Studies in Economics and Finance Volume 31 Issue 1 2014 [Doi 10.1108%2Fsef-02-2013-0017] Ben Othman,...

8/20/2019 Studies in Economics and Finance Volume 31 Issue 1 2014 [Doi 10.1108%2Fsef-02-2013-0017] Ben Othman, Haki…

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The use of discretionary loan lossprovisions by Islamic banks and

conventional banks in the MiddleEast region

A comparative study

Hakim Ben Othman and Hounaida Mersni Accounting and Finance Department, Tunis Business School,

University of Tunis, Tunis, Tunisia and LIGUE-ISCAE, University of Manouba, Tunis, Tunisia

Abstract

Purpose – The purpose of this paper is to study earnings management practices of Islamic banksand conventional banks in the Middle East region. First, the authors examine factors that mayinfluence Islamic banks managers’ use of discretion in reporting loan loss provisions (LLP). Second,the authors investigate differences that may exist between Islamic banks and non-Islamic banks interms of discretionary loan loss provisions (DLLP) used to manipulate accounting earnings.

Design/methodology/approach – This empirical study uses an unbalanced panel data of 21 Islamic banks, 18 conventional banks with Islamic windows and 33 conventional banks, from sevenMiddle East countries during a period that ranges from 2000 to 2008. The authors use a two-stageapproach in order to examine factors that may influence the use of discretion by Islamic banks’managers.

Findings – The empirical results reveal that Islamic banks use DLLP for both earnings and capital

management. External financing is also found to be a determinant of DLLP. Additional findings showno significant differences among Islamic banks, conventional banks with Islamic windows andconventional banks in using DLLP. These three groups of banks behave similarly in terms of discretion based on DLLP.

Practical implications – The findings are potentially useful for regulators, auditors and investors.This study provides regulators with insights to strengthen their financial regulations in order toimprove accounting quality. In addition, it helps auditors when considering the provisioning policiesadopted by banks in order to detect specific manipulations of accounting earnings. The results mayalso help investors to focus on the impact of managerial discretion on accounting earnings forevaluation purposes.

Originality/value – This study contributes to the literature on Islamic banking. On the one hand,it extends prior research by examining the discretionary component of LLP, instead of being restrictedto total LLP. On the other hand, it compares the use of discretion among three groups of banks: fullIslamic banks, conventional banks with Islamic windows and full conventional banks.

Keywords Earnings management, Islamic banks, Conventional banks,Conventional banks with Islamic windows, Discretionary loan loss provisions

Paper type Research paper

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1086-7376.htm

JEL classification – G34, M40, M41, M42

Studies in Economics and Finance

Vol. 31 No. 1, 2014

pp. 106-128

q Emerald Group Publishing Limited

1086-7376

DOI 10.1108/SEF-02-2013-0017

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1. IntroductionA wide literature has addressed the issue of earnings management in the bankingindustry. It is shown that banks around the world are found to manage their earningsand banks’ managers are motivated to minimize the earnings volatility over time.

Current literature provides evidence that loan loss provisions (LLP) are used by banksas an instrument for long-term earnings management (Collins et al., 1995; Ismail andBe Lay, 2002; Anandarajan et al., 2005, 2007; Taktak et al., 2010a). Most existingstudies have concentrated on conventional banks. However, little attention has beengiven to earnings management in Islamic banks in the Middle East region.

Recent studies such as Zoubi and Al-Khazali(2007) and Taktaketal. (2010b) addressedtheissue of the use of LLP in Islamic banks.Zoubiand Al-Khazali (2007)arguethat Islamicbanks use LLP to manage earnings while Taktak etal. (2010b) defend the idea that Islamicbanks do not use LLP to smooth their results. Although a few studies have provided someevidence on the use of LLP by Islamic banks, the discretionary component of this variableremained unexplored. Following Kanagaretnam et al. (2004) and Kwal et al. (2009), weisolate, in this study, the discretionary component of loan loss provisions (DLLP) and weuse it as our dependent variable. The purpose of this paper is to examine factors that caninfluence the Islamic banks managers’ use of DLLP. More specifically, we determine first,whether managers use discretion to manage earnings and capital ratio in Islamic banks.Second, we explore if there is any difference in the use of discretion between Islamic banksand non-Islamic banks in the Middle East region.

Using panel data of 21 Islamic banks, 18 conventional banks with Islamic windows and33 conventional banks pertaining to seven countries from the Middle East region(i.e. Bahrain, Egypt, Jordan, Kuwait, Qatar, Saudi Arabia and UAE), we find that Islamicbanks use their discretion for earnings management. Indeed, we find that earnings beforetax and provisions ratio (EBTP) has influence on the discretion of Islamic banks proxied byDLLP. In addition, results show a positive and significant relationship between capital

adequacy ratio (CAR) and DLLP, suggesting that managers in Islamic banks use discretionto manage their capital ratio to enable banks to avoid violating minimum requirements.Moreover, our findings reveal that Islamic banks and non-Islamic banks behave similarly interms of DLLP. In effect, there is no substantial difference in the use of DLLP by managers of Islamic banks, conventional banks with Islamic windows and conventional banks.

Our study contributes to the earnings management literature in Islamic banking.We extend prior work by focusing on the use of the DLLP rather than the total amount of LLP. Furthermore, we compare the use of discretion between Islamic banks and their“non-Islamic” counterparts. To our knowledge, this research is the first one thatdistinguishes between conventional banks withIslamic windows and conventional banks.

Our findings are of interest to the interests of investors, standard setters and auditors.This study helps investors to consider the impact of managerial discretion on

accounting earnings for evaluation purposes. Standard setters and regulators should beable to provide adequate standards that regulate the estimation of LLP by banks. Theyshould require additional disclosure from banks in order to constrain discretionarybehavior of managers and to prevent from an aggressive earnings management.Auditors have to focus more on the provisioning policies adopted by banks in order todetect specific manipulations of accounting earnings.

The remainder of the paper is organized as follows. Section 2 presents thespecificities of Islamic banks. Section 3 provides backgrounds for the study and

Use of DLLP byIslamic banks

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develops hypotheses. Section 4 introduces the sample and describes our researchdesign. Section 5 presents descriptive statistics and reports results of our analysis basedon our DLLP panel-regression model. Section 6 concludes the paper.

2. Specificities of Islamic banks 2.1 Islamic banks’ principlesIslamic banks are based on the sharia law, which derives from the interpretation of theQuran and Sunnah and from other secondary sources of Islamic law, such as Ijma’(unanimous agreement among sharia scholars about specific issues not envisaged by theQuran or the Sunnah), Qiyas (the use of deduction by analogy) and Ijtihad(personal reasoning) (Al-Gamal, 2006). The adoption of sharia leads Islamic banks tofocus more on ethical and moralvalues in their banking industry rather than credit value(Hamdi and Zarai, 2012). The code of conduct of Islamic banks requires financing legalactivities which are sharia compliant. Certain commodities such as alcohol, illegal drugsand illegal arm dealing are not allowed by the sharia law. Islamic banking, must avoid

also uncertainty (Gharar) and gambling (Mayser). Whence, any contract based on riskyor hazardous events and generated an easy profit, without breaking sweat, is notallowed (Al-Gamal, 2006). The distinguishing feature of Islamic banks is the prohibitionof interest. According to Islamic law, money should not bread money, so both thecharging and the receiving of interest are strictly forbidden (Taktak et al., 2010b;Taktak, 2011; Hamdi and Zarai, 2012). The profit sharing concept is used as analternative to the interest based banking. Consequently, Islamic banks become partnersand they share risk both with depositors and shareholders (Taktak et al., 2010b;Farouk et al., 2012). The banning of interest and the activating of profit sharing principlemake the investment approach adopted by Islamic banks unique and different fromconventional banks (Taktak et al., 2010b; Hamdi and Zarai, 2012). Unlike conventionalbanks, Islamic banks have only one kind of loan and that is Qard-el-hassan (literally

good loan). This type of loan is a profit-free loan for which the bank does not charge anyinterest or additional amount over the money lent (Al-Gamal, 2006).

