Essay: Banking capital – Islamic banking

The banking industry is one of the business units that need to be managed properly and yet still refers to the rules set by the regulator. At the end of the estuary of the banking business, both conventional and Islamic banks must perform well as a company, and the important thing in this industry is the management of capital adequacy ratio (CAR) in the risk sector of banking industry. Capital is a mean to finance income-producing assets and the protector of stability. From the point of view of efficiency and return, capital are part of bank funding sources that can be used directly to purchase assets and also to raise other funds. From the viewpoint of stability, the bank’s capital act as a protector to absorb the shock of the loss of business and maintain solvency, to the benefits received by customers and other stakeholders. Capital Adequacy Ratio is one of the important concept in banking which measures the amount of a bank’s capital in relation to the amount of its risk weighted credit exposures. With this study the authors wanted to fill the void in the context of the present study is to see Islamic banking strategy in the management of the fulfillment of capital (CAR) not only from the internal side but also includes influences from the external side. The ability of banks to maintain liquidity affected the efficiency of the bank’s risk management in creating a foundation in business activities as well as bank must choose the level of risk and profit ratios the best. The bank’s risk can impact effect on operational costs and ultimately impact the Capital Adequacy Ratio (CAR) of a bank (Jasiene, M., 2012). Kweme (2003), noted the importance of capital adequacy for banking business activities. This means that banks will be able to absorb the liquidity risk in the market, if it has a capital adequacy ratio (CAR). To encourage the prudent management of the risks associated with the structure of the balance sheet, the authorities in most countries introduce specific capital adequacy requirements. At the end of year 1980, Basel Committee on Banking Supervision lead in developing capital adequacy standards-based risks that will lead to international convergence regulatory oversight governing the capital adequacy of international banks are active, with the aim to strengthen the health and stability of the banking system, which then developed further by the Islamic Financial Standards Board (IFSB), which in turn set standards of capital adequacy for Islamic banks is not lower than 8%.
In 2004, Basel II proposes a tightening of the rules of CAR. Meanwhile, Basel III is no improvement associated with increasing riskweighted capital requirements (divided into Tier 1 and Tier 2) and nonrisk-weighted leverage ratio. Polat and Al-Khalaf (2014) in his research to analyze the relationship specific variables banks, including CAR (dependent variable), profitability (ROA), non-performing loan (NPL), loan-to-deposit (LTD), leverage (LEV), the dividend payout ratio (DPO), loans (LOA), bank size (Size). This indicates that the ability to maintain the CAR is very important for the health of a bank. Interesting study also done by Siti Rochmah et al (2011) regarding the financial performance of Islamic banks and conventional banks. Now, the conditions are different. The financial performance of Islamic banks are not better than commercial banks. This is reflected in the measurement of the CAR, ROA, ROA, and LDR or FDR as follows:
From several studies including that conducted by Erico and Partners Farahbaksh (1998) states that the rules of economic authority for sharia bank can basically use the same size with the bank, although in some cases the management of Islamic banks and conventional is similar.
