Does Shariah Compliance lead to Managerial Trustworthiness? Evidence from empirical analysis of Capital Structure of Shariah and Non-Shariah Firms in Pakistan
Does Shariah Compliance lead to Managerial Trustworthiness? Evidence from empirical analysis of Capital Structure of Shariah and Non-Shariah Firms in Pakistan

Summary/Abstract: The Shariah law makes Amanah (trustworthiness) a fundamental obligation for all the contractual parties. From the agency theory perspective, we, thus, investigate managerial trustworthiness in capital structure decisions of Shariah firms and compare it with those of Non-Shariah firms, in the light of Islamic principle of Amanah (trustworthiness). Specifically, we examine whether capital structure of Shariah firms is partially influenced by managerial ownership under the motivation of self- interest. Using the data from Pakistan, our results show that, unlike Non- Shariah firms, leverage ratios in Shariah firms are insensitive to the varying degree of managerial ownership, indicating absence of managerial opportunism in financial decisions of these firms. For the Non- Shariah firms, on the other hand, our results confirm findings of previous research which reveal that managers manipulate leverage ratios in their own interest the cost of firm value, indicating the severity of agency conflicts among these firms. Invoking agency theory, we argue that certain firm characteristics (such as lower free cash- flows and lesser liquidity), achieved through Shariah compliance, help Shariah firms mitigate agency conflicts. These features persuade managers to behave less opportunistically than their counterparts in Non- Shariah firms as shown from their financing choices. The results are important for understanding nature of the two types of firms studied and the cross- sectional differences between the capital structure choices of these firms. Besides, our findings have also implications for growing number of Shariah compliant firms and a new clientele of Islamic investors who have entered capital markets due to the Islamic image of Shariah firms in Muslim majority country like Pakistan.

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