Finance & Banking


Corporate governance, ethics and
compliance are three topics of huge
importance on their own. This short article treats
these topics separately first to discuss how they
are interrelated. References are also made to
Islamic banking.

Modern corporations, typically listed companies
brought to the world a phenomenon of a “divorce”
between ownership and control. Although a divorce
sounds rather unpleasant, in this context this
separation is in fact a requirement for the smooth
functioning of a complex organisation. Companies
go public in two ways, either government owned
entities are privatised, and investors with surplus
capital invest in the entity to become owners. Or,
an entrepreneur may take a company through
various layers of investments, own sources,
angel investors, venture capitalists, and private
investments from other large companies, to an IPO.

In either case one or more entities may end up
holding a large percentage of the shareholding. In
the latter case, often the founding owner of the
company may retain a dominant shareholding.

Shareholders enjoy the right to cast a vote, one
share and one vote, in nominating directors who
subsequently hire a chief executive officer (CEO)
to run the company. Companies, or individuals,
that own a large share of the rights issue, can
nominate a director on the board of directors
(BOD), whose role is to protect the investments
of the shareholders. In various jurisdictions a
shareholding of 5% may allow the right to nominate
a director, in others the percentage may be higher
or lower. Thus, in this manner, shareholders, that
are owners of a company, nominate members to
a BOD.

The BOD provides direction to a company, and
hires a CEO that acts upon the direction provided
by the BOD. A conflict of interest may arise,
where a director may make recommendations
that are in the interest of those shareholders that
nominated the particular director. However, a
director has a fiduciary duty to act in the interests
of the company at large and not the shareholders
that nominated him.

Companies have executive directors (EDs) that play an active role in the functioning of a company,
non-executive directors (NEDs) that make up part
of BOD but do not have any ancillary role in the
functioning of the company, and independent
directors. Of late, independent directors have
been gaining importance, as they function more
as the “moral voice” of a company. Independent
directors are nominated by the BOD (which is a
bit of a contradiction), and they may be involved in
the audit committee, the remuneration committee,
and their job is to ensure that the company is
following the rules of industry and the government
– basically to ensure that the company is playing
by the rules. They report to the chairman of the
BOD, who along with directors is answerable to

In the case of financial intermediation, and
especially banking, many critics have commented
that depositors, being the major capital providers
should also enjoy representation on the BOD. This
means that customers, especially those that place
a considerable amount of funds with a bank should have the right to nominate someone on the BOD
who can protect their interests and keep them informed of the bank’s operations and internal functioning.

In the context of Islamic banking and finance, the
Islamic Financial Services Act 2014 in Malaysia
recommends appointment and nomination of
an independent director to ensure segregation
of mudaraba funds placed in an Islamic bank.
Another issue for Islamic banks is the role of
Shari’a committee. Certain commentators feel that
an Islamic bank’s Shari’a advisor should have the
status of an independent director, thus allowing
oversight of all functions of a bank beyond just
product development.

Modern corporate governance structures however
have revealed a fundamental fault related with
responsibility and accountability. Under pressure
from shareholders to generate profits, directors
may pass the pressure on to management to missell products, not fully disclose losses, or engage
in activities, which would not be in line with the
culture of the company or even the law. In such
allowing accountability to dilute within different
departments of banks.

However, ultimately, the BOD is the thinking
mind of the legal entity known as a company and
bears the responsibility for the actions of the
management. This accountability is not limited to
shareholders but regulators as well as customers
and other stakeholders.
We conclude this discussion by adding one final point: companies enjoy legal and economic
existence. Companies too become shareholders
in other companies and nominate a director on
the BOD of another entity. In fact this allows
shareholders to leverage their influence over
other companies. For instance, XYZ family has
51% shareholding in Company A and nominates
50% of the directors and thus have control over
the management of the company. Company A,
buys 5% shareholding in Company B. This allows,
Company A to place a director in Company B. XYZ
family with 51% shareholding in Company A, now
also enjoys some control over Company B.

Different countries adopt various corporate
governance structures, certain companies, have
two boards, others rely on just one, but the main
purpose of the board is to protect the interests of
the company and its shareholders.

Ethics is a subject that is as distant from the world
of financial services as the sun from the earth.
The Global Financial Crises (GFC) – which is now being called the Great American Recession –
revealed the lack of ethics in the financial services
industry in the world’s largest markets. Whether
it was the fraudulent mortgage activities of real
estate brokers, casual ratings offered by the ratings agencies to financial products backed by these
mortgages, the deliberate oversight by regulators,
the LIBOR rigging scandal which involved Barclays,
or the many other scandals involving compliance
fraud, and opening accounts of sanctioned
individuals, financial institutions have revealed
over the past 10 years a complete lack of integrity
and credibility. Banks, at one time, enjoyed the
credibility of churches in the developed world;
bankers were trusted. Ratings agencies enjoyed
the credibility of priests and investors trusted the
products rolled out by financial institutions in the
manner that crowds trusted a sermon. What is
amazing is that in the post-GFC world, the financial
universe is still dominated by the same institutions
that were part and parcel of the crises. Banks like
Citibank, Goldman Sachs, HSBC, Barclays, UBS,
Merrill Lynch, and others that defrauded the public,
still enjoy the credibility of the public. Citizen’s
money that is channelled through forced savings
plans, pension funds, is still being invested in the
very same mortgage backed securities, which now
have a new name, “bespoke tranche opportunity”.

