ANALYSIS OF CORPORATE GOVERNANCE DISCLOSURE

IN ISLAMIC COMMERCIAL BANKS’ ANNUAL REPORTS:

A COMPARATIVE STUDY OF ISLAMIC COMMERCIAL BANKS
IN MALAYSIA AND INDONESIA

Shahul Hameed bin Mohamed Ibrahim1

M.I. Sigit Pramono2

Paper presented at the

Accounting, Commerce and Finance: The Islamic Perspective

Conference, Jakarta, March 29-31, 2005

1
Dr. Shahul Hameed bin Mohamed Ibrahim is Head of Department of Accounting, Kulliyah of Economics and
Management Sciences (KENMS) at the International Islamic University Malaysia (IIUM)
2
M.I. Sigit Pramono is Lecturer at STIE SEBI, Jakarta. He is in the final stages of Master of Science in Accounting
degree program at KENMS-IIUM

1
 ANALYSIS OF CORPORATE GOVERNANCE DISCLOSURE
IN ISLAMIC COMMERCIAL BANKS’ ANNUAL REPORTS:
A COMPARATIVE STUDY OF ISLAMIC COMMERCIAL BANKS
IN MALAYSIA AND INDONESIA
Shahul Hameed bin Mohamed Ibrahim3
M.I. Sigit Pramono4
ABSTRACT
Although, corporate governance has been an element of the business world for a long time,
only in recent years has it become more in the realm public interest since the occurrence of
several corporate scandals involving huge corporations such as Enron, WorldCom, and so
forth. Corporate governance issues have become of great prominence over the last two
decades (Wright, 2002). A review of the literature shows a dearth of studies that
specifically elaborate corporate governance issues in Islamic banks. This study is meant as
a small contribution to overcome the paucity. It is an exploratory study which tries to
examine the extent of disclosure of corporate governance practices in Islamic banks’
annual reports in Malaysia and Indonesia. Through this research, there are three objectives
that are expected to be fulfilled. Firstly, to elaborate the nature and theoretical implications
of good corporate governance in Islamic banks. Secondly, to explore the level of voluntary
corporate governance disclosure practices of Islamic banks in Malaysia and Indonesia
based on the scoring of corporate governance disclosure made in the annual reports. Lastly,
to provide descriptive analysis of the implementation of code of best practices for
corporate governance between Islamic banks in Malaysia and Indonesia. This comparative
study will be discussed within the banking regulations and institutional background of
corporate governance frameworks in each country. We develop two set of corporate
governance scores indices for Islamic banks. The first set will use national codes of
corporate governance in each country. In this approach, each of the Islamic banks’ annual
report will be examined for disclosures of corporate governance practices which are
required by code of each country. On the other hand, the second set of corporate
governance scores, which we consider as a comprehensive benchmark of corporate
governance requirements for Islamic banks are derived from some international standards
and codes such as: Code of Best Practices for Corporate Governance in Islamic Financial
Institutions (Chapra and Ahmed, 2002), The Governance Standard for Islamic Financial
Institution (GSIFI) (AAOIFI, 2002) and recommendations in Enhancing Corporate
Governance for Banking Organisations (Basel Committee on Banking Supervision, 1999).
This study would contribute to present a better understanding of the process and issues of
corporate governance in Islamic banks. It will also contribute to the empirical literature on
corporate governance practices in Islamic banks in Malaysia and Indonesia. In turn, this
will hopefully enable the scholars and the regulators to further develop a model for
effective corporate governance mechanisms for Islamic banks.
Keywords: Corporate governance, Islamic banks, investment account holder, shari’ah
compliance, accounting for Islamic banks, Islamic bank annual reports.

3
Dr. Shahul Hameed bin Mohamed Ibrahim is Head of Department of Accounting, Kulliyah of Economics and
Management Sciences (KENMS) at the International Islamic University Malaysia (IIUM)
4
M.I. Sigit Pramono is Lecturer at STIE SEBI, Jakarta. He is in the final stages of Master of Science in Accounting
degree program at KENMS-IIUM

2
 1.0. INTRODUCTION

Corporate governance issues have become of great prominence over the last two

decades (Wright, 2002). Although, corporate governance has been an element of the

business world for a long time, only in recent years has it become more in the realm public

interest since the occurrence of several corporate scandals involving huge corporations

such as Enron, WorldCom, and so forth.

Recently, since there is a demand to fulfill a high level of corporate

governance practices requirement from business entities, many countries in the world

have drawn up rules and codes of practice to improve governance. (McConomy and Bujaki,

2000; Goodwin and Seow, 2002).

One of the central issues of the corporate governance debate is the effectiveness

of corporate governance in the banking sector. Since the banking system is a critical

element of the economy, the quality of corporate governance of banks has become a crucial

issue and the approach to the regulation and supervision of banks will tend to categorize

banking industry as a highly regulated industry (Basel Committee on Banking Supervision,

1999). Therefore, the implementation of rule and code practices in corporate governance in

banking industry will play an important role in ensuring sound business practices in the

banking industry.

Over the last 25 years, we have witnessed that a large number of Islamic financial

institutions have been set up around the world (Chapra and Ahmed, 2002). According to

Suleiman (2000), there are more than 180 financial institutions world-wide which comply

with Islamic banking and financing principles. These financial institutions have been

developed in more than 45 countries around the world.

3
 Unfortunately, despite the fact that there is much literature on corporate

governance, studies on corporate governance in Islamic banking is scarce. This is because,

the issues of corporate governance in banking, mostly, have been discussed in the context

of conventional banking.

However, corporate governance issues in Islamic banks are quite different

compared to conventional banks. (Algaoud & Lewis, 1999; Suleiman, 2000). Algaoud and

Lewis (1999) underline that Islamic bank’s operation has to comply with shari’ah

principles. Therefore, the shari’ah compliance in Islamic banks will lead to differences in

governance mechanisms in Islamic banks. They argue further that central to the framework

of corporate governance for Islamic banks is the Shari'ah Supervisory Board (SSB) and the

internal controls which support it.

Suleiman (2000) opines that the fundamental departure of corporate governance

issues in Islamic bank is caused by the development and implementation of Islamic

financing modes which must be in line with shari’ah rules. Thus, the Islamic bank’s

activities should be based on the Islamic worldview and must stay within the restrictions of

the shari’ah (Suleiman, 2000).

Although, the literature is lacking, the importance of good corporate governance

practices in Islamic banking circumstance has been recognized by scholars. Chapra and

Ahmed (2002), for example, argue that if an effective corporate governance mechanism is

not in existence in Islamic banks’ operation, it is impossible to strengthen and to enable the

Islamic banks to grow fast and fulfill their functions effectively.

4
 2.0. OBJECTIVE OF THE STUDY

In this regards, the motivation for our study is to analysis the disclosure of

corporate governance practices in Islamic banks’ annual reports in the case of Malaysia and

Indonesia.5

Through this research, there are three objectives that are expected to be fulfilled.

Firstly, to elaborate corporate governance issues in the terms of nature and theoretical

implication of good corporate governance in Islamic banks. This is considered as crucial

because without a proper understanding on the specific characteristic of corporate

governance structure and mechanism in Islamic banks, the performance of corporate

governance practices in this institution can not be measured.

