Financing Structures, Bank Specific Variables and Credit Risk: Malaysian Islamic Bank

Faridah Najuna Misman1a

Abstract
Empirical literature on credit risk has mostly focus on conventional banks. As Islamic banks become one of the fastest growing industries globally, understanding about credit risk is important. This study will identify the relationship between types of financing structure, bank specific variables and credit risk in Malaysian Islamic banks. This study uses bank level data for a period of 1995 to 2010. The result finds financing structures and several bank specific variables have a significant relationship with credit risk. This finding will contribute a new literature in Islamic banking studies.

Fields of Research: Islamic Banks, Credit Risk

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School of Economics and Finance, Faculty of Law and Management, La Trobe University, Kingsbury Drive, Bundoora, Vic 3083, Australia. Phone: +613 9479 5318. Fax: +613 9479 1654. E-mail: fnmisman@students.latrobe.edu.au a Faculty of Business and Management, Universiti Teknologi MARA, Malaysia

1.0 Introduction
Islamic Banking is one of the fasters growing industry in Islamic financial market. After three decade, Islamic banking is not a new phenomenon. In every corner of world, Islamic banking been discusses and introduced by not only Muslim country but non-Muslim country such as United Kingdom, France, Hong Kong and Singapore. The acceptance of customers towards Islamic banking system are proven through the amount of Islamic assets where as it reach up to USD 1 trillion in 2009. According to Islamic Financial Service Board (IFSB), the amount of assets will reach USD1.6 trillion by 2012. Looking to the current situation of Islamic banking industry, understanding about risks involved in Islamic banks operation is vital. Objective of bank is to maximise profit and increase shareholder wealth. In order to achieve this objective it requires a proper assets portfolio management. Accurate risk pricing is important as it will affect profit level of banks(Bonfim, 2009) Loans hold the biggest proportion in the bank assets. Due to this situation, loan default will give huge impact to profit level of banks. Clear understanding about credit risk divers will help banks in managing their assets portfolio. Bonfim (2009) discuses there are three groups of model related to credit risk management; (i) models that uses accounting variables; (ii) models rely on market information; (iii) models that uses macroeconomics variables. The objective of this paper is to identify the determinants of credit risk in Islamic banks by applying the first group of model which used bank specific variables. Using the data from Malaysian Islamic banks for the period of 1995 to 2010, this paper will estimate the relationship between financing structures, bank specific variables (BSV) and credit risk. Malaysian has been choose as a sample country because of it position in the Islamic banking industry.

2.0 Literature Review

Most of the empirical studies in credit risk are focussing on conventional banks (Berger and DeYoung, 1997, Akhter and Daly, 2009, Cebenoyan and Strahan, 2004, Chen, 2007, Dangl and Zechner, 2004). Several issues of credit risk in conventional banks such as the causes of credit risk, capital structure and many more been studied. Even though, Islamic banks has comes into existence more than three decade, a studies about credit risk is still limited. Among the early researchers studies about credit risk in Islamic banks are Ahmad and Ahmad (2004), How, Karim and Verhoeven (2005), Khan (2003) and Rahman and Shahimi (2010) . Early studies in Islamic banks credit risk focus more on theoretical basis. Credit risk is a risk that the value of their portfolio will change due to the unexpected changes in the credit quality of issuers or trading partners (McNeil et al., 2005). In the case of Islamic banks, the trading partner can be classified as a borrower or counterparty or investor. The changes in credit quality such as downgrading of borrowers in an internal or external rating system can cause losses to the banks due to the defaults by the borrowers. In traditional banking system, lending activities is considered as a credit risk business. However, in Islamic banking system, lending operations have been replaced with investment and partnership contracts, thus
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credit risk management becomes more important and crucial matter to looks and discusses. Basically there are three types of financing structure in Islamic banks namely asset based, debt based or supporting types of financing. All types of financing are binding by the Shariah law which free from riba, gharar and maysir. Ariffin et al (2009) explained that Islamic financing structures promotes a principal of risks sharing which is this principal is not available in conventional banking practices. In Islamic banks, each type of contract will bring different credit risk exposure to the banks profit. Among many types of contracts in Islamic banks, credit risk is expected to be higher in asset based financing under Mudharabah and Musharakah contracts. This happen due to asymmetric information problem where as the entrepreneur may do not provide sufficient information to the bank (Khan and Ahmed, 2001). Previous empirical studies on credit risk suggest there are two main determinant of credit risk in banks. First determinant is bank specific variables (BSV). BSV has a significant relationship to credit risk exposure of commercial banks (Ahmad and Ahmad, 2004, Berger and DeYoung, 1997, Angbazo, 1997, Ahmad and Ariff, 2007, Jimnez and Saurina, 2004, Cebenoyan and Strahan, 2004). Second determinant of credit risk is macroeconomic variables such as growth domestic product (GDP), money supply, interest rate and inflation. Ali and Daly (2010), Bonfim (2009) and Hackbarth et al. (2006) find that macroeconomic does affect credit risk level in bank. This study will focus on BSV as a determinant of credit risk in Malaysian Islamic banks.

