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

TLDR: In this paper, the authors examined whether the difference in governance structures influenced the risk taking and performance of Islamic banks compared to conventional banks and concluded 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.

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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Table 3 Descriptive statistics This table presents the descriptive statistics for the variables used in the models for both Islamic and conventional banks. We report the paired sample mean diff rence (T-test) in column 14. See Table 2 for the definitions of the variables. The *** , ** , and * represent p-values of 0.01, 0.05, and 0.10.

Table 4 Difference in governance between Islamic and conventional banks and its impact on risk taking This table presents the regression results for the governance difference betwe n conventional and Islamic banks and its impact on risk taking. The risk-taking proxy is Log_Z. We use a corporate governance index (CGI) as the proxy for governance. See Table 2 for definitions of the other bank-specific and country-specific variables. Robust standard errors are reported in the parentheses. The *** , **, and * represent p-values of 0.01, 0.05, and 0.10.

Table 1 Sample distribution This table describes the sample of the study. The study considers 156 banks (52 Islamic and 104 conventional) in 14 countries for the period from 2005 to 2013. The country-wise distribution of the banks, observations, and percentages are in columns 2–6.

Table 5 Difference in governance between Islamic and conventional banks and its impact on financial performance This table presents the regression results for the governance difference betwe n conventional and Islamic banks and its impact on financial performance. The performance proxy is ROA. We use a corporate governance index (CGI) as the proxy for governance. See Tabl 2 for definitions of the other bank-specific and country-specific variables. Robust standard errors are reported in the parentheses. The *** , **, and * represent p-values of 0.01, 0.05, and 0.10.

Table 2 Description of the variables This table presents the descriptions of the governance and other firm- and country-specific variables and includes the calculation procedure for each variable.

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Mollah, Sabur, Hassan, M. Kabir, Al Farooque, Omar and Mobarek, Asma 2017. The governance,
risk-taking, and performance of Islamic banks. Journal of Financial Services Research 51 , pp. 195-
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The Governance, Risk-taking, and Performance of Islamic Banks
Sabur Mollah • M. Kabir Hassan • Omar Al Farooque • Asma Mobarek
Journal of Financial Services Research, Forthcoming
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.
Keywords Corporate governance • Risk-taking • Firm performance • Islamic banks
JEL Classification G34 • Y90 • G01
Sabur Mollah (Corresponding Author)
Stockholm Business School, Stockholm University, Sweden
M. Kabir Hassan
Department of Economics and Finance, New Orleans University, USA
Omar Al Farooque
UNE School of Business, University of New England, Australia
Asma Mobarek
Stockholm Business School, Stockholm University, Sweden

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1 Introduction
The recent literature on Islamic banks mainly attributes their better performance during crises
to the nature of their financial products and operating models (Hasan and Dridi 2010;
Bourkhis and Nabi 2013). In this paper, we add a new dimension to this literature by
examining the impact of the difference in governance structures between Islamic and
conventional banks on their risk taking and financial performance.
In the field of banking and finance, the world has experienced in the last few decades
the evolution of the Islamic mode of banking and its rapid growth in Muslim countries. In
particular, Muslim countries contain more than a quarter of the world’s population.
1
In
addition, Islamic finance has seen substantial expansion in non-Muslim countries in terms of
global financial assets and market share. The financial assets of the Islamic financial sector
totalled US$1.7 trillion in 2013 and grew 50% faster than the overall banking sector with an
average annual growth of 17.6% from 2008 to 2012 (Ernst & Young 2012). Further, Islamic
bank assets are expected to reach US$3.4 trillion by 2018 (Ernst & Young 2013) and US$6.5
trillion by 2020 (IFSB 2010; Cihak and Hesse 2010). Despite the progress made by Islamic
banks, the Islamic banking industry should not be viewed in isolation. The specific codes of
behavior in the Muslim religion (see, e.g., Abedifier et al. 2013) and the distinctive character
of Islamic banking have led to increasingly unique differences between Islamic and
conventional banks.
The difference between Islamic and conventional banking is that Islamic banking
discards the conventional interest-based financial system and follows the principles of Islamic
law promoting property rights, profit-risk sharing, and the sanctity of contracts (Zaher and
Hassan 2001; Iqbal and Llewellyn 2002). The prohibition of interest or usury (riba) in Islam
does not mean that credit is prohibited, capital is not rewarded, or that risk is not priced. By
developing a Shari’ah-compliant alternative, Islamic banks offer a distinct business model
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).

