Voluntary Corporate Governance Disclosure Practices of Islamic Banks in the

Southeast Asian and the Gulf Cooperation Council Regions

ABSTRACT

This study explores the determinants of voluntary corporate governance disclosure practices

of Islamic banks in the Southeast Asian and Gulf Cooperation Council regions. The empirical

procedures involve a cross-sectional analysis of the annual reports of 67 Islamic banks from

these two regions in 2009. We find that the level of corporate governance disclosures in

annual reports is less than 50 percent. The findings from our study also reveal that a

combined corporate governance index is positively related to voluntary corporate governance

disclosures. Additionally, voluntary corporate governance disclosures are also found to be

negatively associated with the level of political and civil repression, and positively associated

with Islamic banks located in code law countries. Our results inform the global debate on the

need for corporate governance reform by Islamic banks by providing insights on the part

played by corporate governance mechanisms in encouraging enhanced disclosure in the

annual reports of Islamic banks.

Key words: Corporate governance; Shari’ah Supervisory Board; Islamic Banks; Disclosure

JEL classification: M14, M40, M41, M48, P48, Z12

1

Voluntary Corporate Governance Disclosure Practices of Islamic Banks in the

Southeast Asian and the Gulf Cooperation Council Regions

1. Introduction

In the years 2008 and 2009, while the finance world was in crisis due to banking failures, the

Islamic banking systems were said to have remained resilient (Perry, 2011). Perry (2011)

suggests that elements in the governance systems of Islamic banks may have protected them

from the problems faced by conventional banks. However, at the same time, it has been

argued that Islamic banks are not immune to corporate governance failures due to incidences

of collusion between the board of directors and management, audit failure and excessive risk-

taking by management (Grais and Pellegrini, 2006a, Ginena, 2014).1 Of further concern is the

additional layer of corporate governance in Islamic banks in the form of Shari’ah2

governance, which has raised questions of efficiency (Van Gruening and Iqbal, 2008). Added

to this, the use of mudarabah investment accounts (IAs)3, as a form of financing based on

profit sharing, imposes a unique set of risks not present in conventional banking.

A key mechanism of Shari’ah governance is the Shari’ah Supervisory Board (SSB) (Grais

and Pellegrini, 2006a). The SSB assists Islamic banks to manage their funds efficiently while

at all times complying with Shari’ah (Khir et al., 2008). Failure to comply with the principles

of Islamic finance could expose Islamic financial institutions to reputational risk, not only to

that institution, but also to the Islamic finance industry as a whole (Besar et al., 2009; Grais

and Pellegrini, 2006a). Stakeholders, such as investors and depositors, rely on the SSB to

make sure that their investments are mobilised in accordance with Shari’ah (Van Gruening

and Iqbal, 2008). While SSBs are currently self-regulating, the Accounting and Auditing

1There are three well-known cases of financial distress relating to Islamic finance, namely, the collapse of the Bank of Credit

and Commerce International (BCCI) in 1991, which affected several institutions that offer Islamic financial services; the

collapse of Ihlas Finance House of Turkey in 2001; and the failure of the Patni Cooperative Society of Surat, India in 2003

(Grais and Pellegrini, 2006b). 2Shari’ah is Islamic religious law derived from the Qur’an and the teaching of the Prophet Muhammad (peace be upon him).

Shari’ah is regarded as the legal and ethical rules to guide a Muslim in life (Thani et al., 2003). 3 Mudarabah is identified as trust financing, trustee profit sharing, equity sharing, sleeping partnership, dormant partnership

or profit sharing (Thani et al., 2003; Venardos, 2005). The mudarib, as an entrepreneur, runs the business using the money or

property provided by the rabb al-mal (capital provider). The mudarib returns the investment to the rabb al-mal together with

a share of the profit according to the profit ratio that is fixed at the time of the contract (Tamer, 2005). In order to avoid

inefficiency, the rabb al-mal is not allowed to intervene in the business operations. However, they are able to perform

follow-up or supervisory tasks (Mirakhor and Zaidi, 2007; Thani et al., 2003; Venardos, 2005) in order to oversee their

investment venture.

2

Organisation for Islamic Financial Institutions (AAOIFI) is drafting a standard to regulate

them (Richter, 2010). However, as yet, no standard has been released.

Given the unique characteristics of Islamic banks, the quality of corporate governance

disclosure is extremely important in order to maintain stakeholders’ confidence in their

financial systems. Failure to maintain this confidence can lead to stakeholders reacting

negatively, for example, depositors and investors withdrawing their investment (Chapra and

Ahmed, 2002). Hence, the objective of this study is to examine the extent of corporate

governance disclosures in the annual reports of Islamic banks and to explore the determinants

of such disclosures.

Our sample comprises 67 Islamic banks in the Southeast Asian (SEA) and the Gulf

Cooperation Council (GCC) regions. The selection of these regions is justified on a number

of grounds. They are among the most progressive regions in Islamic finance, being among

the first to establish Islamic banks. Moreover, in these two regions, organisations such as the

AAOIFI, the Institute of Corporate Governance and other bodies4 have been established to

support the development of Islamic finance (Matoussi and Grassa, 2012). As a result, it is

expected that Islamic banks in these regions should have relatively high standards of

disclosure. In fact, the AAOIFI standards have been adopted, adapted, or recommended in

most of the countries in the SEA and GCC regions, for instance, Malaysia, Indonesia, the

United Arab Emirates (UAE), Saudi Arabia, Bahrain and Qatar (Grais and Pellegrini, 2006b).

Our study is also motivated by the fact that most prior research on corporate governance

disclosures of Islamic banks is based on samples from a single country (Abdeldayem, 2009;

Abuhmaira, 2006, Majid et al., 2011) although similar characteristics and values are upheld

by Islamic banks worldwide. We extend prior studies by developing corporate governance

disclosure indices specific to Islamic banks which can be applied across jurisdictions.

Subsequently, we explore the association between the extent of these disclosures and the

characteristics of Islamic banks as well as societal variables5 surrounding the banks. Among

4 The Liquidity Management Centre, the International Islamic Financial Market, the Islamic International Rating Agency,

the Islamic Financial Services Board (IFSB) and the Hawkamah (the Institute for Corporate Governance). 5Thomas (1991, p.42) defines societal variables as “factors to which all enterprises within a particular country are subject

and which vary between nations”.

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the factors that make our study different from past studies is our focus on corporate

governance, Shari’ah governance and mudarabah investment account holders (IAHs).

Our findings reveal that the level of voluntary corporate governance disclosure of Islamic

banks in the SEA and GCC regions averages only 37.007 percent. We also find that strong

corporate governance, measured by a corporate governance index, is positively associated

with the level of voluntary disclosure. Further, the results reveal that banks in code law

countries have higher levels of voluntary corporate governance disclosures while voluntary

disclosures are negatively associated with the level of political and civil repression.

Generally, the results suggest that agency theory can be used to partially explain the

relationship between Islamic bank characteristics such as governance strength and managerial

decisions on voluntary corporate governance disclosures.

The study makes a number of key contributions. It provides evidence on the extent of

corporate governance disclosures and their relationship with Islamic bank characteristics and

societal variables. We also develop a corporate governance disclosure index specifically for

Islamic banks. Our findings have implications for several stakeholder groups. The results

should be of interest to Islamic bank managers, central banks, and regulators and accounting

policy makers internationally and in the nine countries in the study. Other stakeholders (for

instance, zakat6 payers, zakat beneficiaries, IAHs, creditors, customers and the Muslim

population) should also benefit from the findings of this study in their demand for useful

information.

The remainder of the paper is structured as follows. Section 2 discusses the need for different

Islamic accounting practices and corporate governance structures for Islamic banks. Section 3

develops the hypotheses. Section 4 outlines the research method while section 5 discusses the

results. Section 6 contains some concluding comments.

6Zakat is a compulsory levy that must be allocated from the well-to-do among the Muslim society to the beneficiaries

specified according to Shari’ah.

