Islamic banks are established as ethical financial institutions with the fundamental requirement for their product and services to be wholly Shariah compliant. The concept of Islamic banking first emerged in the late 1940s but the pioneering effort in bringing Islamic banking principles into practice only became reality in 1963 with the development of the Mit Ghamer Savings Bank and the Nasser Social Bank in Egypt. However, the activities of these two banks were only attuned to collecting small savings and making direct investments in agricultural and industrial activities or to small local businesses and hence, were more akin to a social bank. In 1975, the Organisation of Islamic Cooperation (OIC) inaugurated an inter-governmental Islamic bank, known as the Islamic Development Bank (IDB), which was established with the sole purpose of fostering economic development and social progress among member countries and their Muslim communities in accordance with the Shariah laws. Now, there are over 300 Islamic banks offered across 75 countries and this market industry has grown 50 per cent faster than their conventional counterparts (The Banker
2015).
According to the Islamic faith, the Shariah is regarded as a divine law that is derived from two main sources—i.e., the Quran and Prophetic traditions and sayings (otherwise known as Hadith). In the absence of clear guidance from these two main sources, the Shariah is also derived from secondary sources which include:
ijtihad (legal reasoning),
qiyas (analogical reasoning),
istihsan (juristic preference),
maslahah mursalah (unrestricted public interest), and ‘
urf’ (customary practice). This provides justification for scholars to utilise the
ijtihad facility to provide Shariah rulings (i.e., otherwise known as a
Fatwa). The interpretation of a
Fatwa or ‘religious ruling’ is provided only by religious scholars based on Islamic doctrine, the four main schools of thought are the Shafii, Hambali, Hanafi and Maliki Schools of Jurisprudence)
1 with the ultimate aim of meeting the “objectives of Shariah”.
The objectives of the Shariah were clarified by Islamic jurists such as Imam al-Ghazali amongst others as: faith; life; intellect; lineage; and, property (Kamali
2008) and was then applied in various contexts of a Muslims’ life including issues relating to human relations (
mu’amalat). Other studies have concluded that the operations of Islamic banks promote the realisation of an Islamic financial system that is drawn from Islamic law (see for example Iqbal
1997; Zaher and Hassan
2001). Among others, Shariah law permits Islamic banks to operate business based on four principles: (1) risk-sharing or concept of equality; (2) materiality or economic value; (3) no exploitation whereby neither party nor the transaction should be exploited and (4), no financing of activities that are banned by the Quran (e.g., alcohol, pork products, etc.). Additionally, Shariah law forbids Islamic banks in business dealing with elements of
riba (interest),
gharar (speculative trading) and
maysir (gambling) as such activities lead to the conditions that may facilitate economic exploitation and unlawful profit (Naughton and Naughton
2000; Lewis
2007; Hassan and Lewis
2007; Hossain
2009).
When attention is turned to governance, there are various mechanisms in place to ensure that the integrity of the Islamic banking industry is upheld, including the appointment of competent SBs who are entrusted with the highest responsibility on aspects of religious compliance. Unlike their counterparts, assurance on religious compliance is unique to Islamic banks as it builds stakeholders confidence on religious legality of the products and services that banks provide. Several studies have, indeed, highlighted the key governance role of SBs in overseeing and monitoring the religious compliance aspect of Islamic banks (see for example Briston and El-Ashker
1986; Tomkins and Karim
1987; Karim
1990a,
b; Banaga et al.
1994; Najeeb and Ibrahim
2014; Ginena
2014; Bougatef
2015; Almutairi and Quttainah
2017). These studies outline the duties of SBs in assuring that Islamic banking operations along with their products, contracts and management of
Zakat comply with Islamic principles. Therefore, the issue of competency and independence of each SB are key governance features which demonstrate the reliability and soundness of SBs’ role in assuring ethical legitimacy.
2 For this reason, members of SBs comprise of individuals who are experienced and qualified in various disciplines such as Islamic law, accounting, auditing and finance (see for example Gambling et al.
1993; AAOIFI
1997, para 7; Grais and Pellegrini
2006b; BNM
2011, p. 17; Ginena
2014) enabling them to competently manage and evaluate Islamic banking issues (Malik et al.
2011).
Moreover, given that the requirement of SB independence is consistent with the current practice of external auditors, several studies have documented that auditor independence is associated positively with the effectiveness of audit committees in issuing quality audit reports (Bédard and Gendron
2010; Kueppers and Sullivan
2010; Jamal and Sunder
2011; Dobija
2015). After all, issuing a quality audit report also requires the external auditor to be competent and transparent in providing complete and truthful information to enhance understandability and reduce information asymmetry among investors (Graham et al.
