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EFFECTS OF CORPORATE GOVERNANCE CONTROL
MEASURES ON ISLAMIC BANKS’ FINANCIAL
SOUNDNESS: EVIDENCE FROM THE INTERNATIONAL
FINANCIAL CRISIS
Ghada BEN ZEINEB1
Sami MENSI2
Abstract:
This study aims to analyze the roles of corporate governance control variables on
Islamic bank’s soundness before, during and after the recent financial crisis.
Moreover, it investigates the impacts of some specific Islamic bank corporate
governance factors, namely ownership structure, CEO duality and Shariah-Board Size
on the distress of Islamic banks. Using cross-country bank data in 6 countries from
the Gulf Countries Council(GCC) region where the largest Islamic banks exist, we
calculate the Z-score for a sample of 51banks over the period 2004-2013. Based on
the empirical research, we show that the financial Crisis does not significantly affect
the soundness of the banks during this event. Moreover, we mention that these banks
were capable to reduce the negative impact and remain their soundness after this
financial trouble with regard to the global corporate governance index. Concerning
the corporate governance variables, results notice a positive and significant impact of
CEO duality and Shariah-Board Size on the soundness of Islamic banks. More, this
paper assesses the soundness of GCC non-conventional banks under three types of
bank ownership (Private-owned, Institutional-owned and Foreign-owned banks). The
result shows a positive association between Private ownership, Foreign ownership
and soundness. Contrarily, we find a negative association between the percentage of
Institutional ownership and soundness. The results confirm the importance of the
governance mechanisms to act as immunity system of the Islamic Banking.
Key Words: Islamic Banks, the Subprime Crisis, Z-Score, Governance, Ownership structure,
GCC region.
Classification JEL: C26, G21, G32, G33
1 Ecole Supérieure de Commerce de Tunis (ESCT). Univer.Manouba Tunisia & ECSTRA Laboratory; E-
mail:[email protected] 2 Ecole Supérieure de Commerce de Tunis (ESCT). Univer.Manouba Tunisia & ECSTRA Laboratory; E-
mail : [email protected]
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I. Introduction:
Thanks to its major role in ensuring a nation’s growth, banking sector as an activity dates
back to ancient civilizations in Greece and Rome when credits to certain industries formed the
vital part of trade. For instance, Banks occur as a crucial and major role in economic growth.
More, the health of the banks and the health of economy are closely correlated. Thus, a healthy
and sound banking sector is a key ingredient for growth, economic prosperity and general
welfare. (Romeo-Avila (2007), Levine (2011), Ayadi et.al (2013).
The decade before the recent global financial crisis which is called The Subprime Crisis,
conventional banks have been trying to innovate and being more creative in order to extend its
outreach of products to satisfy its customers’ needs and to promote economic development. As a
result of this accelerated development in the world, traditional banking sector becomes a well-
developed and sophisticated sector. ( Lee KheeJoo et.al (2010) ,Haron et.al (2011)).
Unfortunately, during the last two decades of the 20th century, the financial world has witnessed
indefinite financial depression that is more than 100 crises have occurred in the banking system
across the globe, starting with the crisis of 1930-31,the 2007-2008 crisis called the Subprime
crisis, the European financial crisis in 2009, and concluding until with the 2013’s world crisis.
These crises are particularly harmful for the health of banks since their cost is very enormous3.
Accordingly, due to the Subprime Crisis which is more severe than any other in the past, a
series of breakdowns, of failure and impairment of the majority of conventional financial
institutions was happened, as witnessed by the collapse of the Lehman Brothers4and Bear
Stearns5in USA, London Scottish Bank
6in Manchester…, after 2007-2008.This crisis, started in
USA and slopped rapidly over into other economies and banking markets due to the financial
globalization and liberalization. It has not only negative impact on banks in developed countries
as the USA and Europe, but also it has caused a negative impact of developed countries as Gulf
Countries Council (GCC) countries.
Regarding the close connection between the banks’ soundness and the health of the economy,
the Subprime crisis damage led to a decline in the economic situation and a nervous distress
about the future of the global economy. Experts agree that, this turbulence in the financial
3From the Bank of England (2008). “Financial stability report”: No. 24, October 2008.London: Bank of
England “, banks are estimated to have lost around US$2.8 trillion during the 2007-08 financial crisis 4Lehman Brothers Holdings: the fourth largest investment bank in the USA
5The Bear Stearns companies are one of the largest investment banks in the USA, failed in 2008.
6London Scottish Bank, even, it had been established for over a century, it buried all its activity in
November 2008 after the crisis.
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system which has created anxious impression about the functioning of the banking system is
caused by something erroneous with the system since almost conventional banks suffer from
bankruptcy.
Theoretical researches performed by Bryant (1980), Diamond (2000) Stiglitz (2008), Siddiqi
(2008), Brooks (2009) and Matthews and Tlemsani (2010), show that the structure of
conventional banking is inherently unstable and, therefore, it is fertile to economic trouble.
More, principles of interest-based transactions and risky investments on which the western
banking is based, could be the origin of crisis. Moreover, the recurrent feature of financial
crises, the similarity of their essence and the severity of the last one i.e. Subprime crisis,
recommended a better financial architecture able to avoid such lesion in the future. By another
way, this recent financial scandals led to a focus on “ethics” and the need for reviewing the
financial strategies.
During the last decade and exactly in 1970s, a new financial engineering called “Islamic
Finance” which is different from the conventional one, has emerged. Islamic finance is a system
which identifies its principles, practices, operations and objectives with the spirit of Islamic law.
Thus anew branch shows key differences from Western system since it is based on interest-free
transactions and Profit Loss Sharing (PLS) between banks and investors. Thus, while the
reputation of traditional system was blackening and losing their shine due to the financial crisis,
this new financial architecture attracts the international attention of experts thanks to its ethical
principles.
