Munich Personal RePEc Archive

ISLAMIC BANK PERFORMANCE AND CAPITAL STRUCTURE

Pratomo, Wahyu Ario and Ismail, Abdul Ghafar (2006): ISLAMIC BANK PERFORMANCE AND CAPITAL STRUCTURE.

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Abstract

The choice between debt and equity financing has been directed to seek the optimal capital structure. Under the agency costs hypothesis, a high leverage or a low equity/asset ratio reduces the agency costs of outside equity and increases firm value. Several studies show that a firm with high leverage tends to have an optimal capital structure and therefore it leads to produce a good performance, while the Modigliani-Miller theorem proves that it has no effect on the value of firm. The importance of these issues has only motivated researchers to examine the presence of agency costs in the non-financial firms. In financial firms, agency costs may also be particularly large because banks are by their very nature informationally opaque – holding private information on their loan customers and other credit counterparties. In addition, regulators that set minimums for equity capital and other types of regulatory capital in order to deter excessive risk taking and perhaps affecting agency costs directly to change banks’ capital structure. In this paper we attempt to prove the agency cost hypothesis of Islamic Banks in Malaysia, under which high leverage firm tends to reduce agency costs. We set the profit efficiency of a bank as an indicator of reducing agency cost and the ratio equity of a bank as an indicator of leverage. Our findings are consistent with the agency hypothesis. The higher leverage or a lower equity capital ratio is associated with higher profit efficiency.

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