Impact of corruption on bank soundness: the moderating impact of Shari’ah supervision
| DOI | https://doi.org/10.1108/JFC-03-2021-0063 |
| Published date | 22 June 2021 |
| Date | 22 June 2021 |
| Pages | 962-983 |
| Subject Matter | Accounting & finance,Financial risk/company failure,Financial crime |
| Author | Mushtaq Hussain Khan,Ahmad Fraz,Arshad Hassan,Syed Zohaib Hassan Kazmi |
Impact of corruption on bank
soundness: the moderating impact
of Shari’ah supervision
Mushtaq Hussain Khan
Department of Management Sciences, The University of Azad Jammu & Kashmir,
Muzaffarabad, Pakistan
Ahmad Fraz
Pakistan Institute of Development Economics, Islamabad, Pakistan
Arshad Hassan
Faculty of Management and Social Sciences, Capital University of Science and
Technology, Islamabad, Pakistan, and
Syed Zohaib Hassan Kazmi
Department of Management Sciences, The University of Azad Jammu & Kashmir,
Muzaffarabad, Pakistan
Abstract
Purpose –This study aims to examine whether the soundness of Islamic banks is differently affectedby
corruption compared to conventional counterparts. Moreover, the Shari’ah supervisory board (SSB), as a
cornerstone of Islamic banking and representing a multi-layer corporate governance model, is expected to
moderatethe influence of corruption on soundness for Islamic banks.
Design/methodology/approach –This study considers a unique sample of 1,528 observations on 71
Islamic banks and 120 conventional banks operating in 11 emerging and developing Muslim countries
over the 2010–2017 period. This study uses generalized least squares regression model and the
coefficients are estimated by using random-effects estimator. In addition, to overcome a potential
endogeneity concern for corruption and bank stability relationship, this study uses Two-Stage Least
Squares regression instrumentalvariable estimator.
Findings –The authors find consistent evidence that higher levels of corruption adversely impact the
soundness for conventionalbanks, in favor of the sand the wheel hypothesis in the corruption–development
nexus. However, as expected, this study finds a less negativeimpact of corruption on soundness of Islamic
banks. Moreover, SSB moderatesthe relationship between corruption and soundness of Islamic banks.The
findings arerobust to a battery of alternative checks.
Research limitations/implications –Findings of the paper regarding the detrimental impact of
corruption on bank soundness justify the urgency of the anti-corruption campaigns in these countries,
particularly for conventional banks. Moreover, the findings provide support for the positive
contribution of SSBs to overcome the adverse effect of corruption on soundness of Islamic banks and
thereby underscoring the need for enforcement and regulatory mechanism for SSBs to be more
effective.
JEL classification –O16, G21, G34
The authors are extremely grateful to Dr. Imtiaz Hussian Khan, Faculty of Computing and
Information Technology, King Abdulaziz University Jeddah, Saudi Arabia for proofreading of the paper.
Funding: The authors received no specific funding for this work.
JFC
29,3
962
Journalof Financial Crime
Vol.29 No. 3, 2022
pp. 962-983
© Emerald Publishing Limited
1359-0790
DOI 10.1108/JFC-03-2021-0063
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1359-0790.htm
Originality/value –Tothebestoftheauthors’knowledge, this is the first study to examine the
moderating impact of Shari’ah supervision on the relationship between corruption an d soundness of
Islamic banks.
Keywords Corruption, Islamic banking, Shariu2019ah supervisory board, Bank soundness
Paper type Research paper
1. Introduction
Corruption, generally defined as the abuse of entrusted public power for private gain, is a
social, political and economic phenomenon prevalent globally but more pervasive in less-
developed economies [1]. In addition to bribery and extortion, which defines corruption in a
narrow sense, corruption is also manifested in collusion, cronyism, nepotism, fraud,
deception, embezzlement, the misuse of government power and other related activities. In
prior literature on corruption–development nexus, corruption is widely believed to be
pernicious to entrepreneurs’investment incentives, the composition of government
expenditure, the accumulation of humancapital, the inflow of foreign direct investment, the
effectiveness of international aid, among others, and thus detrimental to economic growth
(Murphy et al.,1993;Shleifer and Vishny, 1993;Mauro, 1995, 1997; Bardhan, 1997;Wei,
2000;Reinikka and Svensson,2004;Adit, 2009).
Despite a rich body of research on the corruption–development relationship, there is a
limited number of works on the role that corruption plays in the field of financial
intermediation and banking. On the one hand, corruption may hinder lending and increase
the probability of borrowers’defaultby raising the cost of debt, but on the other hand, firms
with higher productivity and efficiency can bid higher bribes and are morelikely to receive
more loans (Chen et al., 2015).The most popular justifications of the beneficial or detrimental
effects of corruption rest on the so-called “grease the wheels”and “sand the wheel”
hypotheses. Leff (1964),Huntington (1968) and Leys (1965) the pioneers of the “grease and
the wheels”hypothesis assume that corruption could be beneficial in a second-best world
because of the distortions caused by ill-functioning institutions. Empirically, Chen et al.
(2013) find that bribery enables more productivefirms to be granted larger loans, consistent
with the “grease the wheel”hypothesis. Similarly, Meon and Weill (2010) find supportive
evidence for the “grease the wheels”hypothesisparticularly in poorly governed countries.
However, the evidence from business surveys and empirical studies also seems to support
the “sand the wheel”hypothesis of corruption. For example, Khwaja and Mian (2005) find that
politically connected firms obtain more loans from banks but end up with a higher default rate.
Charumilind et al. (2006) find that firms with connection to politicians have better access to
long-term bank loans and need less collateral. Detragiache et al. (2008) and Weill (2011a,2011b)
find that the growth of lending decreases with more severe corruption. Park (2012) finds that
non-performing loans increase in countries plagued by higher corruption. Finally, Chen et al.
(2015) examine the indirect effect of corruption on banks’risk-taking channeled through
monetary policy and find that the impact of monetary policy on banks’risk-taking behavior is
more pronounced with the increasing severity of corruption.
In this paper we extendthe literature by examining how bank level governancestructure
can mitigate the impact of corruptionon bank soundness. Our paper aims to fill this void in
the context of commercial Islamic banks and conventional banks operating in 11 Muslim
countries [2] with dual banking systemswhere Islamic and their conventional counterparts
operate alongside each other. We hypothesize that the multi-layer corporate governance
model (Shari’ah supervision boards[SSBs]) in Islamic banking and the expected adherence
of Islamic banks to ethical behavior,which is theoretically the cornerstone of Islamic banks,
Impact of
corruption on
bank
soundness
963
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