Disclosure and Governance islamic banking in malaysia.

Disclosure and governance of Islamic banks:A case study of Malaysia

Elsa Satkunasingam* and Bala Shanmugam

*Monash University Malaysia, No 2 Jalan Kolej, 46150 Bandar Sunway, Petaling Jaya, Selangor

Darul Ehsan, Malaysia

tel: +60 03 56360600 ext. 3336; e-mail: [email protected]

Elsa Satkunasingam is a lecturer in Busi-

ness Law at the School of Business

Monash University Malaysia. She lectures

on Malaysian Corporate Governance and

is currently pursuing her PhD with the Law

School at Monash University Australia. The

PhD is related to the protection of the cus-

tomer in the goods and services industry.

Bala Shanmugam holds the Chair of

Accounting and Finance at Monash Univer-

sity Malaysia, where he is also the Head

of the Department of Accounting and

Finance. Professor Shanmugam has pub-

lished extensively on Corporate Govern-

ance and has wide international

consultancy experience in the same area.

He is the current Director of the Banking

and Finance Unit at Monash University

Malaysia.

ABSTRACT

This paper investigates the current state of cor-porate governance in Malaysia while at thesame time it outlines operative aspects of Isla-mic banking. The low level of enforcement ofcorporate governance in Malaysia coupled withthe high level of trust implicit in certain aspectsof Islamic banking appears to be a perfect recipefor disaster. Bankers who are beginning to rea-lise this fact are slowly backing away from thistype of Islamic banking. The paper highlightsthe need for greater disclosure such that patrons

of Islamic banking will realise the extent oftheir risk exposure.

INTRODUCTION

Islamic banks were set up as an alternativeto conventional banks. Muslim depositorswho believe that interest (riba) is incongru-ent to their religious tenets have no choicebut to resolve this conundrum by deposit-ing their funds into Islamic banks or bankswhich have services that comply with Isla-mic law. Thus, such banks have a moralburden placed upon them as their veryfoundation is based upon religious princi-ples and the banks and their Muslim custo-mers believe that they answer to a higherauthority.With reference to principles of corporate

governance and customer protection thispaper will examine the extent to whichMalaysian law takes cognisance of themoral aspects of the banker–customer rela-tionship in Islamic banks. It examines thequestion of whether the corporate govern-ance rules in Malaysia sufficiently addressthe unique position of Islamic banks andthe duty of such banks towards their custo-mers. This paper will specifically focus onone particular type of account (mudaraba),which is unique to Islamic banks, to illus-trate the effect that poor corporate govern-ance may have on the Islamic bankingsector.

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Journal of International Banking Regulation Volume 6 Number 1

Journal of International Banking

Regulation, Vol. 6, No. 1,

2004, pp. 69–81

# Henry Stewart Publications,

1358–1988

ISLAMIC BANKS AND CORPORATE

GOVERNANCE

The Islamic religion relates directly to allaspects of life of Muslims including theirwealth and finance. While there is no prohi-bition on the accumulation of wealth, it isconsidered sinful to do so at the expense ofthe poor. Wealth is considered a trust and atest. Failure to use it wisely, especially toalleviate the hardship of the poor is detri-mental to the person who holds that wealth.1

One of the most important prohibitionsagainst misuse of wealth is the prohibitionagainst ‘riba’, which is generally translatedto mean ‘usury’ or ‘interest’.2 The pre-Isla-mic Arabs had a practice of granting loanswith interest and when the debtorsdefaulted the interest rate was doubled,tripled or quadrupled, thus making itimpossible for the economically disadvan-taged to free themselves from debt.3 SinceIslam places importance on social welfarepractices, this practice was prohibited. Itwas also deemed to create unjustified prop-erty rights. Obtaining wealth by charginginterest on loans especially to the poor andneedy was considered un-Islamic as itamounted to accumulating wealth withoutlabour at the expense of those in need.4

While there are differing viewpoints as towhether the term refers to usury or simpleinterest it is not within the scope of thispaper to discuss these matters.

