1

The use of discretionary loan loss provision by

Islamic banks and conventional banks in the
Middle East region: A comparative study


Hakim Ben Othman*
EAA, AAA, AIA, AAAA, ASTCF, ATSG member
Matre de ConfrencesAgrgof Accounting & Finance at Tunis Business School (TBS)
Senior Research Associate at CGA Accounting Research Centre,
Telfer School of Management, Univ. of Ottawa
Senior Researcher at LIGUE, ISCAE, Manouba.
Address: TBS, El Mourouj 2074, TUNISIA
Phone: (216) 71.470.570 / 71.476.600 (Extension: 272)
Mobile : (216) 98.357.789
Fax: (216) 71.477.555
E-mail: hakim.bo@planet.tn
* Corresponding author

Hounaida Mersni
Contractual assistant in accounting at Tunis Business School (TBS)
PhD student in Accounting at ISCAE, Manouba
Member of LIGUE, ISCAE, Manouba.
Address: TBS, El Mourouj 2074, TUNISIA
Phone: (216) 71.470.570 (Extension:211)
Mobile : (216) 26.188.743
Fax.: (216) 71.477.555
E-mail: h.mersni@planet.tn

Abstract: The purpose of this research is to study earnings management practices of Islamic banks and
conventional banks in the Middle East region. This paper seeks first, to examine factors that may have
influenced Islamic banks managers use of discretion in reporting loan loss provision and then to find out if
there is any difference in theuse of the discretionary part of loan loss provisionbetween Islamic banks and
Conventional banks. Our empirical study is based on a sample of 21 Islamic banks, 18 conventional banks with
Islamic windows and 33 conventional banks, from 7 Middle East countries during a period that ranges from
2000 to 2008. Our empirical results reveal that Islamic banks do not use discretionary loan loss provision to
manage their earnings; conversely, they use this item only to manage their capital. Other findings show no
significant difference between Islamic banks, conventional banks which provide also Islamic services and
conventional banks, in the use of discretionary loan loss provision; all banks behave in the same way dealing
with DLLP.
Our study contributes tothe existing literature onIslamic banking; it extends prior research by focusing on the
use of the discretionary component of loan loss provision, unlike prior studies which evaluate the total loan loss
provision item.

Key words: Islamic banks, conventional banks, conventional banks with Islamic windows, earnings
management, discretionary loan loss provision





2
1.Introduction
A wide literature has addressed the issue of earnings management in the banking industry. It is shown
that banks around the world are found to manage their earnings and bank managers are motivated to minimize
the earning fluctuation over time. The existing literature provides evidence that loan loss provision is used by
banks as a tool for long-term earning management. Most existing studies have concentrated on conventional
banks. However, little attention has been focused on the earnings management by Islamic banks in the MENA
region.

Recent studies, such as Zoubi et Al-Khazali (2007), Taktak et al (2010a), addressed the issue of the use
of loan loss provision in Islamic banks. Theory gives contradictory predictions, Zoubi et Al-Khazali (2007)
argue that Islamic banks use loan loss provision to manage earnings while Taktak et al (2010a) defend the idea
that Islamic banks do not use loan loss provision to smooth their results. Although a few studies have provided
some evidence on the use of loan loss provision by Islamic banks, the discretionary component of this variable
remained unexplored. Following Kanagaretnamet al (2004) and Kwal et al (2009), in this study we isolate the
discretionary component of loan loss provision and we use it as our dependent variables. The purpose of this
paper is to examine factors that can influence the Islamic banks managers use of discretionary loan loss
provision. More precisely we try to determine first, whether managers use discretion to manage earnings and
capital ratio in Islamic banks. Then, we explore if there is any difference in the use of discretion between
Islamic banks and non-Islamic banks in the Middle East region.
Using a panel data of 21 Islamic banks, 18 conventional banks with Islamic windows and 33
conventional banks in 7 countries from the Middle East region: Bahrain, Egypt, Jordan, Kuwait, Qatar, Saudi
Arabia and UAE, we find that Islamic banks managers do not use their discretion to manage their earnings.
Indeed, we find that earnings before tax and provision ratio is not significant in our regression model. In
addition, results show a negative and significant relationship between capital adequacy ratio and discretionary
loan loss provision, suggesting that managers in Islamic banks use their discretion to manage their capital ratio
to enable banks to avoid violating minimum requirements. Other results reveal that Islamic banks and non-
Islamic banks behave in the same way dealing with DLLP. In effect, there is no difference in the use of DLLP
by managers between these banks.
Our study contributes to the earnings management literature in Islamic banking; it extends prior
researches by focusing on the use of the discretionary component of loan loss provision rather than the total
amount of this item. In the other hand, we seek to compare the use of discretion between Islamic institutions and
their non-Islamic counterparts. This research is the first one that distinguishes between conventional banks with
Islamic windows and conventional banks.
The remainder of the paper is organized as follows. Section 2 provides backgrounds for the study and
hypothesis development. Section 3 introduces the sample and describes our research design, while section 4
presents descriptive statistics and reports results for our analysis based on our discretionary loan loss provision
panel-regression model. The last section concludes the paper.

