HumanomicsCorporate governance disclosure in the annual report: An exploratory study onIndonesian Islamic banksSalim Darmadi

Article information:To cite this document:Salim Darmadi, (2013),"Corporate governance disclosure in the annual report", Humanomics, Vol. 29 Iss 1pp. 4 - 23Permanent link to this document:http://dx.doi.org/10.1108/08288661311299295

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Corporate governance disclosurein the annual report

An exploratory studyon Indonesian Islamic banks

Salim DarmadiIndonesian Capital Market and

Financial Institution Supervisory Agency (Bapepem-LK),Jakarta, Indonesia and

Indonesian College of State Accountancy (STAN),Tangerang Selatan, Indonesia

Abstract

Purpose – The purpose of this paper is to explore disclosure on corporate governance mechanisms inannual reports of Islamic commercial banks in Indonesia.

Design/methodology/approach – Employing a sample comprising seven Islamic commercialbanks in Indonesia, the present study constructs the so-called Corporate Governance Disclosure Index(CGDI) to score the banks’ disclosure level. Corporate governance mechanisms addressed in this studyinclude Shariah Supervisory Board, the Board of Commissioners, the Board of Directors, boardcommittees, internal control and external audit, and risk management.

Findings – It is revealed that Bank Muamalat and Bank Syariah Mandiri, the county’s two largestand oldest Islamic commercial banks, score higher than their peers. Disclosure of the sample banks onsome dimensions, such as board members and risk management, is found to be strong. On the otherhand, disclosure on internal control and board committees tends to be weak.

Practical implications – This study shows that the average disclosure level among the samplebanks is relatively low. Hence, this result has important implications for the enhancement of corporategovernance disclosure of Islamic banks, thereby wider acceptance and enhanced reputation couldbe gained.

Originality/value – This paper is believed to be among the first to explore the practice of disclosureon corporate governance mechanisms among Islamic commercial banks. Additionally, it focuseson Indonesia, the largest Muslim country that has a different institutional setting from that in otherMuslim countries.

Keywords Corporate governance, Disclosure, Indonesia, Islamic banks, Banks

Paper type Research paper

1. IntroductionBeing the largest Muslim country in the world, Indonesia experiences rapid growth inits Islamic banking industry. Even though the market share of Islamic banks in thecountry is still below 4 percent, the total value of Islamic banks’ assets in 2010 hadbeen 50 times larger than that in 2000. As of 31 December 2010, there were 11 Islamic

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The views expressed in this paper are those of the author and do not necessarily reflect the views ofBapepam-LK. The author gratefully acknowledges helpful comments by Amir Shaharuddin andparticipants at the 2011 Islamic Seminar and Conference on Islamic Economics at UniversitasNegeri Jakarta, Indonesia. All errors and omissions remain the author’s responsibility.

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HumanomicsVol. 29 No. 1, 2013pp. 4-23q Emerald Group Publishing Limited0828-8666DOI 10.1108/08288661311299295

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commercial banks and 23 Islamic banking units, as well as 150 Islamic rural banks, inthe country[1]. The Islamic Banking Law, as the legal foundation for the Islamicbanking development, was also enacted in 2008[2]. It is expected that the IndonesianIslamic banking industry continues to grow, following increased awareness of theIndonesian Muslims, growing well-educated population, and increasingly widespreadbranches throughout the country.

Since modern commercial banks are generally run as corporations, agencyproblems (as theorized by Jensen and Meckling, 1976) may arise due to differences ofinterests between shareholders and management. In firms with a higher level ofownership concentration, such problems may occur between the controllingshareholder and minority shareholders (Shleifer and Vishny, 1997). Hence, variouscorporate governance mechanisms are intended to minimize this conflict. In thebanking industry, corporate governance has a higher level of significance since banksmobilize public saving, depend on public trust, and have more diverse stakeholders.Weak governance in banks has resulted in the collapse of banks during crises, as wellas financial scandals involving the owner and management, which could havesystemic impacts on the economy. In Islamic banking, greater attention should beplaced since Islamic banks are exposed to more non-compliance risks, as well asweaker institutional environments of emerging markets in which they mostly operate(Claessens, 2006). Further, in Islamic banks, investment depositors appear to be part ofthe agency conflicts since they participate in the profit and loss like shareholders,making good governance mechanisms highly required to protect their interest and tomaintain their confidence. Due to the banks’ diverse stakeholders, such governancemechanisms need to be disseminated and disclosed in corporate reports.

The present study explores the practice of disclosure on corporate governancemechanisms in annual reports of Indonesian Islamic banks. It contributes tothe knowledge in at least two important ways. First, this study is conducted in theIndonesian context. Even though studies using data across different countries, such asthose conducted by Haniffa and Hudaib (2007) and Hassan and Harahap (2010), mayprovide more powerful insights, studies in the context of one single economy is stillimportant since one particular economy has its unique national characteristics.Indonesia has a relatively different institutional environment from other Muslimcountries. For instance, the country adopts two-tier board structure, where corporationsshall have a supervisory board (called “board of commissioners” – BOC) and amanagement board (called “board of directors” – BOD). The Islamic banking industry inthe country, which emerged in early 1990s, was initiated by the Muslim society insteadof the government. Further, the country’s fully pledged Islamic banks are generally theresults of conversion from conventional banks or spinoffs from their conventional-bankparents. Second, exploratory studies on corporate governance of Islamic banks, based oninformation disclosed in corporate annual reports, are relatively scarce in the literature.Such exploratory studies have addressed corporate social responsibility (Maali et al.,2006; Hassan and Harahap, 2010) and ethical identity (Haniffa and Hudaib, 2007).

