A key difference between Islamic and conventional financial institutions is the legal rights of depositors. While in practice, institutions treat their (profit-and-loss-sharing mudarabah) depositors as if they were conventional deposits, they are subject to losses as if they were equity instruments (the depositor as rabb al-mal shares profits with the bank but remains subject to losses).
Despite being on the hook for losses from the mudarabah assets in a similar way as the equity investors are to the overall institution’s losses, mudarabah depositors are not permitted to vote and can effectively only vote with their feet by withdrawing their deposits if they believe them to be at risk of loss or can find a higher return elsewhere. In this regard, mudarabah depositors (or as they are usually called — profit-sharing investment account holders or IAHs) do have priority over equityholders in the liquidity they are granted, which, in normal situations, entitles them to withdraw their deposits without any loss.
All of these factors contribute to the need to develop standards on the governance within Islamic financial institutions (IFIs), which AAOIFI instituted in 2005. The particular standard that focuses on corporate governance issues begins by outlining the underlying principle for the management that ensures they are “held to the highest fiduciary standards since they are accountable not to the equity-holders who appointed them but also for the safety of all key stakeholders as well as the community the IFI serves”.
The governance standard is that — just a standard — so it doesn’t prescribe certain methods for ensuring that an Islamic financial institution must do certain things as a result of its fiduciary standard; that is left up to the individual institution. However, it does outline some principles that are of interest to IAHs and how the financial institutions ensure what is referred to as “equitable treatment of fund providers and other significant stakeholders”.
Without really laying out what these principles are, it does provide specific context about the transparency responsibility of IFIs towards ‘fund providers’ (which includes the IAHs): “An IFI should ensure equitable and unbiased treatment of fund providers and other significant stakeholders and associated investments as well as in relation provision of adequate financial and non-financial information to allow them to take appropriate decisions regarding their dealing with the institution.”
Many IFIs provide at least the minimum transparency to IAHs that they do to their equity investors in the form of interim and annual reports available on their public websites. They also have specific presentations for investors that cover some of the information that depositors (or those who advocated on behalf of depositor protection) would need to identify the strength and stability of the bank and trends in the payout.
The investor presentations (for the institutions that produce them) and annual reports (to shareholders) provide details on the stability of the institution and its ability to generate profits to share with depositors. This is a good step towards transparency (and banks should be required to make their annual reports available if they take deposits from retail depositors), but this information does not address the underlying conflict that the governance standard asks banks to meet.
By not creating a report that addresses the conflicts of interests inherent in managing a financial institution where management and those whose funds they are managing (like IAHs) can diverge, it leaves the goal of the standard unfulfilled. More importantly, it leaves the process of generating profits as a ‘black box’ that makes it easy for critics to suggest that there is no difference between Islamic banks and conventional banks and that the statements of profit-sharing between the banks and their deposits is artificial. Greater transparency would help cut through these arguments and encourage better practices by Islamic banks.
Find out more information about the governance standards which are now accessible through the Legal & Shariah section of Zawya Islamic.