Capital Structure And Islamic Banking Performance

Published Date: 02 Nov 2017

CHAPTER 1: INTRODUCTION

1.1 Introduction

Many firms hire external agent to manage their business professionally (Pratomo W. A. & Ismail A. G., 2006). However, when the manager of firms expands the business through acquisition, this agency can be costly and as a result of reduces its share price, pursue his own interest, or attempts to maximize shareholder value (Pratomo W. A. & Ismail A. G., 2006). As the effect of this situation, firms normally will suffer of losing value from professional managers maximizing their own utility, rather than the value of the firm. Plus, trust and interest of public toward the credibility of the firm might be decrease. The prior theory suggests that the choice of capital structure may help mitigate this agency cost (Pratomo W. A. & Ismail A. G., 2006). According to Pratomo W. A. & Ismail A. G. (2006), under the agency costs hypothesis, a high leverage or a low equity/asset ratio reduces agency costs of outside equity and increases firm value by constraining or encouraging managers to act more in the interests of shareholders.

Zuraidah et al. (2012) once said that company can measure its performance by analyzing the correlation between its operating performances. For example, measure of bank’s profit efficiency (EFC) as to know the value of the company according to Berger and di Patti (2002) which used ratio of equity capital to gross total assets (CAP), standard deviation over time of the bank return on equity (SDROE), size, loan and total bank investment in securities (SEC) as variables for the result. These all variables have been used to have an influence on company operating performance and mostly founded by most literature and been used as control variables (Berger and di Patti, 2002).

According to Damodaran (2001), capital structure decision is the combination of debt and equity that been used by most of companies to it businesses. Therefore, the role of capital structure decisions have been broadly studied as to measure the company value in the past many years. This is also can be proven by Modigliani and Miller (1958) when they said that, in a world with no resistance, there is no difference between debt and equity financing as regards the value of the company. Thus, he added that in making financing decision there is no value and are therefore of no concern to the managers. In fact this does not capture in reality (Modigliani and Miller, 1958). However, capital structure is one of the important financial decisions for any business company nowadays. This is because, financial decision of a company is apart from investment decisions and it is important since it involves big amount of money and has long-term implications on the company. Besides that, decision also will help the company’s ability to deal with its competitive environment.

From the study made by Pratomo W. A. & Ismail A. G. (2006), he said that the optimal capital structure can be directed seek if we know how to choose between debt and equity financing. Few of studies done before, firm with high leverage (debt) tend to have an optimal capital structure and therefore it leads to produce a good performance (Pratomo W. A. & Ismail A. G., 2006). It is different with the Modigliani-Miller theorem, where they suggested that it has no effect on the value of firms/organizations. Since there is some confusing in knowing the theory, I am interested to dig deeper by doing some study regarding to the topic.

1.2 Problem Statement

In a world full of challenging and move fast, no doubt there are some banks or companies that have succumbed to success in their race. The banks need to achieve high performance to maintain its success. Plus, high performance is not easy to attain. Many banks suffer of having deficit and bad result from their performance. In addition, Islamic banking system is not widely been used in Malaysia. Therefore, lack of branding and perception of the brand have been the biggest problem among Islamic banking for several years. Customers and shareholders are the main sources of income for the bank. Hence, the banks have to bring the positive perception to them. Banks have to maintain its good performance as to show their business in a good record. Even though the performance can either be analyzed from the return of asset (ROA) and return of equity (ROE), but refer to Berger and di Patti (2002) the bank’s profit efficiency EFC is the closest to this research. Thus, this study will overlook in more details on how to bring the bank’s performance on a good pace by referring to Berger and di Patti’s formula.

Bank’s profit efficiency and capital structure will relate with each other where capital structure will influence more on the result of the performance (Pratomo W. A. & Ismail A. G., 2006). By according to them (Pratomo W. A. & Ismail A. G., 2006), capital structure consists of two main variables, which are debt and equity. Both variables will be divided into few classes, such as capital to gross total assets (CAP), standard deviation of return on equity, size, loan and security. Meanwhile, according to Wikipedia (2013), capital structure is refers to the way a corporation finances its assets through some combination of equity, debt or hybrid securities. A firm’s capital structure is then the composition or ‘structure’ of its liabilities (Wikipedia, 2013). Other theory that has been advanced to explain the capital structure of firms is suggested by Ahmad et al. (2013) include the pecking order theory, static tradeoff theory, and the agency cost theory. They added, pecking order theory suggests that firms will initially rely on internally generated funds, and then firms will turn to debt if additional funds are needed and finally firms will issue equity to cover any remaining. Thus, according to the pecking order hypothesis, firms that are profitable and therefore generate high earnings are expected to use less debt capital than those who do not generate high earnings. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued (Myers and Majluf, 1984).

