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1
Dr. Shahul Hameed bin Mohamed Ibrahim is Head of Department of Accounting, Kulliyah of Economics and
Management Sciences (KENMS) at the International Islamic University Malaysia (IIUM)
2
M.I. Sigit Pramono is Lecturer at STIE SEBI, Jakarta. He is in the final stages of Master of Science in Accounting
degree program at KENMS-IIUM
1
ANALYSIS OF CORPORATE GOVERNANCE DISCLOSURE
IN ISLAMIC COMMERCIAL BANKS’ ANNUAL REPORTS:
A COMPARATIVE STUDY OF ISLAMIC COMMERCIAL BANKS
IN MALAYSIA AND INDONESIA
Shahul Hameed bin Mohamed Ibrahim3
M.I. Sigit Pramono4
ABSTRACT
Although, corporate governance has been an element of the business world for a long time,
only in recent years has it become more in the realm public interest since the occurrence of
several corporate scandals involving huge corporations such as Enron, WorldCom, and so
forth. Corporate governance issues have become of great prominence over the last two
decades (Wright, 2002). A review of the literature shows a dearth of studies that
specifically elaborate corporate governance issues in Islamic banks. This study is meant as
a small contribution to overcome the paucity. It is an exploratory study which tries to
examine the extent of disclosure of corporate governance practices in Islamic banks’
annual reports in Malaysia and Indonesia. Through this research, there are three objectives
that are expected to be fulfilled. Firstly, to elaborate the nature and theoretical implications
of good corporate governance in Islamic banks. Secondly, to explore the level of voluntary
corporate governance disclosure practices of Islamic banks in Malaysia and Indonesia
based on the scoring of corporate governance disclosure made in the annual reports. Lastly,
to provide descriptive analysis of the implementation of code of best practices for
corporate governance between Islamic banks in Malaysia and Indonesia. This comparative
study will be discussed within the banking regulations and institutional background of
corporate governance frameworks in each country. We develop two set of corporate
governance scores indices for Islamic banks. The first set will use national codes of
corporate governance in each country. In this approach, each of the Islamic banks’ annual
report will be examined for disclosures of corporate governance practices which are
required by code of each country. On the other hand, the second set of corporate
governance scores, which we consider as a comprehensive benchmark of corporate
governance requirements for Islamic banks are derived from some international standards
and codes such as: Code of Best Practices for Corporate Governance in Islamic Financial
Institutions (Chapra and Ahmed, 2002), The Governance Standard for Islamic Financial
Institution (GSIFI) (AAOIFI, 2002) and recommendations in Enhancing Corporate
Governance for Banking Organisations (Basel Committee on Banking Supervision, 1999).
This study would contribute to present a better understanding of the process and issues of
corporate governance in Islamic banks. It will also contribute to the empirical literature on
corporate governance practices in Islamic banks in Malaysia and Indonesia. In turn, this
will hopefully enable the scholars and the regulators to further develop a model for
effective corporate governance mechanisms for Islamic banks.
Keywords: Corporate governance, Islamic banks, investment account holder, shari’ah
compliance, accounting for Islamic banks, Islamic bank annual reports.
3
Dr. Shahul Hameed bin Mohamed Ibrahim is Head of Department of Accounting, Kulliyah of Economics and
Management Sciences (KENMS) at the International Islamic University Malaysia (IIUM)
4
M.I. Sigit Pramono is Lecturer at STIE SEBI, Jakarta. He is in the final stages of Master of Science in Accounting
degree program at KENMS-IIUM
2
1.0. INTRODUCTION
Corporate governance issues have become of great prominence over the last two
decades (Wright, 2002). Although, corporate governance has been an element of the
business world for a long time, only in recent years has it become more in the realm public
interest since the occurrence of several corporate scandals involving huge corporations
governance practices requirement from business entities, many countries in the world
have drawn up rules and codes of practice to improve governance. (McConomy and Bujaki,
One of the central issues of the corporate governance debate is the effectiveness
of corporate governance in the banking sector. Since the banking system is a critical
element of the economy, the quality of corporate governance of banks has become a crucial
issue and the approach to the regulation and supervision of banks will tend to categorize
1999). Therefore, the implementation of rule and code practices in corporate governance in
banking industry will play an important role in ensuring sound business practices in the
banking industry.
Over the last 25 years, we have witnessed that a large number of Islamic financial
institutions have been set up around the world (Chapra and Ahmed, 2002). According to
Suleiman (2000), there are more than 180 financial institutions world-wide which comply
with Islamic banking and financing principles. These financial institutions have been
3
Unfortunately, despite the fact that there is much literature on corporate
the issues of corporate governance in banking, mostly, have been discussed in the context
of conventional banking.
compared to conventional banks. (Algaoud & Lewis, 1999; Suleiman, 2000). Algaoud and
Lewis (1999) underline that Islamic bank’s operation has to comply with shari’ah
principles. Therefore, the shari’ah compliance in Islamic banks will lead to differences in
governance mechanisms in Islamic banks. They argue further that central to the framework
of corporate governance for Islamic banks is the Shari'ah Supervisory Board (SSB) and the
financing modes which must be in line with shari’ah rules. Thus, the Islamic bank’s
activities should be based on the Islamic worldview and must stay within the restrictions of
practices in Islamic banking circumstance has been recognized by scholars. Chapra and
Ahmed (2002), for example, argue that if an effective corporate governance mechanism is
not in existence in Islamic banks’ operation, it is impossible to strengthen and to enable the
4
2.0. OBJECTIVE OF THE STUDY
In this regards, the motivation for our study is to analysis the disclosure of
corporate governance practices in Islamic banks’ annual reports in the case of Malaysia and
Indonesia.5
Through this research, there are three objectives that are expected to be fulfilled.
