The impact of product diversification strategy on the financial performance of Islamic banks in Malaysia

Abstract

Banks are increasingly diversifying their income streams to include a greater portion of non-interest income-earning products. This is supported by deregulation in the banking industry. This change in the product mix offered by banking institutions renders them to be more competitive and able to generate more stable and sustainable income. Hence banking institutions are encouraged to develop and promote new products that boost their financial performance. The growing demand for Islamic banking products has increased the competitive market for the products in the commercial banking industry and facilitating the need for banks’ product diversification strategy. Islamic banking operates according to the principles of the Shariah, and their products are Shariah-compliant. However, there is a lack of information and understanding concerning the specific contracts or products offered by Islamic banks. This research investigates the impact of product diversification strategy on the financial performance of Islamic banks in Malaysia using the Prudential and Structural Islamic Financial Indicators (PSIFIs) data established by the Islamic Financial Services Board (IFSB). This research applied the Autoregressive Distributed Lags (ARDL) model to examine the products that contributed to the banks’ performance for the period starting from January 2014 up to June 2018 using quarterly frequency data. The results of the bounds test indicated that there is a cointegration relationship between banks’ assets classification, banks’ liabilities classification and capital with banks’ financial performance in the long-run for Islamic banking institutions in Malaysia. In particular, banks’ financial performance, which is measured through Return on Asset (ROA), Return on Equity (ROE), Financing-based Income (RFIN), Investment-based Income (RINV), Fee-based Income (RFEE), Gross Non-Performing Financing (GNPF) and Net Profit Margin (NPM), reveals the existence of a long-run equilibrium relationship with the banks’ products, namely financing assets (FA), investment assets (IA), liabilities (LI) and capital (CAP) in Islamic banks in Malaysia but with different signs. The positive and negative signs in both the long-run and the short-run relationships indicate that different products have different impacts on the level of performance, which should guide the diversification strategy of Islamic banks in Malaysia. These results can be used to guide banks’ management, policy makers or regulators, and potential or existing investors, to create an efficient investments portfolio that generates high levels of return with low levels of risk.