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from the conventional banks.
2
Unlike their conventional counterparts, Islamic banks have
developed specific forms of financial contracts to replace the interest rate mechanisms in
financial transactions.
Furthermore, due to Shari’ah supervision on risk taking, Islamic banks are not equally
exposed to external shocks.
3
Hence, these banks are less susceptible to insolvency because of
the nature of Islamic financial contracts that have a wider range of arrangements for risk and
liability sharing between the bank and their clients compared with conventional banks. These
differences provide for social, ethical, and moral financial solutions to economic problems in
transactions through conformity with Shari’ah principles. Moreover, while conventional
banks provide financial intermediation services on the basis of a rate of interest on assets and
liabilities, Islamic banks can act as both an intermediary of funds and as an entrepreneur and
financier of real business activities in their own right.
What distinguishes Islamic banks from their conventional counterparts is not only the
replacement of interest but also the significant monitoring role that Shari’ah law plays in the
governance structure as opposed to conventional banks (Mollah and Zaman 2015). In Islamic
banks, while the customary board of directors performs the executive role, they also enforce
the authority of the Shari’ah board to perform either supervisory or advisory roles, or both.
Chowdhury and Hoque (2006) consider the Shari’ah board as a supra authority that is an
integral part of Islamic banks’ governance.
4
Further, in a study covering Islamic banks in 25
countries, Mollah and Zaman (2015) find a positive impact of the Shari’ah board’s
supervisory role on the performance of Islamic banks.
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 and Gintzburger 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).

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The key question of this paper is: how strong is the governance structure of Islamic
banks? We argue that the nature, quality, and commitment of the regular board of directors in
Islamic banks and in conventional banks are different. This is because the former is charged
with adhering to Islamic doctrine, which demands that specific codes of behavior be followed
and reflected in financial arrangements and transactions. Thus, the governance structure in
Islamic banking is unique because of the Shari’ah board’s supervision.
Accordingly, there is an open empirical research question as to whether the different
governance structure explains the risk taking and performance in Islamic banks. Therefore,
given the distinctions between Islamic banks and conventional banks, this study examines
whether their governance structure influences risk taking and performance differently. By
using a sample of 52 Islamic banks and 104 conventional banks in 14 countries over the
period from 2005 to 2013, we conclude that the governance structure in Islamic banks plays a
crucial role in increased risk taking as well as enhanced financial performance, which is
different from conventional banks.
This study contributes to the literature on banking in several ways. First, this is the
first cross-country study that examines the influence of the governance structure on the risk
taking and financial performance of Islamic banks. By simultaneously analyzing both Islamic
banks and conventional banks, we complement the works of Cihak and Hesse (2010), Hasan
and Dridi (2010), Abedifar et al. (2013), Beck et al. (2013), and Mollah and Zaman (2015).
These studies provide comparative analyses on financial stability, risk management,
performance, and efficiency between these two types of banks.
Second, this study constructs a unique database by using 12 hand-collected
governance items, which has not been done in previous banking governance research. This
data set captures a wider spectrum of measures of board and CEO structures, board
competence, and board diversity for both Islamic banks and conventional banks. Therefore,
this study provides a new governance dimension to the banking literature.
Finally, in examining the effect of governance on risk taking and performance, this
study also extends pooled sample estimations by splitting the sample into big and small

Frequently asked questions

Q1. What are the contributions in "The governance, risk-taking, and performance of islamic banks" ?

The authors 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, the authors 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, the authors 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. 

Q2. What are the future works in "The governance, risk-taking, and performance of islamic banks" ?

Additionally, future research could further extend the role of the Shari ’ ah supervisory board. 

Q3. What are the main factors that influence the risk management of Islamic banks?

In addition, Islamic requirementsthat limit negligence or misconduct (operational risk) and difficulty in accessing liquidity putpressures on Islamic banks to be more conservative. 

Q4. What is the expected growth of Islamic bank assets by 2020?

Islamicbank assets are expected to reach US$3.4 trillion by 2018 (Ernst & Young 2013) and US$6.5trillion by 2020 (IFSB 2010; Cihak and Hesse 2010). 

Q5. What is the average annual growth of the Islamic financial sector?

The financial assets of the Islamic financial sectortotalled US$1.7 trillion in 2013 and grew 50% faster than the overall banking sector with anaverage annual growth of 17.6% from 2008 to 2012 (Ernst & Young 2012). 

Q6. What is the main reason why Islamic banks have agency problems?

In general, the agency problems in conventional banks arise when managers deviate from their obligation to maximize shareholders’ wealth. 

Q7. What are the main reasons why shareholders prefer to take risk?

Similar to other corporations, bank shareholders have a preference forexcessive risk taking due to the moral hazard problem, limited liability, and convex pay-offsystems (Galai and Masulis 1976; Jensen and Meckling 1976; John et al. 1991). 

Q8. What are the factors that influence the Z-scores?

the Z-scores tend to decrease with profit volatility (Stdroat-1), size (Log_TAt-1), country-level supervision, and the inflation rate, as expected. 

Q9. What is the effect of the variables on ROA?

For the control variables, both loans and profit volatility (STDROAt-1) show a strongpositive effect on ROA that indicates high risk taking enhances financial performance. 

Q10. What is the role of the Shari’ah board in Islamic banks?

Chowdhury and Hoque (2006) consider the Shari’ah board as a supra authority that is an integral part of Islamic banks’ governance. 

Q11. What is the effect of the CGI variables on the Z-scores?

both the Islamic bank dummy and the CGI variablesindividually indicate a positive effect on the Z-scores that suggest the Islamic banks have lessof a desire for high risk taking, consistent with Cihak and Hesse (2010).