Corporate Governance in Islamic Financial Institutions: An Ethical Perspective

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Corporate Governance in Islamic Financial Institutions: An Ethical Perspective


Dr. Zulkifli Hasan

1.0 Introduction

Islam is neither simply a religion nor a mere ideological vision. It is a practical system of life and balance between human bodily requirements, spirit and reason. Islam is a comprehensive religion and it covers aqidah (belief), Shari’ah and akhlaq (ethics). In contemporary perspective, the ideal practice of Islamic finance tends to provide evidence about the comprehensiveness of Islam by invoking these three core elements.

Contrary to the ideal assumption that Islamic finance is about belief, Shari’ah and ethics, it is observed nevertheless that in actual practice, Islamic finance is more anxious on the legal and mechanistic aspect of Shari’ah compliant. At this point, Balz, (2010: 250) views that Islamic finance is now experiencing a “formalist deadlock” where the industry is more concerned with formal adherence to Islamic law instead of promoting Islamic ethical values. This is affirmed by El Gamal, (2006) when he severely criticized the practice of Islamic finance particularly by highlighting the issue of Shari’ah arbitrage. Significant criticisms by numerous scholars about the current practice of Islamic finance have led to series of questions as to the distinctiveness of Islamic finance with its conventional counterparts. Chapra, (2010) and Siddiqi (2007) for instance view that the practice of Islamic finance seems unable to attain its authenticity and share many common similarities with conventional finance. As a result, Islamic finance industry is also experiencing the impact of recent financial crisis such as in the case of closure of Ihlas Finance House in Turkey, the Islamic Bank of South Africa and Islamic Investment Companies of Egypt. These corporate failures raise an issue on the importance of ethics as the core element of Islamic finance.

There are numerous observations about major causes of corporate difficulties as experienced by several IFIs and one of them is weak of corporate governance . The analysis of such corporate failures in the existing literature nevertheless is found to heavily emphasize on the aspect of regulatory failure, management failure and control failure in corporate governance structure. It is observed that there is lack of discourse on the issue of ethics or the ethical failure aspects in IFIs that lead to such corporate difficulties. In view of scarcity literature on this subject, this article aims at providing general overview and basic understanding on the ethical perspective of corporate governance in IFIs. This article adds the previous literature on ethics and corporate governance by highlighting the distinctiveness of Islamic ethical principles and possible mechanism to institutionalize it. The remainder of this article is structured as follows. The next section reviews western and Islamic literature on ethics and corporate governance and section 3 specifically explains conceptual framework of Islamic ethics and its underlying principles. Section 4 attempts to highlight possible approach to promote and implement ethics by advocating the institutionalization of ethics and finally, section 5 concludes the discussion.

2.0 Ethics in Western and Islamic Theory of Corporate Governance

Becht and Barca, (2001) provide a literature review of a number of corporate governance models as possible solutions to solving the collective action problem among shareholders such as takeover model, block holder model, board models, executive compensation models and multi-constituency models. Another examination of the existing corporate governance theory can be found in Lewis, (1999: 33-66) where he examines the Anglo-Saxon model, the Germanic model, the Japanese model, the Latinic model, the Confucian model and the Islamic model. Generally, all of these corporate governance theories are either developed on the basis of agency theory or stakeholder theory orientation.

The Anglo-Saxon model of corporate governance which is also known as market-based systems or shareholder-value system or principle-agent model is considered as the most dominant academic view. Miller (2004:2) views that shareholders value orientation concerns on the sovereignty of individual where sole consideration is given to shareholders. Stakeholders’ value model on the other hand focuses on a relationship-based model that emphasizes on maximizing the interests of a broader group of stakeholders (Adams, 2003: 4). Both these Western theories of corporate governance tend to focus on the mechanism of resolving the agency problems. These theories nevertheless have failed to certain extent to take into account the element of ethics as an essential component of corporate governance. Only after the incident of significant corporate failures and financial scandals due to lack of ethical consideration, there were suggestions to integrate ethics into corporate governance framework such as Drennan, (2004), Cladwell and Karri, (2005), Arjoon, (2005) and Sullivan and Shkolnikov, (2007) .

The notion of integrating ethics as part of corporate governance system then raises an issue of philosophical foundation of ethics in conventional literature. Basically, the ethical dimension in western theory is built on the basis of utilitarianism, relativism and universalism (Beekun, 1996). The ethical principles that extracted from these theories are based on philosophical ethics which is constructed from social interaction. All of the universal ethical principles which are applicable to corporate governance such as accountability, transparency, fairness and responsibilities are socially constructed through human reason and experiences.

