Corruption and Bank Risk‐Taking in Dual Banking Systems

• Published date: 01 November 2024
• Author: Mushtaq Hussain Khan,Mohammad Bitar,Amine Tarazi,Arshad Hassan,Ahmad Fraz
• Date: 01 November 2024
• DOI: http://doi.org/10.1111/corg.12579

Corporate Governance: An International Review, 2024; 32:984–1015

https://doi.org/10.1111/corg.12579

Corporate Governance: An International Review

ORIGINAL ARTICLE OPEN ACCESS

Corruption and Bank Risk- Taking in Dual Banking Systems

Mushtaq HussainKhan1 | MohammadBitar2 | A mineTarazi3,4 | ArshadHas san5 | AhmadFraz6

1Cardiff School of M anagement, Cardiff Met ropolitan University, Cardi ff, UK | 2Notti ngham University Busi ness School, Nottingham , UK | 3LAPE ,

Université de Limoges , Limoges, France | 4Institut Universitaire de F rance (IUF), Par is, France | 5Facu lty of Management & Social Sc iences, Capital

University of Science & Tech nology, Islamabad, Paki stan | 6Pakist an Institute of Development Economics , Islamabad, Paki stan

Correspondence: Mushta q Hussain Khan (mkhan3@cardiffmet.ac.uk)

Received: 17 November 2022 | Rev ised: 18 January 202 4 | Accepted: 2 Februar y 2024

Funding: This research did not re ceive any specific gr ant from funding agencies i n the public, commercial, or not- for- profit sectors.

Keywords: corporate gover nance | bank risk | cor ruption | Shari'ah super visory board | female memb ers | academic qualif ications

ABS TRACT

Research Q uestion/Issue: We investigate whether the risk- taking of Islamic banks is affected differently by corruption com-

pared to conventional banks. We also examine whether the character istics of the S hari'ah Supervi sory Board (SSB) of Islamic

banks and the character istics of the board of directors of conventional banks play an effect ive role in moderating such an effect.

Research Findings/Insi ghts: We find con sistent evidence that ba nks in countries with higher c orruption have higher ba nk

risk for both conventional and Islamic banks. However, this association is attenuated by the size of the SSB, the presence of fe-

male board members, and higher academic quali fications of SSB members. For conventional banks, the moderating effect of the

presence of female directors and academically qualified members on the board of directors is also prevalent but to a lesser extent.

Theoretica l/Academic Implication s: This study contributes to the corporate fina nce literature more generally by highlight-

ing the role played by c orporate governance, particula rly the presence of female members and aca demically qualified members

on the SSBs of Islamic banks and on the board of directors of conventional banks, in mitigating the effect of corruption on bank

risk- tak ing for the two bank types.

Practit ioner/Policy Implications: Ou r findings are based on a matched sample of banks operating in 10 OIC (Organization of

Islamic Cooperation) countrie s and have important implications for bank stability and bank governance reforms. On the detri-

mental side , urgency of the ant i- cor ruption campai gns in these cou ntries is just ified due to the sig nificant effect of corr uption on

risk- taking for both conventional and Islamic banks. Overall, to better fight corruption in countries with dual banking systems,

there is a need to enforce stricter ru les for all types of banks.

1 | Introduction

We investigate whet her corruption differ ently affects the r isk-

taking of Islamic and conventional banks. In addition, we ex-

amine whethe r the characteris tics of the Shari 'ah Supervis ory

Board (SSB) of Islamic banks and the cha racteristics of the

board of directors of conventional banks play an effective role

in moderating such an effect . Although much work has been

done in the literat ure on the role that corr uption plays in non-

financial institutions, we know little about how corruption

af fect s the ri sk- tak ing of bank s in cou ntri es wit h dua l bank ing

syst ems. For i nstanc e, the cor porate financ e literat ure foc uses

on the association b etween corr uption and fi rm performa nce

(Brown et al.2021; Van Vu etal.2018), c orporate inno vation

(Gan and Xu2 019; Sena etal .2 018), efficiency (Hanous ek

etal.2 019), corporate investments (Pan and Tian 2017), cash

holdings (Thakur and Kannadhasan2019), and credit con-

straints ( Wellalage etal.2 019). However, few empirica l stud-

ies invest igat e the ef fect of corr uptio n on ban k risk- ta king . For

instance, Bermpei etal. (2021) find that str ong institutional

This is an open ac cess article un der the terms of the Crea tive Commons Attr ibution License, wh ich permits use, d istribution and rep roduction in any mediu m, provided the ori ginal work is

properly cited.

