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Improving Islamic bank
performance through agency
cost and dual board governance
Early Ridho Kismawadi
Department of Islamic Banking, Faculty of Islamic Economics and Business,
IAIN Langsa, Langsa, Indonesia
Abstract
Purpose –This study aims to examine the impact of agency cost, Islamic board characteristics and
corporate governance on the performance of Islamic institutions.
Design/methodology/approach –Based on the selected criteria, 92 Islamic banks (IBs) from 20
countries were selected for further research. The authors used generalized method moments (GMM)
estimation method. The agency cost and Shariah board characteristics are the explanatory variables. The
author uses the age of the bank and the size of the bank for variable control.
Findings –Empirical results indicate that first, agency costs represented by cast/total assets negatively
affect IBs’return on equity and net income. As agency costs rise, IBs’financial performance declines. Second,
Shariah supervisory board (SSB) size and board independence affect IB performance. The study found that
SSB size positively affects IB performance.
Research limitations/implications –This research contributes to the literature on IBs in different
countries, which policymakers and practitioners can use to improve agency cost functions and Shariah board
characteristics. Second, this analysis shows that IBs require specific attention for agency charges, given their
operations and business structures. This study contributes to agency theory, which requires Islamic banking
information and practices. Finally, the author has aided regulators and IBs by identifying the sources of
agency cost practices that can be resolved. The other bank governance contribution is twofold. First, the
author studied dual board governance in IBs (SSB and ordinary boards of directors). Second, the author
examines how SSB and traditional board governance affect IB performance. This research focuses on banks
listed on stock exchanges in the 20 countries analysed.
Practical implications –The research has policyand practical implications for central banks and IBs. By
outlining appropriate regulatory guidelines and reporting systems, regulatory authorities can ensure Sharia
compliance and protect the independence of IB Shariah department officers. Regulators and relevant
stakeholders must ensure Sharia compliance,audits, inspections, reporting and accurate disclosure for IBs.
Originality/value –This paper offers original contributions to professionals in the field of IBs and
stakeholders investigating the relationship between agency costs, governance of IBs, characteristics of
Islamic supervisoryboards and the performance of IBs.
Keywords Agency cost, Shariah board characteristics, Corporate governance,
Performance Islamic banks
Paper type Research paper
Introduction
There are likely to be discrepancies between conventional and Islamic bank (IB) business
models (Boukhatem and Djelassi, 2022). IBs may be governed by both central bank
regulators and autonomous Shariah oversight bodies (Nawaz et al.,2019). This study
noticed a unique structure for the investigated IB, the investigated IB originating from
countries that play a significant role internationally. First, the bank under study is a
subsidiary of a global IB with the greatest total assets (TA). Second, the bank under review
Islamic bank
Received 30 January2023
Revised 11 June2023
Accepted 11 September2023
Journal of Islamic Accounting and
Business Research
© Emerald Publishing Limited
1759-0817
DOI 10.1108/JIABR-01-2023-0035
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1759-0817.htm
is an IB with a distinctive operational and managerial structure. Using this one-of-a-kind
scenario, the researcher intends to give empirical data on the influence of agency expenses,
Shariah board features, corporate governance (CG) and IB performance in the context of
Islamic banking operations in various nations. For empirical study, this study sampled the
banks with the highest global TA.
Recent financial literature researching agency costs (Alam et al., 2020;Dai and Guo, 2019;
Nawaz and Virk, 2019), especially those researching agency costs in IBs (Abdelsalam et al.,
2016;Dai and Guo, 2019;Farag et al., 2018). It is still very limited and very difficult to obtain
research that examines agency costs, Shariah board characteristics, CG and the performance
of IBs. Several studies have shown that agency cost has a positive influence on the
performance of IBs (Alam et al., 2020;Dai and Guo, 2019;Farag et al.,2018;Nawaz and Virk,
2019); however, other studies have found that agency cost has a negative influence on
company performance (Boshnak, 2023;Kendo and Tchakounte, 2022;Khuong et al., 2022).
There is very little empirical study on agency cost, Shariah board characteristics, CG and
the performance of IBs, and it is difficult to find studies that used samples from the biggest
IBs in the world. This research contributes to the Islamic banking literature on IBs in
different countries, which policymakers and practitioners can use to enhance agency cost
functions and Shariah board characteristics. Second, this analysis demonstrates that IBs
demand special consideration when it comes to agency expenses, given that their operations
and business models are distinct from those of normal banks. Third, this study presents a
contribution to agency theory, which necessitates complete information and policies for the
Islamic banking business. Finally, we have helped to national regulatory agencies and IBs
by elucidating the causes of agency cost practices that are amenable to resolution by
regulators and IB organizations. Our other contribution is to the literature on bank
governance is twofold. First, we investigated how IBs’dual board governance procedures
work (Shariah supervisory board [SSB] and ordinary boards of directors [BOD]). Second, our
research looks into the channels via which the SSB and conventional board governance
affect the performance of IBs. More precisely, we investigated whether the SSB and ordinary
board governance processes influenced the construction of IB performance by boosting
managerial competences. Our paper’s uniqueness is described.
Given all of this, the main goal of this paper is to look at the relationship between agency
cost, Shariah board characteristics and the performance of IBs in the context of Islamic banking
operations in different countries. This will help fill in some of the gaps in the literature. More
specifically, this study will look at the issues of agency cost, Shariah board characteristics and
the performance of IBs in different countries, as well as how well they help solve problems
related to agency goals. This will help us understand the differences between agency theory
and Islamic banking. This study will build a theoretical foundation by taking a close look at
how IBs work and what they do now. This can then be used to deal with the problems that
come up when applying agency theory to Islamic financial institutions (IFIs).
CG is a topic of immense practical importance. Even in highly developed market
economies, there is substantial debate over the quality of the existing governance structures
(Shahzad Bukhari et al., 2013). In actuality, the circumstance is more complex. First, if the
contracts signed by management and investors are to be enforced by outside tribunals, they
cannot be subject to excessive interpretation. Second, because financing necessitates the
gathering of cash from numerous investors, these investors are frequently little and
insufficiently informed to exercise the actual control rights they possess. Individual
investors suffer the free rider dilemma, which makes it unattractive for them to learn about
the enterprises they have backed or even engage in governance. Any wrongdoing on the
part of the bank could hurt its stakeholders and could lead to agency problems and conflicts
JIABR
of interest between the management and those who have put their money in the bank
because they trust it to handle their money better.
