Credit Risk Factors In Islamic

Banking: A Case of Malaysia

Dr. Kogulan Mohan
Faculty of Humanistic and Social Sciences, University od Rijeka
Hemaviknesh Supramaniam
The University of Economics in Bratislava,
Bratislava, Slovakia

Abstract: The rationale of this paper is to look into the

determinants of credit risk on account of Islamic banking
industry of Malaysia. Researchers have taken 13 Islamic banks
information from the year 2005-2017, this paper makes
utilization of the fixed effect regression model to give
observational confirmations on credit risk behavior with respect
to Islamic banking industry in Malaysia. The findings show that
capital ratio and financing quality reveal steady outcomes
regardless of specification and estimation models. The finding
added critical verification to the present writing on layaway
hazard specifically Islamic banks credit Risk. Management of
Islamic Banks in Malaysia should consider that BSV do
significantly effect on credit risk for management in Islamic
Banks. They should keep in mind that any worsening in
financing will be result in higher loss provisions.
Keywords: Credit risk, Financial expenses, Islamic Banking
1.1 Background of the Study
The Islamic managing an account and back (IBF) undertaking hasseen
various fundamental events amid the most recent decade in light of
the fact that their commencement in 1975, IBs have now end up being
a worldwide marvel, alongside the UK , China (Hong Kong), Australia,
Singapore and loads of Europe. In specific nations like Malaysia,
Malaysia and Bahrain, the Islamic managing an account (IB) endeavor
has progressed from a commonly residential trouble to positively one
of overall centrality. By utilizing the aggregate resources for the
development of Islamic Banking industry which arranged from US$1.8
trillion assessed at the stop of 2013 and is anticipated to be additional
than US$2.0 trillion by the surrender of 2014 (IFSB, 2014). In the
course of the most recent ten years the IB business has seen changes
in monetary conditions and the beginning of a budget crisis.
(Iqbal, Z. , & H.V. Greuning, 2008) Financial intermediation plays vital
role for crating healthy financial system in any economy. Major
countries financial intermediation consist on banking system. There is
also two types of banking system first one is conventional banking
system and second one is Islamic banking system. As we know that
Islamic banking system is based on Sharia rules and regulations and
providing services to those customers which are not using
conventional Banking system. Sharia provide complete guidelines for
performing any financial transactions for the purpose adding value in
economy.

* School of Computing College of Arts and Science Universiti Utara

Malaysia
** School of Computing College of Arts and Science Universiti Utara
Malaysia

(Tafri, H.F., R. Abdul Rahman, & N. Omar, 2011)Risk management

is necessary for the profitability and achieving growth for any
organization. Risk management is key for the success of any type of
organization specially banks. Bank which is enable to manage their
risk can earn high profit as well as grow but the bank which is not
enable to manage their risk will default in near future.

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There are two general approaches for risk management of bank or
any other type of firm. First one is risk aggregation which will be
covering through simply diversification and second one is Risk
disintegration which consist of finding risk covering process and
dealing with each one by one.
Early researches on the determinants of credit risk had mainly
focused on conventional banking credit hazard control in particular
in developed nations (Berger & DeYoung, 1997; Berger & Udell,
1990). As an instance, (Febianto ,2012) carried out a library-primarily
based studies analysis, and Abedifar, Molyneux, and (Tarazi ,2012)
did an empirical analysis on 24 agency of Islamic Cooperation (OIC)
nations. This paper goals to look at the key components of credit risk of
Islamic banks in Malaysia by presenting Islamic financing sorts and
ownership frame factors. Malaysia has been chosen on the
grounds that the example us of an in light of its job inside the
worldwide Islamic managing an account venture. Given that at that
point, the scope of Islamic Banking products has extended with the
execution of interest free Banking Scheme in 1993. This scheme
allowed commercial banks to provide Shariah-accredited products
through Islamic home windows. Islamic banking structure in
Malaysia procured hearty help from the specialists, and as on the
end of 2014 there were 8 totally fledged Islamic banks and 5
worldwide Islamic banks working inside the nation.
1.2 Overview of Target Population
Malaysia Banking industry consist of both conventional and Islamic
banking system. This study is solely on Islamic banks so our target
population is 13 Islamic banks of Malaysia which providing Islamic
banking services in Malaysia. We collect data from year 2005 to 2017.
1.3 Research Objectives
Malaysia is an Islamic country and there is a lot of customers which
reluctant to use conventional banking system. There are following
research objectives which given below:
1. Contribute for growing Islamic banking system in Malaysia
2. Provide helping to those customers to use Islamic banking
services which are not agree to use conventional banking
system.