Firstly, to elaborate corporate governance issues in the terms of nature and theoretical
practices of Islamic banks in Malaysia and Indonesia based on the scoring of corporate
implementation of code of best practices for corporate governance between Islamic banks
in Malaysia and Indonesia. This comparative study will be discussed within the banking
country.
The third section presents the literature reviews of the issue. The fourth section
describes the research methodology of the study. This is followed by the result and
5
This study will focus only on Islamic commercial banks in Malaysia and Indonesia which are categorized as full-fledged
Islamic banks. We exclude the Islamic banks division/windows in conventional bank in which the circumstances of these
institutions are quite different in terms of corporate governance structure for Islamic banks.
5
3.0. LITERATURE REVIEW
late 1980s and 1990s is the issue of governance and information risk. Hence, companies
around the world are encouraged to disclose more in particular information such as
ownership of firms’ shares) and risk disclosure (financial and business risks). Basically this
type of disclosure is required by the authoritative body in such country after incorporating
It can be recognized that sound governance in the business sector has an important
impact on the quality of financial reporting. (Goodwin and Jean, 2002). Whittington (1993)
reporting on the quality of financial reporting. It means that, the failure of corporate
governance may be caused by insufficient financial information, but on the other hand
some problems of financial reporting process may be due to deficiencies of the system of
corporate governance.
On the other hand, Baker and Wallage (2000) conclude that the role of financial
reporting should not be limited only to the needs of investor decision-making, but should
governance to give equal benefit to all of stakeholders and for society as a whole. This
corporate governance mechanism and financial reporting. As Baker and Wallage (2000, p.
6
173-174) has mentioned that “an effective system of corporate governance requires an
effective system of financial reporting, and that an effective system of financial reporting
The main aim of the code of corporate governance is to encourage better and
Financial statement and annual reports represent a business language that allow
management to communicate the financial condition, the results of operations and other
could identify the role of the board in financial reporting under corporate governance since
the board is expected to prepare some form of disclosure to reduce asymmetry information
of the company. Recently, corporate governance and disclosure quality issues have
generated much interest. Some studies examine the issue of corporate governance
disclosure e.g. Eng and Mak (20003), Carson and Simnett (1998), Bujaki and McConomy’s
(2002), Guay and Ow-Yong (2002), Irwanto (2002) and Haniffa and Cooke (2000).
look for explanation or to recognize factors which influence reporting decision of the
‘specific disclosure analysis’ which could take the form of mandatory, voluntary or
discretionary disclosures.
7
3.2. Corporate Governance in Islamic Banks
3.2.1. Islamic Worldview and Values: It’s Implication for Socio Economic Norms
Literally, Islam has meaning as “peace” and “submission” to Allah (swt) (Abdul-
that, everything a Muslim does is to be in harmony with God’s wishes in this world. This
attitude is accordance with what Allah (swt) has declared, “I have only created …men that
and explicit assumptions about the beginning of the universe and the nature and purpose of
human life”. Another Islamic scholar, Al-Faruqi (1992), argues that the worldview is the
way in which a person sees and explains the world and his place in it. Therefore, in human
life, the worldview will affect his way of thinking and acting.
Hameed (2003) argues that Islam has dual worldviews, this world and the
hereafter. It means that whatever a person does, in all areas, will affect his prospects in the
In Islam, the concept of tawhid (unity of God) is central to the Muslims faith (Al-
Faruqi, 1992). In accordance to this fundamental principle, Muslim recognizes some other
principles in the universe should be originated from, i.e.: the unity of creation; the unity of
truth and knowledge; the unity of life and humanity; and the complementary nature of
8
Abdul-Rahman (1998) extends the explanation of tawhid concept to the important
concept in Islamic beliefs which is khilafah (vicegerency). According to this concept, Man
is a trustee of Allah (swt) on this earth and required to act as a deputy in dealing with the
universe and its environment and as a guardian of the resources entrusted to him.
basic concept i.e. taklif (accountability) concept. Accountability from Islamic perspective
will imply that Man is accountable for their actions or inactions on the Day of Judgment
(Abdul-Rahman, 1998). Accountability in Islam means that one must accept all the duties
and liabilities as well as the benefits of any ownership or responsibility entrusted unto
them. Allah (swt) said in the al-Qur’an, “Surely Allah takes account of all things” (al-
Qur’an, 4:86).
(trust). The concept of amanah, explicitly has been given only to Man (al-Qur’an, 33:72)
as khalifah of Allah (swt) in this earth. This amanah provide restrictions on the use of the
economic activities. In economic framework, these basic concepts of Islamic teaching will
lead to the creation of falaah (welfare in the world and in hereafter). In other words, in
achieving the individual and social welfare and public benefit, human beings should attain
a tangible quality with the aim of obtaining God’s pleasure (Siddiqi, 1979).