IBs have distinct principles, operations, governance and goals (Aracil, 2019). The reason
for these differences is that IBs must follow the rules of Shariah in everything they do. The
spirit of Shariah is to avoid transactions with interest, gharar and maysir and to create
economic justice and look out for the well-being of the whole community and its
environment. The goal of avoiding transactions with interest is to make sure that money is
shared fairly and fairly reduce poverty. Managing the amanah is another important Islamic
spirit (trust) (Mukhibad et al.,2022). In addition to being expected to provide social care, IBs
must also demonstrate strong financial performance as businesses.
The agency dilemma arises when the interests of ownership and management are
distinct. As a result of the conflict of interests between managers and owners and between
different stockholders, firms incur agency expenses to ensure that managers behave in the
best interest of shareholders (Khasawneh, 2021). Greater moral accountability in IBs is
anticipated to reduce agency expenses by preventing needless risk-taking and discouraging
earnings management techniques. Due to the complexity of their operations, banks are
vulnerable entities that exacerbate the information gap between managers and stakeholders
(Alam et al.,2020;Nawaz and Virk, 2019).
The agency cost hypothesis has become one of the most influential theories for analysing
the impact of the ownership structure on a company’s performance (Dai and Guo, 2019).
More the magnitude of the uncontrolled contracts, the greater the agency cost charged by
IBs. This suggests that Mudaraba contracts are one of the most prevalent causes of agency
conflicts in Islamic institutions (Farag et al.,2018). Entrenched managers may pursue
possibilities that violate the value maximization rules to increase their grip over the
organization and their personal luxuries (Nawaz and Virk, 2019). An organization’s internal
agency cost is a major factorthat slows down the capital adjustment structure, alongside the
transaction costs of external funding (Dai and Guo, 2019).
The banking industry’s agency conflict requires a particular examination. The banking
industry’s agency structures are further complicated by the regulator’s role, the absence of
transparency and the inherent risk of systemic failure. Although IBs are a subgroup of the
banking industry, their operational and strategic characteristics are distinct. IBs are
supposed to operate in a Sharia-compliant way in addition to maximizing shareholder value
(Farag et al.,2018). IBs are based on a limited financial model that prohibits riba (usury),
gharar (extreme uncertainty) and maysir (speculation) and supports the sharing of earnings,
losses and risks. Constraints of the Islamic banking paradigm necessitate the existence of
two agency cost orientations. On the contrary, IB depositors are designated as investment
account holders (IAHs). IAHs lack board representation and are unable to directly oversee
bank performance. The non-representation of IAHs on the BOD is an additional agency
expense borne by the depositors. In contrast, the religious commitment of IBs suggests a
potential reduction in agency costs due to organizational moral accountability limits. When
managers, owners and different stockholders have different goals, firms have to pay agency
costs to make sure that managers are acting in the best interest of the shareholders
(Khasawneh, 2021). When an IAH invests in an IB, they are acting as principle and
entrusting their money to the care of the bank’s management, who are acting as agents for
the Islamic bank’s shareholder principals. This emphasizes the difficulty of agency
relationships in IBs compared to those of mainstream banks (Farag et al., 2018). When
organizational structures depart from their typical mainstream principles, agency
relationships and CG concerns become more complicated. Relevantly, two elements of the
Islamic financial system are established –governance and moral norms. The moral
Islamic bank
obligation and ethical sensibility of IBs are expected to diminish agency-driven
repercussions, such as a reduction in required risk-taking measures. Unlike traditional
banks, which allow managers to participate in the generation of endless profits, cooperative
banks prohibit managers from engaging in such activities. In companies governed by
Islamic moral and/or ethical values, it is least promoted (Hassan et al., 2022).
AAOIFI has launched the creation of Islamic accounting standards for IBs to circumvent
the issues with conventional accounting norms. IBs are required by AAOIFI Governance
Standard 1 to establish the SSB, which consists of a minimum of three members (Alam et al.,
2020). Shareholders of the bank appoint the members of the SSBs, who then provide
recommendations to the BOD (Nawaz and Virk, 2019). It is still thought that the existence of
SSB can play a significant role in the operations of IBs, including social activities
and reporting (Fachrurrozie et al.,2021). Given the crucial role, the SSB plays for IBs,
increased SSB size could improve bank performance by effectively regulating board activity
and limiting excessive risk-taking. In the existence of a larger and independent board,
stakeholders can argue that a larger SSB is an unnecessary expense (Nawaz, 2019a). The
SSB is an integral part of Islamic banking’s Shariah governance (SG), guaranteeing
customers and depositors that their money is being handled in accordance with Islamic law.
Because this is the case, IBs use a different type of board (Farag et al.,2018). It is anticipated
that the presence of the second layer of governance in IBs will reduce the likelihood of
financial reporting fraud and reduce IBs’agency expenses. IBs reduce the likelihood of fraud
in financial reporting and agency cost. Consequently, the limits imposed on some
transactions prevent IBs from engaging in speculative and risky operations, minimizing the
management’s opportunities to act unethically (Alam et al., 2020). That being said, one may
theorize that Islamic organizations would benefit from stronger CG if they were run with
greater accountability and openness at the highest levels.
The paper is organized as indicated below. Starting with introduction, followed by a
literature analysis according to agency cost, Islamic supervisory board characteristics and
bank performance. Section 3 describes the study’s approach. The findings and discussion
have been discussed in Section 4. The conclusion is followed by limits and suggestions for
additional research in the following section.
2. Literature review
2.1 Corporate governance
CG is defined by the Organization for Economic Cooperation and Development as “a set of
relationships between a company’s management, its board, its shareholders, and other
stakeholders”(Ajili and Bouri, 2018). Governance frameworks are the established norms
and rules through which BOD promotes fairness, accountability, openness and equality in
the institution’s interaction with its stakeholders (investors, management, customers,
society, investor, government and shareholder) (Alam et al., 2022a,2022b,2022c).
