Corporate Governance 337
institutions. As a result, IAHs do not have any direct means to protect their
rights. Since they do not have any participation in the governance mecha-
nism they are at the mercy of public policymakers, regulators and Shari’ah
boards. A transparent and effi cient governance arrangement should be devised
to include and protect the rights of IAHs.
IFIs as stakeholders By design, a considerable portion of the IFIs’ assets side
could include profi t/loss - sharing instruments, akin to those of mudarabah
and musharakah. Because of the high degree of asymmetry of information
in equity and profi t/loss - sharing contracts, there is greater need for close
monitoring of such investments by IFIs. Therefore, to minimize the cost
of monitoring, there is need for institutional arrangements to facilitate
monitoring and governance of such equity - based investments made by IFIs.
The absence of such a governance mechanism is one of the reasons why
the share of profi t/loss - sharing instruments on the assets side of the IFIs is
currently small.
Furthermore, the presence of profi t/loss - sharing instruments creates a
situation where fi nancial institutions themselves become stakeholders in the
businesses to whom they provide fi nance. This is similar to the “insider”
system of governance as seen in the German model of banking, where bank-
ers may also be represented on the board of directors or may participate in
the management of the business. Although not much attention is paid to this
aspect at present, it does impose an additional governance burden on the
fi nancial institutions.
Governance of reserves Maintaining reserves to smooth income over a
period of time is becoming a common practice. The objective of the profi t
equalization reserve (PER) is to hedge against future losses or low income by
keeping a portion of current profi ts to pay off investment account holders
in the future. While this practice is in alignment with prudent risk manage-
ment, it raises a governance issue that needs attention. Firstly, limited disclo-
sure of such reserves makes investment account holders uneasy because they
have no rights either to infl uence the use of such reserves or to verify the
exposure of overall investments. Someone with long - term investment objec-
tives may welcome this practice, but an investor with a short - term view may
feel that he is subsidizing the returns of the long - term investor. Some banks
(including the Islamic Bank of Britain) require investment account holders
to waive their rights to these reserves.^26
Islamic fi nancial institutions should standardize the practice and
the rights to these reserves should be clearly stated and explained to the
depositors. One suggestion is that deduction from the profi ts belonging to
investment account holders should apply only to long - term depositors, who
are more likely to be exposed to such risk.
The role of Shari’ah boards as stakeholders As we have seen, Shari’ah boards take
on a major responsibility and serve as stakeholders as they are the protectors