The Role Of Banking Governance In Financial And Ethical Profitability: The Case Of Malaysian Islamic Banks Houssem Rachdi1 Abstract During the last two decades, many countries are trying their best to propagate the idea of Islamic finance. Islamic banks are developed as an alternative to conventional banks to serve the interest of Muslim community around the world and to reconcile economic activities to religious rules. Conducted by the principles of Shariah, Islamic banks should not deal in prohibited services, commodities and products. To promote banking governance of Islamic banks, the Islamic Financial Services Board, which is the equivalent of the Basel Committee and the National Shariah Advisory Council were established to enhance the stability and the performance of banks in Malaysia. Also, in 2001, the Malaysian Code on Corporate Governance is created to reinforce practices and rules of good governance after the Asian crisis of 1997-98. In 2006, Malaysia adopted and enforced the International Financial Reporting Standards. In 2010, the Malaysian Accounting Standards Board developed the accounting standards to enhance the financial reporting practices. The relationship between banking governance and performance remains a fundamental issue in the literature. Using a comprehensive dataset from Malaysia over the 2000-2011 period and using many econometric approaches (fixed effects, random effects and GMM-in-System), this paper aims to refine and to highlight the relationship in Islamic banks between measures of banking governance and performance by introducing new measures of performance: profit/loss sharing ratio, performance of zakah ratio and Islamic income ratio. This is what actually makes the outstanding aspect of this research.

Keys words: Islamic banks, financial and ethical profitability, banking governance and Malaysia. Jel Classification: G21, G28, G30, E44.

Introduction In 1963, the Mit- Ghamr Saving Bank was the first Islamic bank established in Egypt. The creation, in the seventies, of Al Baraka bank and Dubai Islamic bank in Bahrain and Islamic Development Bank in Saudi Arabia is the starting point of the 1

Prof. Dr. Houssem RACHDI: Faculty of Law, Economics and Management of Jendouba, University of Jendouba, EAF Research Unit: Faculty of Economic Sciences and Management of Tunis, University of Tunis El Manar (Tunisia) and French Corporate Governance Association (France). E-mail : [email protected] Cell Phone : +216 98 650 660. Office : Faculté des Sciences Juridiques, Economiques et de Gestion de Jendouba : Campus Universitaire de Jendouba Avenue de l’UMA 8189 Jendouba, Tunisie I thank Professor Dr. Muhammad MUSA for valuable comments.

modern Islamic banking movement around the world. In the eighteen, many Islamic banks were created in Europe (Luxembourg and Great Britain). The growth of Islamic banking world-wide in muslim and non-muslim countries has been phenomenal with the volume of assets. Referring to Khan (2010), Islamic Banking has become a growing force in global financial circles, with Islamic Banks found in over 70 countries worldwide. In 2008, the value of the world’s “Islamic assets” was about US $700 billion. There are now about 270 Islamic financial institutions worldwide (Al-ali and Yousfi, 2012). Abdulle and Kassim (2012) confirm that Islamic banks have greater resilience to the financial shocks compared to the conventional banks. In contrast of conventional banks that are guided by the profit maximization principle, Islamic banks are guided by the principles of shariah (the sacred law of Islam derived from the Quran (The Muslim Holy book)) and doctrines of Islam and promoted the sharing of risk (profit and loss) between contracting parties (banks and depositors). Islamic finance encouraged active participation of Islamic banks in stimulating the prosperity and the growth of the economy. For Yazdan and Mohammad Hossein (2012), the theory of Islamic banking is based on the concept that interest is strictly forbidden in Islam, and that Islamic teachings provide the required guidance on which to base the working of banks. However, Islamic banks are strongly regulated like conventional banks. The special nature and the complexity of Islamic banks make the problems involved in their corporate governance highly specific. The responsible parties of governance in Islamic banks are regulatory bodies, shariah board, board of directors and external auditors. Shariah board plays a powerful and authoritative role in controlling banking activities and must ensure that practices and products of banks are conforming to principles and teachings of Islam (common law and Islamic jurisprudence) derived from the Quran and the Sunna (Practices, sayings, deeds and traditions of Prophet Mohammed). This board distinguished the structure of governance of Islamic banks is distinguished from non-Islamic banks and constitutes a key organ of governance in an Islamic bank. Best practices of governance are necessary to enhance the profitability of Islamic banks, support stakeholder interests and encourage Islamic banks to use efficiently their resources. Also, Good practices of banking governance have to lead to a stronger Islamic economic growth. This paper contributes to the exiting literature by determining the relationship between governance and profitability by four aspects: Firstly, according to Chong and Liu (2009), Malaysia is widely believed to have the most developed Islamic

