Sharia compliance, national governance, and value of cash in Organization of Islamic Cooperation countries

The study addresses whether and how Sharia (Islamic law) compliance and national governance shape the value of corporate cash holdings in OIC countries. Motivated by the relative resilience of Islamic economies to global shocks and the unique liquidity constraints imposed by Sharia (limited non-interest-bearing instruments and low liquidity requirements), the paper asks if Sharia-compliant firms can use cash more effectively to enhance firm value. It further posits that both internal governance (via Sharia compliance) and external governance (via national institutions) influence corporate governance quality, which prior work links to the value of cash. The study contributes by: (1) establishing that cash is value-enhancing in OIC countries; (2) showing that Sharia compliance and strong national governance are associated with higher cash value; and (3) demonstrating that strong national governance reinforces the positive effect of Sharia compliance on cash value.

The review covers three streams. 1) Cash holdings: Firms hold cash for agency, precautionary, speculative, and transaction motives. Tradeoff theory suggests an optimal cash level; agency theory highlights agency costs of free cash flow; financing hierarchy theory posits no optimal level as internal funds dominate. Empirical work links cash to firm-level factors (leverage, growth, dividends, control, entrenchment) and to country-level governance (e.g., weaker investor protection and securities laws, and lower control of corruption associate with higher cash holdings). 2) Value of cash: Cross-country and U.S. evidence shows cash is more valuable in better-governed contexts; stronger investor protection and governance reduce dissipation and increase marginal value of cash (e.g., Pinkowitz et al., Dittmar & Mahrt-Smith, Kalcheva & Lins, Chen). 3) Islamic countries: Prior studies largely single-country, focusing on determinants of cash (e.g., Pakistan, Saudi Arabia, Jordan). Evidence on cash value is mixed and context-dependent (e.g., more valuable post-crisis in Jordan). A gap remains on the role of Sharia compliance per se in determining cash value. Hypotheses developed: H1: cash value is higher for Sharia-compliant firms; H2: national governance positively affects cash value; H3: national governance reinforces the positive effect of Sharia compliance on cash value.

Data: 10,878 firm-year observations from non-financial, non–government-related firms across 16 OIC member countries, 2000–2015. Firm data from Global Vantage; World Governance Indicators (WGI) and Private Credit (PC) from World Bank sources. Financial ratios are winsorized at 1% and 99%, and observations with market-to-book above 10 are excluded. Variables: - Dependent variable: Market-to-book ratio (MTB) = (book value of debt + market value of equity) / total assets. - Key regressor: Cash holdings (CH/NA) = (cash and equivalents + short-term investments) / net assets (total assets minus cash). - Controls: SIZE (ln total assets in USD millions), CF/NA (EBITDA less interest, taxes, and common dividends divided by NA), CAPX/NA, LEV (total debt/total assets), DIV (dummy =1 if pays dividend), PC (domestic credit by financial sector/GDP). - Sharia compliance (SC): Dummy =1 if three ratios are each < 0.33: (cash and equivalents + short-term investments)/market cap; accounts receivable/market cap; total debt/market cap. Firms in prohibited industries are not in the sample. - National governance: WGI is the arithmetic mean of six indices (voice and accountability, political stability/absence of violence, government effectiveness, regulatory quality, rule of law, control of corruption), ranging from −2.5 to 2.5. A median split (Hi_WGI) is also used with threshold 0.223. Model: Dynamic panel model (Arellano–Bond GMM) to estimate cash value and address endogeneity, incorporating lagged MTB, firm-level controls, country/year-specific instruments, and year dummies. Benchmark specification includes CH/NA; interactions with SC and WGI test H1–H3. Additional estimations partition samples by national governance (weak vs strong WGI) and by Sharia compliance (SC=0 vs SC=1). Diagnostics: Arellano–Bond tests for AR(2) and Hansen’s J for overidentifying restrictions reported; VIFs below 2.5 indicate low multicollinearity.

