The Islamic financial system, which had worked effectively for centuries during the heyday of the Muslim civilization, but which had become displaced by the conventional system after the colonization of most Muslim countries, has been having a resurgence over the last two to three decades. A number of Islamic financial institutions have been established around the world and several conventional banks have also opened Islamic windows. These have done fairly well so far and gained international acceptance. They need, nevertheless, to be strengthened further to enable them to continue their rapid expansion and enhance their international acceptance.

This brings into focus the measures that need to be taken to strengthen these institutions. One of these measures is the creation of an enabling environment. Some of the ingredients of such an environment are: proper market discipline in the financial sector, moral integrity on the part of financial institutions as well as users of funds, an appropriate socio-political environment along with the needed shared institutions, and effectively enforced legal and institutional checks. What is also indispensable is improved corporate governance, which has gained prominence over the last two decades even in the conventional financial system. It is, however, of even greater importance in the Islamic system because of the additional risk to which the depositors get exposed as a result of risk-sharing.

This takes the paper into a discussion of some of the most crucial aspects of corporate governance, including its objectives, mechanisms and tools. One of the most important objectives is resolution of the principal/agent conflict of interest with a view to promote the interests of all stakeholders as well as the soundness and stability of the financial system. The most important mechanisms for this purpose are the Board of Directors, Senior Management, shareholders and depositors. The paper discusses the measures that need to be taken to make the Board and the Management more effective and accountable in the performance of their roles and to enable the shareholders and depositors to play a greater role in protecting their own interests. The paper then addresses some of the standard tools that are available for making the Board and the Management more effective and accountable. These include proper internal controls, risk management, transparency, loan accounting and disclosure, Shar?‘ah clearance and audit, external audit, and regulation and supervision. It is necessary to apply all these effectively. This will, however, not help dispense with the need for a serious moral commitment on the part of all operators. Without such a commitment, it will be difficult to have self-enforcement. Market operators will try to find different ways of violating the law without getting detected and punished. This would necessitate a rise in legal checks and controls, the effective enforcement of which would raise transactions costs significantly. What is also needed is the establishment of a number of shared institutions to enable the Islamic system to operate effectively. If these institutions do not get established, even banks with the best corporate governance may not be able to avoid crises.

Since the effective performance of the mechanisms and tools of corporate governance as well as the establishment of shared institutions will take place gradually over a period of time, the Islamic financial system will evolve only gradually. This need for a gradual approach should not, however, be taken as a license for doing nothing to enable the system to expand and improve rapidly to be able to meet successfully the challenges that it faces.

To give a realistic touch to the study, an empirical Survey of regulators, financial institutions and depositors was conducted in the IDB member countries. The sample was, however, relatively small and it would, therefore, be desirable to be careful in drawing conclusions. Nevertheless, the Survey results give a fairly good idea of some major features of Islamic banks. They indicate that Islamic banks operate in an unfriendly environment and some of their difficulties are perhaps the result of this. Since these banks have not yet been able to make a significant headway towards the profit-and-loss sharing (PLS) mode of financing, the regulators do not see any significant difference in the risks involved in Islamic and conventional banking. This has become reflected in the regulatory and supervisory environment. Consequently, there is considerable room for regulatory reform to enable Islamic banking to meet successfully the challenges that lie ahead. The results also indicate that there is need for improvement in the composition of the Board of Directors as well as in Management, legal procedures and protection of the rights of stakeholders other than shareholders, particularly depositors. The Survey of depositors indicates that market discipline does play an important role in disciplining the Management of banks. This could, however, be further strengthened if, as a majority of depositors felt, they had representation on the Board.