2. Backgrounds and hypothesis development
Prior studies indicate that in banking industry, managers have incentive to smooth earnings via the
most important accruals in the banking sector; loan loss provision for many objectives such as; earning
management (Greenawalt andSinkey, 1988; Beatty et al., 1995) and capital management (Moyer, 1990; Collins
et al.,1995; Kim and Kross, 1998). Most studies are generally interested to analyze such behavior in
conventional banks.The findings reveal some mixed evidence; a large body of empirical resultssuggests that
managers engage inearnings managementthrought loan loss provision (Ma (1988), Collins et al (1995),
Greenwalt and Sinkey (1988), Bhat (1996), Lobo and Yang (2001), Kanagaretnam et al (2004), Anandarajan et
al (2005), Anandarajan et al (2007), Kwal et al (2009), Pinho and Martins (2009), Taktak et al (2010b)).In the
same vein, Wetmore and Brick (2009) showed that bank managers take large loan loss provisions in a good
year so that extra reserves are available for bad years. Conversely, some papers found no relationship between
LLP and earning management (Wintmore and brick (1994), Beatty et al (1995), Ahmed et al (1998), Ismail el al
(2005)).Table 1 provides a summary of these studies.
As shown previously, recent years investigations have given rise to a vivid interest in empirical
research related to earnings management in conventional banks, however, studies related to Islamic banks are
limited and report mixed results. We start our evidence by looking to the paper of Ismail and Shahimi (2003)
that proved the use of loan loss provision by Islamic MlaysianBnaks for their earnings and capital management
during the period 1997 to 2001. Similarly, Zoubi and Al-Khazali (2007) studied 55 conventional banks and 10
Islamic banks in the Gulf cooperation council region (GCC) during the period 2000-2003. They outlined that
Islamic and conventional banks managers in the GCC region use total loan loss provision to smooth their
3
results; they asserted that both Islamic and conventional banks in the GCC region follow the same income
smoothing practices.Quttainah et al (2011) have interested on 11 countries from ERF region (Arab countries,
Iran and Turkey) during the period 1994-2008. They used loss avoidance and abnormal loan loss provision as
proxies for earnings management to compare earnings management behavior between Islamic and conventional
banks; they found that Islamic banks are less likely to conduct earnings management compared to their non
Islamic counterparts.
4

Studies that examined association between LLP and earnings management in conventional banks
Authors Results
Ma (1988) Focus on the income smoothing practices in US banks and using a panel of 900 observations for the period 1980-1984. Results prove that US
banks engaged in earnings management through provisioning policy

Greenwalt and Sinkey (1988) Use of a sample of 106 banks during the period 1976-1984. Results assert that US banks smooth their results using loan loss provision. Thus,
money-center banks are less likely to engage in income smoothing compared to regional banking companies in US.

Collins et al (1995) Consider the period 1971-1991.Findings exhibit that LLP is used as an instrument for earnings management, whilst loan charge-off and
securities insurances are used for capital management.

Bhat (1996) Examinesthe income smoothing hypothesis for a sample of the 148 banks during the period 1981-1991. Results reveal that US banks do not use
loan loss provision for earning management.

Lobo and Yang (2001) Use of a US banks sample during the 1981-1996 period, and analysis the use of discretionary loan loss provision. Results indicate strong
evidence for income smoothing, capital management and signaling.

Ismail and Belay (2002) Studyof 34 commercial banks in Malaysia across 1997-1999, and using a model of loan loss provisions which incorporates the sectorial effect
and the economic risk pertaining to those sectors. Results outlinethat conventional banks in Malaysia use loan loss provision to manage their
earnings.

Kanagaretnam et al (2004) Based on 22,640 year-observations over the period 1992 to 2001, findings provideevidence that US banks use discretionary loan loss provision
to reduce earnings volatility and to manage capital. Results also prove that bank managers decisions to reduce earning variability are related to
the need for external financing and to securities gains and losses.

Anandarajan et al (2005) Useof a panel of 970 observations of depository institutions in Spain during the period 19861995.Empirical results assert the use of loan loss
provision for capital and earnings management.

Anandarajan et al (2007) Use of a sample of 50 Australian commercial banks over the period 1991-2001.Results prove that Australian banks use loan loss provision for
capital and earnings management. However, there is no evidence on the use of LLP for signaling future intentions of higher earnings to
investors . Further, listed banks are more likely to engage in earnings management than unlisted commercial banks.

Kwal et al (2009) Based on a sample of 31 Japanese banks across the period 1996-1999, findings indicate that discretionary loan loss provision is used extensively
for earnings and capital management. In addition, results show that discretionary loan loss provisions are positively related to the demand for
external financing, realized securities gains and prior years taxes.

5

Pinho and Martins (2009)

Use of a sample of 35 financial institutions operating in Portugal from 1990 to the end of 2000. Findings indicate that Portuguese banksexhibit a
discretionary behavior in setting up their provisions. Evidence of income-smoothing and capital management is provided.

Taktak et al (2010b) Use of a sample of 278 commercial banks operating in OECD countries. Results highlight that a large number of banks engage in intentional
income smoothing either by using loan loss provisions or by selling traded securities.




