Interdisciplinary Journal of Research in Business

Vol. 1, Issue. 6, June 2011(pp.50-57)

Risk Management Practices and Islamic Banks: An Empirical Investigation from Pakistan
Naveed Ahmed
Hailey College of Commerce, University of the Punjab, Lahore, Pakistan E-mail: naveed_hailey@ yahoo.com

Muhammad Farhan Akhtar

Hailey College of Commerce, University of the Punjab, Lahore, Pakistan E-mail: vjfarhan@ yahoo.com

Muhammad Usman
Hailey College of Commerce, University of the Punjab, Lahore, Pakistan E-mail: Usmanhc@ hotmail.com

ABSTRACT This study aims to determine the firms level factors which have significantly influence the risk management practices of Islamic banks in Pakistan. For this purpose, the current study selects credit, operational and liquidity risks as dependent variables while size, leverage, N PLs ratio, capital adequacy and asset management are utilize as explanatory variable for the period of four years from 2006 to 2009. The results indicate that size of Islamic banks have a positive and statistically significant relationship with financial risks (credit and liquidity risk), whereas its relation with operational risk is found to be negative and insignificant. The asset management establishes a positive and significant relationship with liquidity and operational risk. The debt equity ratio and N PLs ratio have a negative and significant relationship with liquidity and operational risk. In addition, capital adequacy has negative and significant relationship with credit and operational risk, whereas it is found to be positive and with liquidity risk. Keywords: Risk Management, Liquidity Risk, Credit Risk, Operational Risk, Islamic Banks of Pakistan 1.0 INT RODUCTION In order to appraise and weigh up the soundness and reliability of banking industry, the information on connection between fluctuations in banking industry and the risk which is faced by banking sector is important. Appalling financial conditions can deteriorate the value of the banks portfolio, engendering liquidity and credit losses, which ultimately reduce profits of the banks. Therefore, a sound and reliable banking system dishes up as a significant feed for accomplishing economic growth all the way through the mobilization of monetary resources, placing them to dynamic use and transforming various risks. Under the international and open economic state, the job to construct an accurate and suitable risk management turn out to be very crucial and demanding, inconspicuously for Islamic banks as new thread in the banking industry of Pakistan. Al-Jarhi&Iqbal (2001) stated that Islamic bank as a banking organization demeanor all acknowledged banking activities together with borrowing and lending without interest. Hull (2002) studied that the banking business practiced rigid rivalry with banks and with financial institutions to catch the attention of probable customers. Mounira(2008) found financial institutions based on Islamic Shariah principles area of modern academic and of policy significance. It is also accounted that due to the superior levels of customer satisfaction and enhanced service quality, Islamic banking is more attractive and pleasing than conventional banking (Ahmad, Rehman & Saif, 2010).Particularly, Islamic banks with their exclusive values and operations precisely recognized the deposit characteristics, their investment pattern and prospect to successfully administer their liquidity (Ismal, 2010). To facilitate a significant number of stakeholders, Islamic banks execute numerous functions. This incorporates the pool of funds through the recognition of deposits. These funds are therefore forwarded to entrepreneurs or firms for dynamic and fruitful ventures to breed profits. In addition Islamic banks offers interest free products to dish up the diverse economy segments in compliance with Shariah principles. Moreover the Islamic bank is to endorse and encourage trade behavior as a dynamic interaction of the economy.

