Over the last ten years, the demand for Islamic banking and finance products has grown strongly. In mid-2004, the Islamic financial market had 265 banks among assets of more than $262 billion and investments of more than $400 billion (IOSCO, 2004)[1]. From simple profit and loss sharing (PLS) savings accounts, Islamic savings and investment products have now proceeded to hedge funds, bonds and derivatives. The proliferation of Islamic banking products to longer than 50 countries, including USA and Europe is comprehensible as international banks can see a profit opportunity by tapping into the large and growing banking needs of the Muslim population in Middle East, Asia and somewhere else.
The rapid and energetic changes in the global financial landscape pose various risks to banking traditions. Operating side by side with conventional banks, Islamic banks are not pardoned but equally exposures to risks. The exception is that the nature of risks facing Islamic banking in Yemen is unique. This uniqueness arises from the constitution of its assets and liabilities.
On the asset side, investments, whose funds are Shari'ah based, can be commenced in the form of profit sharing modes of financing (Mudarabah and Musharakah), fixed-income modes of financing such as Murabahah (cost-plus or mark-up sell), installment selling (medium/long term murabahah), Istisna /salam (object to deferred sale or prepaid sale) and Ijarah (leasing). In contrast, on the liability side, its deposits can either be possessed in the form of current accounts or in investment accounts. Current account depositors get their deposits on demand, although investment depositors in Islamic bank are rewarded with the opportunity to share with the bank the profit and business risks (or losses) of the investment project. The different character of its asset and liability composition and the profit and loss sharing basis change the character of risks that Islamic banks face.
Credit risk is one of the leading risks that seriously affect banks' viability as evident from the wave of Bank's bankruptcies in the globe. To this extent, Sarker (1999) established that the amount of bad debts in Islamic banking is growing. Further, Khan and Ahmed (2001) find that bankers of the opinion that there is a lack of understanding of risks concerned in Islamic banking. This gap supports new productions to examine as to why Islamic banking experiences increasing bad loans and high credit risk. This involves an investigation on the factors influencing Islamic banking credit risk. To guarantee that the viability and sustainable growth of Islamic banking are maintained, it is important that these factors be recognised early to ensure necessary precautions and preventions are taken. It is a modest attempt in this paper to (i) investigate the factors influencing credit risk of Islamic banking and (ii) identify whether there exists any difference among credit risk determinants of Islamic banking and conventional banks in Yemen.
Performance of Islamic Banking Systems in Yemen
The Islamic Bank of Yemen for Finance and Investment, a Yemeni shareholding corporation (YSC) (The Bank), was incorporated on 25 April 1995 pursuant to the Minister's of Trade and Supply Command No. 137 of 1995. The Bank started operations on June 8 1996. In accordance with article no. (26) of Law no. (21) for the year 1996 with regard to Islamic banks, the Bank is authorized to the privileges, and exceptions stipulated in the Investment Regulation.
The Banks was substantiated for the purposes of covering the social and economic needs in investment, finance and banking services in conformity with the principles of the Islamic Shari a.
In 1996, the Islamic banking was announced in Yemen with the establishment of Islamic Bank of Yemen. The revival of Islam worldwide has covered the way for Islamic banking growth as more people intentionally seek to lead their lives in accordance with the Syariah. In tandem with the global trend, Islamic banking in Yemen has achieved a rapid expansionary appearance since its inception in 1996. It's commendable performance and its attendance as an alternative banking with good growth potential has, in fact, been the trademark for Islamic banking among many Arab countries.
The number of Islamic banks has increased since 1996 to become four Islamic banks at the end of 2006, with the current policy of allowing foreign banks to offer Islamic banking products and services. The total deposits and financing of Islamic banking grew from YR 290 billion in 2000 to YR 753 billion by December 2005. Its market share (represented by the percentage of loans over the total loans of the banking system) increased from 0.3% in 1996 to 9.7% in 2005. With a greater number of players and the incorporation of a second Islamic bank, the Islamic banking is stable for further growth and is competing aggressively with the conventional banking, particularly in extending financing to customers. These funds are increased to the different sectors of the economy.
