Corporate Governance in Islamic Banks

The Handling of a Complex Agency Problem

Term Paper, 2009

21 Pages, Grade: 2,1

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Table of Content


The Agency-Problem
Characteristics of Islamic Banking

Profit Distribution Policy
Depositor participation in Corporate Governance


Intrinsic PLS Challenges
Resolution Measures

Conventional Solutions



The new wave of Islamic banking brings along new ethical requirements and challenges to the corporate governance (CG) subject. Key characteristics of Islamic banking is the Sharia -conformity (Islamic-law) by avoidance of interests by risk sharing modes, material finality by linking the transaction to a real good, avoidance of exploitation and avoidance of financing sinful activities (El-Hawary et al., 2004; Grais & Iqbal, 2004). The overall goal of Islamic banking is the strict compliance of Islamic teachings and capital provision in an ethical manner, which means providing entrepreneurs with capital to a relatively low rate of return. In the light of Islamic teachings a two-tier Profit and Loss Sharing (PLS) mode for fund mobilization and utilisation was developed. The first tier is for the capital mobilisation through a money pool where shareholders and depositors pool their money for investment activities; hence depositors are entitled to share the profits and losses of the investments at a predetermined ratio. This paper deals with the “Unrestricted-Investment-Account”, where the investor gives the bank full authorisation to manage the fund as this is the most significant form in this debate. The s econd tier is on the investment side, where Islamic banks provide entrepreneurs with capital through a partnership relation what entitles the bank to a profit-share of the venture. Under this directive, Islamic bank’s have a partnership with clients rather than a clientele ship. The Islamic bank acts merely as an agent for shareholders and depositors by screening, executing and monitoring new investment opportunities and charges for their service a management fee; which belongs finally to the shareholders. As a result Islamic Financial Institutions (IFI) board activities are primary subject to Islamic-law rather than to financial laws or regulations and IFI’s established Shariah -Supervisory-Boards (SSB) to ensure the legitimacy by certification and verification of the financial instruments. Behind this model lies a complex agency-problem because conventionally only the shareholders are principals who examine the managers. But through this model the depositors as quasi-shareholders suffer lacking principal rights because as partner they have neither a creditor status in case of the bank’s bankruptcy nor do they have any voting rights because their deposits do not belong to the banks equity. Hence depositors bear the same business-risk like shareholders with fewer protection-rights. Moreover, the management allocate the returns from the investments between these two groups and faces a goal conflict by the profit distribution.


The two-tier Profit and Loss Sharing Model

illustration not visible in this excerpt

The aim of this paper is to analyse this complex agency-problem, examine the consequences and present a collection of the literature solutions. The focus is on the agency-problem which is caused by PLS-contracts and the general principal-agent problem regarding shareholders is ignored. In the first stage the CG and key features of Islamic banking are described. In the next step is the agency-problem regarding the capital rising of IFI through deposits assessed and deals with the necessity for a superior information disclosure policy. The consequence is a low PLS-application by the banks and finally a brief literature evaluation.

Regarding the methodology, this literature review intends to contribute to the gap of depositor protection in IFI’s by collecting and evaluating the CG issue of IFIs in the literature of Islamic finance. This is an analytical paper by examining the existing literature through databases such as Business Source Premier, ANTE, Econlit and Science Direct and finally Google Scholar for relevant journal articles. As Islamic finance is a relatively young discipline the literature is rather limited and relevant journal articles are limited to the last 15 years. Thus for deeper investigations certain books of Islamic finance are revised. Research key words were Islamic banking/ finance, profit distribution, agency-problem, profit and loss sharing.


The Agency-Problem

The agency-problem as part of CG in the modern finance literature is defined as: “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment” (Shleifer & Vishney, 1997, Page 737). Fama & Jensen (1983) characterised CG of large corporations by the separation of management and ownership. They defined management as initiation and implementation of projects by an active involvement. C ontrol, on the other hand is the right to ratify and monitor these projects. The separation of ownership, decision making and risk bearing is in the literature known as principal-agent problem. Eisenhardt (1989) identifies two reasons for the agency-problem; either there is a goal conflict between the two parties or it is too difficult or expensive for the owners to monitor their agent’s performance.

Characteristics of Islamic Banking

The main feature of Islamic banking is the PLS-mode. Islam emphasises on the risk sharing element in case of losses in comparison to the obligatory interest payments by conventional banks. The typical PLS-modes are:

- Mudarabah is an arrangement between at least two parties, whereby the bank contributes the entire capital and the client provides his/her labour and expertise. Any profits are shared at a pre-determined ratio whereas losses are exclusively borne by the financier. The entrepreneur leads the business autarkic, hence the bank has no management or information right and a profound agency-problem occurs.
- Musharakah is similar to Mudarabah whereby every party contributes capital and as a result all members are entitled to participate in the management process. The profits and losses are likewise shared at predetermined ratios. Musharakah solves many of the inherent Mudarabah agency-problems.

Alternative to the PLS-modes are mark-ups, which are basically service compensations for the bank. In mark-up contracts the bank usually retains ownership of the assets as collateral. The most used modes are:

- Murabahah is the most common mode in Islamic finance whereby an Islamic bank purchases a tangible asset on behalf of the customer and resells it to him with a mark-up.
- Ijara works like a common leasing contract, whereby the Islamic bank buys an asset on request of the client and then leases it out to the client.

