Impaired Financing Determinants of Islamic Banks in Malaysia

Despite commendable growth of Islamic banking on a macro level, impaired financing is an issue among Islamic banks at the micro level. The 2008 Global Financial Crisis shows large credit risk was largely attributable to staff inefficiency. This study investigates the moderating effect of staff efficiency on determinants of credit risk or impaired financing of sixteen Islamic banks in Malaysia over the 2005-2013 periods. The determinants include new variables such as political stability index and corruption index besides GDP, inflation, finance to deposit, loan loss provisions, liquidity, capital, net interest margin, profitability, loan growth and net charge offs. The study highlights new findings where impaired financing reduced with higher political stability index and corruption index. Loan loss provision has significant positive whilst loan growth has negative impact on impaired financing. Staff efficiency significantly moderates the impaired financing relationship with capital ratio, profitability and loan growth. This relationship yields model fit of 0.889. The results support Resourced based Theory and provide statistical evidence of the importance of staff efficiency in managing banks’ credit risk. None of the external factors had significant influence on impaired financing, which statistically proved that the profit and loss sharing concept of Islamic banking provides effective tool to mitigate external risks.


Introduction
According to Ahmed (2009), the global financial crisis (GFC) that began around 2006, caused several countries like Greece, Portugal, Ireland and Spain into bankruptcy. Laeven and Valencia (2008) highlighted that GFC had caused many banks to face high credit risk due to over leveraging and speculative activities in mortgage markets. The GFC did not only destroy many mega banking institutions such as Northern Rock, Bear Stearns, Indy Mac Bank and Washington Mutual, but also caused misery to millions of American and European society (Ahmed, 2009). They found that non-performing loans or impaired financing caused 124 systematic banking crises over the period of 1970 to 2007. Impaired financing leads to formation of credit risk. Credit risk reduces asset quality (Rose, 2002). The central bank of Malaysia defines impaired financing when principal or interest payment is three months or more in arrears (BNM, 2012). The consequences of impaired financing on bank are reductions in their profits or at times, lead to losses. As such, a bank managing their impaired financing from getting higher is a continuous challenging task. Ahmad and Ahmad (2004) study on the key factors influencing credit risk of Malaysian Islamic banks found out that Islamic banking credit risk remains relatively high despite the risk sharing between the bank and the clients. The factors studied are management efficiency, risky sector financings, property financings, capital to total assets, loan loss provision, funding cost, risk-weighted assets, and natural log of total asset and financing to deposit. In this study, the effects of four new variables such as political stability index, corruption control index, net charged off and staff efficiency on impaired financing of Islamic banks intend to fill the gap in Ahmad and Ahmad (2004).
Problem Statement: Chapra (2008) highlighted that Islamic banking system despite being acceptable as a better intermediation channel could not escape from incurring high impaired financing. Table 1 shows the average impaired financing albeit credit risk of Malaysian Islamic banks over 2005 to 2013 periods. This phenomenon indicates that there are still pertinent new factors that need to be examined besides those covered in past studies (BNM, 2013). Among the new factors, human resource efficiency is the most vexing managerial issue in Islamic finance system where lack of skills, knowledge and incompetence workforce will lead to higher operational and credit risks which stifle the Islamic banks' growth potential (Mohd-Sultan, 2008). The study provides fresh suggestion that the deterioration in financing quality of Islamic banks might have occurred due to lack of staff efficiency in terms of their credit assessment, apart from the influence of macro-economic factors. Meanwhile, Abd-Karim, Chan and Hassan (2010) highlighted that higher impaired financing or credit risk reduces cost efficiency and lead to inefficiencies in the banking sector. Credit risk can also be due to staff inefficiency in handling credit management process, either in financing processing, documentation or monitoring process. Moral hazard and agency problem have been shown from previous studies to affect bank credit risk. However, little attention was given to staff efficiency in previous studies. A survey of the past literature only shows efficiency and cost efficiency relationship by Abd-Karim et al. (2010). This gap in the literature motivates the present study to focus on staff efficiency as a moderator in determining factors influencing impaired financing of Islamic banks in Malaysia. This new approach will highlight the inclusion of new macro-socio variables, such as political stability index and corruption control index. Malaysia is selected because it is the biggest hub of Islamic banks (Sufian, Mohamad Noor & Majid, 2008). The objective of this study is to share the findings on the determinants of impaired financing with the moderating effect of staff efficiency have significantly affected the Islamic bank in the way statistically and economically significant.

