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FACTORS AFFECTING THE PERFORMANCE OF FINANCIAL

SECTOR IN MALAYSIA

Bong Lie Lin

BG
173
B713 Corporate Master in Business Administration
2012 2012
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MALAy LA SARAWAK

P.KHIOMAT MAKLUMAT AKAOEMIK

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FACTORS AFFECTING THE PERFORMANCE OF FINANCIAL SECTOR


IN MALAYSIA

BONG LIE LIN

A dissertation submitted in partial fulfillment of the requirements


for the degree of Corporate Master in Business Administration

Faculty of Economics and Business


UNIVERSITI MALAYSIA SARA W AK
2012
ABSTRACT

0'his paper is to analyze and detennine the factors that affecting the financial sector

perfonnance in Malaysia for the period of five years, from year 2006 to 2011. From

the study, the result shows that, the perfonnance of Malaysian financial sector is

stable and quite profitable because of systematic Malaysian financial systems

regulations and the strong financial capital. However, the global financial crisis

occurred during year 2008 to 2009 was affected the financial sector globally and

affected the financial institution's service qualit~ The study will use the financial

ratios and apply the CAMEL Model namely, Capital adequacy, Asset quality,

Management, Earnings, and Liquidity to detennine the factors affecting the financial

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sector perfonnance. So, in order to identify the detenninants of perfonnance of

Malaysian financial sector during 2006 to 2011, this study has chosen mUltiple

regression analysis. Besides that, the dependent variables are consisting profitability

ratio, which Return on Assets (ROA) and Return on Equity (ROE), then independent

variables are the CAMEL Methods. So from the study, the results also shows that, the

ROA and ROE are depends on the CAMEL. Lastly, there are a significant

relationship between the dependent variables and the independent variables.


ACKNOWLEDGEMENT

My highest and more sincere appreciation goes to my beloved parents, and my

families, who have always encouraged and guided me to be independent, never try to

limit my aspirations.

I would like to express my great appreciation to my supervisor, Dr Chu Ei Yet for his

understanding, attention, kindness and encouragement. His supervision, idea,

guidance and critics of the research paper have been an enormous help. Words alone

cannot be expressed my greatest appreciation and thanks to him. I

I would like to express my high appreciation to my all lectures of Faculty Economics

and Business, especially lecturers of Finance. Thanks again to everyone including

those who I have probably forgotten to mention here.

ii
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,.

Pusat Khidmat MakJumat Akad emik

UNlVERSm MALAYSIA SARAWAK

TABLE OF CONTENT

ABSTRACT i

AKNOWLEDGEMENT ii

TABLE OF CONTENT iii

LIST OF FIGURES v

LIST OF TABLES v

LIST OF ABBREVIATIONS vi

1. INTRODUCTION

1.1 Background 1

1.1.1 Malaysian Gross Domestic Product (GDP) 4

1.1.2 Malaysian Financial System Challenges in Malaysian Financial

Sector 6

1.1.3 Challenges in Malaysian Financial Sector 9

1.2 Problem Statement 10

1.3 Theoretical Framework 12

1.3.1 Agency Theory 12

1.3.2 Characteristics ofAgency Problems in Financial Institutions 13

1.4 Conceptual Framework 15

1.5 Scope of the Study 16

1.6 Research Objectives 17

1.6.1 General Objective 17

1.6.2 Specific Objectives 18

1.7 Significance of the Study 18

1.8 Organization of the Study 19

1.9 Conclusion 20

2. LITERATURE REVIEW
2.1 Introduction 21

2.2 Literature review on CAMEL Approach 22

2.3 Financial Institutions Rating in Malaysia 24

2.3.1 Capital Adequacy 24

2.3.2 Asset Quality 26

2.3.3 Management 29

iii

,...