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The importance to investigate the risks that are faced by the Islamic banks of Pakistan could be best justified by the fact that in Pakistan the Islamic banks are engaged in significant roles to complementing the services as parallel to the conventional banks. Islamic banking has established its success to participate with the profound entrenched conventional banking system in Pakistan (Ahmad, Humayoun, & Hassan, 2010).Islamic banks of Pakistan show a significant growth from the last many years. past many significant growth has been reported by the Islamic banks According to the State Bank of Pakistan, total assets of Islamic banks reach to Rs, 424 billion at the opening of last quarter of 2010 while 31% yearly growth has been observed for Islamic banks of Pakistan. Similarly at the end of the quarter, deposits and financing & investments advanced by 3 8.2% and 17.7% respectively and attain to Rs.338 billion and Rs.233 billion. In addition, the overall share of Islamic banking industry in the countrys banking system also improved to 6.4% at the end of 1 quarter . In view of the fact that, the business of Islamic banking has numerous idiosyncratic characteristics, the temperament and extent of risk confronting such organizations may be considerably different due to the concept of profit-sharing approach in Islamic banks. There have been a fairly small number of academic studies available on Islamic banks about risk management, however, this study creates uniqueness with the extent of influence involved. The paper is ordered as follows. Section 2 reports literature review. Section 3 focuses on methodology and data collection. Section 4 indicates the empirical findings. Section 5 wraps up with the conclusion. HYPOTHESIS The study aimed to testing the following hypothesis: H 0: There is no relationship of firms level characteristics with credit risk, liquidity risk and operational risk. H 1: There is a relationship between size of the banks and credit risk H 2: There is a relationship between non-performing loans with credit risk H 3: There is a relationship between capital adequacy ratio (CAR) and credit risk H 4: There is a relationship between debt to equity ratio and the credit risk H 5: There is a relationship between asset management and the credit risk H 6: There is a relationship between size of the banks and liquidity risk H 7: There is a relationship between non-performing loans with liquidity risk H 8: There is a relationship between capital adequacy ratio (CAR) and liquidity risk H 9: There is a relationship between debt to equity ratio and the liquidity risk faced by the banks H 10: There is a relationship between asset management and the liquidity risk for banks H 11: There is a relationship between size of the banks and operational risk H 12: There is a relationship between non-performing loans with operational risk H 13: There is a relationship between capital adequacy ratio (CAR) and operational risk H 14: There is relationship between debt to equity ratio and the operational risk faced by the banks H 15: There is a relationship between asset management and the operational risk for banks

2.0 LITERATURE REVIEW 2.1 Liquidity Risk Kim and Santomero (1988) examined the responsibility of bank capital regulation in controlling solvency risk. By employing mean-variance model, they found capital ratios unproductive way to restrict banks insolvency risk (Bauer &Ryser, 2004) regulatory restrictions, debt ratio, volatility of risky assets, size of liquidation costs and spread between deposit rate and riskless interest rate are the significant constraints that compel banks hedging decisions. Siddiqui (2008) found that Islamic banks in Pakistan were more liable towards considering projects with long-term financing and better performance in terms of assets and return established improved risk management with keeping safe liquidity. Sensarma and Jayadev (2009) investigated the risk management of public and domestic private banks of India for the period 1998 to 2006. They found an enhancement on risk management aptitude of the banks. Akhtar et al., (2011) established better performance in elements of assets and return which recognized that conventional banks had improved liquidity risk management than Islamic banks in Pakistan.

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Interdisciplinary Journal of Research in Business Vol. 1, Issue. 6, June 2011(pp.50-57) 1 Source: Islamic Banking Bulleting, September 2010, 5 (3) - State bank of Pakistan (data for which is based on Unaudited Quarterly Accounts *number includes sub-branches)

