Islamic

Corporate Governance (IFI)

Dayah Abdi Kulmie

MBA (Banking and Finance)

Plasma University
2021
 Unit 3
Risk Governance
in Islamic Financial Intuitions
 Chapter Objectives
• Understand Concept of economic power
• Understand banking system and Islamic banking
• Understand Islamic Corporate governance as Risk Management tool
• Risk Management Process
• Risk Management in Islamic Veiw
• Understand the importance of Islamic social finance
• Corporate governance framework of Islamic financial institutions
• Principles of Islamic corporate governance
 Concept of Economic Power
• Capitalist economies are organized on the basis of free market mechanism
where production of goods and services comes from a combination of
capital and wage labour.
• The capital is provided both as equity and as interest-bearing loan.
• The market, though theoretically free, is dominated by mega-corporations
which:
• Determine the price level
• Influence the level of:
• investment,
• saving,
• production, and
• consumption.
Concept of Economic Power
• The law of perfect competition
• This is classical economic analysis
• Become irrelevant due to the concentration of economic power in
the hands of mega-corporations.
• This accumulation is caused by a number of factors:
1. The interest income of the rentier class turns the flow of wealth
from the poor to the rich.
2. Due to the legal innovations of incorporation and limited
liability, the corporations can collect huge amounts of capital on
account with limited risk.
• The profits is unlimited, but the risk (loss) is limited.
Concept of Economic Power
3. The benefits of technological developments:
• are not passed on to the consumers in the form of
lower prices.
• are mainly appropriated by the mega-corporations
• monopolistic power to fix prices.
Banking System in Islamic Economy
• The banking system in an Islamic economy is based on the concept of
sharing profit as well as loss.
• The general principle is that those who want to earn a return on their
savings should also be willing to assume a risk.
• The importance of equity capital in economic development is now
well appreciated in the financial circles. A truly Islamic financial
structure would be one wherein like other factors of production
capital is also required to bear risk.
What is Islamic Economics & Finance?
• Islamic economics:
• deals with a paradigm that links the concept of responsible resource
allocation and income distribution,
• the maximisation of utility by consumers and profit by businesses
• taking into account property rights of members of the society in a
way that maximis es social welfare,
• The Islamic law and rules (Sharia), covers a comprehensive range
of rules and regulation relating to:
• Religious, social, economic and financial affairs
• The governance of the financial dealings of groups and
individuals in an Islamic society.
Islamic Banking
• What is an Islamic bank?
• Islamic banking referred to as Islamic finance or shariah-compliant
finance, refers to finance or banking activities that adhere to shariah
(Islamic law).
• Two fundamental principles of Islamic banking are:
• The sharing of profit and loss, and
• The prohibition of the collection and payment of interest by lenders
and investors.
Islamic Banking
• The principles which emphasise moral and ethical values in all
dealings have wide universal appeal.
• Islamic banking has the same purpose as conventional banking except
that it operates in accordance with the rules of Shari’ah, known
as Fiqh al-Muamalat(Islamic rules on transactions).
Islamic Banking Business
• The Islamic banks carry their business on the basis of:
• Equity-participation (musharakah, and muqarabah),
• Leasing (ijarah),
• Lease-purchase (ijarah wa iqtina'),
• cost-plus financing, (bay' murtiba~ah), and
• rent-sharing.
• These institutions have also innovated in devising some new
financial instruments like:
• Participatory Term Certificates (PTC),
• Term Finance Certificates (TFC),
• Muqaraqah Bonds,
• Leasing Certificates, etc.
Financial Service
• Financial services are core to economic activity.
• Individuals and institutions need to place excess liquidity and access
financial resources for investments or consumption.
• They need financial services to settle their transactions.
• The financial intermediation industry has developed over time,
responding to these economic needs but also to prevailing societal
values.
• Most regulation governing finance provide public trust in an industry
based essentially on information and confidence.
• Trust and confidence are essential values