© 2024 The Autho rs. Corporate G overnance: An I nternational Re view published by Joh n Wiley & Sons Ltd.

984

environment moderates the negative effect of corruption on

bank- lending in t he United States.

Corruption is generally defi ned as t he abuse of public power for

private benefit (Agui lera and Vadera2008). In addition to bribery

and extortion, which define corruption in a narrow sen se, corrup-

tion is also manifested in conf licts of interest, fraud, deception,

embezzlement, the misuse of government power, and other related

activities (Gorsira etal.2018). More importantly, Jim Yong Kim,1

the pr esident of the World Ban k, decl ared co rrupt ion as the “p ublic

enemy number one” for most developing economies.

In corporate finance, on the one hand, efficient and productive

firms may receive more loans by biddi ng higher bribes; on the

other hand, likelihood of borrowers' default may als o increase

due to corruption, which hinders lendi ng by raising cost of debt

(Chen etal.2015). According to the “sand t he wheels” hypothe-

sis, corruption is harmful to investment and economic growth.

This hypot hesis is largely supported b y existing studies. For in-

stance, Char umilind etal.(2006) find that politically connecte d

firms receive more long- t erm loans from banks w ith less col-

lateral. Park(2012) f inds that non- perfor ming loans increase in

corrupt c ountries. Likewise, Weill(2011) f inds that corruption

hampers bank lending in Russia and act s as an obstacle to eco-

nomic growth. In contrast, Wil liams etal.(2 016) and Wil liams

and Mart inez- Perez(2016) find consistent evidence supporting

the “grease the wheel s” hypothesis in developing countries.

They conclude that bribery serves as a “helping hand” in i n-

creasing fir m performance.

In the cas e of dual banking sy stems, resea rch has focuse d on com-

paring conventional and Islamic bank s with respect to business

model (Beck etal. 2013), governance (Molla h and Zama n2015),

deposit insura nce premiums (Grira etal. 2016), capital structure

(Bitar et al.2018; Bitar and Tarazi 2019), asset volatility (Belkhir

etal.2019), equity financing costs (Grira etal.2019), Fi nTech in no-

vations and regulatory challenges (Grira and L abidi2021), an d ris k-

taking (Abe difar etal. 2013; Bitar etal. 2021). However, research

on how corruption af fects the risk- taking of convent ional and

Islam ic banks is stil l scarce. Our study fills th is gap in the bank ing

literature. We conjecture that the adherence of Islamic banks to

ethical behavior (K han2010; Qutt ainah and Almutairi 2017) and

the Shari 'ah supervisory boards (SSBs) having multi- layer corpo-

rate governance structure (Mollah and Zaman2 015) may mitigate

the ef fect of corruption on bank risk- taking. Our mai n findings

show that the ef fect of corruption on risk- taking is sig nificantly

positive for the t wo bank types , although this effect is weaker for

Islamic banks than for conventional banks .

For deeper insights , we examine whether the effect of corruption

on ban k risk- tak ing is attenuated depending on the characteris-

tics of their board. For Islamic banks, we consider the size of SSBs,

the presence of females in SSBs, and academ ic qualif ication of

SSBs members. For conventional banks, we exam ine the effects

of the size of the board of di rectors, the presence of female board

members, and academically qualified members. Our results show

that S SB moderates the link between corruption and bank r isk-

taking. Spe cifically, the positive effect of c orruption on the risk of

Islamic banks is mitigated with higher academic qua lifications of

SSB members and higher representation of women on the SSB. As

for conventional ba nks, we f ind a weak effect when we consider

the character istics of the board of di rectors. Specifica lly, we find

that th e effect of the presence of fem ale direc tors and aca demical ly

qualified members on the board is marginal (significance at the

10% level only) in attenuating t he association between corr uption

and the risk of c onventional banks. O ur findings are robust to a

battery of specif ications, including the use of alternative measures

of corr uption and bank risk- taking as well as additional control

variables such as in stitutional environment, national culture, a nd

religion. Finally, the findings remain significant when we employ

an instrumental var iables (IV) approach to deal with endogeneity.