The first Islamic bank in Malaysia wasestablished in 1983 under the Islamic Bank-ing Act 1983.5 Known as Bank IslamMalaysia Berhad (BIMB) it began to offerservices aligned to the precepts of Syariah(Islamic law). The Islamic Banking Act1983 does not, however, have comprehen-sive provisions for Islamic banking. TheAct relates to the manner in which an Isla-mic bank can be established and managed.It does not provide for the resolution ofdisputes between Islamic banks and theircustomers. This is governed by civil law.6

The National Syariah Advisory Council is

the highest authority that can issue opi-nions or edicts on Islamic banking. Islamicbanks are also subject to the supervision ofthe Central Bank in Malaysia.

Islamic banks and financial markets havebecome sophisticated over the years and inMalaysia these institutions co-exist withinthe current regulatory mechanisms. TheKuala Lumpur Stock Exchange has intro-duced a system that tracks Syariah-compli-ant stocks while the Securities Commissionhas established the Islamic Capital MarketUnit and the Syariah Advisory Council toassist it in regulating Islamic banks andfinancial institutions.7 The mechanisms toensure that banks, financial institutions andcorporations are syariah-compliant arenumerous but Islamic banks have no extraprecautions that take into account the spe-cial and vulnerable position of depositors.Since one of the cornerstones of Islamicbanking is the sharing of profit and lossrather than the imposition of interest alone,good corporate governance is crucial toensure that the depositors suffer no losssimply because it is easier to ‘fleece’ themthan depositors in conventional banks.

THE RATIONALE OF ISLAMIC BANKING

Ideally the objectives of Islamic banks arethreefold. The first objective is to offerMuslims an alternative to conventionalbanking and this alternative is interest-freebanking. The second is to achieve equitabledistribution of income and wealth whilethe third objective is to promote economicdevelopment.8 There are several views asto how these objectives can be fulfilled.One view referred to as Chapra’s (1985)model sees an Islamic bank as having asocio-economic purpose. Riba is abolishedand banking transactions must not besolely profit oriented but aimed at promot-ing Islam and protecting the needs of Isla-mic society as a whole. This modelpromotes the establishment of non-bankfinancial institutions to provide credit to

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Disclosure and governance of Islamic banks

small businesses and those who may find itdifficult to obtain loans from more estab-lished Islamic banks. Thus this modelplaces great responsibility upon Islamicfinancial institutions to achieve the threeaforementioned objectives.9

Ismail’s (1986) framework is an alternativeto the earlier model and views Islamic banksas a commercial entity, which has theresponsibility of carrying out business in amanner consistent with Islamic law. Thebanks’ main responsibility is to shareholdersand depositors and social welfare objectivesare to be fulfilled by other bodies such as thegovernment.10 BIMB tends to followIsmail’s (1986) model of commercial bank-ing, probably due to the large non-Muslimpopulation who do not view banks as instru-ments of social engineering. It should benoted, however, that neither model protectsdepositors from the effects of bad corporategovernance practices.Islamic banks have varying types of

investments and depositors have a widechoice of services. In Malaysia, Islamic banksand conventional banks offering Islamicbanking facilities stress the fact that theiractivities are free of riba and are in accor-dance with the tenets of Islam. Despite thisthere is some dispute as to how ‘Islamic’their services are11 followed by argumentsthat there is no requirement for the entrepre-neur to give any collateral to the bank as thewhole system is based upon trust.12

The Malaysian government implicitlyand unilaterally guarantees all deposits inbanks in Malaysia. It, however, gives nowritten guarantee to this effect.13 Consu-mers implicitly understand that in theevent that a bank invests and loses deposi-tors’ funds, the loss will have to be borneby the bank alone and the government willrefund the depositors’ savings even if onlyin part. The conventional banking systemplaces the risk of loss first and foremost onthe shoulders of the bank and its ownersand not the depositors.

