Corporate Ethics: Evidence from Islamic Banks

Abstract

The purpose of this study is to investigate whether banks’ management behavior is related to corporate ethics. We employ earnings-management and expense-preference measures to evaluate management behavior. Using a very large sample of banks from 15 countries and controlling for a number of bank- and country-level factors, we find that managers in Islamic banks are less likely to engage in unethical business practices compared to those in commercial banks. We also document that Shari’ah supervisory boards embedded in Islamic banks affect and shape managerial behavior and mitigate agency problems. These results establish a link between corporate ethics and management behavior through Shari’ah and Shari’ah supervisory boards.

Introduction

Ethical corporate governance has increasing influence on the global economy and various social issues. However, many shareholders, blockholders, and stakeholders are losing confidence in companies’ abilities to behave ethically, in turn affecting market values. As a result, strong corporate governance (hereafter, CG) mechanisms have become important to reduce moral-hazard problems. Despite the variety of CG mechanisms, they can work simultaneously as one system to ensure effective CG within firms. CG literature typically concentrates on two issues that shape the behavior of corporate managers. The first issue involves possible solutions to the threats shareholders might face, such as takeover models, blockholder models, board models, executive compensation models, and multiconstituency models (Becht and Barca 2001). The second provides CG theory based on the agency theory and the stakeholder theory (Lewis 1999). Though thorough, the literature does not address the importance of CG mechanisms in organizations that follow religious guidelines and whether those guidelines affect financial performance or ethical behaviors among managers, however. Given the importance of CG mechanisms, one might question whether religious organizations with strict codes of ethics drive better management behavior. This paper contributes to the literature by focusing on organizations that follow Islamic jurisprudence (hereafter, Shari’ah). The process of promoting and implementing Islamic ethical principles in such organizations requires strict adherence to religious rulings issued by a second board, the Shari’ah supervisory board (hereafter, SSB). These formal initiatives have to be endorsed by the board of directors (hereafter, BOD) and stakeholders to implement them properly (Quttainah et al. 2013). Such process thus is a major factor in controlling and addressing ethical issues in corporations (Vitell and Hildago 2006). The practice also shows that institutionalizing ethics can occur via a permanent, board-level committee responsible for setting ethics policy, issuing ethics rules, organizing ethics training, reinforcing employees’ organizational commitment, and encouraging an ethical organizational culture (Sim 1991). These actions also create awareness about ethics and promote ethics as part of corporate governance. However, Islamic banks (hereafter, IBs) that embed SSBs may not require such board-level committees to ensure the implementation of policy and ethics (Quttainah et al. 2013). 

Objectives

• First, no prior study examines whether Shari’ah reinforces ethical standards in business and hence influences management behavior. Rather, prior research focuses on the association between management behaviors and corporate governance (e.g., Westphal and Zajac 2013; Filatotchev and Nakajima 2014; Peters and Romi 2014). Corporate governance would be less relevant if managers always behaved ethically (Labelle et al. 2010). However, regulations on corporate governance must change overtime to hinder managers’ unethical business practices. Unlike References CBs, however, IBs have an ethical identify based on Shari’ah law (Haniffa and Hudaib 2007).

• Second, because our sample is large in terms of number of banks, number of countries, and number of years covered, our findings should be representative for a large number of banks around the world. In addition, when we include other corporate governance mechanisms (e.g., BOD characteristics) in our empirical models, we s?ll find a strong link between Shari’ah and management behavior. We conclude that the impact of Shari’ah-based ethical values on management behavior is not subsumed by other factors discussed in prior literature.

• Furthermore, as our empirical tests control for BOD characteristics, we report that IBs with SSBs exhibit an almost nonexistent probability of unethical business practices by managers. All of these findings emphasize the need for IBs to invest more in SSBs (e.g., independence and competence of SSB members).

Method

• We employ earnings management and expense preference as proxies to measure unethical behavior among managers. Our empirical analysis consists of two measures of earnings management. The first is managing earnings for loss avoidance. Bank managers have incentives to manage earnings (Altamuro and Beaby 2010; Beaby et al. 2002), and empirical evidence (Degeorge et al. 1999; Burgstahler and Dichev 1997) indicates that loss- avoidance is an important benchmark for managers. Consequently, we define loss avoidance (LossAvoid) as an indicator equal to 1 if a bank has a small ROA (income before taxes scaled by total assets) between 0 and 0.01; LossAvoid equals 0 otherwise (Kanagaretnam et al. 2010).

• Abnormal (discretionary) loan loss provision (ALLP) is our second earnings- management measure of managers’ unethical business behavior. It is widely used in banking for earnings management and is the absolute value of the residual.

• Our second proxy for unethical behavior among managers, expense preference, is based on the notion that some managers tend to spend more money on items within their control to maximize their personal wealth at the expense of shareholders. To measure this behavior, we use the noninterest expense (NIExp) ratio, measured as the sum of all noninterest expenses (e.g., salaries, wages, office expenses, and other related expenses) scaled by lagged assets (Johnson 1993; Srinivasan and Wall 1992).

• We deploy for both measures OLS cluster robust standard-error estimation regressions.

Results

Findings indicate that IBs are less likely to demonstrate ethically unacceptable behavior, measured by earnings- management and expense-preference behavior, compared to CBs.

• The results show that IBs are about 11–22 % less likely than their counterparts to use earnings loss-avoidance techniques, depending on different model specifications.

• In addition, the average abnormal loan-loss provision of IBs is about 1 % lower than that of CBs.

• The results are both statically and economically significant, indicating Shari’ah effectively constrains earnings-management behaviors in IBs.

• We also find that the effectiveness of IBs that do not integrate SSBs suffers due to the centralization and delays of issuing religious rulings (Shari’ah compliance reports), providing more leeway for managers to manage earnings and demonstrate expense-preference behaviors.

• We find that several SSB characteristics are important determinants of earnings-management and expense-preference behavior for IBs that embed SSBs.

Conclusion

This paper examines whether IBs, which operate in one of the most heavily regulated industries, follow strict codes of ethics, and deploy contemporary and religious corporate governance, improve and sustain ethical management behaviors. Using a large sample of banks from 15 distinct countries and employing different measures of management behavior, we find that moral and ethical conformity to Shari’ah makes managers of IBs less likely than CB managers to engage in unethical business practices, as measured by expense-preference behavior and earnings management.

Moreover, in the context of earnings management and expense-preference behavior, we find that IBs with SSBs adhere to ethical standards better than IBs with no SSBs. The results show that IBs with SSBs significantly monitor managers’ behavior; provide substantial advice to their BODs, managers, and employees; and are more efficient than IBs without SSBs. Hence, findings are important to generalize and implement here in the State of Kuwait. Generalizing and passing legislative laws to engage the SSBs within the Islamic and traditional business boost morale and ethical standards.