The motivation for studying the effect of corruption on the risk-

taking of Islamic banks compared with conventional ba nks is

driven by the need to investigate a unique channel of the rela-

tionship between corruption and bank- risk in countries with

dual ba nking sy stems. Islamic banking is character ized by its

adherence to Shari'ah principles, representing a dist inct subset

of the financial industry w ith its own set of ethical and practical

standard s. Understanding how corr uption influences Is lamic

banks compared w ith conventional banks is of key i mportance,

as it prov ides insig hts into how differing ethical frameworks

might affect susceptibilit y to corrupt practices and risk manage-

ment proce sses withi n these institutions. The fi ndings of this

work have the p otential to inform reg ulators and policym akers

about the strengths and the weaknesses of e ach system in com-

batting c orruption, thereby c ontributing to t he development of

a more r esilient and ethical ly sound financi al system. B y com-

paring these two distinct bank ing models, we aim to deepen our

understand ing of the multifaceted relationship between cor rup-

tion and risk- taking, facilitating corporat e decision- maki ng for

various stakeholders in the financia l landscape.

This study contributes to the literature in two ways. First, it ex-

tends the broad literature on risk in Islamic ban king (Abedi far

etal.2013; Abedi far etal.2017; Be ck etal.2013; Khan etal.2020;

Mollah and Zaman2015), by investigating how the risk- takin g of

Islamic banks is di fferently affected by corruption compared with

conventional bank s. In addition, this study examines the role of

SSBs and the board of d irectors as potential channels to moderate

the effect of corr uption on bank risk in countries with dual bank-

ing syst ems. Second, we also contribute to the corporate finance

literature more general ly by highlighting the role played by corp o-

rate governance (Dela Rama2012 ; Fu2019; Lombardi etal.2019),

particularly the presence of f emale members and academically

qualified members on the SSBs of Isla mic banks and on the board

of directors of conventional banks, in mitigating the effect of cor-

ruption on bank risk- taki ng for the two bank types.

The rest of this paper is organized as follows. S ection2 develops

the hy potheses. Section3 presents the sample, the variables and

the empirical model. S ection4 discusses the main results, the ro-

bustness tests, and additional investigations . Section5 concludes.

2 | Hypotheses Development

2.1 | Corruption and Bank Risk- Taking

The effect of corr uption on risk- taking of Isla mic and conven-

tional banks can be explained through the lens of “grease the

wheels” and “sand the wheels” hypotheses. The former hy-

pothesis suggests t hat corruption may support bank lending

to politically connec ted and profitable firms, a lbeit at the cost

of increase d bank ris k- tak ing, while t he latter presumes that

corruption has a harmful impact on the stabilit y of banks. I n

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existing banking literature, studies support both “grease the

wheels” and “sand the wheels” hypotheses but a dominant

part of t his literatu re supports “sand the wheels” v iew. For

instance, Chen et al. (2013) document that due to br ibery

more loans are granted to productive fi rms, in- line w ith the

“gr ease the whe els” hy poth esis of corr uptio n. Sim ilar ly, Ak ins

etal. (2017) report that the timely recognition of loan losses

can hinder lendin g corruption by improving the chance s of

identifying problem loans at an earlier stage. However, timely

loan loss recognition i s less assoc iated with reduced cor-

ruption in countries where there is significant government

ownership of the banking system and where banks are less

disciplined by their capital providers, such as the government

and depositors.

Contrary, in the ca se of “sand the wheels” hy pothesis,

Bougatef (2017) reports that corruption impedes bank profit-

ability by diverting funds to undeser ving projects. Likewise,

Yak ubu (2019) and Asteriou et al. (2021) find a signif icantly

negative impac t of corr uption on bank profitability and stabil-

ity. Finally, Chen etal.(2015) find t hat corruption increases the

risk- tak ing of conventional banks.

Our study extends t he work of Chen et al. (2015), Pan and

Tian (2017), Sena etal. (2018), and Bermpei et al. (2021) by

examining t he “grease the wheels” and “sand the w heels” hy-

pothe ses in t he contex t of Isla mic and co nventiona l bank s. We

argue that Islamic banks are based on the religious doctrine

of Sha ri'ah, wh ich may di fferently affect t he link be tween cor-

ru pt ion an d ri sk- ta ki ng for t hes e ba nk s com pa red wit h co nve n-

tional counterpa rts. Existing studies show t hat religion plays

an imp orta nt role in r educing corrup tion in ba nk lendi ng (Niu

eta l. 2022) b y encouragi ng ethical behavior (Calkins 2000;

Callen and Fang 2015). Previous research demonstrates that

religious individuals have conservative moral values (Barnett

et al. 1996; Omer et al.2 018). Bitar a nd Tara zi(2019) also

argue that religious customers of Islamic banks exh ibit a more

inelastic demand for Shari'ah- compliant product than other

customers, as they are driven by loyalty and respect for the

Shari'ah law.

