Capital Structure Effect Islamic Banking Performance

Published Date: 02 Nov 2017

TABLE OF CONTENTS

Islamic banking can be defined as a system of banking that complies with Islamic law also known as Shariah law. Islamic banking contracts are the back bone to the Islamic banks’ products and services. Mutual risk and profit sharing between parties are the fundamental principles that govern Islamic banking, while the assurance of fairness for all and the transactions are based on an underlying business activity or asset.

These principles are supported by Islamic banking's core values whereby activities that cultivate entrepreneurship, trade and commerce and bring societal development or benefit is encouraged. Activities that involve interest (riba), gambling (maisir) and speculative trading (gharar) are prohibited.

Definition by Bank Negara of Malaysia

‘Through the use of various Islamic finance concepts such as ijarah (leasing), mudharabah (profit sharing), musyarakah (partnership), financial institutions have a great deal of flexibility, creativity and choice in the creation of Islamic finance products. Furthermore, by emphasizing the need for transactions to be supported by genuine trade or business related activities, Islamic banking sets a higher standard for investments and promotes greater accountability and risk mitigation.Islamic finance has grown tremendously since it first emerged in the 1970's. There are over 300 Islamic financial institutions worldwide across 75 countries According to the Asian Banker Research Group. Malaysia's Islamic finance industry has been in existence for over 30 years.  The enactment of the Islamic Banking Act 1983 enabled the country's first Islamic Bank to be established and thereafter, with the liberalization of the Islamic financial system, more Islamic financial institutions have been established. Malaysia's long track record of building a successful domestic Islamic financial industry of over 30 years gives the country a solid foundation - financial bedrock of stability that adds to the richness, diversity and maturity of the financial system. Islamic banking in Malaysia began in September 1963 when Perbadanan Wang Simpanan Bakal-Bakal Haji (PWSBH) was established. The first Islamic bank in Malaysia was established in 1983. In 1993, commercial banks, merchant banks and finance companies were allowed to offer Islamic banking products and services under the Islamic Banking Scheme (IBS). These institutions however, are required to separate the funds and activities of Islamic banking transactions from that of the conventional banking business to ensure that there would not be any co-mingling of funds. In Malaysia, the National Syariah Advisory Council additionally set up at Bank Negara Malaysia (BNM) advises BNM on the Shariah aspects of the operations of these institutions, as well as on their products and services. In June 2005, Dow Jones and Company of New York and RHB Securities of Kuala Lumpur, teamed up to launch a new "Islamic Malaysia Index" — a collection of 45 stocks representing Malaysian companies that comply with a variety of Shariah-based criteria.’– Sources from Bank Negara of Malaysia, 2010.

CHAPTER 1: INTRODUCTION

1.1 Introduction

As the world move fast, many firms nowadays hire external agent to handle their business professionally as to put their image and performance at the high stage plus it is easy to control (Pratomo W. A. & Ismail A. G., 2006). However, when the managers of firms try to expand their firms through acquisition, this agency can be costly and sometimes it can cause waste. As the effect for this situation, firms normally will suffer of losing value from professional managers maximizing their own utility apart of value of the firm itself. 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). For some cases, this capital structure will also help to determine the performance of the company without have to involve the agency. The performance of company can also be measured.

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 defiance, there is no difference between debt and equity financing as concerns 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 challenge, 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, definition defined by 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, capital structure variables will be used as the factors to determine the result of performance. Hence, capital structure will be a part of method in findings the efficiency of Islamic banking institutions’ performance.

Pure Islamic banking institutions will be chosen as selected organization for target population since it is quite new in Malaysia and 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 justify 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 since the scope is in Malaysia and close to us because it is our practice (Muslim).

1.4 Background of Study

This research intends 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. 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).

The terms of capital structure has 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 firm. 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 measure whether capital structure can define performance of Islamic bank. Besides, it is as stated below:

1. To examine whether capital to gross total asset influence Islamic bank performance.

2. To examine whether standard deviation of return on equity influence Islamic bank performance.

3. To determine whether size of Islamic bank can affect its performance.

4. To analyze whether loan made by Islamic bank can influence its performance.

5. To identify whether Islamic bank investment in securities have effect towards its performance.

1.6 Research Questions

Research question is the most critical part in research. It defines the whole process, it guides the arguments and inquiry, and it provokes the interests of the reviewer. If question does not work well, no matter how strong the rest of the research, the endeavor is unlikely to be successful. Research question can be defined as statements of the specific components of the problem. This means the components of the problem will clarify the problem in specific terms, which will help in developing an approach. The research questions are constructed in order to answer the research objective. This study is aimed at answering the following questions:

1. Does the capital to total gross assets influence Islamic bank performance?

2. Does the standard deviation of return on equity influence Islamic bank performance?

3. Does the size of Islamic bank can affect its performance?

4. Does the loan made by Islamic bank can influence its performance?

5. Does the Islamic bank investment in securities have effect towards its 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 understand how capital to gross total assets can potentially help in improve and developing performance of Islamic bank in Malaysia. In other words, knowing the relationship of the Islamic bank with the standard deviation of return on equity will theoretically raise the performance of the company. This research actually can help to determine whether size, loan and investment in securities of the company relate with the performance. Thus, this research can apply those finding to turn up the performance of Islamic bank.

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".

According to Berger and di Patti (2002), the impact of capital structure on firm performance can be determined 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. Hence, there are 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. The model is written as follows:

EFC = CAP + SDROE + SIZE + LOAN + SEC

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. However 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).

Besides, corporate governance theory has predicts that leverage affects agency costs and thereby influences firm performance. This research propose a new approach to test the theory using profit efficiency, or how close a firm’s profits are to the benchmark of a best-practice. The research is the first to employ a simultaneous-equations model that accounts for reverse connection from performance to capital structure and control for measures of ownership structure in the test. Along the research, the result shows that data on U.S. banking industry are consistent with the theory, and statistically significant, economically significant, and robust (Berger and di Patti, 2002).

According to the research done by Saeed et al. (2013) on the study of the impact of capital structure on performance of Pakistani banks. Throughout the study, five years from 2007 to 2011 been examined. Along the study, performance is measured by return on assets, return on equity and earnings per share. While the determinants of capital structure includes long term debt to capital ratio, short term debt to capital ratio, short term debt to capital ratio and total debt to capital ratio. As a result, findings of the study validated a positive relationship between determinants of capital structure and performance of banking industry.

2.2 Hypotheses

Hypothesis can be defined as a logical conjectured relationship between two or more variables expressed in the form of testable statement. It is also explained the influence of variables which are independent and dependent. There are two types of hypothesis which are null hypothesis and the alternate hypothesis. Null hypothesis (H0) stand for statistics that shows the result of there is no relationship or no variation exists between variables. It is the conjecture that proved no relationship between variables. It is assumed to be true until there is a result or an experiment that can be proven to show that there is a relationship between two variables, therefore alternate hypothesis (H1) take place. The alternate hypothesis is one that to considered only when null hypothesis are proving to be wrong. It is the conjecture that proved the relationship between variables.

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 (The World Bank Group, 2013).

Hypothesis 1 is to determine the relationship between capital to gross total assets and Islamic bank performance.

H0: There is no significant relationship between capital to gross total assets and Islamic bank performance.

H1: There is a significant relationship between capital to gross total assets and Islamic bank performance.

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.

Hypothesis 2 is to determine the relationship between standard deviation of return on equity and Islamic bank performance.

H0: There is no significant relationship between standard deviation of return on equity and Islamic bank performance.

H1: There is a significant relationship between standard deviation of return on equity and Islamic bank performance.

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.

Hypothesis 3 is to determine the relationship between size of bank and Islamic bank performance.

H0: There is no significant relationship between size of bank and Islamic bank performance.

H1: There is no significant relationship between size of bank and Islamic bank performance.

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).

Hypothesis 4 is to determine the relationship between loan and Islamic bank performance.

H0: There is no significant relationship between loan and Islamic bank performance.

H1: There is a significant relationship between loan and Islamic bank performance.

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).

Hypothesis 5 will determine the relationship between securities and Islamic bank performance.

H0: There is no significant relationship between securities and Islamic bank performance.

H1: There is a significant relationship between securities and Islamic bank performance.