financial system in the world and in the Asia Pacific region (Muniandy and Ali, 2012). In Malaysia, the implementation of the Basel II framework has started since 2008. The Central Bank of Malaysia has issued several guidelines for the purpose of customizing the standards issued by the international organizations and smoothen their implementation (Diaw and El Tahir Babikir Mohamed, 2011). Secondly, few scientific papers treat banking governance in Islamic banks only in the theorical framework. We focused more specifically on the contribution of determinants of governance (board size, independent directors, duality of the general manager, Shariah Committee…) in explaining financial and ethical performance in Islamic banks. Thirdly, the Islamic finance sector attracts a great interest by investors because Islamic banks are more profitable than conventional banks. Finally, previous studies had found that the link between mechanism of bank governance and performance in conventional banks is mixed.

Review of related literature Many countries introduced bank governance reforms to enhance performance and to reduce risks. The existing literature of the relationship between bank governance and performance offers mixed results. According to Cheng (2008), the relation between independence, size, CEO duality of the board of directors and performance continues to be a fundamental issue in the bank governance literature. With some differences in terminology, standards and rules of bank governance for conventional banks are applicable to Islamic banks. Abdelkarim (2001) points out that the implementation of banking governance for Islamic banks differs slightly from those of conventional banks. Like in traditional banks, board characteristics (composition, size, independent directors and duality) play a central role in high-quality bank governance in Islamic banks. Garas (2012) argues that Islamic banks and conventional banks have similar governance structure (board of directors, external auditor, board committee…). According to Fama (1980), independent directors2, contribute positively to effective control of managers in consideration of their incitement to exercise control. Lefort and Urzúa (2008) confirm that the increased number of independent directors on the board promotes firm’s performance. Lunck et al. (2008) are able to exercise more effective control on the board of directors and promote performance. Chen et al. (2009) confirm that independent Board may exercise effective control over 2

An Independent Director (also sometimes known as a outside director) is a director (member) of a board of directors who does not have a material or pecuniary relationship with company or related persons, except sitting fees.

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managers and hence, it promotes corporate performance. Sarker and Sarker (2009) conclude that independent board of directors’ members promote value creation. Fosberg (1989), Yermack (1996) and Adams and Mehran (2003) conclude that independent directors does not improve the performance of the firm. Sarkar and Sarkar (2009) confirm this conclusion in the Indian context. Kaymak and Bektas (2008) conclude that it is the insiders who drive to the increase of the returns on assets and not the outsiders. Yermack (1996) was the first to study the correlation between board’s size and firm performance. He concludes that there is a statistically significant relationship between board of directors’ size and performance. The board of directors’ size was proved negatively associated with companies’ profitability. Cheng et al. (2008) have reached the conclusion that the board directors’ size is negatively related to performance measured by return of assets ratio (ROA). Bennedsen et al. (2008) approve this correlation on a panel of 700 companies in Denmark. Lipton and Lorsch (1992) and Jensen (1993) argue that large boards are generally less efficient than smaller ones. A small board of directors can effectively controls, protects the interests of all stakeholders, aligns the decisions between directors and managers of the firm and reduces agency costs between board members. Cheng et al. (2008) conclude that large boards are negatively correlated with the annual return on assets. Andres and Vallelado (2008) conclude that a small board of directors is more efficient. Lau el al. (2009) illustrate that the small board of directors’ size could be more effective when disciplinary measures to the failing managers are imposed. Adam and Mehram (2003) mark down these works and underline that the banks who have a large board of directors will realize better performance.