4

2. The need for different Islamic accounting practices and corporate governance

structure for Islamic banks

Islamic banks are established to fulfill the need of Muslims to conduct transactions under the

framework of the Shari’ah (Gambling and Karim, 1986; Antonio, 2001). Accordingly,

interest is avoided in the operation of such institutions. The main concept that underlies the

existence of Islamic banks is the prohibition of riba. Riba has a broader meaning than merely

“usury” or “interest” (Tamer, 2005). Due to the stringent prohibition of riba in Islamic

finance, the capital structure of an Islamic financial institution must preclude riba-bearing

financing, such as preference shares, debentures, riba-leasing transactions, notes payable,

notes receivable and bonds (Haniffa and Hudaib, 2004; Sulaiman, 2003). These interest-

bearing instruments are replaced by profit and loss sharing agreements such as mudarabah.

The existence of these financial instruments leads to the requirement for different reporting

practices by Islamic banks.

Islamic banks self-regulate their financial reporting to avoid attempts by the regulatory bodies

to mandate accounting standards for their banking operations (Karim, 1990). Concern that a

regulatory board might issue accounting standards and rules that were incompatible with

Islamic banking operations led to the establishment of the AAOIFI to develop accounting

standards for Islamic banks. AAOIFI standards aim to promote comparability and

transparency of financial statements in order to enhance public trust in Shari’ah investment

vehicles. Prior to the issuance of the AAOIFI standards, Islamic banking faced problems of

inconsistent accounting practices, lack of transparency and non-comparability. Even the

International Accounting Standards (IASs) are considered inadequate to cope with the

demands of Islamic bank financial statement users (Hameed, 2007). Indeed, the AAOIFI has

contributed to the development of an accounting system that is more in line with the precepts

of Shari’ah, particularly with regards to promulgating accounting standards to be adopted by

Islamic banks.

From a corporate governance perspective, Safieddine (2009) argues that Islamic financial

institutions face additional agency problems beyond what is normally encountered in

traditional banks. The need for good corporate governance is even more relevant for Islamic

banks due to a number of factors. First, the issue of the separation of ownership and control,

which underlies agency theory, becomes greater for Islamic banks as compared to

conventional banks. In addition to their responsibility to maximise shareholders’ wealth,

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managers of Islamic banks must make sure that they carry out their dealings in compliance

with Shari’ah (Archer et al.,1998; Safieddine, 2009; Sarker, 2000). Shari’ah non-compliance

could impair the reputation of the bank and potentially lead to a loss of customers. Chapra

and Ahmed (2002) reveal that depositors in Islamic banks in Bahrain and Sudan are willing

to withdraw their deposits if they find cases of non-compliance. According to Hasan (2008),

and Bhatti and Bhatti (2009), the corporate governance model for Islamic banks should be

based on: 1) the Islamic principle of property rights7 and contracts; 2) compliance with

Islamic law; and 3) the protection of the rights of stakeholders, including management,

shareholders, employees, suppliers, depositors and also the community. The distinctive

characteristics of Islamic banks must be acknowledged in order to provide regulatory

infrastructure that supports the growth of corporate governance mechanisms in the institution

(Grais and Pellegrini, 2006a).

Islam recognises that individuals are accountable to God for the resources entrusted to them

and they therefore need access to information that enables them to make sound economic and

business decisions (Abu-Tapanjeh, 2009). Following the broader stakeholder model of

Islamic corporate governance, we argue that the accountability of financial institutions to a

broad group of stakeholders requires an ethos of enhanced disclosure and transparency in

their corporate reports (Deegan, 2002; Islam and Deegan, 2008). Further, a lack of

transparency in this regard could lead to information asymmetry between the bank and its

stakeholders, exposing the bank to the risk of gharar.8

AAOIFI GSIFI 2: Shari’ah Review, particularly emphasises the role of the SSB in corporate

reporting reviews, which include the review of “contracts, agreements, policies, products,

transactions, memorandum and articles of association, financial statements, reports

(especially internal audit and central bank inspection), circulars, etc.” (paragraph 3). By

reviewing the financial reports, the SSB is expected to exert some influence on the disclosure

aspects of Islamic banks. Farook et al. (2011) found that the combined characteristics of the

SSB (proxied by the existence of the SSB, SSB size, SSB’s multiple memberships, doctoral

7The fundamental principles of property rights in Islam are that (1) the rights to the property must be in accordance with

Shari’ah, (2) the enjoyment of the right to the property must be balanced with the rights of the society, community and the

state on the property (Hasan, 2008), (3) individuals and society are regarded as stakeholders to the property, and (4) the

Islamic law recognises the rights of the stakeholders (Hasan, 2008, 2009; Iqbal and Mirakhor, 2004). 8Gharar depicts negative elements, such as deceit, dishonesty, fraud, uncertainty, danger, speculation, cheating, risk, peril

and hazard that might lead to destruction and loss (Algaoud and Lewis, 2007; El-Gamal, 2006; Iqbal and Molyneux, 2005;

Shariff and Abdul Rahman, 2004; Tamer, 2005; Venardos, 2005).

6

qualifications of SSB members and reputable scholars as SSB members) influence the level

of corporate social responsibility (CSR) disclosure in Islamic banks.9 The authors use both

legitimacy theory and agency theory to explain the incentives for CSR disclosures. In Islam,

Islamic related information must be disclosed regardless of whether it can be quantified.

Thus, to fulfil the objective of enhanced disclosure, social and environmental information,

information on zakat and transactions involving riba, information on halal dealings, and

information relating to the community, debtors, employees and products should be disclosed

(Mirza and Baydoun 2000; Haniffa, 2002).The same applies to corporate governance

disclosure, with information about Shari’ah governance being part of an enhanced disclosure

concept. The analytical disclosure literature suggests that full disclosure is unlikely to prevail

as an equilibrium (Grossman, 1981; Milgrom, 1981; Verrecchia, 1983). Moreover,

strengthening stakeholders’ confidence in relation to Shari’ah compliance is important to an

Islamic financial institution.10

In view of the above, if the SSB is to fulfil its role as a

Shari’ah review mechanism, it should encourage management to be transparent. An Islamic

financial institution has an obligation to disclose relevant information to its stakeholders,

regardless of whether the disclosure could lead to a negative impact on the institution’s

operations (Maali et al., 2006).

3. Development of research questions and hypotheses

Given the discussion in the previous section, we draw on both agency theory and stakeholder

theory to explain the corporate governance disclosure practices of Islamic banks.

9 The study examined 47 banks from 14 countries as follows: Bahrain (6), Bangladesh (5), Egypt (1), Iran (4), Jordan (2),

Kuwait (5), Malaysia (2), Pakistan (8), Qatar (2), Saudi Arabia (5), Sudan (1), Turkey (2), United Arab Emirates (3), and

Yemen (1). 10Chapra and Ahmed (2002) found that 81.7 percent of the surveyed depositors in Islamic banks in Bahrain will punish

Islamic banks by moving their funds to another Islamic bank if they find that the bank does not comply with Shari’ah, and

76.8 percent will move to another Islamic bank if they find that the Islamic bank is involved with interest (riba).

Safeguarding depositors’ interest is important, not only for the survival of banks, but also to maintain systemic financial

stability. Chapra and Ahmed (2002) proposed a few devices for safeguarding depositors’ interests: i) regulatory authorities

should select a representative on the board to act for depositors; ii) the establishment of a depositors’ association to protect

their rights; iii) specialised Shari’ah expertise firms to watch over the interest of depositors; or iv) appoint external auditors

to protect depositors in a similar way to how auditors safeguard the interest of shareholders.

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3.1. Corporate governance strength

In this sub-section we discuss some characteristics of corporate governance mechanisms

which are expected to influence the level of corporate governance disclosure. Our focus is on

board independence, board size, the separation of the roles of board chair and CEO, audit

committee independence, audit committee size and audit committee financial expertise.

The composition of the board generally, and the role of outside directors specifically, are

frequently examined because they play an important role in controlling owner-manager

conflict that will reduce agency costs (Hermalin and Weisbach, 2003). Beasley (1996)

provides evidence that the higher the proportion of outside directors on the board, the lower

the possible risk of fraud incidence. The evidence of an association between board

independence and disclosure is mixed. Board independence is found to be positively

associated with corporate governance reporting (Ben-Amar and Boujenoui, 2007; Bujaki and

McConomy, 2002; Parsa et al., 2007), suggesting that, as board independence increases, there

is a greater awareness of the need to disclose more corporate governance information to

investors. Chen and Jaggi (2000), in a Hong Kong study, argue that board independence

could increase monitoring capabilities and eventually adoption of disclosure requirements.