In a conventional banking system, the responsibility of governance is limited to
stockholders and management, whereas SG include all stakeholders in an Islamic banking
system. The goal of SG is to handle all disputes among stakeholders in accordance with
Shariah principles and under the direction of the Shariah board. IBs are built on profit and
loss sharing, whereas conventional banks are based on interest, so these are obviously two
distinct types of financial institutions (Mansoor et al.,2020). Therefore, IBs must seriously
consider adopting new strategic priorities, such as efficient investments in fresh capital and
the implementation of governance structures that will aid in sustaining their performance
(Nawaz et al.,2021). Governance regulations, the violation of which can be fatal, can even
result in the insolvency of an organization. IB is also not divorced from the problem of SG
JIABR
failure, which causes financial failure and trouble (Prasojo et al.,2022). Given that IBs adhere
to a distinct governance structure, the Shariah laws and values distinguish its governance
model from that of regular banks. IBs establish a Shariah board that opposes
the conventional interest-based basis and adheres to Shariah norms and principles. The
incorporation of Shariah norms into the paradigm of CG transforms it into Islamic CG (Jan
et al.,2021).
CG plays an important role in shaping the performance of IBs. It includes the
implementation of systems, structures and practices that govern the behaviour and decision-
making processes of bank management, BOD and shareholders. By adhering to Islamic
principles and ensuring Shariah compliance, effective CG in IBs promotes transparency,
accountability and ethical standards. A strong governance framework contributes to
improved risk management, enabling the identification and mitigation of potential risks.
This, in turn, ensures the stability and resilience of the bank (Baklouti, 2022;Khan et al.,
2020;Nobanee and Ellili, 2022). In addition, transparent governance practices inspire
investor confidence, attract capital inflows and foster long-term relationships. A well-
defined governance structure facilitates sound decision-making, strategic planning and
efficient resource allocation, leading to improved overall bank performance. In addition, CG
protects the interests of various stakeholders, including shareholders, customers, employees
and regulators, thus ensuring their protection. By upholding ethical standards and adhering
to Islamic principles, strong CG promotes integrity, fairness and social responsibility in IBs.
In short, implementing effective CG practices is critical to the sustainable growth,
profitability and reputation of IBs, as it ensures adherence to Islamic principles, reduces
risk, increases trust and fosterslong-term sustainability in the competitive banking industry
(Aslam and Haron, 2020;Harun et al., 2020;Khan and Zahid, 2020).
2.2 Dual board governance
The SSB is one of the most important parts of Sharia governance in IBs. Its main job is to
reassure stakeholders that the bank is following Islamic law. So, we say that IBs have a
unique structure with two boards (Alam et al.,2020;Nomran and Haron, 2019;Safiullah
et al., 2022). Due to the increased frequency of meetings in single-level board structures, the
decision-making process is significantly accelerated compared to dual-board arrangements.
Moreover, all directors (executive and non-executive) participate in the decision-making
process and have equal access to information, thereby improving the flow of information. In
contrast, the primary shortcoming of the unitary board structure is the lack of separation
between supervisory and managerial duties. In addition, IBs must be monitored to ensure
that they continue to function in accordance with Islamic law A significant component of
bank services is influenced by the dual board governance processes of IBs (SSBs and
conventional BOD) (Safiullah et al.,2022).
The CG framework is the set of policies and procedures by which the BOD affirms
accountability, fairness and openness with the different stakeholders (customers, investors,
shareholders, management, employees, government and society).(Alam et al., 2022a,2022b,
2022c). Due to the diverse legal norms and regulations of affiliated nations, the SG practices
of global IFIs differ (Alam et al., 2022a,2022b,2022c). The purpose of SG is to resolve all
disputes between parties in accordance with shariah law, as directed by the shariah board
(Nawaz et al.,2021). SG holds that businesses must be handled in accordance with the Quran
and Sunnah. Shariah encompasses not only religious ceremonies, but also social, political,
economic and corporate components (Ridwan and Mayapada, 2022).
Islamic bank
2.3 Agency cost
Agency cost, which allude to the costs associated with conflicts of interest between
stakeholders (principals and agents), have a substantial impact on the performance of IBs.
Nonetheless, the mechanisms and principles of Islamic banking give this relationship a
distinctive quality. The profit-sharing principle in Islamic banking stipulates that the bank
and the customer partake in the profits and losses of the business, typically through
Mudarabah (investment partnership) and Musharakah (joint venture) contracts. This shared
risk can reduce agency expenses because the principal and agent’s interests are more
aligned. However, this can also lead to new agency problems, such as moral hazards and
adverse selection, which, if not managed properly, can impact the performance of the bank.
Sharia law prohibits such practises as charging interest (riba) and investing in haram
activities. Noncompliance can increase agency expenses because it can erode trust with
customers and shareholders and result in regulatory sanctions. Maintaining compliance can
be a costly endeavour, and if these costs are not effectively managed, it can negatively
impact a bank’s performance (Hijriah et al.,2021;Khan et al., 2021;Khasawneh, 2021). The
governance structure ofIBs, which frequently includes a SSB, plays a crucial role in aligning
the interests of management and shareholders and ensuring Sharia compliance. High
agency cost may indicate a governance failing, which has a negative impact on investor
confidence and the bank’s reputation, which can have a negative impact on the bank’s
performance. Transparency is essential in Islamic banking to maintain confidence and
honour. Due to information asymmetry, a lack of transparency can increase agency costs,
resulting to poor decision-making and resource allocation, which can negatively impact
bank performance. Reducing agency cost in IBs requires alignment of all stakeholders’
interests, robust CG, Shariah compliance and promotion of transparency and disclosure. By
effectively managing agency cost, IBs can enhance their performance and reach their
objectives (Farag et al.,2018;Muhmad et al., 2022;Quttainah et al.,2017).
