Credit Risk Management of

Islamic Banks in Bangladesh

Course title: Business Research methods

Course code: Bus 485

Section: 05

Done by:

ID Name Report Presentation Viva Total

1421549 MD. Humayan Kabir
1522425 Mohammad Marufur
Rahman Monen
1410475 Khandokar Asadur
Rahman Ony
1410004 Inzamam-Ul-Islam
 Letter of transmittal

July 17, 2018

Mr. Naheem Mahtab, CPA

Lecturer

Department of Accounting

School of Business Independent University, Bangladesh (IUB)

Subject: Submission of Report “Credit Risk Management of Islamic Banks in Bangladesh”

Dear Sir,

With due respect we the undersigned students of BBA have completed this report on “Credit
Risk Management of Islamic Banks in Bangladesh” under the course: Business Research Method
(BUS 485). Though we are in the learning phase, this report has enabled us to gain insight into
the Effect of Credit Risk Management on the Performance of Islamic Banks of Bangladesh. It
was an extremely challenging and interesting experience. Thank you for your supportive
consideration for formulating an idea. Without your Inspiring this report could not have been
completed. Lastly we would be thankful once again if you please give your judicious advice on
effort.

Yours’ sincerely,

Group Members
 Executive Summary
Our research aims to provide the idea of credit risk management in financial institution. The
purpose of this report is to have an idea about the credit process and risk management procedure
of the Islamic Banks of Bangladesh. All the Islamic Banks follows the rules and regulation
prescribed by the Bangladesh bank. To manage credit risk, all the Banks applies credit limits to its
customers and obtains adequate collaterals. Basically credit risk is the potentiality of not paying
loans by financial institutions according to credit terms. Another thing comes in mind along with
this word “Risk” is that how these institutions manage this risk, their policies their management
process. The term credit risk management is not only confined to loan management; other factors
such as bonds, equities, interbank transactions, credit terms, the settlement of the transactions,
extension of commitments, economic condition and financial futures are also associated with credit
risk management. Now a days there are counterparties and intermediaries present in this credit
approach that help to occur diverse range of credit risk. On the other hand suffering from high
levels of non-performing loans, lack of cash bad controls financial institutions lacks cash to lend
out to their clients. They sometimes don’t measure their client’s creditworthiness. Poor risk
management can lead an institution to go into bankruptcy or direct or non-direct losses.
Inappropriate credit risk framework, organization lack oversight, poor monitoring process, biased
auditing process, unskilled staff, wrong goals, corruption are interrelated with poor risk
management. A strong mitigation package can help to reduce this credit risk. But the action
depends on the competitiveness of each institution. An active credit administration can review
loans and can ensure the credit quality of transactions. Credit limit and a sound credit granting
criteria should be introduced. An effective credit culture should be placed with necessary credit
policies and procedures should be implemented throughout the financial institution.
Table of Contents

1. Introduction ................................................................................................................................. 1

2. Problem statement ....................................................................................................................... 2

3. Purpose of the study .................................................................................................................... 4

4. Literature Review........................................................................................................................ 5

4.1 Return on Assets ............................................................................................................... 5

4.2 Loan loss provisions ......................................................................................................... 6

4.3 Relationship between Loan Loss Provisions and Return on Asset ................................... 8

4.4 Number of active borrowers ........................................................................................... 10

4.5 Relationship between Number of active Borrow ............................................................ 12

4.6 Gross Portfolio Yield ...................................................................................................... 13

4.7 Relationship between Gross Portfolio Yield and Return on Asset ................................. 14

4.8 Capital Asset Ratio ......................................................................................................... 16

4.9 Relationship between Capital Asset ratio and Return on Asset ...................................... 18

4.10 Debt to Equity Ratio ..................................................................................................... 20

4.11 Relationship between Debt Equity Ratio and Return on Asset .................................... 22

5 Conceptual Framework .............................................................................................................. 25

5.1 Equation .......................................................................................................................... 26

6 Research Questions and Hypothesis .......................................................................................... 27

7 Research design ......................................................................................................................... 30

8 Sampling .................................................................................................................................... 32

8.1 sample size ...................................................................................................................... 32

8.2 sampling unit ................................................................................................................... 32

 8.3 Sampling Method ............................................................................................................ 32

9 Data collection method .............................................................................................................. 32

10 Data Analysis ........................................................................................................................... 33

10.1 Descriptive Statistics ..................................................................................................... 33

10.2 Correlation .................................................................................................................... 35

10.3 Equation ROA ............................................................................................................... 38

11 Significance of the Study ......................................................................................................... 40

12 Conclusion ............................................................................................................................... 41

13 References ................................................................................................................................ 42
 1. Introduction

Credit risk management’s function is to maximize a bank’s risk adjusted rate of return by
keeping the credit risk exposure within acceptable parameters. Basically it is the core of any
commercial banks. Credit risk determines the worth ability of borrowers which indicates the
performance level of any financial institution. If the credit risk management is not handled with
care, then it could turn out to be a big threat for any financial institution. This will let the
profitability to decrease in huge level. (A. Lebbe, A. Rauf, A. H. Mulafara (2016)

In order to maintain the credit risk exposure under control, the commercial bank should look more
into the industry the borrowers belongs to. The banks should focus more the financial, economic
and financial situation of the borrowers. (Seyfried B (2001)

The credit risk function increases the level of investment in the economy and also related to the
main income source of commercial banks as interest. This also comes up with huge risks between
the lenders and borrowers. If the obligations of the agreement are not met completely then it creates
an obstacle in the functioning of commercial banks. The higher the credit risk it is most likely to
experience the more financial crisis in the long run. (E. T. Awoke, 2014).

The banking industry remained stabled and calmed till the crisis that took place 10 years back in
2007-2008. Banks all over the globe faced profit deficit in immense amount. The low performance
of the banking industry has slowed down the growth of world economy. According to (Hassan H,
Maher A, Khalil) (2009)

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 2. Problem statement

Credit risk is the risk of on a debt that may arise from a borrower failing to make required
payments. In the first resort, the risk is that of the lender and includes lost principal and interest,
disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an
efficient market, higher levels of credit risk will be associated with higher borrowing costs.
Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk
levels based on assessments by market participants. Losses can arise in a number of circumstances.
A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or
other loan. A company is unable to repay asset-secured fixed or floating charge debt. A business
or consumer does not pay a trade invoice when due. A business does not pay an employee's earned
wages when due. A business or government bond issuer does not make a payment on a coupon or
principal payment when due. An insolvent insurance company does not pay a policy obligation.
An insolvent bank won't return funds to a depositor. A government grants bankruptcy protection
to an insolvent consumer or business.

With the global financial crisis still recent, credit risk management is still the focus of intense
regulatory scrutiny. While stricter credit requirements as a “top-down” approach has helped
mitigate some economic risk, it has left many companies struggling to overhaul their approach to
credit risk assessment. In the scramble to implement risk strategies to improve overall performance
and secure a competitive advantage, a company must overcome significant credit risk management
challenges, such as Inefficient Data Management, Limited Group-Wide Risk Modeling
Infrastructure, Lacking Risk Tools, Less-than-intuitive Reporting and Visualization.