Secondly, to explore the level of voluntary corporate governance disclosure

practices of Islamic banks in Malaysia and Indonesia based on the scoring of corporate

governance disclosure made in the annual report.

Lastly, our third research objective is to provide descriptive information of the

implementation of code of best practices for corporate governance between Islamic banks

in Malaysia and Indonesia. This comparative study will be discussed within the banking

regulations and institutional background of corporate governance frameworks in each

country.

The third section presents the literature reviews of the issue. The fourth section

describes the research methodology of the study. This is followed by the result and

discussion section. Finally, the conclusion is presented in the sixth section.

5
This study will focus only on Islamic commercial banks in Malaysia and Indonesia which are categorized as full-fledged
Islamic banks. We exclude the Islamic banks division/windows in conventional bank in which the circumstances of these
institutions are quite different in terms of corporate governance structure for Islamic banks.

5
 3.0. LITERATURE REVIEW

3.1. Corporate Governance Disclosure

According to Rashid (2000), one of important issues in financial reporting in the

late 1980s and 1990s is the issue of governance and information risk. Hence, companies

around the world are encouraged to disclose more in particular information such as

governance type information (i.e. directors’ remuneration, details of the directors,

ownership of firms’ shares) and risk disclosure (financial and business risks). Basically this

type of disclosure is required by the authoritative body in such country after incorporating

the recommendations in the Code of corporate governance.

It can be recognized that sound governance in the business sector has an important

impact on the quality of financial reporting. (Goodwin and Jean, 2002). Whittington (1993)

hypothesized that there is an inter-dependent role of corporate governance and financial

reporting on the quality of financial reporting. It means that, the failure of corporate

governance may be caused by insufficient financial information, but on the other hand

some problems of financial reporting process may be due to deficiencies of the system of

corporate governance.

On the other hand, Baker and Wallage (2000) conclude that the role of financial

reporting should not be limited only to the needs of investor decision-making, but should

also be viewed in relation to the more general concerns of corporate governance. In

essence, financial reporting will contribute to enhancing the objective of corporate

governance to give equal benefit to all of stakeholders and for society as a whole. This

proposition only could be achieved if we recognized a reciprocal relationship between

corporate governance mechanism and financial reporting. As Baker and Wallage (2000, p.

6
173-174) has mentioned that “an effective system of corporate governance requires an

effective system of financial reporting, and that an effective system of financial reporting

requires a well-ordered system of financial accounting.”

The main aim of the code of corporate governance is to encourage better and

extensive disclosure of information to various stakeholders. This effort should lead a

greater transparency of the company.

Financial statement and annual reports represent a business language that allow

management to communicate the financial condition, the results of operations and other

information to interested parties in any organization (Harahap, 2000). In this context, we

could identify the role of the board in financial reporting under corporate governance since

the board is expected to prepare some form of disclosure to reduce asymmetry information

and solve the agency problem.

Among others, one of the main objectives of good corporate governance is

intended at improving the organization’s management through increasing disclosure quality

of the company. Recently, corporate governance and disclosure quality issues have

generated much interest. Some studies examine the issue of corporate governance

disclosure e.g. Eng and Mak (20003), Carson and Simnett (1998), Bujaki and McConomy’s

(2002), Guay and Ow-Yong (2002), Irwanto (2002) and Haniffa and Cooke (2000).

According to Rashid (2000) the most important aims of disclosure literature is to

look for explanation or to recognize factors which influence reporting decision of the

company. In this regard, he categorizes corporate governance disclosure as one type of

‘specific disclosure analysis’ which could take the form of mandatory, voluntary or

discretionary disclosures.

7
 3.2. Corporate Governance in Islamic Banks

3.2.1. Islamic Worldview and Values: It’s Implication for Socio Economic Norms

Literally, Islam has meaning as “peace” and “submission” to Allah (swt) (Abdul-

Rahman, 2003; Al-Faruqi, 1992). A principal consequence of acceptance of the faith is

that, everything a Muslim does is to be in harmony with God’s wishes in this world. This

attitude is accordance with what Allah (swt) has declared, “I have only created …men that

they may serve me” (al-Qur’an, 51:56).

Chapra (1992, p. 4) defines a worldview (weltanschauung) as “the set of implicit

and explicit assumptions about the beginning of the universe and the nature and purpose of

human life”. Another Islamic scholar, Al-Faruqi (1992), argues that the worldview is the

way in which a person sees and explains the world and his place in it. Therefore, in human

life, the worldview will affect his way of thinking and acting.

Hameed (2003) argues that Islam has dual worldviews, this world and the

hereafter. It means that whatever a person does, in all areas, will affect his prospects in the

hereafter. It is supported by Sardar (1988) as he believes that Islam is an integrative

worldview, which integrates all aspects of reality by providing a moral perspective on

every aspect of human endeavor.

In Islam, the concept of tawhid (unity of God) is central to the Muslims faith (Al-

Faruqi, 1992). In accordance to this fundamental principle, Muslim recognizes some other

principles in the universe should be originated from, i.e.: the unity of creation; the unity of

truth and knowledge; the unity of life and humanity; and the complementary nature of

revelation and reason (Abdul-Rahman, 1998).

8
 Abdul-Rahman (1998) extends the explanation of tawhid concept to the important

concept in Islamic beliefs which is khilafah (vicegerency). According to this concept, Man

is a trustee of Allah (swt) on this earth and required to act as a deputy in dealing with the

universe and its environment and as a guardian of the resources entrusted to him.

Furthermore, the implementation of khilafah concept will be related to the other

basic concept i.e. taklif (accountability) concept. Accountability from Islamic perspective

will imply that Man is accountable for their actions or inactions on the Day of Judgment

(Abdul-Rahman, 1998). Accountability in Islam means that one must accept all the duties

and liabilities as well as the benefits of any ownership or responsibility entrusted unto

them. Allah (swt) said in the al-Qur’an, “Surely Allah takes account of all things” (al-

Qur’an, 4:86).

Moreover, this concept of accountability is related to the concept of amanah

(trust). The concept of amanah, explicitly has been given only to Man (al-Qur’an, 33:72)

as khalifah of Allah (swt) in this earth. This amanah provide restrictions on the use of the

God-given resources to be in line with God’s commands (Al-Faruqi, 1992).

As a comprehensive way of life, Islam attaches a great deal of importance to

economic activities. In economic framework, these basic concepts of Islamic teaching will

lead to the creation of falaah (welfare in the world and in hereafter). In other words, in

achieving the individual and social welfare and public benefit, human beings should attain

a tangible quality with the aim of obtaining God’s pleasure (Siddiqi, 1979).

Based on Islamic teachings, business activities are a part of ibadah (worship and

obedience of Allah), therefore they have to be performed in line with shari’ah Islamiyah

(Maududi, 1988). Whereas, as an Islamic business institution, Islamic banks must conduct

9
their activities and behavior toward their stakeholders in accordance to Islamic values

(Beekun, 1997). However, it does not mean that Islamic banks are prohibited from gaining

profit. On the contrary, it is encouraged in Islam as long as it does not cause the imbalance

of economic society; and is not achieved at the expense of others.

