Abstract
The rapid and dynamic changes in the global financial landscape pose various risks to banking institutions. Operating side by side with conventional banks, Islamic banks are equally vulnerable to risks. The future of Islamic financial institutions in Yemen will depend on how well they manage the credit risks. This ability could be enhanced if the factors affecting these risks are systematically identified. This paper examines the factors affecting credit risk, being the main risk faced by banking institutions and systematically identifies the key factors influencing credit risk formation in Islamic banking operations in Yemen. A comparison of these factors between Islamic and conventional banking operations is highlighted. Several policy implications are addressed to promote risk management culture in Islamic banking industry.
Contests:
1-0 Introduction 3
1-2 Problem Statement 4 1-3 Performance of Islamic Banking Systems in Yemen 5
1-4 Research Questions 6
1.5 Research Objectives 6
2-0 Literature Review 7
3.0 Methodology 10
3.1 Data collection 10
3.2 frame work 10
3.3 The Model 11
3.4 The Hypothesis 11
4.0 Conclusion 12
5-0 The References: 13
CHAPTER ONE
1.0 Introduction
The rapid and dynamic changes in the global financial landscape pose various risks to banking institutions. Operating side by side with conventional banks, Islamic banks are not spared 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 composition of its assets and liabilities.
On the asset side, investments, whose funds are Shari'ah based, can be undertaken 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 sale), installment sale (medium/long term murabahah), Istisna /salam (object deferred sale or prepaid sale) and Ijarah (leasing). In contrast, on the liability side, its deposits can either be kept in the form of current accounts or in investment accounts. Current account depositors get their deposits on demand whilst 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 activity. The different nature of its asset and liability composition and the profit and loss sharing basis change the nature of risks that Islamic banks face.
Credit risk is one of the main risks that seriously affect banks' viability as evident from the wave of Bank's bankruptcies in the world. To this extent, Sarker (1999) found that the amount of bad debt in Islamic banking is growing. Further, Khan and Ahmed (2001) find that bankers of the view that there is a lack of understanding of risks involved in Islamic banking. This gap justifies new efforts to examine as to why Islamic banking experiences increasing bad loans and high credit risk. This entails an investigation on the factors influencing Islamic banking credit risk. To ensure that the viability and sustainable growth of Islamic banking is maintained, it is important that these factors be identified 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 between credit risk determinants of Islamic banking and conventional banks in Yemen.
1.2 Problem Statement
Past studies have covered the risk and factors contributing to risks of financial institutions in the conventional banking system, however its importance to achieving good risk management in Islamic banking, these factors have not been widely investigated and documented.
Previous attempts to study Islamic banking in other countries such as Malaysia mainly evolve on conceptual issues underlying interest free system (Hassan and Bashir, 2002). The issue of the viability of Islamic banks has not received great attention. Hence, given the unique nature of Islamic banking and the dynamic changes in the global financial markets, which pose numerous risks to banks, there is a need to identify empirically, key factors influencing risk formation in Islamic banks - an area that has not been widely studied.
This study is organized as follows: Chapter 2 entails review of related literature,
Chapter 3 describes the methodology. Section 4 concludes the paper with contribution of the study and policy implications.
1.3. Performance of Islamic Banking Systems in Yemen
In 1996, the Islamic banking was introduced in Yemen with the establishment of Islamic Bank of Yemen. The revival of Islam worldwide has paved the way for Islamic banking growth as more people consciously 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 performance since its inception in 1996. Its commendable performance and its presence as an alternative banking with good growth potential have in fact, been the hallmark for Islamic banking among many Arab countries.
The number of Islamic banks has increased since 1996 to become 4 Islamic banks at the end of 2006, with the current policy of permitting 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 poised for further growth and is competing aggressively with the conventional banking, particularly in extending financing to customers. These funds are extended to different sectors of the economy.
In the case of conventional banks, the funds are extended to customers as loan, advances or financing. These modes are interest-based and credit risk is borne entirely by a conventional bank. But for Islamic banking, the financing extended to customers is mostly in the form 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 sale) 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 through the profit and loss sharing basis absorb the credit risk.
1.4 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?
which variable has the most influence on the credit risk of the Yemeni Islamic Banks?
1.5 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.
Identify whether there exists any difference between credit risk determinants of Islamic banking and conventional banks in Yemen.
