THE INFLUENCE OF CORPORATE AND SHARĪ’AH

GOVERNANCE MECHANISMS ON THE ISLAMIC

ECONOMIC AND FINANCIAL PERFORMANCE OF
ISLAMIC BANKS IN MALAYSIA

BY

MEMIYANTY ABDUL RAHIM

A thesis submitted in fulfilment of the requirement for the

degree of Doctor of Philosophy in Islamic Banking and
Finance

IIUM Institute of Islamic Banking and Finance

International Islamic University Malaysia

AUGUST 2018
 ABSTRACT

The responsibility and accountability of boards of directors and its effectiveness as

part of governance mechanisms are important in assessing corporate performance. In
the context of banking industry, corporate scandals and failures have attracted
considerable amount of public attention. Hence, the need to understand the essentials
of governance mechanisms have emerged. These mechanisms are crucial to ensure
adequate accountability from the key players to protect not only the interests of
shareholders but other stakeholders, in achieving performance. For Islamic banks,
there is an emerging issue of inadequate, inappropriate and insufficient performance
measurements. This study measures the acceptance of elements and ratios for the new
performance measurement as well as develops a new performance measurement
which is Islamic economic performance (IEP) as derived from Islamic economic
objectives. This study also examines the influence of both corporate and Sharī’ah
governance mechanisms on the Islamic economic and financial performance. In order
to produce a reliable research, qualitative and quantitative research techniques have
been used; via primary and secondary data collection methods, which covers interview
(structured survey), questionnaire, annual reports and financial database. The sample
of this study is 13 Islamic banks in Malaysia. The data had been gathered for three
years since the start of the Sharī’ah governance Framework (SGF) full
implementation in 2012, until 2014. The data has been analysed via SmartPLS SEM
to assess the influences of corporate and Sharī’ah governance mechanisms on Islamic
bank performance. This study adopts the Islamic governance and accountability
perspective which was developed by Abdul Rahman (1998) in deriving the theoretical
framework and hypotheses. The IEP measurement has been accepted and developed in
three elements such as need fulfilment and equitable distribution, economic growth
and economic stability and seven ratios to represent the achievement of Islamic banks
in Islamic economic objectives. The corporate governance mechanisms (CGM) and
Sharī’ah governance mechanisms (SGM) were found to have a positive effect on the
financial performance (FP) for Islamic banks in Malaysia. Not only that, SGM also
has a positive effect on IEP. However, CGM brings no effect on IEP at all. The results
indicated that the practices of corporate and Shari’ah governance mechanisms of
Malaysian Islamic banks are considered to be sufficient as majority of the practices
are aligned with most recommendations made by the relevant authorities. The findings
of this study signify the importance of Islamic rules and regulations, moral values and
ethics in enhancing Islamic economic and financial performance of the Islamic banks.
This study also offers new measurement which can assist top management of Islamic
banks to develop new strategies to further improve their banks’ performances. It is
hoped that this research can positively impact the policies and regulations in
scrutinizing the roles, duties and responsibilities of board and Shari’ah committee in
enhancing accountability, moral values and ethics matters. This study contributes to
the body of knowledge as it develops and provides a set of new performance measures
in measuring Islamic economic performance, which is also known as the M Score.