Panel B: Studies that examined no association between LLP and earnings and capital management in conventional banks
Ismail el al (2005) Based on a sample of 21 Malaysian banks during the period 1996-2002, results indicate that banks in Malaysia do not use loan loss provision to
smooth income.

Wintmore and brick (1994) Considering 82 US banks across the period 1986-1990, results assess that, contrary to prior studies, there is no evidence of income
smoothingpractices; indeed, US banks do not use LLP for the earnings management purpose.

Beatty et al (1995) Consideringthe period 1987-1990 for a sample148 banks, findings prove that LLP is not used as an instrument to manage earnings in US banks.

Ahmed et al (1998) Results indicate no evidence of earning management through loan loss provision, it is demonstrated that LLP is used only for capital
management

6
In the same vein, Misman and Ahmad (2011) compared Islamic and conventional banks in Malaysia;
they proved that both Islamic and conventional banks use loan loss provision for their earnings and capital
management purpose. However, findings reveal significant differences between Malaysian Islamic and
conventional banks when managing their loan loss provision. Conversely, Taktak et al (2010a) provide contrary
evidence; using a sample of 66 Islamic banks in Muslim countries over the period 2001-2006, they sought to
detect income smoothing practices by Islamic banks and to examine the use of total loan loss provision for this
purpose. Based on Beidlemans and Eckels coefficients, they pointed out an extensive use of income
smoothing by Islamic banks . However, they did not find evidence on the use of total loan loss provision; they
showed that contrary to conventional banks, Islamic banks do not smooth income via total loan loss provision.
Moreover, Taktak (2011) examined the nature of smoothing returns practices in Islamic banks. She sought to
assess if the smoothing mechanism is natural or intentional. Using a sample of 79 Islamic banks from 19
countries during the period that ranges from 2001 to 2006, she found that Islamic banks do not use discretion to
smooth their earnings; the results indicate that larger number of Islamic banks engage in natural income
smoothing.
Prior literature provides conflicting predictions and reveals some mixed results about the use of loan
loss provision by Islamic banks. Thus, conversely to conventional banks, prior studies do not examine the use of
discretion by Islamic banks. Indeed, Taktak (2011) do not provide evidence that Islamic banks engaged only on
natural income smoothing; the results indicate that a number of banks smooth their income intentionally. In the
other hand, Quttainah et al (2011) are restricted in comparing Islamic and conventional banks earnings
managements behavior; they did not investigate whether managers use desertion to smooth earnings. As a
consequence, it would be necessary to test the use of discretion by Islamic banks. Unlike prior researches, who
evaluate the total loan loss provision, and following kanagaretnam et al (2004) and Kwak et al (2009), we isolate
the discretionary component of loan loss provision and we investigate if Islamic banks managers use their
discretion for earnings and capital management.
Empirical investigations about the relationship between DLLP and earnings management asserted that
managers will recognize provisions only if the result is enough, managers of banks with high earning variability
will have a stronger incentives to smooth earnings through LLP (kanagaretnam et al (2004)). Kwalet al (2009)
documented that managers, through loss provision, are able to shift earnings among periods to smooth income
over time. Based on the existing literature, we expect that managers use discretion to underestimate LLP if the
earnings before tax and provisions ratiois low, and overestimate LLP if the EBTP is high. Hence the first
hypothesis:
H1: There is a positive relationship between DLLP and earnings before tax and provisions (EBTP) in
Islamic banks.
Looking to the use of DLLP for capital management, prior researches support either a positive and
negative relationship between DLLP or LLP and capital adequacy ratio (CAR). Some papers showed that banks
with low capital ratios could report low DLLP to boost earnings and capital (Kim and Kross (1998) and Ahmed
et al. (1999)). Other studies presented by kanagaretnam et al (2004) and Taktak et al (2010a), assessed that
banks managers with high equity incentives are more likely to manage earnings, so the lower the capital ratio;
the higher will be the LLP. In the same vein, we hypothesize the following:
H2: There is a negative association between DLLP and capital adequacy ratio (CAR) in Islamic banks.
Several studies considered external financing as an instrument to smooth reported earnings. In fact, to
attract external funds, a bank reports low loan loss provision to reduce the perceived risk and to increase reported
income. Loan to deposit ratio is often used as a proxy for external financing ((Kanagaretnam et al (2004) and
Zoubi et Al-Khazali (2007)). If loan to deposit ratio is high, this indicates that total loans are greater than
deposits, so banks need to attract more deposits by customers. To do that, banks managers use their desertion to
report low loan loss provision in order to enhance reported earnings to attract depositors. This suggests the
following hypothesis:
H3: There is a negative relationship between DLLP and loan to deposit ratio in Islamic banks.
In the existing literature, it is often argued that bank size is considered as an important factor that
influences earnings management behavior. Following prior research like Zoubi and Al-Khazali (2007), Taktek et
al (2010a) and Quttainah et al (2011) who are interested on Islamic banking, we expect that larger banks will
have higher DLLP than smaller one; we state the following hypothesis in the null form:
H4: There is a positive relationship between DLLP and bank size in Islamic banks.
In order to compare Islamic and conventional banks earnings management behaviors. Prior studies used
a dummy variable to control for the type of the banks. Empirical results show mixed findings; indeed, Zoubi et
Al-Khazali (2007) found that Islamic and conventional banks in the GCC region follow the same provisioning
practices. Conversely, Quttainah et al (2010) asserted that Islamic banks are less likely to manage their earnings
compared to conventional banks. Given the divergent findings of previous literature, our hypothesis is:
H5: No relationship between DLLP and type is expected.
7