The main products offered by Islamic banks based on profit sharing principles areMudharaba and Musharaka contracts. The Mudharaba contract is a type of apartnership, in which one partner provides the capital and the other provides expertiseand management. If the project generates profit, each partner gets a pre-arrangedpercentage of profit. If there are losses, the capital provider bears all financial losseswhile the entrepreneur supports only, the operating costs of their own efforts. TheMusharaka contract requires that the bank and the depositor establish a jointcommercial enterprise, in which all partners contribute capital as well as labor andmanagement and share profit and loss in a pre-arranged way (Al-Gamal, 2006). Withthis respect, the loan portfolio of Islamic banks is diversified and it includes

Qard Hasan, Musharaka, Mudharaba and many others financing techniques that aresharia compliant (Turen, 1996; Zoubi and Al-Khazali, 2007).

2.2 Provisioning practices of Islamic banksConventional banks and Islamic banks follow substantially different provisioningpractices (Taktak et al., 2010b; Hanif, 2011; Farouk et al., 2012). The Accounting andAuditing Organization for Islamic Financial Institutions (AAOIFI) requires the use of dynamic provisioning, which is a macro-prudential tool used to reduce the procyclicity of

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banks’ provisions and earnings and thus their probability of default (Wezel et al., 2012).The fundamental principle underpinning dynamic provisioning is that a forward-lookingprovision, based on long-run expected annual losses, is made each year.

The AAOIFI’s standard (11), which sets out the accounting for provisions and

reserves, defines provisions as “setting aside certain amount from income as expenses torevaluate receivables, financing and investment assets”, when the probability of uncollectible amounts or assets impairment occur. This standard advocates therecognition of two types of provision: general and specific provisions. The first oneshould be recorded in order to cover potential losses that results from unidentifiablerisks related to assets, and the second one is recognized when the asset is impaired, inorder to reduce its amount to its net realizable value. Therefore, the LLP is recorded tobetter anticipate the credit risk of the bank. These characteristics in provisioning policyadopted by Islamic banks are more sophisticated than conventional banks in that it doesnot take into consideration the actual loss only, but it considers the expected futurelosses (Salman, 2004; Taktak et al., 2010b; Taktak, 2011; Quttainah, 2011).

However, it is noteworthy that, the AAOIFI’s standards are not applied by all Islamicbanks in all countries[1]. It is not easy for these banks to adopt unique accountingstandards into their practice because of the absence of a legal framework (Sarea, 2012).In this regards, Islamic banks must comply with the accounting standards applicable inthe country and that can be different from the AAOIFI standards. Accordingly, theprovision practice may differ across Islamic banks and countries. Therefore, it becomesnecessary to examine the effect of the use of AAOIFI standards on DLLP.

3. Background and hypothesis developmentA growing body of empirical research provides evidence that banks manage their earnings(Shen and Chih, 2005; Cornett et al., 2009; Wang et al., 2012). It is noteworthy that earningsmanagement in banks is more problematic than in other firms. This is due to the

importance of banks to national, regional, and global economy. Banks have an importantrole forthe economic growth, thestability and thewelfare of thecountries (Quttainah, 2011;Hamdi and Zarai, 2012). As such, earnings manipulation can have harmful implications tothe whole economy, as visualized by the last financial depression that originated in thebanking sector. During the last financial crisis, the collapse of banks made it clear thatinformation asymmetry problems between managers and shareholders are very severe(Palia and Porter, 2007). Earnings management is considered as a constraint for investorsto predict banks’ future performance accurately using the current financial information.This practice increases information dissemination problems between banks and investorsand reduces banking sector stability (Quttainah, 2011; Hamdi and Zarai, 2012).

This information dispersal originates from the agency theory, which suggests thatmanagers do not act in the best interest of the shareholders, they exhibit tendencies to

divert from their duties and to “pursue strategies that meet their own goals, rather thanthose of the owners” (Jensen and Meckling, 1976; Fama, 1980). Theses agencyproblems occur when shareholders lack the necessary power to monitor and control themanagers that have an opportunistic behavior (Macey and O’Hara, 2003).

Prior work offers evidence that accounting accruals are affected by agency issuesand asymmetric information (Bae et al., 2009; Cornet et al., 2009). Managers in thebanking industry have incentives to smooth earnings via LLPs considered as the mostimportant accruals in the banking sector. These incentives are basically related to


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earning management (Greenwalt and Sinkey, 1988; Beatty et al., 1995) and capitalmanagement (Moyer, 1990; Collins et al., 1995; Kim and Kross, 1998). Most of thesestudies focused on conventional banks and their findings reveal some mixed evidence.A large body of empirical studies provides evidence that banks engage in earnings

management throughout LLP (Ma, 1988; Collins et al., 1995; Greenwalt and Sinkey,1988; Bhat, 1996; Lobo and Yang, 2001; Kanagaretnam et al., 2004; Anandarajan et al.,2005, 2007; Kwal et al., 2009; Pinho and Martins, 2009; Taktak et al., 2010a). In the samevein, Wetmore and Brick (1994, p. 299) showed that bank managers “take large LLPs ina good year so that extra reserves are available for bad years”. Conversely, some otherstudies found no relationship between LLP and earning management (Wetmore andBrick, 1994; Beatty et al., 1995; Ahmed et al., 1998; Ismail et al., 2005). Table I providessummary of these studies.

As shown previously, recent investigations have given rise to a vivid interest inempirical research related to earnings management in conventional banks. However,studies related to Islamic banks are limited and reported mixed results. We start ourevidence by referring to the paper of Ismail and Shahimi (2003) that proved the use of LLP by Islamic Malaysian banks for the purpose of manipulating their earnings andcapital management during the period 1997-2001. Similarly, Zoubi and Al-Khazali (2007)examined 55 conventional banks and ten Islamic banks in the Gulf Cooperation Council(GCC) region during the period 2000-2003. They outlined that managers of Islamic andconventional banks in the GCC region use total LLP to smooth their results. Theyasserted that both Islamic and conventional banks in the GCC countries follow similarincome smoothing practices. Quttainah (2011) examined 11 countries pertaining toEconomic Research Forum (ERF) (Arab countries, Iran and Turkey) during the period1994-2008. He used loss avoidance and abnormal LLP as proxies of earningsmanagement to compare earnings management behavior between Islamic banks andconventional banks. Findings show that Islamic banks are less likely to engage in

earnings management compared to their “non-Islamic” counterparts.In the same vein, Misman and Ahmed (2011) compared Islamic and conventional banks

in Malaysia. They proved that both Islamic and conventional banks use LLP for theirearnings and capital management purpose. However, findings reveal “significantdifferences between Malaysian Islamic and conventional bankswhen managing their LLP”.

