Financial Contracts in Conventional and Islamic Financial Institutions: An Agency Theory Perspective

Abstract

This study examines the differences in the relationships between different stakeholders in conventional and Islamic financial institutions. The accounting and finance literature identifies the major contractual relationships as being those between managers and shareholders (employment contracts) and between shareholders and debt-holders (lending contracts). Both these types of contracts are usually considered to be financial-based contracts, because they rely, among other things, on the firm’s reported earnings. This paper applies agency theory to examine these contractual relationships in the two different financial system. The agency problem can have various forms in Islamic institutions. The agency problem has an additional dimension when managers deviate from the Islamic principles of Shariah. This study is intended to fill a gap which exists in the current literature, relating to the implications of Shariah rules for agency relationships. It also provides an analysis of how agency relationships are different as compared to conventional counterparts and the implications that this has for optimizing the agency relationships by reducing inherent frictions. In this way, this study extends and develops the literature on agency relationships in Islamic finance, thus paving the way for future studies in the direction of corporate governance, contractual relationships, and better disclosure in Islamic financial institutions. The study concludes that Islamic financial institutions have fewer agency problems than their conventional counterparts.

Keywords: Accounting Contracts, Islamic Finance, Agency Problems, Compensation Schemes, Conventional Finance, Corporate Governance

JEL Classification: G2, G3, M4