2.3.4 Earnings 30

2.3.5 Liquidity 31

2.4 Empirical Literature: Determinants of Financial Institutions

Profitability 32

3. METHODOLOGY
3.1 Introduction 34

3.2 Data 35

3.3 Sample 35

3.4 Variables used in the study 36

3.4.1 Dependent variables 36

3.4.2 Independent variables 36

3.5 Empirical Model 43

3.6 Concluding Remarks 44

3.7 Conclusions 45

4. FINDINGS AND CONCLUSION


4.1 Introduction 46

4.2 Descriptive Analysis 46

4.2.1 Descriptive Analysis/or the Dependent and Independent

Variables 46

4.2.2 Trend Analysis 48

4.2.2.1 Return on Asset (ROA) 48

4.2.2.2 Return on Equity (ROE) 49

4.3 Correlation Analysis 49

4.4 Model Summary and coefficient Analysis 52

4.4.1 Model Summary 52

4.4.2 Coefficient Analysis 0/ ROA 53

4.5 Chapter summary 56

5. CONCLUSION AND RECOMMENDATIONS


5.1 Introduction 57

5.2 Summary of Findings 57

5.3 Recommendations and Suggestions 59

REFERENCES 61

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LIST OF FIGURE

Figure 1: Malaysia Real Growth Rate ........ ...... . ... ....... . .. ... ..... .......... ........... 5

Figure 2: Malaysia GDP Per Capita (US$) ............... ...... .................... .......... 5

Figure 3: The Conceptual Framework for Financial Sector Performance ............... 16

Figure 4: Trend Analysis ofROA of Malaysian Financial Sector ................... . .. .48

Figure 5: Trend Analysis of ROE of Malaysian Financial Sector ... ....... . ... ...... ....49

LIST OF TABLES

Table 1: List of Financiallnstitutions as Public Listed in Bursa Saham Malaysia ..... .4

Table 2: The Malaysian Financial System .......... ......... .. ................................ 8

Table 3: Independent Variables and their Proxies .............. ........ ................... .42

Table 4: Descriptive Analysis for the Dependent and Independent Variables ..... . ... .47

Table 5: Correlation between ROA and all ratios ...... . . ........... . ... , '" ., ....... ...... 50

Table 6: Correlation between ROE and all ratios ........... ......... ...................... .51

Table 7: Summary of Analysis Return on Assets (ROA) and Return on

Equity (ROE) ......................... ........... ........... ........... ....... . ... .... 52

Table 8: Coefficient Analysis and Collinearity Statistic (ROA) ....... ...................54

Table 9: Coefficient Analysis and Collinearity Statistic (ROE) ...................... ....55

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,...
....

LIST OF ABBREVIATIONS

ASST Asset Quality

BNMlGP8 Financial Reporting for Licensed Institutions

CAP Capital Adequacy

CTD Cash to Deposit

EARN Earnings

FDI Foreign Direct Investment

FDIC Federal Deposit Insurance Corporation

FIs Financial Institutions

GDP Malaysian Gross Domestic Product

LIQ Liquidity

LPI Lonpac Insurance

LTD Loan to Deposit

MARC Malaysian Rating Corporation Berhad

MBSB Malaysia Building society Berhad

MNGT Management

MNRB Malaysian Reinsurance Berhad

NPL Not Performing Loan

OLS Ordinary Least Squares

RHB Rashid Hussein Bank

ROA Return on Assets

ROE Return on Equity

vi

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,.......

RWCR Risk Weighted Capital Ratio

VIF Variance Inflation Factor

vii
CHAPTER 1

INTRODUCTION

1.1 Background

The global financial crisis from 2008 t02009 had brought huge impact for the world

economy due to the price of the assets which has been over inflated and caused the

sub-prime mortgage booming and exploding into housing and banking crisis with a

cascading effect on consumer and investment demand. In addition, the financial market

becomes panic due to the subprime mortgages and the failures of Lehman Brothers

and Washington Mutual in United States .The government of United States had

implemented some solutions and actions to reduce the panics during the first half of

October by promoting the liquidity and the solvency of the financial sector, reducing

the prices for the asset classes and the commodities, the cost of the corporate and the

bank borrowing rose significantly and high volatility in financial market which

increasing infrequently? In the case of Malaysian economy, the country's economy was

sheltered from the direct effects of financial exposure because the new derivatives were

not allowed into the country. The global financial crisis may result the Government's

plans to achieve vision 2020 being interrupted because of decreasing in the exports and a

slowdown in foreign direct investment (FDI).