3. Methodological approach
3.1 Sample selection
The sample selection process started with identifying Islamic Banks and conventional banks with
Islamic windows in the Middle East region from the leading online business intelligence platform focusing on
the Middle East & North Africa, Zawiya. We founda list of 200Islamic banks from 12 countries. Our original
intention was to include all these banks and countries, but given that data are not available for all the banks, the
sample covered only 21 Islamic banks and 18 conventional banks with Islamic windows in 7 countries from the
Middle East region: Bahrain, Egypt, Jordan, Kuwait, Qatar, Saudi Arabia and UAE. Then we collected the list of
conventional banks operating in the countries included in our sample, we selected 33 conventional banks.
Table 2 presents the sample selection. Data consists of annual year-end information for Islamic and
conventional banks in the Middle East during the period ranges from 2000 to 2008. We included all banks, for
which complete data across this time period was available. We have to note that, at the firm level, some data are
missing for one or several years; this constitutes an unbalanced panel study of the data sets including 519 total
observations of which 129 observations represented Islamic banks, 141 observations represented conventional
banks which provide also Islamic services and 251 observations represented conventional banks.

Table 2: Number of banks and observations in the sample by country
Country Number of Banks Number of observations
[1]
*
[2]
**
[3]
***
[1]
*
[2]
**
[3]
***
Bahrain 4 1 4 21 9 34
Egypt 3 0 6 14 0 43
Jordan 1 0 10 6 0 83
Kuwait 4 1 5 29 9 34
Quatar 3 5 0 15 34 0
Saoudi Arabia 3 6 1 18 49 9
UAE 3 5 7 24 40 48
Total 21 18 33 129 141 251
7 countries 72 Banks 519 observations
[*] Islamic banks that are fully sharia compliant, [**] Conventional banks with Islamic windows, [***]
Conventional banks


3.2 Model
To examine the use of discretion by Islamic banks managers and compares it to conventional banks in
the Middle East region, we use thetwo-stage approach.In the first stage we use specific accruals to measure
artificial earning management in Islamic Banks. More specifically, we use a major accrual in the banking sector,
loan loss provision (LLP). This proxy is divided into two components; both discretionary and nondiscretionary.
Thus, the basic model takes the form:

LLP = Nondiscretionary LLP + Discretionary LLP

Following Zoubi et Al Khazali (2007), and Taktaket al (2010a), we take into consideration specificities
of Islamic banks. These institutionsoperate under sharia law, and use techniques conform to sharia principles; the
composition of their portfolio loan is different from conventional banks. The loan portfolio of Islamic banks
includes four important types; Quard Hassan (loan), musharaka, murabaha and mudaraba investment, thats why,
we use for our study the item loss provision for loans, murabaha, musharaka, mudaraba investment (LLPI) to
estimate total loss provision for Islamic banks.
The non-discretionary component of LLPrepresents the portion of total accruals dictated bychanges in
bank business conditions.Since itcannot be directly observed, it is estimated by variables reflecting the level of
losses in the loan portfolio.Similar to Kanagaretnam et al (2004) and Kwal et al (2009), NDLLP component is
estimated using a set of informational variables including the beginning balance of nonperforming loans, change
in nonperforming loans and change in total loans.We expect to have a positive correlation between loan loss
provision and the independents variables mentioned above.We expect that, if the beginning balance of
nonperforming loans is high, banks will report a high level of loss provision. In the other hand, an increase in
nonperforming loans is likely to result in an increase in loan loss provision and a positive change in total loans
8
increases the risk of uncollectible accounts, this led to an increase in the amount of loss provision. We estimate
NDLLP using equation [1].

9
We used a panel data over the period 2000-2008 for our sample. Each observation of our sample has
two dimensions (firm, year). The estimation method of our model using panel regression techniques is
appropriate. According to the available datathe use of non-balanced panel data techniques is adequate. Indeed,
the available panel data set for our sample is unbalanced since each variable is observed over varying time-
period length.

LLP it =
0
+
1
NPL
it-1
+
2
NPL
it
+
3
TL
+

it
[1]

Where:
LLP it: Total loan loss provision for bank i at the year t, deflated by beginning loans;
NPL
it-1t:
the beginning balance of nonperforming loan for bank i at the year t deflated beginning loans;
NPL
it:
Change in the value of nonperforming loanfor bank i at the year t, deflated by beginning loans;
TL
:
change in the value of total loan, for bank i at the year t, deflated by beginning loans,

The discretionary component of loan loss provision DLLP consists of the LLP prediction error; it is
estimated by the residual from equation [1].
First of all, we estimate equation[1] for Islamic banks that are fully sharia compliantto obtain the estimates
of
0
,
1
,
2
and
3
.Table 3reports themean coefficient estimates for equation [1] based on panel estimation
techniques. The Hausman specification test is used to choose between the fixed or random effects model for our
sample of Islamic banks. This test is significant, this resultled to the validation of the fixed effect. The
explanatory power is high, with the mean R overall 39.03%. As expected we find a positive and significant
relationship at the level of 0.01 between LLP and total loan. However, the coefficientsof NPL and NPLare not
significant.
Then, using the estimated coefficients (
0
,
1
,
2
,
3
) from equation [1], we evaluate the non-discretionary
component of loan loss provision, NDLLP.