2.1 Financing Structures and BSV

As explain in previous section, there are three types of financing in Islamic banks (Figure 1). Assets based financing which follows profit and loss sharing principle carry higher credit risk compared to the other two types of financing (Khan and Ahmed, 2001). According to Angbazo (1997) asset quality has been identified as one of the factors influenced on credit risk in commercial banks. As the proportion of loan in bank assets is big, assets quality normally being measured by using a ratio of loan loss provision to total assets (LLP). Previous studies find that loan quality has a significant and positive relationship with credit risk (Eng and Nabar, 2007, Ahmed et al., 1999). When banks make a higher provision for loss, this indicates that the loans or financings are low quality. Thus it will increase the credit risk level. Another important variable related to asset is loan expansion (TL). TL is a ratio of total loan to total asset. The higher proportion of total loan to total asset will potentially increase non-performing loan and credit risk. The other important BSV in determinant of credit risk is capital. Higher capital will reduces the risk of insolvency. Capital consists of equity or debt capital or both. Increased in equity capital will lower cost of borrowing, however it will also increased the average cost of capital. It is because equity capital is more expensive sources of capital compared to debts. Therefore the higher the ratio of total equity to total asset (TE) will potentially increase the credit risk level, because higher net interest margin could be required (Angbazo, 1997). Thus, TE is expected to have negative relationship with credit risk level.
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Capital adequacy requirement introduced by Basel committee with intention to reduces or control risk taking by the banks. Commercial banks including Islamic banks are required to follow the capital adequacy ratio which is consisting of TIER 1 and TIER 2 capital. All commercial banks must maintain a minimum total capital of 8% from risk weighted assets (RWA) of the bank (Basel, 2001). Under this framework, TIER 1 must exceed at least 4% of the risk weighted assets and 3% of total assets. In TIER 2, the amount must not exceed the amount of TIER 1. This system therefore requires at least 50% of the amount of total capital to be supplied by TIER 1 capital. There are mixed result regarding relationship between capital ratios (CAPR) with credit risk. Berger and DeYoung (1997) suggest that capital ratios will have negative relationship with credit risk. While Ahmad and Ariff (2007) finds a positive relationship between regulatory capital and credit risk in Japan, Malaysia and Mexico. Figure 1: Three Types of Financing in Islamic Banks

Size of the bank is expected to have either positive or negative relationship with credit risk. Previous study done by Rahman and Shahimi (2010), Al-Smadi and Ahmad (2009), Ahmad and Ariff (2007), Ahmad and Ahmad (2004) and Konishi and
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Yasuda (2004) reports mixed results. Size (TA) being measured by taking a natural log of total assets of the banks. Theoretically, larger bank will be able to absorb more risk taking activities compared to the smaller banks. Thus size of the banks may increase credit risk as larger banks are able to offer more loan compared to small banks.

3.0 Data and methodology 3.1 Data

The data for this paper is gathered from the financial statements and annual reports of each Islamic bank in Malaysia. The data were gathered from Bankscope databases and website of each bank. As at June 2011, there are 17 full-fledge Islamic banks in Malaysian banking system and 4 international Islamic banks. In this paper, the observation focuses on the 17 full-fledge Islamic banks as data for international Islamic banks are not available in the Bankscope databases. Table 1 below provide a list of Malaysian Islamic banks and year of establishment. Table 1: List of Full-fledge Islamic Banks in Malaysia
No 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Affin Islamic Bank Berhad (L) Al Rajhi Banking & Investment Corporation (Malaysia) Berhad (F) Alliance Islamic Bank Berhad (L) AmIslamic Bank Berhad (L) Asian Finance Bank Berhad (F) Bank Islam Malaysia Berhad (L) Bank Muamalat Malaysia Berhad (L) CIMB Islamic Bank Berhad (L) EONCAP Islamic Bank Berhad (L) Hong Leong Islamic Bank Berhad (L) HSBC Amanah Malaysia Berhad (F) Kuwait Finance House (Malaysia) Berhad (F) Maybank Islamic Berhad (L) OCBC Al-Amin Bank Berhad (F) Public Islamic Bank Berhad (L) RHB Islamic Bank Berhad (L) Standard Chartered Saadiq Berhad (F) Name Year of Establishment 2006 2006 2008 2006 2005 1983 1999 2006 2006 2005 2004 2005 2008 2008 2008 2005 2008

