Perspective of corporate governance and ethical issues with profit sharing investment accounts in Islamic banks

Abstract

Purpose The purpose of this paper is to examine the practices of Islamic banks in managing the so-called profit sharing investment accounts (PSIA) which they offer as a Shari’ah-compliant alternative to interest-bearing deposit accounts using an unrestricted Mudarabah contract. In particular, the paper aims to examine the risk-return characteristics of such accounts and to compare these to the returns and risks of shareholders in the same banks. It is relevant that PSIA holders (unrestricted investment account holders – UIAH) are exposed to losses on the assets in which their deposits are invested, while the bank as asset manager (Mudarib) does not bear these losses and as Mudarib typically receives more than 50 per cent of the profits earned on the PSIA. The issue is whether the UIAH are being treated equitably. The influence of a set of corporate governance variables on this issue was also analyzed. Design/methodology/approach A sample of 28 Islamic banks was selected from five countries for the period 2002-2013, with data being obtained from Bankscope and Bloomberg and, where necessary, from the banks’ annual reports. First, the risk-return characteristics of the UIAHs’ rates of return and shareholders’ rates of return on equity (ROE) were compared by calculating for each bank the coefficients of variation (CV) of the two series of rates of return. Second, a panel data approach was used to evaluate the effectiveness of corporate governance by examining the extent to which the size of the difference between the rates of return for shareholders and for UIAH was associated with a set of corporate governance variables. Third, a comparison was made between the risk-return characteristics of UIAH’s rates of return and shareholders’ dividend yield rate for a sub-sample of 20 banks for which the information was available. Findings For a significant proportion of the banks (9 out of 28), the CVs of the PSIA returns were higher than those of the shareholders’ ROEs, which suggested that in these cases the PSIA holders were receiving inequitable treatment. Likewise, for 7 out of the 20 banks in the sub-sample, the CVs of the PSIA holders’ rates of return were higher than those of the shareholders’ dividend yield rate. In explaining the size of the differences between the rates of return on PSIA and the shareholders’ ROEs, the variable with the greatest explanatory power was the return on assets, implying that when this was high the bank took a maximum Mudarib share of profits. Some other corporate governance variables had the expected signs, as did a country dummy representing the maturity of the market for Islamic banking, but there was little evidence of the effectiveness of corporate governance in protecting the interests of the UIAH. Research limitations/implications A limitation of the research was that the inefficiency of the stock markets in the relevant countries and the fact that a few of the banks were not listed made it impossible to use shareholders’ stock market returns. ROE is not a very good proxy, as it is unclear how much value should be placed on retained earnings. Dividend yield rates provide a better comparison with UIAH rates of return, but the data were available for only 20 of the banks. Nevertheless, the results of the analysis strongly suggest that in a significant proportion of cases, UIAH are not being treated equitably. Practical implications The implication is that the regulation of Islamic banks needs to be improved to provide better protection to UIAH. Social implications Islamic banks operate mainly in emerging markets where the effectiveness of regulation is limited. The ethical basis of Islamic finance provides some mitigation of this problem but apparently fails to do so in a significant proportion of cases. This should be borne in mind when assertions are made about the ethical basis of Islamic finance. Originality/value There is a dearth of empirical studies of the practices of Islamic banks and in particular of their treatment of their customers. This is because of various factors: the relative novelty of Islamic finance, the paucity of data and the relatively small size of the body of researchers in the field. This paper aims to contribute to filling this gap.

Analysing Islamic banking ethical performance fromMaqāṣid al-Sharī‘ahperspective: evidence from Indonesia

“…Hence, IBs institute interest-free concepts and promote PLS products such as Mudarabah and Musharakah that direct the society towards socio-economic justice. However, Alhammadi et al (2018) suggest that the practice of IBs was unsuccessful in applying the principle of PLS, which indicates that IBs' principles exist more in literature and theory than in real practice. Thus, IBs should comprise Islamic ethical values to compete with conventional banks regarding profitability and efficiency.…”

“…In contrast, the first generation of scholars have prioritised Maqās id al-Sharī'ah fulfilments as a crucial objective to achieve social justice (Hassan and Aliyu 2018). As stated by Alhammadi et al (2018), Islam does not object to the profit motive as such but insists on equity and fairness. Islamic economics seeks to promote PLS on both sides of the balance sheet.…”

Corporate governance mechanism and the ratings of Islamic and conventional mutual funds: Evidence from Pakistan

“…Ashbaugh-Skaife et al (2006) and Grassa (2016) showed that CEO duality negatively affects the firm's credit rating. On the other hand, Alhammadi et al (2018) showed that CEO duality affects the rate of returns between the two classes of stakeholders in Islamic banks. In the case of duality in any Islamic bank, the shareholders get a better return on their investment.…”

Integration of Islamic bank specific risks and their impact on the portfolios of Islamic Banks

“…Displaced commercial risk occurs when the profit expectations of Islamic bank investment account holders are higher than actual returns (Toumi et al , 2019). This makes Islamic banks subject to withdrawal risk (Archer et al , 2010; Aysan et al , 2014; Alhammadi, 2016; Aysan et al , 2016; Alhammadi et al , 2018; Noor et al , 2019a) that may hamper their financial standing and subject them to systemic risk (Toumi et al , 2019). To ensure their competitiveness, Islamic banks bear losses when their expected pay off to investment account holders is lower than the market and retain a higher share of profits when their expected pay off to investment account holders is higher than the market (Alhammadi, 2016; Alhammadi et al , 2018; Noor et al , 2019a; Toumi et al , 2019).…”

“…This is because Islamic banks do not have any obligation to pay returns to Unrestricted Investment Account Holders (UIAH) in the absence of profits, and in any case, may use reserves taken from prior-year UIAH profits to pay returns in years when profits are lacking. In the absence of governance rights, the only safeguard UIAH’s might have would be effective competition between Islamic banks for their funds together with transparency and market discipline, but the evidence suggests that these are insufficient.” (Alhammadi et al , 2018; p 16).…”