The sample of this study consists of seven banks whose 2010 annual reports areavailable on their web sites; namely Bank Muamalat, Bank Syariah Mandiri, BankMega Syariah, Bank Syariah Bukopin, Bank Victoria Syariah, BCA Syariah, and BJBSyariah. The so-called Corporate Governance Disclosure Index (CGDI) is constructedfor each bank to measure the extent of governance disclosure. The corporate

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governance mechanisms addressed include the Shariah Supervisory Board (SSB), theBOC, the BOD, board committees, internal control and external audit, and riskmanagement[3]. The result reveals that Bank Muamalat and Bank Syariah Mandirishow higher CGDI scores than their peers. Some other banks show low levels ofdisclosure. Three areas requiring much improvement are internal control and externalaudit, board committees, and corporate governance implementation reporting.

The remainder of the present paper is structured in the following manner. Section 2reviews prior theoretical and empirical work on corporate governance of Islamic banksand corporate governance disclosure. This is followed by Section 3, which brieflydiscusses the characteristics of the sample banks, as well as the methodology to scorethe disclosure level. In Section 4, the results of CGDI scoring are presented and furtherdiscussed. Finally, Section 5 concludes the paper.

2. Literature review2.1 The importance of corporate governance in Islamic banksIn the banking industry, corporate governance practices are unique compared withthose in other sectors where governance mechanisms are “simply” intended to align theinterests of shareholders and managers ( Jensen and Meckling, 1976), or in the cases offirms with more concentrated ownership structure, of the controlling shareholder andminority shareholders (Shleifer and Vishny, 1997). The uniqueness is due to the duty ofmanagers to manage and safeguard the funds provided by various parties, includingdepositors. Economic behavior of the banks can also affect economic outcomes, wherein some countries banks act as a major source of external financing for firms. Further,banks have more diverse stakeholders and thus monitoring costs tend to be high,leading to the importance of corporate governance mechanisms. Banks’ business isalso risky due to highly leveraged nature of its capital structure, where banks facemany short-term claims and are relatively dependent on depositors’ confidence.

In Islamic banking, greater attention needs to be placed on corporate governance forat least three reasons. First, Islamic banks need to comply with shariah law, in additionto adherence to banking regulations (Archer et al., 1998). Chapra and Ahmed (2002)state that most depositors and investors of Islamic banks are highly concerned thattheir funds are managed in accordance with shariah rules. Hence, such banks are moreexposed to non-compliance risks. Chapra and Ahmed’s survey also shows that mostdepositors of Islamic banks are prepared to withdraw their funds if those banks fail tooperate in accordance with shariah rules. Safieddine (2009) explains that:

[. . .] while agency problems in conventional companies arise when managers deviate fromtheir duty to maximize shareholders’ wealth, any divergence by managers of Islamic financialinstitutions from placing all supplied funds in Sharia-compliant investments creates anadditional source of agency problems (p. 144).

Second, Islamic banks have unrestricted investment account holders (IAHs). Theseaccount holders appear to be part of the agency conflicts since they participate in theprofit and loss like shareholders (Chapra and Ahmed, 2002; Nienhaus, 2007). Eventhough their deposits are generally higher than shareholders’ equity, they have novoice in shareholders’ meetings. However, allowing depositors to have voting rights inshareholders’ meetings is unlikely to do since IAHs are much greater in number andmore poorly organized compared to shareholders. As contended by Chapra and

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Ahmed, all precautions need to be taken to maintain confidence of depositors in Islamicbanks. The tools may include sufficient regulation, proper supervision, sound riskmanagement, and good corporate governance (GCG). Again, when an Islamic bankfails to protect the depositors’ interests, depositors are likely to protect their own rightsby withdrawing their deposits in the bank.

Third, most Islamic banks operate in emerging markets, where the institutionalenvironment tends to be weaker (Claessens, 2006). In such markets, where high levelsof ownership concentration and family control are more prevalent, applicableregulations tend to be less protective for minority shareholders (as well as IAHs) fromasset expropriation committed by the controlling shareholder. Additionally,transparency and disclosure practices are also weaker in these markets comparedwith those in more developed economies, making monitoring costs and informationasymmetry higher. Alternatively, lack of market discipline appears to be another issuein less developed markets (Claessens, 2006). These conditions, hence, stress theimportance of GCG in Islamic banks.

2.2 Corporate governance disclosure in the annual reportIn the framework of agency theory, agency costs arise due to information asymmetrythat exists between shareholders and managers, or between the controlling shareholderand minority shareholders. Increased corporate disclosure is viewed as one way tomitigate the information asymmetry. Managers, who are more inclined to have detailedknowledge on the firm’s operation, provide shareholders and other user groups withparticular information that may influence their economic decision (Cooke, 1989;Narayanan et al., 2000). Financial reporting regulations generally require minimumdisclosure requirements, thus other information to be disclosed is considered voluntary.Voluntary disclosure is managers’ discretion, and as contended by Verrecchia (1983),managers will disclose voluntary information when the benefits outweigh the associatedcosts. Healy and Palepu (2001) identify five forces that motivate managers to discloseadditional information, namely the hypotheses of capital market transactions, corporatecontrol losses, stock compensation, litigation costs, and proprietary costs.

There are a number of techniques that can be used by firms to distribute corporateinformation to external stakeholders (O’Sullivan et al., 2008). However, as argued byBotosan (1997), the corporate annual report is viewed as the principal medium toconvey financial and non-financial information in a detailed manner. The annual reportis considered important because of its effectiveness in conveying a certain corporateimage or message (Preston et al., 1996), managing external impressions, andpossessing a certain degree of credibility (Neu et al., 1998). As argued by O’Sullivan et al.(2008), even though the annual report is not the only way to disseminate information,firms with high-quality disclosure will ensure that important information isincorporated in their annual reports.

Further, it is also argued that information on corporate governance is important to bedisclosed by the firm. Bushman and Smith (2003) define corporate transparency as “thewidespread availability of relevant, reliable information about the periodic performance,financial position, investment opportunities, governance, value and risk of publiclytraded firms” (p. 76). Bhat et al. (2006) contend that knowledge on a firm’s governancestructure will be useful to assess the credibility of financial information, as well as toaccurately set expectation and to reduce uncertainty concerning the firm’s performance.