Based on Islamic teachings, business activities are a part of ibadah (worship and
obedience of Allah), therefore they have to be performed in line with shari’ah Islamiyah
(Maududi, 1988). Whereas, as an Islamic business institution, Islamic banks must conduct
9
their activities and behavior toward their stakeholders in accordance to Islamic values
(Beekun, 1997). However, it does not mean that Islamic banks are prohibited from gaining
profit. On the contrary, it is encouraged in Islam as long as it does not cause the imbalance
Hameed (2001) and Haniffa (2002) define the Islamic worldview’s implication
for socio-economic norms (see Table 3.1). Thus, all economic activities must be driven by
shari’ah precepts i.e. prohibition of interest, prevent hoarding etc. More over, those
particular activities must present positive influences to the achievement of the prosperity of
the ummah. In conjunction with the later statement, Islam obligates the Muslim to perform
zakah. Zakah is a religious levy on Muslims who hold wealth which attains the zakatable
minimum amount (nishab) to furnish the right of the poor in their wealth. Hence, it is one
of the ways to distribute the wealth to other people rather than just concentrating it on a few
people.
10
Table 3.1 Comparison of Some Western Economic Norms and
Islamic Economic Norms
Source: Adapted from Hameed (2001) and Haniffa (2002)
governance may not suitable for Islamic banks. It might be caused by the lack of ethical
dimension and societal concern in its structure and mechanism (Abdul-Rahman, 1998;
11
governance can not avoid inherently a set of value-loaded mechanisms. In short, he
concludes that:
concern of environment are but would remain as mere noble codes if the issues of
man, his values, ethics and moral conduct are not tackled in the first instance” (p.
100).
Chapra and Ahmed (2002) opine that “moral dimension” is indispensable together
business. In this sense, it is not sufficient condition to have market mechanism and
invoking the regulatory framework, but higher ethical values should be involved in creating
perspective, we have to infuse the Islamic values of taqwa; ibadah; al-adl wal ihsan; and
amanah and mas’uliyah into those particular corporate governance principles highlighted
potential investors to make business decisions in line with profit motives oriented (Yaya,
2003). Consequently, the disclosures practiced by the business organizations merely take
into account all information pertaining to the company’s profit and risk pursuits. By
contrast, according to dual worldview principle in Islamic teachings, the disclosure based
12
on transparency principle has to be considered not only the material aspect but also
Thus, from Islamic perspective, corporate reporting has two major objectives to
be achieved (Baydoun and Willet, 1997; Askary and Clarke, 1997). The primary objective
is to disclose compliance with religious requirements. This particular objective requires the
full disclosure of information even though the information reflects the negative acts of the
organisation. Askary and Clarke (1997) concluded that the relevant principles are
repeatedly stated in six verses in al-Qur’an which requires to disclosure of all facts and not
Gambling and Karim (1991) conclude that since the financial information will be
addition, Hameed and Yaya (2003) envisage that as one of the Islamic business institution,
Islamic banks are not only obliged to report the information regarding the economic
performance of the Islamic banks but also the information about the banks’ achievements
in fulfilling their Shari’ah compliance and reporting the social and environmental concerns
In other hand, Maali et. al. (2003) opine that the objectives of social disclosures
of Islamic business organization are: (1) to show compliance with Islamic principles in
conduct of their business; (2) to show how the organization contribute to the Muslim
community; and (3) to assist Muslim to carry out their religious obligation.
pay zakah and to conduct of fair and honest business dealing while forbidding riba,
13
monopoly, cheating, hoarding, producing unlawful product and the like (Yaya, 2003).
Hence, in an Islamic model of corporate governance, the company should disclose not only
information relating to the company’s profitability as the performance measure and risks
those face to the company, but also the information related with their fulfillment on zakat
The advantages of this disclosure is to care to protect the society from the
destructive action of the corporation and at the same time to encourage corporation to
contribute to their society, at least by fulfilling their zakah obligation, voluntary charity
(sadaqah) and furthermore by their concern and contribution to solve social and
that there is little literature on governance structures in Islamic banking, despite the rapid
growth of Islamic banks for the past three decades and their increasing presence on world
financial markets.
Algaoud and Lewis (1999) argue that governance issues in Islamic banks are quite
different from conventional banks since the unique characteristics inherently attached to the
Islamic banks. They conclude that Islamic bank represents a fundamental departure from
interesting features emerges since the operation of Islamic banks must be in line with
Islamic financing modes i.e. equity participation, risk and profit-and-loss sharing
arrangements.