2.3 Theoretical framework

Most research is founded on a question. The researcher or writer of the report not only questions, but ponders and develops thoughts or theories on what the possible answers could be. These thoughts and theories are then grouped together into themes that frame the subject. This is what is known as a theoretical framework. Theoretical framework can be defined as a process of identifying a core set of connectors within a topic and showing how they fit together or are related in some way to the subjects or variables. Variable has two type which are independent and dependent variables. An independent variable is the variable that is changed in a scientific experiment to test the effects on the dependent variable. Meanwhile, dependent variable is the variable being tested in a scientific experiment. In this research, capital to gross total assets, standard deviation of return on equity, size, loan and securities will be independent variable and bank’s profit efficiency tend to be its dependent variable. The framework for this theoretical study as shown below:

Capital to gross total assets

Standard deviation of return on equity

Bank’s profit efficiency

Size of bank

Loan

Securities of investment

Independent Variables Dependent Variable

CHAPTER 3: METHODOLOGY

3.1 Introduction

Methodology can properly refer to the theoretical analysis of the methods appropriate to a field of study or to the body of methods and principles particular to a branch of knowledge. The data for the study are selected figures from the financial statements of 3 out of 16 from listed Islamic banks which are Bank Islam Malaysia Berhad, Bank Muamalat Berhad and Al-Rajhi Bank Berhad and been shortlisted based on the requirement, such as financial statement of above 6 years and purely deals with Islamic banking system. All the information will be gathered from Bank Negara Malaysia records and from the websites of the banks itself.

3.2 Research design

Research design is a detailed outline of how an investigation will take place. It will typically include how data is to be collected, what instruments will be employed, how the instruments will be used and the intended means for analyzing data collected. The study will involve the evaluating the role of Capital Structure in affecting the Islamic banking sector performance in Malaysia. Consequently, the research will be designed to achieve the objectives set out by the researcher whether capital structure can influence the performance of Islamic bank. This study used survey strategy that collects quantitative data which is through the secondary data such as annual financial report.

3.3 Sampling Design

3.3.1 Population

A research population is usually a large collection of individuals or objects and institution that is the main focus of scientific request. It is for the benefit of the population that research that researches are done. A research population is also known as a well-defined collection of individuals or objects and institution known to similar characteristics. Therefore, target population for this study is the Islamic Banking sector in Malaysia. This sector will be chosen because of its presence still new in Malaysia. In addition, this sector becomes more favorites in Malaysian banking sector. 16 Islamic banks have been listed under Bank Negara of Malaysia as a research population.

3.3.2 Sampling Frame

Sampling frame can be defined as a set of information used to identify a sample population for some research. It is also explained as a representation of the element of the targets population that consists of the list identifying the target population. Thus, this study will focus on Islamic banking sector in Malaysia.

3.3.3 Sample size

Sample size, or the number of observations and investigations being used to make population estimates, is critical in research. Without an appropriate sample size, data may not be reliable, and conclusions may be based on misinformation. This is because of the research has bundle of information without specialized on specific criteria. Therefore, this study will focuses only 3 out of 16 Islamic banks that operate in Malaysia.

3.4 Measurement

Measurement is at the core of doing research. Measurement is the assignment of number to things. Measurement consists of two basic processes called conceptualization and operationalization. Conceptualization is the process of taking a construct or concept and refining it by giving it a conceptual or theoretical definition. Meanwhile, operationalization is the process of taking a conceptual definition and making it more precise by linking it to one or more specific, concrete indicators or operational definitions. Thus, the study will use financial statement or annual report of the bank. All the information and data will obtain from the report which related to the study topic. Besides, I will choose Islamic bank which has 6 years and above of financial statement and type of bank will be focus only on pure based Islamic banking system. The variables of used are capital to gross total assets, standard deviation of return on equity, size of bank, loan and securities of investment. This research has set the formula by Berger and di Patti (2002) as the way to measure the performance. The model is written as follows:

EFC = CAP + SDROE + SIZE + LOAN + SEC

3.5 Data collection method

Secondary data is an instrument that use in this study. Secondary data is a data that have already been collected and are readily available from sources. For example, journal, magazines, internet, previous research report, company annual report, books and many more. This study tends to use secondary data since most of the finding can be found based on the information given by the bank itself such as financial statement and annual report. Method of searching and finding of data is through the bank’s website and data stream. List of Islamic banking in Malaysia can be found in the Bank Negara Malaysia website.

3.6 Conclusion

This research attempts to show the relationship and effect of capital structure and Islamic banking performance in Malaysia. This is aimed to meet the objectives and solve the questions regarding to the topic discuss. Furthermore, this research will show whether capital structure can mitigate the agency cost and its use. I hope to have clearer understanding of what leads capital structure (capital to gross total assets, standard deviation of return on equity, size, loan and securities) to Islamic banking performance. By based on the result gained soon, those sector can determine how these variables can potentially help to improve and developing performance of Islamic bank in Malaysia. As a conclusion, level and understanding of public towards Islamic banking sector in Malaysia can be more understandable in tandem with other banking sectors.