Journal Pre-proof

The Impact of Corporate Governance and Agency Effect on Earnings

Management – A Test of the Dual Banking System

Naifs Alam (Conceptualization) (Methodology) (Writing - review and

editing) (Supervision) (Project administration), Jayalakshmy
Ramachandran (Resources) (Writing - review and editing)
(Visualization), Aisha Homy Nahomy (Software) (Validation) (Formal
analysis) (Data curation) (Resources) (Writing - original draft)

PII: S0275-5319(19)30707-X
DOI: https://doi.org/10.1016/j.ribaf.2020.101242
Reference: RIBAF 101242

To appear in: Research in International Business and Finance

Received Date: 18 June 2019

Revised Date: 27 April 2020
Accepted Date: 9 May 2020

Please cite this article as: Alam N, Ramachandran J, Nahomy AH, The Impact of Corporate
Governance and Agency Effect on Earnings Management – A Test of the Dual Banking
System, Research in International Business and Finance (2020),
doi: https://doi.org/10.1016/j.ribaf.2020.101242
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© 2020 Published by Elsevier.

The Impact of Corporate Governance and Agency Effect on Earnings Management – A
Test of the Dual Banking System

Dr. Naifs Alam

Associate Professor
Henley Business School , University of Reading , ersiaran Graduan Kota Ilmu, Educity 79200 , Iskandar Puteri Johor, Malaysia.
n.alam@henley.edu.my

Dr.Jayalakshmy Ramachandran*
Assistant Professor, The University of Nottingham in Malaysia, Jalan Broga, 42500 Semenyih, Selangor Darul Ehsan, Malaysia
Jayalakshmy.rama@nottingham.edu.my
Tel: +603 89248779

Aisha Homy Nahomy

PriceWaterhouseCoopers Indonesia, WTC 3, Jalan Jendral Sudirman, Jakarta, Indonesia
aisha.nahomy@gmail.com

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*Corresponding author

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Graphical abstract
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Abstract
This study investigates the impact of the Board characteristics, Chief Executive Officer’s (CEO) power and
Shariah supervision on Earnings Management (EM) within conventional and Islamic banks. We provide
evidence that EM levels do not significantly differ between Islamic and conventional banks. Contrary to
public belief, additional value-based attributes such as the Shariah Supervisory Board (SSB) that promotes
ethical and religious values, do not help in the restriction of opportunistic behaviour in Islamic banks.
Additionally, attributes such as board size, firm size and leverage have a significant negative influence on
EM of both Islamic and conventional banks. Our results are important in deliberating that the word ‘Islamic’
must not be used merely as a profit manifestation, but instead must promote a value-based business, which
in turn could ensure reliability and sustainability.
Key words: Corporate Governance, Agency Cost, Islamic financial institutions, Sharia, Supervisory Board,
Earnings management

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JEL: E58, G15, G28, M48, N25,

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1. Introduction
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Earnings Management (EM) is one of the most stimulating topics in the field of finance and
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accounting research. EM contributes additional agency costs for a company, to the extent that it covers up
the actual performance and lessens the capability of shareholders to make decisions (Xie et al., 2003). The
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scandal of Enron, Toshiba and the collapse of some banks during the financial crisis in 2008 are some of the
extreme cases that have been witnessed by the global business world that demonstrate how financial
reporting and earnings manipulation could harm not only shareholders, but also stakeholders. Among all
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industries, EM in the banking industry has been studied extensively due to its significance in relation to the
financial system as a whole. A fraud in the financial reporting conducted by one bank could affect the entire
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banking industry.

Pertinently, the fundamentals of the Islamic financial system include, among others, strong
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governance and embedded ethical values1. Ideally, issues such as ‘EM’ or ‘Creative Accounting’ that are
currently prevalent under the conventional governance regime should not be experienced under the Islamic
shield due to the presence of religious values (Musa, 2011; Ha-Brookshire, 2015; Mersni & Othman, 2016;
Kanagaretnam et al., 2015; Abdelsalam et al., 2016). The barrier of greater moral accountability in Islamic
banks is expected to lower agency costs such as reducing unnecessary risk-taking behaviour and
discouraging EM practices. Banks are vulnerable institutions due to their complex operations and thus

1
http://www.bankislam.com.my/en/Documents/Shariah/PresentationtoFSTEP-DSZ.pdf
2
increase the information asymmetry between managers and stakeholders. They allow more opportunity for
managers to engage in EM (Anandarajan et al., 2005; Cornett et al., 2009; Taktak et al., 2010 (a);
Ramachandran et al., 2015), which is least expected of institutions pursuing Islamic principles (Dyreng et
al., 2012; Quttainah et al., 2013; Ha-Brookshire, 2015). Islamic financial institutions incorporate the Shariah
Supervisory Board (SSB) as an additional key feature in their corporate governance mechanism (Choudhury
& Hoque, 2006). SSB certifies and monitors all financial contracts and bank activities on behalf of
stakeholders to ensure compliance with the Shariah law (Alman, 2012), which resultantly reduces the
management’s opportunistic behaviour.

Contrary to expectation, Islamic financial institutions are no exception to the risk of EM (Lassoued et
al., 2018) and observations have indicated that both Islamic and conventional banks with more concentrated
ownership use discretionary loan loss provisions (Fonseca & Gonzales, 2008; Taktak et al., 2010 (b);

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Dechow et al., 2010; Othman & Mersni, 2014) to manage their earnings and generate or record profits
(Zoubi & Al-Khazali, 2007). Zainuldin and Lui (2018) contribute further by stating that Islamic banks

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engage in higher EM practices through abnormal loan loss provisions while reporting smaller positive
earnings in comparison to their conventional counterparts. Additionally, asymmetric information and
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conflict of interest that exist in Islamic banks (Safieddine, 2009; Bukhari et al.,2013) may encourage
managers to behave unethically, although such actions are against Islamic beliefs or values. Similar studies
in the past have also led to inconclusive results (Olson & Zoubi, 2008; Abdelsalam et al., 2016).
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Many previous studies have focused on the relationship between corporate governance and EM in
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conventional banks (Cornett et al., 2009; Ebrahim, 2007; Xie et al., 2003; Leventis, 2012; Laksmi &
Kamila, 2018). However, empirical research on the impact of Shariah corporate governance on bank
performance, specifically as a deterrence to EM, is very limited and serves as the motivation of this paper.
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Furthermore, we observe that the literature surrounding Shariah governance is more normative and
theoretical (Choudhury & Hoque, 2006; Grais & Pellegrini, 2006; Hassan, 2011). EM studies are popular in
the Middle East and North Africa (MENA) region (Mersni & Othman, 2016; Quttainah et al., 2013; Hamza,
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2013), especially in the Gulf Cooperation Council (GCC) region, due to the vast Islamic finance market
present. At the same time, other countries such as Malaysia, Indonesia and Bangladesh that have abundant
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Islamic market potential are equally important in the development of Islamic finance and yet remain
underexplored by researchers. The Islamic Finance Country Index (IFCI) 2019 revealed that Malaysia
ranked second in terms of growth in Islamic finance2. In retrospect, statistics show that Malaysia has
dropped in ranking while Indonesia has topped the index. Therefore, with developing countries making a

2
http://www.gifr.net/publications/gifr2019/ifci.pdf. IFCI is the oldest index for ranking different countries with respect to the
state of Islamic banking and finance
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footprint at the global level, there is a definite need and motivation to look at how these countries handle
governance to demonstrate sustainability.

Additionally, several problems such as limited Shariah scholars, Shariah board interlock, and
differences in regulations and Madhab (School of Thoughts) used by Shariah scholars still exist in the
implementation of Shariah governance (Grais & Pellegrini, 2006). The interlock of the SSB is a very
common practice in Islamic banks as a result of the limited number of competent scholars available to
represent the SSB (Unal, 2010). This interlock problem in the Shariah network has not been examined in
depth by existing literature (Zainuldin & Lui, 2018). The gaps identified in this study allow us to explore
further, as the main objectives of this study are to examine: (i) the level of EM between Islamic and
conventional banks; (ii) the effect of the Board quality and CEO power towards EM in Islamic and
conventional banks; and (iii) the impact of SSB interlock on EM in Islamic banks.