14
The efforts in establishing good corporate governance in Islamic banks have
become essential on which the future of Islamic banking dependent on. This opinion could
unable to be strengthened and it would be difficult to enable them to expand rapidly and
When we reflect the causes of success and credibility which have been shown by
Islamic financial intermediaries in the golden history of the Muslim classical civilization
namely sarraf, we can conclude that key to the success of institutions are establishing
business environment which have implemented good corporate governance principles such
Islamic banks are expected to have a high level of accountability and proper disclosure in
minimized.
compliance commitment for Islamic bank is the core issue related to the objective of
originally is to realize their economic activities according to the tenets of Islam (Ilyas,
2003). In this context, shari’ah compliance will provide a guarantee that Islamic banks is
15
conducting their business free of interest (riba) transactions and ensure that all investment
In this regard, to address shari’ah compliance matters, most all of Islamic banks
Board (SSB) (Karim, 2002). From this point, we have seen that many scholars have placed
(Banaga et. al., 1994, Algaoud and Lewis, 1999; Suleiman, 2002; Chapra and Ahmed,
2002). Algaoud and Lewis (1999) assert that the core element of corporate governance
framework for Islamic banks is the Shari'ah Supervisory Board (SSB) and the internal
In addition, Algoud and Lewis (1999) opine that SSB has a vital role in the
corporate governance structure for twofold reasons. Firstly, to ensure that the bank’s
operations are in accordance with shari’ah principles and to maintain this compliance at all
conducting their business will act as a counter to the potential incentive problem and the
At the same time, as Islamic business institutions, Islamic banks in conducting their
business performance. It is interesting here to quote Banaga et. al. (1994, p. 169) asserts
that:
16
In the other hand, Banaga et. al. (1994) opined that corporate governance system
for Islamic banks will affect and is affected by the social system embodying corporate
culture and also by the strategic management adapted by the banks to respond to the
changing market and business environments. In this regard, they assert that Islamic banks
a strong corporate culture if they recognize that Islam a complete way of life. In line with
this opinion, Algoud and Lewis (1999) argue that Islamic values as basis of corporate
culture of Islamic banks should reflected in all facets of attitudes in conducting business
‘Islamic banks have a major responsibility to shoulder ... all the staff of such banks
and customers dealing with them must be reformed Islamically and act within the
framework of an Islamic formula, so that any person approaching an Islamic bank
should be given the impression that he is entering a sacred place to perform a
religious ritual, that is the use and employment of capital for what is acceptable
and satisfactory to God, the Almighty.’
We conclude with the issues of shari’ah compliance and Islamic business ethics
should coalesce into what we term as shari’ah governance. This should be a central
17
below. This model shows that, each element in either in the part of corporate governance
Internal
Domina- Regulatory
tion System
Coalition
Corpora- External
te cultu- Shari’ah Regulatory
re in Spi-
Governance System
rit of Is-
lam
External Internal
environ- Control Corporate
ment System governance
Islamic bank have specificities regarding the key players who are involved in their
business environment. Chapra and Ahmed (2001) described the relationship of these key
players in the corporate governance structure for Islamic banks in Figure 3.2. As shown,
18
the solid arrows indicate that a structured link exists between the key players, whereas the
dotted arrows indicate that the structured link does not exist.
Environment
(Economic system, Laws and regulations, Legal system, Accounting systems, etc.)
Regulators
Supervisors
Financial Institution
Management
Customers/user Shari’ah audit
of funds
Employees
In discussing some main stakeholders in Islamic bank, firstly, Chapra and Ahmed
(2001) opine that Islamic bank should take into account that the most important stakeholder
for Islamic banks is Islam itself. Thus, Islamic banks actually have greater responsibility to
19
perform well because if the corporate governance mechanism fails in Islamic banks it will
Secondly, Chapra and Ahmed (2001) argue that, in contrast with the conventional
bank’s corporate governance mechanism where in the depositors’ interest does not receive
much attention, Islamic banks’ corporate governance should give emphasis to protect
depositors’ interest in their business. One argument for this is that all type of depositors
(e.g.: demand deposit, investment deposit and investment account holders) in Islamic banks
will have influence in profit and loss performance of the Islamic banks and plays an
that depositors in fact have provided a large portion of fund to the bank rather than the
shareholders. Therefore, the nature of conflict of interest in the bank will raise here not
only between management and shareholder, but also will involve the depositors’ interest as
well.
depositors’ interest in Islamic bank. According to him, Islamic banks’ depositors are
different to depositors in conventional bank who do not play such important role in the
bank’s corporate governance structure. There are reasons for this conditions which are: (1)
based on interest system and debt mechanism, conventional banks have liabilities to pay
back the depositors’ fund; (2) there are some guaranteed scheme or deposit insurance for
such kind deposit in conventional bank; and (3) as a highly regulated industry there are
some prudential banking regulations from central bank in conventional bank, e.g. capital
20
Similar to the Chapra and Ahmed’s (2001) model in defining stakeholders in
Islamic banks, Ilyas (2004a) depicts the stakeholders in Islamic banks in the context of
Islamic bank’s operation has a unique characteristic with regard the system of
saving and financing activities served to their customers. Since Islamic banks do not apply
interest-bearing deposits, as an alternate Islamic banks offer profit and loss sharing (PLS)
for investment accounts, where, investors (depositor) will get return based on the profit/loss
sharing ratio apply to the investment result (Archer and Karim, 1997). For this purpose,
21
Islamic banks usually use mudaraba and musyaraka contracts to the depositors. There are
two two types of mudharaba contract, i.e.: (1) unrestricted investment account (mudharaba
mutlaqa) in which the investors’ fund will be placed to finance the Islamic bank’s general
pool of assets, and (2) restricted investment account (mudharaba muqayyada) while the
Archer et al (1998) argue that factually mudharaba contract can not be perceived
either as an equity investment or a liability contract for Islamic bank. In contrast to the
equity instrument, Islamic investment accounts are exchangeable at maturity date or at the
accounts are not liability of the Islamic banks since they share in the profit or bear any
This unique relationship between Islamic banks and depositors will have different
Karim (1997) argue that agency theory is relevant to the Islamic banks through the two
reasons. Firstly, on the liabilities side, the bank has responsibility to the various investment
account holders and the shareholders in order to protect their interest and perform the
bank’s business in a proper manner. Whereas, in the “asset” side, from their financing
activities in a number of Islamic financing modes, the bank will face the problem of
incorrect project reporting by the investee resulting in the bank failing to prepare a fair
financial reporting for the stakeholders. Thus, they conclude that in Islamic banking
context, there is an essential role for accounting standards and for auditing over and above
22
Archer et al. (1998) opine that Islamic banks management in the agency theory
relationship will act as an agent for shareholders and depositors as well. In one scenario,
Islamic banks’ management will act as agent for the shareholders, while as a fund manager/
entrepreneur (mudarib) they will act as agent for the investment account holders (IAH). At
the same time, however, Ilyas (2003) assert that mudharaba contract in fact raise the
problem of mudharib and shohibul maal (fund owner) relationship in which Islamic banks
can act in two roles which are as mudarib and as shohibul maal ( fund owner) in their
operation.
