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From Knowledge to Wisdom: The Case of Corporate Governance in Islamic Banking Samy Nathan, New York Institute of Technology,
[email protected] Vincent Ribière, New York Institute of Technology,
[email protected] Authors listed in alphabetical order since contributions to this work were equal
Abstract
Purpose: This paper defines and explores the concepts and relationships between Intellectual Capital, Knowledge, Wisdom and Corporate Responsibility in the context of the corporate governance of Islamic Financial Institutions. Design/methodology/approach: This paper presents an adaptation of the Nicholson and Kiel (2004) Intellectual Capital model of the Board of Directors including the role of the Shari’a Supervisory Board (SSB). It is driven by the following research questions: How does the SSB add value to the corporate governance model of IFIs through their intellectual capital? Is there any value of replicating the IFIs structure in Western conventional banks, and if yes, how could it be done without the religious and cultural impacts? Findings: We recently entered the knowledge economic era and organizationas are slowly realizing the need and the benefits not only to better manage knowledge, but also to manage it in a wiser way. The concepts and values carried by Islamic banking and by social responsible investments have a lot in common and they both tend to bring wisdom to the organization’s operations and goals Originality/Value: This paper explores how the core concepts of Islamic banking governance could be adapted to conventional banking. It shows the need for organizations to continue their knowledge management journey by integrating organizational wisdom to their decisions and actions. Corporate Social Responsibility is perceived has being a first step to reach organizational wisdom. This paper touches on various critical issues and we hope that it will be source of inspiration for numerous research questions and debates on these topics. Article Type: Research paper Keywords: Boards of Directors, Intellectual Capital, Islamic Banking, Shari’a Supervisory Board, Wisdom, Corporate Social Responsibility
1. Introduction “Twenty five years ago Islamic banking was virtually unknown. Today the market size is estimated, by some commentators, to be growing at a double digit rate per annum. Islamic banks currently operate in approaching 75 countries and the industry has a market estimated at US $250-300 billion” (Bahrain Monetary Agency, 2006)
Over the last three decades, Islamic banks, which will refer to as “Islamic Financial Institutions” (IFIs), were slowly introduced in the Middle East countries as a new player in the financial markets against conventional banks. Islamic banking refers to the conduct of banking operations based on Islamic principles. Islam
2 forbids the charging of interests, but encourages the earning of profits. Banks are not permitted to charge for the mere use of money. Purely speculative transactions are not allowed in Islamic banking. Banks are also not allowed to finance any enterprise involved in; pork, pornography, finance service (conventional), arms and munitions, cinema, tobacco, gambling, and alcoholic liquor. Also Islam law encourages people to use their money and not to keep it inactive so banks cannot mobilize founds on the traditional way they manage it in return of receiving a share of the profits. IFIs are also radically different from their conventional counterparts in major aspects such as foundation, management, and products. On the management side, IFIs operate under a different structure of corporate governance than the one used in conventional banking. IFIs are obliged to appoint a board of Islamic scholars called "Shari'a Supervisory Board" (SSB). Islamic banking is governed by the Shari’a (Islamic law, also referred as Islamic Jurisprudence). Islamic Shari’a Laws provide rules to encompass the allocation of resources, management, production, consumption, capital market activity and the distribution of income and wealth (Bahrain Monetary Agency, 2006). This board is appointed by the general assembly of shareholders and recommended by the Board of Directors (BoD). The SSB is not only independent from the BoD, but it is also allowed to attend the BoD meetings to discuss the religious aspects of their decisions (Abu Ghudda 2001, 6, AAOIFI 2004-5, 15). Although there is no limitation on the number of the SSB members, arguably the ideal number would be three to five members. The SSB objectives can be summarized in guiding the IFIs in the setting of policies and regulations according to Shari’a; in approving their financial transactions from legal side and in preparing their contracts for future transactions according to the Islamic Shari’a (Daoud, 1996). SSB authority is derived from different resources other than what the BoD has in conventional banks. SSB authority comes from religious, legal and systemic resources. SSB represents the bank in public (i.e., conferences and seminars) and clarifies any religious doubt that the stakeholders might have regarding any transaction. In addition, the SSB provides advice to the BoD as well as the top management about religious issues, and conducts internal auditing regularly on the IFI documents to ensure their conformity with Shari’a. The culture plays a significant role in the SSB nomination. Since Islam has four different sects (Hanafi, Hanbali, Maliki and Shafi’i) which interpret the Islamic holy book (Quran) differently, SSB members should be selected from the dominant sect(s) in the country and consequently reflect their own understanding of Quran onto the transactions of IFIs. For example, what might be applicable/accepted to IFIs in Malaysia might not be in the Kingdom of Bahrain. 2. Research Questions This research focuses on the role of the SSB in corporate governance of IFIs. How does the SSB add value to the corporate governance model of IFIs through their intellectual capital? Is there any value of replicating