ii
 ‫ملخص البحث‬

‫إن مسؤولية ومساءلة جمالس اإلدارة وفعاليتها كجزء من آليات احلوكمة أمر مهم للغاية يف تقييم أداء‬
‫الشركات‪ .‬وقد جذبت فضائح الشركات واالخفاقات املختلفة قدراً كبرياً من االهتمام العام ضمن سياق‬
‫الصناعة املصرفية‪ .‬ونتيجةً لذلك‪ ،‬ظهرت احلاجة لفهم جوهر آليات احلوكمة‪ .‬تلك اآلليات ضرورية‬
‫إلجناز التقييم الكايف يف حتقيق األداء األمثل من اجلهات الفاعلة الرئيسية بغية محاية مصاحل محلة األسهم‬
‫باإلضافة اىل أحاا املصاحل اآلخرين أما فيما خيص املصارف اإلسالمية‪ ،‬فهناك قضية ناشئة عن عدم‬
‫كفاءة وفعالية ومالئمة تقييم األداء وبالتايل‪ ،‬فإن هذا الباث يقيس مالئمة العناحر والنسب‬
‫أيضا قياس أداء جديد وهو أداء‬ ‫إلجراءات اإلجناز اجلديدة ليس هذا فاسب‪ ،‬بل تطور هذه الدراسة ً‬
‫االقتصاد اإلسالمي (‪ )IEP‬املستمد من أهداف االقتصاد اإلسالمي لذلك‪ ،‬ميكن أن تساعد هذه‬
‫الدراسة يف فاص تأثري آليات حوكمة الشركات واحلوكمة الشرعية على االقتصاد اإلسالمي واألداء‬
‫املايل مت استخدام تقنيات الباث النوعية والكمية من خالل مجع البيانات األولية والثانوية‪ ،‬وقد تنوعت‬
‫مصادر مجع املعلومات والبيانات من مقابالت الشخصية واالستبيانات والتقارير السنوية وقواعد البيانات‬
‫ا ملالية وذلك هبدف احلصول على حبث موثق متت دراسة ثالثة عشرة مصرف إسالمي يف ماليزيا كعينة‬
‫مستخدمة يف هذا الباث من خالل مجع بيانات لفرتة ثالث سنوات منذ بدء التنفيذ الكامل لـ ‪ SGF‬يف‬
‫عام ‪ 2102‬وحىت عام ‪ 2102‬ومت حتليل البيانات عرب ‪ Smart PLS SEM‬لتقييم تأثري آليات حوكمة‬
‫الشركات واحلوكمة الشرعية على أداء املصارف اإلسالمية‪ .‬يعتمد هذا الباث على نظرية احلوكمة‬
‫واملساءلة اإلسالمية اليت طورها عبد الرمحن (‪ )0991‬يف استخالص اإلطار النظري والفرضيات‪ .‬لقد مت‬
‫قبول وتطوير مقياس ‪ IEP‬يف ثالثة عناحر مثل حتقيق احلاجة والتوزيع العادل والنمو االقتصادي‬
‫واالستقرار االقتصادي وسبعة نسب متثل إجناز املصارف اإلسالمية يف أهداف االقتصاد اإلسالمي‪ .‬وقد‬
‫خلص الباث إىل أن هناك عالقة اجيابية بني آليات حوكمة الشركات )‪ (CGM‬وآليات احلوكمة الشرعية‬
‫)‪(SGM‬على األداء املايل )‪ (FP‬للمصارف اإلسالمية يف ماليزيا‪ .‬ليس هذا فقط‪ ،‬فان آليات احلوكمة‬
‫الشرعية هلا تأثري إجيايب على األداء املايل ومع ذلك‪ ،‬ال يوجد أي تأثري آللية حوكمة الشركات على‬
‫مقياس ‪ IEP‬على اإلطالق استناداً إىل النتائج‪ ،‬نود االشارة إىل أن ممارسات آليات حوكمة الشركات‬
‫واحلوكمة الشرعية يف املصارف اإلسالمية املاليزية تعترب كافية ألن غالبية املمارسات املستخدمة تتماشى‬
‫مع معظم التوحيات اليت تقدمها السلطات املختصة‪ .‬كما تشري نتائج هذه الدراسة إىل أمهية القواعد‬
‫واألنظمة اإلسالمية والقيم األخالقية وأخالقيات املهنة يف تعزيز األداء االقتصادي واملايل اإلسالمي‬
‫جديدا ميكن أن يساعد اإلدارة العليا‬‫ً‬ ‫قياسا‬
‫للمصارف اإلسالمية‪ .‬تقدم نتائج هذه الدراسة أيضاً ً‬
‫للمصارف اإلسالمية على تطوير اسرتاتيجيات جديدة لزيادة حتسني أداء هذه املصارف‪.‬ومن املؤمل أن‬
‫يؤثر هذا الباث إجيابياً على السياسات واألنظمة للتدقيق يف أدوار وواجبات ومسؤوليات جملس اإلدارة‬
‫واللجان الشرعية لتعزيز املساءلة والقيم األخالقية وأخالقيات العمل‪ .‬ميكن هلذا الباث أن يساهم يف‬
‫تكوين املعرفة‪ ،‬لكونه اعتمد على جمموعة من مقاييس األداء اجلديدة املستخدمة لقياس أداء االقتصاد‬
‫أيضا باسم درجة ‪ ،M‬وعمل على تطويرها وتفعيلها يف هذه الدراسة‬‫اإلسالمي والذي يُعرف ً‬

‫‪iii‬‬
 APPROVAL PAGE

The thesis of Memiyanty Abdul Rahim has been approved by the following:

___________________________________
Syed Musa Syed Jaafar Alhabshi
Supervisor

___________________________________
Abdul Rahim Abdul Rahman
Supervisor

____________________________________
Noraini Mohd Ariffin
Internal Examiner

___________________________________
Nor Hayati Ahmad
External Examiner

___________________________________
Azlan Amran
External Examiner

___________________________________
Ismaiel Hassanein Ahmed Mohamed
Chairman

iv
 DECLARATION

I hereby declare that this thesis is the result of my own investigations, except where

otherwise stated. I also declare that it has not been previously or concurrently

submitted as a whole for any other degree at IIUM or other institutions.

Memiyanty Abdul Rahim

Signature ………………………………… Date ……………………………..

v
 INTERNATIONAL ISLAMIC UNIVERSITY MALAYSIA

DECLARATION OF COPYRIGHT AND AFFIRMATION OF

FAIR USE OF UNPUBLISHED RESEARCH

THE INFLUENCE OF CORPORATE AND SHARI’AH

GOVERNANCE MECHANISMS
ON THE ISLAMIC ECONOMIC AND FINANCIAL
PERFORMANCE OF ISLAMIC BANKS IN MALAYSIA

I declare that the copyright holders of this thesis are jointly owned by Memiyanty
Abdul Rahim and International Islamic University Malaysia.

