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Interdisciplinary Journal of Research in Business Vol. 1, Issue. 6, June 2011(pp.

50-57)

Risk Management Practices and Islamic Banks: An Empirical


Investigation from Pakistan
Naveed Ahmed
Hailey College of Commerce, University of the Punjab, Lahore, Pakistan
E-mail: naveed_hailey@ yahoo.com

Muhammad Farhan Akhtar


Hailey College of Commerce, University of the Punjab, Lahore, Pakistan
E-mail: vjfarhan@ yahoo.com

Muhammad Usman
Hailey College of Commerce, University of the Punjab, Lahore, Pakistan
E-mail: Usmanhc@ hotmail.com

ABSTRACT

This study aims to determine the firm’s level factors which have significantly influence the risk management
practices of Islamic banks in Pakistan. For this purpose, the current study selects credit, operational and
liquidity risks as dependent variables while size, leverage, N PLs ratio, capital adequacy and asset management
are utilize as explanatory variable for the period of four years from 2006 to 2009. The results indicate that size
of Islamic banks have a positive and statistically significant relationship with financial risks (credit and liquidity
risk), whereas its relation with operational risk is found to be negative and insignificant. The asset management
establishes a positive and significant relationship with liquidity and operational risk. The debt equity ratio and
N PLs ratio have a negative and significant relationship with liquidity and operational risk. In addition, capital
adequacy has negative and significant relationship with credit and operational risk, whereas it is found to be
positive and with liquidity risk.

Keywords: Risk Management, Liquidity Risk, Credit Risk, Operational Risk, Islamic Banks of Pakistan

1.0 INT RODUCTION

In order to appraise and weigh up the soundness and reliability of banking industry, the information on
connection between fluctuations in banking industry and the risk which is faced by banking sector is important.
Appalling financial conditions can deteriorate the value of the bank’s portfolio, engendering liquidity and credit
losses, which ultimately reduce profits of the banks. Therefore, a sound and reliable banking system dishes up as
a significant feed for accomplishing economic growth all the way through the mobilization of monetary
resources, placing them to dynamic use and transforming various risks.

Under the international and open economic state, the job to construct an accurate and suitable risk management
turn out to be very crucial and demanding, inconspicuously for Islamic banks as new thread in the banking
industry of Pakistan. Al-Jarhi&Iqbal (2001) stated that Islamic bank as a banking organization demeanor all
acknowledged banking activities together with borrowing and lending without interest. Hull (2002) studied that
the banking business practiced rigid rivalry with banks and with financial institutions to catch the attention of
probable customers. Mounira(2008) found financial institutions based on Islamic Shariah principles area of
modern academic and of policy significance. It is also accounted that due to the superior levels of customer
satisfaction and enhanced service quality, Islamic banking is more attractive and pleasing than conventional
banking (Ahmad, Rehman & Saif, 2010).Particularly, Islamic banks with their exclusive values and operations
precisely recognized the deposit characteristics, their investment pattern and prospect to successfully administer
their liquidity (Ismal, 2010).

To facilitate a significant number of stakeholders, Islamic banks execute numerous functions. This incorporates
the pool of funds through the recognition of deposits. These funds are therefore forwarded to entrepreneurs or
firms for dynamic and fruitful ventures to breed profits. In addition Islamic banks offers interest free products to
dish up the diverse economy segments in compliance with Shariah principles. Moreover the Islamic bank is to
endorse and encourage trade behavior as a dynamic interaction of the economy.

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The importance to investigate the risks that are faced by the Islamic banks of Pakistan could be best justified by
the fact that in Pakistan the Islamic banks are engaged in significant roles to complementing the services as
parallel to the conventional banks. Islamic banking has established its success to participate with the profound
entrenched conventional banking system in Pakistan (Ahmad, Humayoun, & Hassan, 2010).Islamic banks of
Pakistan show a significant growth from the last many years. past many significant growth has been reported by
the Islamic banks According to the State Bank of Pakistan, total assets of Islamic banks reach to Rs, 424 billion
at the opening of last quarter of 2010 while 31% yearly growth has been observed for Islamic banks of Pakistan.
Similarly at the end of the quarter, deposits and financing & investments advanced by 3 8.2% and 17.7%
respectively and attain to Rs.338 billion and Rs.233 billion. In addition, the overall share of Islamic banking
industry in the country’s banking system also improved to 6.4% at the end of quarter 1.