Conversely, Taktak et al. (2010b) provided contrary evidence. Using a sample of 66 Islamic banks in Muslim countries over the period 2001-2006, they investigatedincome smoothing practices by Islamic banks and examined the use of total LLP for thispurpose. Based on Beidleman’s and Eckel’s coefficients, they pointed out an “extensiveuse of income smoothing by Islamic banks”. However, they did not find evidence on theuse of total LLP They showed that, contrary to conventional banks, Islamic banks do notsmooth income via total LLP. Moreover, Taktak (2011) examined the nature of

smoothing returns practices in Islamic banks. She aimed to assess if the smoothingmechanism is natural or intentional. Using a sample of 79 Islamic banks from19 countries during the period that ranges from 2001 to 2006, she found that a largernumber of Islamic banks engage in natural Income smoothing. Furthermore, results donot provide evidence that Islamic banks resort only to natural income smoothing.

Empirical literature on Islamic banks provides conflicting predictions and revealsmixed results about the use of LLP for earnings management purpose. However, contraryto conventional banks, prior studies do not examine the use of managerial discretion.

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Authors Results

Panel A: studies that examined association between LLP and earnings management in conventional banksMa (1988) Focusing on the income smoothing practices in US banks and using a

panel of 900 observations during the period 1980-1984, results provethat US banks engaged in earnings management through provisioningpolicy

Greenwalt and Sinkey (1988) Using a sample of 106 banks during the period 1976-1984, resultsassert that US banks smooth their earnings using LLP. Thus, money-center banks are less likely to engage in income smoothing thanregional banking companies in the USA

Collins et al. (1995) Considering the period 1971-1991, findings show that LLP is used asan instrument for earning management while loan charge-off andsecurities insurances are used for capital management

Bhat (1996) Examining the income smoothing hypothesis for a sample of the 148banks during the period 1981-1991, results reveal that US banks do not

use LLP for earning managementLobo and Yang (2001) Using a sample of US banks during the 1981-1996 period, andanalyzing the use of discretionary LLP, findings indicate strongevidence for income smoothing, capital management and signaling

Ismail and Be Lay (2002) Studying the case of 34 commercial banks in Malaysia across 1997-1999, and “using a model of LLP which incorporates the sectorial effectand the economic risk pertaining to those sectors”, results outline thatconventional banks in Malaysia use LLP to manage their earnings

Kanagaretnam et al. (2004) Based on 22,640 firm-year observations over the period 1992-2001,findings provide evidence that US banks use DLLP to reduce earningsvolatility and to manage capital. Results also prove that bankmanagers’ decisions to reduce earnings volatility are related to theneed for external financing and to securities gains and losses

Anandarajan et al. (2005) Using a panel of 970 observations of depository institutions in Spain

during the 1986-1995 periods, empirical results assert the use of LLPfor capital and earnings management

Anandarajan et al. (2007) Using a sample of 50 Australian commercial banks over the period1991-2001, results prove that Australian banks use LLP for capital andearnings management. However, there is no evidence on the use of LLPfor “signaling future intentions of higher earnings to investors”.Further, listed banks are more likely to engage in earning managementthan unlisted commercial banks

Kwal et al. (2009) Based on a sample of 31 Japanese banks across the period 1996 to 1999,findings indicate that DLLP are used extensively for earnings andcapital management. Results also show that DLLP are positivelyrelated to the demand for external financing, realized securities gainsand prior year’s taxes

Pinho and Martins (2009) Using a sample of 35 financial institutions operating in Portugal from

1990 to the end of 2000, the findings indicate that Portuguese banks’have a discretionary behaviour in setting up their provisions, and findevidence of income-smoothing and capital management

Taktak et al. (2010a) Using a sample of 278 commercial banks operating in OECDcountries. Results highlight that a large number of banks useintentional smoothing results either by using LLP or by selling tradingsecurities

( continued )

Table I.Summary of prior studies

that examined LLP


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Unlike prior studies, that stick to evaluate total LLP, we follow Kanagaretnam etal. (2004)and Kwal etal. (2009). We isolate the DLLP in order to investigate the factors that influencemanagers’ use of discretion in estimating LLP.

A variety of studies provide evidence that managers use their discretion inreporting LLP for both earnings and capital management purposes.

3.1 Earnings management Empirical investigations about the relationship between DLLP and earningsmanagement asserted that managers are inclined to recognize provisions whenaccounting earnings are high enough. Managers of banks with high earning variabilitywill have stronger incentives to smooth earnings through LLP (Lobo and Yang, 2001;Pinho and Martins, 2009). Kwal et al. (2009) documented that “managers, through lossprovisions, are able to shift earnings among periods to smooth income over time”. TheEBTP is widely used in the literature to capture earnings management practices. Basedon the existing literature, we expect that managers use discretion to underestimate LLPif the EBTP ratio is low, and overestimate LLP if the EBTP is high. Hence, the firsthypothesis:

H1. There is a positive relationship between DLLP and EBTP in Islamic banks.

3.2 Capital management Following previous studies, the capital structure is measured by the CAR. Considering theuse of DLLP for capital management, prior literature supports either a positive and

negative relationship between DLLP or LLP and CAR. Some papers showed that bankswith low capital ratios are inclined to use their discretion and report low DLLP in order toreport higher capital and earnings (Kim and Kross, 1998; Ahmed etal., 1999). Otherstudiessuggested that well-capitalized banks are subject to a lower level of monitoring byregulatory agencies (Kanagaretnam et al., 2004; Taktak et al., 2010b). Therefore, they areable to use more discretion to boost earnings and capital. Consequently, we hypothesizethe following:

H2. There is a negative association between DLLP and CAR in Islamic banks.

Authors Results

Panel B: studies that examined no association between LLP and earnings and capital management inconventional banks

Ismail et al. (2005) Based on a sample of 21 Malaysian banks during the period 1996-2002,results indicate that banks in Malaysia do not use LLP to smoothincome

Wetmore and Brick (1994) Considering 82 US banks across the period 1986-1990, results assessthat contrary to prior studies, there is no evidence of income smoothingpractices. Indeed, US banks do not use LLP for the earningsmanagement purpose

Beatty et al. (1995) Considering the period 1987-1990, for a sample148 banks, findingsprove that LLP is not used as a tool to manage earnings in US banks

Ahmed et al. (1998) Results indicate no evidence of earning management through LLP, it isshown that LLP is used only for capital managementTable I.

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The incentives of Islamic banks to manage accounting earnings via LLP are likely tobe influenced by bank-specific factors. We examine three factors that may affect theearnings management behavior of Islamic banks’ managers.

3.3 External financing Several studies considered external financing as an instrument to smooth reportedearnings. In fact, to attract external funds, a bank reports low LLP to reduce theperceived risk and to increase reported income. Loan to deposit (LD) ratio is often usedas a proxy for external financing (Kanagaretnam et al., 2004; Zoubi and Al-Khazali,2007). If LD ratio is high, this indicates that total loans are greater than deposits and,therefore, banks need to attract more deposits from customers. For that, banks’managers have incentives to report low LLP. Thus, we expect that the degree of earnings management through DLLP is negatively related to the demand for externalfinancing. This suggests the following hypothesis:

H3. There is a negative relationship between DLLP and LD ratio in Islamic banks.