To understand the nature of Islamic banking it is important to have a look at the customers and their bank-selection criteria. Apparently, Islamic banks depend in the same way on depositors’ money as conventional banks and in the combat of competition with conventional and other Islamic banks it is this essential (Haron & Ahmad, 2006). Several studies by Erol & El-Bdour (1989), Haron & Ahmad (2000), and Gerrard & Cunningham (1997) have identified that religion is not the only reason for customers to deposit their money in Islamic banks. According to their findings the main motivation is a religious combined with an economical. Conversely studies by Metawa & Almossawi (1997) in Bahrain document that the predominant reason to select an Islamic bank is a religious criteria followed by the rate of return, which deems accurate in less secular societies (Zaher & Hassan, 2002). Thus Islamic banks have to pay a competitive “rate of profit” to depositors at the level of the interest rate of conventional banks and if a bank fails to pay a comparable rate of return the depositors tend to withdraw their money from that bank (Haron & Ahmad, 2000; Gerrard & Cunningham, 1997).


Due to the profit distribution, the management of an IFI suffers a goal conflict between the shareholders and depositors, whereby a disparity on the depositor side occurs (El-Gamal, 2005). The Islamic bank has mainly three profit distribution obligators:

- Shareholders
- Depositors
- Bank

Profit Distribution Policy

It is assumable that the shareholders enjoy higher returns through their voting rights and the shareholder oriented management, who employs the management. However, fact is that Islamic banks are enforced to pay competitive returns to customers even if these payments are absorbed by the bank or shareholder profits. This practice of income adjustment is in the literature called “displaced commercial risk” (Archer & Karim, 2006; Grais & Pellegrini, 2006; El-Hawary et al., 2004; El-Gamal, 2005). This practice is essential to attract clients as financial performance seems to be the main banking selection criteria. On the other hand Islamic banks “smoothes” the returns of depositors by retaining the profits of profitable periods and pay them in less profitable periods to prevent runs for the highest rate of return (Zaher & Hassan, 2002). This smoothing process can be done by varying the percentage of the management fee, varying the percentage of depositor funds by investments or by a contracted right to retain a certain profit percentage. In the long term is the displaced commercial risk in comparison to the smoothing process negligible, otherwise the bank would pay out all their profits and go insolvent, as it happened with the International Islamic Bank for Investment and Development in Egypt (Warde, 2000). The bank as third party retains profits in form of profit smoothing and management fees, whereby it is partly used for the profit adjustments.

Thus returns are a quite variable figure and are not observable from financial statements. El-Hawary et al. (2004) observed, according to this research correctly, that the risk sharing benefit is neutralised through the profit smoothing and adjustments, which generate a major debate in the Islamic finance literature.

Depositor participation in Corporate Governance

Under conventional banking structures depositor protection is not a CG issue, as depositors are creditors and first claimants of the bank. IFI’s different capital structure makes CG requirements for depositor protection mechanisms; namely how get depositors a relatively fair return according to their risk bearing investment. As depositors are not matters of CG under current IFI structures (El-Gamal, 2006; Zaher & Hassan, 2002; Archer, Karim & Al-Deehani 1999; El-Hawary et al., 2004), depositors have neither influence on the appointment of the management, SSB or external auditors (Archer et al., 1999) nor information or monitoring rights (Zaher & Hassan, 2002). IFI’s deny the disclosure of profit distribution or monitoring by the depositors and as the common practice is to place deposits under a Mudarabah -contract, the bank is not compelled to do it (Archer et al., 1999). Due to historic development of colonisation is the Anglo-American model of CG mainly in IFI’s leading, hence the management is rather shareholder oriented and El-Gamal (2006) and Archer et al. (1999) suggest as consequence board representation and /or voting rights for depositors. A feasible solution could be an equal measure of shareholders and depositor representatives in the supervisory board; similar to the German alternative. Although most OIC (Organisation of Islamic Countries) members fulfil international financial standards based on Basel’s core principles, these regulations serve merely the payback capability of banks with no regard to the principal-agent problem (Muljawan, Dar & Hall, 2002).

An uncomplicated and cheap CG-medium is the rise of debt from a third party, since debt is compulsory it puts a certain pressure on the management behaviour. However, Al-Deehani, Karim & Murinde (1999) found out that through the altered capital structure of Islamic banks an increase in deposits results in an increasing market value and rate of return for the Islamic bank; with neither additional risk nor higher capital costs.

The only alternative for depositors to exercise power in the management is to withdraw their money and deposit it in conventional banks with similar returns and lower risk. This market discipline applies quite well because IFI’s depends heavily on deposits (Haron & Ahmad, 2006) therefore Archer et al. (1999) proposes a shared monitoring of the management by shareholders and depositors in cause of their goal congruence. This shared monitoring would only work in respect to the general agency-problem but not by the profit distribution; hence they require the extension of external auditing to depositors as well. However this problem could be solved through a Musharakah -agreement rather than the common Mudarabah -agreement, since in a Musharakah -agreement the financer (depositor) has an information right.

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Corporate Governance in Islamic Banks
The Handling of a Complex Agency Problem
University of the West of England, Bristol
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Banking, Islamic Banking, Islamic Finance, Corporate Governanace, Agency Problem, Sharia conform, Principal Agency Problem, Finance, Finanzwesen, interest free, alternative investment, zinsfrei
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Karime Mimoun (Author), 2009, Corporate Governance in Islamic Banks, Munich, GRIN Verlag,


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