The agency cost hypothesis presumes the best capital structure that maximizes business
wealth by avoiding shareholder and manager disputes (Farooq et al.,2020). The agency cost
theory has become one of the most prominent theories for analysing the effect of the
adjustment structure of corporate ownership on the performance of a corporation. Equity
structure determines the amount of agency cost, and the company’s inside shareholding
structure is mainly manifested in the shareholding ratio of a company’s internal shareholder
and managers (Dai and Guo, 2019). Choices of equitable agency costs are the most
problematic sort of agency cost. Currently, the majority of costs select the appropriate
indicators to measure. In domestic and international research studies, the definition and
magnitude of the expansion of company characteristics index as an equity agency index
predominate.
Due to the nature of specificfinancial instruments Mudaraba contracts, we assert that
IBs have special agency connections. We discover that larger SSBs may result in reduced
agency expenses. Intriguingly, as the size of Mudaraba contracts increases, so do the agency
costs of Islamic banks. The finances/TA and equity/TA ratios are used to capture the
variations in Islamic banking financing operations and efficiency (Farag et al.,2018).
Furthermore, we use the cash flow-to-TA ratio and the overhead ratio as surrogates for
agency expenses. According to the agency theory, agency costs can be kept to a minimum if
the ownership structure and capital structure are optimal (Gharaibeh, 2020). Agency
expenses are variables that influence the commercial performance of banks (Dai and Guo,
2019;Alam et al., 2020;
Calopa et al.,2020;Dai and Guo, 2019;Farag et al.,2018;Farooq et al.,
2020;Nawaz and Virk, 2019):
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H1. Agency cost has a positive influence on IB performance.
2.4 Board size
The number of directors on a board is referred to as board size. According to agency theory
and resource dependence theory (RDT), a larger BOD increases the board’s power to
supervise and advise executive management (Naim and Abdul Rahman, 2022). An IB’s
board size, the credentials of its members and the participation of independent non-
executive directors provide the resources that can impact a bank’s capacity to comply with
the fundamental criteria of governance and properly discharge its fiduciary duties (Farag
et al., 2018). Board size positively affects firm performance (Grassa et al.,2018;Mansoor
et al., 2020;Mollah and Zaman, 2015;Naim and Abdul Rahman, 2022). The size of the board
is inversely related tohow well a company does financially (Farag et al.,2018):
H2. The size of the SSB will be related to the performance of the IB.
2.5 Board cross-membership
One of the most hotly debated topics in CG studies is “cross-directorships,”which imply that
directors serve on more than one board. Consistent with the agency theory, the posts of chair
and chief executive officer should be separated because they constitute a conflict of interest
given that the board is responsible for overseeing and managing the CEO of the firm (Naim
and Abdul Rahman, 2022). But the fact that the SSB has two roles is thought to reduce its
independence and flexibility (Wijayanti and Setiawan, 2022). Nomran and Haron (2019)
revealed a favorable correlation between SSB size and performance, supporting the
stewardship theory and RDT. Through conversations between SSBs, cross-memberships
can help SSBs learn more about Sharia practices and understand them better. The diversity
of SSB’s membership is a key factor in the organization’s ability to attract and retain top-tier
funding talent. This is why the SSB’s diverse membership will lead to better oversight and
more thorough reporting from management (Mukhibad et al.,2022):
H3. SSB cross-membership will be related with improved IB performance.
2.6 Shariah board educational
A board member with a high degree of knowledge is able to handle any new actions
effectively. In addition, board members with degrees above a bachelor’s degree have a
positive impact on a company’s performance (Alam et al., 2022a,2022b,2022c;Algabry
et al.,2020;Assenga et al., 2018;Isa and Lee, 2020;Shahrier et al.,2020). The qualifications of
the board members are a vital factor in determining the quality of the board (Shahrier et al.,
2020). Knowledge and skills can enhance directors’critical thinking that is essential in
discharging their main roles of monitoring, advisory and providing important resources
(Assenga et al., 2018). The qualifications of board members have an effect on a company’s
performance (Dzmitryieva, 2019). In light of the minimal number of PhD holders among
Shariah-compliant firms’BOD, the following theories are proposed:
H4. SSB educational attainment will correlate positively with IB performance.
Islamic bank
3. Sample, data and methodology
3.1 Sample and data
Our data set is a cross-sectional examination of the association between agency cost, SSBs,
CG and IB performance. We select samples using the OSIRIS database and the annual
reports of publicly traded companies. Manual data collection from the bank’s yearly report.
All annual reports are available on the official website of the bank. In the end, all data is
collected in millions of US dollars. Several prior studies have also used this type of data for
this kind of investigation. The investigation included 92 companies listed of 20 Islamic
Banks’countries of origin.
3.2 Empirical models
To empirically investigate the relationship between agency cost, SBCs, CG and the
performance of IBs, we use the following generalized method moment (GMM). Here is the
model:
ROA ¼
a
0þ
a
1AC1þ
a
2OR2þ
a
3SSB Size3þ
a
4Cross4þ
a
5Edu5þ
a
6BSize6
þ
a
7ACS7þ
a
8BI8þ
a
9Dual9þ
a
10Bank Size10 þ
a
11Age11 þ2
t(1)
ROE ¼
a
0þ
a
1AC1þ
a
2OR2þ
a
3SSB Size3þ
a
4Cross4þ
a
5Edu5þ
a
6BSize6
þ
a
7ACS7þ
a
8BI8þ
a
9Dual9þ
a
10Bank Size10 þ
a
11Age11 þ2
t(2)
Net Income ¼
a
0þ
a
1AC1þ
a
2OR2þ
a
3SSB Size3þ
a
4Cross4þ
a
5Edu5þ
a
6BSize6
þ
a
7ACS7þ
a
8BI8þ
a
9Dual9þ
a
10Bank Size10 þ
a
11Age11 þ2
t
(3)
where AC: agency cost; OR: overhead ratio; SSB size: number of Shariah board,
including a chairperson; Cross: percentage of members with cross-membership in SSBs
and other entities; Edu: percentage of Shariah scholars who have a PhD degree; B size:
number of BOD, including a chairperson and independent directors; ACS: number of
audit committees on the board; BI: the ratio of the number of independent directors to
the number of all directors; Dual: CEO duality is a dummy variable, which take a value
of one if the CEO is also the chairperson of the BOD, and zero otherwise; Bank size:
the natural logarithm of total assets (TA); Age (Bank age): the natural logarithm of the
number of years since the firmwaslisted;ROE:theratioofearningstaxestoTA;ROA:
the ratio of earnings taxes to equity; and net income: income deductible tax (as shown in
Table 1).
