Islamic Financial Institutions and Corporate Governance: New Insights for Agency Theory

ABSTRACT Manuscript Type: Empirical Research Question/Issue: This paper takes a theory building approach to highlighting variations of agency theory in the unique and complex context of Islamic banks, mainly stemming from the need to comply with Sharia and the separation of cash flow and control rights for a category of investors. Research Findings/Results: The paper provides insights that agency structures in the context of Islamic banking might give rise to trade‐offs between Sharia compliance and mechanisms protecting investors' rights. Alternative models of idiosyncratic governance might be effective in balancing the two cornerstones of the agency dynamic. In practice, the paper finds that most of the surveyed Islamic banks appear to recognize the value of governance and institute some basic mechanisms. Nonetheless, some governance flaws relating to audit, control, and transparency are observed, a situation further exacerbated by the fact that investment account holders are not represented on the board, and are not granted control or monitoring rights. This leads to a discussion on the tradeoff between the costs and benefits of such a practice. Theoretical Implications: This study contributes to the agency theory literature by providing theoretical propositions highlighting challenges to this theory whereby mechanisms with the purpose of mitigating agency problems might lead to a divergence from Islamic principles of Sharia. Practical Implications: The paper motivates Islamic banks to improve governance practices currently in place. It alerts policy makers to the need to tailor the regulations to safeguard the interests of all investors without violating the principles of Sharia.