Copyright © (2018) by Memiyanty Abdul Rahim. All rights reserved.

No part of this unpublished research may be reproduced, stored in a retrieval

system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording or otherwise without prior written permission of the
copyright holder except as provided below.

1. Any material contained in or derived from this unpublished research

may be used by others in their writing with due acknowledgement.

2. IIUM or its library will have the right to make and transmit copies
(print or electronic) for institutional and academic purposes.

3. The IIUM library will have the right to make, store in a retrieval
system and supply copies of this unpublished research if requested by
other universities and research libraries.

By signing this form, I acknowledged that I have read and understood the IIUM
Intellectual Property Right and Commercialization policy.

Affirmed by Memiyanty Abdul Rahim.

………..…..…………………….. ………….…………………..
Signature Date

vi
 ACKNOWLEDGEMENTS

All thanks, adoration, and praise belong to Almighty Allah (S.W.T), the Creator and
Controller of the universe. May Allah’s peace and blessing be upon Prophet
Muhammad )S.A.W(, on His family and His companions.

Special thanks to Assoc. Prof. Dr. Syed Musa AlHabshi and Prof. Dr. Abdul
Rahim Abdul Rahman for their excellent and perfect guidance. Wonderful
supervisors! They always keep me moving forward. It is only Allah (S.W.T) that can
adequately reward these great contributions in this world and the Hereafter. Amen.

My strong supporter, Mohd Sirajuddin Siswadi Putera and my lovely children

– Nur Radhiah Amirah Puteri, Muhammad Sirajuddin Shith Putera, Eisyatyne Nur
Aliyyah Puteri, Eisyateen Sofeiyah Khadiejah Puteri, and Putra Haidar Dzil Ikram –
for their lovely understanding, sacrifice, and prayers. They always make me calm and
cool.

My constant GURUs (parents); ‘Abah,' Haji Abdul Rahim Shafiai, and ‘Emak,'
Hajah Siti Ainah Abdul Jalil. In laws; Haji Mohamed Shith Mohamed and Hajah
Kalsom Yahaya. My siblings: Hasrin, Esmahan, Putra ‘Ataillah and Rahimie. No
words can describe your endless support and prayers.

Appreciation also goes to Universiti Teknologi MARA (UiTM) and

Kementerian Pengajian Tinggi (KPT) Malaysia for the support and scholarship
throughout my study. Also to all who are on a long list that cannot be mentioned here,
but who have contributed directly and indirectly to the completion of this doctoral
study, thank you very much.

May Allah (S.W.T) make this humble endeavour a positive initiative towards
the Maslahah of the Ummah that earns greater returns for the author and supervisors
in the Hereafter, InShaaAllah.

vii
 TABLE OF CONTENTS

Abstract .................................................................................................................................... ii
Abstract in Arabic ................................................................................................................... iii
Approval page ......................................................................................................................... iv
Declaration ................................................................................................................................v
Copyright Page........................................................................................................................ vi
Acknowledgements ................................................................................................................ vii
List of Tables .......................................................................................................................... xi
List of Figures ....................................................................................................................... xiii
List of Abbreviations ..............................................................................................................xv

CHAPTER ONE: INTRODUCTION ...................................................................................1

1.1 Background of Study.............................................................................................1
1.2 Problem Statement ................................................................................................6
1.3 Motivation for the Study .....................................................................................10
1.4 Research Objectives and Questions ....................................................................13
1.5 Overview of The Research Methodology ...........................................................14
1.6 Significance of the Study ....................................................................................14
1.7 Definition of Terms .............................................................................................15
1.8 Structure of the Thesis ........................................................................................21

CHAPTER TWO: AN OVERVIEW OF GOVERNANCE AND PERFORMANCE ....23

2.1 Introduction.........................................................................................................23
2.2 Corporate Governance ........................................................................................23
2.3 Governance in Islamic Financial Institutions......................................................28
2.3.1 Corporate Governance in Islamic Banks ..................................................28
2.3.2 Sharī’ah Governance in Islamic Banks ....................................................33
2.4 Islamic Economic Objectives in Measuring Performance ..................................40
2.4.1 Islamic Economic Objectives (Chapra, 2000) ...........................................43
2.4.2 Islamic Economic Objectives (Naqvi, 1994) ............................................47
2.4.3 Basic principles of Islamic Economic System (Al-Mawdudi, 2010) .......49
2.4.4 The Objectives of the Islamic Economic System (Manzoor Alam,
1996) ........................................................................................................51
2.5 Conclusion ..........................................................................................................52