According to International Monetary Fund (IMF) statistics(2011) “Islamic banks were more
resilient to crisis than conventional Banks thank to its essentially different character”. As
opposed to conventional banking, some of the theoretical and empirical literatures show that
Islamic finance is sounder than the other banking system and can avoid the worst effect of a
crisis thanks to its ethical principle. Al Haddad and El Diwany (2008), Hassan and Kayed
(2009),Mirakhor and Krichene (2009), Smolo & Mirakhor (2010) and Derbel et al (2011) agree
that Islamic finance as a competent model has avoided the negative effect of a crisis and keep
their solidity even during crisis. More, recently in 2013,El Hussein states that “the profit sharing
feature on the asset and by avoiding a domino effect also adds to the stability of the financial
system as a whole” However, in practice, as experience shows, some Islamic banks were
affected negatively by the crisis and even closed their doors. (Al Rajhi bank in Saudi Arabia,
Dubai Islamic Bank in UAE and Kuwait finance house in Kuwait)
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The Gulf Cooperation Council (GCC) countries is the largest Islamic banking system within the
Arab world, were thus impacted by the effects of this financial lesion although it involves the
leads Islamic banks in the world. In research studies, Hasan and Dridi (2010), Zarrouk (2012)
and Bourkhis and Nabi (2013),have demonstrate that Islamic financial institutions are exposed
and vulnerable to financial trouble like conventional ones. More, during the recent financial
crisis, many banks, both Islamic and Conventional, fell into distress and filed for bankruptcy (Li
& Zhong, 2013). Moreover, Crisis periods represent unique opportunities to reconsider the
actual governance practices, which have showed their limits during the subprime crisis.
(Kirkpatrick (2009)).In the other side, ownership structure is shown as a major determinant of
bank risk-taking.
Until nowadays, this conflict is not resolved and causes are not determined. In this context, the
present study is an attempt to fill this gap and to investigate the determinants of the soundness in
Islamic Banks with regards to the corporate governance control measures.
This paper consists of four sections. Section 2 reviews the literature related to the topic of the
soundness of Islamic banks especially in GCC countries face to financial crisis. Then, section 3
after presenting the Sample, period and methodology, provide an empirical answer to the
problem. Finally, the last section deals with the main results and conclusions stipulated by this
article.
II. Literature Review:
The recent global crisis, despite of its severe impact and the series of conventional bank’s
failures, has shown that “bank’s business model and funding structure are important to its -
resilience” Organization for Economic Co-operation and Development (OECD2010), and has
triggered an attention and questioning to the resilience of banks. According to Bryant (1980)
and Diamond and Dybvig (1983) “traditional banks are inherently unstable since they are
deposit-taker institutions; they do not expect all depositors demand money back in the same
time and naturally banks cannot satisfy their demands in the same time”. Thus, if a bank is
enable to repay simultaneously theirs depositors, then, it is considered unstable and a prey to
bankruptcy. Khan (1991) has explained that the Islamic Banking model is related to the
vulnerability of banks. He argues in his theoretical analysis that, “the business model
(developing interest-free financing instruments) of Islamic banks can explain the failure of
traditional banks in maintaining stability and soundness during crisis”.
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Other theoretical studies performed by Ahmed (2002),Kia and Darrat (2003)and Syed (2007),
showed that “the PLS principle plays also a critical role in keeping banks solidity by allowing
the bank to maintain its net worth under difficult economic conditions and avoiding the balance
sheets deterioration”. Thus thanks to PLS intermediation Islamic system may be more resistant
face to the financial crisis. Again, in the same topic, Ahmed (2002) argues “that this Islamic
banking system could prevent the financial crisis and instability by the prohibition of Riba and
the linkage with the real economy”. In fact, under the principle of Prohibition of Gharar and
Maysir and Tangible asset backing ,there is no place for speculative behavior and any financial
assets based on other financial assets cannot be traded, that leads to instability like what is
happen in the U.S subprime crisis.
In the other side, the findings of Isa (2006) are not in line with previous results. He found that
“the Islamic and conventional banks systems are both vulnerable and can be badly impacted by
financial shocks». In this line, Shamshad (2009) affirmed “Islamic banks have been impacted
because of their higher exposure to real estate and their limited reliance on risk sharing or
equity based transactions.”
Many existing theoretical studies have been developed in order to answer this questioning.
However, unfortunately, they have not provided a clear view on how and whether Islamic banks
aspects including business model and reaction face to crisis differ from traditional banks. This
conflict may refer to the restrictive number of empirical studies examining the solidity of
Islamic and traditional banks against financial crisis.
The first empirical study examining the theme of Islamic Banking solidity compared to
conventional peers, was established by Cihak and Hesse (2008) “in which stability of full-
fledged banks were measured with an insolvency risk indicator in 18 countries with significant
Islamic Banking Industry”. This study is the only study discussing the solidity of Islamic banks
compared to conventional banks in a cross-country analysis during the period 1993-2004.They
found “that small Islamic bank tend to be more stable than small conventional banks. On the
contrary, large conventional banks are more stable than large peers. Also, small Islamic banks
are more stable than large one”. Hasan and Dridi (2010) assessed and compared the impact of
the global financial crisis on the performance of the two types of banking industry. They show
that “in terms of assets and loans, Islamic banks showed much higher growth in the times of
crisis and the assessment of external rating agencies indicates relatively stable ratings for
Islamic ones.”
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In another side, Turk-Ariss (2010) found that “Islamic banking is less competitive than
conventional banking so less stable and more vulnerable to the crisis’s effect”. The author
recommended that future research should examine whether Islamic banking industry differ from
the conventional banking industry. Kassim and Majid (2010), Smolo and Mirakhor (2010),
analyzed the effects and the implications of the global financial crisis on the Islamic financial
industry. The findings reveal that “although the crisis had restricted impact on Islamic
Financial Institutions(IFI), Islamic and conventional banks are both vulnerable to financial
shocks”. Omar and Duasa (2011) found that Islamic banking system is more stable against the
financial crisis than conventional one thanks to Profit and Loss Sharing nature. Moreover, in
2013, other authors (Beck, Deminrguç-Kunt, and Merrouche)demonstrate that “Islamic banks
perform better during crisis in terms of capitalization and asset quality”.