The financial system of the developed countries
is so heavily leveraged that the key players know
the markets cannot be called. For instance, gold
futures contracts are being traded on the London
Metal Exchange, in notional values, which far exceed the actual values of gold available for
investment or other uses. In this universe of paper
assets, intelligent people realise that this allows
them room to sell financial products that have
opaque pay-outs, vague regulatory environments,
and a chance to speculate in such a manner that
the upside is rewarded with bonuses and the
downside is rewarded by a bailout. In 2004 the
financial markets were primed for ethics breaches.
Ethics violations occur in environments of severe
information asymmetry. Products like MBS, CDOs,
CDO^2 and ABS etc. created this information
asymmetry not only because no one knew what
quality of mortgages backed the bonds issued
against them. No one even bothered to check. If
the ratings agencies said they were AAA grade,
then they must be AAA. Any one with an ounce
of common sense would wonder again and again,
how $11 trillion of mortgages could all have ratings
between A and C. It is as if everyone in the US was
a doctor or a nurse with secure lifetime earnings.

However, what the financial crises exposed in the
global financial system was a complete lack of ethics
and a sense of responsibility not only exhibited by
those who sold such products, those who rated
them, regulated them and those who callously
bought these products with their customers’ money.

The saddest thing however is that while key players
in the Islamic finance space claimed to offer an
alternative to the leveraged, debt based model
offered by conventional finance, issuers of sukuk
went running to the same investment banks involved
in the scandals for running their books, finding
investors for their somewhat opaque instruments,
and to the very same companies to rate these
issues. Asset backed sukuk and asset based sukuk
create an environment of uncertainty that definitely
speaks loudly of information asymmetry, and lack of
certainty when it comes to rights of investors in the
event of default.

Nevertheless, a system of credit, which is what the
modern financial system is based upon, demands and
requires, above all, credibility. It seems that financial
institutions that built up customer confidence over
the years, took advantage of this trust to sell the
same clients junk, in no polite terms. Ethical finance
seems like an oxymoron in todays day and age, and
it seems that the emergence of FinTech companies
may be the signs of people looking for alternatives
to keeping money in the banks.

Many industry observers have started proposing
an ethics filter in the process of Shari’a screening,
which is also lacking in sufficient moral fibre. A
company is like a citizen, and like a citizen can act
ethically or unethically. Companies may violate
labour laws, hire underage labourers, violate rules
of safety and security (especially mining companies),
expose workers to unsafe working environments (Samsung asbestos scandal), and so on. Although
much of the internal information of the working of a
company is unknown to investors, ethical investors
should make extra efforts to know more about the
companies they invest in.

Nevertheless, an ethical fabric is required to keep
any complex society to function. A lack of ethics
in transactions enhances counter-party risk and
performance risk, which cannot always be priced into
a product. Credit risk is based upon the willingness
and ability of a counter party to pay. Although the
ability to pay back can be calibrated and the risks
associated can be priced, but willingness to repay or
perform cannot be priced accurately.

Financial institutions play an integral role in modern
society, they can help organisations and individuals
raise money and to hide it. Money earned through
illegitimate means needs legitimate channels to
hide its trace. As bankers often attend trainings in
anti-money laundering, anti-terrorism financing,
due diligence workshops, rating of clients and the
like. This subject may here be discussed from the
perspective of industry practice and concerns.

In an ethical world, most citizens would earn their
wealth through legitimate means, pay the required
taxes on earnings and so on. In the real world this is
not entirely the case. Individuals and corporations
attempt to conceal legitimate earnings from
regulators to save on taxes, or earn money through
illegitimate means, which needs to be “laundered”
into the fabric of the financial system. For instance,
a drug peddler amasses a great fortune from illegal
activity – cash that cannot be kept at home. Often
a drug dealer would have earnings incommensurate
with the earnings linked to his or her levels of skill or
existing legitimate commercial activity. Were such
an individual wish to open a bank account, a good
officer while conducting due diligence would identify
the gaps in the drug dealer’s expected balances
and reported earnings. The drug dealer would
conceal his or her source of funds but would want
to possibly utilise these funds through legitimate
channels. Layering is a technique adopted by such
individuals where illegitimate earnings are shown
instead as legitimate earnings of a cash intensive
business such as a restaurant or retail outlet. In
this manner illegal funds find their way into the legal
world. It is a bank’s role to curb such behaviour and
act as a deterrent to corrupt practices. Sadly, banks
have not played such a role and as recent scandals
have shown have facilitated the process of helping
high net worth individuals conceal their wealth from
the government and thus caused severe social cost to societies.