CHAPTER THREE: LITERATURE REVIEW ................................................................53

3.1 Introduction.........................................................................................................53
3.2 Governance .........................................................................................................53
3.2.1 Empirical Studies on Corporate and Sharī’ah Governance and
Performance in Banks ..............................................................................53
3.2.2 Studies on Sharī’ah Governance ..............................................................58
3.3 Empirical Studies on Islamic Bank Performance ...............................................63
3.4 Gap in Empirical Studies ....................................................................................70
3.5 Conclusion ..........................................................................................................72

CHAPTER FOUR: THEORETICAL FRAMEWORK AND HYPOTHESES

DEVELOPMENT .................................................................................................................73
4.1 Introduction.........................................................................................................73
4.2 The Underlying Theories ....................................................................................73
4.2.1 Corporate and Sharī’ah Governance Mechanism ....................................82

viii
 4.2.2 Islamic Banks Performance ......................................................................88
4.3 The Theoretical Framework ................................................................................90
4.4 Hypotheses Development ...................................................................................93
4.4.1 Corporate Governance Mechanism and Islamic Banks Performance ......93
4.4.2 Sharī’ah Governance Mechanism and Islamic Banks Performance ........98
4.5 Conclusion ........................................................................................................102

CHAPTER FIVE: RESEARCH METHODOLOGY ......................................................103

5.1 Introduction ......................................................................................................103
5.2 Research Objectives and Research Questions ..................................................103
5.3 Research Design ...............................................................................................105
5.3.1 Sample Selection, Research Process and Data Collection......................105
5.3.2 Conceptual Definitions and Variables Measurement .............................110
5.4 Partial Least Squares - Structural Equation Model (PLS - SEM) ....................115
5.4.1 Overview of the Application ..................................................................115
5.4.2 Reasons for Using SmartPLS SEM ........................................................117
5.4.3 Model development for Hypotheses Testing ..........................................119
5.4.4 Research Model .....................................................................................122
5.4.5 Assessment of the Measurement Model (MM) .....................................130
5.5 Conclusion........................................................................................................134

CHAPTER SIX: FINDINGS AND DISCUSSION...........................................................135

6.1 Introduction ......................................................................................................135
6.2 The Acceptance of New Performance Measurement for Islamic Banks ..........136
6.2.1 Expert Construct Content Validity Via First Survey .............................140
6.3 Islamic Economic Performance Measurement .................................................146
6.3.1 Weighted Importance Score for Islamic Economic Performance
Via Second Survey ................................................................................146
6.3.2 The Computation of Islamic Economic Performance (IEP) ..................154
6.3.3 M Score..................................................................................................156
6.4 The Influence of CGM and SGM on IEP and FP of Islamic Banks .................159
6.4.1 The Assessment of the Structural Model ...............................................159
6.4.2 Islamic Bank Performance: Islamic Economic and Financial
Measures ................................................................................................165
6.4.3 The Influence of CGM on the IEP and FP of Islamic Banks in
Malaysia.................................................................................................188
6.4.4 The Influence of SGM on the IEP and FP of Islamic Banks in
Malaysia.................................................................................................197
6.5 Conclusion........................................................................................................207

CHAPTER SEVEN: CONCLUSION ...............................................................................209

7.1 Summary of the Research Findings..................................................................209
7.1.1 The Acceptance of New Performance Measurement for Islamic
Banks .....................................................................................................210
7.1.2 Islamic Economic and Financial Performance Measures ......................210
7.1.3 The Influence of Corporate and Sharī’ah Governance Mechanisms
on the Islamic Economic and Financial Performance of Islamic
Banks in Malaysia..................................................................................212
7.2 Contributions of the Study ...............................................................................213
7.2.1 Theoretical Contributions ......................................................................214
7.2.2 Practical Contributions ..........................................................................216
7.2.3 Methodological Contributions ...............................................................217
7.3 Limitations and Suggestions for Future Research ............................................218
7.4 Conclusion........................................................................................................219

ix
BIBLIOGRAPHY ...............................................................................................................220

APPENDIX 1: A SUMMARY OF THE DEVELOPMENT OF THE ISLAMIC

BANKING INDUSTRY AT THE INTERNATIONAL LEVEL ........244
APPENDIX 2: A SUMMARY ON THE MALAYSIAN DEVELOPMENT OF
ISLAMIC FINANCE ..............................................................................247
APPENDIX 3: QUESTIONNAIRE ON CONSTRUCT CONTENT VALIDITY
OF ISLAMIC ECONOMIC PERFORMANCE .................................249
APPENDIX 4: QUESTIONNAIRE ON WEIGHTED IMPORTANCE SCORE
FOR ISLAMIC ECONOMIC PERFORMANCE ...............................253
APPENDIX 5: CORE VALUES OF TOP THREE OF M Score ..................................260
APPENDIX 6: DESCRIPTIVE STATISTIC RESULTS ..............................................262

