cost of information-gathering, monitoring and auditing
e) Reform of disclosure laws
f) Training.
Shari’ah Governance Framework
Corporate Governance arrangements in Islamic Financial Institutions are mostly modeled along