How Does Central Bank Deal with Islamic banks?

Muhammad Abubakar Siddique,

Lecturer, Int’l Institute of Islamic Economics (IIIE),

Int’l Islamic University, Islamabad.

Muhammad.abubakar@iiu.edu.pk

Website: http://islamicfina.com/

Oct. 11, 2021

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Video Lecture of This Reading 

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Central Bank’s Requirements from Banks (Conventional and Islamic Banks)

Reserve Requirements: Reserve requirement of banks is to hold liquid assets in the form of cash and, approved securities. SBP requires scheduled banks in Pakistan to maintain two types of reserve requirements, i.e. cash reserve requirement (CRR) and statutory liquidity requirement (SLR).     

1. Cash reserve requirement (CRR): CRR is the 5 % of banks’ applicable time and demand liabilities (TDLs) that they are required to hold in the form of cash with the SBP on fortnightly average basis. CRR is maintained in current account with the condition of maintain minimum reserve level with the central bank on daily basis. Required level of reserves for a bank in a reserve maintenance period are worked out on the basis of applicable TDLs of that bank at the end of the first day (i.e. Friday) of the maintenance period. Banks are not allowed to carry their excess of reserve position over the next maintenance period. Also, SBP does not remunerate deposits that banks keep with it for meeting the cash reserve requirement. 
2. Statutory liquidity requirement (SLR): SLR is the 19% for CBs / 14% for IBs liabilities that they are required to invest in approved securities and/or hold in the form of cash; including balances with SBP, with NBP, balances left in the vault of banks, banks’ investment in capital of Micro-Finance Banks (MFBs).

            Like CRR, maintaining period for SLR is also fortnightly that starts from Friday and ends at Thursday of the subsequent week. Applicable Time and demand liabilities at the end of the Friday (i.e. the first day of the maintaining period) are taken into account for the determination of SLR to be maintained during the maintaining period (if Friday is a holiday then time and demand liabilities as of close of the preceding working day is taken into account for calculating the SLR.)

            Increase in SLR ratio implies that banks are required to hold a larger share of their funds into liquid assets approved/notified by the Federal Government for this purpose. Changes in SLR may change the composition of banks’ assets.

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نیچے دیے گئے لنک پر کلک کریں اور سبسکرائب کریں ۔

اسلامی معلومات ، روایتی معاشیات ، اسلامی معاشیات اور اسلامی بینکاری سے متعلق یو ٹیوب چینل
https://www.youtube.com/user/wasifkhansb?sub_confirmation=1

                    Islam Vs. West: Resources and Desire

Muhammad Abubakar Siddique,

Lecturer, Int’l Institute of Islamic Economics (IIIE),

Int’l Islamic University, Islamabad.

Muhammad.abubakar@iiu.edu.pk

Website: http://islamicfina.com/

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Efficient Use of Resources – PPF Curve 

A production possibility frontier (PPF) shows the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed. Conventional Economics provides general principles about how choices are made in a world of scarcity. It forms the foundation of neo-classical economics, which calls for the efficient allocation of resources into productive activities as scarce resource cannot be used wastefully. There are two important points need to understand the PPF-curve;

1. Any point on the PPF curve shows that resources are being fully and efficiently used in production process and there is no wastage of resources.
2. Any point below the PPF curve shows the inefficient utilization of resources which means some of resources are being wasted.

Area below the PPF curve is Undesirable: What is the Rationale?

Area below the PPF curve is undesirable as per Islamic as well as conventional economics. However, both economic system varies regarding the rationale behind the undesirability of this area.

Demand Oriented Rationale – Conventional Economics

According to conventional economics, scarcity of resources is an economic problem. Hence, resources are very limited to meet the demand which is triggered by desire. Therefore, conventional economists presented the idea of PPF curve which describes the efficient use of resources so that maximum demand (desires) could be met with limited resources. Otherwise, wastage of resources will cause so many economic problems. In short, conventional economics dislikes the area of production below the PPF curve because of demand oriented rationale.

Value Oriented Rationale – Islamic Economics

According Islamic economic system, there is no scarcity of resources. On the contrary, in Islamic economic paradigm, the Holy Quran insisted that Allah S.W.T. has complete earth and heaven with resources that are unlimited as sustenance for His creations seen and unseen includes human, animals, plants, jinn and etcetera.

روى زيد بن أسلم عن أبيه عن عمر بن الخطاب رضي الله عنه ،أن رجلا أتى رسول الله صلى الله عليه وسلم فسأله أن يعطيه ، فقال رسول الله صلى الله عليه وسلم ما عندي شيء ، ولكن ابتع علي فإذا جاء شيء قضينا فقال له عمر : هذا أعطيت إذا كان عندك فما كلفك الله ما لا تقدر . فكره رسول الله صلى الله عليه وسلم قول عمر ، فقال رجل من الأنصار : يا رسول الله : أنفق ولا تخش من ذي العرش إقلالا فتبسم رسول الله صلى الله عليه وسلم ، وعرف السرور في وجهه لقول الأنصاري . ثم قال رسول الله صلى الله عليه وسلم : ( بذلك أمرت ) .