Contrarily, Zarrouk (2012) agrees that “even Islamic banks have avoided the subprime
exposure”. More, these findings indicated that Islamic banks solidity has decreased in two
phases during the global recession originated by the sub-prime chock. The first decrease was in
2008 and the second decrease was in 2009. The long duration of this crisis has affected Islamic
banks. Choong and Liu (2009),argue that Islamic banking deviates from the PLS paradigm, so,
they suggest that Islamic banks should be treated similarly to their traditional counterparts.
In2013, Bourkhis and Nabi, using Z-score, conclude that, “before the financial crisis, Islamic
banks were sounder than Conventional banks. Then in 2008, and during the crisis, only large
Islamic banks could escape the negative effect of the crisis .Also in 2009, after the crisis,
Islamic banks outperforms conventional peers.”
Masouros (2014) points that the ability of a banking system to resist a crisis depends on
corporate governance configurations in a given country. The empirical evidence supports the
prediction that corporate governance variables have significant impacts on the risk of financial
distress and the impacts remain significant even after controlling for the corporate financial
performances. (Deniz Anginer et.al(2014)). As a vital part of the banking system, the Islamic
community has an expectation that Islamic banks place utmost importance on corporate
governance (CG), due to the additional risks embedded in Islamic financial instruments.
Boumediene and Caby (2009) argue that Islamic financial institutions face additional agency
problems above what is normally encountered in traditional banks. Thus, the need for good CG
is even more relevant for Islamic banks. Shehzad et al. (2010) find that if ownership
concentration increases, the credit risk decreases. The type of shareholders could also represent
a source of risk in firms. Family companies, for example, may also avoid risk taking because
their objective is to transfer a firm to the next generation. Iannotta et al. (2007),compare the
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performance and risk of a sample of 181 banks from 15 European countries. They find that
state-owned banks have poorer loan quality and higher insolvency risk than private and mutual
banks while mutual banks have better loan quality and lower asset risk than both private and
public sector banks. Other studies compare foreign-owned banks with other types of banks.
III. Empirical Research:
III.1. Methodology:
To assess the impact of the crisis on the solidity of Islamic Banks in GCC countries, we use
bank-level data on Islamic banks. To build this study, individual bank data are drawn from the
widely used Bankscope database and the annual reports of these banks. Our sample includes 51
Islamic banks, over the period 2004 to 2013,are operating in the countries of Gulf Cooperation
Council Region.
The GCC region is one of the fastest growth Islamic banking markets in the world. In fact the
banking sector has responded positively to the emergence of the Islamic finance: the proof that
the leaders and largest Islamic banks are situated in this region. Moreover, a substantial number
of conventional banks have also opened Islamic branches so as to offer different levels of
Islamic financial.
We analyze the effect of the financial crisis on the Islamic banks in GCC countries by
performing an inter-temporal analysis: during and after crisis using the Z-score for each bank i
at time t in the country j. The Z-score ratio is a popular measure of bank soundness since it is
inversely related to the probability of a bank’s insolvency which is the probability that the value
of its assets becomes inferior to the value of the debt. It can be denoted as
Z= (μ+K)/σ
μ : denotes the bank's average return on assets (ROA= net income /total assets)
K: the ratio of equity to assets (the equity capital in percentage of total assets)
σ : is the estimated standard deviation of the ROA as a proxy for return volatility.
An elementary characteristic of the Z-score is that is fairly and objective measure of soundness
across different other such as financial ratio and Financial Soundness Indicators… It focuses on
the risk of insolvency which every whether the bank is Islamic or conventional runs out of
assets.
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Čihák (2007) also states that “this indicator has the advantage that it can be used for
institutions where more sophisticated market data are not available. With the Z-score, the risk
of default in different groups of institutions can also be compared”. Moreover, Demirgüç-Kunt
and Detragiache (2009) argue that “this measure is the improvement of the measures used in the
previous studies, such as loan spread, and capital adequacy, especially for cross-country
studies”.Moreover, Čihák (2007) also states that “this indicator has the advantage that it can be
used for institutions where more sophisticated market data are not available. With the Z-score,
the risk of default in different groups of institutions can also be compared”.
Based on panel data analysis, we estimate a modified version of Cihak and Hesse(2008)and
Bourkhis and Nabi (2013)’s econometric models that enable us to assess the impact of some
corporate governance control measures before, during and after the financial crisis while
controlling for the bank specific vector of variables, industry vector specific variables and
macroeconomic variables. Appendix 1 presents the variables retained, definitions and main
sources. The model adopted is as follows.
i: the bank j:the country t:the year
The first technique used is the Ordinary Least Square (OLS) which is based on a simple linear
model. Then, we use the Generalized Least Square (GLS) which is categorized into GLS Fixed
effects and GLS Random Effects. The GLS Fixed effects approach is built on model with fixed
individual effects. Under this approach, individuals which are observed, have well-defined and
specific characteristics that do not vary over time. By this way, they are independent and
uncorrelated; in this case individual are the Banks. The second approach is GLS with Random
Effects in which the differences between individuals are random.
III.2- Main Findings
One consequence of the current financial crisis is that many countries began to reevaluate their
financial systems and search for causes and solutions. As a result, financial soundness which
has a magnitude that cannot be neglected, or more often in these latter days, financial instability
is the topic of many discussions and scientific papers. At the international level, international
+
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regulators such as Basel Committee or international financial institution make all possible
endeavors to encounter the endangering of instability.