3 the IFIs structure in Western conventional banks, and if yes, how could it be done without the religious and cultural impacts? To answer these questions, a review of the very limited available literature was conducted focusing mainly on the value added by the SSB intellectual capital, and its influence on the board of directors. A model of corporate governance in IFI is presented, followed by a discussion on how Islamic banking model could be replicated/adapted to conventional banks. 3. Literature Review The existence of the SSB is central for ensuring the integrity and credibility of IFIs (IFSB 2005, 10). The SSB acts as a steward on behalf of equity holders as well as investors to protect their rights and ensure complete transparency between the two parties and the management (Karim 1990, 34; Hassan 2001, 9; Abdulla 2001, 23). The SSB is involved in both internal and external auditing processes to ensure the right implementation of Shari’a rulings. Thus, the role of SSB is vital in creating trust between IFIs and their stakeholders by disseminating timely and sufficient information (financial and non-financial) regarding its operations and performance (AAOIFI 2006, 6). The concept of Intellectual Capital (IC) has been under research for a long time. IC used to be called “goodwill” (Brookings 1996, 12), but it is currently the subject of numerous academic research (i.e., Bontis, 1999; Brooking, 1997; Keenan and Aggestam, 2001; Saint-Onge, 1996; Stewart, 1997; and Sveiby, 1997). IC is the knowledge that can be converted into profit and increases the value of the firm (Wiig 1994). It can be identified as a by-product of “organizational design” that is aligned with organizational success (Sullivan 1998, 3). The gap between the firm’s book-to-market value is the firm’s Intangible Assets (IA). Therefore, the leaders of U.S. successful companies realized that IC could provide tangible bottom-line results, if the sources of value are extracted (Green 2004, 11). Thus, IC/IA models are being developed to supplement traditional accounting methods (Shand 1999, 37).
In brief, intangible assets, intellectual capital, and
knowledge assets essentially have the same meaning (Lev 2001, 5). Recently, they became the main asset in the organization where knowledge is the main sources of the firm’s progress. 4. Intellectual Capital Model of the Boards
Different theories have been developed to describe and to better understand the role of the BoD (i.e. Agency theory, stakeholder’s theory, stewardship, resource dependence etc..). These theories provide a comprehensive explanation about board independence, but not about board effectiveness through the IC perspective, which will be addressed in this paper. In addition, these theories assume that there is only one independent board, but in IFIs there are two independent boards (BoD and the SSB) which work together
4 side by side. These two points will be discussed through our adaptation of Nicholson and Kiel (2004) Intellectual Capital Model of the BoD, which is presented in their publication “Breakthrough board performance”. The original model focuses on the BoD, our adaptation of their model (Figure 1) incorporates the roles of the two boards, and how they affect the firm’s performance. Let’s first provide a definition of the concept of IC applied at the board level: “The intellectual resources such as knowledge, information, experience, relationships, routines and procedures that a board can employ to create value” (Nicholson and Kiel, 2004) adapted from (Stewart, 1997)
IC is composed of three components: human capital, social capital and structural capital. Human capital can be described as the individual components of the IC where abilities, skills, knowledge and creativity constitute the tacit knowledge of the board members (BodD & SSB) and assist them in making their decisions (Bontis et al. 1999, 443). It is the fundamental part of IC because it forms the basis of the capacity for the board to act upon (Bassi et al., 1999) and enables the board members to play their roles effectively (Castanias and Helfat 2001, 673). Through the board skills, expertise and understanding of the firm’s business situation, the board can act as a potential source of advantage to the firm (Nicholson et al. 2004, 10). Social capital covers different levels of social structures starting outside the organization and moves inside (Adler and Kwon, 2002). It can be classified into three levels: the relationship between the board and the external environment (extra-organizational relationship), the relation between the board and management (board-management) and finally, the relation inside the board (intra-board) (Nicholson et al. 2004, 10; Nahapiet and Ghoshal, 1998). In practice, the board members acquire their knowledge from the external environment through their personal relations and interactions. This knowledge facilitates the execution of the board roles. On the other hand, the board-management relations moderate the human capital of the board members and assist them in analyzing their information properly before moving to the explicit side. Finally, the intra-board social capital moderates the relationship among the members themselves. In brief, both human and social capitals are rooted inside the board members, but structural capital is the function of the board (Castinas et al., 2001). Structural capital is the codified knowledge that can build the competitive advantage of the organization through the board routines, policies and procedures (Bontis et al., 1999). Structural capital refers to the routines of corporate governance in an organization, where board members share both tacit and explicit knowledge by turning their know-how knowledge into group property (Edvinsson and Sullivan, 1996).