A man visited the Holy Prophet (SAWW) and asked him for help. Holy Prophet (SAWW) replied “I don’t have anything, but buy whatever you need on credit, I will pay the debt of it”. Hadrat Omar (RA) said to Him (SAWW): “If you had something, you would give it to him. Allah (SWT) did not cost you what you cannot afford”. The Holy Prophet (SAWW) did not like Omar’s saying, and a man from the Ansar said: ‘O Holy Prophet (SAWW); Spend and do not fear of scarcity from the Allah (SWT).  The Holy Prophet (SAWW) smiled, and the signs of happiness appeared on His face because of the words of the Ansari. He (SAWW), further, said: “This is what I have been commanded”.

(Al-Titmazi. Al-Shama’il. Bab maa jaa fi khulq e Rasul Allah (SAWW), p: 225.)

  قال علماؤنا رحمة الله عليهم : فخوف الإقلال من سوء الظن بالله ; لأن الله تعالى خلق الأرض بما فيها لولد آدم

Our scholars said: The fear of scarcity is due to the mistrust on Allah.  Because Allah Almighty created the earth and what is in it is for the son of Adam.

Islam announces the enrichment of resources along with some controls like dividing the desire into permissible and prohibited desire. In many verses, Allah (SWT) described it. For example, in Surah Al-Hadeed, He (SWT) said:

۞ٱعْلَمُوٓا۟ أَنَّمَا ٱلْحَيَوٰةُ ٱلدُّنْيَا لَعِبٌ وَلَهْوٌ وَزِينَةٌ وَتَفَاخُرٌۢ بَيْنَكُمْ وَتَكَاثُرٌ فِى ٱلْأَمْوَٰلِ وَٱلْأَوْلَـٰدِ ۖ كَمَثَلِ غَيْثٍ أَعْجَبَ ٱلْكُفَّارَ نَبَاتُهُۥ ثُمَّ يَهِيجُ فَتَرَىٰهُ مُصْفَرًّا ثُمَّ يَكُونُ حُطَـٰمًا ۖ وَفِى ٱلْـَٔاخِرَةِ عَذَابٌ شَدِيدٌ وَمَغْفِرَةٌ مِّنَ ٱللَّهِ وَرِضْوَٰنٌ ۚ وَمَا ٱلْحَيَوٰةُ ٱلدُّنْيَآ إِلَّا مَتَـٰعُ ٱلْغُرُورِ۞

Know that this worldly life is no more than play, amusement, luxury, mutual boasting, and competition in wealth and children. This is like rain that causes plants to grow, to the delight of the planters. But later the plants dry up and you see them wither, then they are reduced to chaff. And in the Hereafter there will be either severe punishment or forgiveness and pleasure of Allah, whereas the life of this world is no more than the delusion of enjoyment. (Al-Hadeed, 57: 20)

In Surah Al e Imran, Allah (SWT) said:

۞زُيِّنَ لِلنَّاسِ حُبُّ ٱلشَّهَوَٰتِ مِنَ ٱلنِّسَآءِ وَٱلْبَنِينَ وَٱلْقَنَـٰطِيرِ ٱلْمُقَنطَرَةِ مِنَ ٱلذَّهَبِ وَٱلْفِضَّةِ وَٱلْخَيْلِ ٱلْمُسَوَّمَةِ وَٱلْأَنْعَـٰمِ وَٱلْحَرْثِ ۗ ذَٰلِكَ مَتَـٰعُ ٱلْحَيَوٰةِ ٱلدُّنْيَا ۖ وَٱللَّهُ عِندَهُۥ حُسْنُ ٱلْمَـَٔابِ۞

The enjoyment of ˹worldly˺ desires—women, children, treasures of gold and silver, fine horses, cattle, and fertile land—has been made appealing to people. These are the pleasures of this worldly life, but with Allah is the finest destination. (Al Imran, 3: 14)

Same message has been conveyed in surah Al-Naazi’aat:

۞وَأَمَّا مَنْ خَافَ مَقَامَ رَبِّهِۦ وَنَهَى ٱلنَّفْسَ عَنِ ٱلْهَوَىٰ۞  فَإِنَّ ٱلْجَنَّةَ هِىَ ٱلْمَأْوَىٰ ۞

And as for those who were in awe of standing before their Lord and restrained themselves from ˹evil˺ desires. Paradise will certainly be ˹their˺ home.