The system is notably different withreference to Islamic banks. The principlesby which mudaraba accounts operate aredifferent. The bank acts as a mudarib (entre-preneur) and uses the funds of depositors toinvest in business activities. The profits areshared between bank and depositor but thelatter bears all the losses if they occur.14

This is a crucial factor that illustrates howrisky the position of a depositor can be. Ifthe Malaysian government does not guar-antee the deposits in Islamic banks, deposi-tors investing in mudaraba accounts wouldbe exposed to high risks indeed. The resultscan be devastating where depositors areindividuals who have invested their hard-earned savings in such a system.Islamic banks sell the fact that their

banking transactions are free of riba. Thislegitimises their activities in the eyes ofmany Muslims. In Malaysia, the presenceof legislation specifically governing Islamicbanks, Syariah Advisory Councils andstrong backing by a predominantlyMuslim government have propelled thesuccess of Islamic banks. Even conventionalbanks are offering services similar to Isla-mic banks (known as Islamic windows).Yet there are immense unresolved pro-blems relating to Islamic banking services,especially mudaraba accounts.The mudaraba system was probably tai-

lored to suit the early Islamic way of lifewhen a man’s integrity and character wereworth much because of the close-knit com-munity that people lived in. The fabric ofsociety was woven close enough to holdmost entrepreneurs to their word to usetheir best endeavours and obtain profits. Inaddition, the society was probably predo-minantly Muslim and there was a commonfactor in that most of them accepted thetenets of Islam. The situation is vastly dif-ferent today especially in Malaysia where aconsiderable number of the population isnot of the Muslim faith. Urbanisation hasresulted in the loosening of societal bonds.

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Satkunasingam and Shanmugam

What is there to make borrowers keeptheir word when obtaining funds under themudaraba scheme, which if applied strictly,does not even require the borrower tostake any collateral? The mudaraba scheme,which is based upon the concept of trust, isopen to great abuse and banks now havethe additional duty of acting as entrepre-neurial watchdogs to ensure that theirdepositors’ investments are protected. Fail-ure to protect the investors’ funds willresult in losses to the investor/depositor.The effect of such losses on the ordinaryperson could be catastrophic.

Mudaraba schemes in Islamic banksinvolve three parties. The depositors areinvestors who deposit their funds with anintermediary (who is supposed to act as anentrepreneur) to finance projects put for-ward by borrowers.15 The profit and losssharing rationale in Islamic banking makesit crucial for the intermediary to monitorthe activities of the borrower although theintermediary is not managing the project.16

The monitoring is usually carried out byinsisting that the borrower has a completeand accurate bookkeeping system in place.The intermediary must have access at alltimes to the entrepreneur’s accounts toinspect and keep track of the accounts. Thisis absolutely crucial, as technically bor-rowers need not provide security for thefinancing that they have obtained. In anideal world, the intermediaries will have theexpertise to vet and select more viable pro-jects to finance and the borrower will becooperative in giving full and fair disclosureof the accounts to the intermediary.17

The intermediary, however, is rarelycapable of being fully involved in this typeof lending and may be at the mercy ofunscrupulous borrowers. If all parties,namely the intermediary and the borrower,are honest and responsible then the systemwill work well, barring unforeseeable cir-cumstances that could result in losses. Itwould also ensure that the intermediary

could halt the borrower’s activities in theevent that the losses are above permissiblelevels and still recoup some of the capitaladvanced by the investors. When this isadded to the pool of investments, the lossesmay not be high and the investor may stillobtain returns from other investments,provided of course that this loss has beenan isolated incident.

The crux of the matter is that muchdepends upon the efficiency and honesty ofthe intermediary and the borrower but itwould be time-consuming and near impos-sible to assess a person’s character with anysort of certainty. There is great demand forexpertise in monitoring projects financedby these banks. It is difficult enough toevaluate the creditworthiness of a borrowerbut to be able to evaluate the viability of aproject is even harder. Added to this diffi-culty is the need of Islamic banks to moni-tor closely the project as well as theaccounts (books) of the borrower, since thereturn to the banker is a proportion of thetotal profits (profit and loss sharing). It isin view of these prerequisites demanded byIslamic banking principles that furtherintensify the need for greater disclosure andgovernance. Of course the argument thatcan be put forward is simply to obtain col-lateral from borrowers before placingfunds with them but this will result incounter arguments about whether thetransaction is masquerading as ‘Islamic’when it is ‘conventional’.