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 3. Through this research study conventional banking system
will get motivation to moving Islamic banking system
through managing their credit risk.
1.4 Significance of the Study
As we know that Malaysia Banking industry consist of both Islamic
and conventional Banking system. They have to serve same
customer with both services. It’s important for banking industry to
know how they have managed credit risk in conventional as well as
Islamic Banking system. This research will indicate how they have
to manage credit risk in Islamic banking industry of Malaysia. If
Islamic banking industry management not fully aware of credit risk
management, it can be result insolvency of Banks.

1.5 Research Questions

RQ1. Is there any significant relationship between Financing quality
and Credit Risk for Islamic Banking Industry of Malaysia?
RQ2. Is there any significant relationship between Bank Capital and
Credit Risk Islamic Banking Industry of Malaysia?
2. Literature Review
2.1 Related Literature Review
Particularly in advanced countries Credit risk control research have
attracted the attention of numerous events. Researching the
components that focused the credit risk scoring inside the banking
industry isn't constantly easiest imperative to the budgetary
foundation's administration yet additionally to administrative
government. Early studies have measured the credit hazard by using
the ratio of non-performing loans. In managing an account explore,
the home loan is surveyed as NPL while the charge of intrigue and
essential are past due through 90 days or more prominent. Better
NPL reasons the banks to encounter diminish income edges and if
the inconvenience transforms into additional genuine, it can prompt
an emergency. (Najuna Misman, Bhatti, Lou, Samsudin, & Abd
Rahman, 2015) Deliberate the Islamic banks credit risk. Authors use
Panel data technique for gathering data and Pairwise correlation
matrix for obtaining results. Their finding shows that few specific
variable influences credit risk for Malaysia Islamic banking industry.

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Mostly studies suggest that there are strands of writing on the
components that drive chances of credit. The most extreme
mainstream strand demonstrates that financial assessment risk is
pushed by methods for a few bank exact factors and the second one
strand contends that macroeconomic components significantly
influence the FICO assessment shot of banks. A study of the writing
educates us that previous examinations generally tried the
determinants of credit risk either utilizing BSV or macroeconomic
components as logical factors. On the other side few studies used
each macroeconomics and BSV variables to explain the non-
performing loans of banks. The precedents comprise of (Louzis,
Vouldis, and Metaxas ,2012) who take a gander at the determinants
of credit risk in Greece's managing an account district by method for
the utilization of macroeconomic and BSV as illustrative factors.
They utilized the non-performing loans of different advance classes
as the needy factors and find that NPL of Greek banks are
specifically clarified by means of macroeconomic factors which
incorporates joblessness, GDP and leisure activity charges.
Greatest exact investigations that investigate the impact of the BSV
on NPL, makes utilization of home loan increment, advance lovely,
control excellent, estimate, contract focuses, and capital on the
grounds that the factors. (Demirguc-Kunt, 1989) has reviewed
experimental literature on deposit institution disasters. They infer
that capital adequacy ratio, assets fine, administration fitness and
income are a considerable lot of the huge logical factors for bank
disappointment. (Berger and DeYoung, 1997) perception on the BSV as
a pointer for problem credits and execution of the banks. The useof
a US business banks dataset for the term 1985 to 1994, they triedthe
between transient seeking among inconvenience advances and
esteem productivity. There are four hypotheses in this study like
horrific control express as low-price efficiency sign for negative
management, horrific luck referring to external events, ethical
danger and Skimming difficulty. They find verification that expense
effectiveness and capital are contrarily connected with issues of
credit. (Angbazo ,1997) makes utilization of US money related
establishment name record records for 1989 to 1993 to view the