The financial services sector is the bedrock of any economy. It is the key to the overall

economy by providing various fonns of capital to enable the growth of other

industries in the economy. All large and successful economies require strong banks

system, vibrant capital markets and well-functioning financial infrastructures.

Moreover, the sector is also a core component in a services-based economy and a key

growth engine in its own right. As demonstrated by the emergence of international

...__...._--==========-=-:-------:::---=---=------- ---_.
,...

financial services centres worldwide, the financial sector growth comes from serving

domestic businesses and consumers as well as tapping external markets and sources of

, funds.

Mansor (2007) states that financial liberalization and development has been the major

financial feature in many developing countries. Malaysia is a highly open economic

country and it also witnesses a respectable economic growth and rapid financial

development since the introducing of Financial Sector Masterplan in 2001, the

Malaysian financial sector has undergone significant transformation and progress. The

banking sector especially has undergone restructuring, consolidation, and

rationalization. Moreover, the flexibility and the performance of the financial

landscaping had been improved due to the transformation and deregulation and

liberalization. Moreover, a stable and effective financial sector will affect the

performance of the financial sector and it will become an important pillar of strength

in our economy.

Schumpeter (1911) contends that the services provided by the financial intermediaries

are essential drivers for innovation and growth. Well developed financial systems

II channel financial resources to the most productive use. Malaysia's Prime Minister,

Dato' Sri Mohd Najib bin Tun Hj Abdul Razak states that financial sector in Malaysia

is expected to have a greater role in assisting the economic growth as Malaysia transit

towards achieving a developed economy status by year 2020. The financial sector is

able to assist the economy growth and encourage the economy transformation into the

next phase of development and provide the world class, high value added financial

products and services at the competitive prices and speed up the new economic

sectors. In order to enhance the economy's expansion, Government has taken the

initiatives to promote structural change within the economy and diversify the sources

of the financial sector's growth by offering liberalisation package from 2009 to 2012.

The foreign equity limits of investment banks, Islamic banks, insurance companies

and Takaful operators had increased from 40 percent to 70 percent. The alliances will

strengthen business potential and enhance the growth of the financial institutions

through international expertise and global network foreign shareholders. The rapid

growth and the strong financial sector of the country will enable the consumers to get

more infonnation, between the financial service providers, the regulators and the

authorities will need to provide the conducive environment that raises the consumer

empowennent. The more consumers can afford and able to buy the products or

services provided by of the financial institution, such as commercial bank, investment

company, or insurances company, will positively affect the perfonnance of the

financial sector.

As a result, the financial sector plays crucial role for the economic growth and the

country's development. From Table 1 it shows that then financial sector comprises of

26 institution consisting 4 commercial bank, 6 insurance company, 14 investment

holding companies, stock broking companies, finance companies and the exchange

holding companies. The lists of the financial institutions in Table 1 are public listed

on the Bursa Saham Malaysia.

,...