2005; Barth and Schipper
2007; Billings and Capie
2009). However, since Islamic finance broadens the governance function of SBs into a wider spectrum of religious compliance, SBs are not only accountable to provide an independent and transparent religious report to stakeholders but also to ensure religious compliance of banking operations. By religious compliance we argue that SBs has the single most important authority to conduct regular reviews and monitor assessment to ensure that Islamic banks do not contravene religious principles governing its operations. When focussing on the issue of independence of SBs, several studies have claimed that the minimum supervision and monitoring role of SBs is due to lack of standardization in the governance of religious audit as well as a shortage of qualified and independent religious auditors in Islamic banks (see for example Garas and Pierce
2010; Najeeb and Ibrahim
2014; Othman and Ameer
2015). For instance, Rahman (
2008) highlight that only a few Islamic banks undertake the crucial responsibility of reviewing and checking the transaction after the accomplishment of contracts and products noting that these could be due to a lack of regulation of the religious audit framework and the required expertise to perform this task.
Other empirical studies have also been undertaken on matters surrounding the role of SBs. For instance, Ullah et al. (
2016) applied grounded theory to key stakeholders of three Islamic banks in two different countries (i.e., Pakistan and the United Arab Emirates). The authors report that individual religious scholars as well as SBs tend to play only a limited role in safeguarding and promoting religious principles as management of Islamic banks attempt to avoid the supervision and audit role of SBs. In doing so, managers do not truly uphold religious principles, but merely aim to seek religious certification for their banking products. In fact, Ullah et al. (
2016) highlighted that some Islamic banks engage in recruiting liberal scholars to attain permissibility of action especially when dealing with Islamic transactions or financial contracts. The concern was raised because managers may attempt to dictate to SBs’ decisions and opinions to tie up to their goal and objectives which is referred to by the authors as “Fatwa Shopping”. This could well amount to ‘managerial opportunism’. In an earlier study conducted by Garas (
2012) on the key Islamic financial institutions (IFI) in the GCC countries, the researchers identified conflicts of interest in SBs and six specific independent variables: the SB executive position, SB remuneration, the relation between the SB members and board of directors (BOD) and the multiple memberships in Islamic funds, issuers of bonds and companies trading in capital markets. Garas (
2012) asserts that a significant conflict of interest exists between executives and SB members, the membership in Islamic funds and the relation between the SB and the BOD. Furthermore, the study provides key evidence that the independence of SB should not be compromised if SB members do not hold any managerial position in the IFI and fixes SB remuneration.
Discussion on the governance of SBs was also highlighted recently by researchers such as Mollah and Zaman (
2015) who examined the effect of SBs and corporate governance on the performance of Islamic banks from 25 countries for the period 2005–2011. They claim that SBs provide a positive impact on performance of Islamic banks but there is still much need for further improvement in the effective oversight and monitoring role of SBs. In an earlier study, Alhabshi and Bakar (
2008) conducted a survey to examine the prevalence of SBs of institutions offering Islamic financial services across several jurisdictions. The study highlighted that SBs have inherent deficiencies when fulfilling the religious compliance review role in relation to the development of Islamic financial products. Similar findings were further highlighted in a survey conducted by Hasan (
2011) to examine the current governance practices of IFIs in Malaysia, UK and the GCC countries. The study revealed that SBs have minimum participation in conducting their review task as 58% of the SBs delegated their religious compliance review function to be carried out by the internal religious compliance unit.
Additionally, Rammal and Parker (
2010) conducted interviews to investigate the role of SBs in IFIs in Pakistan and their study highlighted grave concern on the credibility of SBs deliberating on Islamic banking issues and the limited pool of religious knowledge amongst the participants of Islamic banks that would then create a conflict of interest between SBs and management. Interestingly, Hassan (
2012) conducted in-depth interviews with 46 key leaders in the Malaysian Islamic banking industry to identify the role, independence and the effectiveness of the religious compliance review of SBs. The study revealed that under the GPS-1 regime (discussed in the next section), Islamic banking operations in Malaysia experienced weaknesses in the quality of religious assurance provided by SBs as the religious compliance review function of SB was found to be mainly undertaken by internal officers and results presented to SB for approval. Hassan (
2012) reported that SBs issued their religious assurance without proper due diligence as SBs were found to rely heavily on the result performed by internal officers with top management found to be over-ruling decisions of SB. Therefore, the arguments brought forward indicate that the quality of religious assurance could be improved with the adoption of the new 2011 Malaysian SGF framework which places substantial emphasis on the religious audit function to enhance the governance process and ultimately the credibility of SB, this is the subject of the next section.
