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Wednesday, July 13, 2011




Finance what ever the form it takes, cannot be separated from risk, risk is an inherent part of finance. Kurfi (2006) adopting the widely accepted definition of risk put risk as ‘variability or dispersion of returns from those that are expected’; Akingunola and Oluwatusin (2000), following the same line defined risk as ‘the variance of the anticipated returns on investment’. Because of the possibility of risk government, business, and individual do not consider only the expected return from their investments but also the degree of risk that is associated with that particular type of investment. People can be classified into three group base on their relationship with risk; risk lovers, risk neutral and risk averters.
     One important concept in the literature on risk is portfolio diversification, ‘portfolio’, write Kurfi, ‘is a combination of investment in various assets or securities.’  Osaze (2007) goes further to describe the nature of assets mostly included in a portfolio to be of either financial or physical nature ‘which an investor holds to satisfy his defined returns objectives.’ Investors diversify their portfolio in order to reduce the degree of risk that is inherent in any particular sequences of investment. The nature of portfolio management that a particular investor adopted depend on him being either risk averse, neutral or lover. It is not all risk that can be diversified, risk such as the one associated with the whole market cannot be diversify by the normal method of holding different types of assets. Portfolio diversification according to Lipsey and Chrystal (2004) only help in diversifying specific risk by means of risk pooling.   


      Risk is as varied as the different categories of instruments and markets we have. Some types of risks are specific to the banking industry while others are aligned to the capital and foreign exchange markets. Some common types of risk found in the banking industry include: credit risk associated with the extension of loan, Interest rate risk resulting from movements in interest rate, liquidity risk associated with inabilities of banks to fund decreases in liabilities or increases in assets, Operational risk that arises from breakdown in internal controls, Solvency risk force on banks due to persistence decline in the value of the risky assets holding by the bank, Macro or systemic risk that affects the whole of the economy, and Settlement risk that arises from inability of settlement in transfer system to take place.
       Capital market risks include business risk associated with a particular business stock, default risk associated with the risk of default on a particular security, moral risk that is linked with insider activities on shares, portfolio risk inherent in a particular portfolio selection, market risk associated with the whole market, and economy wide risk like the last global economic crisis. Foreign exchange market risks all center on the major risk of movements in foreign exchange markets around the world.