In view of the fact that, the business of Islamic banking has numerous idiosyncratic characteristics, the
temperament and extent of risk confronting such organizations may be considerably different due to the concept
of profit-sharing approach in Islamic banks. There have been a fairly small number of academic studies
available on Islamic banks about risk management, however, this study creates uniqueness with the extent of
influence involved. The paper is ordered as follows. Section 2 reports literature review. Section 3 focuses on
methodology and data collection. Section 4 indicates the empirical findings. Section 5 wraps up with the
conclusion.

HYPOTHESIS

The study aimed to testing the following hypothesis:

H 0: There is no relationship of firm’s level characteristics with credit risk, liquidity risk and operational risk.
H 1: There is a relationship between size of the banks and credit risk
H 2: There is a relationship between non-performing loans with credit risk
H 3: There is a relationship between capital adequacy ratio (CAR) and credit risk
H 4: There is a relationship between debt to equity ratio and the credit risk
H 5: There is a relationship between asset management and the credit risk
H 6: There is a relationship between size of the banks and liquidity risk
H 7: There is a relationship between non-performing loans with liquidity risk
H 8: There is a relationship between capital adequacy ratio (CAR) and liquidity risk
H 9: There is a relationship between debt to equity ratio and the liquidity risk faced by the banks
H 10: There is a relationship between asset management and the liquidity risk for banks
H 11: There is a relationship between size of the banks and operational risk
H 12: There is a relationship between non-performing loans with operational risk
H 13: There is a relationship between capital adequacy ratio (CAR) and operational risk
H 14: There is relationship between debt to equity ratio and the operational risk faced by the banks
H 15: There is a relationship between asset management and the operational risk for banks

2.0 LITERATURE REVIEW

2.1 Liquidity Risk

Kim and Santomero (1988) examined the responsibility of bank capital regulation in controlling solvency risk.
By employing mean-variance model, they found capital ratios unproductive way to restrict bank’s insolvency
risk (Bauer &Ryser, 2004) regulatory restrictions, debt ratio, volatility of risky assets, size of liquidation costs
and spread between deposit rate and riskless interest rate are the significant constraints that compel bank’s
hedging decisions. Siddiqui (2008) found that Islamic banks in Pakistan were more liable towards considering
projects with long-term financing and better performance in terms of assets and return established improved risk
management with keeping safe liquidity. Sensarma and Jayadev (2009) investigated the risk management of
public and domestic private banks of India for the period 1998 to 2006. They found an enhancement on risk
management aptitude of the banks. Akhtar et al., (2011) established better performance in elements of assets and
return which recognized that conventional banks had improved liquidity risk management than Islamic banks in
Pakistan.

1
Source: Islamic Banking Bulleting, September 2010, 5 (3) - State bank of Pakistan (data for which is based on
Unaudited Quarterly Accounts *number includes sub-branches)

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Interdisciplinary Journal of Research in Business Vol. 1, Issue. 6, June 2011(pp.50-57)

2.2Credit Risk

Wilson, Summers and Hope (2000) stated that the inclusion of non-financial data and prototype of payment
behavior in business failure can improve the certainty to manage credit in moreappropriate manner. Barnhill,
Papapanagiotou, & Schumacher (2002) found credit value of portfolio of a bank’s the most important risk
factor. Peter & Peter (2006) reported statistically momentous impact of loan-to-value ratio and negative equity
risk as drivers of default credit risk. Fatemi and Fooladi (2006) stated the solitary most vital fundamental
principle of credit risk models it to be acquainted with default risk of counterparty. Hassan (2009) persuaded
risk identification and risk assessment & analysis were fairly competent in risk management practices. Mounira
(2008) established Islamic banks to be riskier that conventional banks, and argued to strengthen and support risk
management practices for Islamic banks as they have less risk hedging gears accessible in the market.

2.3 Operational Risk


Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009) argued that Islamic banks of UAE and Brunei
Darussalam faced the credit and operational risk more severely than other types of risks. Ray and Cashman
(1999) reported that operational risk influence decision making in numerous ways. Blacker (2000) stated how
mitigation of operational risk is being detained by British retail banks and found responsibility for operation risk
lies with business unit management. Allen and Bali (2007) found significant affect of business cyclical factors in
measuring operational risk, while studying the affect of operational risk management on profitability of banks
through risk adjusted return on capital (RAROC) Chapelle et al. (2008) found that far-reaching funds can be
conquered through energetic risk management techniques. In addition, the inclusion of innovative products in
the financial businesses found to have huge cross-correlation with increasing operational risk (Philippas &
Siriopoulos, 2009).