Brédart (2014) has pointed that the governance is one of the causes of the large number of
filings for bankruptcy procedures that has exploded since 2007. To confirm, as mention in the
ECB (2010)document, the origins of financial instability are usually identical: “balance sheet
mismatches, high leverage and very rapid growth of financial institutions”. Somehow, all these
elements are interlinked with corporate governance.
In our study, the tables 1,2,3,4 and 5 in appendix examine the effect of corporate governance
(CG) variables (Individual and composite), during and after crisis, on the soundness of Islamic
banking institutions (IBIs) in GCC countries. It presents OLS regression findings.
In regard to CEO duality, the coefficients show a positive and significant impact of the CEO
duality on banks soundness of the IB in GCC countries. This result is consistent with Pathan’s
(2009) result suggesting that CEO duality is crucial to a bank’s financial stability since it leads
to a high Z-score. To explain, older CEOs have more experience and better management skills
than their younger colleagues. Moreover, the presence of members having accounting/finance
and Islamic competence on the Shariah Supervisory Board SSB affect positively and
significantly the financial stability of the bank. To add, Pathan (2009), reveals that CEO power
is associated with lower bank risk taking, high Zscore, and more soundness. He explains that
managers are risk averse when they occupy the CEO and chairperson positions and their interest
become less aligned with shareholders ,who prefer more risk taking. This result is consistent
with the findings of Gill and Mathur (2011), VO and Phan (2013), Alshehr (2015). All these
studies indicated that the duality of the CEO affects positively banks’ soundness.
On the other hand, the result is contradicted by the findings of Kaymak and Bektas (2008),
Chaghadari and Chaleshtori (2011), and Ujunwa (2012).They believe that it increases the risk of
the abuse power and managerial entrenchment. Moreover, a concentration of decision
management and decision control reduces a board’s effectiveness in monitoring top
management.
In the governance literature, board size is regarded as a corporate governance mechanism.
(Dalton et.al 1999). With regard to the variable, size of the Shariah Supervisory Board (SSB),
the estimated coefficients in these regressions of Board size are positive and significant,
indicating that a larger members serving on the Board size are likely to lead to a higher Zscore
then more soundness. In others words, the inclusion of more directors increases the board’s
10
monitoring capacity. In this line, John and Senbet (1998), Dalton (1998) argue that larger boards
are likely to provide more expertise and diversity. More, Buniamin et al. (2008) are convinced
that when the board size is large, the board is likely to be more effective in terms of monitoring
the management, and consequently, provide greater soundness and resilience. Furthermore, a
large board size is practical because complicated operations need to be monitored by a large
number of people (Cole et al 2008). Further, the size of boards can also affect banks risk taking
behavior. Rachdi and Ameur (2011) suggest that the numbers of directors increases the use of
sophisticated instruments to protect against risk increases which justify financial soundness.
In the other hand, effective Shariah governance is crucial in strengthening the credibility of
Islamic banks because when the number of members of any board is high, it can create a
conflict between them especially in the Shariah board as it is concerned with the religious aspect
of the overall behavior of Islamic banks and can thus negatively affect the performance of
banks. (Bourakba and Zerargui 2015). This result may be explained by the idea that a larger
board becomes diluted and less effective so may not allow an efficient allocation of resources
due to difficulties in coordination to the extent that it harts the stability of the bank. This result
is consistent with the AGT precepts which postulate that smaller BOD size is appropriate to
minimize agency monitoring costs and to ensure good communication and coordination
amongst board members. Moreover, to confirm, Lipton and Lorch (1992)and Jensen (1993)
suggest that larger boards could be less effective than smaller boards because of the
coordination problems and the free riding of directors. These are the reasons why AGT scholars
(Fama and Jensen, 1980; Yermack, 1996; Jensen, 1993) recommend a relatively small Board
size. These contradictory outcomes are really alarming that Board Size is actually of great
importance.
We now consider the role of ownership nature as it relates to bank’ soundness. This choice is
consistent with the hypothesis that different categories of shareholders have different risk
attitudes. As reported in these regressions, the coefficients associated with the Private
ownership variable are positive and significant. Private ownership is positively related to Z-
score conducting to financial soundness. In other word, high proportion of private ownership
can contribute to achieve high Zscore then more soundness. This result is in line with Beck’s
results which suggest that privately-owned banks are more profitable and better capitalized than
both savings and cooperative banks (Beck 2010).
As regards the effect of institutional ownership on banks' soundness, we find that the coefficient
of the state variable is significantly negative for Zscore model. Thus, state-owned banks have
11
greater proportions of non-performing loans then lower Zscore than other banks. Several studies
(e.g., Berger et al., 2005, Cornett et al., 2010 ) have found that the relationship between
government participation in banking ownership and soundness is negative and significant.
According to these studies, state-owned banks have poorer loan quality and higher default risk
than privately owned banks. Our finding is contradictory to Cornett et al. (2010) ‘outcomes. The
authors argue that the increasing globalization of financial services, and increased competition
create a pressure to improve banking policy that disciplines inefficient regulators and enhances
the performance of state-owned banks.
Concerning foreign ownership, positive and significant coefficients reveal that banks dominated
by foreign ownership are sounder and less risky. Our results are in line with Levy and
Mico(2007), Matos and Ferreira (2008), Angkinak (2010).The governance variable tends to be
strongly positive and significant in all regressions in which it is entered, suggesting, as
expected, that better governance is correlated with higher z-scores. In other words, the quality of
corporate governance can positively affect the financial soundness, and when missing, can
conduct to financial distress. In the 2004 edition of corporate governance principles, the
Organisation for Economic Cooperation and Development mentioned that corporate governance
is highly important for financial stability and economic growth by ensuring credibility and
reliability for investors and general stakeholders. The International Monetary Fund (2014)
reportconducts an empirical analysis and finds evidence at the international level that some
indicators of corporate governance are dependent to risk taking actions in financial institutions.