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Using a sample size of 1,165 bank year observations from ten different countries with the highest
development in Islamic finance industry between 2006 to 2016, we performed a two-stage regression

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analysis through random effects-Generalised Least Square technique. This study contributes to the EM
literature in the dual banking system in three ways.: Firstly, although EM for both conventional and Islamic
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banks are different, they are not statistically significant, thus implying that Shariah governance practices do
not act as strong barriers to unethical practices of management as expected. Secondly, the Board size
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negatively influences EM for commercial banks, whereas splitting of responsibilities between the CEO and
chairman contributes positively towards reducing EM for Islamic Banks. Thirdly and most importantly,
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SSB interlocks are important to reduce EM. However, the independence of SSB members is likely to be
compromised when they seek positions outside their home country. Inter-country appointments of Shariah
scholars are inevitable due to limited experts and this is likely to be viewed as an opportunity by the scholars
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to focus more on increasing their own wealth, thus encouraging wrong practices. Conducting robustness
checks by replacing the conventional discretionary accruals with loan loss avoidance scores as a measure of
EM does not result in significantly different findings.
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This paper is an extension to the work of Zainuldin and Lui (2018) on EM in dual banking
economies. Zainuldin and Lui (2018) only used only five years’ data (2006 - 2011) that included banks
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from GCC countries and two South Asian countries while our paper covers the top 10 Islamic finance
countries in the world as stated in the IFCI index3. Our paper includes a more robust model and factors such
as board effectiveness and the role of the CEO in EM literature and controlling of factors such as GDP and
inflation, which was were missing in the research of Zainuldin and Lui (2018). One of the biggest
contributions of this paper is the investigation of the role of SSB interlock, which was not covered in the

3
http://www.gifr.net/publications/gifr2017/ifci.pdf
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research of Zainuddin and Lui (2018). It is noted in literature that SSB interlock, if used religiously can help
to curtail EM, which we have empirically proven. The findings of this study are significant in emphasising
the role of the BOD Board of Directors (BOD) and the CEO’s duality in reducing EM. More specifically, we
focus on the specialised role of SSB interlocks both locally and internationally for Islamic banks. As
interlock studies are rare, through this study we contribute to the understanding of the importance of such
interlocks, therefore, also contribute to existing literature that will pave the way for future studies in this
area.

2. Theoretical framework and hypothesis development

EM in the banking industry is the most appalling compared to other industries. The motivation for
EM can be explained by the ‘Agency Theory’, where the interests of the managers are different from that of
the fund providers (Jensen and Meckling, 1976), thus leading to unfavourable decisions by the managers.

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Complementing this theory would be the institutional theory, which explains the processes through which
structures, including schemes, rules, norms and routines, are grounded as authoritative guidelines for social

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good and changes within institutions (Tina Dacin et al., 2002). Several studies have reported that internal
governance mechanisms are more effective than the external mechanisms, especially in the banking industry
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(Cornett et al., 2009; Leventis, 2012; González & Meca, 2014; Abdelsalam et al., 2016; Mattoe & Francisco,
2018). The complexity of agency problems, tight regulations, as well as significant asymmetric information
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between outsiders and insiders have caused a deterioration of the role of external mechanisms to supervise
management actions (Mersni & Othman, 2016). Among the internal mechanisms, the BOD are seen as
essential pillars to reduce agency conflicts as they are appointed directly by shareholders (Cornett et al.,
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2009; Leventis, 2012; González & Meca, 2014; Abdelsalam et al., 2016; Mattoe & Francisco, 2018).

Nevertheless, it is proven time and again that members of the board act in an untrustworthy manner.
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Studies have concluded that managers in banks usually use provisions for loan loss to manage earnings.
Regulators require the management to estimate Loan Loss Provision (LLP) to reflect changes in expected
loan losses and leaving unexpected losses to be absorbed by the bank capital (Fonseca & Gonzalez, 2008).
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The amount of LLP booked by banks during the year is subject to managerial judgement with regards to its
timing and magnitude. Even in highly regulated reporting systems, managers have the discretionary power
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to send distorted signals to stakeholders and hide matters of substance (Dermine & Carvalho, 2008; Elnahass
et al., 2014; Huang et al., 2019; Premti & Smith, 2020). A growing number of studies have proven that
managers in banks exploit flexibility in accounting principles to manage reported earnings (Fonseca &
Gonzales, 2008; Taktak et al., 2010 (a); Dechow et al., 2010; Othman & Mersni, 2014; Campa, 2019).

On the other hand, Islamic banks vary from conventional banks due to the fact that they are based on
Islamic laws known as the Shariah law. Shariah law differentiates Islamic banks from conventional ones
where the application of interest (riba), gambling (maysir) and uncertainty (gharar) in its activities are
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prohibited (Ayub, 2007). Uniquely, Islamic institutions are also required to adhere to conventional
governance mechanisms alongside Shariah (Grassa, 2013). The uniqueness of Islamic banks’ business
model such as equity partnership and profit-loss sharing (PLS) create a need for specific accounting methods
to accommodate these features. The nature of the PLS method led the Accounting and Auditing
Organisation for Islamic Financial Institutions (AAOIFI)4 to issue FAS 11, which requires Islamic banks to
use dynamic provision, allowing them to anticipate their credit risk. Dynamic provisioning sets provisions
for loans to take account of expected losses (E-LLP) rather than actual losses (Taktak et al., 2010 (b);
Quttainah et al., 2013). Meanwhile, conventional banks adopt IAS 39, which uses an incurred loan loss
model. They recognise loss when there is an evidence of any event that is likely to have an impact on the
estimated future cash flows of financial assets (Ernst and Young, 2011). A recent study by Elnahass et al.,
(2016) concluded that the use of the ‘incurred’ model by conventional banks led to significant opportunistic
EM behaviour. In contrast, they found no evidence of opportunistic management behaviour in Islamic banks

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that implemented the expected losses model, either by regulatory capital management or the smoothing of
earnings through LLP.

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Additionally, AAOIFI has initiated the development of Islamic accounting standards to overcome the
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problems of conventional accounting regulations for Islamic banks. AAOIFI Governance Standard 1
requires Islamic banks to establish the SSB, which consists of a minimum of 3 members (Hasan, 2011). The
presence of the second layer of governance in Islamic banks is expected to decrease the possibility of fraud
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in financial reporting and lower the agency costs in Islamic banks (Mensah, 2014). Thus, the constraints
imposed on certain transactions prevent Islamic banks from engaging in speculative and risky transactions,
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thereby reducing the management’s opportunities to behave unethically (Farook et al., 2014). Researchers
have proven that companies which that encourage moral and religious values backed by ethical codes are
immune from opportunistic behaviour such as EM (Dyreng et al., 2012; Ha-Brookshire, 2015) and are less
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likely to engage in financial reporting irregularities (McGuire et al., 2012). It is natural to believe that the
Islamic financial regulations, owing to its their religiosity and stringent monitoring, is are able to curtail EM
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better than conventional banks (Quttainah et al., 2013; Abdelsalam et al., 2016). The control of EM,
irrespective of conventional or Islamic institutions, is most likely to be addressed by strong corporate
governance that is practiced within the firm (Xie et al., 2003; Fonseca & Gonzales, 2008; Park & Shin,
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2004; González & Meca, 2014). Then, hypothetically it can be argued that Islamic institutions must be better
managed through high-level accountability and transparency, along with a strong commitment to corporate
governance. Lassoued et al., (2018) argue that EM is visibly lower in Islamic banks than in conventional
banks. In this regard, past researchers have also provided mixed contributions. Although most studies favour

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The AAOIFI is a standard-setting body established in 1997 in Bahrain. Its objective is to develop, prepare, promulgate, interpret, review and
amend accounting and auditing standards for Islamic financial institutions. It also commissions research in the area of Islamic accounting and
auditing (AAOIFI,2010).
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Shariah governance to be a contributing factor towards better management and reduction of opportunistic
behaviour (Garas, 2012; Wan Ismail et al., 2015; Kanagaretnam et al., 2015; Elnahass et al., 2016), some
have also argued otherwise (Nomran, Haron & Hassan, 2018). Sabrun et. al., (2018) provides clear evidence
that Shariah mechanisms do not help in deterring EM mechanism. Particularly in Malaysia, SSB members
seem to use Shariah regulations more as a ‘ceremonial role’ and not as ‘vigilant monitoring’ (Waemustaffa
& Abdullah, 2015). Based on the above discussion, we hypothesise that:

