The Profitability Liquidity and Credit Risk Finance Essay

The chapter will discuss aspects of research methodology applied in this study. It will also discuss on the data collection method and other statistics tool that will be used in evaluating the performance of the banks. This study will use descriptive financial analysis to describe, measure, compares, and classifies the financial solutions of Malaysian banks. To evaluating banks' performance, this study uses a ratio measure that is not a new method in the literature. The use of ratio method has many advantages and the most important benefit is that it compensates bank disparities. Banking firms are not equivalent with respect to sizes. The ratio removes the disparities in sizes and brings them at par. In order to examine whether there is a difference in performance between Islamic banks and conventional banks of Malaysia, equality of mean test is performed. The equality of mean test used for comparing statistics from two or more samples of numeric data drawn from two or more populations is most widely used in the literature of performance and the typical text in statistics. The hypothesis is that the performance ratios are normally distributed. The null hypothesis of the equality of mean for the conventional banks and Islamic banks is tested against not equality of mean.

Dependent variable

The dependent variable for this research is performance Islamic banks comparable to conventional banks in Malaysia, coded 1 if a performance Islamic bank is at par with the conventional banks and 0 otherwise.

Independent variable

The independent variable for this research is comprising (1) profitability performance, (2) liquidity performance and (3) credit risk performance that will influence the overall performance Islamic banks comparable to conventional banks of Malaysia.

3.3 Data collection

In this study, the performance of Islamic banks in Malaysia is compared with the conventional banks. The data for financial ratios are obtained from the respective banks' annual report each year for 10 years from the period 2002 until 2011 of the both Islamic and conventional banks (include foreign banks). Therefore, the growth rate of the banks are measured based on 2011 as the base year consist of : Local full-fledge Islamic banks Bank under this category is classified as standalone Islamic commercial banks established with no relationship with conventional bank either as tha parent or subsidiary company, such as, Bank Islam and Bank Muamalat. Local Islamic subsidiary banks Islamic subsidiary banks are those banks that have been established after the migration of conventional banks with Islamic bank windows into a full licensed of Islamic bank status. Foreign banks (both conventional and Islamic) Foreign banks are those foreign players that have been granted a license by BNM to established financial institutions in Malaysia. The data employed is obtained from the annual reports of respective banks. All data for Islamic subsidiary banks are taken from the annual report of the parent bank is annual report is not available, that is prior to establishment of standalone Islamic banks.

3.4 Sample

The sample banks for this study are forty three (43) banks (include foreign banks) comprising two (2) full-fledge Islamic banks, other fourteen (14) Islamic banks and twenty seven (27) conventional banks. The unavailability of audited financial statements of some banks limits us to use bank population for analysis.

3.5 Performance measures

This study uses internal factors for those related to items of balance sheet and income statement of banks and well within the control of the bank management. After examining the income statement and balance sheet of Islamic banks and conventional commercial banks of Malaysia, this study utilizes seven financial ratios for evaluating the financial performance of Islamic versus conventional of bank of Malaysia. These financial measures of performance are placed under three categories as given below: Profitability Performance Liquidity Performance Credit (loan) Risk Performance

Profitability performance

There are some financial measures for evaluating profitability performance of a firm. This study uses the following three basic. They are: Return on Assets (ROA) = profit after tax/total assets ROA is a superior indicator of a bank's financial performance and managerial effectiveness. It shows how proficient the management is in allocating asset into net profit. The higher the ROA, the higher the financial performance or profitability of the banks. Return on Equity (ROE) = profit after tax/equity It shows a rate return on base capital, i.e., equity capital. The higher the ROE, the more efficient is the performance. Cost to Income (CTI) = total cost/total income. Cost incurred per ringgit generation of income or in other words, income generated per ringgit cost. It is indeed considered to be one of the best indices for measuring economic efficiency or profit performance. The lower the CTI ratio, the better is the profitability performance of a bank.

Liquidity performance

Liquidity is the life of a commercial bank. Liquidity means cash availability: how quickly a bank can convert its assets into cash at face value to meet the cash demands of the depositors and borrowers. The higher the amount of liquid asset for a bank, the greater is the liquidity of the bank. Among the various liquidity measures, this study uses the following: Cash Deposit Ratio (CDR) = cash/deposit. Cash in a bank vault is the most liquid asset of bank, therefore, when withdrawal exceeds new deposit significantly over a short period, banks will get into liquidity problem. Bank with higher CDR is relatively more liquid than a bank which has lower CDR, thus enhance depositors' trust. Loan Deposit Ratio (LDR) = loan/deposit. It indicates the percentage of the total deposit locked into non-liquid asset. The higher the LDR, the higher is the liquidity risk.

Credit risk performance

Three financial ratios are used for measuring loan/credit risk performance of a bank. These are: Equity to Asset ratio (EQTA) = common equity/assets. It measures equity capital as a percentage of total assets. EQTA provides percentage protection afforded by banks to its investment in asset. It measures the overall shock absorbing capacity of a bank for potential loan asset losses. The higher the ratio of EQTA, the greater is the capacity for a bank to sustain the assets losses. Equity to Net Loan ratio (EQL) = total equity/net loans. It measures equity capital as a percentage of total net loans. EQL provides equity as a cushion (protection) available to absorb loan losses. The higher the ratio of EQL, the higher is the capacity for a bank in absorbing loan losses.

T-test analysis

A t-test is any statistical hypothesis test in which the test statistic follows a student's t distribution if the null hypothesis is supported. In order to examine whether there is a different in performance between Islamic banks and conventional banks of Malaysia, t-test is performed for all financial ratios. The assumption is that the performance ratios are normally distributed. The t-value is an indication the probability that both selected samples have the same mean and that differences in the sample means are due to fluctuation. As the t-value gets smaller (approaches zero) the probability that sample means ate the same gets larger. As the t-value gets larger (in either the positive or negative direction) the probability that sample means are the same gets smaller. Whereby: n = sample size s² = variance = sample mean df = degree of freedom subscript1 = sample from Islamic banks subscript2 = sample from conventional banks Since t-value is used to determine whether there are significant differences between two groups, the comparison is made between conventional banks and each category of Islamic banks.

Regression analysis

In statistics, regression analysis includes a lot of techniques for modeling and analyzing several variables, when the focus is on the relationship between a dependent variable and one or more independent variables. Regression equation : A…A· = a + bx Once you have the regression equation, using it is a snap. Choose a value for the independent variable (x), perform the computation, and you have an estimated value (A…A·) for the dependent variable. Regression model : A…A·Islamic = a + bx1 + bx2 + bx3 A…A·Conventional = a + bx1 + bx2 + bx3 Whole model : A…A·Malaysian banks = a + b1PROFITABILITY + b2LIQUIDITY + b3CREDIT RISK Whereby : A…A· = performance of banks (each and both) (dv) a = a constant terms bx1 = profitability performance (iv1) bx2 = liquidity performance (iv2) bx3 = credit risk performance (iv3) Regression analysis is also used to understand which among the independent variables are related to the dependent variable, and to explore the forms of these relationships. In restricted circumstances, regression analysis can be used to infer causal relationships between the independent and dependent variables. All these method can be identified by using SPSS to see the result of every method one by one. Regression analysis includes a few techniques for modeling and analyzing several variables, when the focus is on the relationship between a dependent variable and one or more independent variables (Keller, 2008).

3.6 Chapter summary

This chapter contains a description of the research methodology that will be used in this study. Furthermore, the research design and method, sampling, data collection method and the types of analysis to be used are also discussed. The results of the study as well as the conclusions to be drawn from the findings will be constructed in the next two chapters.

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