Accordingly, we hypothesise that board independence will enhance the extent of corporate

governance disclosure in Islamic banks.

It is argued that board size influences the monitoring quality of the board of directors

(Chiang, 2005; Anderson et al., 2004; Williams et al., 2005). Larger boards could incorporate

more representatives from different stakeholders groups and thereby provide a greater

breadth of experience, expertise and specialised skills (Chaganti et al., 1985; Klein, 2002;

Williams et al., 2005). Chiang (2005) voices concern that issues will not be sufficiently

discussed in a small board. In their study of the transition to International Financial Reporting

Standards (IFRS) by Australian listed companies, Kent and Stewart (2008) find that a greater

level of disclosure information is associated with larger boards. On the other hand, Anderson

et al. (2003), in their United States (US) study, find that the market does not react to earnings

surprises conditioned on the size of the board. Zaluki and Wan Hussin (2009) reveal that

board size is not associated with the quality of financial disclosures in initial public offering

(IPO) companies in Malaysia. Beasley (1996) finds that financial statement fraud in US

companies increases as board size increases. His result supports the contention of Jensen

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(1993) that a smaller board provides a better controlling function while companies with a

larger board have a tendency to be controlled by CEOs. However, due to the concerns of

Islamic banks in safeguarding stakeholders’ rights, we argue that boards should be larger in

order to represent the broader group of stakeholders in accordance with the Islamic corporate

governance model, as suggested by Hasan (2008) and Bhatti and Bhatti (2009). In addition,

Zahra and Pearce (1989) argue that a larger board would dilute the power of the CEO on the

board and increase the independence of the board. Therefore, we maintain that larger boards

are better equipped with skills and experience as well as providing greater representation of

stakeholders, thereby enhancing monitoring quality in Islamic banks.

It is also argued that separating the roles of CEO and board chair enhances the effectiveness

of corporate mechanisms and accordingly improves firm performance. Failure to separate

these roles (CEO duality) can lead to a concentration of power (Beasley, 1996; Davidson et

al., 2005). For example, the CEO/chair will control board meetings which are supposed to

review his/her performance. There is also an increased risk that the CEO/chair could act in

his/her own personal interest (Jensen, 1993), creating agency conflicts (Booth et al., 2002).

The separation of the roles of board chair and CEO is also considered to be part of the board

independence characteristics (Brickley et al., 1997). In addition, arguments regarding

separation of CEO and board chair have enhanced applicability to Islamic banks, due to the

additional agency relationships. Hence, we argue that separating the roles of CEO and board

chair will improve the level of corporate governance disclosure in Islamic banks.

The responsibilities of the audit committee include recommending the appointment of the

external auditor, overseeing the audit and assuring the credibility of financial reporting

(Menon and Williams, 1994). Beasley et al. (2000) and Abbott et al. (2000) note that ‘fraud’

companies have less independent audit committees than ‘non-fraud’ companies Similar to

Menon and Williams (1994), we posit that an audit committee should comprise entirely of

independent directors to be more effective. In fact, the SEC warns that an audit committee

with inside directors is worse than no audit committee at all (Collier and Gregory, 1999)

because the benefit of an independent check is lost.

DeZoort et al. (2003) suggests that audit committee members with background experience in

financial reporting and auditing, especially those who are certified public accountants

(CPAs), understand auditors and are more supportive of auditors as compared to audit

committee members who have no similar experience. Experience in accounting, internal

9

control or auditing is therefore considered fundamental to enable the audit committee to

understand and oversee the financial reporting system of the company. DeZoort (1998)

contends that audit committees with more internal control experience makes decisions or

judgments similar to auditors as compared to those without experience. Accordingly, we

expect that having an audit committee with financial expertise leads to an improvement in the

level of corporate governance disclosure.

Anderson et al. (2004) find that the cost of debt is negatively related to audit committee size.

Audit committees have many responsibilities, for instance, overseeing the audit process,

management and internal audit. Similar to the arguments relating to the board of directors, the

larger the audit committee, the more responsibility that could be delegated to the committee.

Thus, larger audit committees could lead to a higher level of transparency, thus providing

stronger monitoring (Davidson et al., 2005; Anderson et al., 2004).

The present study uses a combination of six factors to investigate the role of corporate

governance in Islamic banks. By combining the six factors, the study applies a similar

methodology to that used by Yeoh and Jubb (2001), Nelson (2007), Brown and Caylor

(2006), Gompers and Metrick (2003) and Coulton and Taylor (2001). Arcay and Vazquez

(2005) argue that analysing individual corporate governance mechanisms does not provide a

full assessment of the corporate governance role in promoting transparency. Furthermore,

there are other disadvantages in using individual corporate governance mechanisms because

the mechanisms sometimes complement or substitute for each other. A corporate governance

measure could offset or interact with other corporate governance measures (O’Sullivan,

2005). For instance, the effectiveness of the audit committee depends on both the board

composition and background of directors (Peasnell et al., 2000; Vicknair et al., 1993). Thus,

to mitigate the problems, an overall corporate governance score is calculated for Islamic

banks (the score will be subsequently referred to as corporate governance strength). This

leads to the following hypothesis:

H1: A positive association exists between corporate governance strength and the extent of

voluntary corporate governance disclosure of Islamic banks.

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3.2. SSB strength

We can observe three SSB characteristics that may influence corporate governance

disclosures, i.e. SSB size, SSB cross memberships and SSB financial expertise. Firstly, we

expect the size of the SSB to influence the extent of corporate governance disclosures. Islam

encourages discussions, meetings and co-operation in reaching a decision. Therefore, we

argue that a larger SSB enables the functions and duties of the SSB to be delegated and

allocated among the members. Accordingly, certain members will have the time to review

and deliberate on issues relating to corporate reports. Large SSBs, with multiple perspectives

as well as educational and industry experience, would be expected to drive better governance

on Shari’ah and provide a closer review of corporate reporting, including various facets of

corporate governance disclosures. By having a larger SSB, Islamic banks should be better

able to respond to their diverse stakeholders. As a deterrent mechanisms against Shari’ah

non-compliance, the SSB plays an important function in monitoring corporate governance

disclosures, particularly Shari’ah related disclosures. The IFSB (2006a) proposed that the

SSB should work together with the audit committee of Islamic banks as well as with the

governance committee.

Multiple cross-memberships arise when a SSB member sits on several SSBs. We suggest that

cross-memberships provide members of the SSB with more experience, enabling them to

make comparisons of best practices among Islamic banks. We acknowledge that sitting on

multiple boards can increase the risks of conflict of interest and confidentiality (Unal, 2011)

as well restrict the amount of time a SSB member can devote to each board. As a result, the

AAOIFI has considered issuing guidelines on the number of boards on which an SSB

member can serve (El Baltaji and Anwar, 2010). However, other scholars argue against

restricting the membership of the SSB, claiming that the restriction could limit the growth of

the $1 trillion Islamic finance market. Currently, regulators are struggling to set-up global

standards for the SSB (Richter, 2010). Many argue that Islamic banks do not have a sufficient

pool of talent to meet the demand of new Shari’ah-compliant instruments (El-Baltaji and

Anwar, 2010; Richter, 2010; Van Gruening and Iqbal, 2008). Apprenticeship of junior

scholars to senior scholars is a way to train junior scholars until the formal training programs

are established (Richter, 2010). As suggested by the proponents of interlocking directorships

(Dahya et al., 1996), we suggest that SSB members with multiple memberships will have a

better understanding of corporate governance practices, particularly those specific to Shari’ah

11

governance. Hence, we include multiple cross-memberships as a characteristic that should

enhance corporate governance disclosures.

We argue that Shari’ah scholars with accounting, banking, economic or finance expertise

could influence corporate governance disclosure. Our argument is similar to the arguments on

audit committee expertise (Abbott et al., 2003; Bédard et al., 2004; Kent and Stewart, 2008).