x
 LIST OF TABLES

Table 5.1 Research Objectives, Research Questions, and Hypotheses 104

Table 5.2 Research Process/Stages, Sources of Data Collection,

Purpose and Outcome 107

Table 5.3 Conceptual Definition and Operationalization of

Exogenous Variables 111

Table 5.4 Code, Conceptual Definition and Operationalization of

Endogenous Variables 112

Table 5.5 Specific Terminologies in PLS-SEM for this Study 118

Table 5.6 Model Development for Hypotheses Testing 120

Table 5.7 Label and Type of Key Constructs 124

Table 5.8 Decision Rules for Determining Whether a Construct is

Formative or Reflective 126

Table 5.9 Significance and Relevance of the Formative Indicators 132

Table 5.10 Collinearity Issues 134

Table 6.1 Structure of Question in the First Survey 136

Table 6.2 Results from Expert Construct Validity - Need Fulfilment 140

Table 6.3 Equal Distribution 141

Table 6.4 Universal Education 142

Table 6.5 Economic Growth 142

Table 6.6 Economic Stability 143

Table 6.7 Maximizing Employment Generation 144

Table 6.8 Decision Made 146

Table 6.9 Islamic Economic Performance Measures 146

Table 6.10 Structure of Question in the Second Survey 147

Table 6.11 Profile of Survey Respondents - Academicians 151

xi
Table 6.12 Profile of Survey Respondents – Practitioners 153

Table 6.13 Changes in M Score (Unavailability of Data in Annual

Report) 155

Table 6.14 M Score Equation 157

Table 6.15 The Results of R² 162

Table 6.16 Path Coefficients and Hypothesis Testing 164

Table 6.17 Summary Results of Research 165

Table 6.18 The Investment in Real Economic Sector (IRES)

Performance 169

Table 6.19 The Zakat Paid Over Assets (ZPA) Performance 171

Table 6.20 The Tax Paid Over Assets (TPA) Performance 173

Table 6.21 The Total Financing over Assets (TFA) Performance 175

Table 6.22 The Income Generation over Assets (IGA) Performance 177

Table 6.23 The Income Generation over Equity (IGE) Performance 179

Table 6.24 The Employee Remuneration over Assets (ERA)

Performance 181

Table 6.25 The Return on Equity (ROE) Performance 184

Table 6.26 The Return on Assets (ROA) Performance 184

Table 6.27 The ‘CTI’ Performance 187

Table 6.28 M Score Ranking 204

xii
 LIST OF FIGURES

Figure 3.1 Literature Gaps 70

Figure 4.1 An Islamic Corporate Governance Framework 83

Figure 4.2 Relationship of Key Players in the Corporate Governance

Structure of the Islamic Banks Environment 86

Figure 4.3 Stakeholders for Islamic Banks 87

Figure 4.4 Theoretical Framework 92

Figure 5.1 Research Model 123

Figure 5.2 Inner Model for Corporate Governance Mechanisms 127

Figure 5.3 Inner Model for Sharī’ah Governance Mechanisms 127

Figure 5.4 Inner Model for Islamic Economic Performance 128

Figure 5.5 Outer Model for the Study as a Whole 129

Figure 6.1 Results 160

Figure 6.2 Investment in Real Economic Sector 168

Figure 6.3 Amount Spent on Zakat 171

Figure 6.4 Amount Spent on Tax 173

Figure 6.5 Total Financing 175

Figure 6.6 Income Generation Over Assets 177

Figure 6.7 Income Generation Over Equity 179

Figure 6.8 Employee Remuneration 180

Figure 6.9 Return on Equity 183

Figure 6.10 Return on Assets 185

Figure 6.11 Cost To Income 187

Figure 6.12 Board Size 190

Figure 6.13 Independent Non-Executive Directors 192

xiii
Figure 6.14 Board Competency 193

Figure 6.15 Board Meetings 195

Figure 6.16 Sharī’ah Committee Size 199

Figure 6.17 Sharī’ah Committee Meetings 200

xiv
 LIST OF ABBREVIATIONS

AAOIFI Accounting and Auditing Organizations of Islamic Financial

Institutions
BAFIA Banking and Financial Institutions Act 1989
BNM Bank Negara Malaysia
BCBS Basel Committee on Banking Supervision
BC Board Competency
BS Board Size
BOD Board of Director
CGM Corporate Governance Mechanism
CTI Cost to Income
EG Economic Growth
ES Economic Stability
FMM Formative Measurement Model
FP Financial Performance
IEP Islamic Economic Performance
IFIs Islamic Financial Institutions
IFSB Islamic Financial Services Board
IIUM International Islamic University Malaysia
KPI Key Performance Indicator
MCCG Malaysian Code of Corporate Governance
NED Non-Executive Directors
NFED Need Fulfilment and Equitable Distribution
OECD Organization of Economic Cooperation and Development
PLS Partial Least Squares
ROA Return on Assets
ROE Return on Equity
SBS Sharī’ah Committee Size
SBM Sharī’ah Committee Meeting
SC Social Contribution
SEM Structural Equation Modelling
SGF Sharī’ah Governance Framework
SGM Sharī’ah Governance Mechanism
SM Structural Model
SPSS Statistical Package for Social Science
UKM Universiti Kebangsaan Malaysia
UM Universiti Malaya
UPM Universiti Putra Malaysia
UUM Universiti Utara Malaysia
VIF Variance Inflation Factor
WIS Weighted Importance Score
WRIGA Weighted Ratio of Income Generation over Assets
WRIGE Weighted Ratio of Income Generation over Equity
WRIRES Weighted Ratio of Investment in Real Sector over Assets
WRERA Weighted Ratio of Employee Remuneration over Assets
WRTFA Weighted Ratio of Total Financing over Assets
WRTPA Weighted Ratio of Tax Paid over Assets
WRZPA Weighted Ratio of Zakat Paid over Assets