Said (2012) conducted a study on how the application of the system of Islamic banking ranging from the establishment of the beginning of the establishment of the Dubai Islamic Bank in the United Arab Emirates, then continues in Jidda, Saudi Arabia, Egypt, Sudan, Kuwait, Bahrain and other countries. The need to put forward that are relevant to my research is put forward a study conducted in Indonesia are carried out by Umar, Majid and Rulindo during 2002 to 2004 at 21 private banks with DEA method. With a sample consisting of two Islamic banks and conventional banks remaining. Likewise research done by Saifullah, on 2004-2008 found that Islamic banks are better in business development, profitability, liquidity and solvency compared with conventional banks. This was stated in the Journal of Literature Review, that on variety of studies both conventional banks and Islamic banks is mainly related to the bank’s financial performance, especially in terms of efficiency between Islamic banks, including a variety of discourse, controversy and inconsistency of various studies. In this study the approach to measure efficiency was still simple. The purpose of this paper is to present conceptual framework to see what factors are affecting the Capital Adequacy Ratio, which include internal factors which consists of some financial ratios, then Size banks and external factors, namely inflation rate. Many studies, linking the effect of achieving the CAR management, attributed to internal factors and financial ratios. But, not many who measure CAR, from internal and external at the same time, the macroeconomic factors in this study is the inflation rate. Lia Amaliawati and Lasmanah(2014) addressed the issue of Capital Adequacy Ratio and some other financial ratio bu there, CAR is not as dependent variables but parallel with the other variables acts an antecedent and also was associated with bank management efficiency. Many studies, linking the effect of achieving the CAR management, associated with its financial ratios. But, from the reference study, there has been no or not much that incorporate elements of management initiatives, namely the management of measurement of the size of CAR in the bank. In one article(Cohen, 2014), the author fill the research gap on this side. Also Schaffer(2011) delivered on banking studies which incorporate at least the macro element in the management of his CAR, has been a differentiator with previous studies, the researchers conducted answers to the current debate between the management of CAR. Research conducted Dreca Nada (2013) and Ahmet and Hasan Buyuk salvarci Abdioglu (2011) convey the determinant factors affecting capital adequacy / CAR, but seen from internal factors. The dynamics of the market risk in theIndonesia banking structure requires to be able to manage capital adequacy ratio (CAR) which is able to adapt to external shocks. As also stated by Nnanna (2003), a common indicator of macro factors developed by the IMF in assessing the health of the Bank with the acronym CAMELS which include Capital (adequacy), Assets, Quality, Management, Earnings, Liquidity, and Sensitivity to market risks. Research on the CAR, especially in Islamic banking has been done by several researchers, although not much compared to conventional banks, but in this study the researchers wanted to know CAR associated with the external dynamics that inflation rate. Empirical studies on the determinants of banking Saudi Arabia against CAR (Polat and Al-khalaf, 2014) as well as the idea to include macro policies factor into it (Cohen and Scatigna, 2014), an interesting topic for research on Islamic Banking in Indonesia. Because not much research, especially for Islamic banking which combines internal factor by factors external / macro against Capital Adequacy. Some studies usually do so partially, this is where the researchers want to find a gap theory that has never been done by other researchers. Many studies, linking the effect of achieving the CAR management of both conventional and Islamic banking more just through its financial ratios or internal factors. But there has been no or perhaps rare that CAR management for Islamic banks that combined with external factors. The purpose of this study is to propose a more comprehensive research model to complete some previous research that can be developed more fully and comprehensively to determine the determinant factors on the capital adequacy of Islamic banks.
Literature Review,
Capital Adequacy
The bank as a business unit requires “blood” of the business, namely capital. In other words, the bank’s capital is an important aspect for a business unit of the bank. Because operates whether or reliability of a bank, one of which is strongly influenced by the condition of capital adequacy.
Lia Amaliawati and Lasmanah (2014) addressed the issue of Capital Adequacy Ratio and some other financial ratio but here, CAR is not as dependent variables but parallel with the other variables as antecedent and also was associated with bank management efficiency.
Bank capital has three functions (Johnson and Johnson, 1985) which are:
As a buffer to absorb operational losses and other losses. In this function of capital provides protection against failures or bank losses and the protection of depositors.
As a basis for the set lending limit. This is an operational consideration for the central bank, as the regulator to limit the amount of lending to each individual bank customers. Through this restriction the central bank forced banks to diversify their credit in order to protect themselves against credit failure of one individual debtor.
Forms the basis for market participants to evaluate the relative levels of the bank’s ability to generate profits were. The rate of return for investors is estimated by comparing net profit with equity. Market participants to compare the return on investment among the existing banks.
While Hempel, Coleman and Simonson (1986) in relation to the function of the bank’s capital, stressing there are four things, namely:
To protect the depositors , when in a state bank and liquidation insolvency
To absorb unexpected losses in order to maintain public confidence that the bank can continuously operate.