In other instances, individuals with limited earnings,
but in roles of immense influence in governments
have also used banks to place moneys earned from
kick backs, bribes, and so on. Often politicians are classified as politically exposed persons and thus
rated high risk when establishing bank accounts for
instance. Bank due diligence forms require clients
to reveal not just their wealth but their source
of wealth and their specific financial behaviour
as well. Thus, if a high school teacher with no
other documented source of wealth opens a bank
account with say a $1,000,000, red flags should
pop up. Or, if a restaurant with monthly deposits
of just $20,000 begins to deposit $45,000 in cash
and alters their financial behaviour, a relationship
manager would and should be concerned.

In most cases, clients fill out diligence forms that
actually enter how many deposits and withdrawals
they intend to make in their accounts every month.
The source of funds for these accounts had to be
disclosed as the purpose of utilising those funds
along with (at times) a description of whom the
funds are received from and whom they are paid
to. A conscientious bank would monitor the flow of
funds from its branches for instance.

Once a customer’s financial profile is fed into a
banks software, any deviation from expected
financial behaviour is picked up by the system and
transactions that break from the norm pop up
on the screens of the bank’s compliance officers.
Compliance officers then in turn seek documented
explanations from the relationship managers for
the behaviour. Often an account relationship
manager would have to then speak to a client
to seek justification and at times documentary
evidence to support any suspicious transaction.

Compliance from this perspective thus helps curb
channelling ill-gotten money into the banking
system. Know your customer (KYC) and due
diligence are important components of compliance

Shari’a compliance is another issue altogether.
Critics of Shari’a compliant financial products
feel that these products are Shari’a compliant in
form only and not in substance. This criticism is
valid but needs to be taken with a pinch of salt.
Islamic banking was engineered with the purpose
of replicating conventional financial products albeit
without the element of interest based lending.
Liability products based upon wadi’a (safekeeping)
and wakala (agency), certainly fulfil the criteria
of Shari’a compliant products. The concept of
mudaraba has not been fully embraced by customers
as a pass through liability product. Products
based upon commodity murabaha certainly do
not reflect any consistency in substance or form
but are accepted in certain jurisdictions. Asset
based products based on ujr, ijara, murabaha and
diminishing musharaka incorporate within them the
same debt based approach found in conventional
banks but do not breach any Islamic principles.
Products based upon wakala, such as letters of
credit, and kafala and letters of guarantee, whereas
export financing which are based upon bai’ al-dayn
are still controversial.

Shari’a audit teams are busy ensuring that financial
products are designed, sold and processed in a
manner that adheres to the law. However, they are
more focused upon form rather than substance.

Corporate governance, ethics and compliance are
interrelated concepts. For a company to exist as
a moral and conscientious corporate it is essential
that they be managed with responsibility, with
ethical business practices and in compliance
with the rules and regulations of the industry.
However, business managers with a short-term
approach feel that these very same principles are
deterrents to short term profits. Certainly the
behaviour of certain financial institutions over the
past 10 years reveals a lack of regard for guidelines
laid out by rules of corporate governance, ethics
and compliance. It is also evident that a breach of these guidelines creates private benefit at social
cost and thus breaches need to be adequately
addressed. Corporate profits cannot come at the
expense of mis-selling products, violating industry
rules, exploitation of natural resources, lack of
concern for the environment, lack of concern
for labour laws and so on. Thus, a moral sense,
developed by a core body of ethics is necessary
to keep companies in line. These ethics may well
be developed by a worldview offered by a religion,
be it Islam, Christianity or any other faith, or by a
secular set of laws defined to create social systems
that benefit humankind as a whole.

Modern corporations enjoy financial power,
political influence, influence over natural resources
of nations in a manner unprecedented in human
history. Many have balance sheets larger than
the GDP of countries they do business in, employ
workers in, and buy resources from. This creates
ample opportunities for moral hazard. A coal
company buying coal from a small nation like
Mongolia for instance can exert considerable
influence over the state in defining the terms and
conditions at which the resources can be extracted
for instance. Large corporations are able to fund
lobbies to sway legislation in their favour in their
home countries and the countries they operate in
and a kind of a supra regulatory body is required to
monitor and regulate the behaviour of these large

Islamic banks are being criticised for not offering
a distinctly different economic value than their
conventional counterparts. Apart from differences
in terms of Shari’a compliance, Islamic banks
continue to follow market practices and regulatory
restrictions with respect to corporate governance,
ethics and compliance. The fast emerging landscape
of financial services offers an opportunity to Islamic
banks and financial institutions to develop a more
comprehensive corporate governance regime, set
of ethical values and compliance standards. The
multi-million question – Is the industry ready to
embark upon it? – remains unanswered, at least to date.

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