Unavoidably, the notion of the PLS system in Islamic banks’ operation which
have discussed above will give rise to the possibility of conflict of interest facing the
Islamic banks’ management, the shareholder and the IAH. Nienheaus (2003) describes the
Profit
sharing Shareholders
ratio
Zero-
sum Corporate
distribu- Body
tive
conflict Systematic
neglect of
Management deposiors’
Employ- interest
ment of Divergent
deposits risk,
maturity, lack of
preference expert
Investment
know-
Account
ledge
Holder (IAH)
23
3.2.2.4. The Implication of Smoothening of PLS Deposit Returns
Although the Islamic banks by nature have commitment to compensate the IAH
based on PLS ratio, Nienhaus (2003) exposes that factually the Islamic banks practice
smoothening of IAH returns which is approximately in line with the prevailing market rate
(as a benchmark determined by interest rate in the conventional financial system) in order
to stabilize the returns on investment deposit. In periods where the depositors share of
income generated by the investment of the PLS deposits is less than the market rate, the
Islamic banks will top up the depositors’ share of profit allocation to attain competitive rate
of return.
At the first sight, if bank cushion the returns of the depositors, it might be viewed
as just or fair policy and contributes to the Islamic banking development in the public
interest. This practice may be seen as an example of good corporate governance in benefit
of the depositors of Islamic banks. However, in the closer observation, in fact this practice
Karim (2004, p. 10) argues that the pertinent method which Islamic banks use to
smooth the IAH returns is a way in which the shareholders of Islamic banks take advantage
themselves at the expense of IAH using profit equalization reserve (PER) and investment
risk reserve (IRR). In this regard, he defines PER as “an amount set aside from the income
of both IAH and shareholders before the allocation of the bank’s share as a mudarib to
smooth the profit of IAH to match the returns of instruments in the market, thereby
encouraging IAH to retain the funds with the bank to manage them on their behalf”’.
Whereas, IRR means as “an amount set aside from the income of IAH, but not the
24
shareholders, after the allocation of the bank’s share as a mudarib to absorb losses
attributed to investments financed by IAH before the losses affect the equity of IAH.
compensating IAH for losses, which is strictly prohibited by the mudaraba contract”.
Considering that smoothing policy borne by the shareholders’ fund could not be
sustained in the long run, the Islamic banks management propose PER which aimed to
reduce the volatility of IAHs’ returns. Originally, it will equip the Islamic banks
management with “a mechanism to tap this pool of funds to hide their inefficiency or to
mitigate problems of asset-liability management, and to relieve shareholders from the
burden of smoothing the returns of IAH” (Karim, 2004, p. 11).
On the other hand, the implementation of IRR in Islamic banks tends to encourage
the bank management to involve in excessive risk taking because this reserve is financed
only from the funds of IAH and not shareholder. It is obviously that moral hazard takes
place because if the Islamic banks in such financing projects used IAH’ s fund suffer any
loss, it would be absorbed by IRR, but in case of profit obtaining the shareholders would
take as the mudarib share allocation (Karim, 2004).
Nienhaus (2003) hypothesizes some implications of smoothing of PLS deposit
returns in Islamic banks with regard to good Islamic corporate governance. Firstly, these
efforts to stabilize the PLS deposits return will diluting the ideal profit and risk sharing as
Islamic banks should promote this suitable with Islamic business pursuit. Secondly, this
particular policy will emerge an element of ambiguity into the PLS contracts between the
bank and the depositors. In this regard, the ratios of profit and loss sharing allocation
specified in the mudaraba contract will not effectively applied between the bank and the
IAH. Thirdly, special discretion, let say IRR policy, could increase ambiguity and unequal
treatment for the depositors in such cases, for example: certain depositors whose returns are
stabilized by recourse to the reserves participate in earnings which have not fully been
generated by the employment of their own funds solely but to some extent derived from the
employment of PLS funds of other depositors in prior periods when the cushioning reserves
were built up. Thus, this will face shari’ah compliance problem.
