Governance Indicator in Islamic Financial Industries and What Should Be Improved

Abstract            

The good corporate governance (GCG) is very crucial given its central role in islamic financial institution (IFI)’s development. The rapid increase in the quantity of IFIs, over the years has triggered a question whether its GCG has improved respectively. To answer this, the governance indicators published by Thomson Reuters are used. Furthermore, it is complimented by deeper analysis on the IFIs need. As the result of the analysis, some recommendations to improve Governance Indicator are drawn.

Keywords: Good Corporate Governanc (GCG), Governance Indicator.

1.      Introduction

The issue of governance in IFI has been a long interest of the world scholars. Research on the topic have been done in analytical as well as in its technical aspect.

CG has main functions: to assurance the existence of ‘TARIF’ (Transparency, Accountability, Responsibility, Independence, and Fairness) in company. It is aimed to ensure the interest of all stakeholder.  CG also can be tool to influence the performance of corporation. In islamic context, comprehensive islamic compliance make confidence to the public and the financial market on the credibility of Islamic finance operations.

The responsibility to develop GCG not solely in the hand of Board or Supervisory Sharia Board only, rather, participation from the employee as well as customer, and enforcement from regulator are highly needed, nonetheless, providing the gate keeper like Governance Indicator is very crucial in this effort.

In 2014, Thomson Reuters  published new governance indicator related to the soundness of islamic bank, that cover the regulation, CG, SG assesment in IFI around the world. However the question remains: Has the current indicator to assess GCG run its role properly? In this paper, the indicator GCG will be elaborated, followed by assessment of IFI need, and closed by conclusion.

2.      Governance  Indicator and Its Impact on IFI

Throughout few decades, the development of Islamic finance has retained the attention from many prospects of investors as well as consumers. However, this development shall be measure through the health of Islamic finance industry that rely on foundations of checks and balances that stimulate its growth, and the best practices to boom the further development of the industry. Hence, here comes the governance indicator as the tool to measure the check and balance as well as reliability of an Islamic financial institution. It examines the three components of governance which are regulation, corporate governance and shariah governance respectively.  

Regulation	Sharia Governance	Corporate Governance
This component focusing on the absence or presence of the respective regulations related to the six sectors of the IFI which are Islamic banking, takaful, sukuk, funds, accounting and auditing, and sharia (separate from, and not to be confused. It does not take into account the quality of the regulations.	This component focusing on the absence or presence of the centralized sharia committee at the national level as well as the total of number of sharia scholars in that country (via their representation in IFIs), Number of scholars with more than five board memberships (negative score), and Number of institutions with more than three members on their sharia supervisory boards.	This component basically assesses on the four pillars of corporate governance which are accountability, independence, transparency and fairness applied in the top management in the IFI.

Source: IFDR 2014, processed by author

These components are relevant to what to the industry thrive for; enabling regulations, effective corporate and shariah governance, and an appropriate risk management oversight that privilege accountability, transparency and probity. Therefore, governance indicator is highly recommended to be used as an achievement target by the IFI in order to not only acquire the confidence of investors as well as the consumers that become the ‘asset’ of an IFI, but preventing from collapsing of an IFI,  misappropriation of funds  and others unethical conduct. Further, stronger governance (especially regulations) would better facilitate cross-border sharia-compliant flows and the industry’s aspirations for globalization

3.      Result: Governance Indicator  of Islamic Financial Institution vs Global Standard

Figure 1:  Top 10 Countries for Governance Indicator of IFI  vs Top 10 Governance Metrics International for Financial Institution (FI)

Rank	Sub1: Regulation	Sub2: Sharia Governance (SG)	Sub 3: Corporate Governance (CG)	Total Result: Top 10 Governance Indicator (IFI)	Top 10 Governance Metrics International [1](FI)
1.	Bahrain	Sudan	Kuwait	Bahrain	United Kingdom
2.	Malaysia	Bahrain	Oman	Malaysia	Canada
3.	Nigeria	Malaysia	Malaysia	Pakistan	Ireland
4.	Pakistan	Kuwait	Sri Lanka	Kuwait	United States
5.	Iran	Bangladesh	Bahrain	Sudan	New Zealand
6.	Kazakhstan	United Arab Emirates	Qatar	Indonesia	Australia
7.	Brunei	Indonesia	Pakistan	Oman	Netherlands
8.	Indonesia	Pakistan	United Kingdom	United Arab Emirates	Finland
9.	Oman	Egypt	Singapore	Bangladesh	South Africa
10.	Sudan	Lebanon	Indonesia	Qatar	Sweeden
….
17					Singapore
24					Malaysia
33					Turkey
36					Indonesia

Source: Islamic Finance Development Report (2014), and Governance Metrics International processed by author

From figure 1, writer’s analysis that:

1.      the  top 3 sound governance of IFI (Bahrain, Malaysia, Pakistan) are the country rank highly on all three sub-indicators.

2.      the  top 3 sound governance of IFI (Bahrain, Malaysia, Pakistan) are greatest strength lies in regulation.