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association between web premium edges and premium charges
danger, default hazard and shaky sheet exercises. The researcher
entitlements that there is a strong and positive relationship among
default hazard, length and net interest margin. Most recent
researches emphasis at the BSV as the core components of credit
score risk include (Jiménez, Lopez, and Saurina ,2007), (Konishi and
Yasuda ,2004) and (Godlewski ,2005)
(Hassan Al-Tamimi & Al-Mazrooei, 2007) Investigated Bank’s risk
management and compare UAE state banks and external banks.
Authors used questionnaire technique for the purpose of collecting
data which were consisting on close ended interval scale as well as
close ended ordinal scale questions. Researchers find that Credit risk
effect UAE commercial banks.

2.2 Islamic banks and credit Risk

Progressively more research on chance administration of Islamic
banking system mindfulness at the systems of threat administration,
Shariah issues and related hurdles looked by Islamic banking
system. Only a couple of investigates address the trouble of danger
determinants, specifically financial assessment chance. Despite the
fact that the wide assortment of exact research on Islamic banking
system, scoring of credit risk hazard is little, some endeavored to
deliver the inconveniences identified with this exact sort of hurdles
(Al-Tamimi & Al-Mazrooei, 2007; Hassan, 2009; Makiyan, 2008;
Wilson, 2007). Analysts have tended to different threat control
inconveniences which incorporates credit risk; be that as it may,
every one of these investigates don't experimentally see the
determinants of Islamic banking financial assessment danger.
Numerous empirical analyses have a look at their hazard and
maximum of them used a single United States of America evaluation
and BSV as the explanatory variable. Most recently (Aisyah, Abdul
Rahman, Mansor, and Meera ,2009) examine the impect of loaning
structures and specific bank variables on the insolvency factors of
Commercial banking and Islamic banking in Malaysia from 1994 to
2006. This end implies that the administrative bodies need to present
stand-out capital recommendation for both managing an account

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structures, on account that their activities and items are significantly
unmistakable.
The contrary investigation by utilizing (Ahmad and Ahmad ,2004)
check out the key components impacting the credit peril of Islamic
banking system of Malaysia . They utilized a dataset involving one
completely fledged Islamic bank, 6 Islamic windows and 6
Commercial banks for the duration 1996 to 2002. This take a gander
at reports that administration proficiency, risk weighted effects and
size impact of Malaysia i Islamic bank credit risk measurement. They
additionally presumed that there are similitudes and varieties
between credit assessment risk determinants for Commercial banks
and Islamic banks. (Aisyah Abdul, Rahman and Shahimi ,2010)
dissect the impact of financing structure and Bank specific variables
on layaway score chance the use of board records investigation for
Malaysian Islamic banks from 1994 to 2008. They likewise joined
macroeconomic factors into their system. The outcomes show that
sort of financing responds in another approach to credit risk while
the model ended up controlled for macroeconomic factors. The
credit sources and unfurl of long-term premium charge and money
commercial center charge finy affect financial assessment hazard.
These infer that the Islamic banking system ought to be fit for control
credit supply through now not unreasonably loaning to
unpredictable divisions, on the off chance that you need to handiest
increment the credit peril exposures.
2.3 Gap Statement
Finding the effect of financing quality on credit risk of Islamic
banking industry of Malaysia.
3. Data and Methodology
3.1 Nature and Source
The records are accumulated from monetary statements and annual
reports of 13 Malaysia n Islamic banks; those files are positioned at
the State Bank Scope database and each financial institution’s
website.169 observations have been collected from these 13 banks.
3.2 Variables
The present study of credit risk measurement for the Islamic banking
sector of Malaysia uses financial data of various variables which are