The position of the depositors becomesmore vulnerable when the intermediarywho is expected to look after their invest-ments has poor corporate governance prac-tices and is subject to political pressure tolend to well-connected entrepreneurs.

THE MALAYSIAN CODE ON

CORPORATE GOVERNANCE

The Malaysian Code of Corporate Gov-ernance was developed in March 2000 bythe Working Group on Best Practices in

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Corporate Governance and approved bythe Finance Committee on CorporateGovernance. It was developed to initiatereforms of standards of corporate govern-ance in line with international standards toenable Malaysian companies, whetherbased upon Islamic principles or not, tocompete globally. One of the main aims ofthe Code is to encourage companies tohave independent non-executive directorson the board. The Code makes recommen-dations for an independent board of direc-tors to be appointed. This requirement isto have a balance between executive andnon-executive directors so that no oneperson or group can dominate the deci-sion-making process (Part 1, A II). In addi-tion there should be transparent proceduresfor the appointment of new directors tothe board and all directors should submitthemselves to re-election at regular inter-vals (Part 1, A IV and V). The Code alsoreiterates the importance of an Account-ability and Audit Committee whose role isnot only specified within the Code but alsoby the Kuala Lumpur Stock Exchange(KLSE).How does the Code improve the princi-

ples relating to corporate governance?While it merely aims to lay out broadprinciples of good corporate governance,companies listed with the KLSE have tostate how they have applied the recom-mendations in their company. This wouldprobably mean that there would be an endto domination of the board by a person orgroup. It should herald in a new era wherecorporations, including banks, are moreaccountable to all stakeholders. The princi-ples are certainly in place for this to occur.Part 2 of the Code lays out the best

practices and among these is the recom-mendation that the position of chief execu-tive officer and chairman is divided toensure a balance of power and authority(Part 2, AA II). In addition, it states thatindependent non-executive directors should

make up at least one-third of the board’smembership (Part 2, AA III). Where thereis a majority or significant shareholder inthe company, there should be a sufficientnumber of non-executive directors torepresent the other shareholders (Part 2,AA IV and V). More importantly, theboard has to put in place a process to assessthe effectiveness of the board as a whole(Part 2, AA X).The Code provides for balanced and

independent financial reporting which iscrucial to the management of companies. Itrecommends a system of internal controland states that there should be a formal andtransparent arrangement to depict the rela-tionship between the company and itsauditors (Part 1, D). The board has toestablish an audit committee of at leastthree directors, which is chaired by anindependent non-executive director. Thecommittee should have investigativepowers. The board has to devise propercorporate strategies and then evaluatewhether the management of the companyis carrying out the strategies properly. Inaddition, the board has to identify principalrisks and ensure the implementation ofproper systems to manage these risks (Part4, AA – 4.17). With reference to mudarabaaccounts in Islamic banks the risk manage-ment factor is of great importance todepositors and shareholders alike. How-ever, no additional risk management appa-ratus has been introduced by banks offeringmudaraba accounts.The Malaysian Code on Corporate Gov-

ernance 2000 aims to introduce good cor-porate governance in companies. The mostcrucial factor in the Code is the indepen-dence of the board and the chairman. TheWorking Group that drafted the Code hasstated in the explanatory notes:

‘One issue that surfaces in the Malaysiancontext in respect of the role of theChairman is the almost ‘‘too ready’’

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acceptance of the views of the dominantvoice at the meeting. There is a generalunwillingness by boards to pursue debateand a perhaps over-eager desire to find aconsensual resolution to issues andproblems. Achieving consensus moreoften than not is a compromise towardsthe most entrenched view on the board,of sometimes a single voice rather thanthat of the majority of board members’(Part 4 AA – 4.21).

This is a very important acknowledgmentby the Working Group as the generalunwillingness to engage in debate and con-frontations must be overcome if the boardis ever to be independent and protect theinterests of the company, shareholders andcreditors. The drawback, though, is in thedefinition of the term ‘independence’which is ‘independence from managementand independence from a significant share-holder’ (Part 4 AA – 4.23). It is almost as ifthe Working Group shied away fromaddressing another serious problem withcorporate governance, which is indepen-dence from politics.