Members with this type of expertise are more likely to understand the importance of

disclosure to stakeholders and would be expected to recommend enhanced disclosure during

their Shari’ah review procedure on the financial reports of Islamic banks.

We adopt a similar methodology to that of Farook et al. (2011), using a specific SSB score

based on the above-discussed characteristics of the SSB. The following hypothesis is tested:

H2: A positive association exists between SSB strength and the extent of voluntary corporate

governance disclosure of Islamic banks.

3.3. Mudarabah investment account (IA)

As noted, Mudarabah is a contract between capital owners or financiers (known as rabb al-

mal) and an investment manager (known as mudarib). The rabb al-mal entrusts their capital

to the mudarib who runs the business using the funds provided. The mudarib returns the

investment to the rabb al-mal together with the profit determined by the profit ratio fixed at

the time of the contract (Tamer, 2005). The aim of this type of financing is to align the needs

of owners of capital (but with no opportunity or expertise to carry out a business) with those

of the entrepreneur who has the opportunity, labour and skills but insufficient funds to carry

out the project.

An IA contract creates agency problems between Islamic bank managers, shareholders and

IAHs, by potentially providing opportunities to manipulate returns at the expense of IAHs

(Archer and Karim, 2002, 2006; Errico and Farahbaksh, 1998; Karim, 2001). The

fundamental tenet in mudarabah is the segregation between the contribution and management

of funds. In the agency structure of an Islamic financial institution, bank managers act as

agents of shareholders as well as IAHs. However, the contract of mudarabah does not allow

IAHs to intervene in the decision making of Islamic banks. Thus, IAHs have no authority to

select or fire the management, the board, the SSB or the external auditors. Although there is a

similarity in the agency relationships of management-IAHs and management-shareholders,

12

IAHs risk more of their investment than shareholders. Additionally, according to Safieddine

(2009), the issue of the separation of control rights and cash flows for IAHs affects the

agency relationships in Islamic banks. Although the IAs constitute a major part of Islamic

bank funds, IAHs are not given the rights to control the behaviour of managers.

Moreover, the capital of IAHs and their return of income are not fixed and guaranteed even

though they share the risks as the shareholders do. Dissatisfied IAHs will display their

dissatisfaction by withdrawing their funds (Archer et al., 1998). Thus, this situation presents a

unique Islamic bank agency theory problem which does not occur in conventional banks

because deposits in these banks are generally insured and the interest rate is pre-determined

in advance (Chapra and Ahmed, 2002).11

There are also arguments that management will

favour one stakeholder group at the expense of another, for instance, distributing profits to

shareholders at the expense of IAHs (Al-Baluchi, 2006). Shareholders are said to be able to

influence the decisions of the management of Islamic banks, although the same privilege is

not given to IAHs (Archer et al., 1998).

The inability of stakeholders (particularly IAHs) to observe how profit is being calculated in

determining distributions presents another fundamental agency problem (Mustafa, 2003).

Risk increases when managers are allowed to commingle IAHs’ funds with shareholders’

funds for investment in the same portfolio (Archer and Karim, 2006; Hameed, 2007; Karim,

2001; Safieddine, 2009). This situation further impedes the process of transparency and the

reliability of financial information, and hampers the ability of investors to assess the bank’s

actual performance (Archer and Karim, 2002; Karim, 2001). Thus, the concern of lack of

protection for IAHs necessitates Islamic banks providing more transparent disclosures

beyond what is required, as compared to conventional banks (Sundararajan and Errico, 2002).

Al-Baluchi (2006) also contends that mudarabah contracts, with features of profit sharing,

require disclosure of information above what is normally mandatory. The risks with IAs

could be reduced by disclosing relevant information such as profit-and-loss sharing ratios and

cost allocations on the IA as well as disclosures on corporate governance mechanisms to

11In conventional banks, deposits are insured and depositors are guaranteed a positive return on their investment. Thus

depositors are safeguarded against any possible loss. However, in Islamic banks, guaranteeing the deposit is in conflict with

the basic principles of Islamic finance whereby profit cannot be determined in advance. Investment depositors have to share

the profit and loss as the shareholders do. Furthermore, the IA contract disallows insurance protection (Chapra and Ahmed,

2002).

13

portray the effectiveness of the role played by management in the governance of Islamic

banks.

Al-Baluchi (2006) finds that there is a positive relationship between the proportion of the

IAHs funds to total financing and voluntary disclosure. Farook et al. (2011) also find a

significant positive association (at a 10% level) between the level of CSR disclosure and the

ratio of IA funds to paid-up capital. This association reflects the effort of Islamic banks to

strengthen their relationship with mudarabah IAHs via more extensive disclosure.

Similar to the arguments of Farook et al. (2011) relating to CSR disclosure, we argue that

Islamic banks will increase corporate governance disclosures in order to strengthen their

relationship with IAHs. Thus, we hypothesise that the extent of corporate governance

disclosure will be an increasing function of the ratio of IA to equity:

H3: A positive association exists between the ratio of mudarabah IA to equity and the extent

of voluntary corporate governance disclosure of Islamic banks.

3.4. Size of Islamic banks

There is evidence of a positive relationship between disclosure and the size of the firm

(Ahmed and Courtis, 1999; Buzby, 1975; Chow and Wong-Boren, 1987; Cooke, 1989;

Hamid, 2004; Hossain et al., 1995; Raffournier, 1995). These positive relationships are

mainly due to the economies of scale enjoyed by larger firms, which indicate the ability of

larger firms to publish information at a lower cost (Ben-Amar and Boujenoui, 2007; Buzby,

1975; Singhvi and Desai, 1971; Watts and Zimmerman, 1978). The relationship between firm

size and corporate governance disclosures are expected to be positive as evidenced in

Andersson and Daoud (2005), Ben-Amar and Boujenoui (2007), Bujaki and McConomy

(2002) and others.12

With respect to the association between corporate governance disclosure

quality and size, Islamic banks are predicted to behave similarly to other types of entities.

This leads to the following hypothesis:

12 Carson (1996), Hossain (2007), Kusumawati (2006) and (2007), Labelle (2002), Ntim et al. (2012), Pahuja and Bhatia

(2010) and Parsa et al., (2007).

14

H4: A positive association exists between bank size and the extent of voluntary corporate

governance disclosure of Islamic banks.

3.5. Level of political and civil repression

According to Iqbal (2002), accounting is influenced by environmental factors such as the

economic system, the political system, the legal system, the education system and religion. In

turn, the economic, political and civil systems are closely related and could be influenced by

the educational system. Williams (1999) and Farook et al. (2011) found that the political

system explains variations in corporate social and environmental disclosures between

countries. Both studies report the existence of significant relationships between political

rights13

and civil liberties14

variables (proxied by political rights and civil liberties index

scores from Freedom House) and the extent of disclosure. Stakeholders are bound to expect

more disclosure from countries with more political freedom and open communities. Thus, we

hypothesise that a higher level of corporate governance disclosures by Islamic banks are

associated with countries with more freedom and less repression.

H5: A negative association exists between the level of political and civil repression and the

extent of voluntary corporate governance disclosure of Islamic banks.

3.6. Legal system

The legal system could influence accounting and disclosure practices in a country. According

to Alrazi et al. (2011) and Van der Laan Smith et al. (2005), stakeholder relations are

reflected in the corporate governance structure of companies in code law countries. Ball et al.

(2000) also argue that companies in code law countries have objectives beyond wealth

maximisation (Alrazi et al., 2011; Kolk and Perego, 2010) and implement “a stakeholder

governance model” in their corporate governance structures (Ball et al., 2000, p.3), to meet

the demands for representation by stakeholder groups such as labour unions, banks and

13 Political rights are defined as “the rights of people to take a guaranteed role in deciding the political future of their own

society. In large states, this means voting directly on legislation or, more generally, electing representatives to legislate for

the people, and executives to administer the laws decided by such representatives (Gastil, 1981, p. 3).” 14Civil liberties are defined as “the guaranteed immunities of citizens from government interference with the expression of

opinion, or with political, religious, business, or labour organisations, and immunity from arbitrary imprisonment, torture, or

execution. Civil liberties imply the rule of law and the right to defend oneself before a court both from government and other

citizens (Gastil, 1981, p. 3).”