Tacit
Intellectual 5Capital
Human Capital (Individuals)
Social Capital (Teams)
-
- Intra Board - Board Mgmt - Extra Org. - Relationships - Social ties - Trust
Creativity Knowledge Skills Ability
Shari’a Supervisory Board Roles
Board of Directors Roles Monitor & Control
Access to Resources
Strategizing
Advice & Counsel
Moderates
Explicit Structural Capital (Organization) - Process - Procedures - Routines - Practices - Audits - Corporate governance routines - Regulations
Monitor & Control
Access to Resources
Advice & Counsel
Contingency
Board Effectiveness
Firm Performance
Figure (1): The Intellectual Capital Model of IFIs Boards adapted from Nicholson and Kiel (2004) 5. The Board of Directors Roles Based on the model presented by Nicholson and Kiel (2004) the IC of the BoD impacts the board effectiveness. We also agree with the authors that the role of monitoring and controlling should come on top of the list because it measures the performance of decision agents (Fama and Jensen, 1983). This role does not include so much audit or internal control, but getting assurance that the board is in control of the situation and not dominated by management (Van del Berghe and Baelden, 2005). This role can be achieved through the delegation policy of the board which works as an important determinant of the board’s monitoring role. On one side, the board should monitor the delegated tasks and on the other side, the board should prevent high concentration of power in the management’s hand as it alarms the board control. The second role is focused on the degree of involvement in strategizing process which is unique to the BoD compared to the SSB. In this part, the board takes an active role as independent thinkers in shaping the strategic directions of their organization (Walsh and Seward, 1990; Davis and Thompson, 1994). They will be responsible for monitoring and influencing the strategy rather than implementing the strategic decisions
6 (Forbes and Milliken, 1999). Their role leans towards guidance to the top management rather than setting up the actual strategy (Ingley and Van der Walt 2001, 176). However, they should not satisfy the management requirements in any way that might turn out their role to one that becomes passive (Herman, 1981). Since the quality of decision making is dependent on the volume, relevancy and quality of collected information, the third role emphasizes the area where the Chief Executive Officer (CEO) and executive members should be responsible for making information available to the board. This issue is always viewed as a challenge to the quality of monitoring and decision making of non-executive directors (Nowak and McCabe 2003, 303). The fourth role follows Zahra and Pearce (1989) by confirming that the BoD should have an active strategizing role in counseling and advising the CEO and providing strategic alternatives that assist the top management in fulfilling their tasks. Similarly, Hermalin and Weisbach (1988) found that CEO relied on directors for input in the formulation of strategy. Also, Helmer (1996) asserted that the board’s role in strategy was to establish standards, counsel the CEO and monitor strategy implementation. The contingency portion of the model represents both internal and external environmental factors. The internal part includes organizational size, production life cycle and management experience (CoulsonThomas, 1993; Johnson, 1997). The external part includes industry lifecycle, market share, and competition (Johnson, 1997). These factors can drive the board’s performance to its optimum level by fitting the board design with the organization size and regulations (Pfeffer 1972; Donaldson and Davis, 1994). 6. The Value-Added Roles of Shari'a Supervisory Board Unlike the BoD, the SSB members are specialized jurists in Islamic commercial jurisprudence and experts in the field of Islamic financial Institutions (AAOIFI 2004-5, 5; Al-Mahmoud 2007, 8; Al-Qattan 2007, 26). This common background among the SSB members facilitates their communication and enables them to share and transform their tacit and explicit knowledge into a faster and clearer way than the members of the BoD. The conversion of knowledge can be explained by Nonaka (1994) in his model of “Socialization, Externalization, Conceptualization and Internalization – SECI” and the common shared culture/background is described by Nonaka (1998) as the “Mental space” of the “Ba”. Nonetheless, the SSB members should be intellectually honest and free of conflict of interests to enhance the public confidence in IFIs activities (AAOIFI 2006, 4) to reflect the religious image of the organization. On the other hand, the SSB members do not have professional code to follow, except their understanding and interpretation of Shari’a.
