Islamic finance: Strong standards of corporate governance are a 'sine qua non'

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Proper corporate governance practices in financial institutions should provide added value by enhancing the protection of depositor and investor rights, facilitating access to finance, reducing the cost of capital, improving operational performance, and increasing institutions’ soundness against external shocks. Ensuring strong corporate governance standards is thus essential to the stability and health of all financial institutions, worldwide.
Good governance is an important priority for Islamic finance, an aspect of international finance that has enjoyed a stage of significant growth over the past decade. The volume of financial assets that are managed according to Islamic principles has a value of around $2 trillion, having experienced a cumulative average annual growth rate of about 16 percent since 2009 (Graph 1).

Graph 1: The Size of Islamic Finance Assets (USD Billion)

Banking has traditionally been the leading sector in the realm of Islamic finance, but the share of other products and institutions within the total realm of Islamic financial assets has been steadily increasing,  as well (Graph 2). For instance, the Sukuk sector – which focuses on securitized asset-based securities – has seen considerable growth over the past six years and, as of 2014, amounted to more than $300 billion. Similar momentum is driving the growth of the Islamic Funds and Takaful (Islamic insurance) sectors. From 2009 to 2014, the assets under management of Islamic Funds has increased from about $40 billion to about $60 billion, while the amount of total gross contribution to Islamic insurance has surged from $7 billion to more than $14 billion.

Graph 2: The Size of Islamic Finance Assets by Sector 2014 YE (%)


Amid the rapid growth of Islamic finance, asserting strong corporate governance practices has become all the more important, so that Islamic finance can maximize its contribution to overall economic development. Establishing proper mechanisms for corporate governance has become especially vital in the case of Islamic banking, which has grown significantly compared to conventional banks in those countries where the Islamic banking sector has developed (Graph 3).

Graph3: Growth of Conventional and Islamic Bank Assets
Compound Annual Growth Rate (%) Between 2009-2013


Islamic finance and Islamic banking depend on two basic principles: that all transactions should bear the element of risk-sharing, and that all transactions should be backed by (or based on) real assets. The first principle requires the parties engaging in transactions to carry proportional risks associated with the business or asset that is going to be financed; the second principle avoids the risk of establishing debt-based relations, where merely the exchange of money for money is taking place. In this way, equity-based finance is promoted and finance becomes an activity to support real (not just financial) economic activity.
Consider an example of the impact of such features: the case of depositors in Islamic banks. A depositor or investment account holder in an Islamic bank differs from his or her counterpart in a conventional bank, since his or her deposits are not guaranteed with an ex-ante fixed return: Instead, they carry the risks of losses associated with the investments of the bank. This makes the need for appropriate governance in Islamic banks all more vital. Furthermore, the ethical principles surrounding Islamic finance requires the providers of Islamic financial services to implement a rule-based incentive system, so that compliance with the rules is ensured, and so that an efficient governance system helps preserve social justice and order among all members of society. (For a more detailed discussion related to the corporate governance practices in Islamic Finance institutions, see “Corporate Governance in Islamic Finance Basic Concepts and Issues,” by Hussein Elasrag, Lambert Academic Publishing, 2014.)
Motivated by these concerns, such international institutions as the Islamic Finance Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) focus on the development of principles and standards for corporate governance practices and reporting requirements of Islamic banks and Islamic financial institutions. Such standards are in line with international standards described by institutions like the Financial Stability Board (FSB), the Basel Committee and IOSCO.  
Recognizing the increasing importance of corporate governance practices for Islamic financial institutions, the General Council for Islamic Banks and Financial Institutions (CIBAFI) – the global umbrella of Islamic financial institutions – and the World Bank’s Finance and Markets Global Practice recently organized an international conference on “Corporate Governance for Islamic Financial Institutions: Lessons from Recent Global Developments” in Amman, Jordan. The conference, on September 15 and 16, brought together various stakeholders from the private sector, multilateral development institutions, international and national regulatory bodies, policymakers, and academia to discuss the issue of corporate governance in the Islamic financial industry.

The conference in Amman offered an excellent platform for the exchange of ideas on a wide array of topics, such as board effectiveness and accountability, risk governance and the risk-management framework, transparency and reporting requirements, and Shariah governance for Islamic banks and other financial institutions. It also provided a platform to stimulate the discussion on the role of an effective regulatory and supervisory framework and strong risk-management practices, aiming to strengthen the corporate governance of Islamic financial institutions from both the micro- and the macro-prudential perspectives.
The continuing growth of Islamic finance can make a significant contribution to development finance, and it will be especially important as the global financial system seeks to fulfill the newly adopted Sustainable Development Goals. For the global economy to derive the greatest possible benefit from Islamic finance, policymakers and private-sector leaders must ensure that strong corporate governance standards are adopted, thus energizing the full potential of this important channel of finance for development.    



Nihat Gumus

Financial Sector Specialist

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