Sample, variables, econometric models and majors results Presentation of models and sample Chong and Liu (2009) report that Islamic banking was implemented in Malaysia following the enactment of the Islamic Banking Act in 1983 and the subsequent creation of its first Islamic bank Bank Islam Malaysia Berhad in 1983. As of end2004, there were 29 Islamic banks in Malaysian banking system. To study the empirical relationship between proxies of bank governance and performance in Malaysian Islamic banks, we will refer to the study of Pathan (2009) conducted in 212 American conventional banks over the period 1997-2004. Models to be tested are the followings:

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Equation 1: Financial profitability FPi , t = α + β1Ln (TA )i , t + β 2 ( AB )i , t + β 3 ( DEBTB )i , t + β 4 (SC )i , t + β 5 ( BS )i , t + β 6 (INDIR )i , t

+ β7 (BD )i , t + β8 ( EXPFA )i , t + +β8 ( SCHM )i , t + ε i , t

Equation 2: Ethical profitability EPi , t = α + β1Ln (TA )i , t + β 2 ( AB )i , t + β 3 (DEBTB )i , t + β 4 (SC )i , t + β5 ( BS )i , t + β6 (INDIR )i , t

+ β 7 (BD )i , t + β8 ( EXPFA )i , t + +β8 ( SCHM )i , t + ε i , t

Where subscripts i denotes individual banks (i = 1,2, . . . ,12: Al Amin Bank, Al Rajhi bank, Alliance Islamic Bank Berhad, AmIslamic bank, Asian Finance Bank, CIMB Islamic Bank Berhad, EONCAP Islamic Bank Berhad, Hong Leong Islamic Bank, HSBC Amanah Malaysia Berhad, Kuwait International Bank, Maybank Islamic Berhad and RHB Islamic Bank), t time period (t = 2000,…,2011) and Ln is the natural logarithmic. β are the parameters to be estimated. ε is the error term. Financial measures of profitability (FP): performance measure is very complex in the literature because there exists no single, unique measure of bank performance. In this study, we employ three measures. These include ROA 3 (Return on Assets: Profit before Taxes and Zakah4 to Total Assets), ROE5 (Return on Equity: Profit before Taxes and Zakah to Total Shareholders'

3

This is perhaps the most important single ratio in comparing the efficiency and operational performance of banks as it looks at the returns generated from the assets financed by the bank (Islamic Banks and Financial Institutions Information, 2012).

4

Zakah is a mandatory religious levy imposed on all Muslims beginning with the year 624 A.D. It is still in use today and can be imposed at a 2.5% annual rate on idle wealth above some threshold level (Olson and Zoubi, 2008).

5

The return on equity is a measure of the return on shareholder funds. Obviously here the higher the figure the better but one should be careful in putting too much weight on this ratio as it may be at the expense of an over leveraged balance sheet(Islamic Banks and Financial Institutions Information, 2012).

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Equity) and CIR6 (Cost Income Ratio: Total Expenses and Provisions to Total Income). Ethical measures of profitability (EP): we measure ethical performance by using: PLS (profit/loss sharing: Mudaraba7 finance plus Musharaka8 finance to total finance of the investment), ZP (performance of zakah: zakah to net assets) and IIR (Islamic Income Ratio: Islamic Income to Islamic Income plus Non Islamic Income) Bank size (TA): natural logarithmic (Ln) of Total assets as at the end of each fiscal year. Age of the bank (AB): natural logarithmic (Ln) of the age of the bank. Debt of the bank (DEBTB): total debt to total assets. Shariah Supervisory Committee (SC): The number of scholars in the Shariah Board. The Accounting and Auditing Organization for the Islamic Financial Institutions (AAOIFI) in Governance Standards for Islamic Financial Institutions, Accounting and Auditing Organization for Islamic Financial Institutions, recommends 3 members in the Shariah Supervisory Committee. Board size (BS): The number of directors in the bank board. Independent directors (INDIR): The proportion of outside directors who are not holding managerial positions at the Islamic bank. Board duality (BD): it equals1 if the general manager and the chairman is the same person and 0 otherwise.

6

This is one of the most focused on ratios currently and measures the overheads or costs of running the bank, the major element of which is normally salaries, as percentage of income generated before provisions. It is a measure of efficiency although if the lending margins in a particular country are very high then the ratio will improve as a result. It can be distorted by high net income from associates or volatile trading income (Islamic Banks and Financial Institutions Information, 2012).

7

Mudaraba: An Islamic bank provides funds to a borrower (entrepreneur) who has ideas and expertise to use the funds in productive activities. Profit is shared between the two parties based on an agreed upon ratio. Loss is borne by the provider of the funds-in this case the Islamic bank. The bank is a passive partner (Olson and Zoubi, 2008).