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Such disclosure also reveals who are responsible for governing the firm, how theircompensation is structured, and how and where they invest financial resources(Bushman et al., 2004). Additionally, disclosure on the features of corporate governancecan enhance monitoring and internal control, improve firm performance (Labelle, 2002),and drive improvements to the internal structure and process (Association of CharteredCertified Accountants, 2009). If the governance mechanisms are not disclosed, the firm’sstakeholders may not be able to access such information. In the banking sector, due to itsopaque and highly regulated characteristics, corporate governance is subject to theregulation of banking authority. Hence, disclosure on governance mechanisms may playa more important role compared with that in other sectors.

Islamic banks appear to be financial institutions with a religion-based identity;hence, they are expected to adhere to the Islamic ethical values in their operation, inaddition to applicable regulations. Islam itself encourages good governance within afirm. In Islam, corporate governance is aimed to protect the interests of all stakeholderswith adherence to shariah principles (Hasan, 2009). The Islamic concept of corporategovernance stresses the important areas of accountability and trustworthiness. Haniffaand Hudaib (2004) suggest that:

[. . .] one of the avenues to demonstrate their accountability and commitments in serving theneeds of the Muslim community and society in general is via disclosure of relevant andreliable information in their annual reports (p. 5).

With respect to the spirit of transparency and accountability, Islamic banks areexpected to disclose the features of their corporate governance to their stakeholders,enabling the stakeholders to assess how the bank is governed and how theirinvestments is managed in shariah-compliant and prudential manners.

2.3 Corporate governance mechanisms in Indonesian Islamic banksBased on previous studies (Chapra and Ahmed, 2002; Haniffa and Hudaib, 2007;Safieddine, 2009), the present study addresses a number of corporate governancemechanisms and tools that need to be disclosed by Indonesian Islamic banks. Thesemechanisms include SSB, the BOC, the BOD, board committees, internal controland external audit, risk management, and corporate governance implementationreporting.

Shariah Supervisory Board. It is important to note that various parties have stressedthe importance of a SSB, which can ensure that the activities of an Islamic bank are inline with shariah law (Safieddine, 2009). Hence, the SSB plays an important role as aninternal control mechanism (Haniffa and Hudaib, 2007), with the duties of reviewingand supervising the activities of an Islamic bank in order to ensure that they are inaccordance with shariah principles. The SSB is an independent body within an Islamicbank and, therefore, it is not subject to instructions and influences by management, theBOD, or shareholders (Nienhaus, 2007).

In Indonesia, as regulated by the Islamic Banking Law, Islamic banks are requiredto have an SSB, whose members are appointed by the shareholders’ general meetingbased on recommendations provided by the Indonesian Council of Ulamas (MajelisUlama Indonesia). Bank Indonesia requires the SSB of Islamic banks to have boardmeetings of at least once a month and to submit periodic supervisory reports to BankIndonesia[4].

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Boards of commissioners and directors. The BOD is viewed as one of the importantdeterminants of effective corporate governance, since it plays an important role tomitigate conflicts between shareholders and managers (Klein, 1998). The characteristicsof the board, including board size and board independence, have been widely addressedin either theoretical or empirical research. Even though there are persisting debates onwhether firms should have large or small size of the board, some studies suggest thatfirms with more complex operations need to have a greater number of people serving onthe board (Klein, 1998; Coles et al., 2008). Further, it is believed that that a largerproportion of independent directors on the board will be advantageous to the firms sinceit would lead to better monitoring, as well as wider perspectives and expertise (Hermalinand Weisbach, 1998; Pearce and Zahra, 1992). The presence of independent boardmembers is also intended to protect the right of minority shareholders.

Concerning the legal form of the firm, Indonesia’s Islamic Banking Law determinesthat an Islamic bank should be a corporation. This means that Islamic banks mustadhere to the Corporation Law[5]. Indonesia inherits some aspects of the Dutch law,including its two-tier board system. According to the Corporation Law, Indonesianfirms shall have two boards in their organizational structure, namely the BOC and theBOD. The members of these two boards are elected or appointed by shareholders in theshareholders’ general meeting. The BOC represents shareholders and conductsadvising and monitoring roles on the firm’s management. Hence, the role of theBOC is entirely non-executive, and its members consist of the representatives ofshareholders and/or independent commissioners (from outside the firm). Further, theBOD conducts the day-to-day management of the firm, and is responsible to boththe BOC and shareholders[6].

In Indonesia, all of BOC and BOD members are subject to the fit-and-proper testsconducted by Bank Indonesia. Such tests are aimed to assure that board members ofIslamic banks possess adequate levels of competence, credibility, and integrity, as wellas the commitment to enforce GCG. Different from the regulation for conventionalbanks, Bank Indonesia requires Islamic banks to have at least one independentcommissioner on the BOC, without determining the number of BOC members shouldbe employed by the bank. The BOD is fully responsible in conducting management ofthe bank based on shariah and prudential principles.

Board committees. The BOC can conduct its duties by itself or delegate its authorityto standing committees responsible to the board (Klein, 1998). The establishment of aboard committee can be mandatory for firms to a particular extent, for example forlisted firms or banks. Klein (1998) contends that due to the need of expert-providedinformation about the firm’s activities, certain committees are set up to assist indecision making process. Further, board committees are expected to conductindependent monitoring on the firm. For example, the audit committee helps alleviateagency problems by ensuring that accurate and unbiased accounting information isreleased in a timely manner to shareholders, creditors, and other stakeholders. Theimportance of board committees attracts more interests following financial scandalsinvolving high-profile companies.

In Indonesia, the Code of GCG, the latest version of which was issued in 2006, statesthat the BOC can establish board committees to support its function. Alternatively,Bank Indonesia has determined that it is compulsory for conventional and Islamicbanks to form at least three committees: the audit committee, the risk-monitoring

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committee, and the remuneration and nomination committee, where a committee is ledby an independent commissioner. The audit committee evaluates the bank’s internalaudit function and recommends a public accounting firm to be hired.The risk-monitoring committee evaluates the bank’s policy on risk management.The remuneration and nomination committee has responsibilities in evaluating thecompensation policy, as well as providing recommendations on suitable candidates toserve on the BOC, BOD, and SSB.

