Regulatory capital funds and risk-sharing behavior in distressed financial conditions

Abstract

Purpose This paper aims to investigate the adequacy of regulatory capital funds through loss provisioning policies because of worsening credit quality associated with distressed financial conditions. A financial distress occurs when banks have difficulty in honoring financial commitments. This paper is expected to unveil how the provisioning mechanisms can address concerns associated with pro cyclicality of regulatory capital funds requirements, and how the banks behave in distressed financial conditions to share risks. The pro cyclicality of regulatory capital funds is the effect of various components of the financial system that aggravates the economic cycle such as during the expansion of the economy when banks are able to provide more loans and meet regulatory capital requirements with ease, while during the contraction of the economic cycle, can lead to deterioration of asset quality, and the resultant need to make loss provisions and recognize impairment. In turn, the situation puts further pressures on the capital requirements held by banks and their risk-sharing behavior. The paper analyzes a sample of Islamic banks in Malaysia. Design/methodology/approach By estimating credit risk-related information through loss provisioning policies, the paper uses an unbalanced panel data on all Islamic banks in the Association of Islamic Banking Institutions Malaysia from 2003 to 2014. The association consists of full-fledged Islamic banks and several foreign-owned entities. Findings The paper findings support that Islamic banks during observed period of distressed financial conditions were less discouraged to increase their regulatory capital funds to share risks. Intuitively, they were more encouraged to engage in risk-shifting behavior. Also, the risk-shifting behavior was found to have a significantly high potential in foreign-owned Islamic banks than in domestic Islamic banks. Research limitations/implications Although the study is based on a sample of Islamic banks in Malaysia, the findings suggest targeted interventions aimed at discouraging risk shifting or transfer of risks in an interest-free Islamic financing. Practical implications The outcome of this paper has practical implications for Islamic banks to build a buffer of capital funds to face downward pressures during heightened financial uncertainties while serving as protection to depositors. Moreover, this study has practical implications for shareholders to avail themselves the benefits of high investment accounts financing. The Islamic banks can continue to play their role in promoting inclusive growth, reducing inequality and accelerating poverty reduction. Social implications Although the current study is based on a sample of Islamic banks in Malaysia, the finding suggests that the extent of risk shifting was significantly more incentivized among the foreign-owned rather than the domestic Islamic banks. This information can be used to develop targeted interventions aimed at discouraging risk shifting or transfer of risks in an interest-free Islamic financing. Originality/value This paper is the first that investigates on adequacy of regulatory capital funds of Islamic banks through loss provisioning policies.

Bank loan loss provisions research: A review of the empirical literature

“…", The question has been addressed by several studies related to management behavior. To answer the second question, several studies use different samples, and examine the relationship of several topics such as smoothing income, capital management, signaling towards LLP (Anandarajan, Hasan & Lozano-vivas, (2003); Ahmed, Takeda & Thomas, 1999;Taktak, Zouari., & Boudriga, 2010;Sood, 2012;Bushman & Williams, 2012;Othman & Mersni, 2014;Bryce et al, 2015;Cummings & Durrani, 2016;Ozili & Outa, 2017;Abuserdaneh, 2018;Pinto & Picoto, 2018;Isa & Rashid, 2018;Jin et al, 2018;Aristei & Gallo, 2019). Beatty & Liao, (2014) also asked questions about how to prove the use of LLP as a means of income smoothing and capital management activity tools, so far we have only found studies that examine income smoothing and the relationship of capital management and LLP using regression analysis.…”

“…This study concludes that there is an impact of the financial crisis in several European countries using fuzzy-set qualitative analysis (fsQCA) there are indications of reducing earnings management and capital management practices. Some research articles state that banks use LLP as a tool to carry out long-term income management (Anandarajan, Hasan, & Lozanovivas, 2003;Laeven & Majnoni, 2003;Taktak, Zouari., & Boudriga, 2010;Taktak, 2011;Othman & Mersni, 2014;Shawtari et al, 2015;Wijayanti & Diyanty, 2017;Curcio, Simone, & Gallo, 2017;Abu-serdaneh, 2018;Isa & Rashid, 2018;Ozili & Outa, 2018) On the other hand there is research which states that bank managers do not use LLP as a tool to practice earnings management (Ahmed, Takeda & Thomas, 1999;Leventis, Dimitropoulos, & Anandarajan, 2013;Adzis, Tripe, & Dunmore, 2016)…”

“…Comparative research in the Middle East countries in the period 2000-2008 also states that Islamic banks use LLP for earnings management and capital management, there is no significant difference between Islamic banking and conventional banking in manipulating financial statements and external funding is also stated as one of the determinants of LLP formation (Othman & Mersni, 2014). Isa & Rashid (2018) conducts research on Islamic banks in Malaysia related to regulations governing capital and risk. The results of the research are regulators are advised to improve specifications in regulations, for example in regulation of capital and risk.…”

“…Companies that provide positive signals can attract investors and outsiders to invest in companies (Fitriana & Arfianto, 2015). Management tends to increase LLP to show that bank finance is strong enough to face future losses (Isa & Rashid, 2018). research Abuserdaneh (2018) shows significant evidence that LLP is used by managers to signal positive changes in future income.…”

“…There are several articles that focus on income smoothing and LLP in banking industry (Taktak, Zouari., & Boudriga, 2010;Taktak & Taktak, 2011;Leventis, Dimitropoulos, & Anandarajan, 2013;Beatty & Liao, 2014;Adzis, Tripe, & Dunmore, 2016;Cummings & Durrani, 2016;Wijayanti & Diyanty, 2017;Ozili & Outa, 2018;Pinto & Picoto, 2018;Isa & Rashid et al, 2018), another topic focus on signaling activities and LLP examine by (Sood, 2012;Othman & Mersni, 2014;Fitriana & Arfianto, 2015;Abuserdaneh, 2018;Ozili & Outa, 2018;Isa & Rashid, 2018).…”