The Muslim banking world faces the challenge of
expanding internationally while remaining true to Islamic principles
By Nasser M. Suleiman
governance in banking has been analysed almost exclusively in the context
of conventional banking markets. For example, there has recently been some
discussion of the role 'market discipline' exerted by bank shareholders and
depositors in constraining the risk taking behaviour of bank management. At
the same time, there is growing interest in, and analysis of, banks as
stockholders in companies themselves playing a central role in corporate
governance, especially in Germany
and other countries with universal banking structures of the traditional
contrast, little is written on governance structures in Islamic banking,
despite the rapid growth of Islamic banks since the mid 1970s and their
increasing presence on world financial markets. There are now over 180
financial institutions world-wide which adhere to Islamic banking and
financing principles. These banks operate in 45 countries encompassing most
of the Muslim world, along with Europe, North America
and various offshore locations. Islamic financing increasingly is a market
segment of interest of Western banks, and the latest addition to the list
of Islamic banks in October 1996 in the Citi
Islamic Investment Bank, Bahrain
a wholly owned subsidiary of Citicorp.
banking represents a radical departure from conventional banking, and from
the viewpoint of corporate governance, it embodies a number of interesting
features since equity participation, risk and profit-and-loss sharing
arrangements from the basis of Islamic financing. Because of the bank on
interest (riba), an Islamic bank cannot charge
any fixed return in advance, but rather participates in the yield resulting
from the use of funds. The depositors also share in the profits according
to predetermined ratio, and are rewarded with profit returns for assuming
risk. Unlike a conventional bank which is basically a borrower and lender
of funds, an Islamic bank is essentially a partner with its depositors, on
the one side, and also a partner with entrepreneurs, on the other side,
when employing depositors' funds in productive direct investment.
financial arrangements imply quite different stockholder relationships, and
by corollary governance structures, from the conventional model since
depositors have a direct financial stake in the bank's investment and
equity participations. In addition, the Islamic bank is subject to an
additional layer of governance since the suitability of its investment and
financing must be in strict conformity with Islamic law and the
expectations of the Muslim community. For this purpose, Islamic banks employ
an individual sharia Advisor and/or
examination of corporate governance in Islamic banking begins with the
comparing governance structures in the Islamic bank and will continues with the principles of Islamic banking. This
study compares the Islamic banking, financial model and its implications
for governance structures. The study intends to give a small picture on the
principles of Islamic banking.
The Islamic bank
structures are quite different from these under Islamic banking because the
institution must obey a different set of rules - those of the Holy
Qur'an - and meet the expectations of Muslim community by providing Islamically-acceptable financing modes. These
profit-and-loss sharing methods, in turn, imply different relationships
than under interest-based borrowing and lending.
1 sets out the key stockholders in an Islamic
bank. There are two major difference from the
conventional framework. First, and foremost, an Islamic organisation must
serve God. It must develop a distinctive corporate culture, the main
purpose of which is to create a collective morality and spirituality which,
when combined with the production of goods and services, sustains the
growth and advancement of the Islamic way of life. To quote janachi (1995):
banks have a major responsibility to shoulder ....all the staff of such
banks and customers dealing with them must be reformed Islamically
and act within the framework of an Islamic formula, so that any person
approaching an Islamic bank should be given the impression that he is
entering a sacred place to perform a religious ritual, that is the use and
employment of capital for what is acceptable and satisfactory to God.'
are equivalent obligations upon employees:
staff in an Islamic bank should, throughout their lives, be conducting in
the Islamic way, whether at work or at leisure.' (p.28).
obligations also extend to the Islamic community:
who truly believe in their religion have a duty to prove, through their
efforts in backing and supporting Islamic banks and financial institutions,
that the Islamic economic system is an integral part of Islam and is indeed
for all times ... through making legitimate and Halal
interest-free banking is based on the Islamic legal concepts of shirkah (partnership) and mudaraba
(profit-sharing). An Islamic bank is conceived as financial intermediary
mobilising savings from the public on a mudaraba
basis and advancing capital to entrepreneurs on the same basis. A
two-tiered profit-and-loss sharing arrangement operates under the following
The bank receives funds from the public on the basis of
unrestricted mudaraba. There are no
restrictions imposed on the bank concerning the kind of activity, duration,
and location of the enterprise, but the funds cannot be applied to
activities which are forbidden by Islam
The bank has the right to aggregate and pool the profit from
different investments, and share the net profit (after deducting
administrative costs, capital depreciation and Islamic tax) with depositors
according to a specified formula. In the event of losses, the depositors
lose a proportional share or the entire amount of their funds. The return
to the financier has to be strictly maintained as a share of profits.
