Analysing Financial Distress in Malaysian Islamic Banks: Exploring Integrative Predictive Methods

Abstract

Against the background of global financial crisis, some argue in favour of the ‘resilience’ of Islamic finance, while others suggest that Islamic financial institutions are not more prone to distress and crisis than their conventional counterparts. However, there have been a number of cases of Islamic finance and banking distress in recent years, including instances in Malaysia. These cases, hence, motivated this study in terms of emphasising the importance of employing financial distress prediction models for analysing Islamic banks.
This study aims at empirically exploring, examining and analysing the financial distress of the Malaysian Islamic banks. In doing so, the effectiveness of the existing early warning statistical insolvency prediction models that have been used in previous studies, and a particular model adapted by Islamic banks in Malaysia were critically evaluated. This study, hence, employed a number of models to predict the financial distress faced by Islamic banks in Malaysia. In addition, an attempt was made at the modification of the existing early warning insolvency prediction models in evaluating and analysing the financial distress of Malaysian Islamic banks. This research is constructed within four empirical chapters by employing three prediction models in assessing the financial distress of Islamic banks.
The first empirical chapter analyses the secondary data collected from a sample of Islamic banks, based on selected ratios developed in the literature, whereby a comprehensive description of these selected financial ratios in terms of descriptive statistical analysis for the selected Islamic banks in Malaysia is provided.
The second empirical chapter investigates the performance of the ‘emerging market Z-score’, introduced by Altman in predicting the performance of Islamic banks and conventional banks in Malaysia. The study aimed to introduce the EM Z-score as a valuable analytical tool in monitoring the deterioration of the performance of banks as well as looking at the impact of the global financial crisis on the performance of Islamic and conventional banks. This chapter examines thirteen Islamic banks and ten conventional banks during the period of 2005-2010. The results show that the EM Z-score for all banks is well above the cut-off point of 2.6, although for Islamic banks the EM Z-score showed a declining trend whilst for conventional banks it showed an increasing trend. This empirical evidence is important for the banks since it provides a warning signal to the banks’ management as well as the related parties involved in the planning, controlling and decision making process.
The third empirical chapter presents the newly constructed integrated predictive model designed to evaluate and analyse the financial distress of Islamic banks in Malaysia, which can be used as an alternative model for regulators in monitoring the performance of Islamic banks that are experiencing any serious financial problems. This paper develops a preliminary model for the prediction of the performance level of Islamic financial institutions for the period of December 2005 to September 2010 by using quarterly data for ten selected Islamic banks in Malaysia. For this, factor analysis and three parametric models (discriminant analysis, logit analysis and probit analysis) are used. The results depict that the first few quarters before the benchmark quarter are the most important period for making a correct prediction and crucial decisions on the survival of Islamic banks. Thus, the results demonstrate the predictive ability of the integrated model to differentiate between the healthy and non-healthy Islamic banks, therefore reducing the expected cost of bank failure.
The fourth empirical chapter conducts further exploration in predicting the financial distress position of Islamic banks by introducing new variables such as the funding structure, deposit composition, and macroeconomic variables. Using the same sample and data set for Islamic banks as in the previous chapter, this study shows the relationship between the banks’ funding profiles and other alternative variables, and the Islamic banks’ performance in Malaysia. For this, the logit model is used. Based on the results of all models, this study recommended two final models, which showed an excellent fit for predicting the Islamic banks’ performance. The results indicate that none of the macroeconomic variables included were significant, thus suggesting that the performance of Islamic banks in Malaysia was not affected by the economic conditions throughout the study period. This can perhaps be attributed to efficient regulation and supervision by the relevant authorities in the country.