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The governance, risk-taking, and performance of Islamic banks

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Abstract

We examine whether the difference in governance structures influences the risk taking and performance of Islamic banks compared to conventional banks. Using a sample of 52 Islamic banks and 104 conventional banks in 14 countries for the period from 2005 to 2013, we conclude that the governance structure in Islamic banks plays a crucial role in risk taking as well as financial performance that is distinct from conventional banks. Particularly, we show that the governance structure in Islamic banks allows them to take higher risks and achieve better performance because of product complexities and transaction mechanisms. However, Islamic banks maintain a higher capitalization compared to conventional banks. These results support the research on Islamic investment and risk taking. Our results add a new dimension to the governance research that could be a valuable source of knowledge for policy makers and regulators in the financial services sector.

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Notes

  1. In 2014, Muslim population was 2038.04 million, which was 28.26 % of the total world population of 7151.51 million. Muslim countries in Asia and Africa had 27.56 % Muslim population (i.e., 1971.08 million), while non-Muslim counties in North America, Europe, Oceania, and South America had 0.7 % (i.e. 66.96 million) (see http://muslimpopulation.com/World).

  2. Islamic banking offers a two-tiered business model: mark-up financing (murabaha) and profit-sharing financing (mudaraba and musharaka). Overtime, the former became the dominant mode of financing in Islamic banks given that there are some inherent problems in applying the latter in practice, such as moral hazard.

  3. Islamic banks are neither exposed to toxic securities nor offered products like CDOs or MBS due to the prohibition by the Shari’ah (Ahmed 2009). The derivative products like CDS are prohibited under Islamic law due to the existence of risky or hazardous sale. In fact, Islamic law prohibits any transactions involving unnecessary uncertainty (gharar) and gambling (maysir), which includes short selling, arbitrage, betting and speculation (Aziz et al. 2009).

  4. Although the governance structure of conventional banks in some countries like Germany or Austria includes a supervisory board, the monitoring mechanism of the Shari’ah Supervisory Board (SSB) is much more effective (Mollah and Zaman 2015).

  5. We take the definition of Islamicity from Rehman and Askari (2010).

  6. Bankscope database offers six accounting consolidation codes: C1, C2, U1, U2, C*, and U*. Banks having accounting consolidation codes C1, C2 and C* indicate that the financial statements of the parent bank is consolidated with its subsidiaries, but the financial statements of the parent bank are not consolidated with its subsidiaries for the codes U1, U2, and U*. Thus, un-consolidated statements do not offer a complete financial picture of those banks.

  7. This independence indicator consists of five categories. The categories A and B include companies where the main shareholder holds less than 50 % of the total ownership of a company. We made this choice because in non-independent banks the governance mechanisms are influenced by the parent bank.

  8. We discuss model 6 (GMM) in subsection 4.3

  9. See footnote 8 for model 6.

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Acknowledgments

We are grateful to the Editor, Prof. Haluk Ünal, the Managing Guest Editors of the special issue, Prof. M. Shahid Ebrahim, Prof. Phil Molyneux, Prof. Steven Ongena, and two anonymous referees for valuable comments. We acknowledge financial support from Jan Wallenders och Tom Hedelius Stiftelse, Handelsbanken, Sweden, for this research (Project ID P2010-0144: 1). An earlier version of this paper was presented at the 47th Euro Working Group on Financial Modeling, October, 2010, Prague, Czech Republic; at the seminar on Islamic Finance, 14 January, 2011, University of Dhaka, Bangladesh; the 61st Midwest Finance Association 2012 Meeting, 22–25 February, 2012, New Orleans, USA; and the Bangor-JFSR Conference, 15 September, 2014, Bangor, UK. We are thankful to Meryem Duygun for her valuable comments as a discussant at the Bangor-IRTI-JFSR conference. We have hugely benefitted from the comments by the discussants and participants in the conferences. We are also grateful to M. Shahid Ebrahim, Philip Molyneux, Omneya Abdelsalam, and Wares Karim for their comments on the earlier draft of this paper. We are also thankful to Omar Sikder, Sharifur Rahman, Al-Amin, Ziauddin, Zahiduzzaman, Humyra Jabeen, and IK Nahid for research assistance with the hand collected data. The authors are responsible for any remaining errors.

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Authors and Affiliations

  1. Stockholm Business School, Stockholm University, Stockholm, Sweden

    Sabur Mollah & Asma Mobarek

  2. Department of Economics and Finance, New Orleans University, New Orleans, LA, USA

    M. Kabir Hassan

  3. UNE School of Business, University of New England, Armidale, NSW, Australia

    Omar Al Farooque

Authors
  1. Sabur Mollah
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  2. M. Kabir Hassan
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  3. Omar Al Farooque
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  4. Asma Mobarek
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Corresponding author

Correspondence to Sabur Mollah.

Appendix

Appendix

Table 6

Table 6 Descriptive statistics for corporate governance variables. This table presents the descriptive statistics for the 12 governance items we use in constructing the corporate governance index (CGI)
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Mollah, S., Hassan, M.K., Al Farooque, O. et al. The governance, risk-taking, and performance of Islamic banks. J Financ Serv Res 51, 195–219 (2017). https://doi.org/10.1007/s10693-016-0245-2

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