3.4 Bank sizeIn the existing literature, it is often argued that bank size is considered as an importantfactor that influences earnings management behavior. Following Zoubi and Al-Khazali(2007), Taktak et al. (2010b) and Quttainah (2011) who are interested in Islamicbanking, we expect that the larger is the bank size, the higher is the DLLP. We state thefollowing hypothesis in the null form:

H4. There is a positive relationship between DLLP and bank size in Islamic banks.

3.5 Accounting standardsAs stated above, the Islamic financial accounting standard (IFAS 11), which is relatedto provisions and reserves, requires the use of dynamic provisioning. Subsequently,Islamic banks are more inclined to set-up an allowance for loss provision to absorb anyfuture losses. Thus, the use of Islamic standards leaves little discretion to managers tomanipulate accounting earnings.

However, it is to be noted that, Islamic standards are not implemented in allMiddle East region. These standards (IFAS) are mandatory or recommended for alimited number of countries. A dummy variable will be included in the model to controlfor the use of Islamic accounting standard. Hence, we expect that managers are lessmotivated to manage earnings through DLLP when IFASs are used by banks toprepare their financial statements. More specifically we expect that the use of dynamicprovisioning reduces the DLLP. Our hypothesis is:

H5. There is a negative relationship between DLLP and AAOIFI.

4. Methodological approach4.1 Sample selectionThe sample selection process started with identifying Islamic banks and conventionalbanks with Islamic windows in the Middle East region from the leading online businessintelligence platform focusing on the Middle East and North Africa, Zawiya. We found alist of 200 Islamic banks from 12 countries. We intended first to include all these banksand countries, but given that data are not available for all the banks, our sample covered


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only 21 Islamic banks and 18 conventional banks with Islamic windows inseven countries from the Middle East region: Bahrain, Egypt, Jordan, Kuwait, Qatar,Saudi Arabia and UAE. Then we collected the list of conventional banks operating inthese countries, we selected 33 conventional banks.

Table II presents the sample selection. Data consists of annual year-end informationfor Islamic and conventional banks in the Middle East during the period ranges from2000 to 2008. We included all banks, for which complete data across this time periodwas available. We have to note that, at the firm level, some data are missing for one orseveral years. This constitutes an unbalanced panel study of the data sets including519 total firm-year observations of which 129 firm-year observations represent Islamicbanks, 141 firm-year observations represent conventional banks providing Islamicservices (with Islamic windows) and 251 firm-year observations representconventional banks (with no Islamic windows).

4.2 Model To examine the use of discretion by the managers of Islamic banks and compare it to

conventional banks in the Middle East region, we use the two-stage approach. At thefirst stage, we use specific accruals to measure artificial earnings management inIslamic banks. More specifically, we use a major accrual in the banking sector, LLP.This proxy is divided into two components: discretionary and non-discretionary.Whence, the basic model takes the form:

LLP ¼ Non-discretionary LLP þ Discretionary LLP

Following Zoubi and Al-Khazali (2007) and Taktak et al. (2010b), we take intoconsideration the specificities of Islamic banks. These institutions operate underSharia law, and use techniques conform to sharia principles. The composition of theirportfolio loan is different from conventional banks. The loan portfolio of Islamic banks

includes four important types; Quard Hassan (loan), Musharaka, Murabaha andMudaraba investment. Consequently, we use for in our study the item loss provisionfor loans, Murabaha, Musharaka, Mudaraba investment (LLPI) to estimate total lossprovisions for Islamic banks.

Number of banks Number of observationsCountry (1)

a(2)

b(3)

c(1)

a(2)

b(3)

c

Bahrain 4 1 4 21 9 34Egypt 3 0 6 14 0 43

Jordan 1 0 10 6 0 83

Kuwait 4 1 5 29 9 34Quatar 3 5 0 15 34 0Saoudi Arabia 3 6 1 18 49 9UAE 3 5 7 24 40 48Total 21 18 33 129 141 251Seven countries 72 banks 519 observation

Notes: aIslamic banks that are fully Sharia compliant; bconventional banks with Islamic windows;cconventional banks

Table II.Number of banks andobservations in thesample by country

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The non-discretionary component of LLP represents the portion of total accrualsdictated by changes in bank business conditions. Because it cannot be directlyobserved, it is estimated through variables reflecting the level of losses in the loanportfolio. Similar to Kanagaretnam et al. (2004) and Kwal et al. (2009), NDLLP

component is estimated using a set of informational variables including the beginningbalance of non-performing loans, change in non-performing loans and change in totalloans. We expect to have a positive correlation between LLP and the independentsvariables mentioned above. We expect that, if the beginning balance of non-performingloans is high, banks will report a high level of loss provisions. On the other hand,an increase in non-performing loans is likely to result in an increase in LLP and apositive change in total loans increases the risk of uncollectible accounts. This involvesan increase in the amount of loss provisions. We estimate NDLLP using equation (1).

We used panel data over the period 2000-2008. Each observation of our sample hastwo dimensions (firm, year). The estimation method of our model using panelregression techniques is appropriate. Due to data availability, we used non-balancedpanel data techniques. Our sample consists of unbalanced panel data because each

variable is observed over varying time-period length:

LLPit ¼ b0 þ b1 NPLit21 þ b2 DNPLit þ b3 DTL þ 1it ð1Þ

where:

LLPit total LLP for bank i at the year t, deflated by beginning loans.

NPLit21 the beginning balance of non-performing loan for bank i at the year tdeflated beginning loans.

DNPLit change in the value of non-performing loan for bank i at the year t,deflated by beginning loans.

DTL change in the value of total loan, for bank i at the year t, deflated bybeginning loans.

The DLLP consists of the LLP prediction error; it is estimated through the residualobtained from equation (1).

First of all, we estimate equation (1) for Islamic banks that are fully Shariacompliant to obtain the estimates of b0, b1, b2 and b3. Table III reports the mean

Mean coefficient estimates for the model in equation (1)Variables Coefficient estimate ( p-value)

Intercept 0.0169 (0.005) * * *Beginning balance NPL 20.1498 (0.163)DNPL 20.0001 (0.780)DTL 0.0078 (0.000) * * *

F -Fisher 10.2300 (0.0001) * * *

R 2-overall 39.03%

Notes: Significant at: *10, * *5 and * * *1 percent levels; LLPit ¼ b0 þ b1 NPLit21 þ b2 DNPLit þb3 DTL þ 1it

Table III.Result of the regressionmodel from equation (1)


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coefficient estimates for equation (1) based on panel estimation techniques. TheHausman specification test is used to choose between the fixed or random effects modelfor our sample of Islamic banks. The statistic of Hausman test is significant. As aconsequence, we validate the fixed effect. The explanatory power is relatively high,

with the mean R 2

overall 39.03 percent. As expected, we find a positive and significantrelationship at the level of 0.01 between LLP and total loan. However, the coefficients of NPL and DNPL are not significant.

