Corporate governance especially relevant to Islamic financial institutions
Why is corporate governance especially relevant to Islamic financial institutions and what advantages does it give them? Ans.: Corporate governance especially relevant to Islamic financial institutions because it involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. It provides a structure through which the objectives of the company are set and the means through which these objectives are obtained and performance can be monitored. Such a framework sees corporate governance as a dynamic interplay of internal and external incentives, which affect the performance of a firm.
Why is corporate governance especially relevant to Islamic financial institutions and what advantages does it give them
The internal incentives are the firm’s organizational arrangements that allow owners to direct managers to pursue goals set by the shareholders, while the external incentives on regulatory structures, voluntary standards accepted and followed by the firm and competitive market forces all exert discipline on the performance of owners and managers from the outside. By adhering both to internal and external incentives, a company can reduce its cost of capital, thereby increasing its profits.
Islamic financial institutes have some characteristics that require special care in designing their corporate governance mechanisms.
A} Stakeholders include a large number of depositors whose deposits are not guaranteed.
B} Islamic financial institutions operate on the basis of universal banking, which is close to deregulated banking environment. Financial activities cover wider spectrum than is customary in traditional finance, including equity holding, leasing and credit purchase finance on a mark-up basis.
C} Equity-holding by Islamic financial institutions would enable them to sit on the Board of directors of firms and thereby influence the corporate governance mechanisms of the latter.
D} Entry of Islamic finance market is restricted by the authorities in most countries, which provide Islamic financial institutions with a higher degree of monopoly than in conventional finance.
E} Islamic financial institutions operate predominantly in developing economies, where questions of governance in general are new and attract less attention.
Corporate governance is especially relevant to Islamic Financial Institutions (IFIs) because of their unique dual responsibility: they must not only operate profitably and efficiently like conventional banks, but also comply with Shariah (Islamic law) principles. These principles prohibit interest (riba), excessive uncertainty (gharar), and unethical or speculative transactions — all of which demand extra layers of oversight, transparency, and accountability.
Let’s break this down in detail:
Why Corporate Governance Is Especially Relevant to Islamic Financial Institutions (IFIs)
1. Dual Accountability: Shariah & Stakeholders
Islamic banks are accountable to two sets of standards:
Conventional corporate laws and financial regulations, and
Shariah principles, which emphasize justice, equity, and ethical conduct.
This dual accountability means IFIs must have governance systems that ensure both financial soundness and religious compliance. Corporate governance provides the structure to balance these dual responsibilities effectively.
2. Protection of Stakeholders’ Interests
In Islamic finance, stakeholders include not only shareholders and customers but also the wider community — since money must be used for socially beneficial and ethical purposes. Good corporate governance ensures:
Transparent profit-sharing between investors and banks (e.g., Mudarabah contracts)
Proper handling of Zakat, charitable funds, and investment accounts
Protection of Investment Account Holders (IAHs), who share in profits and losses
3. Ensuring Shariah Compliance
A Shariah Supervisory Board (SSB) is a key element of corporate governance in IFIs. It monitors:
Strong governance ensures that the SSB operates independently and effectively — maintaining the credibility and authenticity of Islamic financial operations.
4. Building Trust and Reputation
Trust is the cornerstone of Islamic finance. Investors and depositors rely on the belief that their money is managed in a Shariah-compliant and ethical way. A sound governance framework:
Enhances transparency and disclosure
Strengthens public confidence
Reduces reputational risk, which is particularly important for IFIs that depend heavily on ethical reputation
5. Preventing Conflicts of Interest
Because Islamic banks often engage in profit-and-loss sharing (PLS) relationships, there’s a higher risk of conflicts between shareholders, management, and investment account holders. Corporate governance mechanisms — such as independent boards, transparent reporting, and internal Shariah audits — help ensure fair treatment of all parties involved.
6. Compliance with International Standards
Islamic financial institutions operate globally, so strong governance helps them align with:
AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions)
IFSB (Islamic Financial Services Board)
Basel Core Principles
This alignment improves global credibility, supports foreign investment, and facilitates cross-border transactions.
Advantages of Strong Corporate Governance in IFIs
Advantages
Description
1. Shariah Credibility
Ensures all financial activities comply with Islamic law, maintaining moral and religious legitimacy.
2. Enhanced Transparency
Strengthens disclosure practices, allowing stakeholders to make informed decisions.
3. Risk Reduction
Minimizes operational, Shariah, and reputational risks.
4. Stakeholder Confidence
Builds trust among depositors, investors, and regulators.
5. Sustainable Growth
Promotes ethical, stable, and long-term financial development.
6. Better Decision-Making
Encourages accountability, independent oversight, and professional management.
7. Global Recognition
Facilitates integration with international financial systems while retaining Islamic identity.
Example: How Governance Strengthens an Islamic Bank
Let’s take Bank Islam Malaysia Berhad or Dubai Islamic Bank as examples:
They maintain independent Shariah Boards and audit committees.
Their governance systems require regular Shariah reviews and public disclosure of compliance reports.
This strengthens investor confidence, attracts ethical investors, and differentiates them from conventional banks.
✅ In Summary
Corporate governance is vital for Islamic Financial Institutions because it:
Ensures ethical integrity and stakeholder protection, and
Provides competitive advantages through transparency, trust, and global credibility.
In short, good corporate governance is not just a legal necessity for IFIs — it is a religious, ethical, and strategic imperative that underpins the entire philosophy of Islamic finance.