Table 1: List of Financial Institutions as Public Listed in Bursa Saham Malaysia

Code in
Bursa Financial Insituitions Type of Firms
5185 Affin Bank Bhd Commercial bank
1015 Ambank(M) Bhd (AMMB) Commercial bank
1155 Malayan Banking Bhd Commercial bank
1295 Public bank Berhad Commercial Bank
5258 BIMB Holding Bhd Investment holding company
2143 ECM Libra Financial Group Investment banking group
6688 Hwang-DBS Malaysia Bhd Investment company
3379 Insas Berhad Investment holding company
6483 K&N Kenanga Holding Bhd Investment company
8621 LPI Capital Bhd (Lonpac Insurance) Investment holding company
6459 MNRB Holding Bhd Investment holding company
1236 MBF Holding Group (MBFHLDG) Investment holding company
5053 OSK Investment bank Bhd Investment holding company
6009 Pacific&Orient Berhad
Insurance company
4782 PacificMas Bhd (PACMAS)
Investment holding company
1066 RHB CAPITAL
Investment company
9296 RCE Capital
Investment company
4898 T A Enterprise Bhd
Investment holding company
1163 Allianz Malaysia Bhd
Insurance company
5097 KURASIA (Kumia Asia Bhd)
Insurance company
1198 MAA
Insurance company
1058 MANULIFE
Insurance company
6139 TAKAFUL
Insurance company
5088 APEX Equity Holding Bhd
Stock broking company
1818 Bursa
Exchange holding company
1171 MBSB Exempt Finance Company

Sources: Share Info Bursa Malaysia

1.1.1 Malaysian Gross Domestic Product (GDP)

Malaysia is a rapidly developing economy in Asia, and the financial services sector is

an integral component of the economy. The total population of Malaysia was 28.3

million (Census 2010). Besides that, Malaysia's GDP has a strong growth in year

2010, as shown in the Figure 1, the Malaysia real GDP growth rate was -7.2 percent,

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Pu ot Khidmat Maklumat Akademik
UNlVERSm MALAYSIA SARAWAK

largely driven by the Services sector and Manufacturing sectors of 6.8 percent and

11.4 percent respectively (Department of Statistic, Malaysia 201 O).This is the 'positive

sign for the country since 2008 and 2009 which real GDP growth rate was -1.6

percent and 4.7 percent (CIA, World Factbook).

Figure 1: Malaysia Real Growth Rate

GDP Growth Rate

8.00%

1
7.00%

6 .00%

5 .00%
4.00%

~ 5.20%

3.00% ~ GDP Growth Rate


2.00%

j
1 .00%

0.00%
,
-1.00%
2006 2007 2008 2011
-2 .00%

Figure 2 shows that the Malaysia's GDP per capita was US$14,744 and estimate that

in the Year 2011 the GDP Per Capita will increase to US$15,579. As a result,

Malaysia is a middle income country with the openness of economy to encourage the

foreign investor to invest in the country.

Figure 2: Malaysia GDP Per Capita (US$)

Malaysia GOP Per Capita (US$)


$16,000 '
$15,579
$15,000

$14,000

$13,000
-+- GDP Per Capita (USS)
S12,OOO

$11,000

$10,000
2006 2007 2008 2009 2010 2011

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1.1.2 Malaysian Financial System

The Malaysian Financial System consists of Bank Negara Malaysia (Central Bank of

Malaysia), banking institutions (commercial banks, finance companies, merchant

banks and Islamic banks) and a miscellaneous group (discount houses and

representative offices of foreign banks).As shown in Table 2 shown that the Malaysia

fmancial system is structures into two major categories, Financial institutions and

Financial Market. The Financial Institutions comprise Banking System and Non-bank

Financial Intermediaries. The Financial Market in Malaysia comprises four major

markets, which is Money and Foreign Exchange Market, Capital Market, Derivatives

Market, and Offshore Market. Besides that, the banking system is the largest

component of the financial system, accounting for about 67% of the total assets of the

fmancial system.

On the other hand, the Asian financial crisis of 1997 and 1998, had give a valuable

lessons for Malaysia by focusing on enhancing the institutional capacity through

consolidation and strengthening the regulatory and supervisory framework. The

consolidation of 22 banks into 9 anchor banking groups has created sizeable and

profitable institutions that have stayed strong throughout the recent global financial

crisis. The strong capital positions of banks, coupled with ample liquidity in the

financial system, provided a buffer against the global downturn. The levels of non

perfonning loans held by commercial banks declined in 2009.