Banks are exposed to five core risks through their operation, which are-credit risk, asset/liability
risk, foreign exchange risk, internal control & compliance risk, and money laundering risk. Among
these risks management of credit risk gets most attention. Credit risk arises due to the possibility
that the borrower may fail to repay the loan. Following the recent global financial crisis, which
originated from poor management of credit risk, credit risk is the most discussed topic in banking
industry. Credit risk is one of the most vital risks for any commercial bank. Credit risk arises from

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non-performance by a borrower. It may arise from either an inability or an unwillingness to
perform in the pre-commitment contracted manner. The real risk from credit is the deviation of
portfolio performance from its expected value. The credit risk of a bank is also effect the book
value of a bank. The more credit of a particular is in risk, the more probability of a bank to be
insolvent. Therefore, the status of depositor in the bank is at risk and probability of incurring loss
from their deposited value.

To analyse the relationship between the Dependent variable with the Independent variables we
have calculated the value of all independent variable. The Dependent variable is Return on Asset
(ROA) and the Independent variables are Number of Active Borrowers (NAB), Loan Loss
Provision (LLP), Capital Asset Ratio (CA), Debt Ratio (DR), Gross Profit Yield (GPY). To do this
we took the five years data (2012-2016) from the banks Islami banks named Shahajalal Bank, First
Security Islami Bank, Al-Arafah Islami Bank, Social Islami Bank Limited, Exim Bank Limited.

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 3. Purpose of the study

The objective of this study is to apply what we have learnt in our classroom with real world data.
The study has been done to do the following:

i. To identify the effect of Credit risk management on Financial institution of Bangladesh

ii. To find out which variables affect the institutions the most

iii. To analyze the credit risk management techniques used by financial institutions of
Bangladesh

iv. To understand the degree to which different variables affect the wellbeing of financial
institution.

v. To analyze the current situation of commercial banks and their situation in the market

vi. To create an accessible medium to provide future researchers with relevant information

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 4. Literature Review

4.1 Return on Assets

Return on Assets is an overall measure of profitability that reflects the profit margin. Simply put,
it measures how well the institution uses all its assets to generate revenue.

In a recent study, Tehulu (2016) inspected the determining factors in credit risk management of
MFIs in Ethiopia using Morgan Stanley’s rating methodology and GLS random effect regression.
The study covered the period 2003-2013, using a sample of 15 MFIs with 81 observations and
unbalanced panel data. His findings reveal that return on asset, operating efficiency, and size of
the portfolio have a negative and significant impact on credit risk.

However, liquidity, leverage, productivity, and age do not affect credit risk. Therefore, the most
essential variables that account for variation in credit risk among MFIs in Ethiopia are the size of
the portfolio, the operating efficiency, and the Return on Assets (ROA).

Felix and Claudine (2008) investigated the relationship between credit risk management and
banking performance. The result of their study shows that ROA and return on equity, both
profitability measures are inversely proportional to the ratio of non-performing loans to total loans
of financial institutions.

Financial performance as approximated by ROA revealed a negative and statistically significant

relationship at 5% with PaR. this is in line with that of Kwan and Eisenbeis (1995), Godlewski
(2005), Altunbas et al. (2007), and Chaibi and Ftiti (2015) who maintain that any rise of the
institutions’ financial performance helps reduce default risk.

Godlewski (2004) is used the adjusted ROA as a proxy for performance, showed that banks
profitability negatively impacts the level of non-performing loans ratio. Garciya-Marco and

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Robels-Fernendz (2007) found that profit maximizing policies will be accompanied by higher level
of risk

Naceur (2003) who studied the determinants of the profitability of the Tunisian banking industry;
used ROA as a measure of performance and profitability. This observation is supported by
Athanasoglou, Brissimis and Delis (2008) who argue that ROA is considered to be a core
performance indicator used in the majority of empirical studies. Studies by Golin (2001) and Rose
and Hudgins (2008) confirm the view that ROA is one of the most important measures of
profitability in banking literature. The performance of commercial banks is normally measured by
the return on assets (ROA) which reflects the ability of bank management to generate profits from
the available assets

4.2 Loan loss provisions

Loan loss provisioning among Islamic banks and conventional banks is often unclear and the pro-
visioning rules for both Islamic and conventional banks are the same. The relationship between
discretionary provisions and stock returns because changes in stock prices may be driven strongly
by other unobservable factors rather than discretionary loan loss provisions. he main criticism of
Basel II's loan loss provisioning system was that it allows provisioning only at one point in time,
say, at the beginning of the reporting year or quarterly or semi-annually (Hull, 2012; Wezel et al.,
2012).Basel III improves on Basel II by introducing a loan loss provisioning system that require
banks and financial institutions to set aside specific provisions on newly-originated loans based on
individual borrower characteristics that drives the performance of the loan (Wezel et al., 2012).
Bank capital is derived partly from loan loss provisions (or reserves), and also because general
provision is included in Basel's definition of bank capital ,therefore, regulatory capital
requirements should include sufficient loan loss provisions due to the close relationship between
loan loss provisions and capital. loan loss provisions in the computation of regulatory capital ratios
will motivate bank managers to manipulate LLP estimates in order to influence the level of

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regulatory capital above the minimum limit. When earnings are low, banks will keep fewer LLPs
in the current period and draw up from the loan loss provisions or reserve accumulated in the
previous period to cover for actual loan losses in the current period. A loan loss provisioning
system where banks report higher LLPs during good economic times and report fewer LLPs during
economic downturns so that the surplus LLPs accumulated during good economic times are used
to mitigate bank losses during economic downturns (Saurina, 2009). In principle, the objective of
a dynamic provisioning model is to enhance the safety and soundness of banks by building up a
stock of loan loss provisions (or reserves) in good times so that banks will not face insolvency due
to rising loan losses when a recession sets in, and banks can use the accumulated stock of
provisions to smoo th out loan losses during bad times (Balla and Mckenna, 2009) After the2008
financial crisis, bank regulators require banks to take pro-active or forward-looking measures
towards provisioning which includes keeping sufficient (or high) LLPs even when expected credit
risk is apparently low so that banks can have enough loan loss reserves/provisions to act as buffers
to absorb loan losses that materialise during bad times .(Ozili,Outa,2017)

We examine the implications of banks’ credit risk modeling (CRM) for the timeliness of their loan
loss provisions (LLP) and the procyclicality of their loan originations. We examine the
implications of public traded U.S. commercial bank holding companies’ credit risk modeling
(CRM) for the timeliness of their loan loss provisions (LLPs) and the procyclicality of their loan
originations. That banks’ loan loss reserving reflect more judgmental forward-looking factors and
with the widespread use of non-performing loans as a forward-looking benchmark for banks’s loan
loss reserving. LLPs exhibit lower loan growth on average, consistent with banks’ loan loss
provisioning contributing to loan origination procyclicality.(Bhat, Ryan, Vyas, 2012)