On the other hand, Islamic model of corporate governance advocates comprehensive approach by emphasizing the elements of ethics as propounded in al Quran and al Sunnah. Unlike ethics from western theory perspective, the Islamic ethical principles are divine and religious construct. Wilson, (2002: 53) states that the Islamic ethics as being enduring and based on holy revelation while the ethics in western theory derived from social values are more transitory in nature. Al Quran and al Sunnah provide guidelines and principles of ethics that can be universally applied including in the matter of corporate governance.

3.0 Ethical Dimension of Corporate Governance from Islamic Perspective

3.1 Conceptual Framework of Ethics

The word ethics is derived from the Greek word ethos, which means character or custom (Solomon, 1984: 3). It represents a wide meaning of character, behavior or code of conducts. In Islam, the word ethic is synonym with the term adab and khuluq (Siddiqui, 1997: 423). These two terms denote good behavior or a standard of conduct to be observed in social interactions (Saedon and Kamal, 1992: 51-62) or the set of moral principles that distinguish right and wrong (Beekun, 1996: 2). In the holy al-Quran the term khuluq can be found in Surah al-Qalam verse 4 as Allah says: “And surely you (Prophet Muhammad) have the best form of morals,” and in surah al-Shu’ara verse 137: “There is no other than khuluq of the ancient”. Apart from these, the Prophetic hadith had also made reference to ethics and morality where Aishah reported that that “the Khuluq (Morals) of the Prophet was based upon the Qur’an” and the Prophet says that “I have come to complete the code of moral conduct” (Muslim).

In deconstructing the Islamic ethical principles within the realm of economic, Naqvi, (1981: 45-57) advocates four important axioms that specifically reflect its relevancy in determining the rules of economic behavior in a society. The axioms of unity, equilibrium, free will and responsibility are the basis for deriving a set of ethical system and principles that would be appropriate to nurture and guide the economic behavior from Islamic point of view . These divine formulated axioms provide very useful guidelines in identifying and recognizing legitimate ethical principles in economic.

Another construct of ethics to legitimize the ideal Islamic economic behavior refers to the principle of adl (justice), amanah (trust) and ihsan (benevolence). Based on the ethical axioms of unity, equilibrium, free will and responsibility, Islamic ethics must at least have three important characteristics namely the criterion of adl (justice), amanah (trust) and ihsan (benevolence) (Beekun and Badawi, 2005: 134-135). The first feature of ethics in Islam requires all individual to behave justly to all . The managers for instance shall treat equally the employees without discrimination. The concept of amanah then further characterizes Islamic ethics by considering individual as a vicegerent of God and he is accountable to Him in which requires him to be responsible in whatever he does. Finally, the concept of Ihsan represents the core and most important element of Islamic ethics. Unlike justice which is mandatory, Ihsan denotes what is above and beyond mandatory (Al Qurtubi, 1966) . In this regard, Ihsan requires extra caution, effort and good intention where the individual performs good deeds with the realization that Allah is watching him at all times . The criterion of ihsan then expects all stakeholders in IFIs regardless of shareholders, managers, board of directors (BOD) and employees to observe the set of Islamic ethical principles which is divinely revealed and clearly stipulated in al Quran and al Sunnah.

3.2 Ethical Principles

In discussing ethics in the context of corporate governance in IFIs, this article highlights several Islamic ethical principles that relevant to key stakeholders and these include prohibition of riba, maysir and gharar, to observe good behavior and conduct with candor, courtesy and fairness, to acquire knowledge, diligence and competence, to uphold interest of all stakeholders, fair competition, transparency, confidentiality and fair price and wages. All of these ethical principles are extracted and derived from the Islamic ethical axioms of unity, equilibrium, free will and responsibility as well as the criterion of adl, amanah and ihsan. It is worth noting that this list is non-exhaustive.

Islamic Ethical Principles

(i) Prohibition of Riba (Interest)

“O you who have attained faith! Remain conscious of God, and give up all outstanding gains from Usury, if you are (truly) believers” (Al Quran, 2: 278) .

