Credit Risk and The Financial Performance of Islamic Banks in Africa: A Critical Literature Review

Credit risk management is an important contributor to the financial performance of banks as the success of banks financial performance is often dependent among other factors on how effectively the bank manages its credit risk (Prakash and Poudel,
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  1 Credit Risk and The Financial Performance of Islamic Banks in Africa: A Critical Literature Review Awosanya Yusuff Adewale*, Dr. Platonova Elena** *PhD Student, Center of Islamic Finance. University of Bolton ** Senior Lecturer in Islamic Finance, Center for Islamic Finance. University of Bolton. Abstract: Credit risk management is an important contributor to the financial performance of banks as the success of banks financial performance is often dependent among other factors on how effectively the bank manages its credit risk (Prakash and Poudel, 2012). The unique banking system in Islamic banks causes differences in the level of credit risk faced by Islamic banking compared to the conventional banking system which consequentially affect the financial performance of both banking system in different ways which necessitated this study. This paper surveys the influence of credit risk on the financial performance in Islamic Banks in Africa. The literature review provides a comprehensive analysis of past studies on the relationship between credit risk and the financial performance of both commercial banks and Islamic banks in Africa. Thus, analysing the major findings from the various studies. The study commenced with an explanation of the credit risk in Islamic banking and the relevance in the Islamic banking products before proceeding further to dissect the determinants of credit risks in Islamic banks. A critical review of the past literature was used to establish findings in this sparsely research aspect of Islamic Finance which is lacking in the developing countries. This paper uses a comparative analysis of studies on credit risk and financial performance in the African region on both commercial banks and Islamic banks and then attempts to analyse the major disparities found in these studies. An in-depth literature review of past studies helped to identify the existing research gaps in the topic area and from this, found that most of the studies on the relationship between credit risk and commercial bank financial performance in Africa (Nigeria, Tanzania, Kenya, and Ethiopia as represented in the review) found a significantly inverse/negative relationship between credit risk and the financial performance of commercial banks in African countries; while most of the studies in Africa on the relationship between credit risk and Islamic bank financial performance also found a negative relationship between credit risk and the financial performance of Islamic banks in Africa despite the uniqueness of the Islamic banking system. However, due to the uniqueness of the Islamic banking system and the insignificance of interest rate risk, the relationship between credit risk and profitability of Islamic banks have been adjudged to be positive in countries like Jordan, Pakistan, Malaysia, Indonesia, and Middle Eastern countries that have a strong background and structure for Islamic banking. Findings from this study suggested that the disparity between the findings from African countries and other countries like Jordan, Indonesia, Pakistan, Malaysia and Middle Eastern countries that have more developed Islamic banking system is due to challenges relating to the compliance and regulations of Islamic banking products; higher risks in regulatory sector financing in Africa; and peculiar challenges faced by African Islamic lenders like the lack of collateral, absence of property titles, thin business plans, and inadequate financial documentation which impacts due diligence and efficient credit risk management in the African region. All the studies relied upon for this study utilised a quantitative research method as well as secondary data collection. Conclusion and Recommendations were developed from the findings from studies, and the critical and logical analysis of trends, patterns and relationships of these findings. Key Words: Risk Management, Credit Risk, Financial performance, Islamic banks, Africa.  2 1.Introduction Islamic products like any other financial product involve exposure to credit risk which vary based on the nature of the products. According to Rahman and Shahimi (2010), the nature of the Islamic products differs from other financial products which makes credit risk in Islamic banking differ (Rahman and Shahimi, 2010). Islamic products like Murabahah, Istisna, Ijara, Salam, and  Musharakah  have varying nature of credit risk from the products from conventional banks which will be briefly discussed in this study. As opined by Waemustafa and Sukri (2015), there is need to understand how credit risk is formed in the Islamic banking context while considering both the internal and external determinants. Hence the study will attempt to review how credit risks is involved in the main products offered by the Islamic banking system before it delves into the main objective which is the impact of credit risk on the profitability. From an economic standpoint, Murabahah  financing and interest-based financing are quite similar expect in their contractual features (Samad, 2004). Murabahah (sale of goods with mark-up) is the most popular Islamic banking product as it makes up about 80% of all transactions in the Islamic banks (Ahmed and Mohamed, 2011). In this