In another surah, He (SWT) said:

۞أَرَءَيْتَ مَنِ ٱتَّخَذَ إِلَـٰهَهُۥ هَوَىٰهُ أَفَأَنتَ تَكُونُ عَلَيْهِ وَكِيلًا۞

Have you seen ˹O Prophet˺ the one who has taken their own desires as their god? Will you then be a keeper over them? (Al-Furqan, 25:43)

All these verses demonstrates that Allah (SWT) prohibited many of desires which cannot be desired by mankind. However, it is also extracted from these verses that there are also permissible desires.

وعن أبي جحيفة وهب بن عبد الله رضي الله عنه قال‏:‏ آخى النبي صلى الله عليه وسلم بين سلمان وأبى الدرداء ، فزار سلمان أبا الدرداء، فرأى أم الدرداء متبذلة فقال‏:‏ ما شأنك قالت‏:‏ أخوك أبو الدرداء ليس له حاجة في الدنيا، فجاء أبو الدراداء فصنع له طعاماً، فقال له‏:‏ كل فإنى صائم، قال‏:‏ ما أنا بآكل حتى تأكل، فأكل، فلما كان الليل ذهب أبو الدرداء يقوم فقال له‏:‏ نم، فنام، ثم ذهب يقوم فقال له ‏:‏ نم، فلما كان من آخر الليل قال سلمان‏:‏ قم الآن‏:‏ فصليا جميعاً، فقال له سلمان‏:‏ إن لربك عليك حقاً، وإن لنفسك عليك حقاً، ولأهلك عليك حقاً، فأعط كل ذى حق حقه، فأتى النبي صلى الله عليه وسلم فذكر ذلك له، فقال النبي صلى الله عليه وسلم ‏ “‏صدق سلمان‏”‏ ‏(‏‏(‏رواه البخاري‏)‏‏)‏‏.‏

Abu Juhaifah (May Allah be pleased with him) reported: The Prophet (ﷺ) made a bond of brotherhood between Salman and Abud-Darda’. Salman paid a visit to Abud-Darda’ and found Umm Darda’ (his wife) dressed in shabby clothes and asked her why she was in that state. She replied: “Your brother Abud-Darda’ is not interested in (the luxuries of) this world. In the meantime Abud-Darda’ came in and prepared a meal for Salman. Salman requested Abud-Darda’ to eat (with him) but Abud-Darda’ said: “I am fasting.” Salman said: “I am not going to eat unless you eat.” So, Abud-Darda’ ate (with Salman). When it was night and (a part of the night passed), Abud-Darda’ got up (to offer the night prayer) but Salman asked him to sleep and Abud-Darda’ slept. After some time Abud-Darda’ again got up but Salman asked him to sleep. When it was the last hours of the night, Salman asked him to get up and both of them offered (Tahajjud) prayer. Then Salman told Abud-Darda’: “You owe a duty to your Rubb, you owe a duty to your body; you owe a duty to your family; so you should give to everyone his due. Abud-Darda’ came to the Prophet (ﷺ) and reported the whole story. Prophet (ﷺ) said, “Salman is right”.

These text from Quran and Sunnah reveals where Islam announces enrichment of the resources, it also protect them through the strong controls of prohibition and permission of desires.

Secondly, Islam protects the resources by preventing their wastage. In Islamic paradigm, mankind is vicegerent of Allah (SWT) on the earth. He is not owner but trusty of Allah (SWT). Hence, it is obligatory upon mankind to utilize the resources in capacity of trusty who is not allowed to waste the trust. As the Holy prophet (SAWW) said:

عَنِ ابْنِ عُمَرَ رَضِيَ اللَّهُ عَنْهُمَا عَنِ النَّبِيِّ صلی اللہ علیہ وسلم أَنَّهُ قَالَ أَلاَ كُلُّكُمْ رَاعٍ وَ كُلُّكُمْ مَسْئُولٌ عَنْ رَعِيَّتِهِ فَالأَمِيرُ الَّذِي عَلَى النَّاسِ رَاعٍ وَ هُوَ مَسْئُولٌ عَنْ رَعِيَّتِهِ وَالرَّجُلُ رَاعٍ عَلَى أَهْلِ بَيْتِهِ وَ هُوَ مَسْئُولٌ عَنْهُمْ وَالْمَرْأَةُ رَاعِيَةٌ عَلَى بَيْتِ بَعْلِهَا وَ وَلَدِهِ وَ هِيَ مَسْئُولَةٌ عَنْهُمْ وَالْعَبْدُ رَاعٍ عَلَى مَالِ سَيِّدِهِ وَ هُوَ مَسْئُولٌ عَنْهُ أَلا فَكُلُّكُمْ رَاعٍ وَ كُلُّكُمْ مَسْئُولٌ عَنْ رَعِيَّتِهِ۔ (صحیح مسلم کتاب الامارہ، بَابٌ : كُلُّكُمْ رَاعٍ وَ كُلُّكُمْ مَسْؤُوْلٌ عَنْ رَّعِيَّتِهِ)

It has been narrated on the authority of Ibn ‘Umar that the Holy Prophet (May be upon him) said: Beware, every one of you is a shepherd and everyone is answerable with regard to his flock. The Caliph is a shepherd over the people and shall be questioned about his subjects (as to how he conducted their affairs). A man is a guardian over the members of his family and shall be questioned about them (as to how he looked after their physical and moral well-being). A woman is a guardian over the household of her husband and his children and shall be questioned about them (as to how she managed the household and brought up the children). A slave is a guardian over the property of his master and shall be questioned about it (as to how he safeguarded his trust). Beware, every one of you is a guardian and every one of you shall be questioned with regard to his trust.