Then, using the estimated coefficients ( ̂b0, b̂1, b̂2, b̂3 ) from equation (1), we evaluatethe non-discretionary component of LLP, NDLLP:

NDLLPit ¼ b̂0 þ b̂1 NPLit21 þ b̂2 DNPLit þ b̂3 DTLit ð2Þ

Finally, we obtain the discretionary component of LLP by calculating the differencebetween total LLP and estimated non-discretionary LLP. Our basic estimationequation becomes:

DLLPit ¼ LLP it 2 ½ b̂0 þ b̂1 NPLit21 þ b̂2 DNPLit þ b̂3 DTLit ð3Þ

At the second stage, we use the discretionary LLP component as our dependentvariable. The independent variables in equation (4) below represent factorshypothesized to influence DLLP. We examine whether, Islamic banks managers usetheir discretion for both earnings and capital management:

DLLPIit ¼ b0 þ b1 EBTPit þ b2 CARit þ b3 LDit þ b4 Sizeit þ b5 AAOIFIit

þX11

j¼6

b j countries þ 1 itð4Þ

where:

DLLPIit discretionary loss provisions for loans, Murabaha, Musharaka,Mudaraba investment for bank i at the year t.

EBTPit earning before taxes and provisions deflated by total assets for bank i atthe year t.

CARit capital adequacy ratio for bank i at the year t, measured by average totalequity over average total assets.

LDit loan to deposit for bank i at the year t.

Sizeit bank size for bank i at the year t, expressed as natural log of asset.AAOIFIit dummy variable that takes 1 if the bank uses AAOIFI’s accounting

standards, 0 otherwise.

SCountry a set of country dummy variables controlling for specific differencesacross countries.

We conduct our study first, on Islamic banks, then conventional banks with Islamicwindows and conventional banks. The procedure for determining the DLLP for

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conventional banks which provide also Islamic services and conventional banks issimilar to that used before.

In order to determine whether observed differences between groups, the separatesamples are pooled and we include the variable type to compare the use of discretion

between:. Islamic banks vs conventional banks with Islamic windows.

. Islamic banks vs conventional banks.

. Islamic banks and conventional banks with Islamic windows vs conventionalbanks.

The new model is presented as follows:

DLLPIit ¼ b0 þ b1 EBTPit þ b2 CARit þ b3 LDit þ b4 Sizeit

þ b5 AAOIFIit þX11

j¼6

b j countries þ Type þ 1itð5Þ

where:

DLLPIit discretionary loss provision for loans, Murabaha, Musharaka,Mudaraba investment for bank i at the year t.

EBTPit earning before taxes and provisions deflated by total assets for bank i atthe year t.

CARit capital adequacy ratio for bank i at the year t, measured by average totalequity over average total assets.

LDit loan to deposit for bank i at the year t.

Sizeit bank size for bank i at the year t, expressed as natural log of asset.

Type is a dummy variable taking 1, if the bank is Islamic and 0 otherwise.

AAOIFIit dummy variable that takes 1 if the bank uses AAOIFI’s accountingstandard, 0 otherwise.

SCountry a set of country dummy variables controlling for specific differencesacross countries.

5. Empirical results5.1 Descriptive statisticsTables IV and V present descriptive statistics for the dependent and independent

variables used in this study. On average, in Islamic banks, LLP and beginningnon-performing loans represent, respectively, 1.38 and 4.3 percent of beginning loans.Our findings are consistent with those reported by Zoubi and Al-Khazali (2007),Taktak et al. (2010b) and Quttainah (2011) who found that Islamic banks make a lowestimation of loss provisions and non-performing loan. The mean ratio of change in totalloan equals 60.81 percent, like Taktak et al. (2010b) and Quttainah (2011), results instandard deviation indicating a large dispersion in the level of loans provided byIslamic banks. The mean DLLP, measured as the residual value from equation (1),


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I s l a m i c b a n k s t h a t a r e f u l l y s h a r i a c o m

p l i a n t

C o n v e n t i o n a l b a n k s w h

i c h I s l a m i c

w i n d o w s

C o n v e n t i o n a l b

a n k s

V a r i a b l e s

M e a n

S D

M i n .

M a x .

M e a n

S D

M i n .

M a x .

M e a n

S D

M i n .

M a x .

L L P r a t i o

0 . 0

1 3 8

0 . 0

2 2 1

2

0 . 0

0 7 1

0 . 1

3 1 2

0 . 0

0 6 3

0 . 0

0 8 1

2

0 . 0 0 9 7

0 . 0

4 6 5

0 . 0

1 1 6

0 . 0

2 0 2

2

0 . 0

2 2 8

0 . 2

0 6 7

C h a n g e i n t o t a l

l o a n r a t i o

0 . 6

0 8 1

3 . 6

1 6 5

2

1

3 5 . 9

6 2 8

0 . 2

0 4 8

0 . 8

6 1 6

2

1 . 0 0 0 0

8 . 7

9 1 7

0 . 2

0 2 1

0 . 9

4 1 5

2

1 . 0

0 0 0

8 . 0

0 7 3

B e g i n n i n g n o n -

p e r f o r m i n g l o a n

r a t i o

0 . 0

4 3 6

0 . 0

3 1 5

0 . 0

0 4 3

0 . 1

2 7 9

0 . 0 5 6 4

0 . 0 7 3 7

0 . 0 0 4 7

0 . 4

1 2 8

0 . 0

8 3 6

0 . 1

2 5 2

0 . 0

0 1 5

1 . 0 5 9 7

C h a n g e i n n o n -

p e r f o r m i n g l o a n

r a t i o

6 . 2

1 £

1 0 2

0 7

3 5 5 . 2

1 7 2

2

2 , 3

2 4 . 2

0 0 0

1 , 7 5 3 . 7

0 0 0

0 . 0

0 6 2

0 . 0

6 2 1

2

0 . 2 6 2 9

0 . 4

1 2 8

0 . 0

1 1 1

0 . 1

0 8 6

2

0 . 3

3 5 8

1 . 0 5 9 7

E B T P r a t i o

0 . 0

3 4 8

0 . 0

3 0 3 0

0 . 0

0 1 7

0 . 1

4 4 7

0 . 0

3 5 5

0 . 0

4 8 3

0 . 0 0 9 2

0 . 2

1 6 9

0 . 0

2 3 8

0 . 0

1 4 7

2

0 . 0

7 2 0

0 . 1

0 7 0

C A R

1 7 . 8

8 9 0

1 3 . 3

0 5 6

4 . 0

9 6 0

5 1 . 9 5 0 0

1 2 . 7

6 8

9 . 6

2 3 0

8 . 0 2 6 2

5 1 . 6

0 0 0

1 1 . 5

2 4 0

3 . 8

2 4 8

2 . 7

0 0 0

3 2 . 2

0 0 0

L o a n t o d e p o s i t

1 5 6 . 1

3 0 5

1 7 5 . 5

4 3 1

2 6 . 9

9 9 5 . 3

0 0 0

7 4 . 8 5 1 0

2 1 . 6

6 1 3

2 3 . 4 0 0 0

1 3 4 . 5

0 0 0

0 . 7

3 9 8

0 . 2

2 7 1

0 . 2

5 1 4

1 . 3

0 8 0

S i z e

3 . 4

3 7 4

0 . 4 5 2 4

2 . 5

0 6 4

4 . 4

2 8 5

3 . 9

0 6 0 7 5

0 . 4

0 6 0

3 . 0 8 5 0

4 . 4

3 8 7

3 . 4

9 3 3

0 . 6

3 4 6

1 . 8

7 3 9

5 . 2

4 4 3

D L L P

0 . 0

0 0 0

0 . 0

3 4 9

0 . 2

9 7 9

0 . 0

8 3 9

0 . 0

0 0 0

0 . 0

0 8 0

2

0 . 0 1 7 2

0 . 0

4 1 2

0 . 0

0 0 0

0 . 0

2 1 5

2

0 . 0

4 9 3

0 . 2

2 7 7

Table IV.Descriptive statistics forall the variables includedin the regression models

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was zero, with a minimum of 3.49 percent and a maximum of 29.79 percent. The average of EBTP to total assets is 3.48 percent with a maximum of 26 percent and a standarddeviation of 3.56 percent and is slightly higher to the mean of 2.23 and 2.29 percentreported, respectively, by Zoubi and Al-Khazali (2007) and Taktak etal. (2010b). The meanvalue of the natural log of total assets in Islamic banks is 3.43 percent and the standarddeviation 0.50 percent.

