Corporate governance, ethics and compliance are three topics of huge importance on their own. This short article treats these topics separately first to discuss how they are interrelated. References are also made to Islamic banking.
Modern corporations, typically listed companies brought to the world a phenomenon of a “divorce” between ownership and control. Although a divorce sounds rather unpleasant, in this context this separation is in fact a requirement for the smooth functioning of a complex organisation. Companies go public in two ways, either government-owned entities are privatised, and investors with surplus capital invest in the entity to become owners. Or, an entrepreneur may take a company through various layers of investments, own sources, angel investors, venture capitalists, and private investments from other large companies, to an IPO.
In either case one or more entities may end up holding a large percentage of the shareholding. In the latter case, often the founding owner of the company may retain a dominant shareholding.
Shareholders enjoy the right to cast a vote, one share and one vote, in nominating directors who subsequently hire a chief executive officer (CEO) to run the company. Companies, or individuals, that own a large share of the rights issue, can nominate a director on the board of directors (BOD), whose role is to protect the investments of the shareholders. In various jurisdictions a shareholding of 5% may allow the right to nominate a director, in others the percentage may be higher or lower. Thus, in this manner, shareholders, that are owners of a company, nominate members to a BOD.
The BOD provides direction to a company, and hires a CEO that acts upon the direction provided by the BOD. A conflict of interest may arise, where a director may make recommendations that are in the interest of those shareholders that nominated the particular director. However, a director has a fiduciary duty to act in the interests of the company at large and not the shareholders that nominated him.
Companies have executive directors (EDs) that play an active role in the functioning of a company, non-executive directors (NEDs) that make up part of BOD but do not have any ancillary role in the functioning of the company, and independent directors. Of late, independent directors have been gaining importance, as they function more as the “moral voice” of a company. Independent directors are nominated by the BOD (which is a bit of a contradiction), and they may be involved in the audit committee, the remuneration committee, and their job is to ensure that the company is following the rules of industry and the government – basically to ensure that the company is playing by the rules. They report to the chairman of the BOD, who along with directors is answerable to shareholders.
In the case of financial intermediation, and especially banking, many critics have commented that depositors, being the major capital providers should also enjoy representation on the BOD. This means that customers, especially those that place a considerable amount of funds with a bank should have the right to nominate someone on the BOD who can protect their interests and keep them informed of the bank’s operations and internal functioning.
In the context of Islamic banking and finance, the Islamic Financial Services Act 2014 in Malaysia recommends the appointment and nomination of an independent director to ensure segregation of mudaraba funds placed in an Islamic bank. Another issue for Islamic banks is the role of Shari’a committee. Certain commentators feel that an Islamic bank’s Shari’a advisor should have the status of an independent director, thus allowing oversight of all functions of a bank beyond just product development.
Modern corporate governance structures however have revealed a fundamental fault related with responsibility and accountability. Under pressure from shareholders to generate profits, directors may pass the pressure on to management to mis-sell products, not fully disclose losses, or engage in activities, which would not be in line with the culture of the company or even the law. In such environments, it may well be difficult to place the blame on any individual in the case of wrongdoing. Various scandals have hit the banking industry over the past few years since the subprime mortgage crises. The LIBOR rigging scandal haunted the career aspirations of Bob Diamond, the American CEO of Barclays. With all the court hearings, and legal investigations involved, one of the major problems was finding someone to pin the blame on. According to Bob Diamond, the blame could have been shared even with the Bank of England right down to those individuals that misreported the rates at which they were borrowing money from the interbank market.
Silos are another management structure introduced to the banking industry, which divides up roles in such a manner that no one individual may have the complete visibility over a product, from how the product behaves on the balance sheet to how it is sold to customers. This structure is another mechanism that shields the bank from taking responsibility for any wrongdoing and allowing accountability to dilute within different departments of banks.
“Different countries adopt various corporate governance structures, certain companies, have two boards, others rely on just one, but the main purpose of the board is to protect the interests of the company and its shareholders.”
However, ultimately, the BOD is the thinking mind of the legal entity known as a company and bears the responsibility for the actions of the management. This accountability is not limited to shareholders but regulators as well as customers and other stakeholders.
We conclude this discussion by adding one final point: companies enjoy legal and economic existence. Companies too become shareholders in other companies and nominate a director on the BOD of another entity. In fact this allows shareholders to leverage their influence over other companies. For instance, XYZ family has 51% shareholding in Company A and nominates 50% of the directors and thus have control over the management of the company. Company A, buys 5% shareholding in Company B. This allows, Company A to place a director in Company B. XYZ family with 51% shareholding in Company A, now also enjoys some control over Company B.
Different countries adopt various corporate governance structures, certain companies, have two boards, others rely on just one, but the main purpose of the board is to protect the interests of the company and its shareholders.