1.3 Scope of Study

This study focuses on performance among Islamic banking institutions in Malaysia. Throughout the study, I will use capital structure variables as the factors in determine the result of performance. Hence, capital structure will be a part of method in findings the efficiency of Islamic banking institutions’ performance.

I have chosen purely Islamic banking institutions as the selected organization for target population since it is quite new in Malaysia and I am trying to find how efficiency of its performance since it is newly implemented here. This study will take 6 years of performance by looking at its annual financial report. In a meantime, it is easy to track Islamic banks in Malaysia because of their population still minor in number. Besides, as a Muslim country, this study will support and prove to the world that Islamic method has its own brand. Plus, this study will promote Islamic banking system since it is still in recognition stage to the world. It is also easy to gather information as well as collect data.

1.4 Background of Study

This research will intend to study on the relationship between capital structure and Islamic banking performance in Malaysia. 6 years of review will be the minimum requirement to analyze the effectiveness of the study and it is quite enough to obtain the result. In capital structure, there have two main variables as to see the company’s performance. There are debt and equity. Capital structure theory was introduced first by Modigliani and Miller in 1958 who examined the firm's value (performance) changes though changing its capital structure Modigliani and Miller (1958, 1963). After that, lots of studies have been take part and written investigating the subject and trying to find the effect of capital structure on banking performance. Financial scholars have put great attention of an issue of capital structure and its influence on the firm financial performance and overall value since the decisive research of arguing that under perfect market setting capital structure doesn’t influence in valuing the firm (Modigliani & Miller, 1958). Thus, this proposition explains that value of firm is measured by real assets instead the mode they are financed.

The terms of capital structure was been defined by Investopedia (2013) as a mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure (Investopedia, 2013). In a meantime, the definition of Islamic banking that been explained by Bank Negara of Malaysia (2009) is ‘banking based on Islamic law (Shariah). It follows the Shariah, called fiqh muamalat (Islamic rules on transactions).The rules and practices of fiqh muamalat came from the Quran and the Sunnah, and other secondary sources of Islamic law such as opinions collectively agreed among Shariah scholars (ijma’), analogy (qiyas) and personal reasoning (ijtihad)’. Through the time, Malaysia's Islamic finance today continues to grow fast. This is because it has been surrounded and supported by a conducive environment that is renowned for continuous product innovation, a diversity of financial institutions from across the world, a broad range of innovative Islamic investment instruments, a comprehensive financial infrastructure and adopting global regulatory and legal best practices. Besides, Malaysia has also placed a strong emphasis on human capital development alongside the development of the Islamic financial industry to ensure the availability of Islamic finance ability. All of these value propositions have transformed Malaysia into one of the most developed Islamic banking markets in the world (Bank Negara of Malaysia, 2010).

1.5 Research Objectives

The main objective of this study is to test whether capital structure is significantly related to affect the Islamic banking performance. Based on agency cost theory (Jensen and Meckling, 1976), it suggests that debt is used as a motivating factor for managerial staff. Agency theory states that separation of top end management and ownership has a negative effect on firm performance; there is no incentive for management to perform at maximum capacity (Skopljak, 2012). Debt is enrolled as an instrument to heighten work ethic and performance of management; however an increase in the proportion of debt causes the firm to experience higher financial distress (Harris and Raviv, 1991). Besides, this study also aims to identify the main cause of Islamic bank in making decision. In a meantime, this study will focus on the performance of Islamic banks in Malaysia. I have decided to take only pure based of Islamic banks which have minimum of 6 years operating in Malaysia. This is because to ensure the only stream Islamic banking operating system been chosen.

1.6 Research Questions

1.6.1 What variables that affect Islamic bank performance?

1.6.2 How to measure level of Islamic bank performance?

1.6.3 What actions should be taken after result of the performance?

1.6.4 Is there any relation between capital structure and Islamic banking performance?

1.7 Significance of Study

Upon completing this research I hope to have clearer understanding of what leads capital structure to Islamic banking performance. The significance of the study will be to:

1.7.1 Improve Islamic banking system in tracing what actually affect its performance.

1.7.2 Improve in making decision for Islamic banking.

1.7.3 Improve the Islamic banking performance.

CHAPTER 2: LITERATURE REVIEW

2.1 Capital structure and Islamic Banking performance

Research on the theory of capital structure was pioneered by the seminal work of Modigliani and Miller (1958). They found that the value of a firm is not affected by its financing mix when the study of financing choices initially received little attention. From the research, they concluded that the financial leverage does not affect the firm’s market value under perfect market condition on the broadly known theory of "capital structure irrelevance".