This
difference is accepted among the SSB members because of the different in Islamic sects of Hanafi, Hanbali, Maliki and Shafi’i; however, it leaves a gap of arguments between the management and SSB, if they have different points of view (Karim 1990, 39).
7 The SSB have the same roles as the BoD except the planning and strategizing roles, because its task focuses on present and historical events rather than building up a future strategy (AAOIFI 2004-5, 15). First, the SSB controls and monitors the religious side of IFIs transactions, services, and products. The board has to review all the decisions of the BoD and top management to ensure their compliance with Shari’a. Also, it has to approve the articles of incorporation along with the entire policies, code of ethics and code of conduct. Furthermore, they authorize all the financial products and transactions and ensure their compliance with Shari’a. SSB has the right to appoint Shari’a internal auditor to monitor the day-to-day transactions and report directly to them (Al-Mahmoud 2007, 9). If the SSB discovers that any transaction violated the Shari’a and that this transaction has generated revenue to the IFI, they separate this type of earnings aside and donate it to charitable organization or spend it in any similar manner. Secondly, the top management and the CEO have to provide all the information that might assist the SSB members in applying Shari’a rules over the transaction/product regardless of the outcomes. The reason behind this attitude is the stakeholders’ belief that Islamic banking should provide Islamic financial products according to Shari’a. By having access to all resources of information, SSB can justify their decision and relief the management from any responsibility in the decision. Thirdly, the SSB has a lot to do with advising and counseling starting from the external environment where stakeholders, regulators, and central banks and going inside to enlighten the management and employees. The SSB is responsible in finding the religious proposals and suggestions for the financial transactions that might contradict with Shari’a. Furthermore, the board should reply all the investors’ queries and clarify any ambiguity in any transactions. In the meantime, the SSB should continuously guide and train the top management to apply the Islamic rules in the daily transactions and avoid any conflicts before going into any agreement with the investors.
7. From Knowledge to Wisdom We previously highlighted the various benefits (IC) brought by the SSB to the BoD; however, it seems that Islamic banking is not likely to be as widely accepted in Europe or in the USA as it is in the Middle East and in Southeast Asia. The national regulatory challenges associated with other operational barriers in western countries could eventually be overcome (Silva, 2006) but the “religious/Islamic” label and values attached to IFIs might not be universally shared and adopted by all global customers. Thus, it becomes interesting to understand how the benefits brought by the SSB could be replicated in conventional banking without integrating the religious dimension to it. Some conventional banks (i.e., Citibank, Dresdner Kleinwort Benson, Goldman Sachs and ABN AMRO) have already developed Islamic banking
8 capabilities by opening “Islamic Windows” to their customers offering Shari’a compliant products and services (Moore, 1997). However, such traditional institutions are limited by the amount of investments they can offer. Since they are not required to have a SSB to overlook their activities, they are not appealing to some clients because they do not trust them so much as they trust a pure Islamic bank. We can summarize the main values brought by the SSB to the institution by; transparency, trust, ethical behavior, credibility, as well as the philosophy, values, and beliefs underlying Islam (Aqidah (Faith & Beliefs), Shari’a (Practices & Activitites) and Akhlaq (Moralities and Ethics)) (Thomas, Cox and Kraty 2005, 15). A large portion of Islamic banking and finance customers join IFIs because they strongly believe in these values and have the desire to support their religion and community.