Research Question
 How do external factors (gross domestic products, inflation, political stability index and corruption control index) influence the level of impaired financing among Islamic banks in Malaysia?  What are the effects of internal factors (financing to deposit ratio, loan loss provision, liquidity ratio, capital ratio, net interest margin, profitability, loan growth and net charged off) towards the level of impaired financing among Islamic banks in Malaysia?  Are the effects of the internal factors on impaired financing among Islamic banks in Malaysia is moderated by staff efficiency?

Significance of the Study:
This study is a much needed attempt to present a comprehensive analysis of impaired financing determinants in Islamic banks involves the identification of external factors and internal factors which are associated with increases in impaired financing of Islamic bank. The effect of staff efficiency as a moderator between internal factors and impaired financing would also position the Islamic banking to cater to human resource competencies as an important tool to reduce impaired financing. This is a new dimension from the financial factor analysis aspect. Khan and Ahmed (2001) revealed that one of the challenges in Islamic banking is credit risk. This risk will occur when customers fail to meet their financing obligation fully in stipulated period which is associated with the financing default. Table 2 below, shows several factors contributing to impaired financing (IF). Related Theories to the Study: Resource-based theory explains that success in competition for the organization is based on internal and external resources owned by the organization. Staffs which are internal resource are assets to the banks and their efficiency and productivity will lead to the success of the bank. This theory postulates that when employees are highly competent and knowledgeable, they are more able to contribute towards bank efficiency, generate revenues and profit. Another related theory is theory of financial intermediation. The Islamic banking system is not only intermediaries but also an entrepreneur to manage the capital provided by the investor or capital provider. Any profit generated from the capital is shared between the capital provided and entrepreneur according to mutually agreed profit sharing ratio. This dual roles played by Islamic bank is different from conventional bank which only acts as an intermediaries. Islam is very concerned about credibility and sincerity of the staff in discharging their daily duties assigned. This was revealed in Al-Quran: "O believers! Do not betray the trust of Allah and His Rasool, nor violate your trust knowingly" (Al-Anfal: 27).

Literature Review
Efficient and outstanding employees should have the integrity, potential to think, strategize, implement and achieve the level of success in discharging their duties in seeking the blessings of Allah. Staff with high credibility and efficiency would contribute to the lower default account and impaired financing to the banks.

Methodology
The research theoretical framework for this research inclusion of dependent variable, independent variable and moderating variable is as illustrated in Figure 1 below.

Staff Efficiency
Data Collection: This study used secondary data over 2005 -2013 periods. The sources of the data for external factors were obtained from Regional Economic Outlook. For internal and moderating factors, the data comprising financial ratios were obtained from annual reports of 16 Malaysians' Islamic banks published in bank scope database. Political stability index and corruption control index which are the new variables to be tested were extracted from World Governance Indicator Reports (Wgidataset.com).