H1: Islamic banks are less likely to manage earnings compared to conventional banks, ceteris paribus

The wide range of services offered by Malaysian Banks have rendered banking institutions to be
highly susceptible to fraud (Sanusi et al., 2015). The recent political chaos in Malaysia is a constant
reminder that the governance mechanisms are insufficient in the current state of affairs. Among the internal
governance mechanisms, the BOD is expected to work towards reducing agency conflicts as they are

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appointed directly by shareholders (LaFond & Roychowdhury, 2006; Machuga & Teitel, 2009). The BOD’s
main obligation is to ensure maximisation of shareholders’ values by monitoring the management’s

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performance and preventing any actions through which the shareholders are disadvantaged (Man & Wong
2013). Specifically, the board’s responsibility is to ensure compliance with accounting principles (Dechow
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et al., 1996) and confine EM practices (Klein, 2002; Xie et al., 2003; Cornett et al., 2009). To execute its
role effectively, the board’s structure should be designed while considering the size, composition and
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leadership structure (Zeghal et al., 2011; Martin & Herrero, 2018).

Numerous researchers have established the importance of the board’s composition in economic value
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creation for firms (Rashid et al., 2010; Ramachandran et. al., 2015; Man & Wong, 2013). Researchers have
indicated both positive (Veklenko, 2016; Egbuneke & Odum, 2018) and negative impacts (Wang and
Oliver, 2009) of the board’s composition on EM. Various committees such as nomination (Agyemang-
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Mintah, 2015; Leung et al., 2014, Farooque et. al., 2007), remuneration (Appiah & Chizema, 2015), risk
management (Tao & Hutchinson, 2013; Kallamu, 2015), audit (Choi et al., 2014) and internal audit and
control (Raiborn et al., 2017) can assist with the split of responsibilities contributing to board effectiveness
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and the enhancement of board quality. Based on the Agency Theory, the board should be independent and
diligent (Chatterjee, 2019) to avoid managerial conspiracies (Eisenhardt, 1989; Fama & Jensen, 1983). This
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view implies that CEO duality will reflect lower board oversight (Finkelstein et al., 2009) and resultantly
lower EM. Overall, CEO power is an important determinant of the magnitude of EM (Baker et al., 2019).
Furthermore, monitoring of SSB for Islamic banks consisting of at least three members (Hasan & Dridi,
2010) and the presence of the second layer of governance is expected to decrease the possibility of fraud in
financial reporting and lowering the possibility of EM (Mensah, 2014). Thus, the presence of an efficient
board for different industries based on the extent of accountability should clearly reduce EM. We, therefore,
hypothesise that:
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H2: Board quality and CEO power will negatively impact EM in Islamic and conventional financial
institutions

Board interlock studies are not new in the area of corporate governance. It is justified that Board
interlocks may be positive or negative depending on power balance or ownership and CEO concentration
(Zona et al., 2018). At the same time, research has suggested that board interlocks are very useful in
increasing innovation (Helmers et al., 2017). In the case of Islamic institutions, SSB should consist of a
scholar who has adequate knowledge of Shariah law and technical understanding of the financial product to
be able to execute its role effectively. These abilities are very important as the Quran does not specifically
give direct guidance on contemporary financial products or operations, thus leaving it to the discretion of
the Shariah scholar to determine whether a particular product or bank’s operation has been carried out
according to Islamic law using ijtihad consensus (ijma’) or reasoning by analogy (qiyas) (Bassens et al.,

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2011). However, due to the multidisciplinary and complex nature of the skills needed, the number of
qualified Shariah scholars are limited (Bassens et al., 2011). For example, a need for 956 Sharia scholars in

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the GCC was filled only by 180 scholars (Unal, 2010; Hasan, 2011). Obviously, each Shariah scholar would,
by default, be appointed to more than one board in Islamic banks (interlock), either in the same country or
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even in different countries (Alman, 2012). Similarly, the top 50 Shariah scholars dominate 1142 Shariah
board directorships worldwide, as claimed by Razak (2018). The author also claims that such concentration
of power poses a great risk to the ability of the Shariah board to manage Shariah activities with due
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diligence. Other views on Shariah interlocks suggest positive (Bassens et al., 2011) as well as negative
effects (Issa, 2012) on Islamic financial institutions. Additionally, a shortage of Shariah scholars creates
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conflicts of interest and restrictions on confidentiality (Al Qattan, 2008; Hameed, 2009; Wilson, 2009) while
seeking higher remuneration (Garas, 2012) that could hinder independence. It can be observed that SSB
interlocks cannot be avoided due to limitations in specialisation. Hence, they must be used appropriately to
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help reduce EM rather than to increase opportunistic behaviour. However, studies with respect to Shariah
interlocks are very limited, providing a niche for this study. We hypothesise that:
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H3: Diligence in SSB interlock will negatively influence EM

3. Methodology
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The population for this study covers banks from the top 10 Islamic countries according to the ICFI, which
ranks countries based on their leadership role in Islamic banking and finance as issued by the Islamic
Banking and Finance Association (IBFA), with an aim to set benchmarks internationally5. According to the
2017 index, Malaysia is ranked topmost, followed by Iran, which is excluded here due to its unique

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http://www.gifr.net/publications/gifr2017/ifci.pdf
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characteristics (EY 2016)6 that makes the country incomparable with their conventional counterparts, thus
leading to an erroneous outcome if included (Farook et al., 2014). This study used unbalanced panel data
with observations from 2006 to 2016. Corporate governance and Shariah board data were collected from
annual reports of respective banks. The banks’ financial data was collected from the Datastream and
BankScope databases while macroeconomics data such as GDP growth and inflation were obtained from the
World Bank database. The final sample was chosen based on the availability of complete corporate
governance data from the annual report. The final sample consisted of 39 Islamic banks and 97 conventional
banks with a total of 1,165 observations. All the Islamic banks used in the sample are full-fledged Islamic
banks (See Table 1 below).

Table 1 Geographical distribution of the samples

Country Number of banks Number of samples

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CB IB Total CB IB Total

Bahrain 5 7 12 48 49 97

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Bangladesh 12 6 18 104 43 147

Indonesia 19 2 21 175 20 195

Kuwait

Malaysia
5

13
4

11
9

24
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39

127
32

90
71

217
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Pakistan 12 3 15 99 27 126

Qatar 5 2 7 44 13 57
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Saudi Arabia 6 2 8 56 18 74

Turkey 11 1 12 94 8 102

United Arab Emirates 9 1 10 72 7 79

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Total 97 39 136 858 307 1165

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We use LLP as a proxy for EM, which is similar to previous studies in the banking industry
(Kanagaretnam et al., 2004; Leventis, 2012; Elnahass et al., 2014; Abdelsalam et al., 2016). LLP is an
expense in the income statement, which reflects the management's assessment of the level of future loan
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losses in the current period. LLP is by far the major and most essential accrual for banks (Ahmed et al.,
1999; Shen & Huang, 2013) for many reasons. Firstly, as discretionary accrual, LLP balance is relatively
large in conventional banks, and therefore has significant impact on earnings. Secondly, it is relatively
uncomplicated to find proxies for the non-discretionary component of loan loss provisions (NLLP), which
permits researchers to estimate the impact of the discretionary portion (DLLP). Additionally, a robust

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https://islamicbankers.files.wordpress.com/2016/12/world-islamic-banking-competitiveness-report-2016-ey.pdf
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empirical relationship has been found between earnings and LLP in multiple types of settings (Beatty et al.,
2002; Kanagaretnam et al., 2010; Cornett et al., 2009; Fonseca & Gonzales 2008). Despite having numerous
governance variables that can explain EM, we limit our focus to the role of the main pillars of governance
mechanism, which are board quality and CEO power with SSB characteristics as additional explanatory
variables for Islamic banks. The chosen variables are the most prominent proxies for board quality, CEO
power, and SSB characteristics. The summary of variables and proxies used is described in Table 2.