product, the borrower provides all the necessary details to the bank regarding the purchasing requirements which the banks then go ahead to make purchase of the product and resells to the borrower with a profit margin. The credit risk in this product arises when the borrower fails to meet his obligation to pay for the product at the time of delivery. Non-binding Murabahah  also exposes the bank to credit risk as the borrower might refuse the product delivery at a later date after the bank must have purchased the product because of reasons like variations in product quality or product prices (Iqbal and Mirakhor, 2011). As explained by Boumediene (2011), credit risk also occurs in Islamic banks’ Murabahah financing when customers  fail to complete the instalment repayment for the goods as stipulated which also causes credit risk to Islamic banks. Musharakah  (profit and loss sharing) is an Islamic product that is similar to the joint venture partnership financial product offered by their conventional counterparts where the banks and other partners provide the funds for the business and the profit and loss is shared at a predetermined ratio (Kabir, et al., 2015). Most Shariah scholars argue that the Musharakah  is the closest Islamic banking product to interest-based financing as the predetermined ratio upon which the profit and loss is shared has an element of interest rate variation (Errico and Sundararajan, 2002). However, the Islamic banks face credit risk on this product because of the asymmetry of information from the partner. Thus, the bank is often exposed to high capital impairment risk as well as a high level of credit risk with the partner investor. This is because as opposed to the conventional banks, the Islamic banks have to cover its share of any loss incurred due to the negligence of partner and may lose all its invested capital in the process (Errico and Sundararajan, 2002; Haron and Hock, 2007).  3 Ijarah  (leasing) is another Islamic financial product that is popular but has lower credit risk than other Islamic financial products. This is because Islamic banks are only exposed to credit risk relating to  Ijarah  only when the lessee defaults on payment when rent is due. Unlike Leasing in the conventional banking system, Islamic banks in compliance with Shariah cannot transfer all the risks and rewards of the asset ownership to the lessee as the asset is required to be reported as an asset to the Islamic bank throughout the term of the lease contract (Boumediene, 2011). Also, banks encounter credit risk on Ijarah  when the lessee cancels the lease before the stipulated time which makes the banks possess a purchased asset that has no expected return until the lease agreement runs out. Salam  (forward sale) is a contract that involves a buyer paying on a stipulated date on the contract in full and the seller delivering later. Islamic banks engage in two parallel Salam contracts at once and they both work independently. The first contract is with the seller while the second is with the buyer. The credit risk inherent in this Islamic financial product is the event of a failure to deliver the products at the stipulated time. Also, due to adverse fluctuations, the bank might face higher credit risk as a result of default from the seller and thus not deliver the products. This will mean the bank will have purchase the product at a higher price from another seller in order to deliver to the buyer (Rahman and Shahimi, 2010). Istisna  is another Islamic product like Salam which is also forward sales-based mode of financing but the Istisna  is used mainly for manufacturing goods. There are two ways under the Istisna  in which Islamic banks are exposed to credit risk. The first way is the event that the bank fails to deliver the product at the stipulate time to the buyer which might be due to late delivery from the manufacturer. This will make the bank purchase the product at a possibly higher price from another manufacturer. The second way is the event that the bank sells the product in instalments to the buyer and the buyer defaults on the payments which results in a loss of receivables for the bank (Boumediene, 2011). 2. Research Problem The recognition of factors that affect financial performance in financial institutions is one of the most important areas that stir the interest of researchers in the financial field where researchers could identify the factors that significantly influence the financial performance of financial institution. However, this research has mostly been carried out on the conventional banking system which necessitated this critical literature review. Various studies on the relationship between credit risk and bank profitability has been largely done using commercial banks but the study on Islamic banks still lack literature especially in developing countries like the African region. Hence, due to lack of studies in Africa and other developing countries on the impact of credit risk on financial performance, this paper attempts to critically review existing literature on credit risk in Islamic banks in the developing  4 region and perform a critical comparative analysis with existing literature on credit risk in commercial banks. Thus, analyse the disparities between the major findings from the studies.  3. Research Objective The objective of this paper is to investigate and critically survey the relationship between credit risk and the bank performance of Islamic banks in Africa. 