       The works of Markowitz (1952, 1959), Evans and Archer (1962), Sharpe (1964), Hamada (1969), and Tobin (1952, 1958, and 1965) in portfolio theory set the stage for later developments in the field. In order to simplify and further extend portfolio theory a model name Capital Asset Pricing Model (CAPM) was developed using Beta as measure of a security’s risk relative to the market portfolio (Kurfi 2006). CAPM hold that investment decision should be concerned with systemic risk and forget about unsystemic risk. Investment decision under CAPM is centered on the need for investment to bring required rate of return with minimum risk (Osaze 2007).
      Due to some weaknesses in CAPM (for example in a recent study by Ali, Islam, and Chowdhury 2010 to find out the validity of the model in emergent market, they find it to be weak) another model called Arbitrage Pricing Theory (APT) was developed to take care of those weaknesses. APT is more useful as a tool for building portfolios adapted to a specific need (Akingunola and Oluwatusin 2000), in contrast to CAPM which attempted to be a kind of ‘one size fits all’. One of the most widely used tools for managing risk is Value at Risk (VAR) developed by the investment bank J.P. Morgan in the early 1990s. VAR was built to summarize investors’ risks in a single number (Smutniak 2004).  It has been argued for example by experts like Avinash Persaud that VAR models rather than help minimize risk increase it through what he called herd mentality, by making the market to move in the same direction.
       Derivatives, another instrument developed to manage risk, is a financial instrument whose value is based on the value and characteristics of one or more underlying assets such as shares, bonds, commodities, interest rates or exchange rates (Kurfi 2006). The initial idea behind derivatives is risk shifting from one party to another (Smutniak 2004). Many pundit (for example Warrant Buffet, a global investor and Bill Gross an American fund manager) have argued that derivatives instead of reducing risk increase them by hiding losses and enabling corporate treasurers to gamble with shareholders’ money (Smutniak 2004). Derivatives comes in different formats, Kurfi classified them into four groups; Options, Futures, Forwards and Swaps. Options give you the right but not the obligation to buy an asset, Futures agreements to buy an asset in the future at fixed price, Forwards similar to futures only differs in that forward is an informal derivatives that cannot be trade on organize exchange, and Swaps allowed future exchange of payments in one currency for one in another.
             Insurance as a technique of risk management involves risk pooling of similar but independent events. Risk pooling allowed risk sharing between individual participants; risk sharing also extends to the insurance company sharing the insurance with other companies, called re-insurance. The literature on conventional insurance is very vast that span many years of research and practice.  One particular form of insurance that continue to generate a lot of worries of recent is credit insurance because of it association with the last global financial crisis. A credit derivative is a corporate contract that pays its holders if a certain company goes bust (Smutniak 2004). Credit derivatives are highly complex products that lend themselves to numerous applications a lot of them not necessarily beneficial. Some techniques developed to manage risk like the Collateralized Debt Obligation (CDO) were so complex that the chains from borrower to end investor so long that thorough due diligence was impossible (Valencia 2010).  At the height of the last financial crisis CDO s’ were used to package supreme assets which were later sold to the unsuspecting public.
     Basel the global framework for managing risk by financial institutions of which we now have Basel I, II, and III, is an attempt at providing a harmonized method of detecting and dealing with risk by regulators mostly central bankers.  The Basel I drawn up in 1988 requires bank’s capital to be at least 8% of its risk weighted assets. The weight for each class of asset ranges from zero for safe asset to 100% for unsecured loans (Lane 2004). Banks were able to side step the Basel I by practices such as regulatory arbitrage. The Basel II developed to replace Basel I revolves around how capital is allocated and how much capital is set against various risks (Shirreff 2005). Basel II is divided into three pillars, pillar 1 requires banks’ capital to be at least 8% of risk weighted assets, pillar 2 demands banks to increase their capital cushions if national supervisors consider them too thin, and pillar 3 give prominence to the issue of market discipline and want banks to be more about risks to their capital positions and profitability (Lane 2004).  Basel III develops in the aftermath of the last global economic crisis aims at dealing with the regulatory weakness that led to the last global financial crisis. The Basel III is still in the pipeline as it is expected to address micro and macro prudential elements. “The Framework sets out higher and better-quality capital, better risk coverage, the introduction of a leverage ratio as a backstop to the risk-based requirement, measures to promote the build up of capital that can be drawn down in periods of stress, and the introduction of two global liquidity standards.” (BIS 2010) 