To obtain the physical facilities and other basic necessities needed to offer bank services.
As a means of implementing regulations controlling improper asset expansion.
See capital above functions, it can be seen that the position of capital is an important thing that must be met primarily by the founder of the bank and the bank’s management for the bank operation.
Capital resources of banks according to Hempel, Coleman and Simonson (1986) is divided into three main forms of subordinated debt, preferred stock and common stock. Some types of subordinated loans and preferred stock convertible into common stock, and common stock can be developed, either external or internal.
Sources of capital above is the concept of capital theory in conventional banks. For Islamic banks, loan capital (subordinates loan) including greetings qard categories, namely loans refundable price. In fiqh literature Ash SalafSalih, qard categorized in aqadtathawwu, or contract mutual help and not a commercial transaction (Muhammad, 1999).
The main sources of Islamic bank capital is core capital (core capital) and quasi-equity. Core capital is capital from the owners of the bank, which consists of the capital subscribed by the shareholders, reserves and retained earnings. While quasi equity funds recorded in the accounts for the results (mudaraba). This is the core capital that serves as a buffer and absorbing failures or bank losses and protect the interests of account holders deposit (wadiah) or loans (qard), mainly on assets funded by its own capital and funds wadiah or qard.
The capital adequacy is important in the banking business. Banks that have a good level of capital adequacy shows indicators as healthy banks. For capital adequacy of banks shows that the situation is expressed by the so-called act a certain ratio of capital adequacy ratio or the Capital Adequacy Ratio (CAR). The capital adequacy level can be measured by (Zainul Arifin, 2002):
Comparing capital with third-party funds
Viewed from the angle of the protection of the interests of the depositors, the ratio between capital and liability items is an indication of the level of security in bank deposits by the masses. The calculation is the ratio of capital associated with third party deposits (current accounts and savings accounts) as follows:
(Capital and Reserves)/(Demand Deposits + Savings)=12%
From these calculations it can be seen that the capital ratio on deposits simply by 10% and the ratio of bank capital that is considered healthy. Ratio between capital and public deposits should be integrated with asset and should take account of the risk. Therefore, the capital must be supplemented by various capital reserves as a buffer, so in general the bank’s capital consists of core capital and supplementary capital.
Comparing capital to risk assets
The second measure is today into an agreement BIS (Bank for International Settlements), namely the organization of central banks of developed countries sponsored by the US, Canada, the countries of Western Europe and Japan. The agreement on capital requirements was achieved in 1988, by setting the minimum CAR ratio is the ratio between capital base with risky assets.
(Capital and Reserves)/(Risk Weighted Assets)=12%
This agreement was motivated by the observation banking experts developed countries, including the experts of the IMF and the World Bank, of the existence of structural inequality and the international banking system. This is supported by a number of indications as follows:
Loan crisis countries of Latin America were speculative disrupt the smooth flow of international money circulation.
Which is considered unfair competition among Japanese banks with banks of America and Europe in the International Money Market. Japanese banks lend very soft (low interest) because of the provisions of CAR in the country is very soft, which is between 2 to 3 percent.
Disruption of international lending situation which result in disruption of international trade.
Based on the indications mentioned above, the BIS establishes protection provisions of the Capital Adequacy Ratio (CAR) to be followed by banks worldwide as a rule in a fair competition in the global financial markets, the ratio of minimum 8% capital against risky assets (Muchdarsyah, 1994).
Internal Factor
Internal factors affecting capital adequacy in this study uses several financial ratios and size of the bank.