Internal control and external audit. The existence of an effective internal controlsystem is highly important in Islamic financial institutions, in ongoing efforts to ensuremanagement oversight and to develop a healthy culture within the organization(Chapra and Ahmed, 2002). Banking supervisory authorities also need to ensure thatinternal control systems in all banks are in line with the nature of their risks. One of theimportant parts of internal controls is the internal audit system. Chapra and Ahmed(2002) suggest that the internal audit function should be strong and independent andshould report directly to the board and senior management. In addition, financialaudits conducted by an independent auditor appear to one of the important externalmechanisms of corporate governance. An audit provides independent checks on theinformation provided by managers, and therefore plays a crucial role in maintainingconfidence in financial reporting as well as reducing agency costs ( Jensen andMeckling, 1976; Imhoff, 2003).

Through the regulation of Bank Indonesia, Indonesian Islamic banks are required tohave an effective and independent internal audit function, which is conducted bycompetent personnel. Further, with respect to the independent audit on financialstatements, Islamic banks shall appoint a particular public accounting firm that areregistered in Bank Indonesia.

Risk management. A number of risks are inherent in banking business, including inIslamic banking. Banks need to be highly cautious for their exposure to all risks. Asstated by Chapra and Ahmed (2002), board members and senior management shouldbe aware of the risks and develop sound risk management within the bank. Banks’failure to manage such risks can lead to declining confidence of depositors, as well assystemic impacts on the economy. To support this, banking supervisory authoritieswill need to promote effective risk management. In Basel II, a number of risks havebeen incorporated to ensure that banks have adequate capital to deal with those risksand mitigate their impacts, namely market risks, credit risks, operational risks, andother risks.

Bank Indonesia has issued a regulation that guides banks in managing theirrisks[7]. The regulation requires Islamic commercial banks to implement riskmanagement for at least four risks, namely market risks, credit risks, liquidity risks,and operational risks. Further, an Islamic bank with a higher degree of businesscomplexity should also manage other four risks, including legal risks, compliancerisks, strategic risks, and reputation risks. The BOD shall establish a risk managementdivision that is independent from other units.

Corporate governance implementation reporting. In line with the Code of GCG, BankIndonesia determines that Islamic banks shall prepare a report on the implementationof GCG at the end of a financial year. The report should disclose such items as boardequity ownership, remuneration policy, board meetings, internal fraud, and thedistribution of charity funds. Such a report is also generally incorporated as part of the

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banks’ annual reports. Further, Islamic banks are required to conduct self-assessmentson the implementation of GCG at least once a year. The self-assessments include anumber of elements, such as the implementation of the boards’ duties andresponsibilities, the implementation of internal and external audits, and financialand non-financial transparency.

3. Sample and methodology3.1 Characteristics of the sample banksAs previously mentioned, there were 11 Islamic commercial banks at the end of 2010.The sample of the present study consists of seven banks whose 2010 annual reports areavailable on their web sites, namely Bank Muamalat, Bank Syariah Mandiri, BankMega Syariah, Bank Syariah Bukopin, Bank Victoria Syariah, BCA Syariah, and BJBSyariah[8]. This subsection highlights the characteristics of the seven banks, whichinclude firm-level characteristics and ownership structure.

Table I shows firm-level characteristics of the sample banks. I include a number offinancial figures and indicators, namely total assets, financing, third-party funds,return on assets (ROA), and return on equity (ROE). In these variables, generally BankMuamalat and Bank Syariah Mandiri lead their peers. Further, even though its sharesare not publicly traded on the stock exchange, Bank Muamalat is a publicly heldcorporation, while other banks are privately held[9]. The sample banks have not yetissued shares on the stock exchange, and the Bank Muamalat is the only bank issuingsukuk on the Indonesia Stock Exchange (IDX).

Table II reports the controlling shareholder of each sample bank. I also indicate theownership type of each bank, whether it is controlled by a foreign institution, a family,the government, or other types of institution. The ownership type is indicated bytracing the ultimate controlling shareholder (the parent of its parent company). Forexample, even though BJB Syariah is controlled by Bank Jabar Banten, its ownershiptype is “government-controlled” since Bank Jabar Banten is controlled by a regionalgovernment. Except for Bank Muamalat, the ownership structure of the Indonesian

BankMuamalat

BankSyariahMandiri

BankMega

Syariah

BankSyariahBukopin

BankVictoriaSyariah

BCASyariah

BJBSyariah

Total assetsa 21,401 32,482 4,638 2,194 337 875 1,930Financinga 15,918 23,958 3,154 1,612 28 417 1,603Third-party fundsa 17,393 28,998 4,041 1,622 167 557 1,322Return on assets (%) 1.36 2.21 1.90 0.74 1.09 1.04 0.72Return on equity (%) 17.78 63.58 26.81 9.65 2.41 1.67 1.62Year operation starts 1992 1999 2004 2008 2010 2010 2010Number of branches 368 507 394 41 8 15 21Public/private Public Private Private Private Private Private PrivateIssuing stocks incapital market

No No No No No No No

Issuing sukuk incapital market

Yes No No No No No No

Note: aStated in billion Indonesian Rupiah (IDR)Source: 2010 annual reports and financial statements of the sample banks

Table I.Firm-level characteristics

of the sample banks

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Islamic banks generally shows a high level of ownership concentration. Family controlalso appears to be the most common type of ownership.