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2.2Credit Risk Wilson, Summers and Hope (2000) stated that the inclusion of non-financial data and prototype of payment behavior in business failure can improve the certainty to manage credit in moreappropriate manner. Barnhill, Papapanagiotou, & Schumacher (2002) found credit value of portfolio of a banks the mo st important risk factor. Peter & Peter (2006) reported statistically momentous impact of loan-to-value ratio and negative equity risk as drivers of default credit risk. Fatemi and Fooladi (2006) stated the solitary most vital fundamental principle of credit risk models it to be acquainted with default risk of counterparty. Hassan (2009) persuaded risk identification and risk assessment & analysis were fairly competent in risk management practices. Mounira (2008) established Islamic banks to be riskier that conventional banks, and argued to strengthen and support risk management practices for Islamic banks as they have less risk hedging gears accessible in the market. 2.3 Operational Risk Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009) argued that Islamic banks of UAE and Brunei Darussalam faced the credit and operational risk more severely than other types of risks. Ray and Cashman (1999) reported that operational risk influence decision making in numerous ways. Blacker (2000) stated how mitigation of operational risk is being detained by British retail banks and found responsibility for operation risk lies with business unit management. Allen and Bali (2007) found significant affect of business cyclical factors in measuring operational risk, while studying the affect of operational risk management on profitability of banks through risk adjusted return on capital (RAROC) Chapelle et al. (2008) found that far -reaching funds can be conquered through energetic risk management techniques. In addition, the inclusion of innovative products in the financial businesses found to have huge cross-correlation with increasing operational risk (Philippas & Siriopoulos, 2009). 3.0 RESEARCH METHODOLOGY To highlight the firms level factors which significantly influencing the risk management practices of the Islamic banks of Pakistan, this study utilizes the financial data of Islamic banks of Pakistan from the period of 2006 to 2009. Various sources like State Bank of Pakistan, Karachi stock Exchange and websites of Islamic banks have been used for the collection of data. The list of Islamic banks which are included in this study is reported in appendix I. 3.1 Research Models Model (A) Credit Risk = + X11 + X22 + X33 + X44 + X55 + Model (B) Liquidity Risk = + X11 + X22 + X33 + X44 + X55 + Model (C) Operational Risk = + X11 + X22 + X33 + X44 + X55 + Table 3.1 goes here 4.0 STATISTICAL RESULTS 4.1 Descriptive Statistics Descriptive statistics containing values of means and standard deviation are reported in Table 5.1. The variables Credit risk, liquidity risk and operational risk are dependent variables, while the rest of them are independent variables. Table 4.1 goes here 4.2 Pearson Correlation Coefficients In addition, the values of Pearson Correlation Coefficients are reported in Table 5.2 indicates that the problem of multicolinearity does non-exist. Table 4.2 goes here

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Vol. 1, Issue. 6, June 2011(pp.50-57)

4.2.0 Regression Results Table 4.3, 4.4 and 4.5 reports the regression results of model (A), (B) and (C). Model (A) uses credit risk as dependent variable while liquidity and operational risks are used as dependent variables in Model (B) and Model (C) respectively. The value of Prob. F-statistic in all three models is 0.000 which represents that the models are good fitted. 4.2.1 Credit Risk The credit risk is a big threat for banks as the value of any organization measures by its credit worthiness. In model (A), as reported in table 4.3, the value of adjusted R-square represents that almost 86% change in the dependent variable can be observed with the variables under study while the rest of 14% is due to those factors that are not included in this study. In regression results, the credit risk is found to be a highly affected by all explanatory variables. The size of the bank and debt equity ratio, capital adequacy found to have a positive and statistically significant relationship with credit risk at 5%, 1% and 5% level respectively. Thus, this study accepts H 1, H 3 and H 4.The NPLs ratio found to be an insignificant relationship with credit risk. The regression results reports a relation but this relation is statistically insignificant, so H 2 is rejected. While the asset management established the negative but significant relationship with credit risk at 5% level, therefore H 5is accepted. Table 4.3 goes here 4.2.2 Liquidity Risk In model (B), as reported in table 4.4 the value of adjusted R-square shows that about 65% change in liquidity risk can be observed with the explanatory variables under this study. The relationship of debt equity ratio and capital adequacy ratio is found to have significant and negative relationship with liquidity risk at 1% and 10% level respectively. The better size of bank indicates that the banks have the better ability to establish big market share and generate higher profits. In this model, size of the bank is found to have a positive and significant relationship with liquidity risk at 1% level. The asset utilization ratio established the positive and significant relationship with liquidity risk at 5% significance level. The relationship of NPLs ratio with liquidity risk is negative and statistically insignificant. According to regression results, the study accepts H 6, H 8, H 9 and H 10, however H 7 is rejected as the relation of non-performing loans with the liquidity risk is statistically insignificant. Table 4.4 goes here 4.2.3 Operational Risk Regression results for Model (C) are reported in table 4.5. The value of adjusted R-square is 0.59 which shows that almost 59% change in operation risk can be attributed to the independent variables under this study. The results indicate that asset management positively an significantly associated with operational risk while NPLs the relationship between the operational risk and NPLs ratio is found to be a negative. On the other hand, size of the bank, debt equity ratio, and capital adequacy ratio found to be insignificantly affecting the operational risk of Islamic banks. Consequently the study accepts, H 12, H 15 and rejects H 11, H 13, H 14. Table 4.5 goes here 5.0 CONCLUSION AND POLICY RECOM M ENDATIONS The study aimed to investigate the fir ms level factors which significantly influencing the risk management practices in Islamic banks of Pakistan for the period 2006-2009. This study has employed credit, liquidity and operational risk as dependent variables to evaluate the risk management practices of Islamic banks in Pakistan. Empirical results reported that the size of bank has positive and significant relationship with financial risks (credit and liquidity risk), whereas its relation with operational risk is found to be negative and statistically insignificant. The asset management establishes a positive relationship with liquidity and operational risk, The debt equity ratio and NPLs ratio has a negative and significant relationship with liquidity and operational risk while they have positive relationship with credit risk. The capital adequacy has a negative and significant relationship with credit and operational risk, whereas it is found to be positive and significantly affected to liquidity risk. The core purpose of this study is to provide the guidelines to Islamic banking industry of Pakistan that how the management of the Islamic banks can manage the credit, operational and liquidity risks. In