xv
 CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF STUDY

Generally, the development of Islamic banking started with the endeavour for social

obligation-based initiatives. The efforts made were based on social obligation, such as

in Malaysia via the Pilgrimage Fund in the mid-1940s, in Pakistan in the late 1950s by

means of the Indian Jama’at Islami in 1969, in Egypt through the Mit Ghamr Saving

Banks between 1963 and 1967, and the Naseer Social Bank in 1971.

The development of the Mit Ghamer Saving Bank and the Nasser Social Bank

in Egypt were the pioneers of the Islamic banking system in 1963. Nevertheless, at

that particular time, they only collected small savings and made direct investment in

agricultural and industrial activities, and small local businesses. Twelve years later, in

order to foster the economic development and social progress among the member

countries and their Muslim communities to comply with the principles of Sharī’ah,

the Organisation of Islamic Conference (OIC) inaugurated an inter-governmental

Islamic bank, known as the Islamic Development Bank (IDB). The Islamic banks have

been monitored by special enactments, legislation, and infrastructure. Many Muslim

countries adopted Islamic banking practices alongside conventional banking. A

summary of the international development in Islamic finance can be referred to in

Appendix 1.

Meanwhile, the growth of Islamic finance in Malaysia has been developed via

four distinct phases (Dusuki & Abdullah, 2011). The first phase was the establishment

of Islamic Financial Institutions (Islamic banks), the second phase was the Islamic

1
windows; the third phase was the Islamic subsidiaries, and the fourth was the

liberalization of Islamic finance. The development of Islamic finance in Malaysia can

be referred in details in the Appendix 2.

Corporate governance is essential to ensure the smooth running of any

business, and it has been seen as a mechanism to improve accountability and

performance. However, there is a critical debate on the governance and performance

based on the increasing number of corporate/bank closures and difficulties. The

people comprising the management of the institution are the key players that bear the

ultimate responsibility and accountability to run the business properly. However, there

were cases around the world involving senior persons in the business operations who

were not acting in the best interests of shareholders and other stakeholders.

In 1999, the Malaysian Finance Committee Report defined corporate

governance as “the process and structure used to direct and manage the business and

affairs of the institution toward enhancing business prosperity and corporate

accountability with the ultimate objective of realising long-term shareholders’ value,

whilst taking into account the interests of other stakeholders”.

Moreover, the Organisation for Economic Co-operation and Development

(OECD) in the Principles of Corporate Governance (2000, revised April 2004) defines

corporate governance as the “…set of relationship[s] between a (company’s)

management, its board, its shareholders and other stakeholders. Corporate governance

also provides the structure through which the objectives of (the company) are set, and

the means of attaining those objectives and monitoring performance are determined.

Good corporate governance should provide proper incentives for the Board and

management to pursue objectives that are in the interests of (the company) and its

shareholders and should facilitate effective monitoring. The presence of an effective

2
corporate governance system, within an individual company and across an economy

as a whole, helps to provide a degree of confidence that is necessary for the proper

functioning of a market economy.” It is emphasized that corporate governance

involves a set of relationships between an institution’s management, its board,

shareholders and other stakeholders.

In fact, the code also further explains that corporate governance provides the

structure through which the objectives of the company are set, and the means of

attaining those objectives and monitoring performance are determined. Therefore,

from the definition itself, corporate governance can be illustrated as a mechanism for

managing and monitoring a corporation to achieve its objectives, and, at the same

time, to ensure that the interests and welfare of the shareholders and stakeholders are

protected. Indeed, Bank (2009) also highlights that good governance is an effective

mechanism for protecting stakeholders, whilst poor governance puts all parties at risk.

By having the best practices of governance in place, the interests of shareholders and

other stakeholders are guaranteed by the proper running of the business, which is

handled by the appropriate and responsible individuals.