3.2 MethodologyIn the present study, I construct the so-called CGDI by employing a comprehensivechecklist, comprising items related to the SSB, the BOC, the BOD, board committees,internal control and external audit, risk management, and corporate governanceimplementation reporting (see Appendix). In order validity to be enhanced, itemsare carefully developed from a number of studies and guidelines[10]. Scoring of theindex for each bank is conducted through a content analysis, where the entire annualreport is read before making any judgment (Cooke, 1996). Similar to Haniffa andCooke (2002), in scoring items, the approach is essentially dichotomous, where anitem scores 1 if disclosed and 0 if it is not, without any penalty for each undiscloseditem. All items are equally weighted. The index is calculated using the followingformula:

CGDI ¼

Pnjt¼1Xij

nj

where nj is the number of items expected to be disclosed by jth Islamic bank;Xij equals 1 if ith item is disclosed and 0 if ith item is not disclosed. Hence, the CGDIwould have the minimum value of 0.00 and the maximum value of 1.00.

The sample banks are then ranked based on their CGDI. The higher the index, themore transparent the bank is in disseminating information on its corporate governancemechanisms in the annual report.

BankOwnershiptype Shares ownership of the controlling shareholder

Bank Muamalat Foreign 32.82% Islamic Development BankBank Syariah Mandiri Government 99.99% Bank Mandiri, one of the largest banks, a listed

bank, 66.68 per cent of shares being held by theIndonesian government

Bank Mega Syariah Family 99.99% Mega Corpora (a privately held, domesticcompany)

Bank SyariahBukopin

Cooperative 65.44% Bank Bukopin, a listed bank, 39.54 per cent ofshares being held by Kopelindo (a cooperative)

Bank Victoria Syariah Family 99.98% Bank Victoria International, a listed bank,38.01 per cent of shares being held by VictoriaSekuritas (a privately held, domestic company)

BCA Syariah Family 99.99% Bank Central Asia, a listed bank, 47.15 per cent ofshares being held by an Indonesian family througha Mauritius-based company

BJB Syariah Government 99.00% Bank Jabar Banten, a listed bank, 45.36 per cent ofshares being held by the regional government ofWest Java

Source: 2010 annual reports and financial statements of the sample banks

Table II.Ownership structureof the sample banks

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4. Results and discussions4.1 Corporate governance disclosure indexTable III reports the CGDI for the sample banks addressed in this study. For each bank,I calculate the overall index, as well as the index for each of the seven dimensions. Itseems that a wide variation exists in disclosure practices among the seven IndonesianIslamic banks. I rank the banks based on their overall CGDI. It is revealed that BankMuamalat and Bank Syariah Mandiri show the highest CGDIs, scoring 0.89 and 0.83,respectively. This means that two banks disclose 89 and 85 percent, respectively, of72 items constructed in the checklist. On the other hand, BJB Syariah and Bank SyariahBukopin appear to have the lowest CGDIs, scoring 0.32 and 0.49, respectively.

The last column in Table III also reports the average index, for either the overallindex or the index for each dimension. The items on the BOD dimension are the mostfrequently disclosed constructs, with the average of 0.73. Other dimensions showingrelatively high indices are the BOC and risk management, with the dimensional indicesof 0.70 and 0.69, respectively. Alternatively, the aspect of internal control and externalaudit is found to be the category with the lowest level of disclosure, with the averagedimensional index of 0.38. Given the average overall index of 0.60, it can be seen thatthere are only two banks possessing above-average disclosure levels, namely BankMuamalat and Bank Syariah Mandiri.

It can be concluded that Bank Muamalat and Bank Syariah Mandiri show higherlevels of corporate transparency, particularly in terms of corporate governancedisclosure, compared to their peers. The two banks also achieve the highest possibleindex for a number of dimensions. Bank Muamalat achieves perfect dimensionalindices (1.00) for the BOC and BOD, while Bank Syariah Mandiri is excellent atdisclosure on the BOD and corporate governance implementation.

Shariah Supervisory Board. Disclosure on the profile of the SSB would provideassurance that the bank is conducted in accordance with shariah law (Haniffa andHudaib, 2004). Islamic banks are expected to disclose a set of aspects on their SSB,including the description of board members (name, position, picture, and profile),

BankMuamalat

BankSyariahMandiri

BankMega

Syariah

BankSyariahBukopin

BankVictoriaSyariah

BCASyariah

BJBSyariah Average

ShariahSupervisory Board 0.75 0.92 0.50 0.67 0.58 0.42 0.42 0.61Board ofcommissioners 1.00 0.92 0.62 0.69 0.69 0.69 0.31 0.70Board of directors 1.00 1.00 0.67 0.67 0.67 0.67 0.44 0.73Board committees 0.87 0.80 0.67 0.40 0.47 0.53 0.00 0.53Internal controland external audit 0.88 0.50 0.38 0.25 0.25 0.38 0.00 0.38Risk management 0.90 0.80 0.70 0.20 0.70 0.70 0.80 0.69Corporategovernanceimplementationreporting 0.80 0.80 0.40 0.40 0.20 0.60 0.40 0.54Overall index 0.89 0.83 0.51 0.49 0.54 0.57 0.32 0.60Overall rank 1 2 5 6 4 3 7

Table III.CGDI of the

sample banks

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duties and responsibilities, board meetings, meeting attendance, and remuneration forboard members. In addition, they need to communicate the board’s opinion whetherproducts, services, and profits/losses have been in accordance with shariah principles.For this dimension, with the average index of 0.61, Bank Syariah Mandiri scores thehighest, followed by Bank Muamalat, and the lowest being BCA Syariah and BJBSyariah.

It is found that most banks in the sample do not disclose any information regardingboard meetings, meeting attendance, board remuneration, and the compliance ofprofits/losses with shariah principles. Further, it is only Bank Muamalat and BankSyariah Mandiri that disclose the board’s procedure – though not comprehensive – inconducting assessments on the banks’ products, services, and profits, as found in thefollowing statements:

Activities of the SSB in 2010 included [. . .] methods and techniques to be employed in[shariah] audit sampling (Bank Syariah Mandiri Annual Report 2010, p. 15 – translated bythe author).