CHAPTER TWO
2.0 Literature Review
Credit risk in banking is commonly defined as the probability of a borrower defaulting his loan commitments. Credit risk in an Islamic bank is in the form of settlement/payment risk arising when one party to a business transaction pays money (for example Salam or Istina contract) or deliver assets (Murabahah contract) before receiving its own assets or cash, thereby exposing it to potential loss.( Khan and Ahmed, 2001)
A research to Islamic financial institutions in 28 countries by Khan and Ahmed (2001) find that credit risk is found highest in Musharakah (3.69 from a score of 5) followed by Mudarabah (3.25). Their findings highlights that the bankers perceive profit-and -loss sharing (PLS) modes to have higher credit risk. Mark-up risk is found highest in product- deferred contracts of Istina (3.57). Sundararajan and Errico (2002) opine that while PLS modes may shift the direct credit risk of Islamic banks to their investment depositors, they may also increase the overall degree of risk of the asset side of banks' balance sheet since the assets under this mode are uncollaterised. Their deductive intuition is that in principles, the ratio of riskier assets to total assets should typically be higher in an Islamic bank than in conventional bank.
Samad and Hasan (1999) study on Malaysian Islamic banking reveals that Bank Islam performance of risk from 1984-1997 in risky business measured by debt-equity ratio (DER), debt to total Assets (DTAR) and Earning Multiplier (EM) increased over the years. DER and EM are significantly related to profitability. In comparison with two conventional banks; Bank Pertanian and Perwira Affin Bank, Bank Islam risk indicators are lower. The reason for low risk of the Islamic bank is that its investment in government securities is much larger than the conventional banks.
In a study over 1984-1994 period, Makiyan (2003) find that in the Iranian Islamic banking system, the supply of loan is significantly dependant on the changes in total deposits, the changes in the rate of inflation and the changes the time lags of the variables but it is not related to the changes in the expected rate of return on loans assigned to various economic sectors.
As for conventional banks, Brewer, Jackson and Mondschean (1996) find that loan sectors are associated with risk. Fixed-rate mortgage loans, investment in service corporations and real estate loans are found to be significant but negatively related to risk. Non-fixed rate mortgage loan is however, significant and positively related to risk.
Berger and DeYoung (1997) find lagged risk-weighted asset (RWA) is significantly and positively related to credit risk measured by NPL to total loans. They rationalized that a relatively risky loan portfolio will result in higher NPLs. Lagged Capital measured by equity capital to total assets shows mixed results. For thinly capitalized banks, lagged Capital coefficient estimate is significantly but negatively related to risk. This finding supports the moral hazard hypothesis, and suggests that, on an average, thinly capitalized banks take more risky loans, which potentially could lead to higher NPLs
LLP (loan loss provision to average loans outstanding) has been identified in banking literature as a proxy for credit risk (Rose, 1996: 196). Ahmed (1998) find LLP to be positive and is significantly associated with NPL. Hence, a higher LLP indicates an increase in risk and deterioration in loan quality. Fisher, Gueyie and Ortiz (2000) find similar results where LOANQUAL (LLP to total loans) is positively related to risk. They also find Size, (LOGTA), is negative and is significantly related to risk.
CHAPTER THREE
3. Methodology
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 year t
LEVit = Tier 2 capital to Tier 1 capital of bank i in year t
RSECit = risky sector loans (RSEC) to total loans bank i in year t
PSECT = property loans (residential properties loans + non-residential property loans + real estate loans + construction loans) + purchase of securities loans + consumption credit loans
LLPit = loan loss provisions to total loans of bank i in 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.
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 moreLower efficiency in managing earning assts would probably lead to higher credit risk.
4. Conclusion:
By examining closely the relationship between bank specific factors and credit risk of Islamic banking and conventional banks, this paper aims to contribute to the existing literature in several ways. First, the paper provides descriptive statistics about Islamic and selected conventional banks risk characteristics. Second, it uses regression analysis to determine the underlying factors influencing risk of Islamic banking
The analysis will lead us to find what factors critical to influencing credit risk in Islamic banking in Yemen. The results of this analysis will provides information about which of the above variable should pay attention in the banking industry, in order to improve risk management in Islamic banking. Third, the paper will contributes to the current literature, new information on the similarities and differences between credit risk predictors of Islamic banking and conventional banking.
