1. Islamic Finance : Opportunities & Challenges Corporate Governance Issues W orld Bank Seminar, Washington DC, April 24 2006 Simon Archer Professor, University of Surrey, UK Consultant, IFSB

2. 2 Corporate Governance Issues Focus of this talk: –Banks rather than insurance cos. Unrestricted IAH as stakeholders –Ambiguous status –Information rights –Control rights Cross-border Shari’a compliance: home-host issues Operating environment: emerging markets –Concentrated shareholders, ‘grey’ directors and related party transactions –Lack of market discipline & weak information environment –Government interference

3. 3 Unrestricted IAH as stakeholders Ambiguous status Profit-sharing investors or ‘depositors’? –Conventional depositors Don’t need control rights except as creditors in an insolvency Have very limited information needs as their capital is guaranteed and their rate of return established by contract Basically only need to know that bank is solvent –Unrestricted IAH as Profit-sharing investors Have same information needs as shareholders –Risk and expected return What about their control rights? –Conventional interpretation of Mudaraba gives them none, except right to withdraw their funds subject to forfeiting share of profits

4. 4 Unrestricted IAH Assumption that they are passive investors Can they rely on shareholders to monitor management on their behalf? –Possible conflicts of interest e.g. re risk appetite If not, what is appropriate? –Information rights: similar to those of CIS participants Asset allocation, risk & profitability But also: profit allocation & use of reserves (PER/IRR) –Control rights: IFSB ED3 Governance Committee suggestion Requires no active participation from IAH

5. 5 Cross-border Shari’a Compliance: Home-Host Issues Applicable Shari’a rulings may differ between the country of the parent bank and that of a foreign operation (branch or subsidiary) Which rulings should be valid for the foreign operation? –If host country has a National Shari’a Authority (e.g. Malaysia or Sudan) then foreign operation is bound to follow its rulings – If home country has a National Shari’a Authority, but host country does not, does foreign operation have to follow home country rulings? Probably yes if branch But if subsidiary, with own Shari’a Board? –If both countries have National Shari’a Authorities? Need for cooperation between the 2 countries to resolve conflicts

6. 6 Operating Environment (1) Concentrated shareholders May dominate Board of Directors Non-execs may not be independent Risk of related party transactions that may damage the bank –Danger for minority shareholders and IAH –Need for transparency (financial reporting standards) –How much reliance can be placed on external auditors? –Key role of banking supervisor ‘fit & proper’ tests Monitoring of dominant shareholdings Risk of pressure on supervisor

7. 7 Operating Environment (2) Lack of market discipline & weak info. environment Aggravates problems just mentioned Need for regulatory authorities to be pro-active to ‘bootstrap’ info. environment and mkt. discipline May be problematic –Govt. control of, or pressure on, banks’ commercial activities is likely to impede mkt. discipline –Conflict between (a) govt. concern with macro & social role of banks in eco dev and (b) development of robust banking system –Islamic banks not essentially different from conventional banks in this, but may be more vulnerable Financing modes may be more risky but can the risk be priced for (e.g. Salam) ?

8. 8 Concluding Remarks Burden on banking supervisors & regulators to enable the issues outlined above to be handled successfully IFSB’s efforts to provide support –Issued: Standards on Risk Management, Capital Adequacy, ED on Corporate Governance – In progress: EDs on Supervisory Review Process and Transparency & Market Discipline; + complementary standards –Seminars on the above