(Sahih Muslim, KITAB AL-IMARA)

In holy Quran, Allah the Almighty has said:

۞ يَـٰبَنِىٓ ءَادَمَ خُذُوا۟ زِينَتَكُمْ عِندَ كُلِّ مَسْجِدٍ وَكُلُوا۟ وَٱشْرَبُوا۟ وَلَا تُسْرِفُوٓا۟ ۚ إِنَّهُۥ لَا يُحِبُّ ٱلْمُسْرِفِينَ ۞

‘O Children of Adam! Dress properly whenever you are at worship. Eat and drink, but do not waste. Surely He does not like the wasteful. (Al-Araf, 7:31)

These words of Allah the Almighty are describing that wastage of resources are not allowed. With this prohibition, Allah (SWT) also announces that He (SWT) would increase the resources, if one will be grateful to Him for His blessings (resources) as He (SWT) said:

۞وَإِذْ تَأَذَّنَ رَبُّكُمْ لَئِن شَكَرْتُمْ لَأَزِيدَنَّكُمْ ۖ وَلَئِن كَفَرْتُمْ إِنَّ عَذَابِى لَشَدِيدٌ۞

And ˹remember˺ when your Lord proclaimed, ‘If you are grateful, I will certainly give you more. But if you are ungrateful, surely My punishment is severe. (Surah Ibrahim, 14: 7)

Summary:

• Given the scarcity of resources, Conventional economics emphasize the efficient utilization of resources to meet the demand triggered by the desire (lawful and unlawful). It can be said that objective of the efficient utilization of resources is to meet the desires (lawful and unlawful) with limited resources.
• Given the enrichment of resources, Islamic economic system make efficient utilization of resources mandatory so that one can be protected from the painful punishment on the Day of Judgment, when one is inquired about the utilization of resources. It can be concluded that objective of the efficient utilization of resources is to obtain the will of Allah the Almighty which obviously constitute the fulfilment of permissible desire based demand as well as the reward of heaven in the day of judgment.

Wastage of resources and Risk Management

Risk management is closely related to effective and efficient deployment of resources in meeting with a bank’s corporate objectives. Inefficiency in resource utilization at any stage and on any side will expose the banks to various risks.

Various researchers have revealed that US subprime crises of 2007-08 and the Eurozone debt crises 2010-12 emerged because of many types of inefficiencies at various levels. These big crises have demonstrated that a robust risk management framework is needed to address the problems of banking firms and their risk-taking behavior in the handling of public monies. While risk is inherent in all businesses, managing risks effectively management of risk is a core competency within a bank. The legal maxim, “with profit comes risk” (al-ghonm bil ghurm) confirms that a business cannot expect to  make  profit without assuming  potential  loss or  risk;  it does  not  mean simply  letting  its fingers get burnt in the taking of risk. An Islamic bank relies on risk management disciplines to efficiently manage its risks including credit risk, market risk, liquidity risk, operational and Shariah non-compliance risk. As to the unknown outcome of business, one leaves it to the Will of God Almighty alone. The Quran says:

۞وَيُنَزِّلُ ٱلْغَيْثَ وَيَعْلَمُ مَا فِى ٱلْأَرْحَامِ ۖ وَمَا تَدْرِى نَفْسٌۭ مَّاذَا تَكْسِبُ غَدًۭا ۖ وَمَا تَدْرِى نَفْسٌۢ بِأَىِّ أَرْضٍۢ تَمُوتُ ۚ إِنَّ ٱللَّهَ عَلِيمٌ خَبِيرٌۢ۞

“It is He Who sends down the rain, and He Who knows what is in the wombs. Nor does anyone know what it is he will earn tomorrow; nor does anyone know in what land he is to die. Verily with God is full knowledge and He is acquitted with all things”. (Luqman: 34)

                            Corporate Governance

Compiled and Edited by

Muhammad Abubakar Siddique,

Lecturer, Int’l Institute of Islamic Economics (IIIE),

Int’l Islamic University, Islamabad.

Muhammad.abubakar@iiu.edu.pk

Website: http://islamicfina.com/

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Corporate governance

Capitalism is thus called because it is a system organized around the production and allocation of capital. The savings of individuals are the basis of all capital. Yet the ways in which economies accumulate and allocate capital are quite different in different countries, and seem closely related to how each country handles corporate governance issues. Corporate governance—that is, decisions about how capital is allocated, both across and within firms—is entrusted to very different sorts of people and constrained by very different institutions.