To assist the Shariah Supervisory Board in executing its duties at Bank Muamalat a specialunit was formed, namely the Shariah Compliance Unit (ShCU) that acts as Liason Officerbetween the Shariah Supervisory Board and the divisions/business units in Bank Muamalat(Bank Muamalat Annual Report 2010, p. 58).

Additionally, three banks, namely Bank Syariah Mandiri, Bank Mega Syariah, andBank Syariah Bukopin, disclose in their annual reports the SSB’s recommendations tomanagement. The following statement indicates recommendation of the board forimprovements to be carried out by management in the future:

The Shariah Supervisory Board advised Bank Mega Syariah not to focus on business profitsonly, but the bank also needs to adhere to prudential principles in performing bankingbusiness based on shariah rules (Bank Mega Syariah Annual Report 2010, p. 13 – translatedby the author).

Board of commissioners. It is expected that Indonesian Islamic banks communicate a setof important matters with respect to the BOC, namely the description of board members(name, position, independence, picture, profile, and multiple commissionership), dutiesand responsibilities, board meetings, meeting attendance, shareholding, andremuneration for board members. For this dimension, the average index is 0.70. Thissuggests that, on average, the sample banks have disclosed most constructs developedin this dimension. Information on the BOC disclosed in annual reports is expected toprovide assurance to stakeholders that the BOC has effectively conducted monitoringand advising roles on the BOD.

Bank Mandiri gains a perfect score (1.00) by disclosing all items for this dimension,followed by Bank Syariah Mandiri. In their annual reports, these two banks alsocommunicate recommendations provided by the BOC to management, as in thefollowing statement:

The advice from Commissioners for Board of Directors of Bank Muamalat about thefinalization of Bank Muamalat’s business plan in the year 2010 is about improvingManagement Information System so that it can be more accurate and comprehensive forcompiling customer data among all branches all over Indonesia (Bank Muamalat AnnualReport 2010, p. 143).

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Board of directors. The BOD of Islamic banks is entrusted with resources to bemanaged to maximize shareholders’, as well as depositors’, wealth. Thus, as suggestedby Haniffa and Hudaib (2004), stakeholders may need to assess the profile of thosemanaging the business. This implies that information regarding top management teamis important. For this dimension, most items that are important to disclose are similarto those in the BOC dimension.

The dimensional index for the BOD is the highest among seven dimensionsincluded in this study’s checklist. Nevertheless, it is only Bank Muamalat and BankSyariah Mandiri scores above average, where both banks share the highest possiblescore (1.00). While description of the board members are generally disclosed by thesample banks, remuneration for board members is only communicated by three banksin their annual reports, namely Bank Muamalat, Bank Syariah Mandiri, and BCASyariah. For instance, in addition to information on the compensation level for eachindividual board member, BCA Syariah briefly communicates its compensation policyin its 2010 annual report:

The distribution of remuneration and other facilities to the Board of Commissioners, theShariah Supervisory Board, and the Board of Directors referred to shareholders’ decision, asdetermined in the shareholders’ general meeting, taking into account the advice provided bythe Remuneration and Nomination Committee. In general, the basic components ofremuneration include: (1) basic salary; (2) allowance, comprising health allowance, retirementallowance, official vehicles, and Eid-ul-Fitr allowance of once a year (BCA Syariah AnnualReport 2010, p. 50 – translated by the author).

The detailed disclosure on the compensation level is a best practice adoptedinternationally. However, such a practice in developing countries is relatively weak.The disclosure on board remuneration would enable stakeholders to assess whetherthe pay level is appropriate and has represented the performance of board members.

Board committees. Board committees are established to assist the BOC in decisionmaking process, as well as in conducting supervising and monitoring roles onmanagement. The members of the board committees are expected to possess particularexpertise or experiences that would support the effectiveness of such committees.Therefore, information on those serving on the committees is also consideredimportant. Most items for this dimension are relatively similar to those for BOC andBOD dimensions. The items include the description of committee members, committeemeetings, meeting attendance, remuneration for committee members, and theperformance report.

In terms of the performance report, Bank Muamalat and Bank Syariah Mandiri haveincluded such a report from board committees in their annual reports. For instance, thefollowing is taken from the performance report of the Remuneration and NominationCommittee of Bank Syariah Mandiri:

The Remuneration and Nomination Committee held a meeting if it is considered urgentaccording to the Remuneration and Nomination Committee Charter. During 2010, thecommittee held three meetings with the following agendas: (1) discussing the remunerationand nomination of the bank’s board members; (2) reviewing the remuneration of the bank’semployees compared to other banks; (3) nominating the chairman candidate of the bank’sShariah Supervisory Board (Bank Syariah Mandiri Annual Report 2010, p. 102 – translatedby the author).

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The average index for this dimension among the sample banks is relatively low at 0.53,the second lowest after the dimension of internal control and external audit. Again,Bank Muamalat and Bank Syariah Mandiri outweigh their peers in this dimension’sindex. BJB Syariah, one of the newly established Islamic commercial banks inIndonesia as at 31 December 2010, even does not disclose anything in terms of theirboard committees. Further, it is important to note that none of the sample banksdiscloses the remuneration scheme for committee members.

Additionally, none of the sample banks has established a Corporate GovernanceCommittee. Even though not required by Bank Indonesia, such a committee is expectedto provide commissioners or directors with independent recommendations related tocorporate governance matters. The establishment of this committee is recommended inthe Code of GCG, which was issued by the National Committee on Governance Policy(Komite Nasional Kebijakan Governance) in 2006.

Internal control and external audit. Disclosure on internal control systems in theannual report will enable stakeholders to examine that management is adequatelyoverseen, so that the interests of shareholders, depositors, creditors, and otherstakeholders are secure. It is expected that Islamic banks disclose a set of importantfactors, such as internal control framework, duties and responsibilities of the internalaudit division, and internal audit certification held by employees. Further,the bank’s external auditor also plays an important role as abovementioned. Hence,this study expects that Islamic banks communicate their policies regarding theappointment of external auditor.