• trustworthiness, confidence and brotherhood.
 Financial Service
• Financial institutions are the providers of financial services:
• with different ranges:
• from small loans to huge investments
• with different inttities:
• society, business, families and individuals.
• Islamic financial institutions apply Islamic principles on:
• Financial issues,
• business issues and
• managerial issues
• Why?
• to promote the wellbeing of all members of the community
 Islamic Finance & Corporate Finance
Islamic way of corporate finance
• This involves linking mainstream corporate financial decision-making to
the principles and concepts of Islamic finance.
• Capital budgeting decisions
• Investment appraisal techniques
• Valuation tools:
• Do the Islamic firms use Discounted Cash Flow (DCF) techniques?
• What discount rate is appropriate? Is it the cost of equity?
• What is the expected return on sukuk?
• How is weighted average cost of capital calculated?
• Are interest tax shields taken into account?
Islamic Finance & Corporate Finance
• Capital Structure of Firms
• Islamic finance principles in the capital structure
decisions are not only adopetd in Islamic
countries but also be explored in other
economies.
Islamic Finance & Corporate Finance
• Islamic Social finance
• Social finance can be defined as a structure of investment strategies
with the main objective to produce good impact for both social and
environmental outcomes for investors as well as society.
• Hence, it consists of broad scope such as:
• Community investment,
• Microfinance,
• Social impact bonds,
• Community loan funds
 Maqasid Shariah vs Islamic Social Finance
• Islamic Social Finance is social and faith- based financing that provide
financial assistance and support people in need in order to alleviate human
suffering as well as to preserve environment from the conflict and disaster
affected.
• Accordingly, the approach is to manage and invest funds to solve social
challenges and to improve communities and the environment.
• Islamic Social Finance (ISF) provides an alternative approach to the
Muslim society in improving social welfare and the better environment
which is operated based on Shariah compliant. This consists of several
institutions:
• Zakat, Waqf and Sadaqa
• Profit and non-profit Islamic microfinance
The Importance of Corporate Governance in
Islamic Banks
• Corporate Governance is defined as "procedures and processes
according to which an organization is directed and controlled.
• Corporate governance structure
• specifies the distribution of rights and responsibilities among the
different participants in the
• board, managers, shareholders and
• other stakeholders
• lays down the rules and procedures for decision-making".
• stresses the importance of risk governance as part of abank's
overall corporate governance framework
• promotes the value of strong boards and board committees together
with effective control functions
Islamic Corporate governance as Risk
Management tool
• What is a risk?
• The Concise Oxford Dictionary defines risk to imply something bad,
the chance of bad consequences, loss, etc.
• The definitions of risk that are typically found in the literature are as
follows:
• the chance of loss;
• the possibility of loss;
• the dispersion of actual from expected results;
• the probability of any outcome being different from the one
expected; and
• the significance of hazard in terms of the likelihood and severity of
any possible adversity.
Risk governance 
• Risk governance refers to the institutions, rules conventions,
processes and mechanisms by which decisions about risk are taken
and implemented. It can be both normative  and positive, because it
analyses and formulates risk management strategies to avoid and/or
reduce the human and economic costs caused by disasters.
• Risk governance goes beyond traditional risk analysis to include:
• the involvement and participation of various stakeholders
• Considerations of the broader legal, political, economic and social
contexts in which a risk is evaluated and managed
Risk Management
• The Definition of Risk Management
• RM is defined as:
• a scientific approach to dealing with pure risks by anticipating
possible accidental losses and designing and implementing
procedures that minimize the occurrence of loss or the financial
impact of the losses that do occur.
• a comprehensive system that includes creating an appropriate
risk management environment, maintaining an efficient risk
measurement, mitigating and monitoring process and
establishing an adequate internal control arrangement.
  
