Shari’ah Supervisory Board Composition Effects On Islamic Banks’ Risk-Taking Behavior

Islamic banks underlie the fundamental principles of the Shari’ah, which encompass all business activities, financial contracts, and transactions. The Shari’ah Supervisory Board (SSB) monitors and certifies compliancy and is unique to the governance structure of Islamic banks compared to their Western counterparts. This study addresses the question of how the compositional characteristics of the SSB influence the loan portfolio risk-taking of Islamic banks. As such, we analyze to which degree the legal supervisory functions of a SSB affect the banks’ risk-taking behavior. Over the period from 2000 to 2010, we regard cross-country bank-level data from the Middle East and Northern Africa as well as from Southeast Asia. Our results reveal evidence that the loan portfolio risk-taking of Islamic banks is positively influenced by increasing size of the SSB, as well as when top ranked Shari’ah scholars with multiple memberships have board mandates and when annual changes occur in the composition of a SSB, regarding particularly previous period variables with second lags. We find that supervisory effectiveness and disciplining power of individual bank SSBs towards the risk-taking in the loan portfolio of Islamic banks decreases in a decentralized Shari’ah-compliant governance structure. The reverse causality analysis shows strongly that SSB factors affect primarily loan portfolio risk-taking, not the other way around.