3.0 RESEARCH METHODOLOGY

To highlight the firms level factors which significantly influencing the risk management practices of the Islamic
banks of Pakistan, this study utilizes the financial data of Islamic banks of Pakistan from the period of 2006 to
2009. Various sources like State Bank of Pakistan, Karachi stock Exchange and websites of Islamic banks have
been used for the collection of data. The list of Islamic banks which are included in this study is reported in
appendix I.

3.1 Research Models

Model (A)
Credit Risk = α + X1β1 + X2β2 + X3β3 + X4β4 + X5β5 + ε
Model (B)
Liquidity Risk = α + X1β1 + X2β2 + X3β3 + X4β4 + X5β5 + ε
Model (C)
Operational Risk = α + X1β1 + X2β2 + X3β3 + X4β4 + X5β5 + ε

Table 3.1 goes here

4.0 STATISTICAL RESULTS

4.1 Descriptive Statistics


Descriptive statistics containing values of means and standard deviation are reported in Table 5.1. The variables
Credit risk, liquidity risk and operational risk are dependent variables, while the rest of them are independent
variables.
Table 4.1 goes here

4.2 Pearson Correlation Coefficients

In addition, the values of Pearson Correlation Coefficients are reported in Table 5.2 indicates that the problem of
multicolinearity does non-exist.

Table 4.2 goes here

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Interdisciplinary Journal of Research in Business Vol. 1, Issue. 6, June 2011(pp.50-57)

4.2.0 Regression Results

Table 4.3, 4.4 and 4.5 reports the regression results of model (A), (B) and (C). Model (A) uses credit risk as
dependent variable while liquidity and operational risks are used as dependent variables in Model (B) and
Model (C) respectively. The value of Prob. F-statistic in all three models is 0.000 which represents that the
models are good fitted.

4.2.1 Credit Risk

The credit risk is a big threat for banks as the value of any organization measures by its credit worthiness. In
model (A), as reported in table 4.3, the value of adjusted R-square represents that almost 86% change in the
dependent variable can be observed with the variables under study while the rest of 14% is due to those factors
that are not included in this study. In regression results, the credit risk is found to be a highly affected by all
explanatory variables. The size of the bank and debt equity ratio, capital adequacy found to have a positive and
statistically significant relationship with credit risk at 5%, 1% and 5% level respectively. Thus, this study
accepts H 1, H 3 and H 4.The NPLs ratio found to be an insignificant relationship with credit risk. The regression
results reports a relation but this relation is statistically insignificant, so H 2 is rejected. While the asset
management established the negative but significant relationship with credit risk at 5% level, therefore H 5is
accepted.
Table 4.3 goes here

4.2.2 Liquidity Risk

In model (B), as reported in table 4.4 the value of adjusted R-square shows that about 65% change in liquidity
risk can be observed with the explanatory variables under this study. The relationship of debt equity ratio and
capital adequacy ratio is found to have significant and negative relationship with liquidity risk at 1% and 10%
level respectively. The better size of bank indicates that the banks have the better ability to establish big market
share and generate higher profits. In this model, size of the bank is found to have a positive and significant
relationship with liquidity risk at 1% level. The asset utilization ratio established the positive and significant
relationship with liquidity risk at 5% significance level. The relationship of NPLs ratio with liquidity risk is
negative and statistically insignificant. According to regression results, the study accepts H 6, H 8, H 9 and H 10,
however H 7 is rejected as the relation of non-performing loans with the liquidity risk is statistically insignificant.

Table 4.4 goes here

4.2.3 Operational Risk

Regression results for Model (C) are reported in table 4.5. The value of adjusted R-square is 0.59 which shows
that almost 59% change in operation risk can be attributed to the independent variables under this study. The
results indicate that asset management positively an significantly associated with operational risk while NPLs
the relationship between the operational risk and NPLs ratio is found to be a negative. On the other hand, size of
the bank, debt equity ratio, and capital adequacy ratio found to be insignificantly affecting the operational risk of
Islamic banks. Consequently the study accepts, H 12, H 15 and rejects H 11, H 13, H 14.

Table 4.5 goes here

5.0 CONCLUSION AND POLICY RECOM M ENDATIONS

The study aimed to investigate the firm’s level factors which significantly influencing the risk management
practices in Islamic banks of Pakistan for the period 2006-2009. This study has employed credit, liquidity and
operational risk as dependent variables to evaluate the risk management practices of Islamic banks in Pakistan.
Empirical results reported that the size of bank has positive and significant relationship with financial risks
(credit and liquidity risk), whereas its relation with operational risk is found to be negative and statistically
insignificant. The asset management establishes a positive relationship with liquidity and operational risk, The
debt equity ratio and NPLs ratio has a negative and significant relationship with liquidity and operational risk
while they have positive relationship with credit risk. The capital adequacy has a negative and significant
relationship with credit and operational risk, whereas it is found to be positive and significantly affected to
liquidity risk. The core purpose of this study is to provide the guidelines to Islamic banking industry of Pakistan
that how the management of the Islamic banks can manage the credit, operational and liquidity risks. In

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addition, this study elaborates that which types of determinants significantly affect the risk management
practices of Islamic banks of Pakistan, therefore, helpful to the management of Islamic banks while making
decisions.