Source: Bank Negara Malaysia as at June 2011.Note: L = Local owned bankF = Foreign owned bank

This study employed unbalanced sample from the year 1995 to 2010 due to the different in term of year establishment of each banks. Total number of observation is 74.
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3.2 Variables
The objective of this study is to determine factors influence in credit risk level of Malaysian Islamic banks. Credit risk in this study has been defined as a ratio of nonperforming financing to total financing. The definition of non-performing financing is varies among countries. In Malaysia non-performing financing is defined as; (i) where the principal or interest/profit or both is past due for more than 90 days or 3 months. In the case of revolving facilities (e.g. overdraft facilities), the facility shall be classified as impaired where the outstanding amount has remained in excess of the approved limit for a period of more than 90 days or 3 months; or (ii) where the amount is past due or the outstanding amount has been in excess of the approved limit for 90 days or 3 months or less, the loan/financing exhibits weaknesses8 that render a classification appropriate according to the banking institutions credit risk grading framework. Sources: Central Bank of Malaysia (2010). This study only used bank specific variables (BSV) as the independent variables. Five independent variables and three dummies are being regress against the dependent variable to determine the relationship between BSV and credit risk level for Malaysian Islamic banks. The independent variables are constructed using the information from balance sheet and income statement of each Islamic bank. Table 2 explained the detail of the variables definition used in this study.

Table 2: Independent and Dependent variables Variables Credit Risk (CR) Financing Expansion (TL) Financing Quality (LLP) Capital Buffer(TE) Capital Ratio (CAPR) Size (TA) DAB Definition Non-performing financing to total financing outstanding Total financing to total assets Loan loss provisions to total assets Total equity to total assets Total capital (TIER 1 and TIER 2 capital) to total assets ratio Natural logarithm of total assets Dummy variables; 1 for offering asset based financing and 0 for not offering asset based financing Dummy variables; 1 for offering debt based financing and 0 for not offering debt based financing Dummy variables; 1 for offering supporting based financing and 0 for not offering supporting based financing + + +/+/+ Expected Sign

DDB

DSB

+/-

3.3 Descriptive Statistics

Table 3 provide a summary of descriptive statistic for the variables used in this study. In average, credit risk level of Malaysian Islamic banks is about 4.35 percent (from 1995 to 2010). This figure can be considered low as compared to the amount of financing. As we can see, TL (total financing to total assets) is 50 percent. It is mean that 50 percent of the assets in Malaysian Islamic banks is contributed by financing activities. Looking to the provision for loss, Malaysian Islamic banks make quite a small amount of provision. In average Islamic banks in Malaysia only make a provision about 0.7 percent and the highest is 9 percent. This amount of provision is quite lower compared as compared to the ratio of financing to total assets (TL). Size is one of the important BSV that will determine credit risk in bank. In this study, size is measured by taking a value of total assets (TA). Total assets value for Malaysian Islamic banks range from RM291 million to RM44157 million. The range is big may due to the different in age of the sample banks.

Table 3: Descriptive Statistics Variables CR (%) TL (%) LLP (%) TE (%) CAPR (%) FCOST (%) MGT (%) TA (RM) N 74 74 74 74 74 74 74 74 Mean 4.35 50.03 0.70 10.21 23.05 1.87 73.84 10473.05 Std. Dev 3.39 17.98 1.14 9.65 32.74 0.76 17.92 8400.90 Minimum Maximum 1.31 0.83 -0.08 -1.90 -2.80 0.01 17.84 291.38 19.16 79.64 8.99 77.18 211.90 3.89 99.34 44157.50

3.4 Methodology
Panel data set has been used to identify the relationship between BSV, financing structure and credit risks level in Malaysian Islamic banks. Panel data set allow the study to observed on cross-section Islamic banks, over a several times series. The regression is estimates using generalized least square (GLS) method. Below is the general form of panel data estimation equation:

Yit = + X it + it

Equation (1)

Baltagi (2001) states that a one-way error component model is mostly used in panel data techniques. The error term it therefore, can be written as: it = i + vit Equation (2)

The error term represents the unobservable individual firm-specific effect. Estimation equation used: CR = (TL, LLP, TE, CAPR, FCDAB, DDB, DSB) Equation (3)

CRit = 0 + 1 TLit + 2 LLPit + 3 TEit + 4 CAPRit + 5 Log(TA)it + 6 DABit + 7 DDBit + 8 DSBit + it Equation (4)

4.0 Analysis of Finding 4.1 Correlation

Multicollinearity problem have been tested by preparing the correlation matrix using Pearson correlation test. The correlation result indicates there is no serious multicollinearity problem. Thus all the variables can be used to test the model. Table 4 provide the value of correlation for the variables used in the study. From the result, there are mixed relationship between banks specific variables and credit risk level. Out of five variables, three variables have negative relationship with credit risk. TL, TE and CAPR have a negative correlation with CR. LLP and TA has a positive correlation with CR. Table 4: Correlation Matrix CR CR TL LLP TE CAPR TA 1.0000 -0.0743 (-0.6362) 0.5553 (-5.7044)*** -0.2207 (-1.9337)* -0.1781 (-1.5361) 0.3345 (3.0324)*** TL 1.0000 0.1897 -1.6619 -0.2645 (-2.3595)** -0.5183 (-5.1783)*** 0.3033 (2.7382)*** 1.0000 -0.1735 (-1.5158) -0.1729 (-1.4996) 0.1033 (-0.8935) 1.0000 0.5121 1.0000 (5.1291)*** -0.2874 -0.2965 (-2.6160)** (-2.6711)*** LLP TE CAPR TA

1.0000

***, ** and * denotes significance at 1%, 5% and 10% confidence level, respectively.

4.2 Regression Result

Five independence variables and three dummy variables have been regress against credit risk (CR). The estimation result shows that four BSV has a significant relationship with credit risk. TL and TE have a negative significant relationship with CR. Negative relationship between TE and CR is expected as lower equity capital indicates that higher debt capital. Higher debt capital will increased net interest margin ratio. TL has contradicted result; TL is expected to have positive relationship with CR, however this study finds that TL has negative relationship with CR. This result is same with Rahman and Shahimi (2010). LLP has positive significant relationship with CR as expected. Higher amount of provisioning indicates that a bank have a problem with loan quality. Lower quality of loan will potentially increase loan default.

Size as measured by taking a log of TA, has positive relationship with CR as expected. However, TA does not significantly influence CR in this study. Dummy variable has used to identify whether types of financing have significant influenced on credit risk or not. From the regression, this study finds that assets and debt based financing (DAB and DDB) have positive significant relationship with credit risk level in Islamic banks. Debt based financing has more impact to credit risk as the coefficient value is larger than asset based financing coefficient. This situation may due to higher amount of financing using debt based compare to asset based in Malaysian Islamic banks. Supporting based financing does not have significant influence on credit risk. Table 5: Estimation Result Expected Model 1 Coeff. GLS Sign Coefficient T-stat C TL LLP TE CAPR Log(TA) DAB DDB DSB R-Sq Adj. R-Sq DW + + +/+/+ + +/-4.0708 -0.0268* 1.5625*** -0.0600* 0.0227* 0.5570 1.4337*** 2.9192* -0.4079 -1.1607 -1.9199 4.4761 -1.8075 1.8259 1.6570 2.7780 1.9472 -1.1269

Prob.
0.2508 0.0601 0.0000 0.0761 0.0733 0.1032 0.0075 0.0566 0.2647

0.6604 0.6110 1.0473

***, ** and * denotes significance at 1%, 5% and 10% confidence level, respectively.

5.0 Conclusion
This paper aims to identify relationship between BSV, financing structures and credit risk of Malaysian Islamic banks. Five BSV and three dummy have been regress against credit risk. The estimation result shows that four of BSV; TL, LLP, TE and CAPR have a significant relationship with credit risk in Malaysian Islamic banks. Financing structures also influence the level of credit risk. This study suggests that asset and debt based financing will have an impact towards credit risk in Malaysian Islamic banks. This finding gives an indication to the Islamic banks to balance the financing structures used by them in providing financing to the customers.

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