Ethics is a subject that is as distant from the world of financial services as the sun from the earth. The Global Financial Crises (GFC) – which is now being called the Great American Recession – revealed the lack of ethics in the financial services industry in the world’s largest markets. Whether it was the fraudulent mortgage activities of real estate brokers, casual ratings offered by the ratings agencies to financial products backed by these mortgages, the deliberate oversight by regulators, the LIBOR rigging scandal which involved Barclays, or the many other scandals involving compliance fraud, and opening accounts of sanctioned individuals, financial institutions have revealed over the past 10 years a complete lack of integrity and credibility. Banks, at one time, enjoyed the credibility of churches in the developed world; bankers were trusted. Ratings agencies enjoyed the credibility of priests and investors trusted the products rolled out by financial institutions in the manner that crowds trusted a sermon. What is amazing is that in the post-GFC world, the financial universe is still dominated by the same institutions that were part and parcel of the crises. Banks like Citibank, Goldman Sachs, HSBC, Barclays, UBS, Merrill Lynch, and others that defrauded the public, still enjoy the credibility of the public. Citizen’s money that is channelled through forced savings plans, pension funds, is still being invested in the very same mortgage-backed securities, which now have a new name, “bespoke tranche opportunity”.
“Banks, at one time, enjoyed the credibility of churches in the developed world; bankers were trusted. Ratings agencies enjoyed the credibility of priests and investors trusted the products rolled out by financial institutions in the manner that crowds trusted a sermon.”
The financial system of the developed countries is so heavily leveraged that the key players know the markets cannot be called. For instance, gold futures contracts are being traded on the London Metal Exchange, in notional values, which far exceed the actual values of gold available for investment or other uses. In this universe of paper assets, intelligent people realise that this allows them room to sell financial products that have opaque pay-outs, vague regulatory environments, and a chance to speculate in such a manner that the upside is rewarded with bonuses and the downside is rewarded by a bailout. In 2004 the financial markets were primed for ethics breaches. Ethics violations occur in environments of severe information asymmetry. Products like MBS, CDOs, CDO^2 and ABS etc. created this information asymmetry not only because no one knew what quality of mortgages backed the bonds issued against them. No one even bothered to check. If the ratings agencies said they were AAA grade, then they must be AAA. Anyone with an ounce of common sense would wonder again and again, how $11 trillion of mortgages could all have ratings between A and C. It is as if everyone in the US was a doctor or a nurse with secure lifetime earnings.
However, what the financial crises exposed in the global financial system was a complete lack of ethics and a sense of responsibility not only exhibited by those who sold such products, those who rated them, regulated them and those who callously bought these products with their customers’ money.
The saddest thing however is that while key players in the Islamic finance space claimed to offer an alternative to the leveraged, debt-based model offered by conventional finance, issuers of sukuk went running to the same investment banks involved in the scandals for running their books, finding investors for their somewhat opaque instruments, and to the very same companies to rate these issues. Asset-backed sukuk and asset-based sukuk create an environment of uncertainty that definitely speaks loudly of information asymmetry, and lack of certainty when it comes to rights of investors in the event of default.
Nevertheless, a system of credit, which is what the modern financial system is based upon, demands and requires, above all, credibility. It seems that financial institutions that built up customer confidence over the years, took advantage of this trust to sell the same clients junk, in no polite terms. Ethical finance seems like an oxymoron in todays day and age, and it seems that the emergence of FinTech companies may be the signs of people looking for alternatives to keeping money in the banks.
Many industry observers have started proposing an ethics filter in the process of Shari’a screening, which is also lacking in sufficient moral fibre. A company is like a citizen, and like a citizen can act ethically or unethically. Companies may violate labour laws, hire underage labourers, violate rules of safety and security (especially mining companies), expose workers to unsafe working environments (Samsung asbestos scandal), and so on. Although much of the internal information of the working of a company is unknown to investors, ethical investors should make extra efforts to know more about the companies they invest in.
Nevertheless, an ethical fabric is required to keep any complex society to function. A lack of ethics in transactions enhances counter-party risk and performance risk, which cannot always be priced into a product. Credit risk is based upon the willingness and ability of a counterparty to pay. Although the ability to pay back can be calibrated and the risks associated can be priced, but willingness to repay or perform cannot be priced accurately.
Financial institutions play an integral role in modern society, they can help organisations and individuals raise money and to hide it. Money earned through illegitimate means needs legitimate channels to hide its trace. As bankers often attend trainings in anti-money laundering, anti-terrorism financing, due diligence workshops, rating of clients and the like. This subject may here be discussed from the perspective of industry practice and concerns.
In an ethical world, most citizens would earn their wealth through legitimate means, pay the required taxes on earnings and so on. In the real world this is not entirely the case. Individuals and corporations attempt to conceal legitimate earnings from regulators to save on taxes, or earn money through illegitimate means, which needs to be “laundered” into the fabric of the financial system. For instance, a drug peddler amasses a great fortune from illegal activity – cash that cannot be kept at home. Often a drug dealer would have earnings incommensurate with the earnings linked to his or her levels of skill or existing legitimate commercial activity. Were such an individual wish to open a bank account, a good officer while conducting due diligence would identify the gaps in the drug dealer’s expected balances and reported earnings. The drug dealer would conceal his or her source of funds but would want to possibly utilise these funds through legitimate channels. Layering is a technique adopted by such individuals where illegitimate earnings are shown instead as legitimate earnings of a cash-intensive business such as a restaurant or retail outlet. In this manner illegal funds find their way into the legal world. It is a bank’s role to curb such behaviour and act as a deterrent to corrupt practices. Sadly, banks have not played such a role and as recent scandals have shown have facilitated the process of helping high-net-worth individuals conceal their wealth from the government and thus caused severe social cost to societies.
