Determinants of Capital Adequacy Ratio and its Relationship with Risks in Islamic Banks- Case of QISMUT, Kuwait and Bahrain

The study empirically investigates the relationship between the capital adequacy ratio (CAR) and different bank-specific instruments including risk and macroeconomic factors for the selected twenty-eight (28) Islamic banks which are active in Indonesia, Saudi Arabia, Malaysia, United Arab Emirates (UAE), Turkey, Kuwait, and Bahrain. Annual data from 2005 to 2014 is used. This study is the first of its kind to investigate if the CAR in Islamic banks is affected by these such factors mentioned above. The bank-specific control variables in this study are return on assets (ROA), return on equity (ROE), leverage, size, liquidity risk, and credit risk, while the macroeconomic control variables are market capitalization and stocks traded, exchange rate, gross domestic product (GDP), and inflation. In addition, we capture the impacts of the global financial crisis on Islamic banks. Firstly, we employ three methods which are fixed effects, random effects, and ordinary least squares. Then, we employ the Generalized Method of Moments (GMM) dynamic panel data estimator. We find that there are high and statistically significant relationships between the CAR and the bank-specific factors such as ROA, ROE, size, leverage, and credit risk; hence, increases in ROA, leverage, and credit risk of the Islamic banks will lead to increases in the CAR, whereas increases in ROE and size would lead to decline in the CAR. The liquidity risk has an insignificant positive relationship with the capital adequacy ratio. Furthermore, inflation, market capitalization, and exchange rate exert high and statistically significant effects on the CAR, which evidences that higher inflation would result in lower CAR, while an increase in market capitalization and exchange rate would positively contribute to the level of the CAR. On the other hand, GDP is negatively related with capital adequacy ratio while stocks traded are positively related; however, both relationships are insignificant. Finally, we run another model where “equity to assets” ratio is dependent variable with similar control variables; results reveal that, except for inflation and GDP, all the variables exert significant effects on the CAR and on the “equity to assets” ratio. In addition, we captured the effects of the global financial crisis (GFC) on Islamic banks and found that Islamic banks are affected by the GFC at high levels. Keywords: Islamic banks, capital adequacy ratio, bank-specific factors, macroeconomic factors, dynamic panel data, financial crisis