Results
Diagnostic test result of the homoscedasticity test, auto-correlation test and penal data test is conducted and the result is presented in Table 4 below: The Breusch-Pagan test is used to detect the existence of heteroscedasticity in the model. The result in Table 4 shows that this model for Malaysia is found to be significant at p<0.01.The result rejected the null hypothesis and concluded that the presence heteroscedasticity in our model of Islamic bank in Malaysia. Gujarati and Porter (2010) suggested that a Lagram-Multiplier test is most suitable for serial correlation and to detect first-order autocorrelation. The multiple regression analysis is performed to examine the relationship between independent variables and impaired financing. The result of multiple regression tests are presented in Table 5. The F-statistic that explains the overall significance of the model is found to be significant at 0.000 level with R square (R 2 ) of 0.8396 and adjusted R-squared of 0.7754. It shows that the regression model consisting of GDP, INF, PSI, CCI, FD, LLP, LIQR, CAP, NIM PROFIT, LGROW and NCOFF could explain 77.54 percent in IF. Further, the predictors from external variables found to be insignificant such as, gross domestic product (GDP), inflation (INF), political stability index (PSI) and corruption control index (CCI). Meanwhile there are two significant internal variables such as, loan loss provision (LLP) and loan growth (LGROW) which support the hypotheses. Other predictors such as, finance to deposit (FD), liquidity (LIQR), capital (CAP), net interest margin (NIM), profitability (PROFIT) and net charged off (NCOFF) have no impact on impaired financing (IF) of Islamic bank in Malaysia at 0.05. The coefficient estimation of LLP is 0.0215 with t-value of 2.8267 (p < 0.01). This result indicates that a 0.0215 point increase in LLP, result in an increase of 1 point increase in IF of Islamic bank in Malaysia. The coefficient estimation of LGROW is -0.0178 with t-value of -2.7600 (p < 0.01). This result indicates that a 0.0178 point decrease in LGROW, will result in an increase of 1 point in IF of Islamic bank in Malaysia. Although the result is not significant, the negative relationship between LGROW and IF appears to suggest that increase in LGROW reduces IF. Table 6   Model 1: In model 1, internal variables (FD, LLP, LIQR, CAP, NIM PROFIT, LGROW and NCOFF) are found to be significant at 0.000 levels with adjusted R 2 of 0.7619. There are three predictors, which are significant, LLP (β=0.0189,t=2.6283,p<0.01),NIM (β=0.3077,p<0.05). Other predictors such as, FD, LIQR, CAP, PROFIT and NCOFF have no impact on IF of Islamic banks in Malaysia.
The significant relationship of staff efficiency as a moderator is depicted in Figure 2, 3, 4 and 5 below:

Conclusion
This paper concludes the result that external factors such as GDP, inflation, political stability index and corruption control index were not significant in influencing impaired financing of Islamic banks in Malaysia. Meanwhile, only loan loss provision and loan growth were the determinants of impaired financing of Islamic banks in Malaysia. On the other hand, it is found that staff efficiency moderate negatively and significantly the impact of loan loss provision, capital, profitability and loan growth. These result imply that the higher in the staff efficiency in their work, the lower in the impaired financing. In other words, staff efficiency in allocating loan loss provision and managing capital would contribute significantly to reduction in impaired financing of Islamic banks. Reduction in impaired financing could also be achieved when staff is efficient in assessing, selecting, monitoring and controlling the expended loan portfolio or loan growth. In contrast, the negative significant impact of staff efficiency and profit on impaired financing of Islamic banks appears to suggest that staff efficiency is crucial to reduce impaired financing which consequently result in higher profit.

Contribution of the Study:
This study provides empirical evidence that Islamic banks with their profit and loss and risk sharing concept are not extremely affected by macro-economic factors. This finding is in contrast to the result of Hasan and Lehar (2009);Ahmad (2003) and Ranjan and Dhal (2003) which found that macro-economic factors such as GDP and inflation are significantly influence impaired financing of the conventional banks. Another new contribution is the moderation effect of staff efficiency, which has not been analyzed before. The high significant level (0.01) of the impact of staff efficiency on reducing impaired financing suggested clearly that banks' management should give equal emphasis on increasing the level of staff efficiency besides looking at the financial factors in mitigating credit risk.

Suggestion for Future Research:
There is a lot more related field that can be studied for the future research in the Islamic banks system. Impaired financing of Islamic banks remain an important issue in financing activities of Islamic banks. In order to remain equally competitive to their conventional counterparts, Islamic banks should continue to emphasize on impaired financing management and risks management. Hence, future studies are recommended to include robust model which include customers' behavior towards financing preference. A cross-country comparison on impaired financing of Islamic banks especially focusing on Islamic economic blocks such as in OIC countries, GCC and emerging market is highly needed to contribute to the scant literature on Islamic banking studies.