Corporate governance involves the interests of shareholders, the responsibility of the board of directors, the rights of other stakeholders, and appropriate ethical standards, notably of disclosure and transparency.

Individuals can save by investing in corporate stocks and bonds. Companies they view as good bets can raise huge amounts of money by issuing securities. If investors know what they are doing, capital is allocated to firms that can use it well and is kept away from firms that are likely to waste it. This process underlies shareholder capitalism, as practiced in the United Kingdom and United States. Firms in those countries that can issue stock and bonds to investors acquire funds to build factories, buy machinery, and develop technologies. For investors to trust a company enough to buy its securities, they need reassurance that the company will be run both honestly and cleverly. This is where corporate governance is critical. The corporate governance of large corporations in these countries is entrusted to CEOs and other professional managers. Investors collectively monitor the quality of governance of each listed firm, and its share price reflects their consensus.

Characteristics of Corporate governance

One view of corporate governance is that it is based on a series of underlying characteristics;

1. Fairness

The directors’ deliberations and also the systems and values that underlie the company must be balanced by taking into account everyone who has a legitimate interest in the company, and respecting their rights and views. In many jurisdictions, corporate governance guidelines reinforce legal protection for certain groups, for example minority shareholders. It should mean the company deals even-handedly with others.

2. Transparency

Transparency means open and clear disclosure of relevant information to shareholders and other stakeholders, as well as not concealing information when it may affect decisions. It means open discussions and a default position of information provision rather than concealment.

Circumstances where concealment may be justified include discussions about future strategy (knowledge of which would benefit competitors), confidential issues relating to individuals and discussions leading to an agreed position that is then made public.

3. Innovation

The concept of innovation in the approach to corporate governance recognizes the fact that the needs of businesses and stakeholders can change over time. It also has an impact on how organisations respond to meeting the ‘comply or explain’ requirement contained in various codes of corporate governance that are currently in effect.

4. Skepticism

The UK Corporate Governance Code, under the heading of ‘Leadership’, encourages non-executive directors (NEDs) to adopt an air of skepticism so that they can effectively challenge management decisions in their role of scrutiny. Applying professional skepticism is also an important part of the role of auditors and audit committees.

International Standards on Auditing (ISA) 200 defines professional skepticism as: ‘An attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.’ This does not mean that all management decisions and evidence have to be approached with suspicion or mistrust; but rather that an open and enquiring mind must always be employed. A healthy corporate culture and environment is one that encourages and enables such skepticism to thrive.

5. Independence

Independence is the avoidance of being unduly influenced by vested interests and free from any constraints that would prevent a correct course of action being taken. It is an ability to stand apart from inappropriate influences and be free of managerial capture, to be able to make the correct and uncontaminated decision on a given issue. Independence is a quality that can be possessed by individuals and is an essential component of professionalism and professional behavior.

An important distinction generally with independence is independence of mind and independence of appearance.

• Independence of mind means providing an opinion without being affected by influences compromising judgment.
• Independence of appearance means avoiding situations where an informed third party could reasonably conclude that an individual’s judgment would have been compromised.

Independence is an important concept in relation to directors; in particular, freedom from conflicts of interest. Corporate governance reports have increasingly stressed the importance of independent nonexecutive directors, directors who are not primarily employed by the company and who have very strictly controlled other links with it. They should be in a better position to promote the interests of shareholders and other stakeholders. Freed from pressures that could influence their activities, independent nonexecutive directors should be able to carry out effective monitoring of the company and its management in conjunction with equally independent external auditors on behalf of shareholders.

Non-executive directors’ lack of links and limits on the time that they serve as non-executive directors should promote avoidance of managerial capture – accepting executive managers’ views on trust without analyzing and questioning them.

The independence of external auditors from their clients is also important in corporate governance. As the auditor is acting on behalf of the shareholders and not the client, close friendship with the client may influence the external auditor’s judgment, and mean that the external auditor is not effectively representing the shareholders’ interests. Internal auditors also need to be independent of the colleagues whom they are auditing.

A complication when considering independence is that there are varying degrees of independence, lying between total independence(no knowledge/connection with the other party) and zero independence (inability to take a decision without considering the effect on the other party). In real-life situations the two extremes are unlikely, but in most situations independence should be as near to total independence as possible.

6. Probity/honesty

Hopefully this should be the most self-evident of the principles. It relates to not only telling the truth but also not misleading shareholders and other stakeholders. Lack of probity includes not only obvious examples of dishonesty, such as taking bribes, but also reporting information in a slanted way that is designed to give an unfair impression.