In other instances, individuals with limited earnings, but in roles of immense influence in governments have also used banks to place moneys earned from kickbacks, bribes, and so on. Often politicians are classified as politically exposed persons and thus rated high risk when establishing bank accounts for instance. Bank due diligence forms require clients to reveal not just their wealth but their source of wealth and their specific financial behaviour as well. Thus, if a high school teacher with no other documented source of wealth opens a bank account with say a $1,000,000, red flags should pop up. Or, if a restaurant with monthly deposits of just $20,000 begins to deposit $45,000 in cash and alters their financial behaviour, a relationship manager would and should be concerned.
In most cases, clients fill out diligence forms that actually enter how many deposits and withdrawals they intend to make in their accounts every month. The source of funds for these accounts had to be disclosed as the purpose of utilising those funds along with (at times) a description of whom the funds are received from and whom they are paid to. A conscientious bank would monitor the flow of funds from its branches for instance.
Once a customer’s financial profile is fed into a banks software, any deviation from expected financial behaviour is picked up by the system and transactions that break from the norm pop up on the screens of the bank’s compliance officers. Compliance officers then in turn seek documented explanations from the relationship managers for the behaviour. Often an account relationship manager would have to then speak to a client to seek justification and at times documentary evidence to support any suspicious transaction.
Compliance from this perspective thus helps curb channelling ill-gotten money into the banking system. Know your customer (KYC) and due diligence are important components of compliance roles.
Shari’a compliance is another issue altogether. Critics of Shari’a-compliant financial products feel that these products are Shari’a-compliant in form only and not in substance. This criticism is valid but needs to be taken with a pinch of salt. Islamic banking was engineered with the purpose of replicating conventional financial products albeit without the element of interest-based lending. Liability products based upon wadi’a (safekeeping) and wakala (agency), certainly fulfil the criteria of Shari’a-compliant products. The concept of mudaraba has not been fully embraced by customers as a pass-through liability product. Products based upon commodity murabaha certainly do not reflect any consistency in substance or form but are accepted in certain jurisdictions. Asset-based products based on ujr, ijara, murabaha and diminishing musharaka incorporate within them the same debt-based approach found in conventional banks but do not breach any Islamic principles. Products based upon wakala, such as letters of credit, and kafala and letters of guarantee, whereas export financing which are based upon bai’ al-dayn are still controversial.
Shari’a audit teams are busy ensuring that financial products are designed, sold and processed in a manner that adheres to the law. However, they are more focused upon form rather than substance.
CONCLUSION:
Corporate governance, ethics and compliance are interrelated concepts. For a company to exist as a moral and conscientious corporate it is essential that they be managed with responsibility, with ethical business practices and in compliance with the rules and regulations of the industry. However, business managers with a short-term approach feel that these very same principles are deterrents to short-term profits. Certainly the behaviour of certain financial institutions over the past 10 years reveals a lack of regard for guidelines laid out by rules of corporate governance, ethics and compliance. It is also evident that a breach of these guidelines creates private benefit at social cost and thus breaches need to be adequately addressed. Corporate profits cannot come at the expense of mis-selling products, violating industry rules, exploitation of natural resources, lack of concern for the environment, lack of concern for labour laws and so on. Thus, a moral sense, developed by a core body of ethics is necessary to keep companies in line. These ethics may well be developed by a worldview offered by a religion, be it Islam, Christianity or any other faith, or by a secular set of laws defined to create social systems that benefit humankind as a whole.
Modern corporations enjoy financial power, political influence, influence over natural resources of nations in a manner unprecedented in human history. Many have balance sheets larger than the GDP of countries they do business in, employ workers in, and buy resources from. This creates ample opportunities for moral hazard. A coal company buying coal from a small nation like Mongolia for instance can exert considerable influence over the state in defining the terms and conditions at which the resources can be extracted for instance. Large corporations are able to fund lobbies to sway legislation in their favour in their home countries and the countries they operate in and a kind of a supra-regulatory body is required to monitor and regulate the behaviour of these large corporations.
Islamic banks are being criticised for not offering a distinctly different economic value than their conventional counterparts. Apart from differences in terms of Shari’a compliance, Islamic banks continue to follow market practices and regulatory restrictions with respect to corporate governance, ethics and compliance. The fast emerging landscape of financial services offers an opportunity to Islamic banks and financial institutions to develop a more comprehensive corporate governance regime, set of ethical values and compliance standards. The multi-million question – Is the industry ready to embark upon it? – remains unanswered, at least to date.