In the financial services sector, the principal-agent relationship carries the same

definition as is applied in the corporate sector. However, the additional requirements

of governance for Islamic banks need to be understood by the persons responsible

when making decisions for Islamic banks. As highlighted by Chapra (2004), there are

three groups of internal key components in Islamic banks involving decision-making –

the board of directors, the Sharī’ah and key Sharī’ah compliance functions, and the

majority shareholders. They are in the position to make sound decisions and realign

the direction of the business for the sake of shareholders and other stakeholders in

Islamic banks. The International Financial Services Board (IFSB) (2006) defines

3
corporate governance “as a set of relationships between a company’s management, its

BOD, its shareholders, and other stakeholders that provide the structure through which

the objectives of the company are set; and the means of attaining those objectives and

monitoring performance are determined.” This definition has been adopted from

OECD (2000 and revised 2004).

In the context of Islamic banks, good corporate governance should encompass

“a set of organizational arrangements whereby the actions of the management of IIFS

are aligned, as far as possible, with the interests of its stakeholders; provision of

proper incentives for the organs of governance such as the BOD, Sharī’ah Committee,

and management to pursue objectives that are in the interests of the stakeholders and

facilitate effective monitoring, thereby encouraging Islamic banks to use resources

more efficiently; and compliance with Islamic Sharī’ah rules and principles” (IFSB,

2006).

Based on the description as discussed, corporate governance cannot be seen

solely as a set of relationships amongst directors, shareholders and other stakeholders

in an institution. An institution should set up its strategic objectives and ensure that

the objectives can be achieved, whilst, at the same time, the monitoring mechanism

must be in place. Hence, corporate governance in the context of Islamic banks has

been defined by Hasan (2011) as, firstly, a set of relationships among the key players

and stakeholders. Secondly, these banks should have clearer strategic objectives of

their existence. Thirdly, they should also have a proper monitoring mechanism in

terms of the checks and balances of the business operations and activities.

At present, in Malaysia, the Central Bank, i.e., Bank Negara Malaysia (BNM),

has developed the Sharī’ah governance framework for Islamic banks, effective

beginning 1st January 2011 with the ultimate objective being to enhance the role of the

4
board, the Sharī’ah Committee and the management in relation to Sharī’ah matters.

Indeed, the Sharī’ah Governance Framework was the first guideline on Sharī’ah

governance matters to be issued and applied in Islamic financial institutions in

Malaysia.

The definition of Sharī’ah governance in the Sharī’ah Governance Framework

for Islamic Financial Institutions guideline has been adopted from the definition in the

Islamic Financial Services Board (IFSB) (2009). The IFSB (2009) defines the

Sharī’ah governance system as “a set of institutional and organizational arrangements

through which Islamic banks ensure that there is effective independent oversight of

Sharī’ah compliance over the issuance of relevant Sharī’ah pronouncements,

dissemination of information and an internal Sharī’ah compliance review.” Besides

the corporate governance requirements as prescribed by other codes at the

international level and locally, Islamic banks are also required to comply with the

Sharī’ah governance requirements to ensure Sharī’ah compliance.

The agency problems in Islamic financial institutions are unique to other

financial institutions and corporation, and different ways of examining and solving the

issues are needed. As highlighted by Bukhari (2013); Darmadi (2013); Safieddine

(2009); Grais and Pellegrini (2006); Archer and Karim (1998), and Sarker (1999), the

need to comply with Sharī’ah rules and regulations makes a huge difference between

Islamic finance and other modes of financing.

This study aims to fill the research gap by identifying the performance

measurement from the Islamic economic objectives and use them as indicators for

measuring Islamic banks’ performance other than financial performance. This

research also examines how the monitoring and control mechanism of the corporate

and Sharī’ah governance in the form of the board of directors and Sharī’ah

5
Committees can better contribute to Islamic economic and financial success. Hence,

this study highlights the sufficient practices from corporate and Sharī’ah governance

monitoring and control mechanisms that are expected to be able to reduce or minimize

agency and accountability problems in Islamic banks.

1.2 PROBLEM STATEMENT

There is inadequate, inappropriate and insufficient performance measurement for

Islamic banks (Qasim, Mohamad & Ibrahim, 2017; Siswanti, Salim & Sukoharsono,

2017; Mohammed, Tarique & Islam, 2015; Nadia, Sonia & Jaleleddine, 2014; Ajlouni

& Omari, 2013; Mohamed, 2010; Badeldin, 2008; Rosly & Bakar, 2003; Samad &

Hassan, 1999). The measurement for assessing the performance of Islamic banking is

still lacking due to the fact that Islamic banks require a broader measurement rather

than one of simply profit maximization. They are not only expected to make a profit

but also to fulfil the Sharī’ah rules and principles. Their objectives should also

consider the Islamic economic system in designing their achievements. Therefore, the

performance measurement for Islamic banks could differ from corporations and

conventional banks.

Nienhaus (2007), Chapra and Ahmad (2002), Adams and Mehran (2012) have

contended that banks clearly appear to have different governance attributes than non-

financial firms to ensure sound business practices in the banking industry. There is a

lack of understanding of governance attributes due to the higher demand by the higher

authority in governing the financial institutions (bank). The governance in banks is

crucial as they have been categorized as a highly regulated industry by the Basel

Committee on Banking Supervision (1999). Failure to do so, may jeopardise the

performance of the banks. Thus, they need to ensure the governance mechanisms that

6
structured in the bank must be adequate, appropriate and sufficient particularly for

Islamic banks.