      In the first place in Islamic finance there is no gain without taking risk. This is a fundamental concept in Islamic finance unlike in conventional were interest secure depositors returns without sharing in the risk. Risk sharing where risk is shared between all the parties into a particular transaction is encourage in Islam, while risk shifting that involves shifting of risk to a third party outside the transaction is not allowed. Risk shifting is tantamount to gambling, like gambling risk shifting is a zero sum game (Siddiqi 2008). Risk management base on risk sharing is observed to be more efficient and equitable than system built on risk shifting (Siddiqi 1983, 2009). Because of Islamic prohibition on risk shifting system, models built on debt financing cannot be expected to be convertible with the Islamic financing modes. Thus all modes that use interest are not allowed as they shift the whole burden of taking risk to the entrepreneur. The most important modes utilized by Islamic finance industry for sharing risk are Musharakah, and Mudarabah (Siddiqi 1983, 2009 and Al-Omar & Abdel- haq 1996). The Islamic institutions of Musharakah and Mudarabah target value creation and serve as good ways of managing risk (Siddiqi 2008). The Islamic system is asset based, unlike the conventional system that is asset backed. This help to protect the system from some categories of risks.
     In Islamic finance Gharar (uncertainty or speculative risk) and Maisir (gambling) are not allowed because of their effects on equity and fairness between parties to transaction (Al-Omar & Abdel- haq 1996). The above elements and Riba that are part and parcel of modern insurance explain Islam position on conventional insurance (Maiturare 2009). Takaful the Islamic insurance like all other Islamic financial dealings is based on risk sharing. The system is base on mutual co-operation, responsibility, assurance, protection and assistance between groups of participants (Maiturare 2009). Though the Takaful industry is still in it infancy it is expected to grow as the Islamic financial industry growth.
     Islamic scholars like Siddiqi (2009) believed that conventional instruments like Collateralized Debt Obligation (CDO) and Credit Default Swaps (CDS) do not contribute any good to risk management. The use of CDO and CDS resulted in gambling and destabilization of the financial system (Siddiqi 2008). CDS is purely a speculative instrument that help in making the banking institutions more reckless increasing the vulnerability of the global financial system at the eve of the last crisis (Shaharuddin 2010). Islam is not against debt financing what it is against is the charging of interest made possible by conventional debt market. But as it is done currently in the conventional system, debt finance leads to the selling of debt with some additional fixed charges added to the face value of the debt. Sale of debt implies shifting of risk (Siddiqi 2008). Derivatives involves excessive uncertainty, the claim that they increase liquidity and improve operational market efficiency in financial markets remain unsubstantiated (Siddiqi 2008).
       The role of regulators in managing risk in the Islamic financial industry is of great importance. The constituting of Shariah board in all Islamic finance industries is a clear indication of how Islamic finance emphasizes risk management. The Islamic financial services board (IFSB) was established to set international standard for institution engage in the Islamic finance industry in the areas of setting prudential standards, enhancing the soundness and stability of the industry. The IFSB Capital Adequacy and Risk Management standards provide a detailed analysis of contracts, their risks, risk-mitigating factors, and solvency assessments (Hasan and Dridi 2010). There is also the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) set up to develop uniform accounting and auditing standard for Islamic finance institutions around the world. Central banking in the Islamic finance significantly differs from what is found in the conventional system, the replacement of interest with profit and loss sharing changes the whole fundamentals of the system.
      Professor Siddiqi (2009) summarizes the way risk management in Islamic frame work should be:
· Debt proliferation is minimized. This implies that corporations raise additional funds via equity, not by issuing bonds.
· Interest on debt is not practiced. This will in effect kill the bond market.
· Debt is not traded.
· Risks are shared between financiers and producers/businessmen
· Regulators should not allow purchase of business or financial risks by outsiders not involved in the business or supply of investible funds for the business but only taking chances on the outcome.


   Corporate governance is one issue that continues to attract the attention of scholars and practitioners all over the world. There are a lot of literatures written on this area that covers the genesis, dominant form and practice of governance mostly in the western world. According to the dictionary meaning, governance simply means ‘the activity of governing a country or controlling a company or an organization’, the Oxford advanced learners meaning of governance. According to Bala (2006), ‘Corporate governance refers to the method by which a corporation is directed, administered or controlled. It includes the laws and customs affecting that direction, as well as the goals for which it is governed.’ Hasan (2009) sees the definition in two senses, the narrower and extensive.  ‘In narrower sense corporate governance can be defined as a formal system of accountability of senior management to the shareholders. Secondly, in expansive term, corporate governance includes the entire network of formal and informal relations involving the corporate sector and their consequences for society in general.’ Shleifer and Vishny (1997) and Mesnooh (2002) echo the same view on the narrower and expansive senses respectively, likewise Iqbal and Mirakhor (2004).
     Agency problem has been put forward as the main explanation for putting good corporate governance structure on the ground. The theory states that in the presence of information asymmetry the agent is likely to pursue interests that may hurt the principal, or shareholder (Sanda, Garba, and Mikailu 2008). This is the view as it emanate from the American and British angle.  It holds that, ‘Corporate governance issues arise in the corporation in two situations namely whenever there is an agency problem or conflict of interest involving members of the organization such as board of directors, managers and shareholders and cost of business are such that agency problem can not be dealt with through a normal contract (Hasan 2009, sitting Hart 1995). The works of Alchian and Demsetz (1972) put the foundations on which later works on agency theory were built. Corporate governance requires corporations to exercise immense accountability to shareholders and the public, and to monitor the management of organizations in running the affairs of the businesses (Bala 2006).
         Some scholars, Bala (2006), have classified corporate governance into two categories self regulation and statutory regulation. Self regulation is the aspect that is difficult to legislate, while statutory is the aspects that can be legislate in legal terms. Sanda, Garba, and Mikailu (2008) making reference to the work of Levine (2004), Oman et al (2003) argue of a link between corporate governance and economic growth by means of boosting confidence on savings and investments. Of recent international investors have change their attitude to investment, especially in emerging economies, by according higher priority to factors like the environment, Social, and governance (Who cares win 2007). The two dominant types of corporate governance are the stakeholder model and the Anglo-Saxon model.
        The Anglo-Saxon model of corporate governance so far remains the most dominant model of governance. Hasan (2009) argue that shareholders model of governance which is another name for Anglo-Saxon is the major academic view of the corporation. Under this model the main concern of the management is the satisfaction of the shareholder, anything that come after is secondary to this concern. Iqbal and Mirakhor 2004, argue that the model has three characteristics; shareholders control, managers have duty to serve shareholders’ interest alone, and maximization of shareholders’ interest. Because of the wide dispersion of share ownership, the corporation needs strong legal protection to protect the interest of its large and mostly weak shareholders (Hasan 2009). There is argument in some quarters that weak governance mechanisms inherent in this model were responsible for the last global financial crisis. The main concern of the Anglo-Saxon model with only shareholders’ interest has come under criticism. The neo-institutional economists and business ethicists  argue that the firm’s claimants go beyond shareholders and bondholders to include others with whom the firm has any explicit and implicit contractual interaction (Iqbal and Mirakhor 2004).    
       The stakeholder model of governance on the other hand, is focused on a relationship-based model that emphasizes the maximization of the interests of a broader group of shareholders (Hasan 2009 citing Adams 2003). The model which has dominance in the European sub continent, hence the name European model, didn’t accept the exclusion of others interest and profit maximization focus of the Shareholders model. All stakeholders in the business are regarded as contractors with the firm, with their rights determined through bargaining (Iqbal and Mirakhor 2004). Within the context of the stakeholder theory, the problem of agency has been widened to allow for multiple principals, instead of treating shareholders as the sole group whose interest the agent should protect, the theory sees other groups such as employees of the firm, creditors, government, host community etc. also as having equally vital stakes in the performance of the firm (Sanda, Garba, and Mikailu 2008). Some academics, for example John and Senbet (1998), have pointed out that multiplicity of principals inherent in this model give rise to conflict of interests.