25
3.2.2.5. Depositors’ Representative in the Corporate Governance Structure
Karim (2004) opine that since Islamic banks use mudaraba contract to mobilize
fund from the depositors, it may lead the Islamic banks management to an ethical dilemma
in the term of a conflict of interest between the shareholders and the IAH. In this case, it
seems that IAH would be the party with inferior status compared to the shareholders’
position.
In most governance structures and mechanisms only the shareholders have the
right of appointing, evaluating and replacing the management of the bank as well as
appointing and replacing the bank’s external auditors and SSB (Karim, 2004). In addition,
the IAH also cannot intervene in investment management decision. Although this potential
problem could occur as well for creditors conventional banks, but in this particular case the
debt covenant usually provide triggers of default on which a general meeting of creditors
will need to be convened. In contrast, depositors for Islamic banks have no such authority
further important issue whether the depositors should have a representative in corporate
governance structure. Some scholars e..g. Archer (2003) have suggested the possibility of
26
the IAH having representatives at BOD or SSB, whereas Nienhaus (2003) propose that
two-tier structure.
However, Nienhaus (2003) opines that this idea is not easy to be implemented.
who could perform supervisory function on behalf of the depositors. But this will require
strong expertise in Islamic bank accounting and management matters which rarely expected
from an average depositor. He suggest that the depositors’ representative can be appointed
from (1) an independent expert or party in Islamic banks which acts as independent body
literatures are categorized as related to this kind of study e.g. Naser and Idris (1997),
Chapra and Ahmed (2002), Maliah and Latiff’s (2003), Maali et al.’s (2003) and Hameed
et al. (2004)
standards, 2 code of ethics for accountant, auditor and employee of Islamic financial
institutions and 13 shari’ah standards (AAOIFI, 2002). AAOIFI (2002) has promulgated 4
Governance Standard for Islamic Financial Institution (GSIFI) to enhance the role of SSB
in corporate governance and provide guiding principles to harmonize the SSB’s structure
27
and process. GSIFI No 1 provides guidance on the definition, appointment, composition
and report of the SSB. Whereas, GSIFI No. 2 provides guidance to assist SSB in
performing shari’ah reviews to ensure compliance with Islamic shari’ah rules and
principles. Then, GSIFI No. 3 provides guidance on the internal Shari’ah review in Islamic
bank. While, the purpose of GSIFI No. 4 is to define the role and responsibilities of an
Audit and Governance Committee (AGC) for Islamic financial institutions. This committee
relating to the corporate governance issue mostly emphasize on the shari’ah compliance
issues and take initiatives in enhancing the role of SSB in this purpose. This governance
standard (GSIFI) can not be separate but has to be implemented together with the auditing
standards (ASIFI) to enabling the external auditor to express an opinion as to whether the
financial statements are prepared, in material respect in accordance with the shari’ah
principles and accounting standards issued by AAOIFI. The issues of profit equalization
reserve (PER) and investment risk reserve (IRR) are addressed by FAS No. 11 on
Provisions and Reserves which is aimed at setting out accounting rules for recognizing,
measuring, presenting and disclosing the provisions which are formed by Islamic banks.
Moreover, Chapra and Ahmed (2002) propose a code of best practices for
corporate governance in IFI which cover broadly the issues of corporate governance
28
4.0. RESEASCH METHODOLOGY
There are two research questions in this study which are related to the objectives
of this study itself. The first research question is related to the second objective which is to
explore the extent of the level of voluntary corporate governance disclosure practices of
Islamic banks in Malaysia and Indonesia based on the scoring of corporate governance
disclosure made in the annual report. Whereas, the second research question is related to
code of best practices for corporate governance between Islamic banks in Malaysia and
Indonesia.