Guidance in the UK charitable sector has defined probity in terms of receipt of gifts or hospitality by trustees. The Code stresses that all gifts should be clearly recorded, and trustees should not accept gifts with a significant monetary value or lavish hospitality. They should certainly not accept gifts or hospitality which may seem likely to influence their decisions.

7. Responsibility

Responsibility means management accepting the credit or blame for governance decisions. It implies clear definition of the roles and responsibilities of the roles of senior management.

8. Accountability

Corporate accountability refers to whether an organization (and its directors) is answerable in some way for the consequences of its actions. Directors being answerable to shareholders have always been an important part of company law, well before the development of the corporate governance codes. For example, companies in many regimes have been required to provide financial information to shareholders on an annual basis and hold annual general meetings.

9. Reputation

Reputation is determined by how others view a person, organisation or profession. Reputation includes a reputation for competence, supplying good quality goods and services in a timely fashion, and also being managed in an orderly way. However, a poor ethical reputation can be as serious for an organisation as a poor reputation for competence.

The consequences of a poor reputation for an organisation can include:

• Suppliers’ and customers’ unwillingness to deal with the organisation for fear of being victims of sharp practice
• Inability to recruit high-quality staff
• Fall in demand because of consumer boycotts
• Increased public relations costs because of adverse stories in the media
• Increased compliance costs because of close attention from regulatory bodies or external auditors
• Loss of market value because of a fall in investor confidence

10. Judgment

Judgement means the board making decisions that enhance the prosperity of the organisation. This means that board members must acquire a broad enough knowledge of the business and its environment to be able to provide meaningful direction to it. This has implications not only for the attention directors have to give to the organization’s affairs, but also on the way the directors are recruited and trained.

11. Integrity

‘Integrity means straightforward dealing and completeness. What is required of financial reporting is that it should be honest and that it should present a balanced picture of the state of the company’s affairs. The integrity of reports depends on the integrity of those who prepare and present them.’  (Cadbury report).

Integrity (means that) holders of public office should not place themselves under any financial or other obligation to outside individuals or organisations that might influence them in the performance of their official duties (UK Nolan Committee Standards on Public Life).

Integrity can be taken as meaning someone of high moral character, who sticks to strict moral or ethical principles no matter the pressure to do otherwise. In working life this means adhering to the highest standards of professionalism and probity. Straightforwardness, fair dealing and honesty in relationships with the different people and constituencies whom you meet are particularly important. Trust is vital in relationships and belief in the integrity of those with whom you are dealing underpins this.

                            Corporations 

Compiled and Edited by

Muhammad Abubakar Siddique,

Lecturer, Int’l Institute of Islamic Economics (IIIE),

Int’l Islamic University, Islamabad.

Muhammad.abubakar@iiu.edu.pk

Website: http://islamicfina.com/

………………………………………………………………………….

Before, we explain the corporate governance and its various characteristics, it would be better to understand first what is corporation?

Corporation

Origin of the Corporation

During the early Middle Age, corporations existed in the form of universities and ecclesiastical orders and were barred from making profits. While some authors believe that the early Middle Ages was the harbinger of the modern corporate form, others argue that since corporations during this period existed only to serve the society and also since economic motive that is so very ingrained in the corporation as we see today was absent, Middle Ages was certainly not the forerunner of today’s corporate form.

Business history studies have been few and far between; that leaves us with scant literature to trace the exact origins of today’s corporations. However, most business historians concur that not until the East India Company received a charter from Queen Elizabeth in 1600 AD to commence its trading business, was the real corporation born.

Prior to the formation of the East India Company, a few enterprising individuals engaged independently in trading. They would buy tea, raw silk and spices from India and sell them at a profit in their home countries. These individual traders owned their ships and deployed them in their trading business. But as business grew bigger and bigger, the need to raise more capital to shore up shipping vessels for transportation grew, necessitating individual traders to come together and form a syndicate. A closer look at the operations of the East India Company suggests that it was truly the predecessor of the modern corporate form.

What is a Corporation?

A corporation is a private legal entity with rights and duties distinct from those of its members. The liability of the members can often be limited should the corporation fail. Nowadays people are familiar with huge private corporations, including Coca-Cola, McDonald’s, and Toyota. However, the rise of the modern corporation was a twentieth-century phenomena.

There are various forms of businesses, but not all forms of business organization are called corporations. Sole proprietorship, partnership, and company are the best known and most widely discussed forms of businesses.

Sole proprietorship

What comes to your mind when you see a beauty parlor, a small-sized eatery, a grocery shop or a medical shop? Most such small business ventures are funded and managed by individuals and hence the term ‘sole proprietorship.’ You will observe that most businesses around you are sole proprietorships. Why? That is mainly because of the ease in obtaining a license and minimum capital requirement to set up such sole proprietorship businesses. All business decisions are subject to the volition of the proprietor. There are no shareholders to convince.

The biggest limitation of such a form of business is that it cannot grow beyond a certain point, unless the owner is enormously wealthy and is desirous of expanding his/her scope of operations.

