1.

1 Background of Study

The dual banking system in Malaysia is playing a dynamic and central role in overall
economic performance and major involvement in the extensive financial crisis (Kabir et al.,
2015). Since year 1984, Islamic Banking Division has achieved rapid growth and made
significant progress. The growth was attributed by measures taken by Bank Negara Malaysia
to offer broad range of Islamic banking services through creating an interest-free banking
scheme. (Rupa, 2017) The unique characteristics that distinguish Islamic Bank from
conventional bank is their obligation to meet Shariah law and principle. Any transactions
involve interest (riba), gambling and speculative trading are prohibited, and most importantly,
the relationship between depositors and bank are based on profit and loss sharing basis
(Mudharabah and Musyarakah). Whereas in the case of conventional bank, a bank and
customer relationship are mainly based on debtor-creditor relationship. The funds extended to
customers as loan, advances or financing are interest-based. (Norharyati and Shahrul Nizam,
2004)

Consider as the oldest form of risk, credit risk continues to be the largest source of
problem facing banking institution in Malaysia. It may arise when a borrower fails to make
their obligations of required payment and meanwhile the amount of bad debt is growing.
According to the Bank for International Settlements (2010), the global financial crisis is only
the most recent example where credit risk is the main reason that had devastating effect on the
economy and seriously affect banks’ viability and sustainability. The rapid changes of global
financial view in Islamic bank with the distinct nature will raise additional new risks to the
banks It was a major factor in determination of interest rate on a loan in conventional banks
and profit rate in Islamic bank. This credit exposure occurs mainly due to the fact that financing
activity is the major form of principal business operation for most of the banks, so credit risk
is an important risk and could makes up the largest amount for the Basel capital allocation of
risk-based capital. (Khan and Ahmed, 2001). In fact, both operation of Islamic and
conventional bank is equally vulnerable to these risks. Conventional banks face credit risk in
all operations, and in the case of default by borrowers or counterparties, the credit risk is borne
entirely by the bank. As oppose to conventional bank, Islamic banks face this form of risk in
the modes of financing they use such as Murabahah, Istina, and sales with delayed payment.
Through the profit and loss sharing basis, the depositors of an Islamic bank absorb the credit
risk. A credit risk management in Islamic banks is also more complicated because of its ethical
Islamic finance concepts which prohibited from charging interest in order to penalize defaulters.
Uniquely, the risk of Islamic bank will arise because of the different nature of banking
operation which is the asset side of the banks comprise of risky asset. (Harrison and Essam
2016, p.90)

So, the aim of this research is to identify empirically the bank specific factors that
affecting the credit risk between Islamic and conventional banks and to made comparison
whether there exist any differences in term of these credit risk determinants. Similarly, an
appropriate credit risk mitigation and management system could be developed if the factors
affecting these risks are well identified between these two kinds of banking system.

3.2 Research Hypothesis

Based on above nine variables which representing Credit Risk determinants, a few hypotheses
have been developed, while supported by the previous research.

H1: First, it was expected that management efficiency (MGT), regulatory capital (REGCAP)
and natural log of total assets (LNTA) have a negative relationship with credit risk (CR) of
Islamic and Conventional Bank in Malaysia.

H2: On the other hand, loan loss provision (LLP), funding cost (FCOST), risky sector loan
exposure (RSEC), leverage (LEV), Risk weighted assets (RWA), and proportion of loan to
deposit (LD) are expected to have a positive relationship with Credit Risk. (Norhayati and
Shahrul Nizam, 2004)

https://www.nst.com.my/business/2017/10/286454/bank-negara-islamic-finance-will-focus-quality-
growth

https://books.google.com.my/books?id=kkobDQAAQBAJ&pg=PA90&lpg=PA90&dq=islamic+cannot+
penalize+defaulters&source=bl&ots=auX4zQoq10&sig=g3UxqlEagmj1cy8G5VLMcOtcX2M&hl=en&sa
=X&ved=0ahUKEwie27TM8cfXAhXLQY8KHe0hCI8Q6AEIOzAE#v=onepage&q=islamic%20cannot%20p
enalize%20defaulters&f=false