(ii) Prohibition of Maysir (Gambling)

“O you who believe! Intoxicants and gambling, (dedication of) stones and (divination by) arrows, are an abomination of Satans handwork: Abstain from such (abomination), that you may prosper. Satans plan is (but) to excite enmity and hatred between you with intoxicants and gambling, and hinder you from the remembrance of Allah, and from prayer: Will you not then abstain?” (Al Quran, 5: 90-91).
Prohibition of Gharar (Uncertainties) Hadith narrated by Muslim, Ahmad, ‘Abu Dawud, Al Tirmidhi, Al Nasa’i, Al Darami and Ibn Majah on the authority of Abu Hurayra where the Prophet prohibited the pebble sale and the gharar sale.

(iii) Good Character and Behavior

Abd Allah ibn ‘Amr said, the Prophet used to say: “The best of you are those who have the most excellent morals” (Bukhari, 61: 23).

Hadith narrated by Abu Hurairah, the Messenger of Allah said: “The most perfect of the believers in faith is the best of them in moral excellence, and the best of you are the kindest of you to their wives” (Al Tirmidzi, 10: 11).

Muadh Ibn Jabal reported that the Prophet said: Fear Allah wheresoever you may be, follow up an evil deed by a good one which will wipe (the former) out and behave good-naturedly to people” (Al Nawawi, 2001: 35).
Generosity in Doing Business Uthman bin Affan reported that the Prophet said: “Allah will admit to the Paradise a man who is lenient as a seller and a buyer.” (Ibn Majah, 3: 2202)

Jabir bin Abdullah reported that Allah’s Messenger said: “May Allah have mercy on the bondsman who is kind when he sells, kind when he buys and lenient when he demands (his debt)” (Ibn Majah, 3: 2202)

(iv) Diligence and Competence

The Prophet said: “Allah loves to see one’s job done at the level of itqan or wisdom” (Cited in Al Dimasqi, 2006: 385-388).

Saidatina Aishah reported that the Rasulullah said: “The deeds most loved by Allah (are those) done regularly, even if they are small” (Bukhari and Muslim).

(v) To Uphold Interest of All Stakeholders

Ibnu Umar reported that the Messenger of Allah said: “A Muslim is the brother of a Muslim; he does him no injustice, nor does he leave him alone (to be the victim of another’s injustice); and whoever does the needful for his brother, Allah does the needful for him; and whoever removes the distress of a Muslim, Allah removes from him a distress out of the distresses of the day of resurrection; and whoever covers (the fault of) a Muslim, Allah will cover his sins on the day of resurrection”(Bukhari, 46: 3)

Anas reported that the Prophet said: “Help thy brother whether he is the doer of wrong or wrong is done to him.”They (his companions) said, O Messenger of Allāh! We can help a man to whom wrong is done, but how could we help him when he is the doer of wrong? He said: “Take hold of his hands from doing wrong.” (Bukhari, 46: 4).

(vi) Fair Competition

The Messenger of Allah said: “Do not hate one another and do not be jealous of one another and do not boycott one another, and be servants of Allah (as) brethren; and it is not lawful for a Muslim that he should sever his relations with his brother for more than three days” (Bukhari, 78: 57).
The Prophet declared that: He who monopolizes is not but a wrongdoer” (Al-Tirmidhi, 6: 23).

(vii) Transparency

“And if you are traveling and cannot find a scribe, then there be mortgage taken..…and do not conceal not evidence for whoever hides it, surely his heart is tainted with sin and Allah is knower of what yo dou do.” (Al-Quran, 2: 283).

Abdallah reported that the Prophet said: “Truthfulness leads to righteousness, and righteousness leads to Paradise. And a man keeps on telling the truth until he becomes a truthful person. Falsehood leads to Al−Fajur (i.e. wickedness, evil−doing), and Al−Fajur (wickedness) leads to the (Hell) Fire, and a man may keep on telling lies till he is written before Allah, a liar” (Bukhari, 8: 116).

(viii) Confidentiality

Hadith reported by Abu Hurairah, the Prophet said: “Whosoever relieves from a believer some grief pertaining to this world, Allah will relieve from him some grief pertaining to the Hereafter. Whosoever alleviates the difficulties of a needy person who cannot pay his debt, Allah will alleviate his difficulties in both this world and the Hereafter. Whosoever conceals the faults of a Muslim, Allah will conceal his faults in this world and the Hereafter. Allah will aid a servant (of His) so long as the servant aids his brother. Whosoever follows a path to seek knowledge therein, Allah will make easy for him a path to Paradise. No people gather together in one of the houses of Allah, reciting the Book of Allah and studying it among themselves, except that tranquility descends upon them, mercy covers them, the angels surround them, and Allah makes mention of them amongst those who are in His presence. Whosoever is slowed down by his deeds will not be hastened forward by his lineage” (Cited in Al Asin, 1970: 14-15).