4. Results and discussion
Table 2 shows the descriptive statistics. The mean and default deviation for the first bound
variable, return on equity (ROE), equal to 1.23 and 1.56, respectively. The mean and
standard deviation the second dependent variable, return on assets (ROA), are 2.19 and 2.75,
respectively. As for the third dependent variable, net income, the mean is 1. 65, and the
standard deviation is 1.15; this low standard deviation for all dependent variables indicates
that the value of the data set is close to the mean. It is more likely to be distributed normally.
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Table 1.
The variables used in
the study
Research variable Research variable Proxy Variable description
Agency cost Cash/TA Ratio of cash flow to total assets
Leverage Long-term debt/total assets
Shariah board characteristics SSB size A number of Shariah board, including a
chairperson
SSB cross-membership A percentage of members with cross
membership in SSBs and other entities
Shariah board educational Percentage of Shariah scholars who have
a PhD degree
Corporate governance Board size A number of board directors, including a
chairperson and independent directors
Board independence The ratio of the number of independent
directors to the number of all directors
Audit committee size A number of audit committees on the board
CEO duality CEO duality is a dummy variable, which
take a value of one if the CEO is also the
chairperson of the board of directors, and
zero otherwise
Bank performance Return on equity The ratio of earnings taxes to equity
Return on assets The ratio of earnings taxes to total assets
Net income Income after tax
Control variables Bank size Bank size: the natural logarithm of total
assets
Bank age Bank age: the natural logarithm of the
number of years since the firm was listed
Source: Research findings
Table 2.
Descriptive statistics
Mean Median SD Min Max Obs
Cash/TA 0.25 0.13 0.54 1.45 4.64 92
Leverage 0.80 0.88 0.31 0.00 2.51 92
SSB size 3 2 2.57 0 11 92
SSB cross-membership 0.53 1 0.5 0 1 92
Shariah board educational 1.75 1 2 0 8 92
Board size 1.57 1.59 1.34 2 1.95 92
Board independence 1 0 1.6 2 8 92
Audit committee size 7 5 6.29 1 42 92
CEO duality 0.5 1 0.47 0 1 92
Return on equity 1.23 1 1.56 1.69 2.17 92
Return on assets 2.19 1.16 2.75 92692
Net income 1.65 5.71 1.15 2.19 7.76 92
Bank size 1.38 2.55 1.10 2.91 8.38 92
Bank age 30 27 15 6 109 92
Source: Research findings
Islamic bank
The same applies to independent variables except the bank age variable which has a
relatively high standard deviation indicating that the data is distributed over a wider range.
Table 3 shows the correlation matrix. Correlation matrix displays the Pearson correlation
coefficients between the explanatory variables. All of the correlation coefficients are less
than 0.95, indicating that collinearity between variables is not a concern, as suggested by
Gujarati and Porter (2009). Thus, all the independent variables are included in the model.
In this section, we examine the distinctive agency relationships in IBs. In Table 4
showing GMM estimation results, we found that the agency cost proxied by cash/TA is
significantly influenced by the SSB size; the results of the study show a negative influence
between the SSB size and the agency cost proxied by cash/TA. Board size is related to
bureaucratic issues and the board’s functional structure. A company with minimal oversight
needs may be better served by a smaller board. In contrast, companies with complex
portfolios may require intensive advisory and monitoring, necessitating a larger board
membership (Alam et al., 2020). This shows that the SSBsize can reduce agency costs to IBs;
therefore, increasing the SSB size is an option for IBs to reduce agency costs. This is because
the more supervisory boards, the more knowledge, the network they have can be used to
reduce agency costs.
In addition, the size of the bank also has a positive and significant influence on the
agency’s cost proxied cash/TA. This means that the larger the size of the bank, the agency
cost will also increase. In addition, the agency cost proxied by leverage is affected by cash/
TA, meaning that to increase leverage, cash/TA must be reduced. The results of the study
also found that the agency cost proxied by leverage was influenced by the size of the bank.
This means that the larger the size of the bank, the more agency cost proxied leverage will
increase. The results of this study are in line with Alam et al. (2020) and Khasawneh (2021).
Greater leverage increases bank profitability. The high level of information asymmetry
between banks, customers and other credit counterparties results in a higher agency cost for
banks compared to non-financial businesses. The empirical findings indicate that increased
debt financing reduces the agency’s costs, thereby increasing its profitability. It is
anticipated that the higher leverage or lower equity capital ratio will increase profitability.
Table 5 shows that agency costs proxied by cash/TA have a significant influence on the
performance of IBs proxied by ROE and net income. The agency cost proxied by cash/TA
has a negative influence, which means that the increase in agency costs will reduce the
performance of IBs. The results of this study are in line with Alodat et al. (2022),Eldaia et al.
(2022),Jadiyappa et al. (2019),Neralla (2022),Westermann (2018) and Zafar and Nor (2019) In
addition, the SSB size seen in Table 5 affects the financial performance of IBs proxied by the
ROA, and the SSB size has a significant influence on net income.
The cash/TA ratio is one indicator that demonstrates the extent to which banks finance
their assets with available cash. Several factors can explain why the cash/TA ratio reflects
the impact of agency cost on ROE (Boshnak, 2023;Chong et al., 2018;Semenenko, 2023).