CORPORATE GOVERNANCE AND

POLITICAL INTERFERENCE

Corporations in Malaysia, including thebanking industry, have been subject topolitical interference and manipulation inthe past — something that still continuesalbeit on a less conspicuous level. The accu-sation levelled against Asian banks andcompanies is that the lack of accountabilityand transparency contributed to the 1997Asian financial crisis.18 The MalaysianCode on Corporate Governance 2000 inpart intended to address this problem byadopting some of the principles recom-mended by the Cadbury and HampelCommittees respectively. It is perfectlynormal in most Asian countries to refer toforeign codes and then adapt the principlesin those codes to accommodate the struc-

ture of companies and the regulatorybodies within that particular jurisdiction.19

Western models are usually used eitherbecause they are deemed superior or havebeen tried and tested and proven reliable. Itis hoped that with the proper codes andrules in place, countries can avoid a recur-rence of the crisis and regain investors’confidence.20

There has been meticulous study of howthe rules should be implemented for thehoped for effect but very little is discussedabout how the political culture of a coun-try impacts upon the implementation ofthe rules. The Malaysian Code has notaddressed one very important point, whichis how to retain independence of the boardfrom political influence. It is of no use toadopt the most sophisticated rules or codesand revamp the regulatory bodies if theapproach by the authorities and companieswithin a particular jurisdiction is to resistsubversively any move for greater trans-parency and accountability while payinglip service to the codes.21

The 1990s heralded a new type of poli-tics in Malaysia defined by close relation-ships between businessmen and politiciansthat was later dubbed ‘cronyism’.22 Evi-dence showed that politicians wereinvolved in awarding contracts to business-men who returned favours. In some situa-tions, politicians or their family membersowned businesses and obtained governmentcontracts easily.23 This was part and parcelof patronage politics practised within poli-tical parties in Malaysia very soon afterindependence.24 In Malaysia, it is believedthat public funds were used to bail outcronies.25

The bankers in Malaysia, namely thecentral bankers, have been subject to politi-cal interference and those more willing toabide by government policies replaced pru-dent governors. The independence of thecentral bank as a watchdog to curb excessesby the government was weakened. Several

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prominent companies, such as UnitedEngineers Malaysia, were allowed to exe-cute a reverse takeover of its parent com-pany Renong, which was heavily in debt.The signal sent to investors was that therules could be changed mid-way throughthe game and there was little heed paid toproper rules of corporate governance. It iswidely believed that government-con-trolled public funds, such as the EmployeesProvident Fund, Permodalan NasionalBerhad and Khazanah, were used to bailout politically connected businesses. Inhindsight it has been argued that this actionand other similar actions were necessary toimprove the Malaysian economy. What-ever the benefits may be from the eco-nomic and financial point of view, itcannot detract from the fact that corporatebailouts were carried out quite brazenlywithout proper explanation and seeminglyto save ‘cronies’ from disaster.26

An example of the effect of the excessesof ‘cronyism’ is when Halim Saad, theChairman of Renong, was bailed out byfunds amounting to RM2.34bn. Stockmarket rules were manipulated to servethe interests of the politically influentialHalim. Many of his business practiceswere officially sanctioned. He is believedto have acted on political instructions totake over the Philippines National SteelCorporation with funds that came from‘a syndicated loan amounting to US$800million from Malayan Banking, BankBumiputra, Bank of Commerce andRashid Hussein Bank, all of which brea-ched their single customer limits’.27 Inaddition, the national petroleum com-pany, Petronas, bought out the primeminister’s son’s stock in a shipping com-pany at a considerably higher price thanit was worth at the time. Furthermore,Koperasi Usaha Bersatu (KUB), whichbelonged to the United Malay NationalOrganisation (UMNO), the ruling partyin Malaysia, obtained the bigger share in

the sale of Sime Bank Berhad, which wasvirtually insolvent.28

The imposition of capital controls madeby the Malaysian government improvedthe economic situation of Malaysia, butdue to the way that businesses were struc-tured at the time, it also improved theposition of politically connected businesses.A study conducted showed that firms thatwere connected to the politicians in powerexperienced better recovery and perfor-mance than firms that were connected tothe former Deputy Prime Minister DatukSeri Anwar Ibrahim after he was removedfrom his position.29