Besides that, this study aim to investigate the impact of capital structure on firm performance by analyzing the relationship between operating performance of Malaysian Islamic banks, and it will be measured by bank’s profit efficiency with looking at equity and debt of the banks generally. Five variables founded by most literature to have an influence on Islamic bank operating performance, namely, equity capital to gross total assets (CAP), standard deviation over time of the bank return on equity (SDROE), size of bank, loan and the bank’s investment in securities. These are used as control variables. In this paper, I will follow Berger and di Patti (2002) that relate bank’s profit and capital structure. The model is written as follows:

EFC = CAP + SDROE + SIZE + LOAN + SEC

Based from the previous studies, modern theory of capital structure began with the paper made by Modigliani and Miller (1958). Since then, several of studies have been directed to explore the optimal capital structure in the absence of Modigliani-Miller’s assumption. This issue was been studied by Jensen and Meckling (1976), for example, argue that an optimal capital structure can be obtained by trading off the agency cost of debt against the benefit of debt.

Capital structure does not affect value if a company’s investment policy is taken as given, then in a perfect world where there is no tax and transaction cost associated with raising money or going bankrupt, and disclosure of all information is credible (Modigliani and Miller, 1958). Hamada (1969) and Stiglitz (1974) have support this theory. Myers and Majuf (1984) suggested that firms will initially rely on internally generated funds, no existence of information asymmetric and profitability firms will generate high earnings are expected to use less debt capital.

2.2 Hypothesis

2.2.1 Capital to gross total assets

From the International Monetary Fund of Global Financial Stability (2013) report defined bank capital to total assets is the ratio of bank capital and reverses to total assets. Capital and reserves include funds contributed by owners, retained earnings, general and special reserves, provisions, and valuation adjustments. Capital includes tier 1 capital (paid-up shares and common stock), which is a common feature in all countries’ banking system, and total regulatory capital, which includes several specified types of subordinated debt instruments that need not be repaid if the funds are required to maintain minimum capital levels (these comprise tier 2 and tier 3 capital). Total assets include all nonfinancial and financial assets (The World Bank Group, 2013).

H0: Capital to gross total assets will be negatively correlated to bank’s profit efficiency.

HA: Capital to gross total assets will be positively correlated to bank’s profit efficiency.

2.2.2 Standard deviation of return on equity

Standard deviation from the view of Investopedia (2013) is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility. Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatility.

Meanwhile, return on equity is the amount of net income returned as a percentage of shareholders equity (Investopedia, 2013). Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.

H0: Standard deviation of return on equity will be negatively correlated to bank’s profit efficiency.

HA: Standard deviation of return on equity will be positively correlated to bank’s profit efficiency.

2.2.3 Size of banks

Size of bank will be defined as dummy variables, value of 1 if the bank has assets more than RM 1 billion and value of 0 if the bank has assets less than RM 1 billion. The more higher the assets of bank, the more bigger the size of the bank.

H0: Size of banks will be negatively correlated to bank’s profit efficiency.

HA: Size of banks will be positively correlated to bank’s profit efficiency.

2.2.4 Loan

Loan is constructed from the total value of loan of the bank. In finance, a loan is a debt evidenced by a note which specifies, among other things, the principal amount, interest rate, and date of repayment (Wikipedia, 2013). A loan entails the reallocation of the subject assets for a period of time, between the lender and the borrower. Normally companies make the loan for the purpose of raising fund or capital. Therefore, companies will have high capital but low in asset. The loan is generally provided at a cost, referred to as interest on the debt, which provides an incentive for the lender to engage in the loan. In a legal loan, each of these obligations and restrictions is enforced by contract, which can also place the borrower under additional restrictions known as loan covenants (Wikipedia, 2013).

H0: Loan of banks will be negatively correlated to bank’s profits efficiency.

HA: Loan of banks will be positively correlated to bank’s profits efficiency.

2.2.5 Securities

Securities will be measured by the total banks’ investment in securities. Investment securities held by banks are usually one of two main sources of revenue, along with loans. Investment securities provide banks with a source of liquidity along with the profits from realized capital gains when they are sold (Investopedia, 2013). Just added from the above, securities are typically divided into debt securities and equities. A debt security is a type of security that represents money that is borrowed that must be repaid, with terms that define the amount borrowed, interest rate and maturity/renewal date. Debt securities include government and corporate bonds, certificates of deposit (CDs), preferred stock and collateralized securities (such as CDOs and CMOs).

H0: Securities of banks will be negatively correlated to bank’s profits efficiency.

HA: Securities of banks will be positively correlated to bank’s profits efficiency.