3.      Strong on regulation only without taking an account into SG and CG is bad. No country that has sound regulation only becomes the top on overall governance. For instance: Nigeria, Iran, Kazakhtan, Brunei

4.      Countries that have sound CG may tend to have a better governance as overall (Kuwait and Oman) for IFI and even for FI (United Kingdom and Singapore)

5.      None of top 10 Countries for Governance Indicator of IFI those become the top 10 on global rank for financial institution. The question remains: Has the current governance in Islamic financial institution run its role properly?

Several issues may arise from this result and should take an account for Islamic financial institution, especially and countries, generally. First, stronger regulatory environment is not a guarantee of bigger market. With regards to our assessment of countries with regulations, the adoption or implementation of up to two regulations still reflects ‘weak’ level of Islamic finance regulatory environment, those with three to four regulations considered as ‘medium’ level and the ‘strong’ level addressed to five to six regulations. Hence, the countries that classified under these three levels are Jordan, UAE and Bahrain respectively. Despite of that, still there is no correlation between the strength of a country’s regulatory environment and the level of its financial assets. The fact is quoted from Islamic Finance Development Report:

“This is most clearly demonstrated in the case of Saudi Arabia which has no dedicated Islamic finance regulations but hold sharia-compliant assets of just over $338 billion. On the flipside, Nigeria has a full set of regulations covering Islamic finance but a low level of sharia-compliant assets compared to its peers in the region.In Southeast Asia, Singapore and Philippines have stronger regulatory environments than Thailand, which has a higher level of Islamic finance assets than the two combined. In Central Asia, Kazakhstan, like Nigeria, has a strong regulatory environment but small base of banking and sukuk assets. Kyrgyzstan has a slightly weaker regulatory environment but a comparable level of assets. Thailand”

Second, it is not enough to adhere to Shariah governance only. Shariah governance is completely added value to the corporate governance of the IFI. Besides that, Shariah governance has significant impact on the continuous good conduct. Nevertheless, knowledge without practicality is not enough. If a person did not understand the worldview of shariah governance, they might deliver bad image of Islam. Thus, shariah governance highly correlated to the service delivered by the IFI’s human capital.

Sharia regulations and governance highest priority Of the 52 countries that registered the presence of measures for any of the three sub-indicators, more of them meet sharia governance best practices (85%, 44 countries) than corporate governance (62%, 32 countries), indicating a higher priority placed on sharia governance in the first instance. This is true for those with and without regulations — 79% (22 countries) of those with regulations also adhere to sharia best practices compared to a higher 92% (22 countries) of those without regulations. However, countries with regulations almost equally meet corporate governance measures — 71% (20 countries) — reflecting a higher commitment on all fronts. (IFDR, 2014)

Third, uneven disclosure practices in Islamic Finance Corporate Governance. The common issues arises from IFI is pertaining the uneven disclosure on necessary details need to be known by the customers or investors. Abandoning the pillars of corporate governance will cause the institution to be categorized as weak corporate governance. Evony (2014) shows that most of 102 Islamic Banks around the world still has low  culture to disclose their performance.

Fourth, the current governance of Islamic financial institution may still left behind the worldwide standard because of poor CG. In the other word, governance indicator for IFI may not still able as a measure tool and then be able to encourage IFI to implement the better good corporate governance (GCG)

Country rankings come as no surprise; the ratings place a great deal of emphasis on transparency and accountability. But a IFI low ranking today also spells opportunity. As Islamic financial institution in particular competes for global capital and develops a cross-border shareholder base, it seems inevitable they will face pressure to become more transparent.

4.         Rational Reason ‘Why CG Should be Concerned?’

From writer analysis in section 3, it is clear that CG is a key to develop good governance. It is better if regulator can do enforcement of regulation; however a willingness an institution to implement it and consciousness that CG is a medium to improve their performance, rather than ‘box ticking’ model is more important.

However, what’s make CG become more relevant today for IFI?

First, globalization process has effects on all sectors include IFI in their business society to consider international market. It is not matter whether the IFI has business activity across other country or not (just locally, nationally). However, having regard to international institutional investment taking place across an electronic, it should be taken  into account that to become the leader in financial industry, they should take into account this area.)

Second, market (investor and client) also concern about what already happened to financial crisis.  They require player to focused on better GCG(Good Corporate Governance). They consider there is a failure of governance” or manipulative CG’ in companies. This current issues make investor and player focus on how the institution and its environment (the country) intention to establish ‘true CG”

Third, to encourage the development of IFI that operate in multiple markets (international market), greater level of harmonisation with regard to corporate governance, regulatory and financial reporting best practices in the region is also highly required..

5.      What Should be Improved

There is not much difference between corporate governance that implemented by a company compared to Islamic financial institution except in terms of motivation. In common corporate governance, we are much focusing on the worldly expectation. In contrast with the governance in Islamic financial institution view whereby we balance it out between worldly and the hereafter achievement. We also have the motivation to conduct in pleasure of our Creator and not for human only. Hence it can be concluded that the corporate governance is still relevant with the need of shariah governance with addition that shariah governance covers a wide scope of the conduct in business activities.