Given that that governance issues in Islamic banking are quite different from
conventional bank (Algaoud and Lewis, 1999 and Suleiman, 2000), we undertake this
disclosure practices of Islamic banks in Malaysia and Indonesia. In this study, we will
Malaysia and Indonesia based on the scoring of corporate governance disclosure made in
corporate governance compliance (S&P and CGFRC, 2004), the study of the quality of
corporate governance disclosure in Islamic bank will enable valuable benchmarking and
29
expose some interesting findings that can help the regulatory bodies as well as the
academicians to propose some improvement in this area . Thus, the first research question
“What is the extent of the corporate governance disclosure practices of Islamic banks
Obviously that the quality of corporate governance of banks and sound business
practices in the banking industry will depend on the implementation of rule and code of
Malaysia and Indonesia based on the corporate governance disclosure made in the annual
implementation of code of best practices for corporate governance between Islamic banks
“What are the current corporate governance practices of Islamic banks in Malaysia
The population of Islamic banks for this study is the Islamic commercial banks in
Malaysia and Indonesia which are categorized as full-fledged Islamic banks. The list of
these Islamic banks will be gathered from data published by Bank Negara Malaysia
(Malaysian Central Bank) and Bank Indonesia (Indonesian Central Bank). Based on
30
BNM’s Annual Report 2003 (BNM, 2003), there were two Islamic commercial banks in
Malaysia consist of Bank Islam Malaysia Berhad (BIMB) and Bank Muamalat Malaysia
Indonesia, at December 2003 (Bank Indonesia, 2003) there are two Islamic commercial
banks in Indonesia, they are PT Bank Muamalat Indonesia Tbk. (BMI) and PT Bank
established under Bank Negara Malaysia’s scheme known as SPTF or SPI. Our reason
being, the circumstances of these institutions are quite different in the context of corporate
A disclosure scoring method will be used to measure to what extent the level of
voluntary disclosure literature (Maali et al., 2003, Carson and Simnet, 1998). In this regard,
we assume that Islamic banks have incentive to more disclose corporate governance
matters due to transparency concept and Islamic moral accountability to the stakeholders as
a whole. In line with the transparency concept, we argue that if the Islamic banks increase
this particular voluntary disclosure, it will reduce agency cost relation between the
shareholders and the management (Carson and Simnett, 1998). Whereas, Islamic moral
accountability in which inherently exist put place as Islamic banks’ characteristic will
31
encourage the Islamic banks’ management to disclose the corporate governance
information in which it will assist the stakeholders in measuring the Islamic banks’
However, our disclosure scoring has some limitations in measuring the level of
corporate governance practices in such Islamic banks due to several reasons. Firstly, our
research mainly use secondary data from annual reports, hence our disclosure index only
measuring as far as the information is disclosed in the annual report only. Secondly, our
practices in Islamic banks since our focus is on ‘to what extent the Islamic bank disclose’
rather than ‘the level of compliance of Islamic bank’ to the corporate governance practices.
We develop two set of corporate governance scores indices for Islamic banks. The
first set will use national codes of corporate governance in each country. In this approach,
each of the Islamic banks’ annual report will be examined for disclosures of corporate
Parties
32
Whereas, in Indonesia, the references used to determine corporate governance
requirements:
On the other hand, the second set of corporate governance scores, which we consider as
(AAOIFI, 2002),
33
• Enhancing Corporate Governance for Banking Organizations (Basel Committee
The first index of our research is for Islamic banks in Malaysia. The main
references from which items are derived are GP8i (2004), KLSE Listing Requirement
(2001) and MCCG (2000). However, this index basically adapted the format and the
we see in Table 5.1., this particular index comprise of fourteen (14) sections and forty-nine
(49) items.
banks in Indonesia. The main references used to derive the items which should be disclosed
in this index are PGCGPI (2004), SGRMB (2003), PSAK 59 (2002) and ICGCG (2000). In
this case, different from the MCGCG (2000), in Indonesia there is no standard or guidance
to present a narrative statement regarding corporate issues in the annual report explicitly
stated in PGCGPI (2004), SGRMB (2003) or ICGCG (2000). Therefore, we follow the
general format of the first index which has been developed for Islamic banks in Malaysia.
structure between Malaysia and Indonesia. In contrast with Malaysia which has one-tier
board (that is the Board of Directors) companies incorporated under the Indonesian
Company Law has two-tier boards which are the Board of Commissioners (Komisaris) who
conduct the supervisory and advisory roles, and the Board of Directors (including
34
management) who act the executive role in the company (Kurniawan and Indriantoro,
2000).
banks in Malaysia and Indonesia is regarding the accounting standard for Islamic banks. In
2002, Ikatan Akuntan Indonesia (IAI, Indonesian Institute of Accountant) has issued PSAK
No. 59 Accounting for Islamic Bank which was effective for Islamic banks’ financial
statement started 1 January 2003. This particular standard is basically adopted from
statements of sources and uses of funds in the Zakah and charity Zakah fund” and “a
statement of sources and uses of funds in the Qard fund” in Islamic banks’ financial
statements. We consider these two types of elements of financial statements are important
as international benchmark for Islamic banks, our main references include SFAIFI/GSIFI
(AAOIFI, 2002), CBPCGI (Chapra and Ahmed, 2002), and Enhancing Corporate
presented, in general we follow the general format of the indices which have been
developed for Islamic banks in Malaysia and Indonesia and we carefully select the items
35
However, based on SFAIFI/GSIFI (AAOIFI, 2002), we add a number of sections
to include some important issues relating to the corporate governance issues in Islamic
banks, i.e.: internal Shari’ah review, social responsibilities for the stakeholders, bases for
profit allocation between owners’ equity and IAH, Bases for profit allocation between
owners’ equity and IAH, and Profit Equalization Reserve (PER) and Investment Risk
Reserve (IRR). In addition, we also insert some detail items regarding Shari’ah
CBPCGI (Chapra and Ahmed, 2002). In addition, we also add some items e.g. IAH
representative from some literature (Archer (2003), Nienhaus (2003) , Karim (2004), and
Ilyas (2004a)). This particular index consists of twenty (20) sections and sixty-six (66)
items.
which each item in our disclosure checklist has the same weight. In our opinion the using
of unweighted disclosure is fairer for this study because the weights would be subjective in
nature and there are difficulties in judging the importance of the items disclosed according
the user of annual report (Carson and Simnet, 1998). In addition, according to Barret
(1976) as quoted by Maali et al. (2003) there is some unpredictability which is obviously
inherent in using any weighted index. On the other hand, the disclosure index in this study
is not intended to be used in a decision making context, thus we assume that each items
which should be disclosed in Islamic banks annual reports have equal priority (Maali et al.,
2003).
