Islamic Financial Institutions and Corporate Governance: New Insights for Agency Theory

• Author: Assem Safieddine
• DOI: http://doi.org/10.1111/j.1467-8683.2009.00729.x
• Date: 01 March 2009
• Published date: 01 March 2009

Islamic Financial Institutions and Corporate

Governance: New Insights for Agency Theory

Assem Saf‌ieddine*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper takes a theory building approach to highlighting variations of agency theory in the

unique and complex context of Islamic banks, mainly stemming from the need to comply with Sharia and the separation of

cash f‌low and control rights for a category of investors.

Research Findings/Results: The paperprovides insights that agency structures in the context of Islamic banking might give

rise to trade-offs between Sharia compliance and mechanisms protecting investors’ rights. Alternative models of idiosyn-

cratic governance might be effective in balancing the two cornerstones of the agency dynamic. In practice, the paper f‌inds

that most of the surveyed Islamic banks appear to recognize the value of governance and institute some basic mechanisms.

Nonetheless, some governance f‌laws relating to audit, control, and transparency are observed, a situation further exacer-

bated by the fact that investment account holders are not represented on the board, and are not granted control or

monitoring rights. This leads to a discussion on the tradeoff between the costs and benef‌its of such a practice.

Theoretical Implications: This study contributes to the agency theory literature by providing theoretical propositions

highlighting challenges to this theory whereby mechanisms with the purpose of mitigating agency problems might lead to

a divergence from Islamic principles of Sharia.

Practical Implications: The papermotivates Islamic banks to improvegovernance practices currently in place. It alerts policy

makers to the need to tailor the regulations to safeguard the interests of all investors without violating the principles of

Sharia.

Keywords: Corporate Governance, Board Evaluation, Board of Director Issues, Gulf States, Agency Theory

INTRODUCTION

Awareness of the potential drawbacks of agency prob-

lems has grown enormously over the past decade. By

now it has become widely accepted that companies are

exposed to agency issues whereby the separation of owner-

ship and control leads managers to seek their personalinter-

ests at the expense of those of shareholders (Fama and

Jensen, 1983a). To mitigate these issues, governance was

adopted (Beasley, 1996; Bebchuk, Cohen and Ferrell, 2004).

These lead to improved mechanisms that align the interests

of managers and shareholders and institutional control is

increasingly performed for corporations (Gompers, Ishii

and Metrick, 2003). However, agency relationships and

governance settings become more complex when corporate

structures deviate from their conventional forms (Dharwad-

kar, George and Brandes, 2000; Kapopoulos and Lazaretou,

2007; Hu and Izumida, 2008).

The paper attempts to explore the agency issues in the

special context of Islamic f‌inancial institutions and further

develop the discussions on the relationship between Islamic

f‌inance operations and agency. We argue that the agency

problems at Islamic f‌inancial institutions deserve separate

and particular examination for a number of reasons. The f‌irst

is directly related to the nature of their operations, which

distinguishes them from conventional corporations and

widens the issue of separation of ownership and control

underlying the agency theory. The key sources of distinction

arise from the observation that managers of Islamic banks

are not only entrusted by shareholders to maximize the

value of their investments, but have a more compelling duty

to achieve these objectives in a Sharia-compliant manner

(Archer, Ahmed. and Al-Deehani, 1998). Furthermore, the

*Address for correspondence: Assem Saf‌ieddine, AssociateProfessor of Finance, Cor-

porate GovernanceProgram Director, the School of Business, American University of

Beirut, Bliss Street, Beirut, Lebanon, P.O. Box: 11-0236. Tel: 961-1-352700; Fax: 961-1-

750214; E-mail: as57@aub.edu.lb

142

Corporate Governance: An International Review, 2009, 17(2): 142–158

© 2009 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00729.x

contracts created between the Islamic banks and investment

account holders (IAHs) allow the banks to share in prof‌its

and not in risks or losses and forbid IAHs from intervening

in the management of their funds. Thus,managers of Islamic

banks are presented with opportunities to extract personal

benef‌its at the expense of IAHs’ interests (Abdel Karim,

2001; Abdel Karim and Archer 2002, 2006). Consequently,

structures where the cash f‌low rights of IAHs are separated

from their control rights are created.

Second, the study of the agency dynamics in Islamic f‌inan-

cial institutions becomes of paramount importance in light

of the tremendous growth rates the industry is experiencing.

Islamic banks expanded to more than 50 countries and

even beyond Muslim countries. Hassoune and Volland

(2004) reported that “the growth rate of Islamic banking

services outpaced that of conventional banking during the

past decade, making it one of the most dynamic areas in

international f‌inance.” In 2004, Islamic banks controlled

approximately $250 billion in assets and they are expected to

grow at an annual rate of 10 per cent to 15 per cent

(El-Hawary,Grais and Iqbal, 2007). This study focuses on the

Gulf Cooperation Council (GCC) region where the growth

rate has been outstanding in comparison with other parts of

the world (Hassoune and Volland, 2004; Grais and Pelle-

grini, 2006a). The Islamic f‌inance industry in this region is

expected to attract 4.50 times the funds to be invested in

conventional assets in the near term. In 2007, the United

Arab Emirates alone issued 52.70 per cent of the global

Sukuk (Islamic bond) (Kuwait Finance House, 2007; Global

Investment House, 2008).