NDLLP
it
=
0
+
1
NPL
it-1
+
2
NPL
it
+
3
TL
it
[2]

Table 3: Result of the regression model from equation [1]
Mean coefficient estimates for the model in equation [1]
Variables Coefficient estimate (p-value)
Intercept 0,0169217 (0.005)***
Beginning balance NPL -0,1498231 (0.163)
NPL -0,0000109 (0.780)
TL 0,0078135 (0.000)***
F-Fisher 10.23 (0.0001)***
R overall 39.03%
Notes:
LLP it =
0
+
1
NPL
it-1
+
2
NPL
it
+
3
TL
+

it

*** Significance level at 1%, ** Significance level at 5%, * Significance level at 10%

Finally, we obtainthe discretionary component of loan loss provisionby calculating thedifference
between total loan loss provision and estimated non-discretionary loan loss provision.Our basic estimation
equation becomes:

DLLP
it
= LLP
it
[
0
+
1
NPL
it-1
+
2
NPL
it
+
3
TL
it
][3]

In the second stage, we use the DLLPI component as our dependent variable. The independent variables
in equation [4] below represent factors hypothesized to influence DLLPI. We try to examine, if Islamic banks
managers use their discretion to manage earnings and capital.

DLLPI
it
=
0
+
1
EBTP
it
+
2
CAR
it
+
3
LD
it
+
4
Size
it
+
it
[4]

Where
DLLPI it: Discretionary loss provision for loans, murabaha, musharaka, mudaraba investment for bank i
at the year t;
EBTP
it:
Earning before taxes and provision deflated by total assets for bank I at the year t;
CAR
it:
Capital adequacy ratio for bank i at the year t, measured by average total equity over average
total assets;
10
LD
it
: Loan to deposit for bank i at the year t;
Size
it:
Bank size for bank i at the year t, expressed as natural log of asset.
11
We conduct our study firstly, on Islamic banks, then conventional banks with Islamic windows and
conventional banks. The procedure for determining the discretionary component of loan loss provision (DLLP)
for conventional banks which provide also Islamic services and conventional banks is similar to that used before.
In order to determine whether observed differences between groups, the separate samples are pooled and we
include the variable typeto compare the use of discretion between 1) Islamic banks VS Conventional banks with
Islamic windows, 2) Islamic banks VS conventional banks and 3) Islamic banks and conventional banks with
Islamic windows VS conventional banks.The new model is presented as follows:

DLLPI
it
=
0
+
1
EBTP
it
+
2
CAR
it
+
3
LD
it
+
4
Size
it
+ Type +
it
[5]

Where
DLLPI it: Discretionary loss provision for loans, murabaha, musharaka, mudaraba investment for bank i
at the year t;
EBTP
it:
Earning before taxes and provision deflated by total assets for bank I at the year t;
CAR
it:
Capital adequacy ratio for bank i at the year t, measured by average total equity over average
total assets;
LD
it
: Loan to deposit for bank i at the year t;
Size
it:
Bank size for bank i at the year t, expressed as natural log of asset;
Type: is a dummy variable taking 1, if the bank is Islamic and 0 otherwise;

4. Empirical results
4.1. Descriptive statistics
Table 4and Table 5 presentdescriptive statistics for the dependent and independentvariables used in this
study.On average, in Islamic banks, loan loss provision (LLP) and beginning nonperforming loans represent
respectively, 1.38 per cent and 4.3 per cent of beginning loans. Our findings are similar to those reported by
ZoubiandAl Khazali (2007), Taktak et al (2010a) and Quttainah et al (2011); who find that Islamic banks make a
low estimate loss provision and non-performing loan.The mean ratio of change in total loan equals 60.81 per
cent, like Taktak et al (2010a) and Quttainah et al (2011);results in standard deviation indicate a large dispersion
in the level of loans provided by Islamic banks.The mean discretionary loan loss provision, measured as the
residual value from our model, was zero, with a minimum of 3.49 per cent and a maximum of 29.79%.The
average of EBTP to total assets is 3.48% with a maximum of 26% and a standard deviation of 3.56% and is
slightly higher to the mean of 2.23% and 2.29% reported respectively by Zoubiand al Khazali (2007) and Taktak
et al (2010a).The mean value of the natural log of total assets in Islamic banks is 3.43 per cent and the standard
deviation 0.50 per cent.
As showing in table 5, we use an Anova analysis, to compare variables between the different types of
banks used in our sample.The evidence on loan loss provision indicates that LLP ratio for Islamic banks is higher
than for conventional banks with Islamic windows and is the same as conventional banks. This led to conclude
that Islamic banks and conventional banks behave in the same manner in dealing with loan loss provision.
Beginning nonperforming loan ratio for Islamic banks is lower than those for conventional banks which provide
also Islamic services and conventional banks. This indicates that full-fledged Islamic banks have less
nonperforming loans problem than the others types of bank.
Change in total loans, EBTP and CAR of Islamic banks are significantly higher than those of
conventional banks.Islamic banks reported statistically significantly smaller discretionary loan loss provision
(DLLP) than their non-Islamic counterparts.
12
Table 4: Descriptive statistics for
all the variables included in the regression models
Islamic Banks that are fully sharia compliant Conventional banks which Islamic windows Conventional banks
Variables Mean Stand Dev Min Max Mean Stand Dev Min Max Mean Stand Dev Min Max
Loan loss provision ratio
0.0138633