First, the greater the cash/TA ratio, the greater the likelihood of an excess of unoptimized
funds in income-producing investments. This can indicate inefficiency in bank resource
utilization and can have a negative effect on ROE. Second, a high cash-to-assets ratio may
suggest a low liquidity risk. It may be challenging for banks with a high proportion of liquid
assets to obtain optimal returns from investment and lending activities. This may hinder
revenue growth and the overall performance of the bank, including ROE (Huang et al., 2020;
Otekunrin et al., 2020;Pandey and Sahu, 2019). Excessive agency costs, as reflected by the
cash/TA ratio, may also indicate a risk management imbalance. If a large proportion of a
bank’s assets consist of cash, this may indicate a reluctance to take the risks necessary to
generate higher returns. In some instances, IBs may be required to assume greater risks to
JIABR
Variable 1 2 3 4 5 6 7 8 9 10 11 12 13 14
1 Cash/TA 1
2 Leverage 0.35 1
3 SSB cross 0.10 0.09 1
4 SSB edu 0.20 0.14 0.47 1
5 SSB size 0.15 0.08 0.51 0.74 1
6 Board size 0.26 0.20 0.25 0.48 0.52 1
7 Board independence 0.11 0.12 0.23 0.17 0.25 0.45 1
8 Audit size 0.00 0.01 0.10 0.11 0.15 0.10 0.28 1
9 CEO duality 0.17 0.18 0.34 0.31 0.18 0.10 0.11 0.13 1
10 ROE 0.01 0.04 0.10 0.05 0.02 0.01 0.02 0.08 0.17 1
11 ROA 0.00 0.15 0.14 0.05 0.10 0.01 0.02 0.06 0.04 0.70 1
12 Net income 0.46 0.43 0.01 0.31 0.15 0.38 0.08 0.14 0.30 0.02 0.07 1
13 Bank size 0.30 0.36 0.00 0.38 0.29 0.49 0.14 0.12 0.24 0.07 0.14 0.89 1
14 Age 0.13 0.23 0.11 0.14 0.06 0.23 0.07 0.00 0.15 0.11 0.02 0.25 0.21 1
Source: Research findings
Table 3.
Correlation matrix
Islamic bank
attain their financial and expansion objectives. It should be noted, however, that the effect of
the cash/TA ratio on ROE may vary depending on other variables such as the fee structure
of the bank, market conditions and the business strategy used. In addition to effective risk
management and diversification of income sources, IBs’performance is also influenced by
efficient use of funds (Alodat et al.,2022;Bian et al., 2019).
The cash/TA ratio is an indicator that measures the extent to which a bank finances its
assets with cash on hand. Several factors can explain the effect of agency costs as
Table 4.
Agency relationship
in Islamic banks
Cash/TA Leverage
Cash/TA 0.161 (0.000)***
Leverage 0.296 (0.102)
SSB size 0.031 (0.000)*** 0.000 (0.718)
SSB cross-membership 0.060 (0.639) 0.050 (0.108)
Shariah board educational 0.000 (0.980) 0.010 (0.269)
Board size 0.031 (0.208) 0.017 (0.439)
Board independence 0.013 (0.710) 0.000 (0.975)
Audit committee size 0.000 (0.932) 0.000 (0.811)
CEO duality 0.021 (0.859) 0.045 (0.122)
Return on equity 0.222 (0.211) 0.009 (0.836)
Return on assets 0.214 (0.292) 0.035 (0.487)
Bank size 0.455 (0.000)*** 0.132 (0.000)***
Bank age 0.002 (0.523) 0.001 (0.174)
R square 0.378 0.280
F-stat (p-value) 0.000 0.010
Obs 92 92
Notes: ***, ** and * indicate significance at the 1, 5 and 10% levels, respectively
Source: Research findings
Table 5.
GMM estimation for
the influence of dual
board structure on
financial
performance in
Islamic banks
Variable
Model 1 Model 2 Model 3
ROA ROE Net income
Cash/TA 0.062 (0.123) 0.100 (0.019)** 0.471 (0.000)***
Leverage 0.083 (0.425) 0.021 (0.869) 0.064 (0.697)
SSB size 0.007 (0.030)** 0.008 (0.594)** 0.090 (0.001)***
SSB cross-membership 0.052 (0.429) 0.057 (0.415) 0.071 (0.584)
Shariah board educational 0.002 (0.893) 0.014 (0.510) 0.024 (0.349)
Board size 0.029 (0.416) 0.011 (0.819) 0.033 (0.722)
Board independence 0.009 (0.203) 0.021 (0.035) 0.043 (0.040)
Audit committee size 0.002 (0.530) 0.000 (0.865) 0.000 (0.920)
CEO duality 0.035 (0.636) 0.071 (0.390 0.064 (0.583)
Bank size 0.157 (0.026)** 0.205 (0.015)** 0.869 (0.000)***
Bank age 0.002 (0.040)** 0.003 (0.042)** 0.001 (0.012)***
Constant 0.019 (0929) 0.160 (0.497) 0.168 (0.657)
R square 0.751 0.760 0.880
Hansen J statistic (p-value) 0.000 0.000 0.000
Obs 92 92 92
Notes: ***, ** and * indicate significance at the 1, 5 and 10% levels, respectively
Source: Research findings
JIABR
represented by the ratio of cash/TA to net income (Garza-Gomez et al., 2015;Lee et al.,2010).
Initially, a high cash/TA ratio may imply an excess of unoptimized funds in an investment
that generates income. If a bank holds the majority of its assets in currency, it may miss out
on potential returns from more lucrative investments. This can inhibit revenue growth and
negatively affect net profit. Second, a high cash-to-acquired assets ratio may also indicate a
low liquidity risk. It may be challenging for banks with a high proportion of liquid assets to
obtain optimal returns from lending and investment activities. High liquidity risk may
impede a bank’s ability to generate enough revenue to attain the anticipated net profit(Hope
and Thomas, 2008;Wang and Ettredge, 2015). Excessive agency costs, as reflected by
the cash/TA ratio, may also indicate a risk management imbalance. A bank that maintains
the majority of its assets in currency may be unwilling to take the necessary risks to
generate higher returns. In certain instances, IBs must undertake greater risk to attain the
intended net profit.
Several factors can explain the negative impact of agency cost represented by the cash/
TA ratio on the performance of IBs. First, a high cash/TA ratio indicates an excess of
unoptimized cash invested in income-generating assets. If a bank maintains the majority of
its assets in cash, it may lose out on potential income from more lucrative investments, such
as financing or productive investments. This can hinder revenue growth and have a
negative effect on Islamic institutions’overall performance (Khan et al.,2021;Khasawneh,
2021).
