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Department of Economics and Finance, Southern Illinois University Edwardsville, Edwardsville, IL, USA
2
Capital University of Science and Technology, Islamabad, Pakistan
3
Allama Iqbal Open University, Islamabad, Pakistan
World Econ. 2017;1–18. wileyonlinelibrary.com/journal/twec © 2017 John Wiley & Sons Ltd | 1
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| KUTAN ET AL.
Although the literature supports the view that top managers are important for organisational
policies and ultimately for the success of organisations, there are limited empirical studies on the
direct link between managers’ financial styles and firms’ risk-taking behaviour and performance.
There are three theoretical views on this issue. The neoclassical theory assumes that managers are
homogeneous and perfect substitutes for each other. In addition, all managers make similar rational
decisions in similar economic situations. According to the neoclassical view, top executives are a
key ingredient in firms’ strategic decisions, but such decisions are not influenced by managers’
individual financial styles (Weintraub, 2002). On the other hand, the upper echelons theory (Ham-
brick & Mason, 1984) argues that managers are different in their decision-making styles and
idiosyncratic differences exist due to different personal values and cognitive styles. Thus, accord-
ing to the echelons theory, decision-making preferences lead to different organisational outcomes.
The echelons theory is based on the characteristics of individuals and their judgement and deci-
sion-making.1 According to the theoretical view based on the judgement and decision-making liter-
ature, person, environment and task-related factors can affect the individual decision-making
(Bonner, 2008). For example, person-related factors refer to individual characteristics such as risk
behaviour, intrinsic motivation and confidence, which all influence the cognitive processes that
lead to decision-making. These personal characteristics are given different names in the literature,
such as financial styles (Prince, 2010; Shefrin & Nicols, 2014), managerial styles (Yang, 2012)
and managers’ fixed effects (Bamber et al., 2010; Bertrand & Schoar, 2003).
Overall, there is enough evidence to suggest that managerial financial styles can influence firm
performance and idiosyncratic risk. The literature, however, pays less attention to the direct role
played by managers in explaining cross-sectional variation in firm performance and idiosyncratic risk
in the context of sharia-compliant (SC) firms. There are only a few empirical studies. For example
Naz, Shah, and Kutan (2017) explore the impact of managers’ financial styles on financial decisions of
the sharia firms for Pakistan and the UK. For every firm, they construct a manager–firm matched panel
data to identify the top executives across the sharia-compliant firms and find that the managers play a
significant role in explaining the differences in financial decisions across the firms and the financial
styles of managers who move between a sharia and a non-sharia-compliant (NSC) firm are different.
Since performance and risk are the outcomes of financial decisions, in this paper we argue that the
managers may also play a role in explaining cross-sectional differences in firm performance and risk.
In another empirical study, Wooi and Ali (2015) show that there is no significant difference in
performance of SC and NSC firms, but the firms whose CEOs are Muslim show significantly lower
performance as compared to the firms of non-Muslim CEOs. They also find that Muslim-dominated
board could facilitate the lower performance of the firm with Muslim CEOs, and, more importantly,
the lower performance could be mitigated if the ultimate owner had a higher degree of control over
the firm. Another important finding in the Wooi and Ali (2015) study is that the Muslim CEOs can
contribute positively to the performance of the firm if the owners hold more controlling rights.
Our paper contributes to this line of research and attempts to fill the significant gap in the liter-
ature. In particular, we examine whether individual top managers are partially responsible for the
variation in firm performance and idiosyncratic risk after firm’s fixed effects and time-varying firm
characteristics are controlled for.2 We focus on the top executives’ effect on the idiosyncratic risk
1
According to the literature of psychology, three types of cognitive characteristics are important for affecting managerial
decisions: styles, abilities and strategies (Ho & Rodgers, 1993; Kozhevnikov, 2007).
2
Very few researchers examine the impact of managerial characteristics on performance and investment of the firm, and even
these do not control for the firms’ fixed effect, nor do they isolate the managers’ fixed effect from the firms’ fixed effect.