Table 2 Summary of variables and proxies used in the study

Abbreviation Variable Proxy Reference
LLP Loan loss provision for loan losses divided by Kanagaretnam et al.,
provision beginning balance of loans (2004)
BNPL NPL beginning beginning balance of non- Kanagaretnam et al.,

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balance performing loans divided by (2004)
beginning balance of loans
CHNPL Change in NPL change in the value of non- Kanagaretnam et al.,
performing loans divided by

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(2004)
beginning balance of loans
CHLOAN Change in loan change in the value of loans divided Kanagaretnam et al.,
by beginning balance of loans (2004)
DLLP
LOSS Earnings loss
avoidance
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Residual of first stage regression
Dummy variable, coded 1 if income
before taxes scaled by total assets
Kanagaretnam et al.,
(2010, 2015)
between 0 – 0.002, zero otherwise
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Board of Directors’ structure
MEETINGS Number of Total board of directors’ meetings Xie et al. (2003); Mollah
meetings during the year & Zaman (2015)
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BSIZE Board size Total members of board of directors Andres & Vallelado
(2008)
INDPT Board Percentage of independent board Andres & Vallelado
independence divided by total number of board of (2008); Cornett et al.,
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directors (2009)
DUAL CEO duality Dummy variable, coded 1 if
chairman and CEO are the same González & Meca (2014)
person, otherwise 0
Shariah supervisory board
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SSBSIZE Proxy of shariah Number of shariah board members Mollah & Zaman (2015);
supervision Othman (2015)
INTLA SSB interlock – Ratio of SSB members sitting in Stuart & Yim (2010);
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local other bank’s shariah board in the Quttainah et al., (2013)

same country, otherwise 0
INTLB SSB interlock – Ratio of SSB members sitting in Stuart & Yim (2010);
international other bank’s shariah board in a Quttainah et al., (2013)
different country, otherwise 0
DISL Islamic and Dummy variable, coded 1 for Mollah & Zaman (2015)
conventional Islamic bank, otherwise 0
banks
Firm control variables
FSIZE Size Log of total assets as proxy of firm Kanagaretnam et al.
size (2010); Sood (2012)

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 LEV Leverage The ratio between the book value of Cornett et al., (2009)
all liabilities and the total assets
OCF Operating cash Net cash from operating activities Abdelsalam et al., (2016)
flow divided by total assets
Macroeconomic control variables
GDP GDP growth rate Average annual growth of a Fonseca & Gonzales
country’s total output that takes the (2008); Mollah & Zaman
gross domestic product divided by (2015)
the country’s population
INF Inflation Inflation rate Fonseca & Gonzales
(2008); Mollah & Zaman
(2015)
Board independence: Board independence is measured by the percentage of independent directors present
in the board (Andres & Vallelado, 2008). According to the Agency Theory, in order to control management
opportunistic behaviour and prevent agency problems, a majority of the board must consist of independent
directors (Quttainah et al., 2013). It is believed that independent directors do not chase their own interests

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such as executive compensation and have no requirement to meet pre-set targets (Man & Wong, 2013).
Thus, boards with more independent directors strive for better quality in earnings quality through proper

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monitoring (Machuga & Teitel, 2009; Man & Wong, 2013; Alves, 2014).

Board size: Board size is related to bureaucratic problems and the functional form of the board. A company
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with low monitoring requirements may be better supervised by a smaller board. In contrast, companies with
complex portfolios might need intensive advisory and monitoring, thereby engaging higher numbers in
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boards (Stuart & Yim, 2010). The effect of board size towards on EM is inconclusive and mixed (Xie et al.,
2003; Andres et al., 2005).
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Board meetings: The number of board meetings held can be a sign of a company operating efficiently.
Frequent board meetings lead to more effective monitoring in a firm (Vafeas, 1999; Cornett et al., 2009; Xie
et al., 2003), which implies more control over the management, and thus, leads to lower levels of EM.
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CEO power: We measured CEO power using CEO duality, which is a situation where the CEO holds both,
the Chairman and CEO positions (Mollah & Zaman, 2015). Duality reduces board independence and
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decreases the flexibility of the board of directors, thus, diminishing the possibility of the board executing
their role of oversight properly (Krause et al., 2014; Grassa, 2015).
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Shariah Board: Due to their functional similarities, the impact of the Shariah board size on EM should
comply with the relationship between board sizes in conventional banking systems and EM. Therefore, the
hypothesis is that larger board sizes enable better supervision and control even in the context of Islamic
banks, and hence, eventually address EM issues (Mersni & Othman, 2016; Quttainah et al., 2013)

Shariah Board interlock: The Shariah Board interlock for this study is divided into two categories, namely
interlock in the same country (INTLA) and interlock in the international network (INTLB). INTLA enables
the company to create links with the external environment (Quttainah et al., 2013). INTLB is introduced to
11
capture the impact of scholars involved in multiple boards across the country due to shortage of Shariah
experts (Nomran et. al., 2018). The data of SSB members collected from annual reports states that SSB
interlock is identified as the number of board members sitting on other boards divided by the total number of
SSB members (Quttainah et al., 2013; Stuart & Yim, 2010; Mardian, 2015). Interlock scores are awarded to
Shariah scholars who serve as SSB members in other banks for 10 years or more, allowing transfer of
knowledge (Stuart & Yim, 2010).

Since this paper uses data from several countries with observations spanning over ten years, control
variables are needed to control the impact of any firm-specific characteristics. This research adds three firm-
specific variables, which are: firm size, leverage and operating cash flow. These are pertinent to banking
research when examining corporate governance (Xie et al., 2003; Cornett et al., 2009; Abdelsalam et al.,
2016).

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Bank size (FSIZE): FSIZE is expected to have a negative relationship with EM. Smaller firms may operate
with less scrutiny and may be able to engage in more EM (Xie et al., 2003).

ro
Leverage (LEV): Previous research indicates that LEV affects EM positively as banks use accounting ratios
to maintain their capital adequacy ratio requirements (Cornett et al., 2009; Leventis, 2012). Companies with
-p
high performance tend to use more conservative accounts so that they are less motivated to manage
accounting earnings.
re
Operating cash flows (OCF): The bank’s financial performance is controlled by OCF. OCF impacts EM
negatively (Abdelsalam et al., 2016; Leventis, 2012).
lP

We also use macroeconomic control variables such as:

GDP growth: GDP growth is used to control the possible countercyclical impact of LLP. GDP growth
na

reflects economic upswings, which indicate improved performance for companies and individuals.
Therefore, it reduces the likelihood of loan default, whereas a recession will have the opposite effect
ur

(Fonseca and Gonzales, 2008). It is expected that GDP growth will affect DLLP negatively.

Inflation (INFL): Similar to GDP, a negative relationship exists between INFL and LLP (Mollah and
Jo

Zaman 2015; Laeven & Majnoni, 2003).

Based on the work of Mersni & Othman (2016), Elnahass et al. (2014) and Shen and Huang (2013), the
model estimation is carried out in two stages. In the first stage, we identify the determinants for the LLP
components, namely discretionary (DLLP) and non-discretionary (NLLP). NLLP contains information about
the default risk and bad debts that cannot be controlled by managers. On the other hand, DLLP is subject to
the manager’s manipulation, given that it involves the management’s judgment especially those who have
private information about default risk in the loan portfolio (Wahlen, 1994). Since DLLP and NLLP cannot

12
be directly observed, a model is developed to estimate them using variables that influence the level of LLP
in the bank’s portfolio (Mersni & Othman, 2016; Eugenie et al., 2016), thus, obtaining residuals from the
estimation. In the second stage, these residuals are regressed against explanatory variables.

First stage regression (Kanagaretnam et al., 2015; Mersni & Othman, 2016).
𝐿𝐿𝑃𝑖𝑡 = 𝛼 + 𝛽1 𝐵𝑁𝑃𝐿𝑖𝑡 + 𝛽2 𝐶𝐻𝑁𝑃𝐿𝑖𝑡 + 𝛽3 𝐶𝐻𝐿𝑂𝐴𝑁𝑖𝑡 + 𝜀𝑖𝑡 (1)

All variables are divided by the lagged beginning balance of loans to avoid the potential problem of
heteroscedasticity (Kanagaretnam et al., 2004). After obtaining the residuals, the absolute value of DLLP is
used as a dependent variable for the second phase.