0.0221691

-0.00718

0.1312678


0.00639

0.00815

-0.00977

0.046521


0.0116

0.020239

-0.0228

0.2067323

Change in Total loan
ratio

0.6081938

3.616521

-1

35.96289

0.20480

0.86164

-1

8.791765


0.2021

0.941531

-1

8.00738

Beginning nonperforming
loan ratio

0.0436319

0.031596

0.004372

0.1279201

0.056431

0.07373

0.00474

0.412824


0.0836

0.125239

0.0015

1.059734


Change in nonperforming
loan ratio


6.21e-07


355.2172


-2324.2


1753.7



0.006279


0.06217


-0.26290


0.412824



0.0111


0.108619


-0.3358


1.059734

EBTP ratio

0.0348

0.03030

0.0017

0.1447

0.0355

0.0483

0.0092

0.2169

0.0238

0.0147

-0.072

0.1070
CAR 17.889 13.3056 4.096 51.95 12.768 9.6230 8.0262 51.6 11.524 3.8248 2.7 32.2
Loan to deposit 156.1305 175.5431 26.9 995.3 74.85106 21.6613 23.4 134.5 0.7398226 0.2271351 0.2514457 1.308
SIZE 3.4374 0.45241 2.5064 4.4285 3.906075 0.4060 3.0850 4.4387 3.4933 0.6346 1.8739 5.2443
DLLP 0.000 0.034937 0.297917 0.0839244 0.000 0.00802 -0.0172 0.041236 0.000 0.02158 -0.0493 0.227702
13
Table 5: Results of Anova analysis
*** Significance level at 1%, ** Significance level at 5%, * Significance level at 10%

Table 6provides Pearson correlation coefficients of the independent variables in our model.The
correlation coefficients are lower than 0.8 which correspond to the limit set by Kennedy (1985) and from which
we confirm the existence of serious multicollinearityproblems.Overall, we can conclude that thecorrelations are
not sufficiently high to bias our results.Consequently we suggest the absence of multicollinearitybetween the
independent variables of our discretionary loan loss provision model.

Table 6: Correlation matrix












*** Significance level at 1%, ** Significance level at 5%, * Significance level at 10%

4.2. Panel regression analysis
In this section, we present and discuss our empirical results concerning the use of discretionary loan loss
provision by Islamic banks managers.Table 7depicts the main results of the second stage regression analysis.
The Hausman specification test is used to choose between the fixed or random effect. This test is statistically
significant at the level of 0.1, this result led to the validation of the fixed effect. Our model is significant at the
1% level (F-value= 5.56), with R overall of 13.47% and R within of 24.11%. Our dependent variable is DLLP,
which correspond to the discretionary component of LLP and represents the residual from equation [1].
Consistent with Taktak et al (2010a) study, we find a negative and significant coefficient at the level of 1% for
capital adequacy ratio (CAR).This result suggests that banks with greater (smaller) equity capital ratio tend to
report lower (greater) discretionary loan loss provision (DLLP), we can conclude that DLLP is used as a tool for
managing capital to enable banks to avoid violating minimum capital adequacy ratio.As expected, the coefficient

Islamic Banks VS
conventional banks with
Islamic windows

Islamic banks VS
conventional banks
Islamic banks and
conventional banks with
Islamic windows VS
conventional banks
Variables Difference in Means Difference in Means Difference in Means
Loan loss provision
ratio

0.007465***

0.002252

-0.002282

Change in Total loan
ratio

0.403385

0.406038*

0.183699

Beginning
nonperforming loan
ratio

-0.0128

-0.040046**

-0.031778**

Change in
nonperforming loan
ratio

-0.006278

-0.011142

-0.007274

EBTP ratio

-0.000696

0.01103***

0.011377***
CAR 5.12138*** 6.43867*** 3.72247***
Loan to deposit 81.2794*** 155.391*** 111.142***
SIZE -0.468638*** -0.055948 0.185694***
DLLP -0.008323*** -0.012127*** -0.007486***
EBTP CAR SIZE

EBTP


1

CAR 0.4294***

1
Loan To deposit

0.0308 0.3456*** 1
SIZE 0.0982

-0.4634***


1
14
of size is positive and significant at the level of 5%. The bank size is linked to a higher magnitude of
discretionary earning management behavior. This finding is similar to that reported by Zoubi et Al-Khazali
(2007) and Taktak et al (2010a) who reveal that larger banks are more likely to report higher DLLP.Contrary to
Zoubi et Al-Khazali (2007), the coefficient of EBTP is negative but not significant; this indicates that Islamic
banks managers do not use their discretion to manage their earnings.Based on this finding and the findings
reported by Taktak et al (2010a) we confirm that Islamic banks managers do not use neither total loan loss
provision nor the discretionary component of LLP to manage their earnings.The variable loan to deposit does not
have a significant effect on DLLP.