Loan loss provisions might be used to smooth income as part of bank discretionary behavior, and
this behaviour might be important to offset a negative impact of non-discretionary provisions on
bank loan growth. With regards to the influence of legal rights on the link between loan loss
provisions and bank loan growth, we consider the influence of the legal rights of borrowers instead
of creditor legal rights as in Houston et al. (2010), because we examine the impact of loan loss
provisions on bank loan growth from the demand side. We examine the link between loan loss

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provisions and bank loan growth in order to highlight whether loan loss provisions are procyclical
over the business cycle. Banks in their sample behave prudently by building up loan loss provisions
to cover default risk exposure following the expansion of lending activities. (Soedarmono, Tarazi,

Agusman, Monroe, Gasbarro, 2016)

One of the most important bank accruals, loan loss provisions (LLPs), is calculated based on an
incurred loss approach and reflects the expected losses arising from their lending business. oan
loss provisioning behavior and there are no studies on the relation between the smoothness of
earnings and the volatility of risk weighted assets. (Stoian, 2013)

Sound credit risk assessment and valuation processes, including well-structured loan classification
systems and robust loan loss provisioning practices, are critical to a bank’s safety and soundness.
Sound loan loss provisioning practices are also an integral part of the credit risk assessment and
valuation process–a means to ensure loans and groups of loans having similar credit risk
characteristics are appropriately valued for credit risk management, accounting and capital
adequacy purposes. (2015)

4.3 Relationship between Loan Loss Provisions and Return on Asset

Loan-loss provisioning policy is critical in assessing financial system stability, in that it is a key
contributor for fluctuations in banks’ profitability and capital positions, which has a bearing on
banks’ supply of credit to the economy (Beatty and Liao, 2009). In principle, loan loss provisions
allow banks to recognize in their profit and loss statements the estimated loss from a particular
loan portfolio(s), even before the actual loss can be determined with accuracy and certainty as
events unfold and are actually written off. In other words, loan-loss reserves should result in direct
charges against earnings during upturns in the economic cycle, as banks anticipate future losses
on the loan portfolio when the economy hits a downturn. When these anticipated loan losses
eventually crystallize, banks can then draw on these reserves, thereby absorbing the losses without

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impairing precious capital and preserving banks’ capacity to continue extending the supply of
credit to the economy.

Bashir (2000) analyzes the factors of Islamic bank’s performance across eight Middle Eastern
countries for 1993-1998 periods. A various number of internal and external determinants were
used to forecast the profitability and efficiencies. Controlling for macroeconomic environment,
financial market situation, the consequences show that higher leverage and large loans to asset
ratios, lead to higher profitability.

Since provisions are a deduction from profits, the sharp increases in loan-loss provisions appeared
to have a substantial impact on banks’ profitability indicators. Return on equity (ROE) and return
on assets (ROA) both declined following the increase in loan-loss reserves (Danvee Floro 2010)

The loan loss provision as an important factor in affecting profitability of banks in ideal condition,
a well establish bank is supposed to be having less loan loss provision and higher profitability
moreover bank deposits and its advances also play a vital role in the stability and profitability of
banks. Loan loss provisions allow banks to recognize in their profit and loss statements the
estimated loss from a particular loan portfolio(s), even before the actual loss can be determined
with accuracy and certainty as events unfold and are actually written off. Loan loss provision is an
independent variable who use to measure over all loans. It measure credit quality of bank as well
as. If bank is working in risky environment negligence to control their lending operations then
bank get the results in a higher loan loss provision to cover this risk. One unit increase in the bank
Loan loss provision will decrease profitability. There is negative relationship between loan loss
provision and bank profitability. In order to determine that the independent variable has a
significant effect on the dependent variable. On banking profitability in Pakistan. Loan loss
provision and profitability have negative relation, less loan loss provision provides more
profitability and surely more safety and similarly more loan loss provision offers less profitability
and instability of the bank. (Tahir, 2014)

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4.4 Number of active borrowers

The number of active borrowers negatively influences the credit risk. Active borrowers
demonstrate a stronger willingness to pay their loans so that the institution grants them more loans
in the future. MFIs with a high number of active borrowers could better support the credit risk.
(Noomen, Abbes 2018)

The overall growth of the loan portfolios of the sample MFIs is mostly due to the increasing rate
of expansion of their respective number of active borrowers. (Ayayi 2012)

It is expected that MFIs must have sufficient information about incomes, repayment capacities and
creditworthiness of borrowers, and that they will use this information to make decisions. However,
after the loan disbursements, the MFIs may be confronted with a moral hazard and enforcement
problems. Further, available literature shows that threatening not to refinance defaulters or offering
larger loans to borrowers who repay their debts, creates an incentive for peer monitoring, peer
pressure and intra-group help among the borrowers (Armendariz & Morduch, 2005; Ogawa,
Parker, Singh, & Thacker, 2009)

Depth assessment of the potential impact of the number of borrowers per loan officer on the qasset
quality of MFIs, using a larger dataset with information from 1,575 MFIs from 109 countries
spanning the period 2006-2013. The relationship between number of borrowers

Per loan officer and portfolio value at risk. The null hypothesis that there is no trade-off between
the number of borrowers per loan officer and MFI asset quality. Our empirical inquiry suggests
that there is no compelling evidence to reject the pull. It is to identify any possible trade-off
between the value of portfolio value at risk and the number of borrowers. Portfolio value at risk,
which indicates that with an increasing number of borrowers per loan officer, MFIs in our sample
improved their asset quality through better repayment performance. Such trade-off between
number of borrowers per loan officer and microfinance institutiom asset quality may also be traced

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in peer selection, peer monitoring, and joint-liability mechanism followed by the microfinance /
]group. (Pal & Mitra 2017)

The growth in the numberof clients (NAB) result in a change of the interest rate? This case is
typical for MFIs like those in Asia, where there is a growing trend in the number of the micro
clients, but the amounts of deposits or credits are very small, so simultaneously there is usually a
smaller average ratio of ALB indicating possible troubles with operating costs. (Janda and Zetek
2013)

A small number of borrowers may result in a very large loss for the MFI (Bessis, 2003). Since
these firms cannot completely do away with the possibility of such losses, it becomes imperative
for management to determine what level of risk is desired. (MARITIM 2013)

Number of Active borrowers refers to the number of individuals or entities who currently have an
outstanding loan balance with the MFI or are primarily responsible for repaying any portion of the
Gross Loan Portfolio. Individuals who have multiple loans with an MFI are counted as a single
borrower. Larger the number of active borrowers, larger the reach of the MFIs.

