Investment Opportunity Set, Corporate Governance Practices and performance of Modarabas

Abstract

The literature on association between corporate governance and firm performance is based on the paradigm that there is a positive relationship between the two. Since better corporate control mechanism reduces the risk of information asymmetry and align the interests of owners and managers. However, prior studies have documented mixed and to some extent weak results. Many researchers believe the global financial crisis of 2007-09 occurred due to slack board oversight and flawed remuneration of managers that boosts aggressive risk taking (Erkens, Hung, & Matos, 2012; Sharfman, 2009). While for ordinary shareholders, it is difficult to monitor the actions of executives, due to costly state verification. This paper, following the approach of Hutchinson & Gul (2004), postulates, as a principal association, a non-positive relationship between growth and performance of modaraba companies; and then investigate how corporate governance proxies moderate this negative association. In Islamic finance, modaraba is a kind of partnership wherein one party extends capital to other for the purpose of carrying business and sharing profits earned through mixture of investment and expertise. Modarabas are shariah-compliant (i.e., pure Islamic based) financial sector firms. The results support this paradigm to some extent and show that the presence of non-executive and independent directors on the board have positive impact on modaraba sector entities of Pakistan. The evidence indicates significant positive moderating effect of higher ratio of non-executive directors (NEDs) in the relationship between growth opportunities and ROE. But insignificant moderating effect for: (a) fraction of outstanding shares held by independent & executive directors and (b) officers' compensation. The findings provide support for the positive contribution of board of directors' role of supervising and controlling managerial decisions that protect the interests of stakeholders and increases value of modaraba companies.