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 explained in detail under their respective headings.
3.2.1 Dependent Variables
The following variables indicating a credit risk which is used as a
dependent variable
 Credit Risk = calculated on the basis of the overall ability
of the buyer to repay the loan
3.2.2 Independent Variables
The following seven independent variables were used as the
measure of credit risk for the research study;
 Financial Exp: General financing/General property
 FL: Provision for loan losses/ General Assets
 C. Buffer: Total Equity/ General belonging
 C. Ratio: (Tier I+ TierII)/ Total assets
 NM: Net hobby margin
 MGT: General Income/Total Assets
 Size: Natural log of assets
3.2.3 Dummy Variables
In addition to the independent variables stated above, the following
two dummy variables were used in the research study;
 EF = 1 use for equity financing otherwise in case of total
financing use 0
 SF = Use 1 for base financing other .

3.3 Modeling of Study

For analyzing the econometric relationship between dependent and
independent variables including dummy variables, the following two
econometric models can be established based on previous research
studies;
(Credit Risk)it = β0 + β1(Financial Exp)it + β2Financial Exp2)it + β3(F.L)it
+ β4(C.Buffer)it + β5(C.Ratio)it + β6(NMe)it + β7(MGT)it + β8(Size)it + Uit
.................................................................................... (i)

(Credit Risk)it = β0 + β1(Financial Exp)it + β2Financial Exp2)it + β3(F.L)it

+ β4(C.Buffer)it + β5(C.Ratio)it + β6(NMe)it + β7(MGT)it + β8(Size)it +
β9(EF)it + β10(SF)it + Uit ...........................................................................(i)
3.4 Hypothesis of study

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 H0: There is significant relationship of credit risk with financial quality and
bank capital of Islamic banking industry of Malaysia .
H1: There is insignificant relationship of credit risk with financial quality
and bank capital of Islamic banking industry of Malaysia .

4. Data Analysis
4.1 Panel Descriptive Statistics
Table I
Panel Descriptive statistics for study
Variable Unit Mean Median S.Dev Minimum Maximum

CR % 6.561 4.843 6.654 0.132 18.543

Fin. Exp % 49.765 47.765 21.765 0.987 80.876

FLP % 0.987 0.765 2.345 -0.345 8.786
Cap. Buffer % 8.906 6.865 7.876 -0.876 68.432
CAPR % 19.654 15.765 32.765 -1.654 93.765
NIM % 4.876 3.654 2.621 0.254 8.567
MGT % 81.876 82.865 21.765 19.765 98.765
SIZE US$ 4,765,453 3,765,342 2,764,342 85,876 32,654,765

4.2 Pearson Correlation Matrix

Table II
Pearson Correlation Matrix for the Study
Credit Financial
FL C. Buffer C. Ratio NM MGT SIZE EF SF
Risk Exp
Credit
1.000
Risk
Financial
-0.271*** 1.000
Exp
FL 0.478*** 0.089 1.000
C. Buffer -0.081 -0.210** -0.129 1.000
-
C.Ratio -0.141 -0.141 0.781*** 1.000
0.471***
NM -0.051 0.119 0.143 -0.052 0.072 1.000

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 MGT 0.223** 0.472*** 0.142 -0.261*** -0.493*** -0.344*** 1.000

SIZE 0.182 0.80*** 0.096 -0.581*** -0.571*** 0.082 0.380*** 1.000

EF 0.570*** 0.073 0.361*** -0.130 -0.245** 0.089 0.678*** 0.456*** 1.000
SF 0.410*** -0.234 0.232** 0.145 0.190 0.145 0.034 -0.067 0.467*** 1.000
*** 1%, **5%, *10%
Number of Panels = 13
Number of Periods = 13
Source: Researcher’s self-analysis using STATA 13

Table II summarizes the cost of correlations for all variables used.