Financial Ratios
Financial ratio analysis as a measurement of financial performance in the financial statements could be used as a basis for predicting the financial condition, business operations, earnings and dividends in the future. Financial ratio analysis combines the financial relationship between the components of the other financial components. In general, the relationship is seen from the ratio between the financial components with one another. Ratio analysis is also useful to compare the company’s performance with each other or compare the performance of the company this year with another year
The ratio of accounting / financial ratios to minimize differences in the size of the bank and make them in average (Samad, 2004). The use of accounting ratios common in the literature (Samad and Hassan, 2000; Samad, 2004). Financial ratios have 13 financial ratios and can be grouped into four broad categories, namely the profitability ratios, liquidity ratios, the ratio of risk and solvency and efficiency ratios.
Mahmud and Halim (2003), Hanafi (2003) measure of performance includes the following ratios:
Liquidity ratio measures the ability of the company’s short-term liquidity to see the company’s current assets relative to current debt (debt in this case is the obligation of the company) that serves to determine the company’s ability to meet its short term obligations or the company’s ability to meet its financial obligations at the time billed. Normally the ratio used is the current ratio, cash ratio and net working capital to total assets ratio.
Solvency Ratio / Leverage ratios measure the extent the company meets its long-term obligations. Companies that are not solvable is a company whose total debt is greater dibadingkan total assets. Ratios include debt to total assets ratio, total debt to total capital assets ratio, total debt to equity ratio, long-term debt to equity ratio, etc.
Profitability ratios measure a company’s ability to generate profit/ loss on the level of sales, assets and certain share capital at a certain period. Some frequently used ratio is the gross profit margin, net profit margin, return on total equity, and so on.
Size Bank
Company size is an idea of the size of the companies that appear in the value of total assets at year-end balance sheet. In terms of obtaining funds, large companies have the flexibility and ability to obtain funding because of the easier access to capital markets.
Measurements size companies conducted by the natural logarithm that transforms heteroscedaticity namely to reduce the presence of enlarged variance or spread on each error that will produce biased estimated coefficients (Gujarati, 1995). The formula company size is as follows:
Firm size = The Natural Logarithm of Total Asset (LnTA)
Titman and Wessels (1988) suggested that the relatively large companies are generally more diversified as it can optimize the use of debt ratio targets, so it is not easy for bankruptcy. Therefore, large companies tend to use higher debt. This is consistent with the theory that trade off the higher rate of profit, the company will ramp to obtain greater profits by reducing taxes and when debt levels are too high, it will be reduced to the optimum targets.
The argument is different from Myer and Majluf (1984), that the size of the company-related negative leverage due to asymmetric information between the internal and external parties that tend to be larger on the smaller company than in large companies, in other words big companies are more transparent and more accessible to the parties so companies tend to fund external financial sources sensitive internal information, which will use equity through the capital market, thus inversely proportional to the size of the company’s corporate leverage. This argument is consistent with the theory of pecking order that obtaining external funds by issuing shares when they cost less than the issuing of debt due to the small degree of asymmetric information, and in this regard large companies are generally more transparent. In contrast to small companies with a large degree of asymmetry would choose a debt due to its lower cost rather than issuing shares.
External Factor
Macro-economic linkages with the business / businesses be interesting to be explored, especially banking financial sector. Monetary policy (and abroad) affect economic activity in the banking financial sector, such as open market operations, the establishment of statutory reserves, the determination of interest rates.
Relations macroeconomic (monetary) and micro, is not a new thing in the world. However, it becomes interesting when studying the implications of the macro sector into the base or foundation of building resilience micro enterprises / businesses. Global economic uncertainty and increasingly demanding national micro sector (bank) must be prepared as such to strongly build the foundation of business.
Banking financial sector has basically been set as an indicator for the security of a financial institution bank and non-bank, that is facing the uncertainty of the macro sector (monetary). Indonesia’s role in the supervision of financial institutions and non-bank banks conducted by the Financial Services Authority (FSA). Prudential regulations set by the FSA include twenty provisions, some of which are core capital of commercial banks, the capital adequacy ratio, net foreign exchange position, lending limits, asset quality, allowance for uncollectible assets, restructuring of credit, restructuring financing for Islamic banks and UUS, statutory reserves, the transparency of the financial condition of the bank, bank product information transparency and use of personal data, and more. Meanwhile, the provisions of the rating of the bank by the FSA, including the risk profile (risk profile), good corporate governance (GCG), profitability (earnings) and capital (capital).