The bank applies the restricted from of mudaraba
when funds are provided to entrepreneurs. The bank has the right to
determine the kind of activities, the duration, and location of the
projects and monitor the investments. However, these restrictions may not
be formulated in a way which harms the performance of the entrepreneur, and
the bank cannot interfere with the management of the investment. Loan
covenants and other such constraints usual in conventional commercial bank
lending are allowed.
The bank cannot require any guarantee such as security and
collateral from the entrepreneur in order to insure its capital against the
possibility of an eventual loss.
The liability of the financier is limited to the capital provided.
On the other hand, the liability of the entrepreneur is also restricted,
but in this case solely to labour and effort employed. Nevertheless, if
negligence or mismanagement can be proven, the entrepreneur may be liable
for the financial loss and be obliged to remunerate financier accordingly.
The entrepreneur shares the profit with bank according to
previously agreed division. Until the investment yields a profit, the bank
is able to pay a salary to the entrepreneur based on the ruling market
of the same restrictions apply to musharaka
financing, except that in this instance the losses are borne
proportionately to the capital amounts contributed. Thus under these two
Islamic modes of financing, the project is managed by the client and not by
the bank, even though the bank shares the risk. Certain major decisions
such as changes in the existing lines of business and the disposition of
profits may be subject to the bank's consent. The bank, as a partner, has
the right to full access to the books and records, and can exercise
monitoring and follow-up supervision. Nevertheless, the directors and
management of the company retain independence in conducing
the affairs of the company.
conditions give the finance many of the characteristics of non-voting equity
capital. From the viewpoint of the entrepreneur, there are no fixed annual
payments needed to service the debt as under interest financing, while the
financing does not increase the firm's risk in the way that other
borrowings do through increased leverage. Conversely, from the bank's
viewpoint, the returns come from profits - much like dividends - and the
bank cannot take action to foreclose on the debt should profits no
structures are depicted in Figure 2 which sketches the conceptual framework
of corporate governance for Islamic bank. Central to such a framework is
the Sharia Supervisory Board (SSB)
and the internal controls which support it. The SSB is vital for two
reasons. First, those who deal with an Islamic bank require assurance that
it is transacting with Islamic law. Should the SSB report that the
management of the bank has violated the sharia,
it would quickly lose the confidence of the majority of its investors
and clients. Second, some Islamic scholars argue that strict adherence to
Islamic religious principles will act as a counter to the incentive
problems outlined above. The argument is that the Islamic moral code will
prevent Muslims from behaving in ways which are ethically unsound, so
minimising the transaction costs arising from incentive issues. In effect,
Islamic religious ideology acts as its own incentive mechanism to reduce
the inefficiency that arises from asymmetric information and moral hazard.
matters are obviously basic to the successful operation of Islamic modes of
finance, and they are assessed in the next section when I examine
Principles of Islamic Banking.
Principles of Islamic banking
Islamic bank is based on the Islamic faith and must stay within the
limits of Islamic Law or the sharia in all
of its actions and deeds. The original meaning of the Arabic word sharia was 'the way to the source of life' and
it is now used to refer to legal system in keeping with the code of
behaviour called for by the Holly Qur'an (Koran). Four rules govern
the absence of interest-based (riba)
the avoidance of economic activities involving speculation (ghirar);
the introduction of an Islamic tax, zakat;
the discouragement of the production of goods and services which
contradict the value pattern of Islamic (haram)
the following part I explain these four elements give Islamic banking its
distinctive religious identity.
the most far reaching of these is the prohibition of interest (riba). The payment of riba
and the taking as occurs in a conventional banking system is explicitly
prohibited by the Holy Qur'an, and thus investors must be
compensated by other means. Technically, riba
refers to the addition in the amount of the principal of a loan according
to the time for which it is loaned and the amount of the loan. While
earlier there was a debate as to whether riba
relates to interest or usury, there now appears to be consensus of opinion
among Islamic scholars that the term extends to all forms of interest.
banning riba, Islamic seeks to establish a
society based upon fairness and justice (Qur'an 2.239). A loan
provides the lender with a fixed return irrespective of the outcome of the
borrower's venture. It is much fairer to have a sharing of the profits and
losses. Fairness in this context has two dimensions: the supplier of
capital possesses a right to reward, but this reward should be commensurate
with the risk and effort involved and thus be governed by the return on the
individual project for which funds are supplied.
