Does corporate governance affect the performance of Islamic banks? New insight into Islamic countries

• Published date: 13 July 2020
• Pages: 1073-1090
• DOI: https://doi.org/10.1108/CG-11-2019-0350
• Date: 13 July 2020
• Author: Ejaz Aslam,Razali Haron
• Subject Matter: Strategy,Corporate governance

Does corporate governance affect the

performance of Islamic banks? New

insight into Islamic countries

Ejaz Aslam and Razali Haron

Abstract

Purpose –Corporate governance plays a significant role to overcomeagency issues and develop the

culture of transparency and openness. In this context, this paper aims to examine how corporate

governancemechanisms affect the performanceof Islamicbanks (IBs).

Design/methodology/approach –Stepwise, two-stepsystem generalize method of moment estimation

technique is used in the analysis in which control variables are added into the model sequentially. This

study used data on 129 IBs from 29 Islamic countries (Middle East, South Asia and Southeast Asia)

during theperiod of 2008 to 2017.

Findings –The findings suggestthat the audit committee (AUDC) andShariah board (SB) have positive

impact on the performance of IBs (returnon assets and return on equity). However, board size and risk

managementcommittee have negative and significanteffect on the performance of IBs. CEO dualityand

non-executive directorshave mixed relationship with the performance of IBs. These resultssupport the

argument that IBs need to improve their financial performance through appropriate governance

mechanism.

Research limitations/implications –The findings of the study added a new dimension to the

governance research thatcould be a valuable source of knowledge for policymakers and regulators to

improvethe existing governance mechanism for betterperformance of IBs.

Originality/value –The study fills the gap in the literature by addressing the issue of corporate

governance on performance of IBs across countries. Agency theory is discussed to explain the

relationshipbetween corporate governancemechanism and performance.

Keywords Financial performance, Corporate governance, Islamic banks, Shariah board, 2SYS-GMM

Paper type Research paper

1. Introduction

Islamic banking is the fastest-growing segment in the global financial industry. According to

the Islamic Finance Country Index Report (2019), Islamic banking and finance grew at the

average growth rate of 12.46% annually (2012–2019) with total assets held by the Islamic

banks (IBs) valued at US$2.591tn by the end of 2018. Based on past literature, Islamic

finance industry remained stable (Chapra, 2011;Hasan and Dridi, 2011;Hussien et al.,

2019), efficient (Bourkhis and Nabi, 2013;Al-Khazali et al.,2014), maintained better asset

quality (Mwamba et al.,2017) and recorded low loan default rates (Baele et al., 2014;

Mollah et al., 2017).

Despite the advancement made by IBs, the Islamic financial industry should not be viewed

in segregation. The precise codes of conducts in the Muslim religion and the distinctive

characters of Islamic banking differentiate it from the conventional banks (Abedifar et al.,

2013). IBs dispose the interest-based traditional system and abide by the principles of

Islamic law to advance the property rights, profit and loss sharing and sanctity of the

Ejaz Aslam and

Razali Haron are both

based at the Institute of

Islamic Banking and

Finance, International

Islamic University Malaysia,

Kuala Lumpur, Malaysia.

Received 18 November 2019

Revised 31 January 2020

25 April 2020

19 June 2020

Accepted 21 June 2020

The authors are grateful to the

anonymous referees and editor

of the journal for their extremely

useful suggestions to improve

the quality of the article.

DOI 10.1108/CG-11-2019-0350 VOL. 20 NO. 6 2020, pp. 1073-1090, ©Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 1073

contracts (Mirakhor and Zaidi, 2007). Therefore, the restriction of interest or usury (riba)in

Islam does not imply that credit is precluded, capital is not remunerated and risk is not

valued (Mollah et al.,2017). Thus, IBs offer distinct banking model comparative to the

conventional banks under the guidance of the Shariah law (Shaffaii, 2008;Noordin and

Kassim, 2019).

What distinguishes IBs from their conventional counterparts is not only the replacement of

interest but also the significant monitoring role of Islamic corporate governance (CG) to

maximise the value of IBs. Several studies focused on the divergence in understanding the

CG concept between the Western and Islamic countries (Andries

,et al., 2018;Farag et al.,

2018;Mollah et al.,2017;Nawaz, 2017). Hassan et al. (2009) documented that the

governance of IBs is not much different from the conventional banks asit referred to a set of

rules and regulations that bring transparency and accountability with the purposeto protect

the shareholders (Sheikh et al.,2018). Additionally, CG deals with the relationship between

the board of directors, managers, employees, shareholders and stakeholders (Wahyudin

and Solikhah, 2017). Thus, CG is widely accepted as a significant determinant to enhance

banks’ performance (Aktan et al.,2018;Aslam et al., 2019a,2019b). Therefore, banks with

prudent CG structure are perceived to be more efficient in allocating the bank resources to

generate more profit (AlSagret al.,2018;Hussien et al., 2019).

Conversely, Magalhaes and Al-Saad (2013) showed that while CG structures relied upon

the advancement of lawful frameworks, as well as administrative and institutional conditions,

CG in the Islamic financial context was viewed as an alternative to the conventional

governance. Furthermore, Mollah et al. (2017) argued that an extra challenge for Islamic

governance is the need of shareholders to trust that the IBs are competent, steady,

responsible suppliers of financial services and complying with the Shariah law. Mollahet al.

(2017) further argued that the governance of IBs stay elusive and the assessment of its

quality needs further examination. Hence, this study aims to revisit the CG of IBs and

contributes to the discussionon the performance of IBs and shed more lights on the idea of

its CG.

This study contributes to the existing literatureof Islamic banking in several ways. First, this

is a cross-countries study thatexamines the impact of governance structure on the financial

performance of IBs in 29 Islamic countries from four different regions. Second, this study

applied the two-step system generalise method of moment (2SYS-GMM) estimation

technique to account for the unobserved heteroscedasticity and endogeneity in the data.

Third, the study used a large data set, so its results provideadditional valuable insights into

the nature and role of governance structure on the performance of IBs. Furthermore, this

study theoretically attemptsto contribute to the existing literature on the effectiveness of CG

in Islamic countries. If adopted,this finding may serve as an empirical evidence of the need

to re-assess the effectivenessof CG mechanisms in Islamic countries.

The rest of the paper is structured as follows. Section 2 reviews the literature and develops

the hypotheses. Section 3 explains the research methodology. Section 4 reports the

outcomes and discussion, andSection 5 concludes the overall study.

2. Literature and hypothesis development

Agency theory is the principal theoretical approach that clarifies the relationship between

CG and financial performance (Almutairi and Quttainah, 2017;Farag et al., 2018;Grove

et al.,2011

). This theory explains that the board of bank entrepreneurial behaviour relies

upon the excellent governance structure of the bank (Mollah et al.,2017). Thus, the primary

concern of promoting better CG is the accessibility of the appropriate mechanism to control

agency conflicts and improve the wealth of the shareholders. Wasiuzzaman and Nair

Gunasegavan (2013) observe that the board of directors play a significant role to serve as

the source of advice, counsel, discipline and responsible for the financial soundness of the

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