See, among others, Malmendier and Tate (2005).
KUTAN ET AL. | 3
and performance in the context of SC firms in both the UK and Pakistan. Our sample includes
only two countries due to data availability. However, our data set is interesting because it includes
firms operating under sharia or Islamic rule as well, allowing us to compare the findings between
a developed country, the UK, and a developing one, Pakistan.
In the context of SC firms, the literature on the importance of managers for firms’ risk-taking
behaviour and performance is very limited, but there are some related studies which address vari-
ous aspects of Islamic finance and business.3 However, these studies do not focus on the role of
manager in this context. In other related studies, Mansor and Bhatti (2011) study the perfor-
mance of mutual funds in Islamic and conventional portfolios and find no difference in between
returns of Islamic portfolios and those of conventional ones. They also report that the Islamic
portfolio is riskier than the conventional portfolios. They argue that the potential reason for this
unconventional finding is that the market penetration for Islamic portfolios is smaller but its
volatility is higher than that of conventional portfolios.4 We, however, argue that the managers’
financial styles may help in explaining such different risk characteristics of Islamic and conven-
tional portfolios.
The contribution of this study to the literature is threefold. First, it addresses the influence of
top managers’ financial styles on firms’ idiosyncratic risk and performance. Second, to explain
changes in firms’ idiosyncratic risk and performance, it examines the financial styles of managers
who switch from/to sharia and NSC firms. To study these issues, this paper uses the data on sharia
firms in the UK and Pakistan. SC firms are becoming increasingly popular after the global finan-
cial crisis of 2008–09. According to Robinson (2007), the market for the financial products of SC
firms has grown by 30% during the last few years. Third, this study extends a recent related study
by Naz et al. (2017) who explore the effect of managers’ financial styles on strategic financial
decisions, working capital and dividend policy of sharia and NSC firms and find that managers
play a significant role in explaining the variation in financial decisions. However, Naz et al.
(2017) focus only on financial decisions, while this paper considers issues related to idiosyncratic
risk and performance.
This paper adopts the research design of Bertrand and Schoar (2003) who construct a manager–
firm matched panel data set, and each of these managers in different firms was tracked for 3 years
at the firm where he/she worked.5 We find that top managers play a statistically and economically
important incremental role in explaining idiosyncratic risk and performance. Moreover, our results
indicate that, when managers move from a non-sharia to a SC firm, there is a statistically signifi-
cant difference between them in terms of their individual effects on firm performance and idiosyn-
cratic risk.
3
See, for example, leverage studies (Al-Deehani, Karim, & Murinde, 1999; Haron & Ibrahim, 2012; Singapurwoko & El-
Wahid, 2011), risk management and performance (Basov & Bhatti, 2014; Dejong & Ling, 2013; Hammoudeh, Kim, & Sar-
afrazi, 2016; Kamil, Alhabshi, Bacha, & Masih, 2014; Khan, Ahmad, & Gee, 2016; Saiti, Bacha, & Masih, 2015), stock
markets (Balcilar & Demirer, 2015; Bley & Saad, 2015; el Alaoui, Dewandaru, Rosly, & Masih, 2015; Kumar (2015);
Najeeb, Bacha, & Masih, 2015), efficiency and mutual funds investment (Al-Khazali, Leduc, & Alsayed, 2015; Merdad,
Hassan, and Khawaja (2016)) and Islamic modes of financing such as Islamic equity funds and sukuk (Islamic Bonds)
(Aloui, Hammoudeh, & ben Hamida, 2015; Kamil et al., 2014; Mohamed, Masih, & Bacha, 2015), differences between
Islamic bonds and conventional bonds (Alam, Hassan, & Haque, 2013). For example, according to Dharani and Natarajan
(2011), as compared to the non-sharia-compliant firms, sharia-compliant firms are less riskier.