            One of the most controversial issues on corporate governance in the recent literature is the issue of share option as part of executive compensation. It is argued that in order to solve the agency problem the interest of the management should be linked to that of the shareholders (Bishop 2002). The argument goes, by liking some percentage of their total compensation to the performance of the corporation shares, the managers will be forced by the law of self interest to serve the general interest of the corporation. But from the 1990s when the practice started to get ground to date share option has declined in importance. There are mountains of criticism lodge against the system. For example, share price option could deviate from their fundamental values and management can make this happen to help them get short term gain (Bishop 2002). One way to remove that incentive, argues Bishop, is to prevent the manager from selling the shares until years after he has left the company. Share option also encourages behaviors that support the acquisition of the corporation by the outside forces.
          Greed has been pin pointed as the single most important cause of the last global crisis outside poor risk management.  Situation where bankers were only concerned with the returns they will make for themselves (and major shareholders) in respective of credit worthiness of a particular transaction have been at the heart of the crisis. The Enron and Madone fiasco, the collapsed of Lehman Brothers, and the global collapse of equity prices can all be linked to greed. How to control greed has become a thorny issue as there is still a substantial section of the management and academia that hold the belief that greed is good. Using the 200 years old argument advanced by Adam Smith that invisible hand will align the interest of the individual with that of the society, the argument goes as individual pursue their greed they are as well helping the society by increasing employment, productivity, profit and economic growth during good time (Bishop 2002).
       Board independence as a mechanism of corporate governance is another proposal that continue to gather momentum as a way out of the increasing poor corporate governance we continue to witness of recent. The board of directors has long been recognized as an important corporate governance mechanism for aligning the interests of managers and all stakeholders to a firm (Sanda, Garba, and Mikailu 2008). The fiascos in the United States where company boards were fingered as parties to chief executives abuses call for the need to erect a wall between the executives and the board. Recent empirical study by Sanda, Garba, and Mikailu (2008) has shown that board independence by way of employing foreign chief executives, disallowing chief executives from membership of Audit committees, and the membership of outsiders on the board increase firm performance.

