Keywords

Board of Directors, Financial performance, Islamic banks, Meetings, Panel data, Shariah Board.

Introduction

Corporate governance is defined as a set of relationships and duties between managers, directors, investors and other stakeholders (Islamic Financial Services Board (IFSB), 2006). Amine (2018) adds that the concept of corporate governance refers to how the company is managed and protects the interests of its stakeholders. The corporate governance of the Islamic banking differs from their conventional ones in that Islamic banking conform to the shariah principles and are allowed to have a shariah governance mechanism in place that supervises their shariah compliance (Khalil & Chihi, 2020; Khalil & Taktak, 2020).

Thus, the Islamic banks are run by two independent bodies namely the Shariah Board and the Board of Directors, which affect their corporate governance Grassa & Matoussi, (2014); Khalil & Chihi, (2020). The Shariah Board is one of the internal governance structures covering the monitoring of the Islamic banks transactions to ensure compliance with Shariah laws, according to Amine (2018); Khalil & Taktak (2020). Plus, Dalwai et al. (2014) and Almutairi & Quttainah (2020) say that the Shariah Council is responsible for all shariah issues, while global corporate governance is discussed by the Board of Directors. Consequently, the Shariah Council and the Board of Directors improve the banks credibility and attract investors (Alam et al., 2020). Muneeza & Hassan (2011) suggest that the Shariah Board scholars should assume their roles as directors. Currently, the corporate governance calls the Board of Directors and the Shariah Board to work collaboratively, specifically on shariah issues (Quttainah et al. 2013; Ramly et al. 2018).

Despite the rapid growth of Islamic banks in the world, we notice that there is no empirical research that explores the features connecting the Board of Directors to the Shariah Board and their influence on the bank performance. This research paper will, thus, be an opportunity to examine the impact of the relationship between the Board of Directors and the Shariah Council on the financial performance of Islamic banks from 2015 to 2018. This study is organized as follows: Section 2 represents the literature review. The sample and the variables measurement are described in the third section. Section 4 discusses the empirical results. Section 5 concludes our research study.

Literature Review

Meetings between the Board of Directors and the Shariah Board

Othman et al. (2012) argue that the Board of Directors and the Shariah Board should work together to minimize the shariah risks and enhance the financial performance of the Islamic financial institution (IFI). Thus, the bank activities will be supervised by the Shariah Board and the directors, according to Qutainah et al. (2013). Almutairi & Quttainah (2020) & Mesliera et al. (2020) argue that the directors work with the shariah scholars to enhance positive managerial behavior and reduce agency costs. Hasan (2011) adds that the number of meetings between the Board of Directors and the Shariah Board enables the two bodies to keep contact and improve communication between members. Moreover, Misman & Bhatti (2020) reveal that the Shariah Council advises the Board of Directors on the credit risk associated with the products before marketing them. Merton (1977) adds that shariah scholars must prohibit the directors from engaging in activities with higher risks, during the financial crisis. Mollah et al. (2016) say that some banking transactions may be prevented by the Shariah Board to avoid any violation of shariah laws and protect the investors’ rights. Consequently, the collaboration between the Board of Directors and the Shariah Board decreases shariah risks and increases the financial performance of banks. Almutairi & Quttainah (2017) investigated 100 Islamic banks over the period 1993-2014 and found that the outside directors meeting the Shariah Board have a positive effect on the financial performance of Islamic banks. Otherwise, IFSB (2006) says that the Board of Directors and the Shariah Council should meet at least once a year to discuss the IFI development. We propose the following hypothesis:

H1. Meetings between the Board of Directors and the Shariah Board have a positive effect on the financial performance of Islamic banks.

Methodology

Sample and Data

Our sample is composed by 32 Islamic banks during the period 2015-2018. We use the Islamic banks website to download the annual reports. The gross domestic product and the inflation rates are obtained from the World Bank website¹.

Our original sample included 80 Islamic banking. We excluded 46 Islamic banking because annual reports and data are missing. Plus, we apply some filtering rules regarding outliers in order to avoid the effect of extreme observations. Our final sample has 124 Islamic banking-years observations. Table 1 describes the sample selection.

Variables Measurement

According to Al-Homaid et al. (2020), Belkhaoui et al. (2020), Khalil & Taktak (2020) & Mkadmi (2020), we measure the financial performance of the Islamic banks by two indicators:

- Return on Assets (ROA). ROA is defined as after-tax profits (net income) divided by total assets. Mkadmi (2020) adds that ROA is the most applied ratio to compare the banks efficiency as it shows the income generated by the assets financed by the banks. The more the ROA enhances, the more the financial performance of banks improves. It is calculated as follows:

ROA = Net income / Total assets (1)

-Return on Equity (ROE). ROE is a percentage ratio of net profits to Shareholder's equity. Al- Homaid et al. (2020) assert that ROE shows how its equity capital is employed successfully by bank managers. The more the ROE increases, the more the financial performance of banks enhances. It is measured as follows:

ROE = Net income / Shareholder's equity (2)

A review of various studies on the Shariah Council and the Board of Directors allowed us to choose one feature in order to examine the interplay between the shariah members and the directors and its impact on the financial performance of banks. (REU) is a binary variable that is equal to 1 if the Board of Directors and the Shariah Council meet together and 0 otherwise1. We notice that the data for the (REU) variable are obtained through the organizational structures and the annual reports of Islamic banks. We employ 3 control variables to improve our empirical results. YEAR is the logarithm of the banks age, GDP is the gross domestic product rate, RINF is the inflation rate.

