The relationship between capital structure and performance of Islamic banks
Purpose – This paper aims to examine the effect of capital structure on Islamic banks’ (IBs) performance to provide guidance to finance managers for raising capital funds. As newcomers to the markets, IBs are facing a trade-off. They can either use high capital ratios which increase the soundness...
| Main Authors: | , , |
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| Format: | Article |
| Language: | English English |
| Published: |
Emerald Group Publishing Limited
2014
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| Subjects: | |
| Online Access: | http://irep.iium.edu.my/41324/ http://irep.iium.edu.my/41324/ http://irep.iium.edu.my/41324/ http://irep.iium.edu.my/41324/1/JIABR-04-2012-0024.pdf http://irep.iium.edu.my/41324/4/41324-The%20relationship%20between%20capital_SCOPUS.pdf |
| Summary: | Purpose – This paper aims to examine the effect of capital structure on Islamic banks’ (IBs)
performance to provide guidance to finance managers for raising capital funds. As newcomers to the
markets, IBs are facing a trade-off. They can either use high capital ratios which increase the soundness
and safety of the bank and lower the required return by investors, or depend on deposits and Islamic
bonds which are considered cheaper sources of funds due to their tax rebate. An IB’s management must
carefully decide the appropriate mix of debt and equity, i.e. capital structure, to maximize the value of
the bank.
Design/methodology/approach – Using a sample of 85 IBs covering banking systems in 19
countries, the study uses a two-stage least squares method to examine the performance determinants of
IBs to control the reverse causality from performance to capital structure.
Findings – After control of the macroeconomic environment, financial market structure and taxation,
results indicate that IBs’ performance (profitability) responds positively to an increase in equity (capital
ratio). The result is consistent with the signaling theory which predicts that banks expected to have
better performance credibly transmit this information through higher capital. Optimal capital structure
results of the IBs found a non-monotonic U-shaped relationship between the capital-asset ratio and
profitability, supporting the efficiency risk and franchise value hypotheses.
Research limitations/implications – Due to limitations for market data, the study uses book
accounting ratios. Future research where market data are available could use performance measures,
such as Tobin’s Q in performance determinants models.
Practical implications – The non-monotonic relationship found between IBs’ return on equity and
capital ratios suggests that equity issuances for IBs’ with low capital ratios (lower than the turning point
of 37.41 per cent) are expensive and have a negative effect on their profitability. On the other hand,
managers of well-capitalized IBs (banks with capital ratios beyond 37.41 per cent) are advised to rely on
equity when faced by a decision to raise capital, as the capital ratio starts to affect their profitability
positively.
Originality/value – Islamic banking literature has been silent on IBs’ capital structure and its
relevance; this study will try to fill in the existent gap.
Keywords Performance, Capital structure, Islamic banks, Optimal capital structure |
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