Full sample (Table 4): - Cash is value-enhancing: CH/NA has a positive coefficient (e.g., 0.234*** in baseline; 0.198*** with SC interaction; 0.157** with WGI interaction). - Sharia compliance increases cash value: SC × CH/NA = 0.714***; implied marginal effect of cash on MTB is 0.912 for Sharia-compliant firms vs 0.198 for non-compliant firms. - National governance interaction is not significant in the full sample (WGI × CH/NA insignificant). - SC main effect is positive (0.417***). By national governance partitions (Table 5): - Weak governance: CH/NA not significant on average, but SC × CH/NA = 0.492**; marginal effect (example reported): 0.170 for non-compliant vs 0.662 for Sharia-compliant firms. - Strong governance: CH/NA positive (0.245***); SC main effect positive (0.346***); SC × CH/NA = 0.549*** (cash more valuable for Sharia-compliant firms). By Sharia compliance partitions (Table 6): - Non–Sharia-compliant firms: CH/NA positive across specifications (e.g., 0.186***); interactions with WGI and Hi_WGI generally insignificant. - Sharia-compliant firms: CH/NA positive (e.g., 0.387***; 0.374**), with Hi_WGI × CH/NA showing borderline positive significance, suggesting cash may be particularly valuable when governance is sufficiently strong. - WGI main effect is mixed (e.g., negative and significant in one SC specification). Hypotheses: - H1 supported: Cash value is higher for Sharia-compliant firms. - H2 partially supported: Cash is generally more valuable under strong national governance, but WGI–cash interaction is not robust in all settings. - H3 supported: Strong national governance reinforces the positive effect of Sharia compliance on cash value. Additional notes: Lagged MTB is consistently positive, supporting the dynamic adjustment assumption; PC tends to have a negative association with MTB; diagnostics (AR(2), Hansen’s J) generally acceptable.

Findings indicate that in OIC countries, corporate cash holdings contribute positively to firm value, aligning with agency and governance theories that better governance disciplines cash usage. Sharia compliance—an internal governance mechanism grounded in broader stakeholder accountability and ethical mandates—elevates the marginal value of cash, consistent with reduced agency costs and improved investment efficiency. External governance at the national level further conditions these effects: where national governance is strong, the general value of cash is higher and the Sharia compliance premium on cash value is reinforced, reflecting complementarity between internal and external governance mechanisms. Conversely, in weak governance environments, cash is not generally valued unless firms are Sharia-compliant, suggesting Sharia adherence can partially offset weak institutional settings by improving governance quality at the firm level. Overall, the results address the research question by demonstrating that both Sharia compliance and national governance materially shape the value of cash, with their alignment producing the strongest effects.

The paper shows that cash is generally value-enhancing among non-financial firms in 16 OIC countries (2000–2015). Sharia-compliant firms derive greater value from cash than non-compliant peers, and strong national governance environments are associated with higher cash value. Importantly, national governance amplifies the Sharia compliance effect on cash value, implying that internal and external governance should co-exist to maximize cash value. Contributions include: (1) cross-country evidence from OIC markets on cash value; (2) identification of Sharia compliance as a governance mechanism that elevates cash value; and (3) demonstration of complementarity between national governance and Sharia compliance in enhancing cash value. Future research directions: extend analysis to outcomes beyond cash value, examine non-OIC settings where Islamic finance is growing, and assess whether Sharia compliance and national governance mitigate poor corporate governance in emerging markets via the cash value channel.

• Scope: Focuses on non-financial, non–government-related firms in 16 OIC countries from 2000–2015; results may not generalize beyond this context or to financial firms. - Sharia classification: Based on financial ratio thresholds; the dataset does not include firms in prohibited industries, so the business activity screen could not be separately evaluated. - Measurement: WGI is an aggregate index; country governance nuances may be obscured. - Endogeneity: Dynamic panel (Arellano–Bond) mitigates but may not fully eliminate endogeneity concerns. - Data access: Underlying datasets are proprietary and not publicly available due to third-party restrictions. - Findings on national governance are mixed in some specifications (H2 only partially supported).