Investor Protection and Dividend Policy: The Case of Islamic and Conventional Banks

This study examines the dividend policy behavior of Islamic and conventional banks operating in Arab markets. I examine countries included in Gulf Cooperation Council and Middle East and North Africa. These banks operate in an environment characterized by Sharia law and low levels of investor protection. I expect that in Arab countries, financial institutions have more potential to exploit the minority shareholders by using the dividend policy. I also expect that within the framework of agency theory, both types of banks set their dividend policies differently. By using the dynamic partial adjustment dividend model for the period 2003-2012, I find that both types of banks follow stable dividend policies having the similar speed of adjustment coefficients. However, conventional banks have relatively more stable and less responsive dividend policies to the changes of earnings. Contrary to the agency theory predictions of higher actual and target dividend payout ratios for Islamic banks, both ratios are substantially lower. Islamic banks in these markets have relatively more willing to payout less dividends and use free cash flow for their personal benefits. In contrast, conventional banks experience relatively less significant agency problems and have more willing to payout higher dividends. The empirical results also show that in an environment characterized by Sharia law and low levels of investor protection, Islamic and conventional banks set their dividend policies in line with substitute and outcome agency model of dividends, respectively. Islamic banks payout lower dividends and use the dividend policy as a substitute mechanism for alleviating relatively more significant agency problems. Sub-classification index results show that Islamic banks increase dividends in response to weak minority investor protection, specifically the inability of shareholders to get corporate documents during litigation against firms. In these markets, conventional banks payout higher dividends as an outcome of strong protection for shareholder rights. Sub-classification index results show that conventional banks increase dividends in response to stronger minority investor protection, specifically for the director liability and the amount of disclosure of related party transactions. Keywords: dividend policy; stability; agency theory; outcome; substitute; Islamic banks; conventional banks