Third, while the previous literature sheds light on a

number of issues faced at Islamic f‌inancial institutions and

recommends possible mitigating mechanisms, little, if any,

research has tackled the issue from an empirical angle. Prior

research hints at the exacerbated agency issues at Islamic

banks (Choudhury and Hoque, 2006), but does not address

the challenges to the theory.Furthermore, to our knowledge,

no research has specif‌ically tackled the agency dynamics of

Islamic f‌inancial institutions operating in developing coun-

tries or the GCC. The paper thus takes a theory building

approach and attempts to f‌ill the gap in the literature by

highlighting how agency theory is different in Islamic f‌inan-

cial institutions. It explores the peculiar governance issues

facing Islamic banks in f‌ive countries of the GCC – Saudi

Arabia, Kuwait, Qatar, Bahrain, and UnitedArab Emirates –

and their effectiveness in mitigating agency problems.

Through a thorough analysis of the operations of Islamic

banks and examination of the practices in place, the paper

builds theoretical propositions that tackle the challenges to

the agency theory in the context of Islamic banking. It also

investigates the impact of a set of governance practices on

performance.

The rest of the paper is organized as follows. The next

section reviews the literature and explores the variations of

the agency theory in Islamic banks. Then the paper presents

an overview of the research methodology and the sample.

The paper proceeds with a section that summarizes the gov-

ernance environment and the regulatory framework in the

GCC countries and then discusses the f‌indings and presents

a set of theoretical propositions. The last section includes our

concluding remarks.

LITERATURE REVIEW

Agency Theory in Different Corporate Contexts

It is widely argued that the contract structure of organiza-

tions separating ownership fromcontrol gives rise to agency

problems resulting from the fact that the agents or managers

do not bear the risks or the “wealth effects of their decisions”

(Fama and Jensen, 1983a; 1983b). Managers would be con-

sequently tempted to diverge from their f‌iduciary duty of

maximizing shareholder wealth. The development of the

agency theory has resulted in the proposition and imple-

mentation of governance structures whereby the control of

decisions is separate form the management of these deci-

sions (Fama and Jensen, 1983a). The reinforcement of the

role of the board of directors and the tightening of audit and

control mechanisms came to serve this purpose. The concept

of corporate governance as “a set of relationships between a

company’s management, its board, its shareholders, and

other stakeholders,” has quickly emerged, fueled by the

desire to mitigate recurring incidents of agency problems

(OECD, 2004).

The research on agency theory has expanded beyond con-

ventional contractual structures between shareholders and

managers. Hu and Izumida (2008) and Kapopoulos and

Lazaretou (2007) tackle the issue of ownership structures

and their implications for the emergence of agency prob-

lems. Kapopoulos and Lazaretou (2007) highlight the issue

of conf‌licting interests between strong blockholders and

weak minority shareholders in family-controlled f‌irms in

Greece and f‌ind that the greater the degree of ownership

concentration, the more effective the control mechanisms.

Dharwadkar et al. (2000) also study the agency theory in a

unique governance setting by exploring the issues that

encounter privatized f‌irms in emerging markets. They argue

that the traditional agency problems are exacerbated, and

issues relating to the expropriation of minorities’ rights are

created. They attribute this to the transfer of ownership and

the weak internal and external governance contexts.

Bebchuk, Kraakman, Reinier and Triantis (2008) address

the agency costs of corporate arrangements separating the

cash f‌low and control rights such as the dual class share

structures. They f‌ind that as the size of cash f‌low rights held

decreases, the size of agency costs increases. Their f‌indings

also suggest that the separation of the two rights could create

agency costs in an order of magnitude larger than those

associated with controlling shareholders.

The Unique Agency Relationships in Islamic

Financial Institutions

The governance of the banking industry in general has also

caught the attention of scholars and regulators. Hagendorff,

Collins and Keasey (2007) concentrate their research on the

banking sector backed by the argument that it requires a

separate agency analysis. The uniqueness of the agency

relationships at banks stems from the managers’ duty to

safeguard the funds of all capital providers, including

depositors (IFQ, 2007). The opaque nature of many of the

banks’ main activities, the role of regulation in the industry

(Basel Committee on Banking Supervision, 2006; Hagen-

ISLAMIC FINANCIAL INSTITUTIONS AND CORPORATE GOVERNANCE 143

Volume 17 Number 2 March 2009© 2009 Blackwell Publishing Ltd