Kirkpatrick (2009), when analyzing the failure of risk management during the financial crisis,
he argues that the corporate governance procedures were a main contributor. Moreover,
Masouros (2014) points that the ability of a banking system to resist a crisis depends on
Corporate governance configurations in a given country. Thus, the enforcement of corporate
governance can give a good health for banks. To insist, as mentioned in Ananchotikul and
Eichengreen (2009),the quality of corporate governance is not only a reflection of financial
development, but it can positively affect it. To confirm, in the wake of last crises, there is an
increased awareness regarding the role of a sound corporate governance framework for
enhancing the financial stability problems. These literature envisaged to be analyzed when
assessing how they affect financial stability. (Lupu2015).
In crisis period, we notice a slightly decrease in the GCC Islamic banks Zscore. This is
confirmed by the negative but not significant effect of the crisis period on the soundness of
these banks. That is to say that these banks lose some point of their soundness degree due to the
subprime crisis in despite of the majority of Islamic banks in GCC countries are leader. This
12
outcome may be confirmed, in practice, by the failure of many Islamic banks and even the close
of their doors as AL Rajhi bank in Saudi Arabia, Dubai Islamic bank in UAS and Kuwait
Finance House in Kuwait…The Global Finance House lost $730 million; Bahrain Islamic bank
had been exposed to lose $51 million, in 2009
Theoretically, our results are in line with Elasrag, Hussein (2011), Turk Ariss (2010),
Smolo2011, Duasa2011, Zarrouk (2012)’ studies. They argue that “Islamic banks are more
vulnerable and can be badly impacted by financial shocks”. However, Bourkhis and Nabi
(2013), Beck et.al. (2013), Hasan and Dridi (2010) are persuaded that Islamic banks are more
resistant and immunized to financial shocks and could escape the negative effect of the crisis.
After each crisis, reforms are carried out to prevent a new episode of financial crises. In this
context, our objective in this study is to examine simultaneously the effect of corporate
governance variables and crisis circumstance on the soundness of Islamic banks. Add, it was
observed that, in a natural way, after each period of financial distress, the corporate governance
standards suffered revisions following widely accepted improvement demands addressed to
features bearing peculiar concern. Moreover, Crisis periods represent unique opportunities to
reconsider the actual governance practices, which have showed their limits during the
subprime’s crisis. (Kirkpatrick 2009)
We find a positive and significant association between performance and banking soundness. As
supported by Jaffar & Manarvi (2011) evaluated the performance of Islamic banks through
CAMEL test during the period 2005 to 2009.They found that when Islamic banks performed
better and have high liquidity, banks seam sound and resistant face to a crisis.
The soundness of a bank depends moreover on its ability to meet its obligations in a crisis
period. This is usually measured by the Capital assets ratio (CAR).
Our use of the GDP as variable is intended to capture the effect of macro-economic conditions
on Z-score. GDP growth has a negative but not significant impact. Otherwise, Countries with
higher level of GDP per capita have higher risk then lower Zscore and lower soundness. As
opposed to our finding, higher levels of GDP per capita reduce bank risk taking. This result
confirms the view that banks from faster-growing countries have a lower portion of bad loans
and are less risky (Angkinand and Wihlborg, 2007 and Laeven and Levine, 2009). Consumer
price inflation leads to banking instability as shown by its negative but not significant impact.
According to La porta et al. (2002), this variable also captures a country’s general institutional
quality. Poorer countries generally have weaker governance structure.
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Looking at the coefficients of Concentration variable in these regressions, we find that a higher
concentration in the banking sector contributed to instability. We show a negative and
significant impact of concentration on Zscore. Then, high market concentration leading to a low
competition affects negatively the solidity of these banks. This is in line with the literature on
banking sector concentration and stability that finds higher concentration to be associated with
lower stability (Čihák and Wolfe, 2009).In the other side, our findings are contradictory to the
argument of Sullivan and Spong (2007) that market concentration decreases bank risk by
exploiting the moral hazard features of deposit insurance.
IV- Conclusion and Policy Implications:
The world has known various financial crises over the course of history, particularly
the recent global financial crisis in 2007-2008, called Subprime crisis. Due to the
central role of banks in the achievement of economic growth and prosperity, this
financial hazards which launched in the USA and proliferate into others economies in
all over the world owning to the liberalization and financial integration, has a great
harmful for the economy and prejudicial for the health of financial sector.
The financial scene, characterized by many bankruptcy cases, makes it possible to
highlight the deficiencies of corporate governance (Magnier, 2010) and their impact
on financial distress. More, many forces led to the largest financial crisis and
corporate governance is one of the most contributing factors. As a result, there is an
increased awareness regarding the role of a sound corporate governance framework
for enhancing the financial stability.
In this paper we intend to unfold the relationship between corporate governance
characteristics and financial soundness measured by the Zscore. According to our
empirical estimations, we find that governance variable tends to be strongly positive
and significant in all regressions in which it is entered, suggesting, as expected, that
better governance is correlated with higher z-scores. In other words, the quality of
corporate governance can positively affect the financial soundness, and when missing,
can conduct to financial distress. More, in particular, we find that changes in
ownership structure are significant in explaining soundness differences between
banks. In others words, our findings reveal that nature of owners is relevant to
explaining soundness and resilience.
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In the other side, Crisis periods represent unique opportunities to reconsider the actual
governance practices, which have showed their role in maintaining soundness. In fact,
we find that, as corporate governance is one of the most contributing factors to
maintain banks resilience in crisis period, the combined effect of crisis and
governance is negative but not significant.
Concluding, over the past few years, financial crises and economic trouble become a
trend owning to their recurrent nature and severe impact. Then, these crises are a good
testing to the solidity of banks since their impact is detrimental for the health of banks.
