By Riazuddin Ahmed and Mohamad Saifullah Bin Mohamad
International Islamic University Malaysia
Cite as: Ahmed, R. and Mohamad, M. S.(2019), "The Practice of Shariah Governance in Islamic Banking and Finance: A Study of Islamic Banks in Bangladesh", International Journal of Management and Applied Research, Vol. 6, No. 4, pp. 271-284. https://doi.org/10.18646/2056.64.19-020 | Download PDF | Cited by
This paper aims to study Shariah governance of Islamic banks in Bangladesh. Desk-based research was conducted for this paper to explore the main challenges faced by Islamic banks in the country. Based on empirical studies and newspapers, this paper concludes that there is a lack of a well-defined regulatory and supervisory framework for IFIs to function effectively in line with the tenets of Shariah. This study also finds that the shortage of Shariah scholars remains an impediment to Shariah compliance. The government and the central bank of Bangladesh should pay greater attention to education and training, in addition to creating a national Shariah advisory council to monitor Islamic banking and financial activities in Bangladesh.
Any financial institution has a fiduciary responsibility towards the interest of its shareholders. Breaches of fiduciary duty typically happen when a fiduciary behaves in a manner which is against the shareholders’ best interests, such as failure to keep information confidential, misappropriation of funds, misuse of positional power, misrepresentation or fraud. Poor corporate governance has often been cited by researchers as one of the main causes of financial crises (Joh, 2003; Johnson et al., 2003; Kirkpatrick, 2008). Islamic financial institutions (IFIs) are not different in this regard. Just like mainstream financial institutions, IFIs are not free from the risk of breaching fiduciary responsibilities. The fiduciary responsibility of IFIs towards their clients is to serve their best interest while at the same time complying with Shariah rules.
The institutional environment in which IFIs operate is important for them to implement good governance through Shariah-compliant operations. Characterised by institutionalised bribery and civil unrest, the institutional environment of Bangladesh is different from neighbouring Islamic countries. Bangladesh is both a challenge and inspiration for bankers. One notable example is Grameen Bank, the pioneer of microfinance. The founder of Grameen Bank, Muhammad Yunus has inspired the global microcredit movement. However, Mr Yunus was forced out as director in 2011; four years later, Grameen Bank was set to go under full government oversight as an attempt by the government to increase its control over the bank (Allchin, 2015). Equally, Islami Bank in Bangladesh, which runs the world’s biggest Islamic microfinance scheme, has also suffered government intervention since 2017, with an immediate decline in financial performance (The Economist, 2019).
Therefore, the objective of this paper is to explore the Shariah practices and corporate governance of Islamic banks in Bangladesh and to identify the main challenges faced by these banks. To attain the objective of this paper the following research questions need to be answered:
- What are the principles of Shariah which ensure good Shariah governance?
- What are the current practices of Bangladeshi Islamic banks which ensure Shariah governance is maintained?
- What are the key challenges faced by Islamic banks in Bangladesh in ensuring Shariah governance and compliance?
2. Risk, Corporate Governance and Shariah Compliance
Good corporate governance is crucial to all organisations, especially financial institutions. Claessens (2006) found that good governance leads to lower cost of capital, greater returns on equity, higher efficiency and an increased level of confidence for all stakeholders. A particular feature in respect of Islamic financial services is Shariah compliance, which means that an Islamic financial institution (IFI) must make sure that their financial products operate in conformity with their religious beliefs.
While Shariah practices differ across Islamic financial jurisdictions, ethical investment is paramount for Islamic banking and finance. Apart from the strict prohibition of riba (interest), gharar (uncertainty), maisir (gambling) and haram (illegal or harmful), Islamic financial products are characterised by the principle of risk-sharing. Central to Islam is the concept of Tawhid, the oneness of Allah (God). Muslims are expected to follow a way of life that submits to Allah in accordance to Shariah law and the teachings of the Quran. Islamic Financial Institutions (IFIs) are no exception. The conceptual foundations and banking practices derived from the above mentioned principles pose challenges to regulators with regard to accounting and documentation standards. Moreover, pressures to tighten the net of prudential supervision emerged after several cases of distress, namely the collapse of Ihlas Finance House (IFH) of Turkey in 2001 and the Tabung Haji scandal in 2018. More often than not, these financial scandals were facilitated by poor corporate governance, where boards fail to manage potential risks or engage in reckless risk-taking behaviours themselves (OECD, 2014). Poor corporate governance in IFIs shares features with other non-Islamic banking scandals, such as mismanagement, audit failure, weak public policy and neglect of minority shareholders’ interests (Grais and Pellegrini, 2006b).
