Risk management practice, efficiency and financial performance of Islamic Banks: an international evidence

Abstract

Global financial crisis had many causes but failures in risk management were a contributory factor (Mitchell, 2010). Significant concerns have been raised on the practice of risk management as a core function of Islamic banks as financial intermediaries, due to the unique nature of the risks that are not well understood. The objectives of this study are, first, to examine the nature of risk management practices in Islamic banks; second, to explain the level of efficiency of Islamic banks and its determinants; and third, to examine the effect of risk management practice on efficiency and financial performance of Islamic banks. Both primary and secondary data were used to achieve these objectives. A self-developed questionnaire was used to measure risk management practices, while data envelopment analysis (DEA) approach was used to measure technical efficiency, and financial performance was measured by using profitability ratios. The samples are gathered from 72 domestic and international Islamic banks domiciled within and outside Malaysia for the period 2006 to 2009. The results illustrated that Islamic banks were doing well in areas of operational risk/ Shariah non-compliance risk management. Nonetheless, they were deficient in the management of both liquidity risks and rate of return risk/displaced commercial risks. The study explains that the main source of technical inefficiency is the scale inefficiency. The economic condition of a particular country is found to be the main determinant of an Islamic bank`s technical efficiency. The study also found that there is a positive effect of risk management practices on pure technical efficiency and financial performance of Islamic banks. Hence, risk management practice is an important but not the sole determinants of efficiency and financial performance. The study provides significant contribution on integrating the theory of financial intermediation where risk management acts as the core function of Islamic banks as financial intermediary to improve their efficiency and financial performance. Finally, the study provides policy implications for central banks and the Islamic Financial Services Board by explaining the current progress of risk management practices undertaken by Islamic banks, the level of efficiency and its common determinants during the study period.