In practice, the shariah-complaint banks are facing profound difficulties of governance
and ownership structure. Thus, to confirm their presence and to demonstrate their
relevance as a powerful alternative to conventional banks, Islamic banks should, in
order ensure a portfolio’s diversification, enlarge their range of activity and increase
their investments fields. In this topic, due to a few years of emergence, individual
Islamic banks are often small. So, to support each other; it is beneficial to enhance
coordination and cooperation among them. Moreover, in order to avoid a massive
withdrawal which leads to a bankruptcy, Islamic financial institutions should keep a
rational proportion of their funds in liquid able to satisfy customer’s needs. Also, to be
protected from the asymmetry of information and the moral hazards problems, Islamic
banks are required to be more careful in governance, selecting their clients and in
raising their funds as well as prudent in investing in PLS projects. Additionally,
Islamic banks should be strict and sever about criteria for membership in the Shariah-
Board since this entity guarantee the compliance of banks’ products to Islamic law and
the effective use of Profit Loss Sharing contracts.
As is usually the case research article, the empirical tests conducted in our analysis
have limitations. This study could be completed by incorporating other variables such
as characteristics of the AUDIT COMMITEE and the age or experience level of banks
and shariah board membership, certainly more difficult to quantify, but which must be
taken into account.
15
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20
Appendix 1. Definitions of all variables and Sources
Variable
Name
Definition Sources
Z-score for bank i at time t in country j
Personal’s
calculations
based on
Bankscope data
(2013)
Vector of Bank
specific
variables
Size: Natural logarithm of total assets. in
U.S billion dollars)
Bankscope
(2013)
CAR: Capital to assets ratio: It measures
Tier 1 + Tier 2 capital as a percentage of
risk weighted assets: The higher the
capital adequacy ratio, the safer the bank.
ROE: Return On Equity
Vector of
industry specific
variables
Bank concentration Assets of 3 largest
banks to total assets of all banks in the
country.
Personal’s
calculations
based on
Bankscope
data(2013)
Vector of
Macroeconomic
variables
GDP Growth(Growth rate of nominal
GDP ,adjusted for inflation)
World Bank
Development
Indicators
(2013)
Inflation (year on year change of the CPI
index
Vector of
Governance
variables
CEO Duality:which takes a value of 0 for
if CEO and chair roles are separated on the
last accounting fiscal year before the filing
for bankruptcy procedure, and 1
otherwise?
Annual Reports of
Islamic banks.
(2013)
Shariah-Board Size: is measured as the
number of religious scholars on the board
of each bank.
Private Ownership: Proportion of shares
held by foreign shareholders
Institutional Ownership: Percentage of
shares held by institutions (e.g., pension
funds
Private Ownership (%): State Proportion
of equity detained by the private person.
Crisis dummies
variables
Equals 1 for the crisis –period (2007/2008)
0 otherwise.
21
Appendix 2. Empirical Results
Table1: Impact of corporate governance on Islamic Banks financial soundness:
empirical evidence from individual control measures
Zscore
Reg 1 Reg2 Reg 3 Reg 4 Reg5 Reg6 Reg7 Reg8 Reg9 Reg10
CEO
19.18***
(4.21)
18.97***
(4.43)
- - - -
17.84***
(4.42)
- 20.93***
- (4.46)
-
Board size
2.77**
(4.13)
- 2.29
**
(2.81) - -
-
1.66
(2.16) - -
3.46***
(4.80)
PrivOwn 15.67
**
(3.13) - -
4.62
(1.36) - - -
1.40 17.18**
(0.46) (3.26)
1.18
(0.40)
InstOwn
-6.80
(-0.83) - -
-
-
15.40**
(-2.58)
- -
-15.07**
- 1.15
(-2.43) (-0.014)
-20.98**
(-3.38)
ForeignOwn
19.94**
(3.42) - - -
-
0.01
(0.00)
- -0.95 15.92
**
(-0.28) (2.79)
5.75
(1.48)
ROE 0.08
(4.93)
0,09***
(5.44)
0.09***