Second stage regression: The second phase of this study is divided into three models:
Model 1 – EM in Islamic and conventional banks

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In order to fulfil the first objective of this study, we employed an independent group t-test to examine
whether EM in Islamic and conventional banks differ significantly. To support the result, a dummy variable

ro
is employed in equation (2).

Model 2 –Board of Directors model -p

In order to examine the second hypothesis in this study, the relationship of the board quality to EM is
described in the model below.
re
𝐴𝐿𝐿𝑃𝑖𝑡 = 𝛼 + 𝛽1 𝑀𝐸𝐸𝑇𝐼𝑁𝐺𝑖𝑡 + 𝛽2 𝐵𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽3 𝐼𝑁𝐷𝑃𝑖𝑡 + 𝛽4 𝐷𝑈𝐴𝐿𝑖𝑡 + 𝛽5 𝐷𝐼𝑆𝐿𝑖𝑡 + ∑𝑘 𝛿𝑘 𝐹𝑖𝑟𝑚𝑖𝑘 +
∑𝑙 𝜆𝑙 𝑀𝑎𝑐𝑟𝑜𝑒𝑐𝑜𝑛𝑜𝑚𝑐𝑖𝑙 + 𝑌𝐸𝐴𝑅 + 𝛿𝑖 + 𝜀𝑖𝑡
lP

(2)

Model 3 – Shariah Supervisory Board model

The third model aims to test SSB role in deterring EM.
na

𝐴𝐿𝐿𝑃𝑖𝑡 = 𝛼 + 𝛽1 𝑀𝐸𝐸𝑇𝐼𝑁𝐺𝑖𝑡 + 𝛽2 𝐵𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽3 𝐼𝑁𝐷𝑃𝑖𝑡 + 𝛽4 𝐷𝑈𝐴𝐿𝑖𝑡 + 𝛽5 𝑆𝑆𝐵𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽6 𝐼𝑁𝑇𝐿𝐴𝑖𝑡 +

𝛽7 𝐼𝑁𝑇𝐿𝐵𝑖𝑡 + ∑𝑘 𝛿𝑘 𝐹𝑖𝑟𝑚𝑖𝑘 + ∑𝑙 𝜆𝑙 𝑀𝑎𝑐𝑟𝑜𝑒𝑐𝑜𝑛𝑜𝑚𝑐𝑖𝑙 + 𝑌𝐸𝐴𝑅 + 𝛿𝑖 + 𝜀𝑖𝑡 (3)
ur

This study employed a random effect-GLS technique (Baltagi & Wu, 1999; Mollah & Zaman, 2015). The
use of random effect estimation is based on the outcome of the Hausman test. Since the time-invariant
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parameter cannot be estimated using a fixed effect model (Baltagi & Wu, 1999), the GLS method is more
suitable (Wooldrigde, 2002). Variable YEAR is included to capture time-specific effects and to counter the
possibility of the heteroscedasticity problem during the error term (Abdelsalam et al., 2016).

Robustness test: In order to ensure that the value of EM in the first stage regression is not affected by
omitted variables, this study uses an earnings benchmark, i.e., loss avoidance as an alternative proxy of EM
(Dichev & Skinner, 2002; Kanagaretnam et al., 2010). Loss avoidance (LOSS) is measured by a dummy

13
variable based on the ROA value (income before tax scaled by total assets). If the bank has a small ROA
value within the interval 0 to 0.002, the dummy variable score assigned is 1. Since the dependent variable is
binary, Model 4 below will be tested using a logistic model. Additional control variables are included to
estimate the logistic model below:

𝐿𝑂𝑆𝑆𝑖𝑡 = 𝛼 + 𝛽1 𝑀𝐸𝐸𝑇𝐼𝑁𝐺𝑖𝑡 + 𝛽2 𝐵𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽3 𝐼𝑁𝐷𝑃𝑖𝑡 + 𝛽4 𝐷𝑈𝐴𝐿𝑖𝑡 + 𝛽5 𝑆𝑆𝐵𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽6 𝐼𝑁𝑇𝐿𝐴𝑖𝑡 +

𝛽7 𝐼𝑁𝑇𝐿𝐵𝑖𝑡 + ∑𝑘 𝛿𝑘 𝐹𝑖𝑟𝑚𝑖𝑘 + ∑𝑙 𝜆𝑙 𝑀𝑎𝑐𝑟𝑜𝑒𝑐𝑜𝑛𝑜𝑚𝑐𝑖𝑙 + 𝛿𝑖 + 𝜀𝑖𝑡 (4)

4. Results and Discussion

Table 3 and Table 4 present the descriptive statistics. It can be seen from Table 3, Panel A that on
an average most banks have approximately 40% independence, with Indonesian banks demonstrating the
highest commitment to independence (55%) while the lowest commitment to independence was recorded

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for by Bangladesh (15%). According to Yermack (1996), the ideal board size that allows appropriate
communication and decision making between the top management and the board is around 6 to 8 members.
Overall, the mean for CEO duality is 0.9, which is measured by a dummy variable. This indicates

ro
appropriate segregation of duties between the CEO and Chairman in most countries, with the exceptions of
Indonesian and Malaysian banks. However, it is important to note that the absence of CEO duality does not
-p
always convey the message of good governance practices (Krause et al., 2014). Lastly, in most banks,
meetings are held about 12 times a year, except as seen in Bahrain and Saudi Arabia (5 times a year). In
re
this regard as well, Bangladeshi and Indonesian banks show a higher commitment (18 times a year) in
demonstrating accountability.
lP

With respect to SSB (Panel B), all Islamic banks have 5 members that maintain AAOIFI
compliance, with the exception of Turkey, where no SSB exists and the law does not impose such a
criterion (Turkiye Finans, 2014)7. It can also be noted from the table that Kuwait has the highest number of
na

Shariah scholars who hold positions in SSB of other countries (INTLB = 75%) compared to any other
country (INTLA = 30%). Meanwhile, Malaysia has the lowest score (11% INTLA and 6% INTLB) in
ur

accordance with the Malaysian Central Bank regulation to avoid conflicts of interest and to maintain
confidentiality, unlike other GCCs where such regulations are less visible. Panel C, on the other hand,
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reveals a similar average value of LEV, FSIZE, OCF and INF for all countries. All banks in the sample
seem heavily leveraged (average 80% debt/equity ratio). GDP grew approximately 4.5% per year, with no
negative value recorded for any country. During the observation period, all countries experienced positive
growth in their economy, with Qatar having the highest GDP growth (11%).

Table 4, Panel A summarises the scores for the variables used in the first stage regression to obtain
discretionary accruals. The average LLP charge during the year for all samples is 1.22% of the loan balance

7
https://www.tkbb.org.tr/Documents/Yonetmelikler/TR_Turkey_eng_digital_002.pdf
14
in the beginning. LLP in conventional banks is slightly higher than in Islamic banks by 0.008% compared
to the average (1.22%). Table 4, Panel B shows the comparison of variables used in the second stage
regression. LLP in conventional banks is slightly higher than in Islamic banks. However, when separated
into discretionary and non-discretionary portions, the discretionary portion of LLP (DLLP) shows that
conventional banks record a lower figure than Islamic banks, but is statistically insignificant. Both groups
have similar percentages of board independence, board size and CEO duality. However, conventional banks
seem to hold more board meetings compared to Islamic banks. This is in line with how the size of
conventional banks (as indicated in FSIZE) are bigger than Islamic banks. Due to the complexity of
transactions for commercial banks, they need higher levels of coordination to tighten their monitoring
process.

Table 5, Panel A provides the correlation statistics for all observations, whereas Panel B provides

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the correlation statistics for Islamic banks. As shown in both panels, the correlation coefficients are
generally low, indicating the absence of multicollinearity problems between independent variables

ro
(Tabachnick & Fidell, 2001) with a correlation value below 0.8 (Field, 2009).