2.2 Islamic banking in Malaysia
Malaysia is regarded as a leading country for promoting Islamic banking and finance and operates a dual-layer Shariah governance and regulatory framework. At the individual Islamic bank level, the governance of bank operations is supervised by an independent SB whereas supervision at the macro level is undertaken by the Shariah Advisory Council (SAC) of the Central Bank of Malaysia or Bank Negara Malaysia (BNM). It was discussed earlier in Sect.
1 that the governance system of Malaysian Islamic banking has experienced several stages of improvement. In 2005, the BNM, introduced the ‘Guidelines on the Governance of Shariah’ otherwise known as GPS-1. Following GPS-1, central requirements were imposed by the BNM which required Islamic banks to have SBs with a minimum of three members responsible to ensure that the business transactions are religious-compliant. GPS-1 also set the limit on membership of SBs to be not more than one bank with appointment of its members being subject to approval of BNM. To determine the extent of the authority of the central religious body, the SAC was authorised with mandated power on its governance role in the recent amendment to the Central Bank of Malaysia Act 2009 in which the resolutions issued by the SAC are binding on all Malaysian IFIs (BNM
2009). This Act repealed the earlier Central Bank of Malaysia Act 1958 which provided regulations for the licensing of the banking sector.
In 2011, the BNM introduced its SGF aimed to enhance the role of the BODs, SBs and management alike in relation to the governance of Islamic banking operations. Since the implementation of SGF in 2011, the quality of religious assurance provided to the stakeholders by Islamic banks is expected to have been enhanced. This proposition is made on the basis that the new SGF places emphasis on the accountability of key organs of an Islamic bank in undertaking their governance function. The SGF further stipulates the minimum requirement for SB membership to be at least five with most members to have a religious educational background. The SB members are also required to be accountable and responsible for their decisions, views and opinions related to religious matters. In strengthening religious compliance and disclosure, the SGF also recommends for Islamic banks to establish Shariah audit and to develop an effective Shariah audit plan according to their particular business objectives, scope, personnel assignment, sampling, control, policies and procedures. Meanwhile, the management of Islamic banks are expected to provide accurate information about the business transactions and operations to the SBs. The SGF has also outlined the importance of religious compliance and religious research functions aimed at the attainment of a religious compliance-based operation environment in Islamic banks.
Meanwhile, in June 2013, the Islamic Financial Services Act (IFSA) was introduced as an empowering mechanism to support the implementation of religious principles and an operational standard for IFI’s, including penalties in the case of non-compliance. Amongst issues highlighted relate to the appointment and qualifications of SB members and accountability of respected parties on the religious assurance of Islamic banking operations. For example, Section 30 of IFSA highlights the appointment and qualifications of SB members in IFIs. In this regard, under the new Act, banks may apply directly to the BNM on the establishment of their SBs to advise and oversee all operations, activities and affairs of the banks and to ensure that activities comply with Islamic law (BNM
2013, para 30). In relation to qualification of SB members, there is a provision for members to meet all standards and requirements that are specified by BNM and other international regulatory body that has significantly influenced the financial reporting of Malaysian Islamic banks including Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFIs) and Islamic Financial Services Board (IFSB). For example, AAOIFI clearly spell out the role of SB’s as “the governance authority who are entrusted with the duty of directing, reviewing and supervising the activities of the IFIs in order to ensure that they are in compliance with Islamic Shariah rules and principles” (AAOIFI
1997, para 2). In a similar context, the IFSB recommended for the Islamic bank to establish an effective governance mechanism for obtaining and applying rulings from SB as well as on monitoring religious compliance aspects including the ex-ante and ex-post of financial transactions and the operations of Islamic Financial Services (IFSB
2006, para 47). To ensure the effective religious compliance procedure, SBs are required to have sufficient knowledge in Shariah as well as knowledge in law, accounting, economics, finance and audit (AAOIFI
1997, para 7; IFSB
2009, para 30; BNM
2011, p. 10). The mixed knowledge and background of SB members provides an effective SB composition on its commitment to ensure operations of Islamic banks are fully Shariah-compliant. As stated in the IFSA 2013, Islamic banks shall, at all times, ensure that business activities and transactions are religiously compliant. In the event of failure of Islamic banks to comply with the above provisions this shall make SB members liable to imprisonment for a term not exceeding 8 years or to a fine not exceeding twenty-five million ringgits or both (BNM
2013, para 29).