(ix) Fair Wages and Price

“Withhold not things justly due to others” (Al Quran, 26: 18).

Hakim bin Hizam reported that the Prophet Muhammad said: “The seller and the buyer have the right to keep or return the goods so long as they have not parted or till they part; and if both the parties spoke the truth and described the defects and qualities (of the goods), then they would be blessed in their transaction and if they told lies or hide something, then the blessings of their transaction would be lost ” (Bukhari, 3: 293).

The command to avoid riba, maysir and gharar is considered as main characteristics of Islamic ethical principles. The prohibition of riba, maysir and gharar is clearly mentioned in al Quran and al Sunnah. Unlike the western ethical code which is based on social interaction in which riba, maysir and gharar are tolerable, Islam vividly declares these three elements to be unethical and can not be compromised at all times. The remainder of the underlying Islamic ethical principles however may share some common similarities with the western ethical code.

4.0 Institutionalization of Ethics in IFIs

Institutionalization of ethics is one of the best approaches to promote and implement the Islamic ethical principles as highlighted above in any organization. Basically, the process of institutionalization of ethics requires a formal initiative to guide key stakeholders in the corporation to implement and promote ethics. Such process is very important in order to control the problem of ethical issues in the corporations (Vitell and Hidago, 2006). The existing practice shows that institutionalization of ethics in corporation can be in the form of establishing permanent board-level committee that responsible to set the policy on ethics , issuance of code of ethics, organizing ethics training, reinforcing the employee’s organizational commitment, and encouraging an ethically-oriented organizational culture (Sim, 1991). All of these actions would be able to create awareness about ethics and at the same time to promote the implementation of ethics as part of corporate governance framework.

Any action and effort to institutionalize ethics adheres most to its key players within the corporate governance structure of the organization. This raises an issue as to the need for specific agent for such purpose. At this point, several key participants of corporate governance either external such as regulatory and supervisory authorities or internal as in the case of BOD, shareholders, managers, employees and Shari’ah board are considered as agents of ethics.

The regulatory authorities play a key role in promulgating a set of law or code of ethics on corporate governance. To complement this function, the supervisory authorities have duty to supervise and monitor the implementation of this code of ethics effectiveness of corporate governance system and to check its. Shareholders have responsibilities to ensure that all business transactions and investment activities are conducted in ethical way. The BOD has responsibility to specify the code of conduct and standard of appropriate behavior for internal usage. Unlike the BOD, the management has fiduciary duty to implement the ethical policies and strategies set by the BOD while the employees, to practice and observe every aspect of ethics as stipulated in the code of ethics.

The most essential agent of ethics in IFIs is Shari’ah board. Basically, the functions of Shari’ah board are two-folds i.e. advisory and supervisory and these include advising IFIs in its operation, to analyze and evaluate Shari’ah and ethical aspects of any banking and financing activities and to monitor and supervise the extent of Shari’ah compliance. Considering to their expertise and knowledge on Shari’ah and the state of its independence, Shari’ah board shall play an active role to promote Islamic ethics and values within the organization. The existence of Shari’ah board within the internal corporate governance structure shall be the advantage for IFIs to further promote the implementation of ethics in daily business activities, decision making process, management style, financial products and services and etc.

5.0 Concluding Remarks

In spite of its similarities and some common principles with the western theory of corporate governance, Islam adds additional value to the existing governance framework whereby it emphasizes on the element of faith, Shari’ah and ethics. The foregoing discussion on the ethical dimension in Islam further validates the need for inserting ethics as part of corporate governance framework in IFIs. Islam highly insists stakeholders of IFIs particularly shareholders, BOD, managers, employees and Shari’ah board to preserve standard of conducts, to observe good ethics, conscience and piousness. Since this article is theoretical in nature, further study is really needed in order to explore the extent of ethical practice in IFIs. This triggers the call for future research to complement the existing theoretical studies on ethics with appropriate empirical data and information.


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Dr. Zulkifli Hasan

Srebrenica, Bosnia and Herzegovina.
More than 8000 Muslims were killed here by units of the Army of Republika Srpska in July 1995

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