As reported in Table V, we use an ANOVA analysis, to compare variables amongthe three different types of banks used in our sample. The evidence on LLP indicatesthat LLP ratio for Islamic banks is higher than for conventional banks with Islamicwindows and is the same as for conventional banks. We conclude that Islamic banksand conventional banks behave in the same manner in dealing with LLP.Beginning non-performing loan ratio for Islamic banks is lower than those forconventional banks providing Islamic services and conventional banks. This indicatesthat full-fledged Islamic banks have less non-performing loans problem than the otherstypes of bank.

Change in total loans, EBTP and CAR of Islamic banks are significantly higher thanthose of conventional banks. Islamic banks report statistically significantly lowersmaller DLLP than their non-Islamic counterparts. This indicates that Islamic banks

are less likely to use LLP to manage accounting earnings compared to conventionalbanks. Referring to Taktak et al. (2010b), this finding could be explained by theprovisioning policy used by Islamic banks. Indeed, to determine provisions andreserves, Islamic institutions use FAS 11 (Financial Accounting Standards (FAS)).This standard “requires an adequate level of provision and therefore, leaves littlediscretion to Islamic banks to manage their earnings”.

Table VI exhibits the correlation matrix for the variables in model (4). Pearsoncorrelation coefficients are reported on the left down side of the matrix while spearman

Islamic banks vsconventional banks with

Islamic windowsIslamic banks vs

conventional banks

Islamic banks andconventional banks with

Islamic windows vsconventional banks

Variables Difference in means Difference in means Difference in means

LLP ratio 0.0074 * * * 0.0022 20.0022Change in total loanratio 0.4033 0.4060 * 0.1836Beginning non-performing loanratio 20.0128 20.0400 * * 20.0317 * *

Change in non-performing loanratio 20.0062 20.0111 20.0072EBTP ratio 20.0006 0.01103 * * * 0.0113 * * *