Hameed (2001) and Haniffa (2002) define the Islamic worldview’s implication

for socio-economic norms (see Table 3.1). Thus, all economic activities must be driven by

shari’ah precepts i.e. prohibition of interest, prevent hoarding etc. More over, those

particular activities must present positive influences to the achievement of the prosperity of

the ummah. In conjunction with the later statement, Islam obligates the Muslim to perform

zakah. Zakah is a religious levy on Muslims who hold wealth which attains the zakatable

minimum amount (nishab) to furnish the right of the poor in their wealth. Hence, it is one

of the ways to distribute the wealth to other people rather than just concentrating it on a few

people.

10
 Table 3.1 Comparison of Some Western Economic Norms and
Islamic Economic Norms
Source: Adapted from Hameed (2001) and Haniffa (2002)

Islamic’s Western Islamic Islamic Economic Norms

Concepts Economic Norms Economic Norms Haniffa (2002)
(Capitaslism) Shahul (2001)
Taqwa Secularism Achieve falah Seek barakah
(welfare in (Allah’s blessing)
the world and in
hereafter)
Ibadah • Liberalism and • Prohibition of • Assist in fulfilling obli
freedom interest Allah, society
• Consumerism • Moral filter and individual
concerned
• Halal dealings
Al-adl wal Primacy of • Primacy of • Assist
al-ihsan profit/ wealth justice and social socio-economic
welfare and justice
• Zakat • Zakat
Amanah and • Sanctity of • Property as trust • All wealth belongs to Allah (swt)
Mas’uliyah and ownership is
private property from God
a trustee
• Disposal of • Succession law • Ultimate
property unrestricted fixes share and identity of is
accountability
beneficieries to Allah

Based on Islamic economics norms discussed above, Western corporate

governance may not suitable for Islamic banks. It might be caused by the lack of ethical

dimension and societal concern in its structure and mechanism (Abdul-Rahman, 1998;

Chapra and Ahmed, 2002; Abod, 2002).

Abod (2002) conclude that fundamentally corporate governance is laid on the

moral and ethical dimensions of managing a company’s business. Indeed, corporate

11
governance can not avoid inherently a set of value-loaded mechanisms. In short, he

concludes that:

”The codes of upholding trust, maintaining integrity, exercising transparency and

accountability, prudent management of resources, maximizing returns, caring and

concern of environment are but would remain as mere noble codes if the issues of

man, his values, ethics and moral conduct are not tackled in the first instance” (p.

100).

Chapra and Ahmed (2002) opine that “moral dimension” is indispensable together

with market discipline as control mechanisms to the companies in conduct of their

business. In this sense, it is not sufficient condition to have market mechanism and

invoking the regulatory framework, but higher ethical values should be involved in creating

an effective corporate governance mechanism.

However, to develop a new corporate governance framework based on an Islamic

perspective, we have to infuse the Islamic values of taqwa; ibadah; al-adl wal ihsan; and

amanah and mas’uliyah into those particular corporate governance principles highlighted

by OECD Principles of Corporate Governance (OECD, 1999) i.e.: fairness, transparency,

accountability, and responsibility.

In relation to the transparency principle, transparency in Western corporate

governance mainly concerns the disclosure of information to guide shareholders and

potential investors to make business decisions in line with profit motives oriented (Yaya,

2003). Consequently, the disclosures practiced by the business organizations merely take

into account all information pertaining to the company’s profit and risk pursuits. By

contrast, according to dual worldview principle in Islamic teachings, the disclosure based

12
on transparency principle has to be considered not only the material aspect but also

spiritual aspect (Shahul, 2003).

Thus, from Islamic perspective, corporate reporting has two major objectives to

be achieved (Baydoun and Willet, 1997; Askary and Clarke, 1997). The primary objective

is to disclose compliance with religious requirements. This particular objective requires the

full disclosure of information even though the information reflects the negative acts of the

organisation. Askary and Clarke (1997) concluded that the relevant principles are

repeatedly stated in six verses in al-Qur’an which requires to disclosure of all facts and not

to hide the truth (e.g, al-Qur’an, 2:42).

Gambling and Karim (1991) conclude that since the financial information will be

relevant to Muslim users’ obedience to Allah, in conducting their business, disclosure of

financial information have to be prepared in accordance with Islamic principles. In

addition, Hameed and Yaya (2003) envisage that as one of the Islamic business institution,

Islamic banks are not only obliged to report the information regarding the economic

performance of the Islamic banks but also the information about the banks’ achievements

in fulfilling their Shari’ah compliance and reporting the social and environmental concerns

as a whole of their stakeholders.

In other hand, Maali et. al. (2003) opine that the objectives of social disclosures

of Islamic business organization are: (1) to show compliance with Islamic principles in

conduct of their business; (2) to show how the organization contribute to the Muslim

community; and (3) to assist Muslim to carry out their religious obligation.

One of Islamic obligation in doing business is that, Islam encourages people to

pay zakah and to conduct of fair and honest business dealing while forbidding riba,

13
monopoly, cheating, hoarding, producing unlawful product and the like (Yaya, 2003).

Hence, in an Islamic model of corporate governance, the company should disclose not only

information relating to the company’s profitability as the performance measure and risks

those face to the company, but also the information related with their fulfillment on zakat

payment and any unlawful action they have taken.

The advantages of this disclosure is to care to protect the society from the

destructive action of the corporation and at the same time to encourage corporation to

contribute to their society, at least by fulfilling their zakah obligation, voluntary charity

(sadaqah) and furthermore by their concern and contribution to solve social and

environmental problems raised in the society (Yaya, 2003).

3.2.2. Important Issues in Islamic Bank Corporate Governance

Although, there is much literature on corporate governance, Suleiman (2000) shows

that there is little literature on governance structures in Islamic banking, despite the rapid

growth of Islamic banks for the past three decades and their increasing presence on world

financial markets.

Algaoud and Lewis (1999) argue that governance issues in Islamic banks are quite

different from conventional banks since the unique characteristics inherently attached to the

Islamic banks. They conclude that Islamic bank represents a fundamental departure from

conventional bank, and from the perspective of corporate governance, a number of

interesting features emerges since the operation of Islamic banks must be in line with

Islamic financing modes i.e. equity participation, risk and profit-and-loss sharing

arrangements.

14
 The efforts in establishing good corporate governance in Islamic banks have

become essential on which the future of Islamic banking dependent on. This opinion could

be traced from two sides’ arguments.

Firstly, without an effective corporate governance mechanism, Islamic banks are

unable to be strengthened and it would be difficult to enable them to expand rapidly and

perform their role effectively (Chapra dan Ahmed, 2002).

When we reflect the causes of success and credibility which have been shown by

Islamic financial intermediaries in the golden history of the Muslim classical civilization

namely sarraf, we can conclude that key to the success of institutions are establishing

business environment which have implemented good corporate governance principles such

as: fairness, transparency and accountability (Chapra dan Ahmed, 2002).

Secondly, as financial institutions involve a broad spectrums of stakeholders,

Islamic banks are expected to have a high level of accountability and proper disclosure in

reporting its performance. As a result, the possibility of information asymmetry could be

minimized.

3.2.2.1. Shari’ah Compliance Assurance in Islamic Banks

According to Karim (2002), shari’ah compliance assurance in Islamic banks

operations is the most fundamental corporate governance issue. Meanwhile, shari’ah

compliance commitment for Islamic bank is the core issue related to the objective of

Islamic bank establishment, since motivation of Muslim in developing of Islamic banks

originally is to realize their economic activities according to the tenets of Islam (Ilyas,

2003). In this context, shari’ah compliance will provide a guarantee that Islamic banks is

15
conducting their business free of interest (riba) transactions and ensure that all investment

activities are in line with shari’ah principles.

