Islamic Financial Institutions and Corporate

Islamic Financial Institutions and Corporate

Governance: New Insights for Agency Theory

Assem Safieddine*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper takes a theory building approach to highlighting variations of agency theory in the

unique and complex context of Islamic banks, mainly stemming from the need to comply with Sharia and the separation of

cash flow and control rights for a category of investors.

Research Findings/Results: The paper provides insights that agency structures in the context of Islamic banking might give

rise to trade-offs between Sharia compliance and mechanisms protecting investors’ rights. Alternative models of idiosyncratic

governance might be effective in balancing the two cornerstones of the agency dynamic. In practice, the paper finds

that most of the surveyed Islamic banks appear to recognize the value of governance and institute some basic mechanisms.

Nonetheless, some governance flaws relating to audit, control, and transparency are observed, a situation further exacerbated

by the fact that investment account holders are not represented on the board, and are not granted control or

monitoring rights. This leads to a discussion on the tradeoff between the costs and benefits of such a practice.

Theoretical Implications: This study contributes to the agency theory literature by providing theoretical propositions

highlighting challenges to this theory whereby mechanisms with the purpose of mitigating agency problems might lead to

a divergence from Islamic principles of Sharia.

Practical Implications: The paper motivates Islamic banks to improve governance practices currently in place. It alerts policy

makers to the need to tailor the regulations to safeguard the interests of all investors without violating the principles of

Sharia.

Keywords: Corporate Governance, Board Evaluation, Board of Director Issues, Gulf States, Agency Theory

INTRODUCTION

Awareness of the potential drawbacks of agency problems

has grown enormously over the past decade. By

now it has become widely accepted that companies are

exposed to agency issues whereby the separation of ownership

and control leads managers to seek their personal interests

at the expense of those of shareholders (Fama and

Jensen, 1983a). To mitigate these issues, governance was

adopted (Beasley, 1996; Bebchuk, Cohen and Ferrell, 2004).

These lead to improved mechanisms that align the interests

of managers and shareholders and institutional control is

increasingly performed for corporations (Gompers, Ishii

and Metrick, 2003). However, agency relationships and

governance settings become more complex when corporate

structures deviate from their conventional forms (Dharwadkar,

George and Brandes, 2000; Kapopoulos and Lazaretou,

2007; Hu and Izumida, 2008).

The paper attempts to explore the agency issues in the

special context of Islamic financial institutions and further

develop the discussions on the relationship between Islamic

finance operations and agency. We argue that the agency

problems at Islamic financial institutions deserve separate

and particular examination for a number of reasons. The first

is directly related to the nature of their operations, which

distinguishes them from conventional corporations and

widens the issue of separation of ownership and control

underlying the agency theory. The key sources of distinction

arise from the observation that managers of Islamic banks

are not only entrusted by shareholders to maximize the

value of their investments, but have a more compelling duty

to achieve these objectives in a Sharia-compliant manner

(Archer, Ahmed. and Al-Deehani, 1998). Furthermore, the

*Address for correspondence: Assem Safieddine, Associate Professor of Finance, Corporate

Governance Program Director, the School of Business, American University of

Beirut, Bliss Street, Beirut, Lebanon, P.O. Box: 11-0236. Tel: 961-1-352700; Fax: 961-1-

750214; E-mail: as57@aub.edu.lb

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Corporate Governance: An International Review, 2009, 17(2): 142–158

© 2009 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00729.x

contracts created between the Islamic banks and investment

account holders (IAHs) allow the banks to share in profits

and not in risks or losses and forbid IAHs from intervening

in the management of their funds. Thus, managers of Islamic

banks are presented with opportunities to extract personal

benefits at the expense of IAHs’ interests (Abdel Karim,

2001;

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