what is forbidden in Islamic is a predetermined return. The sharing of
profit is legitimate and that practice has provided the foundation for
feature condemned by Islamic is economic transactions involving elements of
speculation, ghirar. Buying goods or
shares at low and selling them for higher price in the future is considered
to be illicit. Similarly an immediate sale in order to a void a loss in the
future is condemned. The reason is that speculators generate their private
gains at the expense of society at large.
mechanism for the redistribution of income and wealth is inherent is Islam,
so that every Muslim is guaranteed a fair standard of living, nisab. An Islamic tax, Zakat
(a term derived from the Arabic zaka,
meaning "pure") is the most important instrument for the
redistribution of wealth. This tax is a compulsory levy, one of the five
basic tenets of Islam and the generally accepted amount of the zakat is one fortieth (2.5 per cent) of Muslim's
annual income in cash or kind from all forms of assessed wealth exceeding nisab.
Islamic bank has to establish a zakat fund
for collecting the tax and distributing it exclusively to the poor directly
or through other religious institutions. This tax is imposed on the initial
capital of the bank, on the reserves, and on the profits as described in
the Handbook of Islamic Banking.
strict code of 'ethical investment' operates. Hence it is forbidden for
Islamic banks to finance activities or items forbidden in Islam, haram, such as trade of alcoholic beverage and
as the fulfilment or materials needs assures a religious freedom for
Muslims, Islamic banks are required to give priority to the production of
essential goods which satisfy the needs of the majority of the Muslim
community, while the production and marketing of luxury activities, israf wa traf is considered as unacceptable from a religious
order to ensure that the practices and activities of Islamic banks do not
contradict the Islamic ethical standards, Islamic banks are expected to
establish a Sharia Supervisory Board,
consisting of Muslim jurisprudence, who act as
advisers to the banks.
the restriction against the use of interest might seem to be a binding
constraint upon expansion, Islamic banks and financial institutions have in
fact grown rapidly. Table 1 sets out the number of
banks, paid up capital, total deposits and total assets of these Islamic
banks, classified by region. It shows that the total assets of these
reporting banks amounted to US $155 billion in 1994, with employment in
excess of 220,000 (data supplied by the International Association of
the paying and receiving of interest is prohibited, how do Islamic banks operater It is necessary to distinguish between the
expressions 'rate of interest' and 'rate of return'. Whereas Islam clearly
forbids the former, it not only permits, but rather encourages, trade. In
the interest-free system sought by adherents to Muslim principles, people
are able to earn a return on their money only by subjecting themselves to
the risk involved in profit sharing. As the use of interest rates in
financial transactions is prevented, Islamic banks are expected to
undertake operations only on the basis of Profit and Loss Sharing
(PLS) arrangements or other acceptable modes of financing. Mudaraba and musharaka
are the two profit-sharing arrangements preferred under Islamic law.
mudaraba can be defined as contract
between at least two parties whereby one party, the financier (sahib
al-mal), entrusts funds to another party, the entrepreneur (mudarib), to undertake an activity or venture. This
type of contract is in contrast with musharaka.
In arrangements based on musharaks there
is also profit-sharing, but all parties have the right to participate in
managerial decisions. In mudaraba, the
financier is not allowed a role in management of the enterprise.
Consequently, mudaraba represents a PLS
contract where the return to lenders is a specified share in the
profit/loss outcome of the project in which they have a stake, but no
interest lending, the loan is not contingent on the profit or loss outcome,
and is usually secured, so that the debtor has to repay the borrowed
capital plus the fixed interest amount regardless of the resulting yield of
mudaraba, the yield is not guaranteed in
profit-sharing and financial losses are borne completely by the lender. The
entrepreneur as such losses only the time and effort invested in the
enterprise. This distribution effectively treats human capital with equally
musharaka, the entrepreneur adds some of
his own to that supplied by the investors, so exposing himself
to the risk of capital loss. Profits and losses are shared according to
pre-fixed proportions, but these proportions need not coincide with the
ratio of financing input. The bank sometimes participates in the execution
of the projects in which it has subscribed, perhaps by providing managerial
expertise. Figure 3 illustrates the elements.
Mudaraba and musharaka
constitute, at least in principle if not always in practice, the twin
pillars of Islamic banking.
two methods conform fully with Islamic principles,
in that under both arrangements lenders share in the profits and losses of
the enterprises for which funds are provided and shirkah
(partnership) is involved. The musharaka
principle in invoked in the equity structure of Islamic banks and is
similar to the modern concepts of partnership and joint stock ownership.
banking operations, the mudaraba concept
has been extended to include three parties: the depositors as financiers,
the bank as an intermediary, and the entrepreneur who requires funds. The
bank acts as an entrepreneur when it receives funds from depositors,
and as financier when it provides the funds to entrepreneurs. In other
words, the bank operates a two-tier mudaraba
system in which it acts both as the mudarib
on the saving side of the equation and as the rubbul-mal
(owner of capital) on the investment portfolio side. Insofar as the
depositors are concerned, an Islamic bank acts as a mudarib
which manages the funds of the depositors to generate profits subject to
the rules of mudaraba. The bank may in
turn use the depositors' funds on a mudaraba
basis in addition to other lawful (but less preferable) modes of financing,
including mark up or deferred sales, lease purchase and beneficence loans.