8

Musharaka: An Islamic bank provides part of the equity plus working capital for a specific project and shares in profits and/or losses. The bank provides the funds and becomes an active, or management partner. An Islamic bank finances the purchase of goods or commodities in return for a share in the profits realized. Specifications are provided by the purchaser (Olson and Zoubi, 2008).

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Expertise in Finance and Accounting (EXPFA): Scholars experts in finance and accounting to total scholars in the Shariah Board. Scholars in other banks (SCHM): Scholars members in other banks Shariah Board to total scholars in the Shariah Board of the bank. Table 1 shows the mean, standard deviation, minimum, and maximum values of variables used in all models. Table 2 shows the cross-correlation matrix of all variables. It can be seen that the variables are not highly correlated with each other Table 1. Descriptive statistics VARIABLES ROA (%) ROE (%) CIR (%) PLS (%) ZP (%) IIR (%) Ln (TA) Ln (AB) DEBT (%) INDIR (%) BD BS SC EXPFA (%) SCHM (%)

Observation 144 144 144 140 144 144 83 136 144 144 144 144 101 144 144

Mean -0.029 -0.024 114.64 23.606 0.086 0.505 2.219 0.692 0.897 0.487 0 6.437 3.782 0.001 0.260

Std Dev 0.204 1.182 125.633 124.14 0.340 0.643 0.098 0.410 0.073 0.110 0 1.120 0.831 0.0003 0.320

Minimum -1.505 -8.779 -308.364 0 -0.054 -6.958 1.736 -0.366 0.228 0.25 0 4 3 0.001 0

Maximum 0.142 1.043 907.94 1409.106 3.135 0.975 2.334 1.251 0.968 8 0 9 6 0.002 1

Table 2. Cross-correlation matrix TA AB DEBT INDIR BS SC EXPFA SCHM

TA 1 -0.189 0.600 -0.026 0.554 -0.001 0.063 0.001

TB

DEBT

INDIR

BS

SC

EXPFA

SCHM

1 -0.141 -0.317 -0.297 0.192 0.239 0.533

1 0.169 0.081 0.134 0.156 -0.281

1 -0.363 0.494 0.536 -0.486

1 -0.440 -0.288 0.118

1 0.895 0.038

1 0.000

1

Note: ROA (Return on Assets), ROE (Return on Equity), CIR (Cost Income Ratio), PLS (profit/loss sharing), ZP (performance of zakah), IIR (Islamic Income Ratio), (AB) Age of the bank, (TA) Bank size, (DEBTB) Debt of the bank, (INDIR) Independent directors, (BD) Board duality, (BS) Board size, (SC) Shariah Committee, (EXPFA) Expertise in Finance and Accounting and (SCHM) Scholars in other banks.

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Econometric tests In this section, we include the most usual econometric approaches (fixed effects and random effects) in the empirical literature of governance. For robustness tests, we will demonstrate the empirical and theoretical superiority of GMM-in-System estimator. Blundell and Bond (1998) show that the two-step estimates are biased in small samples. As our data contain a small number of banks, we prefer to display the one-step result. Following the assumption of Blundell and Bond (1998), suggesting that first differences of instrumental variables are uncorrelated with the fixed effects, we use GMM system method. This last method retains a system of two equations-the original equation as well as the transformed one-. The Arellano and Bond test for autocorrelation has a null hypothesis of no autocorrelation and is applied to the differenced residuals. The test for AR (2) in first differences is more important, because it will detect autocorrelation in terms of levels. The validity of the instrumental variables is tested using Hansen test of over-identifying restrictions and over a test of the absence of serial correlation of the residuals.

-0.473 (0.63) -0.037 (0.23) 0.991 (1.75)* -0.355 (0.58) -0.067 (0.85) -0.096 (0.73) 2.489 (0.78) -0.183 (0.33) 0.603 (0.44) 0.58 0.791 60 0.093 0.886 0.432

-2.162 (0.48) -0.340 (0.35) 3.561 (1.05) -1.895 (0.52) -0.365 (0.78) -0.508 (0.65) 1.618 (0.73) -0.854 (0.26) 3.946 (0.48) 0.27 0.971 60 0.046 0.875 0.383