As repositories of funds, banks naturallybecame the favourite ‘hunting ground’ forpoliticians and their cronies. Therefore,while proper corporate governance isimportant and more so for banks, this needis even greater for Islamic banks where theelement of trust is implicit in all trans-actions.

FACTORS THAT CONTRIBUTE TO POOR

CORPORATE GOVERNANCE

What are the factors required to implementthe Code on Corporate Governance in aproper manner? There must be a funda-mental shift in the attitudes of thoseinvolved in implementing the Code evenat the policy level. Currently the SecuritiesCommission of Malaysia and in the case oflisted companies, the KLSE, are the watch-dogs to ensure that the Code is applied andthat over time principles of good govern-ance become the norm. If the Commissionor Exchange is subject to political interfer-ence then it is unlikely that the Code orany other measures to ensure good govern-ance will be implemented properly.The presence of ‘cronyism’ and

unbridled capitalism in the last decade canbe attributed to a powerful executivewhere political interference in securitiesregulation became the norm.30 How wasthis allowed to happen when Malaysia

5


inherited the UK common law system,which believed in separation of powers anda balance of power between the legislature,executive and judiciary? One of the reasonscould be because Malaysia is a country thatlargely (though not wholly) follows therule of political law. This classification wasfirst introduced by Mattei31 and usedwhere the political process and the legalprocess in a legal system are not separate.

Legal systems governed by the rule ofpolitical law often claim that they subscribeto democracy but inevitably democraticprocesses are not the dominant pattern.Political relationships define the legalsystem and there is no real conception offormal law binding the government. Gov-ernments pay lip service to principles ofdemocracy and separation of powers is notpractised purportedly because it will notmaintain stability.32 Very few legal systemstoday are depicted completely by the ruleof political law. It does, however, serve thepurpose of identifying the underlyingassumptions in that legal system.33

The legal system in Malaysia reflects therule of political law at differing levels.Such legal systems do not have indepen-dent courts and are characterised by highlevels of political involvement in the judi-cial system, high levels of police coercion,highly bureaucratised public decision-making processes, drastic governmentalintervention in economic policies and legalcultures that are heavily influenced by for-eign models among its characteristics.34

The rule of political law is one reasonbehind the close relationships betweenbusinesses, governments and banks. Thereare no checks and balances to prevent suchrelationships from occurring, thus allowinga powerful executive to flourish.

The political situation in Malaysiaattaches more risk to investments undermudaraba accounts than would be the casein a Western society where accountabilityand transparency are demanded and

adhered to more often than in the East.Asian countries feel that it is justified tolimit individual freedom in the interests ofthe economy and political stability.35 InMalaysia, the defence mechanism is tomake the troublesome and delicate issuestaboo and not available for public discus-sion.36 There are several statutes such as theSedition Act 1948 (Revised 1969),37 theInternal Security Act 1960,38 the OfficialSecrets Act 197239 and the Official Secrets(Amendment) Act 1989,40 which imposespenalties on people who discuss taboo sub-jects. This is probably one of the reasonswhy many Malaysians choose to keepsilent when politicians abuse their powerby initiating corporate bailouts and pres-sure banks into making loans beyond theircapacity. The banking sector was also notindependent of politicians who interferedwith the central banks’ recommendation ofsound financial practices41 to serve theirpolitical interests or those of their cronies.42

EFFECT OF POOR CORPORATE

GOVERNANCE ON ISLAMIC BANKS

Islamic banks are in a more vulnerableposition than conventional banks if theexcesses of cronyism are unchecked infuture. There are two reasons for this. Thefirst reason is that the list of 30 majorshareholders of BIMB reflects that almostall of them belong to government-owned(wholly or partly) or state-owned corpora-tions. As at 30th September, 2002, Lem-baga Tabung Haji and PermodalanNasional Berhad cumulatively held 41.63per cent of the shares in BIMB HoldingsBerhad. In addition, the Employees Provi-dent Fund Board holds 6.49 per cent ofshares. In the event that there are otherincidences of ‘cronyism’ it would not betoo far fetched to state that BIMB may beone of the targets to provide funds for cor-porate bailouts.