Competing with conventional (non-Islamic) financial institutions in dual banking systems, IFIs are subject to the same legal systems as conventional financial institutions despite the fact that the nature of Shariah law is totally different. In addition to the difficulty in enforcing Islamic financial instruments in certain legal environments (Karim and Archer, 2011), IFIs are exposed to default risk, liquidity risk, market risk, credit risk and Shariah non-compliance risk. In the case of default, IFIs are typically prohibited from charging penalties because such a practice is not Shariah-compliant. Such default risk is unique to IFIs and typical solutions mitigating this kind of risk include additional collateral and personal guarantees (International Monetary Fund, 2018). However, the inability to impose penalties creates delays in repayment thereby increasing loss of opportunity cost for IFIs. Besides default risk, IFIs are also exposed to liquidity risk due to the tendency to hold excessive cash reserves (Karim and Archer, 2011; International Monetary Fund, 2018). Furthermore, IFIs use prudential measures that were designed for non-Islamic banks to manage market risks (International Monetary Fund, 2018); however, the complexity of Islamic financial services and products increases reliance on commodities and cash collateral which may exacerbate credit risks (Karim and Archer, 2011). Additionally, Shariah non-compliance is a risk that is unique to IFI, which occurs when an IFI fail to comply with the Shariah rules and principles.
For these reasons, it is important for the board to review corporate risk policy and ensure that appropriate mechanisms are in place for effective risk management. OECD (2014) articulated the responsibility of the board in managing risk effectively by stating that: “boards have an essential responsibility setting the risk policy by specifying the types and degree of risk that a company is willing to accept in pursuit of its goals” and it is essential for boards to ensure “the integrity of the essential reporting and monitoring systems will require the board to set and enforce clear lines of responsibility and accountability throughout the organisation” (Principle VI.D).
2.1 Corporate Governance in Islamic Banking
Previous research on the corporate governance of IFIs is limited but growing. Grassa and Matoussi (2014) studied the practice of corporate governance in Gulf Cooperation Council and Southeast Asia countries and concluded that there are significant differences between the two in terms of governance structure and Shariah board attributes. The Shariah board is an independent body which reviews and supervises the activities of IFIs. According to Grassa and Matoussi (2014), the size of the Shariah board in Southeast Asia is slightly larger and more diverse than in GCC countries. Moreover, the presence of foreign investors and institutional investors in Southeast Asia is higher than in GCC countries (Grassa and Matoussi, 2014). The study of Grassa and Matoussi (2014) is consistent with the earlier finding of Hassan (2011) which concluded that Shariah practices and governance system differ across national boundaries. Furthermore, Hassan (2011) also identified weaknesses of the existing governance framework used by IFIs. Similarly, Grais and Pellegrini (2006b) analysed the shortcomings of corporate governance arrangement in IFIs and recommended solutions to overcome these shortcomings.
2.2. Shariah Governance
Shariah compliance is the cornerstone of the Islamic finance industry and thus Shariah governance is no less important than corporate governance for IFIs. The Islamic Financial Services Board (IFSB) defines the Shariah governance system as “a set of institutional and organizational arrangements through which IFIs ensure that there is effective independent oversight of Shariah compliance over the issuance of relevant Shariah pronouncements, dissemination of information and an internal Shariah compliance review” (IFSB, 2009, p. 2). This definition raises three main issues for Shariah governance: independence, accountability, and transparency.
The first issue concerns independent oversight. Each IFI has in-house religious advisers who provide consultation and supervisory services to the IFI as part of the internal governance structure of the IFI (Grais and Pellegrini, 2006b). In principle, the Shariah board is an independent body which reviews and supervises the activities of the IFI. However, there is a potential conflict of interest (Grais and Pellegrini, 2006a) between the members of the Shariah board and the IFI because their advisory and supervisory services are remunerated by the IFI which appointed them at first place. Furthermore, such remunerated arrangements may create a symbiotic relationship between the scholars and the IFI that could undermine credibility. The agency problem can be overcome by certification by external reputable auditors and involving self-regulatory Shariah associations to protect integrity (Grais and Pellegrini, 2006b).
The second issue concerns the accountability of the IFI, which can be observed in institutional and organisational arrangements. The board of directors is accountable for all decisions made by the board and thus the board should ensure that internal control system is adequate (Grais and Pellegrini, 2006a). Corporate governance mechanisms are designed to mitigate potential risks by applying appropriate countermeasures and limiting misconduct to serve the best interests of the shareholders in the long-term. These arrangements include appointment of a Shariah board, investment risk reserves and special supervisory attention (Grais and Pellegrini, 2006b). A special risk investment reserve, for example, is used for compensating investment loss.
The last issue relates to the disclosure of all relevant information regarding Islamic finance operations. In addition to improved transparency and increased confidence of stakeholders, disclosure could be the means to address public concerns over financial stability. Ideally, a transparent financial institution would disclose the process of review and decision-making, the composition of its Shariah board, as well as publishing fatwas issued by the committee of the Shariah board (Grais and Pellegrini, 2006a). The openness of IFIs to disclosure of relevant information would strengthen the confidence of stakeholders and investors and enhance their credibility.
2.3. Shariah Governance Framework
A framework that guides IFIs to implement good governance is essential in undertaking Shariah-compliant operations. Haqqi (2014) believes that a comprehensive Shariah governance system is based on the following four pillars: first, management and supervision; second, the Shariah Advisory Board; third, Shariah compliance and review, and lastly, transparency and disclosure. Arguably however, these four pillars are more about the past than the future because there is an absence of research and development of this topic.