In this regard, to address shari’ah compliance matters, most all of Islamic banks

have appointed an in-house committee of religious scholars as the Shari’ah Supervisory

Board (SSB) (Karim, 2002). From this point, we have seen that many scholars have placed

the SSB as an important element in corporate governance structure of Islamic banks

(Banaga et. al., 1994, Algaoud and Lewis, 1999; Suleiman, 2002; Chapra and Ahmed,

2002). Algaoud and Lewis (1999) assert that the core element of corporate governance

framework for Islamic banks is the Shari'ah Supervisory Board (SSB) and the internal

controls which support it.

In addition, Algoud and Lewis (1999) opine that SSB has a vital role in the

corporate governance structure for twofold reasons. Firstly, to ensure that the bank’s

operations are in accordance with shari’ah principles and to maintain this compliance at all

level of the bank’s organization. Secondly, the adherence to Islamic principles in

conducting their business will act as a counter to the potential incentive problem and the

agency theory issues in Islamic banks.

At the same time, as Islamic business institutions, Islamic banks in conducting their

business should show a wider concerning of shari’ah compliance together in achieving

business performance. It is interesting here to quote Banaga et. al. (1994, p. 169) asserts

that:

“The main function of an Islamic organization is to develop a collective morality and

spirituality in conjunction with the production of goods and services needed to

sustain growth and advancement of creations of God”.

16
 In the other hand, Banaga et. al. (1994) opined that corporate governance system

for Islamic banks will affect and is affected by the social system embodying corporate

culture and also by the strategic management adapted by the banks to respond to the

changing market and business environments. In this regard, they assert that Islamic banks

management should agree that shari’ah principle is to be an excellent position to build up

a strong corporate culture if they recognize that Islam a complete way of life. In line with

this opinion, Algoud and Lewis (1999) argue that Islamic values as basis of corporate

culture of Islamic banks should reflected in all facets of attitudes in conducting business

relations and corporate building image in Islamic banks.

Therefore, from corporate culture perspective Islamic banks should create a

corporate culture transformation in which Islamic business ethics will be an inherent

characteristic in Islamic bank practices. As has been hypothesized by Janahi (1995) as

quoted in Algoud and Lewis (1999, p. 9) :

‘Islamic banks have a major responsibility to shoulder ... all the staff of such banks
and customers dealing with them must be reformed Islamically and act within the
framework of an Islamic formula, so that any person approaching an Islamic bank
should be given the impression that he is entering a sacred place to perform a
religious ritual, that is the use and employment of capital for what is acceptable
and satisfactory to God, the Almighty.’

We conclude with the issues of shari’ah compliance and Islamic business ethics

should coalesce into what we term as shari’ah governance. This should be a central

measurement in all codes of corporate governance in Islamic banks. We propose a

transformation model of Islamic bank’s corporate governance structure as in Figure 3.1.

17
below. This model shows that, each element in either in the part of corporate governance

mechanism or corporate culture or executive management mechanism will interface with

the shari’ah governance requirement.

Figure 3.1. Shari’ah Governance

Source: Adapted from Banaga et. al. (1994)
and other sources

Corporate culture and

executive management

Internal
Domina- Regulatory
tion System
Coalition

Corpora- External
te cultu- Shari’ah Regulatory
re in Spi-
Governance System
rit of Is-
lam

External Internal
environ- Control Corporate
ment System governance

3.2.2.2. Defining Stakeholders in Islamic Banks

Islamic bank have specificities regarding the key players who are involved in their

business environment. Chapra and Ahmed (2001) described the relationship of these key

players in the corporate governance structure for Islamic banks in Figure 3.2. As shown,

18
 the solid arrows indicate that a structured link exists between the key players, whereas the

dotted arrows indicate that the structured link does not exist.

Figure 3.2. Relationship of Key Players in

Corporate Governance Structure of Islamic Banks
Source: Chapra (2001)

Environment
(Economic system, Laws and regulations, Legal system, Accounting systems, etc.)

Regulators
Supervisors

Financial Institution

Shareholders Deposit insurance

Board of
Directors

External audit Internal audit Shari’ah Depositors

Board

Management
Customers/user Shari’ah audit
of funds
Employees

In discussing some main stakeholders in Islamic bank, firstly, Chapra and Ahmed

(2001) opine that Islamic bank should take into account that the most important stakeholder

for Islamic banks is Islam itself. Thus, Islamic banks actually have greater responsibility to

19
perform well because if the corporate governance mechanism fails in Islamic banks it will

give a negative impact on the image of Islam to the public.

Secondly, Chapra and Ahmed (2001) argue that, in contrast with the conventional

bank’s corporate governance mechanism where in the depositors’ interest does not receive

much attention, Islamic banks’ corporate governance should give emphasis to protect

depositors’ interest in their business. One argument for this is that all type of depositors

(e.g.: demand deposit, investment deposit and investment account holders) in Islamic banks

will have influence in profit and loss performance of the Islamic banks and plays an

important position in Islamic banks’ corporate governance structure. In addition, it is often

that depositors in fact have provided a large portion of fund to the bank rather than the

shareholders. Therefore, the nature of conflict of interest in the bank will raise here not

only between management and shareholder, but also will involve the depositors’ interest as

well.

Ilyas (2004b) propose another argument to provide more attention to protect

depositors’ interest in Islamic bank. According to him, Islamic banks’ depositors are

different to depositors in conventional bank who do not play such important role in the

bank’s corporate governance structure. There are reasons for this conditions which are: (1)

based on interest system and debt mechanism, conventional banks have liabilities to pay

back the depositors’ fund; (2) there are some guaranteed scheme or deposit insurance for

such kind deposit in conventional bank; and (3) as a highly regulated industry there are

some prudential banking regulations from central bank in conventional bank, e.g. capital

adequacy regulations, regulations to avoid an excessive concentration of lending, etc.

20
 Similar to the Chapra and Ahmed’s (2001) model in defining stakeholders in

Islamic banks, Ilyas (2004a) depicts the stakeholders in Islamic banks in the context of

principal and agency relationship as shown in the Figure 3.3.

Figure 3.3. Stakeholders for Islamic Banks in Agency Theory Perspective

Source: Ilyas (2004a)

Agents Management of Islamic banks

Stakeholders Based on:

Government (Law and regulations Law and regulations
for Islamic banks)
Supervisors
Employees Explicit and implicit
Shareholders contract
Principals Depositors
Investment Account Holders
(restricted and unrestricted)
Current Account Holders
The community (ummah) Ethics and moral
obligations

3.2.2.3. The Nature of Profit and Loss Sharing (PLS) System in

Islamic Banks Operation

Islamic bank’s operation has a unique characteristic with regard the system of

saving and financing activities served to their customers. Since Islamic banks do not apply

interest-bearing deposits, as an alternate Islamic banks offer profit and loss sharing (PLS)

for investment accounts, where, investors (depositor) will get return based on the profit/loss

sharing ratio apply to the investment result (Archer and Karim, 1997). For this purpose,

21
Islamic banks usually use mudaraba and musyaraka contracts to the depositors. There are

two two types of mudharaba contract, i.e.: (1) unrestricted investment account (mudharaba

mutlaqa) in which the investors’ fund will be placed to finance the Islamic bank’s general

pool of assets, and (2) restricted investment account (mudharaba muqayyada) while the

investors’ fund will constrained to financing specified projects or assets.

