Financing Structures, Bank Specific Variables and Credit Risk ...

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1.0 IntroductionIslamic 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 ofworld, Islamic banking been discusses and introduced by not only Muslim countrybut non-Muslim country such as United Kingdom, France, Hong Kong andSingapore. The acceptance of customers towards Islamic banking system areproven through the amount of Islamic assets where as it reach up to USD 1 trillion in2009. According to Islamic Financial Service Board (IFSB), the amount of assets willreach USD1.6 trillion by 2012. Looking to the current situation of Islamic bankingindustry, understanding about risks involved in Islamic banks operation is vital.Objective of bank is to maximise profit and increase shareholder wealth. In order toachieve this objective it requires a proper assets portfolio management. Accuraterisk 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, loandefault will give huge impact to profit level of banks. Clear understanding about creditrisk divers will help banks in managing their assets portfolio. Bonfim (2009) discusesthere are three groups of model related to credit risk management; (i) models thatuses accounting variables; (ii) models rely on market information; (iii) models thatuses macroeconomics variables. The objective of this paper is to identify thedeterminants of credit risk in Islamic banks by applying the first group of model whichused bank specific variables.Using the data from Malaysian Islamic banks for the period of 1995 to 2010, thispaper will estimate the relationship between financing structures, bank specificvariables (BSV) and credit risk. Malaysian has been choose as a sample countrybecause of it position in the Islamic banking industry.2.0 Literature ReviewMost 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 conventionalbanks such as the causes of credit risk, capital structure and many more beenstudied. Even though, Islamic banks has comes into existence more than threedecade, a studies about credit risk is still limited. Among the early researchersstudies about credit risk in Islamic banks are Ahmad and Ahmad (2004), How, Karimand Verhoeven (2005), Khan (2003) and Rahman and Shahimi (2010) . Earlystudies 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 unexpectedchanges in the credit quality of issuers or trading partners (McNeil et al., 2005). Inthe case of Islamic banks, the trading partner can be classified as a borrower orcounterparty or investor. The changes in credit quality such as downgrading ofborrowers in an internal or external rating system can cause losses to the banks dueto the defaults by the borrowers. In traditional banking system, lending activities isconsidered as a credit risk business. However, in Islamic banking system, lendingoperations have been replaced with investment and partnership contracts, thus2
credit risk management becomes more important and crucial matter to looks anddiscusses. Basically there are three types of financing structure in Islamic banksnamely asset based, debt based or supporting types of financing. All types offinancing 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 ofrisks 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 thebanks‟ profit. Among many types of contracts in Islamic banks, credit risk is expectedto be higher in asset based financing under Mudharabah and Musharakah contracts.This happen due to asymmetric information problem where as the entrepreneur maydo not provide sufficient information to the bank (Khan and Ahmed, 2001).Previous empirical studies on credit risk suggest there are two main determinant ofcredit risk in banks. First determinant is bank specific variables (BSV). BSV has asignificant relationship to credit risk exposure of commercial banks (Ahmad andAhmad, 2004, Berger and DeYoung, 1997, Angbazo, 1997, Ahmad and Ariff, 2007,Jiménez and Saurina, 2004, Cebenoyan and Strahan, 2004). Second determinant ofcredit risk is macroeconomic variables such as growth domestic product (GDP),money supply, interest rate and inflation. Ali and Daly (2010), Bonfim (2009) andHackbarth 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 Islamicbanks.2.1 Financing Structures and BSVAs explain in previous section, there are three types of financing in Islamic banks(Figure 1). Assets based financing which follows profit and loss sharing principlecarry higher credit risk compared to the other two types of financing (Khan andAhmed, 2001).According to Angbazo (1997) asset quality has been identified as one of the factorsinfluenced on credit risk in commercial banks. As the proportion of loan in bankassets is big, assets quality normally being measured by using a ratio of loan lossprovision to total assets (LLP). Previous studies find that loan quality has asignificant and positive relationship with credit risk (Eng and Nabar, 2007, Ahmed etal., 1999). When banks make a higher provision for loss, this indicates that the loansor financings are low quality. Thus it will increase the credit risk level. Anotherimportant variable related to asset is loan expansion (TL). TL is a ratio of total loan tototal asset. The higher proportion of total loan to total asset will potentially increasenon-performing loan and credit risk.The other important BSV in determinant of credit risk is capital. Higher capital willreduces 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 increasedthe average cost of capital. It is because equity capital is more expensive sources ofcapital 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 margincould be required (Angbazo, 1997). Thus, TE is expected to have negativerelationship with credit risk level.3
Page 1: Financing Structures, Bank Specific
Page 5 and 6: Yasuda (2004) reports mixed results
Page 7 and 8: Table 2: Independent and Dependent
Page 9 and 10: 4.0 Analysis of Finding4.1 Correlat
Page 11 and 12: 6.0 ReferencesAHMAD, N. H. & AHMAD,

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