The ability of banks to maintain the soundness of the business / her business cannot be separated from management capabilities that has set the level of risk faced. The fourth factor which the provision of health assessment has covered various components that must be maintained and enhanced by the bank. Bank performance (ROA, NPL, ROE, etc.) who either need the support of macro policies to maintain the stability of the banking financial sector. Thus, synchronization between macro policies (monetary) to the micro sector (bank) becomes the main thing in maintaining the health of the banks to face global economic fluctuations which occur in the last decade.
Said (2012) conducted a study on how the application of the system of Islamic banking ranging from the establishment of the beginning of the establishment of the Dubai Islamic Bank in the United Arab Emirates, then continues in Jidda, Saudi Arabia, Egypt, Sudan, Kuwait, Bahrain and other countries. Likewise to be stated that this study is relevant to put forward a study conducted in Indonesia are carried out by Umar, Majid and Rulindo during 2002 to 2004 at 21 private banks with DEA method. With a sample consisting of two Islamic banks and conventional banks remaining. Here in the can that Islamic banks to operate above the average cost and profit efficiency compared to conventional banks.
Likewise research done by Saifullah, on 2004-2008 found that Islamic banks are better in business development, profitability, liquidity and solvency compared with conventional banks. This was stated in the Journal of Literature Review, that on variety of studies both conventional banks and Islamic banks is mainly related to the bank’s financial performance, especially in terms of efficiency between Islamic banks, including a variety of discourse, controversy and inconsistency of various studies.
The research to wanted to see what factors are affecting the Capital Adequacy Ratio, some of them with through the analysis of Financial Ratio, Size banks and of macroeconomic factors.
Dreca (2013) discusses the CAR affected by the capital structure, the size of the bank, an indicator of profitability, participation of deposits and loans on total assets and leverage. Results of the research that Size, DEP, LOA, ROA, ROE and LEV has significant influence, while LLR and NIM does not have a significant impact on CAR.
Bohari, Ali and Sultan (2012), conducted a study on the banking sector in Pakistan. Results of the study found that Average Capital Ratio, capital requirements and portfolio risk ratio showed a weak correlation, while the share of deposits, and ROE has shown strong but negative correlation.
This follows previous studies of the use of studies, models and variables that support this research, can be broken down as follows:
3. Variable and Hypotheses
3.1. Return on Asset (ROA) on Capital Adequacy Ratio (CAR)
The profitability ratio describes the ability of a company to make a profit with a given amount of capital (Melissa, 2012). The profitability ratio in this study was measured using financial ratios, including ROA, ROA and NIM. Polat and Al-khalaf (2014) describes factors that affect the Bank’s CAR in Turkey 2006-2010, ie loan, ROA, leverage, NIM, deposits, and the liquidity and the Bank Size. Buyuk salvarcy and Abdioglu (2011) using ROA as a proxy for profitability, and stated that the tendency to increase the profitability of capital. Sundarajan and Errico (2002) held that the high NPF will reduce the quality of assets and the expected effect on capital adequacy in Islamic banks.
H1: Return on Assets (ROA) has significant effect on Capital Adequacy
3.2. Structure of Deposits (DEP) on Capital Adequacy Ratio (CAR)
Research on the link structure of the deposit to the capital adequacy has been done by Ismal (2011), as well as carried out by Sharpe (1977), Dowd (1999), as well as Harold (1999), which states the importance of deposits for capital adequacy.
H2: Structure of deposits (DEP) has significant effect onCapital Adequacy Ratio
3.3. Liquidity (FDR) on Capital Adequacy Ratio (CAR)
Bank said liquid if it has the ability to meet its obligations, it can repay all its depositors, and meet credit demand submitted. Liquidity ratio illustrates the company’s ability to meet its short term obligations (Melissa, 2012). Melissa (2012) was a component of liquidity ratios that include financial indicators such as loan-to-deposit ratio (LDR) / financing to total deposits (FDR).