Table 7: Result of the regression model from equation [4]
Mean coefficient estimates for the model in equation [4]
Variables Coefficient estimate (p-value)
Intercept -0.0750155 (0.112)
EBTP -0.1123476 (0.513)
CAR -0.0018762 (0.002)***
LD -0.0000668 (0.111)
SIZE 0.0328194 (0.016)**
F-statistic 5.56 (0.0006)***
R Overall 13.47

Notes: DLLPI
it
=
0
+
1
EBTP
it
+
2
CAR
it
+
3
LD
it
+
4
Size
it
+
it
[4]
*** Significance level at 1%, ** Significance level at 5%, * Significance level at 10%

To test for the effect of the type of the bank (Islamic banks, conventional banks with Islamic windows
and conventional banks) on discretionary loan loss provision, we include the variable Type in the regression
model. Type is a dummy variable equal 1 if the bank is Islamic, 0 otherwise.Thus the equation to be estimated
becomes:

DLLPI
it
=
0
+
1
EBTP
it
+
2
CAR
it
+
3
LD
it
+
4
Size
it
+ Type + it [5]

Equation [5] is used to compare the use of discretion between 1) Islamic banks VS conventional banks
which provide also Islamic services, 2) Islamic banks VS conventional banks and 3) Islamic banks and
Conventional which provide also Islamic services VS conventional banksin the Middle East region.Table
8displays the main results of our comparison study; it reports the regression of our three samples. On average, it
is clear from the table that the coefficient of type is not significant for all the groups; this result reveals that there
is no difference in the use of discretionary loan loss provision between Islamic banks and their non-Islamic
counterparts. This finding is similar to that reported by Zoubi et Al-khazali (2007), who found that Islamic and
conventional banks follow the same way of provisioning.

15
Table 8: Results of the regression model from equation [5]
*** Significance level at 1%, ** Significance level at 5%, * Significance level at 10%
Islamic Banks VS
conventional banks with
Islamic windows
Islamic banks VS conventional
banks
Islamic banks and conventional
banks with Islamic windows VS
conventional banks

Variables

Coefficient

(p-value)

Coefficient

(p-value)

Coefficient

(p-value)
Intercept

0.0165113 (0.427) 0.0034987 (0.818) 0.0080736 (0.489)
EBTP ratio

-0.0439758 (0.517) 0.06279 (0.416) 0.029795 (0.546)
CAR -0.0013346 (0.000)*** -0.0016439 (0.000)*** -0.0013033 (0.000)***

Loan to deposit


-0.0000277

(0.188)

-0.0000172

(0.383)

-0.0000331

(0.057)*
SIZE

0.0020135 (0.678) 0.0047152 (0.254) 0.0024921 (0.414)
Type

-0.0034273 (0.680) 0.0002607 (0.970) 0.0022116 (0.693)
Wald Chie2

37.58 (0.0000)*** 54.30 (0.0000)*** 52.51 (0.0000)***
R Overall 18.53% 17.33% 13.63%
Notes: DLLPI
it
=
0
+
1
EBTP
it
+
2
CAR
it
+
3
LD
it
+
4
Size
it
+Type +
it
[5]
16
5. Conclusion
The purpose of this paper is to examine factors that may influence Islamic banks managers use of
DLLP to manage earnings. Using a sample of 21 Islamic banks in the Middle East region over the period 2000-
2008, we find that, Islamic banks managers do not use discretion to manage their earnings, conversely, they use
DLLP to manage their capital. Indeed, our evidence of a negative relationship between DLLP and CAR indicates
that the lower the capital ratio the higher the DLLP, this findings support the fact that well capitalized Islamic
banks embark in less risky activities (Taktaket al, 2010a). Our results also show that larger banks are more likely
to report higher DLLP than smaller banks.To test the effect of the type of banks on DLLP, we use a sample of 18
conventional banks with Islamic windows and 33 conventional banks in the Middle East region. Our findings
indicate the lack of relationship between the type of banks and the use of DLLP.This led us to conclude that
there is no difference between Islamic banks, conventional banks which provide also Islamic services and
conventional banks in matter of discretionary loan loss provision; all banks behave in the same way.
One limitation of our paper is that our sample size is relatively small, given that data are not available for all the
Islamic banks. Future research may extend the sample to all Islamic institutions in the MENA region. Another
avenue for future research could further investigate determinants that have the potential of influencing earning-
management activity in Islamic banks.