4
On the other hand, Al-Khazali et al. (2015) find that conventional stock market indices are more efficient than their Islamic
counterparts. Abbes and Trichilli (2015) report that sharia-compliant shares could offer potential diversification benefits.
5
The three-year requirement will ensure that managers are given the chance to imprint their own “style” on a given com-
pany.
4
| KUTAN ET AL.
The rest of the study is organised as follows. Section 2 presents a brief discussion of the empir-
ical methodology, while Section 3 describes the sample construction and defines major variables
of interest. Section 4 discusses the empirical results, while Section 5 presents the conclusions and
recommendations for policymakers.
2 | EMPIRICAL METHODOLOGY
To estimate the contribution of manager-specific effects to the variation in firm performance and
idiosyncratic risk, we follow Bertrand and Schoar (2003) and estimate the following equations:
6
Untabulated results show idiosyncratic risk and performance are significantly different across UK and Pakistani firms. The
coefficients on dummy variables for all decisions are highly significant. The results are as follows: idiosyncratic risk
0.0113983 (p < .0001), stock prices 2.255 (p < .0001) ROA 0.09004 (p = .05) and ROE 0.087956 (p .0478).
7
The leverage ratio is measured as total debt divided by an average of 12 months’ market capitalisation; the cash ratio is
measured as the sum of the firm’s cash and interest-bearing securities divided by an average of 12 months’ market capitali-
sation, while the liquidity ratio is measured as accounts receivable divided by an average of 12 months’ market capitalisa-
tion. Available studies suggest that the idiosyncratic risk of Islamic firms is lower than the market risk (Al-Zoubi &
Maghyereh, 2007; Natarajan & Dharani, 2010; Shubbar, 2010).
6
| KUTAN ET AL.
Table 1 presents the mean, median and standard deviation of data for firm characteristics and
financial decision variables. All variables are Winsorised at a 1% tail to mitigate the problem of
outliers. The first six columns report the descriptive statistics of the Pakistani and UK sharia-com-
pliant firms, and the next six columns report the descriptive statistics of non-sharia-compliant firms
for Pakistan and the UK. The average size of the UK firms is larger than that of the Pakistani
firms.
to Mian (2001), CFOs retain the crucial responsibility for the design and implementation of the
policy decisions that are directly linked with performance of the firm. In summary, our findings
show that CEOs/CFOs all matter for the firms in Pakistan.
8
A famous example is that of Al Dunlap, a CEO, who displayed a style of massive cost cutting across different firms. The
question that arises is whether the style’s portability reflects a more general phenomenon (Perel, 2003). According to Cron-
qvist, Makhija, and Yonker (2012), the portability of managers’ styles depends on personal and corporate borrowing
choices.
10
| KUTAN ET AL.
(2003) findings of strong correlation, our untabulated results show smaller correlation between the
first and the second firms.9 Our results are more consistent with those of Fee et al. (2013), who
use a comprehensive sample of Compustat US firms from 1990 to 2007 and report that there are
causal managerial style effects that are idiosyncratic but not fully anticipated by the board.
9
The correlation is .070 (p = .452) for idiosyncratic risk, .152 (p = .098) for ROA, .039 (p = .676) for ROE and .785
(p = .4785) for the stock price of Pakistan firms. For the UK firms, the correlation is .074 (p = .468) for idiosyncratic
risk, .089 (p = .380) for ROA, .0785 (p = .425) for ROE and .163 (p = .106) for the stock price.
KUTAN ET AL. | 11
NSC firm. In untabulated results, the joint F test of significance shows that the coefficient of
sharia dummies is jointly significant, showing that the idiosyncratic risk and performance of the
SC firms are different from the NSC ones.10 For the SC firms, there are certain Islamic rules and
guidelines which they must follow. According to the sharia law, SC firms are not allowed to
become involved in the production of any prohibited products and debt is discouraged. When
CEOs/CFOs move from a NSC firm to a SC one, they need to follow the rules of that firm.