Besides that, the debt market activities have remained strong, and Malaysia continues

to be the third largest domestic currency bond market in Asia excluding Japan. In

2009 total corporate debt issuance increased 22 percent year-on-year to reach RM61

billion. In 2009, Malaysia had a dominant share in the global sukuk issuance market,

~~~-~--------::--:::--- -- -
accounting for 47 percent of the global market. Malaysia also has the largest Islamic

fund management industry in the world in terms of number of funds, and is

recognised as a centre for product innovation in the realm of Islamic finance. The

growth of Islamic finance owes much to the strong legal and regulatory framework

that has been established here. In addition, Malaysia has been recognised

internationally for its regulatory environment.

Overall, Malaysia's financial services sector has enhanced its domestic

competitiveness and broadened its activities. However, some segments like banking

are maturing. With a population of 28 million people, the domestic market lacks the

necessary critical mass to further develop these segments. Going forward, there is a

need to look externally for growth and to develop new engines of growth.

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Table 2: The Malaysian Financial System

Financial Institutions Financial Markets

Banking System Money & Foreign Exchange Markets

Bank Negara Malaysia Money market


Banking Institutions Foreign exchange market
- Commercial banks
(Including Islamic Banks) Capital market
- Finance Companies Equity market
- Merchant Bank/Investment Bank Bond market
Others Public debt securities
- Discount houses Private debt securities
Representative office of Foreign
banks
Derivative markets
- Offshore banks in Labuan

Commodity Futures
Non-Bank Financial Intermediaries
KUBOR Futures
(NBFI)

I Offshore market
Provident and pension funds Labuan International Offshore
Insurances companies Financial Centre
(Including Takaful)
Reinsurance cos.
Development finance Institutions
Saving Institutions
National savings bank

- Co-operatives

OtherNBFI
- Unit trusts
- Universal brokers

- Cagamas Bhd

- Credit guarantee corp.

Leasing companies

- Housing Credit Institutions

- Factoring

- Venture capital

Source: Bank Negara Malaysia, the Central Bank and the Financial System in
Malaysia

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1.1.3 Challenges in Malaysian Financial Sector

There are some challenges that being faced by the Malaysia financial sectors. First,

the industry has gone through a phase of consolidation, the segment such as

investment banking and brokerage remain fragmented. Besides that, many of the

Malaysian banks are still significantly smal1er than regional powerhouses. Apart from

this, there is lack critical mass to attract significant levels of investment in Malaysian

capital market.

Second, Malaysia's financial markets are lack of liquidity and diversity in capital

markets. Before the Asian financial crises in 1997 and 1998, the capital markets have

lost some of their vitalities. Moreover, Malaysia's liquidity ranking in Asia has

dropped from 3rd in 1996 to 14th in 2010 (The World Factbook). Between, there is

also limited diversity in the market, in tenns of investors, products or currency.

Third, the level of personal financial literacy is low, thus the growing consumerism as

well as changing in customer expectations. There is a need to reinforce better

management towards their personal finances in order to achieve high income

economy. Lastly, the competition from other regional financial centres will affect the

performance of the local financial services sector. Malaysia continues to face negative

perception issues due to the capital control measurement implemented during the

Asian financial crisis. In addition, the foreign financial centres have developed their

reputations as being open and pro-business. As a result, the foreign investor interest is

currently directed towards North Asia.

Hence this study is to investigate and analyze the factors that affecting the financial

sector performance for the period 2006 to 2011. A question appeal from the study is

how the financial sectors services performs during the 2008 to 2009 and then after the

financial crisis. A large number of studies on the banking sectors examme the

profitability, cost efficiency and market performances of banks.

The study investigates the performance of Malaysian financial services sector during

2006 to 2011 period. The study focuses largely in the context of CAMEL, which are

related to the capital, assets, management, earnings and liquidity considerations.

This chapter will proceed with the description of the problem statement and research

objective. The significance of research will end with the research scope, assumption

and limitation. Chapter 2 will be focusing on the literature that related to performance

of financial sectors in Malaysia and South East Asia by various authors, the definition

of CAMEL components and the relationship between the CAMEL and the

performance of the financial sectors. Chapter 3 describes data and methodology,

