THE IMPACT OF EQUITY HOLDERS' MONITORING ON THE SOUNDNESS OF ISLAMIC BANKS IN GCC COUNTRIES

Abstract

This study investigates equity holders' (EHs) market discipline in Islamic banks (IBs) within the Gulf Cooperation Council (GCC) countries. Market discipline is crucial for enhancing banking institutions' soundness and sustainability. The paper proposes an innovative market signal, the return volatility measured by BETA, to examine EHs' risk estimation and banks' responses to this monitoring. This study addresses two specific agency problems in IBs. First, the bank's incentive for due diligence and loan optimization may be weakened by the risk transfer to Investment Account Holders (IAHs). Second, liquidity management may create information asymmetry for EHs about the actual risk and profit of Profit Sharing Investment Accounts (PSIA). The research fills the gap in the literature by examining market discipline in emerging markets, exploring market discipline in Islamic banking, and addressing the second component of market discipline: banks' responses. Data on IBs from Bahrain, Saudi Arabia, and the United Arab Emirates between 2004 and 2014 are analyzed. The study found that monitoring by EHs is weak in GCC countries, and there is no evidence of banks being responsive to EHs' monitoring. Thus, EHs should be more aware of their critical role in monitoring banks and inducing them to behave consistently with their soundness