The largest share of an MFI’s operating income is generated from the loan portfolio. They asserted
income generated by the loan portfolio is affected by number of loans disbursed, number of active
clients and the effective term for repaying the loan. (MAGALI 2014)

The overall growth of the loan portfolios of the sample MFIs is mostly due to the increasing rate
of expansion of their respective number of active borrowers from 2007 to 2011 and to the
enlargement of the individual loans. (AHMED, SEYOUM, KEDIR,KEDIR 2015)

Bank loans object is an important factor that can influence the bank recover the loan principal and
interest according to contract, and lead to changes of the possibility of loan loss. Loan object risks
include borrower credit risk, risk of borrower repayment ability, risk of borrower repayment
willing, risk of project profitability, risk of project potential. (BIN, 1997)

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4.5 Relationship between Number of active Borrow

A study in 2009 by Anduanbessa, T. found that the deposit mobilized from clients, the number of
active borrowers and the gross loan portfolio load high on one component, established the
outreach performance dimension of the MFIs in the country. On the other hand, profit margin,
OSS, return on asset and gross loan portfolio-to-total asset ratio load high on the other
component, established the financial sustainability dimension. The number / types of financial
services rendered, the number of staff per branch and their capital are found to determine the
outreach performance of the MFIs in the country. (Anduanbessa, 2009). Furthermore, Kinde, B.
A. in 2012 identify factors affecting financial sustainability of MFIs in Ethiopia. The study
showed that microfinance breadth of outreach, depth of outreach, dependency ratio and cost per
borrower affected the financial sustainability of microfinance institutions in Ethiopia (Kinde,
2012).

Regulated has a negative standardized coefficient at the 1% significance level and therefore this
means that regulated MFIs tend to have a lower number of active borrowers as compared to non-
regulated ones. This is in line with the literature review which states that regulating MFIs may in
fact increase their costs per borrower and therefore leading to fewer loans created and lower
number of active borrowers. The overall model testing the relationship between regulation, assets
and deposits of the MFI and its internal sustainability as measured by its ROA is significant.
Regulation which is the primary independent variable of interest is also significant as shown by
the model results above. Regulated has a positive standardized coefficient at the 1% significance
level and therefore this means that regulated MFIs tend to have a Daniel Muwamba Senior
Thesis 2012 higher ROA as regulation will increase ROA. Given that the literature links ROA to
sustainability this result suggests that regulation will increase the operational self-sufficiency of
the MFI.

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The measure of sustainability by ROA returns the utilization of the assets irrespective of the
liability funding them and given the consideration of an ROE impact on the ROA, it’s only
prudent to consider the effect of debt through the debt to equity. The number of active borrowers
that an MFI services and therefore there is no expectation for increased social performance of the
MFI as a result of regulation. On the other hand, regulation has a significant and positive relation
on the ROA of the MFI but no significant relation with the ROE and Debt to Equity. This
implies that the source of funding for the assets isn’t directly affected by the regulatory status of
the MFI and therefore MFIs should be able to attain sustainability through prudent management
without regulation. This follows from the literature review that states manager performance (in
this case measured by ROA) varying directly with the level of financial transparency of the MFI
which regulation enforces. MFIs therefore can be unregulated and financially transparent and
achieve operational sustainability without sacrificing their outreach.

4.6 Gross Portfolio Yield

The first possible way to evaluate the performance of microfinance institutions is to compare them
to classical finance institutions. That is to compare their risk and profitability using portfolio at
risk, yield on gross portfolio etc. However, there is likely to be a systematic error involved in this
approach, since the microfinance institutions aim at reaching the poor whereas the customers of
classical finance institutions have historically higher income. It may, therefore, seem falsely that
lending methodologies of these two types of finance lead to significantly different outcomes
whereas the differences are mainly in the types of customers they reach. (Karel Janda and Batbayar
Turbat 6. September 2013)

For yield in gross portfolio to be meaningful, it must be understood in the context of the prevailing
interest rate environment the MFI operates in. Generally speaking, yield on gross portfolio is the

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initial indicator of an institution’s ability to generate revenue with which to cover its financial and
operating expenses. (KIPKEMOI ERIC, 2015)

Yield on gross Portfolio cuts through the many tricks used by MFIs to disguise their lending rates
such as flat rates, training fees, up-front fees, discounts from disbursed amounts, etc. Portfolio
yield shows how much, on average, the MFI really receives in interest payments on its loans (Tor,
2003). (KIPKEMOI ERIC, 2015)

Group lending increases the yield of the portfolio. Armendáriz and Morduch (2005) suggest that
group lending decreases the risk of default thanks to the formation of groups with individuals of
the same type. That is, risky borrowers form groups with risky borrowers and safe borrowers with
same borrowers. (KIPKEMOI ERIC, 2015)

Yield on gross portfolio does not give a significant explanatory variable for profitability, hence,
there is no general trend between increase in interest rate and increase in profitability. (KIPKEMOI
ERIC, 2015)

4.7 Relationship between Gross Portfolio Yield and Return on Asset

Portfolio yield shows how much, on average, the MFI really receives in interest payments on its
loans (Tor, 2003). According to Arunachalam (2006), yield on gross loan portfolio is the ratio
between interest payments in an MFI’s loan portfolio and the total value of the portfolio. Portfolio
yield also indicates the type of clientele that an MFI serves. Higher yields indicate riskier and more
under-banked clientele. Whereas ROA and ROE indicate whether an MFI can generate sustainable
long-term profits, portfolio yield is an indicator of an MFI’s revenue during a specific period of
time. An efficient portfolio is the portfolio which gives the highest profit with the least risk. The
aim of Markowitz’s methods is to construct that kind of portfolio (Mandelbrot, 2004). Markowitz
argues that the risk of a portfolio is less than the risk of each asset in the portfolio taken individually
and provides quantitative evidence of the merits of diversification (Amenc & Le Sourd, 2003).
Armendáriz and Morduch (2005) suggest that group lending decreases the risk of default thanks

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to the formation of groups with individuals of the same type. The Grameen Bank is based mainly
on this idea. However, Gine et al. (2009) show in their experimental projects that they would
otherwise choose. Gine et al. (2009) argue that group lending facilitates profitable risk taking while
maintain high rates of loan repayment. Good governance leads to higher portfolio yield. Papers
such as Coleman and Osei (2008), and Mersland and Strom (2009) argue that good governance of
MIFs contribute to good performance. Vanguri (2008) suggests from his research on capital
allocation in MFIs that allocating more capital towards loan portfolio will yield better returns.
Berger and Humphrey (1997) review 130 studies on financial institutions and suggest that banks
that have high loans to assets ratios tend to have higher profit efficiency. The value of assets has
been included in financial efficiency models by Luo (2003), Seiford and Zhu (1999). Armendáriz
and Morduch (2005) point out that the non-profit bodies are less 35 successful in enforcing the
loan conditions and managing the portfolio risk. Rothschild and Stiglitz (1970) demonstrated that
greater variance differed from higher risk levels. Meyer (1979) derived conditions under which
maximization of utility on a mean-variance frontier is equivalent to maximizing expected utility.
Russell and Seo (1980) showed how stochastic dominance methods can be used to determine the
expected utility efficient set and establish when meanvariance efficiency is a useful approximation.
Bawa et al. (1985) extended Meyer’s work using exact linear programming algorithms and found
that the dominated set determined by Meyer is too large.