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addition, this study elaborates that which types of determinants significantly affect the risk management practices of Islamic banks of Pakistan, therefore, helpful to the management of Islamic banks while making decisions. REFERENCE: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. Ahmad, A., Rehman, K., Saif, M. I. &Safwan, M.N.(2010). An Empirical Investigation of Islamic Banking in Pakistan based on Perception of Service Quality, African Journal of Business Management, 4 (6), 1185-1193. Akhtar, M. F., Ali, K., &Sadaqat, S. (2011). "Liquidity Risk Management: A comparative study between Conventional and Islamic Banks of Pakistan". Interdisciplinary Journal of Research in Business, 1 (1), 3 5-44. Al-Jarhi, A.M., &Iqbal, M. (2001). Islamic Banking: Answers to Some Frequently Asked Questions, Occasional paper No. 4, Islamic Development Bank, Islamic Research and Training Institute. Ali, K., Akhtar, M. F., & Ahmed, H. Z. (201 1).Bank-Specific and Macroeconomic Indicators of Profitability - Empirical Evidence from the Commercial Banks of Pakistan. "International Journal of Business and Social Science", 2(6), 23 5-242. Allen, L., & Bali, T. G. (2007). "Cyclicality in catastrophic and operational risk measurements". Journal of Banking & Finance, 31, 11911235. Al-Tamimi, H. A., & Al-Mazrooei, F. M. (2007). "Banks risk management: a comparison study of UAEnational and foreign banks". The Jo u r n a l of R i sk F i nan c e, 8 (4), 394-409. ASHRAF, D., ALTUNBAS, Y., & GODDARD, J. (2007). "Who Transfers Credit Risk? Determinants of the Use of Credit Derivatives by Large US Banks". The European Journal of Finance , 13 (5), 483 500. Barnhill, T. M., Papapanagiotou, J. P., & Schumacher, L. (2002). "Measuring Integrated Market and Credit Risk in Bank Portfolios: An Application to a Set of Hypothetical Banks Operating in South Africa". Financial Markets Institutions & Instruments, 11 (5). Bauer, W., & Ryser, M. (2004). "Risk management strategies for banks". Journal of Banking & Finance, 28, 331352. Blacker, K. (2000). "Mitigating Operational Risk in British Retail Banks". Risk M anagement, 2 (3), 23-33. Boudriga, A., Taktak, N. B., & Jellouli, S. (2009). "Banking supervision and nonperforming loans: a cross-country analysis". 1 (4), 286-318. DEMIROVIC, A., & THOMAS, D. C. (2007). "The Relevance of Accounting Data in the Measurement of Credit Risk". The European Journal of Finance, 13 (3), 253268. Chapelle, A., Crama, Y., Hubner, G., & Peters, J. P. (2008). "Practical methods for measuring and managing operational risk in the financial sector: A clinical study". Journal of Banking & Finance, 32, 10491061. Dinger, V. (2009). "Do foreign-owned banks affect banking system liquidity risk?". Journal of Comparative Economics, 37, 647657. Esty, B. C. (1998). "The impact of contingent liability on commercial bank risk taking". Journal of Financial Economics, 47, 189-218. Fatemi, A., & Fooladi, I. (2006). "Credit risk management: a survey of practices". Managerial Finance, 32 (3), 227-233. Gillet, R., Hubner, G., & Plunus, S. (2010). "Operational risk and reputation in the financial industry". Journal of Banking & Finance , 34, 22423 5. Hassan, A. (2009). "Risk management practices of Islamic banks of Brunei Darussalam ". The Journal of Risk Finance, 10 (1), 23-37. How, J. C., Karim, M. A., & Verhoeven, P. (2005). "Islamic Financing and Bank Risks: The Case of Malaysia". Thunderbird International Business Review, 47 (1), 7594. Hull, L. (2002). Foreign-Owned Banks: I mplications for New Zealands Financial Stability, Discussion Paper Series, DP 2002/05. Ismal, R. (2010)."Assessment of liquidity management in Islamic banking industry". International Journal of Islamic and Middle Eastern Finance and Management , 3 (2), 147-167. Isshaq, Z., & Bokpin, G. A. (2009). "Corporate liquidity management of listed firms in Ghana". 1 (12), 189-198. Jacobson, T. J., Linde, J., & Roszbach, K. (2006). "Internal ratings systems, implied credit risk and the consistency of banks risk classification policies". Journal of Banking & Finance , 30, 18991926. Kim, D., & Santomero, A. M. (1988). "Risk in Banking and Capital Regulation". The Journal of Finance, 43 (5), 1219-1233. Laviada, A. F. (2007). "Internal audit function role in operational risk management". Journal of Financial

