Income smoothing behavior and the procyclical effect of loan loss provisions in Islamic banks

Abstract

Purpose This study aims to test whether loan loss provisions in Islamic banks is procyclical by explicitly examining the link between non-discretionary provisions and loan growth. In the next stage, this paper tests whether the link between non-discretionary provisions and loan growth is conditional on bank capitalization and lending. This is to identify whether bank-specific factors affect the procyclicality of non-discretionary provisions and whether such procyclicality can be explained by income smoothing in banks with different capitalization and loan profiles. Design/methodology/approach This study is conducted in four stages. The first stage identifies the determinants of loan loss provisions. The second stage investigates whether income smoothing is affected by capitalization and lending activities. In the third stage, the link between non-discretionary provisions and loan growth is examined. In the fourth stage, this paper tests whether the link between non-discretionary provisions and loan growth is affected by bank capitalization and lending. A two-way panel-fixed effect model is used. Findings Non-discretionary provisions are procyclical, particularly for banks with lower capitalization and lending activities, because such banks do not conduct income smoothing. Specifically, banks with lower capitalization experience a decline in loan growth when non-discretionary provisions to cover credit risk increase. Research limitations/implications The dataset used in this study follows Soedarmono et al. (2017) and does not enable to differentiate types of financing products in Islamic banks that may exacerbate or mitigate the procyclicality of non-discretionary provisions. Originality/value This paper extends prior literature on the procyclicality of loan loss provisions by specifically investigating the influence of non-discretionary provisions on loan growth in Islamic banks and whether such relationship depends on the role of income smoothing undertaken by banks with different levels of capitalization and lending. This paper builds on the work of Soedarmono et al. (2017) in which they do not explicitly examine the relationship between loan loss provisions and loan growth.

Analysis of Risk Taking Behavior of Islamic Banking Financing in Indonesia (Analisa Perilaku Pengambilan Risiko Pembiayaan Perbankan Syariah Di Indonesia)

“…Faktor eksternal meliputi kondisi makroekonomi seperti inflasi, suku bunga Bank Indonesia, dan Indeks Harga Saham Gabungan (IHSG). Berbagai faktor yang mempengaruhi kegiatan pembiayaan bank syariah saling berkaitan seperti risiko kredit yang meningkat dapat mendorong perbankan membatasi ekspansi pembiayaannya dengan meningkatkan loan loss provisions (Bouvatier & Lepetit, 2008;Pramono et al, 2019;Soedarmono et al, 2017). Selain itu, semakin tinggi permodalan yang ditunjukkan oleh rasio total ekuitas terhadap total aset, membuat bank syariah bersifat kontersiklikal melalui siklus bisnis (Soedarmono et al, 2017) namun permodalan yang lebih tinggi juga dapat merugikan dalam penciptaan likuiditas bagi perbankan (Evans & Haq, 2021).…”

Economics of loan growth, credit risk and bank capital in Islamic banks

“…Sobarsyah et al (2020) conduct a study by annual data of Islamic banks from 29 countries and concludes that relationship between loan growth and credit risk vary with the capitalization level. Pramono et al (2019) provide global evidence of the relationship between loan growth, loan loss provision and bank capital. The claims that the banks with lower capitalization experienced a decline in loan growth and remain K 51,12 restricted in their lending portfolio.…”

“…This practice is common in conventional banking research, whereas the pieces of evidence are limited in the Islamic banking context (Sobarsyah et al, 2020;Soedarmono et al, 2017b). The study uses two The moderating role of capital measurements of loan growth (DLOAN) where one is similar to (Pramono et al, 2019;Sobarsyah et al, 2020), and lagged loan growth (LOANG) is similar to (Foos et al, 2010). However, the study uses the following aspects as control variables: bank size, profitability, asset growth, business trend and inflation rate.…”

Can Shari’ah supervisory board and Islamic bank characteristics reduce tax avoidance? Evidence in Indonesia and Malaysia

“…Research conducted in the past focused on explaining that Islamic banks break Shari’ah compliance principles by engaging in unethical practices like income smoothing (Boulila Taktak et al , 2010; Ozili and Outa, 2017; Pramono et al , 2019; Shawtari et al , 2015; Taktak, 2011), loan loss provisions (Ashraf et al , 2015; Farook et al , 2014; Noor and Mohamed, 2019; Soedarmono et al , 2017; Zulfikar and Sri, 2019), earning management (Abdelsalam et al , 2016; El-Halaby et al , 2020; Kolsi and Grassa, 2017; Lassoued et al , 2018; Othman and Mersni, 2014; Suripto and Supriyanto, 2021; Zainuldin and Lui, 2021; Quttainah et al , 2013) and profit equalization reserve (Noor and Mohamed, 2019), rate of return (Zainol and Kassim, 2012), Islamic accounting conservativism (Almutairi and Quttainah, 2019) and deposit rate of mudharabah (Latiff and Halid, 2012). Furthermore, this study contributes to filling two gaps.…”