Fee et al. (2013) raise the question as to whether managers imprint their own preferences on
the corporation or are selected to implement the preferences of the board. Hence, it is important to
identify whether the managers who come from a sharia-compliant firm have distinctive financial
styles as compared to those who move from a non-sharia-compliant firm. To test this in our sam-
ple, we regress the dependent variables against firm’s fixed effects, year fixed effects, control vari-
ables, CFOs’ fixed effects and others’ fixed effects in equation (1) to capture the fixed effects of
the CEO. We then calculate the residuals for the sharia and non-sharia-compliant firms. Note that
these residuals represent the fixed effect of CEOs. We repeat the same process for CFOs and
obtain residuals representing CFOs’ fixed effects. To test the difference in sharia styles of manager
who moved from sharia or non-sharia-compliant firms, we apply a t test on both groups (move-
ment of CEOs/CFOs from non-sharia to sharia-compliant firms or from sharia to sharia-compliant
firm). These results are reported in Table 4.
Panels E-H in Table 4 compare the fixed effects of CEOs and CFOs who move from non-
sharia to sharia-compliant firms and from sharia to sharia-compliant firms of the UK and Pakistan.
When we compare the movement from non-sharia to sharia-compliant firms, all t-statistics are sig-
nificant, suggesting that, in terms of their individual effects on firm performance and idiosyncratic
risk, there is a significant difference between CEOs and CFOs who worked in a non-sharia-compli-
ant firm and then joined a SC firm. On the other hand, when we compare CEOs and CFOs who
move from one SC firm to another, all t-statistics are insignificant, which indicates that there is no
significant difference between CEOs and CFOs who move from one sharia-compliant firm to
another.
10
For the UK, the results are as follows: idiosyncratic risk 9.43 (p = .0022), ROA 174.47 (p = .000), ROE 10.96
(p = .0013) and share price 163.47 (p = .000), whereas for Pakistan, they are idiosyncratic risk 6.96 (p = .0086), ROA 3.86
(p = .036), ROE 9.83 (p = .000) and share price 4.92 (p = .001).
12
|
T A B L E 4 Movement of CEOs and CFOs from sharia- to sharia-compliant firm or non-sharia- to sharia-compliant firm
Non-sharia Sharia Differential mean t-Stat p-Value Sharia Sharia Mean t-Stat p-Value
Panel E: UK: CFO Movement
Idiosyncratic Risk 0.000749 0.001024 0.000275 6.9018 .0002 0.000571 0.000799 0.000228 1.40776 .080449
ROA 12.09349 9.717765 2.375725 2.8347 .01967 6.962162 7.314595 0.352433 0.50839 .305895
ROE 10.78543 7.23658 3.54884 2.8689 .02785 5.7896 6.7895 0.999 0.7896 .45879
Share Price 7.132179 8.007478 0.875299 1.84172 .033568 5.561461 5.764808 0.203347 1.52974 .064168
Panel F: UK: CEO Movement
Idiosyncratic Risk 0.000978 0.000601 0.000377 2.69841 .04603 0.000356 0.001039 0.000683 1.5083 .067442
ROA 4.712309 9.123653 4.41134 5.92153 2.66E08 12.74721 10.59427 2.15294 1.230527 .111031
ROE 3.17895 6.12589 2.94694 3.8967 .00245 10.8965 8.6987 2.1978 1.4879 .14587
Share Price 5.511193 5.642198 0.131005 2.758 .01478 7.23606 8.235163 0.999103 1.32111 .095005
Panel G: Pakistan: CFO Movement
Idiosyncratic Risk 0.006431 0.016195 0.009764 2.50987 .007 0.02439 0.016737 0.007653 0.17309 .2369
ROA 12.34062 8.190492 4.15013 2.739444 .00412 15.08263 16.54184 1.45921 0.69396 .245149
ROE 10.89678 8.12569 2.77109 2.6897 .00785 13.47896 12.78542 0.690418 0.8759 .15698
Share Price 4.837812 9.763886 4.92607 3.903811 .0001 4.241904 4.503378 0.26147 0.49081 .12586
Panel H: Pakistan: CEO Movement
Idiosyncratic Risk 0.012585 0.005297 0.120553 3.999364 .0001 0.028144 0.015882 0.012262 1.258692 .11097
ROA 9.796059 13.36006 3.564001 2.206167 0.0169 20.11264 13.73165 6.38099 1.10264 .14378
ROE 7.4263 12.4786 5.0523 2.7896 .02547 24.7896 16.4895 8.3001 0.8967 .2698
Share Price 4.405706 4.312487 0.093219 2.3585 .0114 4.824364 4.350242 0.474121 0.275847 .39262
Notes: Panels E and F summarise the CFOs and CEOs of UK firms who move from non-sharia-compliant to sharia-compliant firms and from sharia to sharia-compliant firms. Panels G and H
reports the results of CEOs and CFOs of Pakistani firms who move from non-sharia to sharia-compliant firms and from sharia to sharia-compliant firms.