Archer et al (1998) argue that factually mudharaba contract can not be perceived

either as an equity investment or a liability contract for Islamic bank. In contrast to the

equity instrument, Islamic investment accounts are exchangeable at maturity date or at the

willingness of their holders. Different from to debt instruments, Islamic investment

accounts are not liability of the Islamic banks since they share in the profit or bear any

losses incurred in the banks’ investment.

This unique relationship between Islamic banks and depositors will have different

agency problem consequences compared to the conventional circumstances. Archer and

Karim (1997) argue that agency theory is relevant to the Islamic banks through the two

reasons. Firstly, on the liabilities side, the bank has responsibility to the various investment

account holders and the shareholders in order to protect their interest and perform the

bank’s business in a proper manner. Whereas, in the “asset” side, from their financing

activities in a number of Islamic financing modes, the bank will face the problem of

incorrect project reporting by the investee resulting in the bank failing to prepare a fair

financial reporting for the stakeholders. Thus, they conclude that in Islamic banking

context, there is an essential role for accounting standards and for auditing over and above

what is the case for the conventional banks.

22
 Archer et al. (1998) opine that Islamic banks management in the agency theory

relationship will act as an agent for shareholders and depositors as well. In one scenario,

Islamic banks’ management will act as agent for the shareholders, while as a fund manager/

entrepreneur (mudarib) they will act as agent for the investment account holders (IAH). At

the same time, however, Ilyas (2003) assert that mudharaba contract in fact raise the

problem of mudharib and shohibul maal (fund owner) relationship in which Islamic banks

can act in two roles which are as mudarib and as shohibul maal ( fund owner) in their

operation.

Unavoidably, the notion of the PLS system in Islamic banks’ operation which

have discussed above will give rise to the possibility of conflict of interest facing the

Islamic banks’ management, the shareholder and the IAH. Nienheaus (2003) describes the

situation of this particular conflict of interest as shown in Figure 3.4. below.

Figure 3.4. Conflict of Interest Among Shareholders, Management and IAH

Source: Nienheaus (2003)

Profit
sharing Shareholders
ratio
Zero-
sum Corporate
distribu- Body
tive
conflict Systematic
neglect of
Management deposiors’
Employ- interest
ment of Divergent
deposits risk,
maturity, lack of
preference expert
Investment
know-
Account
ledge
Holder (IAH)

23
 3.2.2.4. The Implication of Smoothening of PLS Deposit Returns

Although the Islamic banks by nature have commitment to compensate the IAH

based on PLS ratio, Nienhaus (2003) exposes that factually the Islamic banks practice

smoothening of IAH returns which is approximately in line with the prevailing market rate

(as a benchmark determined by interest rate in the conventional financial system) in order

to stabilize the returns on investment deposit. In periods where the depositors share of

income generated by the investment of the PLS deposits is less than the market rate, the

Islamic banks will top up the depositors’ share of profit allocation to attain competitive rate

of return.

At the first sight, if bank cushion the returns of the depositors, it might be viewed

as just or fair policy and contributes to the Islamic banking development in the public

interest. This practice may be seen as an example of good corporate governance in benefit

of the depositors of Islamic banks. However, in the closer observation, in fact this practice

merely a management decision exclusive of all shareholders’ consent in order to prevent

considerable withdrawals of depositors’ fund from the bank (Nienhaus, 2003).

Karim (2004, p. 10) argues that the pertinent method which Islamic banks use to

smooth the IAH returns is a way in which the shareholders of Islamic banks take advantage

themselves at the expense of IAH using profit equalization reserve (PER) and investment

risk reserve (IRR). In this regard, he defines PER as “an amount set aside from the income

of both IAH and shareholders before the allocation of the bank’s share as a mudarib to

smooth the profit of IAH to match the returns of instruments in the market, thereby

encouraging IAH to retain the funds with the bank to manage them on their behalf”’.

Whereas, IRR means as “an amount set aside from the income of IAH, but not the

24
shareholders, after the allocation of the bank’s share as a mudarib to absorb losses

attributed to investments financed by IAH before the losses affect the equity of IAH.

Shareholders cannot contribute to this reserve because this is considered as indirectly

compensating IAH for losses, which is strictly prohibited by the mudaraba contract”.

Considering that smoothing policy borne by the shareholders’ fund could not be
sustained in the long run, the Islamic banks management propose PER which aimed to
reduce the volatility of IAHs’ returns. Originally, it will equip the Islamic banks
management with “a mechanism to tap this pool of funds to hide their inefficiency or to
mitigate problems of asset-liability management, and to relieve shareholders from the
burden of smoothing the returns of IAH” (Karim, 2004, p. 11).
On the other hand, the implementation of IRR in Islamic banks tends to encourage
the bank management to involve in excessive risk taking because this reserve is financed
only from the funds of IAH and not shareholder. It is obviously that moral hazard takes
place because if the Islamic banks in such financing projects used IAH’ s fund suffer any
loss, it would be absorbed by IRR, but in case of profit obtaining the shareholders would
take as the mudarib share allocation (Karim, 2004).
Nienhaus (2003) hypothesizes some implications of smoothing of PLS deposit
returns in Islamic banks with regard to good Islamic corporate governance. Firstly, these
efforts to stabilize the PLS deposits return will diluting the ideal profit and risk sharing as
Islamic banks should promote this suitable with Islamic business pursuit. Secondly, this
particular policy will emerge an element of ambiguity into the PLS contracts between the
bank and the depositors. In this regard, the ratios of profit and loss sharing allocation
specified in the mudaraba contract will not effectively applied between the bank and the
IAH. Thirdly, special discretion, let say IRR policy, could increase ambiguity and unequal
treatment for the depositors in such cases, for example: certain depositors whose returns are
stabilized by recourse to the reserves participate in earnings which have not fully been
generated by the employment of their own funds solely but to some extent derived from the
employment of PLS funds of other depositors in prior periods when the cushioning reserves
were built up. Thus, this will face shari’ah compliance problem.

25
 3.2.2.5. Depositors’ Representative in the Corporate Governance Structure

Karim (2004) opine that since Islamic banks use mudaraba contract to mobilize

fund from the depositors, it may lead the Islamic banks management to an ethical dilemma

in the term of a conflict of interest between the shareholders and the IAH. In this case, it

seems that IAH would be the party with inferior status compared to the shareholders’

position.

In most governance structures and mechanisms only the shareholders have the

right of appointing, evaluating and replacing the management of the bank as well as

appointing and replacing the bank’s external auditors and SSB (Karim, 2004). In addition,

the IAH also cannot intervene in investment management decision. Although this potential

problem could occur as well for creditors conventional banks, but in this particular case the

debt covenant usually provide triggers of default on which a general meeting of creditors

will need to be convened. In contrast, depositors for Islamic banks have no such authority

to hold general meetings.