In the case of conventional banks, the funds are increased to customers as loan, advances or financing. These modes are interest-based and credit risk is born completely by a conventional bank. But for Islamic banking, the financing extended to customers is mostly in the image of credit sale (al-murabahah and ijara wa iqtina) in which an Islamic bank will purchase goods on a cash basis and sell to customers on credit terms. This financing (known as cost-plus or mark-up sell) accounts for more than 90 percent of its total assets in Yemen. The second largest financing mode is on profit sharing (Mudarabah and Musharakah). Unlike conventional banks, the depositors of an Islamic bank between the profit and loss sharing bases absorb the credit risk.
Problem statement:
The concept of risk was well known in ancient communities. Even in financial decisions, people knew very well that lending to someone who is bankrupt has a high probability of losing the money as compared to a debtor with good position. Nevertheless, risk became a significant tool of decision-making when it became possible to measure it and to assign values to different circumstances.
Previous studies have concentrated on risk factors conducing to risks of financial institutions in the traditional banking system (Khan and Ahmed, 2001, Hassan, 1993.1994, Berger and DeYoung, 1997; Angbazo et al., 1998 and Ahmad, 2003). The bank is a trustee of public funds; it must use these funds to defend the rights of holders of these funds. Therefore, comparative studies on the risks underlying Islamic modes of financing are excessively important.
And its importance for achieving good risk management in an Islamic banking sector, these factors have not been widely studied and documented. Previous attempts to study Islamic finance in other countries like Malaysia evolve mainly on conceptual issues underlying the interests of the free system (Hassan and Bashir, 2002).
The question of the viability of Islamic banks does not have a lot of attention. Thus, given the unique nature of Islamic finance and banking and the dynamic evolution of global financial markets, which poses many risks for banks, it is necessary to identify empirically the key factors influence the formation of risks in Islamic banks - a region that has not been widely studied.
Research Questions:
What is the credit risk among the Yemeni Islamic banks?
What are the factors that affecting the credit risk management in Yemen?
How much he Yemeni environment affecting the Non- performing loan in the Islamic Banks?
Research Objectives:
To determine the credit risk among the Islamic banks in Yemen.
To investigate the factors influencing credit risk of Islamic banking.
To investigate whether certain factors (Top Management, Non-Accounting, organizational size, IT, and product diversity) have any influence on the
credit risk in Islamic banks in Yemen.
CHAPTER TWO
Literature Review:
Islamic banking has developed phenomenally in modern years not only in the Muslim world, but also in the West (Wilson, 2007). Despite growth acceptance of Islamic banking, there is still skepticism as to whether they will be able to manage with international banking standards. Islamic banks will be needed to comply with the standardized approach of risk measurement for the capital competence as emphasized in the Basel II accord. On the one hand, Islamic banks are perceived as the existence too complacent, believing they have a captive market in the Muslim masses which will come to them on religious grounds alone, and in the process lose non-Muslim prospective customers interested in investing in organizations whose activities are regarded as ethical (Haniffa and Hudaib, 2007). On the other hand, it is a general observation that. Islamic banks are lacking professionally managed risk identification (RI) processes and credit risk management approaches, which lead the Islamic banks being weightily, involved in short-term loans instead of long-term equity finance (Hassan and Dicle, 2006).
Credit risk activities are an everyday thing to every person, firm or organization. No business can operate successfully in a free society without taking risks. Financial intermediaries play an important role in the business of a country and often serve as strong indicators of its economic development.
Along with the fast growing banking condition and environment, both externally and internally, Islamic banks as intermediary institutions will always face various risk factors at varying complexities inherent in their business activities. Risk in the context of banking represents probable events. Whether or not the events can be anticipated, they have the potential to impact adversely to the bank's income and capital.
In search of Islamic financial institutions in 28 countries and Ahmed Khan (2001) find that credit risk is higher in Musharakah (3.69 from a score of 5) followed by Mudarabah (3.25) . Their results show that bankers perceive profit and loss sharing (PLS) modes have higher credit risks. Mark-up risk is more in deferred revenue from contracts Istina (3.57). Sundararajan and Errico (2002) opine that while they PLS modes can move the credit risk of Islamic banks to direct their investment depositors, they may also increase the overall level of risk associated with the asset side of banks, because the property under this mode is uncollaterised. Their deductive intuition is that, in principle, the ratio of riskier assets to total assets should normally be higher in an Islamic bank in the traditional banks.