The models below are suggested to investigate the impact of the variable linking the Board of Directors to the Shariah Board on the financial performance of banks, according to Al-Homaid et al. (2020) & Mkadmi (2020).

ROAit = C + β1REUit +β2YEARit + β3GDPit+ β4RINFit + εit (3)

ROEit = C + β1REUit +β2YEARit + β3GDPit+ β4RINFit + εit (4)

Hence, C: a constant, β1 ... β4: the coefficients to be estimated, εit: the error term, i: the individual which varies from 1 to 32, t: the period which varies from 2015 to 2018.

We apply the Panel Corrected Standard Error (PCSE) method to have results that are more robust and avoid autocorrelation and heteroskedasticity issues, according to Beck & Katz (1995); Khalil & Taktak (2020); Beck & Katz (1995) clearly show that the PCSE specification gives a more reliable structure of error than that produced by the method of generalized least squares (GLS) viewed as too confident in Table 2.

Results and Discussion

Descriptive Statistics

Table 3 shows that 40.625% of the Board of Directors and the Shariah Board have meetings. This does not confirm the Pakistan's corporate governance standards requiring that the Board of Directors has to meet with the Shariah Board at least twice a year (Ullah et al., 2014).

Plus, the descriptive analysis indicates that the (YEAR) variable is between 1 and 4.383. The average of the (GDP) variable is 3.621. The (RINF) variable has a mean of 6.196. Table 4 shows that the (ROA) variable varies from a minimum of -314 to a maximum of 11. The (ROE) variable has an average of 11.962.

Cross-Correlation Matrix

According to the Cross-Correlation matrix, all correlation coefficients are less than 0.7, which follows the limit in Table 5 suggested by Kennedy (2008).

Discussion

Table 6 shows that the coefficient associated with (REU) variable has a negative impact on the financial performance measured by (ROE) variable. H1, thus, is not confirmed. This means that meetings between shariah scholars and directors have a negative effect on the financial performance of banks. This result does not support the previous studies (Mollah et al., 2016; Hakimi et al., 2018; Ramly et al., 2018), and indicates that the relationship between directors and shariah members increases the agency costs and conflicts between the Shariah Board and the Board of Directors. This result supports Haridan et al. (2018) study who argues that the relationship between the shariah members and the directors is subject to different aims and contributes to the conflict of interest. Indeed, Khalil & Taktak (2020) say that the Shariah Council inhibits the directors from participating in transactions with higher financial risks over the financial crisis, or valuable and not following the shariah laws. Khalil & Taktak (2020) add that the shariah members require the Board of Directors to distribute illicit gains to the charity. These raise agency costs and interest conflicts between the shariah scholars and the directors and reduce the financial performance of Islamic banks (Alam et al., 2020). Plus, Table 6 indicates that (YEAR) variable exhibits negative coefficients and is statistically significant. This suggests that the old bank cannot be up to date with new technology (Khalil & Taktak, 2020). Moreover, the findings show that other variables (GDP, RINF) do not have any significant effect on the financial performance of banks.

Conclusion

The Board of Directors and the Shariah Council are the two most important bodies that influence the corporate governance of Islamic banking, according to Grassa & Matoussi (2014). The shariah corporate governance is currently calling the Board of Directors and the Shariah Board to work collaboratively, specifically on shariah matters Quttainah et al. (2013); Ramly et al. (2018). Khalil & Taktak (2020) insert that the Board of Directors and the Shariah Board support each other and share control and advisory responsibilities.

Therefore, the purpose of this research paper is to study the impact of meetings between the Board of Directors and the Shariah Board on the financial performance of Islamic banks. A sample composed by 32 Islamic banks is used over the period 2015-2018. The results show that meetings between the Shariah Board and the Board of Directors have a negative impact on the financial performance of banks. This implies that the relationship between directors and shariah members increases the agency costs and conflicts between the Shariah Board and the Board of Directors.

The Islamic banking authorities should, thus, reevaluate the laws and make some more efforts to implement governance reform measures that can ensure the corporate governance mechanisms performance. Besides, the supervisory authorities should reinforce their strategies, avoid any misbehavior, and guarantee the effective governance of Islamic banking. We note that this research paper is the first to examine the relationship between the Board of Directors and the Shariah Council and to empirically investigate its impact on the financial performance of banks. In addition, we use a new measure connecting the Board of Directors to the Shariah Council. This study is valuable for policymakers, academics, bankers, etc., and improves the literature review about the relationship between the Board of Directors and the Shariah Board and their effect on the financial performance of Islamic banks. Moreover, we recommend future researches to investigate other corporate governance mechanisms in order to enhance the corporate governance framework of Islamic banks.

End Notes

¹www.worldbank.org

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