This is a recurrent theme. In the late1970s and through the 1980s there was

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great expansion of the public sector. BankBumiputera Malaysia was one such stateenterprise together with its subsidiary BankBumiputera Malaysia Finance Ltd (BMF).Political supporters of the ruling partywere rewarded with directorships on theboards of such state corporations despitetheir lack of experience and at times lackof integrity.43 In 1981, BMF lost RM2.5bnto three property developers in HongKong. The managers of BMF were foundto have had very cordial relations withthose developers and had made loans thatwere not properly secured and at timeseven without proper documentation. Theresult of the losses ‘virtually wiped outshareholders funds’.44 If mudaraba accountshad operated at that point in time it wouldhave wiped out depositors’ savings andthey would have borne the brunt of losses.The second reason for the extra vulner-

ability of Islamic banks is that the mudarabascheme, if applied strictly, permits entre-preneurs to trade with investors’ moneywithout personal liability on their part forlosses incurred. This type of investmentwill be the main target of politically con-nected businesses. It requires no stretch ofthe imagination to realise that shouldanother situation like the Asian financialcrisis occur, it would be easier to applypressure on Islamic banks to grant loans tobail out politically connected corporationsespecially since the funds in such bankshave increased tremendously in the newmillennium.In the aftermath of the Asian financial

crisis, there was an increase in resolve toimplement good corporate governance inorder to restore public confidence andobtain much needed foreign direct invest-ment. The general election held in 1999resulted in the Barisan Nasional govern-ment losing seats to the opposition, mainlyParti Se Islam Malaysia (PAS).45 This wasseen as a reaction to the excesses of theruling government. In Malaysia under the

New Economic Policy, the governmentpractised a policy of encouraging Malaybusinesses to increase equity holdings andcertain businessmen were identified as cor-porate role models.46 There was a blurringof lines between government policy andcronyism. It was argued that Malay busi-nessmen were given contracts to achievethe aims of the New Economic Policy. Yetthese same businessmen were seen to beclose to certain politicians and benefitedfrom their patronage.The evidence from Malaysia indicates

that close relationships between govern-ment and businesses have continued, albeiton a less conspicuous level. It is unclearwhether the government is still awardingcontracts to certain Malay businessmen aspart of the New Economic Policy inMalaysia or whether it is a continuation ofcronyism with new faces replacing theold.47

Even while the Code was in the processof being drafted and implemented, corpo-rate bailouts of Perusahaan OtomobilNasional (Proton), Malaysia Airline Systemand Indah Water Consortium were carriedout.48 These actions can be interpreted asmopping up operations of messes createdprior to 1997 or reflecting that cronyism isstill flourishing in Malaysia. Very recentlyaccusations of cronyism and corruptionmade against the former leader of theMalaysian Chinese Association (MCA), DrLing Liong Sik, have not yet been investi-gated.49 The Corruption Perception Indexin the post financial crisis period is no dif-ferent from the Index before the crisisoccurred.50 This does not necessarily reflectthat cronyism still exists at high levels, butdoes indicate that corruption does exist inmuch the same manner as in the pre-crisisperiod.While the government refuses to

acknowledge that absolute transparencyand accountability are essential to long-term growth and development, good

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corporate governance principles will not beimplemented properly. This tends to makea mockery out of the Code on CorporateGovernance, which is seen as equivalent to‘law in books’ and not ‘law in action’ (seeFigure 1). Although certain parts of theCode have been incorporated in the KualaLumpur Stock Exchange listing require-ments, the past manipulation of corporatepractices casts a shadow over it.