36
Our data collection mainly emphasizes on the secondary data disclosed in annual
report. We assert that the annual reports are recognized as the primary medium of
communication between the company and its stakeholders as whole for Islamic banks
(S&P and CGFRC, 2004). Then, for scoring purpose, annual reports of each bank were
reviewed page by page for items disclosures according the disclosure index.
For scoring matters, each disclosure related to specific items in the disclosure
index will be awarded one point and in contrast items not disclosed will be awarded 0
point. In addition, cause of some items might not be applicable to some banks; the total
score in disclosure index was constructed as a ratio of the actual score to the maximum
In this research, we take two years annual reports for each bank i.e. 2000 and
2003. The national code of corporate governance was implemented in Malaysia and
Indonesia effectively January 2001. The latest available annual report after the
Islamic banks in Malaysia and Indonesia based on the result of scoring disclosure index, we
will follow the approach used by Irwanto (2002) in which the disclosure score is classified
scores), less informative (51≤66 scores), and not informative (0≤51 scores). Therefore, the
total score that awarded to each bank based on such disclosure indices will be converted to
37
the appropriate category to determine the level of corporate governance disclosure
practices.
banks in Malaysia and Indonesia, we will perform some descriptive analysis based on the
Malaysia and Indonesia using our two sets scoring indices can be seen in Appendix 1, 2
and 3.
In summary the results for Islamic banks in Malaysia and Indonesia respectively
The results on Table 5.1. show that there are significant improvements of the ratios
for BIMB and BMMB from 2000 to 2003 (increasing 55% and 33% respectively). One
argument for this results could be proposed that the implementation of code of corporate
governance in Malaysia in early 2001 have significant implication for Islamic banks in
Malaysia. Another reason for BIMB as a listed company in Kuala Lumpur Stock Exchange
38
The disclosure scores for BIMB and BMMB are classified as not informative for
2000 and very informative and sufficiently informative for 2003 respectively.
The results on Table 5.2. show that there are slight improvements of the ratios for
BMI and BSM from 2000 to 2003 (increasing 20% and 18% respectively). One argument for
this results could be proposed that the implementation of code of corporate governance in
Indonesia in early 2001 have significant implication for Islamic banks in Indonesia, especially
for BSM as a subsidiary of PT Bank Mandiri Tbk, one of state-owned bank as a listed company
in Jakarta Stock Exchange. However, the disclosure scores for BMI and BSM are classified
Table 5.3. Corporate Governance Disclosures Ratios of Islamic banks in Malaysia and
Indonesia using Comprehensive Code of Corporate Governance Requirements
The results on Table 5.3. show that there are significant improvements of the ratios
for Islamic banks in Malaysia whereas there is only slightly improvement for Islamic banks
39
2003 (increasing 29-48% for Islamic banks in Malaysia and 15% for Islamic banks in
Indonesia). One argument for this results could be proposed that the establishment of Islamic
The disclosure scores for Islamic bank in Malaysia and Indonesia using this kind
of comprehensive scores for 2000 and 2003 range from not informative to sufficiently
informative for Islamic banks in Malaysia, whereas for Islamic banks in Indonesia
Interestingly, none of the banks disclosed some specific items unique to Islamic
banks such as internal shari’ah reviews and bases for profit allocation between owners’
equity and IAH. For the items of restricted investment fund statement only Islamic banks
in Indonesia in year of 2003 have disclosed this item. Whereas for smoothening of profit
policy only Islamic banks in Malaysia in year of 2003 have disclosed this pertaining item.
6.0. CONCLUSION
Corporate governance issues for Islamic banks are quite different from conventional
banks and have the specific characteristics since the uniqueness of the Islamic banks’
operations. Basically, these differences originate from the shari’ah compliance commitment
for Islamic banks in their activities. Therefore, we conclude shari’ah governance should be
However, we agree with what Chapra and Ahmed (2002) assert that without an
effective corporate governance mechanism, Islamic banks may not achieve their objectives
effectively. Here, we consider that the existing of corporate governance codes and
40
mechanisms could be adapted in line with the development of corporate governance in
Islamic perspective.
annual repots of Islamic banks in Malaysia and Indonesia using two set corporate governance
comprehensive benchmark as proposed for best practices in Islamic banks. The results show,
in general Islamic banks in Malaysia and Indonesia have addressed concerns on the issue of
corporate governance in their operation. However, the disclosure of items unique to Islamic
banking operations have not been addressed sufficiently in Islamic banks both in Islamic
banks in Malaysia and Indonesia. In general the sufficiently disclosure of Islamic banks are
still far from our comprehensive benchmark for Islamic banks corporate governance
disclosure scores.
Although this empirical study only indirectly reflected the existence of corporate
governance in Islamic banks, this study will benefit both scholars and the regulators to
further develop a model for effective corporate governance mechanisms for Islamic
banks. Meanwhile, there are some limitations of this study in the regards of the sample
selected of the Islamic banks to reflect the extent of the Islamic banks’ corporate
governance. Also, the methodology adopted in this study is only exploratory and
descriptive and no rigorous statistical analyses are possible. Hence, we argue that further
41
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