The funding and investment avenues are now listed.
Sources of funds
their own capital and equity, Islamic banks rely on two main sources of
funds, a) transaction deposits, which are risk free but yield no return
and, b) investment deposits, which carry the risks of capital loss for the
promise of variable. In all, there are four main types of accounts:
accounts are based on the principle of al-wadiah,
whereby the depositors are guaranteed repayment of their funds. At the same
time, the depositor does not receive remuneration for depositing funds in a
current account, because the guaranteed funds will not be used for PLS
ventures. Rather, the funds accumulating in these accounts can only be used
to balance the liquidity needs of the bank and for short-term transactions
on the bank's responsibility.
accounts also operate under the al-wadiah
principle. Savings accounts differ from current deposits in that they earn
the depositors income: depending upon financial results, the Islamic bank
may decide to pay a premium, hiba,
at its discretion, to the holders of savings accounts.
investment account operates under the mudaraba
al-mutlaqa principle, in which the mudarib (active partner) must have absolute
freedom in the management of the investment of the subscribed capital. The
conditions of this account differ from those of the savings accounts by
virtue of: a) a higher fixed minimum amount, b) a longer duration of
deposits, and c) most importantly, the depositor may lose some of or all
his funds in the event of the bank making losses.
Special investment accounts
investment accounts also operate under the mudaraba
principle, and usually are directed towards larger investors and
institutions. The difference between these accounts and the investment
account is that the special investment account is related to a specified
project, and the investor has the choice to invest directly in a preferred
project carried out by the bank.
Uses of funds
mudaraba and musharaka
modes, referred to earlier, are supposedly the main conduits for the
outflow of funds from banks. In practice, however, other important methods
applied by Islamic banks include:
Murabaha (mark up). The most
commonly used mode of financing seems to be the 'mark-up' device. in a murabaha
transactions, the bank finances the purchase of a good or assets by buying
it on behalf of its client and adding a mark-up before reselling it to the
client on a 'cost-plus' basis profit contract. Figure 4 illustrates the
Bai' muajjal (deferred payment).
Islamic banks have also been resorting to purchase and resale of properties
on a deferred payment basis. It is considered lawful in fiqh
(jurisprudence) to charge a higher price for a good if payments are to be
made at a later date. According to fiqh
this does not amount to charging interest, since it is not a lending
transaction but a trading one.
prepaid purchase). This method is really the opposite of the murabaha. There the bank gives the commodity
first, and receives the money later. Here the bank pays the money first and
receives the commodity later, and is normally used to finance agricultural
Istissanaa (manufacturing). This
is a contract to acquire goods on behalf of a third party where the price
is paid to the manufacturer in advance and the goods produced and delivered
at a later date.
Ijara and ijara
wa iqtina (leasing). Under this
mode, the banks buy the equipment or machinery and lease it out to their
clients who may opt to buy the items eventually, in which case the monthly
payments will consist of two components, i.e. rental for the use of the
equipment and instalment towards the purchases price.
Qard hasan (beneficence loans).
This is the zero return type of loan that the Holly Qura'n
urges Muslims to make available to those who need them. The borrower is
obliged to repay only the principal amount of the loan, but is permitted to
add a margin at his own discretion.
securities. Islamic financial institutions often maintain an international
Islamic equity portfolio where the underlying assets comprise ordinary
shares in well run businesses, the productive activities of which exclude
those on the prohibited list (alcohol, pork, armaments) and financial
service based on interest income.
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This treatise, first published in 1990, is distributed by the Baharain Islamic Bank.
The concepts are examined in Siddiqi
(1983) and Abdul Gafoor (1995).
The incentive problems are examined in Ul-Haque
and Mirakhor, (1986).
The higher price shows in (HIB, 1982, vol., p.427).
The five basic tenets ( or pillars) are:
(1) acceptance of shahada, (2) prayer or namaz, (3) zakat or alms, (4)
fasting, and (5) hajj or pilgrimage to Mecca.
The Islam clearly forbids are examined in Khan, 1986, pp. 4-6.