The take a look at identifies a few variables which have a
surprisingly high correlation with the correlation values above
zero.5. The variables are C.Ratio and C.buffer (zero.781), size and C.
buffer (-zero.581) and Size and C.Ratio (-zero.571). To similarly
inspect this difficulty, a VIF post estimation test is implemented. The
effects of this VIF take a look at propose that there is no
multicollinearity hassle happens within the variables.
4.3 Panel Regression Analysis
Table III
Panel Regression Analysis Results
Independent Dependent variable: (Credit risk)
variables
(1) (2) (3) (4)
Coef S.Error Coef S.Error Coef S.Error Coeff S.
C 29.441* 18.987 64.786 46.876 -12.786 14.876 23.345 21.
Financial Exp -0.345** 0.115 -0.056 0.231 -0.043 0.345 0.045 0.
Financial Exp2 0.002 0.002 0.0002 0.002 -0.005 0.001 -0.002 0.
FL 1.453*** 0.234 0.985 0.545 3.200*** 0.310 1.513*** 0.
C. Buffer 0.376* 0.181 0.314 0.501 0.573*** 0.172 0.345 0.
C.Ratio -0.231*** 0.065 -0.097*** 0.052 -0.119** 0.072 -0.089* 0.
NM 0.431* 0.432 0.342 0.163 0.092 0.365 -0.324 0.
MGT -0.053 0.087 -0.098* 0.078 0.045 0.043 -0.061 0.
SIZE -1.200 1.032 -4.654 4.765 2.654 0.564 -0.675 2.
EF -0.654 0.765 4.432 3.
SF -0.243 0.563 1.345 2.

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 R-squared 0.523 0.598
0.418 0.567

Notes: Columns first and 2nd run panel fixed effects regression while on the other hand column 3r
used Ordinary least square regression and in last column researchers used random effects GLS
regression.

Source: Researcher’s self-analysis using STATA 13

The ratio of Non-performing loans to overall financing is regressed

against 7 basic bank variables, two dummies for IFT. The assessment
is conducted the usage of balanced panel facts from 2005 to 2017. The
total quantity of observations is 169 for the model with and without
IFT variables. (White’s,1980) cross-phase is used to adjust thestandard
mistakes for capacity incidence of heteroscedasticity.
Table III deals with the relapse impacts besides section one gives the
effects to base model, while credit danger is backslid towards 7
fundamental banking factors. Distinct dummy variables are
supplementary to the model in columns two to four. Fixed effects
description is used within the regression in columns one and a pair
of only. In columns three and four a dummy for fame is covered in
the model, popularity dummy is time invariant variable.
Consequently, constant results model cannot be applied in those two
columns. The BPLM check suggests pooled Ordinary least saqure
regression is the better desire for the column three model and
random outcomes generalized least squar to be implemented in
column four.
The explanatory energy of results in column one is about 41.8% with
five basic banking variables having large outcomes on credit score
threat at the 1%, 5%, and 10% significance stage. Financing growth
shows a negative coefficient with credit score risk in each constant
outcomes and OLS specification however not in RE-GLS. But, it only
appears to have a vast effect for base version in column one. This
negative considerable end result is regular with (Aisyah Abdul,
Rahman and Shahimi, 2010). The analysis assumes that financing
expansion to have a non-linear relationship with credit score chance.
The quadratic specification is used in all columns. For the FE version
the connection between financing expansion and credit hazard is U-

