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The Role of Corporate Governance in Islamic Financial Institutions

Strong corporate governance, a critical element of business leadership, is important in any industry. But the corporate governance of Islamic financial institutions is especially important for these reasons:

  • Lots of people stand to lose money if the company fails. Financial institutions deal with huge amounts of money collected from lots of investors and depositors. They also have a widespread impact on the economy by extending credit to individuals and businesses. Therefore, the failure of such an institution has a big impact on public interest.

    (Consider the fallout of the 2008 bankruptcy of Lehman Brothers, for example, and the collapse of Bernard L. Madoff Investment Securities in the same year.)

    Another way to explain this idea is to say that financial institutions have more and different stakeholders than other corporations do. These stakeholders include depositors, investors, borrowers, regulatory bodies, and in some cases entire communities.

    Keep in mind that the people who stand to lose money if the financial institution fails aren’t necessarily people who would lose only excess funds. If a bank collapses, it may take with it the modest life savings of many depositors. The immediate impact on these people’s daily lives — not just on their future retirement plans — can be dire.

  • Financial managers must be managed. In any corporation, the governing board has an obligation to manage the people running the company. Depending on the type of company, board members may be clued in to potential problems when product manufacturing decreases, shipments to customers decline, vendors complain of nonpayment, employees alert them to changes in the volume of business, and so on.

    In a financial institution, the nature of the business makes the board’s job just a bit tougher. Reports on the institution’s financial transactions are the board’s primary source of information for determining whether management is doing its job well.

    If information asymmetry exists — if managers know things about the business that the board doesn’t know — the board can’t assess management’s performance accurately. Therefore, the board must make every effort to ensure that management is being transparent and thorough in its reporting.

  • The corporate governance of financial firms impacts other firms. Most corporations interact with financial firms in substantial ways. A bank may provide loans, for example, or a financial firm may acquire or provide equity to start a corporation, making the financial firm a major stakeholder. When a financial institution fails, the ripple effect on other corporations is substantial.

  • Financial institutions are more leveraged than most other businesses. Banks and other kinds of financial firms may have lots of assets on paper but relatively few assets actually sitting in their vaults. After all, money must be invested in order to make more money.

    In a situation in which lots of depositors begin making claims on their money in a short period of time, the firm may experience a serious liquidity problem, which can lead to a panic. The financial institution’s board must pay close attention to the percentage of its leveraged funds and carefully weigh the risk of investments versus having cash sitting in a vault and not increasing in value.

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