Reported in panels E to H is the comparison of fixed effects of managers who moved from non-sharia- to sharia-compliant firms and from sharia to sharia-compliant firms for Pakistan and UK.
KUTAN
ACKNOWLEDGEMENTS
Naz and Shah are grateful to the Gulf One Lancaster Centre for Economic Research (GOLCER)
and Higher Education Commission of Pakistan for financial and academic support. We would like
to thank two anonymous referees and the guest editors, Prof. Dr. Mansor H. Ibrahim and Dr. Nafis
Alam, for their excellent comments and guidance. The usual disclaimer applies.
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APPENDIX
DATA
The data related to stock prices and market capitalisation that are used in this paper are extracted
from DataStream, whereas the data for control variables for the UK used in this paper are extracted
from a major data source, OSIRIS, and data for CEOs/CFOs are extracted from the database of
Who’s Who & Who was Who.
OSIRIS is a database that reports financial variables for more than 80,000 individual worldwide
listed companies.
DataStream comprises key data sets from both developed and emerging markets—equities, mar-
ket indices, company accounts, macroeconomics, bonds, foreign exchange, interest rates, commodi-
ties and derivatives.
For the CEO/CFO information, we used the database Who’s Who, which includes up-to-date
information about over 33,000 influential people from all walk of life, worldwide.
For Pakistan, we used Balance Sheet Analysis (published by the State Bank of Pakistan) for the
collection of decision variables data, while for CEO/CFO information, we used companies’ web-
sites and LinkedIn.
The specific variables used in this analysis are defined as follows:
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where Rjit represents the returns for a firm j in industry i at time t and Rmt is the market return. bji
is the beta for the firm j with respect to the industry returns, and bim is the beta for industry i with
respect to the market returns. Due to the condition of orthogonality, bjm = bji bim, and ~eit is the
residual of industry, and g~ jit is the residual of the firm. The decomposition of variance following
the equation (A1) is as follows:
Using this scheme of decomposition, we have to estimate the industries and firms’ betas which
might be not constant over time. Instead the “market-adjusted return model” is used. See, for
example (Campbell, Lo, & MacKinlay, 1997), for firms’ returns:
This model is only suitable when all firms on the market are included, and the beta can be sup-
posed to be one. Moreover, the beta-free variance decomposition to the model of market-adjusted
returns with the weighted averages across industries can be written as follows:
X X
wit wjit VarðRjit Þ ¼ r2mt þ r2et þ r2gt ; (A4)
i jei
where wit and wjit are the weights of industry and firm, respectively. We utilise equation A4 to
estimate the firm’s specific volatility or its idiosyncratic risk.
To estimate the firm’s specific volatilities, we begin by summing up the squares of the residuals
of equation A3:
X
r^ 2gjit ¼ g2jis ; (A5)
set
where s represents months and t represents years. To obtain the firm’s idiosyncratic risk, we then
multiply the weighted average within every industry with its respective residuals:
X
r^ 2git ¼ ^ 2gjit :
wjit r (A6)
jei