Therefore, we posit that Shari'ah board members may be less

inclined to engage in a corrupt behavior (Niu etal .2022),

thus reducing the effect of corruption on Islamic banks' risk-

taking. Furt hermore, according to social psychology theories,

for ex ample, the l egitima cy theor y, indivi duals of ten confo rm

to the social and cultural f actors such as reli giosity to gain

social recognition and avoid social disapprova l (Chircop

et al. 2020; McGuire et al. 2012; Sunstein1996). Based on

the above discussion, we formulate our f irst hy pothesis as

follows:

Hypothesis 1. The effect of corruption on ri sk- taking is sig-

nifi cantly differe nt for Isl amic bank s than for convent ional ba nks.

2.2 | Corruption and Bank Risk- Taking: The Role

of Board Characteristics

In this section, we further investigate w hether t he effect of

corruption on bank risk- t aking is at tenuated depending on the

board characteristics, namely, board size, fema le board repre-

sentation, and academic qualif ication of board members.

Prior literature suggest s that the composition of boards play

a major role in corp orate governance (Adams et al. 2010;

Baldenius et al.2 014; Coles etal .2014; Masulis etal. 2012),

and effective board s provide important advisory and monitor-

ing role (Schwartz- Ziv and Weisbach2013). The associat ion

between b oard size a nd its advis ory and monitori ng role has

received sign ificant attention in t he corporate governance

literature , a lthough the findings ar e i nconclusive. For con-

ventional banks, Pathan (2009), Dong et al. (2017), and Lu

and Boateng (2018) a rgue t hat lar ger board s ar e less effec-

tive in terms of monitoring due to less cohesiveness, higher

agency costs, and difficulties in communication and coordi-

nation bet ween board members. In contrast, De Andres and

Vall ela do (2008) and Wang and Hsu (2013) show that board

monitoring is positively a ssociated with board siz e becaus e

larger boards typically include members with a diverse range

of expertise.

For Islamic banks, we expect that the size of SSBs to reduce the

effect of corr uption on the stability of Islamic banks. For exam-

ple, Choudhury and Alam (2013) document that SSBs are an

additional layer of monitoring and ov ersight that restrict the en-

gagement of board members and bank management in excessive

risk- tak ing. In addition, Molla h and Zaman (2015) argue that

the business model of Islamic banks is theoretically based on the

premise of ethical behavior, prohibition of interest, and equity-

based fi nancing. Thus, members of SSBs are expected to better

monitor for compliance with Isla mic ethics and hence reduce

the effect of corruption on bank risk- ta king. Thus, we formulate

the following hypotheses:

Hypothesis 2a. A larger SSB moderat es the effect of corrup-

tion on the risk- taking of Islamic banks.

Hypothesis 2b. A larger board moderate s the effect of corrup-

tion on the risk- taking of conventional banks.

There is also an ongoing debate regardin g female board repre-

sentation and its effect on bank performance and risk- taking.

In the conventional banking literature, while some studies

find a positive relationship between the presence of women

on the board of d irectors and bank risk- taking (Campbell and

Mínguez- Vera 2008; Liu et al. 2014; Post and By ron2 015;

Terjesen et al. 2 016), other studies show a negative effect

(Adams a nd Ferreira2009; Ahern and Dittmar201 2). In ad-

dition, studies such as Carter et al. (2010) and Chapple and

Humphrey (2014) do not find a sign ificant effect b etween the

presence of women on the board of di rectors and bank r isk-

taking. In the Islamic bank ing literature, we expect that the

rep res enta tion of wome n on the SSB t o alle via te th e pos itiv e ef-

fect of corruption on risk- taking. Accord ing to Ferreira(2015),

female director s are more independent in their decisions and

more pr one to bett er monitor b ank mana gement and CEOs. In

line with thi s, Sena etal.(2018) argue that independent board

members insulate a firm from the detrimental effect of cor-

ruption on its performance. Thus, we develop the followi ng

hypothese s:

Hypothesis 3a. Female board representat ion alle viates the

positive effect of corr uption on the risk- tak ing of conven tional

banks.

Hypothesis 3b. Representation of female on SSBs alle viates the

positive effect of corr uption on the risk- tak ing of Islamic banks.

Corporate Governance: An International Review, 2024

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