Determinants of Credit Risk in Malaysian Islamic Banks

Abstract

Abstract: Credit risk is the oldest form of risk in the financial markets and has been receiving great attention mainly in the banking institutions. Credit risk continues to be the leading source of problems in banking institutions all over the world. It is the largest source of risk for banking institutions in Malaysia due to the fact that a banking institution's financing portfolio is typically the largest asset and the major source of revenue. Financing default will cause cash flow problems and affect banks liquidity, which then reduce the banks profitability. Therefore, credit risk mitigation and management is very crucial. It is assumed that the more rigorous risk mitigation and management attached in banks management, the lower the credit risk, hence the higher profit received by banks. The aim of this study is to examine determinants of credit risk in Malaysian Islamic banks. The study makes use of panel least squares and generalised least squares regression methods based on an unbalanced panel data of 96 observations from 15 Islamic banks for the period of 1999 to 2007. Twelve variables representing internal determinants are tested empirically using panel data estimation. This study reveals that financing extended to risky sectors, ratio of debt over asset, leverage, financing and bank size determine credit risk significantly in Malaysian Islamic banks. Possible implications are addressed based on the findings to enhance risk management culture in Islamic banking institutions.