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4.8 Capital Asset Ratio

Capital asset ratios are a measure of the amount of a bank’s capital expressed as a percentage of
its risk weighted credit exposures. An international standard which recommends minimum capital
adequacy ratios has been developed to ensure banks can absorb a reasonable level of losses before
becoming insolvent. (Matthews, 1996)

The theory of bank regulation is based on the risks that banks pose to the economy. Banks are
financial intermediaries characterized by a liquidity mismatch between the asset and liability side
of the balance sheet. On the asset side, banks usually hold a large number of long-term, customized
loans. If the bank must quickly raise capital, it can sell these loans, but because the loans are
illiquid, the bank will have to sell them at a deep discount from their face value. (Posner,
September 2014)

Capital adequacy stipulates that a bank’s capital must match its risks. Risk monitoring and risk
measurement are germane because capital is the most scarce and costly resource. The central role
of risk-based capital in regulations is a major incentive to the development of new tools and
management techniques. (Tochukwu, 7, July 2016)

According to Moldigliani and Miller’s (1958) a firm’s capital structure is irrelevant to its value in
an efficient market. As banks are joint-stock corporations, the shareholders’ losses are limited
while their gains are much larger than the fix amount of interest payment for depositors and
creditors. In an efficient market with all information published, creditors require higher loan
interest to cover the higher risk, which forces managers to maximize both share value and bank
total value.

However, Sealey (1985), Baltensperger & Milde (1987) argued that M&M theorem is not
appropriate for banks. According to the information theory, if market was efficient, banks which
do not possess special information would not exist. Therefore, bank’s appearance proves that
M&M’s assumptions have problems. Since creditors are unable to accurately assess the portfolio’s
risks, banks have incentives to increase leverage and take higher risk. As a result, regulators should
implement certain requirements for banks, especially in terms of capital, to avoid default.

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To prevent bank failures and protect the interests of depositors, it is necessarily to require banks
to maintain a high level of capital adequacy. The basic idea of the Basel accord in 1988 has two
parts. First, it established the definition of capital and the distribution between the elements (Tier
1) and additional elements (Tier 2). (Ben Moussa Mohamed Aymen, 2013)

Tier 1 capital can absorb losses without a bank being required to cause trading such as ordinary
share capital (Reserve Bank of New Zealand, 2007, p.1). Tier 1 capital is essential because it
safeguards the survival of the bank and the stability of the financial system (Reserve Bank of New
Zealand, 2007, p.1). Tier 2 capital absorbs losses in the event of a winding-up and provides a lower
level of protection to depositors (Reserve Bank of New Zealand, 2007, p.1). (Li and Zou, 2014)

Boudriga, Taktak & Jellouli (2009 found that CAR seems to reduce the level of problem loans
which means higher CAR leads to less credit exposures. However, Rime (2001) observed a
positive relationship in his research between bank risk and capital ratio of Swiss banks during the
period 1989-1995. (Li and Zou, 2014)

Samy and Magda (2009) investigate the effects of capital regulations on the performance of banks
in Egypt. The research provides a comprehensive framework to measure the impact of capital
adequacy on two indicators of bank performance: cost of intermediation and profitability. The
result of the research indicates that higher capital adequacy “increase the interest of shareholders
in managing bank’s portfolio” which generates “higher cost of intermediation and profitability”
(Samy and Magda, 2009, p. 70). (Li and Zou, 2014)

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4.9 Relationship between Capital Asset ratio and Return on Asset

Vong and Chan (2009) discovered that capital ratio has significant impact on ROA when they used
panel regression in five commercial banks in Macao SAR. They concluded that capital structure
is of paramount importance in affecting bank profitability. Akhtar et al. (2011) similarly concluded
that in six Islamic banks in Pakistan, capital adequacy has a positive effect on ROA. Obamuyi
(2013) found out that capital has a statistically significant effect on ROA in their fixed effect
regression model for 20 banks in Nigeria. Consistently, Akhtar et al. (2011) also found out that
capital adequacy has positive effect on ROE, a finding coherent with Scott and Arias (2011) who
discovered that there is a positive relationship between capital to asset ratio and ROE when they
studied five banks in the United States of America (USA). The only research with a unique result
is that of Poudel (2012) who uncovered that capital adequacy ratio has an inverse impact on bank’s
profitability, based on a study of 31 banks in Nepal. Iloska (2014) indicated that the strength and
quality of capital influence bank profitability. Flamini et al. (2009) forwarded that capital is an
important variable in determining bank profitability and a well-capitalized bank could provide a
signal to the market that a better-than-average performance should be expected. Navapan and Tripe
(2003) asserted that the proposition that there should be a negative relationship between a bank’s
ratio of capital to assets and its return on equity may seem to be self-evident as to not need
empirical verification. It is therefore important to note that Berger (1995) found evidence for a
positive relationship that is, the ratios of capital to assets and returns on equity were positively
related. He argued that a higher capital ratio (with reduced risk of bankruptcy) should reduce a
bank’s cost of funds, both by reducing the price of funds and the quantity of funds required, thus
improving a bank’s net interest income and hence profitability. However, Navapan and Tripe
(2003) found the contrary - that is, negative relationship between capital and profitability exists.
Ghosh et al. (2003) explained that banks are required to hold capital equal to a certain percentage
of the total risk-weighted assets. Under the risk-based standards, capital consists of two parts: tier-
I capital (comprising equity capital and published reserves from post-tax retained earnings) and
tier-II capital (comprising perpetual preferred stock, loan loss reserves, sub-ordinated debt, etc.).
Using the expected bankruptcy theory, Lewis (2008) explained that the expected bankruptcy costs

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hypothesis can be used to explain part of the observed positive relationship between capital asset
ratios (CARs) and return on assets (ROA) under certain circumstances. The higher the capital
levels, the higher the profitability (Bourke, 1989; Berger, 1995). Bank’s size is important because
of its relationship to bank ownership characteristics and access to equity capital (Ahmet
Büyükşalvarcı1* and HasanAbdioğlu 2011, p.6). Jackson et al. (2002) propose that the large banks
wish to keep their good ratings and therefore have considerable marketdetermined excess capital
reserves. Contrary to Jackson, Gropp and Heider (2007) found that a banking organization’s asset-
size is an important determinant of its capital ratio in an inverse direction, which means that larger
banks have lower capital adequacy ratios. Angbazo (1997) states that as the proportion of funds
invested in cash or cash equivalents increases, a bank's liquidity risk declines, leading to lower
liquidity premium in the net interest margins. Capital-ratio was measured by total capital divided
by total assets (Al-Sabbagh, 2004). This led to the evolution of international debt crisis and the
failure of one of the biggest American banks, Franklin National Bank (Koehn & Santomero, 1980).
Marcus (1983) explained the dramatic decrease in capital to asset ratio in U.S commercial banks
during the last two decades. He indicated that the rise in nominal interest rates have contributed to
the fail in capital ratios. Aggarwal and Jacques (2001) reported that US banks increased their
capital ratio without increases in credit risk. Mathuva (2009) indicates that bank profitability has
positive relationship with the core capital ratio and tier 1 risk based capital ratio. The study,
applying the ROA and ROE as proxies for bank profitability for the period 1998 to 2007, also
states that there is a negative relationship between the equity capital ratio and equity. Jeff (1990)
regards the return on assets (ROA) ratio as a major indicator of a well-managed bank.