ROE 0.669 (2.72)*** -11.218 (0.20) -1.943 (0.99) 1.041 (0.19) 6.492 (0.24) 3.082 (0.77) -2.479 (1.94)* 3.429 (1.38) -1.095 (2.31)** 2.63 0.018 60 0.318 0.811 0.003

CIR -5.770 (7.34)*** 0.213 (1.26) 3.030 (5.12)*** 0.352 (0.55) 0.182 (2.23)** -2.708 (9.74)*** 5.462 (4.17)*** -0.655 (1.14) 8.931 (6.24)*** 91.00*** 0.000 60 0.941 0.729 0.896

PLS 0.896 (1.25) -0.004 (0.02) -0.745 (1.38) 0.244 (0.42) 0.004 (0.06) 0.024 (0.19) -1.666 (0.47) 0.130 (0.25) -1.161 (0.89) 0.30 0.961 60 0.050 0.850 0.472

ZP 1.628 (0.52) -0.174 (0.26) -1.659 (0.71) 1.135 (0.45) 0.358 (1.11) 0.266 (0.49) -8.589 (0.56) 1.246 (0.55) -4.468 (0.79) 0.26 0.974 60 0.045 0.001 0.003

IIR

Note: ROA (Return on Assets), ROE (Return on Equity), CIR (Cost Income Ratio), PLS (profit/loss sharing), ZP (performance of zakah) and IIR (Islamic Income Ratio) are dependant variables. Age of the bank (AB), Bank size (TA), Debt of the bank (DEBTB), Independent directors (INDIR), Board size (BS), Shariah Committee (SC), Expertise in Finance and Accounting (EXPFA) and Scholars in other banks (SCHM) are explanatory variables. The numbers in parentheses are absolute value of t-statistics. *, **, and *** indicate statistical significance at the 1%, 5%, and 10% level

Fisher test P-value Fisher N Within R2 Between R2 Overall R2

Constant

SCHM

EXPFA

SC

BS

INDIR

DEBTB

AB

TA

ROA

Table 3. Banking Governance and Profitability of Islamic Banks (Fixed effect model)

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Note: ROA (Return on Assets), ROE (Return on Equity), CIR (Cost Income Ratio), PLS (profit/loss sharing), ZP (performance of zakah) and IIR (Islamic Income Ratio) are dependant variables. Age of the bank (AB), Bank size (TA), Debt of the bank (DEBTB), Independent directors (INDIR), Board size (BS), Shariah Committee (SC), Expertise in Finance and Accounting (EXPFA) and Scholars in other banks (SCHM) are explanatory variables. Wald χ2 statistics: the test is a way of testing the significance of particular explanatory variables in a statistical model. Hausman χ2 statistics: the test evaluates the significance of an estimator versus an alternative estimator. The test statistics has an asymptotic χ2 distribution. The numbers in parentheses are absolute value of t-statistics. *, **, and *** indicate statistical significance at the 1%, 5%, and 10% level.

Table 4. Banking Governance and Profitability of Islamic Banks (Random effect model)

The Role Of Banking Governance In Financial And Ethical Profitability: The Case ... 23

Note: ROA (Return on Assets), ROE (Return on Equity), CIR (Cost Income Ratio), PLS (profit/loss sharing), ZP (performance of zakah) and IIR (Islamic Income Ratio) are dependant variables. Age of the bank (AB), Bank size (TA), Debt of the bank (DEBTB), Independent directors (INDIR), Board size (BS), Shariah Committee (SC), Expertise in Finance and Accounting (EXPFA) and Scholars in other banks (SCHM) are explanatory variables. Estimation method is one-step GMM-in-System estimator (xtabond2). Lag: lagged of dependant variables Wald χ2 statistics: the test is a way of testing the significance of particular explanatory variables in a statistical model. AB test AR(1) and AR(2) refer to the Arellano–Bond test that average autocovariance in residuals of order 1 respectively of order 2 is 0 (H0: no autocorrelation). Hansen = Hansen test for validity of over-identifying restrictions, distributed as indicated under null. This test of over-identifying restrictions is asymptotically distributed as χ² under the null of instrument validity The numbers in parentheses are absolute value of t-statistics. The numbers in brackets are p- value. *, **, and *** indicate statistical significance at the 1%, 5%, and 10% level.