With evidence pointing towards theexistence of corruption and proof of lackof enforcement of good governancerequirements, there is much room for cor-porate mismanagement and abuse. Suchpossibilities will manifest more in areaswhich are vulnerable and that is where Isla-mic banking is going to be adverselyaffected. Sources within the banking indus-try claim that Islamic banking, having

1 20 40 60 80 100

Singapore

Hong Kong

Malaysia

India

South Korea

Taiwan

Thailand

Phillippines

China

Indonesia

Enforcement

Rules, Regulation/adoption of IGAAP

1 = lowest, 100 = highest

Source: The McKinsey Quarterly, 2004, No. 2.

Figure 1 Governance and its enforcement

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realised this weak link in their chain, havestarted minimising their exposure to thistype of account. Islamic banks are thereforediscouraging depositors’ participation inmudaraba accounts. Other types of accounts(Al-Wadiah) are being favoured.

CONCLUSION

It must be noted that a large number of themajority shareholders in BIMB HoldingsBerhad are government-owned corpora-tions or bodies. If Islamic banks in Malaysiaexperience phenomenal success in thefuture, it may become the target of politi-cians in future as an alternative to the cash-rich Petronas. Depositors may in time losetheir profits and may in the worst circum-stances even lose their deposits where thegovernment is unable to make good theunilateral guarantee that it has given. Thishas not happened in Malaysia but it couldhappen in future under a new generationof politicians. Until these politicians recog-nise that ‘Islam’ is not a term that can beapplied to a financial service but to a wayof life and attitude, it would be a misno-mer to use the term ‘Islamic’ banks.The newly appointed prime minister of

Malaysia has called for more accountabilityand transparency and raised massive sup-port for the Barisan Nasional ruling partyin the elections carried out in March 2004.He is seen as a firm leader who has thepolitical will to reduce corruption and cro-nyism and he is obviously supported bypeople as the election results and analysesindicate. However, whether he will be ableto rein in the various party ‘warlords’ whohave reigned supreme for many years andthe patronage politics remains to be seen.Should he succeed, the Malaysian Code onCorporate Governance can be implemen-ted smoothly together with supportive reg-ulations by various bodies such as theKLSE. The customers in mudaraba-typeaccounts in Islamic banks will only have tobear risks normally attached to such

accounts and not risks imposed by unrulypoliticians. Until then, perhaps Islamicbanks and banks offering Islamic servicesshould not operate mudaraba-type accountsor should operate them in a conventionalmanner by requesting collateral from bor-rowers who wish to obtain loans fromthese banks.

REFERENCES

(1) Saeed, A. (1996) ‘Islamic banking andinterest: A study of the prohibition ofriba and its contemporary interpretation’,in ‘Studies in Islamic Law and Society’,E.J. Brill, Leiden.

(2) Haqqi, A. R. A. (1999) ‘The Philosophyof Islamic Law of Transactions’, Univi-sion Press, Kuala Lumpur.

(3) See Haqqi, ref. 2 above.(4) Lewis, M. K. and Algaoud, L. M. (2001)

‘Islamic Banking’, EE Publication, Chel-tenham, UK.

(5) Islamic Banking Act 1983 (Act No. 276).(6) Bidin, A. (2001) ‘The impact of Islamic

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(38) Internal Security Act 1960 (Revised 1972)Act No. 87.

(39) Official Secrets Act 1972 No. 88.(40) Official Secrets (Amendment) Act 1989

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(42) Tesoro, J. M. (1998) ‘Battle for theeconomy’, Asiaweek, 16th January.

(43) See Crouch, ref. 22 above.(44) See Crouch, ref. 22 above.(45) Suh, S. and Ranawana, A. (1999) ‘Stirred

but not shaken’, Asiaweek, accessed 20thJune 2003, www.asiaweek.com/asiaweek/magazine/99/1224/nat.malaysia.html

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(50) Transparency International (1998), TheCorruption Perceptions Index, 31st May,2003, www.transparency.org/cpi1998.html; Transparency International (2002),The Corruption Perceptions Index, 31stMay, 2003, www.transparency.org/cpi2002.html

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