15

business partners (Ball et al., 2000). Therefore, the corporate governance structure of Islamic

banks in code law countries should reflect the importance of other stakeholder groups in

addition to shareholders and this, in turn, should impact the level of corporate governance

disclosure.

Given the arguments discussed above, it is expected that Islamic banks in code law countries

will disclose more corporate governance information compared to Islamic banks in common

law countries. We therefore test the following hypothesis:

H6: A positive association exists between Islamic banks located in code law countries and the

extent of voluntary corporate governance disclosure of Islamic banks.

4. Research method

The following model is used to test our hypotheses:

VCGDINDEX = α + 1CG_STRENGTH +2SSB_ STRENGTH +

3IAHEQUITY + 4SIZE + 5 POLICIV + 6LEGAL +

The variables are defined in Appendix A and explained in more detail below.

4.1. Dependent variable - VCGDINDEX

The extent of corporate governance disclosure is assessed against a disclosure index

developed based on a number of international corporate governance benchmarks including

the Organisation for Economic Co-operation and Development’s (OECD) Principles of

Corporate Governance (2004), the Basel Committee on Bank Supervision (BCBS) (2006)

Report, the AAOIFI’s Governance Standards for Islamic Financial Institutions (GSIFI) and

the IFSB’s “Guiding Principles on Corporate Governance for Institutions Offering Only

Islamic Financial Services (excluding Islamic Insurance (Takaful15

) Institutions and Islamic

mutual funds)”, other standards, codes, guidelines and past literature on corporate governance

15Takaful is an Islamic insurance company.

16

disclosures (See Appendix B).16

These disclosure items cover most aspects of corporate

governance disclosure, which are relevant to Islamic banks. While our focus is on those

disclosures that are not mandated in the respective countries in our study, we acknowledge

that the distinction between mandatory and voluntary disclosure is imprecise (Brown et al.,

1999).

Independent variables

Given the small sample size, the corporate governance characteristics are given equal

weighting and combined into a single score (CG_STRENGTH) in order to test H1. It is

argued that combined factors are able to provide a more complete picture of the corporate

governance mechanisms as a package and their effect on disclosure transparency (Arcay and

Vazquez, 2005). Each individual factor has been coded either as “0” or “1”. It is coded in

such a way to reflect that the higher the score, the stronger the corporate governance

mechanism. The SSB_ STRENGTH score is similarly developed by combining SSB size, SSB

cross-memberships and SSB expertise in accounting, banking, finance or economics,

enabling us to test H2. To test H3, IAHEQUITY is measured as the ratio of IA to equity while

H4 is tested using the natural log of total assets (SIZE). In order to test H5, we use a

combined index score of political rights and civil liberties (POLICIV) for the country where

each Islamic bank is located. The study utilises the scoring system by Freedom House (ranges

from 1 (freedom) to 14 (repression)), which is derived from the Universal Declaration of

Human Rights, adopted by the UN General Assembly in 1948. The research methodology

was developed by Raymond Gastil, a Havard-trained specialist in regional studies from the

University of Washington, Seattle in 1972. The scores are reviewed and modified every year

(Freedom House 2014a and 2014b). Finally, H6 is tested using the dichotomous variable

LEGAL which is coded 1 if the country of location is a code law country and 0 if it is a

common law country. This is based on the classification by Salter and Doupnik (1992).

16 An Islamic bank’s principal point of reference for corporate governance disclosure is the Governance Standards issued by

the AAOIFI. The governance standards on “Shari’ah Supervisory Board: Appointment, Composition and Report (GSIFI No.

1)” and the governance standard on “Shari’ah Review (GSIFI No. 2)” became effective starting from 1 January 1999; the

governance standard on “Internal Shari’ah Review (GSIFI No. 3)” became effective on 1 January 2000; the governance

standard on “Audit and Governance Committee for Islamic Financial Institutions (GSIFI No. 4)” has been applied from 1

January 2002; the governance standard on the “Independence of the Shari’ah Supervisory Board for Islamic Financial

Institutions (GSIFI No. 5)” has been applied from 1 January 2008; the Statement on Governance Principles for Islamic

financial institutions (GSIFI No. 6) was applied with effect from 21 November 2005 and the governance standard on

“Corporate Social Responsibility Conduct and Disclosure for Islamic Financial Institutions (GSIFI No. 7)” became effective

from 1 January 2010.

17

4.2. Sample and data description

According to Lee and Menon (2010), as at 2009, there were 628 Islamic financial institutions

globally. In this study, the sample of Islamic banks is selected from BANKSCOPE, which

provides a database of banks worldwide. This list is then compared to a list extracted from

the Islamic Financial Information Services (IFIS) database, which provides data for Islamic

banks. However, the combined BANKSCOPE and IFIS databases only generated a total of

157 Islamic banks in the listing17

. Of the 157 Islamic banks worldwide, there are 25 in the

SEA region and 52 in the GCC region. Similar to Farook et al. (2011), our definition of

Islamic banks includes commercial banks, service banks, investment banks, mortgage

companies, and mudarabah companies. These banks operate either as publicly listed

companies, private companies or government-linked companies. In the present study, no

distinction is drawn between the types of banks because all Islamic banks claim to comply

with Shari’ah.

Emails were sent to the banks to request their annual reports. Due to time and cost

constraints, only annual reports that are published in English are selected for the sample. Ten

annual reports from the GCC region were unavailable in English, reducing the sample from

this region to 42.

The year 2009 has been selected based on a few significant events in recent years that have

been argued to influence the corporate governance disclosure practices of Islamic banks.

First, the recent events involving the issuance of the various standards and guidelines by the

AAOIFI, the Basel Committee of Banking Supervision (BCBS) (2006) Paper, the OECD, the

IFSB and working papers by the OECD on corporate governance in the Middle East and

North Africa. Second, is the process of convergence with IFRS and third, is the 2008 global

financial crisis which is expected to have raised awareness concerning disclosure and

transparency.

17Islamic financial institutions comprise Islamic banks and takaful (Islamic insurance) companies. Thus, the total of Islamic

financial institutions stated by Lee and Menon (2010) might comprise the entire Islamic financial services industry, which

includes Islamic banks, takaful (insurance) companies and investment funds. However, the focus of the current study is only

Islamic banks.

18

5. Results and discussion

5.1. The nature and extent of corporate governance disclosures in Islamic banks

Table 1 reports the nature and extent of voluntary corporate governance disclosure for the full

sample, for the two regions and for the countries within each region. Panel A shows that the

mean voluntary corporate governance disclosure for all the Islamic banks in the study is

37.007 percent. Panel B reveals that the minimum disclosure level in the SEA banks is

slightly higher (10.000 per cent) than for those in the GCC region (5.900 percent). Similarly,

the maximum level is higher for the SEA region (82.000 percent) than for the GCC region

(76.500 per cent). However, the means for the two regions are similar at 36.011 and 37.600

percent respectively.18

Panels C and D report the disclosure levels for each country in the two regions. Indonesia has

the highest mean of 51.468 percent. The high disclosure relative to other Islamic banks might

be due to the fact that the Indonesian government has produced measures to increase the

transparency of disclosure to shareholders as well as other stakeholders (eStandardsForum,

2009a). Bank Indonesia and Ikatan Akuntan Indonesia have played a prominent role in

strengthening the corporate governance of Indonesian Islamic banks by issuing circular

letters as well as promulgating acts, regulations and standards. Our results are consistent with

those of Askary and Jackling (2004) who found that Indonesian publicly listed companies

have the highest financial disclosure levels among all the Middle East and Asian countries. In

contrast, Brunei, with only one Islamic bank, has the lowest level of voluntary corporate

governance disclosure at 10.000 percent. The result for Brunei is not unexpected given that

the country has no capital market (Yapa, 1999) and has been slow to adopt IFRS.19

18 When we divide the sample into the two regions, we found that there is a lack of normality in the distribution of VCGD

data of both regions. Hence, we use a Mann-Whitney U test to compare the means from the two regions. This test

(untabulated) indicates that the level of voluntary corporate governance in the GCC region (Mean Rank = 34.850, n = 42), is

not significantly higher than the SEA region (Mean Rank = 32.580, n = 25), U = 489.500, z = -0.460, p=0.892. 19 The Accounting Standards Order of Brunei was established to improve Brunei’s image in the eyes of foreign investors.