Second, a high cash-to-acquired assets ratio may also indicate a low liquidity risk. If the
bank does not allocate assets efficiently and maximize the use of available resources, this
can hinder the bank’s ability to generate sufficient revenue to accomplish the desired
performance. In addition to affecting the bank’s ability to meet its payment obligations to
customers and related parties, a high liquidity risk can impair the institution’s capacity to
meet these obligations (Hijriah et al.,2021;Muhmad et al., 2022). Large agency cost as
reflected by the cash/TA ratio may indicate an imbalance between risk management and
fund management. Banks with a propensity to retain their assets in the form of cash may be
less willing to take therisks required to generate higher returns. This can hinder the revenue
and performance growth potential of Islamic institutions.
The results of this study show that the size of the SSB has a positive effect on the
performance of IBs, this means that to improve the performance of IBs, the size of the SSB
must be ideal, the size of the SBB which is too much will have an influence on the
performance of IBs. However, SSB size has a positive influence on ROE. The results of this
study are in line with (Farag et al.,2018;Nomran and Haron, 2020). The study demonstrates
that, to enhance the performance of IBs, SSBs must have the optimal size. A bank’s
performance may be impacted by an SSB that is excessively enormous. Several factors
contribute to the positive influence of SSB size on performance(Farag et al., 2018;Khan et al.,
2023;Mallin et al.,2014;Nomran et al.,2018;Nomran and Haron,2019, 2020;Taufik, 2023;
Taufiket al., 2023). First, larger SSBs can provide Islamic institutions with greater expertise
and diverse perspectives during the decision-making process. SSB can provide valuable
guidance and assure adherence to Shariah principles if it possesses a more extensiveskill set
and body of knowledge. This, in turn, can contribute to enhanced profitability, efficiency
and risk management.
Second, the optimal scale for SSBs allows for effective supervision and management of
bank operations. A well-structured SSB comprised of knowledgeable and experienced
scholars is capable of providing independent oversight and ensuring bank compliance with
ethical and Shariah standards. This positively affects the bank’s performance by enhancing
its reputation, fostering trust among stakeholders and attracting a larger consumer base.
Islamic bank
It is essential to note, however, that while SSB measures have a positive impact on ROE,
their influence on other performance indicators such as ROA and net income may vary.
Other variables, including management practices, market conditions and the competitive
landscape, can also impact the overall performance of IBs. In conclusion, the optimal size of
SSB is essential for the efficacy of IBs. A deftly crafted, well-balanced SSB can provide
valuable guidance, ensure Shariah compliance and enhance the overall performance of a
bank. To achieve sustainable growth and profitability, IBs must consider the magnitude of
the SSB alongside other governance mechanisms and factors.
Board independence has a significant influence on the performance of IBs in both ROE
and net income. The results showed that the independence board had a negative effect on
the performance of IBs represented by ROE and net income. The results of this study are in
line with (Aliani et al.,2022;Hussain et al.,2021;Musleh Alsartawi, 2019;Tazilah et al.,
2021). In addition, the results showed that the independent board had a positive effect on the
performance of IBs. The results of this study are in line with Handa (2022),Kafidipe et al.
(2021),Lee (2020) and Yang (2022). Independent directors provide counsel and direction to
executives and boost board activity (Naysary et al., 2020). Independent directors play the
most significant role in reducing agency costs and insider control, protecting investor
interests and enhancing the company’s ability to make decisions. When an agency conflict
exists, independent directors are able to use their own discretion to protect shareholder
interests. Given the need to build and maintain a positive reputation on the labour market
and the fact that independent directors bring valuable expertise and potential network
connections that could be advantageous to the company, independent directors should be
appointed. Boards dominated by independent directors are in a better position to oversee
and control the activities of managers. Large and independent BOD (and audit committees)
are more likely to have members with diverse experience and extensive networks who can
challenge managers’opportunistic practices and improve the quality of earnings for their
banks (Naysary et al., 2020). The number of independent directors on the board is the most
influential board characteristic on committee assignments. If there are many other
independent directors serving on the same board, a director tends to serve on fewer
committees (monitoring committees in particular). As the number of independent directors
rises, the number of additional committees a director sits on also rises. This is due to the fact
that companies with numerous independent directors are more likely to establish additional
committees, whereas smaller boards typically only have the three required monitoring
committees (Lee, 2020).
Table 5 also shows that the size of the bank affects the bank’s performance in ROA, ROE
and net income. The results showed that the size of the bank had a positive effect on bank
performance in ROA, ROE and net income. This means that banks that have a large size
have the potential to obtain better performance than banks with smaller sizes. The results of
this study are in line with Abdelmoneim and Elghazaly (2021),Ben Abdallah and Bahloul
(2023),Nawaz (2019b), Fachrurrozie et al. (2021),Quan et al. (2019) and Zaiane and Moussa
(2021). This implies that banks with a high asset value should have a high profit margin.
However, financial institutions accept high risk in exchange for high returns. Therefore, an
increase in bank size is indicative of an increase in bank risk (Abou Elseoud et al.,2020).
This positive relationship between bank size and profitability may be due, in part, to the fact
that large banks are more experienced, have a larger market share and possess superior
product design capacity. Large banks may be able to afford to diversify their income
activities and reap the benefits of risk diversification, unlike smaller banks. Their ability to
diversify income activities or portfolios increases, while agency issues are likely to worsen,
and they may benefit from economies of scale, resulting in increased performance.
JIABR
Increasing the size of a bank’s assets can also reduce risk through the diversification of
operations across product lines, industries and regions. Lower risk can increase profitability
either directly by reducing losses or indirectly by increasing the willingness of liability
holders to accept lower returns, thereby lowering banks’funding costs. Finally, small IBs
are inexperienced and cannot always acquire FinTech due to prohibitive investment costs.
Despite the fact that small banks invest in new technologies after large banks, they are still
technologically disadvantaged (Zaiane and Moussa, 2021).