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4.10 Debt to Equity Ratio

For a bank, liquidity acts as a measure of the ability to quickly find cash to meet the demands set
for it. Banks can generate the needed cash in different ways: by selling their assets, holding quickly
sold securities with minimal loss or with direct cash holdings on currency or the Central Bank’s
account, for example. Onaran (2016), compares the liquidity of a bank to a person drinking water.
The liquid used up during the day needs to be replaced with a certain amount of drinking water.
For a bank, the water is replaced with money and sometimes a bank needs to find ways to generate
cash to prevent the liquidity from draining. As well as a person has requirements for how much to
drink water per day, a bank also has restrictions on liquidity. (Elliott 2014, 2; Onaran 2016.)

Solvency means that a bank has enough assets to cover its liabilities. A solvency crisis occurs
when a bank cannot meet its liabilities through assets sold and therefore, it is unable to pay its debt.
This happened in the financial crisis to the Lehman Brothers, which could have accessed temporary
funds from the Federal Reserve, could not meet its liabilities. Even though liquidity and solvency
are closely related, the difference during a crisis is that the liquidity issue is a temporary cash flow
problem whereas insolvency occurs even though there is an access to temporary funds, but the
initial problem of excess debt cannot be solved. (Pettinger 2012.) The capital requirements related
to solvency from Basel III.

Financial ratios enable comparisons between companies in the same business field and between
periods. They also enable tracking profitability and efficiency. Ratios might not be meaningful
themselves as numbers. However, they become meaningful after they are compared with historical
data and field averages. Investors, for example, use ratios to compare companies. Since there are
many ways to use information to measure performance, choosing the right method is important in
order to monitor the wanted part of a company’s performance. (Basu; Freedman; Marsh 2012, 36.)
After all, financial ratios assist to identify and solve business problems. (Keown, Martin & Titman
2011, 76).

Debt capital a company can enjoy tax benefits, which is not the case with share capital. However,
excess debt capital tends to cause insolvency. Therefore, when measuring company’s obligations

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to outsiders in the relation to funds provided by owners, it is imperative to have this relationship
ideal. (Madegowda 2006, 119-120.)

Long-term debt ratio indicates relation of total amount of long term debt and the amount of total
assets of a company. If a company has a high amount of debt that it might not be able to handle, it
is not in a good position to meet all its financial obligations and further not in a good position to
pay out dividends. Therefore, ratio being more than 1 indicates that a company has more long term
debt than it has assets. (Nguyen 2017.)

Ghosh (2012), divides credit risk to two dimensions. First, the possibility of a default by the
borrower or a counterparty on the credit exposure of a bank. The second part is that when a default
occurs, what is the amount bank suffer. The amount of risk from a default can be as high as the
entire liability. When a financial institution grants a loan, for example to a company, there might
be a requirement for collateral. 21 This is an important way of managing the credit risk. (5-6;
Horcher 2005, 104; Hull 2015, 383.)

The positive sign of the net debt ratio that is, significant only in the aggregated sample, is as
expected and reflects the contribution of equity capital to a company’s solvency and stability.
Compared with debt financing, equity is usually characterized by a higher degree of stability, and
the larger its proportion in a firm’s capital structure, the higher the margin of safety available to
cope with times of poor business performances or adverse credit market conditions. A coverage
ratio that measures the company’s ability to meet the total debt with its yearly cash flow from
continuing operations.
Other works based on the same framework are those of Chava and Jarrow who analyze the role
that publicly available data related to the traded equity could have in the prediction of corporate
default, and Beaver et al. Who check the evolution of the forecasting ability of some standard
accounting indicators. In the wake of a similar approach Glennon and Nigro examine the
performance of US firms receiving government-backed guarantees, and De Leonardis and Rocci
propose the application of a frailty extension of the time-discrete survival analysis framework in
the prediction of companies’ defaults.( Daniele De Leonardisa and Roberto Roccib)

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Longstaff and Schwartz (1995) investigated risky corporate debt that incorporates both default and
interest rate risk. They found that the correlation between default risk and the interest rate has a
significant negative effect on the properties of the credit spread.

Jarrow09 Model

Traditional reduced form models assume that default is an absorbing state and the recovery is
known at default. In practice, firms may still operate after default, thus default may not necessarily
be an absorbing state. Moreover, the debt’s recovery rate may be a random variable, paid at some
future date. In order to conform to the actual situation, two economic states, solvency and
insolvency, are introduced right after default. If the firm can maintain solvency, then it pays off
the debt as promised; otherwise, the firm reaches insolvency, goes bankrupt and pays off only a
fraction of the debt’s value.

4.11 Relationship between Debt Equity Ratio and Return on Asset

Fernandez (2001) research concluded that much of the debt ratio increases; return on assets ratio
will increase. It means that more debt will increase profitability and ultimately firm value. Liu et
al (2003) were examined a sample of 3,526 companies listed in China Stock Exchange from 1997
to 2001 and found that the debt ratio significantly and positively related to product market
competition rate. They found that companies use leverage strategically to influence the product
market competition. Akhtar (2005) studied factors affecting the capital structure of the Australian
domestic and multinational companies. The results indicate that in all studied companies, growth
opportunities, profitability and firm size are crucial components of debt ratio. By dividing
industries in some group, the researcher concluded that the above factors in each industry are more
important than other industries. Smith et al (2008) studied the relationship between capital

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structure and competitiveness ability of New Zealand firms and concluded that, in compared to
other industry, the use of long-term debt also increased by increasing sales of an industry. Kouki
& Guizani (2009) studied the effect of ownership structure on dividend policy. The results show a
significant negative relationship between dividends and institutional owners. Also, there is a
positive relationship between dividend policy and public ownership. Aggarwal et al (2010)
examined the relationship between capital structures in multinational firms. They concluded that
the activity and increase the competitiveness of companies abroad, compared with the companies
that are operating in the country, the less debt in the capital structure are used. Kaio and Kimura
(2011) analyzed the levels influence of time, the company, industry and country as factors affecting
capital structure. Leverage is the amounts which can be claimed by other than the shareholders of
the organizations. According to Qureshi et al, (2012) Leverage means funds from the creditors
which are borrowed by the management of the organizations and it can be calculated by divided
total liabilities to total equity. Short term debt and long term debt both are to be returned with
interest so it is important to use both types of debt optimally (DeAngelo and Masulis,1980).
According to (Nelson and Daniel,1991) mix of leverage and equity affects profitability of the
organizations. Capital structure affects the financial performance and riskiness of the
organizations. Many researchers have found the association between return on equity (ROE),
financial leverage and size of firms. Results of their studies suggest that there is a significant
relationship between leverage and profitability of the firms. Mauer et al, (1994) found a positive
and significant connection between the ratio of short-term debt to total assets and profitability but
a positive relationship between the ratio of long term debt to total assets and profitability. Barclay
et al, (1995) have also assessed the association of between leverage and profitability. Their results
have shown positive and significant correlation between the debt ratios and profitability. Return
on assets and return on equity are positively associated with the profitability of the firms. Some
researchers have reported negative association between leverage and profitability of the firms
while some researchers found no significant relationship between leverage and profitability of the
firms. Geske and Robert, (1979) reported a significantly negative relationship between the ratio of
debt to total assets and profitability. Alkhati (2012) in his research found no statistical significant
relationship between leverage and profitability of the firms. According to Myers (1984) leverage
defines capital structure of the firms. Debt portion represent the other’s claim and it reduces the
risk of the owners (Eckbo, B.E., (1986). According to Black et al, (1973) Leverage affects not only