Table 5. Banking Governance and Profitability of Islamic Banks (One step GMM in system)

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Major results Fixed and random effect models Tables 3 and 4 present the results of fixed effect models and the random effect methods. The Hausman test confirms the appropriateness of the random-based effects estimation procedure used in this study (P-values of Hausman test are larger than 5%). The low p-values for the Wald tests suggest that models are well specified and fit the data. Concerning board characteristics, the coefficient on INDIR is negative (0.787, -4.559 and -2.188) across the three measures of financial profitability and statistically significant at the level of 5% for ROA, 5% for ROE and 10 % for CIR. The presence of independent members on board not enhances bank performance. This result corroborates works of Sarkar and Sarkar (2009), Lefort and Urzua (2008) and Adams and Mehran (2003). Like Pathan (2009) for US banks, for the three measures of ethical profitability, the coefficient on INDIR is positive (0.155, 1.008 and 0.310) and only statistically significant at the level of 1% for ZP. The coefficient on BS is negative (-0.080, -0.444, -2.561 and -0.005) across four measures of profitability and statistically significant at the level of 10 % for ROA ROE and CIR except for IIR. This result suggests that, a small bank board is associated with better performance. For PLS and ZP, the coefficient is positive (0.229 and 0.070), and respectively statistically significant. Coefficients associated to SC are negative (0.096 for ROA, -0.506 for ROE, -3.732 for CIR, -2.790 for PLS and -0.097 for IIR). Ghayad (2008) argues this finding that scholars constitute a significant handicap to the progress of Islamic finance and the development of new products because some of whom had little knowledge of modern banking and who often could not understand the language in which transactions were documented. Only for ZP, the coefficient on SC is positive (0.066). This finding can be explained that the main objective of Shariah board is to ensure that banking activities are in compliance with Quran and Sunna. Garas (2012) suggests the increase of members of shariah committee to check each transaction and meet the continuous need of the management for consultation. Similar to expectation, the coefficient on Expertise in Finance and Accounting (EXPFA) is positive (4.669, 2.668, 1.957, 5.727 and 1.476) across ROA, ROE, CIR, PLS and IIR) and respectively statistically significant at the former of 1% for ROA and PLS and at the former of 10% for ROE. Garas (2012) confirms that audit plays a key role in the governance of the institution. For ZP, the coefficient is negative (-5.138) and significant at the level of 5%. This finding point to clear evidence that Scholars expert in finance and accounting in the Shariah Board is not necessary

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because the aim of scholars is to verify the conformity of banking services for customers to Islamic shariah. Coefficients associated to Scholars in other banks (SCHM) are negative (-0.413 for ROA, -2.452 for ROE, -1.515 for CIR and -0.243 for IIR) and respectively statistically significant at the level of 1% for ROA, ROE and CIR. For PLS and ZP, the coefficient is positive (0.034 and 0.592 respectively for PLS and ZP) and only statistically significant at the level of 1% for ZP.

Robustness checks of the results: GMM in system For robustness checks, we perform the analysis by using the GMM system. Table 5 presents the results of GMM in system method. The Wald-test indicates fine goodness of fit, the Sargan and serial-correlation tests do not reject the null hypothesis of correct specification (P-values of Hansen test and P-values of AR (2) test of Arellano and Bond are larger than 5%), lending support to our estimation results. For the INDIR, the reported coefficients estimates are similar to the results issued from GLS RE except for ZP. The coefficient is statistically significant at the former of 1%. For BS the reported coefficients estimates are similar except for IIR. In addition, for BS, SCHM and EXPFA, the reported coefficients estimates are similar to the results issued from random effect model.

Concluding remarks and policy implications This study was an attempt to understand the phenomenon of profitability of Islamic banks in Malaysia. We investigates whether board characteristics (Independent directors, Board duality, Board size, Shariah Committee, Expertise in Finance and Accounting of scholars and Scholars in other banks) is related to bank financial and ethical performance. The results of this paper have potential policy implications for regulators of Islamic banks and financial institutions: to maintain an efficient and a performing Islamic banking system, all countries must strengthen mechanism of banking governance because a well-functioning Islamic banking stream can positively contribute to promote performance. In this light, good practices of rules of banking governance have to lead to a stronger Islamic economic. Islamic banks must recruit Shariah board members with more experience of banking techniques because mangers and members of Shariah board did not speak the same language to enhance performance.

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