384 AN INTRODUCTION TO ISLAMIC FINANCE
conduct thorough monitoring. An institution with adequate resources may
develop processes, systems, and training to undertake effective monitoring.
There is clearly a need for Islamic fi nancial institutions that can offer guar-
antees, enhance liquidity, underwrite insurance against risks, and develop
hedging tools for a fee.
REGULATORY AND GOVERNANCE ISSUES
Several studies have identifi ed weaknesses and vulnerabilities among Islamic
banks in the areas of risk management and governance.^11 Operational risk,
which arises from the failure of systems, processes, and procedures, is one
area of concern. Weak internal control processes may present operational
risks and expose an Islamic bank to potential losses. Governance issues are
equally important for Islamic banks, investors, regulators, and other stake-
holders. As we saw in earlier chapters, the role of Shari’ah boards brings
unique challenges to the governance of Islamic fi nancial institutions. Similarly,
human resource issues, such as the quality of management, technical exper-
tise, and professionalism, are also the subject of considerable debate.
Implementing a risk management framework requires close collabora-
tion between the management of IFIs, regulators and supervisors. At the
institutional level, implementation is the responsibility of management,
which should identify clear objectives and strategies and establish internal
systems for identifying, measuring, monitoring, and managing various risk
exposures. Although the general principles of risk management are the same
for conventional and Islamic fi nancial institutions, there are specifi c chal-
lenges in the management of risk in Islamic fi nancial institutions.
Corporate governance in Islamic fi nance entails implementation of a
rules - based incentive system that preserves social justice and order among all
members of society. Governance processes and structures inside and outside
the fi rm are needed to protect the ethical and pecuniary interests of share-
holders and stakeholders. Iqbal and Mirakhor (2002) present a stakeholder -
centered model of corporate governance based on the principles of Islam and
suggest that an institution operating within an Islamic system is expected to
protect the rights of all stakeholders in the fi rm as well as in the society. At
the operational level, there are serious issues relating to the rights of invest-
ment account holders (IAHs) — that is, the depositors — as their participation
in the governance structure is non - existent. Similarly, Islamic banks main-
tain several reserves to smooth income and to compensate IAHs in times
when actual profi ts are below market expectations. However, there are no
clear rules relating to the governance of such reserves.
Implementation of fi nancial disclosure is another priority. Ideally, juris-
dictions within which Islamic banks operate should implement accounting
and reporting practices in line with accepted international standards. This
could be accomplished by adopting the offi cial AAOIFI standards, using