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Regulation and Compliance, 15 (2), 143-155. 26. Mounira, B. A. (2008). "Managing Risks and Liquidity in an Interest Free Banking Framework: The Case of the Islamic Banks". International Journal of Business and M anagement, 3 (9), 80-95. 27. Ojo, M. (2010). "The growing importance of risk in financial regulation". T he Jo u r n a l of Risk Finance, 11 (3), 249-267. 28. Peter, V., & Peter, R. (2006). "Risk Management Model: an Empirical Assessment of the Risk of Default". International Research Journal of Finance and Economics (1), 42-56. 29. Philippas, D. T., & Siriopoulos, C. (2009). "Influence of financial innovation to the validation of operational risk". Managerial Finance, 35 (11), 940-947. 30. Ray, D., & Cashman, E. (1999). "Operational risks, bidding strategies and information policies in restructured power markets". D eci sio n Support Systems, 24, 175182. Sackett, M. M., & Shaffer, S. (2006). "Substitutes versus complements among credit risk management tools". Applied Financial Economics , 16, 10071017. 31. Sawada, M. (2010). "Liquidity risk and bank portfolio management in a financial system without deposit insurance: Empirical evidence from prewar Japan". International Review of Economics and Finance , 19, 392406. 32. Sensarma, R., & Jayadev, M. (2009). "Are bank stocks sensitive to risk management?". The Journal of Risk Finance, 10 (1), 7-22. 33. Siddiqui, A. (2008). "Financial contracts, risk and performance of Islamic banking". Managerial Finance, 34 (10), 680-694. 34. Stewart, J. G., & Kent, P. (2006). "The use of internal audit by Australian companies". 21 (1), 81-101. 35. Tarawneh, M. (2006). "A Comparison of Financial Performance in the Banking Sector: Some Evidence from Omani Commercial Banks". 101-111. 36. Uddin, M. H. (2009). "Reexamination of stock liquidity risk with a relative measure". Studies in Economics and Finance , 26 (1), 24-35. 37. Wahlstrom, G. (2006). "Worrying but accepting new measurements: the case of Swedish bankers and operational risk". Critical Perspectives on Accounting, 17, 493522. 39. WILSON, N., SUMMERS, B., & HOPE, R. (2000). "Using Payment Behaviour Data for Credit Risk Modelling". International Journal of the Economics of Business, 7 (3), 333-346 Table 3.1: Variable and their proxies Variables Credit Risk Liquidity Risk Operational Risk Explanatory Variables Bank's Size NPLs Ratio Capital Adequacy Debt to equity ratio Asset Management Table 4.1: Descriptive Statistics Variables Credit Risk Liquidity Risk Operational Risk Size of the Bank Debt Equity Ratio Asset Management NPLs Ratio Capital Adequacy Ratio Mean 0.68185387 0.2348 1428 0-0.002339 6.6992435 4.9817105 0.00089330 0.01916096 0.24243750 Std. Deviation 0.296570781 0.22 1547555 0.021069202 2.098607 193 4.120783831 0.01435795 1 0.024063000 0.178561220