(5.73)
0.10***
(6.11)
0.10***
(6.39)
0.10***
(6.34)
0.08
(4.77)
0.10***
0.09**
(6.10) (5.37)
0. 09***
(5.85)
CAR -5.33
(-1.38)
-7.42
(-2.07)
-8.20**
(-2.2)
-5.67
(-1.74)
-3.34
(-0.87)
-6.65*
(-1.99)
-8.39**
(-2.25)
-.307 -4.27
(-0.82) (-1.10)
-4.56
(-1.19)
Concentration -1.12
(-0.09)
7.26
(0.66)
4.38
(0.38)
-4.81
(-0.43)
-15.42
(-1.29)
-5.87
(-0.52)
13.51
(1.17)
-13.94 -4.31
(-1.16) (-0.36)
-8.63
(-0.70)
GDP -41.89
(-1.18)
-24.94
(-0.77)
-8.57
(-0.2)
-13.42
(-0.40)
-29.85
(-0.93)
-18.10
(-0.58)
-17.54
(-0.52)
-26.32 -40.33
(-0.76) (-1.14)
-29.93
(-0.85)
INFLATION 2.54
(0.09)
11.67
(0.43)
5.71
(0.21)
-6.75 (-
0.24)
-24.88
(-0.97)
-11.18
(-0.40)
21.19
(0.78)
-21.41 -1.33
(-0.74) (-0.05)
-13.07
(-0.46)
N 428 429 429 429 429
429
428 429 429 428
R2(Within)
0.1413 0.0951 0.0479 0.0377 0.0377 0.0212 0.1108 0.0387 0.1208 0.0848
Prob>Chi2 0.00 0.00 0.00 0.00 0.00 0.00 0.000 0.000 0.000 0.000
Method OLS OLS OLS OLS OLS OLS OLS OLS OLS OLS
Note: this table presents the estimation results by Ordinary Least Square method of the Z- score for Islamic banks. The first value shows the
coefficient of each variable. The second value in parentheses, mentions t-Student statistic. (***),(**),(*) denote respectively the degree of significance (1%),(5%),(10%)
22
Table2: Impact of corporate governance on Islamic Banks financial soundness:
empirical evidence from composite control measures
Zscore
Reg 1 Reg2 Reg 3 Reg 4 Reg5 Reg6 Reg7 Reg8 Reg9
CEO
-
18.93***
(4.44) - - - - - -
-
Board size - - 2.52
**
(3.27) - - - - -
-
PrivOwn - - - - - 6.07
(1.83) - -
-
InstOwn
- - - - - - -13.56
**
(-2) -
-
ForeignOwn
- - - - - - -
-1.70
(-0.47)
-
OWNINDEX 0 .61
(0.56)
0.39
(0.37) -0.90 (-0.95)
- 1.17
(1.07) - - -
-
GOVINDEX
-
-
-
2.67
(1.89)
3.12**
(2.24)
3.26**
(2.45)
1.90
(1.18)
2.87**
(2)
-
GLOBAL
INDEX - - - - - - - -
2.16**
(1.74)
ROE 0. 10
***
(6.24)
0.09***
(5.26)
0.09***
(5.83)
0.10***
(6.35)
0.10***
(6.02)
0.10***
(5.95)
0.10***
(6.25)
0.10***
(6.13)
0.10***
(5.64)
CAR -6.43
**
(-1.96)
-7.27
(-2.08)
-8.68**
(-2.44)
-6.02
(-1.76)
-5.51
(-1.67)
-4.63
(-1.42)
-3.28
(-0.86)
-5.91
(-1.76)
-6.73
(-1.92)
Concentration -4.44
(-0.40)
8.14
(0.75)
3.32
(2.44)
-7.55
(-0.67)
-5.02
(-0.46)
-6.40
(-0.57)
-15.52
(-1.30)
-5.91
(-0.53)
2.22
(0.19)
GDP -14.83
(-0.42)
-22.84
(-0.66)
-12.42
(-0.35)
-23.48
(-0.71)
-18.22
(-0.52)
-18.62
(-0.54)
-32.28
(-0.99)
-20.57
(-0.58)
-5.66
(-0.16)
INFLATION
-7.97
(-0.29)
13.66
(-0.51)
2.76
(0.10)
-14.97
(-0.52)
-9.17
(-0.52)
-9.49
(-0.54)
-26.08
(-0.88)
-11.83
(-0.42)
3.68
(0.13)
N 428 429 428 428 428 428 428 428
428
R2(Within)
0.0220 0.0954 0.0494 0.0286 0.0314 0.0361 0.0408 0.0292
0.0327
Prob>Chi2 0.000 0.0000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Method OLS OLS OLS OLS OLS OLS OLS OLS OLS
Note: this table presents the estimation results by Ordinary Least Square method of the Z- score for Islamic
banks. The first value shows the coefficient of each variable. The second value in parentheses, mentions t-
Student statistic. (***),(**),(*) denote respectively the degree of significance (1%),(5%),(10%)
23
Table3: Impact of corporate governance and crisis on Islamic Banks financial soundness : empirical
evidence from individual control measures
Zscore
Reg 1 Reg2 Reg 3 Reg 4 Reg5 Reg6 Reg7 Reg8 Reg9
CEO
19.15***
(4.21)
19.10***
(4.49)
- - - -
17.90***
(4. 46)
- 0. 0***
(4.50)
Board Size
2.78***
(4.04)
- 2.30
**
(2.79) - - -
1.65
(2.13) -
-
PrivOwn
15.65**
(3.15)
- - 4.60
(1.36) - - -
1.41
(0.46) 0.001
**
(3.29)
InstOwn
-6.83
(-0.84)
- - -
-
15.48**
(-2.59)
- -
-
15.12*
(-2.45)
0.896
(-0.13)
ForeignOwn
19.94**
(3.42)
- - - - 0.06
(0.02) -
-0.87
(-0.25) 0.005
(2.79)
CRISE
-0.20
(-0.07)
0.95
(0.34)
-1.14
(-0.39)
-0.62
(-0.21)
-1.07
(-0.37)
-0.76
(-0.26)
0.46
(0.16)
-0.98
(-0.34)
0.775
(0.29)
ROE
0. 08***
(4.05)
0. 09***
(4.67)
0.09***
(4.34)
0.
10***
(4.87)
0.
10***
(4.94)
0.
10***
(5.02)
0. 08***
(4.02)
0.