Unfortunately, the disclosure practice of the Indonesian Islamic banks on thisdimension is relatively insufficient. The average dimensional index is 0.38, the lowestamong the seven categories. Bank Muamalat still leads with the score being 0.88,followed by Bank Syariah Mandiri that scores 0.50. The scores of other five banks rangefrom 0.00 to 0.38. A separate internal audit report is also found in the annual reports ofBank Muamalat and Bank Syariah Mandiri. Accordingly, internal audit frameworksand the performance report on the internal audit are also found in the two banks only.None of the sample banks discloses internal audit certifications held by employees. Eventhough not disclosing does not mean that the bank has no certified internal auditors, thedisclosure of this specific skill will assure that the bank’s internal control system issupported by highly skilled human resources. Bank Muamalat appears to be the onlybank disclosing its policy on the appointment of the external auditor.

Risk management. Sound risk management will assure stakeholders that a bank hasbeen prepared for uncertainties in the future, and that the bank has enough capital tomitigate the risks. Hence, it is in the best interests of stakeholders that the risks facedby a business are disclosed in a timely manner, including in its annual report(Amran et al., 2009). In addition to the existence of a risk management unit and a riskmanagement framework, Islamic banks are expected to disclose how they manage fourrisks as required by Basel II and Bank Indonesia, namely market risks, credit risks,liquidity risks, and operational risks. Further, the banks need to disclose risk profileand risk management certification held by their employees.

For the dimension, the index is 0.69 on average, which indicates that the samplebanks already have relatively sufficient awareness to communicate their riskmanagement. Bank Muamalat again leads with the index of 0.90. Interestingly, BJBSyariah, which tend to have the lowest index in previous dimensions, share the second

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rank with Bank Syariah Mandiri, having the index of 0.80. BJB Syariah stresses itsattention to sound risk management in its annual report, which can be seen in thefollowing:

Bank undertook the implementation of integrated risk management through theimprovement of risk management infrastructure and implementation of adequate andsustainable risk management processes based on the prudential banking principle(BJB Syariah Annual Report 2010, p. 30).

Different from that in the internal audit, risk management certification held byemployees is disclosed in annual reports of four banks, namely Bank Mandiri, BankSyariah Mandiri, Bank Mega Syariah, and Bank Bukopin Syariah. However, it is foundthat only Bank Syariah Mandiri and Bank Syariah Bukopin disclose their risk profilein the risk management report.

Corporate governance implementation reporting. All Islamic banks included in thesample have a separate Corporate Governance Implementation Report in their annualreports. Even though the disclosure level varies among the banks, it indicates to aparticular extent their awareness in communicating the features of corporategovernance to stakeholders. Bank Syariah Bukopin states the following:

Transparency, accountability, responsibility, independence and fairness become thefoundation for the Company in implementing GCG. The Board of Commissioners, Directors,Sharia Supervisory Board and all employees of the Company are committed in implementingthe GCG principles and practices (Bank Bukopin Syariah Annual Report 2010, p. 57).

Again, Bank Muamalat and Bank Syariah Mandiri outweigh their competitors in thisdimension. These two banks, being the most well-established Islamic banks inIndonesia, also disclose the code of conduct in their annual report, as stated in thefollowing statement:

Since 2002, BSM has had the Code of Conduct that refers to the akhlaqul karimah(good conduct). The Code is intended to provide guidance in behavioral aspects in line withthe expected values and culture, namely being Islamic, professional, and responsible in theinteractions with all parties, including colleagues, internal groups, customers, vendors, andthe regulator (Bank Syariah Mandiri Annual Report 2010, p. 109).

Bank Indonesia has required Islamic banks to carry out self-assessments on their GCGpractices. In fact, this is only disclosed by three banks, namely Bank Muamalat, BankSyariah Mandiri, and BCA Syariah. In order to convince stakeholders that the bank hasbeen conducted what has been required by the regulator, this aspect needs to be takeninto account for disclosure in the future. However, it is found that none of the samplebanks have an external party assess their GCG practices.

5. Concluding remarksThis paper examines the practice of disclosure on corporate governance mechanismsamong Indonesian Islamic banks. Islamic banks provide an interesting setting incorporate governance studies due to several unique features, such as adherence toshariah principles in operations and unrestricted IAHs. Indonesia, which has adifferent institutional environment from other Muslim countries, provides anotherinteresting viewpoint. Corporate governance mechanisms are intended to align theinterests of various stakeholders. Hence, the disclosure on such mechanisms is argued

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to be advantageous in assuring stakeholders with respect to how an Islamic bank isgoverned, which could influence the way resources entrusted to them are managed.

Employing a sample consisting of seven Islamic commercial banks in Indonesia,this study examines the extent of corporate governance disclosure in seven areas,namely the SSB, the BOC, the BOD, board committees, internal control and externalaudit, risk management, and corporate governance implementation reporting. Usingcontent analyses on the banks’ annual reports, the CGDI is constructed for each bank,either for the overall index or the dimensional index. A checklist as the researchinstrument is employed using a comprehensive set of constructs. It is revealed that forthe financial year 2010, Bank Muamalat and Bank Syariah Mandiri show higher scorescompared to other banks. Given this result, these two banks may be referred to as thebenchmark in terms of corporate governance disclosure. The dimensions of BOC andBOD appear to be the most frequently disclosed by the sample banks. This partlyindicates that the banks put much attention to displaying the profile of their boardmembers. Further, the lowest index goes to internal control and external audit. Thisseems to imply that there is lack of awareness among the banks’ managers tocommunicate such issues in the annual report.

This research is subject to some limitations. The content analysis may be biased toa particular extent, and the research instrument employed here may not represent allaspects of corporate governance disclosure. The small number of observations, despiteits significant proportion to population, is another issue. Given a sufficient number ofobservations, future research is suggested to employ a more rigorous statisticalapproach in examining the determinants of corporate governance disclosure.