CAR 5.1213 * * * 6.4386 * * * 3.7224 * * *

Loan to deposit 81.2794* * *

155.3910* * *

111.1420* * *

Size 20.4686 * * * 20.0559 0.1856 * * *

DLLP 20.0083 * * * 20.0121 * * * 20.0074 * * *

Note: Significant at: *10, * *5 and * * *1 percent levels

Table V.Results of ANOVA

analysis


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E B T P

C A R

L D

S I Z E

A A O I F I

E g y p t

J o r d a n

K u w a i t

Q a t a r

S a u d i

A r a b i a

U A E

E B T P

1 . 0

0 0 0

0 . 3

9 4 4

0 . 2 7 0 6

0 . 1

2 3 5

0 . 2 7 8 9

2

0 . 2 5 1 4

2 0 . 2 0 2 4

2

0 . 0

9 6 4

0 . 4

6 3 3

2

0 . 0

1 3 8

2

0 . 0

6 4 9

C A R

0 . 4

2 9 4

1 . 0

0 0 0

0 . 6

0 0 4

2

0 . 3

6 0 4

0 . 0

1 5 4

2

0 . 4

1 4 1

2 0 . 2 9 1 7

2

0 . 1 7 6 7

0 . 1 7 5 0

2

0 . 1

0 4 3

0 . 4

6 6 5

( 0 . 0

0 0 0 ) * * *

L D

0 . 0

3 0 8

0 . 3

4 5 6

1 . 0

0 0 0

2

0 . 2

3 7 2

0 . 2

8 4 0

2

0 . 2

6 1 0

2 0 . 3 1 9 0

2

0 . 0 7 2 8

0 . 1

3 5 3

2

0 . 3 7 5 3

0 . 2

8 7 6

0 . 7 5 1 5

( 0 . 0

0 0 3 ) * * *

S i z e

0 . 0

9 8 2

2

0 . 4

6 3 4

2

0 . 3

2 3 5

1 . 0

0 0 0

0 . 0

1 5 4

2

0 . 1

6 2 1

2 0 . 1 1 6 7

0 . 3

9 4 3

0 . 0

3 7 4

0 . 2

8 1 5

2

0 . 3

2 6 8

0 . 2 7 7 9

( 0 . 0

0 0 0 ) * * *

( 0 . 0

0 0 6 ) * * *

A A O I F I

0 . 2 5 5 0

0 . 1

6 3 9

0 . 4

0 8 4

2

0 . 0

6 4 2

1 . 0

0 0 0

2

0 . 2 7 9 9

0 . 1 4 3 5

2

0 . 0 5 7 3

0 . 4

4 9 8

2

0 . 3

8 0 5

2

0 . 3

3 9 0

( 0 . 0

0 4 3 ) * *

( 0 . 0 7 8 7 ) *

( 0 . 0

0 0 0 ) * * *

0 . 4 7 8 5

E g y p t

2

0 . 1

6 5 4

2

0 . 2

9 2 1

2

0 . 0

8 1 7

2

0 . 1

6 4 4

2

0 . 3

4 8 6

1 . 0

0 0 0

2 0 . 0 6 9 5

2

0 . 1

9 7 3

2

0 . 1

2 5 9

2

0 . 1 5 4 4

2

0 . 1

3 7 6

( 0 . 0

6 6 3 ) *

( 0 . 0

0 1 5 ) * *

0 . 3 7 9 2

( 0 . 0

6 8 1

) *

( 0 . 0

0 0 0 ) * * *

J o r d a n

2

0 . 0

8 2 6

2

0 . 2

3 7 6

2

0 . 1

3 5 7

2

0 . 0 5 6 1

0 . 1

6 2 4

2

0 . 0

9 1 8

1 . 0 0 0 0

2

0 . 1

2 0 7

2

0 . 0 7 7 1

2

0 . 0

9 4 5

2

0 . 0

8 4 2

0 . 3

6 1 6

( 0 . 0

1 0 2 ) *

0 . 1

4 2 8

0 . 5

3 5 8

( 0 . 0

2 5 9 ) *

0 . 2

1 0 1

K u w a i t

2

0 . 0

8 8 9

2

0 . 1

2 9 5

2

0 . 1

9 8 4

0 . 3

4 3 8

2

0 . 1 5 8 0

2

0 . 1

9 5 9

2 0 . 1 0 7 2

1 . 0

0 0 0

2

0 . 2

1 8 6

2

0 . 2

6 8 1

2

0 . 2

3 8 9

0 . 3

2 6 3

0 . 1

6 6 0

( 0 . 0

3 1 3 ) *

( 0 . 0

0 0 1

) * * *

( 0 . 0

3 0 3 ) *

( 0 . 0

0 7 1 ) * *

0 . 1 4 2 9

Q a t a r

0 . 4 7 9 2

0 . 1

8 2 9

0 . 0

1 1 3

2

0 . 0

1 7 0

0 . 4

8 1 0

2

0 . 1

6 7 7

2 0 . 0 9 1 8

2

0 . 1

9 5 9

1 . 0

0 0 0

2

0 . 1 7 1 1

2

0 . 1 5 2 5

( 0 . 0

0 0 0 ) * * *

( 0 . 0

4 9 5 ) *

0 . 9

0 3 3

0 . 8 5 1 4

( 0 . 0

0 0 0 ) * * *

( 0 . 0

2 1 4 ) *

0 . 2 1 0 1

( 0 . 0

0 7 1 ) * *

S a u d i

A r a b i a

2

0 . 0

0 2 5

2

0 . 1 5 0 1

2

0 . 2

2 9 4

0 . 2

8 6 0

2

0 . 3

4 8 6

2

0 . 1

6 7 7

2 0 . 0 9 1 8

2

0 . 1

9 5 9

2

0 . 1

6 7 7

1 . 0

0 0 0

2

0 . 1

8 7 0

0 . 9 7 8 0

0 . 1

0 7 9

( 0 . 0

1 2 5 ) *

( 0 . 0

0 1 3

) * *

( 0 . 0

0 0 0 ) * * *

( 0 . 0

2 1 4 ) *

0 . 2 1 0 1

( 0 . 0

0 7 1 ) * *

( 0 . 0

2 1 4 ) *

U A E

2

0 . 1

1 1 5

0 . 2

1 1 8

2

0 . 0 7 0 3

2

0 . 1

4 8 4

2

0 . 3

4 8 6

2

0 . 1

6 7 7

2 0 . 0 9 1 8

2

0 . 1

9 5 9

2

0 . 1

6 7 7

2

0 . 1

6 7 7

1 . 0

0 0 0

0 . 2

1 7 8

( 0 . 0

2 2 5 ) *

0 . 4

4 9 3

( 0 . 0

9 9 9

) *

( 0 . 0

0 0 0 ) * * *

( 0 . 0

2 1 4 ) *

0 . 2 1 0 1

( 0 . 0

0 7 1 ) * *

( 0 . 0

2 1 4 ) *

( 0 . 0

2 1 4 ) *

N o t e : S i g n i fi c a n t a t : * 1 0

, * * 5 a n d * * * 1 p e r c e n t

Table VI.Correlation matrix for allindependent variables

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correlations are presented on the right upside. Table VII presents correlations amongthe independent dummy variables.

Results report a high correlation between CAR and LD. Therefore, we conduct twoseparate specifications. In the first one (Panel A), we keep LD and we drop CAR and in

the second one (Panel B) CAR is kept and LD is dropped.Tables VI and VII report correlations below 0.6. Therefore, correlations are not

sufficiently high to pose any serious multicollinearity problem according to the limitset by Gujarati (1995).

5.2 Panel regression analysisIn this section, we present and discuss our empirical results concerning the factors thatmy influence the use of discretion by Islamic banks’ managers in estimating LLP.Table VIII (Panels A and B) reports the main results of the second stage regressionanalysis.

For both specifications, our dependent variable is measured by DLLPI, which

corresponds to the discretionary component of LLP and represents the residual fromequation (1).

The variables of the two regression models are globally significant in Panels Aand B. The wald x 2-test statistic is significant at the 1 percent level in Panel A and at10 percent level in Panel B. R 2 overall is 50.65 percent in Panel A and 14.63 percent inPanel B. Therefore, the variables included in the two models provide a relatively goodexplanation of DLLP.

The result of the regression in Panel A is in accordance with our expectations on theearnings management hypothesis. Similarly to Zoubi and Al-Khazali (2007), thecoefficient of EBTP has the predicted sign and is significant at the 1 percent level. Thisfinding indicates that EBTP is an important factor that can influences the use of direction by managers when reporting LLP. Unlike Taktak et al. (2010b), we found thatmanagers of Islamic banks use their discretion to manipulate accounting earningsthrough LLP.

With respect to capital management hypothesis, results in Panel B are in contrastwith our expectations. Indeed, we find a positive and significant coefficient at the levelof 10 percent for CAR. This outcome confirms the mixed results reported in previousstudies as mentioned above in the hypothesis development section. Our findingscorroborate those obtained by Kim and Kross (1998) and Ahmed et al. (1999). Thissuggests that Islamic banks with high equity incentives are more likely to reportdiscretionary LLP. Overall, the respect of banking regulatory requirements is the main

AAOIFI Egypt Jordan Kuwait Qatar Saudi Arabia UAE

AAOIFI 1.0000Egypt 20.3448 1.0000

Jordan 0.1624 20.0918 1.0000Kuwait 20.1580 20.1959 20.1072 1.0000Qatar 0.4810 20.1677 20.0918 20.1959 1.0000Saudi Arabia 20.3486 20.1677 20.0918 20.1959 20.1677 1.0000UAE 20.3486 20.1677 20.0918 20.1959 20.1677 20.1677 1.0000

Table VII.Spearman correlation

matrix for dummyvariables


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concern of managers. Whence, they are motivated to use discretion in estimating LLPin order to enhance earnings and therefore capital.

The analysis of the results related to our control variables shows that contrary toour predictions the coefficient of size is not significant. Results in Panels A and B do

not support the findings of Zoubi and Al-Khazali (2007) and Taktak et al. (2010b).Indeed, we found that the large-sized banks are not found to report higher DLLP.

As expected, the LD coefficient is negative and significant at 10 percent level. Thisresult shows that external financing need is a prominent factor affecting the estimationof LLP by managers.

As regards the effect of Islamic accounting standard on the estimation of LLP bymanagers, results provide evidence that Islamic banks managers behave in the sameway when reporting LLP. Therefore, the implementation of AAOIFI standard does not

Mean coefficient estimates for the model in equation (4)Panel A Panel B

Variables Coefficient estimate ( p-value) Coefficient estimate ( p-value)

Intercept 0.0257 0.7040 2

0.0710 0.1750EBTP 1.0956 (0.0000) * * * 0.2191 0.2400CAR – 0.0010 (0.0560) *

LD 20.0008 (0.0560) * – – Size 20.0160 0.2810 0.0061 0.6270AAOIFI 0.0103 0.7380 0.0073 0.7710Egypt 0.0188 0.7180 0.0463 0.2390

Jordan 20.0089 0.9880 0.0310 0.4580Kuwait 0.0044 0.9230 0.0192 0.5610Qatar 0.0082 0.8380 0.0346 0.2170Saudi Arabia 20.0040 0.9390 0.0169 0.6710UAE 20.0129 0.8110 0.0052 0.8950Wald x 2 69.8700 (0.0000) * * * 12.2500 (0.02690) *

R

2

overall (%) 50.65 14.63 R 2 between (%) 64.89 43.96

Notes: Significant at: *10, * *5 and * * *1 percent levels:

PanelA : DLLPIit ¼b0 þ b1 EBTPit þ b2 LDit þ b3 Sizeit þ b4 AAOIFTIit þX10

j¼5

b j countries þ 1it

ð4Þ

Panel B : DLLPIit ¼ b0 þ b1 EBTPit þ b2 CARit þ b3 Sizeit þ b4 AAOIFTIit þX10

j¼5

b j countries þ 1it

ð4Þ

where: DLLPIit – discretionary loss provisions for loans, Murabaha, Musharaka, Mudarabainvestment for bank i at the year t; ETPit – earning before taxes and provisions deflated by total assetsfor bank i at the year t; CARit – capital adequacy ratio for bank i at the year t, measured by averagetotal equity over average total assets; LD it – loan to deposit for bank i at the year t; Size it – bank sizefor bank i at the year t, expressed as natural log of asset; AAOIFI – dummy variable that takes 1 if thebank uses AAOIFI’s accounting standard, 0 otherwise; SCountry – a set of country dummy variablescontrolling for specific differences across countries

Table VIII.Result of the regressionmodel from equation (4)

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have any influence on their behavior. Accordingly, the use of the dynamic provisionspolicy does not reduce the discretion of managers. In fact, their behavior remains thesame.

