Voluntary Operational Risk Management Disclosures by Islamic Banks in Muslim Majority Countries

Abstract

In this paper, we develop a new voluntary operational risk management disclosure (ORMD) framework for the Islamic banks by incorporating five dimensions related to operational risk: personnel risk, information technology/system risk, legal risk, social risk, and business performance sustainability risk. We provide a quantitative assessment of the effects of the Shari’ah governance system at the country level and corporate governance at the bank level on the quantity of the ORMD while controlling for the influence of stylized factors. Using a new voluntary ORMD framework, we find that Islamic banks’ ORMD has a pecking order, i.e., more voluntarily disclosed information relates to (i) personnel risk, (ii) social risk, and (iii) performance sustainability risk. This is the first study to provide evidence that a two-tier Shari’ah governance system significantly increases the voluntary ORMD in a Muslim majority country. Our estimation results show that an increase in both the government ownership and the percentage of the independent directors increases ORMD. The evidence presented in this paper also indicates that the nature and scope of internal control requirements for the Islamic financing contracts such as Mudarabah and Musharakah, and adoption of AAOIFI standards, influences the voluntary ORMD. Our results imply that as Islamic banks grow and compete against conventional banks, the Islamic banks must do more, to promote the ethos of Shari’ah by improvements in voluntary ORMD, as disclosing robustness and transparency of their internal controls to stakeholders is promising for the future of Islamic banking. We developed new indicators to measure ORMD to determine whether an understanding of operational risk has a significant impact on the internal control environment of Islamic banks.