Partnership

When two or more than two people come together to own and manage a business entity, it is called partnership. Each partner contributes towards the total capital of the business organization. Also, each partner may bring in a unique skill or expertise to the partnership firm.

Unlike sole proprietorships, partnership firms are legal entities. To set up a partnership firm, a partnership deed that details out the capital contributions, shares, rights, duties and obligations of the partners has to be executed. Partners, as specified by the executed deed, reap the rewards of the business and also assume any resultant liabilities. In partnerships, owners share the business’s risks and benefits.

Corporation

Corporation, thus, is a legal entity that is owned and financed by a diverse group of owners known as the shareholders, who enter into a contract with professional managers to run the day-to-day operations of the company. Together they strive to meet the demands of their stakeholders, be it providing products and services to the consuming public, meeting the operational norms set by the government and regulatory bodies, providing employment opportunities or fulfilling social commitments in societies they operate in

Unlike to partnership, a corporation is owned by shareholders. It can be for-profit or nonprofit. For-profit corporations reinvest profits in the business and pay out dividends to shareholders. Partners in a partnership are at risk if something goes wrong with the business, but corporate shareholders are generally protected. Corporations don’t hold individuals (its shareholders) liable for company obligations or business debt. Because the corporation is a separate legal entity, it’s responsible for assuming legal fees and debts. Shareholders’ personal assets remain protected.

Characteristics of a Corporation

There are a number of features that distinguish the corporation from any other form of business. Some of them are

1.Legal Personality:

A corporation has a distinct legal identity. It is recognized by law as a legal entity, separate from its owners/ promoters and other shareholders. It can sue and be sued in its name. Also, it may own property, borrow or lend money, enter into contracts, own assets or incur liabilities and pay taxes.

2. Limited Liability:

A corporation is owned by multiple shareholders and the liability of each shareholder is limited to the amount invested in the corporation by them. Creditors cannot claim from the personal wealth of shareholders. Should there be any liabilities, the shareholders bear no obligation once their portion of the share capital is paid up.

3. Easy Transferability of Ownership:

Do you or your relatives own shares of any public company? Have you ever seen shareholders sell their shares in the stock market? What does this mean? One can transfer one’s share of ownership rights to a buyer who is interested in buying the stock of the company. A corporation has no say in the trading of shares in the stock markets. It cannot restrain a seller from selling nor can it prevent a buyer from becoming a part owner of the corporation. A corporation can only play the role of a record keeper of its owners.

4. Management:

Corporations are characterized by professional managers. In closely held companies, promoters usually double up as managers. In publicly held companies, investors entrust management to professional managers. These professional managers are responsible for running the day-to-day operations of the corporation.

5. Capital Acquisition:

Corporations have the liberty to sell their stocks or bonds in the market to raise additional capital and fund projects that need additional investment. Easy transferability of ownership and limited liability come as a boon to corporations desirous of raising additional capital.

6. Unlimited Life:

Corporations can acquire an immortal status provided they have the charter to conduct business. Death of investors and shareholders does not deter the corporation from continuing its operations. As long as it has the necessary capital to keep itself operational, the corporation lives on. In some cases, despite bankruptcy, corporations live on expecting bail-outs.

7. Multiple Stakeholders:

Corporations live in societies and affect the day-to-day living of a multitude of stakeholders. Managers and employees who serve the corporation, collaboration partners or joint ventures that help it provide its services, suppliers who supply raw materials, customers who buy its products, investors who invest in its shares, creditors who provide debt capital, governments that legislate and facilitate its existence, communities and environment around which it exists and that are affected by its policies—all these are stakeholders of the corporation.

                            What is Governance?

Compiled and Edited by

Muhammad Abubakar Siddique,

Lecturer, Int’l Institute of Islamic Economics (IIIE),

Int’l Islamic University, Islamabad.

Muhammad.abubakar@iiu.edu.pk

Website: http://islamicfina.com/

………………………………………………………………………….

Governance

We live in a heterogeneous society. Not all individuals are alike, nor do they think alike. Had all of us thought or behaved in a similar fashion, there would be no criminals in the society nor would there be any need for law-keepers. Growth in any sphere of life can be achieved only when there are different perspectives amongst the actors involved. Every individual is motivated by his/her own unique need. If every individual had his/her own way, society could witness lawlessness. To control and govern human behavior, certain rules are made mandatory in the society. While it would be convenient to surmise that rules would take care of any potential lawlessness, individuals belie such a hypothesis. To achieve personal gains, individuals can infringe on the general good of the society. Given the heterogeneity in individual perceptions, the available resources could be wasted with each individual trying to assert his/her supremacy over the other by channelizing the resources to his/her personal gain. It is to subordinate such individual interests to the general interest that governance is needed