H3: FDRhas significant effect on Capital Adequacy Ratio
3.4. Operational Efficiency (OEOI) on Capital Adequacy Ratio (CAR)
Operating efficiency of research has been done by Sahajwala and Bergh (2000) and Sarker (2006). Stating that OEOI / Operating expense on operating income can be used as an indicator to evaluate the quality of bank management, particularly in operational efficiency.
H4: Operational Efficiency / OEOI has significant effect on Capital Adequacy Ratio
3.5. Leverage (LEV) on Capital Adequacy Ratio (CAR)
Leverage is the ratio of equity to liabilities in a company. The magnitude of the leverage ratio of the company describes the level of liabilities to equity gets smaller.
Büyükşalvarcı and Abdioğlu in Polat and Al-khalaf (2014) found that leverage negatively affecting the CAR. This is in contrast with Ho and Hsu (2010) analyzed the relationship between leverage, performance and CAR in Taiwan during the study period 2001-2006, indicates that company size, leverage, and financial costs positively affects the performance of the company. Polat and Al-khalaf (2014) in his study of a number of banks in Saudi Arabia, suggesting that leverage positive effect on the bank’s CAR.
H5: Leverage (LEV) has significant effect onCapital Adequacy Ratio
3.6. Bank Size (SIZE) on Capital Adequacy Ratio (CAR)
Al-Sabbagh in Polat and Al-khalaf (2014), as well as research Goddard (2000) in European banks, and Smirlock (2001) in Liu and Wilson, 2010, stating the effect of bank size on CAR
H6: Bank size (SIZE) has significant effect onCapital Adequacy Ratio
3.7. Inflation Rate (IR) on Capital Adequacy Ratio (CAR) Bank
Variables associated with the influence of external / macro-economics of the capital, William (2011) conducted a study in the banking industry in Nigeria, which are: inflation rate, exchange rate is a predictor of the CAR. Likewise, linking macroeconomic research conducted by JA &AdegbiteOjo (2010) and Newman L (2010).
H7: Inflation Rate has significant effect on Adequacy Ratio
Based on the framework above, the Proposed model of research
3.8. Proposed hypothesis
Based on the identification problem, research objectives and framework, the authors formulate the research related to the tests that will be carried out as follows:
H1 = rate of return on assets (ROA) has significant effect on capital adequacy ratio (CAR) of banks
H2 = Deposit Structure (DEP) has significant effect on(CAR) of banks
H3 = financing to total deposits (FDR) has significant effect on capital adequacy ratio (CAR) of banks
H4 = OEOI (ratio of operating expenses to operating income) has significant effect oncapital adequacy ratio (CAR) of banks
H5 = leverage (LEV) has significant effect oncapital adequacy ratio (CAR) of banks
H6 = Size Bank (SIZE) has significant effect oncapital adequacy ratio (CAR) of banks
H7 = inflation rate (IR) has significant effect oncapital adequacy ratio (CAR) of banks
4. Conclusion
The purpose of this conceptual paper is to investigate the factors that influence the CAR/ Capital Adequacy Ratio, both factors internal, and external micro and what factors are the most dominant influence. Thus it will be utilized for the banking industry and regulators in making decisions.
This type of research is verification, which aims to determine the relationship between variables through a hypothesis testing and other research method which aims to clarify the relationship variables.
Object of this research is the capital adequacy of Islamic banking in Indonesia, which is influenced by internal factors (ROA, DEP, FDR, OEOI, LEV, Size Bank) as well as external factors (IR). Then study the test empris detection accuracy and validation of the model is formed.
In this study the researcher have not entered some other external factor. The factor that affect Capital Adequacy Ratio/CAR, such as Interest Rate, Demand Deposit, Money Supply, and other external factors.