-p
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lP
na
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15
Table 3 Descriptive statistics of all variables considered for this study

f
Panel A Panel B Panel C

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SSB
DLLP DISL INDP BSIZE DUAL MEETING SIZE INTLA INTLB FSIZE LEV OCF GDP INFL
Overall
Obs 1,165 1,165 1,165 1,165 1,165 1,165 299 299 299 1,165 1,165 1,165 1,165 1,165

pr
Mean 0.007 1 41.116 9.267 0.931 12.287 5.087 0.301 0.301 6.919 0.895 0.022 4.845 5.469

Std. Dev. 0.006 - 19.395 3.239 0.253 10.014 2.351 0.300 0.343 0.590 0.054 0.066 3.531 3.778

e-
Bahrain

Obs 97 97 97 97 97 97 49 49 49 97 97 97 97 97

Mean 0.009 0.505 45.731 9.794 0.948 5.722 4.306 0.610 0.727 6.741 0.853 0.017 4.364 2.326

Pr
Std. Dev. 0.008 0.503 14.766 2.131 0.222 1.599 1.176 0.235 0.219 0.465 0.064 0.113 1.973 1.108
Bangladesh

Obs 147 147 147 147 147 147 43 43 43 147 147 147 147 147

Mean 0.005 0.293 15.656 l

14.367 0.966 18.483 9.349 0.184 - 6.198 0.926 0.031 5.999 7.535
na
Std. Dev. 0.004 0.456 8.717 4.123 0.182 6.512 2.768 0.208 - 0.248 0.042 0.085 0.574 1.588
Indonesia

Obs 195 195 195 195 195 195 20 20 20 195 195 195 195 195
ur

Mean 0.008 0.103 55.086 5.754 1.000 18.805 3.150 0.154 0.167 6.838 0.898 0.019 5.515 6.671

Std. Dev. 0.006 0.304 8.899 1.717 - 15.279 0.366 0.161 0.171 0.484 0.036 0.063 0.845 2.437
Kuwait
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Obs 71 71 71 71 71 71 32 32 32 71 71 71 71 71

Mean 0.007 0.451 38.038 9.099 0.803 8.366 4.594 0.672 0.754 7.200 0.873 0.020 1.155 4.143

Std. Dev. 0.006 0.501 13.917 0.988 0.401 3.567 1.012 0.226 0.193 0.367 0.042 0.014 5.292 1.817

16
Malaysia

Obs 217 217 217 217 217 217 90 90 90 217 217 217 217 217

f
oo
Mean 0.007 0.415 51.758 8.507 1.000 11.129 4.978 0.110 0.065 7.060 0.916 0.014 4.732 2.517

Std. Dev. 0.004 0.494 11.953 2.167 - 4.745 1.122 0.135 0.151 0.494 0.032 0.062 2.372 1.286
Pakistan

pr
Obs 126 126 126 126 126 126 27 27 27 126 126 126 126 126

Mean 0.009 0.214 39.756 8.810 0.952 6.675 2.852 0.170 0.253 6.511 0.909 0.028 3.524 9.970

Std. Dev. 0.006 0.412 24.527 1.733 0.214 2.465 1.134 0.147 0.223 0.480 0.086 0.078 1.255 4.634

e-
Qatar

Obs 57 57 57 57 57 57 13 13 13 57 57 57 57 57

Pr
Mean 0.008 0.228 38.557 8.912 0.737 6.930 3.462 0.673 0.532 7.088 0.854 0.027 11.517 3.590

Std. Dev. 0.004 0.423 18.792 1.106 0.444 1.557 0.877 0.343 0.188 0.429 0.060 0.015 7.583 6.097
Saudi Arabia

Obs 74 74 74 74 74 74 18 18 18 74 74 74 74 74
l
na
Mean 0.005 0.243 49.127 9.419 0.986 5.689 5.278 0.159 0.159 7.536 0.870 0.028 5.168 4.496

Std. Dev. 0.002 0.432 15.281 1.239 0.116 1.759 0.461 0.185 0.185 0.275 0.028 0.015 2.495 2.260
Turkey

Obs 102 102 102 102 102 102 - - - 102 102 102 102 102
ur

Mean 0.007 0.078 24.502 10.618 0.980 21.618 - - - 7.473 0.898 0.023 3.942 8.177

Std. Dev. 0.007 0.270 9.147 1.408 0.139 13.323 - - - 0.511 0.038 0.049 3.949 1.234
Jo

United Arab Emirates

Obs 79 79 79 79 79 79 7 7 7 79 79 79 79 79

Mean 0.005 0.089 39.834 9.139 0.595 6.380 4.714 0.214 0.643 7.282 0.865 0.024 3.412 3.415

Std. Dev. 0.004 0.286 20.023 1.872 0.494 1.734 0.488 0.024 0.073 0.430 0.034 0.014 3.663 4.088

17
Table 4 Descriptive statistics of variables used in the first stage regression

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oo
Overall Conventional banks Islamic banks
Variable Obs Mean Std. Dev. Obs Mean Std. Dev. Obs Mean Std. Dev. t-score
Panel A
LLP 1198 0.0122 0.0137 883 0.0124 0.0128 315 0.0116 0.0159 0.9362
CHNPL 1198 0.0004 0.0027 883 0.0003 0.0024 315 0.0005 0.0032 0.1638

pr
CHLOAN 1198 0.1465 0.2097 883 0.1341 0.1981 315 0.1813 0.2361 -0.8381
BNPLT 1198 4.9151 5.3595 883 4.9303 5.4768 315 4.8727 5.0244 -3.4486***

e-
Panel B
DLLP 1165 0.0069 0.0056 858 0.0068 0.0053 307 0.0074 0.0063 -1.6651*
INDP 1165 41.1158 19.3947 858 40.5743 19.3080 307 42.6293 19.5874 -1.5943
BSIZE 1165 9.2670 3.2388 858 9.1725 3.1185 307 9.5309 3.5454 -1.6654*

Pr
DUAL 1165 0.9313 0.2530 858 0.9336 0.2492 307 0.9251 0.2637 0.5041
MEETINGS 1165 12.2867 10.0136 858 13.2914 11.1117 307 9.4788 4.9891 5.8049***
FSIZE 1165 6.9194 0.5905 858 7.0291 0.5747 307 6.6128 0.5229 11.1496***
LEV 1165 0.8947 0.0536 858 0.8984 0.0457 307 0.8845 0.0704 3.9062***
OCF 1165 0.0220 0.0656 858 0.0217 0.0605 307 0.0228 0.0782 -0.2697
GDP 1165 4.8446 l 3.5313 858 4.9013 3.4913 307 4.6862 3.6419 0.9159
na
INFL 1165 5.4693 3.7776 858 5.7833 3.7715 307 4.5917 3.6604 4.7879***
SSBSIZE 299 5.0870 2.3515
INTLA 299 0.3009 0.2998
INTLB 299 0.3013 0.3428
ur

Table 5 Correlation analysis of all independent and control variables

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Panel A
DLLP INDPT BSIZE DUAL MEETINGS FSIZE LEV OCF DUMMY GDP INFL
DLLP 1
INDPT 0.057 1
BSIZE - 0.110 - 0.524 1
DUAL 0.032 - 0.068 0.053 1
MEETINGS - 0.017 - 0.091 0.028 0.129 1
FSIZE - 0.126 0.177 - 0.063 - 0.048 0.075 1
LEV - 0.101 - 0.029 0.096 0.179 0.167 - 0.028 1
18
OCF - 0.065 - 0.080 - 0.003 - 0.027 0.021 - 0.055 - 0.010 1
DUMMY 0.049 0.047 0.049 - 0.015 - 0.168 - 0.311 - 0.114 0.008 1
GDP - 0.050 - 0.014 0.029 0.009 0.041 - 0.083 - 0.068 - 0.006 - 0.027 1
INFL - 0.003 - 0.198 0.080 0.111 0.179 - 0.242 0.085 0.028 - 0.139 0.061 1

f
oo
Panel B
DLLP SSBSIZE INTLA INTLB INDPT BSIZE DUAL MEETINGS FSIZE LEV OCF GDP INFL
DLLP 1
SSBSIZE - 0.259 1

pr
INTLA 0.128 - 0.232 1
INTLB 0.199 - 0.309 0.788 1
INDPT 0.053 - 0.393 0.030 0.163 1
BSIZE - 0.150 0.653 - 0.005 - 0.156 - 0.578 1

e-
DUAL 0.104 0.059 - 0.269 - 0.376 - 0.176 0.078 1
MEETINGS - 0.179 0.453 - 0.352 - 0.400 - 0.243 0.330 0.143 1
FSIZE - 0.185 0.093 0.180 0.256 0.254 - 0.006 - 0.301 0.018 1
LEV - 0.207 0.301 - 0.240 - 0.387 - 0.065 0.107 0.136 0.274 0.084 1