Sam ad and Hassan (1999) study on Islamic banking in Malaysia showed that Bank Islam performance risk from 1984 to 1997 in the risky business measured by the debt ratio (DER), debt to total assets ( DTAR) and gain multiplier (EM) has raised over the years. DER and EM are importantly related to profitability. In comparison with both conventional banks, pointers of the Bank and Bank Pertanian Perwer Affin Bank, the risk of Islam is lower. The reason for the low risk of an Islamic bank is that its investment in government securities is much higher than conventional banks.
In a study over 1984-1994 period, Makiyan (2003) found that in the Iranian Islamic banking system, the supply of loan is appreciably dependent on the modifications in total deposits, the changes in the rate of inflation and the changes the period lags of the variables, but it is not related to the changes in the expected rate of return on loans allocated to different economic sectors.
As for conventional banks, Brewer, Jackson and Mondschean (1996) come upon that loan sectors are connected with risk. Fixed-rate mortgage loans, investment in service corporations and real estate loans are found to be meaningful but negatively related to risking. Non-fixed rate mortgage loan is, nevertheless, significant and positively related to risking.
Berger and DeYoung (1997), lagged weighted assets (RWA) is meaningfully and positively related to credit risk as measured by NPL to total loans. They rationalized that a comparatively risky loan portfolio will result in higher NPLs. Lagged Capital measured by equity capital to total assets indicates mixed results. For banks under-capitalized, offset by the capital coefficient appraisal is significantly but negatively related to risking. This result supports the hypothesis of moral hazard, and suggests that, on average, barely capitalized banks saving riskier loans, which could potentially guide to higher NPLs.
LLP (loan loss provision to average loans outstanding) has been recognised in banking literature as a proxy for credit risk (Rose, 1996: 196). Ahmed (1998) fined LLP to be positive and is meaningfully associated with NPL. For this reason, a higher LLP indicates an increase in risk and breakdown in loan quality. Fisher, Gueyie and Ortiz (2000) find similar results where LOANQUAL (LLP to be total loans) is positively related to risking. They also come upon Size, (LOGTA), are negative and are significantly related to risking.
CHAPTER THREE
3. Research Design:
This chapter described the research methodology of study and it divided into three, namely (a) Data collection (b) the frame work (c) the model use (d) Research hypothesis
3.1 Data collection
The data comprises Islamic banking data and conventional banking data. The Islamic banking data is extracted from the audited annual reports of Tadhamon International Islamic Bank (Yemen ) and the audited financial statements from 4 anchor banks - Saba'a Bank, Yemen and Bahrain Islamic bank, Islamic Bank of Yemen. . The conventional banking data is compiled from the income statements and balance sheets of the 6 anchor banks: Yemen International Bank, al-arabi Bank, Calyon Bank, Yemen and Kuwait Bank. The data is from 1999 to 2005.
3.2 The Frame work:
Earning assetsIndependent variables Dependent variable
Tier 2 capital to tier 1 capital
Risky sector loans (RSEC)
Non-performing loan
Property loans
Loan loss provisions.
3.3 The Model:
The equation for the model used in this study is:
CRit = 0 + 1MGTit +2LEVit +3RSECit + 4REGCAPit +5LLPit +Eit
Where dependent variable is:
CRit = non-performing loan for the current year
Independent variables:
MGTit = earning assets to total assets of bank i in the year t
LEVit = Tier 2 capital to Tier 1 capital of bank i in the year t
RSECit = risky sector loans (RSEC) to total loans' bank i in a year t
PSECT = property loans (residential properties loans + non-residential property loans + real estate loans + construction loans) + purchase of security loans + consumption credit loans
LLPit = loan defeat provisions to total loans of bank i in the year t.
3.4 The Hypothesis:
There is a negative relationship between (CR) the non-performing loan and (MGT) the earning assets.
It is expected that credit risk (CR) have a positive relationship with, LNTA and REGCAP.
Lower efficiency in managing earning assets would probably lead to higher credit risk.
Tire 1: Equity capital includes instruments that can't be redeemed at the option of the holder.
Tier 2 : A term used to describe the capital adequacy of a bank. Tier II capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt, and more