The move was also made to assure investors that sufficient monitoring is made of their investment to increase investor

confidence. Among the objectives of the Order is to regulate the public accountants who provide public accountancy

services (Too, 2011). The Brunei Darussalam Accounting Standard Council announced the full adoption of IFRS effective

from 1 January 2014 (The Brunei Times, 2012).

19

Insert Table 1 about here

Table 2 reports the mean extent of corporate governance disclosures for each category for the

full sample and for the two regions. The “General” category has the highest mean disclosure

among all the categories (69.403 percent). The high disclosure in the “General” component is

expected due to the fact that this component is regarded as financial information normally

presented to highlight achievements to shareholders. On the other hand, the disclosure on

“Avoidance of Conflict of Interest” has a low mean disclosure at 11.940 percent while no

disclosure is made at all on “Code of Conduct and Ethics”. The paucity of information on

these two categories might be due to the limited guidance on how to provide such disclosure

in the annual reports.20

Islamic banks in the SEA region disclose significantly more

information on “Fair treatment of equity holders” and “Appropriate enforcement of

governance principles and standards” while Islamic banks in the GCC region disclose more

on “Equitable treatment of fund providers and other significant stakeholders”, “Audit and

governance committee”, “Risk Management”, “Avoidance of conflicts of interest” and

“Appropriate compensation policy oversight”.

Insert Table 2 about here

5.2. Descriptive statistics for independent variables

Table 3 reports the descriptive statistics for the independent variables used in the model,

including those used to calculate both CG_STRENGTH and SSB_STRENGTH. Mean

CG_STRENGTH is 2.239, with a minimum of zero and a maximum of six. On average, only

19.379 percent of board members and 26.845 percent of audit committee members are

independent. Average board size is 8.426 members while the average AC size is 2.164

members. Only 13.760 percent of the audit committee members have skills in accounting,

banking, economics or finance. Most of the Islamic banks separate the roles of CEO and

board chair (71.60 percent). To oversee the Shari’ah compliance, the banks are supported by

an SSB with an average size of 3.388 members. SSB members hold an average of eight SSB

positions in other financial institutions. Only 22.992 percent of the SSB members have

expertise in accounting, banking, economics or finance.

20Although reference has been made by the OECD (2004), Annotation, Part VA(5) and the United Nations Conference on

Trade and Development (UNCTAD) (2006), Paragraph E, 5, examples have not been provided on how to disclose this type

of information.

20

Most of the Islamic banks in our study are located in countries with a high level of political

and civil repression (average score of 9.412) and are located in code law countries (70.10

percent).21

Insert Table 3 about here

5.3. Multiple regression analysis

Prior to the multiple regression analysis, several assumptions were evaluated, including the

existence of significant multicollinearity between explanatory variables, homoscedasticity,

the existence of measurement and specification errors and also the data distribution. There is

no correlation which is above 0.80 giving an indication of the absence of multicollinearity in

the model (Field, 2009). In relation to the above problems, analysis of the residuals was

undertaken. Further examination of the data indicated that the variables are free from

univariate outliers except for the ratio of IA to equity which has been corrected for outliers by

winsorising. Second, inspection of the normal probability plot of standardised residuals

against standardised predicted values, indicated that the assumptions of linearity and

homoscedasticity of residuals were met. Third, Mahalanobis distance did not exceed the

critical chi-square value for any case in the data for all the models, indicating that

multivariate outliers were not of concern. We also ran normality tests on the data. Some of

the independent variables which did not achieve normality after various types of

transformation (log, square root, inverse transformation) were undertaken have been

winsorised22

or recoded as dichotomous variables23

to correct their distribution. We have run

distribution tests on the residuals and noted that after the transformation of variables, all the

residuals of the variables showed normality of distribution. The dependent variable VCGD, is

found to be normally distributed (except when the data is split between regions as discussed

in Note 18.

21The common law was expanded in Brunei and Malaysia during the expansion of the British Empire whilst undergoing

several changes due to geographical location and the influence of indigenous civilisation. Thailand as a non-British Asian

country adopted code law as did most other non-British Asian countries such as Japan, South Korea and Taiwan. In the Arab

countries (GCC region), a mixed version of the Romano-Germanic-Islamic legal system (a sub-branch of the Romano-

Germanic family) is adopted (Salter and Doupnik, 1992). By virtue of its Dutch colonisation, Indonesia uses code law with

the influence of Indonesian cultural law. 22Winsorising has been used on IAHEQUITY and MUSPOP with a cut-off of 5 percent. 23CG_STRENGTH and POLICIV variables are recoded.

21

The regression results are reported in Table 4. The model has an adjusted R2 of 0.384.

CG_STRENGTH is found to have a highly significant and positive association with voluntary

corporate governance disclosures (at the 1 percent significance level), providing strong

support for H1. This result is consistent with many studies on board independence (Ben-

Amar and Boujenoui, 2007; Bujaki and McConomy, 2002; Parsa et al., 2007), board size

(Adawi and Rwegasira, 2011; Anderson et al., 2004), AC size (Zaluki and Wan Hussin,

2009; Anderson et al., 2004), audit committee independence (Abbott et al., 2000; Beasley et

al., 2000 and Menon and Williams, 1994), audit committee financial expertise (DeZoort,

1998 and DeZoort et al., 2003) and CEO duality (Beasley et al., 1999; Ben-Amar and

Boujenoui, 2007; Carcello and Nagy, 2004a).

No significant association is found between SSB_STRENGTH and voluntary corporate

governance disclosure, providing no support for H2. Our results suggest that SSBs may not

be committed to reviewing financial reports (including corporate governance disclosure). The

AAOIFI has provided standards on Shari’ah review and internal Shari’ah review but, with

the exception of Bahrain, these standards have not been mandated in the countries in our

study. The lack of evidence on Shari’ah review might stem from the fact that many Shari’ah

scholars sit on multiple boards. While we argued that multiple cross-memberships should

strengthen governance disclosures, we acknowledged that such memberships may mean that

scholars have insufficient time to devote to corporate reporting issues. Hence, further

research is needed to fully explore the reasons for our result which is in contrast to that of

Farook et al. (2011) with respect to SSB influence on CSR disclosures.

There is also no significant association between voluntary corporate governance disclosures

and IAHEQUITY. Hence, there is no support for H3. This result is inconsistent with the

findings of Al-Baluchi (2006) and Farook et al. (2011). Al-Baluchi (2006) reports a positive

and significant association between the level of IA and voluntary disclosures in Bahrain and

Sudan. Similarly, Farook et al. (2011) find that the ratio of IA to paid-up capital is positively

associated with CSR disclosures. The current result seems to reflect a lack of demand for

corporate governance disclosure by IAHs. Al-Sadah (2007) argues that IAHs are passive in

dealing with Islamic banks. His findings indicate that IAHs do not use the financial

statements to evaluate bank performance. In fact, IAHs are less equipped with basic

knowledge on the nature of their own contracts and their transactions with Islamic banks.

Therefore, IAHs are mostly inactive in demanding information relevant to them. Moreover,

22

most of the Islamic banks are located in weak information environments with lack of

financial intermediaries for instance, financial analysts and rating agencies.

We find a positive relationship between disclosure and SIZE banks, providing support for H4.

