Authors: Christos Grambovas

Title: Conservatism in Islamic Banking: The role of religion, ownership and corporate governance

Abstract

This study examines whether Islamic banks in the MENA (Middle East & North Africa) region operate in a more conservative manner than conventional banks. We investigate the role of ownership and corporate governance aspects in this relationship. By definition, Islamic banks operate under a stricter, more ethical and risk-sharing regulation framework (due to Shariah law) than conventional banks, while it is, also, argued that the Islamic set of rules entails an additional layer of corporate governance (Lewis, 2005). Also, it has been suggested that religion influences a firm’s adoption of accounting conservatism (Ma et al, 2020). Thus, in principle, we expect Islamic banks to be more conservative than their conventional counterparts.

Furthermore, differences in the ownership structure of the MENA banking sector may create incentives for divergent levels of conservatism. There are two important dichotomies based on ownership. First, the financial institutions may have a majority of domestic or foreign shareholders. The potential conservatism effect of such dichotomy would be related to contracting, accountability issues and corporate governance. The second ownership dichotomy focuses on the division between public sector and private sector. Such dichotomy would create deviations in conservatism due to contracting, e.g. different targets in management contracts and different corporate governance mechanisms to implement them, and to political economy issues, which could lead to aggressive accounting. Overall, it can be said that public sector experiences weak conventional corporate governance mechanisms due to the different focus and targets of its major shareholder. This could have an effect on our findings.

Nevertheless, in the private sector corporate governance became very important in the last decades due to the separation between ownership and control in firms. Since then, boards of directors have to monitor the opportunistic behaviour of managers, fostering in many occasions conservative accounting. In this respect, it has been documented that companies with good corporate governance, i.e. well-functioning boards of directors, experience high levels of conservatism (Leventis et al, 2013). In addition, it has been argued that the effectiveness of boards of directors is raised with greater cultural and gender board diversity (e.g. Adams and Ferreira, 2009, Erhardt et al, 2003). Boards in the region under discussion experience high participation of foreign nationals, and participation of females that varies based on the country. Thus, introducing the diversity of boards in terms of national culture and gender, enriches the discussion with interesting points to examine.

Preliminary evidence suggest that Islamic banks are not more conservative than conventional banks in the MENA countries. Then, the sample is partitioned on ownership and as expected, corporate governance appears to be significant for conservative behaviour in non-state-owned banks (NSO), while it is not the case for state-owned (SO) financial institutions. Specifically, the existence of female directors and foreign nationals in the board enhances the timelier reporting of bad news in NSO banks. Similar results regarding the corporate governance variables are identified when we employ the bank-specific Nichols et al (2009) model. In this setting, NSO financial institutions seem to be more conservative than SO banks.