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

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