Proxies Ratio of Total Debt to Total Assets Capital to Total Assets Return on Total Assets Logarithm of Total Assets Non-Performing Loans/Total Loans Tier 1 Capital + Tier 2 Capital / Risk Weighted Assets Total company debt/equity Asset Utilization Ratio = Operating Income/Total Assets

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Table 4.2: Pearson Correlation Coefficient Size of the Debt Equity Bank Ratio Size of the Bank Debt Equity Ratio Asset Management NPLs Ratio Capital Adequacy 1 .515 1
**

Asset Management .110 .598 1

**

NPLs Ratio .289 .309 -.1 14 1

**

Capital Adequacy .322 ** -.425

**

-.388 .046 1 *. Correlation is significant at the 0.05 level (2 -tailed).**. Correlation is significant at the 0.01 level (2-tailed). a Table 4.3: Coefficients for Model (A) Unstandardized Coefficients B 1 (Constant) Size of the Bank Debt Equity Ratio Asset Management NPLs Ratio Capital Adequacy -.017 .042 .065 -5.541 -.343 .441 Std. Error .078 .018 .012 2.263 1.114 .202 .296 .900 -.268 -.028 .266 F-statistic Prob (F-statistic) Standardized Coefficients Beta t -.215 2.267 5.402 -2.448 -.308 2.182 Sig. .832 .036 .000 .025 .762 .043 29.211 0.000

Model

0.890 R-squared Adjusted R-squared 0.860 Durbin-Watson stat 1.601 a. Dependent Variable: Credit Risk Table 4.4: Coefficients for Model (B) Model Unstandardized Coefficients B 1 (Constant) Size of the Bank Debt Equity Ratio Asset Management NPLs Ratio Capital Adequacy .025 .105 -.079 5.835 .279 -.463 0.730 Std. Error .092 .022 .014 2.653 1.305 .237
a

Standardized Coefficients Beta t .269 .995 -1.464 .378 .030 -.373 4.856 -5.600 2.200 .213 -1.954 Sig. .791 .000 .000 .041 .833 .066

R-squared

Adjusted R-squared 0.655 Durbin-Watson stat 1.592 a. Dependent Variable: Liquidity Risk

F-statistic Prob (F-statistic)

9.729 0.000

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Table 4.5: Coefficients for Model (C) Model 1 (Constant) Size of the Bank Debt Equity Ratio Asset Management NPLs Ratio Capital Adequacy R-squared Unstandardized Coefficients B .002 -.003 .001 1.027 -.266 .039 0.680 Std. Error .009 .002 .001 .274 .135 .025 -.251 .286 .700 -.304 .327 F-statistic Prob (F-statistic) Standardized Coefficients Beta t .222 -1.126 1.006 3.741 -1.970 1.573 Sig. .827 .275 .328 .001 .064 .133 7.658 0.000

Adjusted R-squared 0.59 1 Durbin-Watson stat 2.339 a. Dependent Variable: Operational Risk

APPENDIX List of Banks included in this study Islamic Banks Bank-Islami Pakistan Limited Dawood Islamic Bank Limited Dubai Islamic Bank Pakistan Limited Al-Baraka Bank (Pakistan) Limited Meezan Bank Limited Emirates Islamic Bank

Sr. No. 1 2 3 4 5 6