Risk Management in Islamic Financial Institutions

• The management of Islamic banks needs to create a risk management

environment by clearly:
1. Identifying the risk objectives and strategies of an institution
2. Establishing systems that can identify, measure, monitor and
manage various risk exposures.
• The central components of risk management are identification,
quantification and monitoring of the risk profile including both
banking and financial risks.
• The goal of risk management is controlling risks.
• Risk Assessments
• Quantitative and qualitative
Risk Management Process
• The organization and process of risk management should be bank-
wide, across all business lines.
• Steps in risk management process:
• determining objectives
• identifying risks
• evaluating risk
• considering the alternatives
• selecting the risk treatment device
• implementing the decision and
• finally evaluating and reviewing the process
Risk Management in Islamic Veiw
• The Quranic verse (Al-Baqarah:282) requires Muslims to record debt
or provide witnesses and supported by Hadith (Sunan alTirmidhi:
2517) on the requirement to tie the camel before leaving its fate to
Allah (tawakal).
• Risk management is permissible in Islam and is in congruence with
the objectives of Shari’ah (Maqasid as-Shari’ah) especially with
respect to preservation of wealth (hifdulmaal).
Risk management framework
• A sound risk management framework may help Islamic banks reduce
their exposure to risks and enhance their ability to compete in the
market.
• Extensive investment by Islamic banking required to have internal
risk management infrastructure.
• The requirement to manage risks in Islamic banking becomes more
important due to some special nature of the financial intermediation
process that is guided by the Islamic Shari’ah. Islamic banking enters
into diverse modes of Islamic financial contracts.
Risk Exposure In Islamic Banking
• The risk that Islamic banks face can be divided into:
• Financial risks
• The financial risks generally include credit, market and liquidity
risk.
• Non-financial risks
• The non-financial risks include:
• operational risk,
• regulatory risk,
• business risk,
• legal risk,
• strategic risk
• Shari’ah risk.
Risk characteristics of Islamic banking
• The risk characteristics of Islamic banking differ from conventional
banking.
• The risk’s Shari’ah attributes as:
• Financial assets, or non-financial assets, real estate, commodities or work in process
inventories o
• Their results from financing made on profit sharing basis are exposed to losses
• Islamic Financial Services Board (IFSB) issued a comprehensive standards
document on risk management in Dec 2005 that identifies different risks and
provides guiding principles of risk management for Islamic financial
institutions.
 Risk characteristics of Islamic banking
• Common Forms of Risks
• Three most common forms of risks that Islamic banks are exposed to namely:
• credit risk:
• The potential risk attributed to delayed, deferred and default in payments,
e.g. profit-sharing contracts, working capital financing
• operational risk:
• The risk of loss resulting from inadequacy or failure of internal processes,
as related to people and systems or from external risks and includes the
risk of failure of technology, systems and analytical models.
• Shari’ah risk:
• Related to the structure and functioning of the Shari’ah boards at the
institutional and systemic level.
• nonstandard practices
• compliance failure
The bank-investors (depositors) relationship
• The nature of relationship between the bank and investors/depositors
• It is an agent and principal relationship
• It is based on implicit trust relationship
• It is based on the Shari’ah law
• Breaching the trust and confidence of the depositors/investors will
lead to serious consequences, including:
• The withdrawal and
• Tnsolvency risk/Bankruptcy risk.
Role of Supervisory Authorities in Risk Mitigation

• The risk management infrastructure in Islamic banking must be in

place to:
• Identify, unbundle, measure, monitor and control all specific risks
in Islamic financial transactions and instruments
• Provide for their effective quantification and management.
• Have required capacity and infrastructure to capture the respective
risk weights and assign appropriately
• Supervisory authorities need to be equipped with the specialized
skills necessary to have the right assessments.
• An effective regulation and supervision will ensure the soundness and
the stability of the system.
 Role of Supervisory Authorities in Risk Mitigation
• An effective regulation and supervision:
• Ensure the soundness and the stability of the system
• High priority to ensuring transparency in compliance with the Shari’ah
• Take necessary actions to avoid non-compliance.
• A proper governance framework:
• should be established to consider appropriate level of disclosure that willcreate:
• an adequate level of transparency and
• effective prudential supervision.
• Risk mitigation strategy calls for:
• Collaboration between the management of Islamic banks and regulators
• Harmonization in Shari’ah standards, pool resources among Islamic banks and
• Training programs for human resource development.
End