where it begins with the description of data sources and follows with the explanation

on the analysis of data. As well as the components of the CAMEL and the financial

ratios used to evaluate the performances of the financial services sectors. Chapter 4

represents and discusses the findings. It includes analysis of data for the financial ratio

variables derived from CAMEL assumptions, such as capital, asset quality,

management, earnings and liquidity. Chapter 5 concludes the research findings and

some suggestions to further refine future research on the international financial

sectors and performances of Malaysian financial sectors.

1.2 Problem Statement

The Malaysian financial sector plays a crucial role in the economy. Therefore, the

instability of the financial sector will affect the economy development and overall

country's development. Mansor (2007) states that financial liberalization has been a

financial feature in many nations to develop and liberalize financial markets. This
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follows the argument that the development of the financial sector can promote growth.

The economic growth will encourage more financial institutions, financial products

and services emerge in the markets in response to the higher demand of financial

services.

However, the presence financial institutions in the Malaysia financial sector raised

some challenges which are lack of scale, lack of liquidity and diversity in capital

market, low levels of financial literacy and competitions from other regional financial

centre. Lensik, R. & Hennes, N. (2004) claims that the entrance of foreign investors

had increased the market competitions and improves the quality and the availability of

foreign financial institution and motivate the local financial institutions to enhance

their efficiency and increase the diversity and quality of financial services. The

restructuring of the financial system policy by the Malaysian government after the

economic recession during had brought the important of the growth for local financial

development.

As a result, it is important to analyze the important of financial services sector in

Malaysia because of the stability of the financial services sector will encourage

economic growth and fast growing for a country development. Apart from that,

different structure and characteristics of financial institutions, and the different

influence of external factors on these financial institutions will lead to differences

perfonnances between the financial services, for instance the differences of

performances among commercial bank, investment companies, insurance companies,

and stock broker. In order to evaluate the financial sectors perfonnances, the CAMEL

method was applied and as supervision tool and measure the bank's current overall

financial, managerial, operational and compliance. perfonnance. The empirical

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analysis will assists the financial institutions expand their financial services to the

international market to gain greater profit.

The study is to identify what kind of factors will affect the performance of the

financial sector. Besides that, the relationship between the performance of the

fmancial sectors and the factors will be examined and analyzed in this study.

Although, there are many study had been done to analyze the financial sector around

the world based on the economic development and the financial indicators. However

the study will use the financial ratios to analyze the performance of financial

institution as shown in the Table 1 based on the CAMEL approach on 26 financial

institutions comprising 4 commercial bank, 6 insurance companies, 13 investment

holding companies, stock broking company, finance company and the exchange

holding company.

1.3 Theoretical Framework

1.3.1 Agency Theory

Agency theory or agency relationship is the theory which concern to the relationships

between the owners of the company in the form of shareholders (equity investors) and

those appointed to in charge for the company management, which is a director of the

company. The agency theory plays a crucial role for every aspects of the business

activity especially for the decision-making by directors, which included executive and

non-executive directors). In addition, the agency concepts had became more important

due to the global financial crisis, especially the corporate collapses of the major

multinational companies for instance Enron 2001, WorldCom 2001, and Lehman

brothers 2008, and nationalization of many financial institutions.

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The theory stated that, the owner of the company assigns the day to day decision

making to the directors, who are shareholder's agent. Besides that, the agents are no

necessary to make decisions according to best interest of the principal. The personal

interests of company's senior managers can differ from the company shareholders.

The manager and the owner of the company are differing to each other. As a result,

the board of director of the company plays a crucial role in balancing and control the