Pr
OCF - 0.112 - 0.066 - 0.030 - 0.070 - 0.075 - 0.112 - 0.051 - 0.020 - 0.067 - 0.013 1
GDP - 0.067 0.116 - 0.059 - 0.155 - 0.052 0.072 - 0.032 0.122 - 0.014 - 0.115 - 0.008 1
INFL 0.010 0.129 - 0.174 - 0.171 - 0.285 0.254 0.123 0.104 - 0.406 - 0.008 0.093 0.085 1

l
na
ur
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19
 In order to establish the first hypothesis that EM will be lower in Islamic banks compared to their
conventional counterparts, LLP was regressed against CHNPL, BNPL and CHLOAN for each group and
the residuals for each group indicate that CHNPL and BNPL influence LLP positively at a 1% significance
level (Table 6), which is in line with the studies of Kanagaretnam et al. (2004), Quttainah et al. (2013),
Farook et al. (2014) and Mersni & Othman (2016). This finding implies that an increase in NPL (CHNPL)
is likely to increase LLP. Similarly, higher levels of NPL at the beginning of the period encourages banks
to create a higher provision for loss for that particular period. However, CHLOAN does not influence LLP
significantly. Combining the results of the pairwise t-test analysis (Table 4) and the regression (Table 6), it
can be concluded that a minor difference exists between the EM of Islamic and conventional banks (P =
0.0962). Additionally, the dummy variable (columns 1 and 2 of Table 7) does not affect DLLP
significantly, indicating no significant difference between the levels of EM between the two groups, which
is consistent with Othman and Mersni (2014) and Zoubi and Al-Khazali (2007). Thus, it can be concluded

of
that Islamic banks do not demonstrate lower EM compared to commercial banks. On the contrary,
descriptive statistics show that commercial banks tend to have lower EM compared to their respective

ro
Islamic counterparts. Although several scholars emphasise the role of religiosity, our study purports that the
existence of Islamic values in Islamic banks do not create any distinction in the way managers behave
-p
towards discretionary accruals. The pressure to maintain profitability and accounting methods, among
others, could be the cause attributed to such attitudes.
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Table 6 First stage regression result
(1) (2) (3)
lP

All sample Conventional banks Islamic banks

CHGNPL 1.894 1.786 2.246
(13.36)*** (10.52)*** (8.77)***
CHGLOAN -0.001 -0.001 -0.001
na

(0.80) (0.61) (0.26)

BNPL 0.001 0.001 0.001
(10.23)*** (6.79)*** (8.91)***
ur

Constant 0.008 0.009 0.004

(13.79)*** (14.57)*** (2.78)***
Observations 1198 883 315
R-squared 0.16 0.13 0.28
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Absolute value of t statistics in parentheses

* significant at 10%; ** significant at 5%; *** significant at 1%

To validate the second hypothesis about Board quality and the role of CEO power in EM, Table 7
shows that Board size affects EM levels negatively, which is consistent with the previous studies by Mersni
& Othman (2016) and Xie et al. (2003). It is apparent that a large number of directors deliver the required
skill and knowledge to control managers’ actions, hence, limit EM practices. However, it should be noted

20
that excessive size can be an obstacle for quick and efficient decision-making, due to problems of
coordination and communication (González & Meca, 2014). When the groups are split, we observe that
board meetings and CEO duality negatively influence EM in Islamic banks, which is in line with the
studies of Andres and Vallelado (2008), Cornett et al. (2009), Xie et al. (2003) and Vafeas (1990). A
number of independent directors were found to be statistically insignificant in explaining EM, which is
consistent with the study of Harris and Raviv (2008), who explained that external directors could augment
the free-rider problem. The firm-specific variables FSIZE, LEV, and OCF are found to influence EM
negatively in all models, thereby indicating that managers of big banks, highly levered banks and banks
with high operating cash flows are likely to keep EM lower, perhaps due to external monitoring (Fonseca &
Gozales, 2008; Kanagaretnam et al., 2010; Abdelsalam et al., 2016; Leventis, 2012).

Table 7 Second stage regression results

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All samples Conventional banks Islamic banks
(1) (2) (3) (4) (5) (6)
DLLP DLLP DLLP DLLP DLLP DLLP

ro
INDP 0.000 0.000 -0.000 0.000 -0.000 0.000
(0.10) (0.49) (0.28) (0.14) (0.05) (0.02)
BSIZE -0.000 -0.000 -0.000 -0.000 -0.000 -0.000

DUAL
(2.38)**
0.001
(1.29)
(2.19)**
0.001
(1.43)
(1.97)**
0.000
(0.36)
-p
(1.74)*
0.001
(0.69)
(1.29)
0.003
(1.96)*
(1.28)
0.002
(1.17)
MEETINGS -0.000 -0.000 0.000 0.000 -0.000 -0.000
re
(0.64) (0.17) (0.06) (0.30) (2.47)** (1.64)
FSIZE -0.001 -0.001 -0.002
(3.20)*** (2.58)*** (2.00)**
LEV -0.010 -0.008 -0.015
lP

(2.76)*** (1.66)* (2.42)**

OCF -0.006 -0.004 -0.010
(2.46)** (1.43) (2.13)**
GDP -0.000 -0.000 -0.000
na

(0.94) (0.48) (0.70)

INFL -0.000 -0.000 -0.000
(0.41) (0.16) (0.33)
DUMMY 0.001 0.000
(1.16) (0.20)
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Year Effect Yes Yes Yes Yes Yes Yes

Constant 0.007 0.026 0.008 0.023 0.007 0.033
(5.00)*** (5.53)*** (4.99)*** (4.00)*** (2.42)** (4.01)***
Observations 1165 1165 858 858 307 307
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Absolute value of t statistics in parentheses

* significant at 10%; ** significant at 5%; *** significant at 1%

As for SSB (Table 8), it is seen that the board size has a significant impact on reducing EM for
Islamic banks (Quttainah et al., 2013). However, SSBSIZE matters only when we assume that EM is
influenced by the BOD, CEO duality and SSB characteristics. When controlled by other factors such as
firm and macroeconomic variables, the impact of SSB size on EM is lessened. CEO duality matters
21
significantly for Islamic banks after controlling firm-specific characteristics and macroeconomic variables.
A similar result is obtained for Islamic banks’ BOD and CEO duality as shown in column 3 of Table 8.
This positive relationship supports the research by Klein (2002) and Lo (2008), who reiterated that a
company with different persons serving as CEO and Chairman is less likely to manage earnings. Thus, we
partially support the second hypothesis stating that board matters actively contribute to reduce earnings,
while CEO duality only has a higher impact on Islamic banks compared to conventional banks. Similarly,
control variables are only relevant for commercial banks and not Islamic banks.

Table 8 Regression result of Shariah supervision

(1) (2) (3) (4)
DLLP DLLP DLLP DLLP
SSBSIZE -0.000 -0.000 -0.000 -0.000
(2.04)** (1.12) (1.14) (1.22)
INTLA -0.002 0.002 -0.001

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(0.91) (1.35) (0.60)
INTLB 0.005 0.004 0.005
(2.44)** (2.56)** (2.17)**

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INDP -0.000 0.000 -0.000 -0.000
(0.35) (0.00) (0.06) (0.10)
BSIZE 0.000 -0.000 -0.000 -0.000
(0.02) (0.70) (0.63) (0.48)
DUAL

MEETINGS
0.004
(2.78)***
-0.000
0.002
(1.46)
-0.000
-p 0.003
(1.94)
-0.000
0.003
(1.96)*
-0.000
(0.92) (0.84) (0.51) (0.58)
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FSIZE -0.002 -0.002 -0.002
(2.04)** (2.59)*** (2.62)***
LEV -0.012 -0.009 -0.008
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(2.01)** (1.44) (1.30)

OCF -0.011 -0.010 -0.009
(2.24)* (2.04)** (1.99)**
GDP -0.000 -0.000 0.000
(0.46) (0.01) (0.08)
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INF -0.000 -0.000 -0.000

(0.04) (0.11) (0.20)
Year effect Yes Yes Yes Yes
Constant 0.005 0.030 0.028 0.028
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(1.69)* (3.68)*** (3.51)** (3.45)***

Observations 299 299 299 299
Number of CODE 38 38 38 38
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To assess if the SSB interlock, when used religiously, can help curtail EM, we first collated the
names of 249 scholars as stated in the annual report of the sample Islamic banks. The top 10 Shariah
scholars sat in more than two banks, as illustrated in Table 9. One interesting point in SSB membership is
that during the period of observation, SSB rotation was very rare. Unlike conventional board policies, some
Islamic banks do not state the maximum number of years a Shariah scholar can engage as a SSB member.
Thus, banks can have the same Shariah board for more than 5 years. This study regresses both INTLA and
INTLB at the same time, as well as separately, to understand which interlock status is more significant
22
towards EM. Based on the result in columns 3 and 4, the top Shariah scholars who hold board positions
outside their home country have a significant positive impact on EM, implying that members who sit in the
SSB of other countries tend to compromise their independence. This finding is consistent with the research
by Larcker et al. (2005) and Fich and Sivdasani (2006). Meanwhile, INTLA that represents the score for
SSB members holding positions in other banks in the same country does not show any significant
relationship with EM.