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shaped in preference to an inverted U-form for the RE-GLS model.
Financing reports have significant associations with credit
assessment chance for fixed effect and general least square model
detail in column one, two and three, individually. This variable
distinctly across the board in making sense of the acknowledge peril
as the majority of the coefficients are enormous at 1% significant
level. Those outcomes are of course because of the reality additional
provisioning demonstrates that a bank may likewise have an issue
with financing facilities. The downgrade in financing exceptional
will potentially boom the danger of financing being defaulted. The
coefficient declines inside the constant-consequences specification
version. Its miles worth citing that the fixed effect version explores
the variations between every character bank. This indicates each
bank within the sample well-known shows one of kind traits over
time; as an example, the risk management policy and its influence at
the pleasant of the financing portfolio.
The opposite proxy for the bank capital in this have a look at is the ratio
of general equity to total property, C. Buffer. Past research document
mixed consequences regarding the relationship of capital buffer and
credit threat. As an instance, (Godlewski, 2005) finds a tremendous
tremendous relationship between fairness and danger, even as
(Cebenoyan and Strahan, 2004) report negative relationships among
capital buffer and credit risk. This analysis unearths capital buffer does
have a positive coefficient and is statistically great for columns one and
a pair of whilst the fashions have been now not managed by using the
IFT dummy. An advantageous signal explains that IBs with greater
equity capital tend to have better credit hazard than banks with less
equity. This implies that banks with better fairness capital have a
tendency to engage in greater risky financing sports because they
consider they have got sufficient capital to buffer any ability losses.
NM is most effective significant inside the base version the usage of
the FE estimation technique. When the estimation model consists of
the IFT and standing dummy, NIM is insignificant no matter the
estimation models. The MGT best shows negative great
consequences within the column two estimation, whereas the

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version becomes controlled for IFT. The incomes belongings of IBs
include differently structured IF contracts. Therefore, IBs have to
carefully decide the percentage of every type of financing settlement
because exclusive contracts reveal IBs to extraordinary tiers of threat.
IBs’ inability to control this MGT will lead to an excessive credit score
danger stage. With reference to the relationships among size and credit
score chance, we did not find any huge relationships between these
variables in all estimations.
The account dummies are crucial when inspecting whether or not
different styles of IFT have many effects on credit risk of Islamic
banking in Malaysia . We introduced dummies like EF and SF in
columns two and four. The EF dummy takes a cost of one for Islamic
banking that offers financing primarily based on Profit and loss
saving contracts, even as the SF dummy takes value of 1 if the Islamic
banking offer financing using aside from PLS and buying and selling
contracts. Distinctly, we discover that each IFT dummies do not
show any huge results on credit score risk stage of IBs. This implies
that MIBs have green risk control frameworks in vicinity and
modern-day rules that help IBs to mitigate threat from both varieties
of financing systems.
5. A conclusion of the Research
The impacts support that some basic banking variables do radically
affect financial assessment threats of Islamic banking in Malaysia .
The outcomes prescribe that any disintegration in financing top
notch powers the banks to apportion higher misfortune
arrangements, and subsequently increment the inferred credit risk.
There might be furthermore evidence that capital ratio is awful and
factually huge in making sense of the financial assessment risk level
of Islamic banking sector in Malaysia. Few illustrative factors exhibit
particular results all through the estimation models. For instance,
C.buffer just appears to have a superb full-measure impact using a
credit card score risk in the ordinary least square and fixed effect
estimation models. NM handiest recommends enormous outcomes
inside the base form of the fixed effect model specification. NM is
not an enormous When IFT and possession variables are being taken
inside the estimations.

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 There are a few impediments of this examine must be attention to
take a shot at in future examinations like sample of Islamic banks. For
future take a gander at, an appraisal among commercial banksand
Islamic banks will likewise increase the value of the investigate.
Predetermination investigates my furthermore incorporate
distinctive interior factors and macroeconomics factors in examining
the purposes behind FICO assessment peril in Islamic banks. Through
doing as such, it will cover each miniaturized scale and
macroeconomics factors and the estimation are foreseen to exhibit
additional knowledge on the credit peril administration of Islamic
banks. Management of Islamic Banks in Malaysia should consider that BSV
do significantly effect on credit risk for management in Islamic Banks. They
should keep in mind that any worsening in financing will be result in higher
loss provisions.
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