action of the senior management, who control day to day operation of the company

and on the shareholders' behalf.

Apart from that, the agency relationship occurred because of the different goals and

interests among the agents and the principals. Bohren (1998) assumed that the

individual agents and principal that involved in the agency relationship are

opportunistic, due to they are aiming to maximize their own interest. Thus, there is no

guarantee that agents will always act in the best interest for their principals. Therefore,

if the company unable to manage their agency problem in their company, so it will

affect the company performance due to agents will only aim to maximize their own

interest from the company.

1.3.2 Characteristics ofAgency Problems in Financial Institutions

According to the theory of the firm which views a firm as a "nexus of contract"

between parties and with conflicting interests (Jensen and Mekling, 1976), the agency

problem may occurred among all stacks holders within the company. However, the

agency problem generally refers to conflicts of interest between firm's management

(agent) and its owner (principal). Also, the corporate governance is widely accepted

as a mechanism that makes the management (agent) operate the firms not for him own

sake, but for the interest of the owner (principal). According to the work Fama and
13

Jensen (1983) which views an owner as a "residual risk bearer" and "residual

claimholder", a shareholder generally refers to the owner as who bears the residual

risk. There is a substantial research studying the agency problem focusing on the

problems between company's shareholders and management.

However, the agency problem is not limited to the shareholders and management, but

extends to the company's stakeholders. One of the most critical is the conflicts of

interest between shareholders and debtholders. In a company, only after interest and

other payments are paid to its debtholders, then shareholders hold unlimited claims

for the remainder. On the other hand, debtholders have fixed size senior claims to the

company's cash flows. This arrangement creates incentives for shareholders to pursue

high-risk-high-return businesses to raise the expected value of residual claims. This

may transfer wealth from debtholders to shareholders, which goes against the

debtholders' interest.

The agency problem between the shareholders and debtholders is more important in

financial institutions because they hold their customers' funds as debt, and therefore

customers are debtholders. This distinguishes the agency problem in financial

institutions form other types of firms, for instances, ordinary manufacturing

companies. In a commercial bank, fixed claims are widely dispersed among many

small deposit holders. In this situation, due to the well-known "free rider problem",

each deposit holder has little incentive to monitor and control business decisions made

by shareholders or managements. In addition, the protection for deposited principal

exacerbates this type of moral hazard. Therefore potential agency costs incurred

between shareholders and debtholders can be significantly large.

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Therefore, for the sake of corporate governance of a financial institution, it is not

sufficient to align only the interests of shareholders or management. ' It is also

important to align the interest of shareholders or management and customers by

preventing from institutions the venturing excess high-risk-high-retum businesses

with customer deposit. A possible solution is found in market discipline from

competition where customers pay enough attention when choosing a financial

institution or product. However, the complexity and information asymmetry which lie

in financial products can hamper the effective operation of market discipline. The

other possible option is to strengthen the monitoring and discipline of management's

decision making by customers. However, this is not realistic considering the

customers' lack of expertise and the aforementioned free rider problem. In the end,

the government may have to step in and represent the interest of customers and

taxpayers by monitoring and disciplining the decision making at financial firms. In

today's market, this takes the form of regulations and supervision over financial firms.

lIDs provides partial explanation why regulations and supervision over the financial

industry are generally stronger than those over the general manufacturing industry.

1.4 Conceptual Framework

Figure 3 shows that the diagram of the determinants for the performance of the

financial sector in Malaysia. The independent variables comprise the financial

institution's capital adequacy, asset quality, management, earning, and liquidity.

Furthermore, the dependent variables are Return on Asset (ROA) and Return on

Equity (ROE). The performance of the financial sector will evaluate by using the

financial ratio. The capital adequacy is related to the overall financial leverage of the

firms. The high financial leverage will experience more volatile earni~g behavior. As

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