More recently, the Guideline on Financial Reporting for Islamic Banking Institutions have been revised and became effective on 1 January 2014 to better facilitate users of financial statements to evaluate and assess the financial position and performance of Islamic banks. This new guideline, referred to as GP8-i, provide recommendations for the financial statement (i.e., statement of financial position, statement of comprehensive income) of Islamic banks to have separate disclosure and to be prepared in accordance with Malaysian financial reporting standards (MFRS). In meeting the provision of religious compliance stated in the SGF, this GP8-i also requires Islamic banks to disclose the SB report as part of the annual report and signed by not less than two SB members.
2.3 Theoretical framework
As discussed in the introduction, corporate governance for financial institutions such as banks exhibit different features due to the opacity and regulatory nature of the industry (Ciancanelli and Gonzalez
2001; Andres and Vallelado
2008; Wilson et al.
2010; Mollah and Zaman
2015; Mollah et al.
2016). It is therefore important for financial institutions to be well regulated and for effective corporate governance to be implemented as such mechanisms are instrumental in promoting stability of the financial system as well as enhancing social welfare (Grais and Pellegrini
2006b). Similar arguments are deemed relevant when discussing Shariah governance in Islamic banks. Nevertheless, the distinguishing feature and portfolios of Islamic banks requires additional corporate governance mechanisms that ensure adherence to religious principles in their business operations and transactions. Hence, we examine the quality of religious assurance in Islamic banks using agency, stakeholder and legitimacy theoretical foundations.
3 The agency theory is generally defined as the contractual relationship between the shareholder as the principal and the managers as the agent who are given authority to perform services on behalf of the principal (e.g., Jensen and Meckling
1976; Fama and Jensen
1983). However, the agency problem arises due to information asymmetry between shareholders and management (Agrawal and Knoeber
1996; Heath and Norman
2004). In such cases, it would provide management with scope to engage in self-dealing opportunistic behavior at the expense of shareholders (see for example Culpan and Trussel
2005; Djankov et al.
2008; Cline and Williamson
2016).
Conversely, both the stakeholder and legitimacy theories postulate a much broader concept of corporate governance to be applied in organizations. The stakeholder theory provides greater latitude in widening the corporate governance concept as management not only acts in the interest of shareholders but also pursues interests of other stakeholders (Freeman
1994; Berry and Rondinelli
1998; DesJardins and McCall
2004; Letza et al.
2004; Solomon
2007; Collier
2008; Garcia-Torea et al.
2016). Meanwhile, the legitimacy theory can be translated into the way an organization commits itself to adopting corporate social behavior in its governance system to ensure compliance of values and norms of respective societies in which organizations operate (Suchman
1995; O’Donovan
2002; Deegan and Unerman
2006; Golant and Sillince
2007). The above arguments provide a claim that the integrity of the organization would be undermined if business operations are found to have less legitimate social behavior (Dowling and Pfeffer
1975). Interestingly, Deephouse and Carter (
2005) elucidate that organizational legitimacy and organisational reputation are two concepts representing assessments of an organisation by a social system. Legitimacy also has influence on organisational theories such as institutional theory (see Meyer and Rowan
1977), resource dependence theory (Pfeffer and Salancik
1978) and organisational ecology (Carrol and Hannan
1989). However, it was the frequent appearance of this concept which prompted scholars such as Suchman (
1995, p. 571) to observe that legitimacy is “an anchor-point of a vastly expanded theoretical apparatus addressing the normative and cognitive forces that constrain, construct, and empower organisational actors”. Thus, management has gained reputation in formulating various strategies to maintain the legitimacy of business operations leading to an enhancement of confidence in organisational stakeholders (Ashforth and Gibbs
1990; Patten
1992; Suchman
1995; Deegan et al.
2000; Phillips et al.
2004; Khan et al.
2013).
In this paper, we maintain that from an Islamic banking perspective, legitimacy and reputation can be viewed as a concept that is complex and multi-dimensional and is linked to a variety of stakeholders having significance of being the ‘be all and end all’ of an Islamic bank’s survival. This is because without religious or ethical legitimacy, Islamic banks become meaningless as they require societal legitimacy to attract constituent support. Several studies have also highlighted that agency theory when applied in a conventional setting tends to limit the accountability of a bank’s operations to that of investors alone whereas the Islamic perspective broadens this to include moral integrity, an appropriate socio-political environment and religious compliance (Archer et al.
1998; Chapra and Ahmed
2002; Beekun and Badawi
2005; Safieddine
2009; Belal et al.
2015; Ullah et al.
2016; Almutairi and Quttainah
2017). The next section outlines the research methodology used.