Financial soundness of Islamic banks: does the structure of the board of directors matter?

• DOI: https://doi.org/10.1108/CG-06-2020-0237
• Published date: 10 June 2021
• Date: 10 June 2021
• Pages: 1393-1415
• Subject Matter: Strategy,Corporate governance
• Author: Afef Khalil,Imen Ben Slimene

Financial soundness of Islamic banks:

does the structure of the board of

directors matter?

Afef Khalil and Imen Ben Slimene

Abstract

Purpose –The purpose of this paper is to examine the Board of Directors’ characteristics and their

impacton the financial soundness of Islamic banks.

Design/methodology/approach –Regression analysis is applied to test the impact of the Board of

Directors’characteristics on the financialsoundness of Islamic banks, using a panel data setof 67 Islamic

banks covering 20 countries from 2005 to 2018. The Z-score indicator is used to evaluate the Islamic

banks’ soundness. To check the robustness of the results, this paper uses other dependent variables

(CAMEL)than the Z-score.

Findings –The main resultsshow that the presence of an independent non-executive directornegatively

impacts the financialsoundness of Islamic banks, while the chief executiveofficer duality practice has a

positiveeffect on it. Other characteristics of the Board of Directorsdo not significantly impact the financial

soundness of Islamic banks (foreign director, institutional director, chairman with a Shari’ah degree,

interlockedchairman and the Board of Directors’ size).

Practical implications –This study aims to fill the gaps in the literature that discuss the Board of

Directors’ role in corporate governance and its impact on the financial soundness of Islamic banks. In

other words, it shows the role played by the Board of Directors and improves the knowledge of the

corporate governance-financial soundness relationship. Plus, managers, investors and regulators may

gain evocative insights, particularly those looking to improve their Islamic banks’ soundness by

restructuringtheir boards’ composition.

Originality/value –This study sheds new light on the literature on Islamic banking by clarifying the

relationship between the Board of Directors and the financial soundness of Islamic banks. Contrary to

previous research, this paper uses an additional hypothesis stating that a chairman with a Shari’ah

degree(Fiqh Muamalt) has a positive impact onthe financial soundness of Islamic banks.

Keywords Board of Directors,Corporate governance, Financial soundness,Islamic banks, Panel data,

Sharīʿah-compliance

Paper type Research paper

1. Introduction

After the global financial crisis in 2008, the issue of corporate governance has again

attracted public attention around the world because of the high number of financial

institution failures (e.g. Enron, Global Crossing, Polly Peck International, etc.) (Erkens et al.,

2012;Bukair and Abdul Rahman, 2015;Hakimi et al., 2018;Buallay, 2019;Adedeji et al.,

2020). Policymakers and researchers inferred that corporate governance failure was

responsible for the financial crisis of 2008. In the presence of weak governance, there is a

rise in excessive risk-taking, which leads to higher losses. Consequently, the financial

soundness of banks appears to be negatively influenced (Hakimi et al., 2018;Buallay,

2019). As a result, academics and policymakers argue that there is a need to apply good

Afef khalil is based at

University of Carthage-

Tunisia, Tunisia.

Imen Ben Slimene is based

at CREGO-UHA (EA 7317),

University of Upper-Alsace,

Colmar, France.

Received 17 June 2020

Revised 4 October 2020

9 December 2020

11 February 2021

19 April 2021

22 April 2021

Accepted 23 April 2021

DOI 10.1108/CG-06-2020-0237 VOL. 21 NO. 7 2021, pp. 1393-1415, ©Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 1393

corporate governance (Amine, 2018;Kacanski, 2020;Singh et al., 2020;Steens et al.,

2020). Amine (2018) and Buallay (2019) predicted that a financial crisis enhances the

attention paid to Islamic banks, as many investors observed their stability during this crisis.

Almayatah (2018) argues that Islamic banks are less impacted by a financial crisis than

conventional banks, as Islamicbanking sometimes performs better.

In the past few decades, Islamic banks have rapidly grown in both number and size in

many countries around the world because of the increasing demand from customers who

are more inclined to engage with banks that comply with Sharīʿah principles (Lassoued,

2018;Aslam and Haron, 2020;Mesliera et al., 2020). According to Ulussever (2018),the

financial assets of the Islamic financial sector grew 50% faster than the overall banking

sector, with an annual growth average of 17.6% during the period 2008–2012 and reached

US$1.7tn in 2013. Plus, Islamicfinance assets are expected to achieve US$6.5tn in 2020.

The literature shows that Islamic banks encourage integrity, honesty, accountability, transparency

and responsibility among stakeholders. When choosing their banks, customers consider several

important factors, such as economic factors, reputation and religion (Ashraf et al., 2015;

Nomran et al., 2018). That’s why Islamic banks need to take customer satisfaction into account to

ensure their credibility, which, in turn, increases bank stability and leads to higher market shares

(Nomran et al.,2018). What distinguishes Islamic banks from their traditional counterparts is their

governance structure following Sharīʿah-compliant characteristics and guided by the Shariah

Board (Nomran et al., 2018;Mesliera et al., 2020). According to Buallay (2019), the Shariah

Board is considered to be an independent body that covers the control and monitoring of Islamic

banks’ activities to ensure Sharīʿah-compliance. According to Grassa and Matoussi (2014),the

Shariah Board and the Board of Directors are the two most important organs that play a crucial

role in Islamic banks’ corporate governance.

The Board of Directors is an internal organ linked to the direction and management of the

bank and it is composed of directors named by the shareholders (Abdeljawad et al.,2020;

Jimenez et al., 2020;Rashid et al.,2020;Rehman and Hashim, 2020). This board has the

same legal responsibilities asa conventional bank’s board. More than that, the principlesof

Islamic finance add expectations and responsibilities to the board of an Islamic bank

(Grassa and Matoussi, 2014;Hakimi et al.,2018). Therefore, the Board of Directors must

ensure compliance with Shari’ah law [Accounting and Auditing Organization for Islamic

Financial Institutions (AAOIFI), 2010;Hakimi et al.,2018]. In this regard, the Board of

Directors is responsible for the Shariah corporate governance framework’s effective role

and ensures that this framework is compatible with the size and nature of the Islamic

financial institution’s (IFI) activities (Islamic Financial Services Board [IFSB], 2006;AAOIFI,

2010;Bank Negara Malaysia [BNM],2010).

Based on a panel data set of 67 Islamic bankscovering 20 countries from 2005 to 2018, this

study aims to determine whether and how the Board of Directors’ attributes affect the

financial soundness of Islamic banks. We analyze seven characteristics of the Board of

Directors, namely, independent non-executive directors, foreign directors, institutional

directors, the interlocking directorate, the chairman with a Shari’ah degree, the chief

executive officer (CEO) duality and the Board of Directors’s size. The remainder of this

study is organized as follows. Section 2 presents a literature review of the relationship

between the Board of Directors’ characteristics and financial soundness. Section 3

describes the research design. The discussion of the empirical results is in Section 4.

Section 5 covers the main conclusion.

2. Literature review and hypotheses

2.1 Independent non-executive directors

An independent non-executive director is a member of the Board of Directors who does not

hold an executive office and is independent of management (Ibrahim et al.,2012). Under

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