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the performance of the organizations but also it affects the market value of the organizations as
well. Financial leverage and operational leverage are the part of total leverage which affects the
profits of the organizations, market value and stock price of the organizations (Denis et al, 2012).
Leverage is the amount or funds taken from people other than the shareholders of the organizations.
Debts are the liabilities of the organizations because these are the amount borrowed from others
(Merton, Robert, 1974). Financial leverage and operational leverage are the part of total leverage
which affects the profits of the organizations, market value and stock price of the organizations
(Denis et al, 2012). Debts are the liabilities of the organizations because these are the amount
borrowed from others (Merton, Robert, 1974). Geske and Robert, (1979) reported a significantly
negative relationship between the ratio of debt to total assets and profitability. Alkhati (2012) in
his research found no statistical significant relationship between leverage and profitability of the
firms.

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 5 Conceptual Framework

INDEPENDENT VARIABLES DEPENDENT VARIABLE

Number of active borrowers Return on Asset

Loan loss provisions

Gross portfolio yield

The Capital – Total assets ratio

Debt ratio

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5.1 Equation

𝑌 = 𝛽0 + 𝛽1𝑋1 + 𝛽2𝑋2 + 𝛽3𝑋3 + 𝛽4𝑋4 + 𝛽5𝑋5

Here,

Y = Return on assets. DEPENDENT VARIABLE

𝛽 = Coefficient

𝑋1 = Number of active borrowers. Independent variable

𝑋2 = Loan loss provision. Independent variable

𝑋3 = Gross portfolio yield. Independent variable

𝑋4 = The capital/total asset ratio. Independent variable

𝑋5 = The debt ratio. Independent variable

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 6 Research Questions and Hypothesis

Number of active borrowers (X1) and Return on Asset (Y)

Research question: Does Number of active borrowers (X1) have a significant impact on Return
on Asset (Y)?

Null hypothesis: Number of active borrowers (X1) does not have a significant impact on Return
on Asset (Y)

Alternative hypothesis: Number of active borrowers (X1) has a significant impact on Return on
Asset (Y)

Loan Loss Provision (X2) and Return on Asset (Y)

Research question: Does Loan Loss Provision (X2) have a significant impact on Return on Asset
(Y)?

Null hypothesis: Loan Loss Provision (X2) does not have a significant impact on Return on
Asset (Y)

Alternative hypothesis: Loan Loss Provision (X2) has a significant impact on Return on Asset
(Y)

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Gross Portfolio Yield (X3) and Return on Asset (Y)

Research question: Does Gross Portfolio Yield (X3) have a significant impact on Return on
Asset (Y)?

Null hypothesis: Gross Portfolio Yield (X3) does not have a significant impact on Return on
Asset (Y)

Alternative hypothesis: Gross Portfolio Yield (X3) has a significant impact on Return on Asset
(Y)

Capital Asset ratio (X4) and Return on Asset (Y)

Research question: Does Capital Asset ratio (X4) have a significant impact on Return on Asset
(Y)?

Null hypothesis: Capital Asset ratio (X4) does not have a significant impact on Return on Asset
(Y)

Alternative hypothesis: Capital Asset ratio (X4) has a significant impact on Return on Asset (Y)

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Debt Ratio (X5) and Return on Asset (Y)

Research question: Does Debt Ratio (X5) have a significant impact on Return on Asset (Y)?

Null hypothesis: Debt Ratio (X5) does not have a significant impact on Return on Asset (Y)

Alternative hypothesis: Debt Ratio (X5) has a significant impact on Return on Asset (Y)

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 7 Research design

The research design refers to the overall strategy that you could choose to integrate the different
components of the study in a coherent and logical way, thereby, ensuring you will effectively
address the research problems; it constitutes the blueprint for the collection, measurement and
analysis of data. Steps used in research design are given below.

The degree to which the research question has been crystallized:

Formal study: Our research involves precise procedures and data source specifications to test
the hypotheses and answer the research questions

The method of data collection:

Monitoring: In this report, we have used monitoring method for data collection. We gather
secondary data for our research and observe and inspect the activity of the participants or the
nature of some material

The power of the researcher to produce effects in the variables under study:

Ex-post facto: As we’ll be dealing with data that has already occurred, we have no Control over
the data. We can only report what has happened by analyzing the data.

Purpose of the study:

Causal-Explanatory: In this research study we’ll explain the relationship between how one
variable produces changes in another in terms of Credit Risk Management of financial institution.

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The time dimension:

Longitudinal: we have used longitudinal study in our research work which catches several
moments over time and used to track changes over time.

The topical scope — breadth and depth — of the study:

Statistical Analysis: A statistical study has been used to collect information in our research
work which is an expanded study and changes overtime. Hypotheses are tested quantitatively.

The research environment:

Simulations: we have conducted simulation study as our research environment. The study
environment seeks to replicate the natural environment in a controlled situation and situations are
often represented in mathematical model.

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 8 Sampling

8.1 sample size

We have chosen 5 Islamic banks from the banks that are listed with the Bangladesh bank

8.2 sampling unit

The banks we have chosen are as follows;

1. Shahjalal Islami Bank Limited

2. Social Islami Bank
3. Al Arafah Islami Bank Limited
4. First Security Islami Bank Limited
5. Exim Bank

8.3 Sampling Method

We have randomly chosen 5 Islamic Banks from the banks listed in Bangladesh Bank.

9 Data collection method

We have used secondary data of the banks that have been published by the banks in the
form of annual reports from the year 2012 to 2016

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 10 Data Analysis
10.1 Descriptive Statistics

Table 1

ROA NAB LLP GPY CR DR

Mean 0.008440 26.84000 0.011960 1.503560 0.079240 0.925160
Median 0.009000 24.00000 0.010000 1.549000 0.086000 0.921000
Maximum 0.013000 60.00000 0.036000 2.668000 0.105000 0.963000
Minimum 0.003000 8.000000 0.004000 0.162000 0.036000 0.895000
Std. Dev. 0.003029 13.14876 0.008157 0.511856 0.022129 0.021617
Skewness -0.128174 1.044207 1.417682 -0.361144 -0.929899 0.474561
Kurtosis 1.972187 3.829611 4.458457 3.878428 2.446852 1.902208

Jarque-Bera 1.168869 5.260132 10.58999 1.347226 3.921687 2.193727

Probability 0.557421 0.072074 0.005017 0.509863 0.140740 0.333917

Sum 0.211000 671.0000 0.299000 37.58900 1.981000 23.12900

Sum Sq. Dev. 0.000220 4149.360 0.001597 6.287918 0.011753 0.011215

Observations 25 25 25 25 25 25

The above table illustrates the mean, median, maximum, minimum and standard deviation of our
dependent and independent variables. For the given variable “ROA” the mean of our sample is
0.00840 and for the same variable the median is 0.009000. For our given sample the maximum
and minimum in the Islamic banking industry will be 0.013000 and 0.003000 respectively. The
standard deviation for our sample is 0.003029 which means the mean and median can deviate up
to this much point.