The results of this study may bring some practical implications. Given the averageoverall CGDI of the Indonesian Islamic banks that is relatively low (0.60), this studythen calls for the improvement of such disclosure in the banks’ annual report. Theenhancement of information being disclosed in annual reports is expected to benefit thebanks in several aspects. First, by disclosing the features of corporate governance in acomprehensive manner, the banks can expect to gain wider acceptance in the bankingindustry. This may leverage their reputation, so that the banks can attract more savvydepositors and, in their capacity as issuers in the capital market, good investors.Second, such disclosure can represent to a particular extent the banks’ effort inenforcing GCG within their institutions, which will be a good starting point when thebanks consider seeking other financing alternatives, such as by issuing sukuk or sharesin the capital market. To date, among the Indonesian Islamic banks, it is only BankMuamalat who has been an issuer (for sukuk) in the capital market.

Notes

1. In Indonesia, Islamic banks are called bank syariah (literally means shariah bank). This termis also used in the Islamic Banking Law and other applicable regulations in the country.Nevertheless, in the present study, the term “Islamic banks” is used.

2. The term “Islamic Banking Law” here refers to Law Number 21 of 2008 concerning IslamicBanking.

3. This study addresses corporate governance mechanisms and tools as indicated in suchstudies as Chapra and Ahmed (2002) and Safieddine (2009). Thus, it excludes other relativelyirrelevant variables such as financial governance and corporate social responsibility ofIslamic banks.

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4. This refers to the Regulation of Bank Indonesia Number 11/33/PBI/2009 concerning theImplementation of GCG for Islamic Commercial Banks and Islamic Banking Units.Previously, Islamic banks should adhere to Regulation Number 8/4/PBI/2006 concerning theImplementation of GCG for Commercial Banks.

5. The term “Corporation Law” refers to Law Number 40 of 2007 concerning Corporation.

6. The BOD in the context of Indonesia’s two-tier board system is absolutely different from thatin the unitary system. The BOD in Indonesian firms is equal to top management in unitaryboard systems.

7. This refers to the Regulation of Bank Indonesia Number 11/25/PBI/2009 concerning theImplementation of Risk Management in Commercial Banks.

8. The 2010 annual reports of other four banks (BNI Syariah, BRI Syariah, Bank Panin Syariah,and Maybank Syariah) are not available on either corporate web sites or the internet.

9. The Capital Market Law in Indonesia (Law Number 9 of 1995 concerning Capital Market)differentiates between “public corporation” and “listed corporation”. A firm is a publiccorporation if its shares are “widely held” according to the Law, but not listed on the stockexchange. On the other land, a listed corporation (whose shares are publicly traded on thestock exchange) is definitely a public corporation as well.

10. Sources that are used to develop constructs in the checklist include previous studies, such asHaniffa and Hudaib (2004, 2007) and Kusumawati (2007), as well as Indonesian bankingregulations, Indonesia’s Code of GCG, and guidelines of the Islamic Financial Services Board(IFSB). Other additional constructs, which are considered best practices, are also included inthe checklist.

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Appendix. Checklist of corporate governance disclosureA. Dimension: Shariah Supervisory Board

(1) Names of members.

(2) Positions of members.

(3) Pictures of members.

(4) Profiles of members.

(5) Number of meetings held.

(6) Members’ attendance in meetings.

(7) Remuneration of members.

(8) Duties and responsibilities of the board.

(9) Compliance of products and services with shariah.

(10) Compliance of profit or loss with shariah.

(11) Examination procedures.

(12) Recommendation to management.

B. Dimension: board of commissioners

(1) Names of members.

(2) Positions of members.

(3) Pictures of members.

(4) Profiles of members.

(5) Independence of members.

(6) At least 50 percent of members being independent.

(7) Multiple commissionership/directorship held by members.

(8) Number of meetings held.

(9) Members’ attendance in meetings.

(10) Remuneration of members.

(11) Duties and responsibilities of the board.

(12) Shareholdings of members.

(13) Recommendation to management.

C. Dimension: board of directors

(1) Names of members.

(2) Positions of members.

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(3) Pictures of members.

(4) Profiles of members.

(5) Number of meetings held.

(6) Members’ attendance in meetings.

(7) Remuneration of members.

(8) Duties and responsibilities of the board.

(9) Shareholdings of members.

D. Dimension: board committees

(1) Existence of an audit committee.

(2) Existence of a remuneration and nomination committee.

(3) Existence of a risk-monitoring committee.

(4) Existence of a corporate governance committee.

(5) Duties and responsibilities of each committee.

(6) Committee reports in the annual report.

(7) Names of members.

(8) Positions of members.

(9) Pictures of members.

(10) Profiles of members.

(11) Most members being independent.

(12) Number of meetings held.

(13) Members’ attendance in meetings.

(14) Remuneration of members.

(15) Performance of each committee.

E. Dimension: internal control and external audit

(1) Internal control report in the annual report.

(2) Existence of an internal audit division.

(3) Internal audit framework.

(4) Duties and responsibilities of internal audit division.

(5) Internal audit certification held by employees.

(6) Policies on the appointment of external auditor.

(7) External auditor appointed by the bank.

(8) Performance of internal audit division.

F. Dimension: risk management

(1) Risk management report in the annual report.

(2) Existence of a risk management division.

(3) Risk management framework.

(4) Duties and responsibilities of risk management division.

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(5) Risk management certification held by employees.

(6) Market risk management.

(7) Credit risk management.

(8) Liquidity risk management.

(9) Operational risk management.

(10) Risk profile.

G. Dimension: corporate governance implementation reporting

(1) Corporate governance implementation report in the annual report.

(2) GCG framework.

(3) Code of conduct.

(4) GCG self-assessment.

(5) GCG assessment by an external party.

About the authorSalim Darmadi is a research staff member in Bapepam-LK and a Lecturer at STAN. His researchpapers are forthcoming in such journals as Corporate Ownership and Control and CorporateGovernance. Salim Darmadi can be contacted at: salim.darmadi@bapepam.go.id

Corporategovernance

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