Corporate governance and Shariah non-compliant risk in Islamic banks: evidence from Southeast Asia

• Pages: 240-262
• DOI: https://doi.org/10.1108/CG-05-2019-0138
• Published date: 25 November 2019
• Date: 25 November 2019
• Author: Rohaida Basiruddin,Habib Ahmed
• Subject Matter: Corporate governance,Strategy

Corporate governance and Shariah

non-compliant risk in Islamic banks:

evidence from Southeast Asia

Rohaida Basiruddin and Habib Ahmed

Abstract

Purpose –This study aims to investigate the relationship between corporate governance and Shariah

non-compliant risk (SNCR) that is unique for Islamic banks. The study examines the roles of Shariah

committeealong with the board of directors in mitigating SNCR.

Design/methodology/approach –The paper empiricallyinvestigates the implicationsof characteristics

of board of directors and Shariah committee on the SNCR by using a sample of 29 full-fledge Islamic

banks fromMalaysia and Indonesia over the period 2007-2017.All data is hand collected from the Islamic

banks’annualreports with the exception of country-leveldata collected from the World Bank database.

Findings –The results show that bankswith a smaller board size and higher proportion of independent

board membersare likely to have lower SNCR. The findings also indicatethat the financial expertise and

higher frequencyof Shariah committee meetings reducesthe SNCR. Collectively, the analysisshows that

banks withstrong corporate governance environmentsreduce SNCR.

Practical implications –The findings of the study shed light on the relationship between corporate

governancepractice, Shariah committee characteristicsand SNCR. The results can be used by different

stakeholders such as policymakers, boards of directors and senior management of Islamic banks to

mitigateSNCR.

Originality/value –This study extends the literature on corporate governance and risk-taking by

including additional dimensions of governance and risk type. The corporate governance mechanism at

the board level is complementedby including the Shariah committee characteristicsand SNCR which is

relevantto Islamic financial institutions is examined.

Keywords Malaysia, Indonesia, Islamic bank, Corporate governance, Shariah committee,

Shariah governance, Shariah non-compliant risk

Paper type Research paper

1. Introduction

The topic of risk and corporate governance in banks has received significant attention from

regulators, bank managers, customers and academics due to the nature of high leverage,

great opacity and the complexity of banking assets and activities, especially following the

recent financial crisis. Evidence suggests that banks with poor governance engage in

excessive risk-taking and do so even more during a crisis (Kirkpatrick, 2009;Chen and Lin,

2016;Dı

´az and Huang, 2017). Potentially, the risk exposure may be different and more

complex when the agency relationship and governance setting deviate from their

conventional form.

There are significant differences between conventional and Islamic banks. First, the aim of

the Islamic bank is to maximise shareholder value by adhering to the Shariah law (Islamic

law) (Grais and Pellegrini, 2006a,2006b,Safieddine, 2009). In particular, Islamic banks are

prohibited from taking and charging interest (riba), getting involved in excessive risk

Rohaida Basiruddin is

based at Azman Hashim

International Business

School, Universiti Teknologi

Malaysia, Kuala Lumpur,

Malaysia. Habib Ahmed is

based at the Business

School, Durham University,

Durham, UK.

Received 3 May 2019

Revised 8 September 2019

20 October 2019

30 October 2019

Accepted 1 November 2019

The authors thank Stuart Gillan,

Pradeep Yadav, anonymous

referee, discussants and

conference participants of

KFUPM Islamic Banking and

Finance Research Conference

2017 for helpful comments and

suggestions provided on an

earlier version of this paper.

PAGE 240 jCORPORATE GOVERNANCE jVOL. 20 NO. 2 2020, pp. 240-262, ©EmeraldPublishing Limited, ISSN 1472-0701 DOI 10.1108/CG-05-2019-0138

(gharar) and using different instruments such as derivatives. Second, the governance

setting includes an additional element of Shariah governance with the Shariah committee

(SC) playing a key role in assisting the board of directors (BODs) and management to

ensure that Shariah law is adhered to throughout the business operations (Ahmed, 2011a,

Choudhury and Hoque, 2006). Finally, Islamic banks are exposed to a new type of risk

known as Shariah non-compliance risk in addition to the traditional credit, market,

operational and liquidityrisks.

This paper examines the relationship between corporate governance and Shariah non-

compliance risk in Malaysian and Indonesian Islamic banks in Southeast Asia. These two

countries are among the most progressive in the development of the Islamic financial

services industry (IFSB, Islamic Financial services Board, 2017). Moreover, they represent

the majority of Islamic banks in the Southeast Asian region that includes Singapore, the

Philippines, Thailand and Brunei.

This study contributes to the growing literature on the study of corporate governance and

bank risk exposure. To our knowledge,this paper is among the first to examine Shariah non-

compliance risk and corporate governance that includes features of the SC. Though the

concept of Shariah non-compliant risk (SNCR) has been recognised, we are aware of only

one empirical paper that examines the impact of Shariah non-compliant income assets,

equity and income of Islamic banks. Our study is closely related to that of Mollah and

Zaman (2015) who examine the relationship between the SC and performance. We expand

the governance structure of the SC used in the literature by including additional variables

such as financial expertise, meeting frequency and SC compensation. Furthermore,

previous studies on corporate governance and bank risk-taking have mostly focussed on

traditional risks such as credit risk, market risk, interest rate risk and insolvency risk or the

interaction among the risk categories. However, no existing studies have examined Shariah

non-compliance risk which is only relevant to Islamic financial institutions. Thus, we

complement the work of D’Amato and Gallo (2019),Yeh (2017),Vallascas et al. (2017),

Chen and Lin (2016),Aebi et al. (2012) and Laeven and Levine (2009) by adding another

dimension to the governance and risk literature.

To fill these gaps, we provide empirical evidence on the BODs, SC and Shariah non-

compliance risk. In this study, we examine the impact of individual characteristics of the board

(related to board size, independence directors, meeting frequency and co mpensation) and

SC (size, financial expertise, meeting frequency and compensation) on the Shariah non-

compliance risk. We performed our investigation by using data on Islamic banks from

Malaysia and Indonesia over the period 2007-2017. Based on 183 bank-year observations, we

find that the smaller board and a higher proportion of independent n on-executive directors are

associated with lower SNCR. There is a possibility that the smaller board and independent

board using their oversight function demands additional and extensive Shariah audit to certify

their monitoring role and mitigate the reputational losses. In addition to the se findings, we also

report several new results. We find that the level of SC monitoring on SNCR is driven by the

members that equipped with financial expertise and higher frequency of meetings. Overall,

our analysis suggests that the banks with effective board and SC reduce SNCR. T hese results

are robust to various model specifications and tests.

The remainder of this paper is organised as follows. Section 2 provides an overview of the

Shariah principles and risks, and Section 3 describes the background literature and

hypotheses development. Section 4 presents the data and models specification. Section 5

reports the empirical findings,and Section 6 concludes.

2. Shariah principles, Islamic banking and risks

Starting in the 1970s, from an urge to provide financial services to Muslims who would not

deal with interest due to religious beliefs, Islamic banking hasbecome a significant sector in

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