Grais and Pellegrini (2006a) suggested a combination of external and internal arrangements that can jointly provide an effective framework to assess and monitor Shariah compliance. The internal control system includes a Shariah board which plays an advisory and supervisory role whereas the external arrangement covers regulatory control, standardisation and an audit firm. The framework proposed by Grais and Pellegrini (2006a) emphasises the role of external audit and internal review to ensure Shariah compliance but it overlooks the importance of innovation.
Bank Negara Malaysia (2010) has developed a Shariah governance framework to provide guidance to the management of IFIs and Shariah boards in discharging duties and matters relating to Shariah. The framework is divided into six sections: 1) essential key functions; 2) accountability and responsibility; 3) independence; 4) competency; 5) confidentiality and consistency; 6) Shariah compliance and research functions. Besides emphasising the competency of Shariah board members and consistency of interpretation, the framework also highlights the importance of the Shariah board being independent from management.
The Shariah governance framework provided by Bank Negara Malaysia illustrates lines of command and four key functions to ensure Shariah compliance and innovation in Islamic banking. The board of directors is accountable to shareholders and the public, even though they are not directly controlling the key functions (risk management, audit, review and research). These key functions have their own direct and indirect line of reporting. While risk management is the first line of defence in Shariah governance, the compliance oversight function is the second line of defence and independent assurance is the third. Such multiple lines of defence strengthen financial consumer protection. The roles and responsibilities of each key element are outlined in the following:
- Board of Director: set and enforce clear lines of duties besides overseeing all operations;
- Management: ensure all operations are in accordance with Shariah law and provide necessary support to Shariah board;
- Shariah Committee: accountable for all Shariah related matters;
- Shariah Risk Management: identify, measure, monitor and control Shariah non-compliance events;
- Shariah Review: review operations on a regular basis;
- Shariah Audit: provide independent assessment and objective assurance;
- Shariah Research: conduct in-depth research relating to Shariah
3. Islamic Banking in Bangladesh
There are eight fully-fledged Islamic banks which operate in Bangladesh. The first Islamic bank in Bangladesh is Islami Bank Bangladesh Limited which became incorporated in 1983. Following the success of Islami Bank, several Islamic banks were established, these include: 1) Al Baraka Bank was created in 1987; 2) Al-Arafah Islami Bank and 3) Social Investment Bank were established in 1995; 4) First Security Islami Bank Limited was founded in 1999; 5) Shahjalal Islami Bank was formed in 2001; 6) Exim Bank started a fully fledged Islamic bank in 2004; and lastly, 7) Union Bank Limited was formed in 2013.
3.1. History of Islamic Banking in Bangladesh
After the declaration of independence of Bangladesh in 1971, a number of initiatives were taken to form Islamic banks in the country. In 1974, Bangladesh signed the Charter of the Islamic Development Bank and as a member country, Bangladesh was committed to transform its conventional banking system into a Shariah-compliant banking system (Chowdhury et al., 2016). Apart from that, Bangladesh also privatised banks to liberalise the financial sector and encourage private investment and, in mid 1990s, a Financial Sector Reform Programme was implemented to improve banking operations through skills training and technological development (Rahman and Ara, 2009). The establishment of IBBL in 1983 begins the Islamic banking era (Ullah and Khanam, 2018).
3.2. Legislative Framework of Islamic Banking in Bangladesh
In Bangladesh, there is no specific law that guides and control the operations of IFIs. Like other financial institutions and banks, IFIs in Bangladesh are governed by the Bangladesh Bank Order 1972, the Income Tax Ordinance 1984, the Bank Companies Act 1991, the Companies Act 1994 and the Securities and Exchange Commission Act 1993.
The central bank of the country, Bangladesh Bank, has legal authority to regulate all banks in Bangladesh, including Islamic banks. It regulates prudential matters such as setting minimum capital requirements, limits on loan concentration and statutory liquidity ratios (Ahmad and Hassan, 2007). Bangladesh Bank published Guidelines for Conducting Islamic Banking in 2009 which is supplementary to the existing banking laws in the country. In the case of contradiction, the instructions issued under the Companies Act and Banking Companies Act will prevail (Bangladesh Bank, 2009, p. 1). The guidelines primarily focus on product definition, operational framework and alternative investment modes. There is no Shariah advisory council or board at Bangladesh Bank. The operations of IFIs in Bangladesh are scrutinised by the central bank as per the general rules set for non-Islamic banks. Table 1 summarises the financial regulators and institutions in Bangladesh, which regulate and monitor both conventional and Islamic institutions.
|Bangladesh Bank (Central Bank of Bangladesh)||Regulate banks and financial institutions|
|Securities and Exchange Commission||Regulate capital market|
|Insurance Development & Regulatory Authority||Regulate insurance companies|
|Microcredit Regulatory Authority||Regulate microcredit institutions|