To test for the effect of the type of the bank (Islamic banks, conventional banks with

Islamic windows and conventional banks) on DLLP, we include the variable type in theregression model. Type is a dummy variable that equals 1 if the bank is Islamic,0 otherwise. Thus, the equation to be estimated becomes:



j¼6

b j countries þ b12 Type þ 1itð6Þ

Equation (6) is used to compare the use of discretion between:

. Islamic banks versus conventional banks providing Islamic services (Panel A).

.

Islamic banks versus conventional banks (Panel B).. Islamic banks and conventional banks providing Islamic services versus

conventional banks (Panel C) operating in the Middle East region.

Table IX shows the main results of our comparison study. It reports the regressionresults pertaining to our three groups of banks.

The correlation coefficients show the existence of multicollinearity between CARand TL in Panel A and between LD and Type in both Panels B and C. As aconsequence, we run two separate specifications for each model. We found that resultsremain the same. This finding shows that the correlation between the variables doesnot affect the robustness of our model. Therefore, we report in Table IX, the results of the three regressions including all variables. It is noteworthy that, the matrix

correlation and the separate specifications are note reported in our study.On average, results suggest that type is not significant for all the groups. There is

no difference in the use of discretion by managers when reporting LLP between Islamicbanks and their non-Islamic counterparts. This finding is in accordance with the onereported by Zoubi and Al-Khazali (2007), who found that Islamic and conventionalbanks follow the same way of provisioning.

Additional results reported in Table IX outline that EBTP and CAR coefficients arepositive and significant at different level for our three specifications (Panel A-B-C). So,banks in the Middle East region use DLLP for earnings and capital managementpurpose. And all banks behave in the same way when dealing with DLLP.

The need for external financing is also found to be a determinant of DLLP. Resultsshow a negative and significant relationship between LD and DLLP.

6. ConclusionThe purpose of this paper is to examine factors that may influence Islamic banksmanagers’ use of discretion in estimating LLP. Using a sample of 21 Islamic banks inthe Middle East region over the period 2000-2008, we find that, Islamic banksmanagers’ use their discretion in reporting LLP for both earnings and capitalmanagement purpose. Findings reveal a positive and significant relationship betweenDLLP in the one side and EBTP and CAR in the other side. Our evidence of positive


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relationship indicates that managers are found to use discretion to underestimate LLPif the EBTP and CAR are low in order to enhance earnings and to comply with thebanking requirement regulation. Additional results show that external financing needis an important factor that may influence the managerial discretion.

To test the effect of the type of banks on DLLP, we use a sample of 18 conventionalbanks with Islamic windows and 33 conventional banks in the Middle East region. Ourfindings indicate the lack of relationship between the type of banks and the use of DLLP. This led us to conclude that there is no difference between Islamic banks,conventional banks providing Islamic services and conventional banks in terms of DLLP. Considering DLLP practice, all these banks behave similarly.

Overall, our finding can be useful for standard-setters, auditors and investors.It helps standard setters to take appropriate measures and regulate the provisioning

Islamic banks vsconventional banks with

Islamic windowsIslamic banks vs

conventional banks

Islamic banks andconventional banks with

Islamic windows VSconventional banks

Panel A Panel B Panel CVariables Coefficient ( p-value) Coefficient ( p-value) Coefficient ( p-value)

Intercept 20.0277 0.2460 20.0250 0.1230 20.0206 (0.0760) *

EBTP ratio 0.1179 (0.0850) * 0.2662 (0.0010) * * 0.1467 (0.0020) * *

CAR 0.0012 (0.0000) * * * 0.0008 (0.0030) * * 0.0005 (0.0010) * *

LD 20.0009 (0.0000) * * * 20.0008 (0.0000) * * * 20.0008 (0.0000) * * *

SIZE 0.0036534 0.4760 0.0024 0.5850 0.0029 0.2870Type 20.0069 0.5180 20.0034 0.6690 260.91 £ 102

060.9990

AAOIFI 0.0188 0.1190 0.0129 0.2670 0.0126 (0.0290) *

Bahrain 0.0020 0.8970 20.0005 0.9630 0.0034 0.5750Egypt 0.0271 0.1060 0.0168 (0.0750) * 0.0171 (0.0060) * *

Jordan 20.0007 0.9760 – – 20.0007 0.9010Kuwait 20.0023 0.8710 20.0002 0.9820 20.0011 0.8470

Qatar 0.0030 0.7980 0.0128 0.4460 0.0070 0.2780Saudi Arabia – – 0.0134 0.7940 0.0010 0.8590UAE 20.0052 0.6440 20.0001 0.9840 – – Wald x 2 40.5400 (0.0001) * * 49.67 (0.0000)* * * 56.48 (0.0000) * * *

R 2 overall (%) 23.27 48.34 17.48 R 2 between (%) 56.75 21.25 39.88

Notes: Significant at: *10, * *5 and * * *1 percent levels:



j¼6

b j countries þ Type þ 1itð5Þ

where: DLLPIit – discretionary loss provisions for loans, Murabaha, Musharaka, Mudaraba investmentfor bank i at the year t; ETPit: earning before taxes and provisions deflated by total assets for bank i atthe year t; CARit – capital adequacy ratio for bank i at the year t, measured by average total equity overaveragetotal assets; LDit – loan todepositfor banki atthe yeart; Sizeit – bank sizeforbank i atthe yeart, expressed as natural log of asset; AAOIFI – dummy variable that takes 1 if the bank uses AAOIFI’saccounting standard, 0 otherwise;S Country – a set of country dummy variables controlling for specificdifferences across countries; Type: is a dummy variable taking 1, if the bank is Islamic and 0 otherwise

Table IX.Results of the regressionmodel from equation (5)

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policies of banks. Such measures can reduce the discretion of managers, andtherefore increase the information transparency and improve the accounting quality.Auditors should be conscious of the existence of earnings management practices.Thus, they should focus more on the policy of provision used by banks. Detecting

discretionary behavior in Islamic banks can also help investors in their decisionmaking.

One limitation of our paper is that our sample size is relatively small, given thatdata are not available for all Islamic banks. Future research may extend the sample toall Islamic institutions in the MENA region. Another avenue for future research couldbe to investigate factors that potentially influence earnings-management policy inIslamic banks.

Note

1. Countries where AAOIFI standards are either mandatory or recommended include: Bahrain, Jordan, UAE,Saudi Arabia, Lebanon,Syria, Sudan and Malaysia www.islamicbanker.com/aaoifi-standards

References

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