This result is consistent with studies by Ahmed and Courtis (1999), Buzby (1975), Chow and

Wong-Boren (1987), Cooke (1989), Hamid (2004), Hossain et al. (1995) and Raffournier

(1995). This positive relationship is likely to be due to the economies of scale enjoyed by

larger firms, which provide sufficient resources to publish information such as voluntary

disclosure at a lower cost (Ben-Amar and Boujenoui, 2007; Buzby, 1975; Singhvi and Desai,

1971; Watts and Zimmerman, 1978). The results may also partially be due to the fact that

larger firms are more exposed to political costs and regulatory control, as suggested by

Cooke (1989), Singhvi and Desai (1971) and Watts and Zimmerman (1978). Larger firms

attempt to reduce political costs and regulatory control by providing more disclosures (Watts

and Zimmerman, 1978). In some corporate governance disclosure studies, such as Andersson

and Daoud (2005), Ben-Amar and Boujenoui (2007), Bujaki and McConomy (2002), Carson

(1996) and others24

, the association between firm size and corporate governance disclosure is

also found to be positive.

The level of political and civil repression (POLICIV) is negative and significant in its

relationship with voluntary corporate governance disclosures. Islamic banks located in

countries with more freedom in their political and civil systems tend to provide more

corporate governance disclosures. Thus, H5 is supported. This result is consistent with

Farook et al. (2011) and Williams (1999) with respect to CSR disclosures. Farook et al.

(2011) find that the level of political rights and civil repression explains part of the variation

in CSR disclosures while Williams (1999) reports that political and civil repression in Asia

Pacific countries is negatively related to voluntary environmental and social accounting

disclosure practices.

The result with respect to LEGAL provides evidence that stakeholder-oriented, code law

countries have a significant and positive association with the extent of voluntary corporate

governance disclosure compared to common law countries. Ball et al. (2000) contend that

companies in code law countries implement the “stakeholder governance model” while

24 Hossain (2007), Kusumawati (2007), Labelle (2002), Ntim et al. (2012), Pahuja and Bhatia (2010) and Parsa et al. (2007).

23

companies in common law countries apply the “shareholder governance model”. This result

provides support for H6 and is consistent with studies on CSR disclosures (Alrazi et al.,

2011; Van der Laan Smith et al., 2005). Alrazi et al. (2011), Kolk and Perego (2010) and Van

der Laan Smith et al. (2005) argue that code law countries with stakeholder-orientation have

corporate responsibility which extends beyond wealth maximisation and efficiency unlike the

common-law countries with shareholder-orientation.

Insert Table 4 about here

5.4. Additional analysis

We conduct additional analyses (non-parametric tests using rank regression and

transformation of data into normal scores utilising the van der Waerden approach suggested

by Haniffa and Cooke, 2002) and note similar results with the exception of SSB strength. The

rank regression and the normal scores models reveal that SSB strength has a significant

relationship with voluntary corporate governance disclosure. However, being non-parametric

test statistics, rank regression and normal scores model are generally weaker than parametric

tests (OLS). Therefore, we are satisfied that the OLS regression showed the best results with

the findings that the SSB strength does not have a significant relationship with voluntary

corporate governance disclosure. Moreover, the data (after transformation) satisfies the

assumptions needed to run the OLS.

6. Concluding comments

The higher risks imposed on Islamic banks, as compared to traditional banks, suggest the

need for stronger corporate governance mechanisms, and, accordingly, a higher level of

corporate governance disclosure in their annual reports. At the core of Islamic banking are

risks associated with equity participation, interest-free financial instruments and profit

sharing contracts. Islamic banks are accountable to multiple stakeholders, namely, investors,

creditors, owners and shareholders, management, zakat25

beneficiaries, government,

community, employees, customers and zakat payers. Therefore, stronger governance and

25 Zakat is a compulsory levy that must be allocated from the well-to-do among the Muslim society to the beneficiaries

specified according to Shari’ah.

24

transparent disclosures about corporate governance should enhance the confidence of these

stakeholders in the Islamic banking industry.

In view of the above-mentioned issues, our study investigates the extent of voluntary

corporate governance disclosures and the determinants of such disclosures by Islamic banks

in the SEA and the GCC regions. The findings of our study provide support for the influence

of corporate governance strength on the extent of voluntary corporate governance disclosure.

Stronger sets of corporate governance mechanisms in Islamic banks are more likely to be

associated with a higher level of voluntary corporate governance disclosures. Other factors

that influence voluntary governance disclosures are the size of Islamic banks, the level of

political and civil repression and the legal system. Our results with respect to the association

between corporate governance disclosures and firm size suggest that some conclusions from

other settings are generalisable to Islamic banks.

The results of our study suggest a need for improvement in corporate governance disclosures

by Islamic banks. There are troubling gaps, for instance, in the disclosure of shareholder

related information and mudarabah investment account-related information. The reason for

the lack of disclosure in some countries (Brunei, Bahrain and Qatar) might also be linked to

the absence of an established professional accounting and auditing environment in these

countries. Bahrain and Qatar are found to have weak law enforcement, low audit quality and

also low accounting and auditing enforcement activities (Al-Shammari et al., 2008). Some

regulatory interventions, such as legal backing, incentives, sanctions for violations of

disclosure rules and proper enforcement mechanisms, might be considered as good steps to

encourage compliance with accounting and corporate governance standards, and could

eventually lead to an increase in corporate governance disclosures (Al-Sadah, 2007; Setyadi

et al., 2011).

Our study is not without limitations, and thus caution must be taken in interpreting the

results. First, the number of annual reports available for the sample analysis is relatively

small, which may limit the power of the statistical tests conducted on the data. Second, our

study is restricted to Islamic banks in the SEA and GCC regions and our results may not be

generalisable to banks in other regions or to other sectors of the Islamic financial services

industry. Third, the study is a cross-sectional study with data for a single period. However, in

the absence of significant events that could influence disclosure levels, the extent of

25

disclosure is not expected to vary significantly over time. Fourth, our dependent variable is a

voluntary corporate governance disclosure index which we developed by referring to a

number of key corporate governance benchmarks and guidelines. Inevitably, there is a degree

of subjectivity in constructing such an index and this could have impacted our results. Fifth,

we also developed our own measures of corporate governance strength and SSB strength and

these were limited by data availability. Finally, an assumption of our study is that the

corporate governance strength of Islamic banks influences corporate governance disclosure

behaviour. However, it is possible that the relation between corporate governance disclosures

and governance strength is an endogenous one, with disclosures influencing the strength of

the corporate governance in place (Hermalin and Weisbach, 2003).

Overcoming the above limitations provides a number of avenues for future research. First,

aspects of corporate governance not examined in the study, such as board sub-committees in

addition to the audit committee, high family concentration of ownership, as well as share

ownership by directors, managers and SSB members, could be examined in detail. Second,

studies across other jurisdictions (for instance, Africa, Europe, North and South America,

Middle East and South Asia) could generate stronger results and enable additional factors or

theories to be explored. Third, a longitudinal study could be undertaken, which would

provide evidence of changes in levels and patterns of corporate governance disclosures in

Islamic banks. Fourth, the possibility of an endogenous association between corporate

governance strength and disclosure could be explored in future research. Fifth, alternative

measures of SSB strength may add further insight on the relation between the SSB and

governance disclosures. Sixth, disclosure indices are unlikely to be able to fully explain the

issues on corporate governance and Shari’ah governance systems. Hence, other research

methods, such as interviews and surveys, are needed to enhance the understanding of the

importance of such disclosures (Akacem and Gilliam, 2002). Finally, future studies could be

extended to include other Islamic financial institutions, such as insurance companies and

investment funds.