For the given variable “Number of Active Borrowers” the mean of our sample is 26.84 and for the
same variable the median is 24. For our given sample the maximum and minimum in the Islamic
banking industry will be 60 and 8 respectively. The standard deviation for our sample is 13.14876
which means the mean and median can deviate up to this much point.

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For the given variable “Loan Loss Provision” the mean of our sample is 0.011960 and for the same
variable the median is 0.010000. For our given sample the maximum and minimum in the Islamic
banking industry will be 0.036000 and 0.004000 respectively. The standard deviation for our
sample is 0.008157 which means the mean and median can deviate up to this much point.

For the given variable “Gross Portfolio Yield” the mean of our sample is 1.503560 and for the
same variable the median is 1.549000. For our given sample the maximum and minimum in the
Islamic banking industry will be 2.668000 and 0.162000 respectively. The standard deviation for
our sample is 0.511856 which means the mean and median can deviate up to this much point.

For the given variable “Capital Ratio” the mean of our sample is 0.079240 and for the same
variable the median is 0.086000. For our given sample the maximum and minimum in the Islamic
banking industry will be 0.105000 and 0.036000 respectively. The standard deviation for our
sample is 0.022129 which means the mean and median can deviate up to this much point.

For the given variable “Debt Ratio” the mean of our sample is 0.925160 and for the same variable
the median is 0.921000. For our given sample the maximum and minimum in the Islamic banking
industry will be 0.963000 and 0.895000 respectively. The standard deviation for our sample is
0.021617 which means the mean and median can deviate up to this much point.

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10.2 Correlation
Table 2

ROA NAB LLP GPY DR CR

ROA 1.000000 -0.781808 0.235164 -0.013604 -0.482232 0.581491

NAB -0.781808 1.000000 -0.457685 0.023112 0.438983 -0.595718

LLP 0.235164 -0.457685 1.000000 -0.462604 -0.094951 0.554964

GPY -0.013604 0.023112 -0.462604 1.000000 -0.172577 -0.187259

DR -0.482232 0.438983 -0.094951 -0.172577 1.000000 -0.843665

CR 0.581491 -0.595718 0.554964 -0.187259 -0.843665 1.000000

From the above diagram we can see that “Number of Active Borrowers (NAB)” has a strong
negative correlation with the dependent variable “

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From the above diagram we can see that “Loan Loss Provision (LLP)” has a weak positive
correlation with the dependent variable “ROA”.

From the above diagram we can see that “Gross Portfolio Yield (GPY)” has a weak negative
correlation with the dependent variable “ROA”.

From the above diagram we can see that “Debt Ratio (DR)” has a moderate negative correlation
with the dependent variable “ROA”.

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From the above diagram we can see that “Capital Ratio (CR)” has a moderate positive correlation
with the dependent variable “ROA”.

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10.3 Equation ROA
Table 3

Dependent Variable: ROA

Method: Panel Least Squares
Date: 07/14/18 Time: 00:00
Sample: 2012 2016
Periods included: 5
Cross-sections included: 5
Total panel (balanced) observations: 25

Variable Coefficient Std. Error t-Statistic Prob.

C -0.097427 0.069412 -1.403601 0.1766

NAB -0.000165 3.67E-05 -4.509578 0.0002
LLP -0.239255 0.101127 -2.365883 0.0288
GPY 0.000340 0.000990 0.343914 0.7347
DR 0.108022 0.068451 1.578088 0.1310
CR 0.160496 0.079700 2.013752 0.0584

R-squared 0.719064 Mean dependent var 0.008440

Adjusted R-squared 0.645134 S.D. dependent var 0.003029
S.E. of regression 0.001804 Akaike info criterion -9.591783
Sum squared resid 6.19E-05 Schwarz criterion -9.299253
Log likelihood 125.8973 Hannan-Quinn criter. -9.510648
F-statistic 9.726215 Durbin-Watson stat 1.361402
Prob(F-statistic) 0.000099

The above table shows us that the dependent variable is ROA. The sample are taken from 2012 to
2016 period of five years for five Islamic banks. Now, the equation can be rewriten again as, ROA
equals to -0.097427 + -0.000165(number of active borrowers) + -0.239255(loan loss provision) +
0.000340(gross portfolio yield) + 0.108022(debt ratio) + 0.160496(capital ratio).

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The above table also shows us that the value of r-squared is 0.719064. This means 71.9% of the
variability in the independent variable or dependent variable is caused by independent variable
together.

Now let us assume that the value of alpha is 0.1, so for the group probability for the variable
number of active borrowers is 0.0002 which is less then alpha, so we reject the null hypothesis and
accept the alternate hypothesis. For the loan loss provision variable the value is 0.0288 which is
less than the value of alpha so we reject the null hypothesis and accept the alternate hypothesis.
For the variables gross portfolio yield and debt ratio, the value is 0.7347 and 0.0584 respectively.
Both are greater than the value of alpha so we do not reject the null hypothesis. For the variable
capital ratio its probability is 0.0584 which is less than the value of alpha and hence we reject the
null hypothesis and accept the alternate hypothesis.

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 11 Significance of the Study

Upon conducting this study we have come to an understanding of how credit risk works in the
Islamic banking sector of Bangladesh. By using primary data, our study seeks to examine the
performance of five Bangladeshi Islamic banks. The empirical findings of this study suggest that
bank specific characteristics both positive and negative relationship with both dependent and
independent variables.

After all the tests that have been conducted and shown above, it can be said the model is of good fit.
The calculated result shows that three independents variables number of active borrowers, loan loss
provisions and Capital ratio has a relationship with ROA therefore they do have a significant effect
on ROA because they accept the alternate hypothesis and the other variables Debt ratio and Gross
portfolio yield have no significant effect on ROA and we accept the null hypothesis.

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 12 Conclusion

Although this research has been conducted in accurate way, still there were some unavoidable
limitations. Insufficient experience and efficiency to prepare the report standard is one of the main
limitations for this study. Every bank is mostly concerned with its profitability. In Bangladesh the
banks are very competitive. So, another major limitation is this research has been done in a small
size of sample. Only five Islamic banks had been selected considering their return on assets through
their consecutive years. This amount of data is not adequate or all-encompassing because it is only
focusing on the five commercial banks for a particular period of that sector with a small data set
of this research may not measure the impact of return on asset of Islamic banks of Bangladesh. At
the same it also helped us to understand the overall regression model analysis (coefficient of
independent variables), descriptive statistics (mean, maximum, minimum and standard deviation)
correlation matrix with the chosen dependent variable (ROA) and the independent variables. The
profitability indicators are designed to give you a sense of what the figures mean.

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 13 References

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