The SSB not only
carries/transfers knowledge but, more importantly, Islamic wisdom that drives the operations and actions of the bank. We are suddenly touching on a more abstract layer of knowledge, wisdom! The concept of wisdom is not a new, as it has been the source of numerous discussions and debates over the centuries. Small (2004), Rowley (2006a, 2006b) and Bierly, Kessler and Kristensen (2000) present a comprehensive retrospective of the most important contributors and school of thoughts regarding Wisdom over the ages. We currently do not have a definition of knowledge that we could consider as being a standard definition accepted by everyone. Wisdom being a more abstract concept, sometime considered as elusive (Rowley 2006a), its definition remains a challenge let alone its standardization:. Wisdom, according to the Merriam-Webster dictionary, is defined as the "1 a: Accumulated philosophic or scientific learning-knowledge; b: Ability to discern inner qualities and relationships-insight; c: Good sensejudgment d: Generally accepted belief . 2: A wise attitude, belief, or course of action. 3: The teachings of the ancient wise men"
It is generally accepted that there is a relationship between wisdom and knowledge, but having a lot knowledge doesn’t automatically imply being wise. The concept of wisdom adds the dimensions of morality, ethics, soundness of judgment, social and environmental considerations, right and wrong perspectives, … to the notion of knowledge. Beck (1999) argues that wisdom is comprised of both knowledge (understanding the truth) and action (doing what is good). Bierly, Kessler and Kristensen (2000) define wisdom as “the ability to best use knowledge for establishing and achieving desired goals and learning about wisdom as the process of discerning judgments and actions based on knowledge”. Rowley (2006a) defines wisdom as: The capacity to put into action the most appropriate behavior, taking into account what is known (knowledge) and what does the most good (ethical and social considerations). Wisdom = Knowledge + Ethics + Action
9 Sternberg (1990) argues that “the essence of wisdom is not in what is known, but rather in the manner in which knowledge is held and how that knowledge is put to use”. A lot of emphasis has been put over the past decade on knowledge and its management, but the literature is still very limited concerning wisdom in the context of corporation. It seems like a logic evolution to talk about corporate wisdom since the only availability of knowledge does not guaranty wise decisions and actions. A wise action or decision starts by selecting the right knowledge, so knowledge management systems should provide the ability to present the right knowledge (high quality) to facilitate the making of wise decisions and/or actions. Some authors already refer to wisdom management systems (Thierauf, Hoctor 2006) as optimal knowledge management systems. Such systems will help to answer questions like “What needs to be done” rather than the common question asked “What do you think we should do?”. For others such systems is a utopia (Bellinger et al. 2004) since they believe that “computers do not have, and will never have the ability to possess wisdom. Wisdom is a uniquely human state, or as I see it, wisdom requires one to have a soul, for it resides as much in the heart as in the mind”. So how can individual wisdom be acquired? Bierly, Kessler and Kristensen (2000) believe that wisdom can be learned or developed. They propose three paths: experience, spirituality and passion. Experience involves: interaction between the self and the environment, engaging into experimentation and reflecting on them in order to get a broader understanding. “Spirituality facilitates wisdom insofar as it helps clarify goals and objectives by providing a foundation of core beliefs and a better holistic understanding of one’s purpose in life. It also provides faith, courage (guidance and reassurance) and hope that facilitate decision making and actions (Bierly, Kessler and Kristensen, 2000)”. Finally, passion will be required to take the right decision, whatever it requires to do so. Knowledge champions are for example a good illustration of passionate employees. Small (2004) strongly supports the idea that a “managerial wisdom” course should be integrated in management curriculum since we are seeing more and more cases where “unwise decisions” are made by management practitioners (i.e., Enron, Worldcom etc.).
Having wise employees in your organization does not mean that you have a wise organization. The wisdom will have to be shared, transferred and disseminated to all. Bierly, Kessler and Kristensen (2000) propose three main means that could facilitate such actions: Transformational leadership, organizational culture and structure, and knowledge transfer. We will not describe in details all these three aspects but we will focus on what we think is the most relevant to the topic of this paper. Bolman and Deal (1995) support the fact that transformational leadership provides better results it is closely related to spirituality, promoting commitment and a sense of community. It appears that an organization will become wise, if there is a strong commitment at the different levels of management, starting at the top by having a wise Board of Directors (BoD) establishing wise strategies that will be implemented by wise leaders that will inspire/promote ethical behaviors, trust, loyalty, transparency and respect for stakeholders.