10***
(4.80) 0. 0
***
(4.65)
CAR
-5.34
(-1.37)
-7.38
(-1.03)
-8.25
(-2.21)
-5.71
(-1.73)
-3.37
(-0.88)
-6.69
(-1.98)
-8.36
(-2.21)
-3.11
(-0.82)
0.280
(-1.08)
Concentration
-1.28
(-0.10)
7.97
(0.68)
3.65
(0.30)
-5.22
(-0.44)
-16.18
(-1.28)
-6.43
(-0.54)
13.84
(1.15)
-14.68
(-1.16)
0.776
(-0.29)
GDP
-42.43
(-1.26)
-22.57
(-0.73)
-11.42
(-0.37)
-15.03
(-0.47)
-32.64
(-1.10)
-20.16
(-0.61)
-16.40
(-0.52)
-28.98
(-0.90)
0.259
(-1.13)
Inflation
2.52
(0.09)
11.65
(0.42)
5.91
(0.21)
-6.67
(-0.24)
-24.77
(-0.85)
-11.16
(-0.40)
21.16
(0.78)
-21.41
(-0.74)
0.966
(-0.04)
N
428 429 428 429 429 429 428 428 428
R2 (Within)
Prob>Chi2
0.1514 0.0954 0.0483 0.0258 0.0380 0.0214 0.1109 0.0390 0.1210
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
METHOD OLS OLS OLS OLS OLS OLS OLS OLS OLS
Note: this table presents the estimation results by Ordinary Least Square method of the Z- score for Islamic banks. The first
value shows the coefficient of each variable. The second value in parentheses, mentions t-Student statistic. (***),(**),(*)
denote respectively the degree of significance (1%),(5%),(10%)
24
Table4: Impact of corporate governance and crisis on Islamic Banks financial
Soundness: empirical evidence from composite control measures
Zscore
Reg 1 Reg2 Reg 3 Reg 4 Reg5 Reg6 Reg7 Reg8 Reg9
CEO
- - - - - -
19.05***
(4.50) - -
Board Size - - - - - - - 2.54
**
(3.24) -
PrivOwn - - 1.53
(0.51) - - - - - -
InstOwn
- - - -23.12
***
(-4.32) - - - - -
ForeignOwn
- - - - 8.21
(2.53) - - - -
OWNINDEX
- -1.23
(-1.28) - - -
0.60
(0.55)
0.41
(0.39)
-0.94
(-1.01) -
GOVINDEX
7.42***
(4.20)
7.82***
(4.47)
7.33***
(4.17)
8.43***
(5.21)
8.47***
(4.85)
- - - -
CRISE -0.05
(-0.02)
0.943
(-0.07)
-0.015
(-0.01)
-0.35
(-0.13)
-0.37
(-0.13)
-0.67
(-0.23)
1.01
(0.36)
-1.30
(-0.45)
-0.13
(-0.05)
GLOBAL
INDEX - - - - - - - -
5.03**
(3.04)
ROE 0.08
***
(3.94)
0.08***
(4.02)
0.08***
(3.90)
0.08***
(3.92)
0.08***
(4.06)
0.10***
(4.96)
0.09***
(4.57)
0.09***
(4.41)
0.09***
(4.11)
CAR
-8.92*
(-2.40)
-9.49**
(-2.62)
-8.56*
(-2.37)
-4.32
(-1.11)
-9.61**
(-2.64)
-6.47
(-1.94)
-7.22
(-2.04)
-8.77**
(-2.42)
-6.62
(-1.86)
Concentration 14.69
(1.20)
12.88
(1.07)
14.83
(1.21)
3.15
(0.24)
9.12
(0.75)
-4.91
(-0.42)
8.93
(0.77)
2.44
(0.20)
8.85
(0.72)
GDP -11.97
(-0.39)
-18.48
(-0.56)
-10.40
(-0.32)
-29.63
(-0.95)
-27.94
(-0.84)
-16.61
(-0.51)
-20.23
(-0.61)
-15.85
(-0.49)
-1.64
(-0.05)
Inflation
23.38
(0.87)
18.90
(0.69)
24.46
(0.91)
8.31
(0.30)
12.60
(0.46)
-7.92
(-0.29)
13.73
(0.51)
2.87
(0.10)
16.78
(0.61)
N 428 428 428 428 428 429 429 428 428
R2(Within)
Prob>Chi2
0.1029 0.1059 0.1034 0.1385 0.1147 0.0221 0.0957 0.0499 0.0598
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Method OLS OLS OLS OLS OLS
OLS OLS OLS OLS
Note: this table presents the estimation results by Ordinary Least Square method of the Z- score for Islamic banks. The first value shows
the coefficient of each variable. The second value in parentheses, mentions t-Student statistic. (***),(**),(*) denote respectively the degree of significance (1%),(5%),(10%).
25
Table 5: The simultaneous Impact of corporate governance and crisis on Islamic
Banks financial soundness: empirical evidence from composite control measures
Zscore
Reg 1 Reg2 Reg 3 Reg 4 Reg5 Reg6 Reg7
CEOcroise
15.31**
(2.66)
- - - - - -
Boardcroise - -0.007
(-0.02) - - - - -
INSTcroise - - -15.92
(-2.38) - - - -
FOREIGcroise - - - 3.93
(0.89) - - -
GOVINDEXCROISE - - - - 4.40
**
(2) - -
OWNINDEXCROISE - - - - - -1.56
(-0.94) -
CriseGlobalIndex - - - - - - -0.45
(-0.26)
ROE
0.11***
(6.44)
0.10***
(5.73)
0.09***
(5.58)
0.11***
(5.52)
0.09***
(4.99)
0.10***
(6.28)
0.10
(5.88)
CAR -7.596
*
(-2.16)
-6.65
(-1.96)
-5.40
(-1.5)
-6.64
(-1.97)
-7.77
(-2.13)
-6.86
(-2.08)
-6.61
(1.92)
Concentration -1.19
(-0.11)
-5.91
(-0.49)
-12.32
(-1.04)
-6.75
(-0.61)
-1.10
(-0.10)
-7.71
(-0.70)
-6.70
(-0.60)
GDP -18.21
(-0.55)
-18.26
(-0.59)
-29.61
(-0.93)
-20.76
(-0.61)
-17.78
(-0.54)
-26.55
(-0.73)
-20.43
(-0.57)
Inflation -7.56
(-0.26)
-11.15
(-0.39)
-10.28
(-0.36)
-10.66
(-0.37)
-8.56
(-0.30)
-10.38
(-0.36)
-11.06
(-0.38)
N 429 429 429 429 429 429 429
R2(Within)
Prob>Chi2
0.0465 0.0212 0.0325 0.0239 0.0373 0.0239 0.0215
0.00 0.00 0.00 0.00 0.00 0.00 0.00
Method OLS OLS OLS OLS OLS OLS OLS
Note: this table presents the estimation results by Ordinary Least Square method of the Z- score for
Islamic banks. The first value shows the coefficient of each variable. The second value in parentheses,
mentions t-Student statistic. (***),(**),(*) denote respectively the degree of significance
(1%),(5%),(10%).