Corporations, if left uncontrolled, can hold the society to ransom. Remember, corporations have to exhibit their unquestioned loyalty to the shareholders first. Only then are the other stakeholders’ interests considered. Assume that a manufacturing unit in order to save costs has decided not to invest in an effluent treatment plant. Instead it releases its effluents into the local sewage drains or the nearby river. What would happen to the communities living nearby? What would happen to the environment? While the shareholders’ interests are served, the community at large is exploited. It is to control such value expropriation from stakeholders that governance is needed. Even in a case where the corporation is excessively concerned about the stakeholders and not concerned about its investors’ interests, governance is required. The reason being, the value of one entity is being appropriated for the benefit of the others. Governance ensures an optimal and efficient mechanism by which each stakeholder gains optimally in value in such a way that no other stakeholder feels or experiences his/her value expropriation. Governance helps in exercising authority, giving direction and controlling a corporation so that its objective is achieved. Of late there is a growing conviction that governance should not be left to the corporate boards alone. A certain amount of government and public involvement is necessary to drive the governance of corporations. Today, the financial institutions and other market participants along with the regulatory bodies and global legal requirements are exercising enormous influence on the governance systems of corporations.

What is Governance?

Governance has been defined to refer to structures and processes that are designed to ensure accountability, transparency, responsiveness, rule of law, stability, equity and inclusiveness, empowerment, and broad-based participation.

Governance also represents the norms, values and rules of the game through which public affairs are managed in a manner that is transparent, participatory, inclusive and responsive.

Governance therefore can be subtle and may not be easily observable. In a broad sense, governance is about the culture and institutional environment in which citizens and stakeholders interact among themselves and participate in public affairs.

History of governance

The medieval poet Geoffrey Chaucer (c.1343–1400) wrote of ‘the gouernance of hous and lond’ [the governance of house and land]. He was the first to record the word ‘governance’[1] although he was not sure how it should be spelled.[2] At that time, of course, it was a city or state that needed governing. Nevertheless, although the use of the phrase ‘corporate governance’ is recent, the need for governance of trade ventures is ancient. Shakespeare (1564–1616) understood the challenge. Antonio, his Merchant of Venice,[3] agonized as he watched his ships sail out of sight, knowing that his fortune was now in the hands of others.

Whenever a principal relies on agents to look after his interests, governance issues arise. This agency dilemma has long been recognized. Shareholders in a company elect their board directors to look after their interests. Members of professional bodies elect their council. Members of a club appoint their committee. All corporate entities need a governing body nominated and elected in line with that organization’s constitution. These governing bodies have a variety of names. For companies it is usually the board of directors. For other organisations it may be the ‘council’ or the ‘committee’. The Bank of England has a ‘Court’, reflecting its ancient origins. Oxford colleges, with classical simplicity, often call their governing body ‘the governing body’: surprisingly not‘ corpus governate’

Governance focuses on ownership because ownership, and therefore financing, results in businesses being formed and expanded. Different systems of governance are seen as best practice in different countries, as we shall see later in this text. However, much of the governance debate has been seen in the context of the so-called Anglo-Saxon model where ownership and management are separate, and companies can obtain a listing on a stock exchange where their shares are bought and sold.

Governance in companies and non-governmental organizations

Although mostly discussed in relation to large quoted companies, governance is an issue for all corporate bodies, commercial and not for profit, including public sector and non-governmental organizations. There are certain ways in which companies might differ from other types of organization, such as their ownership (principals), their mission, and the legal/regulatory environment within which they operate.

• Public sector organizations are organizations that are controlled by one or more parts of the state. Their functions are often to implement government policy in secretarial or administration areas.
• Some are supervised by government departments (for example hospitals or schools). Others are devolved bodies, such as local authorities, nationalized companies (majority or all of the shares owned by the Government).

These organisations are in the public sector because the control over a particular public service, utility or public good is seen as so important that it cannot be left to the profit-motivated sector, which may for example seek to close socially vital loss-making services, such as bus routes.

Objectives will be determined by the political leaders in line with government policy. They are likely to focus on value for money and service delivery objectives, possibly underpinned by legislation. The level of control may be high, leading to accusations of excess bureaucracy and cost.

In many countries there are thousands of charities and voluntary organisations that exist to fulfil a particular purpose, maybe social, environmental, religious or humanitarian. Funds are raised to support that purpose. Charities are not owned as such, but will be primarily responsible to the donors of funds and the beneficiaries (those who receive money or other aid) out of the charities’ resources. Charities will be subject to their own legal regime that grants privileges (for example tax concessions) but imposes requirements on how funds can be spent and the charities’ assets managed.

[1] Troilus and Criseyde (Troilus and Criseyde is an epic poem by Geoffrey Chaucer)

[2] ‘gouernance’or‘governaunce’

[3] Shakespeare, William (1598)The Merchant of Venice, Act 1 Scene 1‘In sooth, I know not why I am so sad