However, current CG is also has problem. There is  failure of corporate covernance control in this current practice, that is  lack of Ethics. Many unethical cases; like London interbank offered rate (LIBOR) cas , Saytam  case, etc in fact happened in financial institution that already prove their GCG.

Good general CG framework is not enough to guarantee the better Governance in IFI. The solution is to establish the ethic-embeded governance framework which enforce all stakeholder of IFI properly play their function in their organization. This ethic shoud not become just a code of ethic paper. Because of that, to create CG model of Islamic financial institution, IFI should internalize the ethic in their job environment. How to do that? There is several Governance indicator to be taken account to boost good corporate governance in IFI. However, this indicator is qualitative question[2], that should be developed as further in order to measure the performance of IFI.

First, do the IFI have a integrated program and system to make better character of their employee?

1.      Do the IFI has ‘Building Character Program’ for their employee or not?

It is not just about sharia knowledge program. It is more about mentality and build the concsiousness as a human, vision in the world, discipline, and professional. It is when every personal in IFI know their function and role in company (not just operating skill, but the subtance of their role in company and to the surrounding). 

The sustainable gain will be received,  if the spirit of CG is embeded in character of the personal and company. The spirit born from their ‘god consiusness’ and encourage them to operate with spirit CG. The positive value will affect the every single person involved in company and put their best effort to develop company more.

There is a need to create “God consciousness” in not only prayer but everything we did including while working.  It is the condition when majority of the people in the institutions is working with as if the God exist, there will be less unethical behaviour, thus inculcating self-development and promoting Islam as a religion of life that is practical and promotes good values.

Source: writers analysis

As Islamic financial institution, it is not necessary that they already have good god consciousness.  The true ‘god consciousnesses will be reflected to their professionality, and accountability to other people.  Most of IFI may not able to understand that accountable to god. It is happened when we show the fact about uneven disclosure in Islamic finance of IFI (Evony, 2015)

Second, do IFI build internal control system in their company? The indicators are:

1.      Is there any ‘Repetition power’ in building the character of employee?

It is include the leader, people, environment, and system that always remind the all of people in IFI about the god consciousness.

2.      Is there any ‘Tone at the top’ from leader that influences other subordinate?

3.      Do IFI relate bonus of management not to profit (shor term), but how sustainability to comply ethic and CSR standar?

4.      Do IFI’s create their business model that impact to Economy and Social: promoting welfare and establishing justice?

5.      Do IFI concern about the ‘remedy the evils in modern day consumerism?’

Top management and all employee consider ‘how they create the product for customer’, that does not just fulfill the consumerism. The most important, do IFI create product that encourage the productive activity and entrepreneurial spirit?

 Source: writer recommendation

6.         Conclusion

Good corporate governance of IFI is not able to only depend on regulation, sharia governance, and corporate governance only. Ethics as social engineers should be there. This analysis paper, however has limitation. This paper only focuses on analysing the existing governance indicator in improving GCG in IFI and analysis the ethic point that not already measured. Hence it may not reflect the actual issue and challenge in practice. However this paper suggest to IFI to establish ethical indicator to measure their governance.

References

AAOFI-Governance and Auditing Standards. (2012). 4 Annual IIBI-ISRA Thematic Workshop. London, United Kingdom

Chapra, MU. Ahmed, H. (2002). Corporate Governance in Islamic Financial Institutions. Islamic Research and Training Institute (IRTI). Jeddah.

Alwyni, Farouk Abdullah. (2015). Corporate governance in global Islamic financial institutions.  Islamic Finance News. Accessed July 2015

IFDR (Islamic Finance Development Report). (2014). ICD Thomson Reuters

IFSB Guiding Principles on Shariah Governance System in Institutions Offering Islamic Financial Services (IFSB-10)

International Federation of Accountants. (2007). Tone at The Top and Audit Quality

The End of ethc and A way Backs: How to Fix a Fundamentally Broken Global Financial System. (2013). Theodore Roosevelt Malloch. Wiley

Anand Sinha (2013) Governance in banks and financial institutions. India. L & T Management Development Centre

Evony Silvino Violita (2014). Fungsi Mediasi Elemen Institutional Budaya Terhdap Hubungan Nilai-Nilai Budaya dan Tingkat Pengungkapan Nilai Nilai Islam pada Laporan Tahunan Bank Islam: Studi Lintas Negara. Universitas Indonesia

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[1] Governance Metrics International (GMI), the corporate governance research and ratings firm, announced today new country rankings based on overall quality of corporate governance.GMI publishes research and ratings for 4,207 companies in 45 countries. GMI ratings, are used by a wide array of global financial institutions. GMI is often combined with traditional analytical tools such as discounted cash flow or financial ratio analysis to create more robust valuation models.

[2][2]  This indicator is derived from Theodore Roosevelt Malloch Book, entitled The End of Ethic and A way Backs: How to Fix a Fundamentally Broken Global Financial System. (2013). However, his idea is processed by author and adjusted to IFI.