References
Anandarajan, A., Hasan, I. and Lozano-Vivas, A., (2005), Loan loss provision decisions: anempirical analysis
of the Spanish depository institutions, Journal of InternationalAccounting, Auditing and Taxation, Vol. 14,
No. 1, pp. 55-77.
Anandarajan, A., Hasan, I., and McCarthy, C., (2007), Use of loan loss provisions for capital, earnings
management and signalling by Australian banks, Accounting and Finance, 47, pp. 357379.
Ahmed, A. S., Takeda, C., and Thomas, S. (1998), Bank loan loss provisions: A reexamination of capital
management,earnings management and signaling effects , Journal of Accounting and Economics, Vol. 28,
pp. 125.
Ahmed, A.S., Takeda, C. and Thomas, S., (1999), Bank loan loss provisions: a reexamination ofcapital
management, earnings management and signaling effects, Journal of Accountingand Economics, Vol. 28
No. 1, pp. 1-25.
Beatty, A., Chamberlain, S., andMagliolo, J., (1995), Managing financial reports of commercial banks: The
influenceof taxes, regulatory capital, and earnings ,Journal of Accounting Research, Vol. 33, pp. 231262.
Bhat, V., (1996), Banks and income smoothing: an empirical analysis, Applied FinancialEconomics, Vol. 6,
No. 6, pp. 505-10.
Collins, J., Shackelford, D., andWahlen, J. (1995), Bank differences in the coordination of regulatory
capital,earnings and taxes , Journal of Accounting Research, Issue.33, pp. 263292.
Greenwalt, M., and Sinkey, J., (1988), Bank loan loss provisions and the income smoothing hypothesis: An
empirical analysis , Journal of Financial Services Research, Vol. 1, pp. 301318.
Ismail, A.G. and Be Lay, A.T. (2002), Bank loans portfolio composition and the disclosure of loan loss
provision: an empirical evidence of Malaysian banks, Asian Review of Accounting, Vol. 10 No. 1, pp. 147-
62.
Ismail, A.G., and Shahimi, S., (2003), Do Risk-Based Capital Requirements allocate Financing and Cause a
"Bigger" Loan Loss Provisions For Islamic Banks?,Journal of Islamic Economics, Vol. 4, No. 1.
Ismail, A.G., Shaharudin, R.S. and Samudhram, A.R. (2005), Do Malaysian banks manage earnings through
loan loss provisions?, Journal of Financial Reporting and Accounting, Vol. 3 No. 1, pp. 41-7.
Kanagaretnam, K., Lobo, G.J., and Mathieu, R., (2004), Earnings Management to Reduce Earnings Variability:
Evidence from Bank Loan loss provision Review of Accounting and Finance, Vol. 3 pp. 128-148.
Kim, M., and Kross, W., (1998), The impact of the 1989 change in bank capital standards on loanloss
provisions and loan write-offs, Journal of Accounting and Economics, Vol. 25, No. 1, pp. 69-100.

Kwal, W., Lee, Y.H., and Eldridge, S., (2009), Earnings Management by Japanese Bank Managers :Using
Discretionary Loan Loss Provisions, Review of Pacic Basin Financial Markets and Policies, Vol. 12, No.
1, pp. 126
Lobo, G.J., and Yang, D.H., (2001), Bank Managers Heterogeneous Decisions onDiscretionary Loan Loss
Provisions, Review of Quantitative Finance and Accounting, Issue. 16, pp.223-250.
Ma, C. K., (1988), Loan loss reserve and income smoothing: The experience in the U.S. banking industry ,
Journal of Business Finance and Accounting, 15(4), pp. 487497.
Misman, F.A., and Ahmed, W., (2011), Loan Loss Provisions: Evidence from Malaysian slamic and
Conventional Banks, International Review of Business Research Papers, Vol. 7, No. 4, pp. 94-103.
17
Moyer, S.E., (1990), Capital adequacy ratio regulations and accounting choices in commercialbanks, Journal
of Accounting and Economics, Vol. 13, No. 2, pp. 123-54.
Pinho, P.S., and Martins, N.C., (2009), Determinants of Portuguese Banks Provisioning Policies:
Discretionary Behaviour of Generic and Specific Allowances , Journal of Money, Investment and Banking,
Issue 10, pp. 43-56
Quttainah, M. A., Song, L., and Wu, Q., (2011), Do Islamic Banks Employ Less Earnings Management?,
Politics and Economic development, ERF 17
th
Annual conference March 20-22, 2011, Turkey.
Taktak, N., Zouari, S., and Boudrigua, A., (2010a), Do Islamic banks use loan loss provisions to smooth their
results?, Journal of Islamic Accounting and Business Research, Vol.1, No.2, pp. 114-127.
Taktak, N., Shabou, R., and Dumontier, P., (2010b), Income Smoothing Practices: Evidence from Banks
Operatingin OECD Countries , International Journal of Economics and Finance, Vol. 2, No. 4, pp. 140-151
Taktak, N., (2011), The nature of smoothing returns practices: the case of Islamic banks, Journal of Islamic
Accounting and Business Research, Vol. 2, No. 2, pp. 142-152.
Wetmore, J. L., and Brick, J. R. (1994), Loan-loss provisions of commercial banks and adequate disclosure: A
note , Journal of Economics and Business, Vol. 46, pp. 299305.
Zoubi, T. A., and Al-Khazali, O., (2007), Empirical testing of the loss provisions of banks in the GCC region,
Managerial Finance, Vol.33, No.7, pp.500-11.