324 AN INTRODUCTION TO ISLAMIC FINANCE
liabilities, a legal entity, an economic or social organization, a nexus of con-
tracts, or as a combination of these elements, will infl uence the way in which
the evolution of the concept of corporate governance is analyzed.
Financial institutions have certain features that necessitate that greater
attention be paid to their corporate governance for several reasons. First:
As fi nancial intermediation has become increasingly complex, simple gov-
ernance structures are no longer effective. Financial innovations have intro-
duced complexity and remoteness in governance structure. The resultant
multiple layers of intermediaries and legal entities create ambiguity and con-
fusion in implementing effective governance. Second: Financial fi rms supply
and arrange funding for non - fi nancial fi rms, which may place them in an
advantageous position to exert control over the governance of their clients.
This is particularly problematic when the fi nancial system is dominated by
intermediaries rather than the markets. Third: Financial fi rms are subject to
signifi cant information asymmetries which make it diffi cult to assess their
management performance. Finally, corporate governance has the potential
for free - rider problems. Limitations on takeovers, the concentration of own-
ership, prudential supervision, and investor protection may weaken product -
market discipline and lead to the weakening of incentives for the private
sector to undertake other governance functions.^1
AN ISLAMIC PERSPECTIVE: STAKEHOLDER - ORIENTED
GOVERNANCE
As explained in Chapter 2, the Islamic economic system is a rules - based
incentive system with the ultimate goal of maintaining a just and harmoni-
ous social order. Rules impose restrictions on what the members may do
without upsetting the social order on whose existence all members count
in making their individual choices and actions. Therefore, attachment to
and observance of the established rules guides the members of a society in
their actions. The rules themselves are composed of those which deal with
the individual’s body and his state of consciousness, those which govern his
relationships with others, and those which constitute the code of conduct
necessary for the community as a whole. Rules serve to prevent confl ict, rec-
oncile the different purposes of many individuals and facilitate cooperation
among them. If as a result of growth, a division of labor, or increasing com-
plexities of markets, either the obligations attached to contracts or property
rights are shirked or the rights of the society and the cohesion of the com-
munity are undermined, the legitimate authority is justifi ed in intervening
to take corrective measures.^2 Compliance with the rules promotes social
integration and unity and preserves the intended social order.
The basic agency problem suggests a possible defi nition of corporate
governance as that which constitutes an effi cient monitoring structure solving
the problems of both adverse selection and moral hazard. A corporate gover-
nance structure focused on the investor–manager contract and relationship