The positive effect of bank size on such performance can be attributed to a number of
factors. Large banks have simpler access to larger financial resources, including capital and
funding. They can benefit from economies of scale, reduce operating costs relative to
revenue and enhance operational efficiency (
Calopa et al.,2020;Fachrurrozie et al.,2021;
Nomran and Haron, 2020;Fachrurrozie et al., 2021). This can positively affect ROA, ROE
and net profit. Second, a large bank size is frequently associated with greater risk
diversification. Banks with extensive networks and high asset values can more effectively
distribute risk, thereby reducing the concentration of credit risk in specific business
segments or industries. This risk diversification can provide financial performance with
stability and longevity. Moreover, larger institutions tend to have a stronger reputation and
market trust. This can provide a competitive advantage in recruiting customers, building
stronger relationships with business partners and securing cheaper funding sources (Elgadi
and Ghardallou, 2022;Fitri and Hafiz, 2022;Rusmita et al.,2023;Smaoui et al., 2020). All of
these variables can improve the bank’s performance as measured by ROA, ROE and net
profit.
Keep in mind, however, that the scale of a bank is not necessarily indicative of its
performance. Effective management, sound risk management and a sound strategy are also
essential elements for attaining high performance. In addition, a bank’s size can present
additional challenges, such as management complexity and elevated operational risk.
Therefore, despite the fact that the size of the bank has the potential to impact performance
in terms of ROA, ROE and net income, other factors must also be considered to achieve
sustainable performance.
The age of IBs has a significant influence on the performance of IBs both on ROA, ROE
and net income. The results of the research show that the age of IBs has a positive influence
on the performance of IBs represented by ROA, ROE and net income. The results of this
study are in line with Elgadi and Yu (2018),Kismawadi (2023) and Muhammad) and
Nugraheni (2021). Older banks appear to be more secure and can have higher performance
and a better reputation than their younger counterparts (Elgadi and Yu, 2018). According to
research, the age of IBs has a considerable impact on the bank’s performance, particularly in
terms of ROA, ROE and net profit. Put simply, the longer-established Islamic institutions
tend to exhibit superior performance in terms of return on assets (ROA), return on equity
(ROE), and net profit. Several factors can account for the positive impact of IB age on this
performance (Ben Abdallah and Bahloul, 2023;Hamzah et al.,2019;Haryati et al., 2019;
Hasan and Dewi, 2019;Sarea and Salami, 2021). First, banks that have been in operation for
a long time have a greater advantage in terms of knowledge and experience when it comes
to managing Islamic banking risks and activities. They have the opportunity to build a solid
network, acquire a thorough comprehension of the market and create effective strategies.
Second, the age of Islamic institutions often indicates a high level of customer and
stakeholder confidence and reputation. Customers’relationships with enduring banks tend
to be more stable, which can positively affect growth and profitability (Amara and Najar,
2021;Ikhsan Ramdhoni, 2018;Tamara and Kasri, 2020). In addition, the age of Islamic
institutions can be indicative of their superior management and consistent application of
Islamic bank
Islamic principles. Banks that are able to maintain a high level of Sharia compliance
typically attract more consumers, thereby boosting their revenue and overall performance. It
is essential to observe, however, that the effect of IB age on performance cannot be reduced
to a single factor. Other factors such as risk management, asset quality, product innovation
and operational efficiency also play a significant role in determining IBs’performance. Even
though they have relatively shorter life spans, younger IBs with strong management and a
focus on implementing Islamic principles have a chance to accomplish good performance
(Al-Homaidi et al.,2021;Elgadi and Ghardallou, 2022;Khan et al.,2023;Nawaz et al.,2020;
Nurhayati et al., 2022).
5. Conclusion and recommendations
The Islamic banking sector has experienced rapid growth and now ranks among the leading
sectors in the banking industry. A rapidly expanding industry, Islamic banking provides
goods and services in accordance with Sharia law. The continued expansion of the Islamic
finance industry demonstrates the significance of IB governance and the roles of both the
BOD and the SSB. This paper has three objectives. First, we investigate the relationship
between agency costs and IB performance. Second, we investigate the primary determinants
of the dual board structure and the BOD’s and SSB’s reciprocal relationship. Finally, we
examine distinct agency relationships and limited and unlimited contractual roles.
Using a sample of 91 banks from 20 countries, this study analyses the influence of
agency cost and dual board governance (SSB and ordinary BOD). Empirical results indicate
that: first, agency costs represented by cast/TA have a negative significant influence on the
performance of IBs on ROE and net income. This implies that the financial performance of
IBs declines as agency costs rise. Second, SSB size and board independent have a significant
effect on the performance of IBs; the results of the study show that SSB size has a positive
influence on the performance of IBs. To improve the performance of IBs, increasing the
number of SBBs must be considered. A large SBB size will result in more optimal
supervision, thereby increasing customer confidence in the Sharia compliance of the
products offered. It is anticipated that the presence of SSB in IBs, which distinguishes them
from conventional banks, will play a significant role in determining the role and activities of
IBs.
Our research has several policy and practical implications for central banks and IBs in
various countries. Regulatory authorities can take appropriate initiatives to ensure Sharia
compliance and protect the independence of Shariah department officers of IBs by outlining
appropriate regulatory guidelines and reporting systems. Regulators and relevant
stakeholders need to ensure an appropriate working environment for Sharia department
executives to maintain Shariah compliance, audits, inspections, reporting and accurate
disclosure issues of IBs.
These findings contribute to a better understanding of the relationship between agency
cost, dual board governance and financial performance in IBs; for the first time, IB data
provides new empirical evidence on agency cost, dual board governance and financial
performance in IBs in various countries. Kami emphasized the unique agency relationship
between Islamic institutions. We discovered that larger SSBs can decrease agency expenses.
Our study has several policy consequences. To begin with, we urge regulators to expand
SSBs by using qualified academics in an effort to decrease agency relationships. On the
contrary, larger SSBs have the resources necessary to evaluate the Shariah compliance of
new Islamic financial instruments. Islamic banking regulators can encourage and support
the establishment of professional institutions that train scholars to recognize, comprehend
JIABR
and confirm the authenticity of Sharia-compliant financial products, particularly innovative
ones, to maintain confidence in IBs and their CG.
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Corresponding author
Early Ridho Kismawadi can be contacted at: kismawadi@iainlangsa.ac.id
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