26

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34

Appendix A: Measurement of variables

Variable Measurement

VCGDINDEX Total number of voluntary corporate governance disclosures made

divided by total possible number of voluntary corporate governance

disclosures

CG_STRENGTH BODINDEP + BODSIZE + ACSIZE + ACINDEP + ACEXP + INDCHAIR where

BODINDEP = 1 for percentage of independent non-executive directors on the

board of directors (board) above the median of 0 members, 0 otherwise

BODSIZE = 1 for number of directors on the board above the median of 9

members, 0 otherwise

ACSIZE = 1 for number of directors in the audit committee (AC) above the median

of 3 members, 0 otherwise

ACINDEP = 1 for percentage of independent non-executive directors on the AC

above the median of 0 members, 0 otherwise

ACEXP=1 for the number of AC members formally trained in accounting, banking,

economics or finance above the median of 0, 0 otherwise

INDCHAIR = 1 when the CEO and the Chairman of the Board are separate people

and 0 otherwise

SSB_STRENGTH SSBCRMEMB + SSBSIZE + SSBEXP

SSBCRMEMB= 1 for the average number of cross-memberships of the SSB

member in institutions offering Islamic financial services above the median of 5.5,

0 otherwise

SSBSIZE = 1 for the number of SSB members above the median of 3, 0 otherwise

SSBEXP=1 for the number of SSB members formally trained in accounting,

banking, economics and finance above the median of 0.286, 0 otherwise

IAHEQUITY The ratio of IA to equity

SIZE Total assets of Islamic bank (natural log)

POLICIV Overall combined index scores of political rights and civil liberties based on the

work of Gastil (1981) and Freedom House (2009) for the given nation: 1 (freedom)

to 14 (repression)

LEGAL 1 if code law, 0 if common law (Salter and Doupnik, 1992)

35

Appendix B: Guidelines for Scoring of the Corporate Governance Reporting

No Section Item no Reference/Scoring system

1. General 2 items OECD (2004); United Nations Conference on Trade and

Development (UNCTAD) (2006)

2. Effective Shari’ah 10 items AAOIFI Standards; IFSB Guidelines; BCBS (2006);

compliance Pramono (2005)

structures

3. Fair treatment of 6 items Association of Chartered Certified Accountants (ACCA)

equity-holders, Australia and New Zealand, (2009); BCBS (2006); IFSB

GSIFI No 6 Guidelines; Muhamad et al. (2009); OECD (2004); UNCTAD

(2006)

4. Equitable 9 items AAOIFI Standards, ACCA Australia and New Zealand (2009);

treatment of fund IFSB Guidelines

providers and

other significant

stakeholders

5. Fit and proper 3 items ACCA Australia and New Zealand (2009); Andersson and Daoud

conditions for (2005); Bhasin (2010); BCBS (2006); Bujaki and McConomy

board and (2002); IFSB Guidelines; Standard & Poor’s (2004); UNCTAD

management (2006)

6. Effective oversight 16 items AAOIFI Standards; ACCA Australia and New Zealand (2009);

Andersson and Daoud (2005); BCBS (2006); Ben-Amar and

Andersson and Daoud (2005); BCBS (2006); Ben-Amar and

(2002); IFSB Guidelines; Muhamad et al. (2009); OECD (2004);

Pramono (2005); Standard & Poor’s (2004); UNCTAD (2006)

7. Audit and 3 items ACCA Australia and New Zealand (2009); Andersson and Daoud

governance (2005); BCBS (2006); Bhasin (2010); Bujaki and McConomy

committee (2002); IFSB Guidelines; Muhamad et al. (2009); Standard &

Poor’s (2004); UNCTAD (2006)

8. Risk management 10 items AAOIFI Standards; ACCA Australia and New Zealand (2009);

BCBS (2006); Bhasin (2010); IFSB Guidelines; ; OECD (2004);

UNCTAD (2006)

9. Avoidance of 1 item OECD, (2004); UNCTAD (2006)

conflicts of interest

10. Appropriate 6 items BCBS (2006); OECD, (2004); IFSB Guidelines

compensation

policy oversight

11. Public disclosures 13 items AAOIFI Standards; IFSB Guidelines; OECD (2004)

12. Code of conduct 1 item AAOIFI Standards

and ethics

13. Appropriate 1 item BCBS (2006); IFSB Guidelines; OECD (2004)

enforcement of

governance

principles and

standards

Notes:

Based on our research methodology specified in Section 4, in Malaysia, out of the 81 disclosures, 36

items were regarded as voluntary, Indonesia (37 items); Thailand (70 items); Brunei (73 items);

Bahrain (53 items); UAE (72 items), KSA (47 items); Qatar (51 items) and Kuwait (72 items).

36

Table 1

The nature and extent of voluntary corporate governance disclosure

Panel A: All countries (in Percentage)

Minimum Maximum Mean Standard deviation

All countries (N=67) 5.900 80.000 37.007 0.184

Panel B: Region

Extent of disclosure SEA (N=25) GCC (N=42)

Minimum 10.000 5.900

Maximum 80.000 76.500

Mean disclosure 36.011 37.600

Panel C: SEA Extent of disclosure Malaysia (N=19) Indonesia (N=4) Brunei (N=1) Thailand (N=1)

Minimum 17.600 31.430 10.000 45.500 Maximum 60.600 80.000 10.000 45.500

Mean disclosure 33.626 51.468 10.000 45.500

Panel D: GCC Extent of disclosure Bahrain (N=22) Kuwait (N=3) Qatar (N=5) KSA (N=4) UAE (N=8)

Minimum 9.800 25.400 8.500 27.500 5.900

Maximum 76.500 29.000 54.000 39.600 44.300 Mean disclosure 47.677 27.300 31.700 33.625 19.425

37

Table 2

Extent of voluntary corporate governance disclosure (Category Classification)

Region (Means in Percentage)

Categories of disclosure Full Sample SEA Region GCC Region Significance tests

General 69.403 68.000 70.238

Effective Shari’ah compliance structures 37.235 32.768 39.893

Fair treatment of equity-holders 27.388 38.600 20.714 0.007***a

Equitable treatment of fund providers and other significant stakeholders 35.861 20.886 44.775 0.050*b

Fit and proper conditions for board and management 14.925 10.667 17.460

Effective oversight 40.237 34.752 43.502

Audit and governance committee 25.373 14.6667 31.746 0.008***b

Risk management 33.333 11.332 46.429 0.000***b

Avoidance of conflicts of interest 11.940 24.0000 4.762 0.020**b

Appropriate compensation policy oversight 24.179 12.800 30.952 0.004***b

Public disclosures 30.449 28.868 31.390

Code of conduct and ethics 38.806 40.000 38.095

Appropriate enforcement of governance principles and standards 47.761 76.000 30.952 0.000***a

Notes: aIslamic banks in the SEA region disclose significantly more information.

bIslamic banks in the GCC region disclose significantly more information.

***significant at 1 percent level (two-tailed)

**significant at 5 percent level (two-tailed)

*significant at 10 percent level (two-tailed)

38

Table 3

Descriptive statistics for all the variables in the study Panel A: Descriptive statistics for independent continuous variables

Variable Minimum Maximum Mean Standard Median

deviation

CG_STRENGTH 0 6 2.239 1.724 2.000

BoardIndep 0 91.667% 19.379% 0.271 0

BoardSize 4 13 8.426 2.217 9.000

ACSize 0 5 2.164 1.720 3.000

ACIndep 0 1 26.841% 0.387 0

ACExpertise 0 1 13.731% 0.259 0

SSB_STRENGTH 0 3 1.373 0.998 2.000

SSBSize 0 7 3.388 1.660 3.000

SSBCrossMember 0 34.667% 7.919% 9.912 2.667

SSBExpertise 0 100% 22.992% 0.249 20%

IAHEQUITY 0 10.990 3.730 3.577 2.844

SIZE (USD million) 12.086 45,527.922 4,655.686 7,888.998 2,344.310

POLICIV 5 13 9.418 1.810 10.000

Panel B: Frequencies for dichotomous variables

Variable Coding No. of firms in sample Percentage of sample

INDChair 0 19 28.400

1 48 71.600

LEGAL 0 47 70.100

1 20 29.900

Variables as defined in Appendix A.

39

Table 4

Regression analysis of determinants of voluntary corporate governance disclosure

Independent variable Predicted sign Coefficients t-statistics VIF

Constant -0.250 -0.920

CG_STRENGTH + 0.142 2.972*** 1.802

SSB_STRENGTH + 0.080 1.440 1.040

IAHEQUITY + -0.034 -0.752 1.622

SIZE + 0.074 2.383** 1.437

POLICIV - -0.205 -4.063*** 1.606

LEGAL + 0.207 3.698*** 2.121

Std. error 0.144

F-value 7.847

Sig. F 0.000***

Adj. R Square 0.384

Notes:

***significant at 1 percent level (two-tailed)

**significant at 5 percent level (two-tailed)

*significant at 10 percent level (two-tailed)

Variables as defined in Appendix A.