Therefore, it is important to elaborate the way used by the depositors in order to

protect their own interest within the terms of the mudaraba contract. Archer et al (1998)
argue that IAH exploit ‘vicarious monitoring’ that means that they relying on shareholders'
monitoring in Islamic banks management.
On the other hand, Ilyas (2004) assert that this particular conflict of interest looks
like the case of investors in collective investment scheme (CIS) in the trust fund industry.
However in this case, unitholders use trust company as their representative to safeguard
their interest.
Moreover, our discussion regarding this specific conflict of interest lead us to

further important issue whether the depositors should have a representative in corporate

governance structure. Some scholars e..g. Archer (2003) have suggested the possibility of

26
the IAH having representatives at BOD or SSB, whereas Nienhaus (2003) propose that

IAH might have representative at BOD in a one-tier structure or Board of Supervisors in a

two-tier structure.

However, Nienhaus (2003) opines that this idea is not easy to be implemented.

Therefore, he opines that the depositors’ representative could be placed by a professional

who could perform supervisory function on behalf of the depositors. But this will require

strong expertise in Islamic bank accounting and management matters which rarely expected

from an average depositor. He suggest that the depositors’ representative can be appointed

from (1) an independent expert or party in Islamic banks which acts as independent body

and (2) a state mandated depositors’ advocate.

3.2.2.6 Empirical Studies Related to the Islamic Banks’ Corporate Governance

Empirical study on corporate governance in Islamic banking is scarce. Some

literatures are categorized as related to this kind of study e.g. Naser and Idris (1997),

Chapra and Ahmed (2002), Maliah and Latiff’s (2003), Maali et al.’s (2003) and Hameed

et al. (2004)

In addition, Accounting and Auditing Organization for Islamic Financial

Institution (AAOIFI), as an Islamic accounting body which was established in 1991,

currently has issued 20 financial accounting standards, 4 auditing standards, 4 governance

standards, 2 code of ethics for accountant, auditor and employee of Islamic financial

institutions and 13 shari’ah standards (AAOIFI, 2002). AAOIFI (2002) has promulgated 4

Governance Standard for Islamic Financial Institution (GSIFI) to enhance the role of SSB

in corporate governance and provide guiding principles to harmonize the SSB’s structure

27
and process. GSIFI No 1 provides guidance on the definition, appointment, composition

and report of the SSB. Whereas, GSIFI No. 2 provides guidance to assist SSB in

performing shari’ah reviews to ensure compliance with Islamic shari’ah rules and

principles. Then, GSIFI No. 3 provides guidance on the internal Shari’ah review in Islamic

bank. While, the purpose of GSIFI No. 4 is to define the role and responsibilities of an

Audit and Governance Committee (AGC) for Islamic financial institutions. This committee

is basically known internationally as an Audit Committee.

Overall, we can conclude that the AAOIFI’s (2002) governance standards in

relating to the corporate governance issue mostly emphasize on the shari’ah compliance

issues and take initiatives in enhancing the role of SSB in this purpose. This governance

standard (GSIFI) can not be separate but has to be implemented together with the auditing

standards (ASIFI) to enabling the external auditor to express an opinion as to whether the

financial statements are prepared, in material respect in accordance with the shari’ah

principles and accounting standards issued by AAOIFI. The issues of profit equalization

reserve (PER) and investment risk reserve (IRR) are addressed by FAS No. 11 on

Provisions and Reserves which is aimed at setting out accounting rules for recognizing,

measuring, presenting and disclosing the provisions which are formed by Islamic banks.

Moreover, Chapra and Ahmed (2002) propose a code of best practices for

corporate governance in IFI which cover broadly the issues of corporate governance

mechanisms, shari’ah compliance, transparency and disclosure and code of ethics.

28
 4.0. RESEASCH METHODOLOGY

4.1. Research Questions

There are two research questions in this study which are related to the objectives

of this study itself. The first research question is related to the second objective which is to

explore the extent of the level of voluntary corporate governance disclosure practices of

Islamic banks in Malaysia and Indonesia based on the scoring of corporate governance

disclosure made in the annual report. Whereas, the second research question is related to

the third objective which is to provide descriptive information of the implementation of

code of best practices for corporate governance between Islamic banks in Malaysia and

Indonesia.

Given that that governance issues in Islamic banking are quite different from

conventional bank (Algaoud and Lewis, 1999 and Suleiman, 2000), we undertake this

research, in order to have a better understanding of nature and theoretical implication of

good corporate governance in Islamic banks.

However, our study will focus in exploring issues in corporate governance

disclosure practices of Islamic banks in Malaysia and Indonesia. In this study, we will

examine the extent of corporate governance disclosure practices of Islamic banks in

Malaysia and Indonesia based on the scoring of corporate governance disclosure made in

the annual reports. The examination of corporate governance disclosure can be an

indication of the quality of corporate governance practices in Islamic banks.

Whereas corporate governance disclosure has some limitation as an assessment of

corporate governance compliance (S&P and CGFRC, 2004), the study of the quality of

corporate governance disclosure in Islamic bank will enable valuable benchmarking and

29
expose some interesting findings that can help the regulatory bodies as well as the

academicians to propose some improvement in this area . Thus, the first research question

of our study is:

“What is the extent of the corporate governance disclosure practices of Islamic banks

in Malaysia and Indonesia based on the scoring of corporate governance disclosure

made in the annual report?”

Obviously that the quality of corporate governance of banks and sound business

practices in the banking industry will depend on the implementation of rule and code of

practices in corporate governance in banking industry. Hence, as an exploratory study, it is

interesting to explore the current corporate governance practices of Islamic banks in

Malaysia and Indonesia based on the corporate governance disclosure made in the annual

report. This elaboration will contribute to provide descriptive information of the

implementation of code of best practices for corporate governance between Islamic banks

in Malaysia and Indonesia.

In this regard, the second research question is:

“What are the current corporate governance practices of Islamic banks in Malaysia

and Indonesia in relation specific governance issues?”

4.2. Sample Selection

The population of Islamic banks for this study is the Islamic commercial banks in

Malaysia and Indonesia which are categorized as full-fledged Islamic banks. The list of

these Islamic banks will be gathered from data published by Bank Negara Malaysia

(Malaysian Central Bank) and Bank Indonesia (Indonesian Central Bank). Based on

30
BNM’s Annual Report 2003 (BNM, 2003), there were two Islamic commercial banks in

Malaysia consist of Bank Islam Malaysia Berhad (BIMB) and Bank Muamalat Malaysia

Berhad (BMMB). Whereas, in Indonesia, based on Islamic Banking Statistic of Bank

Indonesia, at December 2003 (Bank Indonesia, 2003) there are two Islamic commercial

banks in Indonesia, they are PT Bank Muamalat Indonesia Tbk. (BMI) and PT Bank

Syariah Mandiri (BSM).

We exclude the Islamic banks division in conventional bank (known namely as

Unit Usaha Syariah/UUS in Indonesia) and Islamic banks division/window which

established under Bank Negara Malaysia’s scheme known as SPTF or SPI. Our reason

being, the circumstances of these institutions are quite different in the context of corporate

governance structure for Islamic banks (Maali et al., 2003).