            The work of Iqbal and Mirakhor (2004) on governance mechanism in Islamic framework argued that corporate governance in Islam is more align to stakeholder model than Anglo-Saxon. They argue that two fundamental concepts of Islamic economic system pertaining to property rights and contracts govern the economic and social behaviors of individuals, society and state, including legal entities like firms. Principles of property rights in Islam clearly justify inclusion of stakeholders into decision-making and accountability of an economic agent’s activities. This inclusion, according to them, ‘is based on the principles that (a) collectivity (community, society, state) has sharing rights with the property acquired by either individuals or firms, (b) exercise of property rights should not lead to any harm or damage to property of others (including stakeholders), (c) rights of others are considered as property and therefore are subject to rules regarding violation of property rights, and finally (d) any property leading to the denial of any valid claim or right would not qualify  to be recognized ‘al-mal’ and therefore will be considered unlawful according to Shariah.’
         On ‘contracts’ their argument is base on the Islamic teaching that Divine Law itself is contractual in its conceptualization, content, and application. They defined contract in Islam as ‘a time-bound instrument, which stipulates the obligations that each party is expected to fulfill in order to achieve the objective(s) of the contract.’ Islam places a significant importance on contracts that the holy Qur’an exhorts believers to fulfill contracts (Q 5:1). Implication of the emphasis placed on contracts in Islam is that it makes the members of the society, government and economic agents aware of the obligations arising from their contractual agreements (Iqbal and Mirakhor 2004). Chapra and Ahmed (2002) in their work on corporate governance share the views of Iqbal and Mirakhor on stakeholder model of corporate governance, that rights of all stakeholders should be protected irrespective of whether they hold equity or not.
      Choudhury and Hoque (2004) put forward the postulate that Tawhidi should be the focal point of corporate governance in Islam, where the Shariah rules embedded in al-Quran and al-Sunnah make the Islamic corporation market driven and at the same time uphold the principle of social justice. The principle of Shura acts as a major decision making mechanism. Shura will provide the widest possible means for all stakeholders to participate in the decision making process. Under this model Shura group should be complemented by the Shariah Board to help with the interpretation of Islamic rules pertaining to workings of the corporation. Chapra (2007) called for the role of Islamic government in enforcement of the Islamic code of corporate governance. The overall arguments of providing theoretical foundation of the stakeholder model of corporate governance in Islamic economic system, argues Hasan (2009), is to establish that Islamic corporation’s objective is to maximize the welfare of all stakeholders and not the shareholders alone.

           The concept of Shariah board as element of corporate governance is unique to the Islamic system. While in United Kingdom you have Chairman, who normally is non executive, to balance the influence of chief executive and run the board meetings, in America chief executive normally do not have rivals, he chairs the board meetings. Under the European model as is found in Germany and France, Board of ‘Directors’ is rival by another Board called Supervisory Board. In the Islamic system according to Choudhury and Hoque (2004) Shariah Board acts as the supreme board. For any corporate institution to claim Islamic compliance it must appoint a supervisory board, committee, or group of advisors, comprising between one and three Islamic legal scholars who have particular expertise in economic and financial transactions (Mahmood 2009). It is also the responsibility of the Shariah Board to ensure Shariah compliance so as to assure the institution’s clients that the business renders services according to Shariah.


           The most challenging job for the financial institutions around the world today is how to deal with the aftermath of the last global economic crisis. In a recent IMF paper by Hasan and Dridi (2010), the result of their study shows that despite Islamic bank resilience during the crisis weakness in risk management in some Islamic banks has contributed in reducing their performance. One of the major risks exposed by the crisis according to the study includes liquidity risk, poor legal framework, and lack of harmonization of regulations. The authors of the study argue that shallow money market and absent of Shariah compliant liquidity management instruments have contributed to the liquidity risk. The study argues that further development of the Sukuk market and mutual recognition of financial standards and products across jurisdictions would help limit the problems.
        One of the major challenges in governance in Islamic finance is the one created by the international Sukuk market. The rapid growth in the sector is going beyond the ability of regulators, issuers and underwriters to provide proper corporate governance standard that will match it (Kablawi 2008). The absence of harmonize legal and regulatory framework across the markets have contributed in heightening the risk face by market participants. Some governance issues highlighted by Kablawi are oversight issues in Sukuk certificate issue through special purpose vehicle (SPV), who should the custodian of an asset be answerable to Sukuk holders or the issuer, remuneration issue of Shariah supervisory board to the transaction, and governance issues involves in arrangers/lead managers deals.