There are three reasons for the different governance structure. Firstly, in

Islamic banks, the ultimate concern is compliance with the Islamic Sharī’ah rules and

principles (Sharī’ah requirements). Besides the banking Acts, they are also required to

fulfil Islamic rules and regulations, moral values and ethics. Therefore, the board of

directors, Sharī’ah Board and key Sharī’ah compliance functions are involved in

Sharī’ah audit, Sharī’ah review, Sharī’ah risk management and Sharī’ah research.

These are the key players responsible for making decisions and implementation and

must be well-versed in both the Sharī’ah requirements and the conventional banking

Acts. They have primary accountability to Allah (S.W.T), and, at the same time, have

secondary accountability to all the stakeholders. The people involved in planning and

making decisions in Islamic banks must have the capacity for monitoring and control

of the institutions. This has been proven by the corporate failures of Islamic banks,

which attracted attention from around the world and the demand for a good and

efficient governance system.

Secondly, Islamic banks have a broader base of stakeholders compared to

corporations and conventional banks. ‘Stakeholders’ in Islamic banks include

employees, customers, suppliers, investment account holders and the community. Due

to the unique role of banks, the supervisors and government are also stakeholders

(BNM/GP1-I, 2007; IFSB, 2006). Nienhaus (2007) highlights and suggests that the

scope of corporate governance for Islamic banking is wider than conventional banking

for Islamic depositors, i.e., investment account holders (IAHs). The Investment

Account Holders (IAHs) are exposed too much higher risks than in conventional

7
banks. It was referring to the different nature of depositors as debt or partnership

arrangement.

The fundamental problem concerning the conflict of interest between Islamic

depositors and shareholders is that both parties share substantial parts of the bank’s

profits, which implies a distribution conflict. Clearly, the profit share based on a ratio

is not numerically defined in the Islamic deposit contracts. This ratio will be decided

by the management decision, which is an issue that may lead to a conflict of interest.

In addition, the requirement for proper internal guidelines for managing investment

account holders (IAHs) was suggested by the IFSB (2006), and highlighted in the

International Financial Services Act (IFSA, 2013).

Thirdly, Islamic banks are heavily regulated. The role of the board of directors

differs in the banking industry in the sense that they have greater responsibility and

accountability in discharging their duties. The duties and responsibilities of the key

players in the Islamic banks (boards, Sharī’ah Boards, key Sharī’ah compliance, i.e.,

Sharī’ah Audit, Sharī’ah Review, Sharī’ah Risk Management and Sharī’ah Research)

are more demanding, in that they must ensure both legal and Sharī’ah compliance as

well as take into account the Islamic moral and ethical values. They are required to be

accountable to the broader group of stakeholders. Ultimately, they are accountable to

Allah (S.W.T) Hence, they are expected to be knowledgeable and skillful in

managing, monitoring, and controlling banking institutions to ensure Sharī’ah

compliance.

There is also a lack of appropriate theories in governance from an Islamic

perspective to address the issue of accountability, and a governance structure to

protect shareholders and other stakeholders as a whole. Stakeholders must be assured

that their welfare will be taken care of properly by the authorized party, as suggested

8
by Iqbal and Mirakhor (2004), and the Financial Sector Master Plan (BNM, 2012).

This is due to the lack of a ‘shareholder model’ of corporate governance, particularly

for Islamic banks. As suggested by Archer, Ahmed and Karim (1998), a proposed

model for Islamic corporate governance is necessary to overcome the lack of a

Western or conventional model of corporate governance to cater for Islamic banks,

especially in protecting IAH rights; for instance, in the case of default and the

investment strategy. Even though in the IFSB (2009) the procedure for minimizing the

risk has been outlined it is worth studying how the top key players in the Islamic

banks are able to enhance performance, which, indirectly, contributes to the

stakeholders’ protection.

The problem that arises as a result of this system of corporate ownership is that

agents do not necessarily make decisions in the best interests of the principal, as both

the principal and the agent have their own interests, which results in a conflict. This is

also known as the agency problem. The assumption underlying this theory is that the

goals of the principal and the agent are often in conflict. Whereby, the primary

objective of the corporation is to maximize the shareholder’s wealth. In practice, this

does not necessarily happen, as it is normal for managers to pursue their own personal

objectives; for instance, to get a bonus every year, which constitutes individual wealth

maximization. They may concentrate on projects and company investments that would

provide high short-run profits as the short-term returns would benefit them via their

pay. In addition, managers are also tempted to gain extra benefits, such as salaries

with other supplements; for example, holiday packages through the company, and

office equipment, etc. This leads to a reduction in shareholder value and is termed

according to the agency theory as ‘residual loss’.