10 If we come back to the case of the Islamic banking institutions, the wisdom is “enforced” by the SSB which controls and supervises the transactions of the bank to ensure their compliance to the Shari’a. Such scholars obtained their Islamic wisdom by experience, spirituality and passion. Stakeholders trust them because of their wisdom. The question becomes how similar wisdom be integrated into western conventional banking? This pattern could be replicated by providing more transparency, ethical behavior, respect for stakeholder groups and attempt to maximize social, environmental and economic goods which are in fact the core components/drivers of Corporate Social Responsibility (CSR). The World Business Council for Sustainable Development (WBCSD) (1999) defines CSR as “the continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as of the local community and society as large”. CSR is not a new concept but organizations are slowly realizing the need and the value to seriously take these issues in consideration. Profitability and responsibility are always seen as conflicting concepts, but stakeholder collaboration is now the key of creating economic wealth (Shahin, Zairi 2007). Social responsibility applied to the finance and banking industry is materialized by social responsible investments. This means that only investments that satisfy the socially responsible criteria adopted by the financial institution will be used. For instance, no investment could be made on activities related to gambling, alcohol, tobacco or any activity that could damage the environment. Investment on companies that have demonstrated CSR will be privileged. The Cooperative Bank in the UK is an example of a bank which fully adopted CSR and demonstrated that it can be ethical and profitable at the same time (Monaghan, 2005). Lord Tim Clement-Jones (2005) states that “Integrated CSR is now seen as an important antidote to corporate greed and rebuilding trust among stakeholders”. His recommendations are aligned with our approach that states that “The need for better corporate governance is set to drive companies towards more ethical behavior from one direction while stakeholders and customers drive more ethical behavior from another”. We believe that CSR is a component or a first step in achieving corporate wisdom, but unfortunately not all organizations are engaged in it. In Islamic banking regulations exist to enforce the Shari’a compliance and the SSB is present at all the levels of the organization to enforce Islamic wisdom. A similar approach could be considered by conventional banks if clear CSR regulations were established, and if a CSR supervisory board was created.
8. Conclusions We recently entered the knowledge economic era and by this case/example we can already identify the need and the benefits for organizations not only to better manage knowledge, but also to manage it in a wiser way. Through our discussion we presented the different roles of Shari’a Supervisory Board (SSB) and how it adds
11 value to the Board of Directors (BoD) in the context of Islamic financial institutions. A model was proposed that presents, through an intellectual capital lens, how the SSB influences and impacts the firm’s performance. We believe that the concepts of trust, knowledge and wisdom are the main benefits brought by the SSB. More importantly, the concept of social responsible responsibility and investment on the West is also emerging, and it is becoming differentiating factor and a way for organizations to demonstrate some corporate wisdom. These concepts and values carried by Islamic banking and by social responsible investments have a lot in common and they both tend to bring wisdom to the organization’s operations and goals. This wisdom will help organizations to gain a competitive advantage by not only doing things the right way, but by doing the right things that will ultimately benefit/preserve the society. This paper touched on various critical issues and we hope that it will be source of inspiration for numerous research questions and debates on these topics.
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15 About the authors
Samy Nathan. Garas, Doctoral Student at the University of St. Gallen-Switzerland; has been working on his dissertation “Corporate Governance in Islamic Financial Institutions”. On 1996, Samy received his CMA through the American Chamber of Commerce-Cairo. On 2005, Samy received his MBA from Phoenix University-Arizona. Since 2003, Samy is a full-time teacher at the New York Institute of Technology (NYIT)-Bahrain Campus, teaching various Accounting and Finance topics
Vincent Ribière, Assistant Professor of Management of Information Systems at the New York Institute of Technology (NYIT), received his Doctorate of Science in Knowledge Management from the George Washington University, and a Ph.D. in Management Sciences from the Paul Cézanne University, Aix en Provence, France. Vincent teaches, conducts research and consults in the area of knowledge management and information systems. Over the past years, he presented various research papers at different international conferences on knowledge management, organizational culture, information systems and quality as well as publishing in various refereed journals and books. He is a contributing editor and reviewer to journals focused on knowledge management. He is the Director for Asian activities at the Institute for Knowledge and Innovation (IKI – George Washington University & Bangkok University).