Table 9 Summary of SSB positions held by top Shariah scholars

Number of Islamic banks

Saudi
Shariah scholar Bahrain Kuwait Malaysia Pakistan Qatar Arabia UAE Total
Dr Abdul Satar Abu Ghuddah 1 1 3 1 2 8

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Shaikh Nedham Yaqoubi 4 1 1 1 7
Ahmad Bezea Al-Yaseen 1 4 5
Dr. Ajeel Jassim Al-Nashmi 1 2 2 5

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Dr. Mohammed Abdul Razaq Al-Tabtabaee 1 2 1 4
Sheikh Dr. Khaled Al-Mathkour 1 3 4
Dr Waleed bin Hadi
Dr. Abdul Latif Al Mahmood 3
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Dr. Ahmed Mohiyeldin Ahmed 1 2 3
Dr. Anwar Shuaib Abdulsalam 1 1 1 3
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Dr. Essam Khalaf Al Enizi 1 2 3

Dr. Hussein Hamed Hassan 1 2 3
Dr. Yusef Abdullah AlShubaily 1 2 3
Mohammed Othman Tahir Shubeir 3 3
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Sheikh Abdullah Sulaiman Al Manee’a 2 1 3

Sheikh Dr. Abdulaziz Khalifa Al-Qasar 3 3
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Sheikh Mohamed Taqi Uthmani 2 1 3

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Robustness test

To assess the validity of the findings, we used non-accrual LOSS (loan loss avoidance) as another
proxy for EM. To test the independent binary variable, logistic regression was carried out and the findings
are reported in Table 10. Overall, the results remain relatively unchanged compared to the earlier results. It
confirms that there is no statistically significant evidence supporting differences between the EM level in
Islamic banks and conventional banks. BSIZE and FSIZE are consistently found to have a significant
negative relationship with EM. However, unlike the original model, GDP affects EM negatively in the

23
robustness test. It can be inferred that when the economy is booming, conventional and Islamic banks tend
to engage less in EM. Meanwhile for Islamic banks, GDP growth is the only control variable that reveals
any impact on EM, while others control variables do not have any significant influence on management
behaviour.

Table 10 Regression result of robustness test

(1) (2)
Loss avoidance score Loss avoidance score
INDP 0.002 0.014
(0.15) (0.59)
BSIZE -0.310 -0.366
(2.68)*** (1.91)
DUAL -1.185 0.468
(1.76) (0.32)
MEETINGS -0.239 -0.218
(2.65)*** (1.72)

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FSIZE -1.377 0.722
(2.44)** (0.73)
LEV 2.756 -3.242

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(0.82) (0.72)
NOCF -1.928 -1.214
(0.80) (0.38)
GDP -0.219 -0.220

INFL
(3.23)***
0.043
(0.88)
-p (2.07)**
0.009
(0.11)
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DISL 0.577
(1.12)
SSBSIZE -0.548
(1.30)
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INTLA -1.163
(0.57)
INTLB -0.480
(0.25)
Constant 8.615 1.995
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(1.96)* (0.32)
Observations 1165 299

Absolute value of z statistics in parentheses

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** significant at 5%; *** significant at 1%

5. Conclusion
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The main objectives of this paper are to study EM level and the impact of corporate governance on
Islamic and conventional banks. In particular, this study examines the role of board quality, CEO power,
role of SSB and the impact of SSB interlocks on EM. Using a sample of 1,165 firms between 2006 to 2016,
it was established that Islamic financial institutions did not demonstrate tendencies to reduce managerial
opportunistic behaviour. On the contrary, there were indications that big and highly levered conventional
banks showed more concern for EM as opposed to the larger expectation of religiosity. Secondly, board

24
quality and CEO power helped in reducing EM for both commercial and Islamic banks. Board size, firm size
and leverage negatively affected EM in conventional banks while board meeting, bank size, leverage and
profitability influenced the discretionary level negatively in Islamic banks. Shariah board size influenced
discretionary LLP negatively, which indicates that a higher number of Shariah board members will be able
to control managerial opportunistic behaviour better. Additionally, the higher number of Shariah board
members registered as SSB members in other banks reduced the time available to monitor management
opportunistic behaviour.

The impact of SSB interlocks on EM were detrimental for cross-country locks rather than for local
locks. The former increased chances of EM while the latter did not have an impact on EM. A robustness
test conducted by replacing discretionary loan loss provisions with loan loss avoidance resulted in similar
findings, allowing us to further strengthen our conclusion. Thus, it can be concluded that agency costs,

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whether Islamic or conventional, cannot be avoided as the current governance proclamations do not
adequately provide solutions for managers’ opportunistic behaviour, culture or religious values. Therefore,

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unless it is ingrained in the institutional system and nurtured to be adapted into corporate culture, it will
remain merely a formality or an ordeal, and more precisely, it will remain ritualistic. We, thus, contribute to
-p
the expansion of literature on the role of agency cost, and corporate and Shariah governance in the dual
banking system. A key message that emerged from our findings is that merely having SSB is not enough.
Islamic banks need to have SSB with the right structure, right people, clear roles and responsibilities. The
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role of SSB should be enhanced not only by focusing on technical aspects and legalities of Islamic bank
transactions, but also by emphasising the obligation to continuously encourage the implementation of
lP

Islamic ethics. An appropriate legal framework coupled with regulatory supervision and enforcement is
crucial for a sound Shariah corporate governance framework. The findings of this study provide some
implications for the shareholders, managers and regulators. Differences in the levels of EM between
na

Islamic and conventional banks cannot indicate that Islamic values in the organisation are not yet fully
regarded. If managers in Islamic banks want to create value additions and attract investors, they should
ur

increase the incorporation of Islamic values in their activities.

This study is not free from limitations. The first limitation is in the variance of the corporate
Jo

governance disclosure in the annual report of sample banks. Each country has its own disclosure standards,
which complicates the data collection process for the corporate governance variables. Some countries such
as Malaysia and Indonesia regulate the minimum governance disclosure which eases the data collection
while in other countries each bank has their own format. Moreover, there was limited data on the Shariah
scholars’ background in the Islamic banks’ annual report, making it difficult to obtain important data such as
qualification and educational background of the SSB members. The inconsistency and lack of uniformity
limits investors who want to evaluate the openness and merit of the company’s corporate governance.

25
6. Scope for future research

Future researchers can investigate the impact of corporate governance disclosure on EM or performance of
Islamic banks. Additionally, future researchers can also consider testing whether the results would change
based on dividend pay-outs. Lastly, it will be comprehensive to study all the banks in GCC countries as well
as other countries practicing Islamic finance to test whether there is a glaring difference in the practice of
Islamic finance in reducing EM and increasing performance.

Author statement

Professor Nafis Alam: Conceptualization, Methodology, Writing- Review & Editing, Supervision, Project
administration
Dr. Jayalakshmy Ramachandran: Resources, Writing- Review & Editing, Vizualisation

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Ms. Aisha Nahomy: Software, Validation, Data analysis, Data curation, Resources, Writing original draft

ro
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re
lP
na
ur
Jo

26
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