4.3. Developing Corporate Governance Disclosure Indices

A disclosure scoring method will be used to measure to what extent the level of

voluntary corporate governance practices of Islamic banks in Malaysia and Indonesia in

their annual reports. Using disclosure indeces is a well-known research method in

voluntary disclosure literature (Maali et al., 2003, Carson and Simnet, 1998). In this regard,

we assume that Islamic banks have incentive to more disclose corporate governance

matters due to transparency concept and Islamic moral accountability to the stakeholders as

a whole. In line with the transparency concept, we argue that if the Islamic banks increase

this particular voluntary disclosure, it will reduce agency cost relation between the

shareholders and the management (Carson and Simnett, 1998). Whereas, Islamic moral

accountability in which inherently exist put place as Islamic banks’ characteristic will

31
encourage the Islamic banks’ management to disclose the corporate governance

information in which it will assist the stakeholders in measuring the Islamic banks’

performance (Maali et al, 2003).

However, our disclosure scoring has some limitations in measuring the level of

corporate governance practices in such Islamic banks due to several reasons. Firstly, our

research mainly use secondary data from annual reports, hence our disclosure index only

measuring as far as the information is disclosed in the annual report only. Secondly, our

disclosure scoring is considered as indirect method to measure the corporate governance

practices in Islamic banks since our focus is on ‘to what extent the Islamic bank disclose’

rather than ‘the level of compliance of Islamic bank’ to the corporate governance practices.

We develop two set of corporate governance scores indices for Islamic banks. The

first set will use national codes of corporate governance in each country. In this approach,

each of the Islamic banks’ annual report will be examined for disclosures of corporate

governance practices which required by code of each country.

In the case of Islamic banks in Malaysia, the corporate governance requirements

are derived from:

• Guidelines on The Specimen Reports and Financial Statements for Licensed

Islamic Banks/GP8i (2004),

• Kuala Lumpur Stock Exchange (KLSE) Listing Requirement (2001)

• Malaysian Code on Corporate Governance/MCCG (2000), and

• Malaysia Accounting Standard Board (MASB) No 8 on Disclosure of Related

Parties

32
Whereas, in Indonesia, the references used to determine corporate governance

requirements:

• Pedoman Good Corporate Governance Perbankan Indonesia/ Indonesia Banking

Sector Code (PGCGPI) (2004),

• Bank Indonesia Circular Letter No.5/21/DPNP on Standard Guidance of Risk

Management in Banks /SGRMB (2003),

• Pernyataan Standar Akuntansi Keuangan/Accounting Standard No. 59 on

Accounting for Shari’ah Banking (PSAK 59) (2002),

• Bank Indonesia Regulation No. 3/22/PBI/2001 on Transparency of Bank’s

Financial Condition/TBFC (2001),

• Indonesia Code for Good Corporate Governance/ICGCG (2000), and

• Pernyataan Standar Akuntansi Keuangan/Accounting Standard No. 7 on Related

Party Transaction (PSAK 7) (1995)

On the other hand, the second set of corporate governance scores, which we consider as

a comprehensive benchmark of corporate governance requirements for Islamic banks

are derived from in addition to relevant elements of the national codes:

• the Statement of Financial Accounting Standard for Islamic Financial Institution

/SFAIFI and the Governance Standard for Islamic Financial Institution/GSIFI

(AAOIFI, 2002),

• Code of Best Practices for Corporate Governance in Islamic Financial

Institutions/CBPCGI (Chapra and Ahmed, 2002),

33
 • Enhancing Corporate Governance for Banking Organizations (Basel Committee

on Banking Supervision, 1999), and

• OECD Principles of Corporate Governance (OECD, 1999), and

• International Accounting Standard/IAS No. 24 on Related Party Disclosure

The first index of our research is for Islamic banks in Malaysia. The main

references from which items are derived are GP8i (2004), KLSE Listing Requirement

(2001) and MCCG (2000). However, this index basically adapted the format and the

framework of narrative statement on corporate governance as recommended in GP8i. As

we see in Table 5.1., this particular index comprise of fourteen (14) sections and forty-nine

(49) items.

The second index of corporate governance disclosure is developed for Islamic

banks in Indonesia. The main references used to derive the items which should be disclosed

in this index are PGCGPI (2004), SGRMB (2003), PSAK 59 (2002) and ICGCG (2000). In

this case, different from the MCGCG (2000), in Indonesia there is no standard or guidance

to present a narrative statement regarding corporate issues in the annual report explicitly

stated in PGCGPI (2004), SGRMB (2003) or ICGCG (2000). Therefore, we follow the

general format of the first index which has been developed for Islamic banks in Malaysia.

However, there is a significant difference regarding corporate governance

structure between Malaysia and Indonesia. In contrast with Malaysia which has one-tier

board (that is the Board of Directors) companies incorporated under the Indonesian

Company Law has two-tier boards which are the Board of Commissioners (Komisaris) who

conduct the supervisory and advisory roles, and the Board of Directors (including

34
management) who act the executive role in the company (Kurniawan and Indriantoro,

2000).

Another important difference between corporate governance practice for Islamic

banks in Malaysia and Indonesia is regarding the accounting standard for Islamic banks. In

2002, Ikatan Akuntan Indonesia (IAI, Indonesian Institute of Accountant) has issued PSAK

No. 59 Accounting for Islamic Bank which was effective for Islamic banks’ financial

statement started 1 January 2003. This particular standard is basically adopted from

AAOIFI’s Statements of Financial Accounting Standards, therefore in term of elements of

financial statements it includes “a statement of changes restricted investment fund’, “a

statements of sources and uses of funds in the Zakah and charity Zakah fund” and “a

statement of sources and uses of funds in the Qard fund” in Islamic banks’ financial

statements. We consider these two types of elements of financial statements are important

items in Islamic banks’ corporate governance disclosure. As consequence, this particular

index encompass of fifteen (15) sections and fifty (50) items.

For corporate governance disclosure index which we constructed to be considered

as international benchmark for Islamic banks, our main references include SFAIFI/GSIFI

(AAOIFI, 2002), CBPCGI (Chapra and Ahmed, 2002), and Enhancing Corporate

Governance for Banking Organizations (Basel Committee on Banking Supervision, 1999).

In developing this index, because these international standards do not require a

narrative statement regarding corporate issues in Islamic banks’ annual report to be

presented, in general we follow the general format of the indices which have been

developed for Islamic banks in Malaysia and Indonesia and we carefully select the items

which perceived are compatible to the Islamic banks circumstances.

35
 However, based on SFAIFI/GSIFI (AAOIFI, 2002), we add a number of sections

to include some important issues relating to the corporate governance issues in Islamic

banks, i.e.: internal Shari’ah review, social responsibilities for the stakeholders, bases for

profit allocation between owners’ equity and IAH, Bases for profit allocation between

owners’ equity and IAH, and Profit Equalization Reserve (PER) and Investment Risk

Reserve (IRR). In addition, we also insert some detail items regarding Shari’ah

Supervisory Board (SSB) as recommended by SFAIFI/GSIFI (AAOIFI, 2002) and

CBPCGI (Chapra and Ahmed, 2002). In addition, we also add some items e.g. IAH

representative from some literature (Archer (2003), Nienhaus (2003) , Karim (2004), and

Ilyas (2004a)). This particular index consists of twenty (20) sections and sixty-six (66)

items.