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Table 3.1: Variable and their proxies


Variables Proxies
Credit Risk Ratio of Total Debt to Total Assets
Liquidity Risk Capital to Total Assets
Operational Risk Return on Total Assets
Explanatory Variables
Bank's Size Logarithm of Total Assets
NPLs Ratio Non-Performing Loans/Total Loans
Capital Adequacy Tier 1 Capital + Tier 2 Capital / Risk Weighted Assets
Debt to equity ratio Total company debt/equity
Asset Management Asset Utilization Ratio = Operating Income/Total Assets

Table 4.1: Descriptive Statistics


Variables Mean Std. Deviation
Credit Risk 0.68185387 0.296570781
Liquidity Risk 0.2348 1428 0.22 1547555
Operational Risk 0-0.002339 0.021069202
Size of the Bank 6.6992435 2.098607 193
Debt Equity Ratio 4.9817105 4.120783831
Asset Management 0.00089330 0.01435795 1
NPLs Ratio 0.01916096 0.024063000
Capital Adequacy Ratio 0.24243750 0.178561220

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Table 4.2: Pearson Correlation Coefficient


Size of the Debt Equity Asset NPLs Capital
Bank Ratio Management Ratio Adequacy
Size of the Bank 1 .515 ** .110 ** .289 .322
Debt Equity Ratio 1 .598 .309 -.425 **
Asset Management 1 -.1 14 ** -.388 **
NPLs Ratio 1 .046
Capital Adequacy 1
*. Correlation is significant at the 0.05 level (2 -tailed).**. Correlation is significant at the 0.01 level
(2-tailed).
Table 4.3: Coefficients a for Model (A)

Unstandardized Standardized
Model Coefficients Coefficients
B Std. Error Beta t Sig.
1 (Constant) -.017 .078 -.215 .832
Size of the Bank .042 .018 .296 2.267 .036
Debt Equity Ratio .065 .012 .900 5.402 .000
Asset Management -5.541 2.263 -.268 -2.448 .025
NPLs Ratio -.343 1.114 -.028 -.308 .762
Capital Adequacy .441 .202 .266 2.182 .043

R-squared 0.890 F-statistic 29.211


Adjusted R-squared 0.860 Prob (F-statistic) 0.000
Durbin-Watson stat 1.601
a. Dependent Variable: Credit Risk

Table 4.4: Coefficients a for Model (B)

Unstandardized Standardized
Model Coefficients Coefficients
B Std. Error Beta t Sig.
1 (Constant) .025 .092 .269 .791
Size of the Bank .105 .022 .995 4.856 .000

Debt Equity Ratio -.079 .014 -1.464 -5.600 .000


Asset Management 5.835 2.653 .378 2.200 .041
NPLs Ratio .279 1.305 .030 .213 .833
Capital Adequacy -.463 .237 -.373 -1.954 .066

R-squared 0.730
F-statistic 9.729
Adjusted R-squared 0.655 Prob (F-statistic) 0.000
Durbin-Watson stat 1.592
a. Dependent Variable: Liquidity Risk

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Table 4.5: Coefficientsa for Model (C)

Unstandardized Standardized
Model Coefficients Coefficients
B Std. Error Beta t Sig.
1 (Constant) .002 .009 .222 .827
Size of the Bank -.003 .002 -.251 -1.126 .275
Debt Equity Ratio .001 .001 .286 1.006 .328
Asset Management 1.027 .274 .700 3.741 .001
NPLs Ratio -.266 .135 -.304 -1.970 .064
Capital Adequacy .039 .025 .327 1.573 .133

R-squared 0.680
F-statistic 7.658
Adjusted R-squared 0.59 1 Prob (F-statistic) 0.000
Durbin-Watson stat 2.339
a. Dependent Variable: Operational Risk

APPENDIX

List of Banks included in this study


Sr. No. Islamic Banks
1 Bank-Islami Pakistan Limited
2 Dawood Islamic Bank Limited
3 Dubai Islamic Bank Pakistan Limited
4 Al-Baraka Bank (Pakistan) Limited
5 Meezan Bank Limited
6 Emirates Islamic Bank

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