Aurora Borealis
4 October 2018 CFA Institute Journal Review

Corporate Governance in Islamic Banks: New Insights for Dual Board Memberships and Agency Relationships (Digest summary)

  1. Michal Szudejko, CFA

Investigating the influence of the dual board structure on the performance of Islamic banks, the authors find that the size of the Shari’ah supervisory board (SSB) positively affects the financial performance as well as the scope of operations of a given bank. At the same time, the relationship between agency costs and SSB size is negative. The size of the SSB largely depends on the size and independence of the bank’s board of directors.

How Is This Research Useful for Practitioners?

The term “Islamic banking” refers to the banking system based on the principles of Islamic law (Shari’ah) and the associated Islamic economics, including the prohibition of interest. A key aspect of the structure of Islamic financial institutions is the presence of an additional body of governance, the Shari’ah supervisory board (SSB). The SSB ensures that all bank operations are performed consistently with Shari’ah.

In recent decades, Islamic banking has grown to become a notable player in the financial industry. The nature of some Islamic financial instruments, known as investment accounts, is such that depositors share in the risks of the bank, as well as the profits and losses. In these contracts, the client appoints the bank to make investment decisions at its discretion either fully (unrestricted investment accounts) or under certain limitations (restricted investment accounts). This approach results in a more complex principal–agent relationship than that between shareholders and management. Investment account holders, as principals, entrust their funds to an agent (bank management) appointed by another principal (the shareholders).

The authors find that banks with larger SSBs display better financial performance and that it would be in the interest of regulators to establish governance mechanisms that ensure the independence of SSB members from the moment of appointment.

In addition, the ability of investment account holders is directly linked to the effectiveness of bank management. As such, they should have stronger rights to monitor and control.

How Did the Authors Conduct This Research?

The authors collect data from a sample of 90 Islamic banks from 13 countries (Islamic banks in Turkey and Iran are excluded because they use a different governance structure). The data take the form of an unbalanced panel over the years 2006–2014 (723 bank-year observations) and are sourced from Bankscope, The Banker magazine, Perfect Information Navigator, and Companies House, as well as the annual reports and websites of the respective banks. Within a fixed-effects panel data model, the authors control for country heterogeneity and other unobservable company characteristics that may leverage the results. SSB proxy variables are lagged to control for the endogeneity problem.

First, the analysis examines the association between a bank’s financial performance and the SSB size as well as the proportion of independent non-executive directors. Second, the relationship between (1) the bank’s complexity and size and (2) the sizes of the board of directors and SSB is examined in detail. Finally, the authors examine the hypothesis that the size of an Islamic bank’s board is a trade-off between bank-specific benefits and costs of increased monitoring.

Abstractor’s Viewpoint

The continued growth of Islamic banks is a clear indicator of how important regulation and governance are in this area of the financial industry. The authors’ research a foundation for further study. Nevertheless, my feelings about this research are somewhat mixed. Foremost, I see no clear connection between the size (measured by the number of people) of any governing body and improved financial performance. The authors should follow up with further analysis, other than purely quantitative, showing how this relationship works in real life.

In my view, the factor that actually drives financial performance is the quality (i.e., level of independence) of the SSB structure. I agree that diversified backgrounds among board members would help Islamic banks to enter new markets. Moreover, the size of the board of directors and the SSB could result from the trade-off between the costs and benefits of monitoring.

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