4.4. Disclosure Index Scoring and Data Collection Methods

In conducting disclosure scoring we perform an equally-weighted scoring in

which each item in our disclosure checklist has the same weight. In our opinion the using

of unweighted disclosure is fairer for this study because the weights would be subjective in

nature and there are difficulties in judging the importance of the items disclosed according

the user of annual report (Carson and Simnet, 1998). In addition, according to Barret

(1976) as quoted by Maali et al. (2003) there is some unpredictability which is obviously

inherent in using any weighted index. On the other hand, the disclosure index in this study

is not intended to be used in a decision making context, thus we assume that each items

which should be disclosed in Islamic banks annual reports have equal priority (Maali et al.,

2003).

36
 Our data collection mainly emphasizes on the secondary data disclosed in annual

report. We assert that the annual reports are recognized as the primary medium of

communication between the company and its stakeholders as whole for Islamic banks

(S&P and CGFRC, 2004). Then, for scoring purpose, annual reports of each bank were

reviewed page by page for items disclosures according the disclosure index.

For scoring matters, each disclosure related to specific items in the disclosure

index will be awarded one point and in contrast items not disclosed will be awarded 0

point. In addition, cause of some items might not be applicable to some banks; the total

score in disclosure index was constructed as a ratio of the actual score to the maximum

possible scores for each bank (Maali et al., 2003).

In this research, we take two years annual reports for each bank i.e. 2000 and

2003. The national code of corporate governance was implemented in Malaysia and

Indonesia effectively January 2001. The latest available annual report after the

implementation was for the year 2003.

4.5. Methods of Data Analysis

In order to analyze the extent of corporate governance disclosure practices of

Islamic banks in Malaysia and Indonesia based on the result of scoring disclosure index, we

will follow the approach used by Irwanto (2002) in which the disclosure score is classified

in four categories: very informative (81-100 scores), sufficiently informative (66≤81

scores), less informative (51≤66 scores), and not informative (0≤51 scores). Therefore, the

total score that awarded to each bank based on such disclosure indices will be converted to

37
the appropriate category to determine the level of corporate governance disclosure

practices.

Furthermore, to explore the current corporate governance practices of Islamic

banks in Malaysia and Indonesia, we will perform some descriptive analysis based on the

information which are disclosed in the annual reports.

5.0. RESULT AND DISCUSSION

The disclosure index of corporate governance disclosure for Islamic banks in

Malaysia and Indonesia using our two sets scoring indices can be seen in Appendix 1, 2

and 3.

In summary the results for Islamic banks in Malaysia and Indonesia respectively

as shown in Table 5.1, 5.2. and 5.3.

Table 5.1. Corporate Governance Disclosures Ratios of Islamic banks in Malaysia

using National Code of Corporate Governance Requirements

Islamic Banks BIMB BMMB

Years 2000 2003 2000 2003

Percentage 38% 93% 36% 69%

The results on Table 5.1. show that there are significant improvements of the ratios

for BIMB and BMMB from 2000 to 2003 (increasing 55% and 33% respectively). One

argument for this results could be proposed that the implementation of code of corporate

governance in Malaysia in early 2001 have significant implication for Islamic banks in

Malaysia. Another reason for BIMB as a listed company in Kuala Lumpur Stock Exchange

(KLSE) had to comply the MCCG requirements.

38
 The disclosure scores for BIMB and BMMB are classified as not informative for

2000 and very informative and sufficiently informative for 2003 respectively.

Table 5.2. Corporate Governance Disclosures Ratios of Islamic banks in Indonesia

using National Code of Corporate Governance Requirements

Islamic Banks BMI BSM

Years 2000 2003 2000 2003

Percentage 26% 46% 28% 46%

The results on Table 5.2. show that there are slight improvements of the ratios for

BMI and BSM from 2000 to 2003 (increasing 20% and 18% respectively). One argument for

this results could be proposed that the implementation of code of corporate governance in

Indonesia in early 2001 have significant implication for Islamic banks in Indonesia, especially

for BSM as a subsidiary of PT Bank Mandiri Tbk, one of state-owned bank as a listed company

in Jakarta Stock Exchange. However, the disclosure scores for BMI and BSM are classified

as not informative for 2000 and 2003.

Table 5.3. Corporate Governance Disclosures Ratios of Islamic banks in Malaysia and
Indonesia using Comprehensive Code of Corporate Governance Requirements

Islamic Banks BIMB BMMB BMI BSM

Years 2000 2003 2000 2003 2000 2003 2000 2003

Percentage 30% 78% 31% 60% 27% 42% 30% 45%

The results on Table 5.3. show that there are significant improvements of the ratios

for Islamic banks in Malaysia whereas there is only slightly improvement for Islamic banks

in Indonesia based on comprehensive scores of corporate governance disclosures 2000 to

39
2003 (increasing 29-48% for Islamic banks in Malaysia and 15% for Islamic banks in

Indonesia). One argument for this results could be proposed that the establishment of Islamic

banks in Malaysia is early in Malaysia compare to Indonesia, in which the regulatory

environment more conducive in Islamic banking industry in Malaysia.

The disclosure scores for Islamic bank in Malaysia and Indonesia using this kind

of comprehensive scores for 2000 and 2003 range from not informative to sufficiently

informative for Islamic banks in Malaysia, whereas for Islamic banks in Indonesia

classify as not informative.

Interestingly, none of the banks disclosed some specific items unique to Islamic

banks such as internal shari’ah reviews and bases for profit allocation between owners’

equity and IAH. For the items of restricted investment fund statement only Islamic banks

in Indonesia in year of 2003 have disclosed this item. Whereas for smoothening of profit

policy only Islamic banks in Malaysia in year of 2003 have disclosed this pertaining item.

6.0. CONCLUSION

Corporate governance issues for Islamic banks are quite different from conventional

banks and have the specific characteristics since the uniqueness of the Islamic banks’

operations. Basically, these differences originate from the shari’ah compliance commitment

for Islamic banks in their activities. Therefore, we conclude shari’ah governance should be

central indicators in all elements of corporate governance practices in Islamic banks.

However, we agree with what Chapra and Ahmed (2002) assert that without an

effective corporate governance mechanism, Islamic banks may not achieve their objectives

effectively. Here, we consider that the existing of corporate governance codes and

40
mechanisms could be adapted in line with the development of corporate governance in

Islamic perspective.

This study analyses the empirical evidence of corporate governance disclosures in

annual repots of Islamic banks in Malaysia and Indonesia using two set corporate governance

disclosures scores based on codes of corporate governance in each countries and a

comprehensive benchmark as proposed for best practices in Islamic banks. The results show,

in general Islamic banks in Malaysia and Indonesia have addressed concerns on the issue of

corporate governance in their operation. However, the disclosure of items unique to Islamic

banking operations have not been addressed sufficiently in Islamic banks both in Islamic

banks in Malaysia and Indonesia. In general the sufficiently disclosure of Islamic banks are

still far from our comprehensive benchmark for Islamic banks corporate governance

disclosure scores.

Although this empirical study only indirectly reflected the existence of corporate

governance in Islamic banks, this study will benefit both scholars and the regulators to

further develop a model for effective corporate governance mechanisms for Islamic

banks. Meanwhile, there are some limitations of this study in the regards of the sample

selected of the Islamic banks to reflect the extent of the Islamic banks’ corporate

governance. Also, the methodology adopted in this study is only exploratory and

descriptive and no rigorous statistical analyses are possible. Hence, we argue that further

studies should be undertaken in these specific issues which will contribute to

strengthening Islamic banks’ corporate governance.

41
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