Risk management practices and profitability of commercial banks vis-a-vis Islamic banks

Abstract

The research consists of two studies; a major study on banking risk management practices and a minor study on the relationship between financial risks and profitability. The study on risk management explores the risk management practices of both the Islamic and conventional banks. It compares and contrasts the way both systems manage their risks and investigates if there is any convergence in the practice of risk management between the conventional and Islamic banking system. The survey conducted on the risk managers of the conventional banks and Islamic banks in Malaysia as well as the Islamic banks outside Malaysia revealed many interesting results. It is found that there exist differences in the practice between the two systems and that the Islamic banks are lagging behind in the adoption of enterprise wide risk management. Although collectively, the conventional and Islamic banks face moderate level of adequacy of risk management tools, Islamic banks indicate that the three most critical areas are lack of information technology (IT) professionals with relevant expertise in the process of integration and risk analytics, IT systems to cater for each Islamic instrument and also the capacity of human capital in the highly technical areas of risk management. This implies that more innovations and product developments are needed for Islamic banking in managing risks. Hence serious effort in training and educating the human capital, well versed in the Islamic principles as well as the technical and quantitative sciences disciplines as the integration of this knowledge is important in order to preserve the Islamic banking industry specifically and the Islamic financial system generally, from degradation and being relegated to just forms only. The second part of the study employs panel data regression analysis of Generalised Least Squares of fixed effects and random effects models to examine the relationship between financial risks (credit risk, interest rate risk, liquidity risks) and profitability (ROE and ROA) of the conventional and Islamic banking in Malaysia for the period between 1996 and 2005. It was found that credit risk has a significant impact on ROA and ROE for the conventional as well as the Islamic banks. The relationship between interest rate risk and ROE were found to be weakly significant for the conventional banks and insignificant for the Islamic banks. The effect of interest rate risk on ROA is significant for the conventional banks. Liquidity risk was found to have an insignificant impact on both profitability measures.