4. Determinants of Credit Risk in Islamic Banking It is imperative to understand the determinants of credit risk in Islamic banks as the efficiency of credit risk management in Islamic banks is often dependent on the management of these determinants. The main determinant of Credit Risk has been debated over the years from studies of different authors using different regions and time periods. However, as suggested by research, the main determinants of credit risk in Islamic banks arise from Islamic financing contract which is closely associated to the Murabahah product; regulatory capital; and risk sector financing. Waemustafa and Sukri (2015) carried out a study on the dynamic determinants of credit risk in Islamic Banks and Conventional banks. The study employed 14 banks specific variables and 6 macroeconomic variables which include new variables like yield curve, output gap, Islamic financing contract (ISCON) and Islamic interbank rate. Pooled model of multivariate regression was used in the study to analyse the variables which were extracted from the annual reports of 15 Islamic banks and 13 conventional banks in Malaysia within the period 2000 to 2010. Based on the findings from the study, the Islamic financing contract (ISCON) based on debt-based Murabahah and deferred payment sale Bai-Bithaman Ajil (BBA) contract showed a positive and significant relationship to credit risk in Islamic banks. This is in line with the study of Rosly (2011), who deducted that Murabahah financing in Islamic banks are the major contributors to credit risk in Islamic banks (Waemustafa and Sukri, 2015). Rosly (2011) explained further that Murabahah mode of financing via differed payment sales or BBA contributes approximately 90% of all financing in Islamic banks. Thus, making ISCON the most important variable in Islamic finance (Rosly, 2011). Rosly and Mohd-Zaini (2008) also reported that the core business of Islamic banking is mainly based on instalment financing such as the Bai-Bithaman Ajil (BBA) or deferred payment sales, and Murabahah, which could explain the positive and significant impact of ISCON on credit risk in Islamic banks (Rosly and Mohd-Zaini, 2008). This further purport that any deterioration in the quality of Murabahah finance would significantly affect credit risk creation. Thus, an increase in ISCON would consequently result in a higher credit risk. The Risk sector financing (RSF) was found in the study of Waemustafa and Sukri (2015) to be the second largest contributor of credit risk for Islamic banks, while Regulatory Capital (REGCAP) was  5 found to be the third largest contributor based on the level of positive significance drawn from the pooled model (Waemustafa and Sukri, 2015). The risk sector financing is a proxy for the banks exposure to the risky economic sectors that have strong correlation to the economic downturn and speculations. Sectors like the property, residential and real estate are considered risky economic sectors as speculative elements of the economic can for instance lead to property price bubbles. Hence, the study deduced that Islamic banks are vulnerable to credit risk from their financing exposure to these risky economic sectors (Waemustafa and Sukri, 2015). Regulatory Capital as a proxy for the capital requirement of Banks is reported in the study by Waemustafa and Sukri (2015) to have a positive significant relationship with the credit risk of Islamic banks while it has a negative significant relationship with the credit risk of Conventional Banks (Waemustafa and Sukri, 2015). This indicates that the risk behaviour in conventional banks are influenced to a great extent by the capital requirement as the lower the capital requirement, the higher the credit risk. This explains the theoretical intuition of Sufian and Muhammed (2011) that purports that since an average conventional bank maintains 4 times lower capital compared to Islamic banks, they are inclined to take on more default risk because lower capital requirement means more funds available which allows the bank to lend more. Arnold and Lemmen (2001) explained that banks also tend to diversify their assets via holding public debts as they are not required to maintain capital against public securities. Thus, the higher the capital requirement, the less assets they diversify into public debts which also explains the negative relationship. However, as the study was conducted in the financial crisis era, the findings could have been influenced by the enormous losses from loans in the conventional banks. The Islamic banks on the other hand maintain 4 times larger capital requirement than their conventional counterparts and although as mentioned earlier, Islamic banks engage more in risky economic sectors, they rely on the regulatory capital to absorb risk which explains why the higher the regulatory capital, the higher the credit risk in Islamic banks. The finding is also consistent with Rahman and Shahimi (2010) as they also reported a positive relationship between credit risk and regulatory capital and further suggested that it could also be as a result of a more prudent risk management in the Islamic banking system compared to conventional banks. Macroeconomic factors like Inflation rate has also been identified to have significant negative relationship with credit risk. According to Castro (2013), high inflation can make debt financing easier by reducing the real value of outstanding loans. Although, it can also weaken the ability for borrowers to service their debts by reducing their real income (Castro, 2013). Mkukwana (2013) also explained that higher inflation rate could force borrowers to miss loan payment in order to fulfil other basic
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