Are top managers important for firm performance and idiosyncratic risk? Evidence from sharia vs non‐sharia‐compliant firms in the UK and Pakistan

• Author: Ali M. Kutan,Syed Muhammad Aamir Shah,Iram Naz
• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/twec.12511
• Date: 01 March 2018

SPECIAL ISSUE ARTICLE

Are top managers important for firm performance

and idiosyncratic risk? Evidence from sharia vs

non-sharia-compliant firms in the UK and Pakistan

Ali M. Kutan

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Iram Naz

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Syed Muhammad Aamir Shah

3

1

Department of Economics and Finance, Southern Illinois University Edwardsville, Edwardsville, IL, USA

2

Capital University of Science and Technology, Islamabad, Pakistan

3

Allama Iqbal Open University, Islamabad, Pakistan

1

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INTRODUCTION AND BACKGROUND

One of the most important objectives of corporate enterprises is the maximisation of shareholder

wealth. In this regard, firm profitability is important. However, such profits are always accompa-

nied by risk driven by both internal and external factors. Uncertainty associated with firms’inter-

nal factors and decisions is referred to as “idiosyncratic risk”(Heinle & Verrecchia, 2012).

Corporations generally do not have control over their external environment, but they may reduce

the idiosyncratic risk through diversification, financial decisions and operating leverage. Top man-

agers and their financial traits are thus important for firm profitability and specific risk. Regarding

the role of managers in managing idiosyncratic risk, the literature provides some indirect evidence.

For example, while dealing with borrowing and investment decisions, managers’reputational con-

cerns may encourage them to pursue overly conservative business strategies (Diamond, 1989; Hir-

shleifer & Thakor, 1992). Managers who are overconfident are more likely to prefer more debt,

which leads to a higher level of idiosyncratic risk (Kraus & Litzenberger, 1973). Rotemberg and

Saloner (2000) and Van den Steen (2005) report that CEO vision is the most important ingredient

for the determination of a firm’s policy. Managers of levered firms tend to select investments that

increase the idiosyncratic risk (Galai & Masulis, 1976; Jensen & Meckling, 1976).

The importance of managerial financial styles in firm performance is also recognised in litera-

ture. For example, some studies argue that managerial styles are related to organisational outcomes

(Bamber, Jiang, & Wang, 2010; Bertrand & Schoar, 2003; Dejong & Ling, 2013; Dyreng, Hanlon,

& Maydew, 2010; Fee, Hadlock, & Pierce, 2013). Others report that managers can impact share

prices, a market measure of firm performance, by altering dividend policies, and firms with better

management tend to have more investment growth (Denis & Denis, 1994; Gunasekarage & Power,

2006; Jones & Brooks, 2005). Chemmanur, Kong, and Krishnan (2014) report that the relationship

between management quality and firm performance is strong. Bertrand and Schoar (2003) find that

management style is significantly related to managers’fixed effect on firm performance and top

managers are important for financial and operating decisions and performance of firms.

DOI: 10.1111/twec.12511

World Econ. 2018;41:763–780. wileyonlinelibrary.com/journal/twec ©2017 John Wiley & Sons Ltd

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Although the literature supports the view that top managers are important for organisational

policies and ultimately for the success of organisations, there are limited empirical studies on the

direct link between managers’financial styles and firms’risk-taking behaviour and performance.

There are three theoretical views on this issue. The neoclassical theory assumes that managers are

homogeneous and perfect substitutes for each other. In addition, all managers make similar rational

decisions in similar economic situations. According to the neoclassical view, top executives are a

key ingredient in firms’strategic decisions, but such decisions are not influenced by managers’

individual financial styles (Weintraub, 2002). On the other hand, the upper echelons theory (Ham-

brick & Mason, 1984) argues that managers are different in their decision-making styles and

idiosyncratic differences exist due to different personal values and cognitive styles. Thus, accord-

ing to the echelons theory, decision-making preferences lead to different organisational outcomes.

The echelons theory is based on the characteristics of individuals and their judgement and deci-

sion-making.

1

According to the theoretical view based on the judgement and decision-making liter-

ature, person, environment and task-related factors can affect the individual decision-maki ng

(Bonner, 2008). For example, person-related factors refer to individual characteristics such as risk

behaviour, intrinsic motivation and confidence, which all influence the cognitive processes that

lead to decision-making. These personal characteristics are given different names in the literature,

such as financial styles (Prince, 2010; Shefrin & Nicols, 2014), managerial styles (Yang, 2012)

and managers’fixed effects (Bamber et al., 2010; Bertrand & Schoar, 2003).

Overall, there is enough evidence to suggest that managerial financial styles can influence firm

performance and idiosyncratic risk. The literature, however, pays less attention to the direct role

played by managers in explaining cross-sectional variation in firm performance and idiosyncratic risk

in the context of sharia-compliant (SC) firms. There are only a few empirical studies. For example

Naz, Shah, and Kutan (2017) explore the impact of managers’financial styles on financial decis ions of

the sharia firms for Pakistan and the UK. For every firm, they construct a manager–firm matched panel

data to identify the top executives across the sharia-compliant firms and find that the managers play a

significant role in explaining the differences in financial decisions across the firms and the financial

styles of managers who move between a sharia and a non-sharia-compliant (NSC) firm are different.

Since performance and risk are the outcomes of financial decisions, in this paper we argue that the

managers may also play a role in explaining cross-sectional differences in firm performance and risk.

In another empirical study, Wooi and Ali (2015) show that there is no significant difference in

performance of SC and NSC firms, but the firms whose CEOs are Muslim show significantly lower

performance as compared to the firms of non-Muslim CEOs. They also find that Muslim-dominated

board could facilitate the lower performance of the firm with Muslim CEOs, and, more importantly,

the lower performance could be mitigated if the ultimate owner had a higher degree of control over

the firm. Another important finding in the Wooi and Ali (2015) study is that the Muslim CEOs can

contribute positively to the performance of the firm if the owners hold more controlling rights.

Our paper contributes to this line of research and attempts to fill the significant gap in the liter-

ature. In particular, we examine whether individual top managers are partially responsible for the

variation in firm performance and idiosyncratic risk after firm’s fixed effects and time-varying firm

characteristics are controlled for.

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We focus on the top executives’effect on the idiosyncratic risk

1

According to the literature of psychology, three types of cognitive characteristics are important for affecting managerial

decisions: styles, abilities and strategies (Ho & Rodgers, 1993; Kozhevnikov, 2007).

2

Very few researchers examine the impact of managerial characteristics on performance and investment of the firm, and even

these do